Other Updates

The Economic Environment

The U.S. economy weakened during the second quarter of 2011, partly due to these factors:

• Disruption in global supply chain, particularly in the automobile and semiconductor industries, as a result of the Japan earthquake
• Oil prices surpassing $100 per barrel
• Extreme weather conditions across many parts of the country

As a result of this deceleration, second-quarter GDP growth expectations have been revised downward to roughly 2.5 percent, following final first-quarter real GDP growth totaling 1.9 percent. Progress on the employment front stalled as well, with the unemployment rate ticking up to 9.1 percent. The ISM manufacturing index also fell from a high of 61 in February to 53 in May, although a reading above 50 still indicates expansion in this sector.

Meanwhile, inflation crept up to a year-over-year increase of 3.6 percent at the end of May, mainly due to rising commodity prices. Despite this upward trend, significant slack exists in the economy, which should keep inflation contained in the near term. With unemployment hovering at 9 percent, wage pressures are minimal. The housing market remains weak, also providing a disinflationary force.

The most anticipated economic event of the second quarter is the end of the Federal Reserve’s QE2 program. Some worry the end of this program will cause the economy’s current soft patch to morph into a double-dip recession. Others fear ending the program will cause interest rates to spiral upward as the Fed ends its purchases of government bonds. While it is true QE2 supported stocks, commodity prices and exports by causing weakness in the dollar, the end of the program has been well-broadcast and, in our view, should not cause major market disruptions.

Periods of volatility and weak economic data are normal following severe downturns such as the one that ended two years ago. This recovery seems to be following a similar pattern. At this juncture, our view is that this is part of the ordinary ebb and flow in an ongoing recovery, and not a precursor to a more significant downturn.

The Stock Market

Stocks hit the ground running in the second quarter, reaching their highs for the year at the end of April. However, as the first-quarter earnings season wound down in May, the stock market began a six-week slide. The net result was a modest advance for the major market indices, as follows:

As has been the case for several consecutive quarters, better-than-expected corporate earnings fueled the rise to new market highs in late April. But once these reports were completed, macroeconomic concerns returned to the forefront for investors. Since May, stock investors have worried about these issues:

• The ongoing debt crisis in Greece and other European countries, including the possibility of default
• Weakening U.S. economic data
• The end of the QE2 program, which has boosted stock prices
• Standard & Poor’s placing U.S. government debt on “credit watch”

Despite these challenges, the stock market has remained in positive territory for all of 2011, with the exception of one day in March. As an indicator of its resiliency, the recent decline from April highs was just 7 percent at the bottom. This represents the largest negative movement in the past year, but by historical standards this is a very mild degree of downside volatility.

One of the primary reasons for this resiliency has been strength in corporate earnings. A sideways-moving market coupled with strong profit gains has resulted in inexpensive valuation levels for most stocks, both here and abroad. At current prices, the S&P 500 trades at about 15 times trailing 12-month earnings and 13 times 2011 estimated earnings. In our view, the attractive valuation mitigates downside risk and also is a source of return opportunity going forward.

The Bond Market

Bond yields defied consensus expectations during the second quarter, declining when most analysts expected them to rise. The yield on the benchmark 10-year Treasury note dropped from 3.45 percent at the start of the quarter to 3.16 percent at the end of June. The result was better-than-expected total returns, with the BarCap Aggregate taxable bond index gaining 2.29 percent during the quarter, while the BarCap Municipal index was up 3.89 percent. Year-to-date returns for the two indices have also been strong by bond standards, at 2.72 percent and 4.42 percent, respectively.

Ahead of the end of QE2, the thought was interest rates would begin to rise, given that the Fed would be stepping away as a significant buyer of government bonds. So why have Treasury rates declined? The most logical explanation is the end of QE2 represents the first action taken by the Fed to effectively remove the addition of liquidity into the economy. This reduces inflation expectations, which are a key determinant of interest rate levels over time, so yields fell commensurately.

With yields declining to their lowest levels of the year, bonds aren’t likely to repeat their first-half performance in the second half of the year. Yet broad diversification across multiple segments of the bond market has not only created a reliable flow of income, but also affords opportunity to achieve solid total bond returns in 2011.

The Investment Outlook

The aftereffects of the severe worldwide downturn continue two years after the trough in the economy and stock market. Sovereign debt concerns, both in Europe and in the U.S., are likely to be in the headlines for many months to come. The poor fiscal condition of many countries has developed over many years and will need similar time to remedy.

Given this backdrop, risk management will continue to play an important role in portfolio construction, as periodic rounds of high volatility should be expected. Our goal is to build client-specific portfolios that can withstand this increased volatility while producing appropriate cash flows and staying at the appropriate spot on the risk-return spectrum to allow each investor to remain engaged with their strategy.

Of course, generating acceptable “real” rates of return is crucial to investment success as well. Recent Consumer Price Index data indicates an inflation rate of 3.6 percent over the past year. For an investor to meet long-run financial objectives, maintaining an allocation to assets offering return potential above the rate of inflation, and perhaps even benefiting from rising inflation, is important.

U.S. companies are on track to reach record levels of profitability in 2011. This can be said for other economies around the world as well. Given the low valuation of global stocks, 2011 offers the potential for solid full-year returns based on earnings growth alone. An increase in the price-to-earnings multiple is not necessary to make progress between now and year-end.

The current environment offers opportunities for investors, but remembering fundamentals will be important going forward. We will face more challenges in the months to come, but we believe that a thoughtful, well-diversified, global investment approach offers the best chance of reaching financial goals, no matter what lies ahead.

For more, contact your BKD Wealth Advisors team member.

The views presented in this Market Commentary are those of the Investment Committee of BKD Wealth Advisors, LLC and do not represent any specific investment returns or promises of performance in the future. The comments in this Market Commentary are not to be construed as investment advice or the recommendation to buy or sell any specific investments. Before making changes to your current portfolio, please contact your advisor for a personal consultation.