Other Updates

The U.S. economy exhibited signs of weakness during the third quarter. Although second-quarter final real Gross Domestic Product (GDP) growth was confirmed at 1.3 percent, growth in the first quarter was revised downward by 1.5 percent, to just 0.4 percent. Despite slowing in recent quarters, the “hard” economic data still indicates expansion in most areas of measure. Here are a few of the most recent data points:

• The ISM manufacturing index for September grew from 50.6 to 51.4 (readings above 50 indicate expansion).
• September payrolls rose by 103,000, above the consensus expectation of 60,000.  In addition, job gains were revised upward for the prior two months.
• Automakers posted double-digit U.S. sales gains in September and the strongest unit sales since April.
• Corporate profits and cash flow have reached record levels.

Source:  Bloomberg, Reuters

This economic data suggests a “slow growth” phase within an ongoing recovery, contrary to the growing expectation of a double-dip recession. In our view, the primary impetus for the current economic anxiety is the significant deterioration in the “soft data.” The political wrangling in Washington over government finances, combined with the complicated European debt situation, has served to undermine confidence that policymakers can effectively address these issues. The net result was a plunge in both consumer and business confidence readings in August.

This crisis in confidence has the potential to become a self-fulfilling prophecy. If consumers, business owners and investors aren’t optimistic about economic prospects, they may further rein in activity, aggravating an economy already showing signs of deceleration. This dynamic will be important to monitor going forward. But interestingly, consumer spending has been resilient in the past few months despite poor sentiment readings—an example of the common disconnect between what people say and what they actually do.

GDP estimates for the third quarter range from 1.5 percent to 2.5 percent, so slight improvement is expected over the prior quarter’s results despite current challenges. As has been the case all year, job gains are critical to sustaining economic growth. Surging corporate profits suggest that companies are able to add jobs, but an improvement in confidence will be essential to create the willingness to do so.

The Stock Market

Fear that debt problems in Europe were spreading from Greece to other countries was the catalyst for the worst quarterly stock market performance since early 2009. Political squabbling over the U.S. debt situation also had a negative impact on investor sentiment, adding to the downward momentum. Here are the index results for the quarter and the year to date:

Although stocks sold off in unison around the globe, segments considered to be riskiest sold off most. U.S. small-cap stocks fell more than shares of larger companies. On the international front, emerging-market stocks fell more than shares in developed markets.

In addition, international market returns were significantly worse than those in the U.S., in part because Europe is at the epicenter of the world’s economic woes. But increased risk aversion during the period also caused the dollar to strengthen against other currencies, serving to amplify the negative returns of both international stocks and commodities. The decline in emerging markets shares this year has pushed the price-to-earnings multiple below 10, while expectations for earnings growth remain in the low teens. Given these underlying fundamentals, and the above-average, long-run growth prospects for these economies, this asset class represents one of the more compelling opportunities arising from the recent market turmoil.

U.S. stock market fundamentals also are attractive, with S&P 500 companies selling for under 12 times 2011 expected earnings. These earnings have continued to grow out of the downturn, reaching record levels. As we close out 2011, investors will become more focused on 2012 earnings expectations, which suggest an even more attractive valuation. Given that last quarter’s market performance reflects recession as a near certainty, any economic performance above that expectation should create rebound potential for stocks.

The Bond Market

The most significant event for the bond market during the third quarter was Standard & Poor’s decision to downgrade U.S. government debt from AAA to AA+ in August—the result of escalating debt-to-GDP ratios, a less than adequate plan for spending cuts and S&P’s perception that legislators may not be able to agree upon a credible plan for fiscal consolidation. Ironically, the downgrade of U.S. Treasury debt sparked a move toward risk aversion, which included a major rally in the same government securities that had just been downgraded! Ten-year Treasury note yields declined from 3.16 percent to 1.92 percent during the quarter. Given this market reaction, it’s apparent U.S. Treasury debt is still considered the safest, most liquid security in the world, despite the S&P downgrade.

The significant decline in interest rates boosted bond returns during the quarter, due to the inverse relationship between interest rate movements and bond prices. The BarCap Aggregate index gained 3.82 percent during the quarter and is up 6.65 percent for the year to date. Municipal bonds also participated in the rally, with the BarCap Municipal index gaining 3.81 percent for the three months ended September 30, and 8.4 percent for the year, according to Morningstar.

Meanwhile, most “satellite” bond segments underperformed in this flight to safety. But given the extremely low yields currently available on U.S. government bonds and related instruments, maintaining broad portfolio diversification in bonds is now more important than ever. This is true from the standpoint of maintaining an adequate income stream as well as a means of risk management. Interest rate risk has largely been absent from the bond market over the last 30 years of falling yields. This risk, related to the price impact on lower-yielding bonds when interest rates begin to rise, is now an important risk to consider. Since Treasuries are at or near all-time lows in yield, it’s likely rates will begin to rise at some point, and when this occurs, principal values will decline.

Through the recently announced “Operation Twist,” the Federal Reserve Bank has indicated its intent to sell short-term government securities and buy long maturity bonds to keep rates low. This should help support bond prices for now. But should the economy and pace of inflation begin to accelerate, yields may be pressured upward.

The Investment Outlook

We enter the final quarter of 2011 in a cloud of uncertainty. With the substantial declines of 2008 and 2009 fresh on investor’s minds, most are conditioned to fear the worst when challenges arise. But there are critical differences between now and then:

• Corporate profits are rising, and S&P 500 companies’ aggregate earnings have reached record-high levels.
• Our banks are far better capitalized. Credit and liquidity conditions also have improved greatly.
• The Fed is extremely accommodative, keeping interest rates at the lowest levels in generations.
• Activity in the housing and automobile industries declined so much during the recession that they can’t drop much farther. The next major turn, when it occurs, will likely be up.

Much work remains to be done to remedy the sovereign debt issues that plague developed economies. These issues will pose a threat to world economic growth for years to come. However, sentiment surrounding these challenges is so bad that the next surprise could be a positive one. At this point, investors are simply looking for policymakers to provide some degree of stability and a reasonable long-run strategy for dealing with these problems.

In the end, all recoveries are characterized by ebbs and flows. Given the magnitude of the last recession, these trends have been especially pronounced during this recovery. However, today’s market is not characterized by excessive stock market valuations or overheating in important parts of the economy, i.e., housing in 2006.

From a valuation standpoint, stocks have rarely looked as attractive relative to bonds as they do today. Companies are generating record profits, and as a result, have very healthy balance sheets. Consumers and businesses are maintaining huge cash balances at little or no return. Eventually, these combined factors should translate into the potential for a strong rebound in share prices from current levels.

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.