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Market Update -- In the Markets

Written by Derrick Wulf, CFA, Portfolio Manager

October 16, 2009

Here's a brief summary of what transpired in the economy and the financial markets during the past three months. We hope you'll find it a handy reference.
 
Growth
GDP rose an estimated 3.2% in the third quarter, aided by increased government spending, a rebound in residential construction, and a restocking of depleted inventories. After four consecutive quarters of economic contraction, the return to growth was a welcome change and helped generate enough momentum to maintain a similar growth rate in the fourth quarter, according to most forecasters. That said, growth is expected to remain somewhat sluggish for the foreseeable future as weak labor markets and tight credit conditions will limit consumption.

Inflation
Headline inflation indices fell deeper into negative territory in the third quarter as year-over-year comparisons continued to reflect sharp declines in energy prices from their 2008 highs. CPI fell 2.1% on a year-over-year basis in July, its biggest annual decline in almost 60 years. PPI, which has a higher correlation to energy prices, fell 6.8% in the twelve months ending in July, its largest annual decline since the Bureau of Labor Statistics began keeping track in 1948. The more stable core inflation measures also declined in the third quarter, but remained above their more recent 2003 lows, with core CPI registering an annual increase of 1.5% in September, down from 1.7% in June and 2.5% a year earlier. Inflation expectations, meanwhile, held relatively steady, with 5-year-ahead inflation expectations declining modestly to 2.8% from 3.0% between June and September, according to the University of Michigan Consumer Confidence survey and 5-year TIPS breakevens declining 11 basis points during the period to end at 1.25%. Despite significant growth in the money supply and a large decline in the value of the dollar, weak consumption and abundant excess capacity are expected to keep prices contained in the near term. The longer-term path of inflation, however, remains much more uncertain.

Jobs
Though still quite weak, labor markets showed continued signs of stabilization in the third quarter. Nonfarm payrolls declined by the smallest amount in a year in August, but disappointed slightly in September as 263,000 jobs were shed. Payrolls have now declined for 21 straight months and the cumulative losses exceed 7 million. The good news was that the 3-month rolling average continued to improve, slowing by 175,000 jobs in the third quarter after declining at a monthly pace of 435,000 in the second quarter and 691,000 in the first three months of the year. The unemployment rate told a similar story, increasing 0.3% to 9.8% in the third quarter after rising 1.3% and 1% in the first and second quarters, respectively. While the rate of decline has moderated substantially, unemployment still remains at a 26-year high and is likely to climb higher as businesses continue to cut costs and workers re-enter the labor force. Though the 4-week moving average of initial jobless claims has declined by well over 100,000 since it peaked in March, it remains stubbornly high at close to 550,000, indicating that a meaningful recovery in employment is still several months off, at best.

Income
Persistent weakness in the labor markets pushed the annual increase in average hourly earnings down to 2.5%, its lowest level since January 2005. With average weekly hours hovering at a record low of just 33.0, total wage income remained depressed in the third quarter. The Bureau of Economic Analysis' measure of personal income growth, however, remained relatively steady at 0.2% in the months of July and August, owing in part to transfer payments related to fiscal stimulus programs.

Manufacturing
The ISM manufacturing survey moved into expansionary territory for the first time since January 2008, with its highest reading in over two years in August. Among the primary drivers of the improvement in manufacturing activity was the government's popular "cash-for-clunkers" program, which helped push total vehicle sales above 14 million units in August. Although vehicles sales fell sharply upon expiration of the program, the ISM manufacturing index maintained its strength in September with strong readings in production and new orders, suggesting that momentum may carry into the fourth quarter.

Retail
Retail sales improved in the third quarter after a string of declines earlier in the year. The cash-for-clunkers program helped advance August retail sales 2.2%, the largest monthly increase in over three years. More impressively, the ex-auto and gas component increased 0.6% despite a late Labor Day holiday which delayed some back to school shopping until early September. Headline retail sales fell in September reflecting some exhaustion after the expiration of cash-for-clunkers, but the decline was smaller than forecast and the core measure excluding autos and gas increased by 0.4%. Though the improvement is heartening, the general outlook is still cautious ahead of the all-important holiday shopping season, as weak labor markets and shifting consumer attitudes may result in more modest spending this year.

Housing
Housing markets showed further signs of stabilization in the third quarter with existing home sales hitting their highest level in almost two years in July. Low mortgage rates, depressed home prices, rising consumer sentiment, and tax credits for first-time home buyers all contributed to the improvement in the sector. High foreclosure rates and bloated inventories of unsold homes have limited the pace of improvement, however, with some 3.6 million unsold homes representing roughly 8.5 months of inventory still on the market in August. The inventory levels, while down significantly from their peak, suggest that some pressure on home prices may persist. The S&P/Case Shiller Home Price Index, which in May of this year registered its first increase since it hit its peak in July 2006, continued to rise in the summer months but was still 13.3% lower from its year-earlier reading in July.

Confidence
The Conference Board's index of consumer confidence hovered within a few points of 50 in the third quarter after staging a modest recovery from its all-time lows earlier in the year. While rising stocks and slowly improving business conditions helped lift spirits, the soft labor markets continued to weigh on overall sentiment. Indeed, the labor differential, a closely watched component of the confidence survey which measures sentiment about the availability of jobs, remained near its recent lows in September. Meanwhile, after a slight disappointment in August, the University of Michigan Survey of Consumer Confidence rebounded 7.8 points in September to 73.5, its highest level since January 2008. While both indices are now running well above the lows reached around the New Year, they remain quite low relative to long-term historical averages.

The Fed
The FOMC convened two formal meetings during the third quarter, voting unanimously to maintain the target fed funds rate at its effective floor, while also voting to gradually slow the pace of its previously announced asset purchase programs "in order to promote a smooth transition in markets." The Fed reiterated that it would maintain "exceptionally low levels of the federal funds rate for an extended period," and that it is "monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted."

By the end of September, the Fed had purchased over $290 billion in Treasuries through its regular open market operations, putting it on schedule to complete its $300 billion of announced purchases by the end of October. The Fed had also purchased close to $900 billion in mortgages and $136 billion of agency debt, leaving about $350 billion of planned mortgage purchases and $64 billion of agency purchases to go. The Fed intends to complete the remaining purchases by the end of the first quarter of 2010.

Treasuries
Treasury yields declined in the third quarter after a sharp selloff in the first half of the year lured investors back into the market. The yield curve also flattened somewhat as cash-laden investors sought to deploy idle resources in higher-yielding sectors of the bond markets and moved out along the curve with their investments. Ongoing weakness in labor markets, a benign inflation outlook, and assurances from the Fed that it would maintain "exceptionally low" rates "for an extended period" provided investors sufficient reason to increase their Treasury holdings despite meaningful improvement in broader economic conditions. Moreover, a reduced availability of other AAA-rated assets because of ratings downgrades, low issuance, and crowding-out from the Fed's aggressive purchase programs in mortgage and agency bond markets left investors with few high-grade investment alternatives outside of Treasuries. As a result, the massive increase in Treasury issuance during the third quarter was met with more than enough demand from investors.

Two-year Treasuries, which yielded 1.11% at mid-year, traded back down to less than 1% by the end of September. The yield on 5-year notes fell from 2.56% on June 30 to 2.31% at the end of the quarter, while 10-year notes rallied 23 basis points to end the period at 3.31%. The 30-year bond, which traded as high as 4.77% in yield in early June, rallied 27 basis points in the period to close at just above 4%.

Bond Markets
Virtually every major sector of the bond markets produced generous returns during the third quarter as long-term interest rates fell and credit spreads continued their impressive move tighter. The Barclays Capital Aggregate Index registered a total return of 3.74% for the quarter, led once again by strong performances from corporate bonds and commercial mortgage-backed securities (CMBS). A return to economic growth and continued improvements in the health of the financial system helped propel the return on corporate bonds above 8% for the period, beating duration-matched Treasuries by over 5.5% as investors pushed the average option-adjusted spread of the corporate bond index 87 basis points tighter to 224 basis points over Treasuries. The CMBS market, which was boosted by prospects of increased demand fueled by the expected fourth quarter launch of the Treasury's Public-Private Investment Program (PPIP), experienced a 226 basis point decline in spreads which, combined with the sector's large outsized yields, led to an astonishing 12.7% return in the third quarter. Similarly, asset-backed securities (ABS), which also continued to benefit from the Fed's TALF program, produced nearly 5% of excess returns in the third quarter. Among the major sectors of the investment-grade bond markets, only agency mortgages saw a widening of spreads, as investors migrated towards higher-yielding sectors amid concerns about the impact of the Fed's eventual exit from the mortgage market. Nonetheless, the yield advantage of the mortgage-backed securities (MBS) sector helped produce 1.12% of excess returns over Treasuries during the third period.

Below investment-grade corporate bonds extended their impressive rally and returned more than 14% in the third quarter according to the Barclays Capital U.S. High Yield Index, bringing their year-to-date performance up to almost 50%. Spread on high-yield corporates tightened 181 basis points and the average yield fell to just over 10%. In the tax-exempt bond markets, increased savings among individual investors and concerns about eventual tax hikes led to another solid quarter, with the Barclays Capital Municipal Bond Index returning over 7% in the three months ending on September 30. Outside of the United States, the global economic recovery and declining bond market risk premiums helped lead the Barclays Capital Global Aggregate Bond ex-USD Index almost 3% higher on a hedged basis, while the weaker dollar helped push the index higher by almost 8% on an un-hedged basis.

Some additional data about the U.S. bond markets are shown in the charts below.