Market and Econom ic Review

The start of the second quarter saw a continuation of the surge in equity and credit-sensitive fixed income securities, as investors looked past significant macro events from the first quarter that created a riskier environment. This price appreciation continued despite the geopolitical risk created by virtue of the so-called “spring revolution” in the Middle East, the partially related surge in commodity prices and the devastation created by the tsunami and nuclear meltdown in Japan with its resultant disruption to global supply chains.

In late April and into early May, however, the tide began to turn for higher risk asset classes, as increased risk aversion entered the market on the heels of disappointing manufacturing and employment data. Manufacturing production fell -0.5% in April, as the disruption in supply chains resulting from the Japanese crisis impacted the output of motor vehicles. Production was only modestly negative in April (-0.1%) when excluding motor vehicles and parts. The employment picture in the U.S. became increasingly cloudy in May, ending a streak of modest, albeit positive, news in labor markets in the U.S. over the past year. In May, however, private sector payrolls only increased by 54,000. Meanwhile, the official unemployment rate hit 9.1% in May with the Bureau of Labor Statistics (BLS) estimating unemployment as high as 15.8% when also considering those who have dropped out of the job market and have stopped looking for new opportunities as well as part-time workers who desire full-time work.

May also featured the release of first-quarter gross domestic product (GDP) for the U.S. economy, which included an unexpectedly tepid 1.9% annual growth rate. In early June, the Federal Reserve, through its Summary of Commentary on Current Economic Conditions (“Beige Book”), stated that the pace of economic growth was slowing in 4 of the 12 Federal Reserve regions including the Philadelphia, New York, Atlanta and Chicago districts. Fed Chairman Ben Bernanke indicated at that time that the overall economic recovery “appears to be continuing at a moderate pace” albeit “frustratingly slowly” for unemployed workers. June brought more disappointing news on the economy, including a U.S. Federal Reserve statement that the percentage of equity owned in homes has reached its lowest levels since World War II as a result of falling home prices.

In late June, Chairman Bernanke further roiled markets by citing continued economic weakness related to declining home prices, persistent high unemployment and ongoing weaknesses in the global financial system – highlighted by the Greek debt crisis. While the Fed Funds rate target remained between 0.00% and 0.25%, Chairman Bernanke indicated QE3 was a viable potential stimulus option, if needed.

Outside the U.S., headlines were dominated during the quarter by the Greek debt crisis with both equity and debt markets across the globe reacting to the ongoing efforts to enable Greece to avoid defaulting on their debt. Even money-market funds were not immune to the noise as investors questioned their potential exposure to the European debt crisis. Toward the end of the quarter, a proposed austerity package briefly tempered investors’ fears about the potential for global contagion related to the Greek debt crisis and allowed risk-based assets, such as global equities, to rally while safe-haven investments like U.S. Treasuries were sold, causing yields to soar.

Bonds

Fixed income markets were higher across the board during the quarter. Longer-maturity bonds – particularly Treasury and Agency bonds – were among the best performers. The broad Barclay’s Capital U.S. Aggregate Index returned 3.20% during the quarter-to-date period, while the Barclay’s Capital U.S. Government - Long Index returned 6.39%. High-yield bonds were in positive territory, but lagged the broader Index, returning 0.47%. Inflation linked bonds, both in the U.S. and globally, performed well during the quarter and are among the strongest fixed income categories thus far in 2011.

Stocks

All global equity markets fell for the quarter, after initially continuing their two year ascent higher. U.S equity markets were lower across the board during the quarter-todate period with the Russell 3000® Index falling -3.95%, and the S&P 500 Index falling -3.89%. Larger-cap stocks generally held up better than their smaller-cap counterparts, as the Russell 1000® Index fell -3.83% and the Russell 2000® Index dropped -5.18%. REITs were the only equity asset class to finish in positive territory during the period, rising 1.25% as measured by the Dow Jones U.S. Select REIT Index. REITs are also among the best performing equity classes on a year-to-date basis. Reversing the trend from last quarter, growth stocks outperformed value stocks across all capitalization levels. At the sector level, energy stocks suffered the biggest decline, falling more than 10% during the period due to the decline in oil prices. Financial stocks also lagged behind the broader market. The more defensive consumer staples, health care and utilities sectors were the only areas of the market in positive territory for the period, each posting relatively modest gains.

Non-U.S. developed markets held up marginally better than U.S. markets, with the MSCI EAFE Index returning --2.89% during the period. While there are a number of positive growth stories outside the U.S., significant issues remain there as well; namely the ongoing recovery from the earthquake and tsunami in Japan and the efforts to stave off a default of Greece’s debt. Emerging markets also declined during the period, returning -3.87% as measured by the MSCI Emerging Markets Index.

Outlook

As we look ahead, we continue to remain cautiously optimistic about the general direction of the global economy, despite the generally disappointing news received during the course of the past several months. While manufacturing data was disappointing during the second quarter, there is sufficient evidence to suggest that the slowdown was driven by supply chain disruptions in Japan and was a temporary setback within a broader secular recovery. We believe these disruptions will lessen by the end of the year, if not sooner, potentially providing solid momentum for manufacturing. In addition, the drop in commodity prices during the second quarter, which coincided with the drop in global equity markets, should provide welcome relief for consumers by providing them with additional disposable income. Stubborn unemployment appears as though it will persist for quite some time, however, and could be a significant headwind to a sustainable recovery. The same can be said for the struggling housing market where compelling mortgage rates have not been nearly enough to overcome the unemployment picture, fall in equity for most homeowners along with rising mortgage standards.

Longer-term, we continue to find evidence supporting riskbased assets such as equities and credit-sensitive fixed income securities. The concept of “financial repression” has gained increasing popularity in the financial media over the past year and we believe this punishment of savers by providing them with real negative interest rates will ultimately push them to riskier assets in an effort to increase returns.

Overall, however, we continue to realize that we live in uncertain times that can be unsettling for investors. Therefore, we continue to encourage investors to take a prudent and diversified approach toward investing consistent with their risk tolerances, financial circumstances and investment objectives.

 

 

(c) Managers Investment Group

www.managersinvest.com