Economic Overview, Summer 2011

US stock market flat in Q2
Whittier Trust’s quarterly economic commentary and a graph of the Standard & Poor’s 500 Index with annotations of significant events is attached below. The trends we have highlighted in our commentary include a first quarter economic growth of 1.9%, which was less than had been expected, a persistently high unemployment rate of 9.2%, and volatile, but essentially flat, second quarter stocks.

While there are many macroeconomic concerns and trends around the globe, one of the most troubling is the sovereign debt crisis in Europe. We will be presenting our views on the effects of these macroeconomic issues during the late summer and early fall. Stephen Smith, our Chief Investment Strategist, will speak on August 25 in Seattle, and, along with Jim Jeffs, our Chief Investment Officer, and Mario Gabelli, will speak on November 2 in San Francisco.

Attendant to economic concerns are concerns about taxes, especially in California. Whittier, along with Nevada attorneys Ernie Maupin and Scott Gunderson, gave a CLE accredited presentation on the “Advantages of Nevada as a Trust Situs” in San Francisco in the spring. We will be repeating these presentations in Los Angeles on October 4 and in Seattle in the fall.

The US stock market was essentially flat in the second quarter (Q2), as the Standard & Poor’s 500 Index returned 0.1%. For the first six months of 2011, the S&P gained 6.0%. Non-US stocks in developed countries have almost kept pace with US equities so far this year, as the EAFE Index is up 5.4% after earning 1.8% in Q2. Stocks in emerging nations have done less well, as they lost 1.1% during the second quarter, and are up 0.8% for the year.

Bonds had a good quarter, due in part to concerns about slowing US growth and European sovereign debt defaults. The Barclays Aggregate Bond Index returned 2.3% in Q2, leaving it up 2.7% for the year through June.

Economist cut estimates of 2011 US economic growth
Economists have cut their estimates of 2011 US economic growth. According toBloomberg’s survey of economic forecasts, US Real Gross Domestic Product (GDP) is projected to grow 2.5% this year, compared to a consensus projection of 3.2% as recently as March. In Q1, GDP rose at a 1.9% annual rate, below the growth rates of 3.1% and 2.6% in the prior two quarters. Growth was hurt by the March earthquake in Japan and the jump in oil prices due to Middle East turmoil.

The biggest drag on the economic recovery has been the tepid rate at which employers have been hiring. The June unemployment rate was 9.2%, which reflects little progress from June of 2010, when it was 9.5%. Businesses have hired less aggressively than they have in past recoveries, for a variety of reasons. They have sent jobs offshore, where wages are lower. They continually try to improve productivity, so fewer workers are needed to produce a given amount of output. Consumer spending has increased just 2.9% over the seven quarters since the recession ended in June 2009. Firms can meet that weak growth in demand without adding workers.

Uncertainty impedes economic activity
Uncertainty is another important factor that impedes economic activity. Businesses are hesitant to add to their work forces while they face so many important unresolved questions about the domestic and global economies:

How will politicians resolve the US’s debt and budget problems, and how will that resolution affect businesses?

Will efforts to curb the deficit help drive the US back into recession?

Will President Obama’s health care reform be modified significantly?

How will the end of the Federal Reserve’s second quantitative easing program (“QE2”) affect interest rates and investment markets?

Will renewed unrest in the Middle East cause energy prices to rise again, effectively diverting consumer spending away from retailers and into the pockets of oil suppliers?

How will efforts to fight inflation by China and other emerging nations impact the world economy?

Will Japan overcome the effects of the earthquake and get its economy growing again?

Will the sovereign debt crisis in Greece and Portugal spread to Italy and Spain, threatening a major banking system meltdown in Europe?

There are always risks on the minds of investors and business people, but the current “worry list” seems to have more significance than usual. Our leaders in Washington cannot answer all of these issues, but the sooner they address the ones they can answer, the better for the economy and the securities markets.

Biggest macroeconomic worry is European debt crisis
The biggest macroeconomic worry is the European debt crisis. Leaders of the Eurozone have been focused for over a year on bolstering the solvency of its weakest countries-Greece, Portugal and Ireland. Bailout packages granted in exchange for governmental austerity programs have helped keep those countries from defaulting on their debt. If they were to default, they would risk losing access to credit markets. Greek government interest rates are already over 20%, even while getting help from Eurozone authorities. Defaults are a big problem for all Europeans, because commercial banks own much of the government debt. If banks take big losses, their solvency may come into question, resulting in a major financial crisis. The austerity programs have already slowed economic growth, so Europe can ill afford a blow to its banking system.

Italy and Spain are often included with Portugal, Ireland and Greece on the “PIIGS” list of the Eurozone’s most financially vulnerable nations. Investors are showing concerns recently about Italy, as they have driven down the prices of Italian stocks and government bonds. Italy’s ratio of government debt to GDP is about 120%, which makes it one of the highest among large nations (including funds owed to Social Security, the US has a debt/GDP ratio of 95%). If Italy or Spain were to need a bailout, the Eurozone would have a much bigger problem than it does now. The combined 2010 GDPs of Greece, Ireland and Portugal is about $738 billion, compared to $2.1 trillion for Italy and $1.4 trillion for Spain. It would be difficult to arrange a bailout for Italy, because the amount of funds needed would probably be large and the monetary authorities had great trouble in producing an agreement for Greece. We expect the Europeans to keep “kicking the can down the road” (i.e., provide funding in relatively small amounts, while buying time to allow conditions to improve). This may mean that a full-blown crisis does not erupt this year, but the situation in Europe is likely to get uglier over time.

US stock fundamentals are excellent
US stock fundamentals are excellent. The S&P 500 is on track to produce operating earnings of $96 per share this year, compared to $84 in 2010, a 14% increase. Wall Street expects an 8% increase next year to $104. Thus, stocks are producing profit growth, even in a sluggish economy. Profit margins are near record levels, thanks in part to the soft labor market keeping wages relatively flat. The US dollar has been weak since last year, making American goods more competitive in foreign markets. Corporate balance sheets are in excellent condition, and many firms have large cash holdings. Stock valuations are reasonable, with a price/earnings ratio of 14 times 2011’s $96 estimate. Large blue chip companies in particular are attractively priced. Merger and acquisition activity has been increasing as companies put their cash to work, which has helped keep valuations up.

US stocks’ good prospects contrast with macroeconomic worries
US stocks’ good prospects contrast with the list of macroeconomic worries. During the next year or two, the global macro problems could easily trump stocks’ strong fundamentals and drive equity prices down. The Eurozone’s difficulties could erupt into a crisis at any time, because stock and bond holders may decide to dump their securities.

Longer term, there is the additional risk of the US slipping into recession in 2012. Over 83% of the $787 billion federal stimulus program has been paid out, and employment is shrinking at all levels of government, particularly state and local. The Federal Reserve has ended its QE2 program, so interest rates may drift up. The economy seems to have enough momentum to continue growing through this year, but economic expansion may stall out next year. Despite these concerns, we expect stocks to produce a positive return for the rest of this year, while recognizing that the timing of a crisis in Europe is very difficult to predict.

The US economy is growing sluggishly, and unemployment is showing little improvement. Worries about macroeconomic conditions have limited stocks’ price increases. The chance of a Eurozone debt and banking crisis is the most serious immediate threat. US stocks are fundamentally strong, and should continue higher near term, despite the challenging global environment.

Source: Kindly provided by & re-posted with permission from the Whittier Trust Company, Investment & Wealth Management

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