July 2010 - Commentary: Cyclical Recovery Has Staying Power

Volatility returned to the global markets in the second quarter, sending the Dow Jones Industrial Average down 10% to 9774, its first quarterly drop since the first three months of 2009. Market sentiment swung towards risk-aversion as investors considered a full range of economic, fiscal and regulatory issues and whether corporate profit expectations were achievable in light of the collective weight of these mounting headwinds.

Following on the heels of the best first quarter market performance in a decade; the second quarter environment was subjected to a litany of global and domestic uncertainties. The sovereign debt crisis in Greece deteriorated as investors drove the cost of borrowing higher, citizens took the streets in protest and contagion fears spread throughout the fiscally troubled countries of Europe. At the same time, investors grew concerned that China’s efforts to slow its booming economy could derail one of the primary drivers of the global recovery. Adding to investor anxiety, the May 6th “Flash Crash,” when the Dow fell 700 points in just eight minutes, raised concerns about the soundness of the day-to-day workings of the stock market. Uncertainty being the enemy of economic growth and risk assets in general, the sell-off brought the indices to their lows of the year.

Although second half economic momentum is slowing as global uncertainties rise and the domestic recovery works through its own structural headwinds, the recent softening of economic data is not consistent with a 1-2% GDP environment, much less a double-dip recession - an outcome that appears to preoccupy the current market downdraft. We think the cyclical recovery has more staying power than market participants currently believe and that the economic environment continues to support a moderate, sustainable recovery against a backdrop of benign inflation and low interest rates.

Investors have become very myopic in recent weeks, emphasizing the slower slope of the recovery while expressing a casual indifference to the evidence that supports a cyclical recovery that remains firmly intact, albeit at a slightly slower rate as we enter the second half of the year. The big picture economic environment points to continued growth: the U.S. Treasury curve is steep; the most consistently reliable economic data (Leading Economic Indicators, ISM Manufacturing and Services reports, and corporate earnings, among many others) are pointing towards economic growth in the 2.5% - 3.5% range; credit market indicators are stable to improving; even the Euro currency appears to have found its footing; while Spain, one of the fiscally troubled countries in Europe, saw their stock market gain more than 10% off its lows in June on the back of strong demand for their government debt.

Furthermore, many of the financial fears are being addressed. The European Central Bank has instituted a TARP-like backstop of substantial size, allowing a workout to unfold among the troubled sovereigns of Europe. Bank stress tests in Europe should also help address worries over bank solvency and debt. Meanwhile, China’s currency revaluation steps most likely mark the end of further policy tightening to combat inflation in that country. Domestically, regulatory and legislative actions are now well defined and understood. And of course, equities already may be pricing in the potential for modestly slower growth in the second half at current levels. Although the carnage of 2008 and 2009 is fresh in everyone’s minds, investor preoccupation with a double dip recession seems disproportionately represented relative to the underlying evidence to the contrary.

The biggest threat to the recovery may be the markets themselves. With the financial markets having undergone two radical re-pricings over the course of the past several years, it is not surprising to see elevated volatility in the aftermath of a crisis of confidence. However, we see the sort of extreme directional moves that have characterized the past two years as the exception rather than the rule going forward. Instead, we believe properly functioning credit markets and the unfolding economic recovery will result in a return to normalization for the markets. So how does the market behave in a more normalized environment? Stepping back for a moment, the chart in this article highlights the volatility seen over 80 years of market history. Noteworthy is the magnitude of declines with market pullbacks of 10% or more, which occur slightly more than annually, vs. the relative infrequency of 20% pullbacks. This pullback has been deeper than a “garden-variety” 10% move, which is appropriate given the scope of issues we are dealing with globally. From our vantage point, we view the market action as normal corrective action in light of the rising uncertainty rather than a reversal in trend – although market action can create a self-fulfilling loop in either direction for the underlying economy.

Overall, we would caution against extrapolating the recent volatility as indicative of a dramatic change in the underlying outlook for the US economy. Strong corporate earnings, an accommodative interest rate environment, benign inflation and an equity market trading at levels not seen since the early 1990’s are all highly supportive - despite the uncertainty around economic policies at home and abroad. Barring a significant decline in corporate profitability, risk assets are attractive here.

The coming months will be instructive as to whether or not we have seen the lows for the market this year. We are very focused on the employment trends and in particular need to see both a continuation and a pick-up in private-sector job growth. Second quarter corporate earnings will also be very telling as to the strength in the underlying economy. We suspect the recovery will prove to be remarkably resistant. Uncertainty remains the enemy of growth and investment. We expect uncertainty to fade as the recovery continues to unfold. Risk assets should behave accordingly.

This information has been developed internally and/or obtained from sources which Sand Hill Global Advisors LLC (“SHGA”), believes to be reliable; however, SHGA does not guarantee the accuracy, adequacy or completeness of such information nor do we guarantee the appropriateness of any investment approach or security referred to for any particular investor. This material is provided for informational purposes only and is not advice or a recommendation for the purchase or sale of any security. This information reflects subjective judgments and assumptions, and unexpected events may occur. Therefore, there can be no assurance that developments will transpire as forecasted. This material reflects the opinion of SHGA on the date made and is subject to change at any time without notice. SHGA has no obligation to update this material. We do not suggest that any strategy described herein is applicable to every client of or portfolio managed by SHGA. In preparing this material, SHGA has not taken into account the investment objectives, financial situation or particular needs of any particular person. Before making an investment decision, you should consider, with or without the assistance of a professional advisor, whether the information provided in this material is appropriate in light of your particular investment needs, objectives and financial circumstances. Transactions in securities give rise to substantial risk and are not suitable for all investors. No part of this material may be (i) copied, photocopied, or duplicated in any form, by any means, or (ii) redistributed without the prior written consent of SHGA.