Half Year Results
Written by Allen G. Oechsner, Senior Vice President
t the half year mark,
the market has been resilient to a great deal of volatility. Despite the gyrating economy earlier in the year, near
record oil prices, rising interest rates, a London bomb scare, continued weakness in housing, and a spate of troubles
for funds that invest in sub-prime mortgages, the market produced good returns for the past quarter. At different points,
sentiment quickly shifted on issues such as expectations of a Fed rate cut to fears of rate hikes. Economic views have
also been subject to wide swings in sentiment. As an example, 10 year Treasury yields surged 60 basis points from 4.6%
in early May to 5.2 in mid June. For a U.S. Treasury note, that is a very large move in just over a month. During this
same period the equity markets became very choppy with the market declining 3% in 3 days starting June 4th. The market
pundits expressed concern that the sharp rise in Treasury yields and borrowing costs would halt economic growth and
also reduce M&A and LBO activity. Earlier in the year many investors were suggesting that inflation would be low
enough for the Fed to lower interest rates, and that forecast began to collapse as the Fed made clear its continued
focus on inflation, and a slowing in economic growth was not as sharp as some expected. Some investors fear that the
stock markets could face trouble if inflation fears or other uncertainties (sub-prime loans) push the yields on the
10 year bond as high as 5.50% or 6%, a level not seen since 2000.
As I write this, corporate earnings reports are being released and the markets are focused on half year results and guidance for the remainder of the year. The sub-prime loan issue is an equally dominate story right now, and is adding to day to day market volatility, especially in the financial sector which accounts for about 20% of the market. There was a similar concern late last year that defaults in sub-prime loans would push the economy into recession. The issue is likely to stay with us for the remainder of the year, and it is indeed a legitimate concern, it does however need to be put into context, specifically sub-prime loans by most conservative estimates account for about 10% of the mortgages outstanding.
Our view on the markets and the economy has not changed, we expected volatility and the markets have not been short of anxiety. While we are concerned about the short-term psychological impact of current volatility we do not believe the fundamentals have materially changed. The markets will continue to be sensitive to all signs of weakness in the economic data. Inflation remains at a level that is at the upper end of the Fed’s target range and market volatility will not subside until the concerns about the housing market and sub-prime loans subside and business investment picks up. We do believe interest rates are likely to remain stable and Fed policy will remain on hold (no reason to raise rates or lower rates) unless inflation picks ups significantly. The housing market continues to be an economic drag. Clearly, the economy has slowed in response to monetary policy as expected in the first half, and until the magnitude of the slow down becomes clearer, the markets will remain choppy. Employment continues to be a bright spot and is an important element in terms of the health of the economy. Overall, consumer spending has held on a steady track due to continued employment, and real wage gains, while business investment is posting more moderate growth. Geopolitical issues remain an ongoing concern and we expect on going volatility. On balance, we continue to believe the markets will produce positive full year returns in line with historical trends.
Our investment focus has not changed. It remains on companies that can deliver growth with some degree
of certainty. We remain cautious and would emphasize capital goods producers based on the need for domestic capacity
expansion and pressures for productivity gains from high labor costs, pressure to increase input efficiency from high
energy and commodity costs and global as well as domestic infrastructure building. Additionally we would to add to
any existing positions in companies that have strong exports based on stronger global growth, global infrastructure
building and a weakening dollar.