The big question on many investors’ minds is whether the Federal Reserve Board has achieved a “soft landing,” a slowing of the economy short of a recession that nevertheless lays the foundation for future growth. The evidence is mixed.
That the economy slowed markedly earlier this year is undeniable. Looking back to the first quarter, the Commerce Department in June reported that growth slowed to an anemic 0.6%, the lowest in four years. The housing market has experienced all the problems one expects when interest rates are rising. What’s more, Fed Chairman Ben Bernanke was quoted in June as saying that the associated economic pain “appears likely to remain a drag on economic growth for somewhat longer than previously expected.” Still, he was encouraged that problems with residential real estate hadn’t yet spilled into other sectors of the economy.
Bright spots
But there were many bright spots in the second quarter. The trade deficit dropped sharply in April, with American exports reaching a record $129.5 billion. Retail sales surged in May by 1.4%, after falling 0.2% in March and 0.1% in April. The increase was double what most economists were expecting. Higher gasoline prices didn’t prevent a 2.1% jump in sales of building material and garden supplies; a 2.7% increase at clothing stores; and a 1.8% rise at sporting goods, hobby and book stores.
Perhaps the most welcome news was the surprising strength in job growth in May; 157,000 new jobs were created that month, compared to 80,000 in April. The unemployment rate was steady at 4.5%. What’s more, hourly wages for rank-and-file workers were 3.8% higher than a year earlier.
Still, inflation cannot be counted out entirely. The underlying inflation rate (exclusive of volatile food and energy prices) is “somewhat elevated,” according to Fed Chairman Benanke. Earlier this year some had hoped that the Fed would act to ease interest rates by summer or early fall. Although that remains a possibility, at this point the Fed is sticking with its 5.25% short-term rate.
Stocks and bonds
Concerns over inflation abroad and anxiety over foreign ownership of U.S. securities drove the interest rate on the benchmark 10-year Treasury note to a five-year high in June. Over the space of just four weeks, the yield rose from 4.7% to 5.249%. Higher borrowing costs could flow through to homeowners with adjustable-rate mortgages, and could dampen the economy generally. Strong growth outside the U.S., coupled with inflation fears, has prompted central banks around the world to raise, or consider raising, their interest rates as well.
The silver lining in this news is that the yield curve has returned to its normal upward slope, as long-term interest rates are higher than shorter-term rates. An inverted yield curve is often thought to be a signal of impending recession, while a normal curve suggests that growth lies ahead.
Rising yields on bonds make stocks somewhat less attractive to investors, and stock prices struggled late in the quarter after both the Dow Jones Industrial Average and the S&P 500-stock index set new highs. Generally, one does not want to buy in at a market top. But stocks do not appear to be substantially overvalued.
The S&P 500 has been trading at 18 times its trailing 12-month reported earnings. Although that is slightly above the historical average price/earnings ratio of 16, it is well below the 30 times earnings touched by the S&P 500 at the end of 1999. Dividend yields, although below the historical average at 1.8%, are about 60% higher than in 1999. What’s more, the volatile technology stocks represent just 15% of the S&P 500’s total value, compared to a third in 1999. These numbers suggest to many that the market still has room to grow.
© 2007 M.A. Co. All rights reserved.
