As has been the case for the last three years running, the spring quarter saw Eurozone fears re-emerge and global equity markets suffer. The S&P 500 Index lost 3.39% during the period while China declined 8.5%. Europe surrendered the most ground, with Germany, France and Spain down 14%, 15% and 11%, respectively. As the drama built in Europe, fixed-income investors sought the safety of U.S. Treasuries and drove the 10-year Treasury note yield down to 1.65% from 2.22% at the beginning of the quarter. The 2-year Treasury ended the period yielding a paltry 0.31%.
The global economy is downshifting. Data out of Europe and China are especially weak, but recent U.S. economic numbers have been trending downward as well. While the U.S. is not decelerating at the rate of either China or Europe, our state of economic fragility makes us more susceptible to contamination from foreign economic fallout. Specifically, the second quarter corporate earnings reports getting underway are sure to feature plenty of cautious commentary about overseas business trends.
Let’s address these regions one by one. First up is Europe. The Greek election on June 17th reaffirmed the Greeks’ collective desire to remain in the Eurozone. However, Greece still faces the very difficult (some would say impossible) task of generating enough revenue to cover their already-reduced debt obligations. It is probable that either another debt restructuring or an exit from the Eurozone is in Greece’s future. The last three months has also seen focus shift to Spain, where the banks are in real trouble due to mounting real estate losses. At the recent European summit—which is summit number 19 to address this crisis—leaders haggled over whether to institute reforms to the Eurozone banking system that would help to boost investor confidence and to dampen fears of financial contagion within the Eurozone. However, whether or not Europe is able to come together to enact reforms sufficient to restore investor confidence in wobbling southern Europe is anyone’s guess. The big question remains how much responsibility Germany is willing to assume for its troubled southern neighbors.
Secondly, China, the world’s second largest economy, has been slowing for six consecutive quarters and is now “only” growing at 7.6%. While on an absolute basis this level is high, the rate of deceleration from a couple of years ago is also high. As China is a huge consumer of raw materials, the decline in its growth has contributed to a steep drop in commodity prices (see details below).
Finally, the U.S. economy remains stuck in a low gear. With the economy only likely to grow 1.2% or so in the second quarter, it remains at least a couple of percentage points lower than it needs to be to start reducing the unemployment rate. As 2012 began, the employment data were heartening, with the economy adding an average of 245,000 jobs in each of the first three months of the year. Recent data have been disappointing, however, and it is clear more needs to be done to kick-start employment. Investors would be prudent to expect a slow-growing, muddle-through economy here in the U.S. for at least the next six months or so.
Given the depth and nature of the headwinds facing the global economy, the U.S. stock market has been quite resilient lately and is presently down only a handful of percentage points from the four-year highs it notched in early April. Why might this be? One reason might be that stocks, relative to their historic averages, are inexpensive, trading at a price-to-earnings multiple of only 12 times while sporting a collective dividend yield that is higher than the yield on the 10-year Treasury note. Thus, while the earnings outlook for U.S. companies, particularly for those with lots of international exposure, has become more uncertain, the major alternatives to equities—namely cash and bonds—feature very, very low yields.
A Silver Lining for U.S. Consumers
One silver lining for U.S. consumers that the weakness in Europe and China has precipitated is a nearly across-the-board plunge in raw materials prices. The Dow Jones-UBS Commodity Index is down 3.7% year-to-date, causing May U.S. consumer prices to drop by 0.3%, the first decline in this measure in two years. Lower energy prices are a particular boon to consumers. During the quarter, crude oil plummeted 18% from $104 to end June at $85 per barrel. As a result, gasoline prices nationwide have fallen to $3.38 per gallon from nearly $4 in April. Natural gas bucked the trend and did manage to rise 33% in the quarter off a very low base, but it still remains below $3 (per million BTUs) and is very affordable on a historical basis. International malaise aside, U.S. consumers are likely to be heartened this summer by softening prices and a housing market that is beginning to show signs of a bottom.