When Is a Slow Economy Good?…When You Want Prices to Fall
To say the least, June of 2008 will not be a month we remember fondly with respect to the equity markets. With oil prices reaching new highs frequently throughout the month, equities have found new lows for the year. While the equity market weakness in late 2007 and early 2008 was focused primarily on the financial sector’s troubles, this month’s decline has been almost solely a function of inflation concerns. There is much concern about the Federal Reserve’s ability to effectively manage the delicate balance between a very soft economy and keeping a lid on inflation. The interesting thing about that relationship is that the former may be the best solution for the latter, and that may be what the Fed is looking for. When the Fed’s Open Market Committee met last week, they left rates unchanged. They slightly reduced their risk assessment for economic growth while modestly increasing inflation risks. Our expectations for future Fed Funds rate moves are for higher rates but not until the fourth quarter.
As the domestic economy remains weak and stagnant while many developed and emerging international economies begin to weaken, inflation pressures (including oil prices) are expected to fall. According to Francois Trahan, portfolio strategist at International Strategy and Investment (ISI), we only have to look back to the summer of 2006 to see slowing global economies, especially developing economies such as China and India, having a significant effect on oil prices. Just before the last correction in oil prices there was: 1) a correction in emerging market equities; 2) slow or slowing economic growth, especially in developing economies; and 3) sentiment for oil at very bullish levels. We are currently seeing these same trends develop. The second half of 2006 saw a 30% reduction in oil prices leading to a 11.6% increase in the S&P 500 (ISI: Portfolio Strategy Report, 6/30/08). We cannot guarantee the same outcome, but the comparison and similarities are definitely worth noting. That said, risks remain such as the current situation with Israel and Iran and continued financial sector turbulence that will keep uncertainty and volatility in the commodity and equity markets at high levels.
I recommend a neutral weighting to equities with a focus on high quality (large cap) domestic and international stocks. There are increased risks in all asset classes at this point (cash included), so we do not recommend making moves outside of one’s investment plan or objective in an effort to chase higher yields and/or returns. Ensuring proper asset allocation and diversification in line with your investment objective is of prime importance at this time.
Have a good holiday weekend.