From StanCorp Investment Advisers
After a relatively complacent first quarter of 2012, market volatility returned in the second. Global growth appears to be slowing again, not only in Europe as expected, but in the U.S. and China as well. April and May saw equity markets drop. We then recovered much of the losses during a very eventful June, which saw the Supreme Court decision on health care and yet another European "solution," set against a backdrop of brutally hot conditions throughout much of the Midwest and Eastern U.S.
Health Care Reform
Justice Roberts surprised everyone by siding with the liberal Supreme Court Justices to uphold most provisions of the Patient Protection and Affordable Care Act in late June. Of course Mitt Romney has promised to issue an executive order to temporarily exempt states in some fashion if he is elected. But political posturing aside, absent a complete Republican domination in November, it appears that the law will stand. The U.S. market's reaction was initially unfavorable when the ruling was heard. The Dow Jones Industrial Average was down 160 points shortly after the announcement. However, by the end of the day the decision didn't seem to dramatically affect the market one way or another, as most of the losses were eventually recovered.
While the ruling did not have a large effect on the market as a whole, it seemed to affect individual sectors and industries. Within the health care sector, the big winners were the hospital companies, which are now likely to get some reimbursement for the uninsured costs that they have had to previously write off. Medicaid can be a notoriously bad payer, with some estimates that hospitals recover only eight cents on the dollar for claims. However, eight cents is certainly an improvement from zero, which is basically what they receive for the uninsured now.
In the long term, the health care sector should benefit now that the decision has been made. Regardless of the ultimate costs and benefits, markets hate uncertainty and the health care landscape has been anything but certain for the past few years.
European leaders surprised the market on the last day of the month with an unexpected consensus on a new plan to rescue banks, relieve debt-burdened governments and restore investor confidence. The leaders agreed to pump money directly into stricken banks and let some countries tap into rescue money without submitting to stringent austerity requirements.
There was also agreement to work toward further economic union for European governments. As usual, the details were scarce. It is not clear how much sovereignty these troubled countries would be willing to give up in order to keep the money flowing. It is also questionable how long Germany will want to keep the money flowing without having some control over how it is spent. One thing that is clear: it will continue to be expensive. Seven euro countries are currently in recession and unemployment in the euro zone is approximately 11 percent overall.
Despite these long-term questions, markets were temporarily pleased with the latest European plan. After the announcement, the cost for Spain to borrow money on the bond market fell by more than half a percentage point, to 6.34 percent. Equity markets throughout the world had one of their best days of the year. The Dow Jones Industrial Average rose by 277 points and commodities surged. The price of oil increased $7.27 per barrel to $84.96, a gain of 9.4 percent, the biggest for oil since March 2009.
After a relatively strong stretch between December 2011 and February 2012, U.S. employers slowed their hiring, creating far fewer jobs in March, April and May than the previous three months. The headline unemployment rate ticked back up slightly to 8.2 percent.
It is hard for employers to justify hiring when U.S. economic growth continues to be sluggish. The final Gross Domestic Product (GDP) reading came in at 1.9 percent for the first quarter and is expected to be near that level for the second quarter as well.
But there have been some signs of life so far this year. Consumer spending has been fairly solid, although it seems to have been mostly funded by borrowing and reduced savings. Corporate earnings have done well, buoyed by lower input costs for both manufacturing (cheap natural gas) and financials (cheap money).
Although it is hard to directly link the sluggish economy to the near record heat that much of the country is experiencing, weather can have unpredictable effects on economic growth. The lack of winter snowfall combined with very limited spring precipitation has left Midwest soil severely dry. The drought in the Midwest is certainly affecting local economies as farmers struggle with very low crop yields for this time of the year. The net result is that some food commodity prices have surged. As of this writing, corn prices are at a record high $7.99 per bushel.
Aside from the potential multibillion-dollar problem that U.S. farmers face, the unrelenting heat may have finally put a floor under natural gas prices. Increased utility usage has caused gas prices to rise roughly 50 percent in the last few months. Natural gas is currently trading at roughly $3 per million BTU, which is still very low by historical measures.
Oil prices have been under pressure for the last three months, amid increased concerns about global growth. Demand has slowed at a time when supply has increased. U.S. inventories as of June 22 stood at 387,166 million barrels, significantly above what is normally expected at this time of the year. Summer is generally considered the peak season, with usage not dropping until early fall.
On the demand side, China has slowed manufacturing and export growth, and much of Europe is in recession. The U.S. is also not immune. The U.S. Energy Information Administration (EIA) estimates that total first-quarter U.S. liquid fuels consumption was down 3.7 percent from the prior year, likely due to a combination of higher prices and a relatively warm winter. For the rest of this year and in 2013, EIA expects a moderate increase of 1.2 percent and 0.6 percent respectively in liquid fuels consumption.
On the supply side, new sources have been coming online. In the U.S., we have increased production through additional drilling projects as well as nontraditional shale drilling efforts. Internationally, Libyan oil is flowing again and Saudi Arabia is producing at the high end of their range.
The delicate supply/demand balance that is working to keep oil prices in check right now is likely a short-term phenomenon. The EIA forecast as of June 25 calls for oil prices to be back over $100 per barrel by 2013.
Equity markets lost ground in the second quarter, as global growth concerns returned. U.S. large companies, as represented by the S&P 500 Index, lost 2.75 percent for the quarter but are still up 9.49 percent for the year. Real estate, as measured by the Wilshire REIT Index, had a good quarter to continue a good year, up 3.71 percent for the quarter and 14.90 percent year-to-date. Other growth assets have not fared as well: The MSCI EAFE, MSCI Emerging Markets, and DJ UBS Commodity Indexes were down 7.13 percent, 8.89 percent, and 4.55 percent respectively for the quarter.
Global concerns have benefited fixed income. The Barclays Capital Aggregate Bond Index, which represents the U.S. corporate bond universe, increased by 2.06 percent for the quarter and is up 2.37 percent for the year. The Barclays U.S. Inflation Linked Bond Index did even better, up 3.15 percent for the quarter and 4.04 percent for the year.
Overall, the markets did not have a good quarter, but most are still showing solid gains for the first half of the year. However, we continue to remain cautious for the near-term future. Lower oil prices should help the U.S. economy in the short term, but markets will likely remain fragile and subject to periodic shocks. One potential shock is the upcoming "fiscal cliff," the $4 trillion of tax increases and automatic spending cuts that could be triggered by the end of the year. Europe still has shock potential as well. The sovereign debt crisis may have been put to rest temporarily, but the underlying problems will ultimately resurface.