Financial Inside This Issue
n Economic Outlook and Review
Market Review n
Stock Market Review
Fixed Income Market Review
Second Quarter 2009 n Alternative Investments Review
Economic Outlook and Review government policies have helped tremendously, overall
success has been limited by reticent consumer spending.
M&I Investment Management Corp.
Consumer spending has been roughly flat for the
Signs of Stabilization (aka Green Shoots) quarter despite government support adding to
Recent economic statistics have been decidedly mixed, disposable personal income. Retail sales, less autos
which should be considered a necessary precursor to and gasoline, are unimpressive at best. We would
economic recovery. Although “less bad” does not yet expect that as wealth slowly rebuilds and confidence
signal an upturn, it does indicate an approaching turns upward, spending growth should advance in
inflection point in economic growth. Take it from Warren line with income. For now, average hourly earnings
Buffet himself who commented recently that the are up a modest 2.7% from a year ago and the average
“economic recovery will be a slow process.” workweek has fallen to a record low 33 hours. No
The Conference Board publishes a measure known as the wonder the personal savings rate has moved from 0%
Leading Economic Index TM (LEI). The LEI increased in April at year-end 2008 to near 7% today (a 15-year high).
for the first time since 2008 and rose again in May. Overblown Inflation Fears
Diffusion indexes such as the purchasing managers’ Over the last three months, the trade-weighted dollar has
surveys appear to have turned the corner, especially the fallen 6%. The CRB® Commodity Index has advanced 30%
new orders component which moved into growth over the same period. Yet, the National Federation of
territory at last report. Initial unemployment claims have Independent Business surveys show very limited pricing
declined to levels consistent with slowing job reductions. power. Massive excess capacity exists in many goods
Temporary employment fell by just over 37,000 jobs in producing companies. Labor has no bargaining power
June, the best performance of this leading indicator in with the national unemployment rate pushing closer to
many months. 10% and much higher in some geographic locales.
Although import prices rose 1.3% in May, they remain
Although it is still likely GDP contracted in Q2 by roughly 17.6% lower than a year ago. Another sensitive barometer,
2%, more prognosticators are pointing to a modest such as the U.S. Treasury Inflation-Protected Securities
rebound by the end of 2009. The near-term outlook market, shows no signs of runaway inflation over the next
remains bright, but in reality a full recovery will be much 10 years. The CPI decline of 1.3% for the 12 months ended
further down the road. The financial markets have in May was the largest decline since 1950.
behaved well, now that the Great Depression scenario
some feared has died away. There’s No Place Like Home
Is the long running slump in housing almost over?
Government Policies Remain Key to Recovery House prices will only hit bottom once the foreclosure
Budding economic optimism is heavily dependent on the share of sales reaches a peak. Unfortunately, that may
effective implementation of a myriad of government not happen soon.
policies. Households are receiving a boost from reduced
payroll withholding and increased Social Security checks. However, the free fall in home prices slowed in April even
Infrastructure spending is set to dramatically rise. The though all 20 metropolitan areas tracked by the Case-
Federal Reserve continues its effort to engineer low Shiller® Index showed declines. Foreclosure sales have
mortgage rates, while the stimulus package also contains definitely helped clear inventories in the most extremely
first time homebuyer incentives. Although aggressive overbuilt areas of the country, but many would-be sellers
facing losses have chosen to stay put unless forced to sell.
Financial Market Review S e c o n d Q u a r t e r 2 0 0 9
Housing starts have leveled off nearly 20% below their Index and the Russell 2000® Index, increased 20.8% and
recent peak. But, we still need to clear the overhang in 20.7%, respectively, for the quarter and 10% and 2.6% year
supply of existing homes. Improvement in credit availability, to date. International stocks (MSCI EAFE Index) soared 25.4%
low mortgage rates and first time tax credits should help in for the quarter and 8% year to date.
Even though markets tend to discount economic news by
No Help from Exports 6 to 12 months, the suddenness and strength of this rally
Over the winter, world trade collapsed under the weight of was surprising. In hindsight, contrary sentiment indicators
the credit crunch. Trade volumes are still 20% below the July were in place as the exhaustive selling associated with the
2008 peak. China’s economy seems healthy, but this mostly bear market reversed in mid-March. The credit markets had
helps commodity exporters. Clearly, the global economy improved as evidenced by the compression of yield spreads
remains debilitated. across the board, including investment grade and high yield
corporate bonds. The credit market collapse led our
The U.S. was the first country to firmly deal with an economic decline and a credit recovery is the first step to an
imploding economy, so it makes sense to believe the rest economic and stock market recovery. The stock market
of the world will lag our own recovery. followed the credit market with the lowest quality, and the
Our baseline expectation is still for the domestic economy most economically cyclical, stocks showing the strongest
to slowly reach positive GDP territory before year end. This returns for the quarter. International stocks followed the
recovery still appears fragile, so while a darker future is less same script with the emerging markets leading the rally.
likely, it is too soon to eliminate that possibility entirely. Despite this recent move, the S&P 500 is up less than 4% for
the year and still stands 40% below its 2007 high. It is
Stock Market Review difficult to get an accurate read on traditional stock market
Equity Policy Group valuation measures such as P/E ratios and yields. Earnings
M&I Investment Management Corp. collapsed and many companies have reduced or eliminated
dividends. Stock valuations are still attractive in a
The stock market recovery that began in March continued as normalized economic environment. Corporate earnings
investors scrambled to put money back into the market. The may be at an inflection point. In the short term, stocks
second quarter turned out to be a mirror image of the first reflect the rates of change in earnings; a less negative
quarter; for example, financial companies, down almost 30% number can be viewed as a positive surprise attracting
in the first quarter, rebounded 35% in the second quarter. buyers. Earnings comparisons against very weak second
This sudden reversal surprised most investors, as the half 2008 numbers will get easier. However, can
economic news was generally mixed with hints of recovery corporations, using less leverage, produce the high
commonly referred to as “green shoots.” As a point of earnings they once enjoyed with robust consumer
reference, this was the strongest quarterly return in over five spending and easy credit? Productivity gains through lower
years. Large stocks, represented by the S&P 500® Index, costs will help, but consumer spending will remain an issue
increased 15.9% for the quarter and 3.2% year to date. Small- for some time.
and mid-cap stocks as represented by the Russell Mid-Cap®
We enter the summer with a long list of concerns and a
healthy dose of skepticism regarding the sustainability of
Stock Market Returns the recovery. Recent mixed economic news has led to a pull
back of commodity prices. We think the breather in the
1st Quarter 2nd Quarter stock market rally, after its sharp increase since early March,
25.4% is normal. Even the most optimistic scenario has to
25 incorporate stock price corrections along the way. Now is a
20 good time for investors to objectively assess their current
15 asset allocation. It was difficult for any investor to calmly
determine their risk tolerance back at the market bottom
only a few months ago. The initial bounce-back phase
occurred much more quickly than most imagined. Looking
0 forward, stock investors need to become more patient as
-5 additional market gains will likely be sporadic as the
-10 -8.9% economic recovery unfolds.
-15 -14.9% -13.9%
S&P 500 Index Russell Mid-Cap Index Russell 2000 Index MSCI EAFE Index
Source: Standard & Poor’s Asset Investment Management (AIM) As of 6/30/09
Financial Market Review S e c o n d Q u a r t e r 2 0 0 9
Fixed Income Market Review Historical Treasury Yield Curve
Fixed Income Policy Group 5.0%
M&I Investment Management Corp. 4.0%
Flight from Quality 3.0%
Despite large-scale purchases by both the Federal Reserve 2.0%
and foreign buyers, Treasurys ended the second quarter with 1.0%
a loss of 3.0% as measured by the Barclays Treasury Index.
This brings the year-to-date loss from Treasurys to 4.3%, the 3 Month 6 Month 2 Year 5 Year 10 Year 30 Year
worst 6-month performance in at least 30 years. Longer 3/31/09 6/30/09
maturity Treasury securities performed particularly poorly, as Source: Bloomberg
indicated by a -6% return for a 10-year Treasury note during
the second quarter alone. By quarter-end, a 10-year Treasury too far too fast. For example, high-yield bonds saw gains
security was yielding 3.52%, substantially higher than the of 23% for the quarter, as credit spreads tightened from
2.68% witnessed at the start of the period. 17% over Treasury securities to approximately 11%. This
magnitude of a move is unsustainable and caution should
Mortgage rates are especially sensitive to changes in 10-year be exercised from this point, especially given that issuers
Treasury yields. Consequently, 30-year mortgage rates continue to bring more supply to the high yield
fluctuated from 4.85% on March 31, 2009 to a high level marketplace. Per Dealogic (a firm that tracks issuance
of 5.59%, only to settle back to 5.42% at the close of the patterns), the friendly market allowed for $41 billion in
quarter (per Freddie Mac statistics). Refinancing activity new issuance year to date.
surged as mortgage rates touched historic lows, but fell
back when rates crept higher. Investment grade (IG) corporate bond buyers enjoyed a
profitable environment as well, with returns of 10.5% for the
Although the Federal Reserve would like to see the level of quarter according to Barclays index numbers. IG spreads to
interest rates low enough to spur a recovery in the housing Treasury securities exceeded 6% at the beginning of the
market, bond buyers don’t always cooperate. So-called quarter, but have retreated to approximately 3.3% today. To
bond market vigilantes demand higher rates whenever put this in perspective, IG spreads were 3.4% prior to the
there is a whiff of reflation in the air. Given the huge Lehman debacle of last year. Another sign of healing in the
amounts of liquidity provided by the Federal Reserve, credit markets was the ability for some large banks to issue
inflation expectations have risen this year. Future inflation debt without government assistance.
expectations as indicated by the 10-year Treasury Inflation-
Protected Securities market (TIPs), rose from zero at year- Subtle Shift in Fed Policy
end 2008 to 1.7% by the end of Q2, however, this level is still Coupled with a massive traditional monetary policy easing,
muted by historical comparisons. we have seen an unprecedented number of unconventional
programs put into place by the Federal Reserve, the Treasury
Huge amounts of Treasury debt issuance can also be blamed and the FDIC. The true test as to the efficacy of these
for higher yields. The United States is expected to issue $3.25 programs can be measured by observing credit conditions
trillion of securities in 2009, nearly four times the level raised in the short-term money markets.
last year. According to government statistics, approximately
51% of marketable Treasury debt is held outside the United By this measure, all these efforts are gradually working. We
States. We will need this continued ownership to prevent have seen the introduction of the Term Asset-Backed
interest rates from jumping a lot higher. Securities Lending Facility (TALF) unfreeze the asset-backed
securities market with $43 billion of new issuance this year.
Risky Business Commercial paper rates have declined to less than 0.4%
Corporate bonds exhibited stellar performance for the according to S&P figures. Just this quarter, three-month
quarter. Buyers piled into riskier debt, allowing many LIBOR has declined from 1.19% to 0.59%. A favorite measure
different types of issuers to tap the market for cash. This all of Alan Greenspan, the LIBOR/OIS ratio has moved down to
happened while Chrysler and GM were filing for bankruptcy, 0.36, with 0.25 considered to be normal. All these signs are
and default rates on high yield debt rose to 8.1% in May, the encouraging.
highest level since October 2002. The still-slowing economy
will inevitably lead to even higher future default rates, a However, don’t miss the subtle change in Fed policy
prospect ignored by yield-hungry investors. announced with limited fanfare during the last week of June.
In recognition of the return to near normalcy in the markets,
Meanwhile, corporate bond investors experienced gains the Fed reduced the Term Auction Facility program and
across the entire quality spectrum. The riskier the better for eliminated the Term Securities Lending Facility altogether.
Q2 returns, with some observers wondering if we’ve gone We believe the Fed when they tell us the Federal Funds rate