The second quarter of 2010 was another volatile period in the equity markets with concerns over European banks and sovereign debt continuing to dominate the financial headlines. The biggest oil spill in US history erupted from the ocean floor of the Gulf of Mexico in late April. While BP tried various techniques for capturing and stopping the flow, no solution has worked to date. The price of oil tumbled over 20% in May before finding a bottom and recovering in June. The pace of the economic recovery slowed in the second quarter as homebuyer tax credits expired, state and local governments slashed spending and consumers postponed home improvements.
The S&P 500 index declined 12% in the second quarter and is down 7.5% for the year to date. This is the worst start for the S&P 500 since 2002 when the index lost 13.8% in the first half of that year. Every sector had a negative return for the quarter with the Materials, Financials and Energy sectors leading the decline. Outside of the US, equity markets performed just as poorly with an average return of negative 13%.1 As we mentioned in our Q4 2009 letter, 2010 has indeed been a disappointment for equity investors thus far.
The largest consumer credit contraction in over 40 years continued in the first half of 2010 with a total decrease of 6% between July of 2008 and May 2010. Consumers continued to pay down revolving credit (credit cards) at an annual pace of 10.5% and non-revolving credit (loans for autos, mobile homes, education, boats, etc) at a 1.4% annualized rate.2
The economic downturn that began in 2007 was not a garden variety recession. The collapse of the housing bubble in the United States started a negative feedback loop between household debt holders and every financial institution that was involved in mortgage finance. In his book The Holy Grail of Macro Economics, Richard Koo argues that this type of recession is unique in the fact that the private sector becomes focused on debt reduction rather than profit maximization. This was the case for private sector companies in the US during the 1930’s and Japan during the 1990’s. GDP contracted by 27% between 1929 and 1933 in the United States as highly leveraged companies used any and all profits to pay down debt.3 Japanese corporations went through the same experience in the 1990’s, but the key difference in Japan was that the federal government ramped up spending to offset the contraction in the private sector. This avoided a contraction in GDP that would have rivaled the US experience in the 1930’s. Fast forward to 2007 and we see similar characteristics to the Great Depression and Japan’s Great Recession. The difference this time is that US corporations (ex financial firms) were not highly leveraged going into the recession. Only financial entities and households piled on liabilities in aggregate that exceeded assets after the housing bubble burst. This bodes well for the future prospects of non-financial firms in the United States as they switch back to profit-maximization mode and pursue opportunities on a global scale. The jury is still out on the financial sector as the major US firms struggle to grow in an environment where trust and loyalty have been badly damaged. Consumers have weathered the storm much better than expected and have added to savings while paying down debt and continuing to spend on health care, staples and even discretionary items. Personal income has increased due to a rebound in corporate profits (bonus pay) and lower mortgage payments. This is a virtuous feedback loop that will counteract the deleveraging process over time and lead to higher GDP growth in the future.
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- Standard & Poor’s – www.standardandpoors.com
- Federal Reserve, Consumer Credit Report – www.federalreserve.gov/releases/g19/current/
- U.S. Department of Commerce, Bureau of Economic Analysis – www.bea.gov