Economic activity in the third quarter remained sluggish, with only pockets of better-than-expected results.
The quarter's data reflected the continuing difficulty that the world economy has had in trying to overcome the fallout from the situations in China and Europe, and central banks' continuing battle against deleveraging and deflation.
Ironically, housing — the economic sector that launched the Great Recession — was the one bright spot during the quarter.
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Economic activity in the third quarter remained sluggish, with only pockets of better-than-expected results.
The quarter's data reflected the continuing difficulty that the world economy has had in trying to overcome the fallout from the situations in China and Europe, and central banks' continuing battle against deleveraging and deflation.
Ironically, housing — the economic sector that launched the Great Recession — was the one bright spot during the quarter.
HOMEBUILDING
The National Association of Home Builders Housing Market Index, a gauge of new-homebuilding activity, rose in September to its highest level in six years. The index has risen each month but two so far this year, reflecting homebuilders' increasing confidence in the market's outlook.
Although analysts are encouraged by the recent trends, many believe that housing won't be able to accelerate much more without more gains on the employment front. In addition, some analysts think that the large foreclosure overhang in some parts of the country will continue to weigh on prices, even to the extent of causing prices to decline more before they build a more stable base.
THE FEDERAL RESERVE
As a result of the continuing drip of disappointing economic data and concerns that the economic recovery isn't gaining enough strength to become self-sustaining, the Federal Open Market Committee announced a third round of quantitative easing at its September meeting.
Fed Chairman Ben S. Bernanke had been very open in recent months in communicating that unless employment growth picked up, the Fed would act aggressively, and with the QE3 announcement, he showed that he meant what he said. The gist of QE3 is that the Fed plans to purchase $40 billion in agency mortgage-backed securities per month.
A key — and aggressive — feature of the plan that the markets hadn't anticipated is that it is an open-ended commitment.
With QE3, the Fed is targeting the housing market and is trying to keep yields on mortgages and other long-term securities low in an effort to boost confidence. In addition, because the program is open-ended, the Fed can accelerate purchases if conditions deteriorate as a result of the upcoming fiscal cliff. Also, as part of the Fed's statement, it announced that it will maintain short-term interest rates at an “exceptionally low” level to mid-2015, and it pledged to use other tools at its disposal until there is substantial improvement in the labor market.
With its aggressive move, the Fed is signaling that it sees the potential benefits of QE3 as outweighing the costs, such as heightened inflation. The Fed seems to be erring on the side of accepting a somewhat higher level of inflation rather than risk a deflationary spiral that can be much more difficult to offset once started.
The Fed said that inflation over the medium term will be close to its 2% objective.
INTEREST RATES
The sluggish economic environment of the third quarter, combined with continuing uncertainty in the eurozone, created an environment where yields on fixed-income securities remained low. Although there were temporary spikes in yields, such as when the European Central Bank announced its bond-buying program, the general “risk-off” environment that prevailed in the second quarter continued into the third.
The result was that the yield on the benchmark 10-year U.S. Treasury fell very modestly to 1.64% as of Sept. 28, from 1.67% on June 29. The yield on the 30-year U.S. Treasury rose slightly to 2.83% at the end of the third quarter, from 2.76% at the end of the second quarter.
EQUITIES
It may be too early to tell whether Bill Gross, founder and co-chief investment officer at Pacific Management Investment Co. LLC, was correct in his assertion in July that “the cult of equity is dying,” but if there is an equity cult, it certainly didn't die during the third quarter.
Investors surveyed what is being done to address problems plaguing the world economy and bid up the prices of stocks. The rally wasn't a result of positive economic data or improving corporate fundamentals but rather an expectation of potential resolution of issues along a number of fronts, including the eurozone problems and the looming fiscal cliff.
With world central banks making aggressive moves to inject the financial system with liquidity, stocks encountered smooth sailing during the quarter. The S&P 500 posted successively higher positive gains each month during the period, resulting in a 6.35% total return for the quarter.
For the quarter, the Russell 1000 Index of large-capitalization stocks posted a 6.31% total return. Small-cap stocks, as represented by the Russell 2000 Index, also gained ground, ending with a total return of 5.25%.
In a continuation of the environment in the second quarter, value stocks outperformed growth-oriented issues. The Nasdaq Composite Index, dominated by information technology stocks, generated a return of 6.5% during the quarter.
In what has become a recurring theme, international stocks underperformed domestic U.S. equities during the quarter, though not by very much. The MSCI EAFE Index of developed-markets stocks rose 6.98% during the three-month period through Sept. 28. Emerging-markets stocks fared better, with the MSCI Emerging Markets Index posting a gain of 7.89%.
OUTLOOK
The market continues to face head winds. The rate of economic growth is likely to remain sluggish as the lack of meaningful employment gains means that consumer spending will remain relatively modest.
Furthermore, the recently reported drop-off in durable-goods orders is evidence that businesses have withheld new investment while they await the outcome of the fiscal cliff, eurozone issues and China's economic slowdown.
But many economists think that though the economy may not accelerate over the next few quarters, it should hold its own and generate perhaps 2% growth. The primary reason for this outlook is the aggressiveness of the Fed and ECB in addressing the various ills ailing the world economy.
For the past four years, the Fed has set policy to offset the deleveraging cycle that was brought about by the collapse in the housing market. There has been an increasing chorus of voices arguing that the Fed, and now the ECB through its various quantitative-easing initiatives, is only stoking the inflationary fires, but the Fed appears to be concerned that deflation is still more of a threat than inflation.
So, leaving aside moral arguments, one could argue that rather than needing less quantitative easing, the world economy actually needs more in order to avert deflation.
