May 2011

As 2010 came to a close, consensus opinion was that Gross Domestic Product would expand at a 3% to 4% annualized rate for the first six months of 2011. Now, as we enter the final month of the first half, economic growth is certain to fall short of that goal. With that outcome, we’ve been asked what happened, and if a forecast of accelerating growth continues to drive our portfolio construction. The question is especially relevant given the pronounced deceleration witnessed over the last six weeks. A recent CNBC segment asked the question “what happened in May” to slow the economy? The answer, as was the case in the first quarter, has been Mother Nature. Recall that blizzard after blizzard brought economic activity to a standstill in the Northeast United States in February. Later in the quarter, manufacturing output slowed as the global supply chain was disrupted by the Japanese catastrophe.

Arguably, the havoc wreaked by nature was far more disruptive to economic activity in the second quarter than in the first. NOAA reports that through May, the rate of tornado activity is more that 100 percent above average. Of particular note this year were Saint Louis, which sustained serious damage in late April and the town of Joplin, Missouri where 142 people perished in the May 22nd twister. Even Springfield, Massachusetts was impacted by the aberrant weather.

Similarly, the central United States suffered as the Mississippi river crested at 48 feet in Memphis, Tennessee on May 10th, only to surpass that mark a week later, cresting at 65 feet in Greenville. In essence, normal economic activity in large regions of the United States ceased in May as people feared for their lives and their homes. With that, it’s no surprise that the economy added fewer jobs than expected for the month. In fact, one could argue that economic growth during the quarter is testament to the resiliency of the American spirit.

On or about June 9th, the Federal Reserve’s current round of quantitative easing, known as QE2, will come to an end. As described previously, we have not been proponents of the program and believe that it will ultimately come to be viewed as a mistake. In the near-term, however, there is much concern as to how the market will perform once the Fed ceases the daily purchase of approximately $6 billion of U.S. Treasury notes. In the near term, we think that rates could rise marginally even if economic data continues to register on the lower end of expectations. However, should growth reignite, the adjustment to higher rates could be sharp and swift. As we’ve discussed previously, QE2 has created a short-squeeze in the Treasury note market and many investors, traders and hedge funds have been forced to buy at higher and higher prices. Should market momentum reverse, those same buyers would likely seek to cut losses by selling. In such a situation, there is a risk that we could reverse the entire rally of the last seven weeks.

Considering the fundamental and technical impact of the adverse weather and the effects of QE2, we have not changed our thesis that economic growth is set to reaccelerate and that interest rates remain at artificially low levels. With that we continue to maintain a defensive posture in the Halyard Fixed Income Fund and have added to our hedge against a rise in short term interest rates.