The fragile and uneven economic growth witnessed so far this year was put at risk by the childish bickering of our elected officials in July. The posturing and gamesmanship that went into negotiating the debt ceiling was far worse than anyone had expected. To be certain, damage was done to investor and consumer confidence, as evident by the wholesale dumping of equities and the price-insensitive buying of Treasury notes. The situation was worsened by the blow-by-blow attention the media devoted to the dual specter of a ratings downgrade and the once unthinkable possibility of a default on United States debt. Despite Congress having finally reached agreement, investor fears continued unabated with the loss in the S&P 500 index wiping out the entire gain of 2011 and the yield on 30-year Treasury bonds falling below 4.00%.
The circumstances surrounding the debt ceiling were, in effect, the fifth “one-in-one-hundred year flood” of the year. Economic activity was disrupted to some degree following the Japanese catastrophe, the mid-west tornadoes, the flooding of the Mississippi river, the European Sovereign debt crisis, and the recent U.S. default risk crisis. In addition to the five natural and man-made disasters, it was reported during the month that second quarter GDP was significantly lower than expected and economic activity in the first quarter was lowered to a mere 0.4% growth rate. Well below the original pace and a level suggesting the economy is teetering very close to recession. What’s perplexing is that revision doesn’t jibe with the positive monthly data released during the period. During the first quarter, monthly employment growth averaged 165,000, retail sales grew an average of 1% a month, and durable goods orders grew an average of 2.5% a month. Given those metrics, we’re suspicious that the benchmark revisions that were included in the release may have had the effect of downwardly distorting the growth rate.
The true casualty of the debt crisis was the second quarter earnings season. Corporate American again surprised investors with terrific results. Earnings grew for the sixth consecutive quarter, and with approximately 70% of companies reporting through month-end, 76% of those companies reported better than expected earnings and 72% reported better than expected revenue, according to Factset. Rising revenue is especially important in that it demonstrates improved overall activity. Better revenue can come in the form of improved sales and/or improved pricing power, both positive signs for corporations. Especially encouraging is the breadth of the positive results. Two notable standouts were Harley Davidson and Polaris Industries. The former manufactures high-end motorcycles, while the latter produces all terrain vehicles and snow mobiles. Both companies are strongly influenced by the state of the economy, as their products are discretionary items with large price tags. Similarly, transportation had an excellent quarter as evident in the results of FedEx and the railroads. Of the seven major rail companies, only Kansas City Southern reported below consensus earnings. Comparatively, CSX and Norfolk Southern exceeded expectations by 5.0% and 7.3%, respectively.
We have not changed the thesis upon which we’ve constructed our portfolio, however, given the damage done to the economy by Congress, we have refocused our timeline for accelerating growth and rising interest rates and have pushed out our expectation for a rise in short term interest rates until late next year. With that said the most recent move in the market has reduced the cost of hedging and we’ve used that move as an opportunity to extend our hedge further out in time. Moreover, we’ve further reduced the sensitivity of the portfolio to interest rate moves.