Jim McDonald
Chief Investment Strategist, Northern Trust

July 20, 2009

After a strong advance in worldwide equity markets from early-March through mid-June, stocks and other risk assets experienced a four-week correction before regaining strength in mid-July. Reflecting the selling of riskier assets, the yield on the 10-year Treasury fell from an intra-day peak of 4% to around 3.65% currently. The sell-off in risk assets has been fairly orderly, with the Chicago Board Option Exchange’s measure of volatility (the VIX Index) and the dollar relatively unchanged. So what led to this retreat from risk, and how serious are the threats to expectations for a sustainable economic recovery starting later this year?

The traditional aspects of business cycle analysis still are generally supportive of an impending economic upturn. Leading economic indicators increased sequentially during the last two months, and appear set to increase again for June. The Institute for Supply Management (ISM) Manufacturing Index is exhibiting a similar pattern, though June new orders did fall back. Manufacturers slashed production during the past nine months, setting the stage for a production bounce with a continued improvement in orders. We continue to expect emerging markets to lead a global rebound, and evidence, such as May trade data, increasingly supports this view.

But we’re not in your garden variety recession and recovery scenario. Severe financial crises tend to generate long recovery periods, and the flow of economic data will not be smooth. A unique aspect of this financial crisis is the amount of credit creation that occurred outside of traditional deposit-taking institutions — and this capacity must be rebuilt before recovery can take a firm hold. The current travails of CIT Group, a significant lender to small businesses, are the most recent reminder that the credit markets have not yet fully recovered. We still believe the economy emerging from the current crisis will be a slower growth economy, held back by higher household savings, a tighter credit environment and a need to source growth increasingly through exports.

U.S. Equity

• June market movements were more subdued as overall volatility fell
• Earnings revisions turned modestly positive due to corporate cost cutting

EAFE and Emerging Markets

• Economies with the biggest industrial production drops have bounced highest
• Chinese car sales have reached U.S. levels, a meaningful secular signpost

Fixed Income

• A decline in Treasury rates reflected both fundamental and technical developments
• We expect no letup in supply of government debt

High Yield

• High-yield risk premiums widened modestly
• The flow of new deals slowed

Global Real Estate

• Refinancings and valuations drove a REIT rally
• We expect to see increasing divergence between public and private real estate

Hedge Funds

• Hedge fund returns moderated in June
• Last year’s losing strategies appear to be this year’s winners to date

Commodities

• Commodity prices followed the broad markets lower as markets consolidated
• Commodities remain an attractive inflation and currency hedge

Conclusion
So what near-term indicators will we be watching closely during the next several months? Guidance from second-quarter earnings reports will help determine whether the softness in June’s ISM orders was a one-time event. Weekly unemployment claims need to continue demonstrating the pace of improvement shown during the last three months. Finally, investors want clear signs that policy developments from Washington will restore predictability to the capital markets.

We continue to believe government involvement has mitigated the risk of another substantial financial system meltdown, but also has added a new political element to the investing process. Our base case remains an inventory-led production bounce in the economy in the fourth quarter of this year, but the recovery’s strength and durability in 2010 and beyond remain the wild card.