Weekly Markets Commentary – April 21, 2008

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Earnings Rally

Investors reacted to last week's earnings reports by pushing stocks sharply higher. Reported first-quarter earnings in the aggregate are actually down sharply. But looking beyond the financial sector, earnings are up. And investors found positives even among financials, struck with a sense of relief that first-quarter results were not worse.

The Dow Jones Industrial Average surged 4.3 percent, as did the S&P 500 Index. The Nasdaq Composite Index gained an impressive 4.9 percent.

The biggest gains were seen among energy stocks, as crude oil climbed to a record high of $116.97 a barrel before settling fractionally lower at $116.69, higher on the week by $6.55.

Technology stocks also rose sharply, helped immensely by a stronger-than-expected result from Google, which roared to $81.96, a gain of 18 percent.

Materials, industrials, and financials all enjoyed strong gains as well. The laggards were the more defensive groups of healthcare, consumer staples, and telecomm, although even these rose for the week.

The positive turn in sentiment was also reflected in the bond market. Nowhere was this more evident than in the shorter end of the yield curve. The two-year Treasury note yield soared 38 basis points to 2.13 percent. In comparison, its yield was 1.33 percent on March 17, during the turmoil surrounding Bear Stearns.

Fed Cut Less Likely

Expectations of future rate cuts by the Federal Reserve also receded. An almost even chance of a half-point reduction at the April meeting and a nearly unanimous expectation of such an outcome by September were virtually eliminated. Currently, there is a nearly unanimous expectation of just a quarter-point cut in April, and nothing beyond.

Even the 10-year note yield rose sharply, climbing 24 basis points to 3.71 percent. On March 17, it was 3.31 percent.

Economic growth should be stronger in the months ahead. A combination of monetary and fiscal stimulus should begin to take effect (beginning with the current quarter) and investors are responding. The index of leading economic indicators rose in March for the first time in six months, it was reported last week.

The advance report of the economy's first-quarter performance will be released on April 30. We expect to see growth of 0.8 percent, compared to the consensus expectation of 0.5 percent. Last year's fourth quarter grew by 0.6 percent. These growth rates are sluggish, to be sure, but not recessionary.

The dollar firmed slightly on the week, especially against the yen. It lost ground against the euro, but finished off the worst levels of the week.

Among commodities, oil, copper, and rice all hit record highs during the week. In contrast, gold retreated, falling $11.40 an ounce to $912.20. On March 17, it was $1,002.60.

Fighting Inflation

Inflationary pressures were evident last week at the intermediate stages of production as the Producer Price Index (PPI) rose 1.1 percent. However, the core rate rose only 0.2 percent. The subsequent reading on consumer prices was also relatively subdued, as the Consumer Price Index (CPI) rose 0.3 percent, and the core rate edged higher by just 0.2 percent.

It remains our expectation that pricing pressures will increase in the months ahead. At present, the trailing 12-month core rate has increased by 2.4 percent, already above the Fed's presumed comfort zone. If fed funds expectations are correct and few, if any, additional rate cuts can be expected, then the building inflation problem will be made no worse. Unfortunately, it may be too late to prevent it from appearing.

The critical question is how sustainable is the equity recovery? If the common element across asset price movements last week was a growing belief that economic conditions are about to improve, then we are going to need to see some tangible evidence. In the meantime, we need to continue to be a little lucky on the earnings front.