October: Welcome Signs of Economic Recovery Kept in Check by Weak Consumer

In the past couple of months, the Fed's $300 billion purchase of U.S. Treasury bonds has supported consumer spending and home building by helping to lower borrowing costs for individuals and corporations alike. With the program winding down by the end of October, however, it remains to be seen if stabilization can become self-sustaining. In the meantime, with U.S. interest rates at historic lows, the U.S. dollar continued its decline against most of the world's major currencies.

Overall, U.S. consumers remained constrained. At the end of October, a report from the Labor Department showed that a higher than anticipated 530,000 workers filed claims for jobless benefits. The jobless recovery is a reflection of the fact that improvements in economic growth have come-so far--primarily from inventory rebuilding and manufacturing. October's report from the Commerce Department showed that September consumer spending in the United States had declined by 0.5%, after the "cash for clunkers" program ended.

Because of concerns about unemployment, consumer confidence dropped unexpectedly during the month, signaling that household spending is likely to remain anemic and that American consumers are unlikely to resume their role as the world's economic engine in the near future. We believe that the U.S. economy will require a stronger consumer rebound than is currently taking place, in order for robust economic growth to return. After the news that personal spending fell and that CIT Group Inc. was heading into bankruptcy, the Chicago Board Options Exchange's Volatility Index, or VIX, jumped at the end of the month, with investors seeking to hedge against potential market declines.

Real estate--both commercial and residential--also reported negative data during October. Commercial real estate's other shoes continued to drop during the month, with potentially serious negative consequences for banks holding securities backed by these assets. Capmark, one of the largest U.S. commercial real estate finance companies, filed for bankruptcy during the month. October data also revealed that sales of new homes in the United States fell unexpectedly by 3.6% in September, most likely due to the anticipated end of the government tax credit for first-time home buyers. At the time of this writing, that credit has been extended, which should lend some support to the residential real estate sector.

Markets reacted to the mixed economic news, and retreated at the end of the month. For October, the S&P 500® Index lost 1.86%, the Russell 2000® Index was down 6.79%, and international equities, as represented by MSCI's EAFE® Index, declined 1.25%. Stocks in the financial and materials sectors were hit hardest, declining 6.04% and 5.33%, respectively, while defensive energy and consumer staples names held up the best and were up 3.15% and 1.04%, respectively.

Looking forward, we believe that October's economic reports confirm that the U.S. economic recovery will be more protracted than the market originally expected, with consumer demand slow to recover and manufacturing providing a larger portion of the economic growth than usual. As these data get processed and discounted by the market, we are likely to see some continued volatility in equity markets before a sustained recovery for stocks can take place. We believe the recent market pullback is a healthy development that reflects economic realities and will provide investors with healthier valuation levels and entry points into equity markets.

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