Recovery begins slowly, as unemployment lingers
Ivy Funds

July 2009

Henry J. Herrmann
Chief Executive Officer
Chairman – Investment Policy Committee

As we opened the third quarter, the financial markets were reawakening from late-June doldrums, stimulated by a wave of favorable second quarter earnings reports, especially those from large financial institutions. It is still early in the earnings season, however, with many companies yet to report. Early optimism could be reversed as things unfold.

The first wave of earnings reports has been positive, though, and has reinforced the developing notion that the economy is no longer on the verge of collapse. By July 17, the S&P 500 Index had increased 39 percent off of the low hit on March 9 of this year.

We believe that the economy is getting better, but the pace of the recovery remains unclear. A V-shaped lift seems unlikely. A slow-paced recovery appears more probable. There are some key areas to watch as signals to the eventual pace of recovery, including inflation, unemployment and the credit markets.

Inflation concerns appear overblown

Ever since Fed Chairman Ben Bernanke first discussed the “green shoots,” or signs of potential economic recovery, the market has shown concerns about a pending increase in inflation. In the latter part of May and in June, interest rates on long-term Treasuries and commodity prices increased sharply. Pundits pegged this as an early sign of inevitable higher inflation, given the vast amounts of stimulus placed in the system. Inflation, of course, is a threat to economic recovery because it would lead to rising interest rates.

It is true that the amount of stimulus in place is unprecedented. But high rates of unemployment, lots of idle capacity and cheap foreign goods will likely offset the stimulus’s inflationary implications. The latest Consumer Price Index numbers show that inflation is at the lowest levels seen in 30 years. It is going to take quite awhile to recreate jobs, fill up empty factories and displace low-cost imports. Inflation just isn’t likely on the near horizon.

Unemployment reality

By the end of the second quarter, national unemployment was at 9.5 percent, its highest level since the early 1980s. It’s hard to realize decent economic growth when consumers are worried about keeping their jobs, or finding a new one. Consumer spending saw a slight increase earlier this year, assisted by last year’s stimulus package of tax cuts, along with tax refunds, severance packages and other unsustainable boosts. Those seem to be mostly behind us.

Currently, we have weakening final demand. The unemployment rate looks to present a continuing headwind, as most observers see the rate exceeding 10 percent by year-end. While we do anticipate that gross domestic product (GDP) should start to grow by year-end, growth is likely to be slow until the jobs picture improves.

Credit market recovery

A positive sign lately has been a strong recovery in many segments of the credit markets. Credit spreads, or the difference between interest rates on private sector debt and debt issued by the Treasury, have narrowed a lot. A principal driver of our current very weak economic performance has been a lack of available credit. Narrowing spreads indicate that credit is becoming more accessible. Our economy can’t grow without credit growth. At this point, the credit market is signaling improvement.

As we look at the latter half of 2009, we believe the equity markets are likely to have some flat and down periods. But the opportunities are there for the diversified investor. We continue to seek out those opportunities as we work through what we see as a slow growth environment.

Past performance is no guarantee of future results. The opinions expressed in this article are those of Mr. Herrmann and are current through July 22, 2009. Mr. Herrmann's views are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. Waddell & Reed Financial, Inc. is the ultimate parent company of Waddell & Reed, Inc. and of Ivy Funds Distributor, Inc.

The S&P 500 is an unmanaged index that tracks the stocks of 500 primarily large-cap U.S. companies.

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