By: Brett Hammond, Chief Investment Strategist
Brett Hammond is a managing director and Chief Investment Strategist for TIAA-CREF Asset Management. His group is responsible for asset allocation modeling and institutional advising, economic and market commentary, and investment product and portfolio research. 

Why we’re optimistic about the economy but cautious about the markets

• For the second quarter in a row, the pace of recovery tapered off, but monetary and fiscal stimulus, increased industrial production, growing world trade and modest new capital spending kept the economy growing.
• Affluent consumers continue to spend, but middle- and lower-income Americans are not contributing to growth.
• Housing prices are no longer falling as rapidly, but, with the end of homebuyer tax credits, new and existing home sales plummeted at the end of the quarter.
• Continued layoffs left the unemployment rate in June near where it was in January (close to 10%), and record levels of people are out of work more than a year.
• The return of equity market volatility reflects the more uncertain outlook for the economy and corporate profits. One exception is high-quality European stocks. Asset allocation and individual stock selection will be important in the months to come.
• Direct real estate returns are leveling out, with prospects for better news later in the year.

The spectacular stock market rally that began in March 2009 faltered in the second quarter, with domestic stock indexes down between 6% and 8% and international indexes between 8% and 14% lower.

After anticipating the return of economic growth—fueled by federal monetary and fiscal stimulus—market investors concluded that economic growth and corporate profits have peaked for the time being, leaving little to drive further advances. As a result, positive returns have become concentrated in a smaller percentage of stocks, so in 2010 investors won’t be able to rely, as they did in 2009, on a broad equity market rally. Value stocks and smaller issues, as well as REITS, outpaced large-cap growth stocks in the first quarter, and sector allocation and individual stock selection will play a more important role as the year unfolds.

At the same time, rising interest rates earlier this year dampened fixed-income returns, except among high-yield and emerging market bonds. But returns from directly owned commercial real estate, which dropped dramatically in 2009, fell at a lower rate in early 2010 and may show more signs of life before the year is out.

Here are four key reasons to be cautiously optimistic about the economy and optimistically cautious about the markets.

1. Corporate profits and inventories: no more room to rise?

During 2009 corporations responded to the financial crisis and economic downturn by dramatically reducing their workforces, capital investment and spending on research and development. With lower expenses, companies were able to take advantage of the positive economic effects of monetary and fiscal policy: a striking reduction in interest rates, rapid increase in the money supply, government purchases of distressed securities and a ramp-up in federal spending/tax cuts. With an additional boost from a steepening yield curve (the difference between long and short interest rates), low inflation and a weak dollar, corporate profitability stabilized and then increased.

As corporate profits began to rise in tandem with rising nominal (i.e., not inflation-adjusted) gross domestic product (GDP), firms began to increase production during 4Q 2009 and 1Q 2010. This added to inventories, which had an immediate effect on U.S. economic growth, accounting for half of the nearly 6% annualized GDP growth in 4Q 2009 and a substantial portion of the 3% growth in 1Q 2010. The challenge now is that economic growth is expected to be nearly flat in 2Q 2010 and less than 3% in the second half of 2010. So far, with persistent unemployment and little prospect for more federal stimulus, conditions are not present for another across-the-board rise in corporate profits.

2. Consumer spending: middle-income Americans remain cautious.

After a small rise in consumer spending early this year, consumer confidence plummeted recently, and retail sales increases are far from robust. Over the past two years, real consumer spending has declined by the largest percentage since the end of World War II. Unsurprisingly, consumers stopped spending during the financial crisis, as their access to credit dried up, household net worth declined because of falling house and stock prices, and workers who lost jobs had a hard time finding new ones. At the same time, household income declined (as inflation-adjusted income has been doing since 2000).

Recently, however, we’ve seen increases in personal income, rising temp employment hiring, more employment listings and a modest return of net new job creation. All offer positive support for an eventual recovery in consumer spending. That seems likely to be muted by a slow job recovery and ongoing weakness in certain employment sectors, such as housing.

3. Housing recovery: fits and starts

Over the last three years, residential housing suffered its worst downturn ever. Housing starts dropped from a 2.2 million annualized rate at the start of 2006 to less than half a million at the start of 2009, and home prices plummeted. Over the past six months, home prices in some areas have appeared to stabilize, while an index of home affordability is close to its all-time high.

The large number of homes in some stage of foreclosure, owned by lenders or owned by people who have taken their homes off the market, will serve to keep a lid on home prices over the coming years. However, the market has adjusted to these conditions, and the Case-Shiller national home price index has finally stopped showing declines in home prices. The problem is that a rise in sales of both new and existing homes hit a wall in the last month, as federal homebuyer tax credits ended, and home sales fell back significantly.

4. World Trade: U.S. exports rising, but for how long?

Economic and market recovery is under way around the world. Leading economic indicators reported by the Organization for Economic Co-Operation and Development have been rising since late 2009 for most economies, with particularly robust growth in most of Asia and parts of Latin America.

As here at home, the overseas recovery has been fueled by government stimulus and corporate inventory replenishment. That recovery has boosted demand for U.S exports, helped further by a weaker dollar and lower labor costs, both of which make our exports cheaper.

Unfortunately, the rapid decline of the euro, following new revelations about the European debt crisis, has pushed up the value of the dollar, limiting an exchange-rate led increase in U.S. exports. While the European debt crisis is likely to be less severe in the long run than it initially appeared, the problems point up the structural weakness of the euro, compared to the dollar. Our currency is backed by a central bank and a federal government with far greater resources than their counterparts in Europe. China, however, has announced a long-term plan to let the value of its currency rise, something that will make U.S. exports to China more attractive.

What are the risks to an economic and market recovery?

The inability of the consumer to step up and begin to replace federal government spending, along with uncertainty about Europe, has brought volatility and declining returns back to the financial markets. Corporate investment-grade, high-yield and leveraged loan markets, which had experienced a recovery, have more recently pulled back in favor of renewed demand for U.S. Treasuries among nervous equity investors and corporate bondholders.

Banks also need to start lending again, which began to seem more elusive as the yield curve flattened. In light of continuing difficulties for consumers and banks, we return to the role of the federal government. The Fed will need to choose the right time to raise short-term interest rates and to begin selling the securities on its balance sheet. The federal government will need to gauge how much additional spending stimulus is needed to create jobs and sustain any nascent recovery. Too soon or too late, too little or too much, could either squash economic recovery or eventually lead to inflation. At the moment, the government seems to be erring on the side of sending mixed signals, with a commitment to deficit reduction along with continued low interest rates.

Another risk to recovery is the very low growth in wages. While this may help drive future demand for labor, the economy faces the risk that household incomes will continue to decline. If so, the expected recovery in consumer spending by middle-income Americans may not appear.

How is 2010 shaping up?

In 2009 it was hard to find an asset class that didn’t perform well, with the exceptions of U.S. Treasuries, directly owned commercial real estate and residential real estate. However, in the first half of 2010 Treasuries, especially long-dated government bonds, outperformed both equities and corporate bonds.

We anticipated the return of volatility and divergent returns during the second quarter, which suggest that sector allocation and individual security selection have resumed their importance at this point of the investment cycle.

At the beginning of the year, many market sectors were benefiting from the low interest rates or from operating leverage—particularly financials, autos, retailers and materials. But then we experienced a sea change; asset classes and companies that weren't sensitive to rising rates did better, especially those that benefit most from rising revenues.

On the stock front, sectors such as semiconductors, software, capital goods, biotech and transportation gained strength. The place to watch now is Europe, where selected companies could benefit from the lower value of the euro and the overreaction of investors to the debt crisis there.

On the fixed-income side, investment-grade corporates and high-yield bonds have posted limited gains, something that may continue as spreads tighten and these securities follow equities. This leaves Treasuries a safer port during higher volatility times, as they were in 2008.

Meanwhile, real estate investment trusts (REIT) gave up some of the gains they had posted earlier in the year, but they are poised to continue a positive trend if the underlying commercial real estate market bottoms out.