Economic Update:

• Economic numbers were mixed, with April figures like retail sales lower, but regional Fed surveys for May showing a bit more promise.  Inflation in CPI/PPI was higher than expected, with food price and housing increases being the primary drivers.
• Markets were mixed, but small cap stocks have suffered in the last two months.  Bond continued to rally as treasury yields have hit the lowest levels in several months.

The more notable consumer price index for April rose +0.3%, which was on par with forecast; the core number was roughly twice expectations at +0.2%.  That took the year-over-year gain in CPI for the headline and core measures to +2.0% and 1.8%, respectively.  The headline portion was heavily influenced by its differentiating components of food and energy, as both were several tenths of a percent higher; the core portion was led by +1% higher transportation prices, which in itself was broken out into gains in both airline tickets and used cars (you think it would be more substantial than these types of things).  Rent of primary residence and owners’ equivalent rent were both a third of a percent higher, which added to underlying upward pressure.

We list the inflation metrics as somewhat neutral in terms of impact, since they are good and bad.  No one wants to see too much inflation begin to emerge, as that has economic consequences, but having some is a byproduct of growth.  The higher food price component is often weather-related and typically self-correcting over time, so not as worrisome, at least in wealthier developed economies that can handle that strain relative to emerging nations, where a higher percentage of household budgets are dedicated to food spending.

Overall, inflation continues to look subdued by conventional metrics.  The Fed tends to use PCE as opposed to CPI as their preferred measure (due to its breadth), with a target of 2%.  Both the PCE and CPI are government-generated, but come from different agencies.  As the composition differs, PCE tends to run a quarter- to half-percent lower than CPI over the last several decades, so call it 2.25-2.50% for an equivalent Fed CPI target (if they had one).  We’re not there yet.  Although arguments for embedded inflation from monetary buildup on the Treasury’s balance sheet has many concerned of an inflation overshoot if/when the floodgates open.  One trigger is wider credit dispersion from banks expanding lending to accelerate the multiplier effect, but this hasn’t happened to a wide extent as banks remain hesitant about credit quality (echos of 2008).  This is probably a good thing long term and hasn’t helped during the recovery, but this is how it often works—banks lend too much and too recklessly when conditions are going well, get burned, then pare back excessively when conditions have bottomed and are improving.  Part of the Fed’s job is providing incentives to offset this behavioral cycle, and we’ve found this is easier said than done.

Stocks were flat to down on the week, depending on the size of company being discussed.  ‘Growth’ sectors technology and health care led returns for the week, up in the +1% range, while financials and consumer staples lagged.

Small-caps, as measured by the Russell 2000 were in the headlines as they entered ‘correction’ territory, down almost -10% from their levels in early March.  Again, due to the higher valuations here, we aren’t entirely surprised.  Large-caps, however, generally haven’t followed suit and that’s an important differentiating factor.  Several comments from a few higher-profile managers at some annual hedge fund conferences added to the confusion, as it was implied that ‘fewer opportunities’ were available which tends to be the obvious case when valuations reach the near-fair value area.

Developed markets on net weren’t too dissimilar from domestic equities, with gains in the U.K, just above flat in Japan and losses of just over a half-percent in greater Europe.  In emerging markets, Indian stocks gained +8% on the week following the victory of an opposition pro-business candidate (although not via a majority, so this may not be as historic as it’s proclaimed to be).  The hope is that reforms needed to get economic growth going again will begin to move forward, but that economy has been plagued with fits and starts as a member of the BRIC group; but it did excite foreign investors.  Indonesia and China were in second place with decent gains in their own right, along with Russia, due to perceived tempering of Ukrainian concerns.  In contrast to U.S. small cap, where any disappointing news could threaten expensive valuations, EM stock valuations are so low that any decent news could result (and has resulted) in positive sentiment.

Bonds rallied again, taking the 10-year treasury down to just above 2.5%.  Long bonds led the way, as did TIPs, due to the inflation figures this week.  The bulk of other bond assets were positive.  Internationally, rates fell as well (actually leading Treasuries a bit and perhaps the catalyst for lower rates) due to dovish comments from the Bank of England pushing the timeline out for rate hikes until likely mid-2015.  The strongest returns originated from developed Europe and Canada, but emerging market debt also gained a bit.

Why are rates hitting their lowest levels since last fall?  Everyone seems to have an opinion.  Part of it is the current low inflation environment—with it running as low as it is, it allows for a lower nominal rate for the same ‘real’ rate (we discussed ‘real’ rates during our advisor meeting last week).  Supply and demand behind the scenes may also be playing a role, as a lower deficit this year means lower Treasury bond issuance, so the supply dynamic is a bit tighter than it’s been recently—so higher prices/lower yields.

Real estate returns were led by REIT indexes in Asia, which gained almost 4%; by contrast, European REITs fell on the week.  The broader U.S. real estate categories were generally flat to slightly positive for the week, led by mortgage and retail.

Commodities were slightly lower on average.  Sugar prices were a few percent higher, as was crude oil, which moved from just under $100 to $102.  Nickel prices fell dramatically last week on some apparent profit-taking (following a surge due to Indonesia’s export ban in recent weeks) and natural gas fell several percent on higher production/supply and warmer weather.

Sources:  LSA Portfolio Analytics, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger’s, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder’s, Standard & Poor’s, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research.  Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends.  Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness.  All information and opinions expressed are subject to change without notice.  Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product.  FocusPoint Solutions, Inc. is a registered investment advisor.