Weekly Markets Commentary – June 2, 2008

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Oil Prices Fall, Stocks Rise

What rising oil prices took from the markets two weeks ago, falling prices gave back last week. July crude oil futures fell $4.84 a barrel to $127.35, sending the S&P 500 Index higher by 1.8 percent.

The closing price of oil was $5.82 below its peak from a week and a half ago. During that same interim, the dollar has also firmed, with the DXY index higher by 1.3 percent. And in early trading this week, the dollar is extending its gains while oil continues to move lower.

Better news on the economy contributed to the sentiment behind the rise in equities. Growth in the first quarter was revised higher to an annualized 0.9 percent from the original 0.6 percent estimate.

Both April durable goods orders and new home sales were better than expected. Even the inflation news was subdued, as the core personal consumption expenditures (PCE) deflator rose only 0.1 percent in April, leaving the trailing 12-month rate unchanged at 2.1 percent.

Not all the news was upbeat, however. The S&P/Case-Shiller Home Price Index showed another significant drop in prices during March. For the month, home prices fell an additional 2.2 percent, having fallen 16.6 percent from their peak in July 2006.

Although we are fast approaching the two-year anniversary of the correction in home prices, the decline shows little evidence of slowing. Until it does, the adverse implications of the negative wealth effect on consumer spending, as well as the prospect of additional mortgage defaults, remain a significant concern for the economy.

The Week Ahead

In the week ahead, the May employment report dominates the economic calendar. The consensus expectation calls for the loss of another 60,000 non-farm jobs and sees the unemployment rate moving higher to 5.1 percent. If realized, this would mark the fifth straight month of job losses.

Stocks rose 1.1 percent in May, as measured by the S&P 500. It was the second consecutive monthly increase after five months of declines. The index is now 5.9 percent higher than where it ended the first quarter, and 4.6 percent lower since the start of the year on a price only basis.

Foreign stocks trailed the domestic averages last week. The MSCI EAFE Index fell 0.5 percent in dollar terms, while the MSCI EMF Index of emerging market equities rose by just 0.2 percent.

For the month, the MSCI EAFE rose 0.3 percent in dollars, its second straight monthly gain after falling in four of the previous five months. So far, the MSCI EAFE is 5.2 percent higher for the quarter, but down 4.8 percent on the year.

The EMF index, meanwhile, climbed 1.6 percent for the month and is 9.5 percent higher for the second quarter so far. It is lower by 2.9 percent for the year.

Inflation in the eurozone rose to its highest level in 16 years, according to reports last week. Through May, prices have risen 3.6 percent, well above the European Central Bank's stated target of close to, but not above two percent.

The euro rallied somewhat on the news on Friday, arresting for the time being a slide that began on Tuesday as expectations of a possible rate cut by the European Central Bank diminished, despite a second consecutive decline in retail sales in Germany, the eurozone's largest economy. The ECB meets this Thursday to consider monetary policy.

In the bond market, the back-up in yields that began in mid-March continued last week, with the 10-year note climbing another 22 basis points, to 4.06 percent. The yield on the two-year note rose 17 basis points, to 2.60 percent.

The yield on the Merrill Lynch High Yield Master II index also advanced, climbing 10 basis points to 10.17 percent. The yield on this index has now risen for two straight weeks, after falling consistently from mid-March.

Nevertheless, the opposite movement relative to Treasury yields has driven the spread between high-yield bonds and 10-year Treasuries from a high of 887 basis in points in March, to 676 at the end of last week.

The continuing rise in Treasury yields reflects clear evidence that the economy seems to have avoided recession - at least for the time being - with a dose of inflationary concern thrown in. However, the recent rise in below investment-grade bond yields betrays some lingering uneasiness regarding the underlying health of the economy.

Meanwhile, for the last six weeks, equity prices have traded in a narrow two percent range around the 1400 level on the S&P 500, searching for direction. For now, the recovery in stocks seems intact, consistent with improvement in the economic data.

As long as that remains the case, stocks can continue to recover. But the recovery feels fragile. A host of concerns remain. Another spike in oil prices, larger-than-expected job losses, renewed weakness in the dollar, further declines in home prices, or the arrival of long-anticipated, rising inflationary pressure could each put stocks under stress once again. In short, the market is at the mercy of the data, and the focus is day to day.