The economic situation remained unsettled in June. Data available to date for the second
quarter suggest that gross domestic product (GDP) growth will be stronger than expected,
perhaps growing by up to 2% in real terms, largely due to the effect of the distribution of
stimulus rebate checks that began in late April. While real discretionary income growth has
been buoyed by the stimulus program, organic real income growth continues to deteriorate
with the labor markets and surging energy prices. This is evident in the forward-looking
expectations components of the various consumer confidence measures, which have declined
to new lows in June, and point to a material fall-off in real consumer spending in the wake of
the stimulus distributions. While economic growth in the first half of the year now appears
likely to be stronger than our forecast had anticipated, growth in the second half is likely to
be weaker and the weakness is likely to carry into next year. While current growth indicators
have been somewhat better than expected, the global inflation environment has deteriorated
meaningfully as energy and commodity prices have lifted inflation rates on a worldwide basis.
This has prompted policy tightening by many foreign central banks in recent weeks, and
contributed to weakness in global equity markets in June. Even with these recent actions,
monetary policies are accommodative in many countries, particularly the emerging markets,
and this suggests that further policy tightening lies ahead in these countries to combat
inflation pressures.
The escalation of energy and commodity prices has not only resulted in a unfavorable
inflation backdrop, but appears to have resulted in profit margin pressure as the selling prices
of final goods have not advanced nearly as fast as the pace of prices paid by producers.
S&P 500 operating earnings expectations have receded further during June to $88.04 from
$89.27 in May. Consensus earnings estimates for the second half of this year and 2009
remain unrealistically high given our outlook for economic activity. Doubts about the
earnings outlook and the negative effect of inflation pressures on valuation resulted in very
weak equity market performance in June.
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