Even though through June 30th, the S&P 500 returned 9.5%, equities remain attractively priced compared to the bond market and historic equity valuations.  The discount on equities is primarily attributable to the uncertainties surrounding growth in the U.S. and world economies.  U.S. employment growth over the last 3 months has not been high enough to reduce the unemployment rate.  Last month, for the first time since 2009, there has been a contraction in U.S. manufacturing.  Retail sales have not grown for 3 months in a row.  Despite these factors contributing to sluggish U.S. growth in the 2nd quarter, pent up demand in key cyclical areas (i.e. housing, autos, inventory rebuilding) and favorable economic conditions for increased consumer spending could provide a foundation for higher growth in the second half of the year.  Low oil prices and reduced mortgage expenses will likely act like tax cuts for U.S. consumers, and stabilization in home prices should create consumer confidence by increasing wealth, lending and construction. In fact, today housing starts and mortgage applications increased more than economists had been expecting.

Threats to derailing U.S. growth remain in the form of the “fiscal cliff” at year end.  The “fiscal cliff” is the combined elimination of the Bush tax cuts, payroll tax cuts, and cuts to government spending.  In combination, these actions would have a large negative impact on current economic growth (estimated at causing a recession by the Congressional Budget Office see link below if you are interested in reading the report).

//www.cbo.gov/sites/default/files/cbofiles/attachments/FiscalRestraint_0.pdf

Politicians recognize it would not be in the best interest of either party to shoot the economy in the foot. Both parties have much to lose without working together, because the Republican controlled House of Representatives can hold Congress hostage using the debt ceiling limitations (as they did in August 2011), and the Democrat controlled Senate  can hold Congress hostage by doing nothing and letting the Bush tax cuts expire.  Because the political scale appears balanced, we anticipate some compromise (after the November election) to occur and the falling over the fiscal cliff to be averted. While the probability of the falling off the fiscal cliff is low, it may be worth hedging against.

Europe will continue to provide the market with headline risk throughout the year.  Unlike the United States, Europe lacks fiscal unity.  Whereas the U.S. federal government is able to distribute assistance to states in need, Europe does not have a similar mechanism in place.   We do not see this fundamental problem dissipating anytime soon, and expect economic volatility in Europe to persist through the remainder of the year.  Because many multinational European companies generate the majority of their revenue from areas outside of Europe and continue to pay higher dividends than their U.S. counterparts, we believe there is still sufficient reason to own these heavily discounted companies in mutual fund portfolios.