Global stock market returns were negative during the second quarter of 2010. The market's volatility increased as a number of issues led investors to question the sustainability of the global economic recovery and the potential for a double dip recession in the US.  Concerns about fiscal deficits in Greece, Portugal, Spain and Italy and the potential for debt contagion negatively impacted the Euro and the returns from European stock markets.  China's tightening of interest rates and the lending rules related to real estate also impacted global markets.

The US stock market (as measured by the S&P 500) lost 7.6% during the quarter, more than negating the gains from the first quarter.  As concerns increased about the pace of the global economic recovery (especially in Europe), The US dollar continued to strengthen against the majority of currencies. The US dollar gained 9.6 vs. the Euro, and 1.3% vs. the Canadian Dollar.           

Due to the recent damage to American personal balance sheets, consumer spending patterns in the US will remain more muted during this expansion than in prior expansions.  While the recession did not significantly impact the wealthy, it did have a big impact on the middle class.  The US savings rate is rising as consumers begin the process of repairing the damage incurred to their personal finances during the last few years. This increased savings is dampening the recovery vs. prior recoveries.  The continued stickiness of the unemployment rate near the 10% mark has led to concerns about the sustainability of the US recovery. 

Typically, at this point in a recovery, double dip recessions becomes a concern as the inventory led rebound slows and investors question what the next driver will  be to sustain the expansion.  While we currently do not believe that the US will experience a double dip recession, it remains a slight possibility.  We assign the highest probability that the US economy will continue its recovery, but at an anaemic pace with fits and starts. 

All signs point to the recovery continuing in US Manufacturing.  Readings from the Empire State Manufacturing survey and Philadelphia Fed survey both continue to be positive.  The ISM Manufacturing Index continues to read solidly above 50%, indicating that US manufacturing continues to experience growth.                                                                                                                                             

Recent data from the service sector also indicates that the US economy continues to expand.  The following chart demonstrates the positive readings since February (above 50), even though they have recently slowed.  The Non-Manufacturing Index tends to give a better reflect the state of the economy (vs. the ISM Manufacturing Index) as manufacturing only represents 10% of US jobs with the remainder being in the service sectors.

We are at the halfway point of 2010 and we still believe global growth will be in excess of 4% for 2010 and 2011.  Europe is forecasted to account for only 0.3% and 0.5% of that growth in 2010 and 2011.  While the southern European countries are taking drastic austerity measures to deal with their fiscal woes, these countries are largely immaterial to the overall European growth rate.  What really matters in Europe is Germany, and right now its export oriented economy is benefiting from the weakening Euro.  Over the last few weeks, companies that have reported earnings or spoken at investor conferences have all uniformly stated that while they are cautious on Europe, none of them have seen any significant change in their demand patterns.  The Euro zone will continue to experience positive growth benefits from their weakened currency.  

When breaking down the 4% global growth rate, it is apparent that almost half of the global growth is coming from non-Japan Asia, with almost 30% of the total growth originating from China. China growth has slowed as the infrastructure build out winds down.  This is being supplanted by Chinese consumption growth beginning to accelerate.  This combination of market changes has led to the leading indicators index suggesting that the Chinese economy is nearing the trough of its growth cycle. Chinese growth continues to remain at lofty levels relative to the rest of the world. We believe this acceleration in the Chinese economy is sustainable as the consumer share of Chinese GDP is only 32%, as compared to 71% in the US.  Other emerging markets in Asia will also continue to benefit from the strength being experienced in China. 

We continue to think that the best way of getting exposure to these growth markets is through US companies that sell into China and other emerging markets.  We do not like investing directly in emerging markets due to the immaturity of their compliance and regulatory environments, their lack of transparency and in some cases questionable management. We believe that investing in companies that are based in developed countries with significant sales outside North America and are focusing a meaningful portion of their investments on these growth markets is an excellent, low risk method of capturing these opportunities. These global multi-nationals have above market dividend yields, less stock price volatility than the overall market and the ability to grow earnings at least 10%.  An additional bonus is that many of these companies are trading at a 20 year valuation lows.

As expected, the Bank of Canada was the first G7 nation to raise interest rates.  With the markets being as unsettled as they have been recently, The Bank of Canada stated than nothing is pre-ordained (vis-vis continued interest rate hikes) and they struck a more cautious outlook. We expect further tightening this year, but the timing will be more measured than is typically seen in a rate tightening scenario.  Canadian housing is beginning to enter the corrective phase as housing sales have been down four of the last five months on a month on month basis and are down for the first time on a year over year basis.

While we are cognizant of the macro risks that are out there and the fragility of the global economic recovery, we continue to believe that the equity markets are poised for continued growth.  It appears to us that we are experiencing a correction in a bull market.  After the huge run up from the bottom in March 2009, it should not be a surprise that stocks need to consolidate their large gains.

Although investors remain pessimistic about markets continuing upward, the global economy continues to experience growth.  Valuations are at historically low levels and we have just come out of a deep recession.  All these provide a solid foundation for the markets to continue grinding upward.

We entered the year believing that economic growth in the developed markets would be good, but not great, with better growth in the developing markets.  We positioned our portfolios accordingly and as such have not made any major changes to our portfolios since the beginning of the year.   Our portfolios are positioned in companies that will continue to achieve their growth targets in a sluggish, yet steady upward US GDP growth environment, and are also exposed to the faster growing emerging markets.