Disappointed By Last Week's U.S. Data? Here Are 3 Ways To Deal

Includes: MUB, OEF
by: Russ Koesterich, CFA

From ISM numbers to jobs reports, last week's U.S. economic data was disappointing and showed that the economy, though it's getting better, isn't recovering as fast as some had hoped. The downbeat data quickly translated into stock market weakness and raises the question: "What does this mean for the U.S. economy and market going forward?"

While I don't believe the reports suggest a recession, they do point toward a tougher economic environment in the second quarter than in the first quarter, in line with what I've been discussing in my recent blog posts and weekly market commentary. Why? Just consider two particularly troubling numbers in the reports:

  1. Hourly wages are now growing at less than 2% year over year, below the rate of inflation. This means that unless consumers are willing to dip further into their already low savings, either wages need to start picking up or consumption will probably fall. As I mentioned in a post last week, a pick-up in wages isn't likely, meaning there's some downside risk to U.S. consumption.
  2. The percentage of the population engaged in the workforce keeps dropping. All else equal, a falling participation rate lowers U.S. growth potential.

As for what the weak numbers mean for the market and investors, there are three implications:

  1. Expect more market volatility. Markets were unusually quiet in the first quarter, with the VIX -- or fear index -- dropping to its lowest level since early 2007. Though last week's data pushed the VIX up significantly, volatility still remains low and likely has further to rise.
  2. Be cautious on small caps. Though I do still expect the broad U.S. market to finish higher in 2013, small caps discounted too much good news and more dramatically pulled back last week than their larger counterparts, which I prefer and which are accessible through the iShares S&P 100 Fund (NYSEARCA:OEF).
  3. Overweight municipals. While yields are likely to rise in 2013, the rise will be a slow and erratic process. And while I prefer equities, investors shouldn't abandon bonds. Instead, they should focus on those parts of the fixed-income space that offer some relative value, like municipals, accessible through the iShares National AMT-Free Muni Bond Fund (NYSEARCA:MUB).

And finally, it's worth remembering that the big risk to the market isn't Washington or an existential crisis in Europe, but rather a more mundane problem: disappointing economic growth.

Source: Bloomberg.

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Disclaimer: Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies.