Osama bin Laden’s death over the weekend was the big news as trading began for the month of May. The US military finally got their man after nearly a decade. We should all feel a sense of relief that the world is a somewhat safer place without this madman on the loose, but while the media continues to focus on this story, it’s important to also keep an eye on the latest economic data.

We have another busy week on the economic and earnings calendar. Data on manufacturing and service sector business conditions is due out this week, plus the April employment report comes out on Friday.

Last week, the advance estimate for US Gross Domestic Product (GDP) came in somewhat short of expectations with the economy expanding at only a 1.8 percent growth rate in the first quarter of 2011, down from a 3.1 percent GDP growth in the fourth quarter of 2010.¹

Expectations had already been tempered for a deceleration in growth, so the news had even less impact. In January, the consensus forecast was for GDP of approximately 3.5 percent for the first quarter. But by last week, estimates had already been whittled down to about 2 percent growth.

The main reason: Higher food and energy prices were widely expected to be a headwind for consumer spending.

Looking inside the headline GDP numbers, you’ll find that overall consumer spending slowed to 2.7 percent last quarter, down from 4 percent in the fourth quarter of last year. This could be evidence that rising food and energy costs are beginning to bite.²

Business equipment and software spending continued to be a bright spot for the economy, rising 11.6 percent last quarter — an even faster pace than in the fourth quarter. But there were two line items in the GDP report that bear close watching.³

First, government spending (or lack of it) was the big, negative swing factor in last quarter’s GDP report. Federal government spending fell nearly 8 percent, mainly due to a large cutback in defense spending. But state and local government spending also declined 3.3 percent.⁴

Of course, Washington has been trying to prime the pump for a faster recovery for several years now. But intense partisan bickering about budget deficits is finally putting the brakes on stimulus spending.

At the state and local government level, many legislatures and city halls are also struggling to balance the books with spending cuts. State and local government coffers simply don’t have robust growth in property tax revenue to count on anymore.

This government deleveraging theme may continue to play out at the federal, state and local levels for some time as governments pay down debts just as consumers and businesses have been forced to do. This likely will continue to be a headwind blowing in the face of the economy.

Second, the ongoing weakness in construction spending — both residential and non-residential — as real estate prices continue to fall is another negative factor for GDP.

Spending on housing dropped 4.1 percent last quarter, more than erasing a small bounce in the fourth quarter. At the same time, nonresidential construction spending plunged more than 20 percent in the first quarter.⁵

These sobering statistics highlight the fact that we still may not have found the elusive bottom in real estate.

In fact, home prices are down 31 percent from the peak, while commercial real estate has plunged 45 percent. Prices remain under pressure because a large number of property transactions — both residential and commercial — are distressed sales. For example, about 40 percent of existing home sales in March were either foreclosures or short sales.⁶

We’re not likely to see a true bottom in real estate until this large shadow inventory of distressed properties is cleared from the market. And just like government deleveraging, the negative wealth effect of real estate is likely to be a persistent drag on the economy.

At Banyan Partners, we don’t believe either of these lingering issues is enough to derail the economy’s expansion or stop the market rally dead in its tracks. In our view, these factors contributed to the slowdown last quarter, but should prove only temporary.

Still, we’ll keep a watchful eye on this data in the months ahead, and you should too.

What It All Means for Your Portfolio

It seems clear to us that the economy and financial markets remain in transition, so what implications does this have for your investment strategy?

As my colleague Bob Pavlik pointed out on CNBC’s Power Lunch earlier this week, we’ve been ahead of the curve in shifting our equity allocation recently to more defensive sectors of the stock market.

In fact, we’ve already seen some sharp rotations take place among certain sectors. Some of the sectors leading the market before the onset of volatility in February and March are no longer performing as well. Meanwhile, others are stepping up to take the baton.

From the time the S&P 500 Index peaked in mid-February … just before Middle East unrest and the earthquake in Japan upset markets … through last week when stocks made new multi-year highs again, we have seen new sectors leading the charge higher.

The best performing sector over this period was health care, up 5.4 percent, while telecom and consumer staples gained nearly 4 percent each. Energy was still outperforming the S&P 500 Index over this period (+ 2.3 percent), but not by as wide a margin as before.⁷

Materials stocks were up only 0.4 percent since mid-February, barely keeping pace with the market overall. And this underperformance is occurring in spite of the headline-grabbing rally in oil and precious metals. This could be an early warning sign that a significant shift in leadership is already underway.⁸

Keep in mind, this doesn’t mean we have given up on these sectors. And we’re not suggesting you sell all of your materials and energy sector stocks either — far from it.

We’ve been consistently overweight these sectors for some time now. That call was driven by our expectation for robust global growth. We believed it was the right call to emphasize economically sensitive sectors, and sure enough, energy and materials have been two of the top three performing sectors over the past 12 months (Telecom is the other).

Here’s the key: We think that big gains in these economically sensitive sectors have already been made … that’s yesterday’s news. At this point, it’s not a bad idea to consider lightening up these positions and taking some profits. Now is the time to identify the sectors with the potential to deliver the best performance over the NEXT 12 months and position your portfolio well ahead of time.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

The opinions expressed in this newsletter are subject to change without notice and do not represent a complete analysis of every material fact with respect to any company, industry or sector mentioned in this report. The strategies mentioned may not be suitable for all investors. This information has been prepared solely for information purposes and is not a solicitation or an offer to buy a security, instrument, or to participate in any trading strategy.

¹ Bureau of Economic Analysis, 4/28/11
² Ibid.
³ Ibid.
⁴ Ibid.
⁵ Ibid.
⁶ New York Times: A Reversal for Real Estate After Some Mild Gains, 4/29/11
⁷ Bespoke Investment Group, 4/26/11
⁸ Ibid.