April 2008
Equities were off sharply in the first quarter as recession fears and a freeze up in the credit markets undermined investor confidence. The combined crises in housing, the credit market, and the economy spurred an activist Federal Reserve Board and the Administration to take unprecedented steps to shore up the economy.
The year started with weak economic data points in manufacturing, employment, and retail sales which sparked fears of a deep and prolonged recession. As growth slowed and the financial system continued to absorb losses related to subprime debt, fear of counter party risk created a debilitating unwillingness to lend during the quarter (borrower solvency came into question.) Unlike Japan in the 1990s (which also imploded after a real estate boom), the central bank employed several tactics to address slowing economic growth and tightness in the credit market. These actions included:
- Cutting the overnight rate by 200 basis points during the quarter.
- Accepting mortgage-backed securities as collateral for loaned Treasuries (essentially buying back the mortgage debt).
- Opening the discount window to non-primary banks (i.e., lending to investment banks).
- Initiating a securities lending program designed to inject liquidity into the banking system.
- Coordinating liquidity efforts with European and Canadian central banks.
The liquidity crisis reached its peak in March when the Fed intervened to facilitate the sale of investment bank Bear Stearns to JPMorgan Chase. Bear, an 85-year-old financial institution, was highly-leveraged and after losing access to capital, was on the brink of insolvency. Seeking to contain the damage and shore up the financial system, the Fed stepped in and engineered the sale of the troubled investment bank.
The Administration and Congress were similarly proactive in addressing the crisis. In addition to enacting a $160 billion fiscal stimulus program (with checks expected to be mailed in the second quarter), the cap on mortgages that Fannie Mae and Freddie Mac can acquire and guarantee was raised in an effort to support home purchases.
The market responded to these palliative efforts with short-term pops but was unable to hold onto the gains. The real action during the quarter was in the commodities markets. Commodities roared ahead in the first quarter driven largely by speculation and a weak US dollar – a casualty of the Fed rate cuts. While there are secular arguments supporting greater demand for metals and agricultural products (i.e., a wealthier world demands more stuff), the peaks reached at the beginning of the year were unsustainable in most cases. Many prices fell back from their highs at the end of the quarter, but the combination of weak dollar/higher prices still fed inflationary pressures during the quarter. The only silver lining to the weakened currency has been the lower relative price of US goods overseas, helping US exports.
The Dollar Continued to Decline During the Quarter
Source: Bloomberg.*
The US Dollar Index (USDX) provides a general indication of the international value of the US dollar by averaging the exchange rates between the dollar and a basket of six major world currencies.
The outlook for stocks in the current environment is not entirely dire. Neither the Dow Jones Industrial Average nor S&P 500 are in bear market territory as it is classically defined. (The same is not true for small-caps, which are now down over 20% from their 2007 high.) Even if GDP were to contract (and the Fed Chairman averred that it might in his testimony to the Joint Economic Committee at the beginning of April), it’s important to remember that stocks can start their recovery fairly early in a recession. In fact, we are already seeing some rotation into Consumer and Financial stocks, although in our view, this is occurring ahead of fundamental improvement. Outside of the Financials sector, most other sectors appear healthy. Growth in international economies may be slowing (largely due to the US slowdown), but the growth trends are still positive which can continue to support Industrial, Materials, and Information Technology stocks. Earnings don’t appear on the verge of collapse; in fact earnings comparisons may get easier over the course of 2008.
Weakness in the housing market and faltering consumer spending remain causes for concern and we do not expect a quick resolution to either variable. There is no shortage of bleak statistics to emphasize the magnitude of the crisis in housing. The delinquency rate for mortgages was reported at 5.82% for fourth quarter of 2007, its highest level since 1985.1 The inventory of unsold homes is at an 18-year high2 and home price declines appear to be accelerating. None of these indicate a speedy resolution to the housing decline.
US Housing Market Weakens Further
Source: Bloomberg.*
However, we believe that the monetary and fiscal stimulus enacted by the Fed and Congress are strong steps toward recovery. As banks clear bad debts from their books, and begin to loan more freely, we believe investor confidence in the financial system will return and expect fundamentals, rather than fear, to guide stock moves. The market was very volatile in the first quarter and we expect the volatility to continue. We think that a bottoming in stocks is more of a process than a singular event and we may see stocks bounce along a bottom for a period before sustaining any gains.
1MSNBC.com, March 6, 2008
2New York Times, April 3, 2008
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