The Economy in 2008: Connecting Uncertainty With Opportunity
by Jim Baird
Universal Advisor, 2008 Issue No. 2 

Not Your Father’s Central Bank Policy

As anticipated, the U.S. economy remained very soft in the first quarter of 2008, following on the heels of a mediocre fourth quarter annualized pace of growth of just 0.6 percent. The preliminary estimate for first quarter GDP growth of 0.9 percent slightly exceeded the prior quarterly result. Combined, the six-month period represented the weakest growth rate over two consecutive quarters for the U.S. economy in five years.

In most circumstances, the concerning signs of a material economic slowdown would be sufficient to motivate the Federal Reserve to provide stimulus in the form of interest rate cuts. However, the continuing dislocations in the credit markets that culminated in the collapse of Bear Stearns (one of the largest U.S. investment banks) served up perhaps the most poignant headline for the quarter. Only an eleventh-hour intervention by the Fed to facilitate a buyout by J.P. Morgan and provide some $30 billion in protection against losses allowed the capital markets — and ultimately the economy — to avoid a much greater disruption.

While the Fed’s direct intervention to defuse that brewing crisis was indicative of its degree of concern about the potential risks to the financial system, it wasn’t the only example of unconventional central bank intervention in recent months. Concurrent with the announcement of the Bear Stearns bailout, the Fed also opened its discount window to investment banks and extended the term of available loans. Historically, this mechanism has been in place to provide a source of liquidity for traditional commercial banks, with the Fed acting as the lender of last resort for institutions in need of funds. The expansion of that capacity was intended to provide that same source of liquidity to investment banks, thus providing another avenue of funding for institutions coming under pressure in the same manner that doomed Bear Stearns.

The Fed also moved rapidly during the quarter to slash its benchmark Fed Funds rate by 2 percent in three separate actions, including two unusually aggressive cuts of 0.75 percent each. By lowering the rate that’s often tied to the cost of borrowing for many individuals and institutions, the expectation is that economic activity can be spurred at the margin. While it’s too early to conclude definitively whether or not a technical recession (defined as six months of economic contraction) can be avoided, the collective efforts of the Federal Reserve can be reasonably expected to mitigate the severity of the current economic downturn.

The Fed under Ben Bernanke was oft criticized in the latter half of 2007 for perhaps not acting as quickly or aggressively as some believed appropriate to head off the current correction in the housing and credit crunch. More recently, the nation’s central bankers have demonstrated both a willingness to pump liquidity into the system through conventional rate cuts and implement aggressive, unconventional policies to stabilize the markets. 

Connecting the Dots

Given the amount of negative economic data that continues to point to a potential recession, it shouldn’t come as a surprise that consumer confidence recently reached a 26-year low. Rising unemployment, rapidly increasing food and energy prices, falling home values, and a declining equity market have provided consumers and investors ample reason for pessimism. Connecting those dots can lead to the conclusion that the economy is going to be under further pressure. A negative reaction from consumers and investors is to be expected.

The risk in such an environment is that investors lose sight of their goals and investment time horizon. Geometric theory teaches that the shortest distance connecting two points is a straight line. Economic and capital market cycles don’t necessarily move in that fashion, as the ebb and flow of risk (both real and perceived) creates volatility in short-term results. When this volatility becomes overdone in a given segment of the market, investment opportunities are created. This volatility also means it’s very difficult to determine the “perfect” time to invest (i.e., when the market reaches the bottom), as further losses could be realized. However, undervalued assets should be expected to provide outsized returns over the course of a full market cycle.

The key for investors is to connect the dots between their long-term investment strategy and the current market environment. By anchoring expectations for portfolio returns and corresponding risk via a well-defined, long-term investment strategy, investors should avoid allowing the short-term vacillations of the market to dominate their decision-making. Investors with the vision to recognize long-term investment opportunities when irrationality takes root in the market should be rewarded as a more upbeat economic environment returns, as it inevitably will.