Market Commentary: October 2007
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Capital Markets

As with the large tectonic plates that together form the land surface of the earth, capital markets can lumber along for extended periods without significant shifts, despite the consistent ebb and flow of tensions beneath the surface. Geologists may attempt to project the probability of seismic activity within a given region, but predicting the timing or severity of an earthquake is a practical impossibility. Likewise, similar dynamics limit the ability of even the most seasoned economic and capital markets forecasters to reliably predict the specifics surrounding events that will disrupt the capital markets. When an earthquake eventually occurs, it generally strikes without warning, leaving those in the affected area with no time to prepare or react before the damage is done. Noteworthy shifts in the capital markets often follow a similar course.

Recently, the re-pricing of risks and resulting volatility in the capital markets was primarily triggered by severe dislocations in the credit markets specifically tied to sub-prime mortgage loans. The existence of this debt was no secret, and some astute market observers had been actively discussing the risks associated with these instruments as well as other credit-oriented debt that had become richly priced for some time. As is often the case in capital markets, the existence of the issue wasn’t surprising; the primary uncertainty surrounded how long it could subsist and the triggering event, severity, and timing of any correction.

We received some answers in August, when market volatility returned with a vengeance.

VIX Market Volatility Index - as of October 1, 2007


Source: Yahoo Finance

The VIX Index, one common measure of volatility, surged in August as investor interest in sub-prime debt nearly disappeared in a matter of days. The resulting selloff in risk assets was symptomatic of the fear that rippled through the markets, with sub-prime debt at its epicenter. Sensing the need to act to ward off a potential credit crisis, the Fed cut the discount rate they charge to banks and eased collateral restrictions and borrowing terms to send the message that the nation’s central bank stood ready to maintain the availability of credit.

The Fed’s subsequent September 18 announcement of a half percent cut in the Fed funds rate surprised a market that had priced in only a quarter percent cut. Investors embraced the move, sending equity markets sharply higher. The late surge pushed large cap stock indexes back into positive territory for the quarter, while partially mitigating the negative returns in mid cap and small cap stocks during July and August. The dollar sold off on the rate cut, further enhancing positive local market returns in international equities.


Source: PMFA

One concern that has been raised relative to the Fed’s decision to ease interest rates is the unintended effect of potentially increasing inflationary pressure. While core inflation has been gradually receding over the past year, most current measures of inflation remain near the high end of the range generally believed acceptable to policymakers. Inflation remains a risk, and the Fed acknowledged that in their statement accompanying the rate cut. However, the recent release of the minutes from the Fed’s September 18 meeting indicate that the negative shift in the outlook for economic growth was of greater immediate concern than the prospect for a reversal in the downward inflationary trend.

Short-term Treasuries rallied early in September in anticipation of a Fed rate cut and gained further momentum after the Fed’s announcement. Bond returns were generally positive for September and for the third quarter as a whole. Expectations for a long-term uptick in inflation are evident in the recent re-steepening of the yield curve. Continued weakness in the dollar is also likely to place upward pressure on long-term interest rates over time. Non-dollar denominated fixed income investments benefited from that weakening during the quarter and continued to provide strong returns to investors.


Source: PMFA

The combination of inflationary concerns and dollar weakness pushed precious metals higher. Oil prices surged past $80 per barrel in September after pulling back in August, also contributing heavily to positive returns in commodities.


Source: PMFA

Generally, equities tend to perform well in the year following the commencement of a Fed easing cycle. As noted above, the markets have already provided positive returns in the wake of the Fed’s announcement. While the Fed’s actions should be a positive for the markets and economy, we anticipate that market volatility may increase again until the economic picture clears considerably. The negative drag of the housing recession appears likely to continue well into 2008. While the economy has proven generally resilient despite housing woes, consumer spending was already fading in the second quarter – before the turmoil of the last few months.

We continue to expect that a combination of cyclical factors and relative valuations should favor large cap stocks over smaller, riskier equities. International equity markets should also continue to perform well given the strength of the global economy and downward pressure on the dollar.

High quality and inflation protected fixed income appears to be a viable safe haven, while emerging market currency exposure should provide attractive yields coupled with the potential for enhanced returns from the falling greenback.

Few market observers have over time demonstrated any proven ability to reliably predict the timing or severity of tremors in the economy or capital markets. We believe the key to weathering such conditions when risks are heightened is to start with an appropriate foundation which can mitigate the potential for damage. The combination of an appropriate asset allocation strategy implemented with prudent risk/return considerations in the current environment should afford investors the best balance between managing downside risk while remaining committed to their long-term plan.

Economy

GDP

The final estimate for Q2 2007 GDP growth was revised downward slightly to a 3.8% annualized rate. The average growth rate over the last four quarters was just 1.9%. The forecasted Q3 GDP growth is projected to be within the Fed’s target range of 2-3%.

While the overall GDP number was strong, softness in consumer spending remains a cause for concern. The primary contributors to positive growth were business investment, government spending, and net exports, which benefited from stabilization in imports and robust export growth due in part to the falling dollar.

Consumer Spending vs. Real GDP - Quarterly % Change

Source: PMFA, Bureau of Economic Analysis (BEA)

Employment

The unemployment rate for September increased slightly to 4.7%. The rate of job creation for the month increased slightly to 110,000. More notably though was the upward revision to the August nonfarm payroll estimate from a preliminarily estimated decline of 4,000 jobs to an increase of 89,000 jobs.

Nonfarm Payrolls & Unemployment Rate - Monthly Net Change

Source: PMFA, Bureau of Labor Statistics (BLS)

Inflation

The Consumer Price Index (CPI) declined 0.2%, while Core CPI increased 0.2% for the month of August. The 12-month trailing core PCE Deflator ticked down to 1.8% in August, remaining within the Fed’s implied target range.


Source: PMFA, BLS, BEA

The Producer Price Index (PPI) dropped 1.4% largely based on declines of gasoline, nearly 14% in August. The PPI is typically more volatile than other inflation indices.

Inflation Indices – 12 Month % Change

Source: PMFA, BLS

Interest Rates

The Fed announced a larger than expected half percent cut in its funds rate, bringing it down to 4.75%. The FOMC statement from the September 18 meeting provided justification that “the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally.”  

Many market observers forecast additional rate cuts to occur over the next three months. Based on Fed Funds futures, the market is anticipating additional cuts of another quarter to half percent by December.


Source: Federal Reserve Bank of Cleveland

Longer term yields fluctuated throughout the month of September, with the ten-year Treasury yield closing September slightly higher than the prior month at 4.6%.  

Ten-Year Treasury Yield - as of October 1, 2007

Source: Yahoo Finance

Short-term rates continued their decline in September, further re-steepening the Treasury yield curve. The one-month Treasury yield decreased 0.6% during the month to 3.4%. Over the last year, the yield curve has shifted from a nominal inversion in August 2006 to a more normal term structure in recent weeks.

Treasury Yield Curve History

Source: PMFA, U.S. Treasury

Currency

The dollar sold off in September in conjunction with the Fed’s rate cut, reaching historical lows relative to many currencies. Relative to the Canadian dollar, a point of parity was actually reached at the end of September for the first time since 1976. 

Domestic large cap companies with an international revenue and income sources particularly benefit from a weak dollar. There is also a high inverse correlation between the price of oil and the value of the dollar.  

Broad Dollar Index vs. Crude Oil Prices

Source: PMFA, U.S. Treasury, EIA

Housing Market

The housing market continues to tumble, exacerbated by notably tighter mortgage lending standards. New home sales declined 8.3% in August and have now declined 38% from their 2005 peak. The inventory of unsold homes on the market reached a new cyclical high of a 10-month supply, nearly double a balanced market supply of five to six months. 

Meanwhile, major home price indexes continued their retreat and have yet to find a bottom. Increasingly, the consensus outlook is that the housing market is not likely to improve until well into 2008 at the earliest.

Home Price Indices - History

Source: PMFA, Standard & Poors, OFHEO

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.  

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other source believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree. 

Plante Moran Financial Advisors publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the sectors mentioned herein may not be appropriate for you. You should consult a representative from Plante Moran Financial Advisors for investment advice regarding your own situation.