Capital Markets

While Presidential election years can be noteworthy in their own right, the first quarter of 2008 alone has already earned a place in the history books. As a starting point, the quarter began without the typical “January Effect,” the term used to describe the typical effect of investors beginning the new trading year by putting liquidity, often raised from end-of-year tax-loss selling, back to work in stocks. Instead, the first quarter started with continued selling in the equity markets and some fairly aggressive moves by the Federal Reserve. The end of the quarter brought with it continued volatility, and an even more creative and active central bank.

The equity markets continued to digest and react to several economic themes. The persistent weakness of the housing market and the ripple effect in financial markets took center stage. Many financial institutions, both global and domestic, continued to write down the value of many of their positions in mortgage backed securities.


Source: PMFA

The losses tied to the sub-prime contagion have already eclipsed an estimated $230 billion. Some firms sought outside capital infusions from private equity investors or traditional mergers and acquisitions to help mitigate the effects of these write downs on their capital structure. The Fed-backed purchase of Bear Stearns by J.P. Morgan and the purchase of Countrywide Financial by Bank of America were the most notable bailouts of institutions on the verge of collapse.

Effects of the sub-prime malaise impacted non-financial sectors as well. Other sectors that were particularly impacted were home builders, auto manufacturers, and retailers. The home builders reeled from a one-two punch of tighter lending standards and a persistent inventory glut. Concessions and other special incentives can provide temporary help with the inventory overhang; fixing it will require better access to financing for potential buyers. The automobile sector suffered from a fall in consumer confidence, as potential car buyers stayed away due to uncertainty about the economy and job prospects. To combat this trend, auto companies again offered interest-free financing. Finally, retailers struggled to lure shoppers through their doors. Price-cutting intended to entice shoppers failed to outweigh the reports of job losses and slowing economic growth. Even the luxury retailers, who banked on their customers’ resiliency to rising food and energy prices, felt the pain. On the whole, the risk aversion among equity investors that began in later 2007 escalated during the quarter. While large, multinational companies held up nominally better than smaller companies, the selloff during the quarter was widespread across the market cap spectrum.

VIX - CBOE S&P Market Volatility Index – 1-Year Change

Source: Yahoo Finance

As investors grew increasingly less comfortable with risk, bonds performed comparatively well. Treasuries were the recipients of tremendous inflows, and the Treasury yield curve steepened considerably. Most of the move in yields occurred at the short end of the curve as the Fed’s rate cutting campaign continued.


Source: PMFA

Longer yields were comparatively steady as buying interest waned in issues with maturities longer than 10 years. Lower-quality fixed income did not hold up as well in the face of investor angst and risk-averse behavior. High-yield bonds turned in negative performance for the quarter.


Source: PMFA

Fed Chairman Ben Bernanke continued to focus on the risks to economic growth and the functioning of the credit markets. The risks to economic growth became elevated as we witnessed job creation give way to job losses. The net change in jobs for the first quarter (while still subject to further revisions) was a loss of 232,000. This loss translated into an unemployment rate of 5.1%. Most of the weakness came from the manufacturing sector, but losses were also experienced in the financial services sector, a direct result of the mortgage market contraction. These job losses became more concerning as the weakness in the Institute for Supply Management Manufacturing Index spilled over into the service sector. March marked the third consecutive reading below 50, which also signals a contraction.

Prior to this event, economists hung their collective hats on the strength of the service sector, which has, over time, comprised an increasingly larger segment of the economy. The Fed’s focus on the health of the credit markets led to some very creative approaches. In addition to the traditional rate cuts, and the renewed use of its Term Auction Facility, the Fed opened the discount window to non-commercial (investment) banks. The latter action marked a reversal of a Depression-era clause and was put into action to help prevent further runs on investment banks. Many market participants viewed these actions positively as they confirmed that the Fed is not only fully aware of the issues, but that it is ready to act accordingly. Previously, concerns were raised that the Fed was going to use only traditional tools to fight a non-traditional battle.

As we turn our focus to the balance of 2008, we anticipate further volatility in the capital markets. This volatility will likely continue until we see a meaningful improvement in both job creation and housing. Given this outlook, we still favor a relatively conservative positioning of portfolios. We anticipate that an emphasis on large, multinational companies in equity portfolios remains prudent. These diversified companies typically hold up better during periods of economic slowdown. While Treasury Inflation Protected Securities (TIPS) remain a viable source of some inflation protection, the real yields associated with TIPS have dipped to extremely low levels after a sharp rally in Treasuries and strong performance relative to other bond sectors over the past several quarters. Non-dollar denominated bonds can add the diversification benefits of stronger economies, attractive yields, and currency appreciation.

While the market remains under a cloud of uncertainty, opportunities do exist for positioning portfolios to weather the storm. Our primary focus remains the identification of reasonable opportunities to reduce portfolio risk, enhance returns, or a combination thereof.

Economy

GDP

The final estimate for Q4 GDP was 0.6%, unchanged from earlier estimates. For 2007, GDP grew at 2.2%, the weakest annual growth rate in five years. Sluggish growth resulted from a decline in inventory investment and decelerations in exports, government spending, and consumer spending.  

Real GDP & Personal Consumption – Quarterly % Change

Source: PMFA, Bureau of Economic Analysis (BEA)

During the first two months of 2008, the pace of consumer spending softened but remained nominally positive at 0.4% and 0.1%, sequentially. The trajectory of consumer spending will be closely watched as it accounts for roughly 70% of GDP. Consumer confidence is one way to gauge the potential willingness of the consumer to spend, which remained at a five-year low in March.

Employment

The labor market experienced another trying month in March, with a decline of 80,000 jobs, significantly worse than the consensus estimate of a loss of 50,000 jobs. Deeper revisions were also made to January and February data, both to losses of 76,000. This represents the third consecutive month of job loss, although the annualized rate of job creation has been softening since March 2006. 

Nonfarm Payrolls & Unemployment Rate – Monthly

Source: PMFA, Bureau of Labor Statistics

The unemployment rate hit a two-year high of 5.1%. Over the last 12 months the unemployment rate has increased 0.7%. Employment data will continue to be closely monitored, as consumer spending (the bulk of GDP) is generally correlated with employment movements, which have been in a steady downward trend.

Personal Consumption & Nonfarm Payrolls – 12-Month % Change

Source: PMFA, BEA, BLS

Interest Rates

The Fed demonstrated ingenuity during the quarter in their commitment to steady the credit markets. One specific action taken by the Fed in coordination with other central banks to foster liquidity within the markets significantly expanded their securities lending program.

In addition, the Fed followed through in March with a 75 basis-point cut in the Fed Funds rate, lowering that rate to 2.25%. The easing was accompanied by their statement citing, “Recent information indicates that the outlook for economic activity has weakened further.” The market is currently pricing in a 25 basis-point cut at the April meeting.

Current Probabilities for 3/18/08 FOMC Meeting

Source: PMFA, Bloomberg

The yield curve trended downward further in March. Shorter term yields declined most significantly, with an 85 basis-point decrease in the one-month treasury yield. Longer maturity yields experienced marginal declines. The ten-year treasury yield ended the month at 3.45%, just 8 basis points lower than at the end of February. 

Treasury Yield Curve History

Source: PMFA, U.S. Treasury

Inflation


Source: PMFA, BEA, BLS

Inflation continues to dampen the potential for further easing by the Fed, although the 12-month trailing Core PCE declined marginally to 2.0%, back to the upper end of the Fed’s implied target range.

Inflation Indices – 12-Month % Change

Source: PMFA, BLS, BEA

The Fed reiterated their concern about elevated inflation in their most recent statement, but added, “The Committee expects inflation to moderate over coming quarters, reflecting a projected leveling out of energy and other commodity prices and an easing of pressures on resource utility.” This expectation has supported the significant easing which has already taken place and may lead to further reductions.

Housing

The housing market grabbed headlines throughout the first quarter. New home sales hit a 13-year low as builders tried to work off their excess inventory. This represented a 58% decline since mid 2005. Seasonally adjusted inventories have skyrocketed to their highest level in over 25 years.

New Home Sales & Monthly Inventory – History

Source: PMFA, U.S. Census Bureau

Prices also remain in decline as the inventory of unsold homes remains high. With the rate of foreclosures projected to escalate, the inventory of unsold homes could move higher still. Although residential construction represents just 4% of GDP, the severity of the decline continues to weigh heavily on consumers and seep into other areas of the economy.




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 (PMFA) 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 PMFA for investment advice regarding your own situation.