Capital Markets

Over time, observers have identified any number of performance anomalies or patterns in the capital markets. One example is the long-term trend of generally better than average equity returns in the third year of a Presidential term. A second is the so-called “Santa Claus” rally that has often historically occurred in the closing days of a calendar year. This year, investors were disturbed to receive the market equivalent of a lump of coal in December in the form of a selloff in the closing days of the month. As a result, equities generally finished down for the month, further deepening the losses from October and November. The bottom line: no Santa Claus rally whatsoever, and sub-par equity returns despite 2007 being that third year in the Presidential cycle.


Source: PMFA

The equity market reacted disapprovingly to negative economic news which appeared to pick up momentum as we edged closer to the new year. While the market appeared to right itself temporarily following the strong tremors emanating out from sub-prime debt in the third quarter, this stabilization appears to have been transitory. Having already posted, in some cases, record losses for the third quarter, major financial institutions continued to revise upward their losses on a variety of debt instruments tied to sub-prime mortgages throughout the final months of the year. Aggregate global losses related to these and other related derivative instruments have been projected to potentially reach hundreds of billions of dollars. The bottom line is that, at this point, no one can reasonably predict the expanse of the aggregate losses that will be ultimately realized.

While investors may or may not experience direct losses as a result of the sub-prime mess, we expect that the aggregate impact on the economy and capital markets has been – and will continue to be – noteworthy. Credit availability has tightened in recent months, impacting individual consumers, businesses, and, in some cases, governmental entities as well. Over the long-term, the periodic tidying up of credit standards is a healthy necessity, effectively purging the system of policies that gradually loosened to the point of excess. Over the short-term, however, the impact can be painful for those borrowers that are directly affected; for the economy, the temporary drying up of credit availability for many prospective borrowers inevitably results in reduction in the pace of economic growth.

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

Source: Yahoo Finance

Market volatility remained elevated in the final months of the year as the perceived risk of recession continued to increase. The VIX Index closed the year at a level indicating that equity market risk had nearly doubled since late 2006, which represented a multi-year low level of volatility. At these levels, market volatility has reached a point last seen in 2003, near the beginning of the most recent equity bull market.

Source: PMFA

Reacting to an acceleration of bad news, bonds extended their third quarter surge through the end of the year. Treasuries rallied, driving the yield curve lower. Much of the Treasury curve remained below the Fed Fund’s rate as of December 31, a clear indication that the market does not believe the Fed has acted decisively enough to ease monetary policy. In his first public comments of 2008, Fed Chairman Ben Bernanke all but promised not only a cut at the January meeting of the Federal Open Market Committee, but hinted at an adjustment of 0.5%.

While disruptions in the credit market remain a key concern for the Fed, other economic data released in the opening days of January provided additional evidence of a fourth quarter slowdown. The Institute for Supply Management Manufacturing Index for December came in at 47.7%, below the 50% “neutral” threshold and indicating that manufacturing activity actually contracted near the end of the year. Shortly thereafter, the Bureau of Labor Statistics reported an unexpectedly sharp uptick in the unemployment rate to 5.0%, indicative of a softening labor market. The preliminary estimate of non-farm payrolls indicated that an estimated 18,000 new jobs were created. While still subject to revision, that rate would represent the slowest pace of job growth for a single month since July 2003. It should be noted that revisions are common, and the final estimate may be substantially higher, although the potential of a downward revision also exists. Consumer sentiment also continued its slide in December.

Taken in their totality, numerous key indicators increasingly point to a meaningful slowdown in the economy. We expect that will play out in the form of additional risk and volatility in the capital markets until some indication of a bottoming out becomes clear.

Source: PMFA

As we head into 2008, we continue to expect that current market conditions currently favor a more conservative stance in portfolios. An emphasis on large, global companies in equity portfolios should perform comparatively well in a slowing economic environment. Additionally, investments in Treasury Inflation Protected Securities and emerging market currencies still have the potential to provide some protection against inflation risk and return enhancement potential. Despite the uncertainty surrounding the short-term outlook, opportunities still exist to position one’s portfolio to outperform in a choppy market. As always, identifying those opportunities remains our focal point.

Economy

GDP

The final estimate for Q3 2007 GDP growth remained unchanged at a 4.9% annualized rate. The big story remains the growth in real exports, which were up 19.1% in the third quarter alone. Consumer spending was up over Q2, but remains below their robust levels in recent years.

Generally, job growth slows substantially during periods of economic slowdown or recession. The potential for of a recession in 2008 remains elevated. Although the Federal Reserve has already taken steps to ease monetary policy, the question that remains at the center of an increasingly heated debate is whether these actions were sufficiently aggressive to avoid a recession.

Real GDP vs. Nonfarm Payrolls – Quarterly % Change
Source: PMFA, Bureau of Economic Analysis (BEA), Bureau of Labor Statistics (BLS)

Forecasts for Q4 2007 GDP growth are mixed, but generally remain in positive territory. Consumer spending was exceptionally strong in November at a 1.1% monthly gain. Consensus expectations for the next several quarters are for a continued material slowdown in the rate of domestic growth, with the prospect for a recession increasingly becoming a mainstream view.

Employment

Nonfarm Payrolls & Unemployment Rate – Monthly

Source: PMFA, BLS

The national unemployment rate for December spiked to 5.0%. The pace of job creation also slowed considerably to 18,000.

Job growth was at its slowest pace in over four years. Over the last three quarters, the unemployment rate has increased from 4.4% to 5.0%, a two-year high. While still relatively low compared to historical levels, the rise in the unemployment rate suggests a substantial softening in the economy has already taken place.

Inflation

Inflation indices were up across the board again in November, as core inflation measures edged slightly above the Fed’s implied comfort zone. High inflation could further complicate the Fed’s upcoming monetary policy decisions. Given the likelihood that the recent cuts have not been fully absorbed into the financial system and economy, the potential for a further surge in inflation appears substantial.

Source: PMFA, BEA, BLS

The Consumer Price Index (CPI) increased 0.6%, while core CPI increased 0.1% for the month of November. The Core PCE Deflator, the Feds preferred inflation gauge, rose 0.2%, while the 12-month trailing percent change was lifted to 2.2%.

Inflation Indices – 12-Month % Change
Source: PMFA, BLS, BEA

Gasoline was overwhelming the underlying catalyst for the significant increase in the Producer Price Index (PPI) of 3.2% for November. Gasoline experienced its largest one-month increase (34.8%) since the index’s inception in 1973. As a result of this spike, the 12-month trailing PPI surged 7.7%.

Interest Rates

Since September, the Federal Reserve cut the Fed Funds rate by 1.0%, bringing the Fed Funds rate to 4.25% to end the year. Not only is the market pricing in an additional cut from the Fed at their January meeting, but the perception is rising that the Fed needs to act more decisively and aggressively to cut by more than 0.25%. From December 26 through January 4, the probability distribution shifted dramatically from roughly a 40% expectation of no cut to a nearly 50% expectation of a 50 basis point cut in the Fed Funds rate to 3.75%

Current Probabilities for FOMC Meeting 01/30/08

Source: Bloomberg, PMFA

In the Feds most recent minutes they noted, “Recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation.” The Fed continues to reiterate they will act as needed to foster price stability and sustainable economic growth.

Treasury Yield Curve History

Source: PMFA, U.S. Treasury

The ten-year treasury yield rose slightly – ending December at 4.04% after trending downward for over six months. Short-term rates also dropped more significantly in December following the Fed rate cut, as the one-month Treasury yield declined sharply to 2.76%. While the curve has re-steepened in recent months, the short end of the curve remains nominally inverted.

ISM Indexes

Despite the substantial pickup in export activity in recent months, manufacturing activity slipped considerably. The Institute for Supply Management (ISM) Index slipped below the important threshold of 50% to 47.7% for December, indicating contraction in manufacturing since the prior month. That result marked a low point for the Index since April 2003, when the economy was emerging from the last recession.

The ISM Services Index continues to hold up better, dipping slightly to 53.9% in December. The Service Index has been consistently above 50% since April 2003 and has not been below 50% for two consecutive months since the last quarter of 2001.

Housing

The housing market continues to show no signs of bottoming, let alone starting a recovery.

New Home Sales & Monthly Inventory of Home – History

Source: PMFA, U.S. Census Bureau

New home sales have fallen to their lowest point in over a decade. Existing home sales have fallen over 20% from a year ago to an annualized pace of about 5 million units.

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.