Market Commentary: October 2008
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Capital Markets
As we go to press this month, events in the capital markets and a series of interventionary steps by the U.S. Treasury, Federal Reserve, the Federal Government, and foreign central banks have been moving quickly. By the time you read this, there is a reasonable potential that these comments may already be outdated depending upon subsequent events in the market which cannot be foreseen. With this challenge as the backdrop against which we work, we will attempt to briefly address the issues that we believe to be among the most significant at press time. Few periods in the recent history of the capital markets have proven as challenging to investors as the environment that we stand amidst today. Under different circumstances, the mergers (both announced and rumored) involving a who’s who of the financial services industry would have dominated the news cycle and – to be sure – they each had their turn in the spotlight. However, the combination of merger talk, the effective nationalization of three former Fortune 500 financial companies (Fannie Mae, Freddie Mac, and AIG), and the spectacular collapses of other financial sector bellwethers (Lehman Brothers, Washington Mutual, and Wachovia) raised the “anxiety ante” in the market to levels that were without recent precedent.
On Thursday, September 18, with major stock indexes faltering and some financial stocks virtually in free-fall, the first rumblings of a massive Federal rescue plan was sufficient to provide a floor and boost stock investors to drive a two-day “about face,” propelling equity indices to much higher ground. At the time, it appeared that the combined clout of the Fed and Treasury and the apparent urgency of the situation may be sufficient to motivate Congress to move swiftly to act.
In the subsequent weeks, the market was whipsawed by the ebb and flow of the forecasted probability of the House of Representatives passing the proposed plan. Initial optimism following the first announcement of a potential deal dissipated as the expected likelihood of passage was diminishing, despite the urgent picture painted by Fed Chief Ben Bernanke and Secretary of the Treasury Hank Paulson. When the House ultimately voted down the rescue package on Monday, September 29, in shocking fashion, the market’s violent reaction was immediate and clear. Polls conducted of voters on “Main Street” revealed little warmth toward the prospects of a perceived bailout of Wall Street (a view that we believe to be partially the result of a poorly presented case for the intervention). In the hours that followed the House vote, Wall Street also “voted” by delivering a failing grade for lawmakers in the form of a 777 point drop in the Dow Index, which was – as widely reported – the largest single day point drop in the index’s history. We should point out that the pullback, while significant, was not even close to the largest single day percentage decline in the history of the index.
Source: PMFA Domestic stocks had been relatively successful in treading water through the first two months of the quarter, but the widespread selloff in September weighed heavily on the returns of all of the major indices. Financial stocks, particularly those associated with some of the largest financial institutions, came under severe pressure, but the selloff was widespread and crossed all sector lines. The Russell Midcap Index fared particularly poorly, as commodity and financial sector stocks in that index were hit hard compared to those in both the Russell 200 and Russell 2000. International equities were hit particularly hard, and those losses were exacerbated by the flight to quality that drove a rally in the Dollar.
Source: PMFA While the equity market was struggling, much of the fixed income market also came under concurrent pressure. On the surface, this would appear to be contrary to what would typically be expected; historically, bonds have often provided positive returns during equity market corrections. Instead, credit markets have been at the epicenter of the current concerns about risk and liquidity. With investor risk aversion increasingly being driven by fear, trading in many areas of the fixed income market appears to have extended beyond simply weak fundamentals and succumbed to an overreaction to the current upheaval in the credit market and the need (real or perceived) to raise cash.
Outside of U.S. Treasuries, which posted positive returns during the massive flight to quality in September, most segments of the bond market finished lower for the month. Effectively, investors painted the fixed income market with a broad brush and divided that market into two baskets: Treasuries (or agencies now explicitly backed by the Federal Government) and “everything else.” Mortgage debt also rallied during the quarter on the effective Federal takeover of Fannie Mae and Freddie Mac. Yields on corporate bonds – regardless of credit rating – increased during the month, resulting in negative performance. High yield bonds were particularly hard hit, pushing the year-to-date return on the Lehman High Yield Index into double-digit negative territory.
Also falling clearly into the basket of “anything but Treasuries,” even high-quality municipal bonds were subjected to pressured selling during September. The Lehman 5-Year Muni Index lost over 2% for the month, while yields on AAA-rated municipal yield curve rose substantially. Long-term munis were hit even harder, as the Lehman 20-Year Muni Index dropped 7.6% during the month. Although they may not have the full faith and credit of the Federal government backing them, taxable equivalent yields on municipal bonds look increasingly attractive. However, in the current environment, the comparatively diminished liquidity in municipal trading remains a consideration and could conceivably place further pressure on muni prices until market conditions begin to improve.
Perhaps indicative of the breadth of investments broadly defined as alternatives and the varying factors that influence their performance, the range of returns for that asset class was wide for both the past month and quarter. Broad commodity prices continued their precipitous decline, as oil recently retrenched below $90/barrel after peaking around $147/barrel on July 11. A double-digit decline in the Dow Jones AIG Commodity Index increased its quarterly loss to nearly 28%. With expectations increasing for a further slowdown in both the U.S. and global economy, an aggregate reduction in demand coupled with seasonal factors could keep oil prices from surging back to recent highs in the near term.
Source: PMFA As we go to press, there have been some positive developments. After a great deal of political wrangling, both houses of Congress were able to push through the Emergency Economic Stabilization Act, and it was quickly signed into law by President Bush. The Federal Reserve has again expanded its reach by creating the Commercial Paper Funding Facility in an effort to provide greater liquidity to the commercial paper market and shore up short-term funding for corporate issuers of that paper. The Federal Reserve, in conjunction with several other foreign central banks, announced an unprecedented, coordinated interest rate cut. This move brought the Fed Funds rate down to 1.5%, but was perhaps more importantly an incremental sign that other central banks may be moving toward a more coordinated and appropriate policy response to what is truly a global problem.
VIX - CBOE S&P Market Volatility Index – History
Source: PMFA, Bloomberg When one boils all of these issues down – the paralysis in credit markets, the re-shuffling of the deck of institutional names on Wall Street (rippling out to Main Street), the correction in stocks and other risk assets, and the probability of a deepening in the economic slowdown – the net result has been a spike in uncertainty and fear in the market. The VIX index, which we often reference as a measure of market sentiment, reached levels in the early days of October not previously touched since its inception in 1993. This result clearly demonstrates that investor fear has continued to build throughout the past several weeks. Ultimately, despite these high levels, the possibility exists that volatility could rise further from here.
From a macroeconomic perspective, we believe that there is still further economic pain for the U.S. to work through. Employers continued to shed jobs in September for the ninth consecutive month. We continue to see softness in consumer spending, manufacturing, and construction activity now spreading into the service sector as well. The short-term benefit of the fiscal stimulus package (tax rebate checks) from Q2 appears to have run its course. We expect Q3 GDP results to soften considerably from the unsustainably high 2.9% result in Q2 (directly attributable to consumers spending those tax rebate checks) and potentially slipping back into negative territory.
In the end, we expect the current legislation aimed at recapitalizing banks and nurturing an improved credit environment to be a positive contribution, but it will not be an immediate fix. Its passage was a critical step, but it does not represent a “silver bullet” that will immediately restore the availability of credit or reverse the de-leveraging process that is clearly underway. Collectively, consumers must still go through the process of rebuilding their personal balance sheets and reducing their degree of dependence upon credit to fund their lifestyles. We expect that credit-worthy borrowers will, in time, find it easier to secure credit, but many individuals with excessive debt and/or marginal credit ratings will find it much more difficult to find sources of borrowing than in the past. Once the urgent issues currently at the front of Washington’s legislative agenda have been addressed, we expect that a push toward increased regulation of the financial services sector is a virtual certainty in 2009.
We recognize that we are currently in the midst of a very challenging time for investors. The events of the past month, in particular, have fed into the cycle of fear that is driving much of the day-to-day volatility in the market. As we evaluate current market conditions and consult with money managers and other industry sources we hold in high regard, we believe that a case can be made that the reaction we are seeing in the market extends beyond simple market fundamentals. When markets trade on fear rather than fundamentals, the ability to make prudent investment decisions becomes a more daunting challenge. Opportunities may exist in the current environment as assets have been increasingly priced lower across a broad swath of the market. Equities (both foreign and domestic), non-Treasury backed fixed income, and even alternative investments have been generally re-priced lower. However, the potential for further losses may restrain greater aggressiveness in buying into a falling market.
We continue to closely monitor market events and evaluate the full range of options at our disposal, including potential reallocations between those strategies and asset classes to which we currently have exposure and other new strategies that could be implemented. While we believe that the current environment may create the need and opportunity to make moderate changes in portfolio allocations, we also believe that such changes should be made with very careful consideration. We believe there is risk in making massive changes in portfolio structure in this volatile environment and believe that prudence dictates a high degree of confidence in the risk/return profile (both long-term and short-term) for any portfolio changes to avoid being whipsawed.
While uncertainty is high, we remain confident in the long-term merits of capitalism and our financial system. In the short term, we expect volatility to remain high and recognize that further losses could be incurred across the spectrum of the capital markets. We are encouraged by the apparent increase in willingness by foreign central banks to join with the Fed in taking more aggressive steps to stem the tide of the credit crisis. While we do not believe that we (or anyone else) can predict the timing of a return to stability and normalcy in the credit market, we believe that the aggressive steps that are being taken are incrementally restoring liquidity to the system. In time, we believe that the cumulative effect of those actions will likely achieve the desired result of re-stabilization. In the meantime, substantial risks remain and the eventual path to normal market conditions will continue to be challenging.
While we navigate these challenges, we recommend that investors maintain sufficient liquidity to insure that they are positioned to meet their spending needs and maintain a reasonable degree of comfort in their ability to do so. In addition, we urge all investors to carefully consider the implications of deviating from their long-term strategy. The merits of diversification and asset allocation, particularly over a long-term time horizon, remain intact and should ultimately reduce portfolio level risk. As we’ve seen in recent days, market sentiment can shift quickly as the policy landscape changes. We cannot be certain what the immediate future holds, nor do we believe that an investment time horizon that is tied to the daily flood of news and information is constructive for prudent decision-making. In time, normalcy will return to the market, and this cycle will again turn positive. At that time, patient investors with exposure to riskier assets will be rewarded, most likely in very handsome fashion. The timing of that cyclical shift is unquestionably in doubt and may not arrive before a further downward leg in the market. Conversely, a great deal of pessimism and risk is clearly being priced into the market. A continuation of significant global policy intervention or other significant news that calms fears could provide the impetus for a positive bounce. Under either circumstance, investors should be better served by maintaining a long-term view and a sufficiently diversified portfolio to provide some downside protection while positioning themselves to participate in the upside in asset classes that have experienced losses.
Economy GDP The final estimate from the Bureau of Economic Analysis reported that the economy grew at a 2.8% annual rate during Q2, incorporating a downward revision of 0.5% from the “preliminary” estimate of 3.3%. Net exports contributed nearly 3% to growth, as exports surged and imports fell. Exports now account for more than 13% of GDP, the highest amount ever. Government and consumer spending were also positive contributors, while major detractors included inventories and housing.
Real GDP & Personal Consumption – Quarterly % Change
Source: PMFA, Bureau of Economic Analysis (BEA) Inflation
|
|
Period Ending August 2008 |
|
Index |
One-Month % Change |
12-Month Trailing % Change |
|
All Items |
|
CPI |
-0.4% |
5.4% |
|
PPI |
-0.9% |
9.7% |
|
PCE Deflator |
0.0% |
4.5% |
|
All Items Excluding Food and Energy |
|
Core CPI |
0.2% |
2.5% |
|
Core PPI |
0.2% |
3.7% |
|
Core PCE Deflator |
0.2% |
2.6% |
Source: PMFA, BEA, Bureau of Labor Statistics (BLS) As anticipated, August headline inflation indicators pulled back after a significant decline in energy costs. Meanwhile, the core indicator, which excludes the more volatile food and energy, ticked up marginally. The one-year change in PPI, at 9.7%, was nearly its highest point since the 1980s.
In August, the consumer price index (CPI) again ticked up by 0.2%. The trailing one-year CPI now stands at 5.4%, near a 17-year high. The one-year change in the core PCE index reached 2.6%, remaining stubbornly above the Fed’s implied comfort range of 1%-2%. We anticipate that a sluggish economy should provide some continued relief in price pressures in the coming months.
Inflation Indices – 12-Month % Change 
Source: PMFA, BEA, BLS Interest Rates On October 8, the Fed announced an intra-meeting half percent cut in the Fed Funds rate as part of a coordinated monetary policy easing by numerous central banks. Prior to that action, futures were pricing in an expectation of a cut at the Fed’s next scheduled meeting on October 29. In the hours immediately thereafter, expectations continue to price in a broad expectation for an additional cut to 1.25%.
Probabilities for future FOMC Meetings as of 10/8/08 
Source: PMFA, Bloomberg There was a desperate flight to quality in September; at its peak, investors bid up prices on short-term treasuries to the point of receiving a negative return. Put simply, prices reached the point briefly that investors were willing to pay to have the safety of the Treasury guarantee. Long-term yields also declined during the month, but to a much lesser degree. As compared to a year ago, there has been a significant steepening of the yield curve. The yield curve ended the month at levels similar to the cyclical bottom seen in March, following the Bear Stearns insolvency.
Treasury Yield Curve– History 
Source: PMFA, U.S. Treasury Employment Job losses continued in September, as non-farm payrolls declined by an additional 159,000. This represents the ninth consecutive monthly decline in the payroll number, with an average loss of over 80,000 jobs monthly since January. Thus far, the pace of loss has not been as severe as that of the last recession, where job losses averaged nearly 200,000 jobs monthly.
Non-Farm Payrolls & Unemployment Rate – Monthly
Source: PMFA, BLS Meanwhile, the unemployment rate remained at an elevated 6.1%. Over the last year, the unemployment rate has increased by nearly 1.5%. As multiple economic indicators continue to slow, the likelihood of a recession has intensified.
Initial Jobless Claims & Unemployment Rate – Monthly
Source: PMFA, BLS ISM Indices The Institute for Supply Management surveys both the manufacturing and non-manufacturing growth based on changes of specific monthly indicators. A reading of 50 would serve as the inflection point where sub-50 readings would indicate contraction and vice versa. Clearly indicators have been slowing since mid 2004 and have been wavering near the breakeven mark for nearly a year. In September, the ISM manufacturing index reported a significant contraction to 43.5%, in line with recessionary levels.
ISM Manufacturing & Services Index – History
Source: PMFA, Bloomberg
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.
