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The recent volatile,
up-and-down movements in the stock market are typical of
periods of market uncertainty. And today's economic and
market environment is surely as confusing and lacking in
visibility as most in recent memory.
Uncertain
Markets
In general, the problems
in the U.S. economy that we've outlined over the past year
have either continued to worsen or have failed to improve.
The housing recession continues, with house prices declining
and foreclosures increasing steadily. Employment growth
has reversed, with modest payroll declines being registered
in each of the past few months. The price of gasoline has
topped $4 per gallon across most of the country as the
price per barrel of oil has recently flirted with the psychologically
important level of $150. Consumer confidence levels are
depressed. As noted, stock prices are down, which, along
with the general declines in housing prices, is undermining
consumer wealth. All of these factors are beginning to
weigh more and more heavily on consumer spending, especially
now that the tax rebate stimulus checks have all been distributed
and probably spent. In short, the prospects for accelerated
economic growth are diminishing.
Aggressive
U.S. Government Response
Similarly, the credit
crunch, originally precipitated by the implosion of the
sub-prime mortgage market but then spreading to the whole
array of credit products, has not substantially dissipated
despite aggressive responses by the Federal Reserve, including
a 325 basis point reduction in the Federal Funds Rate since
September 18, 2007, and the establishment of a variety
of liquidity facilities for banks, brokers and primary
dealers. In addition, the U.S. Treasury has at least been
vocal in supporting congressional proposals for using the
Federal Home Loan system to bail out certain qualified
sub-prime borrowers, as well as in proposing a framework
for a regulatory overhaul of the financial system. Congress
acted swiftly and with rare non-partisanship to pass and
implement a consumer and business stimulus package, which
provided a tailwind to the economy during a period of time
that was anticipated to be the most serious phase of the
credit meltdown.
The sticking point
is the fact that massive amounts of impaired assets remain
on the books of financial institutions and money management
organizations throughout the world. Each quarter brings
a new round of asset write-downs, the cumulative total
so far since the credit crisis began last summer amounting
to about $450 billion. Initial capital raising efforts
were quite successful as a number of Sovereign Wealth Funds
stepped up with equity or near-equity investments in some
of the larger U.S. banks and brokers. It is estimated that
capital raised globally in response to asset write-downs
amounts to about $330 billion, but the rate of increase
has slowed dramatically during the first half of 2008.
The reason: As asset values have remained depressed or
declined further, capital has become more expensive and
difficult to raise.
Fannie
Mae and Freddie Mac
The most recent panic
in the financial system was the precipitous decline of
the stock prices of Fannie Mae and Freddie Mac, the backbone
of the U.S. mortgage market. These publicly traded companies
were originally chartered by the government to fund the
mortgage market and promote home ownership. They have been
eminently successful over the years, but have grown to
gargantuan proportions on very thin equity bases. The possibility
of bankruptcy for these companies raised the specter of
a multi-trillion dollar government bailout, potentially
raising the U.S. debt level by what some analysts say could
be as much as an estimated 50% to around $16 trillion.
In reality, the actual hit would prove much less but would
still represent an unprecedented taxpayer bailout, further
retarding economic growth. During the same week, a formerly
large mortgage lender, Indy Mac, went bankrupt. But in
the context of the Fannie Mae/Freddie Mac meltdown, the
event, which a year ago would have been traumatic in its
own right, seemed a ripple in a sea of trouble.
Of course, the U.S.
Treasury was there with a plan to shore up the government-backed
mortgage agencies. The plan promised to provide loans and
possibly an equity infusion. It also gave the
Federal Reserve a "consultative" regulatory role.
While the plan was short on specifics, it did confirm the
long-standing
notion that the government had always provided an implicit
guarantee of the credit of Fannie and Freddie. That guarantee,
it now seems, may be a lot more costly than ever imagined,
but nonetheless, the Treasury's plan confirms that the
government will do whatever it takes to support the mortgage
market in the U.S. And for investors who own the agencies'
bonds, the plan is good news because it essentially makes
explicit the implicit guarantee of government backing always
assumed by the market.
Commodities
Inflation
In the midst of these
serious threats to domestic growth, the U.S. and the rest
of the world have also been experiencing an inflation threat
spawned by the multi-year, accelerating rise in the cost
of all types of commodities, including oil, metals and
food, all prompted by the rapid growth of emerging market
economies led by China, India, Russia and Brazil during
the current decade.
The dilemma is that
it is virtually impossible for policy makers to simultaneously
fight a slowdown in growth on the one hand and inflation
on the other. Lowering interest rates to stimulate growth
threatens to further inflame inflation, while raising rates
to fight inflation stifles economic growth by raising the
cost of borrowing. As noted in our last Perspective, the
Federal Reserve and other domestic policy makers appear
to be caught in a "box." The Federal Reserve is probably
on hold at least until the fall, and even while most observers
anticipate the next move in the Fed funds rate to be up,
deterioration in the economy might prompt another reduction.
Sideways
Market
We suspect that the
stock market will move in a volatile but sidewise pattern
over the next three to six months as mixed signals on the
economy, and periodic credit market panics, continue to
limit visibility regarding the future trajectory of growth,
inflation and the health of the financial system. In such
markets, we believe broad diversification across industrial
sectors and reliance on fundamental analysis to pick the
best stocks for the current environment should prove the
most prudent course.
This
article has been provided for educational purposes only.
The views expressed in this article are subject to change
at any time based on market and other conditions and should
not be construed as a recommendation. This article contains
forward-looking statements, which speak only as of the date
(July 23, 2008) they were made and involve a number of risks
and uncertainties that could cause actual results to differ
materially from those expressed herein. Readers are cautioned
not to rely on, and that we are not obligated to update,
our forward-looking statements. Readers assume any and all
responsibility
for
any investment decision made as a result of the views expressed
herein.
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