October 2007

Editor’s note: the following review is based on available information as of October 12, 2007.

The third quarter of 2007 produced the most market tumult since 1997-1998, when Asian markets crashed, Russia defaulted on its external debt, and Long Term Capital Management imploded. The Federal Reserve Board (the “Fed”) responded to that episode 10 years ago by reducing the federal funds rate 75 basis points over a period of about six weeks. A similar response to the recent turmoil, or probably more accurately, to the economic and financial market symptoms of their underlying causes, has been witnessed. But first, let us recount the story.

The source of the third quarter’s market tumult was a classic “credit crunch” with a few modern twists. The underlying cause of this credit crunch was an implosion of the market for bonds backed by sub-prime mortgages. In late 2006 and early 2007, reports that delinquencies and defaults among this sector of the mortgage market were rising at unexpected rates prompted a brief market correction in February. Over the next couple of months, many small and mid-sized mortgage companies retrenched, sold themselves, or closed their doors as the sub-prime and other below-standard mortgage origination markets dried up.

Then, in June, Bear Stearns announced that two of its hedge funds specializing in bonds supported by sub-prime mortgages had borrowed heavily to leverage up returns, and had essentially been wiped out. As the value of these bonds came under increasing doubt, their creditors issued margin calls, prompting the hedge funds to attempt to sell the securities to pay off their debt. But the hedge funds either found no buyers or were offered prices significantly below their nominal cost. Therefore, they were unable to pay back their loans. Bear Stearns had to inject nearly $2 billion of its own capital to pay off creditors and shut down the funds.

Fear that the Bear Stearns debacle would continually repeat itself spread throughout global markets. In fact, several more revelations of failed hedge funds surfaced in Germany, Australia and Ireland. Then, in late July, Countrywide Financial, the largest mortgage originator in the U.S., and the world, announced that their current quarter’s earnings would come in substantially below the consensus of analysts’ estimates as a result of a collapse in the resale market for originated mortgages. Countrywide also stated that its originations had declined substantially and were not expected to pick up again over any foreseeable timeframe. Three weeks later, one key brokerage firm came out with a report suggesting that a Countrywide bankruptcy was a very real possibility. During that interval, Countrywide’s stock plummeted nearly 45%.

At the same time, credit availability, especially any based on the value of assets (houses, credit card receivables, automobiles and even corporate receivables), was drying up. The commercial paper market began to shrink precipitously, threatening the loss of short-term liquidity to large segments of the domestic and global financial and industrial system. In what was probably a coordinated effort, central banks around the world, and most prominently in Europe, responded by beginning to inject liquidity into their respective banking systems by making hundreds of billions of dollars available on easy terms.

The Fed springs into action

Then, on August 17, two days after the conjecture began that Countrywide was headed for bankruptcy, the Fed acted, issuing two back-to-back statements. The first announced a 50-basis-point reduction in the Discount Rate (the rate the Fed charges banks on overnight loans), as well as an extension of term from overnight to as much as thirty days at the request of the borrowing bank, and the acceptance of certain types of mortgages as collateral for such loans. Secondly, the Fed explained that it was taking this unprecedented action “to promote the restoration of orderly conditions in financial markets,” because “financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward.” Further modifying its recent contention that the potential for rising inflation was more worrisome than prospects for declining growth, the Fed stated, “downside risks to growth have increased appreciably.”

These actions, even coupled with the liquidity injections of the world’s central banks over the prior few weeks, lacked the oomph the markets desired. Many participants had been calling for a reduction in the Fed funds rate (the interest rate on very short-term loans between U.S. commercial banks), the key policy lever of the Fed’s financial system control. But to do so at the time would have possibly suggested panic by not waiting for the next scheduled Open Market Committee meeting on September 18, and would surely have elicited accusations of having “bailed out” speculators and the risk takers who had created the situation in the first place. There had already been a long, ongoing debate about the Greenspan Fed’s responsibility for having created “moral hazard,” defined as encouraging unreasonable risk taking by always lowering rates whenever markets became too volatile. Under the leadership of the new chairman, Ben Bernanke, the Fed governors decided to take measured, incremental steps in order to retain some options if these did not work to calm the credit markets.

In the month between the discount rate cut and the Fed’s September Board Meeting, the stock market, as represented by the S&P 500, advanced almost 5% after having declined nearly 10% from July 19, when it hit an all-time historical peak. Then, on the afternoon of September 18, the Fed announced not the widely anticipated 25-basis-point reduction in Fed Funds, but a 50-basis-point reduction, along with another 50-basis-point reduction in the Discount Rate. Since then, through early October at the time of this writing, the S&P 500 has advanced another 5% to another all-time record.

Goodbye and good riddance

Credit markets have also begun to normalize somewhat. The commercial paper market has stopped shrinking, and in fact, has begun to see net new issuance. Loans extended by banks to fund private equity leveraged buyouts are being sold to investors after that market had totally frozen up, although that represents only a portion of the $300 billion plus that had been committed, and at prices representing painful discounts for the lenders. Of course, the sub-prime mortgage market has collapsed, probably forever and for good. But in the bond market, some credit spreads have even narrowed a bit after widening substantially during the heat of the crisis.

Of course, whether these concerted actions by the Fed and other central banks will avert a recession remains to be seen. The acceleration in delinquency and default rates on sub-prime mortgages, which sparked the crisis in the first place, most likely will continue to worsen over the next six to nine months. The reason is simple, but startling, nonetheless. The bulk of the sub-prime mortgages outstanding, those originated in 2005, 2006 and into 2007, at initially low “teaser rates,” are scheduled to reset to higher interest rates, requiring higher monthly payments by borrowers who, in many cases, could hardly afford the initial payments, and who will be paying on homes generally worth less than their purchase prices. Meanwhile, sales of new homes have plummeted and, as a consequence, inventories of new homes are running at ten months’ supply, and climbing. That means the housing market will not recover for a long time. The incomes and wealth of millions of consumers will be negatively affected as a result, and that will exert a continuing drag on the domestic economy.

Our belief, however, is that the U.S. economy will muddle through with a couple more quarters of subpar growth before resuming a more robust expansion. We also see the possibility of the stock market trudging higher through the end of 2008, not without ups and downs, but to new highs, nonetheless. We do not expect bond markets to do as well over that period, as necessary monetary easing over the next one to two quarters, and the expected continuing economic expansion beyond then, will create potential inflationary pressure, and, therefore, rising inflationary expectations. Bond prices will fall as interest rates rise, especially on the long end of the yield curve. We believe, however, that credit spreads should remain at current levels, and are more likely to narrow a bit than to widen substantially over the next six to nine months.

Reasons to be hopeful

The reasons for our confidence in this “no recession” scenario remain essentially the same as those discussed in our previous Economic Perspective (August 24, 2007). First, the Fed has clearly signaled that it will use monetary policy as aggressively as needed to prevent a recession. Second, the recent credit crunch occurred at a time of unprecedented growth in the global economy. In that regard, let us repeat a startling statistic: on a year-over-year basis through the end of the second quarter of 2007, only four nations out of 120 that report Gross Domestic Product statistics had grown at a rate of less than 3%; all others had grown at faster rates, and none had negative growth! Third, corporate balance sheets, domestically and globally, remain extremely healthy by historical standards, and corporate profit margins are at peak levels. Corporate profit growth is slowing, but this comes after 13 consecutive quarters of double-digit growth, followed by two quarters of near double-digit growth. We believe profits could conceivably decline over the next few quarters, although not precipitously, and only as a result of a temporary slowdown in top-line growth.

Despite the potential for a short-term slowing of growth in the economy and corporate profits, we believe that many investors will share our bullish, long-term perspective that foresees an eventual continuation of the growth we’ve witnessed in recent years. Consequently, we anticipate that these investors will recognize many stocks as bargains and push stock prices to higher levels. Because stock markets anticipate future earnings, price-to-earnings ratios will, by definition, rise in the interim period until economy reaccelerates and corporate profits advance to new highs.

New (big) kids on the block

There is also another reason for believing stock prices will rise and bond spreads will not widen dramatically, a reason that represents a powerful emerging trend that has only recently become a topic of discussion, namely, the growth of sovereign wealth funds (SWFs). SWFs are pools of excess sovereign reserves that are being set up for active money management in order to diversify a nation’s risk, as well as to improve upon the returns of these reserves. A few such entities have been in existence for years, including the Abu Dhabi Investment Authority, the Government of Singapore Investment Corporation and the Kuwait Investment Authority. SWFs collectively command an estimated $3 trillion in funds currently, and are expected to grow to $12 to $15 trillion over the next decade. That projected amount is equal to one-eighth the size of the entire current global mutual fund market, the current market value of the S&P 500, and almost three times the size of the U.S. Treasury market!

Importantly, these funds represent a totally new and major investor in global markets. Given that most national reserve accounts are invested largely in fixed income securities, and the purpose of these SWFs is to diversify these pools of funds, it is highly likely that an increasing proportion of these new funds will flow to publicly traded equities, private equity deals, commodities, real estate, and even venture capital. Buying in this size by new investors will, at least, put a floor beneath valuations and, at best, a tremendous amount of upward pressure on those valuations. In short, we believe the large liquidity pools that have provided a prop to the stock market expansion over the past half-decade will continue to grow and support upward stock prices. And, of course, a significant amount of this money will likely still be directed toward fixed income assets, helping to maintain historically tight spreads.

We seem to have come through the summer’s financial crisis a bit battered, but basically intact. The key determinant of market action will be, as always, the direction of the economy. While both the domestic and global economies have sustained shocks, they seem to remain sturdy in terms of employment, income, corporate profits and cash flow. Inflation, while a longer-term concern, has moderated recently as growth has slowed. Oil prices remain high, and prospects for significant declines or increases remain murky, and thus represent a risk. China clearly seems to be on its way to assuming the role of “engine of global growth,” with India standing in the wings to play an increasingly important supporting role over time. All things considered, the outlook appears positive for growth and stock price appreciation.

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 they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.

THIRD QUARTER INDEX COMPARISONS

Source: Wall Street Journal

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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 they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.