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Second Quarter 2008 |
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The Fed at an impasse
The Federal Open Market Committee (FOMC) lowered its Federal Funds rate by 25 basis points early in the second quarter to a rate of 2.00%. The move was generally in line with investors’ expectations. However, in June Chairman Bernanke acknowledged that inflation was becoming an increasing concern for the Fed despite a benign reading of 2.1% for the Core PCE Deflator, the Fed’s preferred measure. Bernanke noted that the weak dollar was causing Americans to import inflation, particularly in the form of oil and its attendant effects on other goods. Toward the end of the quarter the Chairman again stated that the forces of inflation “remain high,” hinting that the Fed may take action to prevent this threat. As a result, the Fed did not lower rates further at its June 25th FOMC meeting. As we embark upon the third quarter, the Fed finds itself in a difficult position: any attempts to strengthen the dollar, outside of jawboning, would likely hurt an already weak economy. However, the futures markets show that most investors are now expecting an upward adjustment to the Fed Funds rate of 25 basis points in August, an unlikely move in the near term in our opinion.
The Consumer to slow down
We continue to view inflation as less of a threat than consensus, despite current weakness in the U.S. dollar. It is the financial health of consumers that exhibited continued slowing during the second quarter while wages remained stagnant and job creation declined. This trend will lower pipeline demand and likely reduce inflationary pressures. Readers of this periodical know that the housing market has been a source of stress for consumers, which has led to a more worrisome trend in recent months. At the beginning of the quarter consumers had a record $957 billion in credit card debt, a full 8% more than the same period last year. This year 18% of American workers had taken out loans against their 401(k) plans compared to just 11% a year earlier. In fact, a new industry has flourished to help consumers extract cash out of traditionally long-term illiquid assets such as life insurance, structured settlements, and home equity. For the first months of 2008, reverse mortgage lenders originated over 40,000 loans, nearly 10% more than a year ago. All of these actions represent “last resort” financing because of their incredibly high opportunity costs. The spending patterns of many consumers may indicate near-term subpar consumption, thereby reducing upward pricing pressures on goods and services.
Financial Sector - better but not well
Financial companies from commercial banks, investment banks, and hedge funds remain in, to borrow a healthcare term, “guarded condition.” As investors prepare for the promise of a new quarter, many large financial firms continue to raise large amounts of capital, often to the detriment of stockholders. This quarter saw sudden shakeups in more financial institutions such as Wachovia, Lehman Brothers, and AIG. Optimists cite this activity as the healthy deleveraging which will allow firms to purge risky assets and set the sector up to move forward once again. We believe that this view is premature. Top line revenues might be weak for some time to come. GDP is now running at an estimated 1% and non-financial corporations are holding historically high inventories and facing weaker profits. This delay may push more financials to consolidate before they slowly return to profitability with the rest of the economy.
The Bond Market exhibits volatility
The bond market, as measured by Lehman’s Intermediate Gov’t/Credit Index, fell -1.53% for the quarter. On a relative basis, corporate and agency bonds outperformed U.S. Treasuries for the quarter as investment grade corporates surged ahead in April and May, despite suffering a substantial give-back in June. Intermediate term U.S. Treasuries slid in value during the quarter leaving the 10-year at 3.97%, up over 50 basis points for the quarter. Interest in corporate debt began to surface in the second quarter. Trading in spread product had been exceptionally light for almost six of the previous months. Companies that rely on the credit markets for funding found ample opportunity to issue debt during May, which posted a new record for issuance. In many cases new investment grade bonds were oversubscribed, helping to compress spreads. A sustained shift back to corporate bonds will likely reduce price support for U.S. Treasury debt. The U.S. Treasury market has been the major beneficiary of market anxiety. Ironically, this shift in credit demand has not been followed by credit availability of major banking institutions. The Federal Reserve’s survey of senior loan officers showed that bank lending standards for businesses are near historically conservative levels. The divergence in trends among two important sources of capital demonstrates the benefit of modern financial markets. The decreasing incentive of banks to extend credit is best attributed to weak capital levels of even the most conservative institutions.
Conclusion and Outlook
We believe that portions of the economy are continuing to make good progress as evidenced by the renewed liquidity in the corporate credit markets. However, other factors such as household financial health and high energy and food costs will continue to be drags on the economy for the next several months. The Fed may want to turn its focus back on inflation, but it may be challenged by the need to prop up definitive signs of economic weakness at the same time. Without a clear bias by the Fed, the bond market should languish at current levels for the time being.
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Any sectors, industries, or securities discussed herein should not be perceived as investment
recommendations by Rorer Asset Management. The views expressed represent the opinions of Rorer and
are not intended as a forecast or guarantee of future results. The securities discussed in this
commentary may no longer be held in an advisory account’s portfolio. It should not be assumed that
any of the security transactions listed were or will prove to be profitable, or that the investment
recommendations we make in the future will be profitable.
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