Forth Quarter 2007 - Market Commentary
Economy
The fourth quarter was marked by a continuation – and deepening - of the credit turmoil that bubbled up in the previous quarter. Liquidity issues resulting from the subprime fallout caused an economic slowdown that is likely to border on being recessionary, and continue into at least the first part of 2008. The consensus estimate for GDP growth in the fourth quarter is approximately 1%, and 2.5% for the entire year.
The effects of the crisis were widespread. Mortgage lenders were not the only ones hit hard; large money center banks and investment banks – big investors in securitized packages of mortgage obligations – announced multi-billion dollar write-downs of these assets on a weekly basis. Significant write-downs at Citigroup and Merrill Lynch cost the CEOs of those firms their jobs.
The Fed lowered rates twice in an effort to boost the slowing economy and to avert a recession. The Federal Open Market Committee (FOMC), the Fed’s policy-making arm, lowered the federal funds rate from 4.75% to 4.25% during the quarter, and has dropped rates by 1.00% since the reduction program began in September. The Fed also announced shortly after its December meeting that it had put together a consortium of international central banks to free up credit to a tight market. The plan called for the central banks to make available up to $40 billion for other banks to borrow at favorable rates. The availability of liquidity in the system does not seem to be much of an issue; financial institutions’ willingness to lend the funds appears to be more of a concern. Such reluctance likely will only be overcome through the passage of time.
The dollar continued its downward spiral relative to other currencies. There are both positive and negative implications of the declining dollar. On the positive side, the dollar’s decline makes it easier for US manufacturers of goods to compete effectively against countries with lower labor costs, helping our trade imbalance. Negative implications include less foreign appetite for owning dollar-denominated assets, which may eventually prompt foreign central governments – large holders of US government securities – to scale back their investments.
The housing sector also continued to deflate. According to economy.com, the volume of existing home sales is off as much as 40% since the beginning of 2006. Many economists and housing analysts believe the workout of the housing problems will continue through most of 2008, with prices not leveling off until sometime in 2009. Indeed, the latest home price data available shows that prices in 10 major metropolitan areas in October were down 6.7% from a year earlier, marking the largest year-over-year decline on record.
Inflation is expected to remain benign into 2008. The “core” component of the Consumer Price Index (i.e., CPI ex-food and energy) jumped more than had been expected in November, but this is likely to be a temporary blip because of slowing economic growth.
The risk of recession remains elevated. Consumer and business confidence is eroding. In the fourth quarter, some measures of consumer confidence hit their lowest levels since the early 1990s. Business investment is also lagging, endangering continued expansion. Perhaps the biggest threat to sustained economic growth is the housing situation. Economy.com estimates that the housing recession will eliminate an estimated $2.5 trillion in household wealth. A continued housing recession is the most significant threat to the economic expansion.
Interest Rates
As one might expect, bonds continued a strong recovery in the fourth quarter, primarily due to the expectation of the Fed’s accommodation in order to sustain growth. There was a significant divergence between the performance of taxable and municipal bonds. In the taxable universe, yields across the maturity spectrum declined dramatically in the quarter: the yield on the 2-year Treasury fell from 3.97% to 3.05%; the yield on the 5-year note declined from 4.23% to 3.44%; the yield on the 10-year note dropped from 4.59% to 4.03%; and the 30-year long bond saw its yield slip from 4.83% at the beginning of the quarter to 4.45%.
Municipal bond issues, however, did not fare as well as taxable bonds. At best, yields were unchanged during the quarter, reflecting the softening in the economy. Composite yields on 2-, 5-, 10- and 20-year ended the quarter approximately 0.10% to 0.30% higher. The significantly expanded spread between taxable and municipal yields has many investors looking for opportunities in select municipals.
U.S. Equity Markets
The uncertainty engulfing the overall economy marked a volatile quarter for equities. All-time highs were established in many of the major indices early in the quarter based on expectations that the Fed’s actions would prove to be the antidote for the subprime mess. However, the depth of the credit market’s problems quickly became evident, and the stock market’s foray into record territory was followed almost immediately by what has come to be known as an “official” correction of 10% during the quarter. It was the first correction since the current bull market began in the third quarter of 2002.
The fourth quarter witnessed a continuation of the relative outperformance of Large Cap stocks over Small Caps, and Growth over Value, typical for this point in the economic and market cycles. The Russell 1000 index declined 3.23% for the quarter and gained the 5.77% for the year, while the Russell 2000 index of Small Cap stocks posted a decline of 4.58% for the quarter and lost 1.57% for the year.
The financial sector remained the poorest performer on a relative basis in the fourth quarter, as well as for the entire year. Consumer services stocks, in particular the home improvement retailers, also fared poorly in the quarter as the housing recession has dampened consumers’ willingness to spend.
As we have been anticipating, the recent decline in stock prices, particularly in the financial sector, is beginning to attract savvy investors seeking bargains. Many solid companies with strong franchises have seen a precipitous drop in the value of their stock, and contrarian investors are taking advantage. Three recent cases indicate that the stock market may be stabilizing. First, the investment arm of the government of Abu Dhabi invested $7.5 billion in Citigroup preferred shares, making the Arab emirate the bank’s largest individual holder. Citigroup shares have declined significantly this year, and analysts have touted the Abu Dhabi investment as a bargain. In a second situation of a deep-pocketed investor seeking to exploit low stock prices, Citadel, the large Chicago-based hedge fund, agreed to invest $2.5 billion in E-Trade, which has been beleaguered by its subprime loan portfolio. Finally, Merrill Lynch received an infusion of $4.4 billion from Singapore’s investment arm, Temasek, at an extremely favorable valuation. Expect to see more such deals involving sharp investors, particularly if the market continues to have difficulty finding its bearings.
Domestic and international equities fared similarly in the fourth quarter and for the full year. International developed markets, as measured by the MSCI EAFE index, declined 1.71% in the fourth quarter, resulting in a total return for the year of 11.63%. Emerging markets continued their strong relative performance in the fourth quarter, posting a gain of 3.66%. For the year, emerging markets gained 39.78%.
Looking Forward
The question most investors are asking at this point is: will the troubled housing and mortgage industries take down the economy? The underlying key is consumer spending, which makes up 70% of the economy. The contraction in the housing-related industries has a direct impact on employment and spending, but it is the related credit crunch and its impact on spending that could cause the most damage.
The impact of hundreds of billions of dollars in loan losses to banks, hedge funds, and other investors means less ability to lend, because lenders have less capital. It also means less willingness to lend because they are unsure about the borrowers (including other financial institutions, because the lack of transparency makes it difficult to assess bad debt exposure) and because they have to keep high quality assets (cash) on their balance sheets to cover their own potential losses. Additionally, capital has increasingly come from outside the banking system (hedge funds, non-bank financial institutions, and other unregulated investors through a variety of “structured” vehicles), making it tougher for the Fed to restore confidence and liquidity. It is worth noting that because of global capital markets, the pain has spread beyond the U.S. and is being felt in the European financial markets.
The problem is that it is difficult to quantify the losses and impossible to confidently forecast how restrictive credit will be and for how long. There is also fear that credit problems will spread to other areas, with credit cards being one area of concern because of permissive underwriting standards. At this point it seems pretty clear that banks will have more write-offs over the next few months or quarters and that structured investments (securitized pools of debt), which are often highly leveraged, will suffer through more ratings downgrades as collateral values decline further. It is also very likely that lending practices will be generally more conservative, suggesting slower growth in credit for a sustained time period. A predisposition to conservative lending will make the Fed’s job harder. This suggests that the current trend of less credit and higher costs probably has a way to go. This is true not just in the mortgage market (subprime and prime) but in the consumer and small-business loan market as well.
It is easy to dwell on the negatives and this is a common investment mistake that we’ve seen (and sometimes made) over many years. It is not a foregone conclusion that the negatives will drag the economy into recession—though some slowdown seems quite likely. Although the employment market is showing some signs of slowing (unemployment claims are starting to rise), it remains healthy. Corporate earnings outside of the financial sector are still growing. Emerging markets continue to thrive and are a positive for the global economy. A weaker dollar has helped support a boom in U.S. exports. The Fed and other central banks are aware of the economic risks and are using interest-rate policy and other measures to improve liquidity. They will not stop until they have an impact, though how quickly this will happen and how successful they will be is not yet clear. Overall, global liquidity remains strong with large foreign exchange reserves and huge growth in sovereign wealth funds (government controlled investment funds created to invest foreign exchange reserves). There are already some tangible examples of available liquidity, including recent investments in major but troubled financial institutions (Morgan Stanley, Merrill Lynch, UBS, Citigroup, and Bear Stearns) by Chinese, Singaporean, and Middle Eastern investors. As we weigh the information we have, we know we can’t confidently predict how the macro picture will play out. However, we believe the odds of a meaningful slowdown or even recession have moved sharply higher from a few months ago.
As you know, investment decisions really need to be made on a multi-year outlook. This allows investors to focus on underlying fundamentals and valuations—the factors that ultimately drive returns—and distance themselves emotionally from the day-to-day “noise” of the markets and the financial media. Over shorter time periods these relationships—between fundamentals, valuations, and returns—don’t always hold. This is the point made in the legendary Benjamin Graham saying “In the short-term the market is a voting machine but in the long-term it is a weighing machine.” We could not agree more.