October 31, 2008 Commentary
The Economy
On the final Thursday of October, the Commerce Department reported its “advance, preliminary estimate” of GDP growth for the third quarter 2008. It came in at a negative 0.3% annual rate. This figure will be revised over the next two months – but is expected to remain in negative territory. Furthermore, the outlook for the final quarter is unfavorable, thus giving support to the consensus that the U.S. is in a recession. The question facing economists and investors is: “how long will the recession last and how deep will it be?”
Basically, consumers have lost confidence and stopped spending. The Conference Board’s Consumer Confidence Index fell from 61 in September to 38 in October – an all-time low for this 41-year old indicator. Consumer spending now accounts for 70% of our economy, and it fell 3.1% in the third quarter. This represents the sharpest drop since the recessionary period of 1980.
October was tumultuous and historic. Congress partnered with the Treasury Department, F.D.I.C, and the Federal Reserve to introduce a $700 billion financial rescue package that was signed into law on the third day of the fourth quarter. Stalwart names became history – or will change dramatically over the next couple of years. Those names include Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, AIG, Washington Mutual, and Wachovia.
Wall Street has reacted with a downward spiral in equity prices. On September 29, the Dow Jones Industrial Average fell a record 777.7 points when it appeared that the Troubled Asset Recovery Program (TARP) would not pass. In October, the equity picture worsened and global indices plunged. On October 10, the Dow Jones Industrial Average was down 44% to 7774 from its 52-week intra-day high of 13,963. We discuss equities in our Stock Market section below.
At the end of September, the Labor Department reported a ninth consecutive monthly loss of jobs. That report showed a loss of 159,000 non-farm jobs and an unemployment rate of 6.1%. While the country is not losing jobs at the 1990-1991 recession rate of 200,000 to 250,000 jobs per month, these numbers could appear as we close out the year. An unemployment rate at the 7% level will result in a further decline in consumer confidence and an increase in mortgage defaults. On a positive note, oil prices (NY Mercantile Exchange) fell 33% in October.
Housing continues to be a drag on the economy. Sales of new homes rose 2.7% in September, but were down 12.7% in August. More stringent qualifications for potential buyers will also have an impact on housing. Sales of previously-owned homes also rose in September, but there is a 10-month inventory of unsold homes. As we
have noted in the past, this inventory will have to get back to the historical norm of 4-5 months before housing starts begin to show an increase.
According to the Office of Federal Housing Enterprise Oversight, home prices fell 4.8% between August 2007 and August 2008. This is the largest decline in the 17-year history of that index. The S&P/Case-Shiller Home Price Index (a broader range of home price changes in 20 major markets) was down 16% during the same period.
As we approach the end of 2008, the consensus among economists and analysts is that there is a greater than 50% chance that the country is in a recession. There is a lack of confidence in the U.S., and the malaise is spreading throughout the world markets.
Stock Market
Markets continue to be volatile, and the negative equity performance for the year is noted below. During the first week of October, and after passage of the financial rescue plan, equity markets continued to decline. By the end of October, the S&P 500 Index was down 33% from the beginning of the year.
Equity Total Return Performance as of October 31, 2008
| |
|
October 2008 |
 |
Year-to-Date |
|
|
|
| S & P 500 |
|
-16.79% |
|
-32.84% |
|
|
|
| DJIA |
|
-13.88% |
|
-28.18% |
|
|
|
| NASDAQ |
|
-17.69% |
|
-34.68% |
|
|
The collapse in equity prices has not been limited to the U.S. Standard & Poor’s global indexes have lost a record $6.8 trillion this year. At the end of October, all major international indexes were in negative territory and the EAFE (the standard international benchmark index) was down 45% for the year.
Estimating corporate profits continues to be a challenge. Acknowledging the murky area of potential write-downs in the financial industry, we currently feel the S&P 500 can earn $90 per share in 2009 and trade at 15-16 times estimated earnings – or 1400 by this time next year. The Financial sector accounts for approximately 15% of the S&P 500 Index and as news headlines proclaim, the industry is in a state of flux. Leaders in the industry and in government are taking action. No one knows the future; however, history provides a guide and we know from the past that economic and stock market cycles have not been eliminated.
These are challenging times for investors. However, it is times like these that may also present opportunity. Maintaining a long-term view is essential, and we continue to look for companies that have demonstrated an ability to grow, have under-levered balance sheets, and have above-average earnings and free cash flow yields. Diversification, quality, and portfolio review are most important during these times.
Fixed Income Market
The Treasury market continued to outperform other fixed income sectors in October as the “flight to quality” persisted. Mid-month, the credit crisis reached its climax, as spreads on corporate bonds, agencies, mortgage-backed securities and municipals gapped out, some to the widest spreads on record.
However, the news in the credit markets was not all bad and by month-end, there was some material improvement in the short end of the yield curve. The three-month Libor rate fell from 4.80% on 10/10/08 to 3.02% on 10/31/08. Government programs like the Commercial Paper Funding Facility also appeared to produce positive results.
Monthly and year-to-date index returns are presented below:
| Fixed Income Total Return Performance as of October 31, 2008 |
 |
|
|
|
|
| |
|
October 2008 |
|
Year-to-Date |
|
| Lehman Municipal Bond Index * |
|
-1.02% |
|
-4.18% |
|
| Lehman Aggregate Bond Index |
|
-2.36% |
|
-1.74% |
|
| Lehman Gov’t/Credit Index |
|
-2.51% |
|
-3.16% |
|
| Lehman Intermediate Gov’t/Credit |
|
-1.37% |
|
-1.15% |
|
(Source: Lehman Bros. Indices)
With the existing market turmoil and roll out of several government programs, significant market opportunities exist.
We advocate moving from a neutral duration to a 95% duration stance (that is, slightly shorter than the relevant benchmark). We suggest aggressively adding to spread product (i.e., bonds other than Treasuries), including investment grade corporate, high yield, leveraged loan, MBS, agencies and longer term municipals.
We suggest a significant underweight to nominal Treasuries, but advocate a TIPs position where appropriate.
Closing
While acknowledging the potential for a recession, there is also the other “R-word”; namely, Recovery. Historically, recessions last two or three quarters and then rebound. Lower interest rates, realistic valuations, appropriate government intervention, and an end to the election uncertainty should contribute to a turnaround in the economy and capital markets. More information about MTB Investment Advisors’ investment process, capabilities, and solutions can be found at our website, www.mtbia.com.
Past market performance is no guarantee of future results.
Index performance cited is for illustrative purposes only and is not indicative of the performance of any specific investment. It is not possible to invest directly in any index.
