Third Quarter, 2008

 

The economic picture has been clarified substantially since this time last quarter.  Three months ago, concern about declining growth was being weighed against fears of inflation, and a mortgage meltdown was still not translating into worrisome levels of job losses across the broader economy.  As of this writing, the financial and economic downturns are clear enough, and concern about inflation has faded away amid declines not only in oil and commodity prices, but across many consumer goods.

In the span of three short months, we have experienced either the failure, or some sort of rescue, of IndyMac, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, AIG, Washington Mutual, and Wachovia.  The credit crunch is starting to translate into a real economic slowdown.  We have seen 760,000 jobs disappear year to date, with more expected in the fourth quarter. 

The credit crisis is a result of both a loss of trust among institutions and of insufficient capital in the banking system.  The government has taken extraordinary measures.  The Federal Reserve and the U.S. Treasury Department have injected liquidity into the economy and capital into the banking system, bought up commercial paper, reduced interest rates, raised FDIC limits, and more.  We believe these measures will work to ease the credit crisis.  However, we also believe that the damage has been done to a certain extent.  Reductions in business investment, declines in individual spending, and local and state government budget cuts will likely project the economic downturn well into 2009. 

Equities

The Russell 1000 recorded its fourth straight quarterly decline in the third quarter.  All of this came in September, when the large cap index declined by 9.5%.  When combined with volatile but ultimately modest index changes in July and August, the Russell 1000 declined 9.4% for the quarter.  Small caps held up better, as they did last quarter, and the Russell 2000 was down only 1.1%.  For the year to date, the Russell 1000 was down 19.5% while the Russell 2000 was down 10.4%, although these numbers got significantly worse early in October.  The strongest sector in the broad market Russell 3000 index was consumer staples (up 5%) followed by financial services (up 3% despite several high profile failures).  Energy and basic materials (both down 26%) were the worst performing sectors, as the commodities boom abruptly ended in July, and prices declined for the rest of the quarter.

International markets declined in response to both the spreading credit crisis and concern about a worldwide economic slowdown.  Returns in dollar terms were negatively impacted by a strengthening dollar as well.  The dollar rose 12% versus the Euro and the British Pound (although it was unchanged versus the Japanese Yen).  International large cap stocks, as tracked by the MSCI EAFE index, declined by 20.5% in dollar terms, while small caps, using the S&P Developed ex-U.S. Small Cap benchmark, declined 23.7%.  The best performing sectors in the EAFE index were health care (-8%) and consumer staples (-9%), while the worst performing were energy (-30%) and materials (-39%), which were hit hard by the unwinding of commodity prices.  Similarly, the worst performing countries were resource-reliant areas such as the emerging markets.  Russia was down 48%, and Brazil by 38% in dollar terms.

Fixed Income

Credit markets further deteriorated during the course of the third quarter.  In July, Fannie Mae and Freddie Mac faced imminent bankruptcy, and the government came to the rescue with a bill allowing the Treasury to step in if needed, which it was.  However, the government allowed Lehman Brothers to fail and the credit markets went into a tailspin.  Money poured into Treasuries, with short term Treasury rates even dipping into negative territory for brief periods.  Borrowing costs soared for those who were still able to borrow and spreads over Treasuries jumped sharply.  On single-A-rated bonds, for example, the spread widened to 4.9%, from 2.9% at the start of the quarter.  Although the Federal Reserve did not touch rates during the quarter, it dropped the Federal Funds target rate shortly after quarter end, from 2% to 1.5% on October 8th. 

The Economy

The projected severity of an economic downturn in the U.S. has increased since last quarter.  Recent data continues to point to a worsening economic climate, and there is little sign yet of a turnaround in housing, which started the decline in the first place.  Housing starts fell to a 17-year low in September, falling to 817,000 according to the Commerce Department, below the consensus estimate.  Housing starts have fallen from a peak of 2.3 million in January 2006, and prices are off by 18% since the high, according to the National Case-Shiller Index.

GDP growth in the second quarter was slightly lower than expected, but at 2.8% on an annualized basis, it was better than the fourth quarter of 2007 and the first quarter of 2008.  Unfortunately, the increase was likely temporary.  Looking ahead, the consensus view includes a decline in exports as the global economy slows, a decline in consumer spending due to a fall in household wealth and more difficult access to credit, and a fall in business investment.  Offsets include a smaller negative contribution from housing because housing’s overall share of GDP has now declined, and a positive effect from lower energy prices.

Inflation was 4.9% year over year, down from 5.4% in August.  In fact, there was no change in the CPI from August to September.  Almost all categories are seeing inflation retreat, except food costs, which continued to rise.  The expectation is for inflation to be of little concern in the near term.

Summary

A rebound continues to be dependent on improvement in housing and in the financial services sector.  Even so, any economic recovery is likely to take time, given the negative business and consumer sentiment that has taken hold.  Bold actions are being taken by governments worldwide, and as of this writing there are very preliminary signs that credit conditions are starting to improve.  One hopeful sign is a decline in the London interbank rate, bringing it closer to the rate on Treasuries.  The difference between these rates – the so-called TED spread – has been at historically high levels lately.  While the economic bottom is clearly still ahead of us, we hope that the stock markets will begin to anticipate a recovery sooner rather than later.

 

The statements and opinions expressed in this commentary are those of the author and Franklin Portfolio Associates, LLC as of the date 0f this article. The information regarding economic or market trends or the factors influencing specific sectors or comparing performance are statements of the opinions of the author and are not a recommendation of any security. Past performance is no guarantee of future results. This commentary does not constitute investment advice.