June 5, 2008
JUNE 2008 COMMENTS - END OF THE SPRING THAW?
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Equity prices retreated in May after a powerful rally that began in March which carried the Dow Jones Industrial Average up almost 10% from the low. The May sell-off was against the backdrop of soaring energy, commodity and food costs. The Federal Reserve, while still cognizant of having to deal with economic weakness, has now signaled that interest rate cuts are substantially behind us. The Fed is eyeing warily the increasing cost of goods, worrying that systemic inflation may be developing. A side effect of announcing that the rate cut cycle is nearing an end was short-term improvement in the U.S. Dollar. Higher interest rates often result in a higher dollar which would tend to cool some of the commodity price surge of recent.
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While defending against inflation is clearly important for the stock and bond markets, there is scant evidence that we are out of the economic woods yet with respect to weak growth. The lower dollar has triggered an improvement in our trade balance and overseas demand has been aiding the manufacturing sector. This is fending off a poor showing by the U.S. consumer. Home prices continue to fall sharply with the Case Shiller Home Price Index tumbling 14.4% in March on a year-over-year basis. Clearly housing is not the ATM it once was and the consumer is turning to more unconventional methods of borrowing such as revolving credit. Revolving credit was up 7.9% in March to $957.2 billion with delinquencies rising to 4.86%. This trend is not sustainable
POLITICAL RESOLUTION OR MORE UNCERTAINTY
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Adding to the economic stew is the uncertainty in the political arena. The candidates have been chosen and platforms are being developed. Certainly one candidate is proposing a number of initiatives that will need to be paid for with higher taxes. We suspect that would come in the form of higher personal tax levels, a higher dividend and capital gains tax rate and probably some revision of the estate tax rates. All of the above are not positive for an already weak economy. While we expect this presidential race to be closer than some are now predicting, we are keeping an eye on the potential impact of a sharp turn in tax policy on the economy and the financial markets.
THIS MONTH'S FOCUS - CROSS-CURRENTS IN THE BOND MARKET
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The most fundamental change in the banking system and credit markets for years, if not decades, continues to be the Federal Reserve's hitherto unprecedented action of arranging the sale of a "non-bank" investment bank-i.e. Bear, Stearns & Co.-to the J.P. Morgan Chase commercial bank. This was done to preclude perceived systemic difficulties throughout the global financial system, and some stability appears to have been achieved. With this seminal event as a backdrop, there continue to be many cross-currents in the bond market.
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The reasons why bond prices may rise, and yields decline, center on housing, energy and employment, which are combining to slow the economy. The latest inventory data indicates 5,008,000 homes for sale, little changed from the peak of 5,100,000 last July. Some estimate a more normal inventory level would be in the area of 3,000,000, so there is an "overhang" of about 2,000,000 homes. In terms of energy, at today's level of $125, the price of oil has doubled since last March. This situation is particularly worrisome for airlines (reported to be losing $60 per passenger), autos (changing production from trucks to less profitable cars), and retailers. The employment situation is also problematic, with a decline of 260,000 jobs from December, 2007 to April, 2008 (and the estimated loss of an additional 60,000 jobs for May, 2008 to be reported this Friday). Finally, there is always the prospect of "flight to quality" buying of Treasury securities because of unforeseen events.
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On the other hand, reasons why bond prices may decline, and yields increase, center on concern about inflation, as well as the outlook for Fed policy and the level of rates. For the month of April, 2008, the year-over-year growth rates were 3.9% and 6.5% for CPI and PPI, respectively. Those with an optimistic outlook on inflation suggest that a slowing economy will reduce inflation, although stubbornly high commodity prices may make this scenario more difficult to achieve. Many market participants believe the Fed is now "on hold" through the end of 2008 with respect to further reductions in the Fed Funds rate, which has already been cut from 5.25% to the current 2% level. An additional reason for the Fed's possible status quo stance at year-end could be their desire to appear neutral around the time of the Presidential election. Finally, current interest rates are not historically cheap, with the benchmark 5-year Treasury yield still well below the 3.70% mid-point of its range for the past year. As a result of these conflicting factors, our preferred duration for most portfolios is approximately equal to the benchmark until the outlook becomes somewhat more clarified.
We welcome your thoughts and opinions on this Monthly Commentary and would appreciate your suggestions for topics to be covered in future issues. Please contact your Portfolio Manager or e-mail info@beacontrust.com.