First Quarter, 2008

 

The U.S. credit crisis has been a slow motion train wreck that began in June 2007 with the announcement of significant losses in two Bear Stearns hedge funds from exposure to sub-prime loans and that led to large write-downs among the largest financial firms by the year’s end.  This quarter the damage continued with the near-bankruptcy of Bear Stearns itself, leading to a weekend sale of the firm to JP Morgan Chase.  In the face of the ever-widening crisis, the Federal Reserve has moved from making relatively small cuts in the Federal Funds Rate (two 25 basis point cuts in the fourth quarter of 2007) to doing whatever it takes to avert a derailment – including cutting Fed Funds by a total of 200 basis points in the first quarter, broadening and increasing liquidity programs, making financing available to non-bank primary dealers, and assisting in JP Morgan’s acquisition of Bear Stearns by lending and taking the principal risk on $30 billion (initially) of Bear Stearns’ securities.

Outside of the financial markets the broader economy, which was already showing troubling signs in terms of falling housing prices, declining expectations for corporate earnings, and inflation in commodities, energy, and food, added more fuel to the fire when shortly after quarter end the labor department announced that approximately 250,000 jobs were lost in the first quarter, and unemployment was up from 4.4% at last year’s low to 5.1% in March.  Although a falling dollar and rising exports have helped to provide a bit of a tailwind to offset the domestic economic decline, the slowing global economy will dampen this effect in 2008.  It seems inevitable at this point that the U.S economy will suffer a recession, but if the Federal Reserve is able to resolve the credit crisis and the financial system eases, thereby injecting liquidity into the system and lowering private sector interest rates more in line with the decline in Treasury rates, any recession may yet prove to be relatively mild.

Equities

The markets fell sharply in January, ending the month down across all market segments.  Despite two significant rate cuts by the U.S. Federal Reserve, the market became increasingly concerned about the risk of a recession in 2008, and continued turmoil in the fixed income markets increased investor concerns.  The S&P 500 large cap index fell 6% by January month end.  The U.S. markets continued to decline in February as growth appeared to have stalled in the U.S. and many analysts began predicting negative growth in the first quarter of 2008.  At the same time, inflation became an increasing concern, with the consumer price index registering a 4% year-over-year increase.  The Federal Reserve continued to signal that it intended to keep cutting rates to counteract the negative effects of the mortgage meltdown, despite the increasing inflation risks.  The market reached its low on March 10th, at which point the S&P 500 was down 18.6% from its October peak.  The market has rebounded several percent since then, narrowly avoiding the dubious milestone of an official bear market during the quarter (a 20% peak-to trough decline).

In the first quarter, large cap stocks continued to outperform small cap stocks as they had in 2007, although the spread was narrow.  The Russell 1000 declined 9.5%, while the Russell 2000 declined 9.9%.  In a reversal from last year, however, value outperformed growth in the first quarter, as the Russell 1000 Value index returned -8.7%, versus the Russell 1000 Growth’s return of -10.2%.  This difference was even more pronounced among small cap stocks, as the Russell 2000 Value index declined 6.5%, versus the Russell 2000 Growth’s loss of 12.8%.

In international markets, the MSCI EAFE benchmark net return was –8.9% for the quarter in dollar terms.  The small cap S&P /Citigroup EMI (Extended Market Index) held up better than the large cap benchmark, returning –6.9% for the quarter in dollar terms.  Major currencies gained relative to the U.S. dollar, coincident with soaring commodity prices and an emergency interest rate cut in the U.S.  For the quarter the Swiss Franc was up 14.5%, the Euro was up 8.4%, and the Japanese Yen up 12%, while the British pound was flat with a return of 0.2%.  In dollar terms, the Pacific and Far East regions were the weakest performers.  In EAFE, the Pacific region (Australia and New Zealand) was down -11.8% and the Far East (Hong Kong, Singapore) declined by -15.3%.  Even the best performing regions, Europe and Japan, underperformed by nearly -8%.  Performance in the S&P EMI benchmark was similar.

Fixed Income

The credit crisis continued in the first quarter despite the Fed’s efforts to inject liquidity into the system.  Exhibit A was Bear Stearns, which collapsed after suffering a liquidity shortage, despite continuing to have a reportedly strong balance sheet.  Banks continue to mistrust each other’s collateral and deleveraging is ongoing - sometimes orderly, sometimes disorderly.

Fixed income returns suffered as spreads widened considerably during the quarter, with junk bond yields increasing from approximately 6% over treasuries to 8% over treasuries by quarter end.  Despite defaults remaining low in the market, there were very few deals done.  In investment grade bonds, the increase in spreads was closer to one percent. 

The Federal Reserve cut the Federal Funds Rate three times during the first quarter by 75, 50, and 75 basis point steps.  Longer term yields also fell during the quarter, although not as much, as the 10-year Treasury yield dropped from 4.03% at the end of the fourth quarter to 3.45% at the end of the first quarter.  The resulting steeper yield curve should be favorable to financial institutions and eventually help to encourage them to expand credit.

The Economy

Consensus is building that the U.S. will enter a recession in the first half of 2008.  Although Fed Chairman Ben Bernanke, in testimony to the a congressional committee on April 2nd, was not yet ready to concede defeat, he did note that "It now appears likely that real gross domestic product will not grow much, if at all, over the first half of 2008 and could even contract slightly.”  He added that he believes the economy will rebound in the second half of the year.

Recent data on the main drivers of the U.S. economy have not been encouraging.  Consumer spending has slowed to close to zero, with a 0.1% increase in real consumer spending in January and no change in February, while shipments of capital goods excluding defense goods and aircraft were negative in the first two months of the year.  At the same time, housing prices and stock market wealth are continuing to fall, making a near-term rebound of consumer spending unlikely.  Consumer confidence as measured by the Conference Board reinforces this expectation, as the reading fell by 12 points in March, the first double digit decrease since 1991.

Nevertheless, there is reason to believe that as long as the financial sector returns to some semblance of normalcy, the U.S. economy can correct itself relatively soon.  Although there was much talk and fear of stagflation during the first quarter (due to rising costs of food, energy, and commodities), there is little evidence of a rise in wages or of a broad expectation of rising price levels which would allow a systematic inflation to manifest itself.  The first quarter of 2008 is expected to be the weakest quarter of growth for wages and salaries since 2003 according to economy.com.  Also, the housing glut which has been driving the fall in prices seems likely to improve as a slow down in new housing starts is helping the new listings relative to sales ratio, and inventories have started to come down.  Additionally, the government’s fiscal and monetary stimuli should begin to take effect and impact the rate of spending and borrowing in the economy.

Outside the U.S., the global credit crisis is crimping investment, but in most cases growth is expected to moderate but not turn negative.  While the prospects for recession in the euro zone are slim compared to the U.S., the U.K. is suffering housing price declines and resulting declines in consumer confidence along with the U.S., making prospects there dimmer than in the rest of Europe.  Nevertheless, the U.K. has less exposure to sub-prime and employment is still growing, and so it is also more likely to avoid recession.  The Bank of England is projecting 1.75% GDP growth for 2008.  Japan is suffering sluggish household consumption and although exports have continued to be the main engine of growth to date, there are troubling signs of slowdown which may cause growth – already below 1% in the last quarter of 2007, to slow further.  Finally, China and India are expected to continue to see strong growth in 2008, albeit perhaps in the high single digits rather than double digits, with the Asia Development Bank and the World Bank recently releasing estimates of 7-8% growth for developing Asia.

Industries & Sectors

In the large cap Russell 1000 index, the best performing sectors in the first quarter were transportation, consumer durables, consumer staples, and materials, while technology and telecommunications performed worst.  In small caps, the picture was similar, as the best performing sectors in the Russell 2000 index were energy, transportation, and consumer staples, while the worst performing sectors were telecommunications and technology.

Outside the U.S., sector performance was also similar, with telecommunications and information technology performing worst.  This was true across regions with the exception of the relatively small Pacific region, in which these sectors outperformed the broader benchmark.  Materials and consumer staples held up best internationally, not dissimilar to the stronger sectors in the U.S.  Only in Japan and the Far East regions did the materials sector underperform the broader index.

Summary

With the sharp market declines of the first quarter, fear has clearly trumped greed in the period.  A rebound will be dependent on calming those fears and resolving the root source of the current concern, which is the stability of U.S. financial system.  If liquidity returns and the Federal Reserve’s actions trickle down to the private sector, the economy should begin a rebound on credit availability and lower private sector interest rates.  Most analysts do not expect this to occur in the second quarter, however, and even the optimists are looking ahead to the second half of the year for signs of progress in the economy.

 

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.