U.S. financial markets are responding to growing concerns over financial sector losses due to write-offs in the sub-prime lending business, as well as a growing concern of a general economic recession.
Financial sector losses primarily stem from defaults in the sub-prime mortgage market. In a process called securitization, mortgages are sold from a loan originator to an investment bank that then packages similar types of mortgages together in bundles based on risk. The investment bank then issues bonds which are backed by repayment from the mortgages. The riskiest mortgages result in the highest yield bonds. Securitization is far from standardized and many institutional investors do not fully understand the process and how risk correlates with return. An important feature of this process is that risk is spread from the mortgage markets to the bond markets.
As the Federal Reserve began increasing interest rates in 2004, it wasn’t long before mortgage defaults began to rise. The mortgage defaults undermined the value of the bonds and losses for investment banks ensued. Although many people believe greed is the dominant motivating factor in the growth of securitization and the credit crunch we now face, many other factors also apply. The American Dream of home ownership for all classes of people as well as providing opportunities to help people rebuild their credit, are also contributing factors explaining why our economy embraced sub-prime lending.
Most U.S. businesses and households will be acting in a cautious manner with respect to spending in the near future. Federal Reserve estimates for industrial production and capacity utilization figures remain low for most categories (1.5% on average). Exceptions were construction, dropping 2.2% last year and utilities, which increased 6.9% in 2007. Consumer credit outstanding has continued to climb, up another $110 billion in 2007 to a total of $2.5 trillion. Consumers and businesses are also concerned with inflation. For the past three years, 2007, 2006, and 2005, consumer prices have risen 4.1%, 2.1%, and 4.0% respectively. The national unemployment rate rose in December to 5.0%, up from a year earlier measure of 4.4%. The most recent data (Nov. 2007) shows personal income up 0.4%, consumer spending up 0.5%, and personal saving down 0.5%. Concern over these figures is merited but the U.S. economy has faced similar economic challenges before.
The past two recessions were very mild and very short. At the end of 1990, the U.S. was involved in the first Gulf War and had been suffering for quite some time from a very sluggish economy. That recession lasted less than three quarters and saw the unemployment rate rise from 5.6% to 6.8% between 1990 and 1991.
The most recent recession began in 2000. It also lasted less than three quarters. The U.S. economy was in a period of transition due to a great deal of wealth disappearing due to the bursting of the dot-com speculative bubble. It is estimated that perhaps as much as $5 trillion of market value of technology companies was wiped out between March 2000 and October 2002. The unemployment rate increased from 4.0% to 4.7% between 2000 and 2001.
The daunting realities faced during those past two recessions are different from the specific facts observed today. Today, the U.S. is facing slower economic growth in a high-priced environment. Once again the resilience of our market economy is being put to the test.
The major equity indices in the U.S. (Dow Jones Industrial Average, S & P 500, and NASDAQ) are all down nearly 20% from their highs in October 2007. The U.S. fixed income markets have also been impacted. As fears of recession and the credit crisis spread, we are seeing a flight to quality. Money has flowed into fixed income instruments even as interest rates declined. In particular, we saw major inflows into high grade government securities. In 2007, U.S. government fixed income had a better total return than did investment grade corporate debt. Both of the aforementioned asset classes outperformed high-yield debt that barely showed a positive return for 2007.
At the time of this letter, we see U.S. stock markets responding to the concerns outlined above. Many investment banks and other financial institutions are re-evaluating their assets, writing down values, and reporting losses. This process will take some time. Additional volatility can be expected in equity and fixed income markets. In response, governmental authorities are actively engaged in addressing general economic conditions and working to dampen financial market volatility. The Federal Reserve cut interest rates by three-quarters of a percent on January 22 (the fourth cut since September 2007) and the Bush administration and Congress are poised to implement stimulus packages (approximately $145 billion) that include tax rebates. Both fiscal policy and monetary policy are being brought to bear in order to stimulate the sluggish economy and soothe fears brought on by skittish financial markets.
The U.S. federal government and the Federal Reserve are less concerned with inflation for the time being. These authorities are continuing to rely on domestic market forces to eventually bring food and energy prices down to more reasonable levels. These market forces are actively engaged in the process of identifying and securing the vital elements necessary to foster economic growth and price stability. High gasoline prices have served their purpose of preventing shortages at the pump. As alternative energy forms are explored, refined and adopted we can logically expect energy prices to mitigate. Many other prices, such as food prices can be expected to moderate as a result of that.
Abroad, financial market volatility represents a gauging process as those economies assess their overall economic fitness. This international volatility also reflects the importance of U.S. markets to the global economy. Our economy’s ability to simultaneously thwart a credit crunch, stagnation, high prices, and a weak dollar is a testament to the strength and security our markets offer the rest of the world and ourselves. It is our opinion that prospects for the U.S. economy are bright. Short-term fluctuations are expected to give way to a more promising investing climate in the coming weeks. We believe in this prospect because the issues of slower growth and high prices are being addressed proactively by both the government and the marketplaces.
Nobody can know with certainty when the next (official) recession will be. Nobody can know whether the next recession will be mild and short. What we do know is that recessions as a part of business cycles are a reality. We also know that certain asset classes can display volatility as a result from downturns in the business cycle. One excellent way to combat this volatility is through asset diversification. Pension Consultants can help with asset diversification and other advice. We diligently monitor the performance of your investments and consider the risk and return results against the backdrop of overall economic trends. The current economic picture merits attention but not undue apprehension or brashness. As we keep alert in our observations, please let us know if you have any questions or concerns in which we can be of service to you.
Guest Bloggers:
Pension Consultants Inc.
Steven T. Petty, Ph.D.
Senior Research Analyst
Investment Services
David Richards, CFP
Manager
Investment Services
Brian D. Allen, CFP, QPA
President
Pension Consultants, Inc.