By Bill Knapp and Tony Elavia
Asset values, from equities to commodities to high yield bonds, tumbled during the
3rd quarter with the exception of treasury bonds. Concerns over the credit crisis
lay at the heart of these markets’ malaise as central banks and governments
moved to ease the credit seizure. Continued housing market troubles and
persistently high year over year energy prices compound the situation bringing the
US and much of the world to the brink if not the initial stage of recession.
The Economy
GDP managed to grow 2.8% in the 2nd quarter aided by the government stimulus
plan and robust exports1. Growth in the 3rd quarter will certainly weaken but
should remain positive given continued trade and consumer rebate growth
momentum. Positive growth in the 4th quarter, though, is in doubt given the
deceleration in growth at the end of the 3rd quarter.
Housing continued to show weakness during the quarter as mortgage rates rose
in the wake of trouble at and eventual government conservatorship of Fannie and
Freddie. The Commerce Department reported an 11.5% decline in new home
sales in August from July though inventories are down 23.5% in the past year.
Existing home sales have leveled at the 5mm unit per annum level. Sales fell
2.2% in August versus July with the median price down 9.5% from a year ago2.
The labor market weakened further as the four-week moving average of new
claims for unemployment rose solidly above 400,000 by the end of the quarter.
The September Payroll Survey showed a further decline if 159,000 jobs bring the
year’s total to 760,000 lost. Unemployment rose to 6.1%3.Growing labor market
weakness brought real consumer spending to a halt by August and suggests a
spending contraction in the 4th quarter.
Manufacturing also came under stress as Durable Orders fell in August by 4.5%
from July4. Future weakness in the manufacturing sector was signaled by a sharp
decline in the ISM PMI Index, which fell to 43.5% in September from 49.9% in
August5. The index had been hovering around 50 for the last several months.
The September weakness raises the specter of recession in manufacturing and
possibly the broader economy.
Headline inflation, which includes energy and food, was uncomfortably high at
5.4% in August6. The decline in commodity prices and a weak labor market
should lessen inflationary pressures as the year ends. The Treasury versus TIPS
market suggests inflation falling below 2%.
The Federal Open Market Committee left interest rates unchanged during the
quarter. Rates were put on hold at the June meeting given the Fed’s rising
concern over commodity driven inflation. The Fed, though, did expand its balance
sheet and ability to provide liquidity from about $900 billion to almost $2 trillion.
Markets
Treasury yields were erratic during the quarter, with the 10-year treasury peaking
at 4.15% in July with a trough of 3.4% in September, ending the quarter at 3.8%
not too much below its 4.0% start7. Equity markets were volatile and most indices
fell further into bear territory at the end of the quarter, falling nearly 30% since the
highs of October 2007.
Outlook
For 2008 we feel the S&P 500 will see further volatility and downward pressure
given persistent financial market stress. Within equity we favor large cap growth
stocks due to their attractive relative valuation and typically superior performance
in uncertain economic times. Given the expectation of a stagnating economic
environment, bonds could have total returns of slightly greater than coupon yields
or between 3.5% and 4.5% for intermediate government bonds.
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William Knapp
Investment Strategist
New York Life Investment
Management LLC |
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Tony Elavia, Ph.D.
Chief Investment Officer
NYLIM Equity Investors |
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