Turbulence Continues

In 2009, we are still bouncing in the turbulent wake of 2007’s stormy “Summer of Subprime” and the damaging credit crisis waves it spawned. The original tempest blew in suddenly and anonymously, over mountains of resetting, defaulting, adjustable-rate subprime mortgage loans. In 2008, the crisis adopted a broader, more public image as the waves spread globally and toppled financial industry icons such as Bear Stearns, Lehman Brothers, and Merrill Lynch.

Governments and central banks executed extraordinary coordinated measures—particularly in the third and fourth quarters of 2008—to support economic growth, enhance capital market liquidity, and limit damage from the downfall of those financial industry icons. We believe these efforts helped prevent a complete financial system collapse, but they didn’t We expect conditions to get worse this year before they get better, possibly sometime in 2010. prevent what appears likely to be the deepest recession since the Great Depression of the 1930s. Tough times face the average U.S. consumer, and we expect conditions to get worse this year before they get better, possibly sometime in 2010.

Recession Due to Disabled Housing Market

We believe the U.S. economy is in a consumer-led recession that will follow a long, slow, L-shaped pattern of recovery (as opposed to a V-shaped, more rapid rebound). The National Bureau of Economic Research (NBER)—the think tank that identifies key inflection points in the business cycle—defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months. The NBER has already declared that a recession began in December 2007. We think it will include all of 2008 and much of 2009, possibly extending into 2010.

How did we fall into this recession? We believe it was the same way the financial sector meltdown occurred—beginning with an extended period of easy credit from 2002 to 2004, when the Federal Reserve’s (the Fed’s) overnight interest rate target remained at what was then a generational low 1% rate for over a year. In fact, inflation-adjusted (real) overnight bank lending rates in the U.S. reached negative levels from roughly the fourth quarter of 2002 through the first quarter of 2005. The Fed was essentially paying investors (and speculators) to borrow money, and they capitalized on that opportunity.

We saw easy credit translate to speculative booms in the housing, credit, and securitization markets, followed by bursting bubbles in those areas after the Fed raised rates, the economy weakened, home values declined, and borrowers defaulted on adjustable-rate loans that reset beyond the borrowers’ ability to pay. A vicious credit cycle erupted—credit became increasingly unavailable to financially stretched consumers who had relied upon debt to make ends meet and who needed it more than ever as their expenses increased and incomes remained static or declined.

Financial-Sector Fuse Was Already Lit in 2006

We anticipated that bursting bubbles would rattle the financial sector, and positioned our fixed-income portfolios accordingly, actively shielding portfolios from credit-sensitive areas in both the mortgage and corporate sectors. For example, as far back as March 2006, we were favoring higher-quality government securities over corporate bonds because we felt that corporate securities offered inadequate compensation for the added risk involved.

Last September, when many market participants seemed to optimistically view the government takeovers of IndyMac, Fannie Mae, and Freddie Mac as signs that the credit crisis was coming to a close, we instead hardened our conviction that more subprime-related shakeouts were yet to come. Indeed, by the fourth quarter of 2008, a host of banking and brokerage institutions were in trouble. The impact of their instability extended far beyond their direct business relationships and securities markets, We still strongly believe the ultimate springboard for economic recovery will be housing price stability.compromising even the sanctity of money market funds. Financial sector problems have extended into 2009, and are likely to continue until the housing market and the economy begin to stabilize.

No Consumer Sector Signs of a Bottom Yet

It’s important to note that while we’ve positioned our fixed-income portfolios for recession, we’re also actively preparing for better credit conditions and an improved risk/reward environment. Our investment teams are watching for both economic and market signs that it’s time to seek more aggressive opportunities.

Beyond the attention-grabbing glare of financial-sector fireworks, we still see this recession as consumer- and credit-driven, versus business related. We think the core cause of recent troubles can be traced back to declining home values and consumer-credit repayment issues. Therefore, we still strongly believe the ultimate springboard for economic recovery will be housing price stability, along with improved effective availability of consumer credit.

According to our analysis, neither has happened. We see home prices continuing to decline, and believe the contraction will continue while the employment situation worsens, with the unemployment rate possibly reaching 10% or more. Meanwhile, mortgage interest rates have come down from 2007-2008 levels, but qualifying for those lower rates and actually obtaining a loan from financially stressed lenders has become increasingly difficult.

When will home prices stabilize and credit become more readily available? We believe the latter will help drive the former—increasing demand for housing will be the key factor that ultimately puts a floor under falling prices. But demand requires confidence and credit, which we see in short supply right now. We believe the financial sector needs to stabilize to loosen the lending purse strings, but restoring consumer confidence goes beyond that. It will likely require some combination of increasing labor and housing market stability, low interest rates, easier credit We don’t believe we have reached the bottom of this economic cycle. availability, lower commodity prices, improving corporate credit quality and earnings, and a stock market recovery. We see a couple of those factors already in play, but not enough to make a difference.

Closing Thoughts

The crux of the matter is that we don’t believe we have reached the bottom of this economic cycle; conditions will likely deteriorate further in 2009 before they improve.

As we sensed would be the case back in 2007, the credit crisis launched during the “Summer of Subprime” is still with us, housing prices are still declining, home inventories remain high, and consumer spending continues to be constrained. In a paper distributed at our 2007 National Accounts Investment Forum, we said, “We expect that the housing downturn is far from over, and will continue to exert downward pressure on consumer spending and the economy for months to come. The expansion of subprime woes to other real estate lending sectors, combined with the tightening of credit standards, have the potential to undermine housing prices for an extended period.”

Take away the words “is far from over, and” and we could say pretty much the same thing today.

We think American consumers face hard times ahead that are not addressed directly or immediately by the much-publicized responses to the institutional failures in the financial sector. We foresee weak economic growth well into 2010. Despite that, we remain vigilant for signs that the markets and the economy are turning, and for the opportunities these changes bring.

For now, we favor the securities of large, diversified corporations (businesses likely to survive the recession), U.S. government agency mortgage-backed securities, municipal bonds, and inflation-linked securities. The government is supporting market liquidity and economic growth through various extraordinary activities and facilities designed to mitigate the credit crisis and recession, but we think it’s fighting an extraordinarily uphill battle.

Times like these favor bond managers with superior We remain vigilant for signs that the markets and the economy are turning. security selection skills, risk management discipline, and credit analysis expertise. We believe our fixed-income portfolio management teams at American Century Investments® possess these traits, as their track record shows. We offer a range of fixed income solutions that can help investors generate current income, maintain purchasing power, or accumulate tax-free income, even during turbulent times.

The opinions expressed are those of the Fixed Income investment team and are no guarantee of the future performance of any American Century portfolio. Statements regarding specific holdings represent personal views and compensation has not been received in connection with such views. This information is not intended to serve as investment advice. Diversification does not assure a profit or protect against a loss in a declining market.

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