Weekly Perspective –December 2, 2008

 A Reality Check

The United States Government has pledged approximately $8.0 trillion in rescue efforts primarily designed to avoid a systemic collapse of the financial system.  We see these expenditures as necessary and, at the same time, “empty calories” unlikely to have an effect on growing the U. S. economy. In the spirit of the season, let us provide a holiday analogy.  Each action by the Treasury or Fed has buoyed markets, representing a second or third serving of ice cream and pie. Each additional portion has not moved economic growth forward.  Instead, it has left all of us with a larger waistline and deficit in the end. 

In a discussion last week, our colleague Dr. Gerald Buetow correctly suggested that policy makers are placing too much emphasis on the “effects” of the crisis rather than the “causes” of the crisis.  The fact that the housing market and the non-agency mortgage-backed securities market are both in worse shape today than a year ago serves to validate Dr. Buetow’s comments.  Expectations need to be managed. The reality is we are going through a deleveraging cycle, the outgrowth of almost 30 years of excesses. The process can be assisted, but not rushed.  Reflating the economy will not be easy, thus we are likely in for an extended period of below-trend economic growth. 

We expect the Fed to cut the funds rate a minimum of ¼% at their next meeting scheduled for the 15th and 16th of December.  We have suggested in previous Perspectives that monetary policy alone will not solve the current crisis.  Historically, monetary policy influences financial conditions, which in turn impacts economic activity.  The time horizon from policy action to market impact is almost instantaneous, while the impact on economic activity can lag substantially.  Economists at Barclays Capital suggest, “Do not be fooled by the low funds rate and the massive reserves in the banking system.  Despite the Fed easing, financial conditions have worsened dramatically, with both credit spreads and the Fed’s measure of lending conditions at record distress levels.  The deep freeze in capital markets is only two months old, and thus far policymakers have made little progress in unthawing the markets.”

Speaking of “massive reserves in the banking system”, what are the banks doing with all that money?  We know they are not lending, as loan demand continues to be anemic.  The banks are buying treasury securities at an almost unprecedented pace.  In the past month they added $100 billion* to their portfolios as they ride the steep yield curve to re-liquefy their balance sheets.  We have been advocates of purchasing 10- year treasury securities from approximately the 4.0% level as inflationary pressures abated, economic activity continued to decline, and the Fed pumped reserves into the financial system.  It is counterintuitive that in a period where the Treasury has increased its borrowings significantly, the 10-year note has declined to its current 2.78% level, providing an 8% total return for the quarter to date and a 14% YTD total return.  A further decline to the 2.50% level is not unrealistic assuming the banking system continues to be active buyers of 10-year notes.  

10 Year Treasury QTD

We continue to urge caution as uncertainty remains the common denominator.  Equity markets have had knee-jerk responses to the government’s reactive “policy of the day” approach.  These courses of action have had limited success to date.  Housing affordability continues to be an issue (prices have to come down further), the credit crunch remains, the consumer is disabled, job losses are mounting, the credit market is basically frozen, the banks are not lending, little has been accomplished to stimulate the economy and after a full year of crisis, financial transparency remains an objective.  The fact that Citibank had $300 billion in bad assets as late as November 2008 says it all.  The equity market’s positive reaction to the Citibank bailout was implausible.  Do investors grasp the fact that Citi may not be alone in hiding its lack of transparency?

We were surprised that the equity market rose 6.5% in response to Timothy Geithner’s appointment as Secretary of the Treasury.  We are confident that the future Treasury Secretary is smart and has the required experience.  However, we just do not understand the enthusiasm for a guy who has been at the helm of the New York Fed since 2003.  We are searching for sustainability. Did he see this crisis coming?  He was the gentleman who denied Lehman’s application for a banking license.  Though surprised, we welcomed last week’s historic market move. The S&P rose 12%, the Dow rose 9.7% and the NASDAQ climbed 10.9%, all in the face of abysmal durable goods and personal spending data.   It’s difficult to label this move as sustainable knowing it came in a shortened week with reduced volume and may have been due in part to a short covering bear rally.

Equity prices have historically moved higher approximately 4 months prior to the economy showing legitimate signs of a turnaround.  We do not see the recession abating at the end of the 1st quarter 2009.  The fact that we have a 2-month lame duck period as administrations change reinforces this viewpoint.  Equity investors need to focus on potential earnings and associated multiples at the trough.  Equity price sustainability will be an outgrowth of a strengthening economy and the associated increases in corporate earnings. 

President-elect Obama is planning a fiscal package that may be as large as a $700 billion spread over two years.  Expectations regarding the value of the plan need to be put on hold pending an announcement and review of the specific details.  The key question is what percentage of dollars will be spent on projects which create jobs and improve productivity, and in what time frame?  A welcomed but otherwise unexpected use of the tax code would be to inject “growth serum” (reduction/elimination of the capital gains tax and lower corporate tax rates) directly into the economy’s blood stream.

This PMC Weekly Perspective discusses general developments, financial events in the news and broad investment principles. It does not provide investment advice and is not an offer to sell a security or a solicitation of an offer, or a recommendation, to buy a security. Investors should consult with an investment advisor to determine the appropriate investment vehicle. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon and risk tolerance. The statements contained herein are based upon the opinions of PMC. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. Past performance is not a guarantee of future results.

Economic Calendar Week of 12.1.08

Tuesday 12/2

                                                                                                  Survey:                         Prior:

Domestic Vehicle Sales                                             7.8 M                                   7.9M

ABC Consumer Confidence                                                 -53                                       -52

Wednesday 12/3

                                                                                                  Survey:                         Prior:

MBA Mortgage Applications                                                N/A                                     1.5%

Job Cuts (YoY)                                                                      N/A                                     78.9%

ADP Employment Change                                                    -200K

Nonfarm Productivity                                                              0.9%                                    1.1%

ISM Non-Manufacturing                                                      42.0                                      44.4

Fed’s Beige Book

Thursday 12/4

                                                                                                  Survey:                         Prior:

Initial Jobless Claims                                                                 540K                                  529K

Factory Orders                                                           -4.5%                                   -2.5%

Chain Store Sales (YoY)                                                      -1.1%                                  -0.9%

Friday 12/5

Change in Nonfarm Payrolls                                                  -325K                                   -240K

Unemployment Rate                                                               6.8%                                      6.5%

Consumer Credit                                                                    $1.5B                                     $6.9B

Mortgage Delinquencies                                                        N/A                                       6.41%

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