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Market Update -- In the Markets

Written by Derrick Wulf, CFA, Portfolio Manager

January 13, 2009

Here's a brief summary of what transpired in the economy and the financial markets during the past three months. We hope you'll find it a handy reference.

Growth
Economic growth plunged in the fourth quarter as major systemic disruptions in the capital markets led to a steep decline in consumer, business, and investor confidence. Rapid slowdowns across most sectors of the global economy likely resulted in the sharpest contraction in decades, with most fourth quarter GDP forecasts pointing towards a decline of as much as 5% or more. While an aggressive, unconventional monetary response and large proposed fiscal stimulus package are likely to help the economy recover in 2009, strong headwinds persist, leading most economists to expect continued contraction through the first two quarters of the year.

Inflation
Rapid declines in commodity prices and weakening consumer demand for goods and services sent inflation gauges down sharply in the fourth quarter, reversing much of the increase seen earlier in the year. The Producer Price Index fell a record 2.8% in October and declined another 2.2% in November (December data won't be released until later this month), bringing the year-over-year change down to just 0.4% from its 27-year high of 9.9% in July. Excluding food and energy, core PPI on a year-over-year basis fell slightly from its recent peak of 4.4% to 4.2% in November. The Consumer Price Index also declined in October and November, bringing it down to just 1.1% on a year-over-year basis from its recent peak of 5.6% just four months earlier. Meanwhile, the Personal Consumption Expenditure Core Price Index (Core PCE) fell to 0.0% in November and December, bringing the measure down to 1.1%, its lowest level since early 2004. Most inflation gauges are expected to decline further in coming months reflecting the effects of the recession, but persistent deflation does not yet appear to be a significant risk.

Jobs
Job losses continued to accelerate in the fourth quarter, sending the unemployment rate to a 15-year high in December. At 7.2%, the unemployment rate stood a full percentage point higher than it did at the end of the third quarter, and almost three percentage points above its cycle low of 4.4% in March, 2007. Payroll declines also accelerated during the quarter, with nonfarm payroll losses of more than 500,000 per month on average in the fourth quarter. For the year, payrolls declined by more than 2.5 million, with almost 60% of the losses coming in the fourth quarter. Initial jobless claims, meanwhile, hit a 26-year high of 589,000 in the week of December 19, bringing the four-week moving average up to nearly 560,000, almost double the most recent lows from early 2006. Continuing claims also hit a multi-decade high in December, surpassing the 4.6 million mark for the first time since 1982.

Income
Despite a sharp decline in labor markets, wage and salary income continued to grow at a relatively steady pace in the fourth quarter. According to the Bureau of Labor Statistics, average hourly earnings rose 3.7% on a year-over-year basis in December, matching the highest levels of the year. Further declines in the Average Weekly Hours survey, however, which, at 33.3 hit the lowest level in the survey's history, suggested that wage and salary income growth will come under increased pressure in coming months.

Manufacturing
The manufacturing sector contracted further in the fourth quarter, driving the ISM Manufacturing Index to 32.4, its lowest level since the 1980 recession. The new orders component, a data series that dates back to 1948, recorded its lowest level ever in December, confirming pronounced weakness in the sector. The Department of Commerce durable goods orders excluding transportation and defense showed weakness in the 4th quarter, as business investment suffered from frozen credit markets and an unsettling economic outlook.

Retail
Retail sales fell during the fourth quarter as dramatic declines in gasoline prices failed to bolster spending. The worst holiday shopping season in 40 years highlighted historically low levels of consumer confidence and an increasing marginal propensity to save. November marked the 5th consecutive drop in retail sales and the 9th month of the last ten during which car sales fell.

Housing
The worst housing recession in decades saw no relief in the fourth quarter, as foreclosure sales and weak credit conditions continued to weigh on the market. November existing home sales data compiled by the National Association of Realtors revealed a 13% drop in median resale prices from a year ago, the largest decline on record. The pace of existing home sales, 45% of which were foreclosures or short sales in November, also continued to decline, leaving the months supply of existing homes elevated at 10.3 months'. The S&P/Case-Shiller composite home price index continued to set new lows as the year progressed, registering a year-over-year decline of more than 18% in October. The National Association of Home Builders index of builder confidence, meanwhile, dropped to an all-time low of 9 in November and stayed there in December. A reading below 50 indicates weakness.

Confidence
Consumers welcomed the 61% decline in gas prices since mid summer, but sentiment is now being dictated by a dismal labor market and continued economic uncertainty. The 41-year-old Conference Board's Consumer Confidence index set an all time low of 38.8 in October before rebounding slightly in November and then setting a new record low of 38 in December. The Present Situation component of the Conference Board's index deteriorated further from 61.5 in September to a grim 29.4 by the end of the quarter. The University of Michigan Survey of Consumer Confidence improved modestly in December to 60.1 only after recording a 28-year low of 55.3 the previous month.

The Fed
The FOMC responded aggressively to rapidly deteriorating market conditions in the fourth quarter, announcing several new unconventional policy measures and slashing the overnight lending rate to its effective floor of just above 0%. On October 7, the Fed announced the creation of the Commercial Paper Funding Facility (CPFF) which would extend credit to high-grade corporate borrowers by allowing them to sell commercial paper directly to the Fed (a supplementary program, the Money Market Investor Funding Facility, or MMIFF, a liquidity backstop facility for money market funds, was announced later that month).

The rate cuts came in three separate moves, beginning with an inter-meeting reduction in rates from 2% to 1.5% on October 8, as part of a coordinated effort with other foreign central banks to respond to the "intensification of the financial crisis." Just three weeks after its inter-meeting rate cut, the Fed cut rates again by 50 basis points citing "a decline in consumer expenditures" and "the intensification of market turmoil." As financial market conditions continued to worsen, the Fed continued the expansion of its balance sheet, flushing the system with liquidity and driving the effective fed funds rate well below the official target. While the measures enacted in October were showing signs of success in improving the interbank and money market funding markets, considerable stress in other parts of the credit markets continued to threaten financial and economic stability, prompting the Fed to announce further unconventional policy measures, such as the creation of the Term Asset-Backed Securities Loan Facility (TALF) designed to ease credit conditions for consumers and small businesses. The Fed also announced a program to purchase up to $100 billion of GSE debt and up to $500 billion of agency mortgage-backed securities, and began buying agency debentures in early December.

The final fed rate cut occurred at the FOMC's December 16 meeting, when members voted to reduce the target overnight lending rate to a range of 0.0 to 0.25%. In the accompanying statement, the FOMC cited deteriorating labor markets, declines in consumer spending, business investment, and industrial production, as well as tight credit conditions as reasons for the rate cut. The statement also said that "the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time," and that "the Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability." Additionally, the statement mentioned the expansion of the Fed's balance sheet, its previously announced asset purchase programs, and even the potential for future purchases of Treasury securities. The statement concluded by saying "the Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity," confirming that quantitative easing, or credit easing as the Fed describes it, had become official Fed policy.

Treasuries
Demand for Treasuries grew in the fourth quarter amid heightened safe-haven buying and quantitative easing measures enacted by the Fed. Investor fears sparked by the "breaking of the buck" by a high profile money market fund kept demand for T-bills strong, as government-only money market funds saw large cash inflows. As a result, 3-month T-Bill yields dropped to record lows, trading briefly at negative yields before ending the year at 0.08%. A rapid decline in economic activity, coupled with sharp drops in oil and other commodity prices helped ease inflation concerns, even leading some investors to contemplate the potential for deflation. The changing inflation outlook and the Fed's inability to drive short-term rates any lower caused the yield curve to flatten as Treasury notes and bonds hit record lows. Yields on 2- and 5-year notes fell 120 basis points and 143 basis points, respectively. Ten-year notes and 30-year bonds each saw their yields fall more than 160 basis points, ending the year at 2.21% and 2.68%, respectively.

Increases in Treasury supply were easily absorbed by the market, but further increases are likely as the Treasury department deploys capital through the TARP program and finances a growing budget deficit. In the fourth quarter, the Treasury re-introduced 3-year notes via monthly auctions beginning in November, and announced monthly re-openings of quarterly 10-year notes as well. Net Treasury issuance in 2008 rose to $336 billion from $101 billion in 2007 and is likely to exceed $1 trillion in 2009. The Fed's recent announcement that it is "evaluating the potential benefits of purchasing longer-term Treasury securities" has thus far helped alleviate concerns about a supply-induced interest rate spike in 2009.

Bond Markets
Credit markets continued to underperform Treasuries in the fourth quarter, sending the average option-adjusted spread (OAS) of the Barclay's Aggregate Index to new record wides. The effects of September's bankruptcy filings of Lehman Brothers continued to linger, and risk-aversion among investors remained high while de-levering and liquidations among financial institutions and hedge funds led to more selling pressure among risk assets. The hardest hit sectors during the period were asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS), which underperformed Treasuries by 11.73% and 20.43% on a duration adjusted basis, respectively. Spreads widened into a vacuum, with buyers scarce as banks hedged loan risk and hedge funds unwound positions. The average OAS of the CMBS component of the index nearly doubled in the fourth quarter to over 1,000 basis points, while the OAS on the ABS sector ended the year at 955 basis points. The non-investment grade sector of the bond market fared even worse, with the high yield index posting a loss of almost 18% in the fourth quarter, lagging Treasuries by nearly 25% as spreads widened 648 basis points. The only non-Treasury sector of the bond markets to outperform Treasuries was agency debt, which benefitted from aggressive buying by the Fed and saw demand from investors seeking safe means of adding yield in favor of record-low yields on their Treasury holdings.

Some further data about the U.S. bond markets are shown in the charts below.