Client Quarterly Report - January 2008
FINANCE AND INVESTMENT IN A GLOBAL ECONOMY
By Mary Ann Greenwood
Investors in the securities markets like clarity and certainty; today we have uncertainty
which produces volatility. This uncertainty stems from a dysfunctional credit market, a housing bubble, high energy prices, geopolitical tensions, a weak US dollar, slowing
employment growth and increased recession concerns. Several fundamental strengths offset the negatives, including low inflation, low interest rates, low unemployment rate, positive US
economic growth, global liquidity, global central bank coordination, and global economic growth.
The extent of market volatility is illustrated in the figures below showing the price change of the Dow Jones
Industrial Average and the S&P 500 Index. While year-end gains for the Dow and the S&P were good, the intra year volatility is shown in Figure 1. The news events that drove the ups and downs are seldom
remembered. Alternately, long-term investors may want to look at Figure 2 for a five-year view. Sometimes we can’t see the forest for the trees.
Figure 1: Dow Jones and S&P 500 for Year 2007
Figure 2: Dow Jones and S&P for Years 2003 – 2007
The dysfunctional credit markets are of immediate concern.
Irresponsible lending in the sub-prime mortgage market, excess inventory in the housing sector, and concerns about teaser mortgage rate resets prompted Fed action to ease credit. At the same time, banking regulators were “kicking the tires� and requiring banks to increase their loan loss reserves and increase their capital. These two actions were countervailing and the entire credit markets ‘seized up.’ Suddenly, collateral debt and mortgage instruments (CDOs, CMOs) were questionable and special investment vehicles (SIVs) couldn’t be valued. The SIVs had been designed for specific loan arrangements, each with different parameters and many tied to future events. When the terms and collateral for a loan cannot be easily valued, then the marketability of that loan is impaired.
The Fed action included (1) cutting the Federal Funds Rate a cumulative 100 basis points, (2) lowering the Discount Rate a cumulative 150 basis points, (3) implementing several procedural
changes and liberalizing lending collateral rules, (4) introducing swap lines with foreign central banks and (5) introducing a new tool, the Term Auction Facility (TAF). The TAF is similar to a loan from the Discount Window, but interest rates are set in an auction where each bank can determine how much it is willing to pay and bid accordingly. To date there has been two $20 billion auctions with a new one on the schedule for $30 billion. A parallel auction occurred in Europe under the
European Central Bank.
The TAF is important because it is designed to reduce the credit spreads, especially with the London Interbank Offering Rate (LIBOR) which drives mortgage pricing and reset rates. The process is complex, but we now have global financial markets addressing credit issues in the US. The goal is to regain normalcy in the credit markets. The actions of regulators present a bit of irony in that loan write downs may or may not result in actual losses. To the extent that banks over reserve loan losses, future bottom line earnings may receive a boost. We should expect monetary easing in most of 2008 which is positive for equity and bond markets.
Energy prices seem to have a life of their own with oil reaching $100/barrel, despite the absence of immediate supply shortage or demand expansion.
Nonetheless, gasoline moving from $2.00/gallon to $4.00/gallon will have an impact – the typical driver who uses 1,000 gallons of gas/year must come up with an extra $2,000 (approximately $40/week). Unless hedge funds and private equity funds have, in fact, cornered futures contracts at the margin, market forces will eventually begin to affect price elasticity, either through increased supply or decreased demand.
Geopolitical risk continues to place a premium on energy prices as uncertainty in the Middle East, Pakistan, Afghanistan, South Korea, Venezuela, and Africa continues.
Iran has nuclear power, but apparently we now think they are not a threat, although we did think they were last year. Economic growth and international trade are the best defense against global unrest.
Transition
to a true global economy is another source of volatility in securities markets.
Most sectors of our economy – agriculture, manufacturing, technology and government – are digitally connected and financially interdependent. Central bank coordination discussed above is one global force, but another that is equally important, is the development of Sovereign Wealth Funds. Countries, like China, Japan, Saudi Arabia and other Middle East nations, have amassed trillions of dollars from selling products and services to the United States. These dollars, held by sovereign wealth funds, represent an investment surplus – the opposite of our trade deficit. Abu Dhabi has invested in Citigroup and UBS, China in Morgan Stanley, and Singapore in Merrill Lynch; the list is certain to grow. Initially, Americans did not react favorably to foreign ownership of assets, but recent actions indicate minority investment is acceptable. Sovereign Wealth Funds recognize that the best place to invest dollars is in the dollar denominated country. To wit, the current credit market stress together with security market uncertainty presents an excellent market opportunity for those funds to flow into the US. It remains for academic and practicing economists to develop a workable global economic model to both explain and predict the interactions between and among currencies, trade and investment accounts. While uncertainty and volatility always accompany transitions, they also present opportunities.
Interestingly, as investment and trade flows adjust to more global interdependence, volatility will ease, the dollar will retrace much of its decline and we should have a more stable US and global economy.
Election year rhetoric notwithstanding, pocketbook issues will prevail, especially if geopolitical tensions ease. Recession is unlikely to meet the two consecutive quarterly declines in GDP, but the NBER (the
organization that determines when a recession has occurred) may decide that one sector is sufficient to declare that a recession existed (like business investment spending in 2002).
In any event, we will certainly be out of recession before the NBER declares that one has started. History offers guidance, but as investors we must be forward looking – the glass is half full.
Mary Ann Greenwood, Ph.D., CFA
January 2008
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