The past week witnessed an extraordinary set of events on the financial front, a rogue trader creating havoc at Société Générale, and wild swings on global stock markets as mounting concerns about a recessionary US economy and the implications for global growth continued to weigh on investor sentiment.
The week started off with sharp declines on European and Asian stock markets on Monday (when the US markets were closed in commemoration of Martin Luther King). This was followed by the Fed’s emergency 75-basis-point-cut of its benchmark rate to 3.5% before the opening bell of the US markets on Tuesday, aiming to help support the troubled financial sector and stabilize the economy. The move, which came before the Central Bank’s formal meeting next week and marked the largest cut in the Fed funds rate in more than twenty years, helped prevent a larger drop in US equity prices.
Although investors’ initial reaction was lukewarm, stability returned to stock markets as they took heart from a possible rescue plan for troubled bond insurers (so-called monolines). In addition, the unveiling of a $150 billion US fiscal stimulus package by the Bush administration was viewed in a favorable light even though it was criticized just a few days earlier.
Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance chart.
The Fed’s interim interest rate cut resulted in a further steepening of the yield curve with the aim of enabling shell-shocked banks to start lending again, and to start making profits so that they might be able to grow their way out of the credit crisis over time. The following chart illustrates how the yield curve has steepened since the first reduction in the Fed funds rate in August, 2007.
US YIELD CURVE
As far as economic statistics are concerned, US jobless claims for the week to January 19 surprised on the downside, reflecting a situation not yet commensurate with recessionary conditions. The US housing market, however, remained mired in weakness, according to the National Association of Realtors’ report for December. Existing home sales declined by 2.2% while the median existing house price was down 6% from one year ago. The inventory situation was looking slightly better, with about nine months of available inventories.
The jury is out on whether the FOMC will announce a further rate cut on Wednesday. John Mauldin (Thoughts from the Frontline) argues as follows: “If I am wrong and the Fed was responding to the stock market [when cutting the Fed funds rate by 75 basis points on January 22], then we will likely not see a cut next week. But if we get another 50-basis-point cut, as I think we will, then it means the Fed is responding to concerns about the credit crisis. And we will get another cut at the next meeting and the next until we get down to 2% or below. A 50-basis-point cut takes the rate to 3%. It they had cut the rate by 1.25% next week, the market would have collapsed. Better to do it in two leaps is what I think they are thinking.”
WEEK’S ECONOMIC REPORTS
||Existing Home Sales
Source: Yahoo Finance, January 25, 2008.
In addition to President Bush’s State of the Union Address on January 28 and the FOMC meeting on January 29 and 30, the next week’s economic highlights, courtesy of Northern Trust, include the following:
New Home Sales (Jan 28) – Sales of new homes are predicted to have dropped by 5.0% in December to 645 000. Sales of new homes have declined by 53.4% from their peak in July 2005. On a year-to-year basis, sales have dropped by 35.2% from a year ago. Consensus: 645 000 vs 647 000 in November.
Durable Goods Orders (Jan 29) – Durable goods orders are predicted to have risen in December (+0.4%) after a 0.1% increase in the previous month. In particular, orders of aircraft may have dropped and those of defense items have risen, reversing the performance seen in November. Consensus: +1.6% vs +0.1% in November.
Real GDP (Jan 30) – Real gross domestic product is expected to have risen by 1.2% in the fourth quarter. Positive contributions from consumer spending, non-residential fixed investment and exports are expected to be partly offset by a large drop in residential investment expenditures. Consensus: 1.2%.
Personal Income and Spending (Jan 31) – The earnings and payroll numbers for December suggest a 0.3% increase in personal income. Auto sales posted a small increase in December, while non-auto retail sales were weak. Both of these suggest soft overall consumer spending (+0.1%). Consensus: Personal income +0.4%; consumer spending +0.1%.
Employment Situation (Feb. 1) – Payroll employment in January is expected to show tepid gains (+25 000) after an 18 000 gain in December. Private sector payrolls fell by 13 000 in December, the first decline since June 2003. This report will be watched closely to evaluate the underlying fundamentals of the labor market. The jobless rate is predicted to have risen to 5.1%. Consensus: Payrolls +58 000 vs +18 000 in December; unemployment rate – 4.9%.
ISM Manufacturing Survey (Feb. 1) – The consensus for the manufacturing ISM composite index is 47.0 after a 47.7 reading in December.
Other reports – Case-Shiller Price Index, Consumer Confidence Index (Jan 29), Chicago Purchasing Managers’ Index, Employment Cost Index (Jan 31), Construction Spending and auto sales (Feb 1).
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week.
Source: Wall Street Journal Online, January 27, 2008.
US stocks started the shortened week markedly lower on Tuesday, following a sharp sell-off in global stock markets due to growing concerns about the overall health of the economy and Société Générale’s clean-up operations of its rogue derivatives trader’s positions. Markets, however, managed to recover and reclaimed higher ground as the week progressed. By the close of trade on Friday the Dow Jones Industrial Index (+0.9%) and the S&P 500 Index (+0.4%) were both in positive territory for the week, but the technology-heavy Nasdaq Composite Index (-0.6%) was less fortunate.
Following the surprise reduction in the Fed funds rate, the announcement of the tax stimulus package and a mooted rescue plan for bond insurers, interest-rate- and economically sensitive stocks gained strongly. Examples include banks (+11.4%), REITs (+8.6%), retailers (+5.4%) and small caps (+2.3%).
Elsewhere in the world, stock markets closed mostly in the red. Emerging markets, in particular, had a rough ride and lost 2.2% for the week, including the Shanghai Stock Exchange Composite Index’s decline of 8.1%.
The lower stock markets at the start of the week helped drive the yields on government bonds lower, but the gains were given up as the week wore on, and prices closed the week little changed.
Currency markets also experienced a fairly volatile week and saw the US Dollar Index closing the week 0.7% down. The euro, on the other hand, gained 0.2% on the back of hawkish comments from the ECB. Risk considerations resulted in investors exiting risky carry trades early in the week, pushing the yen to a two-and-a-half-year high against the dollar. As markets calmed down, the yen declined again to end the week lower against both the US dollar and euro.
With most of the action concentrated on stock markets, commodities were somewhat out of the limelight during the past week. Base metals (-0.9%) and agricultural commodities (-1.9%) closed in the red, but crude oil (+0.9%) managed to claw back some of the previous week’s losses.
Precious metals, however, rallied strongly subsequent to the Fed’s rate cut, resulting in gold gaining 3.3%, platinum 7.3% and silver 1.7%. Both gold ($924.3) and platinum ($1 694.9) registered new all-time highs on Friday prior to some profit-taking setting in.
With the FOMC’s meeting on Tuesday and Wednesday, and Q4 GDP and January’s payroll numbers out on Wednesday and Friday respectively, another key week for financial markets lies ahead. Hopefully the words (and graphs) from the investment wise will assist in guiding us through the murky waters and keeping our investment portfolios in good shape.
US economy: Danger from all directions
Source: Slate, January 24, 2008.
Moody’s Economy.com: Survey of Business Confidence for World
“The global economy is stalling according to last week’s business confidence survey results. Sentiment is consistent with a contracting US economy, soft European and South America economies, and an Asian economy that is expanding at the low end of its potential. Expectations regarding the six-month outlook have never been as negative in the over five years of the survey. Confidence is weakest among real estate firms and financial institutions, but it has declined considerably in recent weeks among business service firms and even heretofore more optimistic manufacturers.”
Source: Moody’s Economy.com, January 22, 2008.
International Herald Tribune: US in role of wounded giant at Davos
“The United States has filled various roles at the World Economic Forum over the past decade: dot-com dynamo, benevolent superpower, feared aggressor, and now, wounded giant. On the first day of this conference, a parade of bankers, economists, and political officials expressed deep fears about the faltering American economy, peppered with blunt criticism of its institutions, chiefly the Federal Reserve, which some accused of sowing the seeds of today’s crisis.
“George Soros, the financier who made a fortune betting against the pound, went so far Wednesday as to say that the downturn would put an end to the long status of the dollar as the world’s default currency. ‘The current crisis is not only the bust that follows the housing boom,’ Soros said. ‘It’s basically the end of a 60-year period of continuing credit expansion based on the dollar as the reserve currency.’
“Signs of a new economic order abounded in this Swiss ski resort: the minister of commerce and industry of India, Kamal Nath, noted that China had overtaken the United States as India’s largest trading partner – buttressing his view that India could largely sidestep an American recession. The head of the National Bank of Kuwait, Ibrahim Dabdoub, said Americans who opposed sovereign wealth funds like the one run by his government needed to come to terms with the new reality.
“Nouriel Roubini, an American economist, whose frequent predictions of a downturn have made him something of a soothsayer in Davos, predicted the United States would suffer a recession lasting at least a year. He foresees a flood of defaults on car loans and corporate bonds, as well as a prolonged bear market. ‘The debate is not whether we’re going to have a soft landing or a hard landing,’ he said. ‘The question is only how hard the hard landing will be.’
“The Federal Reserve ‘made bad judgments’, said Joseph Stiglitz, the Nobel Prize-winning economist. ‘It looked the other way when investment banks packaged bad loans in non-transparent ways.’ The rate cut this week, Stiglitz said, would be too little, too late, because monetary policy usually takes between six months and 18 months to be effective, and the United States is in distress now.”
Source: Mark Landler, International Herald Tribune, January 23, 2008.
Asha Bangalore (Northern Trust): Fed cuts rate in surprise move
“In a surprise inter-meeting move, the FOMC lowered the federal funds rate and discount rate 75 bps to 3.5% and 4.0%, respectively.
“The statement noted that (1) ‘weakening economic outlook and increasing downside risks to growth’, (2) ‘deepening of the housing contraction’, and (3) ‘some softening of labor markets’ were reasons for the easing of monetary policy. The statement did not mention equity markets explicitly but cited that ‘broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households’. After the January 21 drop in global equity prices when the US market was closed, a continued downward trend today in these markets and the sharp drop in US equity futures markets this morning before opening probably played a role in today’s Fed action.
“Further easing of monetary policy is on the table, but the magnitude and timing is less clear. There could be preference to wait until the March 18 FOMC meeting to assess the impact of the monetary and fiscal policy easing put in place. The futures market has priced a 50 bps cut for the January 30 meeting. For today, we maintain a Fed on hold at the January 30 FOMC meeting, with a small possibility of further easing.”
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 22, 2008.