Q4 Commentary (2007)
March 2007
“At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained”
May 2007
“…we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system”
Fed Chairman Ben Bernanke
Over much of the last 3 years we have cautioned within these pages on the excesses that had developed in our housing market and the profound economic impact of the related credit cycle. Some early concerns centered on a highly leveraged consumer fueling spending growth via unsustainable home price appreciation. Indeed much of our economic growth and consumption over the last 15 years could be ascribed to asset inflation, first in stocks and then in housing. Subsequent and increased anxiety was expressed a year ago regarding the preponderance of exotic and adjustable loans feeding the marketplace. These loans had nourished the risk appetite of many financial institutions via leveraged securitization.
As evidence mounted concerning the interdependency between Wall Street and Main Street and even internationally (globalization works both ways), our cautious focus turned to the credit markets and the liquidity risks this infestation might create.
The U.S. and, indeed, the developed global economies now enter 2008 with a deepening housing recession, weakening labor markets, high energy and food costs while our financial system remains in the throes of a still widening credit crunch with fragile market conditions and restrictive lending. Indeed, recent polls indicate that over 40% of economists and 60% of U.S. consumers anticipate a recession in 2008.
These tightening lending standards are critical to understanding the slowing economic activity and the impact on the housing market. The challenges of the Federal Reserve are unique in this period as the traditional responses of lowering interest rates (Fed Funds rate was lowered from 5.25% to 4.25% in 2007) and increasing liquidity may literally be pushing on a string. In reality interest rates and liquidity are backseat concerns to institutions willingness to lend. While recent actions by the Federal Reserve and European Central Banks have succeeded somewhat in lowering the cost of borrowing as defined by LIBOR (London Interbank Offering Rate), it will probably take at least 1 to 2 more quarters for financial institutions to identify with greater clarity the respective balance sheet risks.
Additional concerns facing Fed Chairman Bernanke have been rising headline inflation numbers. Despite controlled wage costs, the headline Consumer Price Index (CPI) ended 2007 up 4.3% year-over-year. This past year witnessed the greatest dollar increase in oil opening the year at $61/bbl and increasing to $96, while gas prices at the pump increased 40% nationally from $2.25 per gallon to $3.15. Pressures on the consumer are being felt this winter with natural gas and heating oil prices up 36% and 65% respectively. The Producer Price Index (PPI) experienced a 7.2% year-over-year increase, led by rising import prices (up 11% y/y). With the U.S. Dollar down 12% for 2007 and fully 35% since 2002 and Gold up 32% to an all-time high, the risks of stagflation have created conflicting policy concerns that only recently appear to have tilted towards the weakening economy. As we enter an election year, this takes on even greater potential significance.
This current concern is in strong contrast to recent economic data that had been quite strong with full year GDP anticipated to come in at 2.2% though clearly moderating from the average growth at 3.2% for the prior 3 years. In fact, the 2nd and 3rd quarters of 2007 saw consecutive growth numbers of 3.8% and 4.9% respectively with strong export benefits perhaps masking the underlying weakness developing in aggregate demand. Indeed, improved trade deficits added over 1% to GDP in both quarters despite total U.S. corporate profits up only 1.9% for the year with domestic only profits actually down 8%.
The persistent strength of emerging markets continues to be cited for optimism for sustained U.S. growth. The decoupling crowd has continued to espouse international growth despite a domestic slowdown. Certainly among the benefits of increased globalization is the smoothing out of the cyclical swings that plagued our economy during much of the 20th century. Clearly, improved productivity (technology), enhanced trade and the continued service sector growth trends soften the inventory boom busts of prior cycles. However, the U.S consumer remains the engine of consumption. Despite the growth of the developing economies that now collectively represent almost 30% of global GDP, the U.S economy is actually a greater percentage now at 28% than in 1995 when it stood at 25%. With consumer spending having grown from 65% of domestic GDP to the current level exceeding 70%, the U.S. consumer is now a greater share of global GDP than ever and the U.S. now represents about 24% of China exports. It is incongruous for us to believe that a consumer-led recession in our country would not have pronounced impacts on the export-driven emerging markets.
We admit to being surprised by the unrelenting strength of the U.S consumer during 2006 and most of 2007. Real consumer spending has now been up for a record 64 consecutive quarters despite absolute debt levels and debt service ratios that are now at all-time highs. These had clearly been supported by solid job growth and employment along with the aforementioned asset appreciation. There appears little doubt now that the housing recession and subsequent credit crisis has ended this party. Real consumer spending may still be up 2.4% in 2007 but this is down from over 4% in 2005 and is annualizing at less than 1% quarter over quarter. Retailers reported a disappointing Christmas season. Even well positioned general merchandise retailers such as Target and high-end specialty stores such as Nordstrom and Tiffany, thought to be immune to the slowdown, cautioned analysts. A negative print in spending over the next few quarters would not be a surprise to us.
Nationally, housing prices have now declined over 6% according to the Case-Shiller index. With affordability still low and lending standards tightening, demand has fallen out of bed moving inventory levels to a 22-year high and presaging additional price declines that we anticipate might be another 10%-15% to move more in line with historical retrenchments. Mortgage delinquency rates have jumped to 5.6% (highest since 1986) and foreclosures have more than doubled most of which have occurred even before any mortgage rate resets have taken place. It is this sobering fact that minimizes the impact that government rate freeze proposals may have.
As much of employment growth over the last few years had been due to the tremendous growth of the housing and financial sectors, it is now no surprise to see this also reversing. We have now witnessed the unemployment rate move from a cycle low of 4.4% in March to 5%. A jump of more than 0.4% in this metric historically has 100% accuracy in forecasting a recession. We anticipate this moving to 5.5% or higher. Payroll growth that had averaged over 186K jobs per month during 2006 slowed to a 147K average during the first half of 2007 and to 97K in the second half. While Average Hourly Earnings (AHE) have stayed solid, the average workweek (hence earnings) has declined.
The fixed income markets experienced one of the most volatile periods of recent record. The first half of the year witnessed tightening credit spreads with rising interest rates and the second half saw the summer credit crunch reverse that picture entirely. Mortgage-backed securities trading froze up entirely and the markets for commercial paper, the lifeblood for many financial institutions, virtually disappeared overnight. Running for safety, market participants bid the yield on 30-day Treasury bills down from 4.6% to 2.3% in the week of August 14th alone. Strong concerted actions by the central banks gradually restored some confidence to these markets at least to the levels of functionality. For the year the 10-year U.S. Treasury started 2007 at 4.6% rose to 5.3% in June then collapsing below 4%. This flight to quality created a widening in high yield bond spreads from 250 basis points over Treasuries to the current level of about 600 basis points.
Despite some brief sell-offs in the U.S. equity markets during this period, strong first half earnings in excess of 9.5% appeared poised to extend the record string of consecutive double-digit earnings growth. This combined with powerful global cash reserves to propel the S&P 500 to a record high in October. This would prove to be the high for 2007 as a yearend decline brought the total return for the S&P 500 to 5.5%. This may actually overstate returns as the equal-weighted index only eked out a 0.6% gains and the Russell 2000 small cap index had a slightly negative return of 1.6%. Additionally, of the 5.5% gain 1.25% can be attributed directly to just 2 stocks, Google and Apple.
Earnings growth for the S&P 500 will end the year nearly flat with 2006. Domestically-focused sectors such as Financial and Consumer Discretionary subtracted more than 6% from total S&P earnings growth and led to negative earnings of –4.5% in 3Q and an estimate –10% 4Q decline. Sector performance clearly benefited industries with large foreign operations owing to continued economic strength and the tailwind of a weaker dollar. (This late cycle play in Energy and Commodities appears to us to be extended and one that our expectation of a global slowdown should moderate.)
International markets outperformed again in 2007 as the MSCI EAFE index gained 11.6% with the MSCI Emerging Market index returned in excess of 39%. De-coupling theories will be severely tested in 2008.
As we pack away all the holiday trimmings and look forward to seasonal credit card bills, we see the U.S. economy on the precipice of a consumer-led recession. With increased financial instability comes increased volatility. With increased volatility may come more disappointments to the markets which may not be met with the same optimism as in the prior few years. The Federal Reserve may indeed be “behind the curve” as concurrent fears of inflation have mitigated more aggressive actions. However, we do see the FOMC drastically slashing short term rates through the early part of 2008 to perhaps as low as 3% on the Fed Funds rate. Additional stimulus may well be found in the fiscal arena as immediate tax cuts become increasingly likely. While this may be too late to stave off a mild recession, it should help to alleviate much of the fear in the credit and consumer markets and increase the needed liquidity and confidence in the markets and economy.
We see inflation as potentially the greatest wildcard but believe that a synchronous global slowdown will prove to be deflationary. This reduction in aggregate demand will include China where a very recent narrowing of trade surplus (our reduced imports) and declining money supply growth portend a breather at the very least. An expected decline in commodity and energy prices from here will be a strong positive and help to set the stage for a break from the stagflation environment and position the economy and markets for a subsequent rebound.
Though S&P earnings growth may actually decline in 2008, valuations based on declining interest rates and inflation should support our large cap domestic market. This is our favored area for 2008. As the U.S is further along in the global downtrend, our markets should rebound earlier and be more of a safe haven for more risk averse investors. While defensive positioning is warranted early on, opportunities may be starting to present themselves within the areas that have been impacted the most, Financials and Consumer Discretionary stocks. While our underweight in these early cycle areas has been prudent over the last year, these are the sectors that benefit most from a decline in energy and inflation. A return to trend growth should take longer and be slower as the consumer debt overhang will take a while to alleviate. We will continue to focus prudently on positioning the portfolio in companies with more predictable earnings and cash flow streams but are always looking to uncover companies suffering from investor neglect and fear that offer excellent valuations and risk reward characteristics.