Q1 Commentary (2008)

The first quarter of 2008 represented the most strenuous tests to the US financial system since the Savings & Loan crisis of the early 1990's. Due to the global scope, some have even advanced that the greater comparison may be the Great Depression. In the face of the almost complete paralysis of global credit markets, the Federal Reserve in coordination with other central banks and governmental agencies provided a potentially powerful amount of stimuli.

The unprecedented and creative actions included the expansion of the Term Auction Facility (TAF), the establishment of the Term Securities Lending Facility (TSLF) and the creation of the Primary Dealer Credit Facility (PDCF) in addition to more traditional monetary tools such as a 200 basis point reduction in the Fed Funds rate. All of these moves, done to liquefy the credit markets of frozen mortgage and asset-backed securities, were still not sufficient and on March 16th, the Federal Reserve may have faced their greatest fear. Bear Stearns, the fifth largest Wall Street investment bank, appeared on the verge of collapse. Concerned that the potential bankruptcy would completely freeze tens of billions in counterparty transactions and foster a long and complex legal process, the Fed stepped in to fund and broker the sale of Bear Stearns to JP Morgan via a $30 billion dollar credit line.

As global market participants held their collective breath, the markets appeared to bottom. The following exhale witnessed an easing of most credit spreads and a rebound in the global equity markets over the final 2 weeks of the quarter. The specter of Armageddon in the global financial system appeared at least temporarily to have abated amid the reappearance of some market optimism.

However, while the most acute phase of the crisis may have passed, financial firms are still facing a long period of uncertainty in the middle of one of nastiest periods of de-leveraging our system has endured. Indeed, the International Monetary Fund (IMF) estimates total financial system losses to be $1 trillion! We may now be entering the next phase as fallout from the credit crunch spills over to the consumer. As Bernanke suggested in the latest FOMC minutes, we may have to concern ourselves with "an adverse feedback loop"; a situation where a tightening of credit conditions could depress investment and consumer spending, which, in turn, could feed back to a further tightening of credit conditions.

We postulated in our annual commentary that the U.S. economy was on the verge of a consumer-led recession and there has been little in the economic data to challenge that hypothesis. While there is no doubt that stabilization in the housing market is the pre-requisite to credit market and in turn economic stability, it is the longer-term health of the U.S. consumer that gives us pause. Recent Census Bureau data has confirmed that despite the economic expansion this decade, the median family income adjusted for inflation has actually declined during this period. In fact after doubling in the thirty-year period into the late 70's, real family incomes are only up 25% since. As income gains have stagnated, the U.S. savings rate has declined during this period from 10% to 0%. Critics of this analysis have accurately pointed out that it ignores asset appreciation and, indeed, the U.S. household net worth has grown steadily during this period. However, our debt-to-income ratio has grown as much in the last 6 years alone as in the prior 39 years total.

The U.S consumer contribution to our GDP has increased to approximately 70%. In fact as our economy represents about 30% of global GDP, we have contributed fully 20% to world growth. The asset-based spending of the last two decades fueled first by an 18-year equity bull market and followed by the current decade's unprecedented housing appreciation is being challenged as these asset class returns regress to longer term averages. Consumers must repair balance sheets by increasing savings and in turn reducing spending. Some recent statistics in this regard are quite ominous. In the first quarter average balances on home-equity lines and credit cards have climbed 8% and 10% respectively as home re-financings have slowed the pace of home equity withdrawals. While many view the rebate checks ($47B in May and $117B in total) as buoying the consumer until the markets stabilize, we suggest this may be optimistic and shortsighted as the consumer, like the financial sector, is early in the de-leveraging process.

The slowing in consumer spending along with continued declines in Residential Construction more than offset the strongest U.S. export environment in years bringing the final Q4 2007 GDP to 0.6% and the year to 2.2%. Improving trade, buoyed by our more competitive position in international markets due to dollar weakness, contributed fully 1% to overall GDP. As the consumer slowdown accelerates, we look for the first half of 2008 to flirt with flat growth leading to a rebate-led bounce in Q3.

Led by U.S. weakness, global growth as estimated by the IMF has declined to 3.6% from 4.7% in 2007, and we feel this to have downside risk. Resource rich countries such as Russia, Brazil and Australia continue to see strong export growth. Eastern and Central European economies, which are more levered to the credit markets and the consumer, are slowing. While it is early, we would still anticipate seeing a greater slowdown in Asian countries focused more on consumer goods exports.

The pressure on the consumer has intensified as the employment picture darkened in the quarter. Non Farm Payrolls (NFP) showed a collective job decline of 232,000 and this was accompanied by an increase in the unemployment rate to 5.1% rising from a cycle low of 4.4% in March of 2007. Elevated food and energy costs have pushed the headline CPI to 4% year-over-year though constrained employment costs have maintained core CPI levels of just over 2%. This toxic combination of a weakening job market and declining real income gains has bludgeoned consumer confidence to levels not seen in over 2 decades.In turn, loan delinquencies in everything from mortgages to autos to credit cards have increased.

For the credit markets and the consumer, all eyes will continue to be on housing and a hoped for stabilization. While housing starts (which feed into GDP), existing homes sales and new home sales have declined over the last year by 28%, 24% and 30% respectively, there have been some signs of stabilization in the quarter. In fact, affordability levels have improved to match those of 2003 as prices determined by the Case-Shiller index have declined over 13% from their peaks. As prices decline further, we must see current high levels of inventory start to recede before the market can stabilize. These inventory levels may be further pressured by the continuing threat of rising home foreclosures that are currently running at 3.3% annualized.This may pose the biggest threat to all areas of the economy and any optimistic assumptions on a housing recovery.

We previously discussed that S&P earnings growth might actually decline in 2008 from the levels of 2007 that were themselves essentially flat to 2006. Consensus estimates remain for a gain of about 7% that may prove to be quite optimistic. Though corporate profit margins have declined modestly to 7.9%, they still remain very high historically. Wage pressures may be contained but import prices are now running over 14%. As the consumer weakens, it will be increasingly difficult to pass on these costs. This will put a further squeeze on margins especially for those companies with higher commodity costs and consumer reliance.

In large response to the credit concerns, equities experienced the worst across-the-board returns in two decades as all styles, sizes, and markets were in decline. The S&P 500 rebounded from an early 15% decline to end the quarter down 9.4%. The Russell 2000 small cap index was off 9.9% while the International markets, as defined by the developed country EAFE index and the Emerging Markets index, declined 8.8% and 11% respectively.

As the housing and credit markets debacles continue to unfold, it is the longer-term impact on consumer behaviors that may hold the key to changing markets. It is in just such an uncertain period that the fruits of the Coho philosophy are borne. We will continue to focus on high quality companies that exhibit the ability to continue to grow earnings and dividends in a challenging economy. This will more often be found in the demand defensive sectors of Consumer Staples and Healthcare and companies that generate a large portion of their revenues outside the U.S. We continue to look for and find companies offering attractive valuations and the characteristics that we seek.