Commentary & Insight

Market Update — Let's be careful out there

Ted Truscott, Chief Investment Officer
RiverSource Investments
May 13, 2008

April brought a welcome respite to the downward trend in the stock market and many portions of the bond market saw improved liquidity conditions. It is clear that the Federal Reserve's aggressive monetary easing and unprecedented moves to lend to non-bank financial institutions has helped improve the liquidity squeeze that has been one of the defining features of the financial marketplace during the past 10 months. Short-term lending rates are 2%, while the 10-year Treasury note yield is hovering around 3.8%. If we assume that U.S. inflation is approximately 4%, then interest rates are negative in real terms.

This means that investors in high-quality government instruments are accepting rates that will likely erode wealth over time because inflation will eat away the meager returns on offer. Current monetary conditions are a classic remedy designed to reflate the economy, encourage investors to take on greater risk and improve bank profitability. Bank profitability is set up to improve because the treasury yield curve is sloped upward — meaning that short-term rates are lower than long-term rates. Banks, through short-term deposit taking and the purchase of longer-dated treasuries, have a virtually risk-free way of making money, which helps them rebuild profits and capital.

There is an old markets adage that says "you don't fight the Fed," so at this point it is only natural to ask whether we have emerged safely from the crisis and whether market conditions are likely to improve steadily from here.

Any analysis of current markets must take account of the significant economic issues that remain, while also noting that markets are discounting mechanisms and tend to see into the future for a period of six to12 months. Have markets adequately reflected the headwinds that remain in the future? Has the stock market fallen sufficiently to take account of the profit squeeze that many companies are experiencing? Have bond prices fallen and the amount of compensation (known as the "spread") widened sufficiently to reflect the likely increase in default rates?

As we begin to answer these questions, I should disclose that we are not among those who believe that the negative affects of the housing crisis are over. A recent and extremely sobering analysis by the Bank Credit Analyst points to the fact that housing prices have only declined by about 10% according to one index. This is fairly modest compared to the size of the housing boom. Other countries that have experienced either commercial or residential real estate declines saw prices fall much further, some as much as 40 to 60%, and it took many years for above-par economic growth to return. This includes the commercial real estate bust in the United States that was a hallmark of excessive lending by savings and loan institutions in the late 1980s. In fact, commercial real estate prices in the U.S. fell by some 44% from 1986 to 1991.¹

In short, further house price declines are likely, meaning there will likely be further losses recognized by financial institutions and other investors in securities that reflect the housing market. The only good news is that the size of the write-downs has been so large that at least some of the additional losses may already have been recognized by banks, hedge funds and other players in the debt markets. That said, further house price declines will increase pressure on consumers to save more and spend less. Although this is necessary, consumption accounts for two-thirds of the U.S. economy, so less consumer spending has widespread effect.

At the same time, we need to worry about an increase in the number of firms that enter bankruptcy as a result of the decline in economic activity and the reduction in outstanding indebtedness that must occur. Already we have witnessed many marginal retailers who financed ill-timed expansions with debt enter into bankruptcy or liquidation. Casual dining chains are being squeezed by food price inflation and fewer patrons and some will no doubt fail as well. Airlines are back to losing money thanks largely to excess capacity and soaring jet fuel costs, and we have witnessed at least four marginal carriers liquidate or enter bankruptcy in the last few months. In short, whether we are in a recession or not, the U.S. economy has slowed substantially and weak or highly indebted firms will continue to suffer or fail. The good news, however, is that bond prices may already be discounting the increase in bankruptcies, meaning that yields are at a level necessary to compensate for the increased risk.

Inflation also remains a persistent worry as oil prices continue to set new records and a food shortage, exacerbated by natural disasters, grips the world.

At this point there are two or three scenarios that could play out over the next 12 to 18 months.

1. Optimistic scenario: The Fed has rescued us once again and the economy grows slowly for the rest of the year. Modest growth in the U.S. and slowing growth in the rest of the world forces oil and food prices to decline. Inflation remains under control and the Fed's bet that Core CPI (excluding prices of food and energy) shows the true direction of inflation pays off. Emerging economies continue to grow despite the U.S. slowdown and they are the heroes behind keeping the world economy afloat. Bond spreads more than adequately reflect future risks and the stock market decline ends. Returns are positive in the high-single digits for stocks and mid-single digits for bonds.
2. Pessimistic scenario: The Fed's easing has helped us through the crisis, but housing continues to be a drag on the U.S. economy. The consumer continues to be under pressure and inflation remains stubbornly high because of loose monetary conditions and a supply/demand shift in the price of oil and food. Emerging economies grow, but not sufficiently to prop up the rest of the world. Eventually the Fed is forced to raise rates to fight inflation and the U.S. economy does enter a recession. Bankruptcies rise and corporate bond defaults are higher than expected. Returns in both the stock and bond markets are negative.
3. Middle-of-the-road scenario: There is plenty of bad news and the housing crisis is a drag on the economy as consumers pay off debt and retrench. However, there is sufficient worldwide savings to allow financial institutions and other firms to raise capital to cushion against losses. Emerging economies continue to grow despite the U.S. slowdown and this growth is enough to have a modest positive influence on the world economy. However, it is a benign growth that allows oil and other commodity prices to fall. Stock returns are in the mid-single digits, while bonds offer returns in the low-single digits.

We have long argued that investors should be greedy when others are fearful and fearful when others are greedy. We also have noted that market timing is impossible and should emphasize that any investors who fled the stock markets in January or February missed out on a 5% return for the month of April alone! April results suggest that at least some investors are siding with the optimistic scenario above.

With all of that being said, it is still hard to assign probabilities to any of these scenarios as many variables will determine the eventual outcome. Prudence and caution remain the watchword for the markets today even though opportunities continue to exist in various asset classes. It is for this reason that we advocate not only asset allocation, but financial product diversification. An appropriate mix of financial product solutions ranging from stock and bond mutual funds to insurance and annuities may help insulate against the vagaries of the markets. There is no single financial product that can solve all of the challenges faced by today's investors. The right mix of product solutions may improve the chances of success in both benign and tough market conditions.

Asset allocation and diversification do not ensure a profit or protect against loss.