Commentary & Insight

Market Update — The two-headed monster: Market losses and inflation

Ted Truscott, Chief Investment Officer
June 12, 2008

"Now that the Fed has stepped in, it's possible that things will go back to normal. But let's hope they don't get too normal: One of the biggest problems in the market in the past decade has been that lenders, clients and even ordinary small investors have put far too much faith in the magical abilities of Wall Street firms, and have failed to give their promises and performance proper scrutiny."

James Surowiecki
"Too Dumb to Fail"
The New Yorker
March 31, 2008

"The biggest risk from rising inflation lies in emerging economies, not in the developed world. Because food has a much bigger weight in household spending, not only are those economies more prone to inflation now, but social and political consequences would also be more severe. This week Jean-Claude Trichet, the ECB's president, warned central banks around the globe not to repeat the mistakes of the 1970s."

"An Old Enemy Rears Its Head"
The Economist
May 24, 2008

These two quotes nicely sum up the economic state of affairs in the world. On one end of the spectrum we are witness to huge losses on Wall Street. This is the result of financial speculation in housing and a host of other instruments facilitated by loose monetary policy and poor scrutiny of risk. At the other end, inflation is itself a product of excess saving in emerging economies, pegged currency rates and loose monetary policy. The ripple effects of this two-headed monster continue. The steep fall in housing prices is deeply deflationary and ruinous to consumers with too much debt. On the other hand, rising oil and food prices is inflationary and can destroy wealth as well. This monster needs to be slain and it will not be easy.

This monster is a fearsome one and fear is back because the market is realizing that there are no easy answers. Firms are recognizing that large and painful adjustments will be necessary. We are now seeing job losses from the first round of layoffs at firms adapting to a slower economy and these numbers are finding their way into the unemployment rate.

Housing crisis

Many of our updates note that the housing crisis is not over nor will it be over for some time. This continues to be the case and will be the case for another one to two years. Simply put, prices have not fallen sufficiently for the market to clear itself of excess supply. There are multiple implications of the continued slump in property prices and the excessive inventories of unsold homes on the market.

First, consumers can no longer use their home as an ATM machine. This negatively affects consumer spending and many firms are suffering from this marginal change to spending patterns. We are continuing to see deterioration in recovery rates on liquidation rates of properties that have gone into foreclosure. This then affects the price of a whole range of securities that were formed by slicing and dicing mortgages into brand new securities, many of them highly rated based on a set of assumptions that were patently unrealistic. Home builders and other participants in the boom are now running into trouble themselves and we are witnessing a steep rise in the non-performing loans of commercial banks that have had excessive exposure to housing development or reconstruction projects.

Oil prices

As if this were not enough, oil prices continue to move higher. We believe that there is a fair amount of speculation in the price of oil. With gasoline prices at an average of $4.00 per gallon, demand will certainly begin to drop and eventually this will feed its way into the marketplace. However, there is no question that there has been a demand/supply shift upward in the price of oil and higher prices may well be permanent, albeit at a level that could be below today's levels. Nonetheless, as our chief economist Dan Laufenberg has noted, the Federal Reserve and a number of the world's central banks cannot continue to validate higher food and energy prices with easy money. Higher interest rates are likely to ensure that inflation does not reappear in the destructive form of the 1970s.

Adjustments are needed in the economy and they will continue for some time. A friend recently told me about a major franchisee in the casual dining industry. This franchisee noted that he was absolutely amazed at the amount of cost that the chain had been able to squeeze out of its daily operations as a response to falling consumer demand. He noted that any marginal change for the better would result in a profit explosion for the business thanks to this new found discipline. That profit explosion will not be here tomorrow, but it is our job as investors to determine which firms are making the necessary adjustments to respond to a world that has changed dramatically. In those adjustments are the seeds of growth and optimism that provide both opportunities today and in the future. RiverSource Investments senior portfolio manager Warren Spitz has noted that industrial cyclical stocks may perform well precisely because these firms made painful adjustments to a tough set of operating conditions a long time ago. Much of the rest of the world economy needs to follow suit.

All change occurs at the margin. Marginal changes in consumer spending habits create big effects downstream in casual dining chains, airlines and other businesses. In response, businesses need to tighten their belts so they can survive the downturn and realize better results when activity begins to pick up again. America, both individually and at a corporate level, is on a much needed diet.

What you can do

While the aforementioned monster continues to lurk, we continue to urge clients to consult their financial professional to make any necessary adjustments. One potential adjustment is to ensure that there is proper diversification of product within a client's overall portfolio. There is no single product that can handle all of the risks associated with today's market conditions or the risks from inexorable shift of the responsibility of retirement and longevity onto the backs of individuals.