Commentary & Insight

Market Update from David Joy and Dan Laufenberg

The recent turmoil in U.S. credit markets has created widespread confusion concerning its impact on the broader economy, as well as on stock and bond prices. The call for the Federal Reserve to lower interest rates in response has grown louder in recent weeks, as the housing sector continues to slump. Some are even suggesting the possibility of recession if the Fed fails to act.

We thought this would be an opportune time to share our own thoughts with you regarding current conditions, to help you take a more informed, objective view of the present situation and its likely impact.

For creditworthy individuals and companies who wish to borrow money, it is still readily available. Both the bond and mortgage markets continue to function much as they have before. It is the less creditworthy who are currently finding that their ability to borrow has been impaired. The time when lenders were indifferent to risk has ended, and the cost of borrowing now more accurately reflects the risk involved. The important question is whether this re-pricing of risk will have enough of a negative impact to derail the current economic expansion. We do not believe it will.

Certainly, the downturn in housing will likely be prolonged, and automobile sales may continue to suffer temporarily as a result. However, average home prices nationwide suggest only a modest impact on consumer spending. In addition, personal income growth remains healthy and business spending is also strong, driven by consumer spending, as well as gains in exports and the restocking of inventories. Corporate profits also continue to grow. In short, the drag on the economy from weakness in housing and autos is largely being offset by strength in other sectors, keeping the current expansion intact.

Stock and bond markets, both in the U.S. and abroad, have become more volatile as a result of the credit squeeze. This volatility is reflective, in part, of the widely publicized problems that have afflicted overly aggressive investors in sub-prime mortgages who have suffered severe losses. It is also reflective, to some degree, of the fear that more such losses have yet to surface. It was precisely this fear that prompted the recent intervention by central banks around the globe to ensure the necessary availability of liquidity, as lenders retreated from the marketplace.

A measure of stability has returned recently, but heightened levels of volatility can be expected to persist for some time. It will take time for overly leveraged positions to be unwound and for pending bond underwritings to be brought to market. There will likely be more cases of speculators incurring sizeable losses.

For investors with well diversified portfolios, concentrated in high quality assets, the longer-term impact from the current credit squeeze should be minimal. Eventually, calm will be restored and volatility will subside. Beyond the U.S., global economies remain quite healthy, providing investment opportunities in companies able to take advantage. Valuations in most of the world's equity markets appear quite reasonable, and profits continue to grow.

The adjustment currently taking place in the U.S. credit market is certainly causing a rise in investor anxiety. It is, and in the shorter term will likely remain, a messy process. However, it is also long overdue and the ultimate result will be a more rational lending environment in which risk is more appropriately priced. We will continue to monitor this process carefully, and will keep you informed of our views as it progresses.