Economic Commentary - October 2008   Clare Zempel Economic and Investment Strategies Consultant    Overview Confidence The crisis in confidence in the financial markets deepened in September. The casualty list now includes Countrywide Financial, Bear Stearns, Lehman Brothers, Merrill Lynch, AIG and others. Some were acquired under fire-sale conditions (Countrywide, Bear, Merrill), some went into bankruptcy (Lehman), and others (AIG) received special support – bailout loans – from the Federal Reserve. This has become the most serious financial-market problem since the savings and loan crisis in the 1980s and 1990s.   The causes behind the current financial problems are similar to those that were behind the savings and loan crisis: low interest rates, loose lending standards and excessive leverage. Low interest rates in 2002-2003 initiated a sharp expansion in both real estate demands and mortgage-loan supplies, which lenders funded with short-term borrowings. Home prices soared to unaffordable levels in 2005-2006. Demand for homes peaked in 2005 and home prices peaked in 2006. But lenders loosened their standards in an effort to attract new borrowers and maintain revenues. And loan problems – delinquencies and foreclosures – have soared since then.   The financial markets seemed unconcerned about mortgage-loan problems until August 2007. It was not until then that investors in mortgage-backed securities – commercial paper and other debt, which lenders sold to finance the mortgages – became worried about being repaid. Some investors wanted more compensation – a higher interest rate – for taking increased risk. Others just abandoned mortgage-backed securities and switched to safer investments. The Federal Reserve and other central banks stepped in to lower interest rates and provide short-term loans in an attempt to contain debt-default problems.   But credit concerns were not contained due in part to unresolved uncertainties about just how much repayment risk exists in mortgage-backed securities. To resolve such uncertainties, an investor needs information that takes considerable time and effort to accumulate and process. But even if an investor had complete information about the borrowers and homes involved, uncertainties about the risk that home prices could fall further would still remain. Calculating mortgage-backed security values has become so problematic – and so subject to severe criticisms from regulators and other investors – that most such securities are viewed with suspicion and trading in them has all but ceased. This blanket condemnation has proven lethal to more than a few financial institutions due to the mark-to-market accounting rule.   Mark-to-Market The mark-to-market accounting rule forces firms to revalue their assets to current market values even when the market is frozen or dysfunctional – and to do so even when the assets could be held to maturity and redeemed at face value. Based on this rule, an asset that does not trade has no market value and is worthless. A mortgage-backed asset that is certain to be repaid with interest would nonetheless have to be written off – reducing a firm’s earnings and depleting its capital in the process – if it failed to trade due to chaotic market conditions.   Not all mortgage-backed securities were riskless before August 2007. And not all such securities are worthless now. Substantial recoveries in securities that have been written down or off should occur over time. The crisis in confidence in the financial markets would end quickly if the accounting authorities suspended or eased the mark-to-market accounting rules which seem counterproductive in present circumstances.   Economy The problems in the financial markets have so far neither reflected nor caused economic weakness equivalent to a recession. Real GDP (Gross Domestic Product) has risen 2.2% over the last four quarters with housing’s weakness included and 3.2% without it. Labor market conditions have softened but nowhere near the extent recorded in even the mildest recessions.   The Federal Reserve has been focused on stabilizing and improving the economic and financial market outlook for more than a year now. The real or inflation-adjusted federal funds interest rate has now fallen to or below levels that proved sufficient to end all seven recessions since 1960 – and it is still far from clear that a recession has started. Likewise, the yield-curve spread – the difference between the yield on the 10-year T-Note and the federal funds interest rate – has risen to or above levels that preceded an imminent end to past recessions. Moreover, the decline in oil prices below $100 per barrel should help ease the severe downward pressures on consumer pocketbooks and confidence.   Implications The claim here is not that there are no risks but that the market has discounted the worst-case scenarios that the dramatic easing in the Fed’s policies has made improbable. To be sure, there is considerable doubt that low real rates will prevent a recession, let alone support improvements in business and labor-market conditions. But such skepticism has been present – and was proven to be misplaced – after most if not all slowdowns and recessions in the past.   Should stock investors sell now? Studies show that attempts to “time” the market – to sell at peaks and buy at troughs – have underperformed a simple “buy-and-hold” approach. Other studies show that adherence to asset allocation plans can help support portfolio returns.   Given the stock market’s sharp decline since last fall, restoring a portfolio to the intended long-run asset-allocation mix will probably require buying – not selling – common stocks. Low real interest rates and other fundamental indicators that point to economic and market upturns support such an action. Economic and Market Update: The Continuing Discussion The Federal Reserve’s monetary policies, reflected in real or inflation-adjusted interest-rate levels, provide useful if imprecise clues to both broad and specific future economic developments.   Real or inflation-adjusted interest rates are measured by subtracting inflation from rates quoted in the marketplace. To illustrate, the federal funds rate has been 2.0% since April and the current “core” personal-consumption inflation rate is 2.4%. (“Core” inflation excludes food and energy prices. With food and energy included, “total” inflation is 4.5%. Either measure could be used to calculate real interest rates. The results would differ in detail but not in principle.) (The inflation rates used here are based on the Personal Consumption Expenditure Deflator, a price index that is similar to but more comprehensive than the CPI.) Subtracting inflation from the rates in the marketplace, the real fed funds rate is about -0.4% or -40 basis points. (Figure 1.)   It is important to know where the real fed funds rate is because there has never been a recession in the past until after it rose to or above 450 basis points. The last time the real fed funds rate was above this “tipping point” was prior to the 2001 recession. The maximum that the real fed funds rate reached since then was about 325 basis points in June 2007. Such a level was associated with a sharp economic slowdown and a severe stock market “correction” in 1966-1967, but no recession occurred back then and the stock market rebounded quickly and sharply.   Another reason it is important to know where the real rate stands is that low levels have always ended recessions and spurred recoveries. And the real fed funds rate’s current -40 basis point level is in line with or below the levels that preceded an end to all seven recessions that have occurred since 1960. From this real-rate perspective, a traditional recession has been and remains improbable – because the real fed funds rate never broached the historical tipping point. And if a recession does start, it should be short and mild – because the real rate has fallen so low.   The yield-curve spread supports similar positive conclusions about economic prospects. The yield-curve spread is the difference between the yield on the 10-year T-Note and the federal funds rate. With the T-Note around 3.5% and the federal funds rate at 2.0%, the yield spread is now about 150 basis points. The yield-curve spread has not been sufficiently negative to cause a recession since prior to the 2001 recession. And it is now sufficiently positive to spur an upturn. Based on the real fed funds rate and the yield-curve spread, economic and market conditions should improve sooner than most expect. (Figure 2.)   Real rates and yield-curve spreads are not all that matters but their impact on economic conditions has been powerful and pervasive over the decades. Trends in nonfarm employment continue to conform to their historical relationship to the real fed funds rate. Nonfarm employment has fallen by 602,000 since it peaked last December. Its 12-month growth rate has declined from 2.1% in March 2006 to -0.2% this past August. The pattern has been that job growth has tended to peak whenever the real fed funds rate rose above 325 basis points. More relevant to the future, job growth has tended to turn up as the real fed funds rate fell toward zero. The fact that the real fed funds rate has been below zero since April implies that employment trends should soon recover. (Figure 3.)   The downturn in housing can also be traced in part to the real fed funds rate. The pattern here has been that housing starts have tended to stop rising if the real fed funds rate rises above 325 basis points, to plummet if the real rate climbs above 450 basis points, and to recover as it falls back toward zero. With the real fed funds rate now below zero, housing should stabilize soon. (Figure 4.)   An essential caveat is that the collapse in housing starts since January 2006 was due much more to the rise in home prices to unaffordable levels than it was to interest rates. Future increases in household income should combine with some further declines in home prices to stabilize housing construction within 6-12 months, provided that credit is available. Recent actions by the U.S. Treasury and the Federal Reserve should ensure that it is.   Over the four quarters that ended in June 2008, Real GDP rose 2.2% with the weakness in housing and inventories included and 3.7% without it. Housing does not have to recover to lift Real GDP. Overall economic conditions would improve sharply if housing just stopped declining. Rising oil prices have also been depressing business conditions for quite some time. This has not caused a recession because real interest rates never broached the critical 450 basis-point level and have now fallen. Oil prices remain a critical “wild card” in the outlook. The per-barrel oil price has fallen from around $145 in early-July to less than $100 in mid-September. Further oil-price declines would do much to relieve downward pressures on consumer pocketbooks and sentiment. (Figures 5 & 6.)   The charts support the hope that the decline in the real fed funds rate that has occurred should help economic conditions stabilize and improve soon. The charts also support the view that the decline in real rates will help the stock market stabilize and rebound. It is true that the S&P 500 Common Stock Index fell 26.1% from its peak last October to its recent low in mid-September. It is also true that a 20% decline fits the conventional definition for a “bear market.” It is furthermore true that this writer had contended that a “correction” was more probable than a “bear market” decline in stock prices. (Figure 7.)   The 26% decline in stock prices from last October’s peak to the recent mid-September low is in line with the 22% peak-to-trough decline that occurred in 1966. As indicated earlier, the real fed funds rate had reached about 325 basis points in 1966. The results then included a sharp economic slowdown – but not a recession – and a stock market decline that fit the “technical” definition for a bear market. Over the 52 weeks that followed the stock market’s low in October 1966, however, economic conditions improved – and the S&P 500 Index rose 32.9%.   Low real interest rates should help support and revive the economy and the stock market in the months ahead. Based on the historical relationships displayed in the charts, the improvement could start quite soon. Peaks and troughs in the stock market look obvious in hindsight. But attempts to time the market – to sell at those peaks and buy at those troughs – tend to underperform the simple buy-and-hold approach. (Figure 8.)   Rather than abandon hope and the stock market, investors should check their current asset allocations and rebalance as needed to return their actual portfolio mix to their desired levels. Given the market’s decline, this could require shifting funds into common stocks. Based on the evidence in the charts, such a shift seems warranted and should be rewarded over time.

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