Volatility Surges to Two-Year High (8/07)

   Behind this renewed volatility is fear that contagion in the housing and subprime mortgage market will lead to a full blown credit crunch, in turn putting the brakes on consumer spending and leading the economy into recession. To be sure, the evidence suggests further weakness ahead in housing. In the first half of the year, the number of foreclosed properties rose 58% to 573,397. The national average home price as evidenced by the S&P/Case-Shiller Home Price Index is showing year over year declines for the first time since 1991. And at the current pace of existing home sales, it will take almost 9 months (a fifteen year high) to unload all houses currently on the market.

   The first signs of subprime contagion surfaced with the implosion of at least two Bear Stearns hedge funds that made leveraged bets on subprime mortgage investments. With the subprime assets in these Bear Stearns funds deemed worthless, the markets engaged in a financial witch-hunt on the assumption that what’s bad for Bear Stearns must be bad for other firms. Rather than wait for the next shoe to drop, investors decided instead to indiscriminately sell financial stocks, with those tied to the mortgage industry hit especially hard. Bear Stearns, Lehman Brothers and Goldman Sachs are all down roughly 30% during this correction.

   While a flight-to-safety-rally in Treasury bonds has brought the yield on 10-year Treasuries down to 4.7% today from 5.3% in June, the spread between Treasury bonds and riskier high yield bonds has widened to its highest level since June of 2005. As riskier assets are being re-priced, investors are demanding higher returns to compensate for the risk. Banks have an estimated backlog of $300 billion worth of unsold bonds, all but shutting down the spigot of private equity deal flow. Emblematic of the newfound liquidity issues in private equity, Blackstone Group has declined 40% from its recent post-IPO high. The fear of a growing liquidity or credit crunch has captured the market’s imagination, with the futures market virtually discounting a 100% probability for a Fed rate cut to 5% by the end of the year and another ease to 4.75% by January of 2008.

   Despite these fears, the fundamentals (outside of housing) remain strong. The economy grew at an annual rate of 3.4% in the second quarter, up from the first quarter’s dismal .7% rate of growth. Surging exports fueled by strong demand in foreign markets and a weak dollar, coupled with rising government spending accounted for the big quarter-to-quarter increase in GDP. And global growth seems to be getting more robust, even as the U.S. economy grapples with the weakening housing market. Just last week, the International Monetary Fund increased its forecast for global growth from 4.9% to 5.2%, as it simultaneously reduced its GDP forecast for the U.S. economy from 2.2% to 2% for the year. Strong overseas growth has been especially evident in second quarter earnings reports which are being led by companies with worldwide operations. Earnings for the S&P 500 are now on pace to increase 11% over last year, double the consensus estimate. With such stellar earnings growth in the wake of the recent stock market correction, the S&P 500 now trades at an approximate PE of 15.4 which is the lowest PE multiple since January of 1991.

   Meanwhile, the Fed’s preferred PCE inflation price index that excludes food and energy declined to a 1.4% annual rate, well within the Fed’s 1% to 2% comfort zone. The drop in inflation, the more recent drop in energy prices from $80 per barrel back down to the $70 range and the slight rise in unemployment to 4.6% suggest that the Fed may indeed have wiggle room to lower rates should credit conditions worsen.

    Then, at the August 7th meeting of the Federal Reserve Open Market Committee (FOMC), the Fed kept interest rates unchanged at 5.25% and did not flinch from stating that inflation was its "predominant policy concern. Many market analysts had been predicting that Ben Bernanke and the Fed would adopt an official "neutral" bias, where the risks of slowing growth and rising inflation are balanced. While not quite shifting to neutral, the Fed did take at least a step towards neutral by acknowledging the recent turmoil in the financial markets. The statement that accompanied the Fed’s decision included the following: "Financial markets have been volatile in recent weeks, credit conditions have become tighter for households and businesses, and the housing correction is ongoing." This direct acknowledgement of the current liquidity crunch should give the Fed the ability to move to neutral at its next meeting or even cut rates between meetings should conditions worsen. Moreover, the Fed statement affirms the aforementioned strong fundamentals: "the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy".