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Monday, 15 October 2007 00:00 Written by James Van de Voorde

In last month’s newsletter, we predicted that the weak August jobs report would give the Fed “more than enough cover…to cut by 50 basis points”.  Well, that’s precisely what happened when the Federal Reserve met on September 18.  The fifty basis point cut to 4.75% was the first time the Fed has lowered the Fed Funds rate since June of 2003 (when it was cut to a generational low 1%) and the largest cut since the last fifty basis point move in November 2002. 

   The Fed’s accompanying statement indicates a growing concern of potential spillover from the weak housing market to the rest of the economy and the Fed’s desire to contain the damage:  “Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally.  Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.”

   The initial response by the stock market has been all positive with the Dow Jones Industrial Average and S&P 500 greeting the welcome surprise move by the Fed with fresh runs at new all-time highs.  And while the futures markets were fully discounting at least one more twenty-five basis point cut by year-end, another surprise in the form of a stronger than expected September jobs report has given the markets additional legs.  Not only did the U.S. economy create a better-than-expected 110,000 new jobs in September, the August numbers were revised sharply higher to an 89,000 rise from a previous estimate of a 4,000 decline.

  While the jobs report reduces the odds that the U.S. economy will slip into recession, it also decreases the likelihood for further rate cuts by the Fed.  The Federal Reserve’s swift action combined with the strong jobs report has given Goldilocks and her “not too hot, not too cold” economic soft landing theme a much-needed shot in the arm. 

   Perhaps the new “wall of worry” will be focused on whether the Fed’s aggressive actions and newfound strength in the labor market might reignite inflation concerns.  Signaling this concern, gold has recently surged to a 27-year high, and the U.S. dollar has been struggling to find a bottom against other major currencies.  As the dollar falls, imports become more expensive, sparking inflationary pressures, while gold is the classic hedge in a rising inflation environment.  And the price of oil has remained stubbornly above $80 per barrel, even while fears of recession dominated the headlines.  Since crude oil is priced in dollars, oil producers will manipulate production in order to be compensated for the dollar’s decline.  Higher energy prices translate into higher costs for products that use petroleum based raw materials and higher transportation costs to ship products around the globe.  Yet while the potential for higher inflation deserves our close attention, the fact is that the Fed has at least some leeway since the closely watched core PCE measure of inflation recently came in at a year-over-year trend of just 1.76%, the lowest level since January of 2004.

   Another sign that the markets current strength is on solid footing lies in the recent performance of the major investment banks as they announced “kitchen sink” losses in the billions of dollars.  Citigroup, Deutsche Bank, UBS and Merrill Lynch all rallied after announcing significant, multi-billion dollar charges resulting from losses in CDOs, mortgage-backed securities and other debt instruments that needed to be properly marked to market.  Typically, it is a good sign when the market can rally in the face of bad news, implying that the bad news was already “baked in the cake”. 

   The recent fifty basis point gift from the Fed increases our confidence that the market will surpass our base-case scenario of 1560 predicted in our January newsletter.  In fact, at press time, the S&P 500 is trading just above 1560.  Our more optimistic forecast for an S&P 500 that “might trade as high as 1615” is back on the table.  While the market seems to be waving the “all clear” sign for the final quarter of 2007, we would prefer the market to bide its time and consolidate the recent gains over the coming months.  Whether the market moves higher still and approaches the 1600 level on the S&P 500 may rest squarely on the third quarter earnings season.  The analyst consensus has already been reduced to less than 4% quarterly growth from 9% growth just prior to the August credit crunch.  Warnings from companies within the financial and consumer discretionary sectors have been especially pronounced.  That said, the weak dollar coupled with strong foreign demand should allow leading multinational companies to deliver solid quarterly earnings – this should help drive strong relative performance for Osher portfolios for the balance of the year.

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