There is nearly an unbearable amount of fear and panic in the financial markets today. Indeed, for investors it seems in times like these there are few places to hide even in a well diversified portfolio. If you haven’t opened your 401K statement for the quarter just ended, you might need to sit down first. The $700 billion dollar Emergency Economic Stabilization Package expected to be passed today by Congress will help heal what ails our financial system and credit markets, but don’t expect it to work wonders for your equity portfolio overnight.
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A tremendous amount of economic and financial damage has already been done that will deepen the recession over the next six months. It is this fear about our economic future which has truncated a bailout-fueled equity rally. Indeed, equities are really just the sideshow of this event; the fixed income market is where this financial crisis and panic is really playing out, and the view from that end of the market has only gotten worse. Every day inter-bank money market rates and corporate bond credit spreads remain wide, and commercial paper outstanding evaporates, making borrowing for the average business and consumer more expensive and more difficult to obtain. Even platinum-grade companies like GE and Goldman Sachs are willing to pay upwards of 10 percent yields on preferred shares to obtain capital in this environment, while others that are not so lucky to find investors are left out in the cold. The Federal Reserve has expanded its balance sheet by $502 billion over the two weeks, about a 40 percent increase, as it increases its lending through the Discount window ($49.5 billion), PDCF ($146.6 billion), TSLF ($61.1 billion) and ABCP ($152 billion). The Fed is going all out as lender-of-last-resort to hold the financial system together. It’s like the financial system was a car moving down the highway at 70 MPH when the left rear tire blew out, and now the car is swerving all over the place and Bernanke and company are trying to regain control of the car before it ends up in a ditch or wrapped around a tree.
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While the markets have been glued to the shock and awe of spectacular bank and investment bank failures and takeovers, the economic data for August and September has begun pouring in, pointing to a steep decline in economic activity even before the latest financial fireworks. One month of bad economic activity in the absence of a credit event is no reason for alarm, but given the financial market events of the past few weeks, it is of considerable concern. The four percent plunge in August factory orders foretells a swift decline in industrial production in the months ahead. This outlook was partially confirmed by a steep drop in the September ISM manufacturing index to 43.5 from 49.9. Sub-components on new orders, employment production all took steep dives far into contraction territory. This is clearly no longer a financial event only impacting Wall Street. This will impact everyone as job losses accelerate.
The September payrolls report revealed a doubling of net job losses between August and September, worse than anticipated. The economy shed 159K jobs, with job losses in the services sector of -82K surpassing losses from the goods producing sector of -77K. This is a new troubling development since service job growth had been holding up relatively well so far. Financial services job losses increased to -17K in September, and one can expect even higher losses in the future as consolidation in the industry accelerates. Retailers shed a net -40K, the largest monthly decline for this sector since April. Average weekly hours worked matched the lowest on record at 33.6. The unemployment rate held steady at 6.1 percent, better than we had expected, but that was due to contraction in the labor force as fewer people were actively looking for work. The household survey of employment has even been worse than the establishment survey, revealing a net loss of -564K jobs over the past two months. Finally, the job diffusion index, which measures the breadth of job creation across industries, sank to 38.1 from 44.7 in August with the manufacturing diffusion index plunging to 26.8 from 34.5. Clearly, job creation is occurring in fewer and fewer industries.
As one might expect, our economic outlook has changed significantly, and not for the better. It is highly likely that GDP growth will contract as soon as Q3 2008 and likely remain in contraction at least through Q1 2009, even with the passage of the $700 billion bailout and improvement in financial market conditions. We are currently forecasting a 0.5 percentage point decline in GDP at an annualized rate in Q3, a 1.8 percentage point decline in GDP in Q4, and a 0.7 percentage point decline in GDP in Q1 2009, before growth rebounds to around 2.0 percent in the second half of 2009. It will largely be a consumer-led downturn, the steepest for consumer spending since 1982. We anticipate real declines in consumer spending at a 2.0 percent plus rate over the next two quarters. Business spending won’t be too far behind with non-residential investment dropping into contraction as the cost of borrowing rises, and a lack of demand cools business expansion plans. Perhaps most discouraging is the expectation of a double dip in residential construction. After two plus years of decline, we had started to see signs of stability forming in housing demand. The housing bill, passed a little over a month ago, held out some promise of a brighter future, yet another round of tightening credit, rising foreclosures and skittish buyers will likely prolong the downturn well into 2009, forcing home prices lower even as the government works to offset this adverse feedback loop.
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Job losses are expected to accelerate and continue well into 2009 with the unemployment rate rising to 6.8 percent. Without a bailout package, the labor market would likely deteriorate at a much faster rate, pushing the unemployment rate a full percentage point higher to nearly 8.0 percent.
Clearly, the bailout package will not be enough on its own to end the economic and financial problems facing us all. For its part, we expect the Federal Reserve to step in with further interest rate cuts to help offset the widening of credit spreads and tightening of credit on most businesses. A half percentage point cut in the Fed funds target rate is likely at or before the October meeting. While our economic and financial outlook has darkened further, without the aggressive actions of our government and our central bank over the last few weeks, the economy would be in far worse shape.