Quarterly Market Commentary – Q2 2008

Chairman Ben Bernanke delivered his semiannual monetary policy report to the Committee on Banking, Housing, and Urban Affairs, in the U.S. Senate today. The first paragraph of his prepared statement summarizes the severity of the current economic condition facing the US and the financial institutions.

“The U.S. economy and financial system have confronted some significant challenges thus far in 2008. The contraction in housing activity that began in 2006 and the associated deterioration in mortgage markets that became evident last year have led to sizable losses at financial institutions and a sharp tightening in overall credit conditions. The effects of the housing contraction and of the financial headwinds on spending and economic activity have been compounded by rapid increases in the prices of energy and other commodities, which have sapped household purchasing power even as they have boosted inflation. Against this backdrop, economic activity has advanced at a sluggish pace during the first half of this year, while inflation has remained elevated.”

Officially, the US economy is not in a recession but don’t ask the 346,000 unemployed workers who applied for unemployment insurance benefits for the week ending July 5. This brings first-half job losses to 438,000 with the unemployment rate holding at 5.5%. We predict the unemployment rate to get worse reaching beyond 6% by 2009.

So far we have not experienced an aggregate consumer spending slowdown. Consumers went shopping with their economic stimulus checks in June. Of the first 16 retailers reporting June sales, according to Thomson Reuters, 62% of them beat estimates for same-store sales. Nonetheless, U.S. retail sales rose by only 0.1% month-to-month in June, following the downward revised 0.8% increase in May. 5 of 13 components posting declines for the month were concentrated in discretionary and housing related items such as motor vehicles (-3.3%), furniture (-1.4% ), electronic (-0.6%) and building materials (-0.9%). The biggest increase in spending was reported at gasoline stations which rose by a strong 4.6%. This is another sign of shifting consumer spending patterns and the beginning of an overall consumer spending slowdown.

In the meantime according to RealtyTrac, an online marketer of foreclosed properties, lenders repossessed 71,563 homes in June compared to 26,369 homes just a year ago. In fact 343,159 homeowners lost their homes during the first half of this year which is up 136% from 145,696 during the same period last year. The same report summarized that foreclosure filings of all kinds, including notices of default, notices of auction sales and bank repossessions, increased 53% from June last year to 252,363. For the first six months in 2008, the total filings rose 56% to 1.4 million units. For those who still own a house, the S&P/Case-Shiller 20-city Home Price Index fell to a record low of 15.3% in April on a year-over-year basis and was down 1.4% from March. The 10-city index was down 16.3% year-over-year and 1.6% for the month. As home prices fall, home equity continues to shrink, leaving more homeowners with mortgages worth more than their homes. According to Economy.com over 10 million homeowners are now underwater and this number is growing.

The rise of the emerging and developing economies continues to put increasing demands on oil and other commodities. The rapid global economic expansion over the past few years has strained capacity of oil markets. From $20 per barrel early in this decade, oil is now over $145 per barrel. The spot price of West Texas intermediate crude oil went up by about 60% in 2007 and, thus far this year, has climbed another 50%. With the demand growth concentrated in developing economies to support their rapid industrialization coupled with government subsidies and supply limitations, we are not likely to see any meaningful reduction in energy prices. Oil prices are also likely to remain volatile, due to a combination of low stocks, limited spare capacity, supply disruptions, geopolitical factors and uncertainty over exploiting new reserves and the development of alternative energy sources.

Food prices have accelerated sharply in 2008. Grain prices have more than doubled since January 2006, with over 60% of the rise in food prices occurring since January 2008. Prices have risen due to a number of factors: high energy and fertilizer prices; the continuing depreciation of the US dollar; sharply increased use of both cereals and vegetable oils in bio-fuel production; growing global demand and declining global stocks of food grains. High food prices are also likely to continue. According to the World Bank prices are likely to remain well above 2004 levels through 2015 for most food crops.

Rising global food and energy prices are major contributing factors to global inflation. The Morgan Stanley global economics team has created the Double Digit Inflation Club whose members are countries experiencing double digit inflation rates. The original members were Russia, Ukraine and Vietnam and subsequently South Africa, Turkey, Indonesia and India were added. At the end of the second quarter, an additional 50 countries were identified. It is not surprising that almost all of the Club members are made up of developing economies. Many of these countries have weak and non-independent central banks and institutions and are commodity producers experiencing an internal inflation boom. Also energy and food represents a significant portion of the consumer spending in these economies and surging prices in these areas have a large and immediate inflationary effect. Many of these countries link their currencies to the US dollar, which has seen their values and thus purchasing power drop in locked step. The Club members now represent almost half of the world’s population.

Inflation is becoming a problem for the US economy as well. According to the Bureau of Labor Statistics’ June report, producer prices are up 9.1%, the largest one-year increase since 1981. Prices for intermediate goods are up 14.5%, the most since 1980. Food and energy prices represented the lion’s share of the price increase, but “core” prices are also up at a 4.5% annual rate in the first 6 months of this year and up 3.1% versus a year ago, the most since 1991.

We expect oil and food driven inflation will persist. In the case of food inflation, it takes time to increase crop production and to minimize bio-fuel as a long term viable energy solution. The limited supply with increasing demand will continue to put pressure on agricultural commodities. In the case of oil, the fastest solution is a worldwide recession. This will dampen demand and drive down oil prices, but at what cost?

The collapse of Bear Sterns towards the end of the first quarter was seen as a possible turning point in the market for the financial service sector and that the worst of the sub-prime driven tidal wave was behind us. The market was jolted last week by the Office of Thrift Supervision take over of IndyMac, a CA federal savings bank. This is the biggest mortgage lender to go under since last year. The collapse is expected to cost the Federal Deposit Insurance Corp. between $4 billion and $8 billion. IndyMac was one of the largest savings and loans in the country with about $32 billion in assets. It was created by Countrywide in 1985, to specialize in jumbo mortgages. After becoming independent in 1997, it continued to grow quickly through its specializing in the issuance of Alt-A mortgages. These are mortgages to borrowers with less than excellent credit histories and not quite as marginal as sub-prime borrowers. More banks are expected to go under.

Then there is the speculative trouble with Fannie Mae and Freddie Mac. They are victims of a “negative feedback loop”. It started with the bursting of the housing bubble when the subprime borrowers began defaulting on their loans. With an escalating inventory of new and existing homes on the market, the real estate prices began to plummet. This fed to more defaults and foreclosures as homeowners became unable to refinance their existing mortgages or to sell their homes. In the meantime, the banks began to write down their bad loans and tighten their underwriting guidelines as liquidity dried up. At one time this was limited to the sub-prime lenders and borrowers but has since spread to the rest of the market. It is in this prime borrower market that Fannie and Freddie are dominant players. With growing unemployment and continuing economic weakness, the traditional cycle of rising delinquencies among all borrowers is coming into play which further stresses the system. Fannie and Freddie are the only real players remaining in the mortgage backed securities market. Without them the much needed secondary mortgage market would completely dry up and further exacerbate the negative feedback loop. The US government’s effort is critical in restoring their credibility. This is no longer a domestic housing or mortgage problem; it is potentially an international finance problem. Over $2 trillion of the $3.5 trillion debt issued by Fannie and Freddie is held in foreign portfolios and primarily in foreign central banks.

During the first 6 month of the year, almost every asset class has lost value.

This is further evidence that the US driven financial crisis is affecting all markets and that diversification into foreign countries (developed and emerging) has not yielded the benefits we expected. The US financial markets and, for that matter, the domestic economy will not meaningfully recover until housing prices stabilize with liquidity substantially returning to normalcy. The Federal Reserve will continue to have a tough job of balancing a recessionary economy with one that is confronting commodity driven inflation risks. Globally, other developed economies are beginning to slow and some may experience a recession in the next 18 months. Some observers have suggested that the emerging or developing economies have finally decoupled from the US but this is not likely. The longer the US and other developed economies slow, the more likely the emerging markets will be dragged into the same economic malaise. For the remainder of this year, we expect the market to experience continuing volatility and economic uncertainty. Federal Reserve will not likely raise rates this year, and with all the talk about fighting inflation, the focus remains on the anemic economic condition and to stave off an official “recession”. We expect more trouble in the banking sector. The next leg down is for the banks to face increasing defaults in credit card debts, auto loans, home equity loans and small business loans. This would impact local and regional banks.