Steady As She Goes

Currently, the Dow Jones Industrial Index is up 6.4% from its August 16th intra-day low. The Nasdaq is up 7.25%. More to the point, credit markets are showing signs of improving. The four large banks in a show of support for the Fed’s reduction of the lending rate last week each borrowed $500 million at the Fed discount window. Though they paid the money back a short while later, it was an important symbolic show of support. It also indicates that banks have better options than borrowing at 5.75% from the discount window. But there is still not enough data to show whether non-bank mortgage lenders are gaining access to the recently risk-frozen credit markets. 

Bernanke’s move last week to cut the rate that the Fed lends to banks put the ‘oil’ as close to the seized parts as he could. The Fed cannot lend directly to non-deposit-taking institutions, but they can encourage banks to do so. Wednesday’s news of Bank of America buying two billion dollars worth of Countrywide’s (the nation’s largest mortgage lender) convertible preferred showed that banks are not running from risk.

Interest rate futures indicate that the Fed will have to do more to ease the credit crunch. They point to a cut of a half a percent in the Fed Funds Rate at or before the Fed’s next meeting in September. Downplaying the notion that the Fed was reacting to market volatility alone, Richmond Fed Governor Jeffrey Lacker said at an annual luncheon of the Risk Management Association of Charlotte, that “interest rate policy needs to be guided by the outlook for real spending and inflation,” but markets can change that assessment if they induce changes in economic growth or prices. The Fed will undoubtedly wait to see what effects their moves so far are having on the credit markets before doing something else. 

The news today is good on several fronts. Sales of new homes in the U.S.unexpectedly rose for the second time this year in July by 2.8%. But as some mortgage lenders leave the business and others tighten their lending standards it may be too much to hope that the trend will continue in the short run.

Orders for durables goods made in the US rose more than forecast in July reinforcing the notion that business will continue to bolster an economy buffeted by rising energy costs and falling home values. Demand for products meant to last several years jumped 5.9% after a revised 1.9% gain the prior month according to the Commerce Department. Excluding orders for transportation equipment such as airplanes (which vary widely from month to month), durable-goods orders increased 3.7%, the most since August 2005, according to Bloomberg. 

While these reports are good, they represent data before the credit crunch rocked global markets in mid-August. We will have to wait for several weeks and perhaps months to see whether and how badly consumer and business confidence might have been damaged the dramatic flight from risk. As we point out almost weekly, the consumer may one day buckle under the worries of high gasoline and utility bills, higher interest rates, and lower home values. Business managers having witnessed a virtual credit freeze might put big growth projects on hold foregoing for a time the risks necessary for growth. These questions of confidence will weigh heavily on investors’ minds in the coming weeks.

The actions the Federal Reserve takes in the near future will play a key role in the likely outcome of whether the US economy and perhaps the global economy avoid a recession or not. It is clear that they do not want to reduce rates more than is necessary to keep credit flowing. Creating too much liquidity would put us back in the same environment that started the mess we are in now. It could also spark the worst kind of inflation known as ‘stagflation,’ or rising prices in a stagnant or declining economy.

Ben Bernanke has proven himself to be very protective of his primary mandate; controlling inflation. But he has also shown a willingness to be proactive. He can move ahead of the data to reverse undesirable trends before they cause significant damage. While I believe Mr. Bernanke will not disappoint market expectations that the Fed will do what they need to do to deliver the right doses of liquidity as needed, I also believe he will surprise experts with his creativity. Big Ben likely has a few tricks up his sleeve the futures markets have not anticipated. 

Corporate earnings are the fundamental driver of stock prices over the long term and the outlook remains healthy indeed. Nearly 89% of the S&P 500 companies have reported their earnings for the second-quarter and they are up an average of 7.9%. This number dwarfs the 3.9% gain forecast as late as April 1. Forward earnings for this year and next projections were rising as we headed into the credit crunch. 

The global economy also remains solid. The MSCI All-Country World Index is selling at 16.4 times trailing earnings little changed from the P/E levels when the current bull market began. By contrast, the index’s P/E ratio reached 35 in 2000 when the last bull market collapsed. The strength of the global expansion has provided and likely will continue to provide a strong foundation for theUSeconomy. Most S&P 500 companies reap huge sales and profits from abroad. What’s more, as a group they generate significantly more cash than they need to fund growth. The credit freeze has no real impact on growth of this group of companies.

We believe the US economy will weather the current challenges resuming growth next year. We also believe that global stock markets will outperform the US stocks. Accordingly we expect to take opportunities to overweight allocations to Europe and the Pacific Rim. We will also re-establish some positions in emerging markets as opportunities present themselves. On the fixed income side we expect to keep bond maturities relatively short for the time being and focus on equity income plays such as REITS and other high dividend opportunities.