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Market Update -- In the Markets

Written by Derrick Wulf, CFA, Portfolio Manager

January 4, 2008

Here is a brief summary of what transpired in the economy and the financial markets during the past three months. We hope you will find it a handy reference.

Growth
The domestic economy slowed sharply during the fourth quarter after growing at a strong 4.9% rate in the third quarter. Continued weakness in residential construction and a slowdown in consumption were the primary culprits. Most preliminary estimates of fourth quarter GDP growth are currently in the neighborhood of 1%, with weakness expected to persist into early 2008.

Inflation
Core inflation edged up slightly in the fourth quarter, with the core PCE deflator rising from 1.9% in September to 2.2% in November. Core CPI, meanwhile, rose from 2.1% in September to 2.3% in November. These inflation figures were a bit higher than the Federal Reserve's comfort zone, but additional gains in core inflation readings in early 2008 are not widely expected.

Jobs
The job market showed increasing signs of slowing in the fourth quarter, with initial jobless claims consistently creeping higher and payroll growth slowing. Non-farm payrolls grew by less than 100,000 per month on average during the quarter (the most recent data still subject to revision) after averaging about 134,000 per month in the first half of the year and almost 190,000 per month in 2006. The unemployment rate, meanwhile, rose from 4.7% in the third quarter to 5% in December.

Income
Growth in wage and salary income remained firm in the fourth quarter. Average hourly earnings rose 3.7% on a year-over-year basis in December according to the Bureau of Labor Statistics, while personal income growth, as reported by the Department of Commerce, stood at a healthy 6.1% on a year-over-year basis through November.

Manufacturing
The manufacturing sector weakened during the fourth quarter despite a boost in exports stemming from the weakened dollar. The ISM Manufacturing Index slipped to 47.7 in December, its sixth straight monthly decline and its lowest level in over four years. The new orders component fell to 45.7 in December, its lowest level since October, 2001.

Housing
The housing recession deepened further in the fourth quarter. Existing home sales in October hit their lowest level in years, sliding more than 30% from their peak in September, 2005. New home sales followed an even steeper decline, dropping more than 50% from their 2005 high. The median price for existing home sales in November was down almost 9% from its July, 2006 peak. Months' supply, meanwhile, which rarely exceeded five months during the first half of the decade, remained above 10, suggesting more price declines are likely. The National Association of Homebuilders Market Index hit a new record low of 19 in October and stayed there in November and December, and housing starts hit a 14-year low in November. Finally, the S&P/Case-Shiller composite home price index registered its 15th consecutive monthly decline in October and was down over 6.5% from its July, 2006 peak.

Confidence
Consumer confidence declined again in the fourth quarter amid rising gas prices, slowing labor markets, and continued deterioration in the housing markets. The Conference Board's index of Consumer Confidence slipped below 90 in November and December, approaching its post-hurricane Katrina four-year low.

The Fed
The FOMC convened two official meetings during the fourth quarter, voting both times to cut the benchmark overnight lending rate by a quarter percentage point, bringing rates to 4.25%. The FOMC statement released after the December 11 meeting cited "intensification of the housing correction" and "strains in the financial markets" as important factors in the decision to ease monetary policy. The statement also emphasized "increased uncertainty surrounding the outlook for economic growth and inflation," suggesting that committee members would remain open to making additional adjustments to monetary policy at subsequent meetings as dictated by further developments in the economy and the financial markets.

Fed funds futures closing prices at the end of the year suggested that most investors expect the Fed to cut rates at least another 25 basis points in the first quarter, eventually bringing the rate down to 3.25% or lower by the end of 2008.

Treasuries
Treasury yields fell sharply and the yield curve steepened during the fourth quarter. On a yield basis, two-year notes were the top performer, falling 94 basis points to end the year at 3.05%. Five-year notes saw their yield decline by 81 basis points to 3.44%, while Ten-year notes fell 56 basis points in yield, closing out the year at 4.03%. Thirty-year bonds saw the smallest decline in yields, dropping just 38 basis points to 4.45%. T-Bills, which had been the beneficiaries of significant flight-to-quality buying during the third quarter, continued their march lower as well, ending the year at 3.24%, some 56 basis points below their third quarter close and a full percentage point below the fed funds rate.  

Bond Markets
Credit spreads continued to move significantly wider during the fourth quarter, as a dramatic erosion of investment capital stemming from losses in subprime mortgage related products and a deterioration in economic fundamentals led to a sharp rise in liquidity and credit risk premiums. Easing in federal monetary policy and a decline in Treasury yields helped propel the Lehman Brothers Aggregate Index to a 3.00% total return in the fourth quarter, but widening spreads led to negative excess returns for virtually all non-Treasury sectors.

On an excess return basis, the worst performing sector in the Lehman Brothers Aggregate Index was Asset Backed Securities, which experienced almost 100 basis points of spread widening amid continued deterioration in the subprime mortgage market and posted an excess return of -4.08%. The second worst performing sector during the fourth quarter was corporates, which saw an increase of more than 50 basis points in average option adjusted spread and posted an excess return of -2.62%.

Some further data about the U.S. bond markets are shown in the charts below.