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Market Update -- In the Markets

Written by Derrick Wulf, CFA, Portfolio Manager

April 16, 2009

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

Growth
The recession that began in late 2007 deepened in the first three months of 2009 following the sharpest quarterly contraction in GDP in decades. Real GDP, which declined 6.3% in the fourth quarter, was estimated to have declined another 5% through March. A sharp retrenchment in business and consumer activity in reaction to the housing and financial crisis continued as domestic carmakers teetered on the verge of bankruptcy. In response to the rapid deterioration in the economy, congress passed a $789 billion fiscal stimulus package which President Obama signed into law on February 17. Composed primarily of infrastructure spending projects and tax cuts, the bill, combined with aggressive monetary stimulus measures enacted by the Federal Reserve, is expected to help arrest the decline in growth later this year. While current growth estimates still vary considerably, economist surveys suggest that second-quarter growth is expected to contract moderately before turning slightly positive in the second half of the year.

Inflation
Stabilizing commodity prices helped slow the decline in the broad inflation gauges during the first quarter, but in March, base effects helped push year-over-year CPI into negative territory for the first time in over 50 years. Crude oil, which had traded as high as $146 a barrel in July of last year, hit a multi-year low of just under $40 in February before staging a recovery to about $50 by the end of March. The Producer Price Index, the most commodity-price sensitive of the major inflation gauges, rose 0.8% in January after five consecutive monthly declines and followed the move higher with an increase of 0.1% in February before retreating by 1.2% in March. Core CPI, meanwhile, remained stable in the first quarter, registering another 1.8% gain on a year-over-year basis in March.

The debate about the eventual path of consumer prices has grown more contentious in recent months, as the slowing economy, consumer attitudes, and excess capacity argue for short-term deflation while aggressive quantitative easing and expansion of the Fed's balance sheet are seen as potentially inflationary in the longer term.

Jobs
The unemployment rate hit 8.5% in March, up from 7.2% at end of 2008 and 5.1% a year earlier. Steep declines in payrolls indicated that more than 2 million jobs were lost in the first quarter. This compares to just over 3 million jobs lost in all of 2008. Weekly jobless claims also continued to rise in the first quarter, peaking at 674,000 in the week of March 27, their highest in almost 25 years, while continuing claims rose to more than 5.8 million. Although the total number of job losses rose in the first quarter, the pace of increase showed some signs of stabilization, giving hope to the notion that the worst may soon be behind us.

Income
Average hourly earnings grew only modestly as job losses mounted in the first quarter, rising at an annualized rate of just 2.4%, according to the Bureau of Labor Statistics (BLS). On a year-over-year basis, earnings were up 3.4% in March after averaging roughly 4% annual growth in the previous few years. High unemployment and declines in average weekly hours to just 33.2, the lowest reading in 45 years of BLS data, are likely to keep wage growth low in the coming months. Indeed, only 7.5% of respondents to the Conference Board's confidence survey in March expected their income to increase in the next six months. The Commerce Department's measure of personal income was also quite weak in early 2009, attributed primarily to the weakness in labor.

Manufacturing
While all 18 industry groups in the ISM Manufacturing index continued to contract in the first quarter, the survey results showed some improvement with three consecutive increases through March. The details of the ISM report showed a substantial increase in new orders to 41.2 from the February reading of 33.1. Inventories continued to detract from the overall index as companies continued to work off excess and might now be approaching a time when they will begin restocking.

Retail
Retail Sales snapped six consecutive months of declines with a 1.0% month-over-month increase in January that was later revised up to 1.9%. February's advanced number also exceeded expectations at -0.1% and was revised upward to .3%. Advance retail sales figures for March indicated a 1.1% decline, but the report was subject to some seasonality attributable to the late Easter holiday, which may have caused a substantial shift in spending from March to April. Overall, consumer spending showed signs of life in the first quarter, and the recently-passed stimulus package may provide a further boost later in the year.

Housing
Housing markets remained under pressure in the first quarter amid high foreclosure rates and overall weak economic conditions. Existing home sales fell to a ten-year low of 4.49 million units in January, a decline of 38% from their July 2005 peak of 7.25 million units. Lower prices and falling mortgage rates helped to lure in more buyers in February, however, leading to a 5% increase in sales for the month. Distressed properties made up 45% of sales and the median price was down more than 15% from a year ago. New home sales also hit a low in January, with just 322,000 units sold, down 77% from the cycle-high of nearly 1.4 million homes sold in July 2005. The S&P Case/Shiller Home Price Index, meanwhile, registered a yearly decline of 19% in January, while the National Association of Home Builders Market Index hit a new low of 8 (on a scale of 100) in January before steadying at 9 in February and March. Not surprisingly, new construction remained extremely weak as housing starts in January hit their lowest level in 50yrs of recorded data before improving modestly in February.

Confidence
Dramatic weakening in the labor market, decreased household wealth and continued financial market volatility kept consumer confidence at all-time lows in the first quarter of 2009. After a series low of 25.3 in February, the 41-year-old Conference Board's index improved slightly to 26 in March. The University of Michigan Survey of Consumer Confidence Sentiment posted a modest gain in March to 57.3 from 56.3 in February, and both readings were slightly better than the 28-year low of 55.3 reported in November of 2008. With credit hard to come by, massive job losses, and persistent economic uncertainty consumers are finding little reason to be optimistic in the short term.

The Fed
With no more room to lower the target Fed funds rate, the Federal Open Market Committee (FOMC) focused its monetary sights on nonconventional policy measures. Convening two official meetings during the first quarter, the FOMC voted to broadly expand the size and scope of its credit easing initiatives, by increasing its planned purchases of agency mortgage-backed securities by up to $750 billion, increasing its planned purchases of agency debt by up to $100 billion, and announcing up to $300 billion of longer-term Treasury purchases. The buying of Treasury securities officially added quantitative easing measures to the FOMC's previous strategy of focusing its balance sheet expansion on "credit easing," and suggested that the Fed was more concerned with near-term deflation risks than the potential for longer term inflation.

In its March 18 statement, the FOMC said that the combined $1.75 trillion in asset purchases are designed to "provide greater support to mortgage lending and housing markets," and to "help improve conditions in private credit markets." Further, the Fed launched its Term Asset-Backed Securities Loan Facility "to facilitate the extension of credit to households and small businesses" and announced that it would expand the range of eligible collateral.

Treasuries
After falling to record lows in December, Treasury yields rose and the curve steepened during the first quarter. Despite a further weakening of the economy, fears of another 1920s-style depression began to ease and an extended period of deflation started to look less likely. Aggressive monetary and fiscal initiatives, meanwhile, overcame the market's initial skepticism and led many investors to believe that the worst of the recession may soon be behind us. Although ballooning federal budget deficits raised investor concerns about the potential impact of a massive increase in Treasury issuance throughout the year, the Fed's March 18 announcement that they would initiate a quantitative easing campaign led to a partial recovery in Treasury prices by the end of March. Further, negative net issuance in other sectors of the bond markets limited the impact of the increased supply of Treasuries.

With cash yields hovering just above zero, two-year notes remained under 1% for most of the period, rising just 3 basis points to end the quarter at 0.80%. The yield on five-year notes rose by 11 basis points during the period, while the yield on ten and thirty-year Treasuries increased by 45 and 86 basis points, respectively.

Bond Markets
Despite the rise in Treasury yields, the Barclays Aggregate Index posted positive total return in the first quarter, aided by accumulation of interest income and a modest tightening of credit spreads. The total return for the index was 0.12%, which represented an excess return of 0.66% over Treasuries. The average option adjusted spread tightened by 26 basis points to end the period at 187 basis points.

Credit markets benefitted from a modest tightening of spreads during the first quarter, but the rising tide did not lift all ships, as investors remained cautious and selective with their purchases. While extremely high default rates implied by bond spreads began to appear exaggerated, the improvement in risk assets was limited primarily to those sectors directly targeted by the Fed's credit easing initiatives. Agency notes and agency mortgage-backed securities (MBS) received substantial support through outright purchases by the Fed, while asset-backed securities benefitted from the Term Asset-Backed Securities Loan Facility, or TALF. The two major index components that did not receive direct support from the Fed—namely corporate bonds and commercial mortgage-backed securities (CMBS)—underperformed. Within those sectors, the securities that investors felt confident could withstand even severe economic stress enjoyed some spread tightening, while those that were viewed as more cyclical or credit sensitive underperformed.

Non-taxable and non-investment grade sectors performed very well during the first quarter, with high-yield corporate bonds returning nearly 6% and municipal bonds returning over 4%. The high-yield corporate market benefitted from its interest accrual as well as a tightening of spreads in higher-quality names as worst-case default expectations eased. Municipal bonds rallied in response to the passage of the Federal stimulus package and expectations of tax increases on high income individuals.

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