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Market Update -- In the Markets

Written by Derrick Wulf, CFA, Portfolio Manager

October 9, 2007

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 during the third quarter after growing 3.8% in the second quarter. A decline in residential construction and a softening in the manufacturing sector amid tightening credit conditions were the primary culprits. Most preliminary estimates of third quarter GDP growth are currently in the range of 2.5%.

Inflation
Core inflation continued to moderate during the second quarter, with the core PCE deflator falling to 1.8% on a year-over-year basis in August, its lowest level in over three years. Core CPI also continued to moderate in the third quarter, registering a 2.1% rise year-over-year in August.

Jobs
The job market continued to grow in the third quarter, but the pace of payroll gains slowed. Non-farm payrolls grew by an average of almost 100,000 per month during the quarter after averaging about 134,000 per month in the first half of the year and almost 200,000 per month in 2006. The unemployment rate, meanwhile, rose from 4.5% in the second quarter to 4.7% in September.

Income
Growth in wage and salary income remained firm in the third quarter. Growth in average hourly earnings held near 4% on a year-over-year basis according to the Bureau of Labor Statistics, while personal income growth, as reported by the Department of Commerce, stood at a healthy 6.8% on a year-over-year basis through August.

Housing
The housing recession deepened in the third quarter, with new and existing home sales declining to their slowest pace in years and prices declining in many key markets. The tightening of mortgage credit during the summer further weighed on the already depressed markets, contributing to the largest decline in median new home prices since 1970. The National Association of Homebuilders Market Index tied its record low in September and the S&P/Case-Shiller composite home price index registered a 3.9% decline on a year-over-year basis in July. Inventories of unsold homes, in terms of months' supply, remained more than double the levels seen during the cycle lows, leaving the outlook for a near-term recovery bleak.

Confidence
Consumer confidence slipped in the third quarter amid continued deterioration in the housing markets. A softening in the labor markets also contributed to the declines.

The Fed
At its August 7 meeting, the FOMC voted to keep the target fed funds rate at 5.25% and maintained its inflation risk bias. Less than two weeks later, in an emergency meeting, the Fed responded to rapidly deteriorating credit and liquidity conditions by voting to cut its discount rate by 50 basis points. Then, at its next scheduled meeting on September 18, the Fed cut both the target fed funds rate and the discount rate by 50 basis points, to 4.75% and 5.25% respectively, and shifted its risk assessment to acknowledge increasing risks to economic growth. In the statement released after the Committee's September 18 meeting, the Fed warned that "the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth."

Fed funds futures closing prices at the end of the second quarter suggested that most investors expect the Fed to cut rates at least one more time before the end of the year, eventually bringing the target rate down to 4% or 4.25% by the middle of next year.

Treasuries
Treasury yields fell and the yield curve steepened during the third quarter. The yield on two-year notes declined 87 basis points during the period to end the quarter just below 4%. Five-year notes fell by 68 basis points in yield to close at 4.25% and 10-year notes fell by 44 basis points, closing at 4.59%. The yield on 30-year bonds fell 29 basis points to end the quarter at 4.84%. The spread between 2- and 10-year Treasuries increased by 44 basis points, sending the yield curve to its steepest level since early 2005.  

Bond Markets
Mounting losses in the subprime mortgage markets manifested a spike in volatility and a major tightening of financial conditions in the third quarter, resulting in a flight-to-quality that sent Treasury yields lower and credit spreads sharply wider. Aggressive rate cuts by the Fed restored some confidence to the markets in the latter part of the quarter, helping the Lehman Brothers Aggregate Bond Index increase by 2.84% during the period.

All of the major sectors of the investment-grade markets experienced a widening of spreads, causing the average option-adjusted spread on the overall Lehman Brothers Aggregate Bond Index to increase by 20 basis points. Treasuries were the best performing sector, returning 3.81% in the third quarter, while corporate bonds lagged the most, underperforming Treasuries by 244 basis points on a duration-adjusted basis. The high-yield corporate market, weighed down by a backlog of Leveraged Buyout (LBO) debt, trailed all the major investment-grade sectors, returning an anemic 0.33% for the period.

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