Another Volatile Quarter
I know I risk sounding too negative, but we cannot seem to shake the crisis mentality that keeps whipsawing bond and stock markets. The crisis du jour originated in Europe with crushing debt levels in Greece, Italy, Portugal, Spain, Ireland and who knows where else. Germany remains fairly strong but sometimes appears to be coming to the rescue, sometimes not. Rumors of Greek bankruptcy surface every other day. French banks are the largest holders of sovereign debt, but, out of the blue, a Belgian bank, Dexia, has become the first to fall.
Liquidity is becoming a problem for these banks, and with their stocks battered daily, they have no ready sources of capital. There has been a lot of talk about rescues from the European Union, but the markets want action. The US is not of much help as the economic recovery is stalling and the debt ceiling/deficit debate/fight caused a great deal of harm to both consumer and business confidence.
In an environment like this, volatility rules. Stocks have taken the brunt of investor frustration, selling off steeply in the third quarter for the worst quarterly loss since the height of the financial crisis in late 2008 and early 2009. The Dow Jones Industrial Average was down -12.1% to just below 11,000 in the quarter, while the S&P 500 fell -14.3% and the Nasdaq fell almost -13%. And gold had the wildest price action of the quarter—beginning at $1,500 an ounce, soaring 27% to $1,900 on September 5th, and then selling off steeply by -14.5% to end the quarter at $1,624. Oh, the fortunes won and lost!
Enough about gold, and all I will say about stocks, because I always fear being a jinx, is that the forward price earnings ratio is not even 11 and the dividend yield is currently 2.3%, which exceeds the yield on the 10 year Treasury bond. This does not happen often.
Back to Back Historic Moves
The Federal Reserve made two historical easing moves during the quarter and still the markets are not happy. In August, for the first time since the 1940s, the Fed made a two year “promise”—to keep short term rates at their current exceptionally low levels until mid 2013. If you believe the expectations theory of interest rates, that long term rates are simply the compilation of the expected path of short term rates, then you believe that long term rates will stay exceptionally low too. Maybe this will not affect the really long term rates, such as the 10 year to 30 year range, which are so heavily influenced by inflationary expectations and the international flow of funds, but most other longer rates, such as 2 year to 9 year maturities, will be affected. So why were the markets disappointed in the Fed’s forward guidance? Why did the Fed have to act again in September?
Perhaps it is that the Fed did not tie their promise to economic performance, as I thought they should have, but they only chose an arbitrary period of time. By performance, I mean the unemployment rate, number of jobs created, or GDP growth. The Fed could have, and in my opinion should have, promised to keep rates low until unemployment falls to 7% or less, until we are creating 3 million jobs a year or more, or until real GDP grows at and stays above the 3.3% average growth rate of the past 60 years. Only then will inflation even hint at being a permanent risk.
We can only assess the Fed’s performance in terms of their dual mandate—maximum employment and stable prices—and not in terms of a two year waiting period.
So, disappointment in the “promise” to keep short term rates low until 2013 led to another historic action in September. In another easing action dubbed “Operation Twist,” the Fed stated that they will sell $400 billion of their shorter securities (less than 3 year maturities) and buy the same amount of longer securities (6 to 30 year maturities) by June, 2012. They haven’t tried a “twist” since the 1960s. They also added that they will reinvest cash flows from their mortgage backed securities from their Quantitative Easing QE1 Program into more mortgage backed securities, rather than into Treasuries.
Ben Bernanke was quoted as saying that Operation Twist is the equivalent of a 50 basis point cut in the Fed Funds rate. Hey, when Fed Funds is near zero, you have to try something. And don’t forget the cumulative actions they have taken to date—Fed Funds to 0%, QE1’s purchase of $1.5 trillion of Agencies’ bonds and Agency mortgage backed securities, QE2’s purchase of $600 billion of Treasuries, and now the “promise” and the “twist.” These actions someday will push consumers, businesses, and banks out of the liquidity trap.
Don’t Give Up on the Economy
It is not time to give up on the economy. The data has been weaker in recent months and GDP is stubbornly low, at 1.3% in the second quarter of 2011. Many forward looking indicators are showing positive signs, including the index of leading economic indicators, building permits, industrial production and survey measures, such as the ISM series. We have the full support of the Fed until at least 2013.
Companies are sitting on $1.9 trillion of cash on their balance sheets and banks have at least that amount in reserves at the Fed earning next to nothing. It will take time, but eventually, companies and banks will seek higher returns and invest and lend. We probably do not have much in the way of fiscal support from the government as high debt and the deficit make that unlikely. All companies lack the confidence to invest, to hire, or to move forward.
What is on the horizon to shake up the economy? For one, the original culprit of the economic weakness, in my mind, was the spike in oil prices to $115 per barrel and in gasoline prices to near $4.00 per gallon. Oil prices have slipped back by -30% to $80, while gasoline prices have only fallen by -15% to $3.39. Gas prices clearly have room to move downward. This will act like a tax cut at just the time when it seems Washington DC will not provide one.
Another positive is the beginning of another refinancing wave by consumers as the Fed has pushed down long term rates, including mortgage rates. Companies can take advantage by issuing debt at lower interest costs. Stay tuned!
Thank You, Steve
As I was writing this, I saw the announcement by Apple that Steve Jobs had died, after battling illness for eight years. He had a profound influence on so much of the technology that we use in our daily lives. He made computers easy to use and gave us the iPod, the iPhone, and the iPad. Fifteen years ago, these were products we did not even know that we wanted and needed. I have the iPhone and iPad and cannot imagine life without them. He will leave a huge legacy in the company he co-founded and the products he helped invent. I will miss his brilliance. Thank you, Steve!
Thanks for reading! DJ 10/05/11
Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.
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