Media Center FAFN Leadership

R. Kevin O’Keefe, CIMA®, AIF® | Chief Investment Officer
Fears of a systemic collapse eased in early 2009, as governments around the world stepped up efforts to address the financial crisis. Although a 20%+ rally from the early March lows helped considerably, it wasn’t enough to prevent stocks from posting their 6th consecutive losing quarter, the longest stretch of consecutive quarters of stock market losses since the 18-month period that ended in June 1970.

Volatility was not as extreme as the 4th quarter of 2008, but it was high by historical standards. The Dow Jones Industrial Average fell or rose by more than 2% on one-third of trading days during the first three months of 2009—much less than 61% of the days in the fourth quarter of 2008, but more than twice the 15% during first quarter of 2008.

The heightened volatility reflected investors’ changing opinions about government efforts to address the crisis. 2009 was ushered in with great hope that the new Obama administration would be able to rescue the economy, but that hope soon faded. Major stock indexes posted one of the worst Januarys on record.

A highly anticipated speech by Treasury Secretary Timothy Geithner about the administration’s plans to rescue the banking system on February 10th failed to meet expectations and the selloff in stocks accelerated. By the first week of March, the Dow industrials had fallen 13% below their November 2008 lows and were down 25% for the year (which was only nine weeks old). By that point, the Dow had declined 54% from its all-time peak in October 2007, and investors had experienced the worst bear market since 1929–1932.

Then, during the last three weeks of March, as major banks began to report profits, the stock market surged. The Federal Reserve and the U.S. Treasury announced their expanded stimulus efforts, which fueled the rally. Aided by concurrent improvements in the bond and industrial commodities markets, the stock market turned in its best four-week performance in over 70 years.

Bonds: A Reversal of Q4 2008

The total return for the Lehman U.S. Aggregate Bond Index was +0.12% in the first quarter of 2009, but that figure masks the wide divergences among different bond sectors. The Lehman U.S. Treasury Index fell 1.32% for the quarter, while the High Yield (junk bond) index gained nearly 6%, and the Municipal Index gained over 4%. U.S. Agency bonds, which were granted an explicit U.S. government guarantee in late 2008, returned -0.11%; better than Treasurys, but just behind the overall market.

The seeds of these divergent returns were sown during the panic of late 2008, during which investors sold risky assets indiscriminately, and nearly every category of bond other than U.S. Treasurys were suddenly regarded as risky. This, in turn, drove the yield on Treasurys to extremely low levels. During the first quarter of 2009, corporate bonds rallied, correcting, at least in part, the overreaction of last Fall’s panic.

Municipal bonds also bounced back, with the long-maturity sector leading the way. However, yields on AAA tax-exempts are still higher than those of equal maturity Treasurys, which suggests that the bond market is far from normal. In a normal market, AAA municipals would yield less than Treasurys because the interest from municipals is tax-exempt. Now tax-exempt bonds attract investors in the 15% Federal income tax bracket whereas, for the past decade, they enticed only those in the 28% and higher brackets.

First Affirmative’s resident bond expert, Charles Sandmel, is cautiously optimistic. Aside from financial institutions, auto makers, and opaque asset-backed bonds, he anticipates modest positive returns in the investment grade bond markets through 2009. As for the longer term, he writes: “any business cycle recovery can be expected to raise inflation from a very low base, and the borrowing consequences of the various economic stimuli may put upward pressure on bond yields. The stability of bond returns over the past year of chaos reinforces our view that fixed income is a valuable part of virtually any asset allocation.”

Financial System Recovery

Before the economy can recover, the financial system must do so. And, the fragile financial system appears to be regaining its footing.

Last fall, after Lehman Brothers filed for bankruptcy, banks suddenly stopped lending to each other. The London Interbank Offered Rate (LIBOR)—a key indicator of the health of the financial system—jumped above 4%. The global financial system had suddenly frozen. Since then, LIBOR has declined to 1–2%, still high by normal standards, but well below the levels of last fall. The moderation in the LIBOR rate was perhaps the single most anticipated development on the road to recovery of the global financial system, and it is clear that significant progress has been made.

Other positive signs include:

Issuance of investment grade U.S. corporate bonds rose sharply in January, exceeding $100 billion of new offerings, signaling a return to a more normal market. Globally, companies have sold in excess of $300 billion of investment-grade corporate bonds in the first quarter of this year.

Short-term corporate credit markets have also improved. Interest rates on short-term commercial paper have come down, which has allowed companies to be less reliant on a special Federal Reserve facility serving commercial-paper borrowers.

Although there has been heated criticism of banks for not lending, the evidence says otherwise. The Federal Reserve’s quarterly Survey of Terms of Business Lending (STLB) shows that Commercial and Industrial loans (C&I) made by banks in February show solid growth at record low interest rates.

During the survey period, banks extended 13% more credit than during the same period last year. Moreover, much of the recent decline in rates has been passed through to bank customers: the average interest rate for C&I loans for the first quarter has been 2.34%, the lowest since the inception of the series in 1997.

Quantitative Easing

What has Federal Reserve Chairman, Ben Bernanke, done for us lately? The Fed has:

• Promised to use all of the tools available, including the purchase this year of up to $1.2 trillion of mortgage-backed government agency securities in order to provide support to mortgage lending and the housing market;
• Committed to purchase up to $300 billion of longer term U.S. Treasury securities over the next six months;
• Launched the Term Asset-Backed Securities Loan Facility (TALF) which will extend credit to households and small businesses;
• Pledged to keep interest rates low for as long as necessary to support the economic recovery.

These steps, along with comprehensive measures to eliminate toxic assets from bank balance sheets, are going to make a difference. They will help restore bank lending, which is perhaps the single most important condition for an economic recovery.

The Economy: A Slowing Rate of Decline

It has become fashionable for pundits to characterize the current economic malaise as the most severe since the Great Depression. While there are indeed similarities—such as a preceding period of excessive debt, subsequent asset deflation, widespread damage to the financial system, and a resulting economic downturn that quickly spread around the world—the current crisis is evolving more rapidly and the government’s fiscal policy response has been far more forceful than in the 1929–1932 period.

Despite the similarities, we are neither in nor are we headed for a 1930s-style depression. There are many fundamental differences between 1929 to 1932 and today.

With the unprecedented and massive stimulus spending flowing out of Washington, the outlook for a recovery from this downturn will depend largely on whether government actions are able to stabilize the banking sector. If this is achieved soon—and we expect that it will be, based upon the signs of financial recovery—then evidence of an economic recovery will likely begin to emerge. Indeed, despite rising unemployment and other data showing that the economy is still declining, there are also indicators that show that the rate of decline is slowing, which is a prerequisite to the eventual upturn. Consider, for example:

• Consumers, who account for almost 70% of GDP, continue to cut back on total spending, but not as steeply as they were cutting back late last year. In fact, retail sales actually rose in both January and February 2009.
• The housing slump may be easing as policy efforts to unclog credit and aid borrowers begin to gain traction. Residential construction is increasing.
• Industrial commodity prices and oil have been rising for weeks, evidence that manufacturers have resumed buying, and demand for energy is firming.
• The price of gold fell sharply in recent weeks to below $900 per ounce, suggesting that investors find the safe haven appeal of gold to be less compelling.

What’s an Investor to Do?

This recession is already fifteen months old, four months longer than the average post-World War II recession. There have been ten recessions since 1945, according to the National Bureau of Economic Analysis (NBER). True, this is a particularly nasty one, both in its breadth—global and affecting all economic sectors—as well as its depth. To many investors, it may feel as if nothing quite like this has happened before. But the reality is that business cycles have always been with us. Each recession has its own unique traits; each recession shares similarities with previous recessions; and the same can be said for recoveries.

Perhaps the most-watched economic indicator in a recession is the unemployment rate. As this indicator continues to rise, it appears that conditions are only getting worse. And, the absence of part-time and underemployment figures masks the depth of the problem. But that appearance is misleading. The unemployment rate is a lagging indicator: it won’t start to improve until the recession is over.

It’s important to remember that we will get through these bad times. And, our economy will have changed as a result—hopefully for the better.

It’s also important to remember that the financial markets are forward-looking (beyond the 6-month horizon). So, try to stay positive. There is good reason to be optimistic. In the meantime, here is some old-fashioned advice that still makes good sense:

• Reduce expensive debt. If you carry a balance on high-interest credit cards, reducing your balance is a guaranteed high return investment.
• Live within your means. Many people have never learned to budget. There are several free online tools to help you learn to get control over your spending.
• Diversify your assets and stick to your investment discipline. If you need to make changes, make incremental changes within your strategy. Don’t be impulsive, and don’t overhaul your investment strategy.
• If possible, continue to save for emergencies as well as for the long term. Remember that assets purchased at depressed prices during hard times often provide the greatest long-term financial returns.

And, here’s some not-so-traditional advice which we, at First Affirmative, believe is both appropriate and important at this time:

• Work for transformation. Support energy independence and a low-carbon economy. General Motors shouldn’t be downsized. Let’s support using auto manufacturers’ spare capacity to make buses, wind turbines, electric cars, and public transit vehicles.
• And, let’s work to accelerate the move toward health care reform and increased availability. The recession is causing many people to fall into the cracks of the healthcare system.

Not sure how to get involved, how to make a difference? Ask your First Affirmative network advisor. They care about the needs of others and the needs of the planet just as you do, and they’re available to help you work toward a truly sustainable economy.

Kevin O’Keefe is First Affirmative’s Chief Investment Officer. Charles Sandmel, an Investment Advisor Representative of First Affirmative who manages fixed income portfolios for First Affirmative clients, also contributed to this article.

The views expressed in this Market Commentary are those of First Affirmative and may not be consistent with the views of individual investment advisors, broker-dealers, or RIA firms doing business with First Affirmative. Mention of a specific company or security is not a recommendation to buy or sell that security. For information regarding the suitability of any investment for your portfolio, please contact your financial advisor.