Capital Markets Outlook
The Financial Crisis of 2007 ended swiftly (and at least momentarily) as Federal Reserve Chairman Ben Bernanke eased monetary policy 0.50 percent to 4.75 percent and provided U.S. banks with over $100 billion in short term loans. The intervention was surprising giving Bernanke’s perceived adherence to infl ation targeting when setting monetary policy.
Equity markets have rallied in response as investors appear confi dent the “Greenspan Put”—the idea that the Fed will ease monetary policy to keep markets and the economy from falling—will continue under the new Fed chairman.
However, such optimism may be premature, and we remain concerned about substantial macro-economic headwinds that even a white-knight Fed may be unable to stem. Tens of trillions of dollars worth of mortgage-backed securities are held by the nation’s banks, insurers, and investment and pension funds that bought them based on their higher yields versus U.S. Treasuries with perceived similar credit quality.
Many of them contained subprime mortgages and mortgages from over-levered borrowers who now are dealing with lower home values. Since much of the mortgage-backed debt has yet to be marked-to-market, the true values of these securities will not be known until they are sold, meaning that the fallout from overleverage and excessive risk-taking is likely not over.
In addition, hundreds of billions of dollars of adjustable rate mortgages are set to reset from low “teaser” interest rates to higher rates over the next year—most to nearly 10 percent. Higher mortgage payments and lower household net worth caused by housing prices falling at an accelerated rate in the U.S. could severely hamper American consumers who comprise an awesome 72 percent of GDP.
The Bernanke-Fed likely has its biggest challenges ahead. With infl ation still near the Fed’s implicit target range of 1 to 2 percent, gold at a 27-year high, and the embattled dollar index now at an all-time low, the Fed must juggle fi ghting possible recession and infl ation that will likely pick up with easier monetary policy. The “Bernanke Put” may not last as long as investors think.
Beyond the monetary and debt challenges facing the U.S. is the upcoming battle in Washington over protectionism and increases in taxes. Tax increases on investors may come as early as 2008. Dividend tax rates, at this point in time, look to rise to approximately 40 percent and capital gains tax rates may jump as well. We’re monitoring the current budget battle being fought between the Democratically-led congress and President Bush that could tie in tax changes to fund larger appropriations. As mentioned in earlier Outlooks, we believe higher tax rates, particularly on investing, would precipitate a downward revaluation in stock prices.
We’re not calling for a recession just yet. While consumer spending is slowing and the home building industry is experiencing unprecedented weakness, GDP growth in the U.S. remains positive. Jobs are still abundant with the unemployment rate below 5 percent. Interestingly, initial unemployment claims remain low and the U.S. has never had a recession without a spike in this number (ten out of ten recessions since World War II). More significantly, worldwide economic growth continues to climb, led by developing economies growing at high single digit rates.
The near term future of the U.S. markets and economy are uncertain, and we’re holding a neutral weight in equities. We believe the prospects of continued worldwide growth, a weaker dollar, and an embattled U.S. financial system favor equities with foreign exposure.
We’re overweight large cap growth stocks versus small cap and value stocks as large cap growth companies derive more than half their business from overseas. Likewise, we’ve increased our exposure to foreign equities.
Investments in Australian and Oil Service equities and gold have been maintained, as have currency holdings in the Euro and Yen.
Bond allocations have remained unchanged as we are relatively unconstructive on the yield curve. While longer term bonds will provide a good hedge should the probability of recession in the U.S. increase, the Bernanke Put could very well increase the market’s expectations of future inflation.