Where Are We? Notes on Q4

by: Don Dion

Government Intervention

The backdrop to the extreme volatility we are experiencing has been a deteriorating economic picture and extraordinary government intervention to correct an ailing financial system. In the past eight weeks, the federal government has announced multiple bailout plans, including a $700 billion financial system bailout managed by Treasury Secretary Paulson; $25 billion for the Big Three automakers; $85 billion for AIG in September and another $37.8 billion for AIG in October; and $300 billion for mortgage relief. The SEC banned shorting on financial stocks and the stocks of several firms, including General Electric (NYSE:GE) and General Motors (NYSE:GM), from late September through early October. The Federal Reserve cut 50 basis points on October 8 and 50 basis points on October 29, in sum lowering the federal funds rate from 2 percent to 1 percent. It also extended $30 billion in swaps to each of four emerging market central banks.

These moves have failed to stop the underlying deterioration in economic conditions, but they did lead to an easing of interbank lending rates and a stabilization of the American financial sector. The TED spread, which measures the difference between the interest rate on overnight bank loans and three-month Treasury bills, is typically less than 0.5 percent. During the financial turmoil that started in 2007, the spread went as high as 2 percent, settling at 1 percent this summer. In September, the TED spread rose sharply, and it spiked above 4 percent in early October. The passage of the $700 billion bailout package by Congress didn’t affect the TED spread, but within one week of Henry Paulson’s announcement of a plan to use $250 billion of the package to recapitalize banks, the spread declined to 2.5 percent. It finished the month at 2.65 percent.

Economic Deterioration

With massive amounts of capital pumped into the banking system, the credit crisis may finally be nearing its end. The underlying economy, however, is in trouble. Advance third-quarter GDP numbers showed that the U.S. economy shrank 0.3 percent. For several years, and especially in 2008, inflation has been a great worry for investors and consumers. Starting in early summer, however, commodity prices began to drop rapidly. Even though the Federal Reserve pumped hundreds of billions of dollars into the financial system, inflation has turned into deflation because the Fed can’t force banks to lend. Gold prices, used by many as a measure of inflation, fell during the past two months; SPDR Gold Trust (NYSEARCA:GLD) lost 12.69 percent. Many northeasterners who worried about how they’d pay for heating oil will be relieved to know that wholesale prices have fallen below last winter’s levels, but the implications for the economy are not good.

Several economic indicators reveal a contracting economy. Even in China, the manufacturing index points to recession. Steel mills are cutting output and weaker firms are closing, as demand from producers has declined. The Baltic Dry Index, which measures the price for moving raw materials by sea, tumbled from more than 11,000 in late June to below 900 at the end of October, a drop of more than 90 percent. Part of the decline was blamed on the credit crunch—in September and October alone, the index fell by nearly 90 percent—but real demand is lower.


A buzzword over the past two months has been “deleveraging.” Homeowners, hedge funds, banks, companies, etc., sought to reduce their outstanding debt. For many around the world, that meant selling whatever asset or currency they currently owned to raise cash. Since many had borrowed in U.S. dollars or Japanese yen, which offered low interest rates, the reversal of their borrowing caused the two currencies to soar versus almost everything. The PowerShares Dollar Bullish Fund (NYSEARCA:UUP) climbed 10.69 percent over two months; CurrencyShares Japanese Yen (NYSEARCA:FXY) added 10.17 percent. The gains were especially acute against emerging markets, where central banks were unable to obtain dollars directly from the Federal Reserve. iShares MSCI Emerging Markets (NYSEARCA:EEM) lost 51.81 percent from August 31 through October 27 but bounced off its lows and rallied after the Federal Reserve extended its swaps program to Mexico, Brazil, Singapore and South Korea. EEM finished with a gain of 31.76 percent from October 27 through the end of the month, but it was still down 36.5 percent from the end of August.

Investment and Economic Theories Tested

Events have blown several investment theories out of the water. The decoupling theory proposed that the U.S. was no longer the engine pulling the world’s economic train. The theory said a recession in the U.S. might dent growth in China and other emerging markets, but it would not lead to a global recession. In reality, thus far the U.S. economy has suffered less than many emerging markets. Other theories predicted, through different mechanisms, an abandonment of the U.S. dollar as the global reserve currency, hyperinflation and soaring gold prices. In reality, the dollar has reasserted itself as the global reserve currency and enjoyed a major rally versus many currencies. CurrencyShares Australian Dollar (NYSEARCA:FXA) lost 12.74 percent in October alone, while CurrencyShares Mexican Peso (NYSEARCA:FXM) fell 11.29 percent and CurrencyShares Euro (NYSEARCA:FXE) declined 7.17 percent.

In place of the new theories, old trends reasserted themselves. Emerging markets once again are places of economic risk and long-ignored political risk. Argentina’s seizure of private pension funds will probably not be the last expropriation of private property; one-horse oil economies such as Iran and Venezuela face budget deficits and economic crisis.

Two Months to Go

Looking ahead at the next two months, the global economy will weaken. Anecdotal stories piled up in October, with the scariest reserved for Halloween—third-quarter Volvo truck orders plummeted 99.63 percent from the same period in 2007. Emerging economy stock markets crashed during September and October, but recovery may be delayed because their exporters will be hurt by a U.S. consumer recession. Europe, meanwhile, faces a bigger financial crisis than the U.S., due to loan exposure in emerging markets.

Broadly speaking, the U.S. no longer produces a lot of goods for export, although the export sector is one of the few growing sectors of the economy. Along with reduced imports, the U.S. will see lower trade deficits, and Americans will be forced to fund their own borrowing. Americans will consume fewer goods and services because they will have to save for them first. Christmas sales will disappoint, hurting the retail and consumer service sectors of the economy. There’s a good chance that the Big Three automakers will become the Big Two before year-end, with Chrysler and GM merger talks under way.

Nevertheless, a stock market rally appears long overdue, and an electoral holiday is in the cards. Based on historic returns, November, December and January tend to be positive months following a presidential election. Economic fundamentals continue to point toward a stronger U.S. dollar and Japanese yen in the near term, keeping pressure on commodity prices. Materials and energy ETFs could outperform in a market rally, however, because they suffered more during the decline, and in bear markets, the oversold sectors tend to lead the rebound.