Weak Jobs Report Cements Fed Rate Cut

High volatility conditions continue to prevail in the financial markets. Last Friday’s 250-point drop in the Dow Jones Industrial Average, precipitated by a dismal August employment report (the first monthly decline in payrolls in four years), suggests that after a three-week bounce, the stock market may have some unfinished business on the downside.

The Treasury market, which has been rallying for weeks on flight-to-safety buying, received an additional boost last week as disappointing employment, as well as housing, data increased perceptions of a faltering economy with heightened recession risk. Two-year Treasury yields sank 25 bps to 3.90%, and ten-year Treasury yields dropped 17 bps to 4.38%, the lowest level in 20 months.

With the present fed funds rate at 5.25%, the Treasury market is priced for multiple rate cuts in the months ahead. Markets away from stocks and bonds are also making notable moves. For the week, gold jumped $27 to over $700/ounce, as the U.S. dollar index dropped to a 15-year low. Crude oil rose $2.66 to $76.70, and wheat prices soared again to new all-time highs. One wonders to what extent persistent commodity inflation and U.S. dollar weakness will factor into the Fed’s monetary policy deliberations.

Until last week, the jury was still out on whether the Fed will ease at its next policy meeting on September 18. Last week’s combination of disappointing economic data and market weakness now seals the case that the Fed will cut interest rates next week. Recently released economic data appear to support the Fed’s August 17th policy statement that "downside risks to growth have increased appreciably" and its decision to shift its policy focus from fighting inflation to fighting recession risks.

In addition to Friday’s very weak employment report (4,000 jobs lost in August instead of the expected 110,000 gain), the housing data reported earlier in the week indicated that no bottom is yet in sight for the residential real estate market. According to the National Association of Realtors, the inventory of unsold homes is now at 9.6 months of supply, a 16-year high. The number of existing (rather than new) homes for sale is up 32% year-over-year and a remarkable 114% higher than January 2005.

As a result of this supply overhang, combined with tightened mortgage credit, national average home prices, which fell 3.2% year-over-year in the second quarter according to the S&P/Case-Shiller price index, are expected to continue to decline. Falling home prices and escalating interest rates on resetting ARM loans are causing a spike in foreclosures, which are up 93% year-over-year. No one knows how much more pain lies ahead for the housing market, but we do know that the bottom has not yet been reached and that real estate, as in past economic cycles, will be a key determining factor in whether the economy experiences a recession or a "soft landing" and whether the stock market experiences a correction or a bear market.

Now that it is a foregone conclusion that the Fed will cut rates on September 18, what does that mean for our portfolio strategy? Although we are well aware of the Wall Street admonition to "never fight the Fed," we are inclined to be patient in moving away from our defensive portfolio allocations. A fed funds rate 25, or 50, or even 75 basis points lower is not going to provide a quick cure to the problems afflicting the housing or credit markets.

The housing problem is one of over-supply and over-valuation that will require time, and downward price adjustments, to work out. As for credit markets, risk is being re-evaluated and re-priced after an extended period of extreme complacency, which was seen in the extraordinary tightness in credit spreads on risky debt and the abuse of leverage.

Although we recognize that nothing soothes a falling stock market faster than easy monetary policy, it is premature in our judgment to conclude that the worst is over for stocks. Historic credit excesses are in the process of being corrected, so we should be prepared for this equity market decline to be more pronounced in terms of time and price than prior declines that have occurred in this bull market.

Despite the Fed’s efforts to jumpstart and re-inflate credit markets, we expect that the credit contraction and de-leveraging processes that are now at work will remain a potent headwind for stock prices for a period of time. Against this backdrop, a prudent investment approach requires the focus to remain on capital preservation.