Issue 36 - April 03, 2007

Q1 2007: Two Sides of the Same Coin

Bulls and Bears found much to bolster their arguments during this past quarter.
After a strong run during the first two months – markets reacted abruptly to a series of events including a correction in the white hot Chinese equity market and increasing defaults within the “sub-prime” segment of the mortgage market. Economic Data has been uneven, sending markets higher one day and down the
next. The Federal Reserve remained on the sidelines choosing to take no action at both their January 31st and March 21st meetings. Market pundits parsed the language of both announcements and continued to find rationales for both rate cuts and further potential increases as the year unfolds. The US Treasury yield curve remains inverted with the Federal Funds benchmark rate at 5.25%, while the 30 year note trades at 4.80%. As we have mentioned in previous letters; Wall Street is least comfortable in uncertain times and that is precisely the environment we find ourselves in.

Flat Water

The bullish argument remains largely unchanged: low and stable inflation and
interest rates, full employment, and fair valuations. The bearish camp continues to point to further slowdowns within the housing market as the catalytic event which will create a ripple-effect which will impact broad consumer spending. But this is not an “either-or” scenario. Housing will drag until such time as excess inventory is worked off. But the growth of the economy is not entirely predicated on housing
– far from it in fact. Bear Stearns estimates that since 2003, housing related industries accounted for only 4% of the seven million in net new jobs. IRS withholding is running at +10% year over year and corporate taxes are growing at over 16%.With the bullish backdrop, large amounts of liquidity, and the Federal Reserve on the sidelines, the market should move forward in line with earnings. Not terribly glamorous, but it does provide a reasonable growth environment in which to continue to invest.

The Need to Ease

This past meeting of the Federal Reserve marked the 6th consecutive meeting were the committee left the benchmark rate unchanged at 5.25%. This current period of relative stability followed 17 consecutive increases of 25 basis points across the preceding two years. There continues to be much debate about the need to ease
rates in the coming months particularly among the bears. But what is driving this?
Is there insufficient liquidity or credit available? Is the current absolute level of rates restricting economic activity? It is hard to make these arguments.

There is, however, a rationale which is predicated on the shape of the current yield curve. With longer term US Treasuries trading below 5% - the current yield curve is “inverted” and historically an inverted curve was a harbinger of a recession. The thinking would go as follows. If economic activity is going to slow, interest rates should come down as a result. Bond buyers anticipating an ease would purchase the longest bonds they could in order to enjoy the biggest price appreciation. Long rates would come down faster than short and voila – the curve would be inverted.

But this is not the current fact pattern. This time around the yield curve became inverted during the time the Federal Reserve was raising rates. In addition, we have now been inverted for a much longer period of time than the historical precedents. The current level of longer term rates may be viewed more appropriately as reflective of strong demand required to offset term liabilities of pension and insurance obligations coupled with a level of comfort that inflation is under control. In addition, the current level of Federal Funds may be deemed to be neither restrictive nor accommodative. Their bias reflects an overriding concern regarding inflation in an economy which has been running at close to capacity.

Could the Federal Reserve ease over the course of the year? If growth slows sufficiently to remove their inflation worry, they could lower the benchmark rate. But these changes should be relatively minor. The extraordinarily low rates that we saw
in the early part of this decade reflected a concerted effort to fight deflation and to provide ample cushion for the unwinding of the tech and telecom excesses. The level of rates that we see today is likely to be with us for some time. Market participants may want an easing, but it is unlikely that they will get enough relief to stem their demands for what amounts to cheap money.

The challenge for the market in the coming months will be to gain comfort moving ahead at speeds which are more in line with long term sustainable growth rather than at the above trend speed of the previous few years. This should favor those sectors which have the most predictable earning streams.

• Q1 2007: Two Sides of the Same Coin
• Flat Water
• The Need to Ease