Equity investors took a beating in the 3rd quarter of 2011 as stocks logged their worst drop in 2 ½ years. This was primarily due to a loss of confidence in world leaders’ abilities to deliver effective solutions to domestic and international challenges. With almost no bullets left in its monetary six-shooters, the Federal Reserve announced on September 21 it would begin a ten-month maturity extension program called “Operation Twist” to boost the housing market and the overall economy.
Basically the Fed is going to sell $400 billion of its shorter-term Treasuries and use the proceeds to buy longer-term Treasuries. Additionally, as some of their other bond holdings mature they plan to increase their mortgage-backed securities allocation. The theory is these steps will reduce mortgage interest rates leading to an increase in refinancing and even stimulate housing demand as loans become more affordable. As a bonus, the increased discretionary income from lower mortgage payments will find its way into higher consumer spending and lift the economy. Of course with banks now demanding up to 20% down payments on reduced valued homes, many borrowers will need to cough up additional cash if they want to refinance. As might be expected, investors were less than enthusiastic sending the Dow Jones Industrial Average down 284 points on the day of the announcement. The Fed twisted and investors shouted - sell!
The sell off capped an ugly quarter marked by anxiety about the European sovereign-debt crisis, a U.S. economy tilting toward recession, and signs that some previously fast-growing economies such as China are starting to slow down. Even precious metals, the darling of the inflation hawks, fell during the period. There were few safe havens in the third quarter. Bonds, the obvious exception, continued to rally in price with falling interest rates.
Economic Summary
Housing continues to be the albatross around the neck of the U.S. economy. In the second quarter, residential investment – money spent to build, remodel or maintain a home – stood at just 2.2% of GDP. That was the lowest level since 1945. A year ago it was 6% and the average since 1950 has been 4.7%. There are some reassuring statistics. For example, second quarter GDP was revised upward to an annual rate of 1.3% from 1.0%. Of course the bad news is that second quarter GDP was still just 1.3%. It needs to be a lot higher to reduce unemployment. Third quarter numbers will not be available until later in October, but we are definitely slowing compared to last year when GDP grew at 2.9%. Other encouraging data include an increase in the September readings of the Chicago PMI and the ISM-manufacturing index. Additionally, employment has not turned negative.
True to its word, S&P downgraded the sovereign debt of Uncle Sam from AAA to AA+ on August 5th for the first time in the history of the ratings. They reasoned that the deficit reduction plan passed by Congress on August 2nd did not go far enough to stabilize the country’s debt situation and that policymaking is not stable or effective as needed to address the current economic challenge. Moody’s & Fitch still maintained a US debt rating of AAA following S&P’s announcement.
Market Summary
There is no sugar-coating the damage as quarterly stock losses ranged from -13.87% for large companies (S&P 500) to a loss of -22.56% for international emerging markets (MSCI EEM). The Dow Jones Industrial Average’s September decline made five straight monthly drops in the popular index. Year-to-date, equities are under-water with losses ranging from -8.68% for the S&P 500 to -21.88% for the more volatile MSCI EEM.
As expected, bonds fared much better with the flight to quality. BCI indexes generated positive returns ranging from 0.91% for short maturities to 15.63% for longer bonds for the quarter. Year-to-date the range of returns was 2.65% for shorter bonds to 19.42% for long government/credit maturities. Commodities failed to offer investors the hoped for protection as the DJ-UBS commodities index lost -11.3% and -13.6% for the 3rd quarter and year-to-date respectively.
What’s Next?
Some economists now think we are tipping into a new recession. Others say no recession lies ahead but instead, an environment of slower growth. Consumers are certainly in a de-leveraging mode, either paying down debt or increasing their savings. Additionally, a lack of clarity on tax policy and increased layers of government regulations are creating genuine reasons for pause on the part of employers. At the current pace, it may take a long time to return to normal levels of economic activity and employment.
With the Fed running out of monetary tools to stimulate the economy, additional measures must come from fiscal policy and structural reforms, not monetary policy. Our debt simply cannot continue to grow faster than our GDP. Congress’s Super Committee of 12 is supposed to identify $1.2 trillion worth of savings by Thanksgiving. We’ll soon see how this experiment in government by proxy works.
America’s legacy is one of creativity, innovation and entrepreneurship. That legacy will not be easily broken in spite of the seemingly insurmountable odds facing us. Companies are extremely profitable, their balance sheets are strong and they are sitting on over $2 trillion in cash just waiting to invest when given an “all-clear” signal. Consumers are repairing their personal balance sheets from the 2008 crisis and will unleash a lot of pent up demand once confidence improves. America is still the world’s leader and will continue to be so in spite of the naysayers. I would not bet against it.