Investment Postcards from Cape Town

The decision by the US Federal Reserve to cut interest rates by another 50 basis points on top of the 75-basis-point-cut eight days earlier dominated financial headlines during the past week. On Wednesday the Fed gave stock markets exactly what they wanted and provided respite to a downward trend by slashing the Fed funds rate to 3.0%.

The Fed’s accompanying statement made it clear that it was scared about the markets, which “remain under considerable stress”, and the knock-on effects they could have on the economy, as “credit has tightened further for some businesses and households”.

Jeffrey Saut, chief investment strategist of Raymond James said: “The question du jour is: will the rate cuts, combined with the economic stimulus package, be enough to prevent the normal ending to the business cycle …?”

On this score, Richard Russell, octogenarian author of the Dow Theory Letters, refers to the cover of the latest Newsweek magazine, blaring out “Road to Recession” in large letters. He remarked: “Really, let’s turn to the magazine cover rule – when an item becomes so widely accepted that it makes the cover of a national magazine, the odds are that the item is either not going to happen or it’s over. There ain’t goin’ to be no stinkin’ recession. The magazine (contrary reading) says so, the stock market says so, Richard Russell says so.”

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance chart.

Economy
Negative economic reports during the past week were digested by market participants with relative ease. Examples of disheartening reports include: new home sales falling to a 13-year low, weekly initial claims jumping from 306 000 to 375 000, Q4 GDP growing just 0.6%, and January nonfarm payrolls declining by 17 000.

In addition to putting their faith in a proactive Fed and hyperactive Treasury, pundits preferred to emphasize aspects such as a report that durable orders rose 5.2%, a jump in the manufacturing sector’s ISM Index to 50.7 (a number above 50 reflects growth), reports of a rescue package for the ailing bond insurers, and the Microsoft buyout offer for Yahoo.

Futures signalled the Fed funds rate would reach 2.5% by the summer.

WEEK’S ECONOMIC REPORTS

Date	Time (ET)	Statistic	For	Actual	Briefing Forecast	Market Expects	Prior
Jan 28	10:00 AM	New Home Sales	Dec	604K	635K	645K	634K
Jan 29	8:30 AM	Durable Orders	Dec	5.2%	5.0%	1.5%	0.5%
Jan 29	10:00 AM	Consumer Confidence	Jan	87.9	86.0	87.0	90.6
Jan 30	8:15 AM	ADP Employment	Jan	130K	-	-	37K
Jan 30	8:30 AM	GDP-Adv.	Q4	0.6%	1.9%	1.2%	4.9%
Jan 30	8:30 AM	Chain Deflator-Adv.	Q4	2.6%	3.0%	2.6%	1.0%
Jan 30	2:15 PM	FOMC Policy Statement	-	-	-	-	-
Jan 31	8:30 AM	Employment Cost Index	Q4	0.8%	0.8%	0.8%	0.8%
Jan 31	8:30 AM	Personal Income	Dec	0.5%	0.4%	0.4%	0.4%
Jan 31	8:30 AM	Personal Spending	Dec	0.2%	0.1%	0.1%	1.0%
Jan 31	8:30 AM	Core PCE Inflation	Dec	0.2%	0.2%	0.2%	0.2%
Jan 31	8:30 AM	Initial Claims	01/26	375K	335K	320K	306K
Jan 31	9:45 AM	Chicago PMI	Jan	51.5	52.5	52.0	56.4
Jan 31	10:30 AM	Crude Inventories	01/26	-	NA	NA	2297K
Feb 1	12:00 AM	Auto Sales	Jan	-	5.2M	5.2M	5.5M
Feb 1	12:00 AM	Truck Sales	Jan	-	7.3M	7.2M	6.9M
Feb 1	8:30 AM	Nonfarm Payrolls	Jan	-17K	80K	70K	82K
Feb 1	8:30 AM	Unemployment Rate	Jan	4.9%	4.9%	5.0%	5.0%
Feb 1	8:30 AM	Hourly Earnings	Jan	0.2%	0.2%	0.3%	0.4%
Feb 1	8:30 AM	Average Workweek	Jan	33.7	33.8	33.8	33.8
Feb 1	10:00 AM	Construction Spending	Dec	-1.1%	-0.5%	-0.5%	0.1%
Feb 1	10:00 AM	ISM Index	Jan	50.7	48.5	48.4	48.4
Feb 1	10:00 AM	Mich Sentiment-Rev.	Jan	78.4	80.5	79.0	80.5

Source: Yahoo Finance, February 1, 2008.

In addition to speeches by members of the Fed every single day next week, the week’s economic highlights include Factory Orders on Monday, ISM Services on Tuesday, Productivity on Wednesday, Initial Jobless Claims, Pending Home Sales, and Consumer Credit on Thursday, and Wholesale Inventories on Friday.

Markets
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week.

Source: Wall Street Journal Online, February 3, 2008.

Equities
Global stock markets experienced a shift in sentiment during the past week, resulting in strong gains. The FOMC’s rate cut and the prospect of further easing fueled a rally, resulting in the S&P 500 Index finishing the week 4.1% higher – its best weekly performance for nearly five years. The Dow Jones Transportation Index (+7.4%), the Down Jones Industrial Index (+4.4%) and the Nasdaq Composite Index (+3.7%) all steamed ahead.

Interest-rate- and economically sensitive stocks were at the forefront of the gains in the US. Examples include homebuilders (+17.9%), banks (+11.2%), retailers (+7.5%), small caps (+8.8%) and REITs (+6.3%).

European markets also gained throughout, but the Nikkei 225 Average was less fortunate and recorded a 1.0% loss. The biggest casualty of the week, however, was the Shanghai Composite Index which fell by 9.3% – the steepest weekly decline in a decade – on concerns that the worst winter storms in 50 years will reduce economic growth. The Hong Kong Hang Seng Index (-4.0%) also ended the week in the red.

The gains of most indexes during the past week masked significant declines for the month of January, with the Dow Jones World Index down 6.5% and the S&P 500 Index down 6.1% – the sixth worst in history.

Bonds
US government bond yields fell after the Fed’s rates announcement and indications of further easing of monetary policy. Yields in the UK, Germany, and Japan also moved somewhat lower.

Currencies
The US dollar Index lost 0.7% over the week, dropping below 75 to within striking distance of its record low after the poor jobs report on Friday, but then rebounded on the back of better manufacturing data. The Chinese renminbi, the Japanese yen, Swiss franc and euro strengthened, but the British pound lost ground after poor manufacturing and housing data.

Expectations increased that the Bank of England would cut interest rates next week but that the European Central Bank would maintain its hawkish stance.

Elsewhere on the currencies front, the South African rand dropped by 3.9% over the week after the country’s central bank kept interest rates on hold and a speedy resolution of the electricity crisis appeared unlikely.

Commodities
Industrial commodities were star performers during the past week as a result of severe weather conditions and power supply problems causing disruptions in Chinese production. The entire base-metals complex gained strongly, with aluminum (+10.6%), zinc (+8.6%) and lead (+8.4%) leading the pack.

Opec heeded expectations and maintained production quotas, but crude oil closed the week almost 2% lower on recession worries and the possible impact thereof on demand.

Gold bullion dropped to $910 by the close on Friday, after having recorded a new high of $936.5 earlier during the day. Platinum, however, rose strongly (+5%) to a new all-time high as concerns mounted about the implications of South Africa’s electricity rationing for the world’s largest producers.

Now for a few news items and some words (and graphs) from the investment wise that will hopefully assist to make sense of markets’ action during the week ahead.

Source: Financial Times, January 24, 2008.

Asha Bangalore (Northern Trust): FOMC lowers Fed funds rate by 125 bps over eight days!
“The FOMC reduced the federal funds and discount rate by 50 bps to 3.00% and 4.50%, respectively. The Fed has now lowered the federal funds rate 225 bps since September 18, 2007. The obvious and main conclusion from these aggressive moves is that Fed is more than worried about the economy and financial markets.

“The Fed continues to see weakening economic conditions as the predominant risk suggesting that additional rate cuts are possible. However, today’s statement changed the description ‘appreciable downside risks to economic growth remain’ in the January 22 statement to ‘downside risks to growth remain’. In addition, the statement indicated that the Fed’s actions should help to lift economic growth and reduce risks of a severe downturn. These modifications to the January 22 statement suggest that additional aggressive moves are less likely.

“The FOMC statement made no mention of the fiscal policy stimulus package. The note of optimism that today’s action and prior actions ‘should help to promote growth over time’ probably refers to the impact of a double dose of medicine – a large monetary policy easing and fiscal policy stimulus – to cure an ailing economy. Our most likely scenario is additional easing on March 18.”

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, January 30, 2008.

BCA Research: The Fed delivers!
“The Fed confirmed market expectations for a 50 basis point rate cut today. Policymakers are working hard to get ahead of the curve, against a backdrop of falling house prices, a slowing economy, ongoing financial market turmoil and a dramatic tightening in lending standards that is limiting the impact of easier policy.

“Critically, the FOMC statement retained the open-ended commitment to provide more interest rate relief if necessary, which will reassure jittery investors. Fed Governor Mishkin highlighted again recently the importance of easing early and aggressively in the face of a major negative shock, such as a housing recession.

“The speed of rate cuts will depend crucially on payrolls and the evolution of credit market tensions. Another jump in the unemployment rate and/or a spreading of credit market dislocation would spark further aggressive Fed action.”

Source: BCA Research, January 30, 2008.

The Wall Street Journal: Trichet – Fed’s monetary mistakes have global consequences
“This week the world learned that economic ‘decoupling’ from America is a myth. The next lesson to re-learn is that the Federal Reserve’s monetary mistakes have global consequences, and that one result of the Fed’s great dollar miscalculation this decade has been a dangerous breakdown in world monetary cooperation.

“Look no further than the European Central Bank, which was notably absent when the Fed made its emergency rate cut amid falling global stocks on Tuesday. In testimony Wednesday before the European Parliament, ECB President Jean-Claude Trichet came about as close as a member of the brotherhood ever will to calling out a fellow central banker: ‘In demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility in already highly volatile markets.’

“If we can interpret Mr. Trichet further, he thinks the Fed helped to create the current financial mess by going on a bender in the late Alan Greenspan era, and is now once again running dangerous inflation risks by cutting rates too soon in the face of Wall Street pressure. He’s also unhappy because the dollar’s fall against the euro has increased political pressure on the ECB to ease as well. So now that the Fed wants his help to avoid a further dollar decline against the euro, he’s in no mood to oblige.”

Source: The Wall Street Journal, January 26, 2008.

Bloomberg: US House approves $146 billion economic stimulus plan
“The US House approved a $146 billion economic stimulus plan aimed at averting an election-year recession in part by sending tax-rebate checks to about 111 million Americans.

“Lawmakers voted 385-35 to approve legislation that would also expand investment tax breaks for business and add capital to the slumping mortgage market by allowing federally chartered companies Fannie Mae and Freddie Mac to buy mortgages above the current federal limit. Republican and Democratic lawmakers said the bill would give a much needed jolt to the sagging economy.

“‘This is good news for the American public,’ said House Majority Leader Steny Hoyer, a Maryland Democrat. ‘This stimulus will put money in the hands of hard-working Americans to give them the help they need and at the same time stimulate the economy.’

“The House vote sends the bill to the Senate, where some senators said they would try to alter the House version, potentially delaying passage. Majority Leader Harry Reid, a Nevada Democrat, wants to complete work on the legislation by the end of the week, said his spokesman Jim Manley.”

“Lawmakers have said they want to get the bill to President George W. Bush by Feb. 15 so the government can begin distributing checks before June. Under the House measure, individuals would receive as much as $600 and couples would get up to $1 200. Families would get $300 for each child.”

Source: Brian Faler, Bloomberg, January 29, 2008.

BCA Research: US fiscal stimulus package – how important?
“The proposed $150 billion stimulus package, recently passed by the House, would have a noticeable positive impact on GDP. About one-third of the proposed bill represents accelerated depreciation for business capital spending, which will have little effect on GDP. However, the $100 billion in tax rebates will have a meaningful impact. While not all of the tax windfall will be spent, it should boost real GDP by about 0.5% in the second half of the year. This would bring the total fiscal stimulus for the year to over 1% of GDP, after including other stimulus that is already in the pipeline according to OECD estimates.

“The total stimulus falls far short of the 2003 ‘Jobs and Growth Act’, but will nevertheless be a significant offset to some of the headwinds consumers currently face. Bottom line: Aggressive monetary and fiscal steps may not avert a recession, but will significantly limit the economic downside.”

Source: BCA Research, February 1, 2008.

Financial Times: US bond insurer rescue takes shape
“Efforts to shore up US bond insurers gathered pace yesterday as New York state regulators appointed investment bankers to advise on a rescue plan that could include back-up credit lines for the troubled guarantors. The efforts are being spearheaded by Eric Dinallo, the New York state insurance superintendent, who is being privately supported by the New York Federal Reserve Bank and other regulators, people familiar with the matter said.

“Mr Dinallo met about a dozen banks last week, asking them to provide up to $15 billion for the bond insurers. While there was no indication that any banks had agreed yet, credit lines could help the insurers stave off credit rating downgrades. Some bankers hope the discreet involvement of the Fed will give the initiative greater momentum, because of its influence on Wall Street. The Fed has, for example, been discreetly urging big US banks to shore up their capital bases – with considerable success.

“The rescue efforts come amid concerns that bond insurers are running out of time to reassure rating agencies they have enough capital to deal with losses related to guarantees of bonds exposed to subprime mortgages.”

Source: Aline van Duyn, Saskia Scholtes and Ben White, Financial Times, January 28, 2008.

Standard & Poor’s: S&P/Case-Shiller® Home Price Indices show record declines
“Data through November 2007, released today by Standard & Poor’s for its S&P/Case-Shiller® Home Price Indices, the leading measure of US home prices, show broad-based declines in the prices of existing single family homes across the United States, marking the 11th consecutive month of negative annual returns and a full two years of decelerating returns.

“‘We reached another grim milestone in the housing market in November,’ says Robert J. Shiller, Chief Economist at MacroMarkets.’”

Source: Standard & Poors, January 29, 2008.

Yahoo Finance: Home foreclosure rate soars
“The number of US homes that slipped into some stage of foreclosure in 2007 was 79% higher than in the previous year, a real estate tracking company said Tuesday. Many homeowners started to fall behind on mortgage payments in the last three months, setting the stage for more foreclosures this year.

“About 1.3 million homes received foreclosure-related warnings last year, up from 717 522 in 2006, Irvine-based RealtyTrac said. Foreclosure filings rose 75% from the previous year to 2.2 million.

“More than 1% of all US households were in some phase of the foreclosure process last year, up from about half a percent in 2006, RealtyTrac said.”

Source: Alex Veiga, Yahoo Finance, January 29, 2008.

GaveKal: US GDP growth slowing down, but policy steps reduce risk of recession
“Yesterday, the Commerce Department reported that US GDP growth slowed in the fourth quarter to a worse-than-expected +0.6% YoY, a significant drop from the +4.9% YoY pace in the third quarter. Unsurprisingly, home construction was one of the biggest drags on growth, dropping -24% and subtracting -1.2 percentage points from GDP in 4Q07.

“… the Fed is clearly getting increasingly worried about the recession specter. Indeed, yesterday, the FOMC did what most investors expected them to do and cut interest rates by another –50bps to 3.0%. In addition, the Fed also indicated its willingness to act again in order to prevent a full-scale recession, as the accompanying statement had a significantly more dovish tone – stating that ‘downside risks remain’, and ‘recent information indicates a deepening of the housing contraction, as well as some softening in the labor market’. Overall, the cumulative reduction in interest rates is now the fastest easing of US monetary policy since 1990, making it clear that the Fed is taking the possibility of a US recession very seriously.

“However, we think the important news of the past days is the direction of policy in the US. In the US, US policymakers, whether it be the Fed or the government, are now committed to doing everything in their power to support the economy and the struggling financial sector. While we are once again hearing rumblings that this is nothing more than ‘pushing on a string’, we still believe the risks of a serious recession in America are now much smaller than they were a week ago.”

Source: GaveKal – Checking the Boxes, January 31, 2008.

Asha Bangalore (Northern Trust): Weak labor market conditions point to further easing of monetary policy
“Nonfarm payrolls dropped 17 000 in January after an upwardly revised gain of 82 000 in December. Revisions of November and December estimates resulted in a net gain of 9 000 jobs.

“Nonfarm payroll employment rose only 0.7% on a year-to-year basis in January. The growth in payroll employment peaked in March 2006 (2.14%). The level of payroll employment appears to have peaked in December 2007 for current cycle, which is subject to change after estimates are revised.

“A number of economic reports will be published before the March 18 FOMC meeting. Barring another ‘tantrum’ in the stock market or some other financial market calamity, we believe that the FOMC will refrain from another inter-meeting interest rate cut. Given Chairman Bernanke’s apparent eschewing of Greenspan’s gradualism, another 50 basis point reduction in the fed funds rate cannot be ruled out for the March 18 FOMC meeting.”

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, February 1, 2008.

Asha Bangalore (Northern Trust): Consumer Confidence Index loses ground
“The Consumer Confidence Index dropped to 87.9 in January from 90.6 in the prior month. The Consumer Confidence Index has declined in five out of the last six months.”

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, January 29, 2008.

Financial Times: Corporate America bracing for recession
“Leading US companies are shifting into recession mode and preparing to cut costs, freeze hiring and reduce capital spending as they brace for an economic slowdown, senior executives and industry experts said. Their concerns are likely to be reinforced by the International Monetary Fund, which slashed its forecast for US growth and warned that no country would be completely immune from what it termed a ‘global slowdown’.

“Separately, a US study due out today shows that chief financial officers’ views of the economy are the most pessimistic in nearly four years. Business leaders say rising oil prices, sagging consumer confidence and the on-going credit crunch are prompting them to put in place contingency plans to protect against the expected economic downturn.”

Source: Francesco Guerrera, Financial Times, January 29, 2008.

The New York Times: FBI opens subprime inquiry
“The Federal Bureau of Investigation has opened criminal inquiries into 14 companies as part of a wide-ranging investigation of the troubled mortgage industry, FBI officials said Tuesday.

“The FBI said it was looking into possible accounting fraud, insider trading or other violations in connection with loans made to borrowers with weak, or subprime, credit.

“The agency declined to identify the companies under investigation but said the inquiry, which began last spring, involves companies across the financial industry, including mortgage lenders, loan brokers and Wall Street banks that packaged home loans into securities. It is unclear when charges, if any, might be filed.”

Source: Vikas Bajaj, The New York Times, January 30, 2008.

Bloomberg: Subprime lenders get big accounting break at SEC
“Just when it seemed as if the mortgage mess had hit a new low, now comes this: The Securities and Exchange Commission’s staff has granted the subprime-lending industry a huge exemption from the normal rules for off-balance-sheet accounting. In effect, the move will let home lenders keep their balance sheets looking much smaller and less leveraged, even while the off-the-books loans they made get a makeover.

“For months, banking regulators and politicians have been pressing lenders to freeze the interest rates on many adjustable-rate subprime mortgages that are scheduled to reset soon at higher interest rates. The idea is to minimize defaults and foreclosures.

“While that’s a noble objective, all good deeds must be accounted for, and that’s been a sticking point for many banks. Through September, just 3.5% of subprime mortgages that reset in the first eight months of 2007 had been modified, according to Moody’s Investors Service. Even lenders inclined to help don’t want to hurt their financial results. And now they might not have to, thanks to a Jan. 8 letter from the SEC’s chief accountant, Conrad Hewitt.”

Source: Jonathan Weil, Bloomberg, January 30, 2008.

Bill King, (The King Report): US solons fear system implosion
“Each day it becomes more apparent that US solons fear a system implosion. The fact that the SEC willfu

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