Investment Postcards from Cape Town

Reviewing the past week’s market action I couldn’t help but recall the words of Claudius in Shakespeare’s Hamlet: “When sorrows come, they come not single spies, but in battalions.” A laundry list of ominous economic reports, continuing worries about the credit insurers, more news of mortgage-related write-downs and talk of hedge funds facing margin calls served up the perfect storm of investor anxiety.

Fed Chairman Ben Bernanke was in the spotlight on Wednesday and Thursday when he delivered his semi-annual testimony on the economy and monetary policy to the House and Senate banking committees. Testifying after inflation readings for January showed strongly rising prices, he admitted that inflation risks have increased, but emphasized the Fed’s view that growth risks remained the greater threat to the economy right now.

Bernanke acknowledged that tumbling house prices could set off a second phase of the credit crisis. He said: “Financial markets continue to be under considerable stress,” and also warned of possible small bank failures in the US.

The take-away from Bernanke’s testimony was that the Fed will be cutting rates again at the March 18 FOMC meeting, with the Fed funds futures now seeing a 100% chance of a 50 basis point cut and a 62% chance of a 75 basis point cut.

John Mauldin, author of the Thoughts from the Frontline newsletter, said: “Bernanke practically promised more rate cuts … The Fed is going to cut and cut again … I think it likely they will go below 2%. They may stay there longer than we now think if I am right about a protracted and slow Muddle-through recovery.”

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 round-up.

Economy
A number of important US economic reports were released last week, causing considerable angst among investors that a combination of slowing growth and increasing inflation could result in 1970s-style stagflation.

In addition to Bernanke’s downbeat Congressional testimony, several economic numbers came in worse than expected, namely tumbling house prices, falling consumer confidence, consumer spending close to zero, falling orders for durable goods, a recession-like manufacturing survey, flat GDP growth and signs of a weakening labor market.

Importantly, producer prices rose by 7.4% in January from a year ago, coming on the heels of the news last week that the CPI rate jumped to the highest year-on-year rate in decades.

Research from UBS suggested that total losses for financial firms related to the sub-prime meltdown would reach at least $600 billion against the $160 billion of write-downs so far disclosed.

On the positive side, the Office of Federal Housing Enterprise Oversight announced that it would be removing the portfolio caps on Fannie Mae and Freddie Mac, thereby hoping to improve liquidity in the secondary mortgage market to promote increased lending. Also, Standard & Poor’s affirmed the triple-A ratings for MBIA and Ambac, but this was negated by news that the bailout of the latter had hit a problem.

WEEK’S ECONOMIC REPORTS

Date	Time (ET)	Statistic	For	Actual	Briefing Forecast	Market Expects	Prior
Feb 25	10:00 AM	Existing Home Sales	Jan	4.89M	4.90M	4.80M	4.91M
Feb 26	8:30 AM	PPI	Jan	1.0	0.4%	0.4%	-0.3%
Feb 26	8:30 AM	Core PPI	Jan	0.4%	0.2%	0.2%	0.2%
Feb 26	10:00 AM	Consumer Confidence	Feb	75.0	80.0	82.0	87.3
Feb 27	8:30 AM	Durable Orders	Jan	-5.3%	-5.0%	-4.0%	4.4%
Feb 27	10:00 AM	New Home Sales	Jan	588K	600K	600K	605K
Feb 27	10:30 AM	Crude Inventories	02/23	3231K	NA	NA	4204K
Feb 28	8:30 AM	GDP-Prel.	Q4	0.6%	0.6%	0.8%	0.6%
Feb 28	8:30 AM	Chain Deflator-Prel.	Q4	2.7%	2.6%	2.6%	2.6%
Feb 28	8:30 AM	Initial Claims	02/23	373K	355K	350K	354K
Feb 29	8:30 AM	Personal Income	Jan	0.3%	0.4%	0.2%	0.5%
Feb 29	8:30 AM	Personal Spending	Jan	0.4%	0.3%	0.2%	0.3%
Feb 29	8:30 AM	Core PCE Inflation	Jan	0.3%	0.2%	0.3%	0.2%
Feb 29	8:30 AM	Core PCE Prices	Jan	-	NA	0.2%	0.2%
Feb 29	9:45 AM	Chicago PMI	Feb	44.5	49.5	49.5	51.5
Feb 29	10:00 AM	Mich Sentiment-Rev.	Feb	70.8	70.0	70.0	69.6

Source: Yahoo Finance, February 29, 2008.

In addition to the Fed releasing its Beige Book on Wednesday, the next week’s economic highlights, courtesy of Northern Trust, include the following:

1. ISM Manufacturing Survey (Mar 3): The consensus for the manufacturing ISM composite index is 48.1, after a 50.7 reading in December. Several reports of the factory sector have sent a message of a contracting manufacturing sector. Consensus: 48.1 from 50.7 in January

2. Employment Situation (Mar 7): Payroll employment in February is predicted to have barely risen (+10 000). Payroll employment dropped by 17 000 in January. The jobless rate is predicted to have risen to 5.0% from 4.9% in January. Consensus: Payrolls – +25 000 versus -17 000 in December, unemployment rate -5.0%

3. Other reports: Construction spending, auto sales (Mar 3), Pending Home Sales (Mar 6), Productivity and Costs, ISM Non-manufacturing Survey, Factory Orders (Mar 6).

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

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

Equities
Global stock markets closed the week higher, with the MSCI World Index gaining 0.6%. If not for emerging markets (+1.5%) and the Japanese Nikkei 225 Average (+0.8%) the global index would have been underwater.

A sharp sell-off on Friday (driven by a host of negative news regarding financial stocks) resulted in declines for the US indexes for the week, as follows: S&P 500 Index (-1.7%), Nasdaq Composite Index (-1.4%) and Dow Jones Industrial Index (-0.9%). Gold and silver stocks (+3.5%) were the strongest performers for the week, whereas banks (-6.4%) and brokers ( 5.5%) were on the receiving end of the selling orders.

The major US indexes all recorded declines (ranging from 3% to 5%) for February, resulting in a fourth consecutive month in the red – the biggest losing streak since 2002.

Bonds
Mounting economic concerns caused government bond yields across the globe to decline sharply as nervous investors piled into government debt as a perceived safe-haven asset class.

The entire maturity spectrum recorded double-digit yield declines in the US, with the yield on the two-year Treasury note falling by 34 basis points to 1.64% and the 10-year yield dropping by 27 basis points to 3.52%. Capital markets in the rest of the world behaved similarly.

Currencies
The past week saw the US dollar plunging to lifetime lows on a trade-weighted basis and against the euro as market participants focused on weaker US economic growth leading to further rate cuts by the Fed. “The last time the dollar was this low, Jimi Hendrix was on tour,” said Barry Ritholtz (Big Picture).

The US dollar dropped by 2.3% against the euro based on the view that the European Central Bank would keep interest rates on hold for a while longer. Losses against other major currencies were: Swiss franc (-3.7%), Japanese yen (-2.3%) and British pound (-0.9%). Concerns about the UK economy and slowing house prices impacted negatively on sterling.

Commodities
The Reuters/Jeffries CRB Index (+3.8%) continued its record-breaking ride during the past week on the back of a slumping dollar and increased investor inflows (as also evidenced in an announcement by Calpers to commit large additional assets to commodities). Crude oil (+3.1%), gold (+2.9%), platinum (+1.2%), industrial metals (+4.7%) and agricultural commodities (+4.0 %) all reached record levels.

Inflation concerns and negative real short-term interest rates pushed gold bullion to a record $975.90 en route to the $1 000 level. Silver continues to play catch-up within the precious metal complex, surging by 10.4% to breach $20 before minor profit-taking set in. A trader remarked: “Silver is in huge short supply, and the shortage is getting worse by the day; the silver inventories which depressed the price for more than 60 years are gone.”

West Texas Intermediate oil hit an all-time high of $103.50 as a result of supply disruptions, but eased by the end of the weak as economic worries got the better of supply concerns.

Agricultural commodities and base metals again experienced a strong week.

With the ISM Manufacturing Survey out on Monday and February’s payroll numbers on Friday, another key week for financial markets lies ahead. Hopefully the words and graphs from the investment wise will assist in guiding us through the murky waters and keeping our investment portfolios afloat.

US economy – that recessionary feeling

Source: Tom Toles, Yahoo News (via Barry Ritholtz’s Big Picture).

Moody’s Economy.com: World business confidence stable but weak
“Business confidence is stable but weak; consistent with a US economy that is contracting, expanding only marginally in Canada and Europe, and growing no better than potential in Asia and South America. Businesses’ assessments of current economic conditions dropped to a new low on a 4-week moving average basis. Real estate firms and financial institutions are the most worried, but business service firms and even manufacturers and high-tech firms are measurably more nervous.”

Source: Moody’s Economy.com, February 26, 2008.

Bloomberg: Roubini – Recession may last up to six quarters

Source: Bloomberg, February 26, 2008.

Asha Bangalore (Northern Trust): Predicting a contraction of real GDP
“Real gross domestic product (GDP) grew at an annual rate of 0.6% in the fourth quarter of 2007. The headline was let unchanged after revisions. But, with the exception of exports, all major components of GDP show slower growth compared with the advance estimate.

“Going forward, we are predicting a contraction of real GDP in the first quarter, marking the onset of a recession. The downturn in business activity should prevail until the third quarter of 2008. A revival of business momentum is likely by the end of the year, assuming the Fed eases monetary policy by about 100 bps and financial market impairment ends.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, February 28, 2008.

Asha Bangalore (Northern Trust): Bernanke’s testimony: easing is on the table, but inflation remains a concern
“Bernanke’s testimony addressed expected issues, the only surprise was that his remarks about inflation were quite extensive. A lower federal funds rate is nearly certain on March 18, with the February employment report, auto sales, auto retail sales, and financial market conditions determining the magnitude of the rate cut. Following a repetition of the FOMC’s forecasts, previously published, Bernanke noted that ‘the risks to this outlook remain to the downside. The risks include the possibilities that the housing market or labor market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further,’ which ensures additional easing.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, February 27, 2008.

Bill King (The King Report): Fed must inflate or the system dies
“Bernanke essentially reiterated the dovish braying that Fed VCEO Don Kohn expressed on Tuesday. Ben also sees the financial system and economy as a bigger threat than inflation.

“Ben has to pretend that inflation expectations remain well anchored because he knows the Fed must inflate or the system dies. So Ben once again regurgitated the Fed mantra ‘yes we see inflation but slowing economic growth will arrest it’, which has been chanted for over a year. The second mantra verse is ‘okay we see food and energy inflation but core inflation remains well anchored.’

“This bone-headed Keynesian (slowing economy will offset inflation) delusion was totally debunked in the ‘70s but the Fed believes it has no choice and must lie about inflation on almost a daily basis.”

Source: Bill King, The King Report, February 28, 2008.

Richard Russell (Dow Theory Letters): What else can Bernanke do?
“Kohn is saying that the Fed is far more worried about the US economy than it is about potential inflation. Translation – the Fed will ACT to stimulate the economy but when it comes to fighting inflation – the Fed will resort to TALK.

“Put yourself in Bernanke’s place. What else can he do? Really nothing. He will do as much as possible to reliquefy the banks. He will do what he can to save as many homes as he can. He can hope that a rising stock market will work its magic on the psyches of America’s consumers. And he will shower the US with money in the hopes that this added ocean of currency will somehow float the US out of trouble.”

Source: Richard Russell, Dow Theory Letters February 27, 2008.

GaveKal: Signs of a secular uptrend in inflation
“… as things starting to marginally improve on the growth front, attention is now being directed to the risk of rising inflation.

“Indeed, recent inflation-related data points have not been encouraging. And this is especially true in Asia, where many countries are now experiencing the fastest pace of inflation since before the Asian Crisis. Most recently, Singapore has reported that its CPI has reached +6.6% YoY in January, the highest level since 1982. While, Asian inflation remains centered on food (e.g., wheat prices are up a whopping +19.6% MTD) and energy, we are nevertheless starting to see some concerning signs of a secular uptrend toward higher inflation.

“And even in the US, TIPS are now starting to reflect rising inflationary concerns, as the TIPS spread has widened to the highest level since August 2006 … And looking ahead, there is little evidence that commodity prices are going to offer any relief on inflation. Last week, for example, China’s largest steelmaker, Baosteel, agreed to a +65% input price increase from the world’s largest iron-ore supplier, Brazil’s Vale. In turn, Baosteel announced yesterday that it was increasing its steel prices by +20% (far higher than the +12% to +17% increase expected by analysts).”

Source: GaveKal – Checking the Boxes, February 26, 2008.

The Wall Street Journal: Inflation may be worse than we think
“Amid Wall Street’s recession panic, the latest official inflation news has received less attention than usual. The ‘headline’ consumer price index (CPI) for the year ending in January was up 4.3%, the third consecutive monthly reading above 4%. This has been easy to attribute to rising energy costs, for which the blame is often misplaced on foreigners and oil companies. But as I’ve argued on this page in the past, the real problem is the sick dollar.

“While the practice of excluding energy and food costs to glimpse the ‘underlying’ rate of inflation meets a lot of skepticism, the official consumer-price picture still keeps everyone guessing. The root of the confusion is the fact that the prices consumers actually pay change far more quickly than the CPI.

“The most timely figures come from the commodity markets, where prices are transparent and reflect conditions in the immediate present. Yet commentators tend to discount volatile data like energy and food prices when they assess the ‘underlying’ rate of inflation. This is a big mistake.

“Markets look forward, while government surveys of the cost of living are a rearview mirror. A little ‘indicator analysis’ shows that commodity prices, far from reverting quickly back to the mean, are early-warning indicators of the future CPI. Last year’s large increases in energy and food imply that consumer-price inflation is going to be much closer to today’s ‘headline’ rate of 4.3% than the ‘core’ rate of 2.5%.”

Source: David Ranson, The Wall Street Journal, February 27, 2008.

Times Online: Fed struggles to halt march of stagflation
“The ailing US economy is confronted not by a single threat but by a whole battalion of sorrows on the march that comprises deepening recession and accelerating inflation.

“Last week the Government reported that in the year to January consumer prices rose by 4.3%. This is so far above the top end of anybody’s definition of price stability as to be more than slightly alarming. The detail of the data showed just how pervasive inflation has become. It goes well beyond the usual suspects of oil and energy-related products and even food.

“Last month the prices of three quarters of the goods measured in the official figures rose by more than 2%. This suggests that inflation is more than just spiking in reaction to some short-term cost pressures but is becoming embedded in ways dangerously reminiscent of the late 1960s. That was when the global economy last began a long cycle of high inflation that proved stubbornly hard to conquer, even when demand slumped in the 1970s.

“This is why people in the United States are worrying openly about stagflation. The rising inflation trend seems, at least so far, to be impervious to the weakening economy. Even as price pressures have picked up, the signs of recession have proliferated.

“How much of a constraint will inflation be on the Fed’s room to cut rates further? The view at the central bank seems to be divided between economic pessimists who are optimistic about inflation and economic optimists who are pessimistic about inflation.

“We won’t have to wait long to find out which side is correct.”

Source: Gerard Baker, Times Online, Febuary 26, 2008.

Standard & Poor’s: Case-Shiller – year-end home prices mark widespread declines
“Data through December 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 2007 as a full year of declining home prices.

“The chart above depicts the annual returns of the US National Home Price, the 10-City Composite and the 20-City Composite Indices. The decline in the S&P/Case-Shiller® US National Home Price Index – which covers all nine US census divisions – neared double digits, posting -8.9% versus the 4th quarter of 2006, the largest decline in the series 20-year history. During the 1990-91 housing recession the annual rate bottomed at -2.8%.

“‘We reached a somber year-end for the housing market in 2007,’ says Robert Shiller, Professor at Yale University and Chief Economist at MacroMarkets LLC. ‘Home prices across the nation and in most metro areas are significantly lower than where they were a year ago. Wherever you look things look bleak, with 17 of the 20 metro areas reporting annual declines and the remaining three reporting flat or moderate growth rates.’”

Source: Standard & Poor’s, February 26, 2008.

Asha Bangalore (Northern Trust): US homes – inventories keep climbing
“… it appears that additional price declines are likely given the inventory situation of existing homes. There was a 10.3-month supply of all existing homes in the market and a 10.1-month supply of existing single-family homes in January. A year ago, these readings were 6.7-month supply and 6.5-month supply, respectively. All said, adjustments in the housing market will continue in the months ahead until the inventory situation improves significantly.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, February 25, 2008.

MarketWatch: US mortgage rates rise on inflation concerns
“Mortgage rates rose again this week, bringing the 30-year and 15-year fixed-rate mortgages to levels last seen in November, Freddie Mac’s chief economist said on Thursday. The upward rate movements are a reversal of what was seen in January, when rates had dropped significantly enough to inspire a surge in refinancing.

“According to Freddie Mac, the 30-year fixed-rate mortgage averaged 6.24% for the week ending Feb. 28, up from 6.04% last week. The mortgage is now higher than it was a year ago; the 30-year averaged 6.18% at this time last year. Just three weeks ago the benchmark loan averaged 5.67%, meaning it has jumped more than half a percentage point since then, a significant move given that mortgage rates have not been volatile in the last few years and that the Federal Reserve has been cutting interest rates aggressively.

“‘When mortgage rates move down very sharply, they tend to rebound equally sharply,’ said Greg McBride, senior financial analyst with Bankrate.com. ‘However, there’s usually one catalyst that sparks that rebound, and this time around there wasn’t one single precursor.’

“For one, concern about inflation is putting upward pressure on long-term rates, he said. That’s because inflation erodes the buying power of future payments that a bond holder receives, he added. Rates rise to compensate. Inflation worries will continue to influence rates over the next several months, and continued Fed rate cuts could stoke those worries even more, McBride said.”

Source: Amy Hoak, MarketWatch, February 28, 2008.

Bespoke Investment Group: Greenspan’s irresponsible advice
“Below we highlight a chart of the Fed Funds rate over the last eight years. Almost right after Greenspan suggested homeowners switch to adjustable rate mortgages, the Fed then went on to raise the rates that these adjustable rate mortgages were tied to! While his ill-timed calls regarding the stock market are understandable, Greenspan’s comments regarding short-term rates are especially puzzling. Unlike the stock market where he had no direct control, Fed Chairman Greenspan had ultimate control of where the Fed Funds rate was headed. Suggesting that homeowners migrate out of fixed rate and into adjustable mortgages right before a three-year 5.25% increase in the key short-term rate was not only a bad call, but also irresponsible.”

Source: Bespoke Investment Group, February 25, 2008.

MoneyNews: What crash? Home prices rising in half of US
“If you live in Florida, Las Vegas or California, you probably see a meltdown in your local real estate market. But in nearly half of the country’s 150 metropolitan markets, the median home price rose in the fourth quarter last year, the National Association of Realtors reports.

“The biggest gains came in small cities. The Cumberland area of Maryland and West Virginia topped the list with a 19% jump from a year ago, to a median price of $116,600. Next was Yakima, Wash., up 18% to $170,600, followed by the Binghamton, N.Y. area, up 14.8% to $110,000.

“‘I would call them back-country cities,’ Robert Shiller, the Yale University professor who made himself famous predicting the bursting of the 1990s stock bubble and the 2002 to 2005 real estate bubble, tells The New York Times. ‘They are just going through normal growth, and they are out of the bubble picture.’

“Some big cities have been able to withstand the real estate crunch as well: Manhattan, San Francisco and San Jose, for example.

“‘This proves what my friend Alan Greenspan always said: real estate is a regional, not a national business,’ David Jones, a veteran Wall Street economist tells MoneyNews.com. ‘You see so often the S&P/Case-Shiller Index, which measures the 20 biggest markets, and you think that home prices are falling everywhere in the country,’ Jones says. ‘This National Association of Realtors report proves otherwise.’”

Source: MoneyNews, February 22, 2008.

Richard Russell (Dow Theory Letters): Bill Gross – Housing is key to US economy
“The key to the US economy is housing. America’s consumers are not going to buy while the price of their homes are sinking month after month. Instead, they’re going to ‘pull in their horns’.