Financial markets have been thrown into turmoil in recent weeks. The credit crisis that began with the collapse of the subprime loan industry last
year has resulted in the failure of several financial institutions and banks, the government takeover of several major financial firms and
expectations for more to come. All of this recently culminated in the creation of the new Troubled Asset Relief Program (TARP) as well as unprecedented central bank action. In the following pages, we attempt to provide some
perspective to these events, discuss the broad outlook for the US and global economies and offer some suggestions for where investors can find value in the current market.
The rescue plan: how it will work
As the credit crisis began expanding, the US Treasury Department and the Federal Reserve acted to inject liquidity into the financial system, brokered the sale of several large financial institutions and helped coordinate the government takeover of others. As it became apparent that this piecemeal approach to solving the problem was not having the desired impact of
stabilising the system, the Treasury Department floated the idea
of creating the US$700 billion TARP.
The TARP is designed to allow banks to sell assets to the government. The exact details of how the program will work are still being determined, but the program will allow the Treasury to purchase US$350 billion worth of assets from financial institutions and have access to another US$350 billion at the
discretion of Congress. The Treasury Department has indicated that it plans to work closely with the Financial Deposit Insurance Corporation (FDIC) to help strip away some of the bad assets plaguing bank balance sheets. The hope is that the government’s purchase of some of this debt will prompt other buyers to re-enter this market, creating additional demand, and
eventually, the TARP may be able to re-sell these assets back into the open market. For its part, the FDIC, in addition to the insurance coverage it provides to bank deposits, will continue to, as the Treasury Department put it, use its “lines of credit with the Treasury to… protect depositors, guarantee liabilities, facilitate orderly wind downs, mergers, or adopt other
Central bank action
In many ways, the recent actions taken by the Federal Reserve and other central banks may have just as significant an impact, if not more so, than the TARP in terms of unlocking credit markets.
First, the Fed greatly expanded its Term Auction Facility (the program established last year that allows the Fed to issue shortterm loans at a rate below the discount rate). Secondly, the TARP legislation included a provision that allows the Fed, for the first time in history, to pay interest on its reserve balances, helping the Fed to expand its balance sheet and stabilise overnight
interest rates. Finally, the Fed announced that it would begin lending money directly to nonfinancial corporations by purchasing commercial paper, the short-term debt issued by companies. Together, the Fed’s moves effectively doubled the size of the Federal Reserve’s balance sheet (with more to come),
and will grant it increased flexibility to encourage lending across financial markets.
Following these changes, on 8 October 2008, the Federal Reserve, the European Central Bank and the central banks of England, Canada, Sweden and Switzerland all enacted a coordinated 50 basis point interest rate cut (which brought the US fed funds target rate to 1.5%). Separately, central banks in
China, Hong Kong and Australia also recently cut rates. These coordinated cuts clearly signal that the world’s central bankers are all focused on what has become a global financial crisis and is a strong sign to the markets that they will act as necessary to combat the global freeze in credit markets.
What will the impact be?
Overall, we believe that the TARP and the steps taken by central banks are important and should eventually help stabilise the banking industry and will allow banks to remove some bad deb from their balance sheets. As a result, lending should grow again and some measure of liquidity should return to the markets. We have already seen banks take advantage of the Fed’s new
programs and bank borrowing has increased. It is important to emphasise, however, that credit markets will not be fixed overnight. It will take some time for the Treasury to get the TARP up and running, and we expect to see the impact of this program occur over six to nine months. Likewise, the actions taken by central banks will help, but it will take some time for the effects of the new programs and rate cuts to work their way through the
system. Nevertheless, these moves will help the banking system stabilise so that credit can begin flowing again, but the prospects for the overall economy remain troubled.
The outlook for the economy
The US economic landscape was fragile even before the most recent financial panic. Consumers have been wary and their reluctance to spend has been reinforced by the latest plunge in equity prices and by a weakening labour market. While it has not occurred yet, we expect that we will soon see an actual contraction in consumption levels – an event that has not occurred since 1991. Meanwhile, house prices are continuing to fall. Home sales levels are falling and the market is not clearing.
Additionally, the corporate sector has been coming under pressure, and this is hardly the type of environment in which most companies want to increase either investment or hiring.
Exports have been the one bright light in the US economic picture, but even that sector is dimming, given the deteriorating prospects for the global economy. Conditions seem likely to get worse before they get better.
Until recently, although the US economy had been weakening, its relative resilience had been a positive surprise relative to all of the bad news. Given the severity of recent events, however, we now believe that the economy is in a recession and the recovery will be slow in coming next year.
The outlook is equally difficult on the international front. The entire global economy is likely to slip into a recession, marking the first time since the 1970s that both the US and international economies would be in recession.
Outlook and opportunities in fixed income The main theme that has endured within fixed income markets for some time now is that investors have been fleeing anything that is perceived to have exposure to credit risk in favour of the safety of Treasuries. As a result, credit spreads have widened significantly.
To us, this suggests that there is value to be found in some higheryielding
securities. In other words, we believe that in the near term, some of the best opportunities available to investors across any asset class can be found in the credit markets.
While Treasuries appear to us to be overvalued at current yields, a specific area of the market that we do like is the agency mortgage market. Yields on Ginnie Mae securities, in particular, have been pushed higher in recent weeks. This market sector is backed by the “full faith and credit” of the US government and, at current yields, we believe this sector represents some of the best value available for investors. Likewise, we also favour Fannie
Mae and Freddie Mac securities. On a more selective basis, we also see value in corporate bonds (including some higher-quality financial institutions) in non-agency mortgages and in high-yield bonds at selected companies.
We would also encourage investors to look for opportunities in international markets where many bonds are attractively valued.
In general, government bond yields in most developed non-US markets are higher than they are in the United States (in part because non-US central banks have been reluctant to lower interest rates).
Outlook and opportunities in equities
Equity markets have recently been driven much more by macro issues (such as focusing on the TARP legislation) than they have by fundamentals, and this pattern will likely persist for some time. Looking ahead, we are optimistic that the government rescue plan and central bank action will help, but a sustained rally in equities will require evidence that the measures are working. In particular, we are keeping a close watch on credit spreads. Credit spreads
have widened as investors have become more risk averse. If spreads begin to narrow, it could signal a real and lasting bottom in equity markets. Additionally, we believe equity markets will require ongoing capital raising and continued consolidation in the financial sector. In sum, the equity market sell-off appears to be well advanced, but not yet exhausted, meaning that investors should continue to approach the markets cautiously.
Where, then, should investors be looking for opportunities? In our opinion, the best value in this very uncertain period can be found in higher-quality companies that have relatively strong balance sheets, strong levels of free cash flow and that have adequate financing. In general, this would lead to an
overweighting in large caps and in growth stocks. From a geographic perspective, non-US markets have recently been hit harder than US stocks, largely due to the same quality theme, as well as to the aggressiveness of US monetary and fiscal policy. Going forward, we expect US stocks will continue to outperform other developed markets. Emerging markets have
experienced some of the worst performance lately, but we believe the long-term fundamental case for this area of the market remains intact.
Regarding market sectors, we do not believe that the worst is yet
over for financials and continue to recommend underweight positions. We are, however, seeing value in some financial companies, including some of the larger global banks that are likely to be net beneficiaries in the current environment. One area of the market we do continue to find attractive is US
multinationals. The rise in the dollar has taken some wind out of the sails of this sector, but this area of the market continues to provide evidence of good growth. A final sector theme we believe is important can be found in the resources area. We do believe energy companies remain well positioned and are attractively valued despite the pullback in oil prices, but we are not currently finding most of the materials area of that market attractive.
Conclusions: what to expect
As we have indicated, we do not believe that the passage of the TARP and the recent central bank moves will be a panacea that will fix the global economy, and indeed, equity markets around the world fell again recently as investors remained focused on the downside risks to the global economy. Eventually, we believe that we will see real evidence that credit markets are starting to
recover, but this is likely to be a mid-2009 event rather than a
fourth-quarter 2008 occurrence.
In these circumstances, we remain cautious for a while longer. We focus on capital preservation for the time being, even at the cost of missing some near-term gains in higher risk assets.
That said, however, we do believe opportunities remain, as outlined above.
BlackRock Vice Chairman;
Global Chief Investment
Co-Head of BlackRock’s
Fixed Income Portfolio