Without a doubt, the major financial story since this past summer has been the meltdown in the sub-prime lending market and the subsequent drop-off in housing sales and the impact on home builders and related industries. Standard & Poor's and Moody's fed the fears of a broader market sell-off by dropping the ratings of approximately $17 billion of sub-prime debt issued between 2002 and 2006. When viewed in the context of $2.3 trillion of sub-prime debt issued during this period, the rating cut is insignificant. It is our view that the troubles in the sub-prime market are too small relative to the broader market to have much impact on the economy or on the stock market.
Actually, this year is the sixth time since 1982 that housing prices are flat or negative year-over-year. In each case, the years following those declines have been favorable periods for the stock market and for the broader economy. The fear that a housing market downturn will lead to poor market returns has no historical basis.
Recent turmoil in the bond market can be traced to the Federal Reserve's easy money policy of low interest rates beginning in 2001. This was meant to fight the recession that had begun then. The Fed Funds rate had dropped to 1.00% in June, 2003. With rates this low, adjustable rate mortgages made it possible for nearly anyone to afford to purchase a home until 2006. However, interest rates rose in 2006-2007, so when the re-set dates occurred, some homeowners faced sharply higher monthly payments and delinquencies jumped.
While we are not belittling the matter, we should keep in perspective that only 9% of the $10.4 trillion mortgage market is sub-prime and mortgage delinquencies for prime borrowers are low.
Credit spreads, the difference between interest rates on corporate and government bonds, have increased relative to their extremely narrow levels of a few months ago. Nonetheless, today's spreads are not extreme and are well within historical norms. We see no cause for concern here.
Economic growth is positive, albeit decelerating. Corporate balance sheets still are very strong, inflation is low and within the Federal Reserve's target, long term interest rates are low and behaving well, and global economic growth still is very strong. These factors simply do not add up to any kind of a meaningful credit crunch. Although the odds of a recession in 2008 have increased, the more likely outcome is sub-par growth.
The Federal Reserve has responded to the turmoil in the credit markets with two successive cuts in interest rates designed to prevent a deflationary slump from taking hold. Further interest rate cuts are likely in the coming year as well.
The final phase of the process will be completed when the U.S. housing sector stabilizes in terms of sales activity and prices. This could take another couple of years given that prices still are not at market clearing levels, and because the mortgage tap has been turned off for low income borrowers. Monetary and fiscal policy reflation should allow financial markets to perform well during this final adjustment phase.
The economic expansion of recent years has delivered decent growth, low inflation and good corporate profits. We have been -- and still are -- positive on the stock market, although not wildly so. Most importantly, we are not among those who believe that the U.S. economy and markets are poised for a dangerous fall, and we believe that it will not pay to invest on such assumptions.
The current period of economic and financial uncertainty will continue for a while. Recent bouts of market volatility will continue as well in the coming year. But, we are confident that policy reflation will work as it has in the past and that markets will respond accordingly. We believe in maintaining appropriate overseas exposure in portfolios and that, within domestic portfolios, the shares of globally-focused companies will perform better than their counterparts that depend solely on domestic activity.
Kenneth N. Green, C.P.A, B.S. (in Finance, University of Illinois), and M.B.A (in Finance, University of Michigan), is Senior Vice President and Director of Investments of Marc J. Lane & Company and Marc J. Lane Investment Management, Inc., the investment affiliates of The Law Offices of Marc J. Lane, A Professional Corporation.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright © 2007 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.