Stocks get off to higher start

Steep decline in crude prices prop up major indexes, while investors remain wary about more credit market fallout.

Wall Street on economic, credit watch

Stock futures slightly lower as investors await readings on inflation, health of consumer, weigh new reports of Wall Street woes.

FSM - Yet Another Snip Off The Fed Rate

On 31 October 2007, the Federal Reserve has yet again cut its Federal funds benchmark rate, by another 25 basis points to 4.5% ? a move widely expected by the markets. The move did not surprise many as the futures and options markets were accurate in their prediction of the Fed's decision this time round, following an unexpected 50-basis points cut on 18 September 2007.

We believe it would be necessary for investors who are already invested in the US market, hold USD-denominated assets or keen to invest in the US equities in the near future, to understand the potential repercussions that may result from further policy changes ahead.

For a start, many feel that the press statement that accompanied the FOMC's decision was undoubtedly more hawkish than the earlier one in September. Meanwhile, the FOMC also mentioned an important point which may have caught the market slightly off-guard. It said, "The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth."

Many news reports have already picked up the statement we highlighted, and a number of economists and reporters are conjuring up their respective interest rate predictions for the next FOMC meeting in December this year. In our view, the only option the Federal Reserve is left with currently, would be to adopt a wait-and-see stance before reacting to further economic data.


Interest Rates Are Likely To Remain Flat

Reading closer, we think the FOMC's statement implies a rather optimistic view. Firstly, while inflation is typically the thorn in the flesh of central banks, we see that the Federal Reserve is now marginalizing this issue, for the fear that the housing market fallout would be further aggravated. By cutting interest rates to avert a slowdown in the economy for as long as possible, inflationary fears have been temporarily chucked aside.

Secondly, even as the annualized quarter-on-quarter 3Q2007 GDP figures came in at a higher-than-expected 3.9%, America's free-spending consumers are unlikely to drag the economy out of the shadow of a sharp slowdown once falling home prices and high gasoline prices hit them in the pockets. According to the US' savings rates in July, the typical US consumer only saves 0.8% of their disposable incomes, while preferring to spend almost all of it. At this juncture, it would be difficult for the average US consumer to spend more using either credit or savings.

In addition, we have seen oil prices soar to as high as US$96.21 per barrel (the Nymex Light Crude prices) as at 31 Oct 2007, after the announcement of the rate cut. While the increasing oil prices may not be directly attributable to the rate cuts, a weakening USD resulted from lower interest rates had indeed made oil more expensive for the American consumers.

What does this mean for fund investors who are invested in US equities or hold assets denominated in USD? What are the possible scenarios, going forward?

The Fed Triangle: Interest Rates, Inflation & The Dollar

The Federal Reserve is the central bank of the United States of America, and it is through them that the country's money supply is controlled and monetary policies are implemented. In a nutshell, interest rates which are set by the Federal Reserve tend to affect the supply of money. When the cost of borrowing is cheap because of low interest rates, businesses and consumers tend to borrow more; hence, more money would be created in the economy. As more money starts chasing the same amount of goods, inflation would rise.

The US dollar is not an idle bystander to the workings of money supply and inflation in the economy. While it is not supposed to be directly affected by the rate cuts, we have witnessed the rapid depreciation of the currency since the previous rate cut on 18 September 2007. In the period between the occurrences of both rate hikes (from 18 September 2007 to 31 October 2007), the US dollar has depreciated 4.1% against the SGD. The primary explanation for this is simply that the currency has become less attractive to hold for the foreign investors, whether in the form of deposits or US debt.

To illustrate this relationship further, Table 1 shows us a general idea of what we can expect for these three variables, going forward. However, investors should note that there is no specific time frame for the scenarios illustrated below, and they exist solely for illustrative purposes to explain the relationship between the variables and our long-term view on the US dollar.

Table 1: Possible Scenarios of Future Fed Rate Movements

Source: Fundsupermart.com

Scenario 1: If Interest Rates Are Further Reduced

This will further weaken the US dollar. Year-to-date, as at end-October 2007, the greenback has fallen about 6% against the Singapore dollar; this has effectively eroded returns for Singaporean investors with USD-denominated assets. As lower interest rates will render a currency less attractive to hold, the US dollar will likely depreciate further.

In a gloomy scenario, with inflation rising rapidly, the effect of wealth creation will start to diminish for everyone. When this happens, even as the equity markets may rise to earn a 10% return in a short period, it may not necessarily make one richer ? especially when the prices of goods and services rise sharply.

Thus, although the Fed may have the flexibility to cut rates to 'save' the US economy from a possible recession, such a decision does not come without a cost. Such a move could push the economy's inflation rate up to the roof in the medium term.

Scenario 2: If Interest Rates Are Maintained

The US dollar's depreciation will continue, albeit at a slower pace. While the reasons for the continued depreciation are complex, the US' huge current account deficit is almost certain to be one of them. To reduce this deficit, the US would have to increase its exports. This could be helped by a weaker dollar, as that will increase the competitiveness of their exports. Therefore, we think that a weaker dollar is a trend set to continue in the medium-term. However, forecasting exact prices would be a futile exercise and we think that the market will eventually decide on equilibrium for the US dollar.

However, investors should note that a unique fact about the US dollar is that it is still the world's foremost reserve currency, and many countries still hold a large proportion of their reserves in US debt securities. In this sense, no government will wish to see the currrency depreciate to an extent such that their coffers effectively shrink. Thus, we think that the depreciation is likely to be gradual than steep.

The effect of keeping interest rates unchanged should stabilize the inflation rate in the country. Although the equity markets are expected to react negatively to this decision in the short term, we think this would be a viable option from a medium term perspective.
 

Scenario 3: If Interest Rates Are Raised

We do not see this scenario playing out in the short term. Suffice to say, the effect of raising interest rates in the midst of the US credit crunch would be likened to adding oil to fire. If the Fed makes such a move, financial institutions and consumers in the US would all be burdened with higher interest payments, and this would adversely affect sentiment in the country and equity markets would probably fall sharply as a result.

We think that this scenario is improbable, unless inflation rises to become a foremost threat to the US economy. Also, considering that the Federal Reserve has been unwilling to allow the housing slump to affect the economy at this stage, raising interest rates would certainly sound the note for a recession to occur.

A Word of Advice

As such, we urge Singaporean investors who hold USD-denominated funds not to be overly concerned with the currency effect on their returns. Such investors should note that a USD-denominated fund which invests in Korean or Taiwanese equities would be exposed to the currency effects between the Singapore dollar and the Korean Won or Taiwanese Dollar, and not the US dollar. The US Dollar is only used as the medium of exchange, due to its liquidity.

For investors who are currently invested in the US market or US fixed income instruments, we think that the US economy is due for a sharp slowdown (read more on this in our article " US Economy Heading For A Sharp Slowdown "). The structural problems of the US economy, such as its huge current account deficit, a recession in the housing market as well as debt-ridden consumers do not bode well for the US economy in the short to medium term. Further rate cuts will pose more problems and will only prolong what we think is eventually bound to happen ? a sharp slowdown in the US economy.

In view of this, we advise investors to pare down their holdings in the broad US equity and fixed income markets and switch a portion of their investments to markets or sectors which are poised to do well instead. With the combined effects of a weak US dollar and high oil prices stoking the flames of inflation, we are positive on the energy and commodities sectors.

Look For Better Value

We should all be mindful that economies move in cycles, and that no single economy or market stays buoyant forever. Owing to the economic clout of the United States, the implications of Fed rate cuts for the markets, economies and investors could be complex. In this article, we have outlined some general scenarios we think might occur in the future, based on the future decisions of the Federal Reserve.

In such times of uncertainty, we believe that an investor's best move might be to identify the next best performing market or investment. While we remain pessimistic about the US market, we do not think that all markets will necessarily be adversely affected in time to come.

Dow drops over 200 points

It's a week of big losses as Wachovia, Fannie Mae are the latest lenders caught in the real estate mess. Nasdaq slides over 2.5 percent.

Stocks fell sharply Friday, with the Dow ending over 200 points lower, as mortgage-induced losses at Wachovia and Fannie Mae riled traders already nervous that the woes could spread to the wider economy.

The 30-share Dow Jones industrial average (Charts) lost about 1.7 percent and the broader S&P 500 index (Charts) fell 1.4 percent.

The tech-fueled Nasdaq (Charts) got hammered, tumbling 2.5 percent.

"It got pretty ugly," said Alec Young, an equity strategist at Standard and Poor's Equity Research. "There's just an unprecedented number of negatives coming at the market."

Those negatives include the triple threat of restricted access to credit, a downturn in the housing sector and near record oil prices, said Young.

"People are more and more worried about recession," he said.

For the week, the Dow lost 4.1 percent, while the S&P fell 3.7 percent. The Nasdaq was the biggest loser, dropping 6.9 percent.

Here's what moved markets on Friday:

Wachovia (Charts, Fortune 500), the nation's fourth-largest bank, said this morning the complex debt instruments it held in its portfolio declined in value by an estimated $1.1 billion before taxes in October, leading to a $600 million loan-loss charge for the current quarter. The bank had reported $1.3 billion in pre-tax losses in the third quarter tied to pools of debt backed by home loans.

Fannie Mae (Charts), the largest buyer and backer of home loans in the country, said Friday its profits fell by half over the last nine months.

The government-sponsored company said it earned $1.17 a share from January through September, down from $3.5 billion, or $3.16 a share, in the same period last year. Its shares fell more than 6 percent.

Stocks have sold off as traders worried about the wider economic impact of losses at financial companies and the growing ranks of consumers saddled with expensive mortgages and high energy bills.

"The fear is spreading," said Joe Battipaglia, chief investment officer at Ryan Beck & Co. "Investors think profits may have hit their peak, not just in finacials but across other sectors of the economy."

The losses from Wachovia and Fannie come after Citigroup (Charts, Fortune 500) said last week it expects to write down a further $8 billion to $11 billion in the fourth quarter due to credit- and mortgage-related problems. Citigroup and warnings of more write downs from other banks caused the Dow to lose 362 points last week.

On Wednesday, the Dow posted one of its biggest single-day declines, falling 361 points on further credit market fears.

In recent months, banks and other financial institutions have taken big losses on mortgage-backed securities, which package individual home loans and sell them as an investment.

Those investments soured when people started defaulting on loans because of the decline in the real estate market, which ended their hopes of refinancing on the back of rising home values.

Adding to investor woes was a weak growth forecast from the 27-nation European Union, which said growth is expected to slow to 2.4 percent next year and in 2009, down from 2.9 percent this year. The EU attributed weaker growth to problems stemming from the subprime mess in the United States and the increase in oil prices.

The University of Michigan report on consumer sentiment came in well below estimates but did little to move markets.

A bit of positive news: The U.S. trade deficit fell to the lowest level in 28 months as a falling dollar helped boost exports.

Among stocks in the news Friday, Merck (Charts, Fortune 500) announced it will pay $4.85 billion to resolve most of the 27,000 claims involving its blockbuster pain medication Vioxx. Merck shares climbed nearly 4 percent.

Disney (Charts, Fortune 500) reported earnings that beat expectations on sales that were roughly in line with analysts' estimates.

Clearwire (Charts) and Sprint Nextel (Charts, Fortune 500) said they ended an earlier agreement to build a high-speed wireless network.

Meanwhile, oil prices resumed their assault on $100 a barrel. U.S. light crude for December delivery rose 86 cents to settle at $96.32 a barrel on the New York Mercantile Exchange.

The dollar fell against the euro but rose slightly against the yen. Treasury prices rose, with the yield on the benchmark 10-year note falling to 4.22 percent. Bond prices and yields move in opposite directions.

Major markets in Asia and Europe finished lower on mounting credit fears.

Market breadth was negative. Losers topped winners by 2 to 1 on the New York Stock Exchange as 1.35 billion shares traded hands. Decliners beat advancers by 2 to 1 on volume of 2.32 billion shares.

COMEX gold lost $2.80 to settle at $834.70 an ounce.

Market Indices	Current	Change	% Change		Date
DJ INDU AVERAGE	13,042.74	-223.55	-1.69%		09-11-2007
NAS/NMS COMPSITE	2,627.94	-68.06	-2.52%		09-11-2007
S&P/TSX COMP IDX	13,869.82	-258.77	-1.83%		09-11-2007