We could go on ad infinitum about the recent events taking place in financial markets today–the causes of the credit crisis, why the stock market continues to fall, the long-term impact this crisis will have on the economy and how (and when) it will be resolved. In fact, the story has been told and retold in every newspaper, online blog and TV program over the past few weeks. October comprised a string of historical events, the most pronounced being the worst weekly loss in the history of the Dow Jones industrial average (down 18%).
In an attempt to simplify what has transpired, the violent activity we have experienced in the stock market can be seen as a reaction to the severe tightening in the credit markets. It is as if the stock market has become a lens for the public eye on what is happening in the credit markets–the public sees and understands the Dow Jones activity but doesn't see the lending activity that goes on among banks and financial institutions around the world. As banks worldwide continue to refuse to lend to other banks, companies cannot get the funding needed to sustain day-to-day business. Investors translate this into potential earning losses down the road and thus, sell shares.
The U.S. government, along with our global neighbors, has continued to enact new measures–almost daily–to resolve the tight credit conditions and market imbalances. The goal has been two-fold: give the banks needed funds to begin normal lending practices now, as well as provide the world with confidence that the government is behind the financial institutions. In the past few weeks alone, a wide array of changes have been made, ranging from daily cash injections amounting to hundreds of billions of dollars to a global, coordinated rate cut. Investment banks have become commercial banks and the U.S. government has placed some sort of guarantee on almost all liquid assets. The structure of Wall Street and the financial industry is a mere semblance of what it was even one year ago.
In mid-October our government released its most aggressive plan to date–under the recent $700 billion rescue plan, it agreed to invest $250 billion into banks in exchange for preferred shares. Half of the money is allocated to nine banks that did not have a choice in the matter, whereas the remaining funds will be available to other “healthy” financial institutions on a voluntary basis. The government will receive preferred shares paying 5% for the first five years in return for the assistance. Our country is not accustomed to the government having such direct involvement in the free markets, but most experts agree that today's financial crisis called for drastic action.
What next? The government's full rescue plan still needs to be put into action. But if confidence can be restored enough to stop people from turning their investment assets into cash, then the credit and financial markets should be able to return to normal activity. Banks should begin to trust each other knowing the government is on hand. None of this will occur overnight, but the action of the past few weeks is a good start. As this article is being written, Libor rates–a key indicator of the tightness of the credit conditions–are beginning to show signs of easing. One-month Libor fell over 259 basis points from its recent high of 4.76%.
The next problem we have to deal with–one largely forgotten during the credit crisis–is the state of the economy. A recent survey of economists predicts that we could be in a recession for the next 12 months. Employment forecasts estimate there could be an average loss of 74,000 jobs per month over the next year. Retailers are facing a gloomy holiday season. Data already shows a 9% decline in vehicle sales last month alone. The one positive is the downward pressure to inflation. As oil reaches $80 a barrel, prices at the gas pump continue to fall.
The old rules for understanding how and why interest rates move have basically been thrown out the window. In normal recessionary periods, one could expect to see lower interest rates. This time around, rather than addressing a need to motivate consumers to borrow, the goal is to coerce the banks to lend. So, lowering the Fed funds target rate does not carry the same power it did before. On the other hand, the U.S. Treasury is going to have to raise significant amounts of funds to keep the reform going, which tends to put upward pressure on interest rates (more supply, less demand, higher interest rates).
This being said–with no clear answers given–a prudent investment strategy is to maintain a ladder out to a year, with a little investing past that for some protection. With Libor rates on the high side, short-term corporate certificates are providing substantial yield over overnight share rates.
If you do choose to extend, it is important to make sure you are getting paid for it. While the economic picture is dim, there is enough uncertainty and political change on the horizon to warrant rates moving higher in a year or so. This market is going to require constant checking and reevaluating as progress is made in rebuilding the financial markets.
Sarina Freedland is Georgia Central's assistant vice president of investment services. She can be reached at 770-476-9704 or [email protected]
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