Any investor optimism for the New Year quickly waned as negative economic momentum carried into January and investor fears were reinvigorated by the current crisis in the banking sector. The Conference Board Consumer Confidence Index edged downward in January to a record low of 37.7, suggesting that “consumers have begun the New Year with the same degree of pessimism exhibited in the final months of 2008.”
The S&P 500® Index posted its worst January performance in history — down 8.4% — after a 37% decline in 2008. Common shareholders fearing mounting bank losses and potential dilution of their ownership by further government intervention dumped bank shares en masse. The KBW Bank Index (measuring performance for the largest 24 U.S. banks) is down more than 35% this year alone, and the Obama administration is working on efforts to ease the strain in the banking sector. The plan is likely to focus on removing troubled loans and securities from bank balance sheets, something the $700 billion TARP was originally designed to do.
The Federal Reserve announced Jan. 28 that the economy “has weakened further since December. Industrial production, housing starts and employment have continued to decline steeply, as consumer and businesses have cut back spending. Furthermore, global demand appears to be slowing significantly.” The deterioration in the economy led the Federal Reserve to leave its key fed funds rate at its historic low range of 0% to 0.25% with no expectation for an increase for some time.
While the Fed anticipates a gradual recovery in economic activity later this year, it acknowledges that “downside risks to that outlook are significant.” In light of the precarious situation the U.S. economy finds itself in, the scale of both current and planned monetary and fiscal stimulus is unprecedented in the post WWI era. The Federal Reserve will continue to grow its balance sheet as it provides liquidity to the marketplace and by purchasing mortgage-backed securities in an effort to lower the cost of borrowing. These aggressive actions by the Federal Reserve will likely be further supplemented by a massive stimulus package already passed by the House in late January.
The housing slump remains at the center of the economic crisis, with little in the way of positive news for the sector. A reported rise in existing home sales of 6.5% for December was overshadowed by steep declines in building permits and housing starts which are at their lowest levels since records began in 1959. Furthermore, new home sales recorded double digit declines in both November and December as purchases declined to a 331,000 annual pace — the lowest level since at least 1963. According to the S&P Case-Shiller 20 city composite home price index, home prices declined 18.1% from year ago levels in November bringing the nationwide slide in home prices now to 25% from their 2006 peak.
The economy shrunk by 3.8% in the fourth quarter of 2008 according to the advance estimate of GDP, beating consensus estimates. The decline in economic activity reflects a sharp downturn in exports, the continued decline in housing, a large slide in consumer spending and declining business investment. While less than forecast, a buildup in inventories in the underlying number points to further decline in economic activity as these inventories get unloaded on the market. Excluding the buildup of inventories, decline in GDP was 5.1%.
Companies cutting both spending and their workforces threaten to deepen and prolong the current recession, which is now entering its fifteenth month. Orders for U.S. durable goods fell for a fifth straight month in December, with a larger-than-forecasted 2.6% decline. The employment situation is rather bleak, with more than 100,000 job cuts announced in just the last week of January by an assortment of major companies. Even after the economy shed roughly 2.6 million jobs in 2008, The Conference Board’s Employment Trends Index suggests the economy could shed 2 million more jobs in 2009.
On the bright side, conditions in the financial markets have improved, and banks are lending though credit remains tight. Spreads on corporate and high-yield bonds have tightened as investors have sought higher yield. Credit market health has improved in January, as the TED spread (LIBOR over Three-Month T-Bill rate) has remained near 100 basis points since mid-month.