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The well documented credit crunch impacted liquidity in the financial markets dramatically over the third quarter. Until the Federal Reserve cut interest rates on September 18, the stock market saw extreme volatility and a large pullback. The widely held anticipation that rates will be cut by another 0.5% before year end is now rallying the market again as it approaches its September 2000 highs.

Is the sub prime debt phenomenon over? The answer is no. While the “crisis” may be over, the deflating housing bubble will take significantly longer to follow its course, and may possibly be drawn out over several years. Access to easy credit, whether for homebuyers or consumers, is tightening as banks firm up their lending standards. There is at least a 12-month lag before current rate cuts follow through with a beneficial effect. Furthermore, cutting the Federal Funds rate does not help mortgage holders in the short term, especially those already in the subprime category. By curing today’s problems, Federal Reserve Board Chairman Ben Bernanke has created a bigger problem for tomorrow, namely that of inflation. Anticipation over inflation has provoked a sell-off of the U.S. dollar against most major world currencies, and has also begun to increase long bond yields, upon which adjustable rate mortgages are indexed. In the short term, the subprime mortgage phenomenon will reduce the current rate of inflation because consumers will spend less, having less credit available. On the other hand, the falling dollar is inflationary because imported goods (think Walmart) become more expensive to import. Low unemployment is inflationary as well, putting upward pressure on wages. Food and energy are obviously rising and will continue to do so.

The financial and consumer discretionary sectors were hardest hit by the credit crunch. Investment Banks have lost some important sources of revenue, while retail banks are losing mortgage revenues. Initial jobless claims, although a lagging economic indicator, have yet not dramatically increased despite the fact that the construction, real estate and mortgage industries are all now in recession. Fortunately, American corporations remain strongly profitable and flush with cash; profitability is still at historic highs, and the global economy remains in robust health. With the U.S. constituting a smaller part of the global economy as emerging market economies grow faster, we don’t foresee a sharp downturn in corporate profitability as of yet. The best positioned U.S. companies are those who sell more than 50% of their goods abroad. We believe that further rate cut hopes will likely support the stock market in the fourth quarter, which is typically the best quarter of the year for stock market performance. Over an average thirteen-month Fed easing cycle, the S&P has gained an average of 16%, with consumer staples usually leading the way. While it remains to be seen how the economy and stock market will be affected as the mortgage crisis and the credit crunch play out over the next year, the market seems to be putting the worst behind us at the moment.

For the first three quarters of 2007, the Dow gained 11.5%, the S&P rose 7.7%, and the Nasdaq is up 11.9% .
Grant Rogers Elizabeth Allen

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