Economic Outlook - More Worries

By Dr. Scott Brown, Senior Economist

In its August 7 policy statement, the Federal Open Market Committee acknowledged financial market turmoil, tighter credit conditions for “some” consumers and businesses, and the ongoing correction in the housing market. The Fed noted that downside risks to economic growth have increased “somewhat.” However, officials still saw the risk of inflation as “the predominant policy concern.” The Fed kept its outlook for moderate economic growth, placing its hopes on continued growth in jobs and wages, as well as a robust global economy.

In recent weeks, subprime mortgage worries and credit market turmoil have led to renewed calls for the Fed to cut rates. However, the Fed will not ease to appease the markets. The key question is whether tighter credit conditions will sufficiently restrain economic growth.

Second-quarter GDP growth snapped back after a disappointing first quarter. However, consumer spending growth slowed sharply as gasoline prices cut into the consumer’s purchasing power. Second-quarter growth was also boosted by a narrowing of the budget deficit. More exports are good for the U.S. economy, but slower imports are a sign of weakness in the domestic economy. Business fixed investment has been at a moderate pace, but may slow along with profits and somewhat tighter credit conditions.

Consumer fundamentals remain mixed, with continued sharp divisions across the income scale, but are generally supportive. Job growth has slowed, but the pace in nonfarm payrolls has been near a pace that would keep the unemployment rate about steady. Weekly claims for unemployment insurance benefits have continued to trend at a low level and announced corporate layoff intentions have been relatively low, suggesting a limited pace of job destruction. Still, it remains unclear whether job growth will continue at a moderate pace in the months ahead, or begin to soften further. The pace of job growth will be a critical factor in future Fed policy decisions.

Inflation data have been mixed. Crude oil prices have remained relatively high, but gasoline prices have fallen as refinery production has picked up. Food prices have risen over the last year as the demand for corn has increased (boosting process of other crops and lifting feed costs). Homeowners’ Equivalent Rent, which accounts for 31% of the core CPI, has been moderating. Overall, core inflation remains at the top end of the Fed’s comfort range. Yet, inflation expectations remain contained and somewhat tighter credit conditions for consumers and businesses should dampen growth and help reduce pressures in the months ahead.

The inflation housing market correction will continue well into 2008. The drag from residential construction should continue to wane as homebuilding approaches a bottom. However, spillover effects are likely to increase somewhat. A further drop in home prices would curtail the consumer’s ability to borrow. Problems with subprime ARMs will continue, but will not be enough, by themselves, to push the economy into a recession.

A rate cut now seems likely by the early part of 2008 – if not sooner – but the Fed is unlikely to be as aggressive in lowering rates as the markets seem to anticipate. Much of the recent financial market turmoil may prove temporary. Still, the Fed would be quick to react to signs of more significant economic weakness.

Next: Credit Market Update

Credit Market Update

By Brad D. Tottle, Taxable Fixed Income Trader

I’d like to begin this Income Opportunities edition with an excerpt from the close of our discussion in the last edition: While some, including Chairman Bernanke, believe that the problems in the subprime market can be absorbed; the more immediate impact, and perhaps the one being underestimated right now, is that it has caused banks and financial institutions to reassess risks on all of their clients and on all of their loans. In the last month we have seen this tightening in credit spill across the bond market, from subprime-backed collateralized debt obligations to high-yield corporates and investment grade commercial paper. Instead of the problem staying “contained” it became contagious as devaluations across different asset classes brought on a textbook “flight to quality.”

In order to understand why this got so ugly so fast we must first remember that the recent growth cycle across most asset classes was driven by access to easy capital, via leverage. In a leverage-based rally, the creditors tend to be more concerned with the quality of the underlying collateral to a loan than how much actual cash is on the balance sheet. As long as the assets retain their value, the liquidity provided by these leveraged assets is accessible. But that completely reverses when the perception is that the quality of the underlying collateral is deteriorating or becomes illiquid, which has become the case in the more esoteric realm of the mortgage market. I picture Cuba Gooding Jr. in the movie “Jerry Maguire” as the proverbial creditor shouting, “Show me the money!” What was once a bond market awash with booming new issuance, tight credit spreads and freewheeling credit terms (i.e.,“covenant-light” and “no doc” loans) has become a volatile landscape with little to no tolerance for risk, real or rumored. The movements in the yields on short-term Treasury bills in August illustrate just how fast leverage liquidity dried up. Chart 1 graphs the Federal Reserve funds target rate along with the yield on the 3-month T-bill over the last 12 years.

After numerous banks started to disclose their exposure to subprime-backed collateralized debt obligations in June and July, investors were forced to reassess the risk premiums offered in the market. Since collateralized debt obligations, or CDOs, are more esoteric in nature, their value is based more off of the modeled value of the underlying collateral than an established market price. Given the rise in default rates and continued softness in the housing market, investors were left wondering just how much more downside there could be. As banks holding CDOs collateralized by subprime debt were forced to mark to market the value of these securities, the risk premiums on bank and finance companies blew out dramatically. What was most perplexing was the “AAA” rating that some of these CDOs carried from the major rating agencies, which misled even institutional investors who bought the securities in pensions, endowments, and money market funds, that usually have strict mandates pertaining to the level of risk allowed in the portfolio. The result was a panicked rush into the safest, most liquid short-term assets available, namely T-bills. The drop in yield seen in the 3-month Tbill in the chart above shows the severity of the move, with the only comparable drop being the one seen in 1998 amid the Russian debt default and the fall of Long-Term Capital Management. Those investors seeking the perceived safety of money market rates found out that the asset-backed commercial paper, that some of the funds invested in, was CDO-backed. This caused an even more assertive move towards safety sending a shockwave that was felt across the world’s banks. News spread of failed commercial paper auctions. Institutions that previously had easy access to short-term capital were suddenly requiring emergency loans.

In order to provide some liquidity relief, the world’s central banks responded with over $300 billion in repurchase agreements. The Federal Reserve went a step further and lowered the discount rate by 50 basis points while also extending the term from overnight to as long as 30 days. The discount rate is the penalty rate charged by the Federal Reserve to loan reserve funds to institutions. The statement the Federal Reserve issued after cutting the discount rate was a far cry from the August statement in which they stated that the downside risks to growth increased “somewhat” but that inflation remained the main concern and that growth was likely to continue “at a moderate pace.” The statement released after the cut in the discount rate stated that, “Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in fi nancial markets. It appears that the Federal Reserve may begin easing rates even though it is fervently trying to avoid the perception that it is coming to bail out the markets simply because of a correction, a la the “Greenspan Put.” So how could the Federal Reserve even think about not cutting rates? Well, the dual mandate of the Federal Reserve is maximum sustainable employment with price stability. With relatively solid underpinnings in the job market and core rates easing a bit, but still outside the Federal Reserve’s comfort zone of 1-2% earlier in the year, the Federal Reserve felt justified staying on inflation watch. Chart 2 shows the Federal Reserve funds target rate plotted against the number of continuing jobless claims over the last 10 years. As jobless claims rise (here shown inverted so the red line is falling as claims rise) the Federal Reserve has eased in times of rising unemployment and tightened in times of recovery.

Now the Federal Reserve has to come to terms with a bond market that is dealing with uncertainty and a lack of confidence in collateral and credit. The fact that they cut the discount rate proves how delicate a dance the Federal Reserve must perform right now. Cutting the overnight rate first could be have been perceived as admittance that a bigger problem exists. Bernanke and company may still be holding out hope that this is a temporary hiccup instead of a true collateral crunch. Concern over corporate credit quality shows up in the TED (Treasuries over Eurodollars) spread. TED is classically defined as the spread between futures contracts on the 3-month T-bill and 3-month Eurodollar deposits with similar maturities (90 days). We can also look at cash TED spreads by taking the difference between spot rates on the 3-month bill and current rates on 90-day Eurodollar deposits. The chart below shows the yield charts of the respective rates on the top and the spread between the two on the bottom. In general, a widening of spread is viewed as deteriorating confi dence in corporate credit. This is because Eurodollar deposits are offshore reserves held by commercial banks outside the Federal Reserve banking system, making them perceptually riskier than the T-bill. The cash spread tends to be stable but what you will notice is that the spikes all seem to come at times of instability in the banking system.

The first spike back in 1998 was caused by the aftermath (see LTCM or Long-Term Capital Management) of the East Asian and Russian debt defaults, followed by the increased spread from June-October 1999 when war broke out in the Balkans and current president Pervez Musharraf overthrew the Pakistani Government. The spread spiked in May 2000 after the Federal Reserve hiked rates by 50 basis points to 6.50%, the highest level seen since 1991. We then see another spike shortly after that in the middle of December after the Federal Reserve switched its tune from infl ation fi ghting to signs of weakness. March 2001 is another spike as the Federal Reserve cuts rates by 50 basis points for the third time in as many months as the Dow and S&P plunge wiping out three years of gains.* The spread hits a low, as the Federal Reserve appears to be reaching neutrality, slowing their easing to 25 bps for two consecutive meetings. The spike shortly thereafter is 9/11. Since then, the spread has been relatively stable even through wars fought in Afghanistan and Iraq as well as the accounting scandals in the U.S. in 2002. But this June the spread spiked again as the subprime meltdown started spreading to other asset classes since it was starting to hurt the bigger banks. This recent spike has now surpassed its predecessors, which is why there is cause for concern.

*The Dow is an unmanaged index of 30 widely held stocks and the S&P 500 is an unmanaged index of 500 widely held stocks.

Next: Global Warming

Global Warming

By Carolyn Nees, AVP, Municipal Fixed Income Research

The Winds of Change are Upon Us.

Things are definitely heating up all over the place. Investors everywhere know that the credit cycle has made a major turn. This is evident in the dramatic shift in yields over the month of August. Compared to six months ago, long yields are up more than three-fourths of a percentage point, or almost 20%. Consequently, some investors may find it hard to be enthusiastic about the bond market’s near-term outlook in that a variety of threats and risks that could imperil their portfolios seem to be hovering on the horizon.

Risk-Reward

The subprime debacle is still playing out, but already it has had an effect on the risk premium that investors across all markets expect in the form of additional yield they receive from borrowers.

It’s interesting to note that the pricing of risk has recently shifted from the seller to the buyer. Buyers for quite some time were willing to accept smaller incremental amounts of yield from a seller despite the risks associated with any given investment because of the scarcity of high- yielding paper. For instance, below investment- grade healthcare bonds, considered a relatively riskier sector of the municipal market, have traded at an average about 200 basis points (bp) more yield than the AAA munis over the last 10 years. More recently, the spreads have narrowed to about half that at +100-120 bp. As investors demand more reward for their risk, these spreads have begun to widen back towards the average. This means the market value of these bonds has dropped, since yields and prices move in opposite directions of one another.

So, the “high” may be back in the high-yield market, but higher yields are also expected to ripple into the stronger rating categories as well. Volatility in the broader market continues to leave muni market participants wondering how best to position themselves.

However, this recent market volatility comes amid numerous signals that the economy is on strong footing. So, these widening spreads may actually signal a buying opportunity. Chosen carefully, higher-yielding bonds can provide a good source of current income and total return for those willing to take on some additional risk.

The Tax Exempt Advantage

Risk, however, is a relative thing. The municipal market overall has a strikingly low default rate at less than a half of one percent. In contrast, the historical default rate for corporate bonds is around 4%. Recognizing this, Moody’s recently implemented a Global Rating Scale with Corporate Equivalent Ratings (CER) for taxable municipal bonds to allow investors an “apples-to-apples” comparison. Under this new Global Scale, a Baa1 rated state general obligation (GO) for instance could receive a CER of Aa1. And, those “riskier” hospital bonds mentioned earlier? A below investment grade Ba1 rated bond could jump three rating categories to reach an investment grade CER of Baa1. Consequently, the rating agency is expecting to upgrade a large volume of municipal bonds in the next year or so.

Despite the better credit outlook for munis, corporate spreads will likely continue to drive those in the muni market as well. So, investors should be prepared to see some values drop if spreads widen further.

The Raymond James Advantage

In this volatile market, be aware that if a bond’s yield looks too good to be true, it just might be. Risks are rising for certain sectors and specifi c obligors and insurers like ACA and Radian. It is important to determine if you are getting compensated accordingly for that risk. We suggest adding bonds selectively to a portfolio only when there is a reasonable risk premium paid and favorable call or sinking fund scenarios.

To assist in that effort, Raymond James remains one of the few firms on The Street that retains a dedicated municipal research team to provide the information our clients need to make informed decisions. More in-depth analytic services are also available to the larger portfolios greater than $500,000 in order to more thoroughly review the riskreward relationships and to determine if changes are appropriate given shifting market conditions. Raymond James also has a dedicated high-yield municipal trading operation to support those willing to take on the additional risk of higher-yielding investmentgrade bonds to do so with greater confidence.

Challenging Times

Prudent investors will keep market volatility in perspective. Long-term investors, properly diversified and mindful of a judicious asset allocation, may benefit from the opportunities that this recent volatility provides.

The recent flight to quality has provided muni buyers with a tremendous advantage over other comparable fixed income choices. With muni price increases lagging, the ratio of muni-to-Treasury yields has reached its highest level over the last year, trading close to 100% of the 30-year Treasury yield. Any further flight to quality could signal a selling opportunity for those investors needing to reallocate assets. If spreads narrow, consider swapping weaker credits for higher to improve the portfolio’s risk-reward balance. On the other hand, in the event of any market weakness, consider the prospects for taking any strategic tax losses to offset gains within a portfolio before year end.

On the Horizon

With munis deep into “cheap” territory, more nontraditional players such as arbs and hedge funds are stepping up to buy the quality, not the tax exemption. But when these buyers lose interest or if they decide to pare their risk in the high-yield sector, new issue prices could take a hit due to lower demand as these buyers exit. Levels will be tested as well when a large volume of new issue supply hits the market in the coming months. New bond issuance this year will likely top the $408 billion record set in 2005. And next year, there are expectations for many more sizable infrastructure deals in the wake of the recent Minnesota bridge collapse, as the country recognizes the significant investment needed to bring more roads, bridges and tunnels back to code.

Concerns over the continuing chaos in the subprime lending market and fears that the private equity buying binge may be over, will likely produce more volatility. This then begs the question: Is the repricing of risk done or will we continue to see spreads widen? In this graph, spreads on long-term healthcare muni junk bonds in 1999 went from about +140 basis points over AAA levels to about +300 a year later…ouch! With the 10-year average at about +200 basis points, it appears there is some room to widen from the current narrow spreads.

We urge you to contact your financial advisor to consider this question and to evaluate how your bond portfolio will hold up under the expected near-term volatility. Make sure you are prepared for any storms on the horizon.

Next: Real Estate Market Review

Real Estate Market Review

By Paul Puryear, Director of Real Estate Research

Despite a disappointing year-to-date return (the RMS total return index is down 15% through August 15), we believe the recent sell off provides upside opportunity in REIT shares. In our view, many of the stocks have been oversold in the recent correction and are now trading at well below the intrinsic value of the assets. There are several compelling reasons to consider REITs in an investment portfolio today: cash flows are expected to grow for the intermediate term, the stocks are trading below the replacement cost of the assets, and commercial real estate serves as an inflation hedge. We will cover these attributes in detail below but first wanted to provide some context/background on the volatile and challenging REIT investment landscape.

REITs have corrected sharply over the last six months after what was a surprisingly strong start to 2007. In mid-February the RMZ had climbed 13% year to date, reflecting the markets’ excitement over the Equity Office Properties take out by the Blackstone Group and the huge flow of money still chasing U.S. real estate assets.

Since that peak, the RMZ has corrected 27.7%, with REIT shares first fighting interest rate fears, and subsequently, worries of a credit crunch in the commercial arena and an actual crisis in the residential mortgage markets. Compounding the interest rate/credit crunch-driven pullback was the fact that REITs in February were at all-time high valuation levels on some metrics.

The credit market has been roiled by the repricing of risk as subprime mortgage delinquencies have spread to every corner of the investment universe via securitization and leverage. What was an initial correction marked by increasing spreads on debt instruments and tightened standards by lenders has become a full-fledged crisis in the mortgage markets. The secondary residential mortgage markets have to a large extent shutdown completely for many of the most popular products of the last few years, and the repricing of risk has spread to even the most creditworthy residential borrowers.

The chart above details credit spreads in the CMBS market from January through August 10. It is important to note, however, that in the face of this spread expansion, the 10-year Treasury yield has actually fallen from a high of 5.25% on June 12 to 4.71% on August 15 as debt buyers anticipate a Federal Reserve ease in response to the credit crunch.

This turmoil quickly spread into the commercial markets. From a commercial real estate perspective, the REIT stocks are discounting an expected increase in cap rates driven by a higher cost of capital. Over the past several years, the demand for investments drove the cost of capital for commercial real estate to modern era lows as evidenced by the cap rate chart on the right. Although commercial real estate fundamentals are generally healthy and we have yet to see a back up in cap rates on high-quality assets, it is generally accepted that the turmoil in the credit market and increased debt spreads will drive cap rates higher in certain markets and across some assets.

However, despite some pressure on the cost of capital, we think the public market has overestimated the eventual impact from the turmoil in the residential market on commercial real estate. The stock market has discounted a massive pullback in commercial real estate values, and traded REIT stocks down to what we estimate is a roughly 18% discount to our estimate of NAV, and in general, sizable discounts to the replacement cost of the assets.

In addition, we note that our NAV estimates are fairly recent given that we just finished Q2 earnings, and in many cases reflect upward cap-rate adjustments of 25 - 50 bp. Further complicating the picture, we point out that the 10-year yield has actually gone down over the last two months, meaning the rate on AAA paper today of roughly 6.16% compares to 5.49%, 5.37% and 6.09 % on January 15, March 15 and June 15, respectively. Once again, we reiterate that investors must not confuse the carnage in the $23 trillion collapsing residential real estate market with the fundamentals in the $5 trillion recovering commercial market, the sectors are out of cycle in our current economy. We continue to stress that we are in the early to middle stages of what is typically a five-to seven-year commercial recovery cycle. Cash flows across most commercial sectors are increasing, and the supply picture across appears in check-dynamics that bode well for occupancy and rent growth in the intermediate term and will translate into further cash flow growth.

As we discussed in much detail in the May letter, also bolstering the picture for commercial real estate is the fact that most of the companies are trading below the replacement cost of their assets. Although inflation in materials prices has subsided somewhat, commodity prices are still escalating and replacement cost is climbing in step. This dynamic also positions REITs as an inflation hedge given the global trading of the commodities.

Since 2002, the Bureau of Labor Statistics’ estimates that cost for “Materials and Components for Construction” have outpaced CPI increases by 40 - 300% annually. Numerous inputs such as copper (electrical and other systems), concrete and steel have averaged double-digit increases over the last three years, and are expected to increase 6-8% in 2007. The following chart depicts construction component cost increases since 2000.

Also, it is important to note that replacement cost components and commodities are priced on the world market and are no longer just a function of U.S. demand. Growth in China, India and Asia is driving huge demand in the materials and components used to build commercial buildings in the U.S. This same infl ation is currently squeezing the margins for U.S. homebuilders.

So where do investors go from here? Given the lower beta of income property performance, the inflationary hedging characteristics of the sector and the combination of dividend income as well as the potential for capital appreciation, we continue to like the prospects for REITs in the current investment climate and feel that much of the sell off is unwarranted.

We continue to recommend a market weight in commercial real estate, relative to your benchmark, and that you balance your investments across all property types until the economic picture becomes clearer. While economic data has been mixed with a recent bias to the downside, we continue to fear that the magnitude of the housing crash has not yet fully crept into the broader economy and are not ready to fully favor economically leveraged sectors until we have a better sense of how the economy is positioned for the second half of 2007 and 2008.