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March, 2008
GLOBAL ECONOMIC UPDATE
Commodity
prices, in particular energy, remain elevated and this has been instrumental in
shifting inflation expectations. We expect prices to fall as the global
economy weakens thereby easing inflation concerns. The threat of global
recession has increased and the economic outlook will depend on the persistence
of the credit/banking crisis.
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Key
Consensus Forecasts
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U.S.
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Japan
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Euro
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U.K.
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China
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Global
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GDP
12 month Forecast
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1.9%
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2.2%
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1.8%
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2.0%
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10.5%
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2.7%
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Monetary
Policy 12 month
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3.25%
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0.75%
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3.5%
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5.0%
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8.1%
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n/a
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Bond
Yield 12 month
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4.35%
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1.95%
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4.0%
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4.5%
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n/a
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n/a
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Source: Bloomberg Database 2/2008
The
recent problems in financial markets will have important direct and indirect
macroeconomic effects. The near term effects will be most obvious in the
already weak U.S. housing sector. However, there will also be a sizeable
impact on financial sector employment – which constitutes some 6% of
total employment in the United States. It is clear that the "credit" problem
effect on business sentiment is substantial, manifesting itself in a rundown on
retailer inventories and subdued hiring relative to seasonal norms. Present
U.S. forecasts assume a "V-shaped" recovery in this Presidential year, assuming
a rapid recapitalization of the U.S. banking system – these assumptions,
in our view, may be too positive. Tighten credit conditions and higher energy
prices should constrain spending going forward. Significantly, high-end U.S.
consumers who have been extremely resilient to date are looking increasingly
vulnerable as stocks come under pressure and Wall Street lay-offs appear
likely. Economic data in Europe indicates growth is now beginning to slow with
industrial production and retail sales falling. Economic news in Japan was
negative through December with no sign of domestic demand improving. Japanese
labor income has been weak and the unemployment rate has started to retrace
over recent months. Chinese economic forecasts suggest a reduction from
historic high growth rates as the impact of slower U.S. growth impacts the
export sector in employment, wages and investment.
U.S.
monetary policy seems to be driven by two competing needs; first the need to
reassure markets that the Fed will act in a pre-emptive manner to insure the
banking system is viable and second to off-set an extreme tightening of credit
and finally to give the impression cuts do not trip an inflationary surge in
the U.S. So far, the Feds actions suggest concerns about downside risk to
growth from tighter credit have outweighed inflationary concerns.
U.S. ECONOMY
2007
in Review
The
year is finally over and for most in the financial industry, the end of 2007
was greeted with sighs of relief. The economy expanded by 2.5% in 2007, a rate
below consensus. Housing was the biggest sector accounting for poor economic
growth. Housing starts fell 25% in the 11 months of 2007 as compared to 2006
and unsold single-family homes rocketed by more than nine months' supply. GDP
experienced tremendous volatility in the face of this headwind. The 1st
quarter GDP was at 0.6%, surging to 3.8% and 4.9% in the 2nd and 3rd
quarter respectively. The Unemployment Rate rose to 4.7% in the final quarter.
Although job growth remained healthy in the first three quarters; consumer
spending slowed to 3.0% from 3.4%. Rising energy costs put additional strain
on the economy. West Texas Intermediate Crude rose to close to $92 per barrel
in December and the CPI rose to 4.3% in November.
Business
investment expanded by 5.1% in the third quarter than a year earlier.
International demand for U. S. goods was strong fueled by the weaker dollar.
The dollar's value was 7.1% lower in the fourth quarter. The beneficiary of
the weaker dollar was the international trade deficit. This resulted in a
decline to $533.1 billion.
The
Federal Reserve Board lowered the Fed Funds Rate from 5.25% to 4.25% by the end
of the year. This will be discussed further in our Financial Markets sector as
we believe that the Federal Reserve was not only concerned about the economic slowdown
but also the financial markets.
FINANCIAL MARKETS
No
discussion of the fixed income markets is complete without taking into
consideration the three aspects of risk; default risk, interest rate risk and
changes in investor risk appetite. A mix of high risk tolerance and the
favorable economic conditions of the past decade resulted in the market debacle
of 2007.
Default
risk is the possibility that investors may not get back their principal at
maturity or receive interest payments in full or on time. In the past ten
years, the atmosphere of a stable economic environment increased investor
confidence. This behavior introduced complex financial instruments to the
investing public. This fueled a new generation of securities that funneled
money into riskier ventures; accounting for instruments like Structured
Investment Vehicles (SIV), Collateralized Debt Obligations (CDO) and other
derivative instruments.
Interest
rate risk means swings in interest rates that affect the present value of principal
and interest payments to investors. Federal funds rate from July 2003 to June
2004 stayed at 1%. Low interest rates demanded riskier financial instruments to
fuel steady income necessary for pension funds and insurance companies.
Change
in risk appetite is the acceptance of low premiums to take on a given level of
risk. Again, stable macroeconomic environment and the demand for better yield
led to lower risk premiums and the acceptance of riskier structures.
The
biggest beneficiary of economic stability was the consumer and the housing
industry in particular. A bigger share of the U.S. population was enabled to
fulfill the American Dream. Housing starts increased 53% for the period 1995
to 2005 and new home prices increased 77%. If not a new home buyer, then why
not a bigger home; the demand for 2,400 sq. ft. or larger houses went up from
10% in 1970 to 42% in 2005.
All
good things do come to an end, so did the housing bubble. The Federal Reserve
in the effort to control inflation from rising food and energy cost raised the
Federal Funds Rate from a low of 1% in 2003 to a high of 5 ¼% in
September 2007. This change in Fed policy prevented homeowners from
refinancing mortgages, rationalized the value of housing and caused the
confluence of events resulting in the bank and credit market crisis. Financial
institutions suffered from the housing-busted-bubble ripple effect losing
billions of dollars of capital. As a result, banks turned off the liquidity
faucet (interest rate risk), demanded tighter credit scrutiny (default risk)
and affected the global change in risk appetite.
FIXED INCOME PORTFOLIO COMMENTS
When
we consider specific securities to purchase into our portfolios we look at
these main characteristics; credit, market conditions, liquidity and
suitability. In effect we translate the main components of risk into our micro
considerations. Default risk is translated into credit considerations,
interest rate risk is folded into market conditions and liquidity; and risk
appetite is the main component considered to fulfill the customers' policy
statement.
Our
portfolios did not suffer through the 2007 financial credit crisis. Portfolio
duration was purposefully kept short, convexity stayed positive and the curve
was managed by intentionally staying with steepened strategies. Our strong
bias towards state specific Municipal Bonds helped in the sector and security
selection component.
Bond
Market Total Returns
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2005
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2006
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2007
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Jan-08
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Corporate
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1.97%
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4.37%
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4.64%
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1.18%
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Treasuries
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2.81%
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3.14%
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9.05%
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2.52%
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Agencies
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2.27%
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4.37%
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8.03%
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1.96%
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Mortgages
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2.62%
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5.32%
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6.96%
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1.82%
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Asset Backed
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3.41%
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5.43%
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-4.02%
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-0.62%
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High Yield
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2.83%
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11.64%
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2.17%
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-1.34%
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Municipal
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3.94%
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4.96%
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3.28%
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1.25%
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Source: Merrill Lynch
The
fixed income markets performed well despite the market problems of 2007. The
best performer for the year was the U.S. Treasury market followed by Agencies.
These classes benefited from the flight to quality as Asset-Backed securities
and the High-Yield sector declined.
Meredith
Portfolio Management, in its quest to fulfill its clients' objectives, will
continue to stress a higher level of vigilance in this period of market stress.
We continue to actively monitor client portfolios with a three-pronged
approach of capital preservation, consistent income and reasonable growth.
William
Potter Bing
Garrido
Chairman Managing
Director, Fixed Income
Meredith
Portfolio Management
600
Lexington Avenue FL 29
New
York, NY 10022
Tel: 212-969-9292
800-944-4491
Fax: 212-247-3840
Visit our web site at:
www.MeredithPM.com
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