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The Economy and Financial Markets

The Economy and Financial Markets. February 22, 2008. Economy and Financial Markets: Current Conditions. Economy strong in Q3, slow in Q4 and Q1. Inflation contained – core around 2-2.5%. Profits / Earnings big short-term hit – sub prime related.

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The Economy and Financial Markets

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  1. The Economy and Financial Markets February 22, 2008

  2. Economy and Financial Markets:Current Conditions • Economy strong in Q3, slow in Q4 and Q1. • Inflation contained – core around 2-2.5%. • Profits / Earnings big short-term hit – sub prime related. • Stock price gains in 08 expected to match earnings growth. • Risks are: terrorism, Iraq, oil prices and subprime reaction. • Bond market risk moderate due to good inflation outlook. • Credit market concerns appear overblown, damage limited. • $ exchange rate bouncing off a new record low.

  3. * Q3 GDP Up 4.9%, Q4 +0.6% (Lower Due to Housing & Inventory Drop), Employment Growth +0.7% Quarterly % Change in Real GDP • % Change - Annual Rate 12-Month % Change in Payroll Employment • % Change - Year to Year GDP and Employment Growth.EMF (USECON) GDPH / LANAGRA 891-1064

  4. * ECRI and Dow Barometer Down, Expect Slowdown, Not Recession ECRI Weekly Leading Index • 1992=100 Dow Jones U.S. Business Barometer Index • 2000=100 ECRI and Dow Leading Indices.EMF (WEEKLY) WLIW / MDJBBI 890106-1061229

  5. * Real Personal Income Rising, as is Spending: Not Much Housing Impact Real Disposable Personal Income • SAAR, Bil.Chn.2000$ ICSC-UBS Weekly Retail Chain Store Sales • SA, 1977=100 Real Income and Chain Store Sales.EMF (USECON) YPDHM / MITS 8901-10612

  6. * New Orders Surge But Shipments Still Flat – Business Cost Control Shipments of Manufacturing Durable Goods • SA, Mil.$ New Orders for Manufacturing Durable Goods • SA, Mil.$ Shipments and Orders.EMF (USECON) NMSDG / NMODG 8901-10612

  7. * Order Backlog Very High, Inventories Low Relative to Shipments Shipments of Manufacturing Durable Goods • SA, Mil.$ New Orders for Manufacturing Durable Goods • SA, Mil.$ Shipments and Orders.EMF (USECON) NMSDG / NMODG 8901-10612

  8. * Home Prices Weak, Income Up So Housing “P / E” Now Way Down (Especially Given Low Interest Rates) Ratio: Median Home Price / Disposable Income Per Capita • Indicator of Housing P/ E Median Sales Price For Existing 1-Family Homes • Thous.$ Housing P E.EMF (BONDINDX) _ / HX1PM 6701-10612

  9. * Home Sales and Starts Now Way Down – After 2 Years of Decline, The Worst Likely Behind Us. Ratio: Median Home Price / Disposable Income Per Capita • Indicator of Housing P/ E Median Sales Price For Existing 1-Family Homes • Thous.$ Housing P E.EMF (BONDINDX) _ / HX1PM 6701-10612

  10. * Major Credit Threat? No – Total Bank Problem Loans Low. Q4 Residential Loan Delinquency 3.1%, Defaults 0.4%, Low, But Likely to Rise Loan Delinquency Rate: All Commercial Banks • SA,% Loan Charge-Off Rate: All Commercial Banks • SA,% Loan Charge Off.EMF (USECON) DQ / DY 891-1064

  11. * US Trade Upturn Offsets Housing Weakness. U.S. Exports Are Three Times As Big As Residential Construction. Loan Delinquency Rate: All Commercial Banks • SA,% Loan Charge-Off Rate: All Commercial Banks • SA,% Loan Charge Off.EMF (USECON) DQ / DY 891-1064

  12. * Claims Lead Unemployment Rate (4.9%), Claims Are Up Some, So Unemployment May Drift a Bit Higher. Unemployment Rate • SA, % Weekly Initial Claims for Unemployment Insurance • SA, Thous UR and Claims.EMF (USECON) LR / LIC 8901-10612

  13. Private Sector Employment Cost Inflation at 3% - Benefit Costs Under Control

  14. * Total CPI Inflation Up Due to Oil Prices, Core Still Down at 2.4% Total CPI Inflation • % Change - Year to Year Core CPI Inflation (Excludes Food & Energy • % Change - Year to Year CPI Inflation.EMF (USECON) PCU / PCUSLFE 8901-10612

  15. * Fed Target is (Roughly) Core Inflation + Employment Growth. We Think Rate Cuts are the Right Policy Action Fed Funds Rate Target Set by the Federal Reserve • % Core CPI Inflation + Payroll Employment Growth • % Fed funds target and CPI plus employment.EMF (WEEKLY) FFEDTAR / _ 890104-1061227 Fed funds rate finally below the 3.2% sum of core CPI inflation of 2.5% and job growth of 0.7%. Fed over did it in late 1999 - 2000

  16. * Risks? Sure – Sky High Oil Prices & Lack of Dollar Rebound Crude Oil Price - West Texas • EOP, $/Barrel Dollar Exchange Rate - Major Currency Index • Avg, 3/73=100 PZTEX and Dollar.EMF (WEEKLY) PZTEX / FXTWM 890103-1061226 Record oil price behind us? Record Dollar lows behind us?

  17. * Company Earnings Outside Financials Okay, but Big Q3-Q4 Hit on Financials From the Sub-Prime Fiasco. Operating Earnings per Share S&P 500 • $/share Reported After-tax Earnings per Share S&P 500 • $/share Earnings Reported and Operating.EMF (USECON) SOE500 / SE500 891-1064

  18. * Current Quarter S&P 500 P / E is around 22 – Spike Due to Subprime Hit Higher Risk on the Value Side, Lower Risk on the Growth Side S&P 500 Market Cap / Annualized Operating Earnings • Current Quarter P / E Current Q P E.EMF (USECON) _ 871-1064 Higher Risk Region Lower Risk Region

  19. * Record U.S. Net Stock Repurchases - $610 Billion Last Four Quarters Financial Assets Less Liabilities of All US Nonfinancial Corps. • billions - Net, US companies are now net lenders Net Financial Assets.EMF (USECON) _ 521-1064

  20. * Corp. Balance Sheet – Companies’ Financial Assets Exceed Liabilities by $1.4 Trillion. Now Net Lenders, Usually are Net Borrowers Financial Assets Less Liabilities of All US Nonfinancial Corps. • billions - Net, US companies are now net lenders Net Financial Assets.EMF (USECON) _ 521-1064 Total U.S. non-financial companies net lenders Total U.S. non-financial companies net borrowers

  21. S&P 500 Total Return EOM Lehman Bond Index: US Aggregate Total Return EOP, Dec-31-75=100 2500 2500 2000 2000 1500 1500 1000 1000 500 500 0 0 90 95 00 05 Sources: Standard & Poor's, Lehman Brothers/ Haver Analytics 02/22/08 * Equity Total Return Beats Fixed Income, but with Volatility S&P 500 Total Return • EOM Lehman Bond Index: US Aggregate Total Return • EOP, Dec-31-75=100 Stock Bond Total Return.EMF (USECON) SP5TRE / MLDAGI 8901-10612

  22. * Value Has Outperformed Growth Since 2000 – is Now Reversing Total Return: Russell 3000 Value Index • Avg, 5/31/95=1000 Total Return: Russell 3000 Growth Index • Avg, 5/31/95=1000 Value and Growth.EMF (WEEKLY) SPRU3VT / SPRU3GT 940708-1061229

  23. About 110% Outperformance of Value Since 2000 Now Reversing

  24. * Small Caps Outperformed Large Caps Since 1999 – Now Reversing Total Return: Russell 1000 Large Cap Index • Avg, 12/31/78=100 Total Return: Russell 2000 Small Cap Index • Avg, 12/31/78=100 Small vs. Large.EMF (WEEKLY) SPRU1T / SPRU2T 940708-1061229

  25. Last 28 Years Small Caps have NOT Outperformed Large Caps. Back to Underperforming

  26. Large Cap International Equities (EAFE Index) Now Underperforming The U.S.

  27. * Fast, Deep Short-term Rate Cuts Sharply Lower Recession Probability. Low Long-term Rates Help. 30-Year Treasury Bond Yield • Avg,% 2-Year Treasury Note Yield • Avg, % Yields 2 and 30.EMF (WEEKLY) FTB30Y / FTB2Y 890106-1061229

  28. * High Yield – Spreads Up On Sub Prime Worries Merrill High Yield Rate • - Spread: High Yield Rate Less 5-Year Treasury Rate • Spread: High Yield Rate Less 5-Year Treasury Rate High Yield.EMF (BONDINDX) GFMLHY / _ 960308-1061229

  29. * Shark Chart: Return of Value & Growth Relative to Total Market

  30. Conclusions • GDP growth for 08 expected to be in the 2% range. • $80+ oil knocks 1-2%+ off GDP & cut jobs gain by a million. • Total inflation up on oil prices, but core inflation remains low. • Earnings are generally okay – expect 5-10% in 2008. • S&P 500 P/E spiking up, but expect prices to track 08 earnings. • Non-Financial Co. Earnings and Balance Sheet quality look high. • Bond risk moderate, subprime problems concentrated. • Dollar exchange rate risk now low (recovering from record low). • Further fed funds rate cut to 2.5% likely.

  31. This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL, UVEST Financial Services Group, Inc., IFMG Securities, Inc., Mutual Service Corporation, Waterstone Financial Group, Inc., and Associated Securities Corp., each of which is a member of FINRA/SIPC. Important Disclosures The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The Russell 1000 Index measures performance of 1000 large cap, US companies. The Russell 2000 Index measures performance of 2000 small cap, US companies. The Russell 3000 Growth and Value Indices measure the performance of growth and value stocks respectively. The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries, and widely held by individuals and institutional investors. These 30 stocks represent about a fifth of the $8 trillion-plus market value of all U.S. stocks and about a fourth of the value of stocks listed on the New York Stock Exchange. It is not possible to invest directly in an index. The Lehman Brothers Aggregate Bond Index is composed of securities from the Lehman Government/Credit Bond Index, Mortgage Backed Securities Index and Asset Backed Securities Index. The Merrill Lynch High Yield Index is an unmanaged index consisting of bonds that are issued in U.S. Domestic markets with at least one year remaining maturity. All bonds must have a credit rating below investment grade but not in default. Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors. Small cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the small cap market may adversely affect the value of these investments. P/E Multiple: A tool for comparing the prices of different common stocks by assessing how much the market is willing to pay a share of each corporation’s earnings. It is calculated by dividing the current market price of a stock by the earnings per share. Past performance is no guarantee of future results. Indices such as the S&P 500 may not be invested into directly. The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. The Morgan Stanley Capital International (“MSCI”) Europe, Australasia, Far East Index (“EAFE”) is an unmanaged index of over 900 companies, and is a generally accepted benchmark for major overseas markets. Index weightings represent the relative capitalizations of the major overseas makers included in the index on a U.S. dollar adjusted basis. The index is calculated separately; without dividends, with gross dividends reinvested and estimated tax withheld, and with gross dividends reinvested, in both U.S. Dollars and local currency. Tracking# 396827 (Exp 12/08)

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