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Home > Library > Stable Times > Volume 5, Issue 2
The quarterly publication of the Stable Value Investment Association
Second Quarter 2001 • Volume 5 Issue 2
The Effect of Current Economic Conditions on the Stable Value Market
June 26, 2001
By Steve Wood
Periods of economic
transition, such as the one we are currently experiencing are generally
accompanied by falling short-term interest rates, steepening yield curves,
and high stock market volatility. Such an environment should be quite
favorable for the stable value industry.
After growing rapidly from 1996 through the first half of 2000, the pace
of economic expansion slowed sharply over the last year. Fortunately,
the policy adjustments needed to generate a revival in economic growth
are already in place. However, one of the hallmarks associated with growth
transitions is greater volatility in economic and financial activity.
The economic slowdown of the past year has been primarily due to a delayed
reaction to the combination of higher interest rates and energy costs
in 1999 and 2000, and to the bursting of the Y2K spending (and associated
stock market) bubble. The Federal Open Market Committee (FOMC) lifted
short-term interest rates from mid-1999 through mid-2000 because the economy
was growing so exuberantly at the time that it threatened the maintenance
of price stability.
While higher interest rates did dampen the interest-sensitive sectors
of the economy, the deceleration was much greater than the Federal Reserve
anticipated. This was because there was also a substantial and sustained
increase in energy costs. Because the demand for energy products is relatively
price insensitive, higher prices act very much like a tax increase, draining
purchasing power from households and businesses. Interestingly, the run-up
in energy prices over the past 2 years has been more than twice as much
as the increase in energy costs that precipitated the 1990/91 recession.
A final reason for the sharpness of the economic deceleration was the
evaporation of the pre-Y2K spending euphoria. Throughout 1999 and into
the first half of 2000, both households and businesses went on a spending
binge, particularly for upgrading computer systems and other types of
activities related to the century date change. This burst of spending
came on top of already sturdy sales growth. After the millennium change,
these types of spending began to unwind, adding to the drag on overall
economic activity.
The economy is now passing through a period of maximum weakness. A recession-defined
as 2 consecutive quarters of declining economic activity-is likely to
be avoided but just barely. Moreover, various sectors of the economy are
being impacted differently. The manufacturing sector is already deep in
recession as production has been cut to meet weaker spending even though
consumer spending, housing, and motor vehicles are remain surprisingly
strong and are keeping the overall economy afloat.
However, the economy is already in the grips of a growth recession-a period
when economic growth is positive but so sluggish than unemployment is
rising. Old economy manufacturing, particularly motor vehicles, has already
gone through a fairly severe inventory correction cycle. If vehicle sales
hold near current levels, the production adjustments will be largely complete.
However, new economy manufacturing is only now beginning to bring their
production, inventories, and employment into line with lowered sales.
These rolling industry (and sometimes geographic) recessions are likely
to continue through the end of the year.
Fortunately, the policy actions needed to generate a re-acceleration in
economic activity are already in place. The Federal Reserve has already
aggressively eased monetary policy this year. Lower short-term interest
rates have already had a positive impact on the economy but their full
effect has yet to be felt. Additionally, significant tax relief has just
been passed and will begin to have a major stimulative effect during the
second half of the year. These policy changes may be sufficient to pull
the economy out of its current stupor.
Monetary policy has already been aggressively eased. Though the Fed cut
the target Fed Funds rate by only 25 basis points on June 27, they have
cut this rate by a total 275 basis points since the beginning of the year.
This is as rapid an easing of monetary policy as the Federal Reserve has
ever engaged in except when the economy was mired in recession.
Moreover, the FOMC is likely to ease further. Although there is substantial
monetary stimulus already in the pipeline, the economy is approaching
a period of maximum weakness. Because of the potential for this weakness
to accumulate into a vicious downward spiral in activity, the FOMC is
likely to cut interest rates further as added insurance.
The Federal Funds Futures market currently foresees the FOMC cutting interest
rates by an additional 25 basis points. The market believes that these
will be the Fed's last downward rate adjustments.
The risk, however, is that the FOMC will be more aggressive than the financial
markets expect. Although the full effects of previous interest rate reductions
have not yet been felt and fiscal stimulus is on the way, the risks to
the economic outlook are not symmetrical; rather they are still skewed
to the downside.
When the Federal Reserve was easing monetary policy during the first half
of this year, the Treasury yield curve steepened dramatically. This has
made returns in the bond market highly variable, and increases the value
to investors of stable value investments. The spread between 10-year and
2-year notes has widened by 94 basis points since the beginning of the
year. This steepening came about because the yield of 2-year notes slipped
63 basis points as the Fed eased while the yield on 10-year notes rose
31 basis points.
The yield curve will continue to steepen as long as the market expects
the Federal Reserve to further ease monetary policy. The steepness of
the yield curve has historically been a fairly reliable indicator of future
economic activity. Thus, the increasing steepness suggests that the economy
should rebound sharply next year.
Corporate credit spreads widened earlier in the year (February and March)
but have been narrowing modestly in recent weeks. Despite the recent narrowing,
credit spreads remain exceptionally wide, even surpassing those that existed
during the periods of financial "crisis" in 1991, 1995 and 1999. Although
credit spreads are quite wide, the level of interest rates is about average
for the last 10 years. Spreads will continue to be affected both by Treasury-specific
and corporate-specific events. The narrowing of budget surplus projections
should put some upward pressure on Treasury yields while difficult economic
conditions, earnings shortfalls, and profit squeezes should generate some
upward pressure on corporate yields. Thus, the level of longer-term interest
rates may rise a bit but spreads should remain close to their recent range.
Equity markets are also likely to be quite volatile over the next 6 months
or so. The difficult economic environment, both domestically and internationally,
has greatly trimmed earnings expectations. Indeed, equity analysts continue
to mark their earnings estimates down week after week. Thus, although
all of the major indices have bounced off of their early April nadirs,
they have having difficulty sustaining rallies.
This has been the first sustained bear market in more than a decade. During
this period, the number of investors has exploded because of the widespread
adoption of 401(k) plans and IRAs. Prior to last year, every drop in the
stock market was seen as a buying opportunity. This behavior was consistently
rewarded by the sustained bull market of the 1990s. However, the last
year has not only seen a substantial sell-off in equities but the absence
of any follow through buying. Investor attitudes are changing. The longer
stock markets hold near current levels, and maintain their current volatility,
the more investors will begin to look at alternative investment opportunity.
Stable Value investments represent exactly such an opportunity, and as
such should prove increasingly attractive to investors who have pulled
money out of equities. With equity markets still richly valued (by historical
standards), the difficult economic environment is likely to mean that
the recent volatility in equity markets, and the opportunity for Stable
Value investments, will be maintained through the rest of the year.
However, the amount of liquidity in the economy is growing very rapidly.
As the Federal Reserve has reduced interest rates, the money supply has
exploded. Much of these funds are (temporarily) parked in short-term cash.
This liquidity will provide the fuel for a substantial move in the capital
markets. What remains unclear is when and where this excess liquidity
will flow. When it does begin to move, prices have the potential to move
substantially albeit with substantial volatility.
Current business conditions appear bleak with the economy teetering on
the verge of recession. However, policy actions have already been taken
that should be sufficient to generate a revival of economic growth over
the next year. However, this re-acceleration in economic growth will likely
generate substantial volatility in business conditions and financial markets.
This economic and financial markets outlook should be favorable for the
stable value market. Short-term interest rates are expected to fall further
and the yield curve should remain quite steep. Even if the FOMC begins
to tighten monetary policy next year, intermediate and longer-term interest
rates are expected to rise even if the yield curve flattens modestly.
Additionally, equity market volatility should remain high. This is likely
to limit inflows in equity mutual funds. Moreover, even when equity markets
begin a sustained recovery-which is not likely before next year-the rates
of return are likely to be substantially below those of the late 1990's.
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