Treasury Secretary Timothy Geithner avoided the tough questions yesterday as he rolled out a plan to repair the financial system – and investor disappointment was clear.
Driving investor frustration was Geithner’s failure to clearly address three issues at the heart of the crisis: Will banks saddled with toxic debt be forced to fail? How will illiquid assets be removed from bank balance sheets? And what will be done to reverse the decline in house prices that triggered the turmoil?
“Tim Geithner did a great job in painting the broad strokes of the problem and laying out general principles, but it was a big disappointment not to have more details,” said Kenneth Rogoff, a former chief economist at the International Monetary Fund and current Harvard professor.
Greater uncertainty equates to higher levels of perceived risk in the financial markets, resulting in lower prices. To paraphrase Dr. David Kelly, Chief Market Strategist for JPMorgan Funds, though the current recession is not unprecedented – we have experienced worse – both the circumstances of the financial crisis and the government response are unprecedented. This makes the short-term outlook highly uncertain, though Kelly notes the following encouraging signs:
- Volatility is easing: Yesterday’s market reaction notwithstanding, stock market volatility has been about half of that experienced in the fourth quarter.
- Bank lending is improving: Analyst estimates show that bank lending in the fourth quarter among the nation’s 12 leading lenders increased by nearly 5% over 3Q. While credit markets are still in significant stress, this improvement in lending can help lay the foundation for an economic rebound.
- Positively sloped yield curve: A traditional means for bank profit is paying low short-term interest rates on deposits and lending at higher long-term rates. In the last month, 10-year Treasury yields have risen from 2.25% to 2.84% indicating a steeper yield curve which should boost bank margins.
- Housing is more affordable: Average new home prices are down 25% from their peak and 30-year fixed mortgage rates are near 5%, leaving housing at its most affordable level in decades.
- Money on the sidelines has surged: Cash, CDs, money market funds and saving accounts now total over $8.2 trillion, earning close to a zero interest rate. This compares to a market capitalization for the S&P 500 Index of less than $7.4 trillion, pointing to a potentially heavy flow of money into the stock market when sentiment improves.
Equity markets will continue to reflect this uncertainty until greater clarity is reached regarding both Treasury action and the pending government stimulus package. The natural reaction in the face of substantial uncertainty is to withdraw from investing. However, logic continues to suggest maintaining a portfolio balance of high-quality cash and bond investments to guard against short-term market turmoil and global equities to capitalize on current valuations and long-term economic recovery.