Trust Services

Before the Dawn

Economic conditions continued to soften in the first quarter of 2008.  Labor markets contracted, manufacturing receded, spending declined, and the credit crisis reemerged with a vengeance.  To combat the downturn, the quarter gave rise to additional rate cuts, a tax rebate and business spending incentive program, and expanded mechanisms to meet the liquidity needs of financial entities.  It may not have been fun, but it has been exciting.

Nonfarm payrolls declined throughout the quarter, as job losses in the financial and employment services industries added to the ongoing downturn in manufacturing and construction employment. Job growth in the health care and food services sectors continued.  The number of unemployed persons climbed by 434,000 in March, and pushed the unemployment rate up to 5.1%.  Meanwhile, the number of discouraged workers, identified as people not currently seeking work because they perceive no jobs are available for them, has only risen by 20,000 people over the past twelve months to 401,000.

The Institute for Supply Management’s PMI manufacturing index dropped below 50% for two of the past three months, indicating contraction in the manufacturing sector. Trends in some of the underlying index components – specifically new orders, employment and order backlogs - point to continued weakness in the coming months. Manufacturing prices accelerated throughout the quarter.

To address the weakening economy and the credit seize-up, the Federal Reserve became increasingly proactive and innovative. The Fed Open Market Committee lowered the target federal funds rate three times during the quarter, bringing the rate from 4.25% at the end of 2007 to 2.25% this March.  The Term Auction Facility (TAF), created last December to provide an alternative borrowing source for banks, was expanded to $100 billion in March.  A few days later, the Fed announced the creation of the $200 billion Term Securities Lending Facility (TSLF) as a borrowing mechanism for the primary Treasury dealers, including brokers.  A few days after that, the liquidity issues at Bear Stearns capitulated and the Fed approved a $29 billion financing arrangement with J.P. Morgan to facilitate the takeover of Bear Stearns.  Along with that, the Fed established the Primary Dealer Credit Facility (PDCF) that essentially provides a lending mechanism (similar to the discount window) to primary dealers with a broader range of securities considered acceptable as collateral.  These unprecedented actions demonstrate both the perception of heightened systemic risks and the lengths the Fed is willing to go to stabilize the financial system.

Not surprisingly, weaker economic conditions translated to negative stock returns, as the Standard & Poor’s 500 Index lost 9.44% for the quarter.  All ten major economic sectors within the index experienced price declines, with technology and financial stocks falling farthest; the consumer staples and materials sectors declined the least within the index for the period.  Small and mid cap stocks fared slightly worse in the markets as measured by a -9.9% return for the Russell 2000, while the -8.75% EAFE return indicates that foreign markets performed only slightly better.  The Lehman Brothers Intermediate Aggregate Bond Index returned a respectable 2.35% in the first quarter.  Spooked investors flocked into safer investments, causing Treasury bonds to turn in the best performance within the index.  Asset-backed securities, specifically home equity loans, trailed the index by the greatest margin.  As a result of the scrutiny and subsequent downgrading of some municipal bond insurers, municipal bond performance was especially volatile in February and March.

While our economy has likely slipped into recession, we believe that the substantial cumulation of interest rate cuts coupled with the government’s fiscal stimulus program will keep the downturn fairly shallow. We expect a return to below-average growth later this year, as the recovery remains restrained by housing market fallout.  Times of fear and vulnerability can create opportunities for the disciplined investor, and we have rebalanced portfolios accordingly.

As of Market close Monday March 31, 2008