Peter Gibson
Director of Investment Advisory Services
Looking Behind the Curtain - A Return to Fundamentals?
With the credit and liquidity crisis dominating headlines in recent months, the real economy has received less attention as market participants have had their hands full trying to determine if their counterparties were creditworthy, their management was useful, or if their investments were worth anything at all.
With the combination conservatorship, bail-out, and capital injection plan in full swing, the clear intention of the U.S. government to relieve the stresses present in the credit and equity markets is apparent. While many questions have yet to be answered (mostly centering around the efficacy of allowing the world's largest financial institutions to place trillion-dollar bets using unregulated derivatives and massive leverage), it now appears that the equity capital infusion will help turn the tide on the massive flight to quality. The crisis of confidence which has gripped the inter-bank funding markets may be at an early stage of thawing. However, banks will not ease lending standards overnight and the damage inflicted on consumers by the housing market meltdown and restriction of credit won't be so easily staunched.
With the crisis appearing to be on a path towards resolution, we look ahead and anticipate a return to the economic fundamentals which, in more normal times, would provide the basis for determining the level of interest rates offered in the fixed income markets. Unfortunately, nearly all the economic data we follow indicates that the consumer-spending led economy is slipping deeper into recession.
As those of you who have participated in our webinars and Fall Forums so far this year know, it is clear to us that we are well into a recession which likely began in early 2008. The reason we have such conviction in our view is that the organization which is responsible for dating business cycles has indicated four particularly important indicators it uses to date business cycles. According to our research, all of these indicators peaked between October, 2007 and February, 2008, as the chart below indicates.
(click graph to enlarge)
With the certainty of an ongoing recession coloring our decision-making process, the question remains as to how best to position our investment portfolios to make the most of the remaining risk premiums related to the liquidity crisis while not making imprudent decisions at a trough in interest rates.
The key to managing a credit union's investment portfolio through challenging times is similar to the maxim espoused by personal financial planners: Develop a sound investment policy, emphasizing diversification and a long-term rate of return, and stick to it. The same applies to credit unions, especially recognizing the value of structuring bond and certificate maturities to maintain a relatively level yield despite the volatility in short-term interest rates. Indeed, it is relevant to note that, at least from an interest rate risk perspective, the most conservative investment portfolio is not the shortest-duration portfolio; it is that portfolio which best does the job of aligning the institution's asset and liability durations. Those institutions which have kept their portfolios very short are likely to see net interest margin compression in 2009 as short-term interest rates are low and likely to remain low.
Rates will not rise until the labor market shows signs of recovery, and with nearly one million private sector jobs lost so far this year, we are a long way from that happening. However, it is important to remember that as discounting mechanisms, markets will recover faster than the overall economy. So despite the likelihood of several quarters, and possibly years, of weak GDP growth, we see opportunities for credit union investment portfolios to thrive, taking advantage of the still-present dislocations in mortgage-backed securities markets, the new steeper yield curve, and a liquidity crisis that has temporarily impacted the supply-demand dynamic.
