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Integrity
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The third quarter ended on a positive note, and there was little evidence of a spillover to the broader economy from the decline of housing and the subprime mortgage troubles. Real gross domestic product grew at an annual rate of 3.9% following a similar increase in the previous quarter. Real consumer spending increased at a slightly higher rate than over the past year. Labor market conditions also remained satisfactory, with new jobless claims range-bound at a low level. Foreign trade took up the slack from the weak housing sector. Exports were up 16% in the last quarter, 9.6% over the past 12 months, and at an 8% rate since 2004. As the dollar has weakened trade is capturing a rising share of a growing economy, promising benefits for America’s manufacturing base. On the surface, third quarter economic metrics largely painted an optimistic picture. Not all is rosy as we come to the end of 2007, however.The massive inclusion of banks in the subprime mortgage mess has exposed serious fault-lines in the banking system. The shocking extent of the aggressive use of subprime mortgages by commercial banks was revealed quickly following the collapse of several hedge funds and the failure of some structured investment vehicles to meet withdrawal requests. Even more appalling was the lack of good sense shown by managers of the SIV’s. In a low interest rate era SIV’s promised high returns essentially by investing in longer term high risk assets, primarily thin slices of mortgage tranches. All followed the same investment approach. Funding for these vehicles came from the issuance of commercial paper, often by bank sponsors. As the instruments became suspect and bank participation became known investors turned away from all commercial paper, essentially seizing-up this critical funding source. The damage to bank credibility and public confidence by these actions is real and will take time to heal. Recognition of a problem is half the cure, however, and central banks throughout the industrialized world seem intensely focused on it. By both word and action the Federal Reserve has demonstrated its commitment to providing adequate liquidity. The Fed recognizes that credit induced downturns result when credit worthy borrowers are denied access to credit. Fed actions in reducing both its Federal Funds and discount rates, and broadening the collateral it is willing to accept, were timely in injecting confidence to bank managements that it would reinforce their liquidity requirements, if necessary. At this time credit standards have been raised, the commercial paper market is functioning again, and credit for worthy borrowers is available. The near term outlook for inflation is another worrisome factor adding to the unsettled market conditions and declining consumer confidence of recent months. The primary cause for concern is the highly visible and sharp increases in the price of gasoline and agricultural commodities. The decline in the dollar and rising import prices are also affecting consumer spending. Despite the tame nature of the Federal Reserve’s preferred measure of inflation, which excludes food and energy, the prices consumers pay on a daily basis are likely to rise over the next few months. The rising cost for essentials has the same depressing effect on discretionary spending as a tax increase. For many reasons we believe inflationary forces will dissipate after a few quarters and worldwide deflationary forces will reassert themselves. In the short term, however, softness in consumer spending will result in somewhat slower growth path and reduced gross domestic product performance in 2008. History is instructive in understanding the lasting affects of the current problems in the credit markets. While differing in their causes, each financial crisis carried serious potential consequences for the banking system. The sudden collapse of Long Term Capital in 1998 and the Russian devaluation and default of 2001 ‐ 2002 are most notable examples.While both resulted in serious losses, the devastation was contained and did not spread to the broader economy. As we now know, monetary policy proved effective in calming credit market jitters. The present crisis in the credit markets will follow a similar time line, in our judgment. One of the major differences now from the prior crises is the broad strength of the world economies. Newly assertive emerging economies are hardly likely to return to backwater status because of the inappropriate actions of some financial institutions. Emerging economies will continue to drive global economic growth, and will have a large and generally positive impact on inflation, interest rates, wages and profits of developed countries. This is not to say that the current crisis and economic concerns will not leave an imprint on the financial markets. Notably, there is a demonstrable return to conservatism in investing with an emphasis on quality and higher prices charged for added risk. These are sound practices for all markets. With uncertainty about the economic course in 2008 high on investor’s minds, and anxiety about the course of fiscal policy following the 2008 elections, we believe larger growth companies with quality financial statements and an international reach will be in the ascendancy in the period ahead. Alfred A. Lagan, CFA, Chairman November 14, 2007 Mr. Lagan founded Congress Asset Management Company in 1985 and is Chairman of the firm. Mr. Lagan is a member of the Investment Policy Committee and also Vice Chairman of the Board of Directors of Congress Trust, N.A. Prior to starting Congress, Mr. Lagan held senior investment positions at several financial services firms. Most recently he was Senior Vice President, Senior Portfolio Manager, and director of several investment subsidiaries of the Putnam Companies. Mr. Lagan is a CFA charterholder and a member of the New York Society of Security Analysts, the Boston Security Analysts Society, and the Boston Economics Club. He has an MBA from New York University with distinction and a BA from Iona College. To learn more about Congress Asset Management, please contact us at 800.542.7888 or visit www.congressasset.com
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