Weekly Markets Commentary – April 7, 2008

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Markets Rally

Stocks surged last week on the growing belief that the worst of the credit-induced, economic slowdown may be coming to an end. Stocks even managed to hold their ground after another weak employment report (the third in a row) which showed a decline in payrolls.

The S&P 500 Index posted its best weekly gain since early February. It's now 7.6 percent above its closing low on March 10, but it's 6.7 percent lower on the year.

Consistent with the move in stocks, bond yields also moved higher, and credit spreads narrowed. The yield on the two-year Treasury note climbed 17 basis points to 1.82 percent, while the 10-year note rose six basis points to 3.47 percent.

The option adjusted spread between the 10-year note and the Merrill Lynch High-Yield Master II Index contracted by 25 basis points to 798. On March 17, at the height of the Bear Stearns episode, the spread was 887.

The spread to the Merrill Lynch A-AAA Corporate Bond Index fell 16 basis points to 267. On March 17, it stood at 297.

The surge in stocks was particularly encouraging given the headlines, which were screaming "recession." There's no dispute that the economy's first-quarter performance was weak, but we remain skeptical that the economy will descend to the definition of recession.

But the debate is somewhat irrelevant. What matters is market behavior, and recent performance in the markets suggests that if we are in recession, it is not expected to last very long, nor be very severe.

However, we are not out of the woods just yet. The Federal Reserve may have indeed put a firewall around the credit crisis by allowing primary dealers to borrow directly from it. And, the combination of lower interest rates and the building wave of the stimulus package rolling toward our economic shore may well result in better times just ahead.

But, we still have to deal with the immediate concern of first-quarter earnings season, which gets underway this week. Earnings are now expected to fall 12 percent for the quarter, with financials declining 60 percent.

And, lest we forget what got us here in the first place, the credit mess and its fallout have not fully run their course. Nor have home prices stopped falling.

There is also the ongoing concern that the Fed may be creating an inflationary problem for itself through its intense focus on growth and liquidity. Its priorities are well placed, but the consequences may require a painful change of course down the road.

For the present, equities investors are behaving as if the worst of the storm has passed. For the rally to be sustainable, however, we are going to need some evidence that banks are indeed coming clean on their bad debt exposure, and we?ll need assurance that economic conditions are not deteriorating further.

Overseas markets also rallied last week. In dollar terms, the MSCI EAFE index climbed 3.6 percent, held back somewhat as the dollar rallied modestly. For the year, the EAFE index is lower by 5.9 percent in dollar terms, still better than 6.6 percent decline in the Russell 3000 Index. Dollar weakness, however, accounts for all of the relative strength. In local currencies, the EAFE index is down 11.6 percent.

Emerging markets also rallied, on strength in Latin America, pushing the MSCI EMF index to a gain of 2.9 percent. It is now down 8.1 percent on the year in dollars.

The economic news last week was not uniformly bad. There was little to feel good about in the employment report, but elsewhere the Institute of Supply Management reports on both manufacturing and services came in better than expected, as did construction spending, although it was still down for the month.

This week's calendar is light in the U.S., but central banks in Japan, the U.K., and the European Central Bank all meet to consider monetary policy, with potential implications for the dollar.