Weekly Markets Commentary – October 27, 2008

David Joy — Chief Market Strategist, RiverSource Investments

For more commentary and insight, visit riversource.com/funds

Global Markets Tumble

In more normal circumstances, a five percent decline in the Dow Jones Industrial Average, a seven percent decline in the S&P 500 Index and a nine percent fall in the Nasdaq Composite Index would be headline-grabbing news.

This is precisely what happened last week. But these are not normal times and these declines, despite their magnitude, were not the lead story. That distinction fell to the rout in emerging markets around the globe, which made the declines on Wall Street seem almost tame by comparison.

The MSCI Emerging Markets Free Index fell 17 percent last week, led by regional declines of 20 percent in Latin America and 21 percent in Eastern Europe. It was the eighth straight week of declines in emerging market equities in a stretch that has seen the index cut in half. Since its peak one year ago, it has lost two-thirds of its value. Don't expect to read too much about the theory of decoupling anytime soon, unless it is contained in its obituary.

The flight of capital from assets perceived as risky was to blame, as carry trades continued to be unwound. Fears of a deeper and longer recession in the U.S. and elsewhere continued to spread, calling into question the sustainability of expansions in the export-dependent emerging world, putting their currencies under pressure.

In turn, the dollar and the yen continued to surge. Versus the euro, the yen rose 13 percent and the dollar rose 5 percent. What began as a subprime mortgage problem in the U.S., and then migrated to the European banking system, has now completely ensnared developing markets around the globe.

Developed market equities also were pummeled last week. The MSCI EAFE Index fell 9.8 percent, with 2.4 percent of the decline resulting from the stronger dollar.

Oil prices found little support from OPEC's announcement of a 1.5 million barrel per day production cut. Crude fell $8 on the week to close at $64.15 per barrel. Energy stocks fell by roughly five percent – but fared relatively well on the week. (It seems absurd to characterize a 5 percent decline as being relatively good, but such are the times).

In comparison, consumer discretionary stocks were crushed, down 13 percent with pronounced weakness in the automobile group. Talks between Chrysler and General Motors continued as concerns mounted that bankruptcy was a distinct possibility. Retailers and gaming companies also slumped sharply as recessionary concerns spread. Financials also suffered double digit declines, particularly real estate. Materials and telecommunications each fell in excess of 10 percent. Only the utilities sector managed to eke out a fraction gain, while healthcare suffered only a modest loss.

Bond spreads continued to widen into uncharted territory. After closing the prior week at a record 16.5 percent yield differential above the 10-year Treasury note, the Merrill Lynch High-Yield Master II Index closed on Friday at a spread of 17.25 percent. The 10-year note yield slid 24 basis points to 3.69 percent in flight-to-safety buying.

The Week Ahead

The week ahead is full of economic data from September, when the economy took a decided turn downward. On Thursday, third-quarter gross domestic product (GDP) is expected show a decline of 0.5 percent according to the consensus, although we think it could still be positive based on activity in July and August. Either way, we believe the economy fell into recession in September. Other scheduled releases may confirm that belief.

Consumer spending in the third quarter may have been its weakest since the early 1990s. New home sales, home prices, durable goods orders, and Chicago manufacturing conditions are all expected to have declined in September.

The Federal Reserve meets this week, and many are expecting a half-percent rate cut, as evidence of economic deterioration continues to mount.

Through the end of last week the selling pressure in equity markets showed no signs of abating. The extraordinarily rapid appreciation of the dollar and yen suggests that the process of deleveraging is responsible for at least some of it. Redemptions from mutual funds account for some as well.

The thaw in credit markets that had begun two weeks ago and accelerated at the beginning of last week slowed at week's end. The VIX Index remained extremely elevated as well, reflecting the unprecedented level of fear among investors.

When will it stop and what will it take? These are questions that everyone is asking. Unfortunately, answers are in short supply.

The process of deleveraging will exhaust itself eventually, but how much further it needs to go is not known. Nor do we know when home prices will stabilize. In one hopeful sign, we learned Monday that home sales increased by 2.7 percent in September.

What markets now need most is some period of relative calm to allow investors to simply catch their breath. When that time will arrive is also, unfortunately, unknown.