Investors continued to grapple with exogenous events as volatility in the capital markets remained elevated throughout October. For much of the month, greed ruled as investors moved to buy equities amid a growing perception that the European Union had reached consensus to support the fiscally challenged members of the common currency. Indeed, approval of fiscal restraint by the Greek parliament was the catalyst for the 3.25% rally in the S&P 500 on October 27th. Unfortunately, the entirety of that one day move was undone two business days later when Prime Minister Papandreou vowed to hold a public vote on the newly approved package. In the United States, improving economic fundamentals and investor concern about the very low absolute level of interest rates resulted in the yield-to-maturity on the 10-year U.S. Treasury note rising approximately 20 basis during the month.
The 2.47% decline in price of the S&P 500 on the final day of the month obfuscated what was a surprisingly positive month of economic data and corporate earnings. Arguably the most surprising piece of data, 3rd Quarter GDP, was completely ignored by the market. Consider that just eight weeks prior to the release, consensus opinion was that the U.S. was sliding back into recession. None other than “Economist-in-Chief” Ben Bernanke, in August, communicated that the economy faced “significant downside risk.” To mitigate those risks, the Fed implemented the so-called operation twist, in which they sold government debt with less than five years to maturity and used the proceeds to buy long-term debt. Despite Chairman Bernanke’s dire forecast, gross domestic product expanded by a better than expected 2.5% for the quarter. Digging into the components of the report, the news was even brighter. Exports grew faster than imports, real final sales rose 3.6%, and Gross Private Investment rose 4.1%, as reported by the Commerce Department. Inventories were nearly unchanged for the period, which is a positive indicator of future growth. All things equal, inventories typically expand in step with the economy. If not, supplies decline forcing producers to increase production to restore depleted stocks.
Equally encouraging was the employment growth in October. The non-farm payroll rose 80,000 for the month which, at first glance, was not particularly impressive. However, the Bureau of Labor Statistics revised the number of workers hired in August and September by a total of more than 150,000. Recall that the August jobs report initially indicated that no jobs were added in August. Year to date, the U.S. economy has added in excess of 1.2 million jobs.
Against that backdrop the widening in credit spreads that occurred in August and September has persisted. To put that valuation in perspective, the current spread of the Barclays credit index stands at 189 basis points. That’s just 35 basis points below the widest level reached during the Enron/Worldcom corporate malfeasance era in 2002. With that, we now believe that rising interest rates and tightening credit spreads will likely come to pass.