Thoughts on the recent market volatility

Given the recent activity in the stock and bond markets, I thought a short overview would be helpful in understanding some of the issues making financial headlines. Over the past several weeks, various asset classes around the world have experienced a "re-pricing" of risk, which, in our opinion, has led to heightened volatility in capital markets.

We believe investors have grown increasingly concerned that credit problems originating in the sub-prime mortgage arena could spread to other areas of the fixed-income markets. This has led to a reduction in credit availability.

In addition, the riskier segments of the bond markets have experienced a "bottleneck" as issuers have attempted to get a large amount of financing done in a deteriorating market environment. Thus far, we believe these credit problems are not affecting the otherwise favorable economic, profit, and valuation fundamentals influencing the equity market.

If the credit problem were to expand so as to result in major losses to highly leveraged lenders, it could have a dampening impact on the very favorable monetary and credit environment that has buoyed financial markets in recent years.

Over the past five years, ample global liquidity, in the form of high savings rates internationally and easy monetary conditions provided by many central banks, has been a key driver of the strength in global equity and fixed income markets.

Despite the recent action in bond markets, we do not believe financial conditions have deteriorated to the point where liquidity is a pressing issue, but we do believe it bears continued monitoring.

Looking ahead, we believe that inflation will likely continue on a downward trend. Our economists continue to believe that this will culminate in a "token" interest rate cut of 25 basis points by the Federal Reserve by mid-2008.

If the economy proves weaker, however, perhaps because of another decline in housing or the stock market, that timing could be moved up a bit.

Nonetheless, we still believe that current conditions do not warrant an imminent rate cut, nor do they warrant an extended series of rate cuts over the intermediate term.

Away from the U.S. Treasury market, we are not confident that the recent deterioration in the fixed income markets is fully behind us, especially as we enter August, typically the lowest-liquidity month for the bond markets. The sell-off in bonds has been most pronounced in the corporate sector, where recent developments indicate that the credit cycle may have begun to turn.

One of the catalysts of the recent spike in credit spreads, particularly in the high-yield sector, was the failure to arrange permanent financing for two large leveraged buyouts. This, coupled with an abundance of other scheduled offerings, has created a significant and unprecedented backlog of deals that we believe issuers may need to get done before activity can become more "normalized."

We believe that good value exists in the strongest components of the bond markets, including municipals, high-grade corporate issues, agency debt, and agency-backed mortgage securities. However, given our near-term caution in the fixed-income markets, we recommend that investors position portfolios defensively by concentrating on sectors with high credit strength and good liquidity. We advise against selling high-quality holdings or using the recent weakness to add to lower-quality positions despite what may be perceived as more attractive valuations.

In summary, we have not seen any evidence yet that the recent decrease in investors' appetite for risk and the resulting sell-off in equity and fixed-income markets are harbingers of a more significant or systemic problem in the U.S. economy. The underlying drivers of economic and earnings growth still appear strong to us.

However, our research suggests that financial conditions have now adjusted from very favorable to more neutral levels, and perhaps a bit beyond. Thus, evidence of tighter financial conditions or further weakening in key areas of the economy, like consumer spending, would prompt us to review our generally optimistic view towards the economy and the U.S. equity market.

For more information, e-mail william.a.creekbaum@smithbarney.com or call 689-8700.

Smith Barney does not provide tax and/or legal advice. Please consult your tax and/or legal advisors for such advice.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.