The Fed Had No Choice but to Cut Rates but the Bad News Won't Go Away Overnight

By Ernie Ankrim, Chief Investment Strategist
Russell Investments
January 24, 2008

The markets are once again in turmoil. Fears of recession in the United States and the continued fallout from the credit crunch are taking a big toll on stock markets around the world. In response, before U.S. markets opened Tuesday morning, the U.S. Federal Reserve cut the federal-funds rate three-quarters of a percentage point—the biggest cut in more than 23 years. It was the Fed's first emergency rate cut since 2001. Russell's Chief Investment Strategist, Dr. Ernie Ankrim, provides his perspective.

The Fed obviously recognized the pervasive fear evident in the overseas markets activities on Monday (January 21st). Their ¾-point cut in the fed funds target and discount rate made a statement that they understand the market's concern and they are watching the market and the economy very closely.

They had few options here. Letting the markets sink without response would have exacerbated the flight to safety by many investors. However, they still see that both of their objectives (economic stability and inflation control) demand attention. The Fed's dramatic move helped the markets recover much of Tuesday's early-session losses (the Dow Jones Industrial Average—a price-weighted average of 30 actively traded blue chip stocks—dropped by 460 points in the first few minutes of trading then recovered 360 points in the next 90 minutes).

Clearly, the volatility in this market is as high as we've seen in some time. The Chicago Board Options Exchange Volatility Index—a price-weighted average of 30 actively traded blue chip stocks—reached almost 38 Tuesday, a level last seen in the Fall of 2002. And we're seeing the market already baking in anticipation of further cuts. Futures markets initially showed the market implied a 100% probability of another 50-basis-point cut in the fed funds target when they meet January 29—but as the morning wore on, the odds moved in favor of a 25-basis-point cut.

I believe part of the foreign markets' sell-off on Monday (which started us on this roller coaster) was a fearful reaction to President Bush's economic stimulus package that was released Friday. While policies aimed at stimulating economic activity might be viewed as a positive, the markets' reaction signaled concerns that the U.S. economy might be much worse than most first thought.

Investors need to understand that most rate cuts do not bring immediate relief to the economy. It usually is six to nine months before we start to see an effect in the economy and the market from this action but we do believe that the worst of the bleeding has been stemmed.

I'm not that surprised by what we're seeing. We have felt all along that the first half of 2008 would be very volatile. This is when investors might want to adopt the "Rip Van Winkle strategy" — go to sleep and wake up when summer hits. Granted, we're seeing volatility at its extreme right now but there is good news. The Fed has made a statement that the economy is its top priority and the current administration has done the same. The Fed's goals are to pump more liquidity into the market and encourage banks to lend, indicating additional rate cuts may be likely. Some of our funds' underlying managers, based on feedback gathered in regular conference calls, predict that it will take interest rates down around 3% before we begin to see meaningful turnaround—the Fed seems poised to be moving in that direction. Current valuation trends indicate that the second half of the year looks more promising with the slowdown tapering off. Therefore, we believe that the probability that we are headed for a deep and profound recession is very low.

My best advice for investors—remain disciplined and stick with your current investment strategy. Volatility creates pain and pain often causes us to lose focus and react by fleeing. That's the exact opposite of what investors should do right now. Times like these are when financial professionals can truly demonstrate their value by helping investors manage expectations and behavior.

Our experience researching and monitoring global capital markets for decades tells us that informed and patient investors are more likely to be rewarded with results aligned with their investment goals.

It's in market conditions like these we're experiencing now where Russell's expertise at active management and its highly diversified investment strategy approach can help. Our investment philosophy is designed to help investors ride out these types of market storms.