Market Update – First Quarter 2010

Canadian Equities

The Canadian equity market provided leadership from non-resource sectors during the first quarter. Stocks declined by mid-quarter due to fears of rising interest rates globally and efforts by the Peoples Bank of China to tamp down on excessive lending. Defensive companies lead the market during the period. Strong earnings reports and renewed foreign interest in Canadian stocks provided the drivers for all overall increase in the period. The S&P/TSX Composite Index returned 3.1% during the quarter. The largest contribution came from the Financial Services sector which provided 80% of the overall index return.

Macro economic data indicated that the Canadian economy was posting a strong recovery. Fourth quarter real annualized Gross Domestic Product rose by a faster than expected 5.0%. Growth was realized from greater federal government spending related to an economic stimulus program and from rising demand and prices for commodities including copper, zinc, nickel, crude oil, potash and lumber.

A report from Statistics Canada on the last day of the quarter indicated that the Canadian economy grew in January by a better-than-expected 0.6% month-over-month gain. January's result represented the fastest monthly gain in more than three years. The consensus among Bay Street economists was for a growth rate of 0.5%. Growth in January was driven by manufacturing, up 1.9%, and construction, 1.7%. The data highlighted that the current recovery had spread beyond the initial push in housing and consumer spending, as manufacturing advanced for the fifth straight month. Inventories have fallen in each of the past 11 months, bringing them to levels not seen since late 1998.

Strength in the Canadian economy and its currency relative to other G8 countries had attracted speculative attention by international investors. The Russian central bank recently noted its intentions to diversify its currency reserves by purchasing Canadian Dollars. With the Canadian dollar trading near parity with the US dollar, the Canadian currency was widely considered to be slightly overvalued, a factor that many investment observers fear will stall the manufacturing recovery. But with the US economy steadily improving, the Canadian manufacturing sector can continue to do well, even if the two currencies reach parity. The Bank of Canada confirmed during the period that monetary policy is expected to remain accommodative until the end of June, but hinted that an easy money policy was approaching an end. Anticipation of a tightening monetary policy in the second half of 2010 will prompt a further strengthening in the Canadian Dollar.

Nine of 10 sectors generated positive contributions during the quarter. The best performing sectors included, Health Care (+10.3%), Financials (+8.1%), Consumer Discretionary (+6.2%), Industrials (+6.2%) and Info Tech (+6.0%). Negative contribution was isolated to Energy (-2.0%).

Canadian Fixed Income

With economic conditions gradually improving and the Bank of Canada holding interest rates steady, Canadian bond prices pushed higher through the first quarter of 2010. The DEX Overall Index registered a quarterly gain of 1.26% by the end of March.

The Bank decided to maintain its overnight lending rate at just 0.25% at its most recent meeting on interest rates in early March. The Bank noted that fourth quarter 2009 GDP of 5.0% annualized was much stronger than expected, but pointed to continued slack in the economy, moderating unemployment, and contained inflationary pressures as the key rational for their decision. As the influences of monetary and fiscal stimulus begin to dissipate, the Bank expects domestic growth will moderate in 2010 and 2011.

Comments from the Bank of Canada helped cool enthusiasm for interest rate increases, but short-term yields still advanced between 25 and 34 basis points in 1-3 year Federal bonds. Long term rates however barely moved as the Canada 30-year yield fell just 2 basis points to close the quarter at 4.07%. While the lack of substantial movement in long Federal bonds yields offered little for duration volatility strategies, curve strategies were provided a small but positive lift from the gradual flattening of the yield curve.

As global financial markets continued to improve and economic activity showed further signs of recovery, corporate credit markets remained the best performing sector during the quarter. Credit spreads continued to compress as an increasing appetite for risk left many new issues oversubscribed. Based on DEX Index information, corporate bonds outpaced their federal counterparts by an average of 149 basis points for the quarter. The degree of outperformance was amplified as investors extended the term of their investments and moved down the credit quality spectrum. For example, long-term BBB-rated corporate bonds gained 6.22% for the quarter compared to a gain of just 0.29% for short-term Federal bonds.

Canadian bond markets are expected to further generate small but positive returns in coming quarters while economic growth and inflationary pressures remain tepid and controlled. The Bank of Canada however is expected to eventually increase interest rates in proportion to the velocity of growth and inflation rate increases, especially if either exceeds anticipated growth rates.

U.S. Equities

The U.S. equity market, as represented by the Russell 1000 Index, increased by 5.7% in local currency during the quarter while the smaller cap Russell 2000 Index increased by 8.9%. During the period, the USD continued to lose value versus the Canadian dollar by 3.1%. Consequently, gains made in U.S. stocks in the local currency were modestly offset by translation losses.

Q4 GDP was downwardly revised to a smaller growth rate of 5.6% from 5.9% Expectations were for a 5.8% gain. Nevertheless, it was the largest advance since Q3 2003. Consumer sentiment rose 1.1 points in March from its mid-month reading to 73.6, and remained unchanged from the prior month; reiterating that the US economy continued to be on a slow to moderate recovery during Q1.

Macro economic data was decidedly mixed and underscored that while growth continued to develop, laggards such as housing and the labor market were standing in the way of a full recovery. Single-family home sales fell 2.2% to a 308,000 unit annual rate. During the period, the Commerce Department reported that consumer spending had increased by 0.3% in February, The increase came at the expense of savings, which fell to its lowest annual level in 18 months.

Manufacturing led the economy's recovery from its worst downturn in seven decades. Durable goods inventories posted their biggest gain since December 2008. New durable goods orders excluding transportation rose 0.9% in February after falling 0.6% the prior month.

During March, Initial unemployment insurance claims fell 14,000 to 442,000. It was the second lowest level since August 2008. Expectations were for a decline of 7,000 to 450,000. The four-week average decreased by 11,000 to 453,750 in the latest period. It was the biggest drop in nearly four months to the lowest level since September 2008, indicating a continued downward trend in firings.

The year-long debate on healthcare reform came to a conclusion in March when the bill was passed by the House of Representatives with a 219-212 vote. The next step is reconciliation by the Senate, which is viewed as a formality. It is a controversial piece of legislation that will cost $940B over 10 years. Investors are now of the opinion, that the winners that will benefit the greatest from Health Care Reform are the Life Sciences, pharmaceuticals and biotech companies.

EAFE Equities

Developed international equity markets, as measured by the MSCI EAFE Index, decreased by 2.4% during the quarter. Regionally, Pacific Rim increased by 3.0% and Western Europe decreased by 4.9%.

The first quarter continued to paint a mixed picture in the economic recovery. Increasingly, the Euro zone macroeconomic activity had begun to look weak. Economic stimulus efforts by policy makers have not had the desired outcome. This is most obvious in France, where the auto incentives came to an end in December and household consumption subsequently collapsed, dropping 1.2% in February and 2.5% in January. The same effect was also in evidence in the January manufacturing new orders data, which showed orders in France were down 11% in January, contributing to a 2% drop in euro area new orders.

However in contrast to France, the latest Euro zone business confidence numbers were above expectation. Both the PMI’s and the Germany IFO index in March were driven by a strong increase in export orders and a bounce-back from the earlier cold weather. The euro area manufacturing PMI rose to 56.3, up from 54.2 in February, to reach its highest level since the end of 2006. The latest European PMIs suggest that the euro area is beginning to benefit from the wider global recovery in world trade.

The Euro zone's unemployment rate reached 10% in February while inflation rose much more than expected, highlighting the fragility of economic recovery. The jobless rate was the highest since the Euro currency came into being in 1999. A month earlier, unemployment was at 9.9%.

Debt troubles that had afflicted Greece, moved to other weaker economies. The premium Portugal had to pay on its bonds compared to German Bunds briefly hit a high of 129 basis points.

Emerging Market Equities

The Emerging Markets continued their stock price rally on an improved outlook in March. The MSCI Emerging Markets Index had risen 2.5% during the quarter in local currency. However, strength in the Canadian dollar had negated the positive return, resulting in an overall decline of 0.9% in Canadian dollars. The best performing regions were the Middle East (+6.8%) and Eastern Europe (+2.7%), offset by weakness in South America (-2.9%) and the Far East (-2.7%).

The International Monetary Fund forecasted Asia’s developing economies to expand by 8.4% this year, outpacing growth of 2.7% in developed markets. South Korea reported its industrial output rose 3.6% in February from the previous month, more than double the forecast by economists.

Thanks to an array of stimulus measures by the Chinese government, the country’s economy brushed off the global recession and grew faster than the official 8% target during 2009. While recent policy changes during the quarter have modestly increased reserve requirements for banks, a continuation of highly accommodative monetary and fiscal policies coupled with growing exports are expected to push growth up to 9.5% in 2010. Finally, as temporary drought conditions in India tempered Q4 growth, early indications show manufacturing and investment resuming for the rest of this year.

Global Bonds

Global economic conditions continued to improve over the quarter which lessened the attractiveness of safer assets. The Citigroup World Government Bond index declined 4.51% in the first quarter of 2010 due mostly from weaker global currencies relative to a strong Canadian dollar.

As the US economy continued to show signs of improvement, the US Federal Reserve raised its discount rate from 0.50% to 0.75%, but left the Fed Funds rate unchanged near zero percent. A national unemployment rate running at 9.7% and 30% of the states in the US having double-digit unemployment led Treasury Secretary Geithner to comment that unemployment could remain ‘unacceptably high for a long period of time’. The statement helped reduce expectations for any near term interest rate increase and contributed to a weaker US dollar relative to Canada. The Bank of Canada left its overnight lending rate at just 0.25% and reiterated concerns of a strong currency detracting from export growth.

The Japanese government furthered efforts to stave deflationary pressures across the nation as headline consumer prices fell another 1.1% annually to February. The central bank doubled a lending program for commercial banks to 20 trillion Yen (over C$210 billion) following calls to do more to tackle deflationary pressures. Even though the recent Japanese Tanken survey improved markedly from -25 to -14, economic activity remained anaemic.

European markets were rattled over the quarter is it became increasingly apparent Greece was carrying more debt than earlier believed, and the government’s ability to pay became questionable. The Greece government has been struggling to manage a deficit that has grown to 12.7% of GDP in 2009. Portugal, Italy, Greece, and Spain all suffered due to Greece’s funding problems, which fueled concerns that other European nations may be forced to make painful compromises to buoy the Euro. Despite calls for a rescue package through the International Monetary Fund or European Central Bank, details of any agreement remained unclear. Exposure to German government bonds was modestly beneficial given their quarterly performance was slightly stronger than average bond returns in the Index. In the UK, a deficit to GDP of approximately 11.8% is the largest among major developed countries. UK Government bonds performed inline with the Index. A slight underweight to the British Pound was positive for relative returns as the currency was the worst performer over the quarter. Central bankers will continue to struggle with deteriorating fiscal positions due to falling tax revenues and costly
bailout packages. Despite Canada’s recent deficit announcements, Canada continues to rank as a top performing economy on a relative basis. This could place further pressure on the Canadian dollar in the near term as other nations suffer under significant debt loads.

Commodities

The first quarter of 2010 ended slightly negative for broad based commodity indices. While the first few weeks of 2010 saw a significant downtrend in commodity markets, the energy and metals baskets posted strong rebounds through the second half of the quarter. While the Reuters Jefferies Commodity Index finished down 3.5%, the energy weighted S&P GSCI managed a 1.1% gain.

The energy sector generated modestly positive returns for the quarter as rising Non-Farm Payrolls signaled US economic strength. Gasoline was the strongest gainer with a 12.5% rise, while Crude and Heating Oil returned 5.5% and 2.2% respectively. Natural Gas was weak on the quarter as excess supply along with waning demand lead the commodity lower by 30.6%.

Gold spent the first month of 2010 in a sharp decline to price levels not seen since October 2009. This was spurred by unexpected strength in the USD, as the safe haven currency saw inflows amid Greek default concerns. Nonetheless, as a Greek bailout became more likely and the possibility of contagion throughout the European Union subsided, Gold had a modest bounce and finished up 1.6% on the quarter. Copper followed a similar path as global growth prospects diminished through the first month of 2010, yet the industrial metal finished strong and managed to gain 6.6%.

Turning to the agriculture sector, cattle was the only commodity with a positive return this quarter (+12.3%). Sugar, Corn, Wheat and Soybeans were all lower by 9.5%, 16.7%, 16.8%, 30.6% and 38.4% respectively. A combination of larger than expected crop yields and a strong USD has lead to the decline in the agricultural commodities.

The most significant story on the currency front comes from USD strength. The impending Greek bailout, and concerns around the viability of the European Union put significant pressure on the Euro and Pound as they lost 5.7% and 6.0% respectively. The Swiss Franc and Japanese Yen were relatively unchanged on the quarter, while the commodity driven strength of the Aussie Dollar continued.

Macro Overview

During the quarter, SEI was awarded with two Lipper Awards for achieving the highest risk adjusted returns in the most recent 10 year period. The recipient funds’ were the SEI Canadian Equity Fund (O Class) and the Emerging Markets Equity Fund (O Class). Both funds have been long standing building blocks within SEI’s asset allocation models. The Lipper Award validates the SEI philosophy of achieving long-term growth combined with a disciplined risk management philosophy.

Globally, equity markets were modestly weaker in January and into the first half of February due to concerns over sovereign debt ratings and the increasing probability that a debt crisis in Greece could spill over into other Euro region countries. During this period, the Federal Reserve hiked the discount rate in a process termed “Normalization”. This process was a gentle tweak of the Fed’s policies and were not expected to lead to tighter financial conditions, however investors were concerned with the removal of easy money from the monetary base and the overall exit strategy of prior stimulus efforts.

Strong earnings announcements and improved economic reports helped markets to rally during the second half of the quarter. Canada benefited from both consistent surprises to the upside provided by the US macro economic data, that was not strong enough to initiate Fed rate hikes in addition to the commodity demand theme from China, India and other EM countries.

The Bank of Canada sent signals that short-term interest rates would rise in the second half of the year. This resulted in the Canadian dollar appreciating against the USD, Euro and British Pound.
For investors who wish to utilize currency hedging, SEI is offering a currency hedged share class in select US denominated funds. Currency hedged share classes are available in the U.S. Large Company Equity Fund, U.S. Small Company Equity Fund and U.S. High Yield Bond Fund.

Important Information:

Fund performance discussion is for O Class only (gross of management fees). Index returns are for illustrative purposes only and do not represent actual fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information is for educational purposes and should not be relied upon by the reader as research or investment advice regarding the funds or any stock in particular nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the date of this material that the securities mentioned remain in or out of the SEI Funds.

There are risks involved with investing, including loss of principal. Diversification may not protect against market risk. There are other holdings which are not discussed that may have additional specific risks. In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity. Bonds and bond funds will decrease in value as interest rates rise. Information contained herein that is based on external sources is believed to be reliable, but is not guaranteed by SEI, may be incomplete or may change without notice.

SEI Investments Canada Company, a wholly owned subsidiary of SEI Investments Company, is the Manager of the SEI Funds in Canada.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Mutual fund securities are not covered by the Canada Deposit Insurance Corporation or any other government deposit insurer. The information contained herein is for general information purposes only and is not intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment. You should not act or rely on the information contained herein without obtaining specific legal, tax, accounting and investment advice from an investment professional.