Commentary: Second Quarter 2009

“Less bad” news fuels a surge in investor risk appetite in second quarter

• Rallying financial markets led by stocks, corporate bonds and commodities 
• Assets perceived to be riskier are favoured over more conservative positioning 
• Leading economic indicators point to an end to recession, but overall data is mixed

Stocks surged in the second quarter as investors, spurred on by a slew of improving economic indicators, looked beyond any negative headlines and positioned themselves for a global economic recovery. Bond investors become more willing to take on additional risk for the sake of higher yields as the quarter progressed, and hopes grew that previously frozen credit markets were finally thawing. Sectors that are perceived to be riskier, such as commercial mortgage-backed securities (CMBS), high-yield bonds (those with credit quality ratings below investment grade) and emerging-market debt, posted some of the largest gains for the second quarter.

The MSCI AC World Index ($) surged 22.26% in the three months through the end of June, with Financials and other sectors that are sensitive to economic cycles leading the way. From its lowest close of the credit crisis, reached on March 9, the global index was up roughly 50% at its highest subsequent close on June 2. The Barclays Capital Global Aggregate Index ($) of bond markets gained 4.93%, led by strong returns for non-government sectors. The VIX Index, a measure of implied volatility in the S&P 500 Index that is also known as the “fear index,” dropped back to levels not seen since before the collapse of Lehman Brothers last September, and ended the quarter at 26.35. However, it remained well above long-term averages.

Stocks

In addition to signs of improvement in economic data, global equity markets were bolstered by first-quarter earnings reports that were either better-than or not-as-bad-as forecast. However, in the final weeks of June, investors began to take some profits on recent big gains amid some lingering concerns that recovery may take a long time.

Still, stock markets were able to maintain their poise as more forward-looking economic indicators, such as consumer and business sentiment and earnings outlooks, continued to improve in general. Performance was concentrated in the Financials, Materials, Industrials and Consumer Discretionary sectors of the MSCI AC World Index over the quarter, with all other areas lagging the 22.26% return of the index. The MSCI AC World Value Index ($) outperformed the MSCI AC World Growth Index over the quarter as recovery hopes were stirred, with respective gains of 24.72% and 20.05%.

The situation was reversed in June, however, with Financials, Materials and Industrials suffering losses while the more defensive areas, such as Healthcare, Telecommunications and Consumer Staples led the way. The MSCI AC World Value Index also suffered a loss in June, while its growth counterpart was roughly unchanged.

Bonds

Highlighting the remarkable shift in market sentiment was a gain of 23.94% for high-yield, or “junk,” bonds in the second quarter, as measured by the Global High Yield sector of the Barclays Capital Global Aggregate Index, outpacing even the extraordinary gains in global equities. While concerns about corporate defaults by these lower-quality borrowers remained, investors were nonetheless attracted to the yields available from junk bonds as compensation against this risk.

A surge in commercial mortgage-backed securities (CMBS) over the course of the second quarter was also an example of the positive impact that U.S. government programs were having on investor sentiment. This rally was fuelled in large part by the announcement in May that legacy (previously issued) CMBS would be included in the expansion of the U.S. Term Asset-Backed Securities Loan Facility (TALF) program.
Emerging market debt (EMD), also perceived to be among the riskiest sectors of the fixed income markets, posted strong returns as well. However, gains for high yield bonds, CMBS and EMD were all pared as investors turned somewhat jittery again in the final weeks of the quarter.

Toward the second half of the quarter, investors became wary of the substantial debt governments had to take on in their efforts to bail out banks and other industries (such as automakers) and stimulate their economies. In particular, longer-dated government bonds sold off amid these concerns. Yields (which move inversely to prices) on U.S. 10-year Treasuries rose to just shy of 4.0% and their highest levels since the demise of Lehman Brothers, on concerns that the U.S. Federal Reserve’s program of buying government bonds (known as “quantitative easing”) will not be enough to meet the increase in supply.

The Economy

More forward-looking indicators such as consumer and business confidence and purchasing managers surveys on manufacturing and services activity showed improving trends across major developed economies over the course of the second quarter. However, the housing market continued to deteriorate in the U.S. as mortgage rates rose in tandem with rising U.S. Treasury yields. Rising rates combined with a continuing steady rise in the unemployment rate exacerbated the accelerating pace of delinquent payments and foreclosures. However, weekly jobless claims and the number of jobs being shed showed signs of leveling off in May and June. U.S. and UK retail sales made gains early on only to reverse them as the quarter wore on, casting doubt on recovery in the consumer sector.

Recession in Europe was worse than previously estimated in the first quarter, with an official EU estimate showing gross domestic product in the 16-nation eurozone contracted by a record 2.5%. Sharp falls were also registered in Eastern Europe. The dour sentiment was echoed in the UK, with the Bank of England labelling the economic outlook as "extraordinarily difficult.”

Still, oil prices surged on speculation that global demand will pick up, with WTI Cushing Crude ending the quarter over 40% higher, just shy of $70 per barrel. In the currency markets, mounting recovery hopes meant that the dollar continued to lose its appeal as a “safe haven” in times of global turmoil. It fell about 15% to $1.65 against sterling, while losing roughly 5% of its value against the euro to end the quarter near $1.40 and declining by 2.3% to about 96 yen.

Summary

While risks to the outlook for global financial markets remain historically high, with confidence still shaky and the health of global banks uncertain, in SEI’s view the worst of the recession is probably behind us. SEI believes credit conditions should continue to improve over the second half of this year, as the coordinated government and central bank response to the global credit crisis and recession it triggered really does appear to be gaining traction. If “less bad” news turns into “more good” news, investors would likely continue their move into riskier assets. However, setbacks are inevitable and will correspond with investors’ perceptions regarding the outlook for economic activity and corporate profitability.

SEI believes the environment for equity markets should improve in the latter half of the year as the global economy strengthens. However, the extreme levels of government and central bank stimulus will eventually need to be removed, and this could limit the growth potential of the global economy and corporate profits once they enter into a sustainable recovery. Equity markets may continue to struggle with setbacks as they attempt to climb a wall of worry and are constrained by still-declining earnings and tight conditions in the credit markets.

SEI believes non-government bond markets continue to offer better risk-adjusted opportunities for returns compared with government bonds. While defaults will certainly rise as the global recession continues, SEI believes investors continue to be amply compensated by the spreads offered in both high-yield and investment-grade corporate bonds, as well as mortgage-backed bonds and other structured securities (debt instruments made up of smaller loans packaged into a single security).

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SEI sources data directly from the following vendors: Factset, MSCI Barra, Russell, TOPIX, FTSE, Barclays Capital and Merrill Lynch. Where appropriate, returns in base currencies are converted to the relevant currency using WM Reuters 4pm Spot rates.