Market Commentary: August 2009

Summary:

• Further evidence the global economy is on the mend boosts stocks and bonds 
• After extraordinary gains, global stock markets seen slowing 
• U.S. job market shows signs of improving, Germany and France emerge from recession 
• Oil prices hold steady despite global recovery optimism

Market Overview

Evidence mounted in August that the global economy has turned the corner from recession to recovery, while many companies continued to report better profits than expected. The continuing trend of good news sent the MSCI AC World Index ($) 3.58% higher in August, with Financials and other sectors that are sensitive to economic cycles continuing to lead the way. However, with the MSCI AC World Index having gained 59.29% from lows recorded on 9 March, analysts were generally forecasting a more subdued market for the rest of the year.

The Barclays Capital Global Aggregate Index ($) of bond markets gained 1.76% amid the growing appetite for risk among investors. Gains were led by some of the sectors considered to be the most risky, such as high yield bonds (those with poorer credit quality ratings) and commercial mortgage-backed securities (CMBS), as investors continued to show a preference for higher yields over the perceived safety of government bonds and cash.

The VIX Index, a measure of implied volatility in the S&P 500 Index that is also known as the “fear index,” was little changed over the month, ending August at 26.01. However, volatility remained higher than its long-term average and there continued to be large gaps between the best and worst performing stocks and sectors in the MSCI AC World Index over the month.

Stocks

Investor optimism continued in full force in August, having overcome a brief bout of skepticism in late June, as the trend of encouraging economic news and generally better-than-forecast corporate profits extended through another month.

The Financials sector was by far the main driver of returns in August, posting gains of nearly twice the Industrials sector, the next best performing area within the MSCI AC World Index. While the bulk of the better-than-expected earnings reported by financial companies came in July, a few more added fuel in August to keep the rally in the sector going strong. The Utilities sector performed roughly in line with the overall index, driven mainly by gains at Germany’s E.ON, and all other sectors trailed behind. No sectors within the MSCI AC World Index posted a loss for the month.

Despite all the economic optimism, Energy was the second worst performing sector behind Telecommunications. WTI Cushing crude oil prices were roughly unchanged over the month as well, finishing August at $69.96 per barrel, compared to $69.45 at the end of July. Still, that was more than double the low of near $30.00 reached in December last year.

Recovery hopes drove a large outperformance of the MSCI AC World Value Index ($) compared to the MSCI AC World Growth Index ($) over the month, with respective gains of 5.20% and 1.93%. Because value stocks (those with cheap valuations) are perceived to be more vulnerable to losses, they have tended to sell off more during down markets compared to growth stocks, and also have historically tended to lead when markets rebounded during a recovery.

Bonds

High yield bonds, as measured by the Merrill Lynch US High Yield Master II Index ($), extended year-to-date gains to over 40%, although gains did slow towards the end of the month as some investors began to book profits following the extraordinary rebound in the sector.

Despite a continued deterioration in the commercial real estate market, growing appetite for risk helped CMBS sustain its impressive rally. The sector also continued to be among the best performing in the overall bond markets in the year to date, with gains of around 20% as measured by the Merrill Lynch CMBS Fixed Rate A-AAA Rated Index ($). The Merrill Lynch CMBS Fixed Rate BBB Rated Index ($), made up of lower-rated, poorer credit-quality securities, was up even more, gaining nearly 30% in the same time period. Emerging market debt, another sector considered to be among the riskiest, also continued to be among this year’s top performers, with year-to-date gains of over 20% in the JPMorgan EMB Global Diversified Index ($).

Government bonds, which would normally tend to react negatively to strengthening economic data, also posted good gains in August amid expectations that, globally, inflation pressures should remain subdued and interest rates should remain very low for the foreseeable future. U.K. gilts outperformed all other major government bond markets amid some signs of continued weakness in the U.K. economy and news that the Bank of England would extend its bond-buying program by an additional £50 billion to a total of £200 billion.

The Economy

The month got off to a strong start with a larger drop in U.S. job losses than forecast, together with the first dip in the unemployment rate since last April. The news fanned hopes that the fragile labour market was on the mend and that the world’s largest economy was stabilizing.

The U.S. housing market showed signs of finally stabilising, as the S&P Case-Shiller index of house prices moved higher for the second straight month in the August release. Home prices were also higher by a modest amount in the second quarter compared to the first, for the first quarterly gain in three years.

Retail sales indicators in the U.S., where consumer spending is by far the main driver of growth, remained weak throughout the month. However, in a sign of hope for an improving trend, figures released in the last week of the month showed the Conference Board’s Consumer Confidence Index climbed in August amid surging equities and signs of improvement in the housing market.

The eurozone economy contracted by a smaller-than-expected 0.1% in the second quarter, surprising the majority of forecasters, figures released early in the month showed. Its two largest members, France and Germany, pulled out of recession and both posted growth in gross domestic product (GDP) of 0.3% in the second quarter. The second estimate of U.K. second-quarter GDP showed a smaller drop than the first estimate, but at 0.7% it was still a substantial decline.

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 a little over 1% against the euro to end the month at about $1.44, while declining 2.5% to around 93 yen. Sterling fell against all major currencies, including the dollar, amid relative weakness in the U.K. economy.

Summary

In SEI’s view, global equity markets should be able to extend their rally through the rest of this year, as long as there continues to be supporting evidence that the global economy is improving and corporate profits are rising. However, we believe it is unlikely that the pace of gains witnessed over the past five months can be sustained through the rest of the year.

SEI believes the global economy is going through a healing process, with growth continuing in the developing economies of the world and signs of improvement in developed economies. Over the next year, SEI expects to see decent economic growth across the globe and a rebound in corporate profits. However, as we approach 2010, there will be some headwinds, such as the massive debts that governments have taken on in the U.S. and Europe in efforts to stimulate growth. Further increases in oil and other commodity prices could also put a dent in consumers’ discretionary spending.

We remain optimistic regarding the corporate bond markets. Although high-yield corporate bonds have appreciated strongly, yield spreads (the difference between the higher yields available in this sector compared to equivalent government bonds) remain attractive. We expect non-government bonds to continue to outperform government debt if economic growth turns positive and corporate cash flows improve.

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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.