Market Commentary: Third Quarter 2009

Summary

• Economic improvement, rising risk appetite and low rates fuel search for higher returns
• Riskier segments of the stock and bond markets lead performance in the third quarter
• Spread between corporate, government bond yields back to pre-Lehman bankruptcy levels
• Expectations for emerging markets to lead global recovery boost emerging debt and equities

Market Overview

Just one year on from the collapse of Lehman Brothers, which brought the global financial system to its knees, a staggering shift in investors’ appetite for risk has taken place. Amid a combination of efforts by major central banks around the globe to keep interest rates at or near historic lows and improvement in economic indicators, many investors have left the perceived safety of government bonds and cash in search of higher returns. This has fuelled strong demand for assets that are perceived to be riskier, and therefore offer potentially greater returns for taking on that extra risk.

The MSCI AC World Index ($) rose 17.86% in the three months to the end of September and chalked up a cumulative gain of just shy of 70% from the lows reached on 9 March. As September came to a close, the index had erased roughly half of the loss it suffered amid the credit crisis, from its record high reached in October 2007 down to the lows of 9 March earlier this year. The Barclays Capital Global Aggregate Index ($) of bond markets staged a 6.23% rally during the third quarter, extending year-to-date gains to 7.85%.

More evidence came in during the quarter that the global economy has turned the corner from recession to recovery, and many companies also continued to report better-than-expected quarterly results. However, some of the biggest gainers during the quarter were companies that were still making a loss, albeit a smaller one than previously feared, or had escaped from bankruptcy for the time being.

As has been the case throughout the market recovery, stocks that had suffered the most during the credit crisis continued to lead the rally. This was reflected in the leadership of the cheapest stocks, particularly as measured by prices relative to book values (assets minus liabilities). Companies that had the highest levels of debt also strongly outperformed over the quarter, as more of these companies overcame fears that they wouldn’t be able to secure the funding they needed to remain in business.

In terms of sector performance within the MSCI AC World Index, these themes were reflected in the outperformance of areas that tend to be more sensitive to economic cycles and which were the hardest hit in the credit crisis. The Financials sector topped the list in the third quarter, as it has done since the rally from the March lows. The next best performing sectors in the third quarter were Materials and Industrials, while the more defensive areas of Utilities and Healthcare brought up the rear and lagged the index.

Energy stocks also lagged the MSCI AC World index return, as WTI Cushing crude oil prices ended the quarter just above $70, virtually unchanged from their level at the end of June. Still, that was more than double the low of near $30.00 reached in December last year.

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, ending the three months just shy of 26. 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 global equity markets over the quarter.

Bonds

U.S. high yield bonds, as measured by the Merrill Lynch US High Yield Master II Index ($), extended year-to-date gains to just shy of 50%, outpacing all other sectors of the global bond markets. While the rate of defaults continued to rise, sentiment improved as some companies that were previously on the brink of default were able to secure the necessary funding to remain solvent for the time being.

Despite a continued deterioration in the commercial real estate market, growing appetite for risk helped commercial mortgage-backed securities (CMBS, which are smaller commercial mortgages packaged together into single securities) sustain their impressive rally as well. The sector also continued to be among the best performing in the overall bond markets year to date, with gains of around 24% as measured by the Merrill Lynch CMBS Fixed Rate A-AAA Rated Index ($).

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 25% in the JPMorgan EMB Global Diversified Index ($).
Government bonds, which historically have tended to react negatively to strengthening economic data, posted gains in the third quarter amid expectations that, globally, inflation pressures should remain subdued and interest rates should remain very low for the foreseeable future. UK gilts outperformed all other major government bond markets amid some signs of continued weakness in the UK 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.

Economy

Among the more positive developments over the quarter was a developing trend of three consecutive monthly gains in the S&P Case-Shiller index of U.S. house prices, fanning hopes that the world’s largest economy was stabilizing. However, indicators of U.S. retail sales (by far the main driver of overall economic growth) showed a mixed picture. After some early signs of improvement, U.S. employment data also deteriorated again towards the end of the quarter.

UK house prices also showed sustained gains through the quarter, although the increases came amid a dearth of supply and failed to lift consumer spending. The eurozone’s purchasing managers index (PMI) of manufacturing activity rose to its highest level since December 2004, led by a surge in new orders. This news added to evidence that recession might be coming to an end in Europe.

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 4% against the euro to end the quarter at about $1.46, while declining 7% to around 90 yen. Sterling fell against all major currencies amid relative weakness in the UK economy and finished the quarter about 3% weaker at roughly $1.60.

Conclusion 

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 two quarters 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 coming through in the developed economies. Over the next year, SEI expects to see decent economic growth across the globe and a good rebound in corporate profits. However, as we get into 2010, there will be some headwinds, such as the massive debts that governments have taken on in the U.S. and Europe in their efforts to stimulate growth.

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 maturity 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.

Important Information:

Past performance is not a guarantee of future performance. Investment in the range of SEI’s Funds is intended as a long-term investment. The value of an investment and any income from it can go down as well as up. Investors may not get back the original amount invested. Additionally, this investment may not be suitable for everyone. If you should have any doubt whether it is suitable for you, you should obtain expert advice. No offer of any security is made hereby. Recipients of this information who intend to apply for shares in any SEI Fund are reminded that any such application may be made solely on the basis of the information contained in the Prospectus. 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 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.

If the investment is withdrawn in the early years it may not return the full amount invested. In addition to the normal risks associated with equity investing, international investments may involve risk of capital loss from unfavourable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Products of companies in which technology funds invest may be subject to severe competition and rapid obsolescence. SEI Funds may use derivative instruments such as futures, forwards, options, swaps, contracts for differences, credit derivatives, caps, floors and currency forward contracts. These instruments may be used for hedging purposes and/or investment purposes.

While considerable care has been taken to ensure the information contained within this document is accurate and up-to-date, no warranty is given as to the accuracy or completeness of any information and no liability is accepted for any errors or omissions in such information or any action taken on the basis of this information.

This information is approved, issued, and distributed by SEI Investments (Europe) Limited, 4th Floor, Time & Life Building, 1 Bruton Street, London W1J 6TL which is authorised and regulated by the Financial Services Authority. Please refer to our latest Full Prospectus (which includes information in relation to the use of derivatives and the risks associated with the use of derivative instruments), Simplified Prospectus and latest Annual or Interim Short Reports for more information on our funds. This information can be obtained by contacting your Financial Advisor or using the contact details shown above.

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.