Fourth Quarter 2009 Market Update

Summary

•  Gains in “riskier” assets continue at a slower pace as the rally matures
• Dubai World’s request for delay on debt payments roils markets before being resolved
• Uncertainties remain regarding market reactions to the eventual unwinding of fiscal and monetary stimulus

The MSCI AC World Index ($) rose 4.63% for the fourth quarter as the global recovery continued to take hold in fits and starts. While improving corporate profits stoked investor confidence, overall enthusiasm was limited due to both an increase in government debt and continued weakness in global labour markets.

In the global bond markets, the Barclays Capital Global Aggregate Bond Index ($) fell 0.85% over the quarter, as European and U.S. government bonds faced potential credit-quality downgrades. However, bonds that are perceived to be riskier, such as high-yield (those with lower credit ratings) and corporate bonds, still moved higher, buoyed by increasing profits for many companies.

Stocks

Economic data was generally supportive of global recovery hopes, but investors remained cautiously optimistic regarding the continued pace of rallies in equities, non-government bond markets and commodities over the past several months. While a generally upbeat mood still exists in the market, participants appear to be uncertain about what the upcoming year will bring, particularly when global governments and central banks begin to unwind the stimulus efforts put in place during the recent market dislocation.

Sector performance within the MSCI AC World Index continued to send mixed signals about investors’ recovery hopes. Among the sectors that are more sensitive to changes in the economic cycle (cyclical sectors), Materials led the way, climbing in line with a surge in copper, gold and other metals. Energy and Information Technology also outperformed the overall index, as oil prices moved higher and technology companies continued to show good prospects for the upcoming year in terms of free cash flow and business models focusing on consumer upgrades in the form of software and services. The cyclical Industrials sector slightly underperformed the index, joined by the more defensive Utilities and Telecommunications sectors among the laggards. Financials was the worst-performing sector for the quarter, falling both on fears surrounding the potential for default on Dubai World’s debt as well as increased European forecasts regarding the amount of bad debts still remaining on bank balance sheets.

Still, in a sign that cooler heads may be prevailing, the VIX index of implied volatility in the S&P 500 Index fell by roughly a fifth what it was at the end of September to just above 21 by quarter end.

Bonds

Performance for the year in the fixed-income markets was led by the riskier areas of the market, as the low-quality rally beginning in March gave way to a more balanced perspective among various non-government sectors. A lack of inflationary pressures and continued demand for higher yields were supportive of these non-government bond sectors, as corporate bonds, high-yield bonds (those rated below investment grade) and emerging-market debt moved higher. This was driven largely by glimmers of positive economic news in the form of small improvements in the U.S. labour markets and increasing optimism from UK business owners.

Government bonds in the U.S. Europe and the UK fell for the quarter, with UK gilts falling most, according to Barclays Capital. Standard & Poor’s downgraded Greek sovereign debt and it placed it on negative watch due to murkiness surrounding how the nation would deal with reducing its debt level. This move left European bond markets shaken and worried that other countries with high levels of debt might come under the same scrutiny.
Corporate bonds generally outperformed government bond markets around the globe, and high-yield bonds (those with poorer-quality credit ratings) outperformed their better-quality peers in the rest of the corporate sector as investors searched for yield. Despite a continuing rise in defaults for the commercial mortgage markets, commercial mortgage-backed securities (CMBS, made up of multiple smaller commercial real estate loans packaged into single securities) staged a significant rally for the year, led by those with lower credit-quality ratings. However, these securities were among the few areas in the fixed-income markets to experience a decline in the middle of the quarter.

Emerging-market debt outperformed the overall global bond markets, despite Dubai World’s announcement at the end of November that it was requesting a delay in paying some of its debt. Fears largely vanished after Abu Dhabi announced it would provide $10 billion to help Dubai World avoid default. However, investors wondered whether other emerging countries may face pressures similar to Dubai from an overabundance of debt.

Economy

Although weakness in labour markets continued around the globe, there were some signs of stabilisation in the U.S., The Department of Labour announced that only 11,000 jobs were lost in the month of November, the strongest numbers seen since December 2007. However, during mid-December, weekly jobless claims increased unexpectedly and caused concern that employment would face continued setbacks. In the UK, both purchasing managers and consumers showed increasing confidence in the economic recovery. Datamonitor Group reported that 70% of UK consumers expected to spend more than normal during their holiday shopping. Further signs of improvement also emerged in the U.S. and U.K. housing markets over the quarter.

European Union leaders remained committed to keeping stimulus measures in place until more signs of recovery are seen. In the UK, legislators have proposed a one-time 50% tax on banking bonuses; the European Union is planning to introduce similar measures. At the end of the year, the Bank of England kept interest rates steady at 0.50%, and the European Central Bank kept its rates unchanged at 1.0%.

Oil prices increased over the quarter, with WTI Cushing crude oil prices (a key indicator of movements in the oil market) ending at around $79.36 per barrel. A rebound in the dollar against some currencies earlier in the quarter helped suppress oil prices somewhat (a higher dollar would tend to reduce demand for oil, which is denominated in dollars, by making it more expensive in other currency terms).

The dollar rallied in December after experiencing weakness earlier in the quarter. The dollar rose 1% against sterling to roughly $1.62, and gained 2% to about $1.43 per euro. The U.S. currency was slightly stronger for the quarter against Japanese currency, ending around 92 yen.

Our View

SEI believes there have been continued signs of improvement in the world economy during the past quarter, which should keep the recovery in the global financial markets on track, although the pace of gains is likely to be more tempered in the months ahead. Currently, there is a focus on how interest-rate increases and the removal of bond-buying programs would affect the global economic recovery. In particular, we expect to see a more balanced performance between high- and low-quality stocks, large versus small companies and developed versus emerging markets. Assets that are perceived to be riskiest could continue to perform reasonably well as economic activity revives and corporate profitability improves, but the magnitude of the outperformance should diminish.

Similarly, the dramatic narrowing that has already occurred in the spread between the yields on non-government and government debt probably limits the potential for further price gains in non-government sectors. Although corporate bonds and high-yield debt are still attractive versus U.S. Treasuries (assets perceived to be the least risky), yields have fallen to levels that prevailed before the fall of Lehman Brothers. Emerging-market debt appears expensive, with yields having fallen close to the lows recorded at the previous peak in these markets.

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