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Commentary: Regulation and Recovery: A Volatile Mix

By SEI Investment Management Unit

Concerns about potential financial market regulation and rumbles out of Washington indicating that U.S. Federal Reserve Chairman Ben Bernanke may not be guaranteed a second term served as a catalyst for a market plunge in the closing weeks of January. China’s central bank added to the fray with its decision to limit lending in an effort of head off inflation, and weak economic data out of Europe further fuelled the selloff. While the purely economic issues cause us little concern—for the past few quarters, we have noted that we don’t expect the recovery to come with a smooth upward trajectory—the prospect of increased regulation is something we have highlighted as a potential risk to recovery.

President Obama’s plan for separating banks’ proprietary trading (conducting trades using the bank’s own money to make a profit for itself) from their lending activities—nicknamed “the Volcker Rule” after Paul Volcker, the former Federal Reserve chairman who has a long history championing banking regulations—is intended to limit the risks that banks would be able to take, such as using deposits to invest in speculative ventures. The regulations would not completely separate investment banking and commercial banking, but are a step in that direction. Mr. Volcker’s desire to limit these activities stems from his belief that since bank deposits are insured by the U.S. federal government, banks engage in higher-risk trades.

The Volcker Rule reflects the concerns of governments in the U.S., the UK and other developed markets that are wary of experiencing another financial meltdown like that seen in 2008. To that end, they are looking to protect consumers by separating the risky aspects of financial institutions’ business (such as proprietary trading) from the more stable businesses (like deposit-taking and lending). While no one expects reinstatement of Depression-era regulations such as the U.S. Glass-Steagall Act, which separated commercial banking from investment banking in an effort to protect consumers, the market does fear that the proposed regulations will negatively impact the profitability of financial institutions as well as limit their ability to attract and retain talent through incentive compensation. Goldman Sachs, one of the largest and most successful financial institutions, seems to be under particular pressure for its compensation policy and its business model of generating profit for the bank through proprietary trading, in part because of the government aid it borrowed and has since repaid.

Our View

Many factors are in play right now as the markets try to find their footing. China’s attempt to control its growth, continued weakness in European economic growth and high unemployment in both Europe and the U.S. have combined to provide a strong incentive to take profits after the equity market rebound. We believe a healthy skepticism of the continued growth in capital markets is warranted and the tempering of optimistic investor sentiment is appropriate.

From a regulation perspective, we expect some level of restrictions to be placed on proprietary trading as a result of the government’s policies. The fact that former Federal Reserve Chairman Paul Volcker has weighed in on this issue makes it more likely that regulation will be implemented in some form, as he is respected by both Democrats and Republicans. Rather than having a wholesale negative impact on the financial services industry, we anticipate more of an impact on specific financial institutions. For companies that have little profit generated from such activities, the impact will likely be small. For others that see this activity as more of a core business, the impact will be larger. This may also force some of the larger financial institutions who quickly registered as commercial banks at the height of the crisis (such as Goldman Sachs and Morgan Stanley) in order to gain access to the Federal Reserve’s discount window to rethink their organizational structures.

Our Investments

We remain fully invested in the equity markets and believe that the rally in 2009, which was driven by riskier assets with higher leverage and poorer-quality earnings, will transition to a more fundamentals-driven market where companies will be judged individually based on their position in the market and their growth prospects. Over the course of the past quarter we have allocated more to investment managers who, in our opinion, have strong security selection capabilities. We believe they are in a better position than other managers to navigate such an environment.

From a fund-specific standpoint, our U.S. positions in the Financials sector were generally in line with their respective benchmarks as of December 31, 2009. Within the commercial banking sub-sector, we held a relatively small allocation and an underweight position. Our Funds’ sector positioning and selected securities result from bottom-up stock selection decisions made by the underlying investment managers.

Looking Ahead

We do not believe these concerns or concerns over regulation will be sufficient to de-rail the economic recovery or the market recovery, but they do serve as a reminder of the risks inherent in the current market. These issues can manifest themselves not only in the equity markets but also in the currency markets, as investors fearful of more regulation may use this as an excuse to sell the dollar and buy gold—a commodity that we still believe is overpriced.

Important Information:

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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.