Commentary: January 2010 Market Update

Summary

• Global equity markets fell on concerns that tighter regulations will stymie growth
• Greek government bonds downgraded; Japanese government bonds warned of possible downgrade
• The Japanese yen and the U.S. dollar strengthened against sterling and the euro

Our view that the global economy will continue to recover, albeit in fits and starts, was confirmed in the month of January. While fourth-quarter gross domestic product (GDP) for the U.S. and UK turned positive, ongoing weakness in the labour markets and uncertainties about the sustainability of recovery persisted. While investors were willing to take more risks at the beginning of the month, this impulse was scaled back toward the end of the month, as China and the U.S. announced new regulations and requirements aimed at the banking industry. In China, banks were required to raise their reserve requirements, making it more difficult to lend, in order to control the nation’s rapid growth. In the U.S., the Obama administration proposed separating a bank’s deposit-taking activities from its more speculative business activities, such as making trades for its own profit.

The MSCI AC World Index ($) fell 4.31% in January, as optimism about the global recovery was dampened by the potential for tighter reins on Chinese monetary policy and increased U.S. regulation of the financial markets. The Barclays Capital Global Aggregate Bond Index ($) rose 0.41% over the month, posting smaller gains for government bonds and relatively larger gains for non-government fixed-income sectors that are considered to be riskier.

Stocks

Investors started the year with high hopes that they would see the global economy continue to grow and improve. As the month wore on, though, weak labour markets and a decrease in consumer spending presented challenges to sustained growth. In addition, the unknown effects of the gradual removal of government stimulus packages gave investors more reasons to be cautious about taking on additional risky assets.

Sector performance within the MSCI AC World Index emphasized investors’ caution, as many of them focused on sectors that are less sensitive to broad movements in the markets. For the month, these more defensive sectors led the Index; top performers were Healthcare and Consumer Staples. Information Technology lagged the market, as did the formerly best-performing Materials sector. Financials was again the worst performer, falling on fears that China will begin to slow the pace of its rapid growth and proposals from the Obama administration designed to limit certain higher-risk banking activities.

The Chicago Board Options Exchange Volatility Index (VIX), a measure of implied volatility in the S&P 500 Index that is also known as the “fear index,” rose from around 21 at the start of the month to just above 24 by the end of January, which has been attributed to growing doubts about the sustainability of the recovery.

Bonds

Performance in the fixed-income markets was slightly positive for January, and non-government bonds (which are perceived to be riskier) outperformed government bonds. Although investors were willing to take on additional risk at the start of the month, they returned to assets perceived to be safer on announcements about tighter Chinese monetary policy and increased U.S. regulation for the banking industry.

Greek sovereign (government) debt was downgraded by U.S. credit-ratings agency Standard & Poor’s (S&P), which expressed low confidence in the Greek government’s ability to limit its spending. As a result, the European Union reluctantly announced it would step in to support Greece as necessary, alleviating fears of larger issues in the euro zone. The Greek debt crisis put added negative pressure on the euro. Further negative news on the global government debt front occurred in the form of a downgrade warning for Japan by S&P due to its massive government spending and declining price environment.

Economy

Economic data for month showed that the world has continued to move forward from the turmoil of the past few years. In the UK, fourth-quarter GDP rose 0.10%, marking the nation’s emergence from its longest recession on record. However, this was lower than the forecasted estimate of 0.40%, casting doubts about whether the economy has enough momentum to recover or if it will start to contract again. In the U.S., fourth-quarter GDP rose 5.7% over the previous quarter, its fastest pace in six years. However, concerns remain about whether growth will remain robust after government stimulus efforts are taken away.

Labour markets remained weak worldwide, as the unemployment rate for Europe rose to match U.S. rates of 10%, its highest level in more than 11 years, and U.S. jobless claims rose unexpectedly. However, economic data for the UK released at the end of the month showed that improvements have continued to develop. House prices for the UK had their largest increase in five months, and UK consumer confidence rose in January for the first time in three months.

Oil prices fell for the month, with WTI Cushing crude oil prices (a key indicator of movements in the oil market) ending at around $72.90 per barrel. This decline was in response to several factors including a strengthening U.S. dollar, tighter Chinese central bank requirements, proposed U.S. financial regulation and warmer weather in North America.

The dollar continued its rally, strengthening against sterling, ending the month at roughly $1.60 per British pound and $1.39 per euro. On the other hand, the dollar weakened against Japanese currency, ending at around 90 yen. The yen gained against all of the 16 most-traded currencies for the month.

Our View

In SEI’s view, overly vigorous economic growth in China and other leading emerging economies may foster the need for additional monetary tightening, which could curb the rapid rallies we have seen in emerging-market stocks and bonds. At the other end of the spectrum, growth may continue to be rather slow in the developed world, especially in Europe and Japan. We are focusing on higher-quality sectors of the market and momentum strategies (those that look for market trends that are already in place and expected to continue going forward) that benefit from more consistent market trends.

Substantially increased fiscal restraint and continued low inflation should keep bond yields from rising significantly (yields move inversely to prices) and keep short-term interest rates low. We continue to see opportunities in credit, although the potential for appreciation is far less than it was last year. Although the consensus view on Treasury bonds is that it would be prudent to sell them, we would argue that low inflation and an exceedingly slow exit from monetary easing will offset the pressures of heavy debt issuance to a large extent. We expect trading to stay within a tight price range for an extended period.

The key concern in our view is the exit from governmental life support. A big increase in government spending was certainly the correct response as private-sector demand fell away in the latter part of 2008 and early 2009, but it may reduce economic growth potential over the long term, as stock prices usually fall during times when government spending rises substantially. While we remain optimistic about equities and fixed income, we are unsure whether investors have appropriately assessed the economic and market risks for the year ahead.

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