Commentary: May 2009 Market and Performance Update

Good news trumps bad news amid mixed economic signals

• Investors largely ignore bad news to embrace tentative signs of recovery 
• Major indexes posted third consecutive month of gains
• Inter-bank rates at their lowest since before Lehman bankruptcy 
• Some forward-looking indicators and earnings releases look “less bad” 
• SEI believes economic conditions will continue to improve

Stocks extended their rally for a third month amid a slightly more mixed economic backdrop compared to the improving trend seen in April. Upbeat investors looked beyond any negative headlines and bet that the global economy was poised for recovery. In the bond markets, appetite remained strong for sectors that are perceived to be riskier, with commercial mortgage-backed securities, high-yield bonds (those with credit quality ratings below investment-grade) and emerging-markets debt posting some of the largest gains.

For the month, the Dow Jones Industrial Average rose 4.07%, the Standard and Poor’s 500 gained 5.31% and the Barclays Capital US Aggregate Bond Index rose 0.73%. The MSCI AC World Index was up 9.96% in May, with Financials and other sectors that are sensitive to economic cycles leading the way. From its lowest point reached on March 9, the global index was up 44.14% as May came to a close. The Barclays Capital Global Aggregate Index gained 3.57% despite losses in major government bond markets, which make up a substantial portion of the index. As investors’ appetite for risk improved, 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,” fell to its lowest levels since the collapse of Lehman Brothers in September last year, ending the month at 28.92.

Stocks

Global equity markets jumped at the start of the month amid a flurry of earnings reports that were either better-than or not-as-bad-as forecast. However, the second week of May brought unexpectedly weak U.S. and UK retail sales, poor reports on growth in European gross domestic product (GDP) and a downbeat assessment of the UK economy from the Bank of England. Still, stock markets were able to maintain their poise as more forward-looking economic indicators, such as consumer and business sentiment, and earnings outlooks continued to improve in general.

Bonds

Mixed data in May created the backdrop for a volatile month in fixed-income markets. Although equity volatility measures were down, the MOVE index, which represents the implied volatility of the Treasury yield curve, was up over 30%. Cash and short-term markets remain challenging as credit markets are thawing but are not yet completely liquid. Dislocations are still present, particularly in the Financials sector and in names that have maturities longer than three months. Two measures of risk, the TED spread¹ and Libor, have traded down to pre- Lehman bankruptcy levels, which is a sign that credit conditions are improving. Yet, even with an increased risk appetite, a large number of investors remain cautious to extend out in terms of credit.

Government bonds continued to be shunned, having lost their appeal as a safe haven from market turmoil and suffering from concerns about a glut of new supply as governments increase their borrowing to pay for stimulus measures. As a result of this divergence in performance in the fixed-income markets, the spread in yields (which move inversely to prices) between battered government bonds and outperforming non-government sectors narrowed sharply.

Longer-dated government bonds were particularly under pressure, with yields on the U.S. ten-year note briefly spiking above 3.7%, given concerns that bond purchasing by central banks will not be enough to meet the increase in supply. Investors in non-government sectors shrugged off the jump in government bond yields, which would normally be a concern as it would typically drive up borrowing costs in general.

Toward the end of the month, ratings agency Standard & Poor’s cut its outlook on the credit quality of UK government bonds from “stable” to “negative” citing concerns that debt levels could surpass 100% of GDP, which in turn exacerbated declines in government bonds. The change meant a potential downgrade from top-quality AAA status, and triggered concerns that other major government bonds, most notably U.S. Treasuries, might follow.
Still, investors were more influenced by signs of normal functioning returning to the credit markets, which included declines in inter-bank rates (rates that banks charge for lending to each other) to their lowest level since early September 2008 and strong demand for new issues of corporate debt. Corporate bonds outperformed the broader fixed-income markets despite the flood of new supply.

Municipal debt performed well three out of the four weeks in May. High grade municipals as a percentage of Treasuries continued the move lower, and Build America Bonds continued to aid the sector as supply remained robust. There was modest profit-taking in municipal bond investments as the end of the month approached, which was expected due to solid performance.

The Economy

More forward-looking indicators such as consumer and business confidence and purchasing managers surveys on manufacturing and services activity continued their improving trends across major developed economies in May. However, the housing markets continued to deteriorate in the U.S. amid rising mortgage rates, mounting foreclosures and an ongoing steady rise in continuing jobless claims. Although weekly jobless claims showed signs of leveling off, they remained near their peak levels reached in March. Declines in U.S. and UK retail sales, reversing the gains of the previous month, also cast some doubt on hopes for a rebound in consumer spending.

In the U.S., minutes from the Federal Open Market Committee (FOMC) meeting in April were released in May, stating the Committee remained cautious and ready to keep rates artificially low. It is expected that the FOMC will remain on hold for the foreseeable future and continue to aid where liquidity is needed. The FOMC minutes reflected the view that the economy is showing signs of stabilizing even as the Committee lowered its economic projections. Earlier in May, Fed Chairman Bernanke’s testimony before the Joint Economic Committee indicated that he expects the economy to bottom out and start to ascend later this year.

Recession in Europe was worse than previously estimated in the first quarter, with an official EU estimate showing GDP in the 16-nation euro zone contracted by a record 2.5%. Sharp falls were also registered in Eastern Europe. The dour sentiment was echoed in the UK, with the Bank of England labeling the economic outlook as "extraordinarily difficult.”

Still, oil prices surged on speculation that global demand will pick up, with WTI Cushing Crude ending the month nearly a third higher at $66.31 per barrel. 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 about 8% to $1.61 against sterling, while losing roughly 7% of its value against the euro to end the month near $1.42 and declining by 3% to about 95 yen.

Portfolio Review

During the month of May, markets continued to move upward and attitudes toward risk-taking improved. Investors responded positively to an increased amount of “less bad” economic news, helping our Funds to post mostly positive performance for the month. Despite intervention from the federal government, Federal Reserve and the Department of the Treasury, markets are still waiting to see renewed strength within consumer spending in order to be sure that economic recovery is taking hold. Job losses are still increasing, but the rate of increase has slowed. Overseas, economic data was mixed, but investor confidence strengthened in hopes that economic recovery might take hold late this year and into next year. Global fiscal stimulus seemed to help matters, but investors are exercising caution as there is still a long way to go before economic growth occurs.

In the fixed-income markets, yields rose (prices fell) for U.S. Treasuries, primarily driven by ongoing supply fears and positive sentiment towards riskier assets. The majority of spread sectors outperformed Treasuries in May. The investment grade credit sector posted positive excess returns as positive trends in economic releases and a light new issuance calendar led secondary spreads to move tighter throughout the month. At the end of May, Moody’s U.S. default rate rose to its highest level since June 2002. With credit conditions remaining tight compared with recent years and unemployment still increasing, rating agencies expect defaults to continue to climb, even after the
economy hits bottom.

What Worked in Our Portfolios	What Didn’t Work in Our Portfolios
Overweight to Financials and Information Technology in Large Cap – Financials continued their rally and IT companies have strong growth prospects.	Underweight to Energy and Materials in Large Cap– Increased commodity prices contributed to a rally in these sectors.
Fundamental Managers for Small Cap – Investors are positioning for economic growth later this year.	Exposure to Earnings Momentum in Small Cap – This was the worst-performing factor in May.
Stock Selection for Emerging Markets Equity – Benefited from Consumer Discretionary, Materials and Industrials sectors.	Stock Selection for Emerging Markets Equity – This was especially beneficial in the Utilities and Information Technology sectors.
Overweight to Argentina in Emerging Markets Debt – Bonds rallied 30% on news that the government will likely service its debt.	Security Selection in Russia for Emerging Markets Debt– Positions didn’t keep up with the broader market and were devalued in some cases.
Security Selection within the Chemicals sector for High Yield – Hexion bonds rallied on ample liquidity.	Underweight to Gaming and Banking sectors in High Yield – Both sectors continued to have outstanding performance in May.

Manager Positioning and Opportunities

Despite a reduction in overall market volatility, there is still a high level of individual stock volatility. Investors are focusing on improving credit fundamentals, but concerns remain surrounding the negative impacts faced by consumers, such as increased job losses and rising energy prices. Within investment-grade fixed-income markets, various spread sectors have tightened, and the corporate bond market was helped by the increased transparency that resulted from the government’s stress tests for banks. The investment landscape will likely remain volatile as appetites for risk increase and investors position for future growth prospects.

Within the large-cap portfolios, managers have shifted towards lowering their underweight to Industrials on the margin as they build positions in anticipation of economic recovery. The majority of the underweight is towards the aerospace and defense as well as towards machinery, both of which are under considerable stress. Despite the increase in energy and commodity prices over the past month, our large-cap managers have chosen to invest in other opportunities that stand to benefit from gains in market share and pricing power.

Within our small-cap portfolios, managers have shifted further out along the risk spectrum, bolstered by the continued tightening of high-yield spreads and improving fundamentals. Managers are seeing attractive opportunities within the Technology sector, and most managers continue to avoid the Biotechnology sector as these companies are heavily dependent on binary outcomes linked to product and/or drug approvals. The recent market dislocation continues to provide better risk and reward opportunities with the small- and small/mid-cap spaces.

In the emerging-markets equity space, the portfolio is currently overweight toward Brazil and Thailand and underweight toward Russia and China; however, these country weights are the result of fundamental stock selection and factors and not due to macroeconomic decisions. Within emerging-markets debt, managers are continuing to overweight high-beta securities amid some profit-taking.

Core fixed-income managers remain focused on securitized sectors as they believe these sectors represent the greatest fundamental relative value. Overweights toward non-agency mortgage-backed securities (MBS) are expected to benefit since this sector is substantially over-collateralized and at the top of the capital structure. There is also an overweight to agency MBS, as they have performed well in response to the government’s purchase programs, but this is being reduced because of better values in other sectors. Our high-yield managers have increased risk exposure, but overall, they still maintain a defensive posture with allocations toward bank loans and cash.

Summary

SEI’s view is that the worst of the recession is behind us and that credit conditions will continue to improve. The strong global policy response, both fiscal and monetary, really does appear to be gaining traction. As “less bad” news turns into “more good” news, investors should continue their move into riskier assets. However, setbacks are inevitable and will correspond with investors’ perceptions regarding the outlook for economic activity and corporate profitability.

SEI believes equity fundamentals should improve in the latter half of the year with a stronger economy. However, as long as confidence remains shaky and the health of global banks uncertain, risks remain unusually high. Furthermore, the extreme levels of government and central bank stimulus will eventually need to be removed. Equity markets may continue to struggle with setbacks as they attempt to climb a wall of worry and are constrained by still-declining earnings and tight conditions in the credit markets.

SEI believes non-government bond markets continue to offer better risk-adjusted opportunities for returns compared with government bonds. While defaults will certainly rise as the global recession continues, SEI believes investors continue to be amply compensated by the spreads offered in both high-yield and investment-grade corporate bonds, as well as mortgage-backed bonds and other structured securities.

¹ The TED spread is calculated as the difference between the three-month T-bill interest rate and three-month Libor; it is an indicator of credit risk that exists in the broad market.

Index Definitions

The Barclays Capital Global Aggregate Bond Index (formerly Lehman Brothers Global Aggregate Index), an unmanaged market capitalization weighted benchmark, tracks the performance of investment grade fixed income securities denominated in 13 currencies. The index reflects reinvestment of all distributions and changes in market prices.

The Barclays Capital U.S. Aggregate Bond Index (formerly Lehman Brothers U.S. Aggregate Bond Index) is a benchmark index composed of U.S. securities in Treasury, Government-Related, Corporate, and Securitized sectors. It includes securities that are of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $250 million.

Chicago Board Options Exchange Volatility Index (VIX) tracks the expected volatility in the S&P 500 over the next 30 days. A higher number indicates greater volatility.

The MSCI All Country World Index is a market capitalization weighted index composed of over 2,000 companies, and is representative of the market structure of 48 developed and emerging market countries in North and South America, Europe, Africa, and the Pacific Rim. The index is calculated with net dividends reinvested in U.S. dollars.

Disclosures

This material is for educational purposes only and is not meant to be investment advice. The reader should consult with his/her financial advisor for more information.

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.

To determine if the Fund(s) are an appropriate investment for you, carefully consider the investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the Fund's prospectus, which may be obtained by calling 1-800-DIAL-SEI. Read it carefully before investing.

SEI Investments Management Corporation (SIMC) is the adviser to the SEI funds, which are distributed by SEI Investments Distribution Co (SIDCO). SIMC and SIDCO are wholly-owned subsidiaries of SEI Investments Company.

Diversification may not protect against market risk. Current and future portfolio holdings are subject to risks as well.
In addition to the normal risks associated with equity investing, international investments may involve risk of capital loss from unfavorable 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. REIT investments are subject to changes in economic conditions, credit risk and interest rate fluctuations. Bonds and bond funds will decrease in value as interest rates rise.

Index performance returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Past performance does not guarantee future results.

For those SEI Funds which employ the 'manager of managers' structure, SEI Investments Management Corporation has the ultimate responsibility for the investment performance of the Fund due to its responsibility to oversee the sub-advisers and recommend their hiring, termination and replacement.

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• May Lose Value