Tuesday, May 08, 2007

First Quarter Commentary

Global Equity Markets “Shanghaied”
Along with a reminder that S---[1] happens, the capital markets provided diversified pension investors with a 1.6% return for the quarter, slightly under their pro-rated 8% annual target return. The quarter’s activity also left investors feeling, at least temporarily, more vulnerable due to the collapsing sub-prime mortgage market, declining corporate profitability and the increasingly obvious bipolarity of the Fed’s goals to both stimulate growth and throttle inflation.
The global equity markets, after being “shanghaied” on February 27, rebounded to finish the quarter in positive territory. The uniformity of the February drop indicated no particular geographical or style origin, though financials led the slump. Continued losses in the financial sector for the quarter (-3.4%) confirms that sub-prime fears more than anything triggered the event. The S&P 500 bottomed at -5.9% below its previous high for the year, though it regained over 6.7% as of tax day.

Within the US equity markets, large cap stocks returned +0.6% for the quarter per the S&P 500 index. Style distinctions were trivial, though the overall market returns masked a specific preference for smaller names (Russell Midcap +4.4%) and general distain for mega caps (Russell Top 200 -0.1%). Mid cap stocks lead the US equity market based on the energy sector as oil prices rose 11% during the quarter. The pricing support implied by private equity acquisitions also drove mid caps higher. Utilities and materials, also value sectors, performed well. Small caps returned +2.0% per the Russell 2000, though growth (+2.5%), lead by technology and healthcare, outperformed value (+1.5%).

The fact that investors continue to be indifferent to large caps is puzzling given they have long been considered to be the equity asset class of choice in uncertain times and also have a valuation advantage over smaller caps.

We think institutional investors’ fascination with alternative assets and retail investors’ propensity to chase performance account for some of this lack of interest. Alternative assets (i.e. real estate, private equity and hedge funds) now account for 10% of defined benefit plan assets. The growth in M&A and in particular private equity also appear to be a defining trend in this market. Private equity groups still have hordes of cash to put to work and can continue to shop the market as long as cash-flow yields exceed financing rates. However, their target size hasn’t yet reached the level of US blue chips, leaving large caps with little prospects beyond being proxies for global growth.

In international markets, US dollar investors enjoyed both strong local market returns and the positive foreign currency effect of a declining dollar. MSCI EAFE quarterly returns were +3.4% locally and +4.2% for un-hedged dollar investors. Small and mid caps ( MSCI EAFE Small Cap +7.2%) outperformed large caps internationally as well. The Pacific markets ex Japan generally outperformed Europe. The emerging markets, down -1.6% in February, snapped back in March returning +2.4% for the quarter per MSCI EM. The popular BRIC index didn’t recover from the quarter’s sell-off (-0.4%) as 3 of its 4 constituents ended the quarter down (Russia -3.0%, India -3.4%, China -2.3%, Brazil +6.2%).

Real estate was up just over 2% for the quarter ( NAREIT composite), though money flows were negative as investors feared further sub-prime damage. Hedge funds turned in a respectable quarter, adding 2.3% per the Hennessee Hedge Fund Index. Not surprisingly, merger arbitrage and distressed debt funds lead first quarter performance.

The quarter’s bond market returns don’t fully reflect yield volatility through the quarter. The Fed left short rates unchanged, though the yield curve oscillated with the unveiling of each new piece of economic data and Fed nuance throughout the quarter. Overall, rates fell across the curve, except for the long end, and the curve steepened by quarter end. The curve steepening presents a dilemma. If long rates continue to respond to higher expected inflation, this could act to further constrain economic growth forcing the Fed to cut rates more then might be necessary, sparking additional inflation fears. Returns dispersion across the fixed income sectors was tight Despite the quarter’s general shift in risk appetite, high yield provided the best quarterly returns among US fixed income at +2.7% per the Merrill Lynch High Yield index as defaults remained low. Credit spreads widened somewhat after the market dip in later February. The Lehman US TIPS index returned +2.5% for the quarter as inflation data surprised on the high side. The investment grade mortgage sector returned +1.5% for the quarter per the Merrill Lynch mortgage Master. It is predominantly AAA credits (i.e. Freddie Mac, Fannie Mae) and was minimally impacted by the sub-prime mortgage meltdown. Other domestic bond sectors bunched up in the +1.0% to +1.5% return range for the quarter. International bonds benefited from the quarter’s dollar decline returning +1.2% per the Merrill Lynch Global Broad Market ex US.

[1] Standard deviation

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