Wednesday, January 16, 2008

Capital Markets 4th Quarter 2007

Concerns about the economic and financial risks associated with continued deterioration in the US housing market and a revitalization of the credit crisis during the fourth quarter drove losses in the equity and corporate debt markets while Treasury bonds rallied as investors fled from risk and uncertainty.

Asset prices recovered early in the quarter from midsummer’s credit panic as investors believed the Fed’s liquidity intervention in mid September and large write-off’s by bewildered bankers would substantially address the deteriorating credit and liquidity conditions. However, a substantial new batch of mortgage related downgrades along with escalating oil prices (57% increase in 2007) and an emerging picture of slowing corporate earning growth soured investor sentiment and depressed most market indices for the remainder of the year.

Global stock market results were heavily influenced by troubles in the credit markets for the quarter, though strength in international markets helped US investors and large US companies. Overall, US stocks lost -3.3% for the quarter per the Russell 3000. Full year stock returns were 5.14%, as growth outperformed value for both the quarter (-0.88% vs. -5.91%) and the full year (11.4% vs. -1.0%). Export exposed large capitalization stocks continued to outperform small cap stocks as the Russell 1000 outperformed the Russell 2000 for both the quarter ( -3.2% vs. -4.6%) and the full year ( 5.8% vs. -1.6%). Large capitalization companies derived about 44% of their revenue from overseas sources according to S&P. Financials, which is the largest capitalization weighted sector in the S&P 500 (17% weight at year end vs. 22% at the beginning of 2007), lost -15% for the quarter while energy, the best performing sector, gained only 4.1% for the quarter.

Sector performance generally followed the geographic exposure theme. Energy (32%), materials (20%) and technology (15.5%) were supported by strong international demand while financials (-20.8%), housing , real estate and consumer discretionary (-14.3) were stunted by domestic issues. Utilities (15.8%) traded as a higher yield alternative to bonds. Commercial real estate peaked early in the year and softened significantly through the rest in the face of tightening credit. The NAREIT index lost -12.0% during the fourth quarter, ending the year down -17.8%.

International stocks outperformed the US for the fifth straight year based on stronger growth prospects and a US dollar that reached new all time lows during the quarter. For the fourth quarter the MSCI EAFE lost -1.7% but ended the year with an 11.6% return, almost doubling those of the US. Amidst generally lackluster European returns, Germany stood out with a 22% annual return while Japan lost -4%. Emerging markets continued to benefit from the perception that their strong economic growth would be sustainable in the face of a global developed market slowdown. Emerging-markets stocks returned 3.7% and 39.8% for the forth quarter and full year respectively. Emerging markets overtook the US on a price/earning ratio basis this year. Net redemptions for U.S.-stock funds totaled nearly $31 billion, the highest outflows since 2002, while funds investing outside the U.S. enjoyed net inflows of $100 billion in 2007 per Bank of America.

High quality bonds for the most part had a strong fourth quarter, though spread products were challenged as the price of risk returned and spreads widened. The risks implicit in the “originate and distribute” model of mortgage banking became apparent this year. Structured investments became the markets “hot potato” as investors could not track how losses due to sub-prime mortgage related delinquencies, which rose to 16% in 2007, were distributed through these products. SIVs – a banker’s structured “sleigh of hand” to avoid regulatory capital requirements, came under further pressure as their funding source in the commercial paper market seized up. As a result, investors fled to the safety and security of US Treasuries driving their yields down for the quarter. Even safe havens such as enhanced cash funds and money market accounts became unsuspecting victims as the market for AAA short term collateralized issues sank.

Despite the fact that inflation appeared to be ascending, long duration Treasuries outperformed stocks and other domestic bond sectors for the year. Annual inflation growth was at a 17 year high of over 4%. The Lehman US Treasury Long Index returned 5.7% for the fourth quarter and 9.8% for 2007.

The lack of bond supply and strong demand no doubt offset an expected inflationary premium priced into bonds. Investment grade bonds had a good year, returning 3% for the quarter and 7% for the year per the Lehman Brothers Aggregate. The dispersion in returns across bond managers and bond index funds was high as individual credit positioning and mortgage exposure had a large impact on performance. The cost to buy credit protection also rose significantly through the fourth quarter. As spreads widened, high yield bonds lost ground, returning -1.1% and 2.2% for the fourth quarter and 1 year periods respectively.


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