December 2007 Investment Report
Credit-market concerns drove financial markets in November …
Following signs of economic weakness and easing inflation pressure in November, investors began anticipating the arrival of December 11th, the day the Federal Reserve would make a decision about short-term interest rates. The November employment report showed 94,000 jobs added to the economy. The market viewed this as neither an indicator of economic strength nor economic weakness. Accordingly, in order to prevent further deterioration of the economy, the markets signaled confidence that the Fed would act to stimulate the economy by lowering interest rates.
Indeed, the Fed ultimately lowered the Federal Funds rate, the overnight lending rate that influences borrowing costs throughout the economy, by one quarter of one percent to 4.25%. Additionally, to ensure that banks have access to additional funds, the Fed also lowered its discount rate by one quarter of one percent to 4.75%. The discount rate is the rate charged on direct loans from the Fed to banks. Despite taking action expected by the markets, the magnitude of the change was viewed as a disappointment. Many economists believed the economic weakness precipitated by the mortgage crisis justified a larger reduction in interest rates. As a result, stocks declined as more investors came to believe that an economic slowdown or recession was inevitable.
The Fed did take additional action to strengthen the availability of credit in the U.S. It introduced a “term auction facility” that added $40 billion for banks to borrow at rates below the discount rate. Central banks around the world including the European Central Bank, Bank of England, and the Bank of Canada announced similar measures. The first auctions seemed successful and investors became hopeful that sufficient cash would be available for loans and ease the credit crunch.
… but despite the Fed’s actions, turmoil in the credit markets lingered.
A large Swiss bank, UBS, announced another $10 billion in losses related to subprime mortgages as well as a cash infusion from an investor based in Singapore. Morgan Stanley also announced losses of $9.4 billion and Bear Stearns recognized an additional $1.9 billion loss. During the month Morgan Stanley received $5 billion from China Investment Corp and Merrill Lynch announced that it would receive capital from Singapore’s Temasek Holdings. Additionally, the two major bond rating agencies announced potential downgrades for the major companies that provide insurance to investors that hold a variety of different bonds. This action was viewed as unsettling by the markets and portends the likelihood of more losses associated with subprime debt.
Additionally, other economic announcements were unfavorably viewed by the markets. The core component of the Consumer Price Index experienced its biggest increase since 2005. The wholesale inflation index also moved higher. If the Federal Reserve believes that inflationary pressures abound in the U.S., it may be reluctant to further cut interest rates to try and stimulate the economy. Signs that the economy is slowing were reflected in orders for durable goods, which edged up only 0.1%, below expectations. Although consumer confidence improved in November, attitudes toward the job market worsened. News regarding housing continued to be weak. New home sales plunged by 9% in November, as the supply of houses for sale continued to rise. Existing home sales improved by 0.4% in November, but prices declined and the supply of homes for sale remained elevated. Finally, the Institute for Supply Management manufacturing index fell below the key 50 level (signifying expansion) to 47.7 signaling that the housing and financial troubles were beginning to affect the manufacturing sector.
Other factors affecting investment results in December included investors concern about the strength of the holiday shopping season. Additionally, rising energy prices were viewed as a sign of continuing pressure on inflation. Finally, the death of Pakistani opposition leader Benazir Bhutto reminded investors of instability of Middle East and the link to oil prices.
The annual phenomenon of rising stock prices known as the “Santa Claus” rally failed to appear in December. The S&P500 and Dow both declined 0.7%, and the Nasdaq fell 0.3%. Despite negative returns for the U.S. stock markets in the last two months of the year, stock investors recognized positive gains for 2007 with the S&P500 up 5.5%, the Dow up 8.9%, and the Nasdaq up 10.7%. Though International markets also declined in December, a commonly used global index of international stocks advanced 16.7% for the year. Although investment performance for bonds was positive in 2007, higher quality low risk bonds produced investment results significantly better than bonds perceived as riskier.
Investment Fund Review
Four of the daily priced funds offered by the General Board decreased in value in December. Only the Inflation Protection Fund increased in value. The Domestic Bond Fund was unchanged for the month. Three of the funds underperformed their performance benchmarks in the month. For the year, all of the funds ended with positive returns. Two of the funds outperformed their benchmarks.
The Inflation Protection Fund rose 0.5%, and outperformed its performance benchmark which lost 0.1%. The fund’s investment in commodities added to performance in December as the price of oil increased in the month.
For the year, the Inflation Protection Fund was the second best performing fund offered by the General Board and gained 11.1%, although the fund trailed its benchmark return of 11.8%. Several factors account for the below benchmark performance of the fund. U.S. inflation linked bonds are broadly viewed as the lowest risk long-term asset class. With increased investor uncertainty regarding the future of the economy resulting from worsening credit conditions in 2007, U.S. inflation-linked bonds were in high demand. The General Board has attained diversification in the Inflation Protection Fund through commodities and bonds linked to inflation issued by foreign countries. Although the contribution to performance from commodities and bonds from lesser developed countries actually added to the fund’s performance relative to its benchmark, the fund’s allocation to bonds from developed countries more than offset this performance improvement. Additionally, the fund incurred investment management and fund administration expenses of 0.45%.
The Domestic Bond Fund was unchanged in December and trailed its performance benchmark which gained 0.3%. Once again the fund’s holdings of mortgages that support affordable housing and community development programs was the primary reason why the fund’s December return lagged its benchmark. As has been reported here in the past, the General Board’s portfolio of loans is not traded on a public market. Accordingly, we derive an estimate of fair market value based on publicly traded bonds that have characteristics similar to the General Board’s loans. The market for the bonds from which we derive fair market value has been severely impacted by the credit crisis of 2007. Accordingly, the General Board saw the value of its portfolio of loans decline an additional 2% in December. This brings the total reduction in value for 2007 to slightly more than 11%. We wish to reiterate that the General Board has not experienced deterioration in the quality of its loans. We steadfastly believe that the quality of our loans is very strong and that the decline in value is strictly the result of near term market unease with credit conditions. We are highly confident that the fair value of our portfolio of loans will significantly increase, though we cannot say when. Additionally, in December, strength in the U.S. dollar adversely impacted the fund’s holdings of international bonds denominated in foreign currencies.
For the year the fund gained 4.3% but trailed the return of its performance benchmark which gained 6.3%. With the exception of the portfolio of affordable housing and community development loans, results from other segments of the fund were positive. The fund’s active broad market bond manager added significant value compared to the manager’s benchmark. The fund’s exposure to bonds from both developed and lesser developed countries also added value as the dollar weakened in 2007 and credit conditions in lesser developed countries improved. However, the positive contribution from these segments were overwhelmed by the more than 11% decline in the fair market value of the fund’s affordable housing and community development loans. Fund investment management and administration expenses were approximately 0.46% for the year.
The Domestic Stock Fund declined 1.1% in December and trailed its benchmark return by 0.4%. While the fund’s higher exposure to stocks of smaller company stocks helped performance, three of the funds managers meaningfully underperformed their benchmarks primarily due to their exposure to financial stocks, several of which declined significantly in December. Additionally, the fund’s exposure to stocks of real estate investment trusts also hurt performance.
For the year, the fund gained 6.3%, and surpassed the performance of its benchmark, which rose 5.1%. Factors contributing to the excess performance include: the small and mid-sized company investment managers added significant value compared to their respective benchmarks; additionally, the General Board’s investment in private real estate partnerships positively added to the fund’s performance. These positive factors were partially offset by the fund’s exposure to stocks of real estate investments trusts. After several years of excellent performance, an index of these stocks declined nearly 18% in 2007. Investment management and fund administration expenses also detracted approximately 0.68% from the fund’s return.
The International Stock Fund declined 1.4% in December matching the performance of its benchmark. The fund’s exposure to stocks of companies from lesser developed countries improved the fund’s performance, whereas the fund’s exposure to small companies and international real estate investment trusts detracted from performance.
For the year, the fund has gained 15.9% compared to the benchmark return of 16.7%. The difference closely matches the fund’s investment management and fund administration expenses of approximately 0.77%. The fund did benefit from its allocation to stocks of lesser developed countries and to its investment in international private real estate. However, the additional value from these two factors was offset by weak relative performance by the fund’s value manager and the fund’s emerging markets managers.
The Multiple Asset Fund declined in December by 0.7% compared to its benchmark which declined 0.5%. The underperformance is primarily attributable to worse than benchmark performance by the Domestic Stock Fund and the Domestic Bond Fund.
For the year, the fund gained 8.4% and slightly underperformed its benchmark which returned 8.5%. The Domestic Stock Fund positively contributed to the performance of MAF, but this was offset by lower than benchmark performance of the other three funds that comprise MAF.
The Balanced Social Values Plus Fund declined 0.4% in December, but outperformed its benchmark which fell 0.7%. For the year, the fund has gained 7.3% outpacing its performance benchmark of 5.8%. The fund is comprised primarily of two components: an index fund that replicates the Domini 400 Social Index and loans to fund affordable housing. The General Board replaced its active U.S. equity manager during 2007 with the index fund. At the end of 2007, the fund incurred investment management and fund administration expenses at an annual rate of approximately 0.35%. However, the actual expenses for the year were higher due to higher costs associated with active management.