August 2007 Investment Report
Assessing the impact of the “credit crunch”…
A level of unease permeated financial markets in August as investors continued to assess the level of risk in the marketplace. There continued to be concerns about the housing industry, specifically the mortgage sector, and the credit markets overall. Mortgage defaults, particularly in the subprime sector, continue to trend upward. Demand for housing has slowed causing pain to a lot of homebuilders and mortgage companies. Even Countrywide Financial, the largest originator of mortgages, came under pressure from investors as the company’s ability to borrow to fund mortgages became limited as credit dried up. Merger and acquisition deals which helped propel stocks to all-time highs in July continued to slow as lenders have not been so eager to loan money. Unfortunately, the level of unease is elevated as investors are really unsure where the risk lies. Investors have been quick to react as troubles have moved from mortgage companies to homebuilders to hedge funds. They have sought the safest securities, sending stocks down and U.S. Treasury bond prices higher. The distress in the credit markets has some investors fearing the impact to economic growth. In their panic, investors have turned to the Federal Reserve for some reassurance.
…and the likelihood of the Federal Reserve lowering the interest rates.
The Federal Reserve, along with other central banks around the world, intervened in order to provide support to the volatile financial markets in August. In response to the tightening credit conditions and the absence of the availability of money, the Fed announced two repurchase agreement programs otherwise known as “repos.” With a repo, the Fed agrees to borrow certain types of securities from dealers in exchange for cash. Dealers then deposit the cash into commercial banks, thereby adding money or “liquidity” to the markets. The Fed added approximately $97 billion of liquidity to the financial system to “facilitate the orderly functioning of financial markets.” In addition to repos, the Fed also cut the discount rate, or the rate charged on direct loans to banks from the Fed. The rate was lowered from 6.25% to 5.75%. By lowering the rate, the Fed hoped to encourage borrowing, to add more liquidity into the markets, and to reassure investors that liquidity is available for deal-making. Additional support came at the end of August in a speech by Fed Chairman, Ben Bernanke. He reassured investors that the Fed would remain vigilant by being prepared to act to continue to support the economy, and that it would monitor economic data and the credit markets. President Bush, also provided reassurance by proposing various policies to address the prospect of rising home foreclosures.
Given the distress in the credit markets and the possible impact to economic growth, many investors are watching economic data and anticipating a cut in the Federal Funds rate (the rate at which banks lend to each other overnight). Economic data released in August was somewhat weaker than expected. Fewer jobs were added than expected. In the months ahead, employment levels will be closely watched, as consumers with jobs will be more apt to weather the housing storm. Against the backdrop of volatile markets and sour housing, consumer confidence declined in August. The Institute of Supply Management’s manufacturing index declined in August. Retail sales were modest. However, the second estimate for second quarter Gross Domestic Product, a measure of economic growth, was revised up to 4.0% from 3.4%. Weaker economic data may prompt the Federal Reserve to cut the Fed Funds rate, which would make borrowing cheaper and possibly help stocks. But, lowering the rate could also result in inflation.
Despite the volatility in the market, U.S. stocks surprisingly ended August with positive returns, though international stock markets fell. The S&P500 advanced 1.5%, the Nasdaq returned 2.1%, and the Dow was up 1.4%. Treasury yields continued to decline in August, as demand pushed prices higher. The 10 yr Treasury yield fell from 4.74% to 4.53% by month end. For the year, the stock indices remain in positive territory with the S&P500 up 5.2%, the Dow up 8.8%, and the Nasdaq up 8.1%. International markets continue to outperform domestic markets year to date with a global index of international stocks gaining 10.2%. Bonds have added between 2% and 3% since the beginning of the year.
Investment Fund Review
Two of the six daily priced funds offered by the General Board increased in value in August. The Domestic Stock Fund rose as equity markets responded to support from the Federal Reserve. The Balanced Social Values Plus Fund also rose due to strong performance by the equity manager. The International Stock Fund declined in value as riskier elements of the fund including smaller cap stocks and stocks of lesser developed markets underperformed the broader market. The Domestic Bond Fund and the Inflation Protection Fund declined in August, as yield spreads over Treasuries widened, sending bond prices down. Relative to performance benchmarks, August was a disappointing month for the General Board’s funds. Only the Balanced Social Values Plus Fund provided a return that surpassed its performance benchmark.
The Inflation Protection Fund declined 0.2%, significantly trailing its performance benchmark which gained 0.9%. The fund’s allocation to commodities hurt the performance in August. Additionally, a new allocation to inflation protected securities issued by governments of lesser developed markets fell in value during the month. For the year, the fund has gained 4.2%, and trails its benchmark return of 4.9%. The fund’s three diversifying strategies (commodities, international bonds from developed countries, and international bonds from developing countries) all detracted from the fund’s performance. U.S. Treasury Inflation Linked Bonds have produced strong performance through August, surpassing the performance of nearly every other type of fixed income investment.
The Domestic Bond Fund declined 0.5% in August, and also significantly trailed its performance benchmark which gained 1.2%. Two factors contributed to the fund’s disappointing performance in August. The fund has a significant allocation to mortgages that finance affordable housing and other social impact investments. While the General Board has experienced absolutely no deterioration in the quality of its loans, the fair market value of these loans was adversely impacted by credit conditions in the bond market. The General Board determines the fair market value of its loans based on prices for similar publicly traded securities. Because of the severe credit crisis caused by the subprime mortgage lending debacle, virtually all mortgage securities that are not insured by a federal agency saw a significant decrease in value. Accordingly, the General Board’s portfolio experienced a similar reduction in value. The General Board continues to have a high degree of confidence in the quality of these loans and we strongly believe that the fair market value of its loans will improve (although it may take several years before an increase in fair market value occurs).
Additionally, the fund was impaired by its allocation to fixed income securities issued by lesser developed markets, as investors sought to reduce risk in their portfolios. For the year, the fund has gained 1.1%, but trails its performance benchmark which has gained 2.8%. Virtually all of the underperformance is attributable to the aforementioned reduction in value of the fund’s mortgage portfolio that supports affordable housing and other social impact investments.
The Domestic Stock Fund gained 1.1% in August and underperformed its benchmark which gained 1.4%. The fund trailed its benchmark due to poor benchmark relative performance by several of the fund’s managers. For the year, the fund has gained 6.4%, and remains comfortably ahead of its benchmark which has risen 5.0%. Several factors accounted for the fund’s better than benchmark performance. The General Board’s small and mid-sized company investment managers have added significant value compared to their respective benchmarks for the year. Additionally, the General Board’s investment in private real estate partnerships continues to positively add to the fund’s performance.
The International Stock Fund declined 2.5% in August, behind its performance benchmark which declined 1.6%. The fund’s allocation to smaller companies and companies from lesser developed countries detracted from performance as these companies are perceived to have more risk. For the year, the fund has gained 11.1% compared to the benchmark return of 10.2%. Despite the negative impact on performance in August, the fund’s allocation to smaller companies and companies from lesser developed countries has positively impacted the fund’s performance for the year. Additionally, the fund’s allocation to international private real estate as also positively contributed to excess performance.
The Multiple Asset Fund declined in August returning -0.2% and significantly trailing its benchmark which gained 0.6%. The under performance is attributable to below benchmark performance by the four funds that comprise the Multiple Asset Fund. Despite a disappointing August, the fund has gained 6.0% which favorably compares to its benchmark return of 5.5%. The fund’s excess performance is attributable to the better than benchmark performance by the Domestic Stock Fund and the International Stock Fund.
The Balanced Social Values Plus Fund rose 1.7% in August, ahead of its benchmark which rose +1.2%. The primary factor contributing to the fund’s outperformance was the strong performance by the equity portion of the fund. For the year, the fund has gained 4.8%, outpacing its performance benchmark by 0.6%.