Investment Performance Services

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Financial Market Performance

The Economic Market

The structure of the US and global financial system is changing dramatically. Widespread credit problems have weakened many of the largest financial institutions and unprecedented intervention by the Federal Government has been needed to prevent widespread failures and a complete loss of confidence. Both the Federal Reserve and the Treasury Department in conjunction with the US Congress have established numerous programs designed to generate the liquidity and confidence needed to reestablish a functioning financial system. These unprecedented programs have been well publicized and are too complex to adequately explain in this brief overview. Further measures may still be needed.

The financial crisis has taken a toll on the economy and the probability of a protracted and severe recession is a great concern. Economic growth has slowed worldwide, unemployment is rising, consumer confidence has weakened and the problems in the housing sector persist. Lower interest rates and falling commodity prices will help, but not solve, the problems in the economy. Also, under these conditions, additional spending by the government seems very likely.

Defined benefit plans have had difficulty meeting their assumed rates of return in the past decade and the prospect for significant improvement in the near term is uncertain. The total return for the past ten years for the S&P 500 Index is a shocking 2.9%; the Lehman Brothers Aggregate Index returned 5.7%. With a traditional mix of 60/40% stocks and bonds the total return for the past ten years is 4%.

The US Equity Market

In response to the financial crisis and imminent recession, the stock market has fallen approximately 45% from the all-time high reached last October (10/9/07 to 10/27/08), and with extreme volatility.

With the exception of small cap value, all of the equity indices were down sharply in the third quarter. Value generally out-performed growth and the losses were broadly distributed with the S&P 500 down 8.4%, and the Russell 3000 down 8.7%.

In markets like these it is difficult to focus on the big picture. Keep in mind that bear markets like the one we are experiencing do not last forever and at some point a catalyst will emerge to drive stock prices higher. Predicting the timing of such catalysts has proven to be impossible to do consistently, as they frequently come without warning, and at a moment of maximum pessimism. Missing these market movements can dramatically hurt performance.

he International Equity Market

During the third quarter of 2008 international equity indices have been hurt by a strengthening dollar and increased concerns regarding the severity of the global financial crisis on less mature and sophisticated international markets. While currencies gains and losses are usually seen more as a short term phenomena, the weakening US dollar over the past six years has helped the international equity indices to post strong returns over longer time periods versus their domestic counterparts.

Even though the United States continues to have the largest GDP as compared to other developed and rapidly developing countries, our GDP growth has remained relatively consistent as compared to the same countries. While international equity markets have traditional been the tail that follows the trend of the domestic market, there are increased opportunities to diversify globally as the domestic market falls into recession.

The U.S. dollar generated a positve return versus the Yen, Euro, and British Pound Sterling during the third quarter of 2008. However, the currency downturn began in large part in 2002 as the Federal Reserve aggressively lowered interest rates in an effort to fuel our economy. The other countries have not been as aggressive regarding their monetary policy resulting in strong local currencies and export opportunities with the US.

The Bond Market

The bond market went into panic mode in September as a lifetime’s worth of historic and unprecedented events were packed into a single month. FNMA and FHLMC were placed into conservatorship, Lehman Brothers collapsed, Bank of America bought Merrill Lynch, the government bailed out AIG and guaranteed money market balances after the Reserve Primary Fund “broke the buck”, the FDIC seized Washington Mutual, which was the largest bank failure ever, and a $700 billion mortgage rescue plan was proposed by the Treasury but voted down by Congress.

Interest rates fell back toward the lows reached in this period of financial market stress, as a fierce flight-to-safety bid re-emerged. Three-month Treasury bills pushed temporarily into negative yield levels while the 30-year Treasury bonds made a new yield low. The Fed expanded liquidity facilities but otherwise kept policy rates unchanged through the end of the third quarter. The Fed did lower the target rate from 2.0% to 1.5% on October 8, 2008.

Yield Curve

The crisis of confidence, which centered on the finance sector as several established Wall Street giants struggled to survive, spilled over into the general market and credit spreads exploded in September. As spreads have increased, the price of corporate debt has dercreased. While this has created negative returns in the fixed income indices it has also created a buying opportunity for fixed income managers who are searching for value and larger yields.

The Real Estate Market

The credit crisis and the resulting weakness in economic activity are having its effect upon near-term future returns. Basic real estate fundamentals remain favorable but are being affected by developing recession in the economy. However, the most important factor is the poor state of the capital markets that is leading to a dramatic decline in transactions and rising capitalization rates, driving property values down. One forecaster who has been accurate in the past is looking for the NCRIEF Index to have the following returns for the next 3 years: 0% to -2% for 2008, -2% to -5% for 2009, and 2% to -2% for 2010, but these returns are heavily dependent upon the state of the economy. After that adjustment period, real estate returns should meet or exceed the long-term target of IPS of 7.5% net of fees.

The chart below indicates that a 0.50% rise in capitalization rates (the expected return for an investor) results in property price depreciation of -7.7%. However, the loss can be somewhat offset by rental income growth; a 6% rise in income in this scenario softens the negative return from -7.7% to -2.2%. This appears to be the environment the real estate market is facing in 2008.

Due mostly to re-balancing requests, many real estate funds have now developed queues for withdrawals. The most common procedure for handling queues is that each investor in the queue will receive a pro-rata percentage of cash as it becomes available for distribution. At the moment, queues appear manageable.