Fund Update
Credit markets lose flavor, investors find new appetites
The turmoil in the credit markets during the third quarter awakened many investors to risk in other areas of the market. The UNT Foundation’s diverse investment allocations enabled it to see a 2.8 percent return, which was a half-percent better than its benchmark. The Foundation’s portfolio has returned more than 16 percent in the last year, almost three full percentage points better than the S&P 500/Lehman Aggregate.
| Foundation portfolio (implemented 1/1/06) |
Benchmark 75/25 S&P 500/ Lehman Aggregate |
|
|---|---|---|
| Five years | 17.0% | 12.6% |
| Three years | 13.4% | 10.8% |
| One year | 16.5% | 13.6% |
| Quarter | 2.8% | 2.3% |
Hammond Associates, the Foundation’s investment consultant, stated in its Fall 2007 Research Report that capital markets have benefited from very favorable conditions over the last few years — ample liquidity, low interest rates, cheap credit, muted volatility, record high profit margins and strong global economic growth. This appeared to cause complacency and encouraged excessive risk-taking, particularly in credit markets as evidenced by razor-thin credit spreads.
What is the sub-prime meltdown?
An ongoing global economic condition in which lending institutions grant loans to “sub-prime” borrowers - those with a questionable credit record. Widespread default on these loans has led to financial difficulty for the lenders and their investors.
However, a shift in risk tolerance among investors began in June and continued into the third quarter. Worsening problems in the sub-prime mortgage market seemed a catalyst. As sub-prime mortgages losses continued to mount, investors seemed to recognize risks in other areas of the market. Many observers have called the recent problems a sub-prime contagion. More likely, sub-prime was the first symptom of the fallout from a period of excessive risk-taking.
Hammond reported the following general third-quarter conditions and their impact on markets.
- Equity markets shook off turmoil in credit markets with the S&P 500 gaining 2 percent during the quarter. The MSCI EAFE index benefited from a weak dollar. The index declined 2.5 percent in local currency terms, but rose 2.2 percent in U.S. dollar terms. Emerging markets continued to soar, rising 14.4 percent.
- The risk tolerance of investors continues to shift. Credit spreads widened substantially during the summer, with the option-adjusted-spread on high yield bonds moving from a low of 2.33 percent June 1 to 4.04 percent at the end of the third quarter. Sub-prime mortgage debt continued to plummet in value and demand for leveraged loans slowed.
- Treasuries benefited from a flight to quality with the yield on the 10-year Treasury falling from 5.03 percent to 4.59 percent. Treasuries were among the best performing asset class, earning 3.8 percent for the quarter. Uncertainty concerning the exposure of banks to losses in the credit markets caused money market rates to behave erratically during the quarter.
- The dollar continues to tumble in value. The trade-weighted dollar declined 5.4 percent during the third quarter and has fallen 8.6 percent so far in 2007. A weak dollar should help improve the current account deficit by improving the competitiveness of exports. While the dollar is undervalued on a purchasing power parity basis, it is likely to fall further in value in order to improve the trade deficit.
- A slowing U.S. economy is likely to place downward pressure on the profits for domestic companies. Falling productivity growth coupled with rising wage growth is likely to hurt profit margins. U.S. companies are benefiting from strong export growth, and overseas profits have risen 20 percent over the last year. Nonetheless, slowing profit growth seems likely and will act as a drag on domestic equities.
- Emerging markets are now trading at a premium to developed market stocks. They have benefited from rapid economic growth and higher commodity prices. However, history suggests caution, as emerging market firms have failed to outperform developed market stocks.
- Tighter credit markets are likely to slow the pace of mega-buyouts. Distressed debt and venture capital presently appear more attractive.
Hammond analysts predicted the following outlook in their Fall Report:
“The impact of higher spreads will be felt over the coming months as less credit-worthy borrowers will be forced to borrow at higher rates if financing is available at all. With the tighter credit conditions, large LBO activity has dried-up. Prices that made sense two months ago are now too high given current credit conditions, and banks have stopped providing bridge financing. Equity markets have temporarily lost a significant source of capital.
“Market conditions have eased after the Fed rate cuts; however, we wouldn’t bet that the worst is behind us. The easy financial conditions of the past few years created significant excesses, and the events of the third quarter were not enough to shake those excesses out. We have yet to see the effects that a slowdown in the economy resulting from the housing bust might have on capital markets. We would not be surprised to see a second leg to this credit crunch as corporate defaults rise.
“If conditions do deteriorate further, the silver lining is that it will create new opportunities to profit. The key is to protect assets in the meantime and be willing to accept risk when it pays well.
“The bear market earlier this decade created tremendous opportunities in international equities, particularly emerging market equities, and the wave of defaults also provided attractive distressed debt opportunities. While its hard to say at this point exactly what these opportunities will be, distressed debt again seems a likely candidate.”
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