Third Quarter 2008
There is an adage on Wall Street that the only thing that rises during a bear market is correlation. The events of the third quarter validated this saying as stock markets around the globe moved sharply downward in lockstep, with virtually no industry, sector, region, or country spared as investors headed for the exits. Investor appetite for risk vanished after the credit crisis enveloped the globe, not only putting the average investor at risk, but also resulting in the demise of some of the largest firms on Wall Street, including Lehman Brothers and Merrill Lynch. Five European banks were either nationalized or failed, and Ireland went so far as to guarantee the debt of its six largest financial firms.
When the quarter started, investors feared ever-higher commodity prices and rising inflation. A scant three months later, numerous commodities had tumbled and inflation was no longer a concern. Crude oil peaked in early July around $147/barrel and began its roller coaster ride down to below $100/barrel. The financial crisis in the U.S. had spread in one form or another to seemingly every country, resulting in talk of a global recession, and requiring central banks around the world to provide liquidity on an unprecedented scale, all in hopes of avoiding a financial meltdown. In effect, the credit markets had lost all credibility and only a concerted effort by the Federal Reserve, the European Central Bank, and others could hold off further deterioration in investor confidence.
Ironically, the U.S. dollar was a beneficiary of all the turmoil. The greenback was seen as a safe haven because the economic outlook in the U.S. suddenly looked better relative to other countries, many of which will likely see a slowdown in their economies as the U.S. struggles to right its ship. For the quarter, the dollar was stronger against almost all currencies, rising 4.8% versus the Canadian dollar, 11.7% versus the British pound, 12.2% against the euro, and 21.3% against the Brazilian real. The dollar’s jump versus the euro was the largest quarterly increase since the euro’s creation in 1999.
Investors who had benefited from a weaker dollar for most of the last five years were stung by the stronger dollar, pushing benchmark returns even further into negative territory. For the quarter, the Morgan Stanley All Country World ex USA Index (ACWI) fell a record 21.84%, while the Morgan Stanley Europe, Australasia and Far East (EAFE) Index, which measures the return of developed countries, slid 20.56%. Higher risk emerging markets, which had benefited from the run-up in commodities, fared worse than developed markets. The Morgan Stanley Emerging Market Index lost 26.95%, marking its worst quarterly performance since the Index inception in 1988.
Given the pervasiveness of the bear market, there was no economic sector that escaped the onslaught of sell orders. All ten economic sectors were decidedly in negative territory. Looking at performance for the Renaissance International Equity Strategy, a large portion of our underperformance versus its ACWI benchmark came from our relative overweights to the energy and materials sectors. In marked contrast to the previous quarter, materials and energy were two of our worst-performing sectors, with our materials positions falling by 39% and our average energy position losing over 30%. On the positive side, our financial stocks fared well, declining 7% versus the 17% decline in the average financial stock in the benchmark.
Similar to the end of the second quarter, the Portfolio finished with a 29% exposure to emerging markets. Both our emerging-market stocks and developed-market stocks underperformed for the quarter. Emerging-market stocks were hindered by our Brazilian holdings, which lost an average of 51%, and our Russian holdings, which lost 19%. Within developing markets, Norway and Canada detracted the most from performance, as those countries had higher weightings in the energy and materials sectors.
As we head into the home stretch for 2008, heightened market volatility seems like a sure bet. The pervasiveness of the credit crunch is of historic proportions. A key for the markets will be the ability of the United States to extricate itself from a financial abyss, a goal to which no one has a clear road map. Foreign markets outperformed the United States markets for five years running, but it appears that those markets will face an uphill battle to retain that crown this year. However, there are some positives for foreign companies. For instance, the stronger U.S. dollar should help exporters become more competitive in shipping their goods to the United States. The lower prices for oil and other commodities should alleviate inflation fears and may act as a catalyst for economic growth. Current market valuations of foreign markets relative to the United States also appear to be attractive on an historical basis, providing further incentive to invest overseas.
During these times of market unrest, it is important to maintain a consistent investment discipline. Part of our screening process utilizes a multi-factor model that includes estimate revision, valuation, momentum, and growth parameters. Certain factors are more effective than others over various times. During the last quarter, for instance, our growth and revision factors were generally ineffective, while valuation parameters added the most value. In the 14 years since the Strategy’s inception, we have experienced bouts of instability similar to this past quarter. Our proprietary screening model has been shown to be effective over market cycles and, based on our experience, we believe that staying the course, especially in these most trying times, is the correct path to take.
The views expressed represent the opinions of Renaissance Investment Management as of September 30, 2008 and are not intended as a forecast or guarantee of future results.
Disclosure
Any sectors, industries, or securities discussed should not be perceived as investment recommendations. Any securities discussed may no longer be held in an account’s portfolio. It should not be assumed that any of the securities transactions discussed were or will prove to be profitable, or that the investment recommendations we make in the future will be profitable.
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