Volatility Returns

In contrast to the calm market tone of the past few years, this past quarter saw the return of more historically typical volatility.

The positive tenor of 2006 continued strong into January and most of February of 2007, setting a new all-time high for the Dow Jones and a six year high for the S&P 500 on February 20. But this was nothing compared to the run up in China’s market…until it faltered more than 9% in one day (February 27) setting off a wave of sharp stock market retrenchments around the world, from which there has only been a partial recovery.

While some liken the internal Chinese stock market mentality to a giant casino, there is an undeniable fundamental validity to its recent market growth. China’s economy grew at a blistering 10.7% pace in 2006 and its trade surplus and consequent dollar reserves continue to expand. However, we think it’s significant that highest level Chinese officials are now publicly expressing concern over the pace of growth and the potential for excess liquidity and backing that up with a recent increase in borrowing rates. Further, China’s monetary authority announced a very modest effort (under 1%) to diversify the currency and asset class exposure of its gargantuan reserve accumulation. We thoroughly expect to hear lots more from China over time; and we will continue to devote considerable attention to the impacts for our clients of China’s risks and opportunities.

Meanwhile, it may be important to note that for most of our clients, direct exposure to China’s economy is very limited. Due to the limitations of China’s internal market and its still deficient accounting and legal regimes, our emerging markets funds focus primarily on China’s neighbor economies’ markets (Hong Kong, Taiwan, Malaysia, etc.) to get effective indirect exposure.

US Interest Rates Steady

Market volatility continued in March, reflecting in the US market concerns over elevated inflation (year over year core CPI is now 2.7%, not very severe in absolute, or historic, terms, but a good deal above the Fed’s target range of 1-2%) or the prospect of a recession (former Fed Chairman, but now private citizen, Alan Greenspan famously gives that a 1/3 chance by year-end) caused by carryover effects of the slowdown in the residential real estate market. The Fed’s decision to leave rates unchanged at its March 21st meeting signaled its conclusion that, for now at least, these risks are in rough balance.

The “Sub-prime lending” Brouhaha: What does it mean for our clients?

Probably very little. First, the greatest pain of what defaults will occur visits the defaulting borrowers most of all. Next come the mostly very large and diversified financial institutions that originate, package, and buy the sub-prime paper. Only third comes the general economy, which could suffer if defaults become very extensive and spill over to other real estate values and general consumer spending.

We think the general risks are not significant. Notwithstanding a good deal of media hand-wringing (and finger wagging) in this example of the “big, scary issue” of the month, the actual financial extent of the problem should be small, in part because it is so broadly distributed, including holdings by central banks, notably China’s. In any event, in the context of the $12 Trillion US economy, the total amount of sub-prime housing loans is tiny and, of course, only a small fraction of those will actually default. Interest rates on many of the variable mortgages may well already have increased as much as they are going to, jobs are plentiful (the unemployment rate just went down to 4.7%) and incomes are rising. Goldman Sachs and other investment bankers see big return opportunities for their portfolios of these obligations.

Still, a Good Start to the Year

Because of our manager and funds selection and our clients’ commitments to overseas small cap stocks and real estate, our clients portfolios did reasonably well, notwithstanding this quarter’s volatility.

On balance, then, we think this relatively modest first quarter of 2007 was a very good result, quelling an unsustainable euphoria we feared might overtake stock markets after the four great performance years leading up to 2007 while showing that the alternative is not a drastic, unrelenting plunge in value. Historically respectable, long term returns in the high single digits should serve our clients very well over the long horizons of their financial objectives. We expect the full year 2007 to produce aggregate, diversified portfolio return results in that vicinity, but probably with greater short-term (day to day, week to week) volatility in distinct portfolio components than many would like. “Liking” isn’t necessary; accepting is…in order to enjoy the higher returns that are the reward for tolerating this risk. Our efforts to broadly diversify clients’ portfolios among common stock asset classes and across lower correlation assets like fixed income, real estate, and commodities, are designed to limit this near-term volatility without significantly reducing the portfolio’s return potential.

Tim Kochis, Editor