Overview

The credit crisis produced by rising defaults in U.S. subprime mortgage securitizations deepened as 2007 ended, and the outlook for recession in developed global markets intensified. As these forces took hold, the assumptions that had supported stock valuations over the past several years unwound, including confidence in steady corporate earnings growth spurred by rising trade between developed and emerging markets, and robust merger and acquisition activity driven by the availability of private equity capital and easy access to leverage. Because of this crisis, investors quickly shifted their focus to risk. And the long run of value investing, amplified by a booming financial industry and rising commodity prices, gave way to a resurgence of growth investing.

Stocks declined in this worsening economic outlook, particularly those with any potential exposure to subprime lending — from the housing and furnishings industry to any sector subject to further weakness in consumer spending. The strongest sectors were defensive, including consumer staples, utilities and healthcare. Energy also produced strong gains as oil prices briefly reached the $100-per-barrel level.

While the U.S. market was the most impacted by subprime troubles, European markets also felt the effects as loose underwriting standards, along with investments in collateralized debt obligations (CDOs) and short-term structured investment vehicles (SIVs) were present there as well. Weakness in European stock returns was somewhat masked by the strength of the pound and euro relative to the U.S. dollar, as non-dollar currencies were supported by divergence in central bank policies on short-term rates. The longstanding strength of Japan’s exporters waned in 2007 on reduced expectations for global trade and economic growth, and Japan’s domestic consumer spending remained stagnant. Strength in emerging markets, which rose 39.8% in dollar terms in 2007, offset the weaker results in developed markets.

U.S. bond returns were led by Treasuries as all other credit sectors were negatively impacted by wider interest rate spreads. Lower quality mortgages along with corporate and asset-backed issues witnessed sharply higher yields due to investor risk aversion, and high quality issues suffered moderately. Federal Reserve rate cuts brought short-term interest rates down from 5.25% to 4.25% and helped drive down rates across the yield curve, which supported solid total returns for bonds. And the U.S. Treasury yield curve steepened as the bond market began to anticipate further Fed rate cuts. The Banks of England and Canada also lowered rates, while Japan and the European Central Banks held rates steady. Coupled with central bank intervention to stabilize capital market problems in the latter half of the year, these actions supported modest positive returns for non-U.S. bonds.

With risk now at the forefront of investors’ concerns, CBIS’ focus on high credit quality in fixed-income portfolios and on strong fundamentals in actively managed equity portfolios should benefit participants during 2008. Indeed, it will likely take time for the recent excesses of abundant liquidity, poor underwriting standards, imprudent security structures and excessive leverage to be purged from securities markets. Despite the discomfort caused by the resulting downside volatility, the upside is that these market conditions create opportunities for active managers to augment returns for many years to come.