October 2008 Investment Report

The financial system remained in turmoil …

It is safe to say that the excessive fluctuation in the financial markets during the month of October was unprecedented. Equity market indices experienced several of the largest absolute and percentage point swings ever recorded for any single month. Despite the fluctuations, the trend was to the downside and, late in the month, the Dow Jones Industrials reached a 5-year low.

… while the U.S. government tried to bring stability to the credit markets.

The month opened with the federal government implementing increasingly aggressive steps to re-establish confidence in the financial system. On October 3, upon the recommendation of the Bush Administration, Congress passed the Emergency Economic Stabilization Act of 2008, which included within it the Troubled Asset Recovery Plan (TARP). TARP was originally designed to purchase up to $700 billion in distressed assets from troubled financial institutions. Credit remained tight as banks instead chose to use any excess liquidity to rebuild depleted capital reserves. The Treasury Department was soon forced to alter TARP to provide direct equity infusions into the country’s largest financial institutions. The definition of an eligible institution was eventually expanded from depository financial institutions to include insurance companies and other third-party lending firms. A laundry list of various measures designed to free credit to the broad economy included:

• two Federal Reserve rate cuts of 0.50%, or 50 basis points (bps), reducing the target rate from 2% to 1%;
• an increase in FDIC insurance on bank deposits from $100,000 to $250,000; and
• the creation of money market and commercial paper liquidity facilities to jump-start frozen short-term credit markets.

Over the course of two short months, the era of the independent investment bank came to an end as the four largest firms were either acquired (Merrill Lynch by Bank of America), went bankrupt (Lehman Brothers) or converted to bank holding companies (Morgan Stanley and Goldman Sachs.) While most financial institutions looked to the federal government for rescue, private capital did play a role in two sizable transactions: Warren Buffett’s Berkshire Hathaway made a $5 billion preferred investment in Goldman Sachs, and Japanese financial conglomerate Mitsubishi UFJ invested $9 billion in Morgan Stanley.

Foreign markets mirrored domestic developments.

The credit crisis was not confined to the U.S., but spread rapidly around the globe to engulf both developed and emerging country markets. Central banks in many countries initiated bailout programs for banks, similar to TARP in the U.S. In fact, near the end of the month, the Fed even extended swap facilities to the G-10 central banks, providing unlimited dollar liquidity in exchange for a corresponding amount of local currency. Demand for the dollar accelerated in a general flight to quality, as investors sought the relative safety of Treasury securities. The dollar gained almost 11% against the Euro during October. One notable international development was the Argentine government’s announced “takeover” of the $26 billion privatized pension system to allegedly protect these assets from market turmoil, but most likely to gain access to fresh sources of liquidity.

Credit remained tight amid a flight to quality …

Interest rate spreads increased across the board despite rate cuts by the Fed and other measures to improve liquidity. AA rated 10-year credit spreads over 10-year Treasury bonds reached nearly 500 bps—up from 150 bps one year ago and up tenfold from 50 bps during the period from 2003 to early 2007. The three-month London Interbank Offering Rate (LIBOR) increased from 3% in the month to nearly 5%, but had retreated back near 3% by month-end as the Fed’s (and global central banks’) liquidity efforts began to gain traction. The yield curve steepened over the month as investor demand and Fed rate cuts drove the price of shorter-term maturity instruments down. At one point during the month, investors in very-short-dated Treasury bills were willing to accept slightly less than their principal investment because they were so worried that they would incur larger losses investing elsewhere. The yield on the 10-year bond increased from 3.8% to 4.0% due to investor focus on near-term liquidity.

… and the economic situation deteriorated.

Advanced third-quarter GDP confirmed most economists’ negative views with a reported 0.3% contraction. Consumer confidence, after posting higher results the last several months, fell dramatically from September (61) to October (38). Retail sales were down, even after excluding dismal auto sales results. Annualized auto sales of about 10 million units fell 15% in October and reached levels not seen since the early 1990s.    

One bright spot was the decline in commodity prices, with the heavily energy-weighted Dow Jones AIG benchmark declining 21% during the month. Crude oil futures on the New York Mercantile Exchange fell 33%, the largest monthly percentage drop since 1983. Average retail gasoline prices followed suit, dropping to around $2.50 per gallon, or 14% lower than at this time one year ago.

Market Reaction

Volatility was even more exaggerated in October than September, as investors tried to discern whether the government’s liquidity-enhancement efforts would actually succeed in reopening the credit markets. The Dow Jones Industrial Average’s drop of 14% was the biggest October decline since 1987, and the Dow had the most down days in a month since August 1973. In addition, the Dow posted its two biggest point gains on record, but also its second-biggest point drop ever. The S&P 500, which fell 17%, has not had such a volatile month since November 1929. Domestic small and mid-sized company stocks as measured by the Russell 2000 Index were off 20%, slightly worse than large company stocks. International equity markets contracted even more abruptly than in the U.S., with the developed market EAFE Index down about 20% and emerging markets down almost 28% for the month. A significant portion of this decline was attributable to the strengthening U.S. dollar.

Investment Fund Review

Inflation Protection Fund

• The Inflation Protection Fund underperformed its benchmark in October, primarily due to the fund’s 10% allocation to commodities. The Dow Jones AIG-Commodity Index fell 21.3% in October, as investors anticipated a reduction in demand for commodities due to the threat of a global recession. The fund’s allocation to inflation-protected securities in developing countries also declined due to significant strengthening of the U.S. dollar compared with developing-country currencies.
• For the year, the fund is underperforming its benchmark, again impacted by the declining value of commodities and the fund’s allocation to developing-market inflation-protected securities. With the focus on the credit crisis and slowing global growth, inflation concerns have become less of an issue for investors. Inflation-protected Treasury Securities have declined as the value of inflation protection has diminished. 

Domestic Bond Fund

• The Domestic Bond Fund declined in October, underperforming its benchmark. The fund’s allocation to foreign debt of developing countries and high yield bonds detracted from its performance.
• For the year, the fund remains ahead of its benchmark, reflecting the one-time adjustment to the pricing methodology for valuing the fund’s holding of positive social purpose investments.

Domestic Stock Fund

• The Domestic Stock Fund outperformed its benchmark in October, primarily due to the fund’s allocation to private real estate and private equity.
• For the year, the Domestic Stock Fund remains in negative territory but meaningfully ahead of its benchmark, due to the fund’s allocation to private equity and private real estate.

International Stock Fund

• The International Stock Fund declined in October, trailing its benchmark. This underperformance is primarily due to the fund’s allocation to developing countries and small companies, both of which declined more than the broad market as the risk of a global slowdown grew.
• For the year, the fund has meaningfully declined and is trailing its benchmark. Whereas individual manager performance has been strong, adding value above the benchmarks, allocation decisions have detracted from the fund’s performance. The largest detractor to performance has been the allocation to developing countries, which have declined by 53.4% year-to-date.

Multiple Asset Fund

• For the month, the fund is slightly ahead of its benchmark, due to the better-than-benchmark performance by the Domestic Stock Fund.
• For the year, the fund remains ahead of its benchmark, due to the strong benchmark-relative performance of the Domestic Stock Fund and the Domestic Bond Fund.

Balanced Social Values Plus Fund