November 2008 Investment Report

Early November saw more of the same as October …

Many of the same themes from October continued into November: worsening credit conditions despite strenuous efforts to improve liquidity in the financial system by the Fed and the Treasury Department, a deteriorating economy and volatile markets. Major equity markets declined throughout the first part of the month. Excitement over the election of Barack Obama as president subsided quickly, as the markets declined 5% for two consecutive days following his election—the largest post-election losses in history. At its lowest point on November 20, the S&P 500 reached a seven-year low.

… amid a worsening economic picture …

A report by the National Bureau of Economic Research (NBER) issued at the end of the month stated that the economy has, in fact, been in recession since late 2007—despite government reports showing Gross Domestic Product declining only in the third quarter of 2008. NBER’s analysis referred to data indicating that payroll employment reached a peak in December 2007 and has declined every month since then. Additionally, the Labor Department reported that the unemployment rate continued to climb, reaching 6.5% in October.

Consumer confidence, after falling dramatically from September to October, actually rebounded in November. Retail sales, a more definitive indicator of consumer behavior, were down 1.8% from October and 7.4% year-over-year, marking the fifth consecutive month of retail sales declines. In fact, discount retail operations, such as Wal-Mart, have been the only ones showing positive sales growth in this dismal retail environment. In addition, auto sales were down 25%, prompting auto manufacturers to seek financial assistance from the U.S. government.

The housing market showed no signs of recovery, with the primary indicators—existing and new home sales and housing starts—down from the previous month. Facilitating access to credit by home buyers appears to be an increasing focus of the government’s credit stimulus programs.

Commodity prices continued to be a source of good news to consumers as bellwether crude oil futures prices dropped a further 28% to below $50 during the month. Average gasoline prices dropped below $2 a gallon, as energy consumption has declined as a result of the worldwide economic slump.

… and renewed government efforts to stimulate credit markets.

The government persisted in its efforts to revive credit markets by implementing several additional measures in November. These included a new, less onerous rescue plan for AIG that expands the total amount of federal assistance to $150 billion. The program also included a proposed plan to bail out Citigroup with a fresh $20 billion equity infusion and the possibility of purchasing up to $250 billion in distressed assets. Additionally, the government implemented a new $800 billion plan to make direct purchases of private-sector debt, such as commercial paper, asset-backed securities, agency and mortgage-backed securities. Reports near the end of the month indicated that the Treasury Department had exhausted nearly all of the first $350 billion in funds from the $700 billion Troubled Asset Relief Program (TARP).

President-elect Obama outlined a potential $500 billion fiscal stimulus package including spending and tax-cut measures that would be enacted over the next two years. In an effort to foster a sense of stability in his transition, Mr. Obama also announced that Federal Reserve Governor Timothy Geithner, who has been an instrumental contributor to the Federal Reserve’s recent initiatives, would be appointed Treasury Secretary and become a key member of the new administration’s growing economic team.

Credit markets showed no signs of recovery.

The fact that interest rates on U.S. Treasury securities reached new lows during November was indicative of the continuing flight to quality by bond investors. The 10-year Treasury bond, which had been trading with an interest rate in the 3.5% to 4% range since mid-September, increased in price as its interest rate dropped to below 3% as a result of concern about the deteriorating economic picture. This drop in longer-term rates is primarily due to investors anticipating attempts by the Federal Reserve to further stimulate lending by banks at more affordable interest rates for consumers. Interest rate spreads for high-quality debt, such as investment-grade corporate bonds, did tighten, but they continued to remain high by historical standards. Mortgage rates declined below 6% on 10-year and 30-year fixed mortgages, as the government indicated it would increasingly focus on helping housing markets, which are perceived to be at the heart of the country’s economic troubles. The London Interbank Offering Rate (LIBOR) returned to more normal levels.

Market Reaction

As mentioned above, the markets’ downward trend in October continued into November. The Russell 3000 Index declined 23% through November 20. It then rallied in the final days of the month after the Citigroup bailout was announced, limiting November’s decline to 8%. This “hockey stick” pattern was fairly typical of other broad domestic and international stock market indices. Small-company stocks performed worse than large-company stocks, with the Russell 2000 Index of small companies down almost 12% for the month. One submarket that has seen extreme volatility is the domestic real estate securities (REIT) market, which dropped about 40% by mid-month only to rally 25%, but nevertheless registering a monthly decline of 24%. Real estate is seen as a lagging indicator, so the REIT market volatility is a likely consequence of investor perception of increasingly troubling real estate fundamentals in the face of worsening economic data. Unfortunately, the good news of the market recovery in late November was dampened by the horrific story of the terrorist attacks in Mumbai, India.

Investment Fund Review

Inflation Protection Fund

• The Inflation Protection Fund once again underperformed its benchmark in November due to the fund’s diversification into inflation-based strategies other than U.S. Treasury Inflation Protected Securities. The largest detractor from performance was the fund’s 10% allocation to commodities. After declining 21.3% in October, the Dow Jones AIG-Commodity Index fell 16.8% in November and was led by a continuing rapid decline in the price of oil. As a result of the global economic contraction, the demand for all types of commodities has declined precipitously. The fund is also diversified by holding inflation-linked bonds from developed and developing foreign countries. Global investors’ risk aversion has negatively affected nearly all asset classes other than U.S. government-issued debt.
• For the year, the fund is significantly underperforming its benchmark for the same reasons cited above. The fund’s commodities investments have declined nearly 48% since the beginning of the year. The fund’s investments in inflation-linked bonds from developing countries have declined nearly 21%. Despite this very disappointing performance, the General Board continues to adhere to its philosophy of building broadly diversified funds and believes that such a strategy will prove to benefit its participants in the long term.

• The Domestic Bond Fund advanced 1.7% in November, though the dispersion among the various fixed-income sectors was significant. U.S. Treasury interest rates continued to decline as a result of global risk aversion, leading to price improvements for these securities. Additionally, higher-quality investment-grade bonds performed very well as investors realized that prospective returns for quality bonds were very attractive. However, below-investment-grade bonds continued their rapid decline due to higher levels of perceived risk and the expected impact of a prolonged economic recession. The best performing manager in the Domestic Bond Fund was a portfolio of high-grade corporate bonds, which advanced 4.2%. However, a portfolio of below-investment-grade bonds declined 6.1%. Despite the broad dispersion among the various elements of the fund, the Domestic Bond Fund just marginally underperformed the performance benchmark.
• For the year, the fund remains meaningfully ahead of its benchmark. This better-than-benchmark performance is primarily attributable to the performance of the fund’s positive social purpose investments supporting affordable housing and community development projects. The fund’s investments benefited from a one-time adjustment to the pricing methodology for valuing the fund’s holdings. Additionally, the performance of the fund’s core manager, PIMCO, has meaningfully surpassed its performance benchmark. These two positive contributors, however, were offset by the fund’s lower-than-benchmark holdings of U.S. Treasury securities. As with the Inflation Protection Fund, the Domestic Bond Fund is broadly diversified by holding below-investment-grade bonds and international bonds from both developed and developing countries. The global economic crisis has resulted in virtually all non-U.S. government bonds underperforming U.S. Treasury securities.

• The Domestic Stock Fund matched the performance of its benchmark in November. The portfolio benefited from its exposure to private real estate and private equity, though performance was impaired by its higher-than-benchmark exposure to stocks of small and mid-sized companies, which performed significantly worse than the overall U.S. stock market.
• For the year, the Domestic Stock Fund has declined significantly, losing 35% of its value. Compared with its benchmark, the fund has benefited from the benchmark-relative performance of its small and mid-sized company investment managers, which have collectively outperformed their benchmarks. The fund has also benefited from its exposure to private real estate and private equity.

• The International Stock Fund significantly declined in November and also trailed its benchmark by 1.1%. The underperformance is primarily due to the fund’s developed market managers underperforming their respective benchmarks and the fund’s higher-than-benchmark weighting in stocks from underdeveloped countries.
• For the year, the fund has lost half of its value and has performed slightly worse than the performance benchmark. Although, collectively, the fund’s managers have performed better than their respective benchmarks, the fund’s higher-than-benchmark weighting in stocks from developing countries and the fund’s diversification into international real estate securities both negatively contributed to its benchmark-relative performance.

• For the month, the fund underperformed its benchmark as all of its underlying funds, with the exception of the Domestic Stock Fund, underperformed their respective benchmarks.
• 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, though this has been partially offset by the significant underperformance of the Inflation Protection Fund.