The year ended on a down note for equities as concerns about a potential recession and higher inflation (stagflation) weighed on investors’ minds. For the year, the S&P 500 ended up 5.5%, well below the average of 11.8% over the past 20 years. Of particular note in 2007 was that growth outperformed value in all capitalizations for the first time this century (see table below).
Also, in a reversal from most of the decade, large cap stocks outperformed small cap stocks. In particular, the largest of the large cap stocks (mega caps) outperformed all other stocks on average.
Among sectors, energy stocks outperformed as the price of oil soared to record highs nearing $100 per barrel. Technology, a traditional growth sector, also posted a strong year with a return north of 16%. Conversely, financials lagged all other sectors. Problems in sub-prime mortgages, which started in February, spread to other areas of the credit markets throughout the year. One result was investors’ flight to liquidity and quality. The problems in sub-prime coupled with higher energy prices also weighed on consumer spending. Shares of consumer related stocks were down more than 13% for the year.
International stocks continued their impressive run in 2007 as the MSCI EAFE returned 11.2% for the year. However, much of the gain was due to the weak U.S. dollar. In local currency terms, the EAFE gained only 3.5%, less than the U.S. market return of +5.5%. In regional performance, Europe outperformed Japan and most other Far East and Pacific Rim countries (see table below). Performance among countries was mixed as Finland (+48.7%), Hong Kong (+41.2%), and Germany (+35.2%) all posted huge gains in both local currency terms and dollar terms. Japan’s market was down more than 10% in local currency terms in 2007, its first losing year since 2002. Emerging markets continued their stunning performance with the MSCI Emerging Markets index rising 39.8% for the year. There were some dramatic performances within the developing markets, perhaps the most notable being the 59% rise in the MSCI BRIC (Brazil, Russia, India, China) index. Most of those gains were due to the performance of infrastructure stocks, particularly in the rapidly developing economies of China and India.
Fixed-income had its best year since 2002 as the Lehman Aggregate Bond Index returned 7.0%. Yields across all maturities declined, with shorter term (three months to five years) maturities falling more than 1.25%. The yield curve steepened throughout the year as short-term rates, represented by the two-year reasury, fell from 4.8% to 3.1%, a decline of 170 basis points. Meanwhile, long-term rates, represented by the 10-year treasury, remained relatively flat, declining about 60 basis points to 4.1%. After 17 successive interest rate increases from 2003 to 2006, the Federal Reserve cut the Federal Funds rate in the second half of the year with one 50 basis point cut in September and two 25 basis point cuts in the fourth quarter (one in October and the other in December). As of the end of the year, the Federal Funds rate stood at 4.25%. Investors are anticipating additional rate cuts in 2008 as the economy may be teetering on the brink of recession. In addition, the Fed injected money into the banking system to provide liquidity, which had dried up in the credit crunch toward the end of the summer. Most segments of the credit markets performed well during 2007. The exception, however, was the 2.2% return for high yield, as problems in sub-prime mortgages spread to stressed credits. Yields on ten-year municipal bonds were flat for the year.
After seven years of impressive returns, REITs turned south as the sub-prime mortgage mess adversely affected other segments of the real estate market. The resulting credit and liquidity crunch made it difficult for many REITs to obtain financing at reasonable rates, and many deals fell apart. The Dow Jones REIT index was down 17.8% for the year.
Commodities posted solid increases during 2007, led by gains in energy. As mentioned above, crude oil nearly doubled in price as it closed in on $100 per barrel. Industrial metals also posted big gains as demand greatly outstripped supply, especially in China and India.
In summary, 2007 was a relatively poor year for investors after figuring in inflation, which stood at 4.3% through November. Assuming inflation was flat in December, the real (after-inflation) return for stocks (S&P 500) was +1.2%, and +2.7% for bonds (Lehman Aggregate). Considering the turmoil that took place during the year, financial markets around the globe held up reasonably well. While it remains to be seen what 2008 will bring, it is likely that the impacts of the sub-prime debacle have not totally played out. With home foreclosures and unemployment on the rise, the dollar continuing to fall and the Fed balancing the need to control inflation while trying to jump-start a slowing economy, we could be in for a bumpy ride.