The "risk on, risk off" pattern and the "herd" mentality dominated trading again during the second quarter, with stocks, currencies, and commodities moving in response to macroeconomic events. Most of the economic data released last quarter was disappointing, especially at the back end. The global economy is struggling to withstand the combination of rising energy prices, the aftermath of Japan's earthquake, U.S. fiscal woes, a slowdown in China, and Europe's sovereign-debt crisis. Despite these challenges, U.S. stocks managed to end the quarter near flat, but slightly positive. European stock markets lost a bit as worries about Greece regained momentum; Japanese stocks experienced minor gains due to rebuilding confidence. Most emerging market indices declined. Indian stocks were the worst performers among Asian markets. Investors fretted about high inflation and risks to growth resulting from the Reserve Bank of India's steep hikes in interest rates over the past fifteen months. Chinese stocks were also hit as government tightened monetary policy and took other measures to tamp down inflation. Benchmarks in Brazil, Mexico, and Argentina exited the quarter with losses.
Market direction for the remainder of 2011 boils down to second and third quarter corporate earning results and the effects of the end of the Federal Reserve's second round of "quantitative easing." Other conceivable headwinds include high unemployment, a depressed housing market and potential for a global debt crisis. Furthermore, slowing manufacturing growth from China to Europe is creating a dilemma for central bankers considering higher interest rates to combat inflation. Europe's debt crisis and slowing U.S. growth are damping demand for goods, putting pressure on policy makers to delay further rate increases even as prices gain. While small spending gains can be expected in the second half of the year, the trend is more likely to vary between lackluster and less than lackluster.
Currency markets were volatile during the second quarter as expectations swung from economic optimism to worries about a slowdown. Central banks around the world have been raising interest rates as the recovery settles in and inflation risk heats up. The U.S. dollar weakened through early May as the euro approached $1.50, then rebounded and bounced around through June. The euro slumped against the U.S. dollar and other major currencies early in the quarter amid signs Europe's government debt crisis was worsening. The euro later gained on the greenback after German Chancellor Angela Merkel said her country would do "whatever is needed to support the euro," euro zone exports grew, and the European Central Bank raised borrowing costs for the first time since 2008.
The Swiss currency has been the largest beneficiary of concerns over euro zone government debt as investors perceived it to be a haven from the region's woes. The Swiss franc was supported by a healthy Swiss economy and the nation's strong fiscal position. The franc appreciated by more than 9% against the U.S. dollar. Sweden's krona joined the Swiss franc as a favored currency for traders looking to profit from Germany's expansion while avoiding the European debt crisis. The Swedish krona gained ground on the U.S. dollar and pushed higher versus the euro after the Swedish Riksbank lifted its repo rate by a quarter-point to 1.75%. The move marked the sixth hike since the start of the central bank's tightening cycle. The Brazilian real also exhibited strength in the quarter. The Latin American currency soared to a twelve-year high against the dollar as investors sought higher-yielding assets. Brazil's rapid economic growth and high real interest rates make its markets a powerful draw for foreign investors. Asian currencies gained on the dollar for the quarter as well. China's yuan strengthened beyond 6.5 per dollar for the first time since 1993, supported by speculation the central bank will allow appreciation to help tame inflation. The yen rose as monetary and fiscal policy in Japan is expected to remain very accommodative as the country tries to recover from its massive earthquake, tsunami, and subsequent nuclear power problems. Portfolio 21 benefited slightly from currency moves as fund allocation is more heavily invested in foreign denominated assets compared with the MSCI World Equity Index.
Portfolio 21 performance was enhanced by sector allocation over the April-June period as defensive stocks fared best among the ten economic sectors during the second quarter, with healthcare the best performing, followed by utilities and consumer staples. Financial firms were hardest hit, followed by energy and technology.
The pharmaceutical industry will see some changes in the coming years due to patent expirations on key drugs and the launch of products now in the pipeline. At Portfolio 21 we focus on drug companies that we feel are best positioned in this regard and we believe the market hasn't fully discounted the potential of many select healthcare stocks. Therefore, we have remained overweighted in this sector. There appears to be some unrealized value in several utilities and consumer staples stocks as well.
Bank stocks underperformed, even after Federal Reserve stress tests showed some financial institutions have regained enough strength to boost dividends and buy back their shares. A lack of loan growth and increased costs from new regulations continued to plague the industry. Furthermore, persistent low interest rates are shrinking interest income as new regulations curtail fee revenue from retail banking. Portfolio 21 is underweighted in financials and will remain so until we come across more transparency and growth potential within the industry.
Energy stocks declined as a group on a sharp drop in commodity prices. Still, forecasts call for more expensive crude in 2012 based on a further narrowing of global capacity. The main sources of demand growth next year are expected to be China, India, and Brazil. Portfolio 21's investment philosophy and criteria keep us away from direct investment here. Fund exposure to rising energy demand and costs comes from energy efficiency and renewable energy technologies.
Some Portfolio 21 stocks gained substantially in the second quarter. Nike rose after it posted fourth-quarter profit that surpassed analysts' estimates and increased its long-term sales forecast. Olympus climbed after JPMorgan upgraded the stock on expectations of synergies between a full year of new product effects from new endoscopes and the benefits of the new president's cost-cutting program. Henkel rose after the consumer-products maker raised its expectations for organic sales growth and reported an 8.9% rise in first-quarter sales. SunPower jumped after Total SA offered to buy as much as 60% of the company and provide as much as $1 billion of credit support over the next five years. Waters rose after the lab-equipment maker reported a 25% increase in first-quarter profit as drug makers spent heavily on research and development. Intel and Johnson & Johnson both appreciated on higher-than-estimated quarterly profits. Ecolab, L'Oreal, British Land, and Adobe also outperformed during the second quarter.
Some Portfolio 21 stocks lost value in the second quarter. Google dropped on anti-competitive concerns. The company received a subpoena from the Federal Trade Commission for alleged antitrust behavior. Investors also fretted over cost controls, even as revenues surged past expectations. Royal Philips Electronics, the world's biggest maker of light bulbs, dropped the most in more than two and a half years after saying it needs to deepen cost cuts to combat deteriorating demand for lighting and consumer electronics. Staples declined the most in eleven years after cutting its profit forecast and expansion plans for 2011 because of the slow economic recovery. Vestas Wind Systems dipped after its first-quarter loss widened. Its loss before interest and tax of EUR69 million was much bigger than analysts expected, while order intake also disappointed. TNT Express plummeted after the company said the unit's earnings were hurt by natural disasters and political turmoil. Natura Cosmeticos, Applied Materials, Sharp, Schnitzer Steel, and Autodesk also lost value during the second quarter.
We engaged in some portfolio rebalancing during the second quarter. We rebalanced our financial services holdings, in essence to move away from institutions that will be inhibited by more stringent regulation and into companies that will be boosted by new regulations. We sold HSBC Holdings and Unicredit on diminishing growth prospects as a result of required capital increases and restrictions on capital market operations. We are much more optimistic about the prospects for IntercontinentalExchange (ICE) and Bank of New York Mellon (BK). A scalable business model and continued product innovation should enable ICE to outperform its financial services peers over the long-term. Furthermore, increased OTC oversight with a focus on transparency should drive more business to the regulated exchanges that ICE operates. BK is the undisputed leader in global custody and issuer services. The bank provides back-office services to other financial firms. Increased government regulations are also driving more customers to BK as it becomes more difficult for asset managers to administer financial assets in house.
We sold our stake in Best Buy on an increasingly competitive landscape in consumer electronics. Mass merchants, warehouse clubs, and online retailers have been taking market share and we are not convinced that the company can fend off encroachment. We reinvested the proceeds and cash inflows in China Mobile, Ormat, Ameresco, Google, L'Oreal, Life Technologies, and Accor. China Mobile dominates the mobile communications market in China, which is relatively immature and growing rapidly, with 70% market share and nearly 600 million customers. The company has massive scale and strong brand recognition. Due to this magnitude, China Mobile can afford considerable spending on technology and can launch new services at a lower cost than its competitors, especially in undeveloped rural markets, where more than 800 million potential customers reside. We purchased shares of Ormat and Ameresco on increased conviction over the companies' business models. Ormat has been a long-time holding, while Ameresco is a new position. We expect robust geothermal expansion worldwide in the coming years and Ormat is the only vertically integrated company primarily engaged in the geothermal and recovered energy power business. Ormat's backlog has more than doubled since the beginning of the year to a record high and the company has increased its product segment guidance by 15% for 2011. Ameresco has seen improvements in contracted backlog. The company recently announced multiple budget-neutral energy efficiency contracts in the Northwest, in addition to broader success with customers around the country. We expect company guidance and analyst estimates to move up to reflect this. In the longer term we are attracted to the company's business model, which addresses energy efficiency solutions, as institutions and corporations move aggressively to manage ecological constraints and trim operating expenses. We bought more Google as investors fretted over cost controls, even as revenues surged past expectations. The sell-off epitomizes Wall Street short-termism. We added to L'Oreal, ahead of Nestlé's likely acquisition of the company. We also purchased additional shares of Life Technologies as the company's model of selling consumables along with systems should enable it to show superior growth and consistency. Life has one of the largest patent portfolios in the industry. We also added to Accor after the hotel group fell in sympathy after first-quarter earnings at competitor Marriott missed analyst estimates due to a slowdown in North American travel and conference spending. We believe the sell-off was overdone as Accor generates less than 10% of revenues in North America. Furthermore, we think occupancy and revenues-per-room metrics are likely to continue to show improvement in the rest of the world.
The information provided herein represents the opinion of the Portfolio Manager of the Fund and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice.
Past performance does not guarantee future results.
Holdings are subject to change and are not recommendations to buy or sell any security. See complete fund holdings information.