Global Economic Review

February 2010

Financial Markets

Equity markets were mixed in February as investors remained wary about the strength of the economic recovery and mounting debt in Europe. European equities traded lower on concerns that some countries, such as Greece, Portugal, and Spain, might not be able to handle their swelling debt. The Bloomberg European 500 Index dipped less than one half of one percent for the month. Worries over monetary tightening in China sent Japanese stocks lower; the Nikkei 225 Index fell close to 1%. China said for the second time in a month that it would force its banks to slow down their lending. A similar action nearly a month ago by China shocked the market and helped start a slide that brought major indices down for four straight weeks. Despite the negative investor sentiment across the globe, U.S. stocks ended the month in the black. The S&P 500 Index recorded a near 3% gain.

The dollar surged to a 9-month high against the euro in February as investors bet that Greece's crushing debt could drag down the entire euro zone. Greece's woes amid soaring deficits have exposed the fragility of the euro zone's government finances and the region's recovery, which overshadows any nervousness about the American economy and the massive U.S. budget deficits. The dollar also rose against other major currencies as the Federal Reserve's surprise move to increase its discount rate suggested a rise in the federal funds rate may happen sooner than previously anticipated. The pound dropped to its lowest level in more than eight months against the dollar on concerns over the UK's economy and fiscal situation weighed on the British pound.

U.S. Economy

The U.S. economy rocketed ahead at a 5.9% pace in the final quarter of 2009, which was stronger than initially estimated. But the growth spurt isn't expected to carry over into this year. Roughly two-thirds of last quarter's growth came from a burst of manufacturing, but not because consumer demand was especially strong. In fact, consumer spending weakened at the end of the year. Instead, factories were churning out goods for businesses that had let their stockpiles dwindle to save cash. If consumer spending remains as lackluster as expected, that burst of manufacturing and its contribution to economic activity will fade. For all of this year, the economy is expected to grow around 3%. Although modest, that pace would mark a big improvement from 2009, when the economy contracted by 2.4%, which was the worst showing since 1946. Yet, as government stimulus wanes and Federal Reserve economic-support programs end, the economy, especially the fragile housing market, could suffer. Economists say the odds of the economy sliding back into a recession this year are low, but they won't rule it out. The Federal Reserve is beginning to rein in support that helped fuel the economic rebound. Federal Reserve Chairman Ben Bernanke outlined the central bank's strategy for reeling in stimulus money once the U.S. economic recovery is more firmly rooted. Bernanke suggested that record-low interest rates are still needed to ensure that the economic recovery will last and to help cushion the sting of high unemployment. However, the Fed did hike the discount rate to 0.75% from 0.5%, while repeating the pledge to hold rates at record lows for an "extended period." Many think that means for at least six more months.

Consumer confidence fell sharply in February as Americans turned more pessimistic about job prospects and the U.S. economy. Consumer spending jumped by a larger amount than expected in January but Americans' incomes barely budged as millions of Social Security recipients did not get their usual cost of living boost. The weak income growth could depress spending in the months ahead. Spending could slow further as consumers continue to dig themselves out of debt. Consumer bankruptcies in January jumped 15% from a year earlier as consumers struggle with high debt loads and elevated unemployment. Layoffs are continuing and jobs remain scarce. The U.S. economy shed 20,000 non-farm jobs in January, but the unemployment rate dipped to 9.7%, its lowest level since last summer. The most recent data indicate the economy has lost 8.4 million jobs since the recession took hold. The Fed suggested the unemployment rate this year could hover between 9.5% and 9.7% and between 8.2% and 8.5% next year. By 2012, the rate could range between 6.6% and 7.5%.

There are signs the housing market's recovery is faltering. New home sales fell for the third straight month to a record low and sales of previously occupied homes took a large drop for the second straight month in January, falling to the lowest level since summer. The drop in sales last month came despite the extension of a popular tax credit for first-time buyers, which was also expanded for repeat buyers. Housing prices have stabilized for now, but waves of foreclosures continue pouring more houses onto the market, which should keep prices in check for some time.

U.S. factories were hammered by the global recession but are bouncing back. The major indicators of manufacturing show rising orders, expanding production, and reduced inventories, led by demand for capital equipment from businesses here and abroad. However, businesses are boosting production without creating new jobs. Productivity has jumped as firms laid off employees and expanded working hours. Economists say the increase in productivity is unsustainable. They expect that companies will soon have to increase hiring to maintain production. The U.S. manufacturing sector grew for a sixth straight month in January, to its strongest level since August 2004. New orders for U.S-made durable goods probably rose by 1.5% in January after a 1% gain in December. Orders for U.S-made durable goods soared on higher bookings for civilian airplanes, however, outside of aircraft, new orders were down. Industrial production rose a stronger-than-expected 0.9% in January, the seventh consecutive monthly increase, as manufacturers continued leading the nation's economic recovery.

The U.S. government ran a budget deficit of $43 billion in January as spending once again outpaced revenue. January marked a record sixteenth straight month in which the government posted a deficit, but the number was down from the year-ago January number of $63 billion. The White House is forecasting a record $1.6 trillion deficit in fiscal 2010, and President Barack Obama is pressing ahead with plans to set up a commission to tackle government red ink. The deficit is expected fall to $1.3 trillion in fiscal 2011 and to continue declining to $706 billion in fiscal 2014 before beginning to rise again.

European Economies

The 16 countries that use the euro barely grew in the fourth quarter. A modest recovery stalled amid turmoil in financially troubled members, such as Greece, and a disappointingly flat performance from Germany, the biggest euro economy. Euro zone gross domestic product (GDP) grew by only 0.1% in the last three months of 2009 from the previous three-month period and dropped 2.1% compared with the fourth quarter of 2008. The wider 27-country European Union, which includes non-euro members, such as Britain and Sweden, as well as east European countries, including Poland and Hungary, saw fourth quarter GDP rise by 0.1%, the same as the euro zone. The figures lagged well behind fourth-quarter growth in the United States and raised concerns that Europe could slip back into recession as government stimulus efforts expire and the continent struggles with a government debt crisis in Greece, Portugal, and Spain. The European Commission is forecasting full-year 2010 growth of just 0.7% for both the E.U. and the euro zone. The European Central Bank kept its main interest rate unchanged at the record low of 1% for the ninth month running and gave its cautious backing to the Greek government's attempt to get a grip on its borrowing. The euro zone's manufacturing sector grew at its fastest rate for two years in January, but the chasm between the bloc's healthiest and weakest economies is widening. The sector's growth was driven by the 16-country bloc's healthiest economies, especially France, now expanding at its fastest pace in close to a decade. Germany and Italy also contributed to the growth. By contrast, the survey reflects the fears about weaker euro zone manufacturers losing their competitiveness. Greece, Spain, and Ireland all recorded lower output and faster contraction. While exports have kick-started the euro zone economy, sustainable growth depends on private consumption and investment, and both have become more sensitive to financial conditions.

Greece's debt levels and budget deficit have occupied center stage recently. But a potentially greater drama is unfolding in Spain. With a Greek-style budget deficit forecast to top 12% of GDP this year, Madrid now forecasts sovereign debt will peak at 74% of GDP in 2012, double the pre-crisis figure, although still far off Greece's current 115% level. That means Spain still has time to put its house in order, which is just as well; with an economy four times bigger than Greece's, any Spanish problems are likely to be more widely felt. Spain's economy shrank further in the fourth quarter of last year, albeit at a slower rate than previously, leaving it one of the last European economies to pull out of recession. GDP in Spain fell 3.1% in the fourth quarter on an annual basis. Growth slowed 0.1% between the third and fourth quarters of 2009. Spanish growth has been negative on a quarterly basis since the third quarter of 2008. Spain's recession has been shallower but longer than that of most of its European neighbors, and economists expect GDP to shrink again over 2010, by about 0.6%, although there is likely to be a gradual recovery from quarter to quarter. Spain's economic crisis has been driven by a collapse in the housing and construction market, which has pushed the unemployment rate to near 20%.

Germany's economic rebound unexpectedly lost momentum in the fourth quarter of 2009. The German economy is heavily dependent on exports and once again they made the only positive contribution in the final three months of the year, since consumption and business investment were both down. The International Monetary Fund nonetheless forecast German growth of 1.5% this year, slightly higher than the government's forecast of 1.4%. December trade figures for Germany highlighted the hit Europe's largest economy took in 2009 from the collapse in global economic confidence at the start of the year. A measure of German business sentiment and investor confidence slipped again in February amid dim prospects for the nation's retail, consumer goods, steel, and chemical sectors.

British economic growth in the final quarter of 2009 was revised upward slightly to 0.3%, which is an improvement from the 0.1% it forecast in its preliminary estimate last month. The figure is still weaker than original expectations and a downward revision to third quarter GDP has widened the annual rate of contraction in the economy to 3.3%. The return to positive growth was driven primarily by a slowdown in the rate of inventory unwinding. Most economists expect Britain to struggle to reach 1% growth this year. Britain is the last major economy to return to growth after the global credit squeeze. It was hit particularly hard because of its huge banking and financial services sector centered in London, which had to be propped up by the government's multibillion-pound bailout of major banks, and higher levels of personal debt among consumers. The Bank of England kept its main interest rate unchanged at the record low of 0.5% and said it would not ask the government for the authority to pump more newly created money into the barely recovering British economy. The Bank of England expects inflation to jump well above 3% in 2010, but thinks that it will fall back well below target over the next couple of years, suggesting that interest rates may remain lower for longer than the market expects. Consumer price inflation in the United Kingdom rose to 3.5% on an annual basis in January, up from 2.9% in December, due to a hike in the national sales tax and more expensive energy.

Asian economies

The Japanese economy is benefiting as sharp growth from China and other neighbors is improving exports and spurring more capital spending by manufacturers, although Beijing's recent moves to prevent overheating could limit the recovery. GDP grew at a 4.6% annualized pace during the fourth quarter. Economic growth was elevated by government spending stimulus that is soon to expire and will be hard to extend, given the country's huge public debt. Japanese GDP growth is likely to slow down to nearly zero in the first half of this year, as the effect of policy stimulus fades. The export sector is recovering nicely, but the consumer sector is suffering as prices continue to decline and shoppers economize. Exports surged in January, helped by a sharp gain in China shipments. Despite the brighter output and export data, a government report on prices showed deflationary pressure has yet to abate. Japan's core consumer price index for January fell 1.3% from the same month a year earlier. The drop in core CPI marked Japan's eleventh consecutive month of deflation.

China, which overtook Germany as the world's biggest goods exporter last year, posted bumper export figures in January when shipments rose 20% from the previous year. On a month-on-month basis, exports fell 16.3%. China's exports, which suffered badly at the beginning of last year, have been picking up in recent months as the global economy recovers, thanks to improving consumer sentiment and inventory restocking. China's purchasing manager indices showed that the economy ran a greater risk of growing too quickly again in January, with rising input and output prices pointing to greater inflationary pressures. Chinese regulators are trying to contain rapid economic growth to prevent speculative investment bubbles there. China has ordered a further clampdown on excessive bank lending to ensure credit has not illegally entered the stock or property markets. In the latest move, the China Banking Regulatory Commission ordered lenders to conduct checks on whether any loans had been used for improper purposes. China also said it would require banks to increase reserve levels, which would limit the amount they can lend. The People's Bank of China said it will raise the reserve ratios that banks in the country must keep to 0.5%. It is the second time that it has increased the ratio in a year. The action is viewed by most economists as a way to head off a sharp increase in inflation caused by lax loan practices and the nation's $585 billion stimulus program.

India's government expects the Indian economy to expand by 7.2% in the year ending in March 31. India's economy is then expected to accelerate to 8% growth in the year ending March 2011, which is close to levels hit during the 2007 boom years, on the back of strong growth in manufacturing. However, a partial roll back of the stimulus introduced by the government during the crisis is expected at some point soon. Still, rising inflation has been the main concern for policymakers in India who fear it could hit the poorer segments of the country's 1.2 billion population. HSBC recently raised its forecast for India's wholesale price inflation for this fiscal year from 8% to 10% this year.

Portfolio 21 Trading Activity

We spent down some cash in February as equity markets weakened. We spread purchases across the globe. In Europe we added shares of National Grid, Unibail-Rodamco, Telefonica, and Nokia. In the U.S. we purchased Ecolab, Baxter International, and Ormat. We also bought additional stock in Canon and Denso in Japan.

Company Performance

Some Portfolio 21 stocks performed very well in February. Cosan rallied after Royal Dutch Shell said it would launch a joint effort with the Brazilian sugar giant to produce ethanol. Shares of Australian lender Westpac Banking rose after it announced a 33% increase in first-quarter cash profit. Whole Foods shares were flying off the shelves after the health food grocery chain posted fiscal first-quarter earnings well ahead of analysts' expectations. Schnitzer Steel and Air Liquide gained on broker upgrades and Autodesk jumped after the design software company reported earnings that topped Wall Street's expectations. Staples, United Natural Foods, ABB, and Herman Miller also rose substantially during the month.

Some Portfolio 21 stocks lost value in February. Electrolux, the Swedish-based producer of home appliances, dropped after it announced a fourth-quarter net profit but posted a drop in sales and released a cautious outlook. French supermarket giant Carrefour dipped after saying that its fiscal-year net profit fell 74%, after being hit by restructuring and impairment charges, and the company gave a cautious outlook for 2010. Tennant, which makes floor cleaning products, fell after reporting quarterly profits that beat analysts' expectations, mainly helped by lower costs, but its 2010 earnings forecast range missed estimates. Denso, Abengoa, Ormat, and Unicredit also underperformed during the month.

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. Portfolio 21 may invest in foreign securities, which are subject to the risks of currency fluctuations, political and economic instability and differences in accounting methods. Investing in foreign securities is riskier than investing in domestic securities. The Fund invests in smaller companies, which involve additional risks such as limited liquidity and greater volatility. The Fund's environmental policy could cause it to make or avoid investments that could result in the portfolio under-performing similar funds that do not have an environmental policy. There are no assurances that the fund will achieve its objective and/or strategy. Please refer to the prospectus for more complete information including risks, fees and expenses.

Holdings are subject to change and are not recommendations to buy or sell any security. See complete fund holdings information.

The Bloomberg European 500 Index is a capitalization-weighted index of the 500 most highly capitalized European companies. The S&P 500 Index is a broad-based unmanaged index of 500 stocks, which is widely recognized as representative of the U.S. equity market. The Nikkei Stock Average is a price-weighted index of 225 selected leading stocks listed on the First Section of the Tokyo Stock Exchange. This is a price only index. One cannot invest directly in an index.

Gross Domestic Product (GDP) is commonly used as an indicator of the economic health of a country, as well as to gauge a country's standard of living.

Consumer Price Index (CPI), also called cost-of-living index, is an inflationary indicator that measures the change in the cost of a fixed basket of products and services, including housing, electricity, food, and transportation. The CPI is published monthly.