Capital Markets Commentary
By Jim Baird
Universal Advisor, 2006 Issue No. 1

The U.S. economy slowed considerably in the fourth quarter of  2005. The headwinds created by rising interest rates, the substantial disruption of economic activity in the gulf region, and rapidly escalating energy costs took their toll. GDP growth for the fourth quarter slowed to a 1.1 percent annual rate. Despite this slowdown, the preliminary estimate of growth for the year still came in at a moderately strong 3.5 percent. Moreover, the outlook for 2006 remains relatively upbeat. The efforts by the Fed to nominally
cool the rate of growth and contain inflation risks showed some signs of effectiveness. Consensus GDP expectations for 2006 are for growth in excess of 3 percent, slightly slower than that of 2005. Inflation concerns remain elevated as a result of the sharp uptick in energy costs due to growing global demand and tight supplies.

The surge in petroleum and natural gas costs in the third quarter
partially receded in the fourth quarter, but fundamental supply/
demand dynamics remain a concern. The hurricanes brought oil
prices back into the headlines, but they weren’t the sole contributor to increasing prices. Uncertainty about the potential long-term economic effects of higher energy costs weighed on the market in the fourth quarter and represented the greatest single source of concern for equity investors.

Since the Fed began its series of short-term interest rate hikes in
June 2004, the U.S. bond market has been under pressure. Rising
interest rates erode bond prices, with longer-term bonds subjected to greater risk of loss. The Fed’s cycle of rate hikes progressed unabated throughout the year, including two additional quarter-point increases announced during the fourth quarter. A total of eight rate increases lifted the Fed Funds rate from 2.25 percent at the outset of 2005 to 4.25 percent at the end of the year. Rising short-term rates took its toll on bond returns; returns for high quality municipal and taxable bonds were in the low single-digit range. That being said, the results would have been worse had the yield curve not flattened further.

Despite the 2.0 percent increase in short-term rates for the year, the benchmark 10-year Treasury yield rose less than a quarter percent to end 2005 at 4.39 percent. In the closing days of December, the 10-year yield was actually lower than that of the 2-year Treasury, creating a mild inversion of the curve and sparking a brief selloff in stocks. Historically, an inverted yield curve has been a leading indicator of an expected economic slowdown or recession. In this case, the inversion was short-lived, and stocks rallied early in 2006. At this point, evidence suggests that structural
supply/demand issues were the cause of the inversion and that the
economy isn’t likely to become recessionary in the next year. We
believe that the preponderance of other economic evidence largely
supports this thesis.

Returns from stocks were a mixed bag, although unfavorable news seemed to dominate the headlines. The S&P 500 Index of large
U.S. companies returned a moderate 4.9 percent for the year, well below its long-term average, but still sufficient to beat the Russell 2000 Index of small caps and its 4.6 percent return for 2005. The Russell MidCap Index was the clear leader of that group, posting a 12.7 percent gain for the year. International equity returns were healthy; the MSCI EAFE Index return of 13.5 percent resulted from broad equity gains from around the globe. Within a global context, the U.S. equity market lagged much of the rest of the developed world. A smattering of European markets and Japan provided strong returns, although the strengthening dollar reduced the net benefit to U.S. investors.

Despite the obstacles affecting the markets, a very broadly  diversified portfolio of stocks and bonds performed reasonably well, particularly when compared to a less diversified, traditional portfolio of U.S. blue chip stocks and high quality bonds. As noted previously herein, portfolio allocations to mid-cap stocks and international stocks and bonds significantly outperformed a traditional blue chip stock/highquality bond portfolio. Further, this result was accomplished without substantially altering the risk of the portfolio. In short, 2005 was a poignant example of the benefits of broad diversification across a range of sub-asset classes.