• The Fed increased short-term rates by another .5% during the quarter, raising the Fed Funds rate to 3.75%. The tightening cycle has now lasted 15 months and encompassed 11 separate increases. Recently, the Fed has stepped up its anti-inflation rhetoric, suggesting that further rate increases are likely forthcoming. Long-term bond yields edged higher, with the yield on the ten-year Treasury increasing .39% to 4.33% and further flattening the yield curve.
  
• Energy prices flared during the quarter in the wake of Hurricanes Katrina and Rita. Oil reached a record price of almost $71 per barrel. The trailing 12-month CPI rose 0.2% from the last quarter to a 3.6% annual rate as of August 31, while the core rate, excluding food and energy, slipped fractionally to 2.1% annualized. Producer prices surged 1.6% for the quarter, bringing the annual rate to 5.1%.
  
• The U.S. dollar continued to strengthen against the Euro, Yen, and British Pound, as the US current account deficit dipped slightly in the second quarter. As expected, the dollar fell fractionally against the Chinese Yuan Renminbi as a result of China’s partial unpegging of its currency.
  
• The unemployment rate rose to 5.1% in September, largely due to jobs lost as a result of Hurricane Katrina. Despite those losses, preliminary estimates indicated 453,000 new jobs were created during the three months ended September 30.
  
• Equity valuations were again mixed during the quarter, with large cap P/Es down fractionally and small cap P/Es ticking upward. Prices relative to cash flow improved across all market caps.
  
• U.S. stocks were up for the quarter, paced by Mid and Small Caps which returned 5.9% and 4.7%, respectively, outperforming the S&P 500 return of 3.6%. International stocks surged by 10.4% for the quarter.
  
• Bonds continue to provide limited returns as most indices were virtually unchanged for the quarter. The Lehman Aggregate Bond Index slipped 0.7% during the period.

Data Source: Bureau of Labor Statistics

October 2005

Markets

Fifteen months since they began, the Fed’s continuing interest rate hikes are beginning to demonstrate increasing efficiency in dampening the pace of the US economic expansion. The recently announced final estimate of second quarter GDP growth of 3.3% (annualized) represents a half point decline from the first quarter. Although early predictions for the third quarter were generally rosy, unexpected subsequent declines in personal income and consumer spending in August have shaken that optimism. Couple these with the short-term negative economic effect of the hurricanes and the corresponding sharp decline in consumer sentiment, and downward revisions in third quarter GDP expectations were a virtual certainty.

Within a few weeks after Katrina steamrolled through the gulf region, gasoline prices had receded toward August levels, only to reverse course after Rita again shut down much of the region’s production and refinery capacity. Some portion of these price increases are likely temporary and attributable to brief localized shortages, fear over the scope of the disaster, and profit-taking by speculators. Those short-term factors notwithstanding, the longer term effects of increasing global demand for oil and a relative shortage of refinery capacity in the United States will likely keep prices high for the foreseeable future. (Included with your quarterly report is a copy of a more thorough analysis of these recent developments.)

The recent release of August personal income and consumption data raised further concerns about the near-term economic outlook. On an inflation-adjusted basis, disposable personal income declined 0.5% and personal consumption expenditures dropped 1.0%. September spending data is not yet available, but the drop in consumer confidence in September was the largest monthly decline since 1990. Since consumer spending dominates GDP, declining personal income and spending tend to be negative indicators for the economy. While these results are concerning, it would be premature at this point to attempt to assess their prolonged impact. Given the broader view, which still tends to be supportive of economic growth, it is possible that these declines were merely short-term aberrations. The picture should become increasingly clear in the coming months.


Despite these developments, the equity markets again exhibited remarkable resilience, pushing the major indices higher both for the quarter and for the month of September. The S & P 500 Index gained 3.6% for the quarter, sufficient to carry the benchmark large cap index back into positive territory for 2005. Smaller companies continued to beat the blue chips, however, as the Russell MidCap and 2000 Indices returned 5.9% and 4.7%, respectively. Strong returns in international equities outpaced domestic equity returns; the MSCI EAFE Index posted a strong 10.4% return for the quarter. Year-to-date equity returns continue to heavily favor domestic mid cap and international issues.

Rising bond yields continue to pressure fixed income returns. Fed policymakers again raised short-term rates a quarter point at their most recent meeting. The combination of continuing Fed action and market forces nudged the yield curve higher and sent the Lehman Aggregate Bond Index to a loss of .7% for the quarter. Despite this drag, the Index has returned 1.8% year-to-date as bonds generally continue to tread water.

Influences and Strategy

As discussed in our previous quarterly letter, the bond yield curve continues to flatten. While the Fed moved to raise short term rates another .5% to 3.75%, the 10-year Treasury yield advanced .39% to close at 4.33%. The resulting spread between short and long term interest rates remains well below the long-term average and has narrowed considerably since the Fed started its tightening cycle in June 2004. Historically, a flat yield curve has often been an early indication that a recession is near. Since the Fed targets short-term interest rates and the market determines long-term rates, long-term yields that are comparable to short-term yields often suggest that the market believes that the Fed has overestimated inflation risk and will need to lower rates as the economy cools.

Although the yield curve is increasingly flat, there is still an incremental increase in yields for long-term bonds. Further, inflationary pressures in both producer prices and consumer prices have been gathering steam. Although the rate of GDP growth will likely be weakened by this inflationary pressure, the current scenario should still provide moderate growth in the near-term. Barring some severe unforeseen developments that would materially alter the economic landscape, we do not expect that energy prices at current levels will tip the economy into recession. Further, while our immediate outlook is for a continuation of moderating GDP growth, the historical usefulness of the bond yield curve in predicting slowing economic growth cannot be overlooked. We will continue to monitor developments in the fixed income markets and evaluate our fixed income strategy accordingly.

Given the recent surge in core inflationary pressure even as the economy is slowing, the Fed may be increasingly squeezed to decide between further rate hikes that could lead to sub-optimal economic growth or temporarily halting the cycle of rate increases at the risk of stoking inflation further. The Fed continues to reiterate that price stability remains near, if not at, the top of its list of priorities. Unless price pressures ease, further Fed increases appear likely. In the short-term, such a conflict between economic growth and price stability could increase market volatility. At the current time, we believe that a defensive to neutral bond maturity position remains advisable.

Stock valuations have also remained in a relatively tight range thus far this year. While Price / Earnings ratios still remain a bit high by historical standards, low bond yields provide some support for these levels. Some economists and investment managers have suggested that equities may be undervalued at current levels. That assertion may be aggressive, but we do not believe stocks to be severely overvalued either. If the economy continues to grow, even at a moderately slowing pace, stocks should provide positive results.

Generally, both the fixed income and equity markets continue to languish in valuation ranges that provide investors with very few “high conviction” opportunities. The ability to benefit from occasional “fat pitches” can augment otherwise tepid returns, but there continues to be a dearth of attractive options. In the equity markets, the gross overvaluations of a few years ago appear to have been corrected, making growth stocks as attractive as they have been in some time. Moreover, the inclusion of international bonds and TIPS in a bond portfolio provides the opportunity for incrementally better returns in a rising interest rate environment. The increased exposure to alternative investments among investors and their propagation in the popular press are in part symptomatic of the desire to improve investment returns in this environment. Hedge funds, commodities, private equity, and real estate are mainstream examples, although we are increasingly encountering new investment vehicles to be considered. We continue to evaluate these alternatives, looking for superior performance or risk reduction potential on either a tactical or strategic basis that would merit including them in a portfolio. In the interim, we will continue to evaluate our current investment allocations and seek opportunities to add value through a combination of periodic rebalancing, tactical re-allocations, or attractive implementation options within existing asset classes.

Industry Matters

Effective September 23, Nations International Value fund was renamed the Columbia International Value fund as part of the consolidation of Nations fund family under the Columbia Management brand. Both fund families have been under the common ownership of the Bank of America. This change does not affect the management of the fund, which remains with Brandes Investment Partners. Further, other than the change in name, no other characteristics of the fund are expected to change. We will continue to monitor the fund for any other changes that might merit further consideration.

We continue to monitor the status of the investigation by the Securities Exchange Commission (SEC) into the trading methods employed by a number of the largest brokerage firms, including Charles Schwab. The investigation relates to allegedly inappropriate trade routing of certain Nasdaq stocks, which may have created a conflict of interest for the brokerage firms involved.

Schwab’s policy is to not comment on ongoing SEC investigations, and there have been no other publicly disclosed developments related to the Schwab investigation in the past quarter. They continue to state that they remain confident that the investigation will show their commitment to providing best execution for client trades. We will continue to monitor the situation and keep you apprised of any significant developments.

As always, if you have any comments, questions or suggestions on the report, please do not hesitate to call.

This report is prepared solely to help you with your investment planning. Accordingly, it may be incomplete or contain other departures from generally accepted accounting principals and should not be used to obtain credit or for any purposes other than your investment planning. We have not performed an audit, review or compilation engagement in accordance with standards established by the American Institute of Certified Public Accountants.