Market Commentary: August 2006

Many expressions have been used recently to describe the U.S. economy. Terms like “temperate”, “modest”, “soft landing”, and even “Goldilocks” (a reference made to investors’ “not too hot, not too cold” sentiment about the economy) have become frequent taglines used by analysts and reporters. With regard to the economy, these generally seem to be fitting. After months of turbulent market swings and high volatility, a result of mixed economic data and wide ranging predictions about how the Fed might proceed, these descriptions have been a welcome relief to investors. And they responded. In August, the major indexes that track equity and fixed income asset classes posted positive returns across the major asset classes.

Behind this sweet spot were economic indicators that pointed to slowing economic growth and signs that an inflection point in the Fed’s tightening cycle may have been reached. July unemployment figures showed that the job market remains fairly robust, with a 0.1% decrease in unemployment that brought that rate down to relatively low 4.8%. Oil prices fell, helping to partially alleviate concerns about continued inflationary pressures and continued monetary tightening. Consumer spending remains relatively strong, increasing at 0.8% despite a cooling housing market. All of these led investors to increasingly expect that interest rates may have peaked. With this optimistic sentiment in mind, investors appear to have again substituted much of their aversion to riskier assets with a search for risk premium.

Equity Markets

At the outset of August, the prospects for strong U.S. stock returns seemed bleak. High tensions in the Middle East, predictions of another active hurricane season, and indications of stronger than-expected inflation contributed to that negative outlook. However, as the month unfolded, investors were generally pleasantly surprised. Tensions in the Middle East began to subside as a cease-fire agreement was reached in Lebanon. Hurricane Ernesto, so far the greatest threat of the season to Gulf oil refineries, veered toward Florida rather than the heart of the Gulf of Mexico. The Fed, in what was apparently a “close call”, decided to maintain interest rates at 5.25%. Even a foiled terrorist plot to highjack flights from London to the U.S. – a poignant reminder of the threat of terrorism that remains -- was not enough to drag market performance into negative territory.

Positive sentiment brought back a search for risk premium and small cap stocks returned to investor favor. During August, small companies lead the domestic market with a return of 3.0% as measured by the Russell 2000 Index. Small cap stocks were followed by mid cap stocks with a return of 2.5% and large cap stocks which were up 2.4%, their highest monthly return since April 2004. Much of small cap’s return to favor has to do with investors’ perception of the economy. A mix of data showing that economic growth is moderating has many investors believing that the Fed may succeed in squelching inflation while not smothering the economy. As a result, investors who may have been risk-averse while the outlook was less rosy are now testing the waters again in search of additional returns amongst riskier small cap stocks.

The pause in the Fed’s tightening campaign not only breathed new life into domestic stocks, but also reinvigorated international stocks. The MSCI EAFE, which measures performance of the stocks in developed international countries, was up 2.8%. In addition to alleviating global fears of a U.S. recession caused by Fed over tightening, the pause gave investors hope that other central banks may follow the Fed’s lead. With this adjustment in expectations, international investors also demonstrated increased interest in riskier assets. Emerging market equities also had a strong month with a return of 2.5%, as measured by the MSCI Emerging Market Index.

Fixed Income

After a stretch of modest returns, bonds rebounded in a big way in August. Driven primarily by the Fed’s decision to pass on raising short-term rates and hopes that they will not tighten further, domestic bonds posted their largest monthly return in years. The Lehman Brothers Aggregate Bond Index was up 1.5%, while the Lehman Brothers Bond 1-3 Year Government Index was up 0.7%. Muni bonds performed similarly with the Lehman 5-Year Muni Bond Index and Lehman 3-Year Muni Bond Index returning 1.1% and 0.8%, respectively. Still of some concern, however, is the mild inversion in the yield curve. A downward sloping yield curve typically implies that investors expect lower interest rates and inflation in the future. In the past, an inverted yield curve has often been an early predictor of an economic recession on the horizon. As of today, the mild inversion appears to be a function of expectations that the Fed may ease rates a bit in the near-term coupled with excess structural demand for long-term bonds, the inverted yield curve is one more indication that the Fed may not be out of the woods yet.

Expectations that the Fed has reached the peak of its interest rate increase cycle, along with solid fundamentals, sent international bonds to their highest levels in months. In August, they outpaced the Lehman Aggregate with a return of 1.6%, as measured by the Citi World Government Bond Index. Emerging market bonds, which in recent months have fallen on uncertainty and a flight to quality, also rebounded. High commodity prices, dwindling supply due to buybacks of sovereign debt by issuing countries, and renewed interest by investors resulted in strong performance. Returns for bonds issued in local currencies performed particularly well, as the dollar fell relative to most currencies during August. In light of the increasing expectation that domestic interest rates may have reached a cyclical peak, many feel that the dollar may struggle to continue to fuel its relative appreciation.

Despite this at least temporary shift in policy, the Fed’s balancing act is far from over. A souring housing market could continue to apply downward pressure on consumer spending. Inflation continues to be of legitimate concern to the Fed, who will be watching productivity reports, wage increases, and jobless claims in early September to determine a course of action at their next meeting. On the other hand, the full impact of prior interest rate hikes has still not been fully absorbed by the economy. We believe that some moderation in investor sentiment may be in order. Short-term investor sentiment is notoriously volatile; the recent resurgence in riskier asset classes notwithstanding, we continue to recommend a long-term view in decision-making that should trump any short-term trends. A strategy that employs broad diversification across a range of asset classes should continue to provide appropriate participation in a positive market environment yet provide adequate protection during down markets