Uncertainty is a common characteristic of transitional periods, and the economy’s current transition to slower growth is no exception. Uncertainty about oil prices, inflation, and whether the Fed would hike the Fed funds rate for an 18^th consecutive time in August led to jittery investor sentiment during July. Of all of these issues the last one, in particular, seems to be the primary cause of investors’ edginess. Adding to investor concerns in mid-July were several geopolitical events that added to short-term volatility.

Overall, 17 previous interest rate hikes seem to be catching traction as the economy has shown some signs of slowing. Gross Domestic Product slowed to a weaker than-expected annual growth rate of 2.5% during the second quarter, down from an unsustainably strong 5.6% annualized rate in the first quarter. The housing market continued its slowing trend as well. Home sales continue to decrease, down 9.6% over the 12-month period. As sales have decreased, the number of houses for sale has reached multi-year highs and is 39% higher than a year ago. The slower demand for houses is a typical reaction by potential home buyers in this stage of the economic/interest rate cycle as higher short-term rates (delete comma) result in higher mortgage rates. Also attributable to the Fed rate increases are higher refinancing rates, which have reduced consumers’ ability to borrow against their homes to support spending.

Oil prices hovering around $75 per barrel throughout July, are finally hitting consumers in places other than at the gas station. At the end of July, the Commerce Department released a report that the price index for personal consumption expenditures (PCE) excluding food and energy jumped ahead to an annual rate of 2.4% in June, indicating that companies are starting to pass their higher energy costs on to consumers. At 2.4%, the PCE rate is at its highest point since 1995 and well above the Fed’s stated comfort-zone for inflation.

Intensifying the jumpiness of investors has been a series of unsettling geopolitical events. The Israeli-Hezbollah conflict, Iran’s nuclear aspirations, Korea’s missile tests, and terror attacks in India have rattled investors. While we do not wish to down-play the devastation resulting from such actions, it is pertinent that we point out that the long-term economic impact of such global events throughout history has been small. Situations involving economic instability, not political crisis, are most likely to have a significant impact on a portfolio. Political unrest, although hard to specifically predict, is generally accounted for as we prepare economic and market expectations. Broadly diversifying portfolios with managers who have asset class expertise and proven records of managing assets during times of geopolitical unrest is the best way to mitigate the risks of an evolving geopolitical landscape.

Stocks suffered in the later part of the month, after soaring early in July. Investors continue to favor larger and higher credit quality companies. This was demonstrated in July by the S&P 500 Index, which led the way for domestic stocks with a return of 0.62%. Bullish sentiments in large cap stocks can largely be attributed to investors’ outlook for slower growth in the economy. Attributes such as stronger balance sheets, more diverse business operations, and generally stronger dividend yields, mitigate these companies’ exposure to a slowdown in economic growth. Medium and small companies, which tend to grow more quickly as the economy heats up, trailed large companies and ended the month with losses. For July, the Russell Mid Cap Index fell 2.2% and the Russell 2000 Index, which tracks small companies, fell 3.3%. As the prospect of future interest rate hikes loom and the economy continues to slow, we expect that continued favor of large cap stocks could persist.

Although interest rates have been rising across many foreign developing countries, foreign stocks outperformed domestic stocks in July. The MSCI EAFE, which tracks international developed stocks, returned nearly 1.0%. Like investors in domestic stocks, foreign stock investors seem to be vigilantly sifting through economic statistics trying to anticipate the Fed’s next move. Strong earnings reports from key industries helped foreign stock performance somewhat. Nevertheless, the appreciation of many major foreign currencies against the dollar appeared to be the greatest contributor to strong foreign stock performance.

Despite a fairly volatile month due to inflationary and geopolitical concerns, domestic bonds outperformed domestic stocks. They were helped considerably toward the end of the month, when comments made by Fed Chairman Ben Bernanke led bond investors to anticipate a near-term halt in monetary tightening policy. Bernanke’s comments combined with signs of a slowing economy have caused many investors to regain a bullish perspective on bonds. Investment grade intermediate-term bonds were among the best performers. For the month, the Lehman Aggregate bond index climbed 1.4%. Shorter-term bonds, which are less susceptible to interest rate movements, posted a more muted gain, as the Lehman Brothers 1-3 returned 0.8%. Municipal bonds also charged ahead as the Lehman 3-year Muni Bond and the Lehman 5-year Muni Bond Indices returned 0.7% and 0.9%, respectively. With the appreciation of longer-term bonds during the month, the U.S. Treasury yield curve has remained flat, mildly inverting at times. This has been primarily a function of the Fed’s 17 consecutive interest rate hikes coupled with high demand for longer-term bonds.

International bonds, like domestic issues, posted solid returns. The Citi World Government Bond appreciated 1.1% in July. Much of that performance also appeared to stem from a consensus view that the Fed may be close to a pause in monetary tightening. As the foreign bond market settled down after much choppiness, its investors, flush with cash from buybacks and coupon payments, are poised to put their money to work. Bonds denominated in foreign currency fared particularly well as the dollar weakened relative to foreign currencies, amid a softening U.S. economic forecast and the outlook for U.S. monetary policy.

With the economy indicating that slower growth is on the horizon and inflation still persisting at higher than optimal levels, the Fed is in a precarious position. Over time, the slowing economy should dampen inflationary pressures. Even with the recent Fed pause, any indication that the economy could withstand another interest rate hike is met with concern from investors and increased volatility. As the uncertainty regarding the direction of interest rates and the economy continue to loom over the markets, we are steadfast in our conviction that a diversified portfolio based on sound financial strategy is the best way to prepare for an opaque economic outlook.