Market Commentary: June 2006

Second Quarter Overview

• The two additional Fed interest rate hikes during the quarter were expected; the hawkish language that accompanied those announcements and some excessively candid “off the record” comments by Fed Chairman Ben Bernanke were not. The latter signaled that the tightening cycle may have further to go than was widely believed and appeared to be the primary force that drove the equity market selloff during May and early June.
• Inflation concerns flared and the markets tumbled after Bernanke rattled the markets with his comments. The 12-month trailing CPI reached 4.2% as of May 31. Excluding food and energy, core CPI also ticked up to 2.4% for the same period, greater than the high end of the range that most believe the Fed deems acceptable.
• The yield curve flattened further as long-term rates failed to fully keep pace with the 0.5% move in the Fed funds rate. The benchmark ten-year Treasury yield finished the quarter at 5.14%, up from 4.85% at March 31. Some portions of the curve remain slightly inverted with very little term premium available across all maturities.
• Unemployment declined slightly to 4.6% in May and was expected to hold steady in June. Job growth remains relatively strong, despite increasing wage pressures and respectable productivity gains.
• Equity markets exhibited a sharp uptick in volatility during the quarter. Motivated by rising inflation concerns, investors erased virtually all of the market’s year-to-date gains. Domestic equities lost ground across the board, although the losses were partially recouped during a rally in the closing weeks of the quarter. Bonds remained flat against pressures from climbing yields.
• From April to June, the U.S. Dollar weakened further against the Euro, Yen, and Pound. The primary weakness came relative to European currencies, where year-to-date losses edged to just over 5.0%.
• U.S. equity P/E ratios moved in opposite directions during the quarter, a divergence primarily influenced by market cap. Large cap P/Es declined, while those for midcaps were flat. Small cap and international P/Es moved higher during the quarter. Relative to one year ago, larger company stock valuations continue to trend most favorably.
• The EAFE’s gain of 0.7% for the quarter was mediocre, but better than the losses posted by the domestic markets. U.S. stocks were down across the board; the S&P 500 Index loss of 1.5% easily outpaced the larger losses put up by small caps.

July 2006

Capital Markets

So far, 2006 has proven to be a bumpy ride for investors. Economic growth in the first quarter was strong and represented a solid bounce after the hurricane-dampened fourth quarter of 2005. Coupled with indications that the Fed may be close to a pause in their monetary tightening, this strong growth propelled the global equity markets forward at their strongest pace in several years. Optimism abounded and was sufficient for Wall Street to shrug off concerns about rising commodities prices, bubbling inflationary pressures, and a softening real estate market. The consensus view seemed to be that the Fed’s cumulative interest rate hikes would take hold in the second quarter, fostering a deceleration in the rate of economic growth and sufficiently checking inflationary pressure. Many believed that a slowing economy accompanied by solid corporate profits would give the Fed the opportunity it needed to pause their tightening cycle and assess whether their actions were enough to gently guide the economy to a “soft landing.”

At the outset of the second quarter, however, it appeared that the cumulative rate hikes had not yet taken hold. Inflationary pressures continued to flare in April, despite another interest rate hike by the Fed. Fed Chairman Bernanke’s “off the record” comments suggesting that inflation fears may be understated and that the need to raise rates may continue further than generally anticipated were reported by the press within days. That report appeared to be the catalyst for the selloff in both the equity and bond markets. Chalk it up as a rookie mistake for the Fed Chief, and one that he is unlikely to make again.

A reprieve came in late June, when the Fed raised its short-term rate once again by another quarter point. Though the increase was expected, it was the tone of the Fed’s statement that eased investor worries. The Fed clearly left the door open for further tightening, but those comments again seemed to indicate that the extended cycle of rate hikes could be coming to a close. The S&P 500 surged ahead 2.1% on the news and the broad, albeit brief, market rally closed out the quarter on an optimistic note.



For the quarter ended June 30, the S & P 500 Index lost 1.5%, slicing its year-to-date gain down to 2.7%; relative to the rest of the domestic market, however, large caps fared comparatively well for the quarter. The Russell Midcap Index fell 2.6%, although small caps experienced the most significant retrenchment. The Russell 2000 ended the quarter down 5.0%, but still has paced the domestic markets with its 8.2% year-to-date mark. Absent a strong rally in the final three weeks of the quarter, the results would have been much worse. During a roughly five-week span starting in early May, the global equity markets sustained significant losses. The Russell 2000 bore the brunt of the decline in the U.S. market, falling 13.9% from its peak before rebounding. During that same period, the S&P 500 fell over 7.5%. As recently as June 13, both the S&P 500 and the Russell Midcap indexes were in negative territory for the year, while the Russell 2000 was clinging to a gain of less than 0.4%.

As is often the case during rough patches in the markets, the recently high-flying asset classes were also among the hardest hit when the market downturn occurred. In May and June, those were small caps and international issues. Volatility was the name of the game for the quarter, but when the dust settled, all of the major indices were in positive territory for the year through June 30. Market leadership shifted to the international markets, as the EAFE Index year-to-date return of 10.2% was 2.0% better than small caps, the best-performing segment of the U.S. market.

As in the first quarter, bond returns were tepid at best during the second quarter. The Federal Reserve announced two additional quarter point rate hikes, bringing the Fed Funds rate to 5.25%, its highest point in over five years. Those moves were largely anticipated in advance and likely had little impact on market volatility.

For the quarter, the Lehman Aggregate Bond Index lost 0.1%, increasing its year-to-date loss to 0.7%. Municipal issues have held up slightly better under rising yield pressures. The quarterly gain of 0.1% for the Lehman 5-year Muni Bond Index accounts for substantially all of its gain for the year. Shorter term issues generally held up better among both taxable and muni bonds. The Lehman 1-3 Year Government Index provided a fractionally positive return of 0.4%, outpacing the Lehman 3-year Muni Bond Index return of 0.1% for the quarter.



Unlike nominal bonds, Treasury Inflation Protected Securities (TIPS) have benefited from increasing inflation concerns. TIPS experienced significant cash inflows during May and June, amidst mounting evidence that inflation may be running higher than previously anticipated. For the quarter, the JP Morgan US TIPS Index posted a gain of 0.3%.

Returns in international bonds were mixed during the second quarter; the Citi World Government Bond Index Hedged was flat for the quarter and remains in a loss position of about 1.0% for 2006. The Japanese and European Central Banks have embarked on tightening cycles. Rising interest rates in those markets have created a strong headwind, particularly for high yield and dollar-denominated emerging markets debt. Attractive yields, coupled with less downward price pressure, continue to provide diversification benefits in selective investments in attractive segments of the international bond market , especially those denominated in foreign currency.

Influences and Strategy

The U.S. economy and capital markets appear to be at a potential inflection point, and the Fed’s short-term interest rate strategy and message to the public may go a long way toward determining their direction. Since late 2005, there has been a general expectation that the Fed would tighten monetary policy a bit further and perhaps be at a point to pause by mid-2006. Instead, inflation fears flared in May and the markets four-week tumble wiped out previously strong gains for the year.

There is no question that the Fed is being increasingly faced with a challenging situation in dealing with their dual goals of maintaining price stability while fostering economic growth. Although recently revised Q1 GDP growth of 5.6% was very strong, that number was higher than would have otherwise been the case due to the temporary slowdown caused by the hurricanes in the prior quarter. That temporary uptick notwithstanding, the Fed’s tightening will certainly slow the rate of economic growth. Higher borrowing costs coupled with a real estate market that appears to be softening will make it exceedingly difficult for consumers to continue to borrow to spend. Given its significance relative to total domestic output, a slowdown in consumer spending will almost certainly slow the rate of growth in aggregate. Mitigating those effects to some degree are strong employment numbers and better than average growth in average hourly earnings. At its May reading of 4.6%, the unemployment rate is at its lowest point since July 2001. Similarly, year-over-year growth in hourly wages of 3.7% as of May 31 has not been so high since the summer of 2001. A tighter employment market should continue to keep wage growth strong and prove supportive of consumer spending.

As noted earlier, it seems that the threat of inflation is proving more persistent than was previously expected. Despite two full years of steady rate increases, most measures of inflation remain at unacceptably high levels. Producer prices and consumer prices are steadily increasing, even after adjustment for energy prices. Headline CPI has risen 4.2% and even core CPI is up 2.4% during the year ended May 31. Consequently, the benefit of solid wage growth has been eroded by the increased cost of living. On an inflation-adjusted basis, average hourly earnings actually declined during that period.

It is likely that the Fed will continue to raise rates as long as they deem inflationary pressures to be excessive, even at the cost of hampering economic growth. Further complicating the matter is the delay before the impact of any change in interest rates can be measured. These risks make the prospect of a more severe slowdown in the economy difficult to overlook. The stagflationary cycle of the 1970’s was only broken after then Fed Chairman Paul Volcker committed the Fed to breaking the back of inflation at the cost of a rather severe recession. While the U.S. economy is on much better ground than at that time, the Fed’s commitment to maintaining price stability would also likely trump short-term economic growth in today’s environment as well.

We do not believe that the current situation suggests that a similar outcome will be a prerequisite to stabilizing prices. The Fed continues to be mindful of the delicate balance between over-tightening and dipping the economy in recession and keeping a check on inflationary pressures. Nonetheless, the current geopolitical tension surrounding a number of oil producing states, the delicate political balance between the U.S. and several of those producers, and an already tight global supply could keep oil prices high for the foreseeable future, applying further upward pressure on headline inflation. In the current scenario, investors continue to hope that aggressive efforts by the Fed will fully address the exogenous inflationary impact of higher oil prices in the short run.

We continue to believe that a well-diversified portfolio provides the greatest probability for success through uncertain times. By emphasizing pockets of value in the equity markets, downside risk can be mitigated to some degree. Our attempt to take advantage of this through a reduction in allocation to small cap stocks proved successful as smaller companies were among the hardest hit last quarter, while larger blue chip names tended to hold up better. International stocks may also exhibit greater volatility in the event of a global downturn, but still provide valuable diversification benefits, especially if the U.S. dollar continues to weaken as anticipated or if U.S. growth falls behind the rest of the world in the short term. As always, a well-diversified bond portfolio should also cushion returns during an economic downturn. Treasury inflation protected securities and non-Dollar denominated bonds may be especially intriguing as hedges against domestic inflation and a weakening dollar, respectively. Already, recent tactical moves to non-Dollar denominated bonds have achieved positive results as they outperformed international bonds denominated in U.S. dollars. While we are far from “making a call” that a slowdown is likely, the degree of uncertainty rippling through the markets and the potential for a short-term economic correction provide ample opportunity to reaffirm the appropriateness of sound investment strategy.

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.