Market Commentary: May 2006
May was a transitional month for the U.S. economy. After three years of above average growth, it seems that much of the slack in the economy has been reduced. Indications of this are the mixed signals the economy is providing to economists and Wall Street. Fundamental measures, such as employment and consumer spending continue to be strong, although a fall off in consumer spending remains a very real risk for the economy. In May, housing seemed to be cooling off as mortgage rates crept higher. At the same time, energy prices continue to move higher. Both of these weigh heavily on spending attitudes and could impact consumer’s discretionary spending. The unemployment rate at the end of May remained low at 4.6%, although the number of jobs added during the month fell well short of expectations. All in all however, the economy continues with adequate momentum along with higher inflation, keeping the Fed vigilant.
May’s mixed economic indicators, along with indications that the Fed may not be finished driving rates higher, resulted in several volatile swings in the market and heightened risk aversion for investors on a global scale. On May 10th the Federal Reserve raised the Fed Funds rate by 25 bps to 5.0%, the 16th consecutive rate hike since mid-2004. With its announcement of the last increase, the Fed laid out a forecast that seemed to indicate that an easing or, at least, a pause in monetary policy would be likely in June. However, in late May, some economic indicators seem to suggest that inflation was running higher than the Fed’s targeted range.
The probability of another rate increase caused domestic equities to retreat across all market caps. Hardest hit were small cap stocks, with the Russell 2000 down 5.6%. The negative performance of small caps ends a rally by that asset class, which stretches back to 2003. Outperforming small caps, although still negative for the month, were mid-cap and large cap stocks. The Russell Mid-Cap and the S&P 500 indices were down 3.4% and 2.9%, respectively.
Like their domestic counterparts, foreign stocks also declined in May. The EAFE Index, a measure of equity performance in foreign developed countries, declined 3.9%. Concerns about U.S. and global interest rates, indications of a slowing global economy, and a flight to less volatile investments seemed to be the catalysts for international equity underperformance. Emerging markets were hit particularly hard during the month, declining by roughly 11%.
Conflicting economic pressures resulted in mitigated returns for the domestic bond markets. The Lehman 1-3 Year Government index was up slightly by 0.1%. The broader bond market as measured by the Lehman Aggregate index ended the month down 0.1%. TIPS prices were on the rise early in the month, as strengthening commodities prices and a weakening dollar drove core inflation projections higher. In contrast, in the latter part of the month, we saw signs of economic activity easing, a strengthening dollar, and more hawkish words from the Fed. The Lehman Treasury Inflation Notes Index was up 0.3% for the month. Long-term and short term municipal bonds performed similarly, as the Lehman 3 and 5 Year Muni Bond Index both returned 0.4%. Some of the recent tailwind experienced by municipal bond investors has been a result of flight to higher quality.
Though international bonds experienced losses during the month, a strengthening dollar was able to generate enough return to create a slight gain for investors who held dollar denominated bonds. During May, the Citi World Hedged Government Bond Index gained 0.5%. A fear of rising global interest rates and inflation were two of the primary drivers of this asset class. Increased risk premium from investors was also a strong headwind, particularly for high yield and emerging markets debt.
While the Fed’s comments during the month were the primary factor leading to the market volatility in May, short term actions by speculative investors also contributed to losses. Though it is uncertain at the time of this article whether short term economic information will lead to further restrictive monetary policy, a potential for higher rates was enough to make short term investors move away from stocks. History, however, has repeatedly shown that short term shifts in investment strategy usually work against individual investors. What has benefited individual investors is a long-term approach based on well thought-out investment objectives, implementation with a strategic allocation, and enough conviction to adhere to the strategy. It is this type of investment strategy that we promote and believe our clients will gain from the most.
