Market Commentary:  January 2007

With a number of final economic indicators of 2006 coming into focus, it seems that we have continued on a path to a slowing but healthy economy. On January 31st, the U.S. Bureau of Economic Analysis reported that the advance estimate for gross domestic product (GDP) for the fourth quarter came in at 3.5%. This stronger than anticipated fourth quarter result brought the estimate of GDP growth for 2006 to 3.4%, slightly above the historical trend. Despite that final quarter uptick in economic growth, inflation has remained subdued. Its marked improvement in recent months is likely a result of easing oil prices and the Fed’s tighter monetary policy, as well as the mid-year deceleration in growth. Inflation, as measured by the year over year change in the Consumer Price Index (CPI), came in at 2.5% for December after reaching over 4.0% in mid-2006. While this inflationary measure persists slightly above the high end of the Fed’s de facto target range, its continued improvement has not been overlooked by market observers or central bankers.

The Fed’s statement from their meeting on January 31^st acknowledged that inflationary pressures appear poised to “moderate over time”. Despite this, the Fed has conveyed that inflation remains a risk, primarily as a result of the tight job market and resulting strong real wage growth. The housing market represents another risk, although recent data coming from the housing sector suggests moderate improvement. The year-over-year slowdown in housing tightens up the ability of consumers to borrow against home equity to spend and has put a drag on the overall construction industry. Some have estimated that the housing downturn’s impact on construction alone may have reduced annual GDP growth in 2006 by over 1.0%[1].

At its last meeting, the Fed maintained its target for the federal funds rate at 5.25%. Although the announcement was made on January 31, leaving little time for that statement to be absorbed by the market before the close of the month, both stocks and bonds rallied. This response seemed to be more a positive reception to the Fed’s stated outlook for continued growth and moderating inflation than a reaction to the Fed’s decision to stand pat, which was widely anticipated by the market.

Reports of moderate economic data kept stocks moving in a positive direction throughout January without regard to market capitalization or style. Small cap stocks bested large cap stocks for the month by a narrow margin. The Russell 2000, which measures small cap stocks, closed the month with a return of 1.7%. The S&P 500, which tracks large cap stocks, returned 1.5% during the same period. Mid-cap stocks paced the U.S. market, as the Russell Mid-cap Index returned 3.4% for the month, showing that stronger relative performance may be incrementally shifting up to larger companies, a typical phenomenon as the economy slows.

Investors continued to benefit from positions in foreign stocks. For January, the MSCI EAFE Index returned 0.7%, as the economic situation abroad continues to be viewed positively by investors. Specifically, Europe has benefited from historically low unemployment, while Japan continues its move to surer economic footing, as its central back decided to hold-off on further rate increases. These factors, combined with growing prospects for a stronger-than-expected U.S. economy, have given investors reason to continue to bid up the price of foreign stocks. A strengthening dollar, however, was a headwind for U.S. investors in most foreign markets. Emerging market stocks were the only equity sub-asset class to sustain losses during the month. The MSCI Emerging Markets Index fell 1.0% in January. Falling commodities prices, negative geopolitical developments, and increasingly positive global economic data that could shore up liquidity for emerging market companies (by way of higher global interest rates) all appeared to contribute to the decline.

The bond markets remained relatively flat during January, as mixed economic data kept the market in a fairly narrow range. The Lehman Brothers Aggregate Bond Index, which measures the broad bond index, effectively provided no return for the month. Shorter term bonds fared only slightly better as the Lehman Brother’s 1-3-year Bond Index returned 0.2%. Returns for municipal bonds generally trailed their taxable counterparts. The Lehman Muni 3-year Bond Index and the Lehman Muni 5-year Index returned 0.0% and -0.2% respectively. Foreign bond investors weighed positive economic news against a slightly improving possibility that global interest rates could increase, creating a wait and see mentality among investors. This left the Citi World Government Bond Index nearly flat with a loss of 0.1%. Non-dollar denominated emerging market debt fell even further as the dollar rallied against most major currencies. This seemed to reflect a growing sentiment that a Fed rate cut in the near term appears increasingly unlikely and an increasing perception that its next move may involve further tightening. Against the Euro and the Yen, the dollar rose 1.8% and 2.2%, respectively.

Overall, it appears that the U.S. economy, while slowing, remains poised to downshift to a sustainable level while avoiding a painful retrenchment. Economic expansion is expected to continue in 2007, albeit at a slower pace than in 2006. Given that expectation, we also expect that equity markets will struggle to replicate last year’s strong returns. From a valuation standpoint, large caps and international stocks appear reasonably valued and could produce solid performance, as is typically the case during the latter stages of the economic growth cycle. Given the unexpected resilience exhibited by the economy recently, investors continue to expect a soft landing. While we still believe this is a likely scenario, we continue to be aware of a number of potential downside risks to the market. The possibility of a meaningful surge in oil prices, reignited inflationary pressure, or a restoration of Fed tightening, although unlikely, could return volatility to the market, especially within the context of a reasonably upbeat economic forecast. As always, prudence dictates diversification across asset classes, market capitalization, and style, as a lower return scenario should not imply lower risk.

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other source believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the sectors mentioned herein may not be appropriate for you. You should consult a representative from Plante Moran Financial Advisors for investment advice regarding your own situation.