Second Quarter 2008 - Market Commentary

Initial Steps Toward Market Normalization

Former British Prime Minister Harold Wilson once said, "I am an optimist but an optimist who carries a raincoat." This quote reflects a perspective on how the current market environment can be viewed. Economic uncertainty persists. However, the second quarter saw the first tentative and essential signs of market stabilization. One step in this process was the Fed's unprecedented policy initiatives implemented during the second half of March. These actions were designed to enhance liquidity and influence interest rate spreads (particularly interbank spreads i.e., the rate at which banks lend to each other) thus easing market disruptions that caused markets to seize during the first quarter.

Economy Continues Under Pressure

The signs of a tentative return to stability in the financial markets were not as visible in the broad based economic data during the second quarter as it continued to suggest a prolonged period of slow growth. The Fed cut the funds rate an additional 0.25% to 2.0% on April 30th and signaled that further cuts were unlikely.

Non-farm payrolls declined 149,000 for the period March through May, while unemployment rose from 5.0% to 5.5% in May. Housing prices continued to decline and mortgage rates rose approximately 0.50% in the last month. Declining home prices and rising mortgage rates do not suggest a quick resolution of the housing crisis. The stabilization of housing prices is critical to long-term economic growth. If housing prices decline more than what is currently anticipated, mortgage portfolios will be negatively impacted. This would raise the potential for additional write-downs by the banking industry and other financial institutions.

The higher than expected level of consumer spending surprised a few analysts during the quarter even as consumer confidence declined to recession levels not seen since 1992. The May tax rebates were assumed to be the rationale for the consumer spending/confidence paradox. Overall economic growth (GDP) is expected to come in around 1.0% - 1.5% for the second quarter.

The Fed, Inflation and Interest Rates

The Fed and the economy continued to face many risks as the second quarter concluded. The potential failure of mortgage related financial institutions and the resultant negative impact on the financial system, while reduced by aggressive Fed actions, still lingers (i.e. Fannie Mae and Freddie Mac). Housing deflation and its broad impact on both consumers and the banking industry is worrisome and that, along with continuing economic concerns, will help to ensure that Chairman Bernanke keeps his day job.

Essential to the Fed's success is identifying and focusing on the "probleme du jour." In early June, the issues of credit and housing were temporarily put aside and focus was directed towards inflation. The driving force in this shift has been the growth in "headline inflation" (which includes food and energy). There is a concern that longer-term inflationary expectations might accelerate if "headline inflation" continues to outpace the rise in core inflation. (The rationale for having different measures of inflation is that core inflation is less volatile and thus more accurately measures inflationary trends). Core inflation remains slightly elevated above the Fed's "comfort zone" of 1% to 2%. In response, financial markets drove interest rates higher.

On Wednesday June 25, the FOMC (Federal Open Market Committee) decided to leave the Fed Funds rate at 2.0%. The aggressive policy actions taken by the Fed over the last ten months have officially ended and we have transitioned into the "pause" stage. One analyst suggested that Bernanke and company are playing "Whac-A-Mole" in attempting to effectively influence independent but overlapping problems facing the economy. The Fed, supported by economic data that suggested a deep recession was not imminent, increased its anti-inflationary expectations rhetoric. The official comment stated that the downside risks to growth "appear to have been diminished somewhat" while the "upside risks to inflation and inflation expectations have increased" (think of oil at over $140 a barrel). Their weapon of choice at this time is strong anti-inflationary rhetoric, though some experts anticipate a Fed rate increase this summer. We'll see.

Equities - "Want to Ride a Roller Coaster with Me?"

Broad Market Index Returns Second Quarter 2008

The equity market had a difficult first quarter with the S&P closing out March down in the double digits. Despite a larger than expected decline in non-farm payrolls for March, the S&P rallied impressively and ended the first week of the new quarter up 4.20%. The good feelings were short lived as General Electric posted disappointing earnings causing the market to give back -2.74%, or more than half of the previous week's gains. The view that increased volatility was an integral part of the investment landscape was reinforced the following week as the S&P moved aggressively higher, finishing the week up 4.31%. The Fed cut the funds rate an additional 0.25% on April 30th and, in response, the market rallied 1.15%, which equated to a recovery of 60% of the decline experienced in the first quarter.

During the first week of May the S&P dropped 1.81% mostly in reaction to rising commodity prices and specifically to a $9 increase in the cost of a barrel of oil. The dance of volatility continued as the S&P rallied 2.67% the following week. A review of the Fed minutes from the April 30 meeting indicated an increasing concern regarding inflationary expectations. This insight, combined with weaker than expected economic fundamentals and oil at $135 a barrel, drove the S&P down 3.47% during the third week of May. Market returns continued to be schizophrenic the last week of May with the release of surprisingly strong economic data. The S&P rose 1.78% for the week on solid durable goods orders, positive April new home sales and core inflation numbers that met analyst expectations.

The rollercoaster ride continued into the first week of June when the S&P lost 2.83%, principally as a result of a spike in the unemployment numbers from 5.0% to 5.5% and the loss of 49,000 additional jobs. The weekly volatility took a breather during the second week in June as the S&P went virtually unchanged for the period. The calm of the previous week was altered as weak economic data combined with negative company headlines took the S&P down 3.10% during the next-to-last week of the quarter. It continued to fall in the last week of June after the Fed announced on June 25 that they were leaving the Fed Funds rate unchanged. After all these gyrations, the S&P 500 ended the second quarter down 2.7% (whew!).

As illustrated in the chart below, the quarter's best performing sectors were energy (up an eye-popping 16.9%), utilities, materials and information technology. Healthcare and telecom services were down again in the second quarter but pared their losses. For the most part, consumer discretionary, consumer staples, industrials and particularly financials repeated their poor performance registered in the first quarter.

U.S. Equity Market Returns by Major Sector (Securities in S&P 500, Second Quarter 2008)

The performance of international equities during the second quarter was good depending on one's viewpoint. Japan, Eastern Europe, Latin America and the Pacific Basin all had positive returns reversing first quarter negative performance. The MSCI EAFE index, Europe and EM (Asia) continued to have negative returns albeit smaller than their first quarter losses.

Non-U.S. Equity Market Returns By Country US Dollars - Second Quarter 2008

Interest Rate Securities - Adjusting to the New Realities

The "flight to quality" strategy that benefited treasury securities in the first quarter began to unwind during mid-April. The 10-year treasury rose from 3.44% on March 28 to 3.86% on May 2. Treasuries remained relatively stable until the middle of June when the market, concerned that the Fed was shifting toward a tightening bias, took the 2-year treasury up 0.625% and the 10-year up 0.375%. The yield curve has flattened as the 2-year treasury has risen 1.0% versus the 30-year treasury rising only 0.25% since April 1st.

U.S. Treasury, Muni and Corporate 30-Year Yield Curves

Corporate bond new issuance set records in the second quarter as corporations employed a "preemptive" strategy designed to borrow prior to any potential rise in rates. As the quarter ended, corporate yields were higher than treasuries.

The municipal market is clearly attempting to adjust to new realities in the market. The subprime crisis has caused the entire concept of insured municipals to be re-evaluated. Investors and professional traders are reverting to the old fashioned, but fundamentally solid methodology of analyzing municipal credit worthiness. We are asking - what is the intrinsic value or underlying strength of the issuer? The municipal market, while going through a major re-structuring, offers value and should emerge substantially stronger