Economic Environment
After considering the continued slump in the housing market, rising long-term interest rates, high oil prices and the state of the sub-prime mortgage market, one could reasonably expect to be in the midst of a very difficult economic environment. Nevertheless, even in these strong face winds, the economy continues to grow at a healthy rate and run at virtually full employment, with the unemployment rate at multiyear lows of just 4.5%. This level of employment has sustained wages, further helping to fuel gains in personal income and retail sales.
There is no doubt that the state of the housing market continues to be one of the most significant potential drags on the economy. Sub-prime mortgage woes are resulting in tighter lending standards and likely will result in continued upward rate pressure on such loans. Should interest rates continue to rise, this may continue pressure on the housing market and impact consumers, many of whom have looked to such value to justify and finance much of their spending. This could dampen consumer spending that has been suprisingly strong through much of this housing market condition, which has persisted for several quarters now.
Also of concern to the general economy would be the yield curve, which has climbed out of its inverse mode (i.e. short-term rates higher than long-term rates). This was seen as long-term rates climbed above 5%, slightly above short-term rates, on overall strong economic news. Historically, equities and bonds have decreased as interest rates have increased. This is generally attributable to the belief that higher interest rates worsen the credit climate for businesses, making it more expensive for them to use leverage to grow. However, though long-term rates are on the rise, they are still not relatively high from a historical perspective. Some economists also believe that the recent rise in interest rates is actually healthy for the economy, as it may help control inflation, strengthen the dollar internationally, temper the rapid pace of deal making in private equity, and discourage excessive risk by hedge funds.
Thus, the case for continued economic strength can be made, but one does not need to look hard to find many potential potholes. Should conditions deteriorate, there will be many who will be quick to tell you they told you so. As there is no way to accurately predict the future in this regard, it is appropriate from an investment policy perspective to not even attempt to do so. Rather, only commit funds to more volatile asset classes such as equities, with dollars that you will likely not need to access for several years. The ability to maintain this growth-oriented exposure through tough times that are bound to occur, will ensure you are fully invested for the good times that will also come.
Equity Markets
The solid economic fundamentals seen during the recent quarters, translated into very favorable performances for equity markets around the world. New all-time highs were common in many equity markets during the quarter, as was the case, for example, for the Dow Jones Industrial Average, which hit a series of new all-time highs and gained 8.5% - its best quarterly statistic since 2003. International emerging markets continued to lead the growth in worldwide equity markets, as they have now for almost two years. The declining U.S. dollar, strong local corporate earnings, and steadily expanding economies in these emerging markets have contributed to this success.
Domestically, for the first time since 2003, growth stocks are outperforming value stocks through the second quarter of 2007. Growth leads value in all three primary capitalization groups: large-cap, mid-cap and small-cap. In addition, large-cap stocks outperformed small-cap stocks in the quarter. Typically, large-cap stocks have been seen to be better able to weather stock market volatility caused by higher interest rates, and benefit more from strong global growth.
Except for the domestic publicly traded real estate market, most other domestic and international equity markets provided exceptional returns for the second quarter of this year. This resulted in strong quarter and full-year returns for U.S. large, mid and small-cap equity indices for the previous twelve months, and very solid results for international averages for the same periods. Further, even in light of weak U.S. real estate markets, this sector has still provided an 11.6% return for the 12-month period ending 30 June 2007.
The table immediately below reflects the quarterly and annual returns seen in benchmark sectors with our model growth component.
Benchmark Sector |
Index |
3 Month Return |
12 Month Return |
|
Large-capitalization Domestic
|
S&P 500 |
6.3% |
20.6% |
|
Mid-capitalization Domestic |
S&P 400 |
5.8% |
18.5% |
|
Small-capitalization Domestic |
Russell 2000 |
4.4% |
16.4% |
|
Developed International Mrkts |
MSCI EAFE |
6.4% |
27.0% |
|
Emerging International Markets |
MSCI EMF |
14.1% |
41.8% |
|
Real Estate Investment Trust |
DJ Wilshire REIT |
-9.5% |
11.6% |