After posting strong returns across the board in the first quarter of the year, the markets bounced around quite a bit during the second quarter. Several factors contributed to an increase in volatility, including a new Fed chairman, higher oil prices, and continued geopolitical tensions in the Middle East.
These choppy markets occurred against a backdrop of a growing domestic economy. GDP growth in the 1st Quarter (the most recent reported period) was a robust 5.6%1, with a portion of this growth due to increased economic activity related to the rebuilding of the Gulf Coast. While this increased activity is not expected to continue, consensus projections indicate that overall economic growth is expected to remain in a healthy 3%2 range for the balance of the year.
Inflation, as measured by the Consumer Price Index, increased during the second quarter, with the May year-over-year figures coming in at 4.2%3 overall, and 2.4%4 excluding food and energy. The main drivers for the overall increase were transportation and energy costs, both of which factor into a myriad of price increases throughout the economy. In response to the threat of continued inflation, the Fed continued to raise short term interest rates, boosting the Fed Funds rate by .25% at both their May and June meetings to a current level of 5.25%5.
The S&P 500 Index reached a year-to-date high in May before sliding sharply, then recovering at the end of June to finish the quarter down 1.44%. Developed international markets, represented by the MSCI-EAFE Index, finished up slightly for the quarter, while the MSCI Emerging Markets Index declined by over 4%, reversing what had been strong performance over the past several quarters.
Within the U.S. markets, small and mid cap growth stocks had a tough quarter, with the technology heavy NASDAQ Composite declining by 7.01%. Growth stocks in general have struggled throughout the first half of the year, due in part to concerns that the Federal Reserve will tighten too much and constrict growth in the economy during the balance of the year. Large cap value stocks, represented by the Russell 1000 Value Index, were the only positive US equity asset class during the quarter with a return of 0.59%.
Bond investors continue to fight the headwind of continued tightening of 17 consecutive rate increases by the Federal Reserve. The benchmark for US bond investors, the Lehman Aggregate Bond Index, was essentially flat for the quarter at -.08%. Global bond returns were more attractive, as the Lehman Global Bond Index returned 2.39%.
As we look forward to the second half of 2006, we see several signs of potential opportunity ahead. As noted above, the U.S. economy is expected to continue to grow at a reasonable rate. In addition, the Federal Reserve may be close to ending their tightening cycle, which would remove a level of uncertainty from the market. Finally, while ongoing geopolitical events can always have an unexpected impact on the financial markets, the world’s capital markets have shown remarkable resiliency in the face of past events and appear to have now “priced” these risk factors into current valuation levels.
1 Bureau of Economic Analysis of the U.S. Department of Commerce: Gross Domestic Product 1th Quarter 200 Final Release, June 29, 2006
2 Average of responses for each quarter of 2006 from Bloomberg Monthly U.S. GDP Forecast of the 60 top economists surveyed
by Bloomberg from May 30th – June 7th, 2006.
3 Bureau of Labor Statistics Consumer Price Index Summary Release for the month of May 2006 released on June 14, 2006
5 Federal Reserve Press Release June 29, 2006 on the actions of Federal Open Market Committee