March 2007 Investment Report

There was negative economic news …

Economic data was broadly weaker in March. Consumer spending, as measured by retail sales, rose a meager 0.1% in February and was less than expected. Continued weakness in housing and frigid weather may have restrained spending. Consumer confidence also fell in February, as consumers demonstrated concern regarding the future of the economy. Business spending was also subdued as durable goods orders (big-ticket items like machinery and equipment) rose 2.5%. However, a subset measure analyzing non-defense related orders excluding aircraft spending, actually decreased by 1.2%. Hence, evidence in February pointed to weaker spending in both the consumer and business sectors.

… and evidence of inflationary pressures.

Additionally, inflation data is trending a bit higher. Inflation as measured by the Consumer Price Index (CPI), rose a higher-than-expected 0.4% in February, with the year-over-year core (which excludes the more volatile food and energy costs) CPI at 2.7%, outside of the Federal Reserve’s comfort zone of between 1% and 2%. The Producer Price Index, a measure of wholesale inflation, was up a very meaningful 1.3% for February. These price increases may not be passed on to consumers by businesses, but the higher number is an indication that price of the price to produce goods is trending higher.

Investors continue to wait for signals from the Federal Reserve …

While slowing economic growth would normally lead the Federal Reserve to cut interest rates, inflation measures seem to be trending higher which would normally lead the Federal Reserve to raise interest rates. Although the Fed left rates unchanged at 5.25% in March, investors’ focus was on the Fed’s statement regarding its bias for the future direction of interest rates—to tighten (raise rates) or to ease (lower rates). The changes in the accompanying policy were widely interpreted as a shift away from a tightening bias as the Fed removed language that economic growth appeared to be “firming” and acknowledged that housing correction was “ongoing” rather than stabilizing. The Fed did acknowledge, however, that inflation continues to be the “predominant” threat.

… and worry about the consequences of default rates in the subprime
mortgage market.

Besides a focus on interest rates and the Fed, the “slowdown in housing” was also prominently in the business headlines in March. New home sales fell again in February, down 3.9%, despite economic forecasts of a 5.7% rise. Existing home sales, however, surprised to the upside by rising 3.9%. New home sales are considered a more accurate measure of housing activity as sales are recorded when a contract is signed. But what truly made headlines in March was the “meltdown” in the subprime mortgage market. Subprime loans are loans made to borrowers that are less credit worthy and the loans usually carry higher interest rates.

Media coverage of the problems of the subprime market was vast and a source of investor concern. Stories ranged from details of high delinquency rates and high foreclosures, to the saga of New Century, the second largest subprime lender and its probable bankruptcy. Subsequently, media coverage shifted to the possible fallout—how the subprime woes could spread, as lenders tighten credit standards and restrict lending, and how consumers will reduce consumption and thus further weaken a slowing U.S. economy.

What about gasoline prices?

In addition to the consequences of a beleaguered housing market and its possible effect on the consumer, the path of oil prices garnered a lot of attention in March. Oil prices continued to move up in March, climbing from $63.97/barrel at the beginning of the month to $67.47/barrel by the end of the month. New tensions with Iran, which captured 15 British soldiers, created anxiety for investors who realized that oil shipments from Iran could be in jeopardy and bid up the price of oil in response.

Market Reaction

Amidst all the uncertainty and the continued market volatility, stock markets ended in positive territory at the end of March. The Dow was up 0.7%, the S&P500 gained 1.1% and the Nasdaq returned 0.2%. U.S. bond markets reacted differently focusing on the inflation threat. For the first quarter of the year, the Dow declined 0.9%. The S&P 500 and Nasdaq markets both produced modest gains of less than 1%. Bond markets gained about 1.5% for the quarter.

Investment Fund Review

Despite the volatility in U.S. and world stock markets, all six daily priced funds offered by the General Board increased in value in March. International stock markets outperformed U.S. stock markets, as global merger & acquisition activity boosted overseas companies and strong commodity prices helped foreign markets. The U.S. stock indices are the weakest performers for the year. Conversely, U.S. bond markets have generally performed better than international bond markets.

The Inflation Protection Fund gained 0.4% in March, outperforming its performance benchmark which returned 0.2%. The fund’s 10% allocation to commodities helped the fund’s performance in March as commodity prices rose. For the year, the fund has gained 2.5%, ahead of its benchmark return of 2.4%. The strong performance by commodities is the primary factor for the fund’s outperformance, although gains in commodities were partially offset by the fund’s holdings of international bonds, which did not perform as well as U.S. inflation linked bonds.

The Domestic Bond Fund gained 0.1% in March, also ahead of its performance benchmark which returned -0.1%. The primary factor influencing the fund’s return in March was the allocation to debt from lesser developed countries. Weakness in the U.S. dollar also helped the fund’s performance of these bonds, which are denominated in currencies other than the U.S. dollar. For the year, the fund has gained 1.5%, slightly behind the 1.6% return of its performance benchmark. There were several factors that both positively and negatively impacted performance. The primary difference between the fund’s return and the benchmark return is attributable to the fund’s investment management and fund administration expenses.

The Domestic Stock Fund rebounded in March, rising 1.1%, keeping pace with its benchmark. As indicated, U.S. markets rose as investors anticipated that the Fed may be inclined to cut interest rates in light of a slowing economy. For the year, the fund has gained 2.6%, ahead of its benchmark which rose 1.3%. Several factors accounted for the fund’s better than benchmark performance. The fund continues to benefit from a higher than average exposures to the stocks of small and mid-sized companies, which have performed better that stocks of large companies. Additionally, the General Board’s small and mid-sized company investment managers have added significant value compared to their respective benchmarks for the year-to-date. A third factor was the positive contributions from the General Board’s private real estate partnerships.

The International Stock Fund was the best performing General Board fund in March, adding 3.0% and outperforming its benchmark, which returned 2.8%. The fund benefited from a higher exposure to companies domiciled in lesser developed countries and to stocks of small companies. For the year, the fund has gained 3.6% compared to the benchmark return of 3.8%. Performance compared to the benchmark is adversely affected by its exposure to stocks from lesser developed countries, which have performed worse than stocks from developed countries.

The Multiple Asset Fund turned in solid performance in March, gaining 1.2%, surpassing its performance benchmark by 0.2%. The fund benefited from the positive performance of the International Stock Fund, the Domestic Bond Fund, and the Domestic Stock Fund. For the year, the fund has gained 2.5% compared to its benchmark return of 2.0%. This difference is attributable to the better than benchmark performance of the Domestic Stock Fund.

The Balanced Social Values Plus Fund advanced 0.6% in March, underperforming its benchmark by 0.2%. Two factors contributed to the underperformance for the month. The fund’s growth style of investing underperformed the broader market in March. Additionally, a rise in yields hurt the affordable housing investments which have longer maturities. For the year, the fund has gained 2.1% compared to the 1.4% return of the benchmark. For the year, the fund’s equity holdings have outperformed the broader market.

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