May 2007 Investment Report

Data on economic growth was mixed, but there are signs of optimism.

Data released early in May continued to signal weakening in U.S. economic conditions. Initially, employment growth was weaker than expected in April with only 88,000 new jobs created. The unemployment rate nudged up to 4.5% from 4.4%. Any weakness in the labor market would confirm slowing economic growth and increase the likelihood of a decrease in interest rates by the Federal Reserve. In addition to weaker employment numbers, retail sales data also disappointed investors. Retail sales fell, as consumers faced higher gasoline and food prices in the month and declining home values. Further, the first estimate for the first quarter’s gross domestic product (a popular measure of economic growth) was revised down to 0.6% from 1.3%. Finally, housing data continued to cause concern. Existing home sales further declined and the data indicated increasing inventory of unsold homes. New home sales, on the other hand, surged in April, perhaps due to builders’ incentives.

However, data issued later in the month were more positive. It appears that business investment may be compensating for the slowdown in housing and consumer spending. Durable goods spending continued to show positive signs. Core orders (the orders excluding aircraft and defense) which serve as a proxy for business investment in machinery and equipment, rose for a third month in a row. Additionally, the Institute of Supply Management index, which measures manufacturing on a national level, also moved unexpectedly higher indicating that company purchasing managers expect that they will be increasing purchases. Also, despite the poor housing markets and gasoline prices, consumer confidence as measured by the Consumer Confidence index moved surprisingly higher. These positive economic signs all but erased expectations of an interest rate cut later this year. In fact, based on the apparent strength of the economy, some market observers feel the Federal Reserve are more likely to raise rates by year end.

Inflationary pressures appear to be easing.

At its May meeting, the Federal Reserve held interest rates steady at 5.25%, citing inflation as the “predominant concern.” Yet, inflation data released in May appears to be moderating. The personal consumption expenditures (PCE) deflator, the Fed’s preferred inflation measure, did not change in March, bringing the year-over-year change to 2.1%, which is just barely outside the Fed’s comfort zone for inflation of 1-2%. The core Producer Price Index, a measure of wholesale inflation, remains unchanged. The core Consumer Price Index decreased in April.

Market Reaction

With strengthening economic growth and decreasing inflationary pressures, investors cheered. The S&P500 reached a new high in May, closing above its March 2000 high for the first time. Strong earnings reports and merger and acquisition activity continued to drive stocks higher. With the stronger economic data erasing hopes for a Fed rate cut, treasury yields moved higher in May up to 4.89%. In May, the Dow Jones Industrial Average was up 4.6%, the S&P 500 gained 3.5% and the NASDAQ returned 3.7%. Fixed income instruments were hurt by increasing interest rates. For the year, the Dow has advanced 10.4%, the S&P 500 is up 8.8% and the NASDAQ is up 10.7%.

Investment Fund Review

Four of the six daily priced funds offered by the General Board increased in value in May. The Domestic Bond Fund and the Inflation Protection Fund declined in May as bond yields rose as a result of stronger economic signals sending bond prices lower.

The Inflation Protection Fund declined 1.1% in May, though it slightly outperformed its benchmark which declined 1.2%. The fund’s 10% allocation to commodities continued to help the fund’s performance in May, as commodities outperformed inflation-linked bonds. Additionally, the fund’s active global bond manager added value compared to its benchmark. For the year, the fund has gained 2.2%, ahead of its benchmark return of 1.9%. Increasing commodities prices and strong relative performance by the fund’s commodities manager contributed the to the fund’s outperformance. The fund’s active manager also added value.

The Domestic Bond Fund declined 0.8% in May, slightly underperforming its performance benchmark, which returned -0.7%. The underperformance can be attributed to the Affordable Housing portfolio which declined in value due to two factors: higher interest rates and a perception by investors that mortgage backed securities are more risky. This was partially offset by excellent performance by the fund’s investment in bonds of lesser developed countries, which surged more than 4% during the month. For the year, the fund has gained 1.6% after all fund investment management and administration expenses matching the return of its performance benchmark. Performance attribution for the year is similar to the attribution for May. Increasing credit concerns for mortgage backed securities resulting from the fallout of losses on subprime mortgages has negatively affected the value of the fund’s affordable housing loans. This has been more than offset, however, by the fund’s exposure to bonds from lesser developed countries.

The Domestic Stock Fund rose 3.3% in May though it trailed its benchmark which returned 3.6%. The fund trailed its benchmark primarily due to the fund’s 10% allocation to real estate and other alternative investments. The value of the fund’s alternative investments remains relatively stable throughout the year and do not fluctuate with the markets. As a result, alternative investments will somewhat drag performance during rapidly rising markets but will positively influence performance in declining markets. Over long periods, however, the General Board believes that alternative investments will continue to very positively influence investment results as they have over the past several years.

For the year, the fund has returned 9.7%, ahead of its benchmark which has risen 9.2%. Several factors account for the fund’s better than benchmark performance. The fund continues to benefit from a higher than average exposure to stocks of small and mid-sized companies, which have performed better than 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 period. A third factor was the positive contributions from the General Board’s private real estate partnerships.

The International Stock Fund also rose 3.3% in May and surpassed its performance benchmark which returned 2.6%. The fund continues to benefit from its exposure to lesser developed countries whose markets have outperformed the markets of developed countries. Additionally, strong performance by the General Board’s active managers added to performance. For the year, the fund has gained 12.0% compared to the benchmark return of 11.3%. Five of the fund’s six investment managers have outperformed their respective benchmarks.

The Multiple Asset Fund gained 1.9% in May and matched the performance of its benchmark. For the year, the fund has gained 7.5% compared to its benchmark return of 7.0%. This excess performance is attributable to the better than benchmark performance of three of the four funds that comprise the Multiple Asset Fund.

The Balanced Social Values Plus Fund advanced 1.7% in May, underperforming its benchmark by 0.3%. The primary factor contributing to the fund’s underperformance was poor performance by the equity portion of the fund. For the year, the fund has gained 5.1% compared to the 6.1% return of the benchmark.

close (X)