July 2007 Investment Report
Economic growth was strong and inflation was tame, but concern grew over consumer spending.
First estimate of the second quarter Gross Domestic Product (also known as GDP which is a measure of goods and services produced in the United States) increased 3.4% indicating strong economic growth. This was higher than economists expected and a significant increase over the first quarter’s growth rate of 0.6%. Growth was primarily supported by an increase in exports due to a weakening U.S. dollar. Consumer spending, which accounts for two-thirds of GDP, slowed as consumers faced higher gasoline prices and ongoing adjustments in the housing market.
Another sign of consumer spending weakness appeared in the June’s retail sales figure. Retail sales fell 0.9% in June, again linked to higher gasoline prices and the slowdown in housing.
Housing related reports remain weak. Both reports on the sales of new homes and existing homes showed declines in June, falling by more than expected. The supply of homes for sales, both existing and new, remains at elevated levels. Weak corporate earnings reports and dismal outlooks from home builders like DR Horton further underlined the downward trend in housing.
Oil continued its ominous rise in July, moving up steadily through the month beginning at $73.36/barrel to end at $78.81/barrel.
Surprisingly, the Conference Board’s measure of consumer confidence moved higher in July to 112.6 from 105.3 in June. Consumers’ outlooks may have been buoyed by the strong equity markets that characterized the first half of July.
Inflation data remains benign. The Producer Price Index, a measure of inflation at the wholesale level, decreased in June on lower energy costs. The Consumer Price Index, a measure of inflation at the consumer level, had a small increase. Additionally, the personal-consumption expenditures price index excluding food and energy (core PCE), the Federal Reserve’s favorite inflation measure, rose only 0.1% in June. The year-over-year measure of core PCE is 1.9%, which is within the Fed’s comfort zone for inflation of 1-2%. Tame inflation reduces expectations that the Fed will raise rates.
But the real story in July was the routing of the equity markets.
Equity markets began July by gaining, supported by strong corporate earnings reports, merger and acquisition activity and corporate share repurchases. The Dow Jones Industrial Average reached a high of 14,000 on July 12th. But, then some profit-taking and weaker earnings reports from Google and Caterpillar, made investors pause and the index retreated.
The retreat quickened as investors became more leery of how subprime mortgage concerns could spread from mortgage banks to other areas of the financial markets, including hedge funds, investment banks, and consumers. News that supported these fears included an announcement by investment bank Bear Sterns that its two hedge funds invested in subprime mortgages were “nearly worthless.” Additional rumors of a “hedge fund in trouble” in Australia added more fuel to the fear fire. Countrywide Financial weighed in with a weak earnings report, raising concern that higher rates were infecting even the borrowers with excellent credit ratings.
As investors became nervous about the subprime markets, demand for U.S. treasuries increased, pushing prices up and interest rates lower. However, corporate bonds and other non-government bonds all suffered price declines and increase in interest rates. Further, many bond offerings were postponed or cancelled because of investor fears. Some market observers believe that the recent mergers and acquisitions boom could come to a screeching halt because investment bankers’ limited access to capital. As a result, equities plummeted as investors feared that the slowing M&A activity would not longer support stocks.
With renewed fears in the subprime mortgage sector, stocks produced negative returns in July despite record setting levels earlier in the month. The S&P500 declined 3.1% in July, the Nasdaq returned -2.1%, and the Dow was down 1.5%. U.S. Treasury yields declined in July, as a result of investors’ “flight to quality”. The 10 yr treasury yield declined from 5.03% to 4.74% by month end. For the year, however, the stock indices remain in positive territory with the S&P500 up 3.6%, the Dow up 6.0%, and the Nasdaq up 5.4%. International markets continue to outperform domestic markets year to date with the broad global index excluding U.S. stocks up 11.9%. Bonds have added 1%-2% since the beginning of the year.
Investment Fund Review
Three of the six daily priced funds offered by the General Board increased in value in July. The International Stock Fund rose in value as the weakening U.S. dollar offset the decline in the equity prices and lesser developed markets continue to outperform. The Domestic Bond Fund and the Inflation Protection Fund rose in July, as yields declined, sending prices higher. The Domestic Stock Fund declined on concerns that subprime issues would spread to the broader market. All of the General Board’s funds continue to match or exceed the performance of their respective benchmarks.
The Inflation Protection Fund gained 2.2%, trailing its performance benchmark which gained 2.3%. The fund’s exposure to commodities added value but this was offset by below benchmark performance by the fund’s active global bond manager. For the year, the fund has gained 4.4%, and is ahead of its benchmark return of 4.0%. The excess performance is attributable to the fund’s 10% exposure to commodities, which has gained 12% so far in 2007. These gains are partially offset by the fund’s allocation to international inflation protected securities as U.S. inflation protected bonds have outperformed international bonds. The fund’s active international manager, however, has performed better than their benchmark.
The Domestic Bond Fund gained 0.5% in July, ahead of its performance benchmark which gained 0.4%. The fund benefited from its allocation to non-U.S. dollar denominated bonds as the U.S. dollar weakened in July. However, the positive contribution from global bonds was partially offset by the fund’s exposure to credit (i.e. non-U.S. Treasury bonds) as investors demanded higher rates of return for non-U.S. government bonds given the continued subprime fallout. For the year, the fund has gained 1.6%, ahead of the performance benchmark which gained 1.5%. For the year-to-date period, the fund’s allocation to debt from lesser developed countries contributed to performance as well as strong performance by the fund’s active manager of this kind of debt. Weakness in the U.S. dollar has also contributed positively to the performance of the fund’s non-dollar debt. The fund’s Affordable Housing mortgage portfolio continues to detract from fund performance, as investors remain concerned about subprime issues and have caused comparable publicly traded issues to fall in value.
The Domestic Stock Fund declined 2.9% in July, although it outperformed its benchmark which declined 3.4%. The fund outperformed its benchmark due to strong performance by the fund’s active managers. For the year, the fund is up 5.2%, ahead of its benchmark which rose 3.5%. Several factors accounted for the fund’s better than benchmark performance. The General Board has a higher than benchmark allocation to small and mid-sized companies. Although these companies, as a group, have performed worse than the overall market, the General Board’s investment managers have more than made up for this shortfall by adding significant value compared to their respective benchmarks in 2007. Additionally, the General Board’s investment in private real estate partnerships continues to positively add to the fund’s performance.
The International Stock Fund rose 0.6% in July, ahead of its performance benchmark which declined 0.3%. The fund continues to benefit from its exposure to companies from lesser developed countries which have continued to outperform stocks of companies from developed countries. For the year, the fund has produced excellent performance both on an absolute and relative basis and has gained 13.9% compared to the benchmark return of 11.9%. For the year, the fund has benefited from its allocation to underdeveloped countries and to it’s investment in international private real estate.
The Multiple Asset Fund also declined in July, returning -0.9% but ahead of its benchmark which declined 1.3%. The excess performance is attributable to better than benchmark performance by the Domestic Stock and International Stock Funds. For the year, the fund has gained 6.1% compared to its benchmark return of 4.8%. This outperformance is attributable to the better than benchmark performance by all of the underlying funds.
The Balanced Social Values Plus Fund declined 1.7% in July, ahead of its benchmark which declined 1.8%. The primary factor contributing to the fund’s outperformance was the strong performance by the equity portion of the fund. For the year, the fund has gained 3.1%, outpacing its performance benchmark by 0.1%.