September 2007 Investment Report

Anticipating a Federal Reserve cut in interest rates …

Investors spent the first half of September evaluating the possibility of an interest rate cut by the Federal Reserve at its policy meeting on September 18th. The August employment report, released in early September, showed the nation’s employment contracted by 4,000 jobs. This was the first decline in almost four years. The weakening employment numbers unsettled investors, who feared the housing slowdown and credit market contraction were beginning to impact the broader economy. Another indicator of the health of the economy for investors was the retail sales report which also showed a sharp decline, further proof that the weakness in housing was adversely affecting consumers. As economic data appeared weaker, investors were calling on the Federal Reserve (Fed) to cut the Federal Funds interest rate (the rate at which banks lend to each other overnight and an influential rate on borrowing costs in the economy) by 0.25%.

… and digesting the impact.

The central bank seemed to listen to investors. On September 18th, the Fed surprised markets by reducing the Fed Funds rate from 5.25% to 4.75%, a 0.50% cut in rates. Wall Street cheered as lower interest rates translate to lower borrowing costs, both for companies financing their businesses and for homeowners with mortgages. Equity markets soared immediately after the announcement. The interest rate yield curve steepened as interest rates for shorter term bonds fell and longer term fixed income interest rates increased on heightened inflation expectations. Although the larger-than-expected cut proves that the Fed wanted to be aggressive and stabilize financial markets despite inflation concerns, inflation risks remain and are now probably elevated.

The dollar has continued to weaken throughout September against other major currencies, declining the most after the Fed rate cut announcement. A weak dollar has both positive and negative implications for the economy. The good news is that products produced in the United States are less expensive to foreigners resulting in higher demand for our products. This ultimately leads to higher corporate profits and increased employment. However, companies producing goods abroad will likely raise prices to compensate for the weaker dollar. Hence, a weaker dollar tends to be inflationary. Additionally, with the anticipation of a stronger economy and an increase in demand for consumable goods, the price of commodities, like oil, increased. Indeed, a barrel of oil topped $83 in September up from $74/barrel, an increase that will be eventually felt by consumers at the gas pump.

Market Reaction

After the Fed interest rate cut, equities soared in September and investors became less risk averse, especially compared to investor attitudes in August. The S&P500 Index advanced 3.7%, the Nasdaq returned 4.0%, and the Dow was up 4.1%. For the year, the stock indices remain strong with the S&P500 up 9.1%, the Dow up 13.3%, and the Nasdaq up 12.5%. International markets continue to outperform domestic markets year to date with a global index excluding U.S. stocks up 17.4%. Bonds have added 3%-4% since the beginning of the year.

Investment Fund Review

The positive developments in the financial markets resulted in gains to all of the funds offered by the General Board during the month of September. The two bond funds reversed their disappointing performance compared to benchmarks in August and both substantially outperformed their benchmarks in September. The two stock funds underperformed their benchmarks, but the Multiple Asset Fund outperformed its benchmark. For the year, all of the daily priced funds have exceeded their performance benchmarks with the exception of the Domestic Bond Fund.

The Inflation Protection Fund gained 2.5%, and more than made up for its shortfall compared to its performance benchmark in August. The benchmark gained 1.3% in September. The excess performance was attributable to the fund’s allocation to commodities and inflation linked bonds from lesser developed countries. Both portfolios rebounded significantly and advanced approximately 7.5% during the month. For the year, the fund has gained 6.8%, ahead of its benchmark return of 6.3%. Two factors have positively benefited performance and one has detracted from performance for the year. The biggest contributor has been the fund’s 10% allocation to commodities futures contracts. The fund’s commodities portfolio is up nearly 14% for the year. Additionally, the recent allocation to inflation linked bonds from lesser developed countries has also benefited performance. The relative gains from these two strategies has been slightly offset by the fund’s allocation to bonds from foreign developed countries which have not performed as well as U.S. inflation linked bonds.

The Domestic Bond Fund advanced 2.2% in September, and regained much of the relative performance it lost to its benchmark in August. The fund benchmark advanced 1.0%. The fund benefited from an 8.5% gain by its allocation to fixed income securities issued by lesser developed countries. The fund also benefited from its holdings of non-dollar bonds from developed countries, which increased in value due to weakness of the U.S. dollar. For the year, the fund has gained 3.4%, but trails the performance benchmark which gained 3.7%. Although the fund has benefited in a meaningful way from its exposure to fixed income securities denominated in currencies other than U.S. dollar as well as excellent performance by the fund’s managers compared to their respective performance benchmarks, one factor has significantly detracted from the fund’s performance. In 2007, the value of the fund’s Affordable Housing mortgage portfolio significantly deteriorated as a result of market concerns arising out of the well publicized subprime mortgage crisis. As written previously, the General Board has experienced absolutely no deterioration in the quality of its loan portfolio. However, we apply an objective methodology to value our loans based on market prices for similar securities that are traded in the public markets. These types of similar securities have seen significant losses in value. The General Board is very confident that values will rebound, though it may take some time to do so. Long term investors should not be concerned about the short term consequences of the recent market perturbations.

The Domestic Stock Fund gained 3.4% in September, but its benchmark produced a return of 3.6%. Despite excellent relative performance compared to benchmarks by several of the fund’s managers, the primary driver of the less than benchmark performance was the fund’s emphasis on the stocks of small and mid-sized companies. The Russell 2000 Index of small companies produced a return of 1.7% compared to the return of 3.7% attained by the S&P 500. For the year, the fund has gained 10.1% and has outperformed its benchmark by 1.3%. Several factors accounted for the fund’s better than benchmark performance. 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. Additionally, the General Board’s investment in private real estate partnerships continues to positively add to the fund’s performance.

The International Stock Fund soared 5.9% in September, but trailed the return of its performance benchmark by 0.7%. While performance was helped by the fund’s allocation to companies domiciled in lesser developed countries (the Morgan Stanley Emerging Markets Free Index gained 11% for the month), the fund was hurt by the below benchmark performance of its two emerging markets managers and the fund’s allocation to small international companies, which did not keep pace with the broad international market. However, for the year, the fund is the best performing fund offered by the General Board and is up 17.7%. The fund’s performance is still slightly ahead of its benchmark for the year, which has gained 17.4%. For the year, the fund has benefited from its allocation to lesser developed countries and to its investment in international private real estate.

The Multiple Asset Fund also advanced in September, gaining 3.6% and surpassing its benchmark which gained 3.3%. The out performance is primarily attributable to better than benchmark performance by the Domestic Bond Fund and the Inflation Protection Fund. For the year, the fund has gained 9.7% compared to its benchmark return of 9.0%. This out performance is attributable to the better than benchmark performance by the Domestic Stock Fund, the International Stock Fund, and the Inflation Protection Fund though slightly offset by the underperformance of the Domestic Bond Fund.

The Balanced Social Values Plus Fund rose 3.1% in September surpassing its benchmark which rose 2.5%. The primary factor contributing to the fund’s out performance was the strong performance by the equity portion of the fund. For the year, the fund has gained 8.1%, outpacing its performance benchmark by 1.3%. Important note: the General Board replaced the manager of the equity component of the portfolio effective October 1st. Please see this link for more information regarding this change.

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