First Quarter 2005 Market Review

Positive returns were scarce during the first quarter of 2005. News on the economy and corporate profits was generally positive for the period; however, this good news was trumped by heightened inflation concerns and rising interest rates, as the Federal Open Market Committee raised the federal funds rate further during the quarter to restrain the economy and inflation. This policy and the macroeconomic backdrop hurt global securities markets, especially in the U.S.

Equities Review

Stock prices fell during the first quarter seemingly due to investors’ low expectations rather than a concern over current company fundamentals.  Dramatically higher energy prices, the Fed’s seven rate increases since last June, and expectations for further rate hikes led to the conclusion that growth, and eventually corporate profits, were going to slow down in the months ahead. Large-cap stocks, on average, declined over 2% during the first three months of the year, while small-cap stocks fell more than 5% as measured by the S&P 500 and Russell 2000 Indexes, respectively. Large-cap, growth-style stocks under performed large value-style stocks by almost 4 percentage points, and the margin of underperformance was only slightly reduced comparing growth to value smaller capitalization stocks.  Aside from energy stocks, which surged over 18% on higher energy prices, and utilities (+5%), no sector rose by more than a couple of percent, and most sectors declined during the quarter. The worst performing sectors were telecommunications services (-8%) and technology (-9%).

The U.S. dollar changed course and rebounded during the period by 1.8% versus 19 currencies tracked by the J.P. Morgan Dollar Index.  In particular, the dollar rose almost 5% against the euro and the Japanese yen, and about 1.5% versus the British pound. Foreign stocks cooled in the first quarter after some big gains in 2004, though many overseas markets still outperformed U.S. stocks. International equities did better in those countries with meaningful energy and materials exposure (e.g., Netherlands and Norway). While the MSCI EAFE Index gained about 3% in local currencies, the rise in the dollar completely offset that gain. Thus, returns from foreign stocks were slightly negative for U.S. investors. Emerging equity markets recorded moderately positive performance for the quarter, driven largely by strong demand for raw materials, especially metals and energy, in many of these markets.

Fixed Income Review

Bonds reacted predictably to further evidence of economic expansion and the threat of inflation. Interest rates rose, which resulted in a loss for most domestic bond indexes. The Lehman Brothers Aggregate Bond Index, for instance, declined –0.5% during the quarter. It was only that index’s third quarterly negative total return since the first quarter of 2000. High yield bond funds returned –1.5% despite generally improving trends in creditworthiness. Shorter-term rates rose faster than longer-term rates, which meant that the strategy of favoring shorter-term bonds over the longest-term issues, normally a risk-reducing tactic, did not work.