Second Quarter 2005 Market Review

U.S. stocks ended the quarter mostly higher following a weak first quarter and month of April. Despite the reality of much higher commodities prices and further tightening of monetary policy, longer-term interest rates fell globally. Accordingly, most sectors of the U.S. bond market had a good quarter.  Meanwhile, the average local-currency gain for foreign stock markets was a solid 4-5%. However, a resurgent U.S. dollar diminished, and in some cases made negative, foreign security returns for U.S. investors. 

Equities Review

The “Goldilocks” economic backdrop (solid growth with tame inflation) was generally supportive for equity market performance.  U.S. large cap stocks, represented by the S&P 500 Index, gained 1.4% during the quarter, while small-cap stocks did better; the Russell 2000 Index increased 4.4% for the period. Based on mutual fund results, the U.S. market exhibited some preference for growth style stocks.  Nonetheless, during the quarter, two industry sectors normally classified as value style, utilities and financial shares (particularly real estate), were among the best performing industry groups. Utility stocks rose over 9%, benefiting from favorable price trends and the involvement of many utility companies in the energy business. Real estate shares gained more than 13%, recovering from a dismal first quarter.

Foreign markets exhibited trends similar to the U.S. market. In local currency terms, utilities, real estate, and energy were among the best performing industry groups.  The U.S. dollar rose during the period by 2.4% versus 19 currencies tracked by the J.P. Morgan Dollar Index. Unfortunately, dollar strength for the quarter was most pronounced against three currencies associated with large securities markets favored by many U.S. investors: the U.S. dollar gained 6.9% versus the euro, 5.5% versus the British pound, and 3.5% versus the Japanese yen.  Thus, solid local currency returns were adjusted downward for the currency impact: while the MSCI EAFE Index rose 4.6% in local terms, it declined 1.0% in U.S. dollars.

The emerging markets offered better returns to U.S. investors: the MSCI EMF Index appreciated 4.1% in U.S. dollars. Many emerging markets are commodity-centric, which continued to be a positive for performance.  Also, currency is less of an impact in the emerging markets, where many currencies are pegged to the U.S. dollar.

Fixed Income Review

The U.S. bond market, meanwhile, had an impressive quarter. Confounding experts, longer-term interest rates took a surprising drop after their first quarter increase.  The yield on the 10-year Treasury, for instance, declined 0.52% (52 basis points) to close at 3.98%. While the aggregate bond market returned a reasonable 3%, longer-term bonds (with maturities of more than 10 years) provided a total return of more than 7% during the quarter. Possible explanations for rates moving opposite to expectations include a U.S. economy on an even keel, almost no increase in the core inflation rate, and high demands by foreign investors for U.S. bonds, particularly Treasuries. There was also a notable bias toward higher quality in the bond market during the quarter. Corporate bonds tended to lag Treasuries and lower quality corporates had much worse performance relative to higher quality corporates.

Finally, interest rates in most foreign markets also declined, providing local currency returns which were in the 3.0% to 4.0% range for most developed countries.  As was the case in equity markets, these returns were adversely impacted by the strong U.S. dollar. Thus, U.S. dollar returns for most of oversees markets were negative. The Citigroup Non-U.S. World Government Bond Index dropped 2.7% during the quarter.