First Quarter 2006 Market Review

Global stock prices rose broadly during the first quarter of 2006. While U.S. economic data was mixed and the Fed did not seem inclined to put an end to its string of rate hikes, corporate profits were generally good. The global economy continued to surprise investors with its resilience and growing strength. As a result, foreign stocks significantly outperformed U.S. stocks. Meanwhile, interest rates rose globally, causing bonds to achieve only modest returns during the quarter.

Equities Review

Overall, the U.S. stock market performed very well with the average diversified U.S. equity fund returning 6.7%. All of the major sectors of the market rose during the quarter, except for utilities (which were essentially unchanged). U.S. small-cap stocks outperformed large caps as the small-cap Russell 2000 Index rose nearly 14% compared to a 4.2% increase for the S&P 500 Index. There was not much difference between the growth and value segments of the market. Also, active and passive management produced similar results when evaluated by capitalization segment. Real estate mutual funds shot up 13.7% and energy stock funds also had a very good quarter.

Outside the U.S., share prices surged. The MSCI EAFE Index, which tracks unhedged results for all developed markets except the U.S. and Canada, rose a healthy 9.4%. Worldwide equity investors seemed to ignore rising interest rates and another jump in oil prices, focusing instead on the good news of an expanding global economy. The rally in European markets, in particular, was based on strong fundamentals during the quarter, and the Mexican and Brazilian markets hit record highs. Japan lagged the MSCI EAFE Index with a still-robust 6.8% gain after a significant increase in 2005. While a small portion of foreign market strength was currency-based due to the decline in the U.S. dollar during the period by .7% versus 19 currencies tracked by the J.P. Morgan Index, the bulk of the gains came from strong local market performance. The dollar lost versus the Euro, the British Pound and the Yen but gained minimally against the Canadian dollar.

Meanwhile, several years of breathtaking gains in emerging markets continued to attract a flood of investor capital. The MSCI EM (Emerging Markets) Index rose 12% during the quarter; nearly every region gained significantly, with the exception of the Middle East.

Fixed Income Review

Bonds experienced a lackluster first quarter as the Federal Reserve, still fearful that a tight labor market and steep energy prices might spark higher inflation, extended the campaign of interest rate hikes it launched in June 2004 (two increases of 25 basis points each). While short-term rates continued to increase at a steady clip, the upward shift of the overall U.S. yield curve was modest. Longer-term rates increased only 30-40 basis points during the quarter, suggesting that bond investors believe that tight monetary policy will eventually slow the U.S. economy and that core inflation is pretty well contained. Rate increases resulted in very slight declines for the broad U.S. bond indexes (Lehman Brothers Aggregate Bond Index was down less than 1% for the quarter). Corporate bonds and mortgage-back securities generally offered about 40 basis points of excess returns over comparable-duration Treasuries.

Outside the U.S., interest rates also rose in many countries. In Japan, medium-term rates rose between 20-45 basis points. While shorter-term rates remained low, there was some speculation about the potential for future policy rate hikes. In Europe, rates rose in a manner similar to the U.S. yield curve, making local currency returns from foreign bonds generally unappealing. As mentioned above, most foreign currencies rose versus the U.S. dollar. These currency gains modestly benefited unhedged U.S. investors in non-dollar bonds, but returns were still only about breakeven.