First Quarter 2007 Market Review

A plunge in Chinese stock prices in late February and worries that the U.S. economy might slow more than expected led to a sharp but brief drop in global equity markets. But by the end of the quarter, international equities, including Chinese stocks and other emerging markets, had recouped their losses. U.S. stocks rebounded too, but less so. As a result, foreign stocks outperformed U.S. stocks. The Fed left interest rates unchanged, and the U.S. dollar moved slightly lower relative to major currencies. Bond returns, although modest, outperformed U.S. large cap stocks.

Equities Review

U.S. stocks rose 0.6% for the quarter as measured by the S&P 500 Index. The average diversified U.S. equity fund returned 2.1%. All of the major sectors of the market rose during the quarter, except for financials (which were driven down by the rise in mortgage defaults and slowing housing sales). Interestingly, Real Estate Investment Trusts performed well on average, which highlights the difference in current sentiment between the state of the housing sector and the status of the market for commercial real estate. Growth funds outperformed value, but more significantly, mid-cap and small-cap funds outperformed large cap funds. The S&P 100 Index, which is a capitalization-weighted index of 100 companies that are among the largest in the U.S., returned -1.1% for the quarter, as eight of the ten largest companies lost value. In contrast, the Russell 2000 Index of small companies increased 2.0%. 

Foreign developed markets provided good results that were enhanced slightly by rising foreign currency prices. The U.S. dollar declined about .3% versus 19 currencies tracked by the J.P. Morgan Index. The U.S. dollar depreciated almost 1% versus the euro, yen, and Canadian dollar and about 0.2% versus the pound. THE MSCI EAFE Index, which tracks unhedged results for all developed markets except the U.S. and Canada, rose 4.1% while the average diversified international equity fund increased 3.8%. As in the U.S., small cap stocks overseas had particularly strong results. Diversified emerging markets were weak compared to their multi-year tear and returned “only” 1.8% as measured by the MSCI Emerging Markets Index. 

Fixed Income Review

Bonds provided low yet positive returns during the quarter as treasury yields ended slightly lower but credit spreads widened modestly. Short-term Treasury yields moved within a trading range throughout the quarter as the Fed held its interest rate target stable. Medium and longer-term rates fell gradually throughout February and moved sharply lower to 4.5% in late February, when equity markets sold off and investors retreated to the safety of Treasuries. Hence, the Treasury yield curve remained in a significantly inverted position, which is typically a symptom of a weakening economy. Corporate yield spreads widened marginally during the period, particularly in the financial sector. Nonetheless, other than the financials and the asset-backed sectors, investment grade and high-yield corporate bonds outperformed Treasuries due to their yield advantage. Foreign bond prices in local currencies did not hold up as well as U.S. bond prices, but were boosted by the declining dollar. The Lehman Global Aggregate Index returned 1.3% in U.S. dollars during the period.