Securities markets rallied broadly during the second quarter. For many equity markets, gains were tremendous; bond returns, particularly for corporate issues, were also significant. It appears enthusiasm in the markets was a function of considerable resolution of non-economic factors, mainly the war in Iraq and SARS, because economic growth was tepid during the quarter. The table on the other side of this page summarizes data for the quarter (reviewed below) and past six months.

Equities Review

Equity markets around the world shrugged off lackluster macroeconomic data. The average domestic stock fund posted a total return (price appreciation plus dividend income) of 17% in the second quarter, according to Morningstar statistics. That was the biggest gain since the fourth quarter of 1999, the waning days of the last bull market. The breadth of the gains suggests an expectation of improving profitability and of a better global economy as a whole. Such expectations were, in turn, supported by continuous aggressive monetary and fiscal policy responses. Every major market index rose by at least 15% and every sector within the broad market rose with the exception of Leisure Equipment & Product, a relatively small segment. The deeply depressed technology stock fund sector was the biggest winner of the quarter and the first half, scoring average gains of 24.6% and 24.1%, respectively, based on Morningstar Inc., mutual fund tracking. Performance of the real estate and natural resource sectors lagged after leading for the past year or more. There was very little difference in the second quarter between value and growth style equity performance.

The U.S. dollar lost value against other developed country currencies, ending the quarter down about 4% versus 19 currencies tracked by the J.P. Morgan Dollar Index. Outside of the U.S., the MSCI EAFE Index, which covers most non-U.S. industrialized nations, returned 19.3% (in U.S. dollars). The decrease in the value of the dollar pushed good local currency returns even higher when translated to dollars. As in the U.S., gains were broadly dispersed around the world, and emerging markets outperformed developed markets somewhat, gaining almost 23%.

Fixed Income Review

Interest rates continued to fall during the second quarter and bonds posted respectable returns. However, rising long-term interest rates at quarter-end indicated that the recent era of heady performance for fixed-income funds may be coming to an end. Despite high unemployment and a mixed bag of other economic news, belief that corporate fundamentals are improving contributed to another good quarter for investment grade U.S. corporate bonds. They returned about 5% during the quarter, their best quarterly return since 1995, and outperformed Treasuries by over 200 basis points (i.e., about 2 percentage points). It was the third consecutive quarter of out-performance by corporates. U.S. high yield bonds soared over 10% during the second quarter. The robust showing of corporate bonds seemed to have been driven more by a perception of bargain prices and relative value than by a surge in credit quality. The California municipal market has been negatively impacted by the state’s unresolved $38 billion budget short-fall and possible recall of the governor, leading to underperformance versus non-California bonds.

Foreign bonds, in addition to experiencing interest rate drops similar to their U.S. counterparts and strong returns from corporate bonds, were boosted by the drop in the dollar. Canadian bonds were among the best performing, gaining almost 12% behind a sharp rise in its currency. Emerging market bonds also provided very strong returns highlighted by tax and social security reforms in Brazil and good performance in Mexican bonds, which closely track the U.S. market. The Salomon Brothers World Government Bond Index returned 4.2% in dollar terms aided by appreciation of major foreign currencies, particularly the Euro and the Canadian dollar.