Stock market investors interpreted the leveling of economic growth coupled with higher raw material prices as indicative of a future slowdown in corporate profits. On the other hand, bond market investors welcomed the more benign economic reports as a signal of less inflationary pressure and more conservative policy responses regarding interest rates in the period ahead.  The results were losses in equity markets and a significant rally in bond markets.  The table on the other side of this page summarizes data for the third quarter (reviewed below) and past nine months.

Equities Review

The S&P 500 index was down 1.9% for the period while the average domestic stock fund posted a total loss of 2.8% in the third quarter, according to Morningstar statistics. Small-capitalization U.S. stocks lost more than large caps (the Russell 2000 Index declined 2.9%).  Within these indices, growth stocks did worse than value.  Given the surge of oil prices, energy was the best performing sector (across all market caps) during the third quarter, followed by telecom service stocks and utilities. Technology, consumer staples, and health care were the worst performing sectors (the latter was hurt by Merck, which announced late in the quarter the recall of Vioxx).  Real estate funds, which had fallen in the second quarter as a result of the sharp rise in long-term interest rates, surged in the third quarter for a gain of 7.9%.

Foreign stocks in aggregate declined as well. The MSCI EAFE Index of developed overseas equity markets declined 1.5% in local currencies but only 0.3% in U.S. dollars due to currency gains for U.S. dollar investors.  Like the U.S. market, international growth lagged value, and international small caps lagged large caps during the quarter. Japan’s stock market fell 6.5% (in local currencies) as the macroeconomic backdrop impacted expectations for the slope of the Japanese recovery. Overseas emerging markets were an attractive source of returns.  Many are suppliers of raw materials, and thus benefited from better pricing power. The MSCI EMF Index rose 7.0% in local currencies and 7.4% in U.S. dollars. The U.S. dollar declined versus virtually all developed currencies, ending the quarter down about 1.7% versus 19 currencies tracked by the J.P. Morgan Dollar Index.

Fixed Income Review

Bond investors were relieved to see the third quarter’s economic data. Bonds had struggled going into the quarter due to the strength of the economic recovery and posturing of the Federal Open Market Committee (FOMC). Indeed, the second-quarter performance of the U.S. bond market was the worst in ten years. However, the evidence of an economic slowdown and the rather conservative language and policy responses of the FOMC resulted in about a .5 percentage point decline in medium- and longer- term U.S. interest rates. The Lehman Brothers U.S. Aggregate Index, which covers the U.S. investment grade fixed rate bond market, rallied 3.2% for its best quarterly return since the third quarter of 2002. Still, the FOMC did increase short-term rates twice. Thus, the U.S. yield curve “flattened” as short rates rose and long rates declined, and the yield spread between 3-month and 10-year Treasuries narrowed to 2.4 percentage points.  High yield bonds surged 4.5% in the quarter (as measured by the CSFB index), outperforming like-duration Treasuries by almost two percentage points.  Strong performance of the corporate bond and high yield sectors reflected the measured tone of the FOMC, only partly offset by the negative effect of the slowdown in economic activity.

Interest rates also declined and yield curves flattened in most other developed countries. The Citigroup World Government Bond Index (formerly Salomon Brothers) increased 3.3% during the quarter. As in the U.S., the credit and securitized segments of the global bond market performed slightly better than foreign government bonds.