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Market Update -- In the Markets

Written by Derrick Wulf, CFA, Portfolio Manager

April 4, 2007

Here is a brief summary of what transpired in the economy and the financial markets during the first quarter of 2007.

Growth
The domestic economy slowed during the first quarter, with most economists now estimating GDP growth of less than 2% for the period. The slowdown follows a 2.5% annualized rate of GDP growth in the fourth quarter of 2006.

Inflation
Core inflation remained “somewhat elevated,” according to the most recent FOMC statement, with core CPI growth running at a 2.7% rate on a year-over-year basis in February. This measure had reached a ten-year high of 2.9% in September, before dropping back down to 2.6% in November and December. The core PCE deflator again matched its 11-year high of 2.4% on a year-over-year basis in February after slowing to 2.1% at the end of 2006.

Jobs
The unemployment rate remained just above its five-year low of 4.4% during the first two months of the year (figures for March are scheduled to be released this Friday). Average monthly payroll growth in January and February was just over 120,000 new jobs (subject to revision), down from an average of almost 190,000 new jobs per month in 2006.

Income
Growth in wage and salary income remained firm in the first quarter amid continued strong demand for skilled workers. Personal income rose 5.3% on a year-over-year basis in February, while real disposable income grew 2.6%. Despite a boost from income gains related to year-end bonuses, however, the rate of income growth in January and February was lower than that recorded during the fourth quarter.

Housing
Housing remained the biggest story for investors in the first quarter as defaults on subprime mortgages spiked and numerous lenders exited the business or declared bankruptcy. Existing home sales rose in January and February, but the month’s supply figure remained at elevated levels and new home sales continued to fall, hitting a six-year low in February. Home prices were also weaker, with the S&P/Case-Shiller Composite Home Price Index registering a year-over-year decline in February.

Confidence
Consumer confidence remained stable during the first quarter. High gas prices and weak housing markets remained a source of concern for consumers, but strong job markets and rising wages kept the outlook positive. The Jobs Plentiful Index, a component of the Conference Boards Consumer Confidence Index, hit a five and a half year high in March.

The Fed
The FOMC met twice during the first quarter, voting both times to maintain the benchmark overnight lending rate at 5.25%. In the statement released after the Committee’s March 21 meeting, the Fed acknowledged the weakness in the housing market, but again cautioned that “recent readings on core inflation have been somewhat elevated,” and that inflation risk remained the Committee’s “predominant policy concern.”

Fed funds futures closing prices on March 30 suggested that most investors expect the Fed to cut interest rates by at least 25 basis points in 2007, beginning sometime in the late second or early third quarter.

Treasuries
Treasury yields fell and the yield curve steepened during the first quarter. The yield on two-year notes fell the most sharply, hitting a 13-month low in March and ending the quarter 23 basis points lower than its year-end 2006 close. Five and ten-year notes declined in yield by 16 and 6 basis points, respectively, while the yield on 30-year bonds rose 3 basis points.

Bond Markets
According to the Lehman Aggregate Index, the U.S. investment-grade bond markets provided investors with total returns of 1.50% in the first quarter. All of the major sectors experienced a widening of spreads amid concern over credit risk and liquidity in the wake of losses in the subprime mortgage market. The incremental yields earned in spread product were not enough to offset the effects of spread widening in most of the major sectors, and the index posted a negative 1 basis point excess return versus Treasuries for the period.

Spreads on corporate bonds widened an average of 4 basis points in the first quarter, leading to 1 basis point of underperformance relative to Treasuries. Commercial mortgage-backed securities, which outperformed all other major sectors in 2006, posted the weakest excess returns during the period, underperforming Treasuries by 18 basis points as the effects of broad market spread widening were compounded by heavy new issue supply in that sector.

High yield markets performed well in the first quarter, with the Lehman Brothers U.S. High Yield Index up 2.64% for the period. Spreads ended the quarter mostly unchanged from year-end 2006, with the average OAS on the index at 275 basis points.

Equities
Stocks had mixed performance in the first quarter as volatility rose amid uncertainty about housing and the subprime mortgage markets. The Dow Jones Industrial Average hit a record high in February before posting its largest one-day point loss since 2001 later that month. By the end of March, the Dow had recovered from its lows to end the quarter down less than one percent. The S&P500 and the NASDAQ Composite, meanwhile, both managed to post modest gains for the quarter after experiencing similar volatility in late February and early March.

Some further details about the bond markets are shown in the charts below.