Financial Markets Review and Outlook

Second Quarter 2008

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1. Economy
2. Stocks
3. Bonds
4. Outlook

After the Federal Reserve’s mid-March establishment of the credit facility to extend overnight funds to primary dealers and the bail out of Bear Stearns, the perceived risk of systemic market failure declined substantially. As a result, the second quarter began with many investors believing that the worst of the credit crunch was over, that economic growth would begin to bounce back toward the end of 2008, and that stock prices, in anticipation of future growth, would advance. That’s actually how it played out – until mid-May that is. Stocks, unfortunately, then sold off during the remainder of the quarter as investors’ concerns over surging energy and food prices, continued fallout from the credit crisis, slow economic growth, and declining corporate profits took center stage. Notwithstanding, the U.S. economy continued to grow, albeit slowly, and showed signs of stabilizing as the effects of monetary and fiscal stimulus, and still-solid demand from abroad provided some offset to the economic headwinds. Meanwhile, the majority of fixed income sectors also struggled in this environment as bond prices receded amid elevated inflationary concerns and higher yields across the yield curve.

Economy

By the end of the first quarter of 2008, most economists believed that the U.S. was in a recession. Under that assumption, the debate had moved to whether the recession would be mild and brief, or deep and prolonged. However, the expectation that first-quarter U.S. GDP would confirm that the U.S. economy was in a recession never materialized. Rather, GDP advanced 1.0% for the quarter, slightly higher than the meager 0.6% growth achieved during the fourth quarter of 2007. This modestly positive growth notwithstanding, the economic news was weak on several fronts.

As was the case during the last few quarters, the U.S. housing market continued to falter. Housing starts and building permits, along with the volume and median price of homes sold, remained very weak. For example, existing and new home sales in May were down 15.9% and 40.3%, respectively, on a year-over-year (“YOY”) basis. Inventories of homes for sale, while declining 1.4% at the end of May, still represented a sizable 10.8-month supply at the current sales pace. On the pricing front, home prices dropped a record 15.3% from a year earlier in 20 major metropolitan areas during April according to S&P/Case-Shiller. Lastly, mortgage delinquencies and foreclosures continued to surpass record levels in the first quarter.

Meanwhile, the U.S. unemployment rate rose to 5.5% in May, up from 5.0% in April, its highest level since October 2004 and sharpest one-month increase in 22 years. Still, nonfarm payrolls lost only 324,000 jobs (0.2%) since January, which suggests the contraction in the economy has thus far been shallow. U.S. construction spending fell by 0.4% in May, the fifth drop in six months. Manufactured durable goods (excluding aircraft and other transportation) declined 0.9% in May from the month before, while orders for nondefense capital goods excluding aircraft, a key gauge of future business spending, dropped 0.8%. Also of note, consumer confidence fell in June to its lowest level in 16 years, with expectations for the future reaching a record low. The Consumer Confidence Index has now declined by more than half since last July.

A number of factors, however, support the thesis for ongoing (albeit weak) expansion, or counter fears of a deep and protracted U.S. recession. Specifically, retail sales increased 1.0% in May – notably above expectations in a sign consumers were spending stimulus checks. Furthermore, we believe the surprisingly strong 1.9% gain in personal income in May, which can be partially attributed to distribution of tax-rebate checks, bodes well for future consumer expenditures. These reports are important since consumer spending accounts for approximately 70% of GDP. Furthermore, exports were up 19.2% on a YOY basis through the end of April, the second highest percentage increase since 1992 (the largest gain since then was set two months ago at 20.6%). Also of note, the Institute for Supply Management’s index of manufacturing activity expanded in June for the first time in five months. The 50.2 reading suggested a weak, but growing, economy.

Despite the softness in U.S. economic growth, inflation concerns have been rising amid soaring prices for energy, food and other raw materials. For the quarter, the Reuters/CRB Total Return Index (i.e., commodities) increased 20.1%, while the Reuters/CRB Energy Sub-Index was up 31.1% (85% over the last year). Meanwhile, consumer prices (CPI) rose 0.6% for the month of May and 4.2% on a year-over-year basis. The core CPI (excluding food and energy), however, advanced at a more modest 0.2% and 2.3%, respectively, thus remaining slightly below the Fed’s 2.5% target. One of the things that this tells us is that while energy and energy-related prices continued to surge, prices in non-energy sectors, like clothing, medical care, and automobiles, appear well contained – at least so far. In aggregate, however, inflation concerns continued to mount, which highlighted the dilemma faced by the Fed as it weighs whether inflation or recession pose the bigger threat to the U.S. economy. During their most recent June meeting, the Fed decided not to change the Fed Funds or Discount Rates, but did express heightened concern about inflation, implying that their next move, although not imminent, would likely be a rate increase. Granted, any future Fed actions will be highly dependent upon new economic and market development.

Further complicating any policy moves, the slowing economy, and higher energy and materials prices are also affecting corporate earnings. According to Thomson Reuters data, analysts now expect the aggregate decline in earnings at S&P 500 companies to be greater then 9.0% for the second quarter, led by a larger-than-expected 50% decline by financials. Both those estimates have declined precipitously since the second quarter began, when analysts were expecting a 2.0% drop in S&P earnings and a 31.0% decline in the financial sector.;

Stocks

Against this backdrop, stocks advanced sharply from April through mid- to late-May, but then sharply retreated. Case and point, the Russell 1000® Index was up almost 9.0% through May 19th for the quarter, but then proceeded to decline close to 10.0%, closing out the quarter with a cumulative decline of 1.9%, the third consecutive quarterly loss for the index.

Returns varied greatly across styles, sectors and capitalizations. In a reversal of the prior quarter, and after only a one-quarter hiatus, growth indices significantly outperformed their value counterparts, which were weighed down by their financial exposure. Specifically, the Russell 3000® Growth Index returned +1.5%, while the Russell 3000® Value Index returned -5.2% for the quarter. Meanwhile, small-cap stocks outperformed their large-cap brethren for the first time since the first quarter of 2007 as the Russell 1000® and 2000® Indices returned -1.9% and 0.6%, respectively.

Within the Russell 3000® Index, performance varied notably by sector, with energy, utilities, materials, and technology stocks moving higher (20.4%, 7.7%, 5.8%, and 3.1%, respectively) and financials, consumer discretionary, industrials and consumer staples declining the most (-16.6%, -8.1%, -6.9%, and -5.5%, respectively). Magnitude aside, the positive and negative performing sectors appeared consistent with the economic environment, along with a more defensive mindset. Specifically, energy and materials advanced on the heels of higher energy and commodity prices. Technology companies benefitted from greater percentage of business overseas, where economic growth was stronger, while utilities tended to be a safe haven, which is typical in challenging markets. Conversely, financials stocks were punished as banks and brokerage firms continued to report bad news in the form of write-downs and recapitalizations. The energy-sensitive consumer sectors struggled as investors worried that higher food and energy prices, along with ongoing weakness in housing, would further curtail spending.

Similar to last quarter, foreign stocks also declined and, like domestic equities, returns also varied greatly by style and sector. Unlike more recent quarters, however, broad-based dollar weakness did not occur, thus, local country returns were not broadly enhanced when translated into U.S. Dollars. The MSCI EAFE Index and MSCI Emerging Markets Index returned -2.3% and -0.8%, respectively, for the quarter in U.S. Dollars.

Bonds

Unlike last quarter, most bond sectors did not prove to be the safe haven of positive returns generally sought by investors during challenging equity markets. Granted, the returns were not abysmal, but they were predominantly negative. Unlike equities, the broad bond market declined at the start of the quarter, before partially rebounding in June. Specifically, the Lehman Brothers U.S. Aggregate Index declined more than 2% through June 13th, before advancing 1.3%, to close out the quarter with a cumulative loss of 1.0%.

As was the case with equities, returns varied across sectors and quality within the bond markets. Lower-quality bonds bounced back from a difficult first quarter, while higher-quality and international fixed securities reversed course from the prior quarter, experiencing losses. As inflationary concerns mounted, and as investors started pricing in higher interest rates, yields rose across the yield curve, although the advances were most pronounced on the shorter end of the curve. For example, 1, 3, 5, 10 and 30-year treasury yields increased by 86, 110, 87, 53 and 25 basis points, respectively, during the quarter. Meanwhile, yield spreads contracted as investors returned to riskier assets, looking to take advantage of attractive opportunities in the lower-quality sectors of the market. Of note, Aaa, MBS, CMBS and U.S. corporate high-yield spreads declined 36, 60, 59, and 77 basis points, respectively. The ultimate result, as noted above, was a -1.0% return for the Lehman Brothers U.S. Aggregate Index. Meanwhile, foreign bonds lost value during the period with the Lehman Brothers Global Aggregate Index dropping 2.9% for the quarter. This was due to a combination of modest strength in the U.S. Dollar and the anticipation of interest rate hikes from the European Central Bank to counter inflation.

Outlook

As we head into the second half of 2008, investors are wrestling with a variety of questions, including whether inflation or recession poses the greater threat, and how best to allocate their investment portfolios given the challenging environment. At the end of March, we suggested that economic improvements would likely occur either late 2008, or early 2009. Given the recent spike in food and energy prices, combined with ongoing housing and credit market concerns, however, we now expect higher, more sustained growth to be a 2009 occurrence. While not our preferred economic course, this year’s lower growth environment should help limit the inflation pass-through from higher energy prices.

Still, from an investment perspective, we remain cautious, not bearish. While the conditions for a sustained equity advance do not yet appear imminent, it should be noted that historically, stocks prices have traditionally bottomed in the middle of recessionary periods, not at the end. It is also important to bear in mind that while the fear of a recession is a legitimate concern for the economic well being of all Americans, a recession does not necessarily imply a weak or negative stock market. In fact, the U.S. equity market (as measured by the S&P 500) has experienced positive returns in over half of the nine recessionary periods since 1953. Even more noteworthy are the returns generated in the six months immediately following the end of the nine recessionary periods dating back to 1953, when the S&P 500 Index produced an average return of 9%.

Meanwhile, challenging and volatile market conditions often lead to market dislocations which present opportunities for disciplined, long-term investors. Some of the more common themes we’ve heard from our subadvisors, which frankly are very similar to what we noted three months ago, include: (1) Domestic P/E ratios are well below their average for the last 10 years; (2) foreign equities appear much more appealing given the recent sharp declines along with still strong growth prospects (MSCI EAFE Index P/E lowest this decade); (3) various fixed income sectors remain appealing given the still high yield spreads; (4) short-term cash vehicles are currently yielding negative real returns when inflation is considered; and (5) challenging environments present great opportunities for active managers, since security selection is of paramount importance.

In summary, our subdued economic expectations for 2008, along with the negative sentiment permeating the marketplace, could easily leave an investor to wonder how best to protect themselves. For astute long-term investors though, the answer to such a question is the same as it has always been: Maintain a broad asset allocation with exposure to various asset classes. While we believe that maintaining a sound long-term asset-allocation strategy will not magically solve all the short-term issues a difficult market environment can bring, the diversification achieved by maintaining this approach can help investors limit their risk exposure, particularly when it is needed most — during challenging markets.

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Any sectors, industries, or securities discussed should not be perceived as investment recommendations. The views expressed represent the opinions of Managers Investment Group and are not intended as a forecast or guarantee of future results.

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Disclosure
Any sectors, industries or securities discussed should not be perceived as investment recommendations. The views expressed represent the opinions of Managers Investment Group and are not intended as a forcast or guarantee of future results. Past performance is no indication of future results.

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