Financial Update: Second Quarter 2007

Release Date: 09.25.2007

U.S. equity markets rallied in April and May only to lose ground in June, felled by investors’ fears of tightening credit, higher interest rates, fallout from subprime loans and rising prices for oil and gas.

The period contained bright spots: Expansion of gross domestic product at an annual pace of 3.4 percent; a robust labor market, low unemployment and rising personal incomes that buoyed personal spending; and key inflation data lower than expected. The Federal Reserve kept its Federal Funds rate at 5.25 percent in an effort to thwart inflation.

Negative developments in the quarter included ongoing weakness in the housing market and tightening credit resulting from fallout from subprime mortgages, including the demise of two hedge funds managed by Bear Stearns. The price of oil was up 40 percent from its January low, while the price of a gallon of regular gas ended the period up 38 percent from its low point in January.

Despite retrenching in June, equity markets performed strongly in the quarter, with a return of 6.28 percent for Standard & Poor’s 500 Index. Large-cap stocks bested smaller issues, while value-oriented stocks underperformed growth-oriented equities. The S&P’s rise was led by energy stocks (+14.92 percent), capital goods (+11.72 percent) and technology (+ 9.94 percent.) Weak performers were tied to interest rates, including finance (+ 2.25 percent), consumer non-durables (+ 3.62 percent) and real estate (DJW Real Estates Securities, -9.35 percent).

Given the general uneasiness in fixed income markets, government-guaranteed paper outperformed investment-grade corporate issuance (Lehman Government, -0.33 percent; Lehman Credit, -0.74 percent). High-yield bonds outperformed the broad investment-grade market as a whole (Lehman Aggregate, -0.52 percent; Lehman High Yield, + 0.22 percent).

Globally, the top performers were emerging market equities, though developed markets also performed well when expressed in U.S. dollars. Despite interest rate hikes for Great Britain and the European Central Bank, the pound and euro both appreciated dramatically against the U.S. dollar. The yen’s weakness against the dollar depressed U.S.-based investors’ returns on a country-weighted basis. Stellar performance in stock markets in India, China and Brazil propelled the broad emerging markets sector to “dazzling” gains, according to Monticello Associates. 

For the period, the Cleveland Foundation reported a return of 5.99 percent, vs. a loss of 0.51 percent during the same period in 2006. Year to date, the return was 7.96 percent, compared with 5.21 percent last year.

News Financial Update Second Quarter 2007 Total Asset Allocation Pie Chart

Third-Quarter Challenges

In July 2007 capital markets in general, and credit markets in particular experienced significant turmoil and volatility, together with rapidly declining liquidity in credit markets. The widely publicized subprime-market problems seeped into the credit derivatives markets, which have grown rapidly over the last five years. The widespread utilization of credit derivatives as hedging tools, together with systemic, excess leverage in the U.S. capital markets, also served in part to facilitate the transmission of subprime concerns into the corporate bond market.

Third-Quarter Challenges

  July August Year to Date thru August
S & P 500 -3.10% 1.50% 5.21%
Lehman Aggregate 0.83% 1.23% 3.06%
High Yield* -3.14% 1.04% 1.48%

Despite this turmoil, markets remain in positive territory year to date.