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Second Quarter 2007

The second quarter of 2007 was marked by questions over the persistence of inflation, a continued slowdown in the housing market, and a surge of subprime loan problems which have impacted mortgage companies and banks. Both the speed and the size of the backup in bond yields suggested a clear inflection point in the level of disinflation (a decrease in the rate of inflation) that we have experienced in recent years. Emerging economies such as India and China have until recently been responsible for exporting disinflation to the U.S., whose consumers have benefited in the form of low priced goods and services. With rising disposable incomes in these emerging countries, and a concurrent increase in food, energy, and wage prices, the disinflationary benefits we get from these economies are beginning to moderate. While the standard definition of “core” inflation excludes food and energy, we do not live in a “core” inflation world; food and energy prices are rising, and in emerging economies, food represents a larger space in the “basket” of household spending. The U. S. Federal Reserve Board remains ever-watchful of increasing inflation; however, in their June meeting, they once again held rates steady. The low U.S. unemployment rate, holding steady at 4.5%, has encouraged increased wages.

In May, housing prices dropped by 2.7% y/y in major American cities, the fastest pace in 16 years. At the same time, 30-year fixed mortgages have climbed by 50 basis points this year, while new housing starts, whose growth only began slowing in May, have been adding new supply to the market, exacerbating the glut and negatively impacting consumer confidence. Durable goods orders for big ticket manufactured goods dropped in June by a larger than expected 2.8%. Although economic growth appears to have rebounded in the second quarter to an estimated 2.3 - 3% from a lackluster 0.7% in the first quarter of 2007, we believe the housing market decline and the associated problems in the mortgage debt market will negatively affect growth in the medium-term.

Our cautious optimism is now moderated by some gathering clouds in what has been a pastoral investment climate since 2003. While the market continues to shrug off the bad news, it has been quite volatile, and we expect more volatility going forward this year. “Volatility” is measurable; there is an index published by the Chicago Board of Options that measures the market estimate of future volatility within the S&P 500, whose ticker is “VIX”. Having hit a low point in December of last year, the volatility index is now some 50% higher, anticipating more variability ahead. For more conservative portfolios we advocate trimming equity exposure after this long bull market, remaining mindful that markets are cyclical in nature.

For the first six months of this year, the Dow rose 7.5%, the S&P gained 6.0%, and the Nasdaq increased 7.7%.

Grant Rogers Elizabeth Allen

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