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he economy in the 2nd quarter of 2006 was characterized by fears of inflation. A coordinated tightening in monetary policy among some of the world’s largest central banks (U.S., Euro zone, UK, China) led to these fears, while uncertainty about new Federal Reserve Board Chairman Ben Bernanke created worries that the Fed might “over-tighten” interest rates. This led to a pullback in stock market indices worldwide, and heightened volatility. Many economists are now divided over whether we may be headed towards a recession due to pressure on consumers from higher interest rates and gas prices. After this month’s interest rate hike, the seventeenth in this rate cycle, we believe that the Fed is now considering a pause in its two year tightening phase, which was borne out in Fed Chairman Bernanke’s comments on June 29th.

The economy grew at a 5.6% rate in the first quarter of this year, and although second quarter figures have not yet been released, they could come in much higher than the now reduced expectations. Merger and acquisition activity worldwide is strongly up this year, and is at its highest level in five years, demonstrating that liquidity is still loose and that corporate cash flows and balance sheets are at the highest levels seen in the current business cycle. Despite higher oil prices and mortgage rates, the residual property related “wealth-effect” continues to buoy the consumer. Americans are more exposed to housing than any other asset class, while U.S. home prices rose at an annualized rate of 7.3% for the quarter. Although there are signs of moderation in some of the more overpriced real estate markets, we do not think there will be generalized downturn in retail sales until housing prices are negatively impacted by higher interest rates. We are still concerned about geopolitical risk and rising energy prices, and do not anticipate any relief on either for some time. Our current position is that the recent market volatility has been exaggerated, and that leading economic indicators are likely pointing to a moderation in growth rather than a serious slowdown.

For the first six months of this year, the Dow rose 4.0%, the S&P increased 1.7%, and the Nasdaq lost 1.5%.

Grant Rogers Elizabeth Allen

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