Stock markets affect inflation, other economic indicators

Nearly all major stock market indexes in the U.S. and abroad declined during the second quarter of 2008, as investors began to worry about how higher energy and food prices might affect inflation and economic growth. The specter of rising prices and a slowing economy, known in combination as "stagflation," came to characterize the 1970s, a period of relatively poor investment returns. That fear, on top of continued write-offs from leading banks and downgrades of financial stocks from Wall Street analysts, led to a losing quarter. In June alone, the Dow Jones Industrial Average dropped over 10 percent, one of the worst monthly showings in years.

There was little relief for investors in the bond markets. With inflationary pressures picking up, central bankers started to signal that higher short-term rates would be needed to quash inflation. In anticipation of higher rates, short-term bonds sold off more than long-term bonds, and yield curves flattened. Three-month U.S. Treasury bill yields climbed as high as 2 percent in June, but closed the quarter at 1.73 percent, up from 1.31 percent on March 31. The 10-year U.S. Treasury rose to 3.97 percent on June 30 from 3.45 percent at the end of the first quarter. Most major bond indexes suffered small losses. Lehman Brothers Government Index dropped 1.91 percent, the Lehman Brothers Credit Index lost 0.9 percent, and the Lehman Aggregate Index, which includes government, corporate, mortgage-backed and asset-backed securities, lost 1.02 percent. Tax-exempts finished on the plus side, but not by much; the Lehman Brothers Municipal Index gained 0.64 percent.

For the stock market, the second quarter ended up looking like an inverted "V." At the beginning, the markets were rebounding from the bottom in March, the point when the Federal Reserve arranged for JPMorgan Chase to take over the troubled investment bank Bear Stearns. The Dow Jones Industrial Average climbed from a low of 11,752.7 on March 10 to 12,244.6 by March 31, a 4.2 percent gain. By May 2, the Dow stood at 13,072.5, an 11.2 percent gain from the low.

Oil, which sold at $101 per barrel at the beginning of the quarter, shot past $130-and later $140-per barrel, further stoking inflation worries. In early June, the U.S. Labor Department reported that unemployment took a huge one-half of one percent jump in May. Leaps of that magnitude in jobless claims are often associated with recessions. In June, selling begat selling, and by the close of the quarter, the Dow was at 11,350. All told, the index was down 7.31 percent on a price basis, or down 6.85 percent in total return. From the Oct. 10 high of 14,164.5 to June 30, the Dow's loss was 19.9 percent. Many market analysts define a bear market as a 20 percent or more decline from the high, so we are certainly on the cusp by this measure.

The depressed real estate market also remains a drag on growth. The S&P/Case-Shiller Home Price Index, an index of resale home prices in 20 major U.S. metropolitan areas, showed significant deterioration. In April, the last month for which data is available, the year-over-year decline was 15.3 percent. In the first four months of 2008 alone, prices as measured by this index dropped 8 percent. Unable to refinance or sell their homes, many people are simply walking away. Nationwide foreclosures in May were 73,000, a 158 percent increase over May, 2007.

The slowing in the economy would normally call for monetary stimulus, but with the increasing inflation threat, that's not happening. In late June, the Federal Reserve decided to hold firm with the federal funds rate at 2 percent, where it had been set at the end of April.

Outside the U.S., equity markets were affected by many of the same concerns-energy prices, the credit woes, inflation and sklowing economic growth. MSCI Europe Australasia and the Far East Index (EAFE) had a gross return for the quarter of -0.55 percent in local currencies, and -1.93 percent in U.S. dollar terms. The return on the MSCI Emerging Markets Index was -1.50 percent in local currencies, and -0.81 percent in U.S. dollars.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.