Editor's note: The following review is based on the most recently available information as of July 17, 2006.

The hurricane season has officially begun along the eastern seaboard and in the Gulf states. Meanwhile, storms of another ilk poured over the world's financial markets on the heels of U.S. government releases showing inflation to be actively on the prowl, followed by an escalation of hostilities in the Middle East.

Inflation, both real and perceived, has metaphorically been the bull in the china shop for several months now. Observers have fretted in anticipation that escalating energy prices would give rise to price increases in other areas that have heretofore absorbed higher fuel costs without passing those costs on to end users. Investors seem to appreciate that price seepage is now fact, with recent fluctuations in the financial markets having been instigated primarily based on interpretations of how various price data will affect interest rates.

Consumer prices rose 0.6 percent in April 2006, according to the U.S. Labor Department, triggering a selloff in both stocks and bonds. The Dow Jones Industrial Average dropped 214 points in the wake of this news, its largest one-day drop in three years. The core Consumer Price Index (or core CPI, which does not take into account volatile energy and food prices) was up 0.3% in each of March, April and May, and has risen at a 3.1% annual rate through May 2006. The core CPI was up just 2.2% for all of 2005. We believe the 3.1% rise is taken as pushing the outer limits of the Fed's comfort zone.

Much of the burden for interpreting just how real the inflation threat remains falls to Federal Reserve Chairman Ben Bernanke. The Fed raised short-term rates to 5.25% at its June 2006 meeting, making that the 17th consecutive meeting at which they have raised rates by a quarter of a percentage point.

How high is up?
Bernanke has hewed to the line emanating from the Fed during the Alan Greenspan era that combating inflation will be the Fed's overarching mission. He explicitly said that further rate increases will be "data dependent," that is, they will take effect if inflationary pressures can be discerned with hard figures. He has, perhaps, wavered a bit with the suggestion that the Fed might "pause" to assess the effects of previous increases that could become apparent only with the passage of time – "lagged effects" they are called. Some observers are calling on the Fed to cease and desist with the rate increases so as not to thwart economic growth. Already, the markets have tried to parse Bernanke's utterances over his five-month tenure for a degree of assurance as to how he will steer the ship, only to grow increasingly frustrated in this quest.

The catalyst for all this angst has been the ebbs and flows in the price of crude oil, which broke through the $75 barrier in April 2006 and is presently situated around $78 per barrel. Although price fluctuations have depended to a large extent on supply and demand pressures, and the fragile nature of the regimes within whose borders oil reserves sit, another variable need also be reckoned with in understanding pricing behavior. That variable is the increased use by institutional investors (such as hedge funds and pension funds) of crude oil as a commodity play, trading on speculation over future supply/demand imbalances. These investors have been looking to add diversity to their stock and bond portfolios, and see trading in crude oil futures as a means to boost their bottom lines.

Unlike the price spikes of previous decades, which were brought about by dwindling supplies, there has been more than enough supply to go around to feed the world economy's thirst for crude oil. That could change if hostilities between Israel and its adversaries escalate and encompass Syria and Iran. Should these and other oil-producing nations find themselves drawn into the conflict, the ability to extract and transport this resource could become imperiled, with consequent price increases. This prospect has already precipitated a $10 per barrel increase since mid-June as investors grow nervous about possible supply disruptions.

Another area of worry for the domestic economy has been the housing market's ability to sustain upward pricing momentum. The world economy, which has been hot to the tune of nearly 5% growth over the last year, has fed off the willingness of U.S. consumers to spend beyond their paychecks. This fearlessness seems to stem from a feeling of wealth that consumers have derived from increases in values of their houses, with the tangible manifestation of hard dollars flowing from financing spigots, such as home-equity loans. Some economists attribute as much as half a percentage point of Gross Domestic Product growth to this spending source. However, even if the air comes out of the housing balloon, consumers may not necessarily be forced to the sidelines. Such a situation could take some time to manifest itself and many of the billions of dollars received from home equity loans are yet to be spent, say economists who monitor this activity.

Consumers leery
The consensus among interested parties is that the housing market has cooled off somewhat, although the quantitative evidence has yet to rise to the level beyond the anecdotal. Consequently, a Fed official flatly stated that the Fed has no intention of using monetary policy actions (such as lower interest rates) to help preserve gains in housing values. Consumers seem to have gotten the word that their houses might no longer generate double-digit increases in their net wealth. The Conference Board's Consumer Confidence Index took a sharp downward turn in May 2006, after rising in March and April, and then reversed course in June with a slight increase. The Index, which is based on a representative sample of 5,000 U.S. households, held up well when respondents were asked their impressions of current conditions, but reflected pessimism about the future. The Conference Board also took the pulse of Chief Executive Officers throughout the country and found that this group as a whole is losing confidence and believes that economic growth will proceed at a slower pace in the third quarter of 2006 than has been the case in recent quarters.

Second-quarter 2006 job growth did not measure up to economists' hopes and expectations. A vibrant economy often adds approximately 200,000 jobs per month. But, only 126,000 nonfarm jobs were added in April, and even that couldn't be bettered or even matched in either May (75,000 jobs added) or June (121,000). These numbers have supported speculation that the economy is slowing. The unemployment rate fell a tick to 4.6% this past May, where it has remained since.

Whereas consumers propped up the economy for several years, the capital goods sector has now assumed that responsibility. Extraordinary corporate profitability and cash flow, as well as global market dynamics, have driven the nondefense capital goods sector. Corporate balance sheets continued to shimmer in this year's first quarter, with earnings up 14% on average from a year ago. But this sector is not immune to inflationary pressures, either. Steel prices are expected to experience double-digit increases this year on the heels of a rise in the cost of iron-ore, which is up 19%. This could put extra cost pressure on manufacturers already contending with rising energy prices.

The dollar has been another source of concern, trading as high as $1.29 against the euro in May, although that softened to $1.26 in July. Dollar depreciation could work to the benefit of trimming the trade deficit, as U.S. exports become increasingly attractive overseas from a price standpoint. On the downside, the declining dollar could make foreign investors (such as the Chinese and Japanese) loath to continue purchasing U.S. Treasury notes, which finance federal budget deficits. The only remedy for this would be a higher interest rate.

Stocks get roughed up
As mentioned earlier, the stock market had a rough go in the spring. Nobody was immune to having their winter gains trimmed, in some cases marginally, in other cases substantially. Small caps took the biggest hit during the second quarter, although they still outpaced large caps and mid caps on a year-to-date basis. The utilities sector best weathered the storm, up more than 4% for the second quarter of 2006. Energy and consumer staples were the only other sectors to emerge unscathed. Technology took the deepest tumble, falling almost 10% for the same period. Emerging markets also experienced heavy turbulence in May, when hedge funds and other speculative investors looked to lock in profits by selling their best performers, meaning heavy selling and loss of value in this sector.

Yields on 10-year Treasuries rose past the 5.00% threshold in the second quarter, a marker that had not been eclipsed in more than two years. They peaked at 5.20% in May and are slightly lower at this writing.

FIRST QUARTER INDEX COMPARISONS

Source: The Wall Street Journal

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