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Advisor Commentary

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Financial Market Review: Economy/Equity Markets/Fixed Income Markets
Third Quarter 2004

Fact of the Quarter

Florida is the first state since Texas in 1886 to endure four hurricanes in a single year.

Economy

After sailing along at a healthy pace, the economy hit what Fed Chairman Greenspan labeled a "soft patch". Second quarter GDP slowed to a 3.3% rate, and third quarter GDP will likely end up between 3 and 4%. Several forces acted to 'take the wind out of the sails' of the economy, including prolonged difficulties in Iraq, rising oil prices, hurricanes, and several summer distractions, including the two political conventions and the summer Olympics.

For its part, the Fed continued its "measured" moves to gradually bring the fed funds rate to equilibrium. The Fed began the last day of the second quarter with a twenty-five basis point tightening, and followed with another twenty-five basis points in each of its regularly scheduled FOMC meetings in the third quarter.

Equity Markets

The equity markets faced a series of challenges and concerns during what can be a dull, uneventful period. Concern in the third quarter focused on the "soft patch" in the economy highlighted by weaker employment growth and a modest slowdown in GDP growth. In addition, oil prices increased to $50 per barrel by the end of the quarter providing additional headwinds to the recovery. Four hurricanes in the Southeast caused additional disruptions. As if this was not enough for the market to digest, the political and geopolitical environment added to the challenges. For the quarter, the S&P 500 lost nearly 1.9%, driven in large measure by a 10% decline in technology. With the rise in oil, energy again led the pack, increasing 11%. So far in 2004, energy is up over 25%. With all of the uncertainties in the marketplace, volatility measures declined and remain below historical averages.

At the last meeting of the Federal Reserve Board, it was suggested that the U.S. economy is continuing to "gain traction". At the same time, economic activity overseas appears solid. As a result, the Federal Reserve continued to remove the "emergency accommodation" by increasing interest rates.

Evidence that the "soft patch" is behind us came as 2nd Quarter GDP was revised from 2.8% to 3.3%. Going forward, oil prices and the political environment appear to be the two major factors impacting the market. We continue to focus on earnings with an eye on energy prices to see if the economic recovery is indeed back on track. If this becomes reality, higher beta stocks could be poised to outperform the overall market. As we enter the fourth quarter, the S&P 500 is up 1.5%.

Fixed Income Markets

The bond markets were torn in two very different directions. On the one hand, the Fed began raising interest rates. Normally, this would cause interest rates to rise and the curve to flatten. On the other hand, a softening economy normally causes interest rates to decline, and the curve to steepen. In the end, it appears the softening economy had the most influence. Interest rates fell across the curve, as the two-year treasury yield fell seven basis points, while the ten-year treasury yield fell forty-six basis points to end the quarter at 4.12 percent. Yet the curve did flatten, as short-term interest rates were dominated by Fed policy.

The bond markets finished the quarter with some nice gains. The Lehman Aggregate Bond Index returned +3.20% in the quarter, led by the corporate sector, up 4.21%.

The views expressed in this investment report represent the opinions of National City Investment Management Company (IMC) and are not intended to predict or depict performance of any investment. All information contained herein is for informational purposes and should not be construed as investment advice. It does not constitute an offer, solicitation or recommendation to purchase any security. The information herein was obtained by various sources; we do not guarantee its accuracy or completeness. Past performance does not guarantee future results. These views are as of the date of this publication and are subject to change based on subsequent developments.

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