Currently the United States economy is in an extended phase of slower growth. Corporations are well balanced with low inventories and appropriate employment levels for the current environment. This is critical to keep wages, employment and corporate profits consistent despite the lack of growth. In other words, the environment for corporate profits does not appear to be worsening despite the sluggish growth. So far.

 

The primary risk in our view is the need to maintain the availability of credit to drive the little growth there is, and to support housing prices. Housing is a key part of the overall puzzle. If inflation forces the Fed to raise rates there is risk of increased housing credit defaults which will affect both the consumer and, more dramatically, the financial sector.

 

If a stabilization of housing is instrumental, then inflation also becomes critical. Again the Fed has a delicate balance of now needing to support the U.S. dollar to slow the rise in commodity costs by at least threatening to raise interest rates. We believe that the Fed is unlikely to actually raise rates in the near-term, preferring to verbally influence the market to support the dollar and keep inflation in check. If the Fed is forced to raise rates we become increasingly concerned that equity valuations will react negatively and a likely additional reduction in credit would impact housing and financials. Employment numbers are increasingly important in this equation since wage growth will likely change the outlook on inflation faster than rising commodities. The Fed hopes that corporations will continue to believe that there no leverage to either raise employee salaries or increase prices for consumers. At the same time, the slow economic growth is helping to keep employees from demanding wage increases.

 

So far this scenario can be positive as long as we continue to walk the tightrope between recession and inflation. The credit crisis has been sufficiently managed to keep it from upending the economy, but concerns remain and certainly continue to weigh on the financial sector. If inflation does become too significant, the Fed will likely be forced to raise rates which could drive the economy into recession.

 

Obviously there is considerable concern for both the near-term and long-term economic outlook. We expect the difficult environment for equities to continue at least through the fall. We have sought to limit exposure to stocks in 2008 choosing sectors carefully. Certainly commodities have been positive and we expect them to go higher. Technology fundamentals for the most part have been positive even if the stocks have been lackluster due to multiple contraction. The difficulties experienced by the financials have been beyond our expectations and are likely to continue. We have reduced our financial stock holdings in accordance with this view. Certain international equity markets appear attractive, particularly where growth is strong, such as Brazil. We continue to concentrate equity holdings in agriculture, industrials and multi-nationals that are benefitting from a weak dollar.

 

We have been reluctant to add significant corporate bond positions due to relatively low coupons and the prospect of potential rate increases. If inflation can remain in check, then corporate bonds around a 6% yield look attractive to us. Municipal bonds, on the other hand are very attractive and we have been accumulating issues in the secondary market that have sufficient credit worthiness. We have been able to accumulate 10 year California tax free municipals approaching a 5% YTM. In addition to municipal bonds, we have been adding structured notes tied to corporate interest rate yield curve spreads. With the prospect of rising rates, we expect these securities to yield more than 10% annually.

 

Lastly, we continue to look for opportunities in both real estate and private company debt instruments in an effort to reduce equity risk and increase income. So far this decade has been a very difficult one for stocks and we believe that this environment will continue for now. Through a narrowed sector focus and an increased exposure to alternatives we are adjusting client portfolios in an effort to maintain performance with an eye on the risks. Our primary goal is to preserve the assets of our clients. After preservation comes performance and we continue to expect positive returns for our clients in 2008 despite the challenges.