The US equity market ended last year with only modest gains in an extremely volatile year. The S&P 500 advanced twenty-five percent from June of 2006 to June 2007, but the specter of large losses in mortgage securities and an unexpectedly deep decline in the housing market rattled investors through year end. The S&P 500 finished the year with a total return of 5.49%, or roughly one half its historical average and only a third of 2006’s return. The NASDAQ performed better than the S&P 500 due to the strength in a handful of technology stocks. The Russell 2000, which represents smaller companies, underperformed for the year because the companies are more domestically oriented and were hurt by the slowing economy. Investors preferred larger multinational companies that continued to benefit from growth overseas.

Stock markets in emerging economies once again led the way. China was the leader again with annual returns for the second year in a row in the triple digit range. India recorded its third year in a row of gains above forty percent; and Brazil also posted a similar gain. The emerging markets have outperformed the markets in developed economies for the past seven years. Investors have been attracted to these regions because of superior economic growth. However, inflation has picked up in India and China, and government authorities are also initiating actions to head off a speculative bubble in their markets. By some valuation metrics, these markets are now more highly valued than the developed markets suggesting that continued outperformance will become more challenging. The stock markets in the major developed economies outside the US, such as the U.K. and France, posted modest gains. Japan’s Nikkei Stock Average was the worst of the lot with a loss of 11%.

Commodity-related industries posted the best returns in the US and in many markets throughout the world. The stocks of oil, mining, steel, coal and agriculture companies all benefited from surging commodity prices. The demand for new infrastructure in China and India as well as strong construction markets in the Middle East have been a boon for commodities. Increased demand for ethanol has pushed up corn and other food prices closer to home. There may be some degree of speculation supporting these outsized advances in commodity prices that exaggerate the underlying supply/demand dynamics. In contrast to the strength in commodity and industrial companies, financial stocks in most developed countries proved to be the worst performers as the mortgage debacle in the US affected financial institutions and investors worldwide.

Bond market returns were competitive with stock returns in 2007 for the first time in five years. Coming off a very weak year in 2006, high quality bonds performed better last year as investors began to discount the possibility of a recession in the US. Prospects for a weak US economy also caused rates on weak bond credits to increase as investors sought the safety of US Treasuries and other high quality credits in a flight to quality.