The Wilshire 5000, the broad market index that encompasses all traded U.S. stocks, was up 3.1 percent in the first six months of the year. The Wilshire moderated its rate of gain in the second quarter (+0.9 percent) relative to the first quarter (+2.2 percent). The Russell 2000, the favored measure of the small cap market, rose 6.2 percent in the first half of the year. The index managed a meager 0.2 percent rise in the second quarter, but held on to the 6 percent gain registered in the first quarter.

All in all, the gains in the first half of the year were downright meager relative to those recorded in the first half of 2003. However, aside from the DJIA, the key indexes were in positive territory despite many obstacles, including a rising interest rate environment, a moderating pace of economic activity, continuous terrorist attacks and threats. But stock indexes did not begin the second half of the year on a good note, falling on Thursday and Friday.

BONDS - A QUARTERLY RECAP
Yields were at their lowest level of the year in mid-March and were already starting to rise by the month's end. The more dramatic rate climb began with the April 2 employment report, which finally showed a dramatic rise in nonfarm payroll employment. The following reports in May and June were equally bullish for the labor market and each one seemed to reduce the probability that rates would decline and increase the likelihood that rates would rise. Indeed, rates climbed ever higher. Oddly enough, rates headed lower in the final week of the second quarter, even after the Fed announced its first rate hike in four years.

The 3-month bill tends to move in tandem with the federal funds rate target. The yield rose 33 basis points from 0.94 percent on March 31 to 1.27 percent on June 30. This was the smallest of the rate gains along the yield curve spectrum. The 2-year note increased 112 basis points to 2.69 percent; the 3-year note rose 114 basis points to 3.08 percent (the largest rate hike along the maturity spectrum); the 5-year note was 99 basis points higher on June 30 to 3.77 percent. The 10-year note increased 74 basis points to 4.58 percent at quarter end, while the 30-year bond increased 51 basis points to reach 5.29 percent on June 30.

The bond market had priced in more than one Fed rate hike. However, while many have talked about a 50 basis point move in August, the market pretty much expects incremental changes of 25 basis points at each successive FOMC meeting through year-end. A 50 basis point rate hike could roil the markets, but the Fed would probably telegraph the message ahead of the decision. When the Fed is in a tightening mode, the best bet is that rates will continue to rise. But for the first couple days of the third-quarter, interest rates went down in fixed income markets due to a drop in stock prices and a weaker-than-expected employment report for June.

Markets at a Glance

Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.

The Economy

Slower employment growth
Nonfarm payroll employment rose 112,000 in June after downward revised gains in April and May. The trend of the past few months shows that payroll growth peaked in March and moderated in the subsequent three months. After increasing for four months, factory payrolls dipped 11,000 in June; even construction employment was unchanged after strong activity in the previous three months. On the service side, government employment decreased in June for the second straight month; wholesale trade payrolls decreased modestly and other key sectors moderated their rate of growth. This could be a one-month anomaly or the beginning of a moderation in economic activity after stronger growth earlier in the year. Several other indicators for June have also shown slightly slower growth.

The unemployment rate remained unchanged at 5.6 percent in June for the fourth time in five months. Both the labor force and household employment posted healthy gains. Indeed, the employment-to-population ratio edged up to 62.3, the highest level since January when it stood at 62.4. Market players focus on nonfarm payrolls and the unemployment rate, but Fed officials also monitor the employment-to-population ratio and this indicator has lagged in recent months despite healthy gains in payrolls. While nonfarm payrolls have grown 1.5 million since September 2003, the employment-to-population ratio tells us that these gains are small given the growth in population.

Now that potential inflationary pressures are moving to the forefront, it is important to monitor wage pressures. In fact, average hourly earnings edged up a modest 0.1 percent in June after increasing 0.3 percent in each of the two previous months and are 2 percent higher than a year ago. Wages are not keeping up with inflation: real (inflation-adjusted) hourly earnings decreased 0.9 percent from a year ago in May (the last month for which figures are available). This was the first dip since March 2003 and the largest since 1991. Given the relatively sluggish growth in employment, workers probably believe that they don't have bargaining power. It is unlikely that wages will start accelerating in coming months.

All in all the employment report was slightly weaker than expected and this will translate into more modest industrial production and personal income growth in June than in the past few months. It may also limit the number of market players clamoring for a 50 basis point rate hike at the August FOMC meeting. A moderation in economic activity certainly promotes the view held by the Fed that the higher rate of inflation over the past few months was due to "transitory factors".

Manufacturing activity moderates
A variety of manufacturing indicators are showing signs of moderation. The ISM manufacturing index decreased 1.7 percentage points in June to 61.1 after reaching the year's high of 62.8 in May. The drop was moderate, but several of the key components, except inventories, were lower in June. The decline in the ISM manufacturing index was not as severe as the 11.6-point drop in the NAPM-Chicago index. It is well worth keeping in mind that the Chicago index fluctuates more dramatically than the ISM most of the time - and it also includes non-manufacturing activity. But there is no getting around the fact that the Chicago index fell to its lowest level in nine months.

Factory orders didn't fare well in May, falling 0.3 percent during the month after a 1.1 percent drop in April. The 1.5 percent gain in nondurable goods orders was not enough to offset a 1.8 percent drop in new orders for durable goods. Both defense and nondefense capital goods orders declined sharply for the month. New orders for information technology also declined for the second straight month after posting a health rise in March. New orders are notoriously volatile from one month to the next but a two-month drop during a recovery is disconcerting.

Motor vehicle sales plummet in June
Motor vehicle sales plunged in June after surging in May. Domestic vehicles were sold at a 12.1 million-unit rate in June, down 15.4 percent from May's 14.3 million unit selling pace. Sales have clearly fluctuated over the past few years depending on the various incentives offered by manufacturers. But even with the fluctuation, there is no question that average vehicle sales have come down in the past six months compared with the previous six months. In the first six months of 2004, domestic vehicles were sold at a 13.2 million-unit rate, down from a 13.9 million-unit rate in the second half of 2003. If automakers want to continue to sell cars and SUVs in the coming months, they are going to have to offer great deals to consumers - who have become quite accustomed to them and won't purchase without significant cash back offers or lucrative incentive financing.

Confidence rises in June
The Conference Board's consumer confidence index increased almost nine points in June to reach a level of 101.9 - the highest level since June 2002. Market players like to monitor consumer confidence because they think that confidence predicts retail sales. It sure did a poor job of predicting motor vehicle sales, which plunged for the month! In any case, the confidence figures have improved because labor market conditions are on the mend. Although, with June's soggy payroll gain, it will be interesting to see whether confidence continues its upward climb, or stalls again.

The Bottom Line
Economic news was on the weak side of expectations this week, although there is no question that business activity continues to hum. The Fed's long-awaited first 25 basis point hike in the federal funds rate target was accompanied by a relatively dovish statement that was little changed from the previous announcement in May, although it did suggest that Fed officials would become less measured and more aggressive should inflationary pressures accelerate in coming months. At this point, Fed officials were confident that inflation would moderate in the second half of the year. The Fed's announcement on June 30 coincided with the month's close as well as the quarter-end close. Financial markets behaved fairly well. However, market sentiment was less promising in the first two days of July as stock prices fell sharply and Treasury yields rose.

The upcoming week is short on economic news - and a short week to boot as it includes Fourth of July celebrations.

Looking Ahead: Week of July 5 to July 9

Monday
Independence Day Observed

Have a Happy Holiday!

Tuesday
Some of the components of the ISM non-manufacturing survey edged down in May. The business activity index, the most widely followed component of this survey, fell back to 65.2 in May from a level of 68.4 in April. Even with the drop, it still represents healthy activity. In contrast, the employment index from this survey increased two points to reach 56.3 percent.

Business activity index Consensus Forecast for June 04: 63.5
Range: 59.5 to 65

Thursday
New jobless claims inched up 1,000 in the week ended June 26 to 351,000, bringing the 4-week moving average to 347,000. The uptick in claims is disconcerting; claims should be on a falling trend given healthy economic growth.

Jobless Claims Consensus Forecast for 7/3/04: 340,000 (-11,000)
Range: 330,000 to 360,000

Consumer installment credit expanded by $5.7 billion in March after inching up a mere $0.9 billion in February. Monthly consumer credit is usually governed by fluctuations in motor vehicle sales since auto purchases are usually financed. Motor vehicle sales did jump in May.