May 2009 Investment Report

Both stocks and bonds demonstrated strong performance in May …

Major equity and credit markets provided positive investment returns in May, as investors continued demonstrating a greater willingness to invest in riskier assets. The S&P 500 and the Russell 3000, two broad indicators of U.S. equity performance, both increased 5.3% in May, resulting in positive year-to-date investment returns for U.S. stocks. International equities, as measured by a broad index of stocks issued by foreign countries, were among the best-performing asset classes and advanced nearly 14% for the month. In addition, the Lehman Corporate Debt Index, a key indicator of the performance of investment-grade bonds issued by U.S. companies, advanced 3.4% for the month. Riskier instruments, such as below-investment-grade bonds, bonds issued by distressed borrowers and debt issued by developing countries, showed even stronger performance.

May was the second month in a row of very strong performance in the financial markets. While some market commentators believe that the markets reached their nadir on March 9, others caution that the recent advance in equities is a “bear market rally” and that the U.S. and world markets could resume their downward spiral. Since March 9, U.S. stocks have increased in value by more than 30% and foreign stocks have risen by more than 50%. Markets for higher-risk bonds have also experienced a significant advance since mid-March.

The General Board continues to follow its long-term investment strategy and does not attempt to predict the future direction of the U.S. and world stock and bond markets. We strongly believe that this approach is the most prudent and offers the best opportunity for ensuring participants’ retirement security.

… with increasing optimism that the economy may be recovering …

Last month’s investment report discussed signs of improving economic conditions referred to as “green shoots.” These signs have strengthened further in May. The revised decline in first quarter 2009 Gross Domestic Product (GDP) at -5.7% was not as severe as the initial release of -6.1%. Job losses were not as high in April as in previous months, although the rate of unemployment reached almost 9%. However, the unemployment rate is widely considered to be a lagging indicator of where the economy has been, rather than a predictor of the future direction of the economy.

Consumer confidence, a guide to future spending behavior, had its biggest monthly increase in six years and attained the highest absolute level since last September. The forward-looking nature of the consumer confidence index was more than sufficient to offset the month’s earlier negative news that actual retail spending continued to decline. Weak automobile (car and truck) sales continue to adversely impact the economic prospects for a variety of industrial sectors. Excess capacity in the auto industry has led to the closing of numerous car dealerships. At the beginning of June, General Motors joined Chrysler in filing for Chapter 11 bankruptcy protection. This is the second-largest bankruptcy filing for an industrial company behind telecommunications giant WorldCom in 2002. While General Motors’ troubles are widely reported in the media, Chrysler’s asset sale to Fiat appears set to take place, which will allow the company to emerge from bankruptcy.

The manufacturing sector, as measured by the Institute for Supply Management (ISM) Index, jumped to its highest reading since September 2008. Durable goods orders also advanced 1.9% in April. Both of these reports indicate improved domestic manufacturing conditions.

… although signals in the ever-important housing market are mixed.

Investors are ultimately looking to the U.S. housing market for signs of a true recovery. However, the housing market continues to send mixed messages. The three consecutive months of positive pending home sales, likely due to the new $8,000 tax credit for first-time home buyers, seems to indicate increasing optimism. In April, the index of signed sales contracts rose 6.7%, which was the biggest monthly jump since October 2001. Typically, there is a one- or two-month lag between the signing of a contract and the closing. Hence, the index is a barometer for future existing home sales. In addition, the rate of decline in home prices appears to have flattened with the Case-Shiller Home Price Index for March down 18.7% versus one year ago, but matching February’s decline. Despite the nationwide Case-Shiller data, a report from the California Association of Realtors revealed that the median price of a home in the closely watched California market, which had been the locus of extreme overbuilding and subsequent foreclosure activity, registered two consecutive months of housing price increases. For the country as a whole, existing home sales were flat in the month, and inventory levels still remain stubbornly in the 10-month range. Perhaps of greater concern is that the bellwether 30-year fixed-rate mortgage climbed from 5.0% to 5.3% at month-end, implying that housing could be less affordable to potential buyers.

Credit markets continue to improve …

Long-term U.S. Treasury interest rates continued to climb in May amidst further signs of economic improvement. While the rate for 10-year Treasury bonds increased another 0.34% to above 3.5%, short-term rates continued to be well-anchored by Federal Reserve policies of making funds more easily available. As such, the Treasury interest rate yield curve steepened dramatically over the month as the differential between two-year and 10-year Treasury instruments reached an all-time high of nearly 2.75%.

The fixed-income credit markets continue to recover from the post-Lehman bankruptcy effects. A widely publicized barometer known as the “TED spread,” which reflects bank funding costs relative to a risk-free rate, has narrowed considerably from its all-time high in October of 2008. As indicated previously, other risk-based fixed-income assets performed robustly in May. The reinvigoration of the securitized credit markets continued in May as markets have further priced in the effects of the various U.S. government-sponsored programs, such as the Term Asset-Backed Securities Loan Facility (TALF) and the Public-Private Investment Program (PPIP).

… but actual lending activity is weak …

The results of the government bank stress tests suggested that many banks have insufficient capital. Accordingly, the tests revealed that banks would need to raise $75 billion in new equity to survive a further downturn in the economy. Fortunately, the recovery in the credit and equity markets facilitated banks issuing upwards of $85 billion in new equity through early June. Banks are using the new funds to take steps to strengthen their financial position, including paying off loans from the Federal Reserve. Nonfinancial companies have been able to access credit markets as well and are also using the capital to retire debt, such as bank loans and commercial paper. However, for the stressed consumer, the government remains the primary lender through its efforts to support bank lending activity and to protect homeowners by restructuring mortgage loans for the purpose of preventing or postponing foreclosures.

… and inflation fears have resurfaced.

Finally, inflation appears to have resurfaced as a possible concern of investors as evidenced by the increase in yields on long-term U.S. Treasury bonds. Inflation-protection assets performed well in May as investors remain anxious about the potential inflationary effect of the U.S. government’s fiscal and monetary policy initiatives. The dollar weakened against major currencies, implying a future increase in the price of imported goods and services. Commodity markets have seen significant spikes in the prices of key components. Crude oil futures prices climbed steadily throughout the month, from around $50 to $66 per barrel, a jump of more than 30%. The price of gold ended May at a three-month high and just short of the $1,000-per-troy-ounce threshold. The Dow Jones AIG commodity index, a broad measure of commodity prices, was up 13% for the month.

Market Reaction

The U.S. stock market experienced a second straight month of strong performance. The Russell 3000 Index rose 5.3% for the month, bringing the year-to-date return to almost 4%. Small-company stocks (up 3.0%), as measured by the Russell 2000 Index, underperformed large-company stocks (up 5.5%) during the month. International stocks (MSCI ACWI ex-US: up 13.9%) had another very strong month, extending their 2009 return advantage over U.S. stocks. Developing-country stocks (up 17.8%) once again performed better than stocks from developed-countries (EAFE) (up 11.8%). The dollar depreciated in value against the euro (-6.6%), the Japanese yen (-3.3%) and the British pound sterling (-8.6%), signaling potential international investor concern over the aggressive U.S. monetary stimulus programs.

Investment Fund Review

Inflation Protection Fund

• The Inflation Protection Fund rose significantly in May due to increasing investor concerns about inflation. The fund outperformed its benchmark primarily as a result of its diversification into inflation-based strategies other than U.S. Treasury Inflation-Protected Securities. In particular, the diversifying strategies of commodities and inflation-linked bonds from developing countries added the most value in May. Specifically, the 13% increase in an index of commodities is attributable to optimism regarding improving economic prospects. An 11% increase in the value of developing-country inflation-linked bonds is attributable to a depreciating U.S. dollar and greater investor risk tolerance.
• As a result of strong May performance and holdings of inflation-linked bonds from developing countries, the fund now exceeds its performance benchmark for the year.

• The Domestic Bond Fund had positive performance in May, as investors became less risk-averse through a greater willingness to invest in bonds other than U.S. Treasury securities. The fund’s benchmark-relative outperformance is primarily attributable to excellent returns from its holdings of both investment-grade and below-investment-grade debt, as well as non-U.S. bonds, particularly bonds from developing countries. The primary detractor was the fund’s investment in positive social purpose investments, which are linked to the performance of U.S. Treasury securities. As indicated previously, interest rates on U.S. Treasury bonds increased in May resulting in lower prices for these securities.
• As a result of strong May performance, the fund maintained positive year-to-date performance and meaningfully exceeds its performance benchmark. The fund has benefited from its below-benchmark weighting of U.S. Treasury securities as investors’ risk tolerance has improved, resulting in better benchmark-relative performance of the fund’s risk-based holdings.

• The Domestic Stock Fund advanced modestly in May but underperformed its benchmark primarily because of a negative contribution from the fund’s private real estate and private equity investments. Changes in the value of these illiquid investments typically lag behind the performance of the public securities markets.
• For the year, the performance of the Domestic Stock Fund is now positive. However, the Fund continues to underperform its benchmark due to valuation declines in the private real estate and private equity holdings. Nearly all of the fund’s active managers are outperforming their respective benchmarks, with 10 of the 13 active managers surpassing their respective benchmarks by at least 3 percentage points.

• The International Stock Fund had very strong positive performance in May as a result of broad strength in the international equity markets. The fund outperformed its benchmark by 0.7% primarily as a result of the fund’s allocation to stocks from developing countries, which advanced 17.1% for the month.
• The fund continues to meaningfully outperform its benchmark on a year-to-date basis. Stocks of developing countries represented the largest contributor to outperformance. In addition, the fund’s small-company manager has significantly outperformed its benchmark, and the fund’s exposure to real estate in developing countries has also added to relative performance. Similar to last month, all but two active managers are outperforming their respective benchmarks.

• For the month, the fund matched the performance of its benchmark. The strong benchmark-relative performance of the Domestic Bond Fund, Inflation Protection Fund, and International Stock Fund was offset by the below benchmark-relative performance of the Domestic Stock Fund.
• For the year, the fund remains ahead of its benchmark due to the strong benchmark-relative performance of the International Stock Fund and the Domestic Bond Fund.