July 2009 Investment Report

The equity rally resumed, and bond markets continued to advance …

Amid increasing confidence that the recession has ended, equity markets finished July with a fifth consecutive month of positive performance. In fact, the bellwether Dow Jones Industrial Average achieved its best performance for the month of July in 20 years. As measured by a broad index of U.S. equities, investment returns for stocks are now in the low double-digits for the first half of 2009, an impressive turnaround from the market lows reached in March. International equities resumed a recent trend of outperforming their U.S. counterparts, with the stocks of companies in developed countries advancing 9.1% for July and the stocks of developing countries gaining 11.3%. The latter group of stocks, also known as emerging markets, has collectively gained an impressive 51% so far in 2009.

Credit markets continued their recovery from severe declines experienced in fall 2008, with investment-grade bonds issued by U.S. companies, as measured by the Barclay’s Corporate Debt Index, advancing 3.8% for the month and resulting in a year-to-date performance of 10.9%. Riskier credit instruments, such as non-investment-grade bonds, also displayed strong performance.

The General Board has continued to follow its long-term, disciplined and diversified investment strategy of not attempting to predict the future direction of the U.S. and world stock and bond markets. This approach continues to prove to be a prudent way to ensure participants’ retirement security.

… amid more favorable economic signs and strong government support.

The Bureau of Economic Analysis (BEA) of the U.S. Department of Commerce released its first estimate for the second-quarter change in Gross Domestic Product (GDP), which is a measure of U.S. growth or contraction. The BEA reported a 1.0% decline in production (after adjusting for inflation), which was better than economic forecasts of a 1.5% decline and a significant improvement over the previous quarter’s rate of 6.4%. Reported job losses in July were lower than expected, down to 247,000 from June’s job losses of 443,000. The unemployment rate for July was 9.4%, which was also slightly lower than the prior month.

Demand for goods and services, however, remains generally weak. Among the components of GDP growth, the only positive contributors were net exports to foreign countries and government purchases. The positive contribution from net exports reflected the fact that actual exports declined less than imports, which does not suggest a recovery in demand. Thus, government spending, which includes a broad array of stimulus programs, was the only element of the GDP report that contributed to increased consumption in the second quarter.

The level of government spending highlights a key question about the sustainability of the economic recovery: Will private-sector demand improve soon enough to replace the “artificial” demand created by public-sector spending? The recently enacted Car Allowance Rebate System (CARS), more familiarly known as “Cash for Clunkers,” is a case in point. This $1 billion government program encourages car buyers, through a cash rebate, to trade in their current automobile for a more fuel-efficient model. The program has led to overwhelming demand for automobiles in the short term. However, there is widespread uncertainty whether demand created by the program will spark a new growth cycle for the auto industry or is unsustainable. The role of government stimulus has certainly been significant. For the first time since 1975, government transfer payments to households surpassed taxes received from households. If one includes public-sector wages, the government is now distributing more money to U.S. households than at any time in the past 50 years.

However, job growth appears tepid …

In its July 15 policy meeting minutes, the Federal Reserve Bank (Fed) seemed to indicate that it is anticipating an economic recovery that is not characterized by strong job growth. Fed officials believe that unemployment could reach as high as 10% by the end of the year. In testimony before Congress, Fed Chairman Ben Bernanke stressed that Fed policy would continue to accommodate the creation of credit, particularly long-term credit, which is not widely available through the typical banking channels. What was encouraging about Bernanke’s statements is his indication that the Fed has been limiting some of its capital injection programs as the severity of the financial system’s plight has eased in recent months. While deflation (declining prices) is still the Fed’s main concern, the fact that the Fed chairman is outlining his contingency plans for the time when inflation (rising prices) may become a concern is another signal that the worst of the credit crisis may be past.

… housing may have reached bottom, though commercial real estate concerns abound …

The June report for new home sales showed an 11% monthly increase. Since the start of the year, new home sales have risen by 17%, sales of existing homes are up 9% and new housing starts have increased by 19%. There was also positive news from the Case-Shiller U.S. National Home Price index, which, on a non-seasonally adjusted basis, registered its first monthly increase since home prices peaked in mid-2006. The housing recovery is fragile, however, with activity still well below normal levels. Also, housing prices could easily suffer a setback if the supply of foreclosed homes on the market were to rise substantially. While the housing industry may be on the mend, commercial real estate markets continue to suffer from high debt levels, limited transaction activity and very restricted opportunities for refinancing. The Moody’s/REAL Commercial Property Index indicates that real estate prices have fallen about 30% from their peak in October 2007.

… and business conditions remain mixed.

Consumer confidence, a guide to future spending behavior, declined for the second month in a row and remains below the key threshold of 50. Retail sales rose in June by 0.6%. However, excluding the impact of higher gasoline prices and volatile auto sales, retail sales actually declined for the fourth consecutive month.

As a result of ongoing consumer caution, businesses continued to slash inventories, down 1% in the month of May, which was the ninth straight month of decline. The manufacturing picture is mixed but shows some signs of stability. The durable-goods report, up 1.1% excluding transportation, suggests mediocre growth in business fixed investment. The Institute for Supply Management (ISM) Index, a measure of manufacturing activity, increased modestly in June to a reading of 44.8, the best in nine months, implying the decline in manufacturing is at least slowing.

Credit market pricing continues to strengthen, but lending levels
remain low …

The difference in interest rates between super-safe U.S. Treasury securities and most other fixed-income securities continued to narrow and has declined dramatically since peaking last October after the collapse of Lehman Brothers. Higher-risk credit-related bonds generated low- to mid-single-digit returns for the month of July and have generated better-than-equity-market returns so far in 2009.

According to the Fed’s data, overall lending activity was stable but low or weakening further for most loan categories. Banks continued to tighten lending standards across the board. Mortgage lending is downm and commercial and industrial loans fell or remained weak. All of this indicates that access to loans remains exceptionally difficult in the current economic environment.

… with limited concerns about inflation.

With the economy still struggling, the prospects of near-term inflation remain limited. Although inflation increased modestly in June, the 0.2% increase is not a concern to most economists. Prices for commodities were mixed in the month. Crude oil futures prices declined about 3% in July to close just under $70 per barrel. Copper gained 13%, and gold ended the month 2% higher, while corn prices declined about 10%, and wheat prices closed the month unchanged. The Dow Jones-UBS Commodity Index, a broad measure of commodity prices, was up about 3% for the month.

Market Reaction

The U.S. stock market rallied sharply in July, due to perceived improvement in the economy, better-than-expected corporate earnings and a benign inflation environment. The Russell 3000 Index rose 7.8% for the month, bringing the year-to-date return to 12.3%. Small-company stocks as measured by the Russell 2000 Index advanced 9.6% for the month and handily outperformed large-company stocks, which were up 7.6% for the month. Stocks of companies in developing countries performed exceptionally well in the month, up 11.3%. The economies of these developing countries, particularly China, Brazil and India, which are characterized by robust domestic growth, are ironically being viewed as the engines for a full-scale global recovery. The dollar declined against the major trading currencies during the month as its attractiveness as a haven of safety waned. Major news this month included ethnic unrest in China, renewed violence in Afghanistan prior to the country’s presidential elections, GM’s potential exit from bankruptcy, debate surrounding President Obama’s health care reform initiative and Congress’s pending confirmation of Sonia Sotomayor, President Obama’s nominee as the Supreme Court justice to replace David Souter.

Investment Fund Review

Inflation Protection Fund

• The Inflation Protection Fund produced a positive return in July. The fund outperformed its benchmark, primarily as a result of its diversification into inflation-based strategies other than U.S. Treasury Inflation Protected Securities. Specifically, the diversifying strategies of commodities and non-U.S inflation-linked bonds added the most value in July.
• As a result of strong July performance, the fund continues to meaningfully exceed its performance benchmark. The diversification benefit from inflation-linked bonds from developing countries and commodities continued to be a value-added factor in year-to-date outperformance.

• The Domestic Bond Fund attained positive performance for the month of July, outperforming its benchmark by 0.7%. Similar to last month, the fund’s sector allocation to investment-grade and below-investment-grade corporate bonds contributed to the fund’s better-than-benchmark performance. In addition, developing-country bonds added value in July. The primary detractor was the fund’s investment in positive social purpose investments, which are significantly linked to the performance of U.S. Treasury securities.
• As a result of strong July performance, the fund continues to maintain positive year-to-date performance and significantly exceeds its performance benchmark. The excess performance is primarily attributable to an overweight exposure to higher-risk, credit-related sectors as investors generally continued to seek more risk in their fixed-income investments.

• The Domestic Stock Fund posted strong returns for the month, although it failed to outperform its benchmark. This is mostly due to negative contribution from the fund’s private real estate and private equity investments, as the value of these nonmarketable investments typically lag the performance of the public securities markets.
• For the year, returns for the Domestic Stock Fund continue to underperform the benchmark, due to valuation declines in the private real estate and private equity holdings. A majority of the fund’s 13 active managers are outperforming their respective benchmarks.

• The International Stock Fund posted very strong performance in July as a result of continued optimism of economic recovery in developing countries. Developing-market equities increased 11.4% for the month. Similar to last month, the fund’s allocation to international public real estate securities added value relative to the fund’s benchmark in July. The fund also gained from an improvement in the value of its private real estate holdings during the month.
• As a result of strong July performance, the fund’s year-to-date returns have reached 31.1%, significantly outperforming its benchmark by 4.5% so far in 2009. This is attributable to excellent benchmark-relative performance by the fund’s managers and the recovery of the fund’s public and private real estate holdings.

• For the month, the fund slightly underperformed its benchmark, due to the benchmark-relative underperformance 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, Domestic Bond Fund and Inflation Protection Fund, although this is partially offset by the below-benchmark performance of the Domestic Stock Fund.