The economy is in the beginning stages of what we expect will be a prolonged recovery. In recoveries profit margins expand and corporate profits accelerate. An acceleration in corporate profits combined with 1950’s interest rates creates a decidedly positive environment for stock investors.

Inflation pressures are building and are causing bond yields to rise from their historic lows. For example, the 10- year US Treasury Note’s yield has climbed from 3.07% on June 13, 2003 to 4.38% today. Economists were surprised that the GDP measures for the 2^nd quarter of 2003 came in above 2%, and further surprised when that number was revised to 3%. We expect another surprise in the 3^rd quarter. GDP could tell top the 5% level, which could easily push the 10-year Note’s yield to the 5.50% to 6.00% range.

The changing environment will favor equity investments in the technology, generic healthcare, energy and consumer discretionary sectors. The financial, utility and communication services sectors will most likely underperform the overall market.

In this interest rate environment, portfolios with a short to intermediate duration and a focus on high quality bonds will outperform their peers. Our focus for our tax-exempt clients will be on US Treasury notes, federal agency notes, and A rated or better corporate notes. Mortgage backed securities will underperform as their durations get pushed ever higher as rates rise.

For our taxable clients our focus will be on ‘Aaa’ and ‘Aa’, state specific municipal bonds. General Obligation bonds will be preferred over revenue bonds, with a specific bias against airport revenue bonds, tobacco securitization bonds, an all California bonds.