Sean Flannery, CIO for North America:

Quality comes to the fore

The U.S. equity market has had a lackluster year, with very modest positive returns on the whole. Not surprisingly, particular sectors—notably oil and energy—diverged sharply and significantly outperformed other sectors of the market in large part due to high energy prices. Related to this phenomenon has been a dramatic underperformance by the auto and consumer discretionary sectors, which are most affected by high prices of oil and gasoline.

Despite this lackluster performance, we believe U.S. equities can continue to generate positive, albeit single digit, returns into 2006. There are several reasons for this. U.S. investors are sanguine about inflation. We are encouraged that core inflation remains stable despite significantly higher oil prices. Interest rates have risen, but in a very gradual fashion which has translated into a well-engineered slowing of the economy. We believe investors may increasingly reward higher quality companies, particularly large-cap entities that generate good quality cash flow. Overall, we see quality coming to the fore and corporate earnings growth coming in slightly above trend.

Economic fate tied to energy prices

U.S. economic growth moderated during the year, although it remains above trend. We expect the economy will continue to slow modestly as it has reached a mature phase of its expansion. Its fate also remains very much tied to energy prices. Although prices have come down a bit lately, we think oil prices will remain relatively high in the mid-$50 per barrel range, particularly as we head into the colder winter months. As a result, consumers may cut back on discretionary spending which we expect may also have a knock-on effect of curbing core inflation.

More rate increases in the cards

We see short-term rates increasing to 5% in 2006, as a result of the Federal Reserve’s continued cycle of increases in the Federal Funds rate. While several more rate increases are in the cards to reach this level, the pace of the Fed’s monetary tightening cycle has been very measured. In fact, the way in which the Fed’s moves have been well-telegraphed and carried out represents the greatest transparency ever seen in a Fed tightening regime. We don’t expect that Ben Bernanke’s assuming the role of Fed Chairman in the coming year will result in any shift in this strategy given the hard-won achievements the Fed has seen.

Richard Lacaille, CIO for Europe:

A performance paradox

A comparison between the U.S. equity market and the European equity market reveals a performance paradox. While the U.S. economy continues to be stronger than the eurozone economy—which has been as flat as a pancake—European equities outperformed their U.S. counterparts during 2005. Why has this been so? European stock market returns have very much been driven by the performance of individual companies rather than the macroeconomic fundamentals.

Good news travels fast

Although European stock analysts were cautious about the prospects for earnings growth in 2005 and remain so for 2006, European companies have outperformed earnings expectations for several reasons. A relatively weak Euro has benefited exports to Asia and elsewhere. European companies have been successful in lowering costs despite the regulatory burden many face. Finally, in contrast to the past, European firms have done a better job at running their companies in the interest of shareholders.

For all these reasons earnings growth in this market has been up more than expected. Investors have recognized this, which is why we’ve seen good performance from European companies overall this year. The valuation gap between U.S. and European equities has now narrowed, and further out-performance of European equities is likely only in the event of substantial earnings growth which is dependent on a more sustainable eurozone recovery.

Eurozone economy needs attention

The macroeconomic background in continental Europe is less favorable than elsewhere partly due to the political situation in the three largest economies: France, Germany and Italy. Unemployment remains the number one political issue, yet it has not affected corporations outside the consumer goods and retailing sectors nor has it risen in such a way as to threaten economic recession. While reforms are unlikely to provide an economic resurgence any time soon, the political outlook for 2006 is improving slowly in several areas—including tax cut proposals and labor deals--and there are likely to be improvements that will be favorable for equity investments going forward.

In addition, corporate management is regaining confidence, reflected in increased mergers and acquisition activity, and steadily rising fixed investment spending. The latter will help to boost eurozone growth in the absence of consumer spending and may also contribute to an easing of the employment picture. Nevertheless for above-trend growth it will be essential to see a sustained improvement in consumer confidence and spending.  

Lochiel Crafter, CIO for the Asia-Pacific region:  

Japan leads region in equity performance

Asia has had an overall good year, led by the Japanese equity market. Japan has benefited from a strong reform agenda, which has resulted in increased investor confidence in its stock markets. The economic environment in Japan has also improved substantially due to improved consumer confidence, an increase in consumer spending, and strong export trade. These factors, together with record inflows of foreign capital, supported an almost 30% rise in Japanese equity prices during 2005 to levels last seen in 2001. In Australia, increasing global demand for commodities has underpinned a third straight year of strong performance from its equity markets. Demand from China has been central to this trend.

China ’s growth to slow

Macro control measures in China have cooled activity in its property markets which have shown significant gains in major cities in recent years. We believe the Chinese economy will slow marginally this year into next but expect it will maintain growth at an 8%-9% rate. Reforms of the A-share market should ultimately improve investor confidence and help in the ongoing development of a vibrant capital market in China that will help ‘self-finance’ a greater proportion of the investment required to sustain such growth rates.

At a company level, managements have reduced debt and improved balance sheets, making current corporate performance more sustainable. While rising interest rates and underperforming property stocks have weakened the performance of the Hong Kong stock market, we believe earnings growth rates for many Asian companies, despite recent downgrades, will increase next year over 2005 levels based on the strength of the global economy and its anticipated growth at or above trend.

Locking in gains

International Developed Markets investors remain overweight in Asia, particularly China, Taiwan and Korea, which are non-benchmark positions that are seen as long-term growth opportunities. Emerging Markets investors however, have been locking in gains in equity prices, notably moving to an underweight position in India after its recent strong run. With projected earnings growth rates for Asia ex Japan having been revised down from 12.9% to 11.5% and now 10.9%, and valuations near their historic norms, Emerging Markets investors have reallocated on fears of further downwards revisions eating into their profits late in the year. We expect that investors may become more risk tolerant again in early 2006.

State Street Corporation (NYSE: STT) is the world's leading specialist in providing institutional investors with investment servicing, investment management and investment research and trading. With $9.8 trillion in assets under custody and $1.4 trillion in assets under management (as of September 30, 2005), State Street operates in 25 countries and more than 100 geographic markets worldwide. For more information, visit State Street’s web site at www.statestreet.com.

State Street Global Advisors, the investment management group of State Street Corporation, delivers investment strategies and integrated solutions to clients worldwide across every asset class, investment approach and style. With $1.4 trillion in investment programs and portfolios (as of September 30, 2005), State Street Global Advisors has investment centers in Boston, Hong Kong, London, Milan, Montreal, Munich, Paris, Singapore, Sydney, Tokyo, and Zurich, and offices in 26 cities worldwide. For more information, visit State Street Global Advisors at www.ssga.com.