The financial markets experienced a sharp rally for the three months ended September, furthering the gains achieved in the previous quarter, amid signs that the recession was ending. The Federal Reserve continued to keep interest rates low by adding even more liquidity into the financial system. Housing showed some signs of stabilizing, albeit at a very low level. Consumers continued to deleverage, increasing their savings rather than spending. Corporate earnings exceeded expectations, as cost cutting was the driving factor.

The Retirement Fund’s portfolio did well in this environment, both absolutely and relative to our benchmark, the second straight quarter of recovery for the Fund. The return for the portfolio was 12.03%, net of fees, for an outperformance of 181 basis points when compared to the 10.22% return, net of fees, for the composite benchmark. Manager performance was the biggest factor in the Fund’s outperformance, led by fixed income, hedge funds and portable alpha, which were the three areas that hurt performance during the financial crisis. In addition, our opportunistic investments in distressed debt and corporate bonds helped as market dislocations eased. Private real estate remains the biggest drag on returns.

Looking forward, we expect GDP to grow 3+% in the third quarter followed by 2-2½% in the fourth quarter. This growth should be aided by some inventory building and a less negative effect from the housing sector. This should officially mark the end of the recession.

Despite this improving trend, the consumer, as mentioned earlier, remains hesitant to spend, and with unemployment at 9.8% and rising, this is not going to be a typical “V” shaped recovery. At best, we are hoping for a slow growth year in 2010 of 2-3%, before the economy gains some traction in 2011. Our biggest concern is that the modest economic growth is not sustainable, leading to the potential double-dip recession pattern that occurred in the late 70’s and early 80’s.

This environment will make for a volatile equity market, particularly given the more than 50% recovery experienced since the March 2009 market low. Some retracement is anticipated and, while that could happen for any reason, investors are focusing on the third quarter earnings to be reported in October. Cost cutting led to better than expected second quarter earnings, but at some point, revenue growth is needed.

As for bonds, the financial community is divided on whether the massive amounts of liquidity injected into the system will cause rapid inflation down the road. Given our modest growth expectations, the excess capacity and large labor pool, we believe inflation concerns, if at all, are being pushed out. In the longer term this will depend on how successful the Federal Reserve and other central banks are in gradually withdrawing excess liquidity.

While the market recovery is certainly better than what was experienced in 2008, now is not the time to be complacent. We continue to seek strategies that will benefit the Fund over the longer term.