Consider first the gross domestic product (GDP). The third quarter saw substantial GDP growth with an 8.2% increase, compared to the adjusted 3.1% in the second quarter. This results largely from an overall improvement in capital spending on the part of businesses. Since consumer spending has stayed relatively strong, businesses have regained their purchasing power.

Next, consider employment levels. As of November 2003, employment persisted in its upward tendency, if only slightly. The unemployment rate decreased to 5.9% from 6.1%. In fact, in the last week of December, initial jobless claims dropped to 339,000, the lowest level since the beginning of 2001.

Now, consider short-term interest rates. The Fed set them at the lowest level in almost half a century. With the federal funds rate at 1%, both households and businesses have incentive to invest and increase spending.

Of course, not all economic factors are on the upswing. The twin deficits, the term coined to describe the budget and trade deficits, have actually worsened during the past year. The weakness of the dollar and heightened risk of terrorist attacks contribute heavily to this phenomenon. Many foreign investors hesitate to take on this kind of risk and have cut back on their U.S.-based assets.

So, what is expected for 2004? Economists anticipate that GDP will continue its growing trend at least for the next couple of quarters. Accordingly, unemployment will continue to decrease, and interest rates may remain at their present level for the next several months.

Stocks finished the year strong, with all of the major averages gaining ground in the fourth quarter. The smaller stocks once again led the indices, with the Russell 2000 advancing 14.2%, while the Dow Jones Industrial Average, NASDAQ and S&P 500 were up 12.7%, 12.1% and 11.6%, respectively. Although the indices all showed substantial gains in Q4, most were only up fractionally prior to the December rally.

Since cyclical companies perform better when the economy improves, these stocks led during the forth quarter. The Materials sector was up over 22%, while Energy, Industrial and Discretionary stocks all gained by more than 14%.

Performance for 2003 was mainly driven by smaller, more speculative equities. This is evident by the performance of the NASDAQ and Russell 2000, as they finished the year up 50% and 45.4%.

For 2004, stocks could continue to advance. Although valuations are stretched, rallies do not normally falter based solely on overvaluation. The S&P 500 trades at roughly 18x forward earnings. This is certainly higher than the mid-teen historical average. However, this is justified by low interest rates. As long as rates stay low and earnings continue to rise, stocks should do well.

Although PacWest has exposure to all economic sectors, the cyclical stocks should continue to perform well in an improving economic environment.  This view has been reflected in our over weighting of these sectors relative to the S&P 500.

The bond market changed direction drastically in 2003 as a direct reflection of the economic recovery. The treasury market rallied during the first half, with investors expecting the Fed to buy long-term treasuries and to lower the fed funds rate to under 1%. In addition, deflation was expressed as a concern of the Fed. Neither event happened.

Interest rates soared in the summer, and the 10-year treasury yield increased from 3.1% to 4.6%. With continuous confirmation of a strong economic recovery during the 4^th quarter, bond prices settled in a trading range. The 10-year treasury traded between 4% and 4.5%.

What is our worry for the fixed income market in 2004? Obviously, it is higher interest rates. With a weak dollar and stronger domestic growth, inflation can creep back into the system. The Fed is telling investors that a policy change will depend on the economic performance. Instead of keeping the fed fund rate at 1%, it may slowly creep toward 2% by the end of 2004.

To protect principal, we have continued to stay at the shorter end of the maturity schedule. Our exposure to preferred stocks has been reduced.  During the last quarter, we also added inflation-adjusted bonds to accounts. We will continue to employ these strategies in the near future.

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International Equities

Not only were U.S. stocks higher in 2003, but markets across the globe were enjoying a strong rally. All countries were able to participate in a widespread market rebound from three years of a global downturn.

The EAFE index continued to power ahead ending the year up over 35%. Europe and Asia were both able to add impressive gains for the year. An improving worldwide economy, a weaker dollar and the perception among many investors that international stocks were relatively undervalued has certainly helped U.S. based investors in the international markets.

Emerging markets, especially Asia, were able to achieve impressive gains for the year. Emerging market investors continued to concentrate their exposure on this area as growth rates are relatively high and opportunities robust. Latin America also contributed to solid gains, but Mexico lagged other markets overall. The hardest hit markets in the past years, such as Venezuela and Argentina, rebounded nicely and ended the year up 117% and 104% respectively.

The international market still looks promising going into 2004. We continue to add weighting in this area due to relatively attractive valuations and the weaker dollar assisting U.S. based returns.

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