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In the Aftermath: Navigating the Sovereign Fiscal Crisis

This is for informational purposes only and should not be construed as investment advice. The information presented is based on our best judgments and we believe it is reliable, but we do not guarantee its accuracy. Any judgments and

assumptions are as of this date and are subject to change at any time due to economic, market and other factors. Opinions expressed will evolve as future events unfold.

• Q4 GDP growth was 5.7%

• Leading indicators have soared

• Job market appears to be stabilizing

• Inventory rebuild should be strong, particularly in tech capital goods

US economic recovery has begun

This is for informational purposes only and should not be construed as investment advice. The information presented is based on our best judgments and we believe it is reliable, but we do not guarantee its accuracy. Any judgments and assumptions are as of this date and are subject to change at any time due to

economic, market and other factors. Opinions expressed will evolve as future events unfold.

In our view—

• Consumer: must still reduce debt and save more; housing wealth unlikely to recover

• Commercial Real Estate: more pain as office and apartment vacancies likely keep rising

• Government Spending I: Federal stimulus peaks in 2010, then fades

• Government Spending II: state and local govt. spending must fall to help balance budgets

• Net Trade: benefits from lower dollar limited by oil, China, European demand weakness

• Demographics: potential GDP growth looks likely to slow

• Recoveries from debt/banking crises typically are slow (‘80s UK, ‘90s Japan)

but the economy faces massive headwinds



• Fiscal Risks to Treasury returns from massive bond supply and policy

gridlock

• Inflation Risks to all bonds from higher core inflation from excessive monetary stimulus if policy gridlock persists

• Growth Risks to equities

• Confidence Risks to all US dollar assets

transition to sustainable growth and satisfactory real yield looks highly uncertain



GLOBAL BOND FUNDS HOLD:

• Non-US, high quality governments and supranationals (safety)

• Emerging market debt (performance)

• Corporate debt (performance)

• Non-dollar securities (safety and performance in a dollar bear market)

advisors may want to consider: diversify fixed income holdings by currency and quality



consumer headwind: personal saving rate may rise to replace lost wealth Percent

Personal Saving as a Percent of Disposable Personal Income

History Forecast

1

2

3

4

5

6

7

8

9

10

11

12

13

48 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08 11

Quarterly data; shaded areas denote NBER-designated recessions. Source: Commerce Department; Loomis Sayles. History through Q32009; forecast through Q42011.

consumer headwind: residential mortgage delinquency rate still rising

Seasonally adjusted quarterly data; shaded areas denote NBER-designated recessions. Source: Mortgage Bankers Association. History through Q32009.

Percent Mortgage Delinquencies: All Loans, Total Past Due

3

4

5

6

7

8

9

72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

10

investment headwind: vacancy rates are still climbing

Quarterly data; shaded areas denote NBER-designated recessions. Source: Commerce Department. History through Q32009.

Percent National Vacancy Rates: Industrial, Downtown & Suburban Office Space

2

4

6

8

10

12

14

16

18

20

22

24

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Industrial

Downtown Office

Suburban Office

• Credit Suisse: $1.4 trillion of US commercial real estate loans maturing in the next four years

• Foresight Analytics: almost 55% of these are currently "underwater“ (1/2010)

• $250 billion in CRE losses? Not good for regional banks, or for regional lending

Source: Federal Reserve Board/Haver Analytics, 1/13/2010.

Loan Delinquency Rate: Commercial Real Estate Loans: All Comml Banks

SA, Percent

10 05 00 95 90

12.5

10.0

7.5

5.0

2.5

0.0

investment headwind

fiscal headwind: OMB projects federal deficits will remain huge

Unified budget basis; fiscal years, annual data. Source: Office of Management and Budget; Commerce Department. Annual history/forecast through FY 2019.

$ (Billion) Percent of GDP

Federal Government Surplus/Deficit

-2000

-1800

-1600

-1400

-1200

-1000

-800

-600

-400

-200

0

200

400

60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08 11 14 17 20

-15.0

-13.5

-12.0

-10.5

-9.0

-7.5

-6.0

-4.5

-3.0

-1.5

0.0

1.5

3.0 OMB Projections (left scale) OMB History (left scale)

% of GDP, History (right scale)

Projections for % of GDP

(right scale)

• OMB: net federal debt held by public, up $2.1 trillion in FY 2009

• Up $9.6 trillion FY 2010 – FY 2019

• Debt-GDP ratio rise to 76.5%, highest since 1950

• May get worse in very long run

Source: Office of Management and Budget/Haver Analytics, 8/26/2009.

Federal Debt Held by Public as a Percentage of GDP

15 10 05 00 95 90 85 80 75 70 65 60 55 50 45 40

120

100

80

60

40

20

government debt stocks are soaring

Source: OECD/Haver Analytics; 8/19/2009.

Japan: General Government Gross Financial Liabilities as % of GDP

United States: General Government Gross Financial Liabilities as % of GDP

Germany: General Government Gross Financial Liabilities as % of GDP

United Kingdom: General Government Gross Financial Liabilities as % of GDP

10 05 00 95 90 85 80 75 70

240

200

160

120

80

40

0

but G3 yields are little changed

Source: FRB, FT, Bbk/Haver.

09 08 07 06 05 04 03 02 01 00

8

6

4

2

0

US: 10-Year Treasury Note Yield at Constant Maturity (Avg., % p.a.)

Japan: 10-Year Government Bond Yield (%)

Germany: Central Government Securities- 9 to 10 Years (Avg., % p.a.)

• US working age population to slow from aging, lower fertility & less immigration

• Potential real GDP growth estimated to slow from 2.9% in 2000s to 2.2% in 2010s

demographic headwind

Source: Congressional Budget Office/Haver Analytics, 1/14/2010.

Real Potential Gross Domestic Product (CBO)

10-year % Change (Annual) Bil. Chn. 2000 $

20 15 10 05 00 95 90 85 80 75 70 65 60 55

4.4

4.0

3.6

3.2

2.8

2.4

2.0

trade headwind: eurozone GDP slowed in Q4

Source: Statistical Office of the European Communities, Haver Analytics.

09 08 07 06 05 04 03

1

0

-1

-2

-3

Euro Area 11-16: GDP at 2000 Prices, Flash Estimate

SWDA Q/Q % Change

china’s imports are growing, europe’s are not

Source: CC, Eurostat/Haver.

09 08 07 06 05 04 03 02 01 00 99

120000

100000

80000

60000

40000

20000

150000

125000

100000

75000

50000 0

China: Merchandise Imports, CIF SA, Mil. US $

EA 16: Imports: Total SA/WDA, Mil. EUR

is china’s 39% M1 growth an inflation risk?

Source: CNBS, PBC/Haver.

09 08 07 06 05 04 03 02 01 00

40

30

20

10

0

-10

China: Consumer Price Index (Y/Y % Change)

China: Money Supply- M1 (Y/Y % Change)

US dollar remains vulnerable to sentiment, carry

Source: JP Morgan; monthly data ended 8/31/2009.

70

80

90

100

110

120

130

Dec-

79

Dec-

82

Dec-

85

Dec-

88

Dec-

91

Dec-

94

Dec-

97

Dec-

00

Dec-

03

Dec-

06

Dec-

09

US

Dollar

JP Morgan Broad Real Effective X Rates

2000 = 100

• US growth will require positive net trade to replace the consumer

— Dollar weakness is more export-friendly

• Higher oil and metals, weaker finance implies adverse us terms of trade

• US dollar is now a funding currency

— Delayed tightening from the fed to foster global rebound

• Asian currencies will need to appreciate

• Commodity and EM currencies may be pulled along

the weak dollar thesis



consider an expanded opportunity set: US is less than 40% of the global bond market

United States

Japan

Germany

France

United Kingdom

Italy

Spain

Canada

Netherlands

Supranational

Belgium

Australia

Austria

S. Korea

Other Countries

Barclays Capital Global Aggregate

% Market Value

Source: Barclays Capital, as of 12/31/2009.

compelling correlations: BGA & BGA Ex-US are weakly correlated to both S&P500 and MSCI EAFE

Source: Zephyr, data from January 2000-December 2009

January 2000 - December 2009 Barclays Global

Aggregate Ex-US Index Barclays Global Aggregate Index

Barclays Global Aggregate Ex-US 1.00 0.98

Barclays Global Aggregate 0.98 1.00

Barclays US-Only Aggregate 0.60 0.75

Barclays US Govt/Credit 0.60 0.75

Barclays US Corp High Yield 0.21 0.22

JPMorgan Emerging Mkt Debt 0.37 0.43

MSCI EAFE 0.39 0.34

S&P 500 0.17 0.14

questions & answers

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In the Aftermath: Navigating the Sovereign Fiscal Crisis

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