A Q U A R T E R L Y P U B L I C A T I O N O F F E R G U S O N W E L L M A N C A P I T A L M A N A G E M E N T

“Taper Tantrum” … a Tempest in a Teapot?by George W. Hosfi eld, CFA, Principal and Chief Investment Offi cer

After a fast start to the year that saw blue-chip equity returns rival the gains posted for all of 2012, the quarter came to a close with equities in the midst of a long-awaited correction. Suddenly discounting a combination of Fed “tapering” and

slowing global growth, investors around the world went into a “risk-off” mode that placed virtually every asset class under pressure, with interest rates and volatility climbing. At the root of the concern is when the Federal Reserve will start to unwind its exceedingly simulative monetary policy known as quantitative easing (QE). This change in strategy has been referred to as “tapering” in the media, because, rather than actively draining reserves from the system or increasing short-term interest rates, the Federal Reserve could simply purchase fewer securities than they have in the past. Typically, this would be a relatively minor change in strategy; however, the bond market has interpreted it as a turning point in the interest rate cycle, and some pundits are calling it “the beginning of the bond bear market.”

Though a slow pullback in quantitative easing is likely, it is not imminent with 7.6 percent unemployment and a 1.1 percent infl ation rate that are both wide of Fed goalposts. We believe that several months of job gains totaling at least 200,000 will be necessary to absorb a “shadow market” of discouraged labor supply and push the jobless rate closer to the Fed’s 6.5 percent interim objective. Subdued unit labor costs and defl ated commodity prices have produced unusually low rates of infl ation that afford policymakers the luxury of waiting to see sustainably better job numbers before changing policy. Thus, we believe that when the Fed does act to slow the pace of its bond purchases, it will be for the right reason, namely, an economy that is on fi rmer footing.

In contrast to a U.S. economy that has prevailed despite fi scal headwinds, Europe remains mired in recession. Emerging market economic growth has undershot expectations. China is growing slower than anticipated, while stubbornly high infl ation in India and Brazil has made more pedestrian growth in these economies less appealing. As a result, emerging market stocks have disappointed; with negative year-to-date returns subdued international equity performance despite the explosive gain in Japan.

Even before the recent pullback, U.S. equity valuations were reasonable. Pullbacks could turn out to be shorter and more shallow in the slow growth global economy that we foresee. With respect to asset allocation, our penchant for equities remains intact. Though we were premature in adding to international stocks at year-end, we continue to foresee faster growing emerging market economies offering superior, long-term equity returns. We remain underweight fi xed income with slightly shorter bond durations helping to cushion portfolios from further advances in interest rates.

In This Publication

Market Perspective...............................1

Weapons of Reason..............................2

Mindful Reminders................................4

Investment Strategies...........................5

Investment Services..............................6

Communication and Education..........6

M A R K E T L E T T E R

Everything we hear is an opinion, not a fact. Everything we see is a perspective, not the truth. – Marcus Aurelius

MARKET PERSPECTIVE: SECOND QUARTER 2013

Abe’s … Big-Keynesian-Adventure by Dean M. Dordevic, Principal

“As legend has it, a man asked his three sons to snap an arrow, which each of them duly did. The man then produced three more arrows, and told the boys to snap all three at once. None of them could. One arrow, the man said, can easily be broken. Three arrows together, like a bundle of birch rods, cannot. It was an exhortation to work together for the good of the clan.”

—Legend of the Three Arrows, originating from the ancesteral home of Shinzō Abe in the Yamaguchi Prefecture¹

For the better part of what now spans a generation, Japan’s economy has been in a debilitating spiral of stagnation and defl ation. It wasn’t always that way. Japan was once an export-driven economic miracle. Its stock and real estate markets were the envy of the world. Indeed, Japan was both admired and feared. Japanese fi nanciers roamed the world widely, buying skyscrapers, iconic golf courses and trophy real estate. Then in 1990, the bubble burst—ushering in more than two decades of pain.² Five recessions followed and from 1990 to 2003, the Japanese stock market lost nearly 80 percent of its value. For investors, Japan was a stock market well worth ignoring.

There are many economists who believe that Japan’s lost decades were a dress rehearsal for the economics of stagnation that grips so much of the globe today. That is, Japan’s initial response to their burst bubble was, among other things, largely focused around public works spending and money printing. But critics claimed that at the fi rst hint of improvement, the government pulled back well before a robust and virtuous recovery could take hold. The resulting defl ationary spiral ultimately became self-reinforcing as investors, businesses and consumers delayed spending and investment. After all, why buy something today when you expect it to only become cheaper tomorrow? What Japan proved somewhat conclusively is that once entrenched, breaking a cycle of defl ation can be very diffi cult indeed. In late December of 2012, Shinzō Abe, the scion of one of Japan’s most prominent political families, began his second stint as prime minister. Since then, his government has unleashed a three-pronged tsunami of deregulation initiatives, extreme monetary easing and structural reforms. These measures have been called Abe’s “three arrows” and his macroeconomic “shock and awe” has been widely dubbed “Abenomics” by the fi nancial media. The sheer size and scope of Abenomics is breathtaking. The prime minister has promised easing in both quantity and quality. Said Bank of Japan Governor Haruhiko Kuroda, “Our stance is to take all the policy measures imaginable.” The Japan Central Bank is now engaging in the purchase of $75 billion securities per month. To put this in perspective, on a GDP-equivalent basis, this would amount to $225 billion per month for our Fed. This is nearly three times larger than the Fed’s third round of quantitative easing (QE3). The goal of the Bank of Japan (BOJ) is to increase the infl ation rate to 2 percent within two years, largely by doubling the size of the monetary base between now and 2014. “What is happening in Japan is revolutionary,” said Mohamed El-Erian, chief executive of Pimco, one of the world’s largest bond managers. “Nothing they’ve done since the Second World War comes close in terms of economic experimentation,” he said.² Japanese corporations hold an astonishing amount of cash on their balance sheets—collectively about $2.3 trillion in cash. While U.S. companies have been rightly lauded for having “fortress-like” balance sheets (currently holding $1.8 trillion in cash), on a GDP-equivalent basis, their Japanese counterparts hold roughly three times as much.³ Mr. Abe is seeking to shake some of that cash loose. Wide-ranging reforms are being pursued, such as tax cuts and incentives, industrial revitalization, infrastructure spending, deregulation and the creation of new markets. Mr. Abe is also looking to boost capital spending by offering targeted tax incentives for replacing aged equipment. Unlike previous attempts at pump priming, some

M A R K E T L E T T E R ● S E C O N D Q U A R T E R 2013

WEAPONS OF REASON

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Never let the future disturb you. You will meet it, if you have to, with the same weapons of reason which today arm you against the present. – Marcus Aurelius

important new features of his growth strategy are “key performance indicators” (KPIs) which include specifi c timetables for each item of emphasis. Said Mr. Abe, “We will implement (these) policies with unprecedented urgency.” He is pushing for greater labor participation rates for existing and older workers, with an emphasis on women. He is also seeking to raise the retirement age in hopes that it will ameliorate, to some small degree, the impact of Japan’s rapidly aging population. Thus far, the results of Mr. Abe’s experiment with the Japanese economy and fi nancial markets have been encouraging. Since the start of Abenomics in late 2012, the Nikkei saw its strongest six-month gain since 1953. Despite a sharp correction recently, the Nikkei has still advanced over 50 percent. The so-called “wealth effect” has been strong, with the sales of Tokyo condos soaring 56 percent over the last six months and sales of luxury goods (e.g., art, precious metals, jewelry) surging 23 percent.³ In the fi rst quarter of 2013, the Japanese GDP showed surprisingly strong growth of 3.5 percent (on an annualized basis). It is estimated that it will continue to rise through the second half of this year. Japanese companies plan to increase capital spending outlays by 12 percent in 2013, which will be the sharpest rise since the Lehman shock of 2008. In May, machine tool orders rose a robust 14.9 percent and from April to May, spending for public works increased 47 percent.6 Mr. Abe also wants to boost Japanese exports so the BOJ moved decisively to dramatically weaken the yen, which has fallen over 25 percent this year. As a result of this move, exports have increased 10.2 percent over the last quarter. Tourism is up as well, with the number of foreign visitors to Japan jumping 31 percent year-over-year in May. But without the political winds at his back, Abe’s arrows will simply go nowhere. After all, Japan is a country that had seven prime ministers during the Clinton administration alone. Yet in the Tokyo elections held on June 23, every candidate from Mr. Abe’s Liberal Democratic Party (LDP) coalition won. Their sweeping victory came with a margin of victory that was the largest in 50 years. Importantly, these victories were achieved despite the recent sharp drop in the Nikkei. But Mr. Abe has a long and diffi cult road to hoe. He must, on the one hand, continue to gradually weaken the yen, while at the same time not ignite capital fl ight out of Japanese bonds. The recent plunge in the Nikkei was

precipitated by just such fears.

To be sure, with a large export base and a plunging yen, Japan has sent a large and unmistakable defl ationary pulse across the Pacifi c. But the weaker yen is nothing short of a gift to the U.S., as Japan has offered American consumers the equivalent of a tax cut coming in the form of lower import prices. With a very weak yen and so many other large and liquid currencies looking quite sick (i.e., euro, sterling, gold), the strong dollar would appear to be an ongoing safe haven. Also, rising yields on U.S. bonds coupled with a strong U.S. dollar suggest continued fl ows into U.S.-denominated debt. Japanese export-oriented companies would also be particularly attractive, in our view, and are duly represented in our international portfolios. While somewhat uncorrelated previously, since the start of Abenomics in late 2013, the correlation between the movement of the yen/U.S.

dollar and the S&P 500, has been nothing short of remarkable. It would be wise to watch this correlation quite closely, as one would now be hard pressed to differentiate between the two indices. Japan is the world’s third largest economy and the second largest in the developed world. Whether or not a portfolio has a single share of a Japanese company, investors are affected. So when a signifi cant change at the margin occurs in such a large economic ecosystem—and since global GDP doesn’t reside in a vacuum—the ripple effects can be potentially very profound. If one were to judge only by the sheer number of Google searches this year, Mr. Abe’s Three Arrows will remain a force to be reckoned with … for quite some time to come.

M A R K E T L E T T E R ● S E C O N D Q U A R T E R 2013

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Abenomics and the 500

S&P

500

75

80

85

90

95

100

105

1300

1350

1400

1450

1500

1550

1600

1650

1700

6/25

/201

2

9/17

/201

2

12/1

0/20

12

3/4/

2013

5/27

/201

3

S&P 500

Yen / U.S. Dollar

Japanese Yen / U.S. D

ollar

AbenomicsBegins

Source: FactSet

There’s a Story Behind Every Nameby Mary A. Faulkner, Vice President of Marketing

For additional resources, please contact info@fergwell.com for a copy of our Glossary of Investment Terms or visit blog.fergusonwellman.com for more defi nitions.

Abenomics: Policy measures designed to address Japan’s macroeconomic challenges. They include economic growth strategies, fi scal policy and monetary policy to foster private investment. The term “Abenomics” refers to Shinzō Abe, who was elected prime minister of Japan in December of 2012 and quickly thereafter announced a ¥10.3 trillion fi scal stimulus strategy for his country. (page 2)

Bear market: A market condition caused by security prices dropping. As investors anticipate further losses in a bear market and selling continues, negative sentiment tends to grow. For many economists and investors, a downturn of 20 percent or more in multiple broad market indexes over more than two months is considered the beginning of a bear market. Conversely, a market correction is defi ned as a short-term trend lasting less than two months. (page 1)

Blue chip: It is believed that this term is derived from poker, where blue chips are the most valuable. In fi nance and investing, blue chip refers to a well-established, fi nancially sound company. A blue-chip stock typically has a market capitalization in the billions and tends to be the market leader or among the top three companies in its industry. (page 1)

Defl ation: A decline in prices often caused by a reduction in the supply of money or credit. Defl ation can also be a result of decrease in government, personal or investment spending. The opposite of infl ation, defl ation can potentially trigger more unemployment because there is a lower level of demand in the economy. (page 2)

Duration: The sensitivity of the price of a fi xed-income investment to a change in interest rates, measured in years. Rising interest rates cause bond prices to fall, while declining interest rates can fuel rising bond prices. The larger the duration number, the greater the interest-rate risk or reward for bond prices. (page 1)

Nikkei: An abbreviation of Japan’s Nikkei 225 Stock Average, which is the leading index of Japanese stocks on the Tokyo Stock Exchange. It was founded in 1949 and named after Nihon Keizai Shimbun—its administrator and leading business newspaper at the time. (page 3)

Quantitative easing (QE): Monetary policy used to increase the money supply through purchases of open-market securities. It is employed by central banks once targeted interest rates are already near 0 percent, in an effort to encourage more lending. (page 2)

Underweight: A term used in actively managed portfolios when the amount of a particular security is less than the security’s weight in the benchmark portfolio. The goal of underweighting is to achieve returns greater than that of its benchmark. (page 2)

Let not your mind run on what you lack as much as on what you have already. – Marcus Aurelius

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M A R K E T L E T T E R ● S E C O N D Q U A R T E R 2013

MINDFUL REMINDERS

Mindful Reminders sources: Business Dictionary, The Economist, Investopedia, Wikipedia

Taper Hysteria – Is the “Bondmageddon” at Hand?by Brad H. Houle, CFA, Senior Vice President

The rise in interest rates for 2013 has been relatively minor with rates up less than .50 percent in longer dated Treasury bonds. Since the start of quantitative easing following the fi nancial crisis, the 10-year Treasury interest rate has increased at least .50 percent, and subsequently retreated eight times. Speculation that the Federal Reserve is going to begin “tapering” its

purchases of debt issued by the U.S. Treasury and mortgage-backed bonds has recently caused a minor correction in the bond market as well the equity markets. Stocks that are considered to be interest-rate sensitive, such as REITs and utilities, have corrected the most return.

The good news about “The Taper” is that if it is indeed under consideration by the Federal Reserve, it validates that economic conditions are improving. Does this portend a vicious bear market in bonds? Not at this point, as conditions for an immediate and sharp correction in bonds are not present. Specifi cally, infl ation has been contained with the Federal Reserve’s preferred measure of infl ation running slightly over 1 percent; it is well under the 2.5 percent infl ation threshold put forth by the Fed when QE3 was initiated. Furthermore, forward measures of infl ation also look fairly tame.

While the economy is slowly growing, it is unlikely that economic growth will accelerate to the point that the Federal Reserve will need to quickly raise interest rates. That said, we do believe that interest rates will seek a higher equilibrium and we are therefore mildly bearish on bonds.

With this outlook, we believe that being modestly short of our duration benchmarks is appropriate. However, we don’t believe that a 1977-1981 style infl ation fueled bear market is on the horizon. Instead, the more likely outcome is a gradual increase in rates over the next two or three years.

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M A R K E T L E T T E R ● S E C O N D Q U A R T E R 2013

INVESTMENT STRATEGIES

Change makes our universe. Thoughts make our lives. – Marcus Aurelius

10-year Treasury Yield

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1.00%

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2.00%

2.50%

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3.50%

May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13

Rat

e

Weapons of Reason footnotes and sources (from pages 2 and 3):1. “Once More With Feeling - Japan and Abenomics,” The Economist, May 18, 2013.2. Jeff Sommer, “So Far, the Battery Charger is Working in Japan,” The New York Times, May 18, 2013.3. Jaewoo Nakajima, “Luxury Sales Driving Japan Dept. Store Sales, et al,” International Strategy and Investment/ISI, misc. Japan Research, June 21, 2013.4. Francois Trahan, “Japan and the ‘Risk On’ Trade,” Cornerstone Macro, Economics, Policy & Strategy, June 17, 2013.5. Brian Bremmer, “In Japan, the Sugar High of Abenomics,” Bloomberg Businessweek, June 6, 2013.6. “Mr. Abe’s “Third Arrow”,” Review and Outlook Asia, The Wall Street Journal, May 17, 2013. 7. Paul Krugman, “What if Abenomic’s Works?,” The New York Times, June 21, 2013.

Resources for You and Your Familyby Lori B. Flexer, CFA, Senior Vice President

We have a saying at our fi rm that is important to us: We believe that everyone can benefi t from more knowledge of fi nance, investing and economics.

Over the years, we have distributed hundreds of copies of our Glossary of Investment Terms to clients and friends of our fi rm. We also provide client education programs on a number of helpful topics. Start Now! Savings Essentials is our newest program, geared toward individuals between the ages of 16 and 22. It emphasizes the important opportunity that young savers have compared to their parents and grandparents … more time to benefi t from the compounded growth of their savings and investments.

We hope you take advantage of these educational resources. If you would like a copy of our Glossary of Investment Terms, please contact us atinfo@fergwell.com or (503) 226-1444.

Our logo features a bronze coin of Marcus Aurelius Antonius, Emperor of Rome from A.D. 161 to 180. According to historian Edward Gibbon, he was the only person in history in which “the happiness of a great people was the sole object of government.” Marcus Aurelius

was the author of meditations that reveal a mind of great humanity, natural humility and wisdom.

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Check in on Your Creditby Scott W. Christianson, CFP®, Equity Trader

As part of our conversations with individual and institutional clients, we are often asked questions that are beyond investment management. One resource worth reminding clients of is the opportunity to “check in on your credit.” It is an important step for three reasons. First, you don’t want to wait until you need a loan to learn that your credit score isn’t where you thought it would be. Second, it is wise to confi rm that your credit report information is accurate before

making a large purchase, buying insurance or interviewing for a job. Third, reviewing your credit report is an excellent way to protect you from identity theft.

The Fair Credit Reporting Act (FCRA) requires that each of the national credit reporting companies provide citizens with a free copy of their reports annually. You have the opportunity to make requests to three companies individually (Equifax, Experian and TransUnion) and stagger the reports you receive throughout the year, enabling you to check your credit for free every four months. These requests can only be made by calling (877) 322-8228 or by visiting annualcreditreport.com. One important note – there are many imposter websites online that will try to trick you into thinking the report is free, but charge you later.

888 S O U T H W E S T F I F T H A V E N U E , S U I T E 1200P O R T L A N D , O R E G O N 97204

503 226 1444 www.fergusonwel lman .com

INVESTMENT SERVICES

COMMUNICATION AND EDUCATION