2009 Secular Forum: An Annual Strategic Review
Investment Outlook and Strategy

Secular Forum Process

Our strategic review process encompasses the following four elements:

• Economic Outlook: Our review process begins with a focus on the economic outlook, both in the U.S. and abroad. We seek to identify the primary economic trends that will impact the near and intermediate term economic environment, in both the domestic and global economies. We review the analysis and forecasts of leading economists and economic observers, and look for where there seems to be  consensus, and where there is a wider divergence of opinion. Based on this information, we develop a number of scenarios, from best case to worst case, and assess what seems to be the most likely outcome, while giving due consideration to less likely outcomes.
• Investment Outlook: Next, we look at the investment outlook, with the objective of identifying both risks and opportunities in U.S. and global financial markets. We review the analysis and forecasts of some of the most thoughtful and insightful investment managers and market strategists. While it is impossible to accurately predict investment returns, we find it helpful to consider a number of possible outcomes, and estimate their likelihood of occurring. We then assess the relative attractiveness of the various asset classes such as large U.S. stocks, emerging markets, high-yield bonds, etc.
• Asset Allocations: Our next step is to review our portfolio asset allocations, and determine whether to add, eliminate, or adjust asset class allocations in the model portfolios. Our model portfolios cover the entire range of investment objectives from aggressive growth to conservative income, with asset allocation selections and weightings varying as the investment objectives change.
• Fund Selections: Finally, we review our fund selections, choosing active management strategies for areas where market conditions seem to provide  opportunities for active managers to create value, and passive management  strategies where there appears to be less opportunity. Our criteria for active  managers include a focus on the track record, management team, investment  philosophy, and the appropriateness of their particular investment discipline for current market conditions.
  

Economic Outlook

U.S. Economic Outlook

There appears to be widespread agreement among economic observers that the recession, which began in December 2007, ended sometime in mid-2009 and that a recovery is underway. There also seems to be a consensus that unemployment will remain high for some time, before gradually declining. However, there continues to be substantial debate over whether the improvements we keep seeing in the economy are merely the result of all the government stimulus programs, with the real economy remaining in disarray, or whether the economic fundamentals are indeed improving. The doubters point to the continuing decline in residential and commercial property values, the high unemployment rate, the continuing tightness of credit, and the financial squeeze on consumers. The optimists contend that, while the economy is still faced with substantial problems, the various stimulus programs have had the desired effect of stabilizing the financial system, improving confidence, and boosting business activity.

There is also much disagreement on how the recovery will unfold, with well reasoned analysis supporting each viewpoint. Some foresee a weak and protracted “U” shaped recovery, while others believe that the recovery will follow a “V” shape, recovering stronger and sooner. Still others worry we may experience a second dip, with a “W” shaped recovery likely.

Those foreseeing the “U” version believe that the economy will be constrained by a  weakened consumer, curtailed bank lending, falling real estate values, and stubbornly high  unemployment. They also observe that historically recessions that are triggered by financial crises tend to be followed by weaker “U” shaped recoveries. Those anticipating the ”V” version look at the pattern of recoveries after typical post-war recessions and see the  recent turning up of many economic measures as reliable indicators of recovery. While  acknowledging the problems cited by the first group, they believe the government stimulus  programs have been successful in jump starting the economy.

Another issue is whether the economy will eventually return to its historical real annual growth rate of approximately 3% (the “old normal”), or whether we are entering a new era of lower real economic growth (a “new normal”) of only 1-2%. Proponents of the “new normal” argue that three key forces will constrain the economy to a slower growth rate. These are: re-regulation, as the government steps in to more heavily regulate financial and business activity; deleveraging, as consumers and businesses pay down excess debt levels; and deglobalization, as developed countries back away from the free trade policies which have resulted in both jobs and entire industries being lost to the developing countries.

Finally, there is growing concern in many quarters that the projected fiscal deficits and likely doubling of the national debt will result in a much weaker dollar, higher interest rates, and a resurgence of inflation. The more optimistic view is that the projected deficits and national debt increases are manageable, necessary to ensure an economic recovery, and won’t sink the economy.

Major Economic Trends
With all the complex issues and trends impacting our economy, it is helpful to look at the important trends dominating the economic landscape today. Most of these trends remain negative, though there have been recent signs of stabilization or even improvement in some areas. A brief summary of each follows:

• Encouraging Developments: Before considering the more challenging issues that face the economy, a brief review of the more encouraging developments is in order. The economy grew at an adjusted rate of 2.2% in the third quarter, after six quarters of decline, and is expected to show even higher growth in the fourth quarter. Corporations have been revising earnings estimates upwards. Many of the major financial institutions that received government “TARP” funds have been able to raise capital in the capital markets and repay the government. The auto companies and Ford in particular have been reporting an improvement in current and projected car sales. Retail sales have been growing and are much improved from last year. Manufacturing and service industry indexes have shown a pickup in activity as the year progressed. All these signs have been offering encouragement that the economy is on the mend. Now on to the more worrisome issues.
  
  
• Residential housing continues to fall in value across the U.S., although there have been some recent signs of stabilization. The economists at Case-Schiller, which produces a national residential housing index, and many other real estate experts expect U.S. housing prices to decline as much as 10% more before bottoming out sometime next year. Since approximately two-thirds of American families are homeowners, stabilizing housing values is key to a sustainable recovery.
  
  
• Home mortgage foreclosures are rising, despite attempts by the administration to encourage lenders to modify mortgage loan terms. Another wave of foreclosures is expected this year, as monthly payments on some $3 trillion of adjustable rate mortgages issued in 2006 and 2007 with low 3 year “teaser” rates reset to higher levels. The American Bankers Association recently reported that one out of every seven mortgages is either in arrears or in actual default, and it is now estimated that one out of three homeowners with a mortgage owes more than their home is worth.
  
  
• Credit availability is still tight for both consumers and smaller businesses. Most banks, including those which received government funds, have been reluctant to make new loans, as they find fewer credit-worthy borrowers and also fear further souring of the loans already on their books. The FDIC has closed over 100 regional and community banks in the last year, and has several hundred banks on its watch list. Outstanding consumer credit has been shrinking as consumers have been paying down debt, and credit card companies have been cutting back on credit lines.
  
  
• Unemployment is at a 26-year high of 10%. Many observers expect it to head even higher before peaking later this year. The underemployment rate, which also includes those able to find only part-time work or have given up looking for a job, is even higher at 17.3%. Additionally, many of the jobs that have been lost are not expected to return. There appears to be a broad consensus that, once a turnaround begins, unemployment will recede only slowly.
  
  
• Federal deficits are growing alarmingly, as government spending increases and tax collections fall with growing unemployment and a slowing economy. The federal deficit is expected to reach a record $1.8 trillion this fiscal year, without allowing for any additional stimulus spending or new programs such as the health care overhaul bill. The Congressional Budget Office now forecasts the federal deficit to be over $1 trillion annually for the next 8 years. Some analysts project the U.S. national debt could double over this period of time.
  
  
• State deficits across the country are surging. On average, states have seen a 15% drop in tax collections, as job losses reduce income tax receipts and sales tax collections slump as consumers spend less. Some states, such as California and New York, are seeking federal help to avoid massive layoffs, service curtailments, and even bankruptcy.
  
  
• Commercial real estate is being impacted by store closings and business retrenchments. Many real estate analysts expect that overall commercial property values will fall by as much as 50%. There is estimated to be $3.5 trillion of commercial property loans outstanding, and commercial loan defaults are on the rise. This is likely to further stress bank balance sheets, and trigger increasing bank failures among the smaller regional banks that have been major commercial real estate lenders.
  
  
• Consumer spending has declined as job losses mount and consumers begin to pay down debt and add to savings. Over the last year, the household savings rate has gone from nearly zero up into the 6% range. Consumer credit has become scarcer and more costly, further crimping spending. In an economy where consumer spending accounts for 70% of gross domestic product, this is having a major impact on the economic recovery. It is likely that consumer spending will be muted for years to come, as consumers rebuild their savings and learn to live without running up credit card debt and drawing on home equity credit lines to finance spending.
  
  
• Higher taxes to reduce the deficit and fund increased government spending on new programs, such as healthcare reform, are widely expected. Rates will rise as the Bush Administration’s tax cuts expire and rates revert to prior levels. New regulations on the banking and investment industries are being debated in Congress in reaction to the financial crisis, and some are likely to be on the excessive side. Both of these developments are expected to result in a drag on long-term economic growth.
  
  
• Inflation vs. Deflation: The debate among analysts about whether the enormous fiscal deficits and expected huge increase in the national debt over the next few years, along with the rapid expansion of the money supply by the Federal Reserve, will ultimately result in inflation or deflation seems to have subsided. There is growing concern that the enormous projected deficits won’t be brought under control, and historically governments have dealt with the ensuing interest burdens on the ballooning national debt by inflating their way out. The most cogent argument appears to be that since the government possesses the means to inflate, and is determined to prevent a deflationary depression, it is much more likely we will see inflation than deflation. The consensus of opinion seems to be that inflation is not an immediate threat, but more likely to be an issue a few years out.
  
  
• All these trends are contributing to what seems to be the most widely held viewpoint, that the recovery will be weak and potentially a “jobless recovery” as employers only slowly begin to rehire. More pessimistic observers believe that the economic growth rate in the U.S. will be only in the range of 1-2% (a “new normal”) for the next few years, rather than returning to the previous 3% real rate that the Administration and the Federal Reserve are counting on to help reduce unemployment and boost state and federal tax revenues.
  

Overseas Economic Outlook
Many of the same forces impacting the U.S economy are also affecting the overseas developed economies of Europe and Japan. In contrast to past global recessions, the emerging economies have fared much better, and many, including China, have actually continued to grow strongly during this period.

     In Europe, of all the major countries, Great Britain was hit the hardest by the financial crises and economic recession. Many smaller countries such as Iceland, Ireland, Greece, and many Eastern European countries are still struggling with financial crises. Questions are being raised about whether the European Union will be able to assist its weaker members in restoring financial stability, and even whether the Union can survive the financial aftershocks of the crisis.

     Japan has experienced a major decline in exports, and has seen its unemployment rate soar. After a “lost decade” of stagnation following its stock market crash in the early 1990s, Japan is now saddled with one of the highest national debts in the world at 170% of its GDP. With both a declining and aging population, and a heavy dependence on exports, many observers foresee a very difficult period ahead for Japan.

     The emerging markets present the brightest picture in the overseas markets. Unlike in past recessions, many emerging markets countries are on a sound financial footing. China is in probably the best shape of any foreign economy, as a result of years of running trade surpluses and accumulating substantial foreign reserves. The Chinese economy grew substantially last year, aided by a government stimulus program, and strong growth is expected again this year. Its economy surpassed Japan’s by late last year, and China is now the world’s second largest economy. However, a few well-regarded analysts question whether the Chinese economy is in fact overheating due to excessive government stimulus, and several high Chinese government officials have expressed concern over whether bubbles may be forming in its real estate and stock markets.

Economic Outlook Summary
The global recession of the last two years is widely acknowledged to be the worst since the Great Depression of the 1930s. The entire world is coping with the aftermath of one of the greatest debt-fueled asset bubbles in history. Several important conclusions seem to be shared by a large number of well-respected economic observers. First, the process of deleveraging or paying down debt in the private sector will take years to play out, and will be a significant drag on global growth. Second, the projected growth of government debt, taken on to stabilize economies across the developed world will greatly increase government debt burdens and will also impact global growth. Third, unemployment in the developed economies will take a long time to come down. And fourth, the highest rate of economic growth will take place in the emerging markets economies, which are not saddled with the debt burdens of the developed economies, and have high savings rates, growing middle classes, and rapidly expanding economies.

Investment Environment and Outlook

U.S. Stock Market Outlook
The market recovery from the lows of last March was unexpectedly sharp and a surprise to many, in view of the enormity of the financial crisis and the severe headwinds impacting the economy. Many valuation-oriented analysts believe the market is currently overvalued by as much as 25% and are expecting a correction. Even many stock market bulls, who think the current stock market level is not unreasonable, are expecting a correction in view of the rapid runup. How the stock market actually performs this year likely depends on several factors. Two big questions are whether or not this year’s corporate profits will meet recovery expectations, and whether longer term interest rates begin to rise as a result of concerns that the huge fiscal deficits will lead to inflation or a weaker dollar. Another major question is what happens to the economy when the Federal Reserve eventually begins to let short-term rates rise, and starts to reverse its “quantitative easing” monetary policies. Some observers think that when the impact of the stimulus spending and the Federal Reserve’s government mortgage security purchasing programs begin to fade, so will the
recent stock market rally.

Historically, the aftermath of major credit bubble unwindings has seen a prolonged period of strong but unsustainable market rallies, as economic fundamentals disappoint expectations. A number of respected analysts think we are likely to experience such a period as the markets cope with the numerous economic headwinds discussed earlier.

     Future growth opportunities will likely be found far from home. Most market strategists think the best opportunities for future growth will come from the emerging markets countries, which are largely in much better financial shape than developed countries. Large U.S. multinational companies are expected to benefit from overseas growth, and many  already derive a majority of their sales from overseas markets. Analysts point out that the large European multinational companies are also poised to take advantage of emerging  markets growth, and are priced at a discount to their counterparts in the U.S. market. We have been continuing to increase our exposure to both developed and emerging markets economies in both the fixed income and equity components of our portfolios.

     Investment Returns: In view of the weak economic outlook, many analysts and market strategists see a long period of lackluster equity returns as corporate profit margins are squeezed by weak demand and higher capital costs. There seems to be widespread agreement that it will be many years before global stock markets return to pre-crash levels. Several market strategists whom we respect project U.S. stock market returns over the next five years to be in the mid-to-upper single digit range, and all come with caveats that assume no further financial surprises.

Investing always involves uncertainties, but we believe the range of potential economic and investment outcomes is particularly wide now, with so many elements of the global economic and financial systems under continuing stress.

Investment Strategies

Based on our economic and investment outlooks, we believe that incorporating defensive strategies continues to make sense for client portfolios. For clients with long-term growth objectives, adding to portfolios on a regular monthly basis is a good way to take advantage of expected market volatility this year. Our decisions with regard to the
various asset classes are summarized below.

• Cash: In view of both the improvement in the credit markets and the minimal yield on money market funds, we are continuing to reduce cash positions to more normal levels in all portfolios.
  
  
• Bonds: Due to concerns about possible future inflationary pressures, we are utilizing Treasury Inflation Protected Securities (TIPS) to fund positions in portfolios with higher bond allocations. With the possibility of higher interest rates later this year, we are emphasizing bond funds with shorter maturities and are adding a floating rate bank loan fund to income-oriented portfolios. We are also adding an emerging markets bond fund to the bond fund mix for more growth-oriented portfolios, as we see opportunities for both higher returns and a hedge against a declining dollar. We have made some adjustments to the bond fund holdings and weightings in some portfolios, trimming passive funds in favor of our previous high-yield bond fund allocations. Our emphasis is on funds holding short to medium-term durations and we are generally avoiding funds with longer maturities.
  
  
• Gold: Due to concerns about the ultimate impact of both the current and projected enormous fiscal deficits, and the Federal Reserve’s massive monetary expansion, we are utilizing a gold exchange traded fund (ETF) in portfolios with higher stock allocations. We view gold as a hedge against a declining dollar, as well as offering some insurance against an unexpectedly negative outcome from our current government financial policies. This past year has seen a higher profile for gold as an investment asset, with some well-publicized central bank purchases as well as a greater investor interest in gold as a store of value.
  
  
• Stocks: We are adding a merger arbitrage strategy fund to the stock fund mix in order to increase our defensive posture. We are also shifting our large cap U.S. value positions to add a dividend growth strategy to the U.S. equity mix. We have made some minor adjustments to the stock fund holdings in some portfolios to accommodate the new merger arbitrage position, but are leaving our stock fund allocations largely unchanged.

Conclusion
We continue to assess the global economic environment and investment markets as we seek to identify the major risks and opportunities that may influence the long-term performance of our clients’ portfolios. Although we typically make more substantial changes to client portfolios following our annual and semi-annual strategic reviews, we will also make changes to portfolios when we see specific opportunities arise.

For the Investment Committee,
Jeffrey H. White

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