Outlook

April 19, 2010

The environment for risk-taking gained increased momentum during the last four weeks as many financial markets reached fresh cycle highs. U.S. small-cap stocks led the parade with gains of more than 6%, and emerging markets regained some momentum with a 5% gain. This performance was supported by relative calm in the currency and bond markets, with the dollar appreciating 1% while U.S. Treasury yields increased slightly. The continued strong performance of the equity markets, along with further reduction in the Chicago Board Options Exchange Volatility Index (VIX) to a cycle low, have finally jump-started equity market inflows — which increased to $24 billion in March from $7 billion in February.

March Purchasing Managers surveys indicate that the United States is seeing the third-highest level of business activity in the world (behind Sweden and Switzerland), and this is now showing up in first-quarter earnings reports. Consumer spending is on track to beat expectations as retailer results from the middle market (Kohl’s and T.J. Maxx) to the higher-end market (Nordstrom) trounced expectations. Corporate activity has also picked up noticeably, from the transportation sector (UPS) to technology (Intel). Because of the considerable slack in the economy, we do not expect this rebound to increase inflationary pressures over the near to intermediate term. We are still concerned, however, about the lack of credit creation, as reflected in the scarce 1.5% growth in M2 money supply last year.

The longer the economy can grow uninterrupted by tightening monetary policy, the greater the chance of a sustainable economic expansion. The recent survey of corporate confidence by the Business Roundtable indicates that CEOs are increasingly looking to boost hiring and capital spending. But the prospects for economic growth and financial markets do not always go hand in hand — at some point in the recovery economic growth that is too strong could actually become a negative for financial assets, as it would increase the likelihood of rising interest rates and possibly an eventual economic slowdown.

U.S. Equity

• All segments of U.S. equity markets continued a steady and positive trend upward
• Evidence supporting a sustainable economic recovery is a positive for stocks

EAFE and Emerging Markets

• After lagging the U.S. market, Europe, Australasia and the Far East (EAFE) and emerging markets are now more attractive
• Euro weakness should continue to help bolster European industrial production

Fixed Income

• Attractive mortgage-backed securities’ valuations bring out the buyers
• Historically low mortgage rates are supporting the economic recovery

High Yield

• The financial crisis led to changing regulations and credit rating methodologies
• These new methodologies could create nontraditional investment opportunities

Global Real Estate

• The FTSE/EPRA NAREIT Global Real Estate Index posted a strong 6.8% return in March
• U.S. real estate investment trusts (REITs) outperformed global REITs by 2.60%

Hedge Funds

• Hedged equity strategies continue to rebound after a dismal 2008
• Sector-focused managers typically outperformed their generalist peers

Commodities

• Financial investment is supporting copper prices
• U.S. offshore drilling announcement was a snoozer

Conclusion
Better than expected economic momentum, supportive valuations and accommodative global central banks lead us to continue to support risk taking in today’s markets. Our view is that in a constructive environment for risk taking, an investor could potentially benefit more from broad market exposure than through a hedged approach.

Our risk-case discussions focus on weak credit creation in the United States, China’s tightening cycle and Europe’s handling of the Greek debt crisis. We think U.S. banks have adequate financial incentive to increase lending, and this should lead to improved money supply growth over time. We also think that, while appreciating the uncertainties involved, China and the European authorities will navigate their current challenges. Increasingly, our discussions will focus on the eventual Fed tightening cycle and whether it will be forced to move at a pace that is disruptive to financial markets.