January 19, 2011

Momentum in global stock markets has carried over into the new year, supported by continuing evidence of acceleration in the world economy. Growing new orders in the industrial sector, against a backdrop of falling inventories, bodes well for growth in 2011 — but sentiment has quickly embraced this more robust growth picture. U.S. markets also continue to be bolstered by evidence of President Obama’s move to the political center. So while our investment policy discussions this month included a checkup on the state of the economic expansion, much time was spent on the risks associated with the challenges in the eurozone and U.S. municipal debt markets.

European policymakers have been dealing reactively with the deterioration of peripheral-country credit quality since early last year. Even though the collective debt burden of the countries in the European Union (EU) is actually modestly lower than that of the United States, the EU’s union of monetary policy without unification of fiscal policy has proven to be a near-fatal flaw. The reluctant participation of the economical Germans has been critical to date, and we expect them to continue to grudgingly increase their support for the European financial stability fund. We anticipate the EU will work its way through this crisis over the next several years, but the path to fiscal reform will be bumpy.

The deteriorating finances of U.S. state and local borrowers has been another outcome of the financial crisis. Municipal bond markets have been under selling pressure since the end of October, as long Treasury yields began climbing, the Build America Bond program faced expiration and budgetary challenges continued. We expect continued credit pressures in 2011, but believe high-quality municipal bonds will prove to be a sound investment. Importantly, we anticipate limited systemic risk from municipal credit problems given the unlikelihood of a meaningful federal government intervention and the immaterial size of potential losses to aggregate consumer net worth.

U.S. Equity

• Taking another look at our valuation case using forward P/E multiples
• Potential headwinds to margins expected to be offset by economic expansion

EAFE and Emerging Markets

• Sovereign credit concerns are still dominating the outlook for this class
• We expect a grudging political will to build

Fixed Income

• European sovereign weakness remains a systemic concern
• U.S. financials have superior balance sheets compared to European peers

High Yield

• The desire to maximize absolute yield led to an increase in new issue maturities
• We expect a greater interest in shorter maturities in 2011

Global Real Estate

• Globally, real estate investment trusts (REITs) were up 6.4% in December
• Merger and acquisition (M&A) activity increased in 2010

Hedge Funds

• Hedge funds gained, on average, 10.4% in 2010
• Performance dispersion was significantly reduced from 2009 and 2008 levels

Commodities

• Commodities surged based on bad weather and strong demand
• Price increases are becoming a concern for economic growth and inflation

Conclusion
Despite a disappointing December U.S. employment report, we continue to believe the U.S. economy is gaining steam and will help support the global expansion. In an investing environment where short-term yields are likely to stay near zero, we think risk-taking will continue to be rewarded.

The primary risks we see include China unsuccessfully managing its inflationary pressures, resulting in a growth slowdown, and systemic risk from the European sovereign debt crisis. We seek to mitigate the risk to China by investing in emerging markets broadly, thereby diversifying our exposure to this single country. To help manage the risk of the European debt crisis, we focus the sovereign debt exposure of our U.S. dollar-based investors on U.S.-domiciled issuers.