CIO Reports

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Lisa Shalett and the Chief Investment Officer Team

SEPTEMBER 22,

2011

Twisting in the Wind

Summary The confluence of the release of the somewhat gloomy Global Economic Outlook by the International Monetary Fund (IMF) and the surprisingly negative commentary that accompanied the Federal Reserves announcement of Operation Twist have investors capitulating on forecasts for global growth and raising the probability and specter of recession in developed economies. Although markets, especially in risk-based assets like equities have appeared to have largely discounted this outcome, the headwind to earnings estimates and to the most important swing factor in the cyclical outlook at the momentbusiness and consumer sentimentare driving an apparent fear-based overshoot to the downside. With GDP growth projections now being questioned even more aggressively by investors, the negative feedback loop to austerity negotiations throughout the Eurozone is intensifying. The urgency for resolution is manifesting on four distinct levels: 1. The need for a clear multi-period plan on Greek debt restructuring beyond the step-wise negotiations of the troika (the European Central Bank (ECB), the IMF and the Economic and Monetary Union (EMU)); 2. The requirement that the most under-capitalized and exposed banksespecially in France recapitalize; 3. That progress is made in governance and monitoring structures for the core Eurozone to prevent contagion to Italy (including a material expansion in the size of the European Financial Stability Facility (EFSF)); and 4. that the ECB relax its monetary policy to support a pro-growth rather than anti-inflation agenda. Furthermore, while the U.S. Federal Reser ves (the Feds) Operation Twist was widely anticipated and is expected to have the effect of reducing long term rates (30 Year Treasuries have fallen from 4.5% to a record low 2.8% in the last year) and flattening the yield curve to stimulate lending and borrowing, it may mark the end of the Feds balance sheet expansiona psychological support for markets since 2008. The apparent dissonance between the Feds strong language on risks and its apparently timid reaction through Operation Twist appears to have market participants assuming that the possibility of a third round of Quantitative Easing (or QE3) is now dead. This new posturing by the Fed has some investors worrying not just about recession risks but about stagflation (with recent CPI readings still stubbornly high) while still others now worr y that we are headed for deflation and a repeat of the policy mistakes of 1937. Clear disagreement among the Fed governors and the increasingly politicized rhetoric surrounding the role of the Fed is further exacerbating confusion in the inflation vs. deflation debate. Investors are extrapolating this scenario on two main levels: 1. It puts even more pressure on fiscal policy responses in Washington D.C., a prospect that unnerves investors; and 2. It suggests a potential pause in systematic U.S. dollar relative depreciation, hurting one of the bright spots of the recent cycleU.S. expor ts. Overall our investment and portfolio advice remains unchanged from last week as we continue to forecast a low/slow growth but no recession scenario.

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SEPTEMBER 22, 2011

As such, we recommend that investors take a cautious and conservative approach as we expect volatility will continue. We suggest three primar y risk mitigation strategies for investors in this environment to deal with sustained elevated levels of risk:
n

WHAT YOU SHOULD CONSIDER IN YOUR PORTFOLIOS

The guidance below, and how it is implemented, should be considered only in light of your individual investment plan including your risk tolerance, horizon, objectives, and liquidity needs. You should discuss these with your Financial Advisor. For clients with cash to put to work today in risk assets: n We would wait out the near-term volatility Shorter-term actions for clients to consider over the next several months: n Focus taxable fixed income exposure to intermediate-term high grade corporate and global sovereign debt in countries like Canada n For non-taxable fixed income look to short to intermediate high quality municipals, where we recommend you consider diversified actively managed investment vehicles n Focus domestic equity exposure on dividend-growing large cap multinationals n Utilize global flexible and unconstrained managers for a portion of core equity risk n Increase tactical exposure to gold n Consider principal/downsideprotected Market-Linked Investments n Use market dislocations to rebalance toward the long-term goal-based strategy For clients with a longer-term investment horizon: n Increase exposure to real assets (including commodities) n Increase exposure to inflationprotected assets (TIPS, pricing power-based equities) n Increase exposure to growth themes (Emerging Market equity/ debt/currencies)

Diversify Risk: Our advice is anchored on our strategic asset allocations, and we have encouraged clients to look within asset classes for opportunities to diversify. Within equities, we have focused on ensuring balanced global exposure and reducing excessive home-country bias. Within fixed income, we have emphasized multi-segment and multi-country exposure, including actively managed corporate high grade and high yield as well as local currency denominated Emerging Market sovereign and corporate debt. Diversification strategies also include expanding asset class exposure where correlations to equities have been low; e.g., real assets, alternatives and precious metals (gold). Reduce Risk: We have been clear about our aversion toward market timing and attempts to go to cash. Instead, reducing risk can be about exploiting volatility to upgrade exposure to the scarcity themes of: Growth, Quality and Yield. Today, valuations suggest those themes are available for patient investors at historically attractive entry points (in equities: multinational dividend growing equities; in bonds: highly rated credits and select municipals). Furthermore, the current environment supports consideration of principal and inflation protection oriented strategies. Actively Manage Risk: Periods of high volatility provide opportunities for more frequent portfolio re-balancing as asset allocation drifts. A more aggressive approach to active risk management allows a more tactical approach to asset allocation, and we have suggested the use of global flexible managers for a portion of equity allocations (10-30%) for investors who need to generate absolute returns.

A final note around risk management is perspective. Although we acknowledge the complexity of the environment and the apparent lack of positive catalysts for markets right now; investors are already discounting significant amounts of risk, with equity risk premiums approaching March 2009 levels (+6%), which marked a market bottom and have only been higher once in the last 35 years (November 2008). Patience has historically been a virtue.

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SEPTEMBER 22, 2011

Supporting Details: IMF Global Outlook. This quarterly report, which was released on Wednesday as a preview to the IMF weekend meetings in Washington D.C., revised down materially its forecast for global GDP from 4.5% in both 2011 and 2012 to 4.0% in each year respectively. Of most concern was the outlook for developed economies, where growth is forecast to be a meager 1.6%. As the report noted, the issue is less about the level of absolute growth than with the persistent imbalances between developed and emerging economies. With the debt deleveraging issues weighing on the West reasonably well documented, the more provocative observations were around mounting pressures in Emerging Markets. Unless emerging economies develop self-sustaining mechanisms like constructive monetary and currency policies, inflation containment as well as development of internal consumption demand, global growth could be even weaker. Implications of the Feds action. Yesterday (Sept. 21), the Fed announced what had been widely telegraphed and discounted in markets, that they would execute Operation Twist, whereby they would extend the duration of their portfolio of US Treasuries by swapping out $400 billion in short-term paper for longer dated 8-year plus bonds. The goal of the program is to reduce long-term borrowing rates and flatten the yield curve while keeping the total size of the Feds balance sheet unchanged. In addition, the Fed also announced that they would continue to roll and maintain their ownership in mortgage backed securities as the agency debt that it owns matures. Both actions are aimed at stimulating the weak housing market. While nothing in the Feds actions were surprising, investors were taken off guard by the juxtaposition of these somewhat modest actions with the very strong language around what the Fed termed as significantly increased risks to the outlook stemming from Europe.

CIO Reports
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SEPTEMBER 22, 2011

GWIM CIO and Head of Investment Management & Guidance

lisa.shalett@ml.com 212-449-0544

THE CIO TEAM Lisa Shalett,

Spencer Boggess,
CIO, Alternative Investments 212-449-3043

Tom Latta,
Global Head, Traditional Manager Due Diligence 201-557-0258

Anil Suri,
CIO, Multi-Asset Class Modeled Solutions 212-449-3385

Chris Wolfe,
CIO, PBIG and Ultra-High Net Worth Customized Solutions 212-236-3159

Jim Russell,
CIO, Portfolio Construction and Multi-Manager Solutions 201-557-0079

Bill ONeill,
CIO, EMEA 44-20-79955745

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