S t r a t e g y I n s i g h t s

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1 S t r a t e g y I s i g h t s First-Quarter 2013 With the major cetral baks floodig their ecoomies with liquidity, it seems atural that ivestors are cocered about the prospect of sharply higher iflatio. We do ot believe that sigificatly higher iflatio is ievitable. However, the threat caot be take lightly. With this i mid we examie how well various asset classes protect purchasig power: Our aalysis cofirms that stocks are likely to provide substatial protectio agaist iflatio i the log ru. With regard to bods ad T-bills, however, the facts do ot appear to be as simple as is geerally assumed. Despite their ituitive appeal as iflatio hedges, commodities ad foreig currecies do ot appear to offer reliable loger-term protectio of purchasig power. Christopher D. Piros, Ph.D., CFA Maagig Director of Ivestmet Strategy christopher.piros@hawthor.pc.com Get Real: Protectig Purchasig Power Most of us have bee taught, either i ecoomics classes or simply by experiece, that rapid expasio of the moey supply almost always leads to rapidly risig price levels. So, with the major cetral baks floodig their ecoomies with liquidity, it seems atural that ivestors are cocered about the prospect of sharply higher iflatio. The cetral baks might say they ited to withdraw the liquidity whe it is o loger eeded ad before it leads to risig iflatio. May ivestors, however, appear skeptical of the baks ability to do so. I additio, with govermet debt levels ad etitlemet obligatios moutig, oe does ot have to be a cyic to thik govermets would like to have the real value of their obligatios dimiished by higher iflatio. Thus, there is a feelig of ievitability to the situatio. While we thik preservig purchasig power should be a importat cosideratio for all ivestors, it is especially so for those lookig to preserve wealth for future geeratios. Barrig hyperiflatio, loss of purchasig power is primarily a issue for the log term. Sice oe eed ot wi every battle to wi the war, we believe ivestors who are ot curretly spedig dow pricipal eed ot be overly cocered with short-term iflatio hedgig. Istead, we suggest they focus o the loger-term protective properties of their portfolios. I this quarter s Strategy Isights, we examie two issues: Is higher iflatio ievitable? How well do various asset classes protect purchasig power? Received Wisdom ad Warig Sigs The late America ecoomist ad Nobel laureate Milto Friedma said that iflatio is always ad everywhere a moetary pheomeo. It is probably ot a exaggeratio to say that thousads of scholarly articles have bee writte tryig to measure ad explai the mechaisms by which moey, however defied for practical purposes, affects prices ad output. May have questioed whether it has ay lastig impact o the level or growth rate of output, but few seriously questio that it affects prices. Accordig to Friedma s dictum, oe should observe that a higher average growth rate of the moey supply should correspod to a higher average level of iflatio. Chart 1 (page 2) plots the average aual iflatio rate i 35 coutries for the period agaist the average aual growth rate of their moey supplies. As show by the upward slopig regressio lie, the relatioship is hawthor.pc.com

2 R 2 : A measure of how well a liear regressio model of the form Y = a + b X explais the observed variatio of the variable Y aroud its average value. A R 2 of 1.00 idicates a perfect fit. A R 2 of zero idicates o relatioship betwee X ad Y. A R 2 of 0.40 idicates that fluctuatios i X accout for 40% of the variatio i Y with the other 60% arisig from sources other tha X. clearly positive; that is, higher moey growth teds to be accompaied by higher iflatio. The relatioship is ot perfect, but the R 2 statistic show ear the lie idicates that differeces i moey growth rates accout for roughly 32% of the variatio of iflatio rates across the coutries. Ivestors who are cocered about iflatio should take heed of rapid growth i moetary aggregates. Chart 1 Iflatio Rates Verus Moey Growth Rates across Coutries Average Iflatio Source: FactSet Research Systems, Ic. Average M2 Growth R 2= Operatio Twist, origi? ally created i the early Whe a cetral bak buys securities from a commercial bak, it pays the bak by 1960s durig the icreasig that bak s overight deposits at the cetral bak. That is, it icreases Keedy that bak s reserve accout. The process is more roudabout if the cetral bak admiistratio, is a buys securities from a obak, but the ed result is the same oce the seller moetary policy tool deposits the fuds i a bak. Similarly, the result is the same if the cetral bak used leds to a bak. The cetral bak s balace sheet expads because it ow has by the Fed to sell ormore assets (the securities or the loa) ad more liabilities (the reserves). With reduce its short?term additioal reserves, the commercial bak ca expad its ow balace sheet by Treasury holdigs i icreasig loas to cliets (the asset side) ad correspodigly icreasig cliet favor of buyig loger? deposits at the bak (the liability side). While there are various defiitios of the term Treasuries. moey supply, most of them boil dow to cash i circulatio plus deposits at The goal is to reduce baks. loger?term iterest rates to ecourage? bor Sice baks typically hold reserves equal to oly a small fractio of their deposits, rowig a $1 icrease i bak reserves creates the potetial for a much larger icrease i ad help stimulate deposits withi the system. That is why the moetary base, defied as currecy i ecoomic activity. circulatio plus bak reserves, is ofte referred to as high-powered-moey. Whe iterest rates are low ad viable ledig opportuities are relatively scarce, the growth rate of bak loas ad deposits may ot keep pace with the growth of bak reserves, as baks allow a icrease i the ratio of reserves to deposits. I this case, the cetral bak is sometimes described as pushig o a strig. 1 O the other had, whe ledig opportuities become very attractive or more pletiful, loas ad deposits may grow much faster tha bak reserves, as baks attempt to maximize their profits by squeezig the ratios of reserves to deposits ad earig assets. I this situatio, the cetral bak may fid it difficult 2 1 It should be oted that most cetral baks, icludig the Federal Reserve, have stopped explicitly targetig reserve levels or moey supply growth rates. Istead, they target a level for the iterest rate at which baks borrow ad led reserves amog themselves. The reasos are ideed related to the issues we discuss here, but to keep our expositio as simple as possible ad to keep our focus o the issue of iflatio, we will ot delve ito operatioal uaces.

3 to restrai the growth rate of the moey supply ad, by extesio, iflatio. To use our strig aalogy agai, pullig o the strig may ot be effective because the strig is elastic. I ormal times, the trasitio from pushig to pullig is usually gradual ad the cetral bak is able to maitai adequate cotrol. Although the strig is flexible ad elastic, the cetral bak ca keep it taut eough to be effective. However, if the cetral bak has had to resort to floodig the system with far more liquidity tha would be prudet uder ormal circumstaces, the it is faced with the problem of how ad whe to take out the slack. I additio, sice the strig is ot taut, the cetral bak does ot really kow how much slack there is. I a utshell, that is the dilemma we face today. Chart 2 shows the explosive growth of cetral bak assets i the Uited States, the Uited Kigdom, ad the Eurozoe sice The assets of each cetral bak are show relative to its assets at the ed of May The assets of the Federal Reserve (Fed) more tha doubled i a mere seve weeks from September 12, 2008, to October 31, By December 7, 2012, they had more tha tripled a aualized growth rate of 30.4% sice the collapse of Lehma Brothers. I cotrast, the Europea Cetral Bak (ECB) has merely doubled the size of its balace sheet over that same period, a 18.8% aualized growth rate. The Bak of Eglad, o the other had, has expaded its balace sheet at a staggerig 42.1% per aum. Chart 2 Growth of Cetral Bak Assets Federal Reserve ECB Bak of Eglad Idex of Cetral Bak Assets /06 11/06 5/07 11/07 5/08 11/08 5/09 11/09 5/10 11/10 5/11 11/11 5/12 11/12 Source: FactSet Research Systems, Ic. Despite the dramatic rise i high-powered moey, iflatio has remaied quite beig. As show i Chart 3 (page 4), the iitial surge of liquidity at the oset of the fiacial crisis i 2008 coicided with a spike i iflatio i five of the six regios show. The impact was greatest i South America, the Middle East & Africa, ad Emergig Europe, regios that are less developed ad/or more depedet o commodity prices. The global recessio brought iflatio dow sharply i I each of the six regios, iflatio i 2012 was at or below the level prior to the explosio of cetral bak liquidity. That is great ews, but it is old ews. What about the future? 3

4 Chart 3 Iflatio Rates by Regio S Asia Middle East & Africa South America Europe Developed North America Europe Emergig 8 Iflatio Source: FactSet Research Systems, Ic. Is Higher Iflatio Ievitable? We do ot believe that sigificatly higher iflatio is ievitable. However, the threat caot be take lightly. As discussed above, the major cetral baks are i a difficult ad uusual positio. It is sometimes take for grated that they will make every effort to prevet the liquidity they have ijected from fuelig a iflatioary spiral, but there is o guaratee that they will succeed. Some market participats seem to questio whether the cetral baks, i particular the Fed, have the tools ecessary to shrik their balace sheets. That is, before eve cosiderig whether they will do it, it is importat to ask whether they ca do it. O the surface, the aswer is clearly yes. They ca sell the securities they have bought ad ca declie to reew loas that they have made to baks. However, this simple aswer misses the real questio: Ca they do it fast eough to rei i iflatio? As oted above, the Fed doubled the size of its balace sheet i just seve weeks. Could it cut it i half i the same amout of time without brigig dow the fiacial system? Almost surely, it could ot. The Fed tripled its balace sheet i a little over four years. Could it reduce it by two-thirds, that is, back to the origial size, i four years? We thik it probably could if growth ad iflatio cosideratios required it, but doig so would put sigificat strai o the markets ad the ecoomy. This little thought experimet makes it clear to us that the pace at which cetral baks eed to withdraw accumulated liquidity will be critical. A slow, draw-out recovery will allow them time to reduce liquidity i a orderly fashio with limited risk of sigificatly higher iflatio. O the other had, if the global ecoomy suddely kicks ito high gear, it may ot be feasible to drai liquidity fast eough to avoid escalatig iflatio. Fortuately, the Fed has two tools oe ew ad oe quite old that could mitigate the eed to reduce the supply of reserves rapidly. These tools affect the demad for reserves. Sice October 2008, the Fed has bee able to pay iterest o bak reserves. By icreasig the rate it pays o reserves, the Fed ca ecourage baks to hold more reserves, at least at the margi. Eve more 4

5 importatly i the curret situatio, the rate the Fed pays creates a floor for the federal fuds rate, the rate at which baks led their excess reserves to other baks. Without this mechaism, the Fed might fid it difficult to eforce a icrease i market rates without first removig all of the slack i the system. The Fed also has the power to require baks to hold a miimum ratio of reserves agaist deposits. For much of its history, the Fed actively maaged these reserve requiremets as part of its policy arseal, but it has ot doe so for a very log time. 2 I cotrast, the People s Bak of Chia uses reserve requiremets as oe of its mai tools. Reserve requiremets are a blut tool; they have o impact uless they are bidig. If they are bidig, however, they are potetially quite powerful i cotrollig the expasio of credit ad moey ad, by extesio, iflatio. To make reserve requiremets a potet policy tool agai, we believe the Fed would have to address at least two issues: Ca it set the requiremet high eough to be bidig o the baks? Sice there are regulatory limits o how high it ca set reserve requiremets, it might have to ask Cogress for broader authority. The Fed must prevet market participats from circumvetig the impact of the requiremets. If bidig reserve requiremets simply push fuds out of bak deposits ad ito other vehicles, for example, moey market fuds, which have o such costraits, the reserve requiremets will ot be effective as a policy tool. Ideed, forcig fuds out of the bakig system would be couterproductive for moetary policy. I this regard, proposals curretly uder cosideratio by the Securities ad Exchage Commissio regardig regulatio of moey market fuds, icludig the possibility of requirig liquidity reserves, are likely to have a sigificat impact o the efficacy of moetary policy. Eve if cetral baks ca maage the liquidity i the system well eough to avoid a iflatioary spiral, the questio remais as to whether they will. They could simply misjudge the situatio, waitig too log or applyig too little restrait. Of greater cocer to us, however, is the possibility that political pressure will systematically bias them ito makig that mistake. Most of the major cetral baks are at least omially idepedet of their respective govermets. Ultimately, however, that idepedece is limited by the govermet s ability to chage the rules uder which the bak operates. As a example, the ew prime miister of Japa, Shizo Abe, campaiged o the otio of forcig the Bak of Japa to adopt a much more aggressive policy stace. He wo, ad the Bak of Japa adopted the more aggressive policy stace, without, it seems, eve pretedig it was their idea. To summarize, the threat of sigificatly higher iflatio caot be take lightly, but we do ot thik it is ievitable. With deft use of the tools available to them, we believe cetral baks have reasoable odds of success i their efforts to facilitate a retur to more robust global growth without escalatig iflatio. Noetheless, we wat to be prepared. To that ed, we ow tur to examiig the relatioship betwee asset class returs ad iflatio. 2 For a history of reserve requiremets i the Uited States, see Reserve Requiremets: History, Curret Practice, ad Potetial Reform, Federal Reserve Bulleti Jue

6 Stocks, Bods, ad Bills I our experiece, ivestors ofte assume that stocks provide a good hedge agaist iflatio, at least i the log ru; that omial bods are a terrible ivestmet i the presece of (uexpected) iflatio; ad that moey market istrumets (for example, T-bills) simply keep up with iflatio. These are hady rough-ad-ready otios, but it is useful to take a closer look at these so-called facts. Correlatio: A measure of the tedecy for two radom variables to move i the same directio. A correlatio of +1 idicates the variables always move i the same directio while a correlatio of -1 idicates they always move i opposite directios. Itermediate values idicate a weaker tedecy to move i the same directio (positive values) or i opposite directios (egative values). Table 1 shows the correlatio of five-year returs o U.S. stocks, bods, ad T-bills with realized iflatio from 1930 to The omial retur o each asset class is positively correlated with subsequetly realized iflatio. As might be expected, omial T-bill returs have the highest correlatio with iflatio. This is cosistet with the fact that moey market rates reset frequetly ad ted to track sigificat chages i iflatio, at least o average. Table 1 Correlatio of Five-Year Returs with Realized Iflatio Jauary 1930 November 2012 Stocks Bods Bills Nomial Retur Capital Gai Icome Real Retur Source: Ibbotso/Morigstar, Hawthor For stocks ad bods, Table 1 reports separate correlatios for the icome ad capital gai compoets of retur. The icome compoet of stock returs, that is, the divided yield, exhibits virtually o correlatio with iflatio. O the other had, the capital gai compoet has a solidly positive correlatio with iflatio. I cotrast, the icome compoet of bod returs has a strog positive correlatio with iflatio while the capital gai compoet is early as strogly egatively correlated with realized iflatio. We ote that these bod returs reflect rollig over itermediate Treasury otes each moth so that the portfolio is always ivested i a ote with roughly five years to maturity ad a coupo that reflects curret market iterest rates. The positive correlatio betwee the icome compoet of retur with iflatio arises from the adjustmet of the coupo ad the rate at which coupos are reivested, as market iterest rates chage over time. The egative correlatio of the price retur reflects the fact that bod prices ad yields move i opposite directios. The overall positive correlatio betwee the omial bod retur ad iflatio idicates that the positive correlatio of the icome compoet outweighs the egative correlatio of the capital gai/loss compoet. This is a reflectio of the relatioship betwee the duratio 4 of the bods ad the assumed ivestmet horizo. The duratio of a bod, or a bod portfolio, may be thought of as a preset-value-weighted average of the time util each cash flow is received. For zero-coupo bods, there is oly oe cash flow at maturity ad the duratio 3 This table is a updated versio of Exhibit 9.4 of Stewart, Piros, ad Heisler, Ruig Moey: Professioal Portfolio Maagemet, McGraw-Hill Duratio ca be defied ad measured i a variety of ways depedig o how it will be used. For preset purposes, we are usig what is kow as Macaulay duratio. 6

7 is simply equal to the time to maturity. For bods with fixed coupos, the duratio is less tha (that is, shorter tha) the maturity. Sice our bods have fixed coupos ad a five-year maturity, their duratio is less tha the five-year ivestmet horizo uderlyig Table 1(page 6). Amog fixed icome maagers, it is commo kowledge that the total retur o a bod will be positively (egatively) related to the level of iterest rates if its duratio is less tha (greater tha) the ivestmet horizo. This is because, over sufficietly short horizos, the capital gai/loss compoet of retur domiates; over sufficietly log horizos, the icome compoet domiates. It turs out that the bod or portfolio s duratio is the horizo over which these effects roughly balace. The upshot is that the retur o short-term bods teds to be positively related to the level of rates over all but the very shortest horizos while the retur o log-term bods is egatively related to rates except over very log horizos. However, what we are primarily cocered about is the real, iflatio-adjusted returs o these asset classes. As show i Table 1, the real retur o stocks is essetially ucorrelated with realized iflatio. That is good ews sice it implies that stocks ted to do a good job of protectig purchasig power. Real returs o bods ad bills, however, are strogly egatively correlated with iflatio. We coclude that both of these asset classes do a poor job of protectig purchasig power. It may seem odd that the correlatios of omial returs with iflatio are positive ad ot dramatically differet for stocks ad bods, yet the correlatios are very differet whe reviewig real returs. The explaatio lies with differeces i volatility betwee stocks ad bods. Recall that correlatio reflects the tedecy of two radom variables to move i the same directio (positive correlatio) or i the opposite directio (egative correlatio) relative to their respective average values. It idicates othig about the relative magitude of the movemets. Just because omial returs o both stocks ad bods ted to move i the same directio as realized iflatio (that is, they are positively correlated with it) does ot mea that they both move eough to fully offset the impact of iflatio. If iflatio turs out to be 1% higher, the a asset s omial retur must also be 1% higher to protect purchasig power. Simply movig i the right directio is ot good eough. Nomial stock returs are much more volatile tha omial bod returs. Hece, give similar correlatios with iflatio, they are much more likely to rise or fall eough to fully offset chages i iflatio. Iroically, higher (omial) volatility works i our favor here. To look at loger ivestmet horizos, it is useful to model the dyamics of returs. There are at least three reasos for this: Eve with 80 years of data, we oly have a few idepedet observatios o, for example, 30-year returs. Modelig the dyamics allows us to ackowledge that ivestmet opportuities are ot ecessarily the same i every period. For ivestmet purposes, oe should focus o the volatilities ad correlatios of the upredictable compoets of returs. If it is predictable, it really is ot risk. I the parlace of statisticias, we are iterested i coditioal measures of risk, which take accout of available iformatio, rather tha ucoditioal risk measures, which do ot. 7

8 Charts 4 ad 5 are based o a dyamic model of stock, bod, ad T-bill returs that icludes as explaatory variables the level of iterest rates, the slope of the yield curve, ad the divided yield. 5 Chart 4 shows the aualized volatility of omial ad real returs for stocks ad T-bills over horizos from 1 quarter to 120 quarters (30 years). If there were o importat dyamic effects, each of the curves would be a flat lie idicatig a costat volatility of retur regardless of horizo. A dowward slope idicates that asset values ted to be pulled back toward a log-term tred; that is, they ted to mea-revert over that rage of horizos. A upward slopig curve idicates that over that rage of horizos asset values ted to be drive away from, rather tha toward, their log-term tred. Oe ca thik of this as mometum. As show i Chart 4, stocks appear to exhibit some mometum over horizos of a few quarters. Beyod that, however, there is clear evidece of mea-reversio as the volatility of both omial ad real returs declies with horizo. This is the rigorous justificatio for the commo otio that stocks are less risky over the log ru. The fact that the volatility of real returs is sigificatly less tha the volatility of omial returs idicates that real returs are more stable tha omial returs over horizos out to 30 years. Over a sigle quarter, the T-bills have zero volatility they are the omially riskless asset but the volatility ramps up quickly, reflectig the tedecy of short-term rates to tred first oe way ad the the other over the busiess cycle. Over loger horizos, the cyclical compoet of rates becomes less proouced ad volatility is dampeed somewhat. O the other had, the volatility of real bill returs rises gradually as the horizo exteds. At very log horizos, real bill returs appear to be as volatile as the omial returs. Chart 5 shows that the volatility of omial bod returs exhibits a eve more proouced rise tha for T-bill returs at short horizos. We attribute this to the cyclical ature of iterest rates combied with the sesitivity of bod prices to Chart 4 Coditioal Volatility of Stock ad T-Bill Returs Stocks - Real Stocks - Nomial Bills - Real Bills - Nomial Aualized Volatility Source: Hawthor Horizo i Quarters 5 The model, which was estimated usig quarterly data from 1952Q2 through 2012Q2, is a updated versio of the model developed i Campbell ad Viceria, The Term Structure of the Risk-Retur Trade-Off, Fiacial Aalysts Joural, Jauary-February

9 iterest chages. Over progressively loger horizos, however, the icome compoet of retur becomes more proouced, ad iterest rates ted to revert to average levels. Hece, the volatility of omial bod returs declies. As with stocks but ulike T-bills, the volatility of real bod returs appears to declie over loger horizos. This reflects both the declie i omial retur volatility ad the positive correlatio of iterest rate levels (ad hece the icome compoet of bod returs) with the level of iflatio. Iterestigly, the volatility of real returs o bods ad bills appears to be about the same over a 30-year horizo, but we do ot fid this surprisig. Most otios of bod pricig posit a close relatioship betwee the retur o bods ad the retur from rollig over moey market istrumets. Thus, market forces esure that a strategy of rollig over bods ad a strategy of rollig over moey market istrumets geerates similar, though ot idetical, returs over log ivestmet horizos. Chart 5 Coditioal Volatility of Bod ad T-Bill Returs Bods - Nomial Bills - Real Bods - Real Aualized Volatility Horizo i Quarters Source: Hawthor To summarize, our aalysis cofirms the covetioal wisdom that stocks are likely to provide substatial protectio agaist iflatio i the log ru. With regard to bods ad T-bills, however, the facts do ot appear to be as simple as is geerally assumed. As with stocks, real returs o bods appear to be more stable tha their omial returs, ad they appear to be more stable over loger ivestmet horizos. Thus, while ivestors may wat to tactically reduce the iterest rate sesitivity of their portfolios i aticipatio of risig iflatio, truly log-term ivestors eed ot abado the diversificatio ad/or icome beefits of bods altogether for fear of permaet erosio of purchasig power. Over log ivestmet horizos, the icome compoet of bod returs domiates, ad that makes them positively, ot egatively, correlated with iflatio. With respect to T-bills, the otio that their retur will ted to track the level of iflatio is correct as far as it goes. However, it overlooks the fact that there are otrivial fluctuatios i real short-term rates. The volatility of real T-bill returs appears to rise with the ivestmet 9

10 horizo. Hece, log-term ivestors should recogize that moey market istrumets do ot ecessarily offer the prospect of a steady real retur. Commodities ad Foreig Exchage I the previous sectio we focused o real returs because stocks, bods, ad T-bills are, for lack of a more precise term, ivestmets. Ivestors expect to ear a fiacial retur by holdig them. Our questio was essetially whether the purchasig power of that retur is likely to be preserved over time i the face of ucertai iflatio. Commodities ad foreig exchage are somewhat differet. Other tha the prospect of makig a profit by tradig them, we view them as offerig little if ay direct fiacial retur. Istead they serve as a store of value, a medium of exchage, or as somethig to be cosumed (used up). It is their role as a store of value that cocers us here. I particular, ca they serve as a store of purchasig power, that is, real wealth? Chart 6 shows the correlatio betwee chages i the geeral price level (that is, iflatio) ad chages i the price of gold, the price of oil, a broad commodity idex, ad the dollar value of a trade-weighted basket of major currecies over five differet horizos sice All four of the asset classes are positively correlated with iflatio over a oe-moth horizo, with oil ad broader commodities showig the highest correlatio. The correlatios for gold, oil, ad broad commodities begi to break dow, however, as we move to loger horizos. Oce the horizo reaches five years, all three have egative correlatios with iflatio. At a 10-year horizo, all three have very strog egative correlatios with iflatio. We ote, however, that this appears to be periodspecific. Data limitatios prevet aalysis of earlier data for oil, 6 but data back to 1973 for gold ad broad commodities show 10-year correlatios with iflatio of 0.25 ad -0.07, respectively. We fid these more ecouragig, at least i the case of gold. Noetheless, we questio the reliability of these asset classes as stores of real purchasig power. Chart 6 Commodities ad Foreig Exchage: Correlatios with Iflatio Correlatio with Iflatio Gold Oil Commodities Foreig Exchage 1 Moth 1 Year 3 Years 5 Years 10 Years Source: Hawthor, FactSet Research Systems, Ic. 6 The first OPEC oil crisis occurred i However, historical series for bechmark oil prices (West Texas Itermediate ad Bret) do ot show frequet adjustmets (with movemets i both directios) util late

11 I cotrast, the correlatio betwee the dollar value of major foreig currecies ad U.S. iflatio is positive over all horizos out to 10 years, peakig at 5 years but still solidly positive at 10 years. Thus, based o the sample period, holdig a basket of foreig currecies appears to offer some loger-term protectio agaist erosio of purchasig power. There are may factors that drive exchage rates. Over relatively short horizos, exchage rates ted to be domiated by ivestmet flows, which are i tur drive by iterest rates ad expectatios of asset price movemets. Trade flows ad relative price levels, which ted to chage more slowly over time, exert a relatively mior ifluece o exchage rates i the short term. I the log ru, however, trade flows ad the relative prices of goods ad services i differet ecoomies become more powerful. Iteratioal ecoomists call the tedecy for the prices of goods ad services to coverge across currecies Purchasig Power Parity (PPP). The essece of PPP is that coutries with relatively high iflatio should see their currecies depreciate agaist coutries with lower iflatio rates. Hece, the idea is that holdig foreig currecies may serve as a hedge agaist relatively high iflatio i a ivestor s home market. Ufortuately, the ecouragig evidece show i Chart 6 (page 10) with respect to foreig currecy exposure is also period specific. If the sample is exteded back to 1973, the begiig of the moder era of floatig exchage rates amog major currecies, the dollar value of the currecy basket shows a strog egative correlatio with U.S. iflatio over both 5-year (-0.26) ad 10-year (-0.40) horizos. Thus, iclusio of the 1970s chages the picture completely. We fid this quite disappoitig, sice the 1970s were exactly the type of eviromet high ad risig iflatio from which ivestors would like to be protected. There are a variety of factors that may help to explai the apparetly ureliable performace of commodities as stores of real purchasig power. Storage costs ad opportuity costs ca make commodities expesive to hold over log periods. This may ecourage short-term tradig istead of log-term ivestig ad weake the lik with aticipated loger-term chages i the geeral price level. Each commodity is subject to its ow supply ad demad fudametals, which could result i large price movemets relative to the broader basket of goods ad services. Some importat commodities, otably oil, are subject to ocompetitive behavior by large producers or buyers. Such strategic behavior could weake the lik with other prices i the ecoomy. I idustrialized ecoomies, the cost of commodities as iputs to productio teds to be oly a small compoet of total cost i most idustries. Thus, the impact of commodity prices o other prices teds to be weak. Similarly, direct cosumptio of commodities (other tha oil perhaps) teds to be a small compoet of the typical cosumer s budget. As with most moder ecoomies, the Uited States is domiated by service idustries with little coectio to productio or cosumptio of physical goods. All of these factors ted to weake the coectio betwee commodity prices ad the geeral price level. I our view, perhaps the most importat reaso that foreig currecies may fail to protect agaist iflatio is the fact that exchage rates are the relative price of oe currecy i terms of aother. PPP implies that exchage rates should 11

12 ultimately reflect relative iflatio rates, ot the absolute level of iflatio. If U.S. iflatio is 5% ad iflatio i the rest of world is 2%, the PPP implies that a ivestor s foreig currecy holdigs should appreciate 3% (5% - 2%) over time. The erosio of a ivestor s purchasig power is ot fully offset, but losig 2% (5% - 3%) is better tha losig 5%. However, if iflatio rates go up to 7% ad 4%, respectively, a ivestor could still expect to get oly 3% (7% - 4%) from appreciatio of the foreig currecy. Now 4% of the ivestor s purchasig power is lost per year istead of 2%. I this example, the foreig currecy exposure offered o protectio from the higher iflatio rate. The hedge would be eve less reliable if the lik betwee exchage rates ad iflatio differetials were weak; that is, if PPP failed. Ufortuately, the literature o exchage rates suggests to us that this lik is ideed quite weak. To summarize our key poits regardig the risk of iflatio ad the likely effectiveess of various asset classes i preservig real purchasig power: Cetral baks are likely to face a dautig task as they attempt to cotrol the impact of the massive pool of liquidity they have ijected ito the fiacial system. To do so, they may have to augmet their stadard policy tools with less frequetly used tools such as reserve requiremets. We do ot thik that substatially higher iflatio is ievitable, but it is a serious risk. The pace at which liquidity must be withdraw from the system is likely to be a critical determiat of success i cotrollig iflatio. Stocks do appear to offer sigificat purchasig power protectio over log horizos. Although omial bods suffer substatial loss of purchasig power over shorter horizos, over loger horizos the positive correlatio of the icome compoet of bod returs with iflatio sigificatly reduces the purchasig power risk. Although their yields ted to float with the level of iflatio, moey market istrumets (T-bills) do ot ecessarily offer a steady stream of real returs. Despite their ituitive appeal as iflatio hedges, commodities ad foreig currecies do ot appear to offer reliable loger-term protectio of purchasig power. As the global recovery progresses ad the risk of iflatio rises, we will udoubtedly retur to the importat topic of iflatio protectio. Now, however, we tur to our themes for Themes for 2013 The year 2012 was fraught with issues ad evets that could easily have derailed the weak global recovery ad puished risky asset positios. There were sovereig debt crises, sovereig bailouts, bak rescues, pivotal electios, geopolitical cofrotatios, costitutioal court ruligs, may do-or-die summit meetigs, riots, ad eve a fiscal cliff. Noetheless, most markets had a good year, some bordered o a great year, ad the global ecoomy is still chuggig alog. We have o doubt that 2013 will be challegig as well. May, if ot most, of the uderlyig issues faced i 2012 have ot bee resolved; rather, they have bee mitigated ad/or deferred. However, the atmosphere of acute distress, for 12

13 example, a impedig collapse of the Eurozoe, a massive fiscal cotractio i the Uited States, or a hard ladig i Chia, has largely bee replaced with the prospect of workig through major issues at a more deliberate pace. Hece, we thik market movemets will be icreasigly drive by fudametal expectatios ad less by abrupt shifts i risk perceptios. This, i tur, implies that the risk of extreme market movemets, that is, so-called tail risk, is dimiished. It has ot, however, bee elimiated. I particular, aother high stakes cofrotatio over the future of U.S. fiscal policy looms oly a few weeks away. U.S. Fiscal Policy It is ot clear to us who, if ayoe, i Washigto really wats to claim authorship, but a deal to avert the so-called fiscal cliff did get doe to avoid roughly two-thirds of the tax icreases ad spedig cuts that were scheduled to take effect Jauary 1, The mai features of the deal are: Permaet provisios: The top margial tax rate rises to 39.6% for households with icome above $450,000. Otherwise, rates o ordiary icome remai uchaged. The margial rate o both divideds ad log-term capital gais rises to 20% for couples with icome above $450,000. The rate remais uchaged at 0% or 15% i lower icome brackets. The Alterative Miimum Tax was idexed for iflatio. The $5 millio estate ad gift tax exclusio amout is retaied ad idexed for iflatio. The tax rate icreases from 35% to 40%. The 2% reductio i payroll tax expired as scheduled. Phaseouts of persoal exemptios ad deductios for high icome earers were reistated (the so-called PEP ad Pease provisios) for household icomes above $300,000. A Medicare surtax of 3.8% was itroduced o ivestmet icome above $250,000. Temporary provisios: Expiratio of exteded uemploymet beefits was deferred for oe year. Cuts i fees paid to doctors uder Medicare were deferred for oe year. Sequester of $110 billio i spedig was delayed util March 1. While it appears that hardly ayoe is happy with the deal, we poit to a few positive aspects: Probably most importat, the risk to ecoomic growth i 2013 has bee substatially reduced because somethig o the 13

14 order of $400 billio of the potetial $600 billio of fiscal cotractio has bee averted. Most of the key tax provisios are permaet. This should sigificatly reduce the level of ucertaity faced by idividuals ad small busiesses. To the extet that this ucertaity hidered cosumer spedig ad small busiess ivestmet ad hirig plas, growth prospects might eve be ehaced. Although it is difficult to say exactly what the market expected, it seems likely that the tax icreases are o more oerous, ad perhaps less oerous, tha was expected. Nobody thought the payroll tax break would be exteded. The cutoff for higher rates was set at $450,000 for couples istead of Presidet Obama's target of $250,000. Also, may people were probably pleasatly surprised by the estate/gift exclusio stayig at $5 millio istead of beig reduced ad by the estate tax rate oly risig to 40%. Iitial estimates i the press suggest the package raises additioal reveue of roughly $600 billio over the ext 10 years, a solid step i the directio of deficit reductio. The bad ews is that the deal sets the stage for aother battle which could be eve more vicious tha the last. The deal did ot cut spedig. I particular, it did ot address the growth of etitlemets. Thus, it did little to address the log-ru issues. Nor did the deal address raisig the debt ceilig, which is expected to become bidig by the ed of February. There is also the ew March 1 deadlie for the $110 billio i across-the-board spedig cuts. O March 27, the cotiuig resolutio that has fuded the govermet i lieu of a proper budget expires as well. To put it simply, the U.S. govermet faces techical default at the ed of February, a large cut i spedig o March 1, ad/or a complete shutdow o March 27 if Cogress ad the admiistratio caot come to terms o issues over which they have bee fightig for at least two years. There is also the likelihood that U.S. debt will be dowgraded by the ratig agecies if serious steps are ot take to address log-term fiscal sustaiability. If it were ot for the debt ceilig, sequester, ad cotiuig resolutio deadlies, the issue of log-term sustaiability ad potetial dowgrades might be fiessed for quite a while. I our opiio, o oe i Washigto would feel compelled to sacrifice his or her priciples to get a grad bargai. The ratigs agecies ad the markets could probably be assuaged with o-goig deliberatios, sice everyoe recogizes the importace of gettig it right. Coversely, if it were ot for the fact that the issue of log-term sustaiability caot be postpoed idefiitely, the debt ceilig, sequester, ad cotiuig resolutio deadlies could probably be hadled with oly modest risk of a major impasse. However, both sides kow that the debt ceilig, sequester, ad cotiuig resolutio battles are really about gaiig cotrol of the log-term sustaiability questio. Both sides kow that these deadlies are the best, ad probably last, opportuity they will have to extract major cocessios before the log-ru sustaiability pla is hammered out. This is especially true for the Republicas sice they are the miority party. Maybe the best ews is that this fierce battle should be over by the ed of first-quarter After that, there are o more obvious deadlies o the global caledar, with the possible exceptio of the Germa electio i September. Thus, cosumers, busiesses, ad ivestors should be able to refocus o loger-term ecoomic decisios with substatially less fear of beig blidsided by politicias. This should be good ews for the markets sice o the whole the global ecoomic eviromet is improvig, which is certaily more tha we ca say for the U.S. political process. 14

15 The Search for Yield As we argued i our third-quarter 2012 Strategy Isights, Paiful Adjustmets ad Big Decisios, we were i a iheretly deflatioary eviromet eve before the fiacial crisis. The recovery from the crisis remais weak, ad, as discussed at some legth above, iflatio remais beig. We therefore expect iterest rates to remai low throughout 2013 ad beyod. With ivestors still chasteed by the fiacial crisis ad a icreasig focus o retiremet icome, we expect the search for yield to remai itese i Combiig this with the fact that divideds will ot be taxed as ordiary icome suggests that divided-focused strategies should geerate solid returs. Similarly, eve though credit spreads are already fairly tight, we thik ivestors ca cotiue to clip those coupos without fear of a sustaied spread wideig. Housig Reboud Housig, i particular residetial costructio spedig, is a small compoet of the ecoomy, just a few percetage poits, but it has always bee a importat cyclical driver. Back whe the Fed imposed a cap o the iterest rate that baks could pay o deposits (kow as Regulatio Q), the housig sector was the whippig boy of moetary policy. Wheever market rates wet above the Regulatio Q ceilig, deposits would flow out of the baks, baks would stop writig mortgage ad costructio loas, ad the housig market would effectively shut dow. As paiful as that was for those impacted directly, it had the beefit of limitig, if ot prevetig, speculative activity i the housig market. While it was ot always as easy to restart the housig sector as it was to shut it dow, at least the mechaism was ot broke. The Fed could tur o the tap agai by lowerig rates, ad i due course thigs would flow agai i the housig market. The latest collapse of the housig market was ot so beig: It was ot iduced by turig off the tap, so it could ot be reversed by simply opeig the tap agai. I effect, the pipes burst ad have had to be replaced before the system could be re-egaged. I 2012 some parts of the system came back o lie, ruig at low pressure, but oetheless ruig. We believe progress will accelerate somewhat i 2013, allowig the housig sector to cotribute meaigfully to both the pace ad the breadth of the recovery. Busiess Ivestmet Revival We have bee sayig for some time that the key to a more robust recovery lies with busiess ivestmet spedig. There are two reasos for this: Neither the U.S. cosumer or the govermet should be expected to accelerate spedig. The household savig rate is still too low from a log-term perspective, ad the fiscal situatio requires spedig cuts, ot icreases. Rapid growth of et exports would be a big help, but aside from the ewly foud atural gas boaza we do ot see ay obvious catalyst for it. That leaves private domestic ivestmet as the oly sigificat source of acceleratig demad. A strog revival of real private domestic ivestmet would suggest that expadig productio capacity i the Uited States is oce agai competitive with expadig offshore. I our third-quarter 2012 Strategy Isights, we argued that secular forces have dictated a flow of productive capital from capital-itesive, high-cost developed ecoomies such as the Uited States to labor-itesive, low-cost developig coutries such as Chia. A resurgece of capital spedig 15

16 here would sigal that we are i the late stages of that process, settig the stage for acceleratio i U.S. hirig ad productio. Barrig a policy mistake that further udermies busiess cofidece, we believe busiess ivestmet should kick ito gear this year. The Calm After the Storm i Eurolad After a roller coaster ride i 2012, we expect the situatio i the euro area to be relatively calm this year. Much remais to be doe, but the crisis atmosphere has largely give way to a gridig process of workig through the issues. Though it may come ad go with little fafare o this side of the Atlatic, the Germa electio will be importat for the itegratio ad stability of the euro area. We expect Agela Merkel, Chacellor of Germay, to be re-elected. Util the, we thik she must appear to keep maximum pressure o the weaker members of the euro area to solve their ow problems. Oce she is re-elected, however, Germa cocessios for the sake of the uio should get a bit easier. We hope the other folks ca behave themselves util the. Curret ad Prospective Ivestmet Strategy I light of the potetial for sigificat chages i the global eviromet, we deemed it prudet to remai close to log-term strategic portfolio allocatios throughout most of As oted above, we believe the risk of extreme market moves, that is, so-called tail risk, has declied ad will be still lower oce the U.S. fiscal battle is behid us. Noetheless we have ot yet moved to take o more tactical risk. As much as we would like to look past the loomig fiscal battle, we do ot thik it is prudet to do so, at least ot yet. Before we would do so, we would like to see two thigs. First, we would like to see the market come to grips with the situatio ad back off the sugar high iduced by the fiscal cliff deal. Secod, ad more importatly, we would like to see some idicatio(s) of a more costructive process i Washigto tha the oe that has prevailed sice the November electio. Noetheless, we aticipate movig to a overweight positio i equities versus fixed icome at some poit. Based o almost ay valuatio metric, equities are cheap by historical stadards. Coversely, uless iflatio drops to ear zero (which we do ot expect), curret omial bod yields caot be sustaied i the log ru. Ultimately, we expect omial 10-year yields to revert to approximately the growth rate of omial GDP, say, 5%. Havig said that, we do ot believe a bear market i bods is immiet. However, upward pressure o yields will likely build as the global recovery solidifies ad we get closer to the ed of quatitative easig operatios. We will wat to shorte duratio ad/or reduce fixed icome exposure ahead of that wave. With rates so low, there is little reaso to wait util the last momet. So we will be lookig to take advatage of opportuities to move i that directio. With respect to allocatios withi equities, it is difficult to pick a clear wier amog the Uited States, developed iteratioal markets (for example, Europe), ad the emergig markets. All have pros ad cos. From a valuatio perspective, iteratioal markets are cheaper tha the Uited States o almost ay metric. They usually are, but over time valuatios should ted to coverge, so this is a plus for iteratioal markets. Europe is i recessio, ad there is much pai yet to be edured i the euro area. Emergig markets have slowed from their prior torrid pace, ad it remais to be see how much mometum they ca regai. Meawhile, the Uited States appears to have avoided most of the potetial drag from the fiscal cliff, housig is pickig up, ad we expect 16

17 busiess ivestmet to revive as well. O balace, we would give the U.S. market the od based o improvig fudametals, eve though top-lie growth remais a cocer. Cosistet with the calm after the storm, we thik prospects for the euro area could brighte as the year progresses. Also, if global growth picks up faster tha the market expects, the emergig markets are likely to be quite strog. All thigs cosidered, we aticipate addig to U.S. equities first, the emergig markets, ad fially developed iteratioal markets. As discussed above, we thik the search for yield will work to the advatage of icome-orieted equity strategies ad of credit positios o the fixed icome side. With that i mid we retai our tactical allocatio to bak loas. We believe that high yield remais relatively attractive as well; hece, we might cosider addig to our credit positio, perhaps i cojuctio with a et reductio i fixed icome. Withi fixed icome we also retai a tactical allocatio to global bods, i particular emergig market debt, seekig to beefit from higher yields ad diversificatio. The chart o the back page of this report shows our curret strategic ad tactical allocatios for a balaced portfolio. I terms of broad allocatios, we are eutral to our baselies with respect to equities, fixed icome, ad alteratives. I more aggressive portfolios, we are slightly overweight equities. As oted above, withi fixed icome we have tactical allocatios to levered loas ad global bods. Withi alteratives, we are overweight real estate ad correspodigly uderweight private equity. 17

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20 Balaced Portfolio Asset Allocatio Baselie Tactical Stocks 50% Stocks 50% Bods 25% Bods 25% Alterative 20% Alterative 20% Cash 5% Cash 5% Equity Allocatio Baselie Tactical U.S.70% 74% U.S. U.S. 70% Developed Iteratioal 20% Developed Developed Iteratioal Iteratioal 20% 16% Emergig Market 10% Alterative Assets Emergig EmergigMarket Market10% 10% Tactical Baselie Commodities/Real Assets 20% Private HedgeEquity Fuds 35% 25% Private Equity 35% Real Estate 20% Private Equity 30% Commodities/ Real Real Assets Estate 20% 25% Real Estate 20% Commodities/ Real Assets 20% Hedge Fuds 25% Fixed Icome Baselie Hedge Fuds 25% Tactical Core Muicipals 100% Core Muicipals 80% Leveraged Loas 10% Global Bods 10% The PNC Fiacial Services Group, Ic. ( PNC ) uses the ames PNC Wealth Maagemet, PNC Istitutioal Ivestmets ad Hawthor, PNC Family WealthSM to provide ivestmet ad wealth maagemet, fiduciary services, FDIC-isured bakig products ad services ad ledig of fuds through its subsidiary, PNC Bak, Natioal Associatio, which is a Member FDIC, ad uses the ames PNC Wealth Maagemet ad Hawthor, PNC Family WealthSM to provide certai fiduciary ad agecy services through its subsidiary, PNC Delaware Trust Compay. This report is furished for the use of PNC ad its cliets ad does ot costitute the provisio of ivestmet advice to ay perso. It is ot prepared with respect to the specific ivestmet objectives, fiacial situatio or particular eeds of ay specific perso. Use of this report is depedet upo the judgmet ad aalysis applied by duly authorized ivestmet persoel who cosider a cliet s idividual accout circumstaces. Persos readig this report should cosult with their PNC accout represetative regardig the appropriateess of ivestig i ay securities or adoptig ay ivestmet strategies discussed or recommeded i this report ad should uderstad that statemets regardig future prospects may ot be realized. The iformatio cotaied i this report was obtaied from sources deemed reliable. Such iformatio is ot guarateed as to its accuracy, timeliess or completeess by PNC. The iformatio cotaied i this report ad the opiios expressed herei are subject to chage without otice. Past performace is o guaratee of future results. Neither the iformatio i this report or ay opiio expressed herei costitutes a offer to buy or sell, or a recommedatio to buy or sell, ay security or fiacial istrumet. Accouts maaged by PNC ad its affiliates may take positios from time to time i securities recommeded ad followed by PNC affiliates. PNC does ot provide legal, tax or accoutig advice. Securities are ot bak deposits, or are they backed or guarateed by PNC or ay of its affiliates, ad are ot issued by, isured by, guarateed by, or obligatios of the FDIC, the Federal Reserve Board, or ay govermet agecy. Securities ivolve ivestmet risks, icludig possible loss of pricipal. "PNC Wealth Maagemet" ad "PNC Istitutioal Ivestmets" are registered trademarks ad "Hawthor, PNC Family Wealth" is a service mark of The PNC Fiacial Services Group, Ic. Ivestmets: Not FDIC Isured. No Bak Guaratee. May Lose Value. Isurace: Not FDIC Isured. No Bak or Federal Govermet Guaratee. May Lose Value The PNC Fiacial Services Group, Ic. All rights reserved.