INFLATION

Overall inflation was +2.7% in 2009, but core inflation (ex. food and energy) was +1.8% reflecting few underlying pressures.  Energy and commodity prices suppressed inflation below core in the early part of 2009, but accelerated in the second half of the year.  Core inflation is expected to remain below +2% for 2010.  The longer-term outlook for inflation is hotly debated with divergent views and significant consequences.  Simply, the high inflation corner points to significant growth in the monetary base caused by the Fed’s stimulative policies and expansionary government policies which may result in too much money chasing too few goods.  Low inflation proponents point to considerable slack in labor availability, industrial capacity, rental vacancy rates and the dependence on low priced imports for consumer goods.  We believe low inflation will persist over the next two years, but acknowledge the fear of higher inflation warrants vigilant attention.  The University of Michigan’s survey of inflationary expectations remains below +3%.  Overall, inflation is subdued and likely to remain low for the foreseeable future due to low income growth, excess capacity and intense worldwide competitive pressures.  Deflation remains a risk, but is unlikely to grip the U.S. at this time.

MONETARY POLICY & INTEREST RATES

Currently,Federal Reserve policy remains accommodative with the federal funds rate lessthan one-quarter percent, but the tightening process has subtly begun with theFed ending most of its emergency liquidity facilities during the first quarterof 2010 and concluding the purchase of $1.25 trillion of mortgage-backedsecurities and $175 billion of agency debt by March 31, 2010.  Previously, the Fed announced the completionof its $300 billion purchase of Treasuries during the fourth quarter.  The Fed is gradually slowing these purchasesto promote a smooth transition in markets. Furthermore, the Fed has recently been conducting tests with banks onmeans to reduce the stimulative effect of these same security purchases viareverse repurchase agreements.  Clearly,the tools to implement more restrictive policy are being fined tuned and weexpect a series of incrementally restrictive measures before an increase in thefederal funds target rate.  Scaling backthese stimulative measures is signaling investors that incrementallyrestrictive policy is the next step and yields on high quality bonds mayincrease.  For example, yields on the 10year Treasury bond increased from 3.40% to 3.65% since the completion of theFed’s T-bond purchases in late October. The Fed remains on record saying “economic conditions are likely towarrant exceptionally low levels of the federal funds rate for an extendedperiod” and it is prepared to modify its current plans if necessary to supportfinancial stability and economic growth. We believe short-term interest rates will remain historically lowrelative to the last 50 years.  We expectyields on high-quality bonds, such as Treasuries and high-grade corporates, toincrease modestly during the year as investors shift assets into equityinvestments based upon an improving economic outlook.  Furthermore, the supply and demand trends inthe Treasury market will worsen as the government issues more bonds and buyersstep back as the premium for safety becomes less important.

INVESTMENT OUTLOOK

The opportunity to earn above-average investment returnsover the intermediate-term is favorable. The investment environment is normalizing from the perspective of riskand reward since the possibility of a depression disappeared and equity pricesexperienced a spectacular rebound.  Thelast 18 months were extraordinary as financial panic, high volatility and greatuncertainty created widespread fears of financial meltdown and depression.  As the environment improved, lower qualityinvestments rallied the strongest with low priced stocks (under $5) and highlyleveraged companies appreciating the most from the market lows after decliningsignificantly during the meltdown.  Weare entering a more normal climate where quality companies with above averagegrowth prospects, financial strength and profitability should exhibit marketleadership.  The S&P 500 isattractively valued at 13.5x and 12.0x estimated operating earnings of $80 and$90 in 2010 and 2011, respectively.  Thestock market’s below average valuation reflects the combined risks that thecyclical earnings recovery will not be sustained in 2011, the lingering fearsof equity volatility after two “bear” markets in the last 10 years and negativereturns for the S&P 500 over the past decade.  From a contrarian’s perspective, the seeds ofa new secular bull market lie in the current caution regarding equities and,historically, equities subsequently achieve above average returns afterextended periods of subpar returns. Interestingly, Wall Street strategists are “bullish”, but equity fundshave experienced outflows while bond funds had inflows. 

Atthis juncture, risks to the outlook include both the possibility of anoverheating or struggling economy after our initial recovery phase.  Thepolicy response would be different in each case, but the risks of achievingeconomic stability would increase.  Also,there are risks that foreigners will buy fewer U.S. bonds which could hurt thedollar’s value and possibly cause interest rates to increase sooner thanadvisable for domestic policy.  Massivedeleveraging of consumer and government balance sheets must occur over theintermediate-term which will suppress spending growth as balance sheets arerestored.  Additional risks includeburdensome regulation, a Chinadebt bubble, geo-political conflicts, more protectionism, sharp increases intaxation, a sovereign debt default and terrorism.

Today,the key question is whether the stock market can experience another favorablereturn in 2010.  We believe it can basedupon an improving economy and earnings gains combined with low inflation andinterest rates, attractive valuations and improving investor confidence.  Also, there is $3.3 trillion of cash on thesidelines and foreign investors are still underweighted in U.S.equity investments.  The technicalposition of the market is favorable, but mid term election years arehistorically volatile and corrections are likely to be short and sharp asinvestors fear being caught in a downdraft like in late 2008 and early2009.  It will be more difficult to timethe market and a strategy focused on owning a core group of quality investmentssupplemented by opportunistic stock selection will be important.  In addition, 2010 is the Chinese “Year of theMetal Tiger” whose signs are bravery and competitiveness combined with traitsof authority, leadership and power. These symbols imply a year of vigorous developments that may generaterenewed respect for the financial markets. Overall, we expect the stock market to climb that “wall of worry” in2010.

                               Appendix: Summary of Key Economic and Financial Measures