Investment Review & Outlook: 2nd Quarter Review

Performance Summary

The second quarter began on an optimistic note but ended with all major domestic and global stock indices in decline. Some of the events that fueled the reversal of the early quarter gains were:

• - The euro zone sovereign debt crisis
• - Weak June data on U.S. housing, employment and retail sales
• - The BP oil spill on April 20th
• - The "flash crash" on May 6th
• - Our view is that we will avoid a double-dip
  The primary concern of investors today remains whether or not the western world's developed economies are heading for a "double-dip" recession. The U.S. economy is downshifting to a tepid growth path and a protracted period of lower returns across most asset classes. However, we believe the recovery has enough momentum, and there are enough key underlying strengths, to keep the U.S. economy moving forward.

Implications for Investors

The investor would do well to proceed with caution.

• We are likely to be facing a protracted period of lower returns for most asset classes.
• Stocks should outperform bonds on a risk-adjusted basis, but it isn’t necessary to be overly aggressive in the stock market at this time.
• With 40% of global GDP in emerging markets, it makes sense to look at high-quality multinationals: the S&P 500 stocks with revenues in Brazil, Russia, India and China and diversified global operations.
• While the euro zone sovereign debt crisis seems to be receding, we continue to monitor this as well as the ongoing risks of global de-leveraging, since these concerns constitute the major risk to our outlook.
• With inflation at bay, the Federal Reserve continues to conduct loose monetary policy and is unlikely to raise interest rates until next year.

We believe that our clients are best served by staying faithful to a long-term, diversified investment approach. Wealth preservation, commitment to long-term returns from quality stocks, income generation from bonds and dividend-yielding stocks, tax-advantaged strategies and appropriate exposure to alternative investments, offer investors the best chance of success in today’s challenging markets.

We reiterate the long-term trends that we believe will influence the markets through much of the decade and that are worth bearing in mind each time we review investment strategy with you:

• Uncertainty is the state of play for the next 5 -7 years
• The millennial shift in global economic power from West to East will accelerate
• Unprecedented government intervention in the economy will continue
• Transformational demographic changes will slow consumption in the U.S. and Europe
• A prolonged period of de-leveraging for governments and consumers
• Reducing structural under employment in developed nations requires innovative solutions not yet apparent
• The likelihood of further “black swans,” or unforeseen events with disproportionately large impact, due to significant leverage in the world and the complexity of globalization

Economic Outlook

Reflecting the events of the second quarter, we have lowered our 2010 GDP forecast to 3.25% which is below the consensus estimate of 3.3%. This rate of growth is considerably slower than the historical norm (see chart 1). Corporations and individuals are still cautious, as de-leveraging continues around the globe and uncertainty about the impact of taxes, financial reform, and energy policy discourages risk-taking. That said, large corporations are in a strong financial position. Excluding financial companies, profit margins remained strong throughout the recession. Companies continue to generate cash, bolstering already strong balance sheets. Assuming inflation and interest rates remain low, corporate America is in a position to lead the domestic economic recovery as confidence returns and risk appetites revive.

From a global perspective, the European debt crisis exposed deep political and economic dysfunction in that critical region. The excessive debt-to-GDP ratio in many countries was fueled by years of generous entitlements, inflexible labor markets, and missed opportunities for investment that resulted in years of tepid growth. The good news is that some European governments are now showing a desire to tackle their problems. Furthermore, dominant countries like Germany and France with export-driven economies are benefiting from a weaker euro. The risk is that Europe, under the leadership of Germany, rejects Keynesian economics in favor of austere fiscal discipline, pushing the region into a deflationary environment.

At some point, Greece will restructure its debt, and the other countries that are most overextended – Spain, Portugal, Ireland and the U.K. – will find a path that preserves some measure of domestic stability while undertaking serious fiscal reforms.

There is talk among the European bankers of finding a mid-point between the U.S. approach to Lehman (let it fail), and AIG, et al. (too big to fail). The euro has begun to stabilize, reflecting growing confidence that balanced measures will be taken.

Thanks to its massive government stimulus package, China has been the engine of global growth for this recovery.

However, this success has stirred inflationary pressures and speculative real estate, provoking the Chinese authorities to implement credit tightening policies. We are hopeful the authorities once again can engineer a soft landing for their economy. We are encouraged by the recent announcement of a $100 billion program to upgrade infrastructure in China’s western territories.

Unlike most of the world today, China has the savings to stimulate capital spending without burdening its economy with debt. The blended Chinese economic model, state-led but market-influenced, is a work in progress, but its low debt, high growth and savings rates, and balance sheet strength, are in many respects the envy of developed nations. Overall, we concur with the consensus forecast of emerging markets GDP growth of 6.8% in 2010 due to China’s strength.

Confidence is the lifeblood of the economy, and in late April fear of the Greek debt crisis contagion shook that confidence as the whole structure of the euro was temporarily questioned by investors. Keying off of the turbulence in the global equity markets, consumer caution weakened retail and housing sales in the U.S. in May. Although part of the housing slowdown was expected, given the April expiration of the government housing credit, the sizable 30% drop in existing home sales suggests weakness in consumer confidence.

Corporations are flush with cash, but cautious executives are reluctant to increase payrolls or invest in plant and equipment until there is more clarity on how Europe will deal with its crisis and how pending legislation on taxes, healthcare, finance and energy is resolved in Washington. Improvements in Europe and China noted above will help encourage spending. Pressure on Washington to take corporate America out of the penalty box has been increasing as politicians realize government spending has not created sustainable employment growth.

With 70% of U.S. GDP driven by personal consumption, improvement in income is key to a sustained recovery. After strong private sector job creation averaging 200,000 in March- May, June saw only 83,000 new private sector jobs. Growth in temporary employment is running ahead of past recoveries, implying employers are reluctant to make permanent additions until there is more certainty on the sustainability of the recovery and on pending government legislation. With inventories still low and global growth moving forward, employment will continue to improve but in a slow and perhaps halting manner.

The precipitous drop in inflation data has exceeded our expectations. Wholesale prices have fallen in two consecutive months as fears of slower global growth put a lid on energy prices. Softer economic data out of China has reinforced this trend. The core rate of consumer price inflation rose only 0.9% year over year, the smallest annual increase since 1966.

Deflation has devastating implications in a world of excessive debt levels. Central banks are cognizant of this danger and will need to keep the foot on the economic accelerator. The silver lining is that lower prices act as a tax cut for consumers by increasing their purchasing power.

While uncertainties abound, the inherent strengths of the U.S. economy should not be underestimated. Despite the political rhetoric, U.S. financial reform legislation is, on balance, a step in the right direction. It pushes more accountability onto firms that take risks, it keeps commercial banks largely out of proprietary trading, and it provides some oversight to the murky derivatives market. The Institute for Supply Management (ISM) indices are above 50, indicating expansion (see chart 2). U.S. productivity and corporate profits are steadily improving, as companies were quick to reduce bloated cost structures and re-build their balance sheets. With about $1.8 trillion in cash, corporations are in a strong position to hire and invest once confidence and stability return. Inflation is low, credit is loosening, and there is adequate liquidity in the system. Consumer and investor confidence is still whipsawed by differing economic reports, but overall there is a path to growth and recovery.

Stock Market Outlook

The U.S. stock market declined across the board in the second quarter. The S&P 500 fell by 11.4% and the Dow dropped by 9.4%, as major events combined with disappointing macroeconomic reports conspired to undermine investor confidence. The Russell 2000 small cap index, down 9.9%, outperformed larger company indices due to lower foreign currency exposure. The MSCI EAFE index of global stocks dropped most precipitously, down 13.7% as the Greek crisis and U.S. dollar strength reduced non-U.S. investment returns. Given the relatively strong growth fundamentals of emerging economies, the MSCI EM (emerging markets) index was the best equity performer, down 8.3%.

Last quarter we made the case that individual company fundamentals would be the primary driver of stock market returns. This didn’t happen and, instead, stocks moved en masse. Once again, during a time of stress, investors chose not to differentiate among the fundamental prospects for individual stocks. If we are correct and the world economy avoids a “double-dip”, the stock market should resume a gradual uptrend, rewarding companies with strong fundamentals.

Perhaps more importantly, we see increasing opportunities to purchase stocks of high-quality companies at what appear to be attractive valuations, especially when using free cash flow metrics.

Free cash flow yield is the cash a company generates in excess of normal operations relative to the market value of the company’s equity. This is the cash that is available for shareholders in the form of share repurchases and increased dividend payout. As indicated on chart 3, using this metric, large capitalization stocks are still attractively valued.

Additionally chart 4 shows that the S&P 500 dividend yield of 2.16% is quite attractive relative to the 1.79% and 2.97% offered by five and ten year U.S. Treasuries, respectively.

Near term, U.S. corporate earnings announcements should provide some ballast to the faltering equity markets. According to Thomson Reuters, earnings per share (EPS) of the S&P 500 are expected to increase 27% from June 2009, driven mostly by cost cutting, while revenue growth is expected to increase 9%

year over year. Highly cyclical sectors including materials and energy should lead the pack with earnings surging over 70%, followed by technology with an expected 56% increase for the sector. Dollar strength during the quarter may dampen earnings of multinationals, but sufficient hedging and geographic production diversification tend to mute foreign currency swings. Over time, growth in overseas markets is more important than the dollar exchange rate. For the calendar year, we are estimating that the S&P 500 will earn $81 for 2010, a gain of 30% over 2009. If revenues are growing, job growth should follow, but the key will be the willingness of companies to invest and deploy their cash to fuel expansion.

Countering the weak housing data and trouble in the Gulf of Mexico, the technology sector enjoyed some fantastic milestones during the quarter. In the wireless sector the iPad became Apple’s most successful product launch, selling over 3 million units in its first 80 days. Sprint introduced the world’s first 4G smartphone based on Google’s (Android) operating system, and Microsoft launched a new handset. It’s remarkable that two of the industry’s strongest competitors today, Apple and Google, did not even participate in the wireless industry three years ago. American innovation and wealth creation are alive and well.

Despite a significant earnings rebound, financial stocks have been weak due to uncertainty surrounding financial regulatory reform. Assuming no major last minute jockeying in the Senate, the end result will be that banks will realize less growth and lower return on equity but will also exhibit a lower risk profile. Many revenue sources will be eliminated or reduced via regulatory price controls and leverage will be lowered. Industry’s response will be to reduce extension of credit to all but the most credit-worthy and to increase fees. As most large cap banks are currently priced in-line or at a discount to current book values, the stocks' recent weakness seems to overly discount the potential adverse impact from increased regulation. LMIC forecasts significant book value growth in the next two to three years, driven by a reduction in both loan losses and the release of reserves set aside for future losses.

The second quarter was marked by the tragic events of the oil spill in the Gulf of Mexico. Investors have reacted to the ongoing uncertainty around these events by selling stocks with direct and indirect exposure to the spill as well as other stocks generally involved in the oil and gas industry. Drilling activity will in fact return to the Gulf, hopefully with the proper safety and oversight to prevent future spills. Even if the moratorium is lifted within the initial six month time frame though, the impact on Gulf oil production will not go unnoticed. Estimated 2011 oil production in the Gulf is likely to be 160k barrels/day lower than previously forecast. This is a significant portion of production growth that now will be deferred into the future years.

Bond Market Outlook

Yields on Treasury securities collapsed (prices rose) during the second quarter as investors fled risky assets (see chart 5). Previous concerns regarding the swelling U.S. fiscal deficit and the inflation gave way to a flight-to-quality rally eerily similar to that seen during the initial stages of the credit crisis. Optimism stemming from improvement in the U.S. economy faded as heightened difficulties in the European community raised the odds of a European banking crisis. Uncertainty bred volatility in the capital markets, and traditional safe havens such as Treasury securities and gold were the beneficiaries.

The yield on the 10-year Treasury bond dropped more than 1% from its high, ending the quarter at 2.93%. Corporate bond returns were relatively poor, reflecting rising credit spreads in an environment of risk aversion. Despite the 1.26% loss in the corporate sector, the 4.68% advance in Treasuries drove returns during the quarter, resulting in a 3.49% gain in the Barclays Aggregate Bond Index, a proxy for the overall market.

While we were correct in our assumption that inflation would be tame, at this point we have been wrong in thinking that the relentless Treasury issuance to fund record deficits would push rates higher. Foreign buying of U.S. securities has been much more robust than we expected and, in fact, reached a record in March as investors sought safety from the uncertainties in Europe. We also assumed that bank lending would have revived somewhat by now, but banks are using funds

borrowed from the Fed at near-zero interest rates to buy higher yielding Treasuries.

We still believe funding the fiscal deficit will result in higher yields, although we were premature with regards to timing. The Fed seems unlikely to raise rates until late 2011 at the earliest. High unemployment and deflation fears will keep the dovish Fed at bay until prices stabilize. While loose monetary policy often results in higher long-term yields as investors worry about inflation, that scenario is unlikely at this point. A secular demand for income as the baby boomers retire will keep a rise in bond yields in check, while instability in the global economic picture also should support Treasuries.

We still like corporate bonds, despite the economic slowdown. New issuance collapsed 39% from last year’s pace as companies accumulated a war chest of cash due to mixed prospects for their businesses. Risk-aversion resulted in a flight-to-quality pushing corporate yields back to attractive levels relative to Treasuries. With yield-producing assets becoming increasingly scarce, investors should return to the corporate sector once risk-aversion fades.

Despite underperforming the taxable market during the second quarter, returns on tax-free bonds were solid nonetheless. The Barclays Municipal Bond index earned 2.03% during the period, with longer maturities faring the best.

The technical picture for the municipal market remains strong, with a strong bid for maturities across the yield curve. The rally in longer maturities remains a product of the Build America Bond program, a stimulus tool enabling local governments to borrow in the taxable bond market and receive a generous federal subsidy on interest expense. Municipalities are rushing to market before the subsidy is reduced from the current 35% to a lower rate currently being debated in Congress. Shorter maturities remain popular for individual buyers preparing for the inevitable rise in marginal tax rates. The coming 3.8% surcharge on investment income to fund healthcare reform also is not applicable to tax-free bond interest, which will help the market going forward.

State and local governments remain engaged in a struggle to balance budgets while maintaining basic services to residents. Numerous states were counting on additional federal help when designing budgets for the coming fiscal year, but that additional help does not seem likely to be forthcoming.

While popular opinion is indeed focused on deficit reduction, the consequences could be dire for many states that cannot cure their structural deficits at these deficient levels of tax revenue. We doubt the public’s desire for deficit reduction will remain as popular when people pay higher taxes for evaporating services they previously took for granted.

Our strategy in this environment remains unchanged. High credit quality on the portfolio level seems prudent, although we have found value in certain A-rated credits. Again, we believe a barbell structure of short and long-intermediate maturity bonds seems the most appropriate at this time. Shorter maturities reduce volatility, while longer bonds provide income and would perform well should rates remain stubbornly low. We are more willing to slightly extend portfolio duration since Treasury rates are falling in an increasingly deflationary setting.