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 Fourth-Quarter 2012 It is oly whe oe imbues them with the power to differetiate ecoomic outcomes that geographic/political boudaries gai sigificace for ivestors. O oe side of the lie there is the familiar, the domestic. O the other side of the lie, laws, customs, regulatios, currecies, cultures, ad resource edowmets are sufficietly differet that they impede full ecoomic itegratio. This is less familiar territory; this is foreig. This is where the early cartographers simply put dragos to war of the dagers of veturig ito the ukow. Iteratioal equities make up 30% of Hawthor s baselie equity allocatios. O the fixed icome side, we curretly have a tactical allocatio to global bods. I this quarter s Strategy Isights, we examie these asset classes with a eye o how they differ from their more familiar U.S. couterparts. Christopher D. Piros, Ph.D., CFA Maagig Director of Ivestmet Strategy christopher.piros@hawthor.pc.com Here Be Dragos: Perspectives o Global Ivestig What makes iteratioal ivestmets differet from domestic ivestmets? It is a simple questio, but although the aswer may seem obvious, it is ot quite as trivial as it may appear. I 2012, a U.S. ivestor who lives i, say, Bosto would ot cosider a ivestmet i, say, Virgiia as a foreig ivestmet. I 1776, however, it is likely that such a ivestmet would have bee deemed foreig. Why? Massachusetts ad Virgiia shared the same atioal govermet a distat kig ad parliamet but otherwise they had little i commo. For oe, they had differet currecies. Havig a differet currecy is probably sufficiet to make a market foreig, but it is ot ecessary. For example, today, Germay ad Greece have a commo currecy, but it is doubtful that may Germa or Greek ivestors really view ivestmets i the other coutry as domestic. A more sigificat factor was that Massachusetts ad Virgiia had much differet ecoomic characteristics, ad due i large part to geographic separatio, their ecoomies were oly weakly itegrated. Virgiia had a slave-based, agraria ecoomy, while Massachusetts had a ecoomy based o trade, idustry, ad services. While movemet of people, resources, ad iformatio betwee the coloies was certaily allowed, it was too slow to effectively itegrate product, factor, ad ivestmet markets betwee the coloies. From a Bostoia s poit of view, ivestmets i Virgiia were foreig primarily because their characteristics ad outcomes were domiated by developmets i the local Virgiia ecoomy rather tha factors commo to both coloies. With today s techology, mere physical distace is ot sufficiet to ihibit itegratio of markets. As every studet of iteratioal ecoomics lears, perfect competitio ad free trade are, at least i theory, sufficiet to equalize prices for goods, services, ad factors of productio (icludig capital) across markets. Thus, oe might well woder if geographic boudaries are still meaigful from a ivestmet perspective. Lies o a map have o ecoomic sigificace i ad of themselves. It is oly whe oe imbues them with the power to differetiate ecoomic outcomes that geographic/political boudaries gai sigificace for ivestors. O the oe side of the lie there is the familiar, the domestic. O the other side of the lie, laws, customs, regulatios, currecies, cultures, ad resource edowmets are sufficietly differet that they impede full ecoomic itegratio. This is less familiar territory; this is foreig. This is where the early cartographers simply put dragos to war of the dagers of veturig ito the ukow. hawthor.pc.com

2 Iteratioal equities make up 30% of Hawthor s baselie equity allocatios. O the fixed icome side, we curretly have a tactical allocatio to global bods. I this quarter s Strategy Isights, we examie these asset classes with a eye o how they differ from their more familiar U.S. couterparts. As we will discuss, the currecy i which assets are deomiated is oly oe of the differeces amog markets. We also examie the risk ad retur characteristics of global markets, with particular emphasis o the impact of currecy exposure. Lastly, we explai why capital mobility does ot make foreig bods redudat, eve if we hedge the currecy. A discussio of our curret strategy follows the overview of global ivestig. The Compositio of Global Equity Markets Expadig ivestors perspectives to ecompass foreig as well as domestic ivestmets broades their choices. I priciple, this caot make us worse off. But how much is really gaied? If iteratioal markets offered othig ew, the the gai might be rather limited. This is especially true for ivestors i the Uited States because the U.S. market already offers a broad, deep, ad liquid array of choices. The MSCI Global Equity Idexes are the de facto stadard for aalysis of global equity markets. MSCI s mai idexes cover large ad mid-cap compaies i 70 markets grouped ito three categories: 24 developed markets i the World Idex, 21 coutries i the Emergig Markets idex, ad 25 coutries i the Frotier Markets idex. The All-Coutry idex combies the developed markets ad the emergig markets. As of August 31, 2012, the developed markets accouted for 76.4% of the $37.9 trillio of total market capitalizatio; emergig markets, 22.6%; ad frotier markets, 1.0%. The Uited States made up more tha half (54.2%) of the developed markets capitalizatio ad 37.6% of the total across all 70 markets. Of the 2,592 total firms covered, 602 (23.2%) were based i the Uited States. Thus, while the Uited States is by far the largest sigle market, there are potetially vast opportuities abroad. Operatio Twist, origi? ally created i the early 1960s durig the Keedy admiistratio, is a moetary policy tool Chart 1 shows the sector compositio of the three market categories. The used fiacial sector has the largest share of market capitalizatio i each market by the Fed to sell orcategory. Withi the frotier markets, fiacials accout for more tha half of reduce its short?term the total; fiacials accout for just uder a quarter of emergig market equity Treasury holdigs i value. This patter should ot be too surprisig sice virtually all ecoomies favor of buyig loger? term Treasuries. Chart 1 The goal is to reduce Sector Compositio of Developed, Emergig, ad Frotier Markets loger?term iterest rates to ecourage? bor 60.0 rowig ad help stimulate ecoomic activity. Percet of Market Capitalizatio Developed Markets Emergig Markets Frotier Markets 0.0 Discretioary Staple Eergy Fiacials Health Care Idustrials Tech Materials Telecom Utilities Source: MSCI, FactSet Source: Research FactSet Research Systems, Systems, Ic. Ic. 2

3 eed local fiacial itermediaries, ad these istitutios are apt to be amog the first to be able to access public markets for their ow capital eeds. I cotrast, there are o frotier market firms i the cosumer discretioary or iformatio techology sectors. I the case of the cosumer discretioary sector, this is probably because of the relatively low per capita icome of may frotier coutries, for example, Bagladesh. With respect to iformatio techology, it probably reflects isufficietly skilled labor ad lack of techology ad ifrastructure required to perform high-volume precisio maufacturig. O the other had, iformatio techology is the secod-largest sector withi the emergig markets, maily due to South Korea ad Taiwaese firms. Iterestigly, despite the fact that several of the frotier markets are i the resource-rich Gulf regio Bahrai, Kuwait, Oma, Qatar, ad Uited Arab Emirates eergy ad materials do ot play a particularly large role i their stock markets. Also, either the emergig markets or the frotier markets have much i the way of health-care compaies. All of the major health-care compaies are i the developed markets, primarily the Uited States, Switzerlad, ad the Uited Kigdom. Sice there is substatial variatio i the sector compositio of equity markets aroud the world, it is atural to ask whether the market value withi each ecoomic sector is broadly distributed across markets or cocetrated i relatively few markets. Table 1 looks at how cocetrated each ecoomic sector is withi the developed, emergig, ad frotier markets. Withi the developed markets, we look at cocetratio with ad without the Uited States. The degree of cocetratio is measured usig a statistic kow as the Herfidahl Idex. If the market value were evely spread across N coutries, the Herfidahl Idex would be 1/N. If all of the market value were i a sigle market, the idex would be 1.0. Itermediate values idicate icomplete cocetratio. The last row of Table 1 shows the idex value that would correspod to a eve distributio withi that set of markets. As a basis for iterpretig umbers i the table, ote that idex values of 0.10, 0.20, ad 0.33 would arise from a eve distributio across 10, 5, ad 3 coutries, respectively. Herfidahl Idex: A idex calculated by squarig the fractio of that sector s market value that is based i each coutry ad summig across coutries. Whe the Uited States is icluded, all te sectors show substatial cocetratio withi the developed markets. Nie of the te sectors have cocetratios equivalet to beig evely spread amog at most five developed markets (a idex of 0.20 or higher). The materials sector is slightly less cocetrated (0.156), while the techology sector is extremely cocetrated (0.742). Each sector is less Table 1 Coutry Cocetratios withi Each Sector Developed Markets Emergig Frotier All Excludig U.S. Markets Markets Iformatio Techology Health Care Cosumer Discretioary Eergy Cosumer Staples Utilities Idustrials Telecommuicatio Services Fiacials Materials If evely distributed Source: MSCI, FactSet Research Systems, Ic. 3

4 cocetrated whe the Uited States is excluded, but eve the most broadly distributed, the fiacial sector, shows substatial market cocetratio (0.109). The materials sector is the oly sector for which excludig U.S. compaies does ot have a large impact o cocetratio. I the emergig markets, each sector is roughly as cocetrated as it is i the developed markets with the U.S. excluded. Not surprisigly, the frotier markets show substatial cocetratios, especially withi the cosumer staples, health-care, ad utilities sectors. For example, ot oly is the health-care sector small withi the frotier markets (Chart 1, page 2), but it is also cocetrated i oly a few of those markets (Table 1, page 3). The fact that the market capitalizatio of each ecoomic sector teds to be cocetrated i relatively few coutries implies that if global maagers seek to target ivestmets ito specific sectors, they could iadvertetly also create cocetrated exposures to specific coutries/markets. What if a maager targets exposure to specific coutries? Based o the precedig discussio, it is apparet that the resultig sector/idustry allocatio would deped o the coutry or coutries selected. What may be surprisig is the extet to which this is true. The vertical bars i Chart 2 show cocetratio idexes for each of the 24 developed markets i the MSCI World idex as well as for the World idex itself. The cocetratio statistic for each coutry reflects the breakdow of market value across 68 idustries. Equal weightig would give a cocetratio statistic of The coutries have bee sorted from least cocetrated o the left to the most cocetrated o the right. The lie i the chart shows the weight of each coutry s largest idustry. Chart 2 Cocetratio by Market Cocetratio Idex Cocetratio Idex Largest Idustry Weights Max Idustry Weight 0 MSCI World Uited States Japa Frace Germay Uited Kigdom Netherlads Swede Italy Sgapore Austria Hog Kog Filad Caada Australiz Switzerlad Norway Portugal New Zealad Spai Demark Irelad Belgium Israel Greece 0 Source: MSCI, Source: FactSet FactSet Research Research Systems, Systems, Ic. Ic. As show i Chart 2, the U.S. market is early as broadly diversified as the overall MSCI World idex. Japa, Frace, Germay, ad the Uited Kigdom are also fairly diverse. Beyod that, however, the degree of cocetratio rises substatially, with the size of the largest idustry above 20%. Oce we move beyod the G-5 coutries, targetig coutry exposure implies cocetrated idustry exposure. I additio, oly 11 of the 68 idustries show up as the largest idustry by market capitalizatio i eve oe coutry (Table 2, page 5). Commercial baks are the largest idustry i 6 of the 24 coutries while the Oil, Gas, ad Cosumable Fuels idustry is the largest i five markets, icludig the Uited States. 4

5 Table 2 Largest Idustry by Market Capitalizatio Idustry Automobiles Beverages Chemicals Commercial Baks Costructio Materials Electric Utilities Food Products Isurace Oil,Gas & Cosumable Fuels Pharmaceuticals Real Estate Maagemet & Developmet Largest i These Developed Markets Japa Belgium, Greece Germay Australia, Austria, Caada, Sigapore, Spai, Swede Irelad, Israel, New Zealad Portugal Netherlads Filad Frace, Italy, Norway, Uited States, Uited Kigdom Demark, Switzerlad Hog Kog Source: MSCI, FactSet Research Systems, Ic. Macroecoomics (coutries ad regios) caot be clealy separated from microecoomics (sectors ad idustries) i thikig about global equity returs. Coutry allocatios imply sector/idustry tilts ad vice versa. Of course, whe drillig dow eve further to the level of idividual securities, there are a multitude of characteristics that vary across markets. To fully uderstad what is happeig withi our portfolios, we aalyze ot just our allocatios to specific maagers ad fuds but also the characteristics implied by the idividual securities held withi the combied portfolios. Before the recet fiacial crisis, some researchers hypothesized that global markets were becomig so thoroughly itegrated that it would o loger matter where a compay was domiciled or where its stock traded. Further, some researchers speculated that so-called coutry effects would o loger matter ad ivestors could simply focus o pickig the best compaies withi global idustries without regard to locale. Eve before the crisis, however, the evidece suggested that both idustry effects ad coutry effects are importat i assessig the risk ad retur properties of global equities. 1 The evets of the last few years have oly served to reiforce the otio that macro matters i global equity ivestig. We therefore employ both top-dow ad bottom-up aalysis i our strategic ad tactical decisios. Global Equities: Risk, Retur ad Diversificatio Let us ow examie the risk ad retur characteristics of global equity markets. Table 3 (page 6) shows the mea (that is, average) retur ad volatility (measured by stadard deviatio) sice December 1995 for each of the 45 curret members of the MSCI All-Coutry idex alog with their correlatios (see margi box, page 6) with the U.S. market. Statistics are show for both U.S. dollar returs ad local currecy returs. The markets are grouped ito developed markets ad emergig markets ad listed i descedig order of average U.S. dollar retur withi each group. Keep i mid that such statistics, especially the average returs, are period specific. Noetheless, they help to illustrate some geeral poits. Stadard Deviatio: A measure of the amout by which a ucertai outcome is likely to deviate from the expected value. If the outcomes are described by the familiar bell-shaped Normal distributio, the there is a 67% chace of a outcome withi ±1 stadard deviatio of the expected value ad a 95% chace of a outcome withi ±2 stadard deviatios. As a example, if a asset has a expected retur of 10% ad a stadard deviatio of 15%, the there is a 67% chace of a retur betwee -5% (= 10% - 15%) ad +25% (= 10% + 15%). Lookig at the mea returs, they do vary substatially across markets. Durig this period, emergig markets geerally outperformed the developed markets by a substatial margi, but eve withi the developed markets there 1 A brief review of precrisis evidece ca be foud i Stewart, S.D., C.D. Piros, ad J.C. Heisler. Ruig Moey: Professioal Portfolio Maagemet, chapter 10. McGraw-Hill,

6 Table 3 Global Equity Risk, Retur, ad Correlatios (December 1995 August 2012) The HFRX Global Hedge Developed Markets Fud Idex is desiged to 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). Combiig variables with low or egative correlatio ca substatially reduce volatility. Cosider, for example, a portfolio that is allocated equally betwee two assets, each with 15% volatility. The table below illustrates the impact of correlatio o the volatility of the portfolio. Correlatio Portfolio Volatility % % % % The reductio i portfolio volatility that comes from combiig less tha perfectly correlated assets is the essece of diversificatio. Aualized Mea Retur Volatility Correlatio with U.S. U.S. Local U.S. Local U.S. Local Dollar Currecy Dollar Currecy Dollar Currecy Demark 13.76% 13.74% 21.09% Swede Norway Filad Caada Australia Spai Hog Kog Israel Germay Sigapore Frace Switzerlad Netherlads Uited States Belgium New Zealad Italy Uited Kigdom Portugal Austria Greece Irelad Japa Emergig Markets Russia Turkey Colombia Egypt Brazil Hugary Peru Czech Republic Mexico Idoesia Idia Korea Polad South Africa Chile Morocco Thailad Malaysia Chia Taiwa Philippies All Coutry Idex 7.18% 6.89% 16.63% All Coutry Idex, 6.87% 6.10% 18.13% Excludig U.S. Source: MSCI, FactSet Research Systems, Ic. 6

7 was sigificat dispersio. A secod observatio is that, with oly a few exceptios such as Turkey, the mea returs i local currecy ad i U.S. dollars were ot dramatically differet. For most markets, the currecy compoet of retur was a fairly modest fractio of the total retur for a U.S. ivestor. Turig to the volatilities, we see that currecy geerally icreases retur volatility, but o average the U.S. dollar returs were oly 15% more volatile (that is, a factor of 1.15) tha the local currecy returs. Although local stock returs ad currecy movemets are both quite volatile, they ofte move i opposite directios. This dampes the volatility of the U.S. dollar returs by eough so that they are oly moderately more volatile tha the uderlyig local returs. As we will see later, currecy has a much more sigificat impact o the risk of foreig bods. I our opiio, this helps explai why most equity maagers do ot actively maage their currecy exposures while most global bod maagers do maage that risk. The last two colums i Table 3 (page 6) show correlatios with the U.S. market. For U.S. dollar returs, the correlatios rage from 0.36 (Colombia) to 0.81 (Caada, Uited Kigdom). With oly a few exceptios, there was little differece betwee the local currecy retur correlatios ad the correspodig U.S. dollar retur correlatios. Thus, the currecy compoet of retur had little impact o the diversificatio that could have bee achieved by combiig a particular market with a U.S. domestic portfolio. Based o the U.S. dollar returs, the average correlatio with the U.S. market was As oted above, the maximum correlatio for a idividual iteratioal market was Yet the correlatio of the MSCI All-Coutry ex-u.s. idex with the U.S. market was That is, the iteratioal idex was more highly correlated with the U.S. market tha ay of its costituet markets! How ca that be the case? The key to this apparet paradox is the diversificatio that occurs withi the iteratioal idex itself. Combiig the iteratioal markets ito a idex portfolio diversifies away most of the coutry-specific risk of each uderlyig market. The risk of the idex is, therefore, drive primarily by commo risk factors that are the source of the correlatio amog markets, icludig each foreig market s correlatio with the U.S. market. As demostrated i Table 3, the diversificatio effect withi the idex ca be so strog that the idex is more highly correlated with the U.S. market tha ay of its costituet markets. The upshot of this is that, at least for relatively small allocatios to iteratioal markets, better overall diversificatio may be achieved by ivestig i oly a subset of markets. 2 The beefit of this approach ca be eve greater if markets with particularly attractive expected returs are selected. Global Fixed Icome: Where the Bods Are Withi the global equity market, o other market matches the breadth of opportuities available i the U.S. market. The same ca be said with respect to the global bod market. Chart 3 (page 8) shows a decompositio of the Barclays Global Aggregate Bod Idex, a broad idex of taxable, ivestmet-grade public debt. For each of four categories of debt Treasury, Govermet-Related, Corporate, ad Securitized the chart shows the 2 Diversificatio withi the iteratioal idex also reduces its volatility relative to the volatility of idividual markets. For large iteratioal allocatios, there is a trade-off betwee the lower volatility arisig from broader iteratioal diversificatio ad the lower correlatio with the U.S. market that ca be achieved usig oly a subset of markets. 7

8 percetage of that category i each of ie coutries or regios. For purposes of this decompositio, supraatioal orgaizatios such as the World Bak are treated as a regio. As Chart 3 shows, most publicly traded bods are from the Uited States, Europe, ad the Asia-Pacific regio. While both Europe ad the Asia-Pacific regio have somewhat larger shares of the Treasury (that is, sovereig) category tha the Uited States, the Uited States domiates the global market for both corporate bods ad securitized debt. Europe is a distat secod i both of these categories. Thus, the global market for publicly traded spread product is cocetrated i the Uited States. We believe the domiace of the Uited States i the corporate bod market reflects, i large measure, the historical reliace o bak fiacig i other parts of the world. The U.S. share (76.2%) of securitized istrumets reflects the growth of both the mortgage-backed ad asset-backed securities busiesses i the Uited States. Chart 3 Geographic Distributio of Ivestmet-Grade Bods Percetage of Category Treasury Govermet-Related Corporate Securitized 0.0 Source: Barclays Uited States Europe Asia & Pacific Rim Lati America Caada Africa Australia Supraatioal Other Give the promiece of U.S. bods ad the reserve currecy role of the U.S. dollar, it should ot be surprisig that U.S. dollar-deomiated bods accout for more tha 41% of the global idex. As show i Table 4, the rest of the bods are almost equally distributed amog the euro, the ye, ad a basket of other currecies. The poud is the fourth most heavily represeted currecy, Table 4 Currecy Deomiatio of Global Bods Govermet- Treasury Related Corporate Securitized Row Total 8 Dollar 14.20% 5.24% 9.42% 12.42% 41.28% Euro % Ye % Poud % Caadia Dollar % Australia Dollar % Other % Colum Total 54.53% 13.62% 15.83% 16.03% Source: Barclays

9 with a modest 6% share. If we focus oly o corporate bods ad securitized istrumets, more tha 60% of the bods are deomiated i U.S. dollars. To complete our brief tour of the global bod market, Table 5 decomposes both the umber of bods ad the market value of bods i each of the four categories o the basis of credit quality. While corporate bods comprise almost 52% of the issues, they accout for slightly less tha 16% of the market value. Thus, the corporate segmet of the market cosists of may relatively small issues. The vast majority of the corporate bods are i the lower two ivestmet-grade classes of A ad Baa. There simply are ot may ultra-high-quality corporate bod issuers ay more. I cotrast, sovereig debt cosists of relatively few (8.4% of the total) very large issues, which accout for 54.5% of the total market value. The vast majority of this debt is rated Aa or better. Securitized issues are predomiatly rated Aaa. Table 5 Decompositio of the Global Aggregate by Credit Quality Aaa Aa A Baa Total Portio of Issues Treasury 3.68% 2.59% 1.29% 0.82% 8.38% Govermet-Related % Corporate % Securitized % Portio of Market Value Treasury % Govermet-Related % Corporate % Securitized % Source: Barclays As our brief review of the global, ivestmet-grade bod market shows, ivestig i o-u.s. bods is ofte about gettig exposure to high-quality, sovereig, ad govermet-related bods deomiated i currecies other tha the U.S. dollar. It is primarily about iterest rate ad currecy movemets rather tha corporate credits or securitized loas. Global Bods: Risk ad Retur Characteristics Whereas may global equity maagers ofte treat currecy exposure as a afterthought, for global bod maagers this exposure is ofte a primary cosideratio. To us, the reaso is simple: currecies are usually far more volatile tha the bods, so currecy movemets ca make or break a maager s performace. Table 6 (page 10) shows the mea retur, volatility, ad correlatio with the U.S. market for 19 coutries i the JP Morga GBI Broad idex, a idex of global govermet bods, for which retur data are available sice the Jauary 1999 iceptio of the Europea Ecoomic ad Moetary Uio (EMU). The table cotais statistics for local currecy returs, U.S. dollar returs (uhedged), ad currecy-hedged U.S. dollar returs. The coutries are listed i descedig order of average uhedged, dollar-deomiated retur. With the exceptio of South Africa ad the Uited Kigdom, currecy exposure icreased the retur to U.S. ivestors durig the period of Jauary 9

10 1999 to August I geeral, the currecy compoet of retur was a sigificat portio of the total retur for a U.S. ivestor. It was o the risk side, however, that currecy played its biggest role. As i Table 6, (uhedged) U.S. dollar returs are typically two to three times as volatile as the uderlyig local currecy bod returs. Thus, o a stadaloe basis, uhedged iteratioal bods ted to be much more risky tha domestic bods. The currecy exposure does, however, geerally reduce the correlatio with the U.S. market ad therefore allow for icreased diversificatio. I additio, foreig currecy exposure provides protectio agaist erosio of purchasig power if the U.S. dollar depreciates. As illustrated i Table 6, systematic currecy hedgig teds to dampe both the dispersio of returs across markets ad the volatility of each market. It does ot, however, make foreig bods perfect substitutes for domestic bods. Therefore, eve o a fully hedged basis, we believe foreig bods ca offer iterestig ivestmet opportuities. Table 6 Global Bod Market Risk ad Retur: Jauary 1999 August 2012 Correlatio Mea Retur Volatility with U.S. Market Dollar Local Hedged Dollar Local Hedged Dollar Local Hedged South Africa 12.12% 12.93% 7.01% Australia New Zealad Polad Caada Swede Demark Austria Netherlads Belgium Filad Germay Frace Uited Kigdom Uited States Italy Japa Portugal Spai Source: J.P. Morga, FactSet Research Systems, Ic. It Is Still about the Currecy It is sometimes assumed that global capital flows should cause default-free iterest rates to coverge. If that were true, there would be little reaso to ivest outside oe s domestic bod market oce the covergece occurred. Therefore, it is worthwhile cosiderig why iterest rates do ot coverge. Turig this questio aroud, uder what coditios would two markets share a commo default-free yield curve? A well-kow arbitrage relatioship called Covered Iterest Rate Parity states that the iterest rate differetial betwee two markets must be equal to the discout or premium built ito currecy exchage rates quoted for future (as opposed to curret) delivery. As a example, if the oe-year iterest rate i U.S. dollars is 1% ad the oe-year iterest rate i Australia dollars is 4%, the 10

11 U.S. dollars to be delivered i oe year must be 3% (4% 1%) more expesive i terms of Australia dollars tha they are for delivery today. Currecy traders would say that the U.S. dollar is tradig at a 3% forward premium versus the Aussie. Equivaletly, the Aussie is at a 3% forward discout. Now suppose that the exchage rate betwee the Australia dollar ad the U.S. dollar were fixed, ad market participats were cofidet that it would remai fixed for more tha a year. The o oe would be willig to buy U.S. dollars at a forward premium or, equivaletly, sell Australia dollars at a forward discout. Everyoe would try to borrow U.S. dollars today, covert them to Australia dollars, ad ivest at the higher Australia dollar iterest rate. This would cotiue util the iterest rate differetial was elimiated. Sice this argumet applies for ay maturity date, we ca deduce that two markets will share a yield curve if the exchage rate betwee their currecies is credibly fixed. If market participats start to doubt that the exchage rate will remai the same forever, the yield curves will start to diverge, which i tur implies differetiated risk ad retur expectatios i the two markets, ad each market will begi to trade o its ow fudametals. This is exactly the sceario that has played out i the euro area over the last couple of years. Ivestors are o loger coviced that the moetary uio will survive, so bod yields have diverged sigificatly withi the euro area. The upshot of this argumet is that it is the lack of a credibly fixed exchage rate that allows iterest rates, ad hece bod returs, i differet markets to be less tha perfectly correlated. Iroically, this implies that eve if we hedge the currecy exposure, it is still about the currecy. It should be clear from our brief tour of the global equity ad bod markets that iteratioal markets are iheretly differet from their U.S. couterparts. We idetify several highlights: They have differet compositios ad preset U.S. ivestors with differetiated risk ad reward opportuities. The U.S. markets are somewhat uique. The U.S. equity market is much more diversified across ecoomic sectors ad idustries tha almost ay other market. O the bod side, the U.S. market has much more spread product i which to ivest tha ay other market. For U.S. ivestors, there clearly are opportuities both at home ad abroad. Hawthor s Curret Strategy May you live i iterestig times. We thik this old Chiese proverb is a apt descriptio of the ecoomic ad market eviromet movig ito the fial quarter of Ideed, these are iterestig times. Ivestmet decisios are always subject to ucertaity, but oly rarely is there a cofluece of systemic issues such as ivestors have faced this year. For example: Global ecoomic growth: Despite aggressive stimulus actios, the global ecoomy has failed 11

12 to reboud briskly from the great recessio. As discussed i our third-quarter Strategy Isights, a secular shift i icome ad wealth from low-savig, high-icome coutries such as the Uited States to high-savig, low-icome coutries likely creates iheret bias toward weak global demad. Europe is i recessio, Japa is i its third decade of stagatio, the Uited States is strugglig to accelerate growth above stall speed, ad there is earest cocer about a hard ladig i Chia. Sovereig solvecy, fiscal paralysis, loomig etitlemets, ad ufuded pesios: I a attempt to save their bakig systems ad prevet a collapse of their ecoomies, the govermets of various developed ecoomies, icludig the Uited States ad the EMU, have issued ad are issuig debt at a pace that could threate their solvecy. Several EMU members, otably Greece, Irelad, Portugal, ad Spai, have received bailouts from the EMU ad Iteratioal Moetary Fud but are strugglig to live up to the terms of those agreemets. I our opiio, a bigger package for Spai is likely, ad a package could be eeded for Italy as well. The Uited States faces roughly $600 billio of fiscal tighteig at year ed (the so-called fiscal cliff) if Cogress does ot act to amed curret law. Little progress is likely ear-term sice Cogress has already adjoured util after the November electios. The ature, scope, ad timig of policy actio are likely to deped o the outcome of the electio. I the Uited States, we believe the day of reckoig for both federal etitlemet programs ad state ad local pesio plas is fast approachig. Political fault lies: The U.S. presidetial electio appears to be shapig up to be a cotest betwee two quite differet ecoomic ad social philosophies. The outcome of the electio likely will determie the course of policy across a broad rage of issues. Whichever cadidate wis, early half of the electorate may be disappoited with that course. Fiscal austerity measures imposed o highly-idebted EMU coutries threate to udermie both social cohesio ad the growth eeded to reduce deficits. Without forbearace, ad perhaps additioal fudig from the leders, these coutries could be forced out of the moetary uio. The eed for greater fiscal itegratio withi the EMU is straiig the resolve of both the fiscally strog ad the fiscally weak to maitai the uio. Territorial disputes betwee Japa ad Chia may sigal risig tesios over ecoomic ad political leadership i the Asia-Pacific regio. Tesios are high agai i the Middle East. Eve the Uited States ad Israel are publicly at odds. Moetary policy ad the fiacial system: I our opiio, cetral baks, for example, the Federal Reserve (Fed) 12

13 ad the Europea Cetral Bak (ECB), are pushig the boudaries of their madates i a effort to use their oly tools liquidity ad direct fudig to overcome the drag from structural impedimets, fiscal paralysis, ad political roadblocks. We ca almost visualize Fed Chairma Be Berake ad ECB Presidet Mario Draghi i the role of Atlas holdig up the world. A sharp rise i iflatio is widely viewed as a ievitable, but ot immediate, cosequece of the extraordiary buildup of liquidity i the system. Deposits are fleeig EMU coutries at risk of abadoig the euro. Massive excess reserves held at cetral baks idicate to us that iterbak ledig chaels, ad hece the fiacial system as a whole, remai fragile. I light of the potetial for sigificat chages i the global eviromet, we have deemed it prudet to remai close to log-term strategic portfolio allocatios. This view has bee drive i part by a sequece of specific dates/evets durig the year, icludig electios, summit cofereces, scheduled debt paymets, ad court ruligs, which could have precipitated sharp chages i the course of the markets. May of those dates have ow passed without icidet. However, the U.S. electio ad the fiscal cliff still loom large o the ear-term horizo. Cosequetly, our basic strategy is to stay close to shore ad wait util we kow which way the wid will be blowig before resettig our sails. Despite the fudametal problems oted above, U.S. equities are tradig ear multiyear highs ad credit spreads are tight. Iteratioal markets, both developed ad emergig, remai well-below their precrisis levels ad have lagged the U.S. market this year, but o the whole it has bee a good year for risky assets certaily much better tha it could have bee, i our opiio. We thik part of this ca be traced to substative progress o the fudametal issues. I particular, otwithstadig some backslidig ad weaker-tha-projected ecoomies, EMU members have made greater strides toward shorig up the euro area tha might have bee expected. I additio, the U.S. Supreme Court avoided castig the whole U.S. health-care system adrift by upholdig almost all of the Patiet Protectio ad Affordable Care Act. The secod, ad i our view probably eve more importat, support for the markets has bee the icreasigly aggressive stace of moetary policy. Both the Fed ad the ECB have ow promised to do whatever it takes to boost U.S. employmet ad save the euro, respectively. That meas the liquidity taps are wide ope ad will stay ope idefiitely. We are remided of two well-wor adages. First, do t fight the Fed. Secod, if somethig caot go o forever, it wo t. The first keeps us from gettig too bearish, ad the secod keeps us focused o the uderlyig fudametal issues ad the risks iheret i their resolutio. There are o easy aswers. As we discussed i our third-quarter Strategy Isights, it is time for paiful adjustmets ad big decisios. The chart o the back page of this report shows our curret strategic ad 13

14 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. Commets o Specific Classes Equities U.S. stocks remai cheap i compariso to bods o a variety of measures. However, cosesus earigs expectatios appear optimistic give the outlook for ecoomic growth ad the fact that profit margis are already quite high. Expectatios for small cap stocks appear especially vulerable to disappoitmet. Reliace o foreig sales/reveue has shifted from a tailwid to a headwid for may U.S. compaies. This factor, we believe, should favor small cap stocks sice they are geerally less depedet o foreig reveue. However, we do ot believe this is sufficiet to warrat a tactical tilt toward small caps give the more aggressive cosesus earigs projectios for these stocks. We have a preferece for higher-quality compaies with stroger balace sheets sice these stocks ca be expected to hold up better if the dowside risks to the global ecoomy materialize. We also have a preferece for stocks that pay a solid, growig divided. These stocks also ted to hold up relatively well i stressful coditios. I additio, they are attractive to ivestors seekig a reliable icome stream. Although sigificat strides have bee made toward shorig up the euro area, we believe there is greater dowside risk i those markets tha i the Uited States. Similarly, we believe there is greater dowside risk i emergig markets tha i the Uited States. Hece, although we have ot adopted a explicit tactical uderweight to these markets relative to the Uited States, we would be iclied to lea i that directio. Fixed Icome I ormal times, bod yields at curret levels would be usustaiable. However, these are ot ormal times. We believe the log-aticipated bear market i bods is still some time away. Hece, we are comfortable retaiig bechmark-like iterest rate exposure (that is, duratio). The Fed expects to keep short-term rates ear zero util 2015 ad has pledged to keep buyig mortgaged-backed securities (ad/or Treasuries) util there is sigificat improvemet i U.S. employmet. We believe this policy will be difficult to termiate i a timely maer. Hece, it raises the likelihood of a evetual iflatio problem ad a substatial rise i iterest rates but ot yet. Although credit spreads have tighteed, we retai our tactical allocatio to bak loas ad correspodig uderweight i core muicipals. I a eviromet of deleveragig ad ultra-low iterest rates, we believe ay back up i spreads should be met with avid demad from yield-hugry ivestors. We also have a tactical allocatio to global bods. We view this allocatio as providig diversificatio i the form of exposure to iterest rate movemets i other markets. I additio, the foreig currecy exposure iheret i this positio provides a modest hedge agaist depreciatio of the U.S. dollar. 14

15 Alterative Ivestmets We have a modest overweight allocatio to real estate ad a correspodig uderweight i private equity. I the aftermath of the fiacial crisis, it appears as though private equity fuds have struggled to put committed capital to work. I additio, a subdued pace of iitial public offerigs has hampered liquidatio of portfolio compaies. I cotrast, real estate, especially public real estate, also kow as real estate ivestmet trusts (REITs), has recovered somewhat more quickly. We believe this reflects, i part, the relatively attractive icome stream REITs provide. With little overall iflatioary pressure i the global ecoomy, we do ot aticipate persistet strog gais for diversified, log-oly commodity positios i the moths ahead. These positios do, however, provide diversificatio ad protectio agaist the loger-term prospect of acceleratig iflatio. We expect substatial market volatility this fall, especially as we approach the U.S. electio ad the fiscal cliff at the ed of the year. For ivestors who are comfortable with derivative istrumets ad/or structured otes, we recommed adoptig positios desiged to beefit from risig volatility. 15

16 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.