Compass September 2013

7/29/2019 Compass September 2013

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Wealth and Investment Management

Global Research & Investments

September 2013

Seismic shifts, the Great Unwind, and looking through to the other side

US CapEx: reasons for optimism

The US economy: a view from the drivers seat

Bet on the consumer?

Real Estate: caution and opportunity in a (not so) recovering asset class

Compass


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Wealth and Investment ManagementGlobal Research & Investments

COMPASS September 2013 1

Contents

The geology of markets 2Seismic shifts, the Great Unwind, and looking through to the other side 3The geology of the markets ........................................................................................... 3 and the resulting tremors ............................................................................................... 4On sale, with attractive valuations and potential returns ........................................... 5Fairly priced, so mark time amid volatility ....................................................................... 6For sale, with more selling pressure ahead ..................................................................... 6Bargains in the making (todays dog, tomorrows darling) ......................................... 6

Why selling municipal bonds now might not make sense ............................... 7US CapEx: reasons for optimism 8Business confidence is rising .............................................................................................. 9Demand for business credit is growing ........................................................................... 9Return on equity remains greater than the cost of it ................................................. 10Job gains drive higher capital expenditures, eventually ............................................. 10The US economy: a view from the drivers seat 11Perfectly correlated and a leading indicator ................................................................. 11Keep on trucking ................................................................................................................. 12Tracking the rails ................................................................................................................. 12I think I can, I think I can ................................................................................................ 15Bet on the consumer? 16The trends favoring increased consumer activity ....................................................... 16The combined result of encouraging trends ................................................................ 18Risks on the horizon, place your bets ............................................................................. 19Real Estate: caution and opportunity in a (not so) recovering asset class 20Cyclicality is a key attribute of real estate ..................................................................... 20For rent: single family homes ........................................................................................... 21A step before foreclosure: buying non-performing loans .......................................... 22Tactical Asset Allocation Review 24Interest rates, bond yields, and commodity and equity prices in context* 26Barclays key macroeconomic projections 28Global Investment Strategy Team 29


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The geology of marketsDear clients and colleagues,

The new Fall line-up being offered to investors presents an interesting mix of viewing.The long-running drama that is the path of economic growth around the world remains

a primetime staple. A few classics the debt ceiling and the ability of Washington to

reach timely and effective decisions on such issues as the budget are likely to be a

compelling mini-series. Syria will likely represent breaking news. Finally, a new reality

show life in a world of tapering quantitative easing is soon launching.

In this issue ofCompass, we offer our take on how these developments will affect the

opportunity set for investors, both near-term and into 2014.

In Seismic shifts, the Great Unwind, and looking through to the other side, we look at

the three financial tectonic plates currently in motion: the beginning of the end of

quantitative easing; the budget and debt ceiling battles set to commence in Washington;

and, the developing (as of this writing) geopolitical situation in Syria. These are likely to

visit renewed volatility upon markets and investors this fall.

Given these challenges, it is helpful to look under these plates to the economic mantle,

by understanding the drivers of economic and profit growth that, longer-term, are likely

to sustain the economy, and perhaps even toggle its trajectory to a more durable path.

In US CapEx: reasons for optimism, we examine the drivers of capital expenditures,and factors that may increase this activity so critical to our commercial and economic

well-being.

We sharpen the focus on transportation trends, which have historically been leadingindicators of economic well-being, in The US economy: a view from the drivers seat.

We answer the question, Bet on the consumer?, with cautious optimism.And we explore an interesting source of return in Real Estate: caution and opportunity in

a (not so) recovering asset class non performing loans. This builds on one of our

favorite themes: exploiting a lack of capital in a market that needs it. As with other

investments weve highlighted in this vein, the returns favor the opportunist.

Four years into the recovery from the Great Recession, investors have enjoyed few

periods of calm yet returns across some assets have been significant for those prepared

to endure the turbulence. Indeed, as we contemplate the period ahead, we expect more

of the same.

We hope you enjoy this edition ofCompass and, as always, welcome your feedback.

Hans F. Olsen, CFA

Chief Investment Officer, Americas

Hans Olsen, CFA

+1 212 526 4695

[email protected]


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Seismic shifts, the GreatUnwind, and looking through

to the other sideThere are three financial tectonic plates in motion which will likely

be the source of market tremors in the months ahead. Indeed, the

grinding of these plates has the potential to pulverize those

unfortunate enough to find themselves caught at the intersection

of these forces. If past is prologue, things will work out fine, but

the path to the other side will be rough.

The geology of the markets

The first plate in motion is the beginning of the end of the Federal Reserves quantitative

easing (QE) program, which has pumped $85 billion a month into the government bond

and agency markets for the past 12 months. The consensus view holds that the

beginning of the Great Unwind will commence this month after the central banks

September meeting. Investors have been anticipating this: Yields have jumped over a full

percentage point since Chairman Bernanke revealed his thinking in May. Bond market

volatility has risen substantially as the anticipated change in Fed stance moves closer to

reality (Figure 1).1

The second plate is the political wrangling over the budget and debt ceiling that is set to

begin in Washington. The federal governments fiscal new year begins on October 1st

and the debt ceiling will have to be raised sometime during the fourth quarter in order

for the government to remain in operation.

2

The third plate is geopolitical and, as it often does, involves the Middle East. Potential

military action against Syria could expand the countrys civil war to neighboring states,

several of which are on unstable footings. Of the three plates pushing against each

other, this one appears least likely to exert durable pressure on financial markets. The

ubiquity of strife in the region is not new, and markets are more accustomed to looking

past the attendant uncertainty.

As it now stands, there is no agreement on

an actual fiscal 2014 budget, or even on its potential size or priorities. Positions of the

opposing parties have hardened to such an extent that the willingness necessary to find

workable compromises is about as prevalent as a rare earth mineral.

1 US stock volatility, as measured by the VIX, has also risen, but less dramatically and has comedown from its highs of 18-20 in late June.2 The Treasury indicated that its extraordinary measures will be exhausted by mid-October,effectively rendering the federal government unable to pay all of its bills and creating a queue ofentities waiting to be paid.

Hans Olsen, CFA

+1 212 526 4695

[email protected]

Three financial tectonic

plates in motion:

quantitative easing,

fiscal battles, and

geopolitical conflict
mailto:[email protected]:[email protected]


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Figure 1: Bond market volatility has risen substantially Figure 2: Federal deficit % of GDP

40

50

60

70

80

90

100

110

120

Jan Feb Mar Apr May Jun Jul Aug

Move Index (Bond Market Volatility)

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

1973 1983 1993 2003 2013 2023

Budget Deficit as a % of GDP

Estimated

Source: Bloomberg as of August 2013 Source: Congressional Budget Office as of May 2013

and the resulting tremors

Combine these forces with this years strong US equity returns and conditions seem ripe

for a proper correction. A market propelled more by cheap money than the healthy lift of

rising sales and earnings is increasingly vulnerable to reassessment by investors, similar

to the rethink this summer in fixed income and emerging markets.

However, the investing landscape this autumn need not be as treacherous as it appears.

First, a return to market-based rather than central-bank driven interest rates is a

return to a healthy state of play. The distortions that quantitative easing has created

must ultimately be corrected for growth and asset price appreciation to be durable. And

across capital markets, this is beginning to happen as evidenced by flagging emerging

market debt and equity markets, and sizeable money flows out of bond funds.

Second, there are underlying trends that are potentially supportive of a more durable and

stronger rate of growth than weve seen in the US recovery to date, as we cover in the

following articles.

Third, the federal budget and debt ceiling debates need not be disruptive as the

countrys fiscal health is moving in the right direction. Higher taxes and lower spending

aided by a growing economy have combined to shrink the deficit from 7.0% of GDP in

2012 to the forecasted 4.0% this year.3

3 Congressional Budget Office Baseline Projections. May 2013.

To be sure, tax revenues were lifted by income

pulled into 2012 ahead of the 2013 tax hikes; however, the tax increases and the

sequestration-driven cuts are durable and will help to move the deficit to the historical

average of roughly 3% of GDP. Yes, more action will be needed from Congress, but thesize of the problem is smaller now than it was two years ago, giving legislators the

benefit of operating from a position of strength. Unfortunately, Congress looks set to

grab defeat from the jaws of victory, as any deal appears elusive and very messy at best.

Together with the other tectonic plates, such dysfunction could sap the will of a

The investing landscape

this autumn need not

be as treacherous as

it appears


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relatively fragile business community to invest in their businesses an activity needed to

prolong and deepen the economic recovery of the last several years and dampen the

native optimism of the US consumer, who has propelled much of the recovery so far.

Given this state of play, in which the shifting tectonic plates reposition, a review of the

landscape for investors is in order.

On sale, with attractive valuations and potential returns

Large European companies in the heart of the Eurozone continue to represent a

compelling opportunity set (compared to their US counterparts) as they trade at

discounts below historical norms (Figures 3 and 4). A catalyst for these stocks has

emerged as the Eurozone economy shows signs of stirring. Our belief had been that

higher stock prices in this bloc would emanate from lower interest rates due to an

enduring recession; however, economic growth will have the same impact risk appetite

for undervalued stocks will rise.4

In the US, small and mid-capitalization stocks continue to be attractive on the operating

fundamentals: Their sales are growing at twice the pace of large companies.

5 While

performance of these companies has been impressive this year, rising over 19% and

making them susceptible to skittishness-induced profit-taking, their operating results

support their enduring favor with investors.6

4 We think it premature to call an end to the Eurozones recession. The growth recently reported isvery uneven driven as it is by Germany and France, the two largest economies in the bloc. We wantto see several quarters of growth with broader participation of the countries in the monetary unionbefore we join the chorus of those claiming the recession has ended.5 Source: Bloomberg, as of September 2013. Q2 2013 sales growth: Russell 2500 3.2% vs.S&P 500 1.4%.6 Source: Bloomberg Russell 2500 Indexs 19.5% total return from January 1 September 3, 2013.

Figure 3: Ratio of European Large Cap stocks price toEBITDA (P/E) to the S&P 500 stocks P/E is at a discountvs. historical norm

Figure 4: Ratio of European Large Cap stocks price-to-book to the S&P 500 stocks price-to-book is at adiscount vs. historical norm

40%

50%

60%

70%

80%

90%

100%

03 04 05 06 07 08 09 10 11 12

%

Relative Price to EBITDA - Eurostoxx 50 vs S&P 100

10 year average

70%

61%

40%

45%

50%

55%

60%

65%

70%

75%

03 04 05 06 07 08 09 10 11 12

%

Relative Price to Book - Eurostoxx 50 vs S&P 100

10 year average

63%

54%

Source: Bloomberg as of August 2013 Source: Bloomberg as of August 2013

European, US small-/

mid-cap and private

equity offer potential

opportunities


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Private equity directed at exploiting broken and dislocated markets in the aftermath of

the financial crisis appears to be one of the most attractive opportunities in terms of the

potential return on offer relative to the risk taken. While the capital commitments are

long and the liquidity low, the potential risk-adjusted returns argue in favor of making a

place for this type of investment as a cornerstone of a portfolio.

Fairly priced, so mark time amid volatility

Large US companies, having risen nearly 17% through early September, appear fairly

priced.7 Earnings growth this year of 3.3% priced at a price/earnings multiple of 15.0

suggests that these companies will mark time through year-end but with considerable

volatility price churn as investors deal with movement of the three plates in the weeks

ahead.8

For sale, with more selling pressure ahead

While 2014 earnings estimates look encouraging, they may be a mirage given the

long-established pattern of downward revisions. Buying markets based on consensus

guesstimates for 2014 is, at this juncture, an exercise in hope over experience.

Developed government bonds have performed as expected poorly as markets have

anticipated the beginning of the end of quantitative easing; investment grade corporate

bonds have suffered a similar fate. Both have suffered as their prices were badly

distorted by investors desperate search for yield in the face of central bank-repressed

interest rates. The Great Unwind is also pulling money from emerging debt and equity

markets. Weak performance has only been exacerbated since the Fed Chairman

announced the advent of tapering in June. Commodities prices, frustrated by weak

growth in China and rising interest rates, have been a standout in terms of their poor

performance, although gold and oil have enjoyed periodic rallies as geopolitical conflicts

have driven investors to these crisis investments.

Bargains in the making (todays dog, tomorrows darling)As prices swing in the face of these tectonic shifts, new opportunities are developing

that merit watching. Markets of rapidly growing economies are being painted with the

same brush as those that are struggling. Equity valuations in places such as Indonesia

and Singapore are becoming increasingly attractive as the BRIC9

trade of the past decade

cracks, casting a pall over all developing markets. Once interest rates settle into their

elevated state, emerging market debt will similarly merit a fresh look. Commodities, too,

will deserve a second chance once the question of Chinas growth is answered. A well-

established feature of markets is that todays dog will be tomorrows darling. Meanwhile,

investors will be well served by being highly discriminating in their choices.

7 Source: Bloomberg. S&P 500 Index total return from January 1 - September 3, 2013.8 Source: Bloomberg. S&P 500 Q2 earnings growth and forward price-to-earnings ratio, as ofSeptember 3, 2013.9 Brazil, Russia, India and China


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Why selling municipal bonds now might not make sense

Given the sharp rise in yields this year, investors are understandably wondering what to do with their municipal bonds. For

anyone holding intermediate (7-10 years) or long (10+ years) maturity municipal bonds, seeing unrealized price declines of 7%

or more creates a powerful temptation to sell out and transition into shorter maturities, which are less sensitive to interest rate

changes. With further yield increases likely (although uncertain, as is the size and timing of any rate change), it is worth

examining why that strategy could be a mistake for bonds held in separately managed or brokerage accounts.

Consider the following scenario, shown below. An investor holds a municipal bond allocation as ballast to the risks of equities and

for more attractive yield generation than cash. Assume this investor paid $125,180 in September 2012 for an 8-year AA municipal

bond whose par value is $100,000. The coupon was 5% of the par value; the yield was 1.63% of the purchase price. 10

September 2013: After one year, yields have risen 115 basis points, causing a 6.97% decline in the bond's price to $116,452,

for a loss in principal value of $8,728. However, the investor has also received a coupon payment of $5,000. If the bond were

sold today, the investor would incur a loss of $3,728. But is that a necessary course of action?

2014-2015: Lets further assume that the investor opts to hold the bond through to Sept. 2015. For our illustration, lets

assume yields have continued to rise: +50 basis points in 2014 and +50 basis points again in 201511

Over the total three-year holding period, the bond's time to maturity has shortened from eight years at purchase to five years

by Sept. 2015 so its sensitivity to interest rate changes has fallen, slowing the rate of price decline. By Sept. 2015, the market

price of the bond is $110,987 (for a principal value decline of $14,193). However, the investor has received three coupon

payments of $5,000, for a total of $15,000. If the investor were to sell now, the value of the coupons cash flow has offset the

price decline.

.

12

Investor buys in Sept 2012.

Further, the investor can invest the proceeds in other municipal bonds that are now offering higher yields.

If bond was sold today If bond was held 'til 2015September 2012 September 2013 September 2015

Bond: 8-yr AA Municipal bond Yields have risen 115 bp since purchase Yields rise another 50 bp in 2014 and again in 2015*

Purchase Price: $125,180 Market Price: $ 116,452 Market Price: $110,987

Par: $100,000 Loss in Principal Value: $(8,728) Loss in Principal Value: $(14,193)

Coupon (% of Par): 5% Coupon Received: $5,000 Cumulative Coupon Received: $15,000Yield (% of Purchase Price): 1.63% Return if sold: $(3,728) Return if sold: $807

Years to maturity: 8 years Years to maturity: 7 years Years to maturity: 5 years

*This is for illustrative purposes and does not reflect the actual performance of any investment. Barclays does not guarantee favorableinvestment outcomes. Nor does it provide any guarantee against investment losses. Source: Barclays Wealth and Investment Management

unless theyre held in a mutual fund

The conclusion may be somewhat different for an investor who owns municipal bonds through a mutual fund. As municipal

bond yields rise and their prices fall, the value of a municipal bond mutual funds shares decline. These mark-to-market losses

typically prompt an increase in investor redemptions. To meet these demands, portfolio managers sell some of the funds

holdings, triggering a capital gains tax liability in cases where the securities were purchased at a lower price because yields

were higher at the time.13

Municipal bond investors should be actively evaluating their holdings along multiple risk and return dimensions before making

any sell or hold decision.

The investor who remains in the fund then faces a potential double whammy at year end: a loss in

value on their mutual fund shares anda tax bill for the capital gains.

10 Our scenario is a simplified one, intended to isolate only on the implications of yield changes.11 The total return scenario could improve if our assumed 100 bp rise in yields over 2014/2015 proves excessive. As of August 30, the yield onfive-year AA municipal bonds was only 75 bp below its 10-year historical average of 2.42%. Source: MMD, monthly data 9/1/2003 7/29/201312 And the investor has the opportunity to use some of the capital loss for tax loss harvesting purposes.13 Municipal bond yields were higher than they are today as recently as 19 months ago.


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US CapEx: reasons for optimism

Business investment spending tends to generate more durable and

higher quality economic growth. It usually leads to more jobs,

sparking a virtuous cycle of higher consumer spending, increased

corporate sales, and often higher equity prices. Examining the

factors that foster capital expenditure, we find reasons to be

optimistic about a continuing increase in this critical driver of output.

As we highlighted in our May edition ofCompass, US business investment as a

percentage of corporate profits has remained at historically low levels in this recovery:

55% compared to the long-term average of 85% (Figure 1). Arguably, it is one reason

this recovery has been relatively tepid.14

With other drivers of higher economic output tapped out (such as increased government

spending or looser monetary policy), we check in on CapEx. A constellation of conditions

seem to favor continuing increases in business investment, providing reasons for optimism.

Indeed, its link to growth of the nations output

is evident in Figure 2, which shows changes in CapEx and corporate sales. When

companies anticipate greater demand for their products, they bolster their ability to

satisfy it, which tends to require higher capital investment.

Figure 1: US capital expenditures as a percent ofcorporate profits (1951-2013)

Figure 2: YoY growth US CapEx vs. S&P 500 Index salesper share

0%

20%

40%

60%

80%

100%

120%

140%

160%

51 56 61 66 71 76 81 86 91 96 01 06 11

CapEx as % of Corporate Profits

Long Term Average (since 1951)

55%

85%

-30%

-20%

-10%

0%

10%

20%

30%

2005 2006 2007 2008 2009 2010 2011 2012 2013

CapEx YoY %

S&P 500 Trailing 12 month Sales Growth Per Share YoY %

Source: Bloomberg as of March 2013 Source: Bloomberg as of June 2013. Note: Capital Goods New OrdersNondefense Ex Aircrafts and Parts is used as a measure of CapEx.

14 John Maynard Keynes highlighted the drivers of output in a 1933New York Timeseditorial: anincrease of output cannot occur unless by the operation of one or other of three factors. Individualsmust be induced to spend more out of their existing incomes; or the business world must be induced,either by increased confidence in the prospects or by a lower rate of interest, to create additionalcurrent incomes in the hands of their employees, which is what happens when either the working orthe fixed capital of the country is being increased; or public authority must be called in aid to createadditional current incomes through the expenditure of borrowed or printed money.

David Motsonelidze

+1 212 412 [email protected]
http://query.nytimes.com/mem/archive/pdf?res=F70A11FB3C5513738DDDA80B94DA415B838FF1D3.http://query.nytimes.com/mem/archive/pdf?res=F70A11FB3C5513738DDDA80B94DA415B838FF1D3.http://query.nytimes.com/mem/archive/pdf?res=F70A11FB3C5513738DDDA80B94DA415B838FF1D3.http://query.nytimes.com/mem/archive/pdf?res=F70A11FB3C5513738DDDA80B94DA415B838FF1D3.


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Figure 3: CEO confidence is subject to sharper swingsthan in the past

Figure 4: Small business confidence remains well belowits pre-crisis averages

20

30

40

50

60

70

80

80 84 88 92 96 00 04 08 12

CEO Confidence Index*

80

85

90

95

100

105

110

80 84 88 92 96 00 04 08 12

Small Business Optimism Index

*A reading above 50 indicates that US CEOs feel positive about thefuture of the nation's economy. Source: Conference Board and Strategas

Research, as of August 2013. June 2013 is the latest data available.

Source: NFIB, as of August 2013. Latest survey data available is forJuly 2013.

Business confidence is rising

Entrepreneurs and corporate captains faith in the future has recovered from its record

low in 2009, and has been steadily increasing since late 2012. The Conference Boards

Measure of CEO Confidence Indexis now within its normal long-term historical range

(Figure 3), while the National Federation of Independent Businesses (NFIB) Small

Business Optimism Indexis at a 67-month high (Figure 4).

At the same time, business confidence appears more susceptible to uncertainty thanin the past. The CEO Confidence Indexhas had sixdouble-digit quarterly swings in the

past three years almost half the number over the preceding 35 years (excluding the

crisis). Small business optimism, meanwhile, remains notably below its long-term

historical average.

Demand for business credit is growing

Large and small businesses have been seeking more loans for commercial and

industrialization purposes. In fact, demand for loans by medium and large enterprises is

at a 6-month high, according to the Federal Reserve, while small business demand is at

an 8-year high. The increased appetite for credit likely reflects both heightened

confidence and a more positive outlook for sales, industry prospects, and the overalleconomy. The percentage of small businesses viewing the next three months as a good

time to expand is at its highest since early 2012.15 Similar readings from CEOs the

percent who anticipate an improvement in economic conditions or in their industries

over the next six months are the highest theyve been in 15 months.16

15 Source: NFIB Small Business Economic Trends, August 2013. Outlook for expansion, highest since

January 2012 (pg 5).16 Source: The Conference Board Measure of CEO Confidence quarterly releases.

Will the animal spirits

return to levels

conducive to greater

business investment

spending?


11/34



Return on equity remains greater than the cost of it

As Figure 6 illustrates, the difference, or spread, between the cost of equity capital and

its return, remains positive. While it has been positive during most of the recovery, the

recent uptick is encouraging. When the spread is positive, CapEx has historically tended

to grow because profitable investment opportunities requiring capital exist so businesses

are more likely to put capital to work.

Job gains drive higher capital expenditures, eventually

As the labor market improves further, business investment should also continue to

increase. In our May Compass, we highlighted the gap that had emerged between

growth in jobs and in capital expenditures. As wed anticipated and is evident in Figure 7,

CapEx has been rising, narrowing this gap. We would expect this trend to continue since

companies cannot increase staffing without ultimately investing in new equipment or

computers or employee productivity is likely to continue to decline.

So what could derail this positive trend, so critical for more sustainable, higher quality

economic growth? Based on what has stymied confidence and CapEx thus far in this

recovery policy uncertainty, higher oil prices and geopolitical conflict (see Seismic

shifts, page 4). The signs suggesting business investment may continue rising and

finally break out to a level consistent with higher growth are encouraging. We will be

watching this closely.

Figure 6: When return on equity net of its cost is positive,YoY capital expenditures tend to grow

Figure 7: Capital spending follows employment growth.Continued jobs growth bodes well for CapEx

-9

-4

1

6

11

16

-30

-20

-10

0

10

20

30

93 95 97 99 01 03 05 07 09 11 13

Spread, %

Capex YoY %, LHS

Spread % (S&P 500 Return on Equity - Cost of Equity), RHS

CapEx YoY, %

-6

-5

-4

-3

-2

-1

0

1

23

4

-40

-30

-20

-10

0

10

20

30

93 95 97 99 01 03 05 07 09 11 13

CapEx YoY %, LHS Nonfarm Payrolls YoY %, RHS

CapEx YoY % Nonfarm Payrolls YoY %

Source: Bloomberg as of June 2013. Note: Capital Goods New Orders

Nondefense Ex Aircrafts and Parts is used as a measure of CapEx. Datais quarterly.

Source: Bloomberg as of July 2013. Note: Capital Goods New Orders

Nondefense Ex Aircrafts and Parts is used as a measure of CapEx. Datais monthly.

The growing spread

between return on

equity capital and its

cost should support

higher CapEx


12/34



The US economy: a view fromthe drivers seat

A vast network of highways and railways lies at the heart of the

nations economy, facilitating daily the transfer of goods from

producers to American consumers. As freight carriers operating on

this network have direct, day-to-day experience of economic activity,

we look down the USs road to recovery from their vantage point.

Perfectly correlated anda leading indicator

Economic growth is the lifeblood of the transportation industry as the almost perfect

(99%) correlation between US industrial production and domestic truck tonnage theweight of freight that trucks carry monthly in Figure 1 attests. The industrys utility as a

leading indicator for the US economy is borne out by the Transportation Services Freight

Index (TSI Freight), which measures US truck, air, rail, water and pipeline activity.

Researchers at the Bureau of Transportation Statistics found that over a three decade

period, index declinespreceded economic slowdowns by an average of four to five

months and in the case of the Great Recession, by 18 months17

With the Federal Reserve signaling that the US economy may be resilient enough to

withstand a reduction in stimulus, and with business and consumer confidence

continuing to rise, the probability of a slowdown seems remote. To understand where

(Figure 2).

Figure 1: Nearly perfect correlation: YoY changes inUS industrial production and US trucking freight volume Figure 2: TSI Freight Indexs economic downturnpredictive capacity decline prior to Great Recession

-20%

-15%

-10%

-5%

0%

5%

10%

15%

Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12

Truck Tonnage* Industrial Production

YoY Growth (%)

98

101

104

107

110

113

2001 2003 2005 2007 2009 2011 2013

TSI Freight Index (12 mo rolling avg)

TSI Freight Index Value

Start of Great

Recession*

*American Trucking Association (ATA) Tonnage Index. TruckTonnage is the weight of freight that trucks carry monthly.Source: Bloomberg, Federal Reserve, ATA, as of July 2013

*The National Bureau of Economic Research defines the most recentrecession as the period between December 2007 and June 2009.Source: Bureau of Transportation Statistics, National Bureau ofEconomic Research, as of June 2013

17 Possible explanations for the longer lead time before the Great Recession include the 2005-2006rise in fuel costs, the magnitude of the downturn, and the housing/ financial crisis that triggered it.

Laura Kane, CFA

+1 212 526 2589

[email protected]

Freight carriers have

first-hand experience

of the countrys dailyeconomic activity and

its trends


13/34



the US economy and financial markets may go from here, its helpful to look at domestic

transportation trends. Trucking and railway companies directly touch producers as well

as intermediate and end consumers of the products they move. We examine freight

carrier activity for real time insights into the health of the economy and sources of

momentum that may drive the next leg of the recovery.

Keep on trucking

Trucking data suggests reasons for a positive near-term outlook. Truck tonnage reached

a record high in June, and freight carriers seem to have confidence that volumes will

persist, based on their planned equipment orders and hiring.

Close to two thirds of trucking carriers now plan to place orders for new vehicles in the

next three months, compared to just over 40% a year ago, according to the CKCVR

Fleet Sentiment survey.18

Truck transportation employment has also been picking up, indicating truck operators

anticipate continued high volumes. It rose by 6,300 jobs in July, more than offsetting the

prior two months declines, which suggests that truck-related production is likely to

accelerate in the second half of 2013.

Some of this increased demand stems from the need to

replace aging trucks. The deferral by freight carriers of new heavy truck purchases has

resulted in the average age of their fleets increasing by more than 15% since 2006. In

addition to replacement demand, 48% of respondents said they were planning toorder new equipment to expandcapacity. That figure is up from 41% in the second

quarter of this year.

These trends are supportive of continued GDP expansion. The upticks in planned

equipment purchases and hiring, in particular, are positive for capital spending, an

important driver of durable economic growth (see US CapEx: reasons for optimism on

page 8).

Tracking the rails

Railway transportation data provides a glimpse into whats currently driving the

economy. The American Association of Railroads reports weekly carload volumes by

product type for North Americas largest railroads. Year-to-date growth reveals various

pockets of strength in the US economy today and, by extrapolation, potential sources of

growth tomorrow (Figure 3).

The shale energy boom

Over the past five years, there has been a dramatic surge in the production of domestic

crude oil due to technological advances in drilling for oil in shale rock. The shale energy

revolution, with its potential to provide independence from foreign oil, will be an important

source of job creation, business investment and economic growth in the coming years.

Existing pipeline capacity is insufficient to handle the burgeoning supply from this shale

energy boom, so railroads are filling the need. In 2008, the largest US railroads carried

just 9,500 carloads of crude oil. By the end of 2012, this number had exploded to nearly

18 Percent of truck fleets planning to place orders for new trucks: 64.6% as of date vs. 41.1% in theQ3 2012. Source: CKCVR Fleet Sentiment survey, as of August 2013.

Trucking transportation

data suggests reasons

for a positive near-term

outlook

Train carloads of

crude oil havegrown exponentially

since 2008


14/34



234,000 carloads. And the momentum has continued this year with carloads of

petroleum products having grown by 32%.

To keep up with the boom, railroads are making the needed capital investment,

suggesting their confidence in continued growth. Deliveries of tank cars have spiked and

are forecast to continue growing.19 Orders for freight cars 80% of which were for tank

cars nearly doubled in the first quarter of 2013, up almost 92% from a year ago.20

The recovery in housing

As the US housing market continues on the path to recovery, carloads of building products,

such as lumber, are up 4.6% year-to-date. More important, theyve not shown any signs of

slowing despite the spike in 30-year mortgage rates since May. In fact, from May 1to

August 17 this year, carloads of building products grew 5.4% versus a year ago.21

The railroad data suggests that recent softness in monthly home sales should be

temporary, which isnt surprising when one considers that homebuilder confidence is at

record highs, mortgage rates are still low relative to history, and housing starts remain

58% below their prior peak in 2005 (Figure 4). Continued housing market strength will

lend support to improving consumer confidence and spending (as we discuss in Bet on

the consumer? on page 17).

Consumer spending on bigger-ticket items

Strength in the transportation of automobile parts and building products, compared toweakness in other categories, points to an interesting and recent dichotomy in the

spending habits of US consumers. Their discretionary dollars are being spent not on

clothing or dining out, but on more expensive durable items that are in need of

replacement, such as cars and home improvement products. This dichotomy is

confirmed by retail sales numbers, with motor vehicles and building materials topping

19 American Rail Car Industries, via Bloomberg Industries, as of August 201320 Railway Supply Institute via Bloomberg Industries, as of June 201321 Association of American Railroads, as of August 17, 2013

Carload volume

increases point to twokey drivers of economic

growth: energy and

housing

Figure 3: Changes in train carload volumes by product this year

-8.2%

-6.8%

-3.9%

-1.2%

1.0%

2.2%

3.5%

4.6%

32.2%

-20% -10% 0% 10% 20% 30% 40%

All Other

Agricultural

Coal

Industrial Bulk**

Automotive

Chemicals

Intermodal

Building Products*

Petroleum Products

YoY Growth (%) YTD

*Lumber and Wood products, Metal Products, Sand/Gravel, Stone, Clay and Glass Products**Minerals, Ore, Scrap Metal, Primary Forest, Pulp & PaperSource: Association of American Railroads, as of August 17, 2013

Railroad data suggests

that recent softness inmonthly home sales

should be temporary


15/34



May-July growth (Figure 5), and by Home Depots and Lowes impressive second-quarter

earnings results as compared to the disappointing results of apparel and discount

retailers, such as Macys or Walmarts.

So far this year, carload volumes of automotive products are up 1%, even after very

strong growth in 2012. They appear to be continuing their upward trend (Figure 6),

supported by sales that are still below the pre-recession annual average (Figure 7). The

recovery in housing prices along with robust stock market returns has not only given

consumers the confidence to buy new cars, it has also bolstered the demand for light

trucks from home servicing professionals, such as contractors, electricians and

landscapers. In fact, for the past five consecutive months, light trucks sales have

exceeded passenger car sales.22

Figure 6: US auto and light truck sales Figure 7: Automotive volumes: recession vs. today

15.9

14.8

16.1

17.0

17.9

15.7

16.2

17.6

17.0

17.7

16.716.6

15.8

10.211.1

12.4

13.5

15.215.4

10

11

12

13

14

15

16

17

18

1995 1998 2001 2004 2007 2010 2013

Light Vehicles, Millions

5,000

10,000

15,000

20,000

25,000

30,000

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52

Week

2009

2012

2013

Number of Carloads

Light Vehicles include cars and light trucks. Source: Bloomberg, as ofJuly 2013. 2013 is the average monthly Seasonally Adjusted AnnualRate (SAAR) through July.

Source: Association of American Railroads, as of August 17, 2013

22 Source: Bloomberg, as of July 2013.

Figure 4: New privately owned housing starts Figure 5: YoY growth/decline in retail sales by category(May July 2013)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

59 65 71 77 83 89 95 01 07 13

New Privately Owned Housing Starts

Housing Starts (Millions)

-4.8%0.3%

1.0%

1.6%

3.0%

1.5%

2.6%

3.3%

4.0%

4.2%

7.4%9.9%

9.6%11.1%

-6% 0% 6% 12%

Department Stores

Electronics and Appliance

General Merchandise Stores

Sports & Hobby

Dining

Health and Personal Care

Gas Stations

Home Furnishing

Dining

Apparel

Misc Store RetailersE-Commerce

Building Materials

Motor Vehicle

YoY Retail Sales Growth (%) by Category

Source: Bloomberg, as of August 2013. Source: US Census Bureau, as of July 2013.


16/34



I think I can, I think I can

Transportation trends this year, particularly in truck tonnage, support the notion of

positive momentum in the US economy. A more confident consumer is spending on

bigger-ticket durable items in need of replacement, such as cars and appliances. Keeping

a close tab on freight volumes may help give investors insight into which sectors mayoutperform as pent-up demand for cars and home goods is satisfied, and more of

consumers discretionary dollars go to purchase retail merchandise and services.

Similarly, as business confidence improves, we should see an increase in spending on

replacement and growth capital. Transportation industry capital expenditures will be

particularly important to watch, as this may be one of the first sectors to see the

significant pickup in investment spending we anticipate. Finally, as transportation trends

indicate, the housing recovery and shale energy revolution should remain sources of

longer term growth.


17/34



Bet on the consumer?

As 2013 began, the American consumer the largest driver of US

output faced headwinds: higher taxes, continuing high

unemployment, and uncertainty about the direction of

government policy. Today, its clear that the consumer has

adjusted to a higher tax rate and is benefiting from rising

employment. But does this key economic actor have enough

confidence to drive the next phase of US growth?

US GDP grew 2.5% in the second quarter, bringing the post-recession average to 2.2%,

well below the 4.3% typical of recoveries since 1947. 23

The American consumers activity is responsible for over 70% of GDP. Consumption, like

the overall economy, has been growing more slowly than it has in the past. But as we

head into the fall, a confluence of positive factors seem to favor a marked uptick in

consumer activity though risks remain on the horizon (See Seismic shifts, the Great

Unwind, and looking through to the other side, page 4.)

With economic growth notably

weaker than it has been historically and corporate earnings expected to pick upmaterially in the fourth quarter, the question on many investors minds is: What might

drive an increase in both economic and earnings growth in the second half of this year?

The trends favoring increased consumer activity

More jobs, higher wages

As of August, US unemployment had fallen from a peak of 10.0% in October of 2008

to a six-year low of 7.3%. Not only do more Americans have jobs, but their average

hourly earnings have been trending up since late 2012, so those who are gainfully

employed are making more money (Figure 1). Wage data has tended to move in long

cycles, suggesting that this uptrend is likely to be sustained. In addition, low inflation

and rising nominal wages have kept real earnings stable, enabling consumers to retain

their purchasing power. Taken together, these trends imply that American consumers

have more cash available to spend than they have had in recent years.

Lower debt service

Household debt service, the ratio of debt payments to disposable personal income, has

been falling steadily over the past five and half years. As of the first quarter, the ratio was

10.5% only a bit higher than the record low of 10.3% in the fourth quarter of 2012

(Figure 2). With lower debt service, consumers have more disposable income available,

which, if used primarily for purchasing goods and services instead of savings, could lead

to a higher rate of consumption.

23 Source: Bloomberg as of Q2 2013

Kristen Scarpa

+1 212 526 [email protected]

The American

consumers activity

is responsible for over

70% of US GDP

With lower debt service,consumers have more

disposable income


18/34



Figure 1: Average hourly earnings are now trendingupward after a five-year downtrend

Figure 2: Ratio of US household debt service todisposable income is near its all-time low

1

2

3

4

5

1985 1989 1993 1997 2001 2005 2009 2013

Average Nonfarm Hourly Earnings YoY SA, %

10

11

12

13

14

15

1980 1984 1988 1992 1996 2000 2004 2008 2012

Debt Service Ratio, %

Source: Bloomberg as of August 2013 Source: Bloomberg as of July 2013

Household Debt Service Ratio the ratio of debt payments todisposable personal income.

Increased wealth

Household net worth, defined as assets minus liabilities, has also been increasing

(Figure 3). The value of a households assets is largely driven by equity and home prices.

Equity markets have exceeded their 2008 highs with the S&P 500 returning an average

of 16% per year since the beginning of 2009, replenishing the wealth lost during the

financial crisis. Home prices have also been on the mend. After falling nearly 34%

between mid-2006 and early 2012, the S&P/Case-Shiller Home Price Index is up almost

16% from its post-recession low. Since mid-2012, home prices have posted consistent

year-over-year gains, rising at an average rate of 7% (Figure 4). In June, the most recent

month for which data is available, they grew an impressive 12%.

Figure 3: US households net worth increases as equityprices (S&P 500 Index) rise

Figure 4: and as housing prices rise, as they have sincelast year based on the S&P/Case-Shiller Index

0

10

20

30

40

50

60

70

80

0

200

400

600800

1,000

1,200

1,400

1,600

1,800

1999 2001 2003 2005 2007 2009 2011 2013

S&P 500 Index (LHS) Household Net Worth (RHS)

S&P 500 Index Value Household Net Worth - Trillions, USD

-30

-20

-10

0

10

20

2007 2008 2009 2010 2011 2012 2013

S&P /Case-Shiller Home Price YoY, %

Source: Bloomberg as of August 2013. Past performance does notguarantee future results. An investment cannot be made directly in amarket index.

Source: Bloomberg as of June 2013


19/34



The combined result of encouraging trends

Improving confidence, strengthening retail sales

The combined result of employment gains, wage increases, lower debt burdens, the

housing recovery, and stock market gains is consumer confidence near a six-year high

(Figure 5). Confident consumers tend to spend more of their discretionary income; less

confident consumers tend to stockpile income as savings. Consumers are currently

saving 4.4% of their disposable personal income, slightly below the average of 5.1%

since the end of the recession in July 2009. Their increased confidence is also evident in

improving retail sales. Year-over-year sales in May, June and July have each exceeded the

previous years average (Figure 6).

Translation to higher sales and earnings growth

The uptick in retail sales, particularly of durable goods, is underpinned by robust

confidence and suggests a resurgence in consumer spending that could fuel increased

Figure 5: Consumer confidence is near six-year highs Figure 6: which has been improving retail sales

20

40

60

80

100

120

2005 2006 2007 2008 2009 2010 2011 2012

Index Value

Conference Board Consumer Confidence

U. of Michigan Consumer Confidence

-12

-10

-8

-6

-4

-2

0

2

4

6

8

10

2008 2009 2010 2011 2012 2013

%, YoY

Retail Sales Annual Average

Source: Bloomberg as of August 2013 Source: Bloomberg as of July 2013

Increases in consumer

confidence tend to lead

sales growth by one

quarter

Figure 7: Consumer confidence vs S&P 500 Index per-share YoY sales growth

45

50

55

60

6570

75

80

85

90

-20

-15

-10

-5

0

5

10

15

20

2008 2009 2010 2011 2012 2013

S&P 500 Sales Per Share YoY%, LHS University of Michigan Consumer Confidence, RHS

S&P 500 Sales Per Share YoY, % University of Michigan Consumer Confidence Index

Source: Bloomberg as of August 2013, University of Michigan Consumer Confidence is a quarterlyaverage, one quarter forward.


20/34



revenues and earnings for companies in the second half of 2013. Historically, increases in

consumer confidence have tended to lead to sales growth of S&P 500 companies by

about one quarter (Figure 7). In that light, the increase in confidence over the past six

months is likely to drive revenue increases in the next six months. Anyone paying

attention to earnings expectations knows we need this. The consensus estimate

forecasts a 1.9% growth in third-quarter S&P 500 aggregate earnings and a whopping

9.0% in fourth-quarter earnings, according to Bloomberg.

Risks on the horizon, place your bets

The relatively encouraging picture painted for consumer spending is not without risks.

The combined impact of lower equity prices and a stalled housing recovery, prompted by

higher interest rates, would definitely weigh on consumer confidence. Similarly, some

combination of acute policy uncertainty, triggered by gridlock in Washington, higher oil

prices sapping disposable income, and prolonged market volatility would surely

undermine consumer optimism.

If these risks are largely avoided, then based on the evidence, wed bet on the consumerto drive economic and sales growth that is worthy of extra attention.


21/34



Real Estate: caution andopportunity in a (not so)

recovering asset classInvestment opportunities exist across real estate cycles. Two

particular approaches currently warrant investor attention.

Cyclicality is a key attribute of real estate

John Kenneth Galbraith noted in The Great Crash, 1929, As protection against financial

illusion or insanity memory is far better than law. Unfortunately, memory often fades

and mans connection with the past grows ever more tenuous and subject to the wishful

thinking that conditions nowadays are different from those of the past. This unfortunatecircumstance has occurred with worrying frequency in real estate, the asset class

arguably most prone to severe cycles. The twentieth century had a number of boom and

bust real estate cycles, starting with the Great Depression during which real estate prices

fell in excess of 30%. 24 This crisis was followed by the real estate run-up of the late

1970s that culminated in the savings and loan debacle of 1986-1995 during which more

than 1,000 thrifts with assets exceeding $500 billion failed.25

Real estate resonates with investors due to the simple fact that we wake every daysurrounded by bricks and mortar. The assets tangibility puts it within everyones reach,

and owners and renters alike are subject to the markets whims. The most recent real

estate boom and bust is most easily summarized in two parts: (i) banks too aggressively

expanding lending without maintaining rigorous underwriting standards, oversight, and

controls; and (ii) borrowers taking on more leverage than they could afford to repay and

more risk than they initially anticipated. According to the Federal Deposit Insurance

Corporation (FDIC), real estate secured loans issued by financial institutions insured by

the agency increased by 101% from 2000-2008 (from $2.4 trillion to $4.8 trillion). Upon

sensing the storm ahead in 2007, these institutions reserved almost $727 billion for loan

and lease losses through 2011, with reserve rates higher for those institutions with more

distressed loan portfolios. Over 400 institutions with $671 billion in assets failed in this

timeframe, consequently losing the FDICs Deposit Insurance Fund close to $88 billion.

Most recently, of course,

was the cycle beginning in 1996 and culminating in the Great Recession during which

prices increased at unprecedented rates in the commercial and residential markets and

ultimately descended from their peaks in a great deleveraging that rattled the United

States economy.

26

24 Source: The Wall Street Journal, Housing Shocker: Home Prices Still Falling, May 31, 2011, MarkGongloff

In retrospect, residential mortgage exposure caused the most distress within the largest

institutions, while commercial real estate (CRE) lending represented an outsized cause

for smaller institutions failure.

25 Source: FDIC Banking Review, The Cost of the Savings and Loan Crisis: Truth andConsequences, December 2000, Timothy Curry and Lynn Shibut.26 Source: Office of Inspector General of the FDIC, Report to Congress, Comprehensive Study onthe Impact of the Failure of Insured Depository Institutions, January 2013.

Seth Katz

+1 212 526 2801

[email protected]

The twentieth century

had a number of boomand bust real estate

cycles, starting with the

Great Depression during

which real estate prices

fell in excess of 30%
http://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdfhttp://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdfhttp://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdfhttp://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdfhttp://fdicig.gov/reports13%5C13-002EV.pdfhttp://fdicig.gov/reports13%5C13-002EV.pdfhttp://fdicig.gov/reports13%5C13-002EV.pdfhttp://fdicig.gov/reports13%5C13-002EV.pdfhttp://fdicig.gov/reports13%5C13-002EV.pdfhttp://fdicig.gov/reports13%5C13-002EV.pdfhttp://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdfhttp://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf


22/34



For rent: single family homes

The cratering of the US real estate market predictably engendered opportunities for

investors willing to wade into the morass. The market for buying distressed bank-owned

single family properties (REO real estate owned) and converting them to rentals

became highly relevant as a consequence of tantalizingly depressed home pricescombined with homeownership rates at their lowest levels in nearly 20 years (65.2% as

of June 30, 2013).27 Investments in these homes bought from banks and other owners

historically were the domain of individuals and small operators for whom the intricate

underwriting and maintenance required for each property was scalable in small numbers.

Interestingly, over the last couple years, the market for buying these assets has seen a

startling confluence of Main Street and Wall Street targeting the same properties.

Whereas the single family home-buying strategy previously didnt scale appropriately

from a capital efficiency and maintenance perspective for large pools of capital, massive

amounts of institutional funding currently flows into the space. For example, two large

players, The Blackstone Group and Colony Capital, bought over 40,000 homes between

them with aggregate capital invested exceeding $5 billion.28 This activity has warped

recent transaction data suggesting increased home transaction volume. RadarLogic, a

real estate analytics company, presented data as of March 2013 on 25 metro areas

across the US that shows institutional investors accounting for 12% of home purchases,

which is 300 basis points higher than the prior year. Without this increase, the number of

home purchases actually declined on a yearly basis.29 Institutional investors competing

for housing stock are playing integral roles in the dramatically rebounding valuations of

homes across markets that suffered most in the downturn. The percentage of buyers

that these groups represent in Las Vegas, Charlotte, Phoenix, and Miami is 19%, 21%,

26%, and 30%, respectively30 while almost 50% of all home purchases in Tampa and

31% of purchases in southern California have been with cash, a hallmark of the

institutional buyer.31

The aforementioned purchase activity has buoyed prices; Phoenix, Las Vegas andAtlanta, for example, have seen asking prices rise 25%, 18%, and 14%, respectively.

Rents, however, are not rising in line with prices: Phoenix rents increased only 1.3% from

a year earlier while Atlanta rents barely increased, and Las Vegas rents actually

decreased by 1.7%.

32

27

The time period for institutional buyers from home acquisition to

rental has elongated as they must hire contractors, renovate and acquire tenants.

According to Reuters in May 2013, about half of the 55,000 homes acquired by

institutional investors remain without tenants. The portent of a glut of homes for rent

combined with dramatic rebounds in home prices supported by neither proportional rent

increases nor comparable local economic growth rates is troubling and points to the

http://www.census.gov/housing/hvs/files/currenthvspress.pdf28 Sources: The Motley Fool, Housing: The Good, the Bad, and the Ugly, August 14, 2013, MariePalumbo. The New York Times, Behind the Rise in House Prices, Wall Street Buyers, June 3, 2013,Nathaniel Popper.29 Source: Forbes, Homebuyers Beware! Short-Term Money and Investors Dominate the RealEstate Market, June 13, 2013, Agustino Fontevecchia.30 Sources: Bloomberg News, Blackstone Crowds Housing Market as Rental Gains Slow, March18, 2013, John Gittelsohn and Prashant Gopal; The Motley Fool, see footnote 5 above.31 Sources: Charlotte Observer, Big Investment Groups Buying Up Charlotte Homes, July 13,2013, Andrew Dunn and Deon Roberts; The Wall Street Journal, Investors Pile Into Housing, ThisTime as Landlords, March 25, 2013, Nick Timiraos. Note: Southern California data is for themonth of March 2013.32 Source: Bloomberg News, see footnote 7 above.

Tantalizingly depressed

home prices combined

with historically lowhomeownership rates

supported the own-to-

rent thesis

Home prices are higher

but rents have not

increased proportionally
http://www.census.gov/housing/hvs/files/currenthvspress.pdfhttp://www.census.gov/housing/hvs/files/currenthvspress.pdfhttp://www.census.gov/housing/hvs/files/currenthvspress.pdfhttp://www.census.gov/housing/hvs/files/currenthvspress.pdf


23/34



possibility of a future institutional sell-off. As Yale economics professor Robert Shiller

said, Betting on home appreciation is not a sure thing. Right now we have the Fed with

a massive subsidy to the housing market, but you cant have a housing recovery without

a jobs recovery.33

A step before foreclosure: buying non-performing loans

An alternative to buying REO homes is to purchase non-performing loans (NPLs) from

banks. In contrast to buying single family homes, NPL acquisition has high barriers to

entry due to the financial wherewithal required to purchase loan pools and the overhead

necessary to properly service, restructure and work-out loans, preferably before they

move into foreclosure and become REO. An NPL buyer purchases bank loans at a

discount and then modifies the terms of the lending agreement with the commercial or

residential property owner, hoping that the loan once again performs and can be sold to

another investor seeking performing paper.

While the REO market becomes more heated, the NPL opportunity continues to have

ample dealflow in a less competitive environment. As the table below exhibits, CRE loanscomprise over 10% of the combined balance sheet of the United States 7,190 banks as

of December 2012. According to Ernst & Young, $164 billion of distressed loans fall

within this grouping, with the bulk of the problem residing within small regional banks.

These banks historically had a disproportionately high allocation to CRE loans (25% as of

December 2012) which contributed integrally, as noted earlier, to many of them being

shuttered by the FDIC.34

Figure 1: Commercial Real Estate (CRE) loans on US bank balance sheets

Banks Total assets

Commercial

Real Estate loans

% of

balance sheet

7,190 total banks US$14.5 trillion US$1.5 trillion 10.4%

Top 100 banks US$11.5 trillion US$755 billion 6.6%

Remaining banks US$3.0 trillion US$760 billion 25.3%

Source: Federal Deposit Insurance Corporation (FDIC) as of 12/31/12

Sales of NPLs reached $26 billion in 2011 largely as a consequence of FDIC sales and

diminished to roughly $15 billion in 2012 as the economy continued to improve.35

Despite a trailing off of FDIC NPL sale activity, a number of factors will influence

continued offloading of NPLs by banks. Improved financial conditions are encouraging

banks to sell underperforming paper as the rest of their respective balance sheets gain

strength. As Deloitte writes in its 2013 CRE outlook, Lenders are focusing on permanent

resolutions of distressed loans versus modifications/extensions, driven by higher

commercial property prices and increased refinancing options.36

33 Source: Reuters, Special Report: Cheap money bankrolls Wall Streets bet on housing, May 2,2013, Matthew Goldstein.

This statement isseconded by Fitch Ratings which finds that with a more benign economic environment,

banks are likely to pursue more bulk sales of distressed loans this year and next and

that higher earnings have given banks the freedom to properly mark down and sell

34 Source: Flocking to Europe: Ernst & Young 2013 non-performing loan report35 Ibid.36 Deloitte University Press, US Commercial Real Estate Outlook: Top Ten Issues in 2013 March 6,2013, Bob OBrien, Surabhi Sheth and Saurabh Mahajan.

An alternative to REO is

buying non-performing

loans, which have higher

barriers to entry and

significant present and

expected dealflow
http://www.ey.com/Publication/vwLUAssets/Flocking_to_Europe/$File/Flocking_to_Europe.pdfhttp://www.ey.com/Publication/vwLUAssets/Flocking_to_Europe/$File/Flocking_to_Europe.pdfhttp://www.ey.com/Publication/vwLUAssets/Flocking_to_Europe/$File/Flocking_to_Europe.pdfhttp://dupress.com/articles/us-commercial-real-estate-outlook-2013/http://dupress.com/articles/us-commercial-real-estate-outlook-2013/http://dupress.com/articles/us-commercial-real-estate-outlook-2013/http://dupress.com/articles/us-commercial-real-estate-outlook-2013/http://www.ey.com/Publication/vwLUAssets/Flocking_to_Europe/$File/Flocking_to_Europe.pdf


24/34



troubled assets and absorb the corresponding losses.37 Despite currently less precarious

market conditions, past missteps remain likely to haunt banks in the near future and

further contribute to NPL sale volume. In addition to challenged loans, banks and CMBS

servicers expect a flood of loans maturing over the next few years that, to be refinanced,

will require more equity albeit based on property values far lower than in 2006-2007

when many of these loans were first underwritten. The resulting equity shortfall,

estimated at about $100 billion annually over the next few years, probably will result in

more NPLs on lenders books.38

Banks and CMBS

servicers expect a flood

of loans maturing over

the next few years thatwill require refinancing

Figure 2: Upcoming CRE debt maturities

0

100

200

300

400

2013 2014 2015 2016 2017 2018

$bn

Commercial Banks, Savings Institutions Insurance Companies

GSEs & Federally Related Mortgage Pools* CMBS**

*GSEs: Government Sponsored Enterprises, i.e. Federal National Mortgage Association (FannieMae), Federal Home Loan Mortgage Corporation (Freddie Mac), Federal Deposit InsuranceCorporation (FDIC), Federal Housing Administration (FHA)**CMBS: Commercial Mortgage Backed Securities. CMBS maturities are estimated to reachroughly $50 billion in 2014, $90 billion in 2015 and, in 2016 and 2017, almost $130 billion,according to Ernst & YoungSource: Federal Reserve, FDIC, Barclays Research

The years leading up to and including the Great Recession once more demonstrated real

estates sometimes harsh cyclicality. The drastic fall in property valuations across the US

generated various investment opportunities, including the purchase of REO properties

and NPLs. Investors should focus on options with high barriers to entry and strong

dealflow prospects. Perhaps most important, recalling Galbraiths statement quoted

earlier, investors ought not let their memory of the not-so-distant bubble fade.

Real estate-related investments may not be suitable for every investor and pose risks

related to overall and specific economic conditions as well as risks related to individual

property, credit, and interest rate fluctuations. For more information, talk to your

Investment Representative.

37 Referenced in Flocking to Europe: Ernst & Young 2013 non-performing loan report38 Ibid.


25/34



Tactical Asset Allocation ReviewTwo major themes have driven our tactical allocation this year: (1) a bias towards Developed Markets Equities above all other asset

classes as they have offered attractive valuation and the most compelling return potential; and (2) a deliberate retreat from, and

rotation within, fixed income because of valuation concerns and in anticipation of higher rates in favor of cash. We are

underweight Short-maturity, Investment Grade and Emerging Markets Bonds, and neutral weight Developed Government Bonds

(where we recommend a low strategic allocation) and high yield debt (Figures 1 and 3).

Our views on Commodities also dimmed recently in light of a sustained slowdown in China and no expected pullback in supply; our

reduction in July to underweight from neutral in this asset class was made in favor of cash. Since early June, we have maintained an

overweight in cash. This reserve will enable us to capitalize on opportunities likely to emerge as tectonic plates rattle markets.

Despite the seismic shifts likely to spark significant price churn this fall namely the unwinding of quantitative easing, fiscal

debates in Washington, DC, and the impact of geopolitical conflict in the Middle East we still favor Developed Markets Equities.

Volatility is likely in the near term, but the catalysts for growth in the longer term are there. Within this asset class, however, the

relative opportunities have shifted, as we outline in Seismic shifts on page 4.

We remain neutral on Emerging Markets Equities because opportunities in certain rapidly-growing economies exist; however, we

view active management as imperative in this asset class. We are also neutral Alternative Trading Strategies; the price swings likely

in markets this fall should provide opportunities for this asset class. Finally, we remain neutral on Real Estate as REITs are fairly

priced and yield spreads over Treasuries are below historical norms.

Figure 1: Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA) by risk profile: asset class39

Low Medium Low Moderate Medium High High

Asset class SAA TAA SAA TAA SAA TAA SAA TAA SAA TAA

Cash and Short-maturity Bonds 46.0% 48.0% 17.0% 19.0% 7.0% 10.0% 3.0% 7.0% 2.0% 6.0%

Developed Government Bonds 8.0% 8.0% 7.0% 7.0% 4.0% 4.0% 2.0% 2.0% 1.0% 1.0%

Investment Grade Bonds 6.0% 4.0% 9.0% 7.0% 7.0% 5.0% 4.0% 2.0% 2.0% 0.0%

High Yield and Emerging Markets Bonds 6.0% 4.0% 10.0% 8.0% 11.0% 8.0% 10.0% 8.0% 8.0% 6.0%

Developed Markets Equities 16.0% 19.0% 28.0% 32.0% 38.0% 43.0% 45.0% 49.0% 50.0% 53.0%

Emerging Markets Equities 3.0% 3.0% 6.0% 6.0% 10.0% 10.0% 14.0% 14.0% 18.0% 18.0%

Commodities 2.0% 1.0% 4.0% 2.0% 5.0% 2.0% 6.0% 2.0% 5.0% 2.0%

Real Estate 2.0% 2.0% 3.0% 3.0% 4.0% 4.0% 6.0% 6.0% 7.0% 7.0%

Alternative Trading Strategies 11.0% 11.0% 16.0% 16.0% 14.0% 14.0% 10.0% 10.0% 7.0% 7.0%

Source: Barclays Wealth and Investment Management, As first published on 11 July 2013. Red indicates where our TAA is slightly underweightour SAA. Green indicates where our TAA is slightly overweight our SAA. Neutral weights are shown in black.

39 The recommendations made for your actual portfolio will differ from any asset allocation or strategies outlined in this document. The modelportfolios are not available to investors since they represent investment ideas, which are general in nature and do not include fees. Your assetallocation will be customized to your preferences and risk tolerance and you will be charged fees. You should ensure that your portfolio isupdated or redefined when your investment objectives or personal circumstances change.

Our Strategic Asset Allocation (SAA) models offer a baseline mix of assets that, if held on average over a five-year period, will in our viewprovide the most desirable combination of risk and return for an investors degree of Risk Tolerance. They are updated annually to reflect new

information and our changing views. Our Tactical Asset Allocation (TAA) tilts these five-year SAA views, incorporating small tactical shifts fromone asset class to another, to account for the prevailing economic and political environment and our shorter-term outlook. For more on our SAA

and TAA, please see ourAsset Allocation at Barclayswhite paper and the February 2013 edition ofCompass.
http://www.barclayswealth.com/Images/asset-allocation-us-march2013.pdfhttp://www.barclayswealth.com/Images/asset-allocation-us-march2013.pdfhttp://www.barclayswealth.com/Images/asset-allocation-us-march2013.pdfhttp://www.barclayswealth.com/Images/us-compass-february-2013.pdfhttp://www.barclayswealth.com/Images/us-compass-february-2013.pdfhttp://www.barclayswealth.com/Images/us-compass-february-2013.pdfhttp://www.barclayswealth.com/Images/us-compass-february-2013.pdfhttp://www.barclayswealth.com/Images/asset-allocation-us-march2013.pdf


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Figure 2: Year-to-date returns and TAA weightings forkey asset and regional sub asset classes (by weighting)

Figure 3: SAA, TAA and tilts with key regional sub assetclasses (Moderate Risk Profile)

19.1%

16.7%

8.6%

3.6%

2.8%

0.1%

8.1%

2.7%

-0.4%

-2.7%

-10.2%

0.1%

-3.3%

-4.6%

-6.2%

-9.8%

US Smid Cap Equities

US Large Cap Equities

Event Driven Strategies*

Relative Value Strategies*

Global Macro Strategies*

Cash

Non-US Developed Markets Equities

US High Yield Bonds

US Developed Public Real Estate

US Government Bonds

Emerging Markets Equities

Short-maturity Bonds

US Investment Grade Bonds

Managed Futures*

Commodities

Emerging Markets Bonds

Year To Date Asset Class Total Return

Overweight

Neutral

Underweight

US LargeCap Equities

US Smid Cap Equities

US Investment Grade Bonds

Emerging Markets Bonds

Short Maturity Bonds

Cash

Relative Value Strategies*

Event Driven Strategies*

Global Macro Strategies*

Managed Futures*

Commodities

Asset Class

(including key regional

sub asset classes)

Recommended

Allocation Tilt

SAA TAA SAA vs. TAA

Cash & Short Maturity Bonds 7% 10% +3%

Cash 0% 7% +7%

Short Maturity Bonds 7% 3% -4%

Developed Government Bonds 4% 4% 0%

US Government Bonds 4% 4% 0%

Investment Grade Bonds 7% 5% -2%

US Investment Grade Bonds 7% 5% -2%

High Yield & Emerging Markets Bonds 11% 8% -3%

US High Yield Bonds 5% 5% 0%

Emerging Markets Bonds 6% 3% -3%

Developed Markets Equities 38% 43% +5%US Large Cap Equities 12% 13% +1%

US Smid Cap Equities 5% 9% +4%

Non-US Developed Markets Equities 16% 16% 0%

Developed Private Equity 5% 5% 0%

Emerging Markets Equities 10% 10% 0%

Emerging Markets Equities 10% 10% 0%

Commodities 5% 2% -3%

Real Estate 4% 4% 0%

Developed Public Real Estate 4% 4% 0%

Alternative Trading Strategies 14% 14% 0%

Global Macro Strategies 3.5% 3.85% +.35%

Relative Value Strategies 3.5% 4.2% +.70%

Event Driven Strategies 3.5% 4.2% +.70%

Managed Futures 3.5% 1.75% -1.75%

Red = TAA is slightly underweight the SAA.Green =TAA is slightly overweight the SAA.

Source: Bloomberg as of August 30, 2013 unless otherwise noted.Diversification does not guarantee against losses. Past performanceis not an indication of future performance.

Red = TAA is slightly underweight the SAA.Green =TAA is slightly overweight the SAA.

Source: Barclays Wealth and Investment Management, AmericasInvestment Committee. As first published on 6 September 2013.

*Returns as of July 31, 2013 for: Global Macro Strategies, Relative Value Strategies, Event Driven Strategies and Managed Futures.

Note to Figure 2: We consider private equity to be part of the overall Developed Markets Equities allocation; however, as a reliable performanceindex is not available, it has been excluded from year-to-date returns/TAA weightings bar chart above.

Total Returns in Figure 2 are as of 30 August 2013 unless otherwise noted and represented by the following indices: Cash and Short-maturity

Bonds: Cash by Barclays 3-6 month T-bills; Short-maturity Bonds by Barclays 1-3 Year US Treasury; Developed Government Bonds: US GovernmentBonds by Barclays US Treasury; Investment Grade Bonds: US Investment Grade Bonds by Barclays US Aggregate Corporate; High-Yield and

Emerging Markets Bonds: US High Yield Bonds by Barclays US Corporate High Yield; Emerging Markets Bonds by JP Morgan GBI-EM Total Return

Diversified; Developed Markets Equities: US Large Cap Equities by Russell 1000 Index; US Smid Cap Equities by Russell 2500 Index; Non-US

Developed Markets Equities by MSCI EAFE Net Return; Emerging Markets Equities by MSCI EM; Commodities by DJ UBS Commodity TR Index; US

Developed PublicReal Estate: by FTSE NAREIT US ALL Equity REITs; Alternative Trading Strategies (*see note above): Relative Value Strategies byHFRI Relative Value Index; Event Driven Strategies by Dow Jones CS Event Driven Index; Managed Futures by Dow Jones CS Managed Futures Index.The benchmark indices are used for comparison purposes only and this comparison should not be understood to mean that there will necessarily bea correlation between actual returns and these benchmarks. It is not possible to invest in these Indices; they are not subject to any fees or expenses. Itshould not be assumed that investment will be made in any specific securities that comprise the indices. The volatility of the indices may be materiallydifferent than that of the hypothetical portfolio.


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Interest rates, bond yields, and commodity and equity prices in context*

Figure 1: Short-term interest rates (global) Figure 2: Government bond yields (global)

0

1

2

3

4

5

6

78

9

Dec-90 Dec-94 Dec-98 Dec-02 Dec-06 Dec-10

Global Government 10-year moving average

one standard deviation

Nominal Yield Level 3 Months (%)

1

2

3

4

5

6

7

89

10

Jan-87 Jan-92 Jan-97 Jan-02 Jan-07 Jan-12

Global Treasury 10-year moving average


Nominal Yield Level (%)

Source: FactSet, Barclays Source: FactSet, Barclays

Figure 3: Inflation-linked real bond yields (global) Figure 4: Inflation-adjusted spot commodity prices

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Dec-96 Dec-99 Dec-02 Dec-05 Dec-08 Dec-11Inflation Linked 10-year moving average


Real Yield Level (%)

70

100

130

160

190

220

250

280

310

340

Jan-91 Jan-95 Jan-99 Jan-03 Jan-07 Jan-11

DJ UBS Commodity 10-year moving average


Real Prices (1991=100)

Source: Bank of America Merrill Lynch, Datastream, FactSet, Barclays Source: Datastream, Barclays

Figure 5: Government bond yields: selected markets Figure 6: Global credit and emerging market yields

0.5

1.0

1.5

2.0

2.53.0

3.5

4.0

4.5

5.0

Global US UK Germany Japan one standard deviation Current 10-year average


2

4

6

8

10

12

Investment

Grade

High Yield Hard Currency

EM

Local Currency

EM one standard deviation Current 10-year average


Source: FactSet, Barclays*Monthly data with final data point as of COB 27 August 2013.

Source: FactSet, Barclays


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Figure 7: Developed stock market, forward PE ratio Figure 8: Emerging stock market, forward PE ratio

8

10

12

14

16

18

20

2224

26

Dec-87 Dec-93 Dec-99 Dec-05 Dec-11

MSCI The World Index 10-year moving average


PE (x)

6

8

10

12

14

16

18

20

22

2426

28

Dec-87 Dec-93 Dec-99 Dec-05 Dec-11MSCI Emerging Markets 10-year moving average


PE (x)

Source: MSCI, IBES, FactSet, Datastream, Barclays Source: MSCI, IBES, FactSet, Datastream, Barclays

Figure 9: Developed world dividend and credit yields Figure 10: Regional quoted-sector profitability

0

1

2

3

4

5

6

7

8

Jan-01 Jan-04 Jan-07 Jan-10 Jan-13

Global Investment Grade Corporates YieldDeveloped Markets Equity Dividend Yield

Yield (%)

3

5

7

9

11

13

15

17

19

World USA UK Eu x UK Japan Pac x JP EM

one standard deviation Current 10-year average

Return on Equity (%)


Figure 11: Global stock markets: forward PE ratios Figure 12: Global stock markets: price/book value ratios

9

11

13

15

17

19

21

23

World USA UK Eu x UK Japan Pac x JP EM one standard deviation Current 10-year average

PE (x)

0.8

1.2

1.6

2.0

2.4

2.8

World USA UK Eu x UK Japan Pac x JP EM one standard deviation Current 10-year average

PB (x)



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Barclays key macroeconomic projections

Figure 1: Real GDP and Consumer Prices (% YoY)

Real GDP Consumer prices

2012 2013 2014 2012 2013 2014

Global 3.2 2.8 3.7 2.9 2.6 3.0

Advanced 1.5 0.9 1.9 1.8 1.4 1.9

Emerging 5.0 4.8 5.5 4.7 4.6 4.8

United States 2.8 1.4 2.3 2.1 1.7 2.2

Euro area -0.5 -0.4 1.3 2.5 1.5 1.3

Japan 2.0 1.7 1.5 -0.1 0.2 2.4

United Kingdom 0.2 1.3 2.2 2.8 2.7 2.5

China 7.8 7.4 7.4 2.6 2.6 3.5

Brazil 0.9 2.3 2.7 5.4 6.3 5.6

India 5.1 5.0 6.2 7.5 5.6 5.5

Russia 3.4 2.3 3.5 5.1 6.6 5.6

Source: Barclays Research,Global Economics Weekly, 23 August 2013.Note: Arrows appear next to numbers if current forecasts differ from that of the previous week by 0.2pp or more for annual GDP and by 0.2pp ormore for Inflation. Weights used for real GDP are based on IMF PPP-based GDP (5yr centred moving averages). Weights used for consumerprices are based on IMF nominal GDP (5yr centred moving averages).

Figure 2: Central Bank Policy Rates (%)

Official rate

% per annum (unless stated)

Forecasts as at end of

Current Q3 13 Q4 13 Q1 14 Q2 14

Fed funds rate 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25

ECB main refinancing rate 0.50 0.50 0.50 0.50 0.50

BoJ overnight rate 0.10 0-0.10 0-0.10 0-0.10 0-0.10

BOE bank rate 0.50 0.50 0.50 0.50 0.50

China: 1y bench. lending rate 6.00 6.00 6.00 6.00 6.00

Brazil: SELIC rate 8.50 9.00 9.25 9.25 9.25

India: Repo rate 7.25 7.25 7.00 6.75 6.50

Russia: Overnight repo rate 5.50 5.25 5.25 5.00 5.00

Source: Barclays Research,Global Economics Weekly, 23 August 2013.Note: Rates as of COB 22 August 2013.
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Documents

Compass September 2013