Gresham Partners, LLC Market Review & Outlook

8/14/2019 Gresham Partners, LLC Market Review & Outlook

1/20

Gresham Partners, LLCMarket Review &Outlook2009 Second Quarter

2Q09

While some economists claim to see the beginnings of recovery in economic

tea leaves, we believe we are in the midst of a long-term, systemic delever

aging that will take years to run its course. While the government necessarilyfocuses on stabilizing the banking system, the health of the U.S. consumer

and the extent to which they deleverage their personal balance sheets will

have a signicant impact on the eventual course of the economic recovery

In this regard, the news continues to be bleak as consumer credit recently

contracted at a rate nearly 8 times greater than analysts expectations.

While the market reacted positively to the new Public-Private Investment

Program and some are seeing signs of the banking system stabilizing andmarket volatility subsiding, we still face the question of whether these efforts

will ultimately succeed. The scale of the existing programs already borders

on surreal and the IMF now expects the eventual cost of credit losses to

exceed $4 trillion, or nearly double the estimate of only several months ago

Our growing fear is that consequences of these solutions may be as toxic as

the assets they were designed to eliminate.

Longer term, we continue to believe that a reordering of the global eco

nomic and political landscape is underway, and possibly accelerating, given

the U.S.s current problems and their potential cures. We remain concerned

that the stimulus programs and their increased debt burdens will debase

our currency, increasing the chance that the U.S. dollar will lose its place as

the primary global reserve currency, and place at risk the global purchasing

power of our clients.


2/20

First Quarter Market Summary

U.S. markets increased nearly 9% in March,

thereby reducing the overall rst quarter de-

cline to 10.8% as shown in Exhibit 1. At the

end of the quarter, U.S. equity markets had

declined nearly 40% over the prior twelve

months. However, these declines hide the

largest six-week equity market rally since

1938, which started in mid-March and contin-

ued into April.

International equities performed similarly,

declining 10.7%, with a strong dollar account-

ing for over 3% of this decline. The near paral-

lel declines of international and U.S. markets

masked large divergences among different

regions of the world. The developed world, in-

cluding Europe and Japan, led the decline by

losing 14.6% and 16.6% respectively, while

emerging markets, and China in particular,

actually increased during the quarter. Overall, the bond market was roughly at

for the quarter. In a reversal of recent trends,

high yield bonds were the top performer, in-

creasing 5.0%, while intermediate Treasuries

declined 5.4%. These movements appear to

be consistent with the markets perception of

the governments bailout efforts, which is one

of increasing effectiveness and cost.

Hedged strategies were at during the quar-

ter, appearing to stabilize after their worst yeaon record. However, we continue to be skepti

cal of reported numbers in this area.

We do not have comparable data to include

in Exhibit 1 for nonmarketable real estate o

private equity markets. We continue to see

a dearth of transactions in the area, making

valuation difcult. Anecdotal information sug

gests both areas continue to weaken and, in

some cases, values are down signicantly.

Exhibit 1:Historical Market Performance

15%

10%

5%

0%

-5%

-10%

-15%

-20%

-25%

-30%

-35%

-40%

-45%

-50%

-55%

-4.6%-0.7%

4.1%

0.6%

-13.6% -13.1%

-3.1%

5.8%

-38.2%

-46.5%

-17.2%

3.1%

-10.8% -10.7%

-0.4%-0.1%

5-Year 3-Year 1-Year YTD

Russe ll 3000 MSCI AC World ex US

HFR FOF Conservative Barclays Aggregate Bond

-------------------------Annualized------------------------

Gresham Partners,LLC

Market Review &Outlook2009 Second Quarter


3/20


4/20

Market Review and Outlook

3

Balance Sheet Recessions and

Consumer Deleveraging

It is worth revisiting the concept of consume

deleveraging to gain some perspective on the

challenges we face. While it is tempting to

draw on past recessions to predict the path o

our current circumstances, there have beenonly a handful of recessions over the last 80

years from which to draw parallels. Moreover

this is not the typical business cycle reces

sion. Rather, we are experiencing a balance

sheet recession, fueled by the systemic de

leveraging of consumer and banking balance

sheets. Accordingly, we are wary of analysts

predictions as to the length and severity of

the downturn based on a few unrelated his

torical events.

While the deleveraging process in nancia

institutions is well underway, consumer ex

cesses that took years to build will likely un

wind over a long period. Exhibit 3 shows tha

the buildup in private sector debt has tracked

mand for consumer credit, which has declined

signicantly over the last few months. Addi-

tionally, U.S. unemployment continues to rise,

with the rst quarter expected to reach 8.5%,

and consumer spending continues to fall, as

evidenced by a 1.1% decline in March.

In a broader context, the retrenching con-sumer is exacerbating already weak econom-

ic conditions. Corporate earnings continue to

soften, contributing to the global economic

decline. The World Bank recently estimat-

ed that falling demand in wealthy countries

would produce the rst yearly decline in world

trade in nearly 30 years and the largest de-

cline since the Great Depression.

On a positive note, the U.S. government

continues to demonstrate its willingness to

throw everything at the problem. Most an-

alysts believe the stimulus efforts will not

end until well after the economic contraction

slows. This may constitute our best hope and

our greatest fear.

Exhibit 3: U.S. Consumer Debt and Spending

Source: BCA Research 2009

Exhibit 3:

Over the last 30

years, increases in

consumer spend-

ing have been built

upon leverage.U.S.

Private Sector Debt* (LS)Consumer Spending (RS)

*Excludes financial sector debt. Source: Flow of Funds

1950

140

180

220

% ofGDP

1960 1970 1980 1990 2000


5/20

Second Quarter 2009

Gresham Partners, LLC 4

2.2

Tn.$

1.8

1.4

1.0

Bn.$

800

600

400

200

2009200820072006

2.2

Tn.$

1.8

1.4

1.0

Bn.$

800

600

400

200

FEDERAL RESERVE BANK CREDIT

TOTAL BANK RESERVES

consumer spending quite closely, illustrating

that American households built a consider-

able portion of their spending increases since

1980 on borrowing. In the past, government

ofcials have been able to stimulate spend-

ing by simply making debt cheaper and more

readily available. Reducing interest rates tomake debt more affordable is no longer an

effective option, as interest rates are essen-

tially zero.

Returning to a more normal balance to

the ratio of household debt and personal in-

come would require signicant adjustments

to savings rates and consumption. One an-

alyst recently estimated that the return of

this ratio to its 1990s average of 90% from

its current 133% would require liabilities to

fall by $4.7 trillion, equivalent to about one

third of U.S. GDP.

Recently, the National Bureau of Economic

Research (NBER) released an interesting

working paper describing the aftermath of -

nancial crises and some of the common con-

sequences that emerge.

Housing prices declined over 35% and de-

clines continued for nearly six years. The cur-

rent housing price decline, measured by the

Case-Shiller index, is now 28% and we are

just in the second year of the current decline.

Equity market declines are even steep-

er, averaging 56% and lasting 3.5 years. The

current market declines did not (yet) reach

this level and were only in the second year of

the drawdown.

Unemployment rates increase over 7

percentage points from pre-crises levels and

last nearly 5 years before recovering to pre-

crisis levels.

On average, GDP declines a stagger-

ing 9.3%, but declines tend to be shorter

than labor market corrections, lasting only 2

years.While all the above statistics provide

sobering benchmarks for this crisis, the most

interesting aspect of the study showed that

real government debt, in the three years fol-lowing the banking crises, increased an aver-

age of 86%. Interestingly, the cost of banking

system bailouts tends to be a minor contribu-

tor to the increased debt burdens, which were

primarily driven by plummeting tax receipts

and large surges in government spending to

ght the associated recession. It is this as-

pect of these large nancial crises that con-

cerns us most.

Exhibit 4: Expanding the Federal Reserve

Balance Sheet and Bank Reserves


Government Stimulus Programs

As we discussed in our last Market Review, the

U.S. Federal Reserve is expected to keep in-

terest rates low for some time. Additionally,

Federal Reserve Chairman Ben Bernanke is

making good on his pledge to use all available

tools to contain the nancial crisis. With noroom to lower interest rates further, the Fed-

eral Reserve has expanded its balance sheet

at the fastest pace on record, more than dou-

bling its size in the last few months (see Exhibit

4, rst panel) to purchase assets and provide

various guarantees. While turning on the spig-

ots is necessary to stabilize the nancial mar-

kets and banking system, we will later discuss

our concerns that contracting the Fed balance

sheet will be difcult given its declining quality

and lengthening maturity structure.

The most important recovery effort that

the U.S. Government announced during the

first quarter was the Public-Private Invest-

ment Program (PPIP) designed to combine

Exhibit 4:

With interest rates

near zero, the

Federal Reserve

has expanded its

balance sheet to

provide liquidity.

Many analysts

expect the increase

to continue.


6/20


5

taxpayer money with private funds to buy

real estate related loans and securities cur-

rently held by U.S. banks. Without using all

the available space of this letter, the basic

concept is as follows: the U.S. Government

co-invests alongside private capital with

signicant non-recourse nancing availablethrough the Federal Reserve or FDIC Guar-

anteed Debt to leverage returns and increase

prices for these assets at auction. While eq-

uity markets applauded the program, rather

than the ad-hoc efforts of the past six months,

many details are yet to be resolved.

With a veritable alphabet soup of stimu-

lus programs (AMLF, CAP, CPFF, MMIFF, PDCF,

PPIP, TAF, TALF, TARP, TLGP, TSLF... and these

are only the ones with acronyms!) combined

with the rapid expansion of the Federal Re-

serve balance sheet through various programs,

it is easy to lose track of all the initiatives.

However, it is important to understand the

magnitude of these programs, which already

borders on surreal. Between guarantees, in-

vestment, recapitalization and liquidity provi-

sions, Nouriel Roubini estimates that the U.S.

Government has committed over $9 trillion to

the stimulus effort. Additionally, most expect

the Federal Reserve to expand its balance

sheet by an additional $1 to $2 trillion in the

coming quarters and the federal government

to quadruple the annual scal decit to $1.8

trillion or 12% of GDP in 2009, the highest

ever for a peacetime economy. Consequently,

U.S. Government debt and guarantees are ex-

pected to increase from 60% of GDP to over

100% of GDP. We have truly arrived at the be-

ginning of what Byron Wien termed theAge

of Interventionism.

Is the Bailout Working?

All this returns us to one central question:

is the bailout working? On the positive side

of the ledger, the stimulus efforts appear to

have calmed capital markets, at least tem-

porarily. Debt markets appear to have stabi-lized and equity markets staged a major rally

in March and into April. One indicator of the

equity markets retracement to more normal

conditions can be seen in the VIX, sometimes

known as the Fear Index, which measures im-

plied future volatility of U.S. stocks. The VIX

recently retreated from its near all-time high

of 80 in November to under 40 today (See Ex-

hibit 5). Unfortunately, uncertainty remains

and we expect elevated volatility levels to

continue as we work through the credit crisis

and the unfolding economic recession.

In the banking sector, we see signs of im

provement, but we have a long way to go be

fore lending conditions return to normal. With

respect to the recently enacted PPIP programdesigned to remove troubled assets from

bank balance sheets, two significant ques

tions remain unanswered:

Will the banks be willing (or able) to

sell assets and suffer a corresponding loss on

their balance sheets? Most analysts believe

that, despite the massive writedowns of the

last few quarters, banks still carry many loans

and securities at values well above prices

that would be attained at an auction such as

that envisioned under PPIP. For the healthie

banks, this will require them to raise addition

al capital to offset these losses. Others may

be unable to take the losses for solvency rea

sons. In the end, no amount of non-recourse

leverage will create incentives for the private

sector to bid on something that is worthless

Exhibit 5:

The VIX is indicating

that the market has

passed the recent

panic stage, but

volatility is expected

to continue.

Source: Bloomberg

Exhibit 5: The VIX: Equity Market Volatility

80

90

60

40

20

10

30

50

70

0

90 94 99 03 08


7/20

Second Quarter 2009


as is the case with many mortgage deriva-

tives. Furthermore, the recent relaxation of

mark-to-market accounting rules lessens the

incentive for banks to sell assets if they can

continue to hold them at inated prices.

Will private enterprise be willing to par-

ticipate in TALF related programs for securi-ties? If recent past is any indication, many

investors may simply pass due to tedious

paperwork, fear of legislative and regulatory

interference, curbs on hiring foreign workers

and fear of the rules changing mid-game.

Much of the liquidity already provided to

the nancial system has yet to make its way

into the broader economy. Banks are hoard-

ing money to heal their balance sheets rather

than resuming lending activity (see Exhibit 4,

second panel). Banks are unlikely to resume

lending until the value of housing collateral

stabilizes. This may not matter much as when

banks are ready and able to resume lending,

they may nd themselves pushing on a string

if demand for loans is declining and savings

rates are climbing.

Unfortunately, it is becoming clear that

recent estimates of global bank losses have

been underestimated. A year ago, analysts

estimated that total losses would exceed $1

trillion. At the beginning of the year, most es-

timates were closer to $2 trillion. The IMF now

expects total global credit losses to exceed $4

trillion and some analysts believe this number

will exceed $5 trillion when the full extent of

losses from Eastern Europe and the commer-

cial mortgage backed security area are known.

In aggregate, banks have raised substantially

less than the capital required to offset these

losses. On a related note, Nouriel Roubinis

recent analysis on the governments stress

test for bank solvency revealed that our cur-

rent economic conditions GDP growth, unem-

ployment rate, and home price depreciation

already lag behind both the governments

baseline scenario and their alternative more

adverse scenario. With the efciency of thetest in question, it is highly likely that most,

if not all 19, banks will pass this now meaning-

less test. It appears that ofcials continue to

play catch-up in their stimulus effort.

In the near-term, we are mindful of these

solutions and their effectiveness. Our con-

cern is increasingly turning to the long-term

consequences of the solutions themselves as

the size of the bailout continues to climb.

Our Approach Revisited

While we believe the risk of a nancial system

collapse has diminished, the range of possi-

ble outcomes remains wide. The truth is that

no one knows where this crisis will lead and

investing exclusively for one extreme or the

other can produce disastrous results if theunanticipated scenario were to occur.

While we always attempt to understand risk

as a core aspect of our investment activities,

this approach is particularly important in the

current environment. It is worth noting again,

that this difcult period has reafrmed many

of our investment principles:

Find Managers who Share our Risk Con-

scious Approach: It is important that these

managers are fundamental in their approach,

believing when they buy an asset that they

are paying a fair price in absolute terms. One

of the most important idiosyncratic risks for

any asset is price. Good assets, appropriately

purchased, typically do not lose money over

time, although they may temporarily decline

from the value at which you purchase them.

In the current market environment, their ap-

proach is often manifested in the patience to

wait for even more attractive investment op-

portunities, positioning portfolios with lower

market exposures, and nding investments

that will produce attractive long-term returns,

while surviving interim market volatility.

Opportunistically Find Attractive In-

vestment Areas: Based on our view of the

world, which our managers significantly in-

uence through their bottoms-up ideas, we

seek investments that may benet from, or

mute, the effects of any major downturn.

While the flexible mandates of most of our

managers allow them to rotate into opportu-

nities, occasionally, we will augment an exist-

ing exposure or add a new exposure that is

outside the scope of our current manager set.

Our partnership-oriented investment struc-

ture facilitates this opportunistic approach in

shifting capital to these areas. Our short sub-prime debt investment and current rotation

into distressed debt are recent examples of

this opportunistic approach.

Keep an Open Mind: For lack of a more

eloquent way to describe this principle, the

frameworks of the past are useful only to a

limited extent. One must continually test to

ensure that past relationships will endure and

be mindful of intellectual laziness that allows


8/20


7

false conclusions from outdated constructs.

A rigid approach prevents the appreciation of

events that make historical practices unlikely

to succeed in the future. Many of our longer-

term themes and concerns described below

are based on changing paradigms, highlight-

ing the risk of rote extrapolation.

Current Positioning and

Investment Opportunities

We are unsure about direction and the valu-

ation of many markets, given the uncertainty

in earnings and cash ows that are highly de-

pendent on both the short-term and long-term

impact of bailout efforts. However, we do be-

lieve there are a number of attractive invest-

ment opportunities on which both we and our

managers are focused. A world short of debt

and equity capital, such as today, tends to

be a point from which investors have realized

unusually good returns in the past.

Given our expectations for ongoing mar-

ket volatility, our equity exposure remains

relatively low through the combination of the

conservative positioning of our risk conscious

managers and our opportunistic allocations to

non-traditional strategies such as distressed

debt. Several of our long-only equity and dis

tressed debt managers maintain large cash

balances to protect capital and wait for even

better pricing. Many of our long-short equity

managers maintain low or even net negative

market exposure. Additionally, we recently

implemented a protective options-based overlay strategy to provide insurance against a

sharp and signicant monthly market decline

Somewhat counter-intuitively, we believe ou

largest risk is the possibility of underperfor

mance should a sharp rally in stocks occur, as

happened at the end of March and beginning

of April.

More specically, we continue to focus on

areas of the capital markets that we believe

provide attractive risk/reward opportunities

more specically:

Distressed Debt: Many holders of debt

securities have become distressed sellers

driving yield spreads on both low quality and

higher quality debt to near historic levels

(See Exhibit 6). If the economy weakens sig

nicantly as expected, we should have a gold

standard opportunity in distressed debt. In

preparation for this, for over a year, we have

been building our stable of proven distressed

Exhibit 6:

Debt markets

have more fully

discounted bad

economic news

as shown by

historically wide

credit spreads.


Exhibit 6: Corporate Credit Spreads

U.S. High-Yield Index* SpreadU.S. Speculative Grade Corporate Bond Default Rate**

**Source: Moodys Investors Service

*Source: Merril Lynch; Option Adjusted Spread

% %

18

1

14

1

1

8

6

4

2

18

16

14

12

10

8

6

4

2

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009


9/20

Second Quarter 2009


debt managers. We feel our specialist man-

agers in this area have greater transparency

than in equity markets and hard catalysts,

such as coupon payments, sinking funds and

maturity dates, which provide a rmer foun-

dation for valuation and risk assessment. Ac-

cordingly, we are allocating assets otherwiseearmarked for equity strategies to these eq-

uity-like opportunities.

Bank Stocks: Valuations for banks have

been devastated given the distress in nan-

cial institutions, and the tendency of investors

to paint every bank with the same negative

brush in a panic. While we expect to see con-

tinuing negative news on banks, including an

increasing number of bank failures, we be-

lieve a manager with a specialists expertise

can identify and purchase survivor banks

at very attractive prices. We have initiated a

slow and disciplined process with such a man-

ager to buy regional and community banks

around the U.S.

International Equity: Our clients will

recognize that we continue to emphasize

international equity over domestic equity.

We describe the rationale for this emphasis

greater later.

Municipal Bonds: The primary fixed

income investment for most of our clients

now yields more than taxable treasury bonds.

While we think inflation will eventually be-

come a larger concern, current yields seem

to justify this risk. As a result, we have re -

duced our long-standing underweight to mu-

nicipal bonds and high quality xed income

generally.

Long Term Themes and Concerns

While we remain concerned about current

conditions and the ability of the U.S. govern-

ment to stabilize the financial system, thetime to think about investing for this environ-

ment was a while ago, and we did. The returns

earned by our clients on shorts of subprime

debt and the ability of our managers to limit

losses in recent difcult markets are evidence

of this. Now, it is important for us to look for-

ward and consider opportunities created by

the current market dislocations and from the

stimulus package itself.

Realignment of the Global Landscape

We agree with the growing number of econo-

mists and analysts who support the thesis that

we are in the midst of a fundamental realign-

ment of global economic influence, includ-

ing a gradual handoff to a set of developing

countries that previously had little systemicinuence. Accompanying this shift is a pro-

nounced, continued accumulation of nancial

wealth by these emerging countries that in-

cludes some more accustomed to being debt-

ors than creditors. The continued growth of

these nancial resources, including sovereign

wealth funds, and their desire to diversify

capital more broadly, will lead to a shift away

from their current U.S.-centric xed income

investments toward a more diversied basket

of assets across a broader array of countries,

asset classes and currencies.

As global leaders recently met to discuss

solutions to the crises, it was an acknowl-

edgement of the shifting economic landscape

that it was the G-20, with signicant inuence

from the BRIC countries, who set the agenda.

The BRIC countries, led by China, are becom-

ing more aggressive in seeking and receiving

more inuence in determining the new global

economic order. It is also important to note

that the IMF, a nearly forgotten body just a

few years ago, gained renewed clout (and

funding), rather than relying on the tradition-

al G7 institutions to lead relief efforts.

Relatedly, the engine of worldwide econom-

ic growth will be less dependent on the U.S.

consumer. Instead, emerging markets will

constitute an increasingly independent driver

of growth, as they further evolve their econo-

mies from export-oriented businesses toward

higher domestic consumption. This trend is

well underway and should accelerate in the

coming years (See Exhibit 7 on the following

page). Additionally, the U.S. economy, which

has long been overly dependent on debt--

nanced consumption, will need to make the

much needed and long delayed adjustmentto create better global economic balance and

reduce its nancial vulnerability.

The current economic and credit crisis cen-

tered in the developed markets is accelerating

these changes. The U.S.China relationship

is at the core of this realignment, but every

nation will feel the impact of the realignment.

Over the last 20 years, the global economy was

built on the tightly integrated, but enormously


10/20


9

the imbalances that led us into this mess, and

the next crisis will be even worse. Thus far

the solutions have yet to address the elephant

in the room.

How Do We Turn off the Spigots?

While many can argue that the current leveof support is required to ensure that we avoid

a banking system collapse, the concern now

becomes how we exit. Given their size, the

solutions may be nearly as toxic as the as

sets that still clog the balance sheets of many

nancial institutions.

Many analysts expect the Federal Reserve

to continue to expand their balance sheet to

$4.5 trillion or more, which is more than ve

times the level seen before the crisis. While

the magnitude of the expansion is troubling

the composition of the Feds balance shee

may prove to be more challenging when the

economy stabilizes. The Fed has two options to

reduce these holdings and corresponding bank

lopsided twin pillars of U.S. over-consumption

and negative savings nanced by Chinas pro-

duction and excess savings. As evidence of the

growth of this imbalance, the U.S. trade de-

cit with China has grown eight-fold over this

period and China is on the verge of overtaking

Canada as Americas largest trading partner(see Exhibit 8). With the U.S. consumer at the

beginning of a long trend of deleveraging and

increasing savings, it is clear this relationship

is about to change dramatically.

Unfortunately, the current administrations

strategy, like past administrations, kicks

these problems into the future by failing to

address these imbalances. Worse yet, the

current solutions appear to be exacerbating

the problems by creating signicant new do-

mestic imbalances.

While unlikely, the bailout may be fabulous-

ly successful and the developed world may

return to its days of leveraged U.S. consump-

tion. In this case, we would be perpetuating

Source: BCA Research

Exhibit 7: BRIC Economies Continue to Grow

Exhibit 7:

BRIC economic

growth is at the

heart of the broader

realignment of the

global landscape.

Share Of Total World GDP*U.S.JapanEurope**BRIC***

6

10

14

18

22

26

%

6

10

14

18

22

26

%

1980 1985 1990 1995 2000 2005 2010

* On Purchasing Power Parity basis, includes estimates. IMF data.** Includes France, Germany, Italy and the U.K.

*** Includes Brazil, China, India and Russia. BCA estimate for Russia prior to 1992.


11/20

Second Quarter 2009


reserves; they can either let the bonds mature

or sell these holdings in the open market.

Historically, the Federal Reserve primar-

ily purchased short-maturity securities. Today,

78% of the Fed portfolio matures in more than

one year. If the Fed needed to drain reserves

quickly, it would need to sell securities in theopen market. This may be challenging with a

dearth of investment capital in the world and

the likelihood that these sales would be com-

peting with a government that will be issuing

more bonds to nance a growing decit.

The Fed, which normally purchases

treasury bonds, has purchased a wider range

of assets, much of which is not nearly as liq-

uid. These bonds would be more difcult to

sell in the open market.

At best, it is difcult to calibrate policy ef-

forts under stable conditions. It will be even

more difcult to withdraw liquidity in the cor-

rect amounts at the correct time under more

difcult circumstances. If history is any guide,

it is likely the Fed will err on the side of cau-

tion far too long. The composition of the Fed

balance sheet makes it even more unlikely

that the Federal Reserve will get it right.

Compounding this problem is the massive

expansion of federal government stimulus

programs. As we mentioned earlier, mostanalysts expect the 2009 annual scal decit

to exceed 12% of GDP and this could expand

further as the recession reduces government

tax receipts. As the decit expands and gov-

ernment debt burdens continue to mount, the

government will be left with few choices to

cure these internal imbalances:

Default/Restructure: This seems to be

an unlikely option, but some analysts believe

the U.S. could be forced to restructure its

debt obligations to delay principal payments.

China, as the largest owner of Treasury bonds,

would lead these discussions.

Raise Taxes/Lower Spending: Ronald

Reagan once said, The government is like a


Exhibit 8: Chinas Trade with the U.S.

Exhibit 8:

The integrated,

but imbalanced,

relationship that

has driven China-

U.S. trade will likely

change over the

coming years.

U.S. Imports FromJapanCanada*China*

24

20

16

12

8

4

24

% ofTotal

% ofTotal

20

16

12

8

4

1975 1980 1985 1990 1995 2000 2005 2010

*Shown smoothed


12/20


11

babys alimentary canal, with a happy appetite

at one end and no responsibility at the other.

Raising taxes will be part of the solution, but

the U.S. already has among the highest cor-

porate and personal tax rates in the world. On

the spending side, unfortunately, government

programs, once started, are notoriously dif-cult to shrink, much less eliminate. Both of

these options have the unfortunate side ef-

fect of slowing economic growth just as we

are likely emerging from the current reces-

sion, when the economy will be quite fragile.

Infation: By allowing excess stimulus to

remain in the system and the Fed to remain

highly accommodative, the U.S. will eventual-

ly begin to debase the dollar and, as we work

off excess capacity created in the current re-

cession, return to a more ination prone en-

vironment. Ination can be helpful as debt is

denominated in nominal terms, allowing the

government to grow (inate) its way out if the

problem of given enough time and latitude by

our larger debt holders, China and Japan.

Ination

Our fears of ination are likely to be a lon-

ger-term consideration. In the near term, the

cur rent recession is creating excess capac-

ity and slack in various parts of the economy,

reducing the possibility of near-term ination.

While actual ination may be further in the

future, we are working on solutions today. We

base our concerns of future ination on sev-

eral factors:

As discussed earlier, history suggests it

will be difcult to remove the unprecedented

level of stimulus in a timely fashion. One key

question that remains is whether this excess

liquidity translates to real goods and services

ination (i.e. CPI ination) or simply reverts

to its bad habits from earlier this decade and

creates a series of asset bubbles.

Over the last few decades, the world

has benetted from the opening of global labor

markets, which despite one of the longest pe-riods of synchronized global growth in history,

led to structural disination. While the world

will continue to benet from labor market glo-

balization, the shrinking wage gap between

developed and developing countries will pro-

vide less deationary benets in the future.

It appears likely that the emerging

economies may lead the global economy out

of recession, as the banking crisis that grips

the developed world does not exist in many o

these economies. We do not mean to suggest

that these economies have decoupled from

the rest of the developed world. These coun

tries remain highly reliant on developed mar

ket consumption, but many of these countries

have surplus funds to create immediate andcredible stimulus, as most have done to stim

ulate domestic lending and the acceleration o

local consumer demand. The emerging coun

try governments prioritize economic growth

over controlling ination to lift their popula

tions out of poverty. They will not hesitate to

allow higher ination, as their growth poten

tial exceeds that of developed economies and

can overcome periods of elevated ination.

The U.S. Dollar

The U.S. begins this journey with a relatively

healthy balance sheet, as direct obligations

of the U.S. Treasury are below 50% of GDP

However, these rapidly growing obligations

which some analysts expect will increase the

U.S. Treasurys obligation to well over 100%

of GDP in the coming years, place pressure on

the governments ability to nance its spend

ing and ultimately the U.S. dollar itself.

A reserve currency is the result of a long

economic evolution. The concept of a single

paper currency as an international store o

value is a relatively recent phenomenon. Afte

World War II, the U.S. dollar was the corner

stone of the Bretton Woods system, with the

U.S. government essentially guaranteeing

xed-rate convertibility into gold. Since the

early 1970s, when Bretton Woods disinte

grated, the U.S. dollar has retained its centra

importance primarily due to a lack of compe

tition. While other freely convertible curren

cies might be considered a reserve currency

the U.S. dollar is still dominant, comprising

64% of global reserves. For comparison pur

poses, the euro accounts for 25% and the yen

accounts for less than 5%. Recently, Chinas

central bank called for the creation of a newglobal reserve currency to replace the U.S

dollar. Importantly, the IMF would control the

new system so that it would be disconnected

from individual nations and is able to remain

stable in the long run, thus removing inher

ent deciencies caused by using credit-based

national currencies. While it is unlikely in the

near-term, the dollar is eventually likely to

lose its unilateral dominance as the primary


13/20

Second Quarter 2009


global reserve currency, consistent with the

realignment of global economic power we dis-

cussed earlier.

Many analysts expect that, if the dollar were

to lose its special status as the worlds prima-

ry reserve currency, it could lead to relative

declines. However, this inevitable evolutioncould be a positive for the U.S. economy. De-

valuing a currency is an appropriate response

by a government to stimulate domestic de-

mand. Recently, BCA Research summarized

this dynamic succinctly by saying that if the

U.S. economy and its assets cannot be de-

valued through a falling dollar, they must go

through a period of real depreciation through

falling asset prices, declining wages, con-

stricting prots and shrinking output. While

a declining dollar and its possible diminution

of its status as the primary global reserve

may be a positive for U.S. economic growth,

we must be concerned about preserving the

global purchasing power and standard of liv-

ing for our clients whose assets are largely

denominated in U.S. dollars.

Implications and Our Approach

These concerns and questions create the need

to look ahead and explore methods of pro-

tecting capital and exploiting opportunities.

Many of these are long-term considerations

without clear and immediate solutions, but

are worth noting to clarify our current think-

ing and communicate our areas of investment

exploration.

U.S. Dollar Debasement: Our concerns

about the devaluation of the U.S. dollar are

particularly acute for our clients, whose as-

sets are predominantly dollar denominated.

With a goal of preserving global purchasing

power, we are more aggressively exploring

ways to eliminate residual dollar exposure

within our international equity investments

and develop an effective method of explicitly

incorporating a short dollar exposure within

client portfolios. However, currency marketsare the ultimate zero sum game, and are

often driven by factors other than fundamen-

tals. Therefore, we approach this question

with caution.

If we are concerned about the debasement

of the U.S. dollar, one question we must an-

swer is debasement relative to what? Many

other freely exchangeable at currencies are

encountering similar issues, as they also face

larger decits and growing bailout expenses.

Recently, our discussions have evolved to in-

clude gold, as many investors still view gold as

a quasi-money standard, despite the elimina-

tion of all formal linkage to currencies nearly

forty years ago. In all likelihood, there will not

be a singular solution to this challenge. International Investors: We expect that

U.S. investors portfolios will begin to look

like other international investors, as we work

through the continuing shifts in the economic

and capital market landscape. Historically, in-

ternational investors have lived with currency

risk and investing in, from their perspec-

tive, non-domestic markets (including the

U.S. market). Many U.S. investors felt they

did not need to seek investment outside the

U.S. markets, which were the largest in the

world. Exhibit 9 shows the U.S. markets de-

clining percentage of global equity markets.

While U.S. markets outper formed interna-

tional markets and temporarily reversed this

trend in 2008, we expect this secular shift to

continue. We describe our interest in interna-

tional equities in more detail below.

Commodities: As consumers in the

emerging economies adopt developed nation

consumption habits, the world will have an

Source: Bloomberg

Exhibit 9: U.S. Market Capitalization in

Relative Decline

Exhibit 9:

The global equity

markets continue

to diminish the U.S.

markets primacy.

To an increasing

degree, U.S. inves-

tors will become

more internationally

oriented.

25

2004 2005

U.S. Market Cap

2006 2007 2008 2009

30

35

40

45

50(%)


14/20


13

increased demand for infrastructure and re-

sources of many types, including commodities.

Historically, our primary concern with invest-

ing in this area has been the predominance

of momentum-driven and speculative strate-

gies that create bubbles and large drawdowns

for investors. One positive is that the currententry point seems much more attractive after

the commodity collapse during the second

half of 2008.

Interventionism: We have entered an

age of unprecedented government interven-

tionism that will lead to unexpected events,

creating higher risk levels for all investors.

Additionally, increasing economic power in

the hands of governments practicing state

capitalism and those who have shown that

they are willing to change the rules of invest-

ing will only increase market volatility. Recent

examples are the U.S. governments decision

to eliminate short selling in nancial stocks

and bailout certain industries and companies,

but not others, in part motivated by political

considerations. This increases volatility in the

markets and the risk of unforeseen outcomes

by our managers.

Domestic Equities

U.S. stocks declined nearly 11% in the rst

quarter and were down nearly 40% over the

last twelve months. While declines may con-

tinue, it appears we have passed an acute

phase of nancial system peril and the market

may begin its tful digestion of fundamental

information, much of which may not be posi-

tive. We expect that the market will remain

highly volatile and even exhibit surprising

signs of strength at times. However, the fun-

damental economic challenges we face will

likely take years to work through.

Currently, we believe our greatest near-

term risk is that the challenges are not nearlyas great as we expected and the stimulus ef-

forts work with great and rapid effect, caus-

ing a strong rally in equity markets. Given our

conservative positioning, our equity strate-

gies would almost certainly lag in such a

turnaround. In fact, due to the strong equity

markets of late March and April, many of our

equity strategies have expectedly lagged dur-

ing this period.

Corporate Earnings Outlook

Current earnings forecasts remain subject

to massive revisions, rendering them nearly

useless. Exhibit 10 shows rapid declines fo

earnings forecasts for the last few quarters

Most remarkable are the rapid declines ove

rather short periods preceding each quarterhighlighting the wide margin by which ana

lysts continue to overestimate earnings. The

good news is that the rate of decline appears

to be slowing.

Earnings forecasts continue to decline

at a remarkable pace, such that future earn

ings estimates appear to be completely unre

liable. The estimated earnings growth rate fo

rst quarter 2009 S&P 500 earnings is now

-38%. On October 1 of last year, the estimat

ed growth rate was a POSITIVE 25% and as

recently as January 1, the estimated growth

rate was -12%.

Downward earnings revisions are no

longer limited to nancials, as all ten sectors

in the S&P 500 are expecting year-over-yea

declines during the rst quarter.

Second quarter earnings are now ex

pected to decline over 32%, down from just

over -11% on January 1.

Additionally, an unexpected headwind fo

corporate earnings is arising in the form of

unfunded pension obligations. Similar to 2002

when interest rates declined (making pension

liabilities larger due to lower discount rates)

and stock markets had fallen (making invest

ment portfolios worth less), unfunded pen

sion liabilities are exploding. Early estimates

by analysts place the incremental short fall in

the hundreds of billions of dollars. Unfunded

liabilities are an additional claim on corporate

assets at a time when many balance sheets

are coming under pressure. Additionally

companies will need to increase annual plan

contribution expenses to close the gap unless

the U.S. government steps in to offer some

form of relief. This is not positive for future

earnings.

Valuation

Valuation remains difcult to assess due to un

certain corporate prot expectations. Based

on analysts current full year 2009 earnings

estimate of just under $60 for the S&P 500

the stock market is trading between 13x and

14x earnings.

On a positive note, this is still slightly below


15/20

Second Quarter 2009


Source: Bloomberg

Exhibit 10: Declining Corporate Earnings Estimates

Exhibit 10:

The rapid declines

of estimated corpo-

rate earnings hasbeen staggering.

Recently, the rate of

decline appears to

have slowed.

the long-term valuation averages. Addition-

ally, during difcult periods, price-earnings

ratios have typically been higher as the mar-

ket tends to discount trough earnings with

some expectation of a rebound. In the ten

market corrections since 1962, most trough

multiples have been in the 10x 15x range.

Based on this information, one might con-

clude the stock market is fairly valued.

On the other hand, the 1974 and 1982 trough

multiples declined to roughly 8x trough earn-

ings. Additionally, some analysts believe we

have not yet reached trough earnings, with

estimates on the lower end reaching the $40

to $45 range. If this were the case, the cur-

rent market, given the recent run-up, would

be trading at nearly 20x.

The truth is that no one knows if the mar-ket is cheap or rich given all of these uncer-

tainties. However, we feel that our current

managers are nding attractive investment

opportunities at valuations that, regardless of

near-term market volatility, will perform well

in the long run. It is wor th reiterating that

both we and our managers continue to view

the debt markets as having better transpar-

ency and valuations than equity markets. In

other words, these markets have more ag-

gressively discounted negative economic and

business trends. Accordingly, we have shifted

significant equity capital to the distressed

debt markets.

International Equities

Foreign stocks performed similarly to U.S.

stocks during the quarter, declining 10.7%.

The dollars appreciation reduced returns

to U.S. investors by over three percentage

points. The nearly parallel performance of in-

ternational equity markets masked large di-

vergences in returns among different regions

in the world. The developed world, includingEurope and Japan, led the decline by losing

14.6% and 16.6%, respectively. In contrast,

emerging markets, in particular China, led

international equity markets and actually in-

creased during the quarter.

Opportunities and Relative Valuation

Our continuing preference for foreign stocks

over U.S. stocks rests on several factors. The

19-Sep-08

-60.0%

-40.0%

-20.0%

-0.0%

20.0%

40.0%

60.0%

10-Oct-09 31-Oct-08 21-Nov-08 12-Dec-08 2-Jan-09 23-Jan-09 13-Feb-09 6-Mar-09 27-Mar-09 17-Apr-09

4Q08

4Q08

1Q09

1Q09


16/20


15

longterm trend toward a new world order

should favor international over domestic in-

vestment. As a natural outcome of this trans-

formation, the opportunity set and the portfolio

positioning of U.S. investors will continue to

incorporate foreign investments to a greater

degree. In addition to these broader struc-tural changes, international equity markets

remain generally cheaper than U.S. markets,

trading at a 10%-20% discount. While risks to

investors can be higher outside the U.S., and

in some cases much higher, it is our belief that

very experienced and risk conscious manag-

ers can effectively navigate such risks.

The higher potential growth rates of the

Asian ex-Japan countries and many other

emerging economies provide wind at the backs

of long-term investors. While these economies

did not decouple the way many analysts an-

ticipate, the BRIC countries will largely avoid

the headwinds of structural deleveraging that

developed economies face and benet from

a shift to a more balanced economy, driven

by increasing domestic demand. In fact, most

analysts believe some BRIC economies are

already beginning to show signs of recovery

Exhibit 11 shows that the velocity of money

in BRIC economies did not suffer the abrupt

declines associated with developed market

banking crises, providing more stable monetary footing on which to recover. In addition

to our expanding interest in international eq

uity markets, we will also likely expand ou

interest in emerging markets at the expense

of developed market international equity ex

posure if current trends continue.

China

We agree with those who believe that the in

dustrialization of China and the emergence

of its consumer class will rank as the worlds

foremost economic change over the next few

decades. As China becomes less reliant on ex

ports and their rapidly expanding consume

class increasingly fuels growth, it should be

come a more stable economy. While China has


Exhibit 11: Money Velocity

Exhibit 11:

While G6 money

velocity collapsed

due to a clogged

nancial system,

BRIC money velocityis accelerating,

indicating stimulus

efforts are working

through a functioning

nancial system.12

13

11

10

9

1

201020082006200420022000

* Shown as M2 money suply relative to MO.** Includes Brazil, Russia, India and China.

*** Includes U.S., Japan, U.K. and euro area.

Money Multiplier*BRIC** (LS)

G6*** (RS)


17/20

Second Quarter 2009


a closed political system, it has a highly entre-

preneurial culture with an increasingly vibrant

society. At this point, these opportunities still

involve high risks and can often be illiquid.

However, we believe the potential for higher

growth and protability justies the risks of

long-term investments. Despite recent gains,valuations in the Chinese markets present the

opportunity to capture higher growth rates

without paying signicant premiums. We ex-

pect to continue to increase our long-term ex-

posure as we become more comfortable with

the Chinese markets and managers.

Japan

From a valuation standpoint, Japan is the most

attractive market in the developed world. For

a number of years, we have been attracted to

the valuations available in the Japanese mar-

kets. Unfortunately, valuations have remained

cheap and became even cheaper. Exhibit 12

shows the market is now trading at a discount

to book value, which is nearly a 30% discount

to the global average. A number of compa-

nies are now trading below the level of cash

on their balance sheet. We expect Japanese

headlines to remain negative, as U.S.-depen-

dent exporters struggle, but opportunities

exist as corporate governance improves and

ties to a growing China strengthen.

Bond Markets

While U.S. Treasuries were the big winner

in 2008, we experienced a bit of a reversal

during the rst quarter, as high-yield bonds

produced a positive 5% return to offset the

5% decline of intermediate Treasuries. Mu-

nicipal bonds continued to provide investors

with positive, albeit modest results, increas-

ing just over 2%. Importantly, it appears that

the forced selling of the last few quarters is,

at least temporarily, over and some stability

has returned. However, we have not seen a


Exhibit 12: Japanese Equity Valuation

Exhibit 12:

Japanese stocks

remain the cheapest

developed market in

the world and have

recently becomeeven cheaper.5

4

3

2

1

5

4

3

2

1

1980 1985

NOTE: MSCI Inc. DATA

1990 1995 2000 2005

Japan

Price to Book Ratio*

2010


18/20


17

rush of capital enter the market to buy heav-

ily discounted loans and bonds. At best, the

market has achieved some form of uneasy

equilibrium.

While the higher-yielding segments of bond

markets appear to have stabilized and even

improved slightly, credit spreads are still quitewide. At the end of the rst quarter, high yield

spreads remain nearly 1700 basis points up

from 850 basis points at the end of the third

quarter (see Exhibit 6). S&P predicts the de-

fault rate will climb from the current 5.5% to

14% within the year. However, current mar-

ket prices, according to some analysts, imply

nearly half of all companies in the U.S. will

default over the next ve years. This is a dra-

matically darker view than implied by equity

markets and why we tend to favor debt mar-

kets in the current environment.

Municipal Bonds

Municipal bonds have stabilized, after a bout

of forced selling from leveraged closed-end

funds and other municipal hedge funds. Mu-

nicipal bond yields exceed those of compa-

rable maturity Treasury bonds, despite their

tax-free status. The absolute level of munici-

pal yields provides some degree of insulation

against our longer-term inflation fears and

could provide appreciation potential in the

short run if we enter a deationary period as

the global economy slows.

As always, we remain focused on high qual-

ity bonds, as these yields may be partially

due to investor perception of increasing credit

risk as state and local budgets face massive

decits and potential defaults.

We have seen seismic structural shifts in

the municipal bond market, as municipal bond

insurers, who once accounted for over 50% of

outstanding issuance, were discredited and

downgraded. We believe this shift provides agreater opportunity for active management

to add value through original credit analysis

within a municipal bond account.

Recently, we par tially reversed our long-

standing underweight in xed income, which

we initiated in 2003 when yields hit what, at

the time, was a 40 year low.

Hedged Strategies

Hedged strategies were at during the rst

quarter, rebounding from their worst yea

on record. History has shown that periods of

poor performance in hedged strategies usu

ally precede above normal returns, as spread

relationships in arbitrage-type trades tend toexhibit strong reversion tendencies. Given the

magnitude of the outows and the signican

reduction of risk seeking capital around the

world over the last few quarters, we expect

the reversion process to take some time.

Late last year, the industry suffered from

massive redemptions that created panic

selling in securities that were crowded with

hedge funds, exacerbating losses in a self

reinforcing cycle that caused further hedge

fund selling. This is a symptom of too much

money invested in the area. According to one

hedge fund research group, the global hedge

fund industry had $2.6 trillion of assets at the

beginning of 2008. The same group estimat

ed hedge fund assets would decline to wel

under $1 trillion by the end of 2009. Some

analysts estimate that, if the disappearance

of bank proprietary trading desks is included

risk-seeking capital available for investment

has declined 90%.

In the near-term, the industry may con

tinue to experience outows, as investors are

dissatised with recent performance and less

willing to tolerate reduced liquidity and paying

incentive fees. Many expect a large numbe

of hedge funds and funds-of-funds will close

while others will suffer signicant reductions

in assets. In fact, the exodus has already

begun, as hedge fund-of-fund assets declined

last year for the rst time since 1996. We may

not know for sometime whether this repre

sents a secular change in the industry that

may restore some of the very attractive risk/

reward characteristics investors enjoyed in

the 1990s or simply a cyclical hiatus. Howev

er, we believe that the hedged strategies area

may be more attractive, at least for a whileWe remain concerned that returns in this

category are systematically more correlated

to other major asset classes, reducing the

diversication benet provided to investors

However, with the reduction in capital, many

managers will operate with smaller asset bases

allowing them to return to exploiting niches

left as commercially unattractive when asset

gathering was simply easier to accomplish


19/20

Second Quarter 2009


than investment performance. The pendulum

may have shifted back in favor of the investor.

Real EstateUnfortunately, the real estate indices we often

quote are now useless. The NCREIF property

index is particularly unhelpful given its back-

ward looking appraisal-based methods, which

incorporate new trends slowly. Even transac-

tion-based indexes, which more quickly reect

price changes, are unreliable as transaction

volume is at the lowest level in more than

15 years. As a result, our conversations with

real estate professionals may provide better

insight into market developments.

Real estate operating fundamentals appear

to be softening to various degrees in all sec-

tors. Anecdotally, weakness is clearest in the

hotel and retail sectors. Additionally, ofce

vacancy is accelerating, with reports of 1%

per month increases in economically sensi-

tive areas such as New York.

Cap rates appear to have increased sig-

nicantly. One indicator is the cost of capital

for publicly traded REITs, which are issuing

debt and equity at rates that exceed 10%.

One market participant believes these rates

are too high and reect some ongoing mar-

ket distress, but agrees that cap rates have

increased several points.

Given this limited data, investors, who

purchased properties at low cap rates and

were highly reliant on debt nancing to pay

historically lofty prices, may face property

value declines of 40% or more. Recently, the

John Hancock Tower, arguably New Englands

trophy commercial ofce property, traded at

about half the price paid in 2006.

While real estate continues to gain cred-

ibility as a mainstream asset class, many in-

vestors likely underestimated the impact of

leverage on returns and the illiquidity associ-ated with the asset class. The result are that

many institutional investors are over-allocated

with little prospect of near-term realizations.

We expect to see the trend toward institution-

alization to continue, but slow signicantly as

many investors have limited capacity to make

additional commitments.

In general, we like our position in commer-

cial real estate. The frothy markets of recent

years resulted in well below target invest-

ment levels for our clients due to a high rate

of sale and a reluctance to chase rising prices

by our risk-conscious managers. As a result,

we have large unfunded commitments in the

hands of very accomplished managers in an

environment where pricing is becoming sig-nicantly more attractive for purchases. The

most attractive opportunities in the near-term

will likely arise through the debt markets as

renancing needs create a catalyst to force

sales at attractive prices.

Private Equity

Similar to real estate pricing, the appraisal-

based data from private equity indices is

largely useless now. Prices have undoubtedly

declined, but with limited transaction activity,

valuations are difcult to determine. Pricing

for all transactions continues to decline and

equity valuations for large buyout funds have

become particularly vulnerable, given the sig-

nicant leverage and the high prices paid in

these deals. Investor interest in this area has

declined signicantly, given the over-allocation

of institutional investors and the magnitude of

price declines now being reported to investors.

The secondary market continues to pro-

vide attractive opportunities, but not without

risk. Buyers who purchased secondary inter-

ests at record discounts late last year may

nd themselves underwater when their next

appraisalcomes from the general partners of

these funds. The liquidity needs combined

with investor over-allocation continues to

drive distressed sales.

While our portfolios have not been immune

to markdowns, our insistence on avoiding the

large buyout area appears to be paying some

relative benets to our clients. In the com-

ing months, we expect to increase our com-

mitment to the secondary market for privateequity. Relatedly, we recently purchased a

secondary market interest at a 100% discount

in a fund we respect and have followed for a

number of years. In other words, we received

the underlying investments, in exchange for

assuming the (admittedly signicant) remain-

der of their capital commitment, for free.


20/20

Summary

The credit crisis continues to erode the global

economy at a rapid pace. Some economists

claim to see green shoots of growth, which may

signal a recovery or simply the deceleration of

the decline. However, if we are in the midst of

a long-term, systemic deleveraging, economicgrowth may face headwinds for years to come.

While the economy will eventually stabilize, a

return to the relatively high growth rates of

the last few decades seems unlikely, at least

in the next few years. In the near-term, real

questions remain about the effectiveness of

the bailout and stimulus programs.

The longer-term picture remains equally

unclear. With a veritable alphabet soup of

stimulus programs combined with the rapid

expansion of the Federal Reserve balance

sheet through various programs, it is impor-

tant to understand the magnitude of these

programs, which already borders on surreal.

Unfortunately, it is becoming clear that recent

estimates of global bank losses are low. The

IMF now expects total global credit losses to

approach $4 trillion and some analysts now

believe this number will exceed $5 trillion

when the full extent of losses from Eastern

Europe and the commercial mortgage backed

security area are known. However, it appears

the government remains willing to throw ev-

erything at the problem. We are concerned

that the scale and scope of these solutions to

these problems may be as toxic as the assets

they are designed to eliminate.

Despite these concerns and ongoing uncer-

tainties, we believe investment opportunities

exist in several areas of the market:

While deation may be the short run

concern, we remain concerned about the po-

tential for higher ination further out. Despite

this, we believe intermediate municipal bond

yields adequately compensate investors. As

a result, we have partially reversed our long-

standing underweight in xed income assets.

The problems in credit markets havecreated many attractive opportunities that our

managers are exploiting. In many ways, given

the hard catalysts and attractive valuations in

this area, we nd the corporate debt markets

more attractive than the equity markets. Ac-

cordingly, we have allocated equity-oriented

capital strategies away from traditional eq-

uity toward distressed debt investments

We continue to emphasize foreign stocks

over U.S. stocks. The rapidly growing emerg-

ing markets, especially the BRIC countries,

offer attractive valuations, despite recent per-

formance gains, and have the highest potential

for earnings growth in the future. Our interest

in China is an example. Additionally, our inter-est in Japan remains high, as it remains the

cheapest market in the developed world.

Despite hedged strategies experienc-

ing its worst year in 2008, we believe current

spreads provide investors with a good oppor-

tunity over the coming quarters. We are still

waiting to see if outows in this area are the

beginning of a secular unwinding of investor

interest or simply a short-term reaction to re-

cent performance and scandals.

While data for the real estate market is

still somewhat thin, it is clear that both valu-

ations and operating fundamentals continue

to decline. We remain comfortable with our

large unfunded commitment in the hands of

experienced managers who patiently wait for

better pricing as the market appears to be

developing into one of the better real estate

investment environments in years.

In private equity, valuations are declin-

ing, but like real estate, transaction volume

is still low, decreasing the reliability of the

data. Investing in the secondary market may

be the most attractive opportunity, as many

investors nd themselves struggling to create

liquidity and nd themselves over-allocated

to the area.

We and our managers remain conser-vatively positioned given our view of the un-

certainties that remain in the global economy

and capital markets. Currently, we believe our

largest risk is that the performance of our eq-

uity strategies would lag during a sharp and

sustained market recovery.

Longer-term, we are concerned that

the solutions to the current problems fail

to address the basic global imbalances that

created the current problems. Worse yet,these solutions appear to be creating a new

set of domestic imbalances. We are actively

pursuing suitable ways to protect the global

purchasing power of our clients, that may in-

clude hard assets, commodities and further

increases in international investments.

2009 Gresham Partners, LLC All R ights Reserved.

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Gresham Partners, LLC Market Review & Outlook