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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.
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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
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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
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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
Source: BCA Research 2009
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.
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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
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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
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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.
Source: BCA Research 2009
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
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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
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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.
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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
Source: BCA Research 2009
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
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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
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Gresham Partners, LLC 12
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(%)
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Market Review and Outlook
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
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Second Quarter 2009
Gresham Partners, LLC 14
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
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Market Review and Outlook
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
Source: BCA Research 2009
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)
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Second Quarter 2009
Gresham Partners, LLC 16
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
Source: BCA Research 2009
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
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Market Review and Outlook
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
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Gresham Partners, LLC 18
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.
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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.
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