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market thoughts The great rotation There is an awful lot being written about the next bursting bubble, which, according to pundits, is fixed income. The fear is either that inflation very quickly begins to reaccelerate because of monetary policy and central banks will need to aggressively slam on the policy brakes, or that investors are going to begin a Great Rotation out of fixed income. The Great Rotation scare being talked about argues that individual investors will apparently all wake up one day and collectively sell their bonds to buy stocks. For individual investors, it’s very unlikely that we will see selling of core bonds until investors actually lose money—and we don’t expect that to happen soon. In our portfolios next year, we envision owning more world equity markets, and owning less cash and short-duration fixed income. So | agree with the risk rotation, but a mad dash by individual investors out of fixed income seems unnecessary and unlikely. The balancing act for central banks is to try to stimulate growth without provoking inflation. There is enough excess capacity in labor markets that the greater policy concern remains disinflationary pressure. While we are keeping a close eye on inflation expectations, which have been rising, our economics team continues to believe inflation comes after growth and therefore isn’t a threat to this cycle of easy monetary policy. We expect the Fed, European Central Bank and Bank of Japan will continue to promote “easy money.” There is going to be an inflation shock that will come with accelerating growth—we just don’t see it next year. But in preparation for that scenario, our team has already begun to do work on the theme of inflation protection. Inflation expectations remain stable 5Y5Y forward breakeven inflation 4% 3% 2% 1% 2009 2010 2011 2012 Source: Bloomberg. Data as of November 2012. U.S. inflation is not yet troubling U.S. CPI YoY NSA 4% 3% 2% 1% 0% -1% -2% -3% 2009 2010 2011 2012 Source: Bloomberg, Bureau of Labor Statistics. Data as of November 2012. Now what? We invest with a 12-month outlook, but also take advantage of short-term trading opportunities. But to borrow a phrase from my daughter, patience is the key to joy. Into year-end, markets face higher uncertainty and weaker activity. We are going to see more headlines, unfortunately with less real news. In the short term, both issues will extract a higher risk premia from risk assets, which should create some interesting opportunities. For where we believe the macro cycle is right now, we want to be increasing our allocation to equities as we look into 2013. We continue to barbell those equity allocations between the United States, which continues to lead the global recovery, and emerging markets, where we see significant growth potential. While we have added to our exposure in Europe and continue to see scope for investment opportunity ahead, we don’t feel it’s a market that is gapping away from us. We are also doing tactical work in our hedge fund allocations. We are looking to be more directional in our risk taking next year, particularly looking at long/short and event- driven strategies. In fixed income, we continue to like credit, but need to be more selective. We are looking at total and absolute return fixed income strategies that can be more nimble in how they invest duration. We expect to hold less short-duration and cash next year across portfolios. AS a last mention, for anyone looking for a timely read, | just finished William Silber’s book about Paul Volcker. It is great context for how we got to where we are today and a reminder that while the past doesn’t ever exactly repeat itself, it does rhyme. It’s also a subtle reminder of why strong leadership and bipartisan counsel are essential for effectively navigating the road ahead. | very much look forward to our ongoing investment dialogue with you. Richard Madigan November 2012 HOUSE_OVERSIGHT_030842