U.S. OVERVIEW

ECONOMY

At the beginning of this year we made the following statement with regard to the domestic economy: “We expect 2012 to be very similar to 2011. The economy might be able to ride the recent momentum for another quarter, but lacking a resolution to some of these headwinds we suspect the middle quarters will be sluggish. The fourth quarter should see an improvement in growth and employment as the November elections bring renewed hope for the economy.” We’re pretty comfortable standing by that statement.

The headwinds remain the European sovereign debt crisis, a mid-year lull (for the third year in a row) for the domestic economy, and a complete lack of fiscal cooperation out of Washington. The European sovereign debt crisis remains a drag on the global economy. While some of the recent European Union agreements, if implemented quickly, should prevent any contagion from reaching our shores, the low-to-negative growth the continent is mired in has had an adverse effect on the domestic and emerging market economies. The domestic economy is being choked by the legislative impasse in Washington. Corporate balance sheets are in great shape, but they are hesitant to make investments in an uncertain political environment.

INFLATION

The Federal Reserve did not initiate another round of quantitative easing in the first half of the year as we anticipated, although it did announce a new round of Operation Twist. Energy prices have fallen 20% since the beginning of the year which should keep inflation in check for a while.

INTEREST RATES

Short-term interest rates will remain low for some time. The Federal Reserve has committed to keeping them low until at least mid-2013—we suspect it could be even longer than that. The Federal Reserve’s Operation Twist is designed to bring down longer term interest rates. Even though rates across the yield curve are at historic lows there is little to suggest they will be going up any time soon as inflation remains in check and growth remains sluggish.

DOMESTIC EQUITY MARKETS

If a weak dollar is good for domestic equities then a strengthening dollar is likely to have the opposite effect. While the European sovereign debt contagion may not pose a direct threat to domestic banks and corporations, slowing economic growth in Europe and Asia will definitely impact revenue growth for domestic companies. Overall, corporate earnings have remained strong and should limit the market’s downside risk, but we don’t anticipate the outsized earnings growth that we saw the past couple years. A major positive for the domestic equity market is the amount of money on the sidelines—any significant declines in valuations will likely be met with renewed buying interest.

DOMESTIC BOND MARKET

We expect interest rates to remain low for some time and if the Federal Reserve initiates another round of quantitative easing longer-term rates could even go lower—that’s a good environment for bonds. Unfortunately, bond yields are already very low and hard to get excited about. Non-traditional fixed income securities such as senior bank loans, convertible bonds and preferred stocks continue to provide the most attractive risk/reward characteristics. Corporate bond yield spreads relative to US Treasury debt remain attractive particularly when one considers the increasing supply of US Treasury debt relative to corporate debt. In our tax-exempt portfolios we continue to emphasize higher quality issuers as declining property values and tax bases are having an adverse effect on many state and local municipalities.

INTERNATIONAL OVERVIEW

ECONOMY

Europe is a mess and it appears the Continent may already be in a recession. Regardless, the economic slowdown in Europe has had a direct impact on economic growth rates for the emerging market economies. Longer-term we expect the emerging markets and the emerging middle class within those markets to drive global growth but the next 6-12 months could be challenging.

INFLATION

Given the Euro Zone’s austerity measures, we believe that deflation poses an even greater risk in the developed international markets than it does in the U.S. In the emerging markets, where the economic growth rates are higher, we would expect that growth to be accompanied by higher inflationary expectations.

INTEREST RATES

We expect the sovereign credit risk issue to remain an investor concern in the months (maybe years) ahead. As we speculated in our last several Global Outlooks, the bond vigilantes did in fact put upward pressure on bond yields in Italy, Portugal, Spain and even France. Until the European Union has a viable solution to this crisis we can expect to see continued upward pressure on longer-term rates, but we do expect that the austerity measures will eventually serve as an effective counterbalance to that pressure. Based on our outlook for higher inflation rates in the emerging markets, we would expect interest rates in those countries to trend higher. International bonds offer higher yields than comparably rated domestic debt but they are also fraught with greater risks, many of which are difficult to quantify.

CURRENCIES

The dollar remains the unquestioned global reserve currency. This is particularly evident in times of global turmoil such as we’ve witnessed with each round of the sovereign debt crisis in Europe. Until the crisis is resolved we would expect the dollar to strengthen and the Euro to decline. However, if the European Union does finally arrive at a viable solution we would expect the dollar to resume its long-term devaluation trend versus both developed and emerging markets. The U.S. has actively pursued an inflationary monetary stimulus policy whereas the rest of the developed world is pursuing deflationary austerity measures.

NATURAL RESOURCES

For the past two years, as the dollar goes, so go the prices of commodities—except in the opposite direction. Longer-term we believe limited supply and rising global demand will naturally drive prices higher, regardless of how the dollar performs.

GLOBAL EQUITY MARKETS

We would continue to underweight most developed international markets as the growth prospects in most of those economies remain stagnant. Emerging markets, which have underperformed domestic stocks for the past 18 months, are reaching historically attractive valuation levels; but, we wouldn’t be inclined to overweight those markets until we see greater stability out of Europe. Global Bond Markets While we remain concerned about the cascading sovereign credit risk crisis, we believe current yield levels offered by some of the non-Euro Zone issuers compensate investors for those risks. Longer term we believe foreign government bonds will outperform U.S. Treasury bonds due to their higher yields and less inflationary central bank policies.