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November, 2010 Investment process: Global Macroeconomic / Fundamental Total firm assets: $4.6 Billion Fixed Income Markets Face QE2 and Midterm Elections John Chalker, Co-Founder & Managing Director Fixed income market participants attempted to position themselves for the mid term elections and the announcement of a second round of quantitative easing (QE2) by the Fed in early November. Domestic fixed income market sectors have posted volatile and uncorrelated returns since mid year as news events related to mortgage backed securities, the foreclosure process and QE2 negatively impacted each fixed income market sector. QE2 was viewed to have both positive and negative impacts on the fixed income market and these had to be integrated with the expected mid term election results and the soft economic data. Specifically, QE2 is viewed positively for all domestic sectors except longer maturity Treasuries. This reflects both the target area of expected Fed purchases and the fears of inflation brought about by QE2. Additionally, the Fed strategy should have a negative impact on the value of the US Dollar versus other key currencies, and this may bring about a negative impact from foreign purchasers of US Treasury securities. Our domestic strategy accounts performed very well in this confused environment due to a slightly long portfolio duration position, coupled with an underweight in the Treasury and MBS sectors. There have been no major changes to the portfolio since mid year, although extreme short and long maturity Treasury positions were swapped to the belly of the curve, resulting in slightly shorter portfolio duration. The underweight position in the Treasury sector and the overweight to the corporate sector continue to contribute positively to portfolio performance. performance Outlook and Strategy We continue to believe that the economic fundamentals are very sluggish and that high GDP growth rates, i.e., three percent or better, are not sustainable. Inflation appears well contained and the threat of deflation appears reduced d d due d to t the th expected t d impact i t from f QE2 We QE2. W expectt that th t another th round d off quantitative tit ti easing i by the Fed will be a positive for the fixed income markets. In our minds, the key question centers on what future action will be taken by the newly elected Congress, with a strong Republican and Tea Party majority, regarding the size of the federal budget deficit and federal debt. Political decisions on these issues, and tax policy, will no doubt have significant impact on the fixed income markets in the year ahead. Our scenario calls for a continued period of slow economic growth with no inflation. Therefore, we are employing a strategy that will maintain portfolio duration slightly beyond the benchmark index, as supported by our Trend Identification Score. 401 B Street, Suite 950 ♦ San Diego, CA 92101 ♦ 619.814.1401 ♦ www.lmcapital.com 1 of 4 November, 2010 Investment process: Global Macroeconomic / Fundamental Total firm assets: $4.6 Billion Emerging Markets Economic Commentary Luis Maizel, Co-Founder and Senior Managing Director The third quarter was positive for EMD as more money flowed into funds seeking higher returns in an environment of very low yields. The past 14 months have seen net additions to the category and have pushed prices to levels not seen in almost a decade. Eliminating issues from countries with non financial issues like Venezuela and Ecuador, the spread has narrowed to record levels and returns are now very similar to comparably-rated US corporations. Mexico issued a 100 year bond with a coupon of 6 1/8% and it was oversubscribed 2.3 to 1. In the aftermarket the paper traded at yields of 5.80%; unheard of for an emerging market for such a long maturity. Brazil, the darling of the emerging markets, had an election where a former guerrilla became president, but nothing can derail that train as it continues to soar. We are seeing more and more long local currency issues at rates below 10%, something we hadn’t seen in a long time. Even an increase in the taxes on foreign investment has not cooled the appetite for new Brazilian paper. Europe is still in a monetary and social crisis and although Ireland is not an emerging country, country its problems are impacting the paper of other countries in the region like most former socialist governments who are emerging economies. Issuance is way down and prices have started to drift downwards as investors don’t like uncertainty. China is trying y g to p put the brakes on its economyy and is limiting g foreign g investment in real estate, shortlyy after raising rates for the first time in 3 years. The one thing they refuse to do no matter how much pressure the US puts on them, is revalue the Yuan as it would somewhat curtail exports and make the creation of jobs more difficult; a social cost the Chinese government cannot afford. There is no doubt in my mind that the EMD will keep on growing as an asset class, but the low hanging fruit has been picked and a lot more work will be needed to get the positive results everybody expects from this investment. 401 B Street, Suite 950 ♦ San Diego, CA 92101 ♦ 619.814.1401 ♦ www.lmcapital.com 2 of 4 November, 2010 Investment process: Global Macroeconomic / Fundamental Total firm assets: $4.6 Billion Another Day, Another Dollar Todd Crescenzo, CFA, Vice President - Research During the third quarter of 2010 we increased our Non-Dollar exposure in LM Capital Group’s Core Plus strategy on the basis that the Federal Reserve would continue to maintain the size of its balance sheet even as its mortgage backed securities holdings rolled off. Halfway through the quarter it became increasingly apparent the US economy had further slowed and additional monetary easing was probably warranted via another round of asset purchases. What was unclear was how aggressive the Federal Reserve would be in purchasing Treasury bonds and what additional implications it would have for the US Dollar. Since quarter end, QE2 is a thing of the past and we now know the Federal Reserve will be buying an additional $600 billion in US Treasury securities through June 30, 2011 along with the ~$35 billion per month in mortgage backed securities roll off. Here are our observations: The Federal Reserve’s balance sheet will expand to something close to $3 trillion from its current $2 trillion level once QE2 is over and done with. Since QE1, QE1 the trade weighted dollar basket has weakened by almost 10% (see chart below). below) The Federal Reserve wants me, you and everyone else to short dollars or more precisely exchange those dollars for something else. If you don’t have dollars in your pocket or corporate coffer you can get even shorter US Dollars by borrowing (the essence of the carry trade, short dollars for future delivery). Of course in exchange for those dollars you exchanged (sold), the Federal Reserve wants you to go out and buy something (consumption). For corporate America, the Federal Reserve wants you to go out and invest in something g ((capital p expenditures). p ) 1.95 1.02 Monetary Base versus Trade Weighted Dollar (Index Levels, 3/11/2009 = 1) 1.80 Federal Reserve Balance Sheet, Lhs 1.00 Trade Weighted Dollar Index, Rhs 1.65 1.50 0.98 1.35 QE 2 Start & Projected Fed B/S Levels 1.20 1.05 0.90 0.96 QE 1 Start 0.94 0.75 0.92 0.60 0.90 0.45 QE 2 Start & Projected USD Depreciation 0.30 0.88 0.15 0.00 0.86 Mar‐09 Jun‐09 Sep‐09 Dec‐09 Mar‐10 Source: Federal Reserve & LM Capital Group LLC 401 B Street, Suite 950 ♦ San Diego, CA 92101 Jun‐10 ♦ Sep‐10 Dec‐10 619.814.1401 Mar‐11 ♦ Jun‐11 www.lmcapital.com 3 of 4 November, 2010 Investment process: Global Macroeconomic / Fundamental Total firm assets: $4.6 Billion Another Day, Another Dollar (cont’d) Investment Implications: • The Federal Reserve’s balance sheet is not the only indicator we look at when we move in to Non-Dollar denominated bonds, but given the Fed’s recent action coupled with the strong balance of payment situation of several countries around the globe, there continues to be a place for Non-Dollar exposure in our Core Plus portfolios. • During the next eight months with QE2 in play we expect the trade weighted dollar to depreciate by another 3% or so. As a result, we will look to opportunistically add to our Non-Dollar positions. We favor countries that meet the following three criteria: fundamentally sound balance of payments, attractive real yields and strong commodity based economies. • Generally speaking it is unclear how much QE2 will boost the US economy. We know the Federal Reserve’s intent – increase consumption and investment so that job creation occurs; however, consumers and corporations remain extremely risk averse as economic uncertainty weighs heavily on their minds so the follow through is unclear. What is clear is another day, another dollar – there will be more dollars floating around the globe looking for attractive return on investment. This commentary is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. 401 B Street, Suite 950 ♦ San Diego, CA 92101 ♦ 619.814.1401 ♦ www.lmcapital.com 4 of 4