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Seeking Growth and Income in an Uncertain World Third Quarter 2011 Richard O. Vandenberg, Jr. [email protected] Disclaimer 3Q11 Atlantic Trust Private Wealth Management includes Atlantic Trust Company, a division of Invesco National Trust Company (a limited-purpose national trust company), and Stein Roe Investment Counsel, Inc. (a registered investment adviser), both of which are wholly-owned subsidiaries of Atlantic Trust Group, Inc. This document is intended for educational purposes only and the material presented should not be construed as an offer or recommendation to buy or sell any security. Concepts expressed are current as of the date of this newsletter only and may change without notice. Such concepts are the opinions of our investment professionals, many of whom are Chartered Financial Analysts® (CFA®). The Chartered Financial Analysts® (CFA®) designation is globally recognized and attests to a charterholder’s success in a rigorous and comprehensive study program in the field of investment management and research analysis. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP® and CERTIFIED FINANCIAL PLANNER™ in the U.S. There is no guarantee that these views will come to pass. Past performance does not guarantee future comparable results. To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Atlantic Trust does not provide legal advice, and the information contained herein should only be used in consultation with your legal, accounting and tax advisers. To the extent that information contained herein is derived from third-party sources, although we believe the sources to be reliable, we cannot guarantee their accuracy. Investment Products Offered are Not FDIC-Insured, May Lose Value and are Not Bank Guaranteed. 2 For Public Use Economy 3Q11 Slow Growth gets Even Slower Consumers Struggling Real Disposable Personal Income (YoY % Change) Real Consumer Spending (YoY % Change) 10 8 6 4 2 0 -2 -4 Source: Bloomberg, LP, 5/31/11 3 For Public Use Inflation Pickup Mostly Due to Higher Energy Prices CPI Index (YoY % Change) CPI Ex Food and Energy (YoY % Change) 6 4 2 0 -2 -4 Source: Bloomberg, LP, 5/31/11 Politics and Policy 3Q11 Government Debt Remains a Big Problem Presidential Re-election and Unemployment Federal Debt Held by Public as % of GDP 195 Margin of Re-election Victory With Expected Policy Changes Enacted 145 WWII 95 45 -5 1790 Great Depression Civil War 1820 1850 WWI 1880 1910 1940 1970 2000 2030 25% '72 20% '84 ‘54 15% ‘96 10% Not Re-elected ‘04 5% 0% -5% ‘80 ‘92 -10% -15% -3 -2 -1 0 1 Change in Election Year Unemployment Rate Source: Congressional Budget Office’s Long-Term Budget Outlook, data after 6/30/11 is projected. 4 For Public Use Source: Strategas, 6/30/11 2 Bonds 3Q11 QE2 Postmortem QE2 Focus: Unemployment and Deflation Non-financial Debt Total Debt November 2010 May 2011 12 10 9.80% 9.20% 8 6 4 2 0.65% 1.51% 0 Unemployment Source: Bureau of Labor Statistics, 6/30/11 5 For Public Use Debt to GDP Ratio, Private and Public Sectors 400% 350% 300% 250% 200% 150% 100% 50% 0% Core CPI (YoY Change) Source: Bureau of Labor Statistics, 6/30/11 Bonds 3Q11 Mini Flight to Quality Investor Preference for Money in the Bank $ Billions Savings and Small-time Deposits Money Fund Assets 7000 6000 5000 4000 3000 2000 1000 0 Source: Bloomberg, LP, 6/30/11 6 For Public Use Corporate Bond Yield High-yield Bonds (%) Investment-grade Bonds (%) 10 9 8 7 6 5 4 3 2 1 0 Source: Bloomberg, LP, 6/30/11 Stock Market 3Q11 Despite Mini Correction, Equities Still in Positive Territory Index: 12/31/10 = 100 Global Equity Returns Equities Relatively Inexpensive S&P 500 Total Return MSCI Emerging Markets Total Return MSCI EAFE Total Return Long-term Historical Average (18.4) S&P 500 Historical Forward 30P/E 115 25 110 20 105 15 100 10 95 5 90 0 Source: Bloomberg, LP, 6/30/11 7 For Public Use Source: Thomson Financial, 6/30/11, Average from 6/30/96 to 6/30/11 Stock Market 3Q11 Large-Cap Equities Remain Attractive Corporate Profits Recovery Is Complete Long-term Historical Average ($65.20) S&P Earnings Estimates $120 $100 U.S. Companies: Rising Reliance on Overseas Revenues S&P 500 Foreign Sales % Total 49% 47% $80 $60 $40 $20 45% 43% 41% 2003 Source: Thomson Financial, 6/30/11. Historical estimates are the historical expected (consensus) earnings, It consists of a rolling four-quarter sum expressed as a monthly series. 8 For Public Use 2004 Source: Strategas, 12/31/09 2005 2006 2007 2008 2009 Non-U.S. Equities 3Q11 The Situation in Europe…Disparity Between Core and Periphery Default Risk Rising in Some Countries December 2010 July 11, 2011 2500 10-year Bond Yield Spread: Greece Versus Germany 16 (5-year Credit Default Swap Spreads) 14 2292 % Basis Points 12 2000 1500 1010 1000 608 8 1113 1001 10 6 501 500 350 338 240 295 Spain Italy 4 0 Greece Ireland Source: Bloomberg, LP, 7/11/11 9 For Public Use Portugal Source: Bloomberg, LP, 6/30/11 The Economic Challenge of Our Time DEBT 10 For Public Use 3Q11 An Economy on Borrowed Time… 3Q11 Credit Ratio: Debt vs. GDP Total Credit Market Debt (All Sectors) as a % of the Economy (GDP) Credit Market Debt as % of GDP Average (2005) 400 350 300 250 200 150 100 50 Source: Ned Davis Research, Inc., as of December 2010 11 For Public Use Dec-10 Dec-06 Dec-02 Dec-98 Dec-94 Dec-90 Dec-86 Dec-82 Dec-78 Dec-74 Dec-70 Dec-66 Dec-62 Dec-58 Dec-54 Dec-50 0 Debt Relocation Rather Than Debt Reduction Change in Debt: June 2007 – December 2010 Source: Federal Reserve as of December 2010 12 For Public Use 3Q11 The Cost of Waiting: The Fiscal Gap 3Q11 Unfunded Promises 125 99.4 100 $ Trillion 76.4 75 62.9 50 25 0 2009 Source: Government Accountability Office, as of March 2011 13 For Public Use 2010 2011 Cost of the Debt Binge: No Easy Way Out Massive Debt and the Cost of Fixing the Problem have Long-Term Implications for the U.S. Economy Slower economic growth Higher inflation and interest rates A weak and declining U.S. dollar 14 For Public Use U.S. Dollar: Reserve Currency in Reverse Real Broad Dollar Index Real Broad Weight Traded Dollar Average (96.8) 140 130 120 110 100 90 80 70 '73 Source: Strategas, May 2011 15 For Public Use '77 '81 '85 '89 '93 '97 '01 '05 '09 U.S. Equity Market: What, Me Worry? S&P 500 Index 1,600 August 2010 Bernanke hints at QE2 1,500 1,400 1,300 1,200 1,100 1,000 900 800 700 Source: Bloomberg, LP as of April 2011 16 For Public Use Apr-11 Feb-11 Dec-10 Oct-10 Aug-10 Jun-10 Apr-10 Feb-10 Dec-09 Oct-09 Aug-09 Jun-09 Apr-09 Feb-09 Dec-08 Oct-08 Aug-08 Jun-08 Apr-08 Feb-08 Dec-07 Oct-07 Aug-07 Jun-07 Apr-07 Feb-07 Dec-06 600 A Profit-Led Recovery Profit Margins Close to a Peak: Now What? 10 8 6 4 2 0 '94 '96 Source: Strategas, as of December 31, 2011 17 For Public Use '98 '00 '02 '04 '06 '08 '10 Investment Strategy in a Time of Unique Challenges “In a volatile world, opportunities will appear and disappear in short order. Flexibility has to be the watch word.” -Peter L. Bernstein 18 For Public Use New Challenges, New Opportunities Successful Asset Allocation Will Require: Casting a wider net Being nimble and opportunistic Embracing growth, avoiding debt 19 For Public Use Where’s the Growth? IMF Data Mapper: Real GDP Growth 2011 Annual percent change 10% or more 6% - 10% Source: Wolfe Trahan, as of April 2010 20 For Public Use 3% - 6% 0% - 3% Less than 0% No data Equity Growth Will Mirror GDP Growth Emerging Markets Equities May Represent 55% of Global Market Cap by 2030 Emerging Markets’ Share of the World GDP Market Cap MSCI World Weight 70% 60% 50% 40% 30% 20% 10% 0% 2010 Source: MSCI, Goldman Sachs Global ECS Research estimates as of December 2010 21 For Public Use 2020 2030 The Global Balance Sheet Favors Emerging Markets Public Debt as % of GDP: Developed vs. Developing Economies Developing Economies Developed Economies 120% 100% 80% 60% 40% 20% 0% '90 '92 '94 Source: Strategas, IMF Estimates Begin After 2008 22 For Public Use '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 Participating in the Emerging Markets… Direct Exposure EM Equities Leading Economic & Earnings Growth EM Debt Improving Fiscal Trends, Rising Foreign Exchange Reserves Indirect Exposure 23 Commodities Strong Demand & Infrastructure Spending U.S. Large Caps Rising Sales Exposure to EM Markets For Public Use Expected Returns Favor U.S. Quality & Emerging Markets GMO 7-Year Asset Class Return Forecasts Stocks Annual Real Return Over 7 Years 6% 4% 2% 0% -2% -4% U.S. U.S. Equities Equities (Large Cap) (Small Cap) +- 6.5 +- 7.0 U.S. High Quality +- 6.0 Int’l Equities (Large Cap) Int’l Equities (Small Cap) Equities (Emerging) +- 6.5 +- 7.0 +- 10.5 Estimated Range of 7-Year Annualized Returns Source: GMO, December 31,2010. *The chart represents real return forecasts 1 for several asset classes. These forecasts are forward-looking statements based upon the reasonable belief’s of GMO and are not a guarantee of future performance. Actual results may differ from the forecasts above. 1 Long-term inflation assumption: 2.5% per year. 24 For Public Use Government Bonds: High Uncertainty, Low Yields Used with permission from Clay Bennett 25 For Public Use Ultra-Low Bond Yields Stock Yields Exceed Bond Yields – not Since the 1950s Yield Comparison: Stocks vs. Bonds Yield Comparison: Bonds vs. Stocks US 10YR Yield DJIA Income Yield 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Source: Bloomberg, Estimates Begin After September 2010 26 For Public Use Risks of Kicking the Can Alternative Scenario Assumption Extension of most 2001 and 2003 tax cuts until 2020 AMT relief extended Growth in discretionary spending indexed to GDP Debt Held by the Public Baseline Alternative Ryan Proposal 150 % of GDP 130 110 90 70 50 30 10 -10 Source: Congressional Budget Office, 3/2011 27 For Public Use 2010 2022 2030 Inflation – No Price / Wage Spiral Inflation and Wages The “pass-through” from energy to income – 67% then, 27% now Excess capacity in labor and manufacturing Energy CPI Personal Income 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Feb. 1979 - Dec. 1981 Source: Bureau of Labor Statistics, Bureau of Economic Analysis as of March 2011 28 For Public Use Jun. 2007 - Feb. 2011 Yield Offers Little Cushion Impact of Higher Rates on the 10 Year Treasury – Then and Now February 1979 Current Yield 9.0% 3.5% Price Change Given 1% Yield Change -6.5% -8.4% 1 Year Holding Return 3.5% -4.9% Source: Bloomberg, Atlantic Trust, April 2011 29 For Public Use Municipal Markets Focused on State Budgets 46 States Faced Budget Shortfalls in 2010 30 For Public Use The Response Budget Balancing Strategies Employed by Number of States Fiscal 2010 Fiscal 2011 Revenue Enhancements 22 24 Job/Salary Cuts 31 30 Cuts to Local Aid 20 19 Rainy Day Fund 23 13 Constitutional requirement for balanced budgets in 49 of 50 states Source: National Conference of State Legislatures, November 2010 31 For Public Use 0% 32 Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming Pension Funding Plan Assets as a Percent of Liabilities 120% 101% 100% 81% 80% Source: Pew Center on the States, April 2011 For Public Use 51% 60% 40% 20% Bankruptcy as an Option Chapter 9 of the Bankruptcy Code – Differences with Chapter 11 No states allowed – Arkansas pre-dates current municipal bankruptcy law Watch the locals – Funding trickles down – High reliance on property taxes – Vallejo, CA – Jefferson County, AL – Harrisburg, PA – Hamtramck, MI – Central Falls, RI – Chowchilla, CA Source: Atlantic Trust, January 2011 33 For Public Use Defaults: The Historical Record The 5 year average cumulative default rate for rated municipal issuers from 1970 – 2009: AAA AAA A Baa Speculative Grade 54 rated municipal issuers defaulted between 1970 and 2009. 42 were in either the Housing or Health Care sectors. Source: Moody’s, as of February 2010 34 0.00% 0.01% 0.04% 0.08% 3.43% For Public Use Municipal Market Summary Significant Challenges and Real Risks - Credit analysis is crucial States have the wherewithal to meet near term imbalances - Revenues coming in ahead of expectations - Expense cuts, while difficult, are likely Diversify income sources - Safety is at a premium - Income is available from a variety of sources with varying risks 35 For Public Use Diversified Income With Bond Market Uncertainty High, A Diversified Approach to Income Generation is Advised… 36 Sector Objective High Quality Core Fixed Income Protection in a deflationary environment, liquidity Senior Bank Loans Income, floating rate coupons, credit improvement Emerging Market Debt Income, currency diversification, credit improvement Higher Yielding Equity Strategies Growth & Income Mix; Dividend Growth For Public Use Higher Yielding Sectors 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% US 3m T-Bill AAA 5 Yr TaxEquiv Municipal Source: Bloomberg L.P.; Lipper and Alerian Indexes, April 30, 2011 37 For Public Use Equity Income Funds Senior Bank Loans MLP Emerging Market Debt