View from the Harbor

US Economic Outlook
March 2012

The US Economy: All Systems Go!

Portfolio: Based on our interpretation of the fundamental trends in the US economy, we have been assuming an aggressive risk profile which favors a healthy exposure to equities relative to bonds. At present, we think that relatively modest equity valuations are bounded to the downside by steady earnings growth, improving confidence, and easing credit standards. More broadly, the current negative real US rate regime should drive capital into higheryielding assets. Economy: Although the last six quarters have been a little bumpy, underlying momentum suggests that the US has regained its footing and is making meaningful progress in its recovery. We believe that the US economy is securely in the middle of the Early Upswing, and will likely remain in this phase through the first half of 2013. We are very optimistic on US prospects as the economy progresses through the business cycle. Housing: We are fairly confident that the worst is over for the US housing market and believe conditions for a recovery are decidedly favorable. The facts clearly reveal that the elements necessary for a sustainable recovery in housing are coming together. The balance of risks to housing in such an environment is firmly to the upside and few in the market are paying attention to what we believe to be a paradigm shift. Strong gains in confidence will support growth Index Value
120 100 80 60 40 20 Jan-06 Conf. Board Consumer Confidence UMich Sentiment

Jan-08

Jan-10

Jan-12

Source: Conference Board, Reuters/University of Michigan

Ratio

Sales price-to-rent near long term averages

25

Gravelle Pierre, CFA gpierre@iharborcap.com Chris Nicholson, CFA cnicholson@iharborcap.com Aditi Thapar, PhD econ@iharborcap.com Jacqueline Hayot jhayot@iharborcap.com Eva Yun

20

15 Asking Sales Price to Asking Rent Average since 1988 10 1988 1993 1998 2003 2008

Source: US Census Bureau, Our Calculations

www.iharborcap.com

The US Economy: All Systems Go!

In the last ten years, investors have been burned during the equity busts of 2001-2002 and 2008-2011 and have faced an environment favorable place. The converse is strictly not true. The US shows notable strength in innovation, connectedness to the global

of sagging confidence and loss of dollar

primacy. It is perhaps natural for the global investor to give pause at the idea of now charging into dollar assets. This back-tested attitude, however, misses a few key fundamentals of the US economy that are now coming into focus. First, the US economy is clearly the most balanced and growth-friendly large developed-market economy. notable allocation. Second, growth on in the US has trade little in At a reasonable valuation, this alone demands a

markets

via

the

English

language

and

immigration, and more favorable demographic trends than other developed markets. For an investor seeking long-term performance with a degree of prudence, we suggest a near-term orientation to China-neutral Asian markets, select value-based purchases elsewhere around the globe, and a US equities core. As we go deeper into US economic

fundamentals herein, the case for core US exposure will become clear.

dependence

international

Iron Harbor, March 2012

comparison to other developed markets. In a

weaker European and Chinese economic

scenario, it is still realistic for US growth to remain firm if the domestic economy is in a

the US economy is clearly the most balanced and growthfriendly, large, developed-market economy

Tracking the Global Business Cycle

Underlying the global economic system are the collective decisions by market participants to put capital at risk in search of return, or to hold progression appeared through to have the business cycle

stalled,

underlying

momentum suggests that the US has regained

back. The sum of these decisions, and the

supply and demand balance that results, normally produces a seven- to ten-year global business/investment cycle that can be

its footing and is again making meaningful

progress in its recovery.
Early Upswing
Increasing confidence Increasing household spending Inventory builds Falling unemployment rates Short-term rates increase Confidence is high Unemployment is low Inflation pick-up, wages accelerate Rapid economic growth Restrictive monetary policy

characterized in distinct phases which inform price movements in different asset classes. Where we are in the cycle. Our analytical framework is based on five distinct phases of the business cycle1:
Exhibit 1: Phases of the business cycle

Late Upswing

We believe that the US economy is securely in the middle of the Early Upswing, and will likely remain in this phase through the first half of 2013. While this phase can be thought of as a

Slowdown

Late Upswing

sweet spot because of low interest rates and

Recession Early Upswing Initial Recovery

excess production capacity i.e., activity can be robust without the threat of higher inflation growth typically continues on firm footing throughout the Late Upswing. several years. We are thus very optimistic on US prospects over the next

Although the last six quarters have been a little

bumpy,

and

at

times

the

economys

1. As set forth by John L. Maginn, et al., Managing Investment Portfolios

(New York: CFA Institute, 2007).

Moving Past the Credit Bust

The biggest known-unknown and the
Exhibit 2: Gas prices making an $ per gallon unwelcome comeback
4.50 4.00 3.50 3.00 2.50 2.00 1.50 AAA Reg. Gas/Gallon 1.00 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

primary risk to this outlook is the lingering impact of the credit bust which introduces

unique factors to consider. On the upside,

the easing of credit underwriting standards by banks, which we discuss below, is likely to provide a very meaningful boost to the economy. Conversely, banks exposure to commercial real estate loans is a source of ongoing downside risk. Beyond the impact of the credit cycle, there are other areas worthy of close attention. We are keeping a close eye on key input costs, which can undermine profits and confidence. Gas prices, in particular, are up 14% since the beginning of 2012 (Exhibit 2). The role of commodities as a store of value also bears consideration. Conservative investors facing inflation-adjusted negative

Source: AAA

Although no two business cycles are the same, the one outstanding difference between the present cycle and every other post-WWII cycle is the presence of an ongoing drag on final

yields

seem

to

be

rotating

from

debt

demand due to credit cycle deleveraging.

From 1995 to 2007, the combination of low concerns about financial distress, optimistic future income expectations, and financial deregulation, prompted US households to leverage their balance sheets by assuming increasing levels of debt. According to the Federal Reserve, during that period the financial obligations ratio rose from nearly 17% to almost 19% per cent of disposable personal

instruments to commodities. This could be a factor driving inflation and in turn, pressing the need for higher rates as the economy progresses through the Early Upswing phase.

the easing of credit underwriting standards by banksis likely to provide a very meaningful boost to the economy

income.

Since 2007 we have seen the

What many market participants have not yet considered is the credit-cycle recovery and its impact on how quickly the US economy moves
Exhibit 4: Households interest payments are also at decade lows
3%

reverse: households have cut back on credit and de-levered as financial distress concerns increased and pessimism regarding future income expectations increased. Over the

course of the recession and recovery, the

financial obligations ratio dropped to nearly 16% by 3Q2011the lowest level since 1993 (Exhibit 3/4). At the same time, banks both reduced the supply and increased the cost of lending. These factors amplified the severity of the Exhibit 3: Households make progress on balance sheets Percent
20 Financial Obligations as % Disp. Pers. Inc. 19

2%

Int. Pymnts % of Disp. Inc.

1% Jan-00

Jan-02

Jan-04

Jan-06

Jan-08

Jan-10

Jan-12

Source: BEA, Our Calculations

18

through the business cycle.

The key to a

sustainable recovery in credit is dependent

17

upon households perceptions of their debt

levels and expectations of future income as well as the health of the banking system. That the academic literature is somewhat divided on which factor plays the leading role in creditdriven household demand is almost irrelevant since both household debt levels and income and are the primary are improving. In the past four years,

16

15 Mar-80

Mar-85

Mar-90

Mar-95

Mar-00

Mar-05

Mar-10

Source: Federal Reserve

deleveraging

cycle

reasons

the

present

recovery-expansion
Of course,

households have made significant progress in reducing debt levels, and low interest rates

process has been so lethargic. everyone already knows this.

have reduced the cost of servicing household debt. At the same time, the housing market, employment growth, wage and salary earnings,

mortgage loans.

This spread suggests that

private financing channels are now healthier than at any point during the past five years.

and consumer confidence have each stabilized

and in some cases are showing modest improvement. In this context, we believe that the balance of risks is to the upside for each the US economy, US asset markets (except for Treasuries), and the US dollar in the near and medium term. The storm is dissipating.

the balance of risks is to the upside for each the US economy, US asset markets (except for Treasuries), and the US dollar in the near and medium term
We remain excited about the trend in

construction jobs growth which has now been positive for five consecutive months and is near its best year-on-year growth rate since October 2006! Residential construction job growth, in particular, is making remarkable progress and is one more reminder that that this sector of the economy has not been permanently impaired. This growth gives us more confidence that demand is again picking up and soon will be

Housing: On the Mend

We are fairly confident that the worst is over for the US housing market and we believe conditions for a recovery are decidedly favorable. Household formation has bottomed out and is again rising at the same time that

starts and permits have stabilized. The ratio of

median US sales-to-rent prices is back near the 20-year average and vacancy rates, while at historically high levels, are beginning to move lower. Foreclosure and delinquency data looks favorable, but there can be meaningful differences between states which are not reflected in the headline numbers. Another indicator that we have closely monitored is the rate spread between jumbo and conforming

more

fully

reflected

in

new

residential

construction figures. As we mentioned earlier, commercial real estate (CRE) will likely continue to be a source of broad uncertainty going forward. Anecdotal evidence suggests that banks are being somewhat more aggressive in writing down the carrying value of CRE assets. Moreover, delinquency rates have moved steadily lower

Figure 1. Housing: On the Mend

Household formation rebounding from multi-decade low could create stepwise change in housing activity
Percent
5% Total Households % YoY Avg % YoY since 1990 4% Avg % YoY 1965-1985 22 3% 20 18 2% 16 14 12 0% 1970 1975 1980 1985 1990 1995 2000 2005 2010 10 1988 1993 1998 2003 2008

at the same time that sales price to rents are near the 20-year average.
Ratio
26 24

Asking Sales Price to Asking Rent Average since 1988

1%

Source: Census Bureau

Source: Census Bureau

Construction jobs growth is making steady progress and suggests demand is again picking up.

Private financing channels are now healthier than at any point during the past five years.
Percent
3

10% 5% 0% -5% -10% -15% -20% Jan-01

NFP Construction % YoY SA (LHS)

Jumbo/Conforming Spread

Jan-03

Jan-05

Jan-07

Jan-09

Jan-11

0 Jan-00

Jan-03

Jan-06

Jan-09

Jan-12

Source: BLS

Source: Banxquote

for the past twelve months and vacancy rates have shown modest improvement though they remain near historically high levels. still remain.
Exhibit 5: Keep a close eye on CRE loans
Percent
10 CRE Delinq. Rate (LHS) US Office Vacancy Rate (RHS)

sustainable recovery in housing are coming together. The balance of risks to housing in such an environment is firmly to the upside and few in the market are paying attention to what we believe to be a paradigm shift.

This

recent data has been encouraging, but risks

Percent
18 16

the facts clearly reveal that the elements necessary for a sustainable recovery in housing are coming together
In the context of the ongoing recovery, we are

14 6 12 4 10 2 8 6 Mar-12

devoting some time to developing a better understanding of what will be the new equilibrium in housing. From 1970-2000, US residential fixed investment benefited from relatively high household formation led by the baby-boomers. By 2000, the boomer effect on household formation and home purchases was winding down and the data is quite startling. From 1970-2000, household formation was

0 Mar-00

Mar-04

Mar-08

Source: Federal Reserve, CB Richard Ellis

Finally, we are cautiously optimistic that there

will be a policy-driven boost to the recovery as policymakers have communicated a renewed interest in providing assistance to underwater homeowners through loan modification and principal reduction. There is, perhaps, ongoing risk for home prices in the near term as illustrated by the December S&P/Case-Shiller data. Beyond the near term, however, the facts clearly reveal that the elements necessary for a

increasing 1.7% a year (Exhibit 6).

Since

2000, household formation has been running at 1.1%; approximately two-thirds the growth rate of the earlier period!
Exhibit 6: Household growth slowing
1947 Present 1947 1970 19712000 2000 Present

Household Growth YoY

1.75%

2.13%

1.69%

1.12%

Source: US Census Bureau, Our Calculations

Although the dramatic decline in household formation had been fundamentally changing housings role in the US economy, the collapse certainly accelerated this change. Again looking at the period 1970-2000, residential

beyond the oft-cited non-farm payrolls and weekly unemployment claims. First, state and local government payrolls are declining at much slower rates and are much less of a drag on headline numbers. convincingly. Second, both weekly

fixed investment and the large array of housing

hours and real wage growth are advancing

Third, job openings and temp payrolls are showing steady progress. To be sure, there are a few data series that require careful attention such as the number of parttime workers for economic reasons and jobs hard to get; neither of which have shown really meaningful progress. Over the next several months, it is possible that the recent trend in payroll expansion may slow a bit, but the overall pick-up in the labor market is a deep enough story to make us fairly confident regarding the likely trend over the upcoming quarters. The primary beneficiaries of the labor market pick-up will be personal income and

A resulting stepwise change in housing activity could quickly create a virtuous cycle ofconsumer spending, business optimism and investmentand wage growth.
services comprised, on average, 18.4% of real GDP. Since the housing bust, that contribution has been 15%; housing is unlikely to be as powerful a force in our economy as it had been previously. Nevertheless, we expect a meaningful uptick in household formation as the economy progresses through the business

cycle. A resulting stepwise change in housing

activity could quickly create a virtuous cycle of wealth-effect induced consumer spending, business optimism and investment, asset price increases, and wage growth.

confidence.

What the Numbers Reveal

Payrolls Steadily Coming Back. The latest US employment numbers are solid, even

the overall pick-up in the labor market is a deep-enough story to make us fairly confident regarding the likely trend over the upcoming quarters

Figure 2. Payrolls Advance Convincingly

Growth in aggregate hours underlines US payroll trends
Percent
4% 2% 0% -2% 96 -4% -6% -8% -10% Jan-08 94 92 90 Jan-12 -4% -2%
Index Total Aggregate Hours (RHS)

and the government sector is much less of a drag in recent data.

Ratio
4%
NFP Total Government % YoY SA Total Payrolls % YoY

Index Value
Index Total Aggregate Hours % Chng YoY (LHS)

102 100 98

2%

0%

Jan-09

Jan-10

Jan-11

-6% Jan-01

Jan-03

Jan-05

Jan-07

Jan-09

Jan-11

Source: BLS

Source: BLS

Temp help payrolls trending lower at same time payroll expansion continues means that
Percent
4% 30% 20% 10% 0% 0% -2% -10% -4% Payrolls % YoY Temporary Hires % YoY Jan-03 Jan-05 Jan-07 -20% -30% Jan-09 Jan-11 3000 4000

companies are hiring. This is for real!

Percent
5000 40%

2%

20%

0%

-20%

-40%
Job Openings (LHS) Job Openings % YoY Chng (RHS)

-6% Jan-01

2000 Jan-02

Jan-04

Jan-06

Jan-08

Jan-10

-60% Jan-12

Source: BLS

Source: BLS

10

Understanding income trends. A data series we closely track is personal income published by the Bureau of Economic Analysis. In order to have a better understanding of the consumer-centric US economy, it is important to first understand what is going on with
6% 4%

Exhibit 8: but wage growth will soon kick-in.

Real Wage Growth YoY (LHS) Avg Weekly Hours (RHS)

34.7

34.5 2% 0% -2% -4% 33.9 -6% -8% Jan-08 33.7 Jan-09 Jan-10 Jan-11 Jan-12 34.3

income because it drives confidence and

consumption. As we have noted previously, real disposable personal income growth has been collapsing: year-on-year growth was negative for most of 2H2011. There is no way around that data point; it is bad from every angle. Yet, there is something going on with personal income that portends good things for consumption. A deeper dive into the BEA data reveals that the main contributor to the collapse in disposable personal income has been shrinking government transfers to individuals.
Exhibit 7: Government gravy train is drying up
16%

34.1

Source: BEA, BLS

Everyone knows that the government gravy

train is drying up. What most observers have not considered is that the main reason disposable personal income has been recently negative is because government transfers to individuals have declined faster than wage and salary growth has increased. The good news is that wage and salary growth has solid momentum and is increasing at its fastest pace since last April. If job growth broadens as we expect, disposable income should also begin again to move higher. So, it is not enough to simply look at disposable personal income and note that it has been negative; the real story is that wages and salaries have been rapidly

12%

8%

4%

0% Gov't Transfers % YoY (LHS) Jan-09 Jan-10 Jan-11 Jan-12

expanding and that jobs growth is the key to

the ignition. Households are already communicating this sentiment.

-4% Jan-08

Source: BEA, Our Calculations

11

Confidence: 10% hard work and 90% delusion. US households are more confident now than they have been at any point over the past twelve months. Prior to the recent pick-up in jobs numbers, wage and salary growth, and

As one would expect during the Early Upswing stage of the cycle, confidence is steadily increasing and consumers are borrowing and spending more. of Data from and both the Reuters/University Michigan

the stunning rally in US equities over the past

three months, we believed that there was a risk of a false bottom and households were deluding themselves. We now believe that the improvement in confidence has legs and is communicating a significant turn in household sentiment that could ignite the virtuous cycle of greater demand jobs growth wage expansion greater demand.
Exhibit 9: Households are feeling good
Index Value
120 Conf. Board Consumer Confidence UMich Sentiment 100

Conference Board confirms the general trend

in confidence. Moreover, both surveys show expectations to be improving relative to present conditions. While we appreciate the fickle nature of households and consumers, they are better positioned now than at any point in the last four years to unleash a torrent of pent-up demand into the US economy. Better sentiment combined with a continued expansion in consumer lending by US commercial banks could be the catalyst for a powerful and enduring expansion. Very few market observers are considering the inflationary consequences of such an expansion.

80

60

[households] are better positioned now than at any point in the last four years to unleash a torrent of pent-up demand into the US economy

40

20 Jan-06

Jan-08

Jan-10

Jan-12

Source: Conference Board, Reuters/University of Michigan

12

Inflation Concerns. Inflation expectations as measured by both the Cleveland Fed and the University of Michigan remain at multi-year lows and are little changed since 4Q2011. Nonetheless, there is trouble in the form of core CPI brewing in this economy which expectations do not yet capture. Core CPI has been trending higher for the past 15 months and is now at 2.3%. The rise in core inflation should make it increasingly difficult for the FOMC to justify its current interest rate outlook given its 2.0% inflation target. Of course, it is always possible that the recent trend in core either reverses or moderates over the next

several months. This, however, is an unlikely scenario because the largest component of core inflation is owners equivalent rent, the rent paid to oneself as an owner-occupant. It has also been steadily rising and is now at seventeen-month highs. The law of supply and demand will eventually drive lower rental prices and owners expectations of for what their home would rent as additional rental capacity comes on line. New construction, however, takes time. This makes it extremely unlikely that core inflation will magically start to moderate within the next few quarters.

Exhibit 10: Expectations do not capture the risk of inflation

3% Cleveland Fed 5yr Expex Cleveland Fed 10yr Expex 4% 3% 2% 1% 0% 5%

Exhibit 11: Core is unlikely to quickly moderate

Core CPI Owners Equivalent Rent % YoY NSA

2%

1% Jan-06

Jan-08

Jan-10

Jan-12

-1% Jan-06

Jan-08

Jan-10

Jan-12

Source: Federal Reserve Bank of Cleveland

Source: BLS

13

Exhibit 12: Activity indicators illustrate broad momentum Index Value

1 0 -1

Exhibit 13: which is captured in capacity data.

Index Value
85

Percent
4

80 3 75

-2 70 -3

1 -4
Chicago Fed NAI 3mma

65
Cap. Util. Qtrly SA (LHS) Avg. Cap. Util. (LHS) Core CPI (RHS)

-5 Jan-00

Jan-03

Jan-06

Jan-09

Jan-12

60 Mar-00

Mar-03

Mar-06

Mar-09

0 Mar-12

Source: Federal Reserve Bank of Chicago

Source: Federal Reserve, BLS

Beyond the immediate signs of actual inflation, and perhaps more important, is the fact that conditions substantial exist for return. inflation to make First, a manufacturing

future and current economic activity and inflation, suggests that US growth is again modestly above trend. The CFNAI threemonth moving average is at its best level in twelve months. Finally, we are keeping tabs on the relationship between M2 and the velocity of money in the US economy; we believe this will likely be the single most important factor in forecasting the speed at which the US economy progresses through the business cycle.

capacity (78.6) is now at 96% of its 2007 levels and again very close to its forty-year average of 80.4. There is much less slack in this economy in 2012 and any unanticipated increase in demand from improved consumer confidence, jobs growth, and income growth could ignite price pressures. Chicago Fed National Second, the Indicator Activity

(CFNAI), which provides a useful gauge on

14

M2 Supply is Only Half the Story

Most market observers are aware that M2 has been expanding at its fastest pace in more than twenty five years, courtesy of the tight; the banks were damming up the supply of M2 and preventing it from entering into the US economy. The velocity of money in the

Fed. The exponential growth in M2 is believed

by many to have the potential to drive inflation beyond the control of the Fed. What this logic has so far failed to capture is the M2 growth is only half of the economy. story.1 The other critical factor to consider is the velocity of money through the Two tangible determinants of velocity are bank credit standards and loan growth. To use an example, credit standards and loan growth act as a dam that regulates the huge reservoir of M2. Over the past several years, the Fed has injected a massive supply of money into the US economy, but US bank lending standards have been exceedingly

economy depends upon the speed with which,

and the degree to which, banks ease credit standardssimilar to a dam gate release. There is a huge reservoir of money supply waiting to be released and banks willingness to lend will determine how fast that supply hits the economy. Bank Standards Easing. We monitor the Senior Loan Officer Survey as a means of gauging credit availability and demand. Of particular interest to us are credit standards and demand for mortgage loans and consumer loans. The trends in credit standards and demand for mortgage loans, as one would

[the] exponential growth in M2is only half the story. The other critical factor to consider is the velocity of money through the economy.

expect, have been steadily improving.

The

percentage of banks indicating easing as opposed to tightening standards for prime loans is more favorable than any time in the past two years.

1.

In fact, the Conference Board recently replaced M2 as a leading indicator noting the difference between the observed relationship between real M2 and general economic conditions. Banks reluctance to lend is one of the reasons that Treasuries outperformed equities in 2011. Banks parked QE1 & QE2 related money supply back into bonds instead of increasing lending.

2.

15

Figure 3. Money Supply and Bank Balance Sheets

The increase in money supply following QE1 and QE2 was previously held on US Bank balance sheets
Treasuries & Cash as % Total Assets (LHS) M2 % YoY (RHS)

and is now being released in the form of consumer loans.

30%

30%

12%

C&I Loans % YoY Consumer Loans % YoY (adj.)

20% 25% 9% 10% 20% 6% 0% 15% 3%

-10%

10% Jan-01

0% Jan-03 Jan-05 Jan-07 Jan-09 Jan-11

-20% Jan-06

Jan-08

Jan-10

Jan-12

Source: Federal Reserve

Source: Federal Reserve, Our Calculations1

as lending standards begin to ease.

Credit standards for approving applications from individuals for prime mortgage loans PRIME Tightened considerably Tightened somewhat Unchanged Eased somewhat Eased considerably Jan-10 1.9 15.1 79.2 3.8 0.0 Apr-10 1.9 9.4 79.2 9.4 0.0 Jul-10 0.0 3.6 87.3 9.1 0.0 Oct-10 0.0 13.0 83.3 3.7 0.0 Jan-11 0.0 3.7 94.4 1.9 0.0 Apr-11 0.0 3.8 92.5 3.8 0.0 Jul-11 0.0 5.7 86.8 7.5 0.0 Oct-11 0.0 4.2 91.7 4.2 0.0 Jan-12 0.0 0.0 94.3 5.7 0.0

Eased - Tightened

-11.3

0.0

5.5

-9.3

-1.8

0.0

1.8

0.0

5.7

Source: Federal Reserve, Our Calculations

1. In 1Q2010, FASB Rules 166 & 167 changed how banks treated off-balance sheet special purpose vehicles (SPVs). In March, 2010, banks began to bring these SPVs back on to balance sheets and consumer loans recognized as assets on balance sheets ballooned. Our adjustment for this increase affects year-on-year growth from March 2010 March 2011.

16

On the consumer lending side, the surveys indicate softer demand among somewhat easier standards. The takeaway is that banks are loosening lending standards. If US activity continues to gain momentum, as we expect, a gate release of M2 by the banks could send the US economy quickly into overdrive and force the Fed to increase policy rates well before the end of 2014.

higher-yielding assets.

Thus, while absolute

valuations are reasonable, relative valuations compared to bonds are even more reasonable. As we have seen over the last few months, investors have been well-compensated for going into cheap US equities in advance of clearer positive economic data. Nonetheless, the US equities trade has now been de-risked, and while valuations are a bit less compelling on an absolute basis, they are highly

Conclusion and Valuation Note

Based on our interpretation of the fundamental trends in the US economy, we have been assuming an aggressive risk profile which favors a healthy exposure to US equities relative to bonds. In upcoming weeks, we will more fully discuss the factors driving these allocation decisions. While our investment process is firmly rooted in fundamental analysis, we do pay attention to valuations. At present, we think that relatively modest equity valuations are bounded to the downside by steady earnings growth, improving household and business confidence, and easing credit standards. More broadly, the

compelling versus interest-rate instruments. In

addition, risk hedging instruments like VIX

futures and put options are now priced for low volatility, which creates a unique opportunity to

we believe skepticism on the US economy and equities are unwarranted, and we recommend fairly aggressive positioning on this theme
construct long-term return portfolios with

dampened downside volatility profiles. For all of the reasons stated above, we believe skepticism about the US economy and equities are unwarranted, and we recommend fairly aggressive positioning on this theme even in

current negative real US rate regime should

drive capital into

fairly conservative portfolios.

17

Iron Harbor Forecasts

2011 Q3 Real GDP Core Inflation Federal Funds Rate Unemployment 1.8 2.5 Q4 2.8 1.9 Q1* 3.0 2.3 2012 Q2* 2.9 2.3 Q3* 2.9 2.4 Q4* 2.7 2.4

0.1
9.1

0.1
8.7

0.1
8.4

0.1
8.3

0.1
8.2

0.2
7.9

Note: * represents forecasted values.

Gravelle Pierre, CFA is the Founder and Chief Portfolio Manager of Iron Harbor. gpierre@iharborcap.com

Chris Nicholson, CFA is the Senior Portfolio Strategist of Iron Harbor cnicholson@iharborcap.com

Aditi Thapar, PhD is a Clinical Assistant Professor of Economics at New York University. Her research focus is on Macroeconomics, Monetary Economics and Applied Econometrics. Her most recent research paper, Using Private Forecasts to Estimate the Effects of Monetary Policy, was published in the Journal of Monetary Economics, 2008. She serves as Head of Global Economics of Iron Harbor. economics@iharborcap.com Jacqueline Hayot is the Chief Operating Officer of Iron Harbor. jhayot@iharborcap.com

18