Geopolitical and socioeconomic challenges remain at the forefront of daily headlines. These issues have taken a heavy toll on investor sentiment the past several years. While markets are usually driven by a mix of expectations and current conditions, we’ve never encountered such an influence of investor sentiment upon economic expectations. In today’s complex world, distinguishing coincidence from causality is becoming more challenging. Learn more at: www.nafcu.org/nifcu$

1. INVESTMENT HIGHLIGHTS June 2012
The World Turned Upside Down (1646)
To the Tune of, When the King Enjoys His Own Again.
“Listen to me and you shall hear, news hath not been this thousand year:
Since Herod, Caesar, and many more, you never heard the like before.
Holy-dayes are despis'd, new fashions are devis'd.
Old Christmas is kickt out of Town.
Yet let's be content, and the times lament, you see the world turn'd upside down”
THE WORLD TURNED UPSIDE DOWN Ireland offers hope for others as its economy is turning
the corner with positive growth in 2011, and is expected
Geopolitical and socioeconomic challenges remain at to continue through 2012, while yields have tightened
the forefront of daily headlines. These issues have taken -1.9% versus six months ago. Improving one’s fiscal
a heavy toll on investor sentiment the past several years. deficit, encourages foreign investment, reduces interest
While markets are usually driven by a mix of rate risk premiums, and restores business confidence.
expectations and current conditions, we’ve never
encountered such an influence of investor sentiment Unexpected political turnover during the last two years,
upon economic expectations. In today’s complex world, suggests voters are losing patience with failure. In a U.S.
distinguishing coincidence from causality is becoming presidential election year, that points to political gridlock.
more challenging. To attract attention, forecasters must In France, President Hollande is the first Socialist
provide uniquely compelling insights, have an president in nearly two decades, after narrowly defeating
exceptional reputation, or be very provocative. The a very unpopular Nicolas Sarkozy. We believe his plan
convergence of cheap access to information combined will do little to bolster 0% growth, while further
with sophisticated data mining tools and increased jeopardizing France’s credit rating. His election platform
computing power has increased reliance on empirically- called for increasing taxes on higher incomes, while
derived conclusions. These tools are very effective used stimulating growth with more government spending,
in the right way, but intuitive fundamental relationships despite France’s already high 5.2% fiscal deficit and
are now being contested more often by potentially debt/GDP of 89%. In contrast, Spain’s conservative
spurious correlations. The leveraging of empirical Popular Party, headed by Mariano Rajoy, overwhelmed
analysis can more easily and convincingly reinforce the ruling Socialist Party last November, as
misguided beliefs in this unprecedented age of contrived unemployment soared to 22%. We don't believe Spain is
reason, swayed by behavioral biases. This isn’t the first headed down the same path as Greece, given its much
time The World Turned Upside Down, and it won’t be the lower debt and policies of its new government. Spain's
last. Thus, we are hesitant to embrace the notion that problems begin with stabilizing real estate and end with
this time is different. bolstering bank capital ratios, as regulators raise the bar.
Greece is an extreme case, so drawing similarities to
Below, we discuss the European Sovereign Debt Crisis other countries should be done with forethought.
and the U.S. Fiscal Cliff, specifically, how both are likely
to impact our outlook in The World Turned Upside Down. European debt markets were calmed when Mario
Many countries within the Eurozone have tipped into Draghi, President of the European Central Bank (ECB),
recession again as the European Debt Crisis continues facilitated security purchases of over €1 trillion through
into its third year. Countries most at risk, including the Long Term Refinancing Operations (LTRO). This
Portugal, Italy, Ireland, Greece, and Spain (that spells program exceeds the Fed’s quantitative easing in QE-1
PIIGS), have witnessed the cost of debt financing soar & QE-2 combined. The Eurozone’s fiscal deficit is
again, with Italian bond yields over 5.7%, notably 4.4% expected to persist due to failing competitiveness and
greater than Germany. Spanish 10-year yields have adverse demographics, resulting from low birth rates that
widened +0.4% over the last six months to 6.6%, while continue to decline, and adverse immigration trends.
Italy has actually tightened -1.1%, suggesting improved European Monetary Union (EMU) members agreed in
confidence in Italy, but not Spain. Austerity measures the Maastricht Treaty to not exceed 60% debt/GDP and
have been effective in reducing projected fiscal deficits a fiscal deficit/GDP of less than 3%. These are assumed
by cutting government spending and raising tax rates. to be prudent levels of fiscal discipline. The Eurozone’s
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2. fiscal deficit averages 4.2% with debt/GDP of 89%, Most analysis of the Fiscal Cliff simply subtracts the total
which exceed the Treaty’s guidelines. Long gone is any aggregate impact, ranging from 0.5-3.5%, from current
hope of the Euro being an alternative reserve currency, real GDP forecasts. Such logic is flawed in many ways,
supplanting the U.S. dollar. Most Eurozone politicians one of which is the confusion between real and nominal
have proven themselves incapable of weaning off effects. Increased taxes and spending cuts are nominal
spending other people’s money, but a few countries set quantities, so the assumed impact on demand fails to
an example by embracing a balanced fiscal approach. account for any offsetting impact on inflation. We believe
transfer payments, such as unemployment insurance
Investor concerns are rightly focused on global growth and payroll tax reduction, have a stimulus multiplier of
and earnings potential, but several concerns continue to less than 1.0 (i.e., growth resulting from increased fiscal
haunt the global economy. Asynchronous Global spending). Most economists agree that the multiplier
Expansion, as a theme for 2012, has already begun to attributed to the American Recovery and Reinvestment
show signs of economic decoupling and reduced global Act of 2009 was much lower than 1.0, so why wouldn’t
contagion. Meanwhile, transitory concerns of 2011 have multipliers of “negative” stimulus be reduced too?
moderated, although some new concerns have Historically, permanent changes to tax policy have
emerged. Economic effects from the European Debt exhibited a higher multiplier than tax rebates and
Crisis have remained limited in other regions, so we still temporary stimulus. Some studies have calculated
favor U.S. and Emerging Market equities. It is hard to multipliers of less than 0.5.
anticipate when capital markets will discount the impact
of the Fiscal Cliff, although we believe it is still too early. The Budget Control Act imposed spending reductions of
A natural tendency is for investors to shorten their time $2.1 trillion over 10 years in exchange for raising
horizons with heightened volatility, although the best Treasury’s debt limit by $2.1 trillion, including $1.2 trillion
response may be to extend one’s time horizon and in across-the-board spending cuts over 10 years. This
rebalance faithfully in The World Turned Upside Down. It sequestration has been in everyone’s forecast since
has paid handsomely to be a contrarian investor, if one September 2011, so subtracting it again from current
can stay the course, particularly since 2009. forecasts is double counting. The total net fiscal impact
calculated by the CBO is just $65 billion (0.4% of GDP)
The Fiscal Cliff Of 2013 in 2013, not 10% of $1.2 trillion or $120 billion. Lower
program spending will force productivity gains in order to
The U.S. Congressional Budget Office (CBO) released a maintain most program objectives. Given dramatic
report in May 2012 summarizing the economic effects of private sector cost rationalization, government should
legislated policy changes under current law, taking effect have room to significantly improve productivity, limiting
in 2013. The combined impact has been referred to as the blunt force of sequestration. Spending cuts are back-
the Fiscal Cliff, and is expected to clip about $560 billion end loaded, and the CBO’s net impact accounts for
from the U.S. fiscal deficit in 2012 - 2013. Without any interest expense savings. Thus, simple subtraction of the
changes, the CBO expects U.S. real growth in GDP will sum of all these changes overstates the net impact.
average 0.5% in 2013. The fiscal deficit should narrow
from $1.3 trillion (8.6% of GDP) in FY2011 to $612 billion By law, both houses of Congress are required to submit
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(3.8% of GDP) in FY2013, representing meaningful and pass a budget resolution by April 15 , thus it should
improvement in our fiscal balance. The CBO estimates a be theoretically possible to pass tax reform or improve
2% reduction in GDP due to the Fiscal Cliff, although upon sequestration. Unfortunately, it has proven difficult
other estimates range as high as 3.5%. Obviously, the to pass legislation, so gridlock may continue throughout
issue is complex and contentious, based on many this election year. The House has passed a budget
assumptions. It is unclear how much of the Fiscal Cliff again this year, but the Senate has failed to pass its own
has already been discounted in forecasts, but we must budget resolution for the third year, and apparently has
close the gap between government spending exceeding no intention of doing so. This election year, it appears
25% of GDP versus the 20% of GDP limit in tax revenue the only hope is a “grand compromise” that slows
(Hauser’s Law) that has never been exceeded, spending, incorporates sequestration, and raises the
irrespective of tax rates, since the Sixteenth Amendment debt ceiling enough to deal with it after mid-2013.
introduced a permanent income tax in 1913.
Pressure is increasing on Congress and the President to
GDP headwinds from the Fiscal Cliff include expiring tax address the Fiscal Cliff. We are assuming capital gains
cuts on income, dividends, capital gains, estate and dividend tax rates will both increase to 20%,
transfers, and indexing of the alternative minimum tax. suggesting some relief on the dividend tax increase.
The payroll tax reduction and extended unemployment Reducing repatriation taxes on foreign earnings has
benefits (99 weeks) will expire at year-end. Health Care bipartisan support, but it is one of many negotiating
Reform will boost payroll taxes, even as Medicare doctor pawns. Overall, we are assuming a net impact of 1.5%
reimbursement rates decline. Our estimate of the reduction on U.S. GDP, which is embedded in our 2.5%
nominal impact is 1.5%, given our assumptions about growth rate for 2012-2013. We assume U.S. real growth
likely adjustments, and is embedded in our 2.5% real would otherwise have the potential of a 3.5-4.0%
growth forecast for 2012-2013. increase without these effects.
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3. Greece: Fait Accompli or Not? membership has risen from 70% to 80% in the last three
months. Following elections, we think that Greece
Greece is a country with 10 million residents producing should seek to exceed the Troika’s prescription:
€229 billion of GDP and €235 billion of sovereign debt implementing tax reform and privatizing additional assets
(haircut from €341 billion), but uncertainty about its to lower debt further and restore confidence in the future.
future has been the most significant reason for wiping
out nearly $4 trillion in global equity capitalization during We believe the likelihood of withdrawing from EMU does
May. Rising odds speculating that Greece will exit EMU increase substantially if Greece defaults, but there is no
has had an exaggerated effect on financial markets. Yet, benefit to exiting from EMU or defaulting. Greece could
the only way for Greece to legally exit EMU is through a default to force further debt restructuring, but the
referendum process. EMU membership is only for a consequences would be grim. Greece is a wealthy
sovereign country to decide. No one apparently country, and has agreed to privatize €87 billion (37% of
envisioned a country might withdraw during the decade debt) in the austerity deal. Why would a country not sell
long effort to form this monetary union. ECB President more assets if needed to avoid default? Default would
Mario Draghi has confirmed the “strong preference” for trigger higher interest rates in peripheral countries,
Greece to share a common currency with the rest of the whereas capital flight is already accelerating with bank
Eurozone, but costs to other countries continues to rise. deposits plunging in Greece and soaring in Germany. It
is in nobody’s interest to repeat Russia’s default in 1998.
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Greek elections on May 6 resulted in significant loss of
support for the ruling Socialist PASOK government. If Greece withdrew from EMU, experts suggest a
During Greece’s fifth year of recession, unemployment devaluation of 30-40% would restore competitiveness. A
rose to 21.7%. Voters endorsed the conservative New currency board would likely manage the transition,
Democracy party, led by Antonis Samaras, while a imposing capital controls for some period. Inflation would
significant protest minority embraced fringe parties that rise significantly under this scenario, and borrowers
opposed the Troika-imposed austerity. These voters would pay a high interest rate risk premium for years.
hoped alternative leadership might negotiate a better Greece’s experiment with Socialism has failed, as it has
deal for more time or increased debt forgiveness. in other countries. Excessive entitlements, diminished
Populist opposition to the Greek bailout is at odds with incentives, an ineffective tax system, political corruption,
support of EMU membership, so anti-austerity parties and inferior competitiveness has put Greece at a global
are also seen as Euro-skeptic, which is more unpopular. disadvantage, while mounting fiscal deficit spending has
compounded into an unsustainable liability. We believe a
Unable to form a government, new Greek elections were change in government is actually Greece’s best hope.
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scheduled for June 17 . Recent polls suggest Mr.
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Samaras is leading again, supporting the Troika Tax collection rates and compliance are abysmal, while
negotiated bailout agreement that kept Greece from tax avoidance schemes are expanding in countries with
bankruptcy in exchange for promised fiscal austerity. Mr. high fiscal deficits. Those avoiding taxes will continue to
Samaras graduated with a degree in economics from pay less than their fair share, no matter how high tax
Amherst College and an MBA from Harvard University, rates are hiked. How bad is Greek tax collection? The
and is well qualified to lead Greece through this period. Ministry of Finance reported in June 2011 that tax
arrears exceeded €41 billion, which would cover the €20
Greece’s inability to form a government and implement billion debt refunding in 2012 and the €17 billion fiscal
the Troika-imposed fiscal discipline has driven up bond deficit. Clearly, there are decipherable policy differences
yields over 29%, although below the previous peak of between countries that distinguish fiscal success or
36.6%. A caretaker government was appointed, but in failure, even at our state level. Membership in EMU has
the interim, uncertainty has had an impact. Bank allowed Greece to enjoy lower interest rates than were
deposits plunged 30% in three weeks, straining capital justified, while failing to meet the Maastricht guidelines.
ratios of impaired Greek banks. Large commercial banks Greece’s only way forward is to accept fiscal discipline
required an infusion of recapitalization funds. Sufficient and forfeit budget control to creditors and the Troika---a
liquidity is available from the Troika to reinforce or lesson the developed world would best learn soon.
nationalize the Greek banks, provided the Greeks don’t
pursue an irrational course, giving creditors reason to We expect the Euro to weaken toward 1.15 US$/€
withdraw financing. U.S. investors have already versus a trading range around 1.33. Germany stands to
withdrawn from funding Eurozone banks. benefit most as the Euro weakens, but growth in Greece,
Portugal, Spain, and Italy is impaired by rising capital
Greece can only legally withdraw from EMU membership costs. Eurobonds and political union of EMU are a long
by referendum, therefore Greek exit is unlikely in the way off, but that may be the final solution. Our attention
foreseeable future, and would require protracted efforts is still focused on the Eurozone, but we believe a more
to accomplish. We believe an exit would be disastrous difficult challenge lies ahead for Japan. A “Lost Decade”
for living standards in Greece, while setting a damaging may limit Europe’s growth, but Japan’s fiscal deficit has
precedent for EMU. Greek popularity of EMU pushed its debt over 230% of GDP. Japan’s credit rating
has been falling, and Fitch lowered their rating again in
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includes European Union, European Central Bank, and IMF May to A+, one notch below Moody’s (AA3) and S&P
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4. (AA-). Only 16% of Japan’s debt is foreign held, but we We believe any indirect effect from the European
recommend hedging Yen exposure and avoiding Sovereign Debt Crisis on the U.S economy should be
government bonds (JGBs), now the largest benchmark limited, since there are no signs of any liquidity strain
exposure in global bond indices. Owners of international outside the Eurozone. U.S. banks enjoy their strongest
bond funds should be attentive to their Japan exposure. capital position in over a decade, after efforts to raise
capital, increase earnings retention, limit dividends,
Conclusion constrain share repurchases, and divest riskier holdings,
despite strong cash flow. Increasing loan demand
We observe that many of the economic threats evident coupled with easing credit conditions, have caused
in 2011 have since moderated or been extinguished, commercial and industrial lending to accelerate to a high
except for the European Debt Crisis. Expanding fiscal of 15.8% annual growth since the Financial Crisis.
deficits across developed countries, including the United
States, Japan, and Europe pose long-term risks to the Never have such perplexing investor behaviors been
global economy. So far, economic effects have remained observed over such an extended period. Increased
limited to Europe. The other worrisome emerging threat uncertainty combined with market volatility can yield
is the Fiscal Cliff, which threatens to undermine U.S. exploitable market inefficiencies in The World Turned
economic growth. Estimates of its adverse impact could Upside Down. Investment discipline and unwavering
reduce growth by 0.5-3.5%, depending on the legislative faith to endure being uncomfortable and contrarian can
response. We expect an impact of 1.5% to limit real help investors seize upon profitable opportunities.
growth in GDP to 2.5% in 2013. Confidence in the ability Alternating between virtuous and malicious self-
to address tax reform and other issues is discouraging reinforcing cycles undermines investor confidence, but
and at a record low. According to Gallup’s most recent we suggest has little relevance to fundamental equity
poll, only 24% think our nation is on the right track. attractiveness, although risk tolerance may decline.
The World Turned Upside Down is an uncomfortable Contrarian investors can benefit most from an “upside
situation for investors. Ongoing concerns about the down” world when they stay focused on compelling
Eurozone’s stability are reflected in volatility of U.S. fundamental value that eventually attracts the empirical
equity and bond markets. Heightened risk aversion has “correctness” of greed. We don’t dismiss any of the
compressed compelling equity valuation multiples further many enumerated global threats, although we believe
and driven real Treasury yields negative across the yield they are overwhelmed by a rising number of improving
curve. The increased equity risk premium suggests global economic trends, strong earnings, compelling
intense geopolitical pessimism about the Eurozone Debt valuations, low interest rates, and an anticipated Era of
Crisis and global fiscal austerity, yet global economic Exceptional Productivity. Asynchronous Global
growth and earnings remain resilient and are showing Expansion is the new paradigm, as we’ve highlighted,
evidence of improving. Resilience in North America will that reinforces decoupling and reduces global contagion.
likely reverse recent sentiment yet again. We believe
relative asset valuations have diverged from equilibrium David Goerz, SVP - Chief Investment Officer
more than anytime since 2001, exposing opportunities. http://commentary.highmarkfunds.com
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