While geopolitical and other challenging headlines have continued to capture our attention, many of the significant economic threats enumerated in 2011, have since moderated or been extinguished. Meanwhile, just under the surface, HighMark’s five drivers of potentially exceptional growth are contributing more to economic activity than lackluster U.S. GDP growth suggests, illustrating that many Little Things Add Up over time. For more info: www.nafcu.org/nifcus

1. QUARTERLY INVESTMENT OUTLOOK SECOND QUARTER 2012
LITTLE THINGS ADD UP below their new target of 2.5%. While 8.2%
unemployment is uncomfortable, capacity utilization has
While geopolitical and other challenging headlines have risen from a 2009 low of 66.8% to 77.8%, nearing an
continued to capture our attention, many of the average of 80.4%. Little Things Add Up, eventually
significant economic threats enumerated in 2011, have reaching a tipping point.
since moderated or been extinguished. Meanwhile, just
under the surface, HighMark’s five drivers of potentially Global risks posed by the lingering European Sovereign
exceptional growth are contributing more to economic Debt Crisis remain significant, but economic effects
activity than lackluster U.S. GDP growth suggests, beyond Europe have remained limited. Other issues
illustrating that many Little Things Add Up over time. emerging in 2012 are concerning, even as many 2011
threats have moderated or been extinguished. A
While stronger measures of economic growth and a worrisome threat is the U.S. Fiscal Cliff, which could
14.8% S&P 500 earnings growth are consistent with undermine economic growth by as much as 2.0-3.5%, if
each other, they are inconsistent with 2011 U.S. real no legislative action is taken. Confidence in government
GDP of 1.7%. Consider why growth in industrial remains an issue as long as the nation believes the
production (3.6%), retail sales (6.0%), business sales country’s leadership is on the wrong track, as Gallup
(9.0%), exports (9.0%) and fixed investment (9.1%), recently revealed that a record low 24% of Americans
during 2011, netted against inflation of 3.0%, exceeds think the nation is on the right track. We are concerned
real GDP growth. Even improving unemployment has about consequences of ignoring increasing inflationary
fallen from over 10% to 8.2% since 2009. The translation forces (Q1/2012 theme), given excess global monetary
of economic growth into stronger earnings suggests liquidity, and which will be difficult to address quickly if
something isn’t being measured quite right, and we global confidence improves. Any necessity to hike U.S.
suspect it is GDP, although composition differences of interest rates earlier than anticipated would surprise
the S&P 500 and U.S. economy are noteworthy. many fixed income investors. Only some unforeseen and
significant exogenous shocks have the potential to derail
Economic measures above should correlate better to accelerating U.S. growth and inflation again.
U.S. GDP, but they actually greatly exceed it. Future
revisions may correct this anomaly, but we believe the Investment Review
source of this inconsistency lies in part in measuring
changes in inventory and net exports (trade). The A remarkable rally in global equities, over the last two
Federal Reserve must eventually normalize monetary quarters, was led by the United States, including a
policy as economic conditions trend toward equilibrium, firming U.S. dollar. Increasing investor risk tolerance has
including raising interest rates. Slowing growth and benefited from moderating threats, still compelling equity
inflation are more likely due to the lagged effects of the valuations, low interest rates, and positive economic
3Q/2011 slowdown, not endogenous weakness or a surprises. Emerging market equities (14%) continued to
precursor to another recession, as signs of outperform developed international equities, (MSCI
reacceleration are evident. The Federal Reserve’s own EAFE: 11%). The S&P 500’s 12.6% rise in the first
forecasts suggest the U.S. will enjoy better than average quarter would represent a good year, but it was the best
potential real growth, accelerating from 2.5% in 2012 to first quarter return since 1998. Typical early cycle
3.6% in 2014. We assume that improving economic leaders with the strongest 2012 expected earnings
growth can yield stronger earnings than expected. growth led in Q1/2012, including Financials (earnings
growth of: 22%), Technology (12%), Consumer
Inflation was accelerated faster than expected in 2011, Discretionary (12%), and Industrials (10%). Meanwhile,
approaching 4%. Although inflation has moderated to defensive high yielding sectors with slow or negative
just above 2.5%, it should begin tracking higher again, growth expectations and high relative price/earnings
we believe. Negative real yields (ref: interest rate – ratios were due for a correction, like Utilities (-1.6%) and
inflation) are likely to persist until the Federal Reserve Telecommunications (2%). Investors are chasing
hikes interest rates. The Federal Reserve maintains that dividend yields taxed at 15% versus income taxed at the
low interest rates are appropriate as long as inflation highest marginal rate (up to 35%), but they are also
remains contained by slack in unemployment and increasingly focused on earnings and fundamentals,
production capacity, but inflation is unlikely to retreat representing a change in leadership.
1

2. second time in 10 years by -10.6%. Diversification hopes
The stock market can rise and fall on fear or greed, to benefit most by negative correlation, yet the
anticipation or apprehension, confidence or confusion, correlation of commodities with equities is 18%, and with
as well as exuberance or panic. Lately, it seems that our bonds is -9%. The bullish case for real assets cites
emotional biases are more important in driving returns exceptionally low interest rates, rapidly expanding
than in driving earnings, economic growth, inflation, monetary base, ballooning budget deficits, political
interest rates, and valuations. The unexpectedly wide gridlock, and higher oil prices, which have remained over
divergence between stocks and bonds in the first quarter $100, well after the Arab Spring conflict. However,
left many investors surprised and confused, but global determining fair value is difficult with no cash flow, yield,
equity valuations remain compelling. or growth potential beyond the cost of marginal
production. The last time gold exceeded two times the
That Rear View Mirror Taking Its Toll CRB Index was in 1980, and it took 29 years before it
exceeded that peak again. Gold exceeded the CRB
Investors should expect investment leadership will Index by three times in September 2011, (turmoil over
change over the next 10 years after a very unusual global fiscal deficits and U.S. debt ceiling extension,)
previous decade. Firming economic conditions, including before it tumbled by -18.2% to $1574 by year-end. Gold
robust profit margins, suggest a trend toward a more is a volatile investment with a 21% standard deviation,
normal macroeconomic equilibrium, not a “new normal”. compared to 15.8% for stocks, 13.8% for commodities,
The transition from a Global Synchronized Recovery to and 5.8% for bonds. Historical commodity returns have
an Asynchronous Global Expansion (Q1/2012: Are The averaged 2.6% (1900-2011), which equates to inflation
Nightmares Behind Us?) is underway. We expect high of 3.1% less holding costs of approximately 0.5%.
return correlations to recede further and Eurozone
contagion risk to diminish, particularly for North America Changes in input costs can’t exceed changes in output
and Emerging Markets. We believe fundamental forces costs, thus commodity returns can’t exceed inflation over
should increasingly overwhelm emotional swings in the long-run. Supply-demand imbalances can persist for
investor confidence, while unique country and regional awhile, but eventually exceptional returns drive
differences, plus diverging monetary and fiscal policies, innovation and competition from reasonable substitutes,
will encourage further decoupling. resulting in oversupply at a lower price. Windfall profits
of producers can’t be sustained forever, but the financial
The approaching 10-year anniversary of the accounting crisis did forestall credit needed for investment. With
scandal that embroiled Enron, WorldCom and Arthur improving financing options, commodity and energy
Anderson in mid-2002, and led to Sarbanes-Oxley, as prices should eventually moderate as production
well as other financial regulation, will define the prior increases will rise to meet demand, and the marginal
decade low for equity indices. The technology bubble cost of production falls.
was nearly deflated by then. Relative differential asset
class returns are already improving dramatically, as Taking Stock
seen in the rear-view mirror. A coinciding reversal in
relative stock vs. bond valuations over the last decade A reversal to more normal asset allocation ranges would
has benefited from strong earnings growth and plunging cause one of the most significant rebalancing of assets.
bond yields. Annualized returns over the last decade Why might this happen now? Investors have tended to
show 10yr Treasury returns of 6.8%, exceeding S&P 500 reduce equity exposure after bonds outperformed stocks
total annualized return of 2.9% through the end of 2011. over the last decade, however relative valuations have
The S&P 500 rolling decade return increased to 4.1% by gone through a significant reversal. Any re-rating of
March 31st, and should exceed 7.6% by Q3/20112, if global equities would provide upside to stocks.
equity indices are flat or higher. This compares favorably Normalization of investor risk tolerance also would have
to both 10yr Treasury and commodity returns of 5.0%. a positive influence on global equities.
The perspective of improving performance over the last Investor risk aversion seems to have increased further,
decade will reflect a more normal equity risk premium despite a strong rally in equities and declining global
evident in 20-year, 30-year, and longer horizon historical equity market volatility. The cause is likely two significant
periods. Convergence toward a theoretically consistent and closely separated equity bear markets in 2001-2002
equity risk premium, over all key measurement periods, and 2008. We think that volatility will remain more
may be sufficient to alter financial planning inputs, and modest this year transitioning toward an Asynchronous
induce investors to increase equity holdings at the Global Expansion. This theme is bolstered by unique
expense of bonds, supported by relative valuations regional economic and policy differences increasing in
favoring equities. Over the next year, potential changes significance again. With diverging sovereign interests,
in investor confidence could be material, and compel including monetary and fiscal policies, the fading forces
investors to finally rebalance their asset allocation. that drove the Global Synchronized Recovery beginning
in 2009, are being supplanted by economic and financial
Gold prices rose 5.7% in the first quarter, while market decoupling. Contagion risk should moderate as
commodities tacked on 1.8%. Despite an 11.1% well. Our research shows that relative asset class
increase for gold in 2011, commodities fell for only the valuations are fundamental drivers of differences in
2

3. asset class returns, over an investment cycle. Our Equity allocations below suggest that many pension
tactical and strategic expected returns suggest that funds never fully rebalanced after the Financial Crisis of
equities will likely outperform bonds by a wide margin. 2008, given changes to their funded ratio and year-end
equity exposures. Many plans appear to have been
Dalbar 2011 results: Dalbar recently published its 18th letting their asset allocation drift, up to the most recent
annual Quantitative Analysis of Investor Behavior in equity allocation decline. Amidst record plan
March, measuring mutual fund cash flow effects of contributions and only an 80% average funded ratio,
individuals’ investment decisions on their holdings. Their plans have increased bond exposure.
objective is to measure the effects of decisions related to
asset allocation and specific fund selection. As noted in
past surveys, individual investors suffer most from a
variety of cognitive and emotional biases that drive
unfortunate investment timing decisions. Dalbar
observes: “Most of this loss in performance is due to
psychological factors that translate into poor timing of
their buys and sells (investor behavior).” Individual
investors failed to reap the benefit of rebalancing, a
discipline beneficial in volatile markets. The results
below highlight the cost of not having or sustaining a
consistent investment discipline. Investors should be
mindful of how intuition can be led astray by spurious Source: Milliman 2012 Pension Fund Study
correlations. Well-defined investment disciplines can
help individuals overcome many behavioral biases that Pension funds have reduced equity and increased bond
can lead to subpar investment performance. Dodging exposure at a valuation extreme that is unparalleled
informational shrapnel these days is particularly critical since 2001, but this time valuations favor equities over
to investment success. bonds. A 2% Treasury Yield is equivalent to a
Price/Earnings ratio of 50X, compared to forward
Disappointing investor performance in the 2011 survey earnings multiple of 13X for the S&P 500 today. We
was even worse than 2010, which Dalbar attributes to suspect increasing bond exposure was not limited to just
exceptional volatility in August 2011. Investor decisions pension funds, but extends to endowments, foundations,
to take losses in stocks had adverse consequences. and other investors. After a 30-year bull market in bonds,
Equity investors realized a disappointing -5.7% average 10-year Treasuries yields that peaked over 14.9% have
return versus a 2.1% return to the S&P 500 for a -7.8% plunged to a 50-year low of 2%. This shift is particularly
shortfall in 2011. A blended equity benchmark returned - troubling given negative real yields across the yield
1.1% (Ref: 65% S&P 500, 15% Russell 2000, 20% MSCI curve with inflation over 2.5%. Highmark’s strategic bond
EAFE), but still outperformed the average equity investor return forecasts suggest a difficult and more volatile
by 4.6%. The shortfall for the average fixed income decade ahead for fixed income investors, since recently
investor was even greater, realizing a -1.3% return updating our strategic expected returns. Over the next 5-
versus the Barclays Aggregate Bond Index return of 7 years, we expect annualized returns for bonds of less
7.8%. The Dalbar results over 20 years conclude that than 2%, with inflation exceeding 2.5%. Equities should
adverse market timing decisions resulted in the largest return over 8.5%. Thus, an unprecedented shift into a
share of the -4.3% annualized equity investor shortfall higher fixed income exposure could have severe
versus the 7.8% S&P 500 return, and -5.6% fixed repercussions for pension funding, but also holds the
income investor shortfall versus the 6.5% Barclays potential for a significant asset allocation swing back to a
Aggregate return. We are fortunate our clients have more normal strategic policy. Plans have never been so
managed to perform much better by rebalancing exposed to rising Treasury yields, and could realized
consistently to our tactical asset allocation targets. significant losses if bond yields moved toward the
average 6.8% yield.
The recent Milliman 2012 Pension Fund Study,
representing $1.3 trillion in assets, reported fixed income Although equities returned 88% and bonds returned 22%
holdings of 41% for the 100 largest plans exceeding over the last 3 years, the average plan’s 80% funding
equities (38%) for the first time ever. Five years ago, ratio hasn’t changed much. Plan contributions must
allocations of 60% equity and 29% bonds were more increase in underfunded plans, particularly those now
consistent with historical averages, so there could be a adopting lower expected returns, in order to hold higher
dramatic rebalancing (buying equities, selling bonds) if fixed income exposure. Low interest (or discount) rates
plans shifted toward a more conventional equilibrium also increased pension liabilities. The new money that
weighting, held up as the prudent pension allocation. has flowed into U.S. bonds over the last three years is
This study highlights concern about asymmetric risk just as likely to flow back into equities. This imbalance is
aversion behavior that is increasingly apparent. gaining national attention as states and municipalities
Alternative investments, including real estate, make up wrestle with soaring defined benefit pension costs.
the remaining allocation, trending toward 20%.
3

4. Plans pursuing liability-driven investment (LDI) strategies and increasing revenues. A record 81% of S&P 500
are increasing fixed income allocations at generational companies have exceeded Q1 earnings forecasts by a
low bond yields, even as funding ratios have fallen back remarkable 9% so far, although only 113 companies
to historic lows of 80% in 2002 and 2008. A LDI strategy have reported. Analysts have revised estimates lower
seeks to reduce annual accounting volatility of corporate since September 2011, but various economic and
liabilities from changes in interest rates and inflation, but geopolitical headwinds appear to have been overblown.
return expectations must also be reduced significantly.
Earnings 2014e 2013e 2012e 2011e 2010 2009 2008 2007
HighMark 7.1% 6.7% 7.2% 14.8% 40.3% -7.1% -23.1% -3.5%
Consensus 12.0% 12.6% 7.9% 14.8% 40.3% -7.1% -23.1% -3.5%
Cyclical Themes
HighMark $ 120.00 $ 112.00 $ 105.00 $ 97.92 $ 85.12 $ 60.80 $ 61.48 $ 85.12
Consensus $ 133.26 $ 118.96 $ 105.63 $ 97.92 $ 85.12 $ 60.80 $ 61.48 $ 85.12
The 2011 economic slowdown now appears to have Financi als 15.9% 15.2% 21.5% 5.2% 288.2% 106.9% -1 30.8% -2.1%
been a mid-cycle transitory pause, similar to 2010, rather Non-Financials 10.6% 12.1% 6.5% 15.7% 28.1% -18.6% 7.2% 3.2%
than a precursor to another recession. Monitoring
Source: HighMark Capital estimates and Thomson Datastream
HighMark’s five drivers of exceptional growth has helped
us better understand and explain the effect of key forces
S&P 500 earnings exceeded $97 in 2011, up 16% last
driving the economic cycle. Four of the five drivers
year and higher than the $93 forecast two years ago.
exceeded expectations in 2011, including growth of
This important milestone surpassed the previous $88
consumption, exports, investment and housing starts.
earnings record of 2006. Since Sarbanes-Oxley and
Only inventory re-stocking disappointed in 2011, but now
Regulation Fair Disclosure became effective in 2003-04,
inventories are even leaner because consumption
sell-side analysts have tended to revise estimates
exceeded expectations. We expect continuing growth in
higher, in a noteworthy departure prior to corporate
capital investment, consumption, and export growth in
accounting reforms, except during the Financial Crisis.
2012, with a pick-up in hiring and housing starts. Overall,
Robust earnings growth is expected through 2014.
construction activity rebounded dramatically from a
contraction of -15% in 2009 to a growth of 5.8% recently,
Shovel-Ready Housing
with both commercial and housing sectors contributing.
Re-stocking inventories and housing starts are most
likely to provide an upside surprise to U.S. growth. Housing starts are an important driver of construction,
but have languished since 2006. The recent rate of
Economic Forecasts 2008 2009 2010 2011e 2012e 2013e 2014e about 700,000 is less than half the average volume of
U.S. GDP (Y/Y Real)
Earnings Growth
-3.4
-23.1
-0.5
-7.1
3.2
43.4
1.7
14.8
2.5
7.2
2.5
6.7
2.8
7.1
1.5 million in the chart below, and just 57% of the
CPI Inflation (Y/Y) -0.0 2.8 1.4 3.0 2.3 2.5 2.8 average household formation rate of 1.2 million since
Unemployment 7.3 9.9 9.4 8.5 8.0 7.5 7.2
Fed Funds Target 0.25 0.25 0.25 0.25 0.25 1.00 2.00 1960. About 20% of housing starts or 300K homes are
Treasury Notes-10y
S&P 500 Target
2.25
903.
3.84
1115.
3.31
1258.
1.88
1258.
2.75
1440.
3.50
1520.
4.0
1650.
replacement due to fire, floods, hurricanes, earthquakes,
and decay. The natural demand for housing starts
Source: HighMark Capital estimates and Thomson Datastream should exceed 1.5 million, including second homes.
New Home Starts
CPI inflation increased from 1.3% to nearly 4% during 3,000
* Peak: 2.2M (12/2005)
2011, although it has recently stabilized between 2.5- 2,500
-- Demand = 1.5 M + Second Ho mes
3.0%. Higher inflation has now become entrenched with 2,000
rising prices for commodities, transportation, food,
1000s
1,500
energy, imports, and shelter now working their way into
cost of living increases, which could exceed 3% this 1,000
800K
year, similar to last year’s CPI inflation. Weekly earnings 500
698K
Demand = Household Formation + Replacement + Second Homes
have increased 2.2% and personal income rose 3.9%. 1.65 million = 1.2 million + 300,000 + 150,000
0
Companies are reporting that new price increases are 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
holding in many of their markets. While this is good news
for profit margins, it suggests the Federal Reserve is Source: HighMark Capital and Thomson Datastream
already lagging behind the curve, and may have to raise
rates sooner and more aggressively than anticipated. Household formation is the most correlated leading
indicator of housing starts, so depressed increases of
Earnings growth is expected to slow this year, but the 398K in 2009 and 357K in 2010 have coincided with well
S&P500 consensus earnings forecast still suggests below average housing starts of about 700,000.
growth approaching 10%. Our $105 estimates are a little However, housing starts have accelerated to 35%
lower than the $107 consensus expectation, but equity recently, and the annual U.S. Census household
valuations are still very compelling, in our opinion, after formation rate released in March exceeded 1.1 million in
the recent six-month rally in global equity markets. 2011, which suggests increasing demand for housing,
Small-cap earnings concensus shows even greater already evident in escalating rental demand, falling
growth potential of 28% in 2012 and 29% next year. vacancies, tumbling inventory, rising rent of 4-6%, and
Price/Earnings multiple expansion potential provides better home sales volume. Median home prices have
upside to equities. Earnings growth and high profit been range bound between $150-175K since 2009.
margins have benefited from above average productivity
4

5. Normalizing housing starts has a significant potential to Indicators of US Economic Activity
reduce unemployment and boost economic growth. 20%
15%
Household Formation (1947-2011) --- Average: 1.2 Million/year
10%
140,000 4,000
2008 772K 5%
Household Formation (000s)
3,500
120,000 2009 398K
2010 357K 3,000 0%
Households (000)
100,000 2011 1,114K
2,500 -5%
Total 118.6M
80,000 2,000
-10% Business Sales: 7.6%
60,000 1,500
Construction: 5.8%
-15%
1,000
40,000
500 -20%
20,000 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
0
0 -500 Total Con struction Business Sales
1955 1965 1975 1985 1992 2001 2011
New Household Formations Households Source: HighMark Capital and Thomson Datastream
Source: U.S. Census
The U.S. savings rate has fallen to 3.7% after peaking
The increase to normal household formation rate, after over 8.3% in 2009. Household net worth and corporate
years of families doubling and tripling up generations balance sheets, including the banking industry, have
under one roof, is yet another observation how the Little improved as asset values recovered and debt levels
Things Add Up, supporting our expectation of a resilient were reduced. Refinancing loans has reduced interest
U.S. economic recovery. expense, while strong cash flows bolstered balance
sheets. Investment spending has remained strong, even
National Housing Inventory
if companies were reluctant to expand their workforce
4,500,000 18
4,000,000 16
given increased regulatory, legislative, and labor cost
3,500,000 14 uncertainty. Credit card balances continue to decline, but
Housing Inventory
Months Inventory
3,000,000 12 non-revolving credit, often used to buy durable goods, is
2,500,000 10 expanding again; both results can be interpreted as
2,000,000 8 signs of economic strength. Mortgage liabilities were
1,500,000 6 reduced by paying down principal, possibly to re-finance
1,000,000 4 into a conforming loan, or the result of short-sales and
500,000 2
foreclosures. In contrast, government liabilities continue
0 0
Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 to expand rapidly with U.S. Treasury debt rising from
Housing Inventory Months Inventory (Right)
$14.1 trillion last August to over $15.5 trillion, and it is
fast approaching the next debt ceiling of $16.4 trillion.
Source: National Association of Realtors
2002-Present vs. 2007
Household Balance Sheet ($B) 2007 2011 A.G.R. A.G.R. 1-Year
Housing inventory continues to decline, but shadow Total Assets 79,545 72,229 | 4.7% -2.4% -0.7%
Tangible Assets 27,970 23,162 | 2.3% -4.6% -1.3%
inventory concerns remain. The long-feared inventory Owner-occup'd Real Estate 20,855 15,964 |
| 1.2% -6.5% -3.7%
surge has yet to materialize. If the concentration of Financial Assets (inc. retirement)
Deposits (Bank + Money Funds)
51,575
7,406
49,067
8,172
|
|
6.1%
5.7%
-1.2%
2.5%
-0.4%
4.9%
|
foreclosed properties is high only in certain regions with Liabilities 14,346 13,774 | 5.5% -1.0% -0.9%
poor job growth, which we suspect is the case, it may Home Mortgages
Consumer Credit
10,546
2,555
9,841
2,521
|
|
6.1%
4.8%
-1.7%
-0.3%
-2.1%
3.5%
|
explain why concerns of shadow inventory remain, Household Net Worth 65,198 58,455 | 4.5% -2.7% -0.6%
Disposable personal income 10,424 11,721 | 5.0% 3.0% 3.4%
despite falling inventories. Why else would banks hold
Source: Federal Reserve, Flow of Funds (Table B.100)
back properties when the market seems to be clearing
inventory, and there are increasing instances of bids Source: Federal Reserve, Flow of Funds (Table B.100)
over asking prices in other regions?
Concern about leverage tends to focus on income
Will Deleveraging Persist? versus debt levels, but interest rates are also important.
In the case of fiscal deficits, we compare gross domestic
Deleveraging has been observed since 2007 across the product (GDP) to outstanding debt. Debt/GDP now
corporate, banking, and household sectors, but it is a exceeds 100% in the United States, while many
transitory state which appears to be reversing. Growth in countries in the Eurozone and Japan far exceed 100%.
business sales and construction indicate that leverage is The ability to service debt is a function of income versus
now increasing. Commercial and industrial loans interest expense. U.S. Treasury yields on 10yr bonds
increased 12.2% over the last year, suggesting bank average over 6%, but today are closer to 2%. After 10
credit terms are improving, while private fixed investment years, the interest plus principal would grow to 47%
expanded by 9.1%. Retail sales of 6.3% suggest more at 6% than at 2%, but after 20 years, the debt
consumers are spending in excess of 3.4% disposable would compound to more than double the lower rate.
income growth. Below we observe a high level of Thus, homeowners and businesses seek to refinance
business sales (7.8%) and the dramatic rebound in higher fixed interest rates, if they qualify, even with pre-
construction, growing 5.8%. These statistics all suggest payment penalties. Any tipping point for a nation’s
stronger growth than real GDP suggests, of course. sustainable debt level varies depending on its interest
rate. Unfortunately, Europe has learned that the cost of
5

6. higher debt can result in higher interest rates, particularly Investors must balance a logical interpretation of
in periods of crisis, and crowd out other fiscal needs. economic conditions, consistent with higher interest
The Eurozone’s central bank can and should cut interest rates, with the old adage: “Don’t fight the Fed”.
rates from 1.0% by 25-50 basis points.
The chart below is interesting because it shows two
Why Is Ben Still So Gloomy? important relationships. First, the yield curve isn’t much
different from what it looked like during the Financial
U.S. interest rates are unsustainably low. With most of Crisis on December 31, 2008. With growth and inflation
its monetary policy tools deployed, the Federal measures hovering close to historical averages, how can
Reserve’s latest initiative is to “manage” inflation and current monetary policy be justified given how much
interest rate expectations to contain any increase in economic conditions have improved? Second, compare
bond yields. This effort included publishing individual the current yield curve to April 2004, just before the Fed
FOMC member economic and interest rate forecasts started to raise interest rates during the last cycle, during
through 2014. Given more upbeat commentary following which 10yr Treasury yields rose about 3%. In 1994, one
the March FOMC meeting, expectations for the first of the worst performing years for Treasuries, Treasury
interest rate hike pulled back to mid-2013 and bond yields rose just 2.5% to 7.8%, while CPI inflation
yields rose from 2.0% to 2.4% over the following week. averaged 2.8%, similar to current inflation. An increase
in Treasury yields of 3% would only align with 2004, just
Economic conditions don’t justify continuing current before the Fed started to raise interest rates. Yield curve
monetary policy stimulus or a new round of QE-3. We comparisons illustrate how far interest rates must rise to
believe current economic conditions justify much higher restore equilibrium (“average”).
interest rates when we apply the Taylor Rule, widely Treasury Yield Curve
recognized in central bank policy making, approaching 8.0
3.4% with a low 2.5% inflation estimate. The Taylor Rule 7.0
Average
illustrates how much conditions have changed over three 6.0
years. This contrasts with the current 0-0.25% target, 2004
5.0
and an April 2009 calculation of -3.6%. With measures of
Yield (%)
2007
4.0
growth and inflation exceeding normal economic
3.0
conditions, the Federal Reserve may compromise its 2008
credibility by trying to justify maintaining current 2.0
emergency monetary policy stimulus. 1.0 Current Dec 2008 Dec 2007
May 2004 Avg:1962-2010
0.0
Negative real bond yields can’t be sustained for long 0 5 10 15 20 25 30
periods without causing financial system imbalances. Maturity (years)
There is also a growing risk of moral hazard as interest Source: HighMark Capital Management and Datastream
rates are held artificially low for what has already been
an extended period. Assurances of “low rates for an Minutes of the Federal Reserve’s mid-March meeting
extended period” by the Federal Reserve may kicked the potential of another round of quantitative
encourage excessive risk taking as investors extend easing (QE-3), beyond the foreseeable future. We think
fixed income durations, underestimating the potential Operation Twist will be winding down by June. Less
interest rate risk of their holdings. The range of creative buying support for Treasuries may tend to drive up bond
monetary stimulus made available during the Financial yields, but there is little economic reason for equities to
Crisis improved liquidity and stabilized credit markets, be affected much. Some investors have associated
but there is an increasing risk of spiking bond yields winding down QE-1 and QE-2 with equity market
when expectations change. The Federal Reserve never corrections in 2010 and 2011, but coincidence is not
before communicated its interest rate expectations to always causality. There are many other likely reasons
this extent. We believe that monetary policy changes are that explain last summer’s economic slowdown, in our
most effective when massive and unanticipated to opinion. We’ve highlighted how ten unrelated Little
surprise markets. The ability to do this has been Things Add Up to a significant global economic
curtailed with their increased emphasis on transparency. headwind in 2011. We are more concerned about tax
increases and other effects of fiscal drag in 2013.
If Chairman Bernanke were more upbeat about the
economy, we believe the Federal Reserve couldn’t During the debt ceiling debate, we discussed how
dangle QE-3 or maintain that interest rates will remain canceling Treasuries owned by the Federal Reserve can
“low” until the end of 2014. The Federal Reserve is increase Treasury debt capacity under the debt ceiling.
attempting to manage both inflation and interest rate The debt ceiling stands at $16.394 trillion, and it is likely
expectations lower, because nearly all other monetary to be exceeded by early 2013, if not sooner. The Federal
policy options are used up. Unwinding Quantitative Reserve’s balance sheet remains between 3-4 times
Easing and low interest rates will be a challenge without larger than in 2007, bloated by an additional $2.3 trillion
undermining economic growth and increasing risk of worth of Treasuries, mortgages, and other credit
stagflation. Growth in the monetary base has ranged securities. Other than selling securities, it is possible to
above 30-110% since 2008, but recently fell to 11%.
6

7. let bonds mature or simply cancel Treasury debt held by Obviously, the issue is very complex and contentious,
the Federal Reserve. The Federal Reserve already based on many assumptions. It is unclear how much of
rebates interest received back to the U.S. Treasury, the Fiscal Cliff has already been discounted in modest
included in most of the $77.4 billion earned last year economic expectations for 2013.
from interest payments on securities held and selling
appreciated assets on its balance sheet. Maturities also Government spending is currently 25% of GDP and at
could be accelerated by reversing Operation Twist (i.e., least 5% over our sustainable rate, based on Hauser’s
replacing longer maturities with shorter maturities). Law (i.e., tax revenues haven’t exceeded 20%,
irrespective of tax rates). Simplistic subtraction models
Unwinding the Federal Reserve’s enlarged balance from baseline GDP estimates is misguided, we believe,
sheet and restoring interest rates to a normal spread but it would be wrong to dismiss the correlated effects of
versus inflation will likely be a difficult transition that is all these changes impacting the economy
best started slowly and early in order to allow for gradual simultaneously. Unfortunately, it has proven difficult to
evolution. We think that hiking interest rates 1% would agree on budgets and difficult legislation most of the
have little effect on fixed mortgage rates, as otherwise time these days, so gridlock may well continue to be the
feared, unless inflation or interest rate expectations norm during this election year.
increased. However, it should also decrease risk of
moral hazard and restore normal function to short-term Sequestration mandates across-the-board spending cuts
fixed income markets. Money supply normally expands totaling $1.3 trillion over 10 years, beginning in 2013. By
5-6% per year, but it will likely contract for a sustained law, both houses of Congress are required to submit and
period, unless the Federal Reserve allows Treasuries to pass a budget resolution by April 15th, so it is possible to
mature without re-investing the proceeds. reconfigure planned sequestration and turmoil over
another debt ceiling increase. The Senate has failed to
Quantitative easing (QE-1) and other creative monetary pass a budget resolution for the third year, and
policies initiated during the depths of the Financial Crisis apparently has no intention of doing so, although the
were effective at stabilizing credit markets and restoring House has met its deadline. In an election year, this will
liquidity. Subsequent easing efforts appear to us to be certainly be an issue. It appears the only hope is a
misguided, and this view is shared to greater or lesser “grand compromise” in Congress that slows spending,
extent by a wide range of economists, other country’s incorporates the sequestration target, and raises the
central bankers, and even several vocal members of the debt ceiling enough to deal with it again after mid-2013.
FOMC. The combined balance sheets of the six largest
major central banks have increased $8 trillion since 2007 Differentiating between economic effects of temporary
from $5 trillion to over $13 trillion. Increasing money and permanent tax policy changes is well-documented.
supply may not directly and immediately boost U.S. or Individual households change their behaviors well before
global inflation, but it has been shown that investors implementation of known adjustments. So if the payroll
often boost their inflation expectations as the economy tax holiday is not renewed, increasing social security
gains traction. As increasing inflation expectations withholding from 4.2% to 6.2%, there is likely to be less
solidify again, it will be difficult to reverse the trend once impact on growth than the full 2% difference assumed.
wage growth accelerates enough. Since the tax break is highly progressive, higher-income
households didn’t benefit, and will not be as impacted by
The Fiscal Cliff Of 2013 expiration. Thus, many other variables are likely more
important to the forecast of U.S. growth in 2012-13.
Many temporary tax cuts are legislated to expire over the
next year, increasing concerns about the likely economic Conclusion
impact. Several expiring tax cuts and stimulus measures
must be extended, made permanent, or addressed in the HighMark’s five drivers of exceptional economic growth
fiscal budget before year-end or they could have a have provided an effective way to communicate how the
negative impact on growth in 2013. The Economic U.S. economy has and could continue to surprise to the
Growth and Tax Relief Reconciliation Act of 2001 upside. The strength of these drivers, however, has
(EGTRRA) provided reform to marginal income tax been inconsistent with lagging real GDP growth, even as
rates, estate exclusions, and retirement savings, which a significant rotation in investment leadership appears to
were designed to be phased in through 2010. The be underway. It is convenient that HighMark’s global
legislation included a sunset provision so that tax law tactical asset allocation forecasts come directly from
changes weren’t subject to PAYGO rules (i.e., maintain interpreting various economic measures, thus avoiding
deficit neutral), impacting the fiscal budget beyond 10 several layers of compounding uncertainty.
years. Tax increases also taking effect in 2013 include:
financing new heath care reform, expiring payroll tax Periods of exceptional productivity have sustained above
holiday for social security withholding, expiring extended average real growth and rising profit margins.
unemployment benefits (up to 99 weeks), and increasing Encouraging innovation has been vital to U.S.
burden from the alternative minimum tax (AMT). The competitiveness. Last quarter, we identified nine
CBO estimates the 2012 “Fiscal Cliff” impact to be 2% of potential drivers of exceptional productivity, which have
GDP, but other estimates have ranged as high as 3.5%. the potential for significantly boosting long-term growth.
7

8. Periods of exceptional productivity have sustained above
average real growth and rising profit margins, as It is hard to say how equities might discount a possible
dramatic as is currently being observed. economic slowdown anticipating the Fiscal Cliff or
probabilities of other concerns, but that likely depends
Investor concerns are rightly focused on global growth on how growth plays out over the first three quarters of
and earnings potential, but it appears that most 2012 and the outcome of U.S. elections. We believe it is
transitory concerns of 2011 have moderated now, even if too early to anticipate adverse effects yet. Sequestration
a few new concerns have emerged. The way that Little as has already been discounted in GDP estimates, and
Things Add Up can reach a tipping point such that there is still a chance that Congress may reverse at least
individual concerns can be overcome, but collectively some of the anticipated tax increases.
become overwhelming. Similarly, the number of positive
forces discussed above may seem relatively insignificant Global equities remain compelling, relative to historic
individually, but in combination can be more powerful valuations and compared to other investment
than their sum. In our opinion, continued strong earnings alternatives, including cash, bonds and commodities. We
growth, has reinforced compelling equity valuations, remain overweight global equities, with a preference for
despite a strong equity rally over the last three months, U.S. and Emerging Market regions, over Europe and
as well as three years. We don’t dismiss any of the many Japan. Emerging market growth is more cyclical now,
enumerated concerns, although they are trumped for but secular drivers of urbanization, industrialization,
now by many positive global economic trends, strong emerging culture of credit, and insatiable consumption
earnings, compelling valuations, low interest rates, and still persist. Within fixed income, we favor high yield and
an anticipated Era of Exceptional Productivity. maintain an overweight to credit, which more than
offsets the lost yield of shorter duration. If commodity
With few signs that inflation is relenting, the presence of and energy prices moderate further, combined with
economic slack in employment and capacity utilization is slower wage growth and easing monetary policy,
a necessary, but not sufficient, condition to contain Emerging Market productivity and profit margins could
inflation. We still expect that interest rates may likely improve materially, as will economic growth and
begin to rise in 2013. HighMark correctly anticipated earnings. We have revised up our earnings forecast,
increases in interest rates that surprised most others in increased our S&P 500 target, lowered our bond yield
2004. Investors seem too complacent about Treasury estimates, and pushed out our first expected hike in U.S.
valuations after a 30-year bull market in bonds drove 10- interest rates.
year Treasury yields below 2.0%. Ignoring the Threat of
Inflation Could Be Perilous with above average inflation David Goerz, SVP - Chief Investment Officer
increasingly becoming entrenched. We think inflation is http://commentary.highmarkfunds.com
the most likely of our concerns to derail the expansion
and robust profit margins in the foreseeable future.
Quarterly Investment Outlook is a publication of HighMark Capital Management, Inc. This publication is for general
information only and is not intended to provide specific advice to any individual. Some information provided herein
was obtained from third party sources deemed to be reliable. HighMark Capital Management, Inc. and its affiliates
make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication
and bear no liability for any loss arising from its use. All forward looking information and forecasts contained in this
publication, unless otherwise noted, are the opinion of HighMark Capital Management, Inc. and future market
movements may differ significantly from our expectations. HighMark Capital Management, Inc., a registered
investment adviser and subsidiary of Union Bank, N.A., serves as the investment adviser for HighMark Funds.
HighMark Funds are distributed by HighMark Funds Distributors, LLC, an affiliate of Foreside Funds Distributors LLC.
Union Bank, N.A. provides certain services for the HighMark Funds for which it is compensated. Shares in the
HighMark Funds and investments in HighMark Capital Management, Inc. strategies are not deposits, obligations of or
guaranteed by the adviser, its parent, or any affiliates. Index performance or any index related data is given for
illustrative purposes only and is not indicative of the performance of any portfolio. Note that an investment cannot be
made directly in an index. Any performance data shown herein represents returns, and is no guarantee of future
results. Investment return and principal value will fluctuate, so that investors' shares, when sold, may be worth more
or less than their original cost. Current performance may be higher or lower than the performance quoted.
Investments involve risk, including possible LOSS of PRINCIPAL, offer NO BANK GUARANTEE, and are NOT
INSURED by the FDIC or any other agency. Mutual fund investing involves risk, including possible loss of
principal. Investors should consider the Funds' investment objectives, risks, charges and expenses carefully
before investing. This and other information can be found in the Funds' prospectus, which may be obtained
by calling 1.800.433.6884 or by visiting www.highmarkfunds.com. Please read the prospectus carefully before
investing. Entire publication © HighMark Capital Management, Inc. 2012. All rights reserved.
8