The fourth quarter of 2012 brought an abundance of angst and speculation surrounding how, and when, Congress might resolve its ongoing battle over fiscal policy. As investors worried about the impact of the tax and spending provisions the Budget Control Act of 2011 would have on an already fragile economy, Congress showed little inclination to reach a bi-partisan compromise. For more info: www.nafcu.org/nifcus

1. Perspectives and Commentary
First Quarter, 2013
January 22, 2013
US Economic and Market Overview
The fourth quarter of 2012 brought an abundance of angst and speculation surrounding how, and
when, Congress might resolve its ongoing battle over fiscal policy. As investors worried about the
impact of the tax and spending provisions the Budget Control Act of 2011 would have on an already
fragile economy, Congress showed little inclination to reach a bi-partisan compromise. The result
was a layer of uncertainty in the financial markets that persisted into the proverbial “eleventh hour.”
Finally, over the last weekend before the New Year, Vice President Joe Biden and Senate Minority
Leader Mitch McConnell negotiated to avoid sequestration. Within seventy-two hours of their initial
discussions, Congress passed, and the President signed, the American Taxpayer Relief Act (ATRA)
of 2012. It appeared that four plus years of dispute over fiscal policy was resolved in less than three
days --- or was it?
The ATRA of 2012 prolongs by two months the budget sequestration deadline established in the Act
of 2011. Congress now has until the end of February 2013 (unless extended) to negotiate spending
cuts intended to lower the Federal deficit. Much now must be done in a short amount of time by a
group that has had little success reaching any sort of consensus over the past few years. Due to this
reality, uncertainty remains high which has not been lost on the financial markets. This thread of
uncertainty can be expected to weigh on investors, and caution will prevail until a detailed plan to
lower deficit spending has been articulated. The sequestration established in the Act of 2011, if
allowed to prevail, could threaten the economy in 2013. A compromise would have less impact on
the economy, though what form any compromise might take is pure speculation. This uncertainty
should dampen upside potential (especially in the equity markets) until a resolution is reached, and
failure to pass a needed increase in the debt ceiling could be most damaging.
Economic Conditions
The debate over fiscal policy had a modestly negative impact on US economic output over the fourth
quarter of 2012. Q3 GDP grew at a stronger-than-expected 3.1%, yet appears to have slowed to
near 2% in Q4 as both businesses and consumers remained reluctant to spend in anticipation of
potential tax increases and further economic slowing. The ongoing recession in Europe and a
modest slowing in emerging markets detracted from US growth as well.
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2. Despite slower growth in Q4, the US added 453,000 jobs over the quarter, keeping the rate of
unemployment at 7.8%, a number consistent with the end of Q3. Dominant areas supporting job
growth include health care, food services, construction and manufacturing.
Though there is little doubt that fiscal drag at the federal government level will detract from economic
growth in 2013, our base case scenario assumes a compromise will be reached that will allow the
economy to expand over the year ahead. We expect any fiscal shock from the compromise will be
most apparent over the first six months of the year, subsiding in the second half as higher taxes and
lower government spending become the established norm.
Source: HighMark Capital estimates and Thomson Datastream
Fixed Income Outlook
On December 12, 2012, the Federal Open Market Committee (FOMC) announced they would
expand QE3 by over 200% (from $40 to $85 billion per month) following the end of Operation Twist
on December 31st. They also moved away from their commitment to keep rates low through 2015 by
pegging their timing for tightening monetary policy to the level of unemployment. We now expect
accommodative monetary policy will remain unchanged until the unemployment rate moves
substantially lower. Given that the FOMC forecasts unemployment to end 2014 at 7.05%, we expect
very low short-term interest rates throughout 2013. We believe this may not, however, be the case
for longer rates – despite the intentions behind QE3.
During 2012, ten-year US Treasury yields ranged between 2.38% and 1.39%, and finished the year
at 1.76%. Peak yield was achieved in March following two months of better-than-expected growth in
non-farm payroll (275k in January and 259k in February), suggesting an acceleration of economic
growth. As it turned out, the economy was not accelerating. In fact, it was slowing, as evidenced by
weak non-farm labor growth averaging only 67k over the second quarter of the year, and a drop in
GDP from 2.0% in Q1 to 1.3% in Q2. Less-than-favorable news pushed the 10-year yield to 1.39% in
July. Despite Operation Twist and the Fed’s desire to hold rates down, market forces continued to
dominate in the face of positive economic news. This suggests that Operation Twist, which has
essentially been extended as part of QE3, may not have the intended influence when the economy is
showing signs of improvement. Given our base scenario, which projects economic improvement over
the second half of 2013, we expect longer yields will move higher, with the 10-year near 2.5% at
year end, despite QE3.
We believe the modest rise in longer Treasury rates over 2013 should not detract from investor
desire to own yield. Economic fundamentals continue to support the ability for companies to service
debt and concern over credit deterioration remains low. Yield spreads, meanwhile, remain modestly
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3. attractive, and the corporate bond component of the Barclay’s Aggregate Index returned 9.82% last
year. As such, we believe investors should be reluctant to abandon the historically strong
performance bonds have offered, since the appetite for yield should continue.
There is risk on the horizon that we expect will eventually push investors to underweight bonds.
Interest rates will not remain near historically low levels forever. QE3 is an open-ended program and
the near-term risk is that the program will end. We expect the program will continue until
unemployment moves much lower, inflation becomes problematic, or the Fed decides they can no
longer allow their balance sheet to expand. We view the last of these risks to be the initial catalyst
helping longer rates to move higher. We expect the FOMC will draw a line on the maximum level of
debt it can hold on their balance sheet before inflation or unemployment will move them to tighten.
At this point, Operation Twist may be reinstituted, but the Fed is running out of options. With no hope
for QE4, we expect longer rates to eventually trend upwards.
Fixed Income Sector Outlook for Q1 2013
We expect the following in 2013:
 US and European Corporate Bonds: Spreads remain attractive, fundamentals remain
supportive, and demand should remain strong. – Positive
 High Yield Bonds: Earnings uncertainty over the near term could influence volatility, but
valuations and technicals remain attractive. – Positive
 Emerging Markets: Emerging economies should continue to expand faster than developed
economies. Credit quality should continue to improve and demand should remain high. –
Positive
 Government Bonds: Real return inside 10 years should remain negative. The Fed may be
unable to hold rates down should the economy accelerate faster than expected. – Negative
 Mortgages: Valuations are inflated due to Fed intervention. The Fed’s plan to purchase $40
billion in Mortgage Backed Securities (MBS) per month is now conditional and tied to inflation
and unemployment targets. Should the Fed exit the market, MBS should underperform. –
Negative
 Municipal Bonds: Fundamentals are supportive and relative value remains elevated when
compared to Treasury securities. However, there is uncertainty regarding a change in tax
status. While the ATRA of 2012 does not address the tax status of municipal bonds, the
Obama Administration has proposed capping tax-exempt income at 28%. Should this occur,
investors with a marginal tax rate above 28% will pay tax on a portion of their municipal bond
income, thereby detracting from the value of municipal bonds. A proposed change in tax
status could surface as the budget debate continues over the course of Q1 2013. Caution
should prevail in the municipal market until a budget resolution is reached. – Neutral
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4. Equity Outlook for Q1 2013
In the midst of election results and the fiscal cliff debate, the stock market spent the fourth quarter
behaving as if stronger growth was imminent. Cyclical firms, small companies and value plays all
posted strong performance over the period, in contrast to the stable growth themes that had
provided the most consistent returns over the previous three quarters.
Looking forward to 2013, we feel the market is slightly overvalued on an absolute basis, yet
competitively valued versus other asset classes.
 Dividend yields are at 2.1%, one of the lowest levels in history.
 Revenues and margins look challenged. With sluggish economic growth, expectations for
sales growth range in the 2-3% level. Margins are at all-time highs, and are likely to come
under pressure.
 Market multiples, whether using a basic trailing or forward looking 12-month, or a smoothed
10-year, are on the rich side compared to history.
Low yields, challenging earnings growth and a high multiple all add up to high overall stock market
valuations. In response to sluggish domestic growth, many firms have been investing considerable
resources into their offshore operations, where growth is higher and margins are better. Equity
markets could respond positively to any rise in bond rates stemming from economic resurgence or
the end of QE activity.
Summary
Equities had a strong year overall in 2012 with the S&P 500 up an even 16%. While the first half of
the year was dominated by the same type of risk-on, risk-off volatility plaguing stock markets for the
last five years, the second half showed signs of stability reminiscent of less volatile markets, which
preceded the financial crisis.
We expect the following in 2013:
 Domestic: We see a market that is a bit expensive on an absolute basis, but priced fairly
compared to returns in competitive investments. The ongoing budget negotiations could be a
catalyst for market direction and quality going forward. A constructive agreement between
Congress and the President could help end the risk-on, risk-off volatility. Against such a
backdrop, firms could plan for the future, confidence among producers and consumers alike
would increase, and positive investor sentiment would likely grow. Alternatively, if we risk
sovereign default as we did in the summer of 2011, we could experience another market
swoon with an attendant rise in volatility levels. This possibility leads us to continued
uncertainty around what lies ahead. – Neutral
 With the broader stock markets, we see potential opportunity in Europe. Valuations in
European markets are coming off of extreme lows, and if we see signs indicative of a
bottoming out, particularly in many of the leading economic indicators, an overweight in
Europe would be prudent. – Neutral to Positive
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5.  Similarly, we have hopes for Japan, based on our recent activity within the country. The
Liberal Democratic Party’s return to power in the most recent election, based in part on a
pledge to reflate the economy through monetary policy, has given investors reason for
optimism. Yet, given the challenging demographics and deflationary competition, we remain
cautious on Japan’s fortunes and recommend market weight on the region, – Neutral
 Emerging markets are resurgent in the last six months as their economies have re-
accelerated in the face of challenges to their growth, – Positive
David Wines – Chief Fixed Income Investment Officer
Derek Izuel – Chief Equity Investment Officer
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