The Outlook

Nevertheless, global imbalances remain. The US is reaching a tipping point in its ability to continue financing its deficit spending. At its current trajectory, the US will be challenged to meet its longer-term obligations and the sheer volume of treasury bond issuance threatens to overwhelm investor demand and further weaken the dollar. The US consumer is also in need of significant balance sheet repair. The US, and to some extent much of the developed world, will need to undergo substantial deleveraging that is likely to suppress economic growth for several years.

At the same time developing economies in Asia and Latin America are undergoing rapid industrialization, which in absolute scale is the greatest the world has ever seen. This industrialization has been led by the “BRIIC” countries (Brazil, Russia, India, Indonesia and China), which have a combined Gross Domestic Product (GDP) of $9.4 trillion (15% of the world’s total) and a combined population of 3.1 billion people (46% of the world’s total). The BRIIC countries have grown to become significant economic powers, yet still have considerable growth prospects as reflected in their low GDP per capita, highlighted on the table below. To put this in perspective, if over the next decade the BRIIC countries were to grow at 7% annually, they would double their GDPs per capita (to roughly $6,000, or just over half the level of Mexico) and add approximately $10 trillion to global GDP.

Therefore we see two forces competing for investor attention: the concern over the structural health of developed economies versus the opportunities emanating from the industrialization of emerging countries. This second force is presenting significant opportunities in the form of profitable, undervalued companies who are benefiting from emerging market demand for their products. Moreover, the weakening US dollar is presenting opportunities for producers of tangible assets such as oil, gold, agricultural commodities and industrial materials, which continue to rise in dollar terms. Our investments are positioned to benefit from these forces, as well as other important investment areas where we expect capital to flow, as described further below.

At the same time, developing and emerging economies continue to experience strong GDP growth. These nations are working to raise living standards for vast numbers of people by investing heavily in their productive capacity and infrastructure. China in particular, as the world’s largest creditor and surplus nation, is able to fund these growth initiatives on the back of historic global financial imbalances and a treasury flush with accumulated and still-growing foreign reserves. With over $2.1 trillion in reserves at latest count and a continuing trade surplus, China can maintain this investment and stimulus for a long time if they choose to. However, China and other developing economies will ultimately need to stimulate domestic consumer spending to build more balanced and self-reliant economies.

In contrast, China’s stimulus package represents nearly 13% of their GDP and is heavily concentrated on productive investment. Of the $586 billion committed, approximately $220 billion is for public infrastructure development (railway, road, irrigation and airport construction), $145 billion is for post-earthquake reconstruction in Sichuan and another $135 billion is for rural and sustainable development and technology advancement, for a total fixed asset investment of over $500 billion, or nearly 12% of GDP. By comparison, the US fixed asset investment of $150 billion represents approximately 1% of GDP. China’s stimulus plan has already been credited with lifting anticipated GDP growth prospects, which were recently revised upward for 2009 by the IMF to 7.5% up from its 6.5% estimate in April. China’s infrastructure plan has also helped to “prime the pump” for other markets as high demand for steel, copper, iron ore and other raw materials have boosted the growth outlook for resource-rich exporting countries such as Australia, Canada and Brazil.

Complementing the two approaches highlighted above, over 700 policy initiatives have been announced around the world since the start of the economic downturn. These have included stimulus programs, tax incentives, industry bailouts, interest rate cuts, lending programs, loan guarantees and quantitative easing (printing money), among others. The majority of this spending is targeted for the second half of 2009, 2010 and 2011. The size and scope of these coordinated actions are without precedent. It is important to note that over 40% of the combined revenues of S&P 500 companies are generated outside the US. As such, many companies stand to benefit from global policy initiatives regardless of the ultimate success of US efforts.

While significant concerns remain, there are key differences, as summarized in the chart below:

These improvements in the financial and economic underpinnings of the US have not corrected the long-term imbalances we face. However, they do reflect and have resulted in greater stability (at least for the time being), which we believe creates an environment where asset classes will not be as closely correlated and the inherent undervaluations of select businesses become more fully recognized.

Our focus continues to be investing in the beneficiaries of where global capital will flow over the next 24-36 months. The portfolios are built primarily with North American-based companies and select American Depository Receipts (ADRs) that will benefit from emerging economy growth without the political and capital market risk of investing directly in foreign markets. Due to their strategic importance and attractive valuations, many of these companies offer the additional benefit of being well-positioned to participate in future industry consolidations.

The equity and balanced portfolios are positioned for the appreciation of real assets against most currencies, a weaker dollar and continued growth in the emerging economies. In response to emerging market infrastructure investment, we see opportunities in companies with significant international sales in the areas of energy (oil), food (fertilizer and seeds) and infrastructure (steel, iron ore, and copper). To protect against further weakness in the US dollar, we continue to invest in gold and silver companies whose operating profits and cash flows would expand appreciably in response to any price rise in the underlying metals. In a rapidly changing world, the need for countries to focus on national security provides targeted opportunities among defense companies.

Our introduction of technology companies in recent months reflects our view of the needs of companies and governments to increase their productivity in both the developed and emerging economies. Finally healthcare companies, many of which were abandoned by the stock market due to concerns over the outcome of healthcare reform, are now trading at historically low valuations with strong balance sheets, high dividend yields, and in many cases, improving fundamentals. With respect to fixed income securities, we continue to focus on shorter-term maturities among investment grade issuers, although we will selectively target longer-term maturities of good credits offering attractive total returns.

As we stated in our last Outlook, we believe that a two-tiered market can develop whereby the beneficiaries become standout opportunities for returns irrespective of broader market performance. This continues to be a time for thoughtful investment security selection in a more complex global environment.

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