Navigating the New Navigating the New Normal: Portfolio Normal: Portfolio

Management in a Post-Management in a Post-Crisis WorldCrisis World

Portfolio Management InstitutePortfolio Management Institute

Atlanta, GeorgiaAtlanta, Georgia

April 22, 2010April 22, 2010

Portfolio Management Portfolio Management in a Hostile in a Hostile

EnvironmentEnvironment

Portfolio Management InstitutePortfolio Management Institute

Atlanta, GeorgiaAtlanta, Georgia

April 22, 2010April 22, 2010

OverviewOverview

Bottom line: From crisis to Bottom line: From crisis to crisiscrisis

ApproachApproach BaselineBaseline ThreatsThreats OpportunitiesOpportunities Mid-TermsMid-Terms

Baseline EconomicsBaseline Economics

Next 12 to 24 months – 2 to 4 % growthNext 12 to 24 months – 2 to 4 % growth Then – 4 to 5 % growth until mid 2 ought Then – 4 to 5 % growth until mid 2 ought

teensteens Then about 2.5 % annualThen about 2.5 % annual Inflation near 2 % through 2010Inflation near 2 % through 2010 Rising to 3 + % by late 2011/early 2012Rising to 3 + % by late 2011/early 2012 Returning to 2 % by 2013Returning to 2 % by 2013 Interest rates + 100 bp then tracking Interest rates + 100 bp then tracking

inflationinflation

Investors’ Threat # 1Investors’ Threat # 1InflationInflation

Timeframe: late 2011 Timeframe: late 2011 Starts and ends with the FedStarts and ends with the Fed Can the Fed nix inflation?Can the Fed nix inflation?

Excess reservesExcess reserves

Investors’ Threat # 1Investors’ Threat # 1InflationInflation

Timeframe: late 2011 Timeframe: late 2011 Starts and ends with the FedStarts and ends with the Fed Can the Fed contain inflation?Can the Fed contain inflation?

Excess reservesExcess reserves VelocityVelocity

Investors’ Threat # 1Investors’ Threat # 1InflationInflation

Timeframe: late 2011 Timeframe: late 2011 Starts and ends with the FedStarts and ends with the Fed Can the Fed contain inflation?Can the Fed contain inflation? Will it? The beguiling role of excess Will it? The beguiling role of excess

capacitycapacity

Investors’ Threat # 1Investors’ Threat # 1InflationInflation

Timeframe: late 2011 Timeframe: late 2011 Starts and ends with the FedStarts and ends with the Fed Can the Fed contain inflation?Can the Fed contain inflation? Will it? The beguiling role of excess Will it? The beguiling role of excess

capacitycapacity Response means slowdown 6 to 9 Response means slowdown 6 to 9

mos. latermos. later

Investors’ Threat # 2Investors’ Threat # 2Washington Anti-Investor Washington Anti-Investor

ClassClass Already extended 3.8% payroll tax to Already extended 3.8% payroll tax to

capital incomecapital income

Obama proposed 20% tax on cap gains and Obama proposed 20% tax on cap gains and dividendsdividends

Obama proposed $3.5 million/45% death Obama proposed $3.5 million/45% death taxtax

Cap’N TaxCap’N Tax

Investors’ Threat # 3 Investors’ Threat # 3 Sovereign DebtSovereign Debt

It could all begin in GreeceIt could all begin in Greece

European ContagionEuropean Contagion

Tidal waves flow in, and outTidal waves flow in, and out

States join in – deficits and unfunded retiree States join in – deficits and unfunded retiree benefitsbenefits

And then there’s WashingtonAnd then there’s Washington

Budget Deficits -- Unsustainable Budget Deficits -- Unsustainable

0

2

4

6

8

10

12

Deficits Average Deficit

CBO, 3/2010

% of GDP

Federal Receipts Return to Federal Receipts Return to NormalNormal

15

16

17

18

19

20

Receipts Modern Average

CBO, 3/2010

% of GDP

Problem is Washington Problem is Washington SpendingSpending

15

17

19

21

23

25

27

Federal Spending Historical Average

Source: CBO 3/2010

Average = 20.3

% of GDP

Unsustainable Federal DebtUnsustainable Federal Debt

102030405060708090

100

Publicly Held Debt Average Debt

CBO, 3/2010

CBO, 3/2010

% of GDP

Investors’ Threat # 3Investors’ Threat # 3WashingtonWashington

Taxes, Taxes, and a more TaxesTaxes, Taxes, and a more Taxes

VATVAT

Income TaxIncome Tax

Environmental TaxesEnvironmental Taxes

A Tale of Two StrategiesA Tale of Two Strategies

Reagan – Starve the BeastReagan – Starve the Beast Obama – Glut the BeastObama – Glut the Beast

A Tale of Two StrategiesA Tale of Two Strategies

Reagan – Starve the BeastReagan – Starve the Beast Obama – Glut the BeastObama – Glut the Beast

Massive spending increasesMassive spending increases

A Tale of Two StrategiesA Tale of Two Strategies

Reagan – Starve the BeastReagan – Starve the Beast Obama – Glut the BeastObama – Glut the Beast

Massive spending increasesMassive spending increases Spending as inevitableSpending as inevitable

A Tale of Two StrategiesA Tale of Two Strategies

Reagan – Starve the BeastReagan – Starve the Beast Obama – Glut the BeastObama – Glut the Beast

Massive spending increasesMassive spending increases Spending as inevitableSpending as inevitable As act of God or natureAs act of God or nature

A Tale of Two StrategiesA Tale of Two Strategies

Reagan – Starve the BeastReagan – Starve the Beast Obama – Glut the BeastObama – Glut the Beast

Massive spending increasesMassive spending increases Spending as inevitableSpending as inevitable As act of God or natureAs act of God or nature As long-term outcomeAs long-term outcome

A Tale of Two StrategiesA Tale of Two Strategies

Reagan – Starve the BeastReagan – Starve the Beast Obama – Glut the BeastObama – Glut the Beast

Massive spending increasesMassive spending increases Spending as inevitableSpending as inevitable As act of God or natureAs act of God or nature As long-term outcomeAs long-term outcome ANYTHING BUT A CONSCIOUS ANYTHING BUT A CONSCIOUS

POLICY DECISIONPOLICY DECISION

Implication of GluttonyImplication of Gluttony

IfIf much higher spending inevitable, much higher spending inevitable, then so are higher taxesthen so are higher taxes

Corporate rate already too highCorporate rate already too high Rangel, Wyden-GreggRangel, Wyden-Gregg

Implication of GluttonyImplication of Gluttony

IfIf much higher spending inevitable, much higher spending inevitable,

Then so are higher taxesThen so are higher taxes

Corporate rate already too highCorporate rate already too high Rangel, Wyden-GreggRangel, Wyden-Gregg

Current system nearly tapped outCurrent system nearly tapped out

Historical Perspective on Historical Perspective on the Fiscthe Fisc

Average federal tax about 18.2 % of Average federal tax about 18.2 % of GDPGDP

Average deficit = sustainable deficit Average deficit = sustainable deficit about 2.2 %about 2.2 %

Average spending about 20.4 % Average spending about 20.4 %

Taxes, Or NotTaxes, Or Not

Existing system to 20 % of GDPExisting system to 20 % of GDP

With 2 % deficit and 25 % spendingWith 2 % deficit and 25 % spending

Leaves gap of 3 % of GDPLeaves gap of 3 % of GDP

Absent fundamental entitlements Absent fundamental entitlements reforms, long-run shortfalls much reforms, long-run shortfalls much higherhigher

Implication of GluttonyImplication of Gluttony

IfIf much high spending inevitable, much high spending inevitable, Then so are higher taxesThen so are higher taxes Corporate rate already too highCorporate rate already too high

Rangel, Wyden-GreggRangel, Wyden-Gregg Current system nearly tapped outCurrent system nearly tapped out Must find another revenue sourceMust find another revenue source Answer – A VATAnswer – A VAT

The VAT WaveThe VAT Wave Volcker – AValue-Added Tax (VAT) “on the Volcker – AValue-Added Tax (VAT) “on the

table”table”

Brookings – 15 to 20 percent VATBrookings – 15 to 20 percent VAT

Congressional Budget Office – Studying VATCongressional Budget Office – Studying VAT

Tax Policy Center – A VAT to replace the Tax Policy Center – A VAT to replace the payroll tax and corporate income taxpayroll tax and corporate income tax

What’s A VAT?What’s A VAT?

An operational national retail sales An operational national retail sales taxtax

Intended as an add onIntended as an add on

VAT rates typically 15 to 20%VAT rates typically 15 to 20%

EU minimum standard rate of 15%EU minimum standard rate of 15%

Glut the Beast = VATGlut the Beast = VAT

Spending means fiscal policy Spending means fiscal policy unsustainableunsustainable

Massive source of new revenues Massive source of new revenues 1 percentage point = net $50 billion 1 percentage point = net $50 billion

in tax revenuein tax revenue 15 percent VAT = $750 billion in tax 15 percent VAT = $750 billion in tax

revenuerevenue 15 percent VAT -> 5 percent of GDP15 percent VAT -> 5 percent of GDP

Why a VAT?Why a VAT?

Massive source of new revenues Massive source of new revenues

VAT is among least damaging to VAT is among least damaging to economyeconomy

VAT is nearly invisible to taxpayersVAT is nearly invisible to taxpayers

Investors’ Threat # 3Investors’ Threat # 3

Glut the Beast – the Glut the Beast – the ConclusionConclusion

Sovereign debt crisis begins in GreeceSovereign debt crisis begins in Greece

Flows across Europe to U.S.Flows across Europe to U.S.

U.S. credit market crisis triggers a panic to actU.S. credit market crisis triggers a panic to act

VAT plus other tax hikes, especially on capitalVAT plus other tax hikes, especially on capital

Or reverse Obama’s spending?Or reverse Obama’s spending?

Opportunities, TooOpportunities, Too

Global economy more balanced Global economy more balanced (India, China, Brazil, etc.) (India, China, Brazil, etc.)

Output Gap over 10 percentOutput Gap over 10 percent Basic institutions remain soundBasic institutions remain sound Entrepreneurial spirit is aliveEntrepreneurial spirit is alive The nation woke upThe nation woke up Mid-Term ElectionsMid-Term Elections

Portfolio Management Portfolio Management in a Hostile in a Hostile

EnvironmentEnvironment

Portfolio Management InstitutePortfolio Management Institute

Atlanta, GeorgiaAtlanta, Georgia

April 22, 2010April 22, 2010

Portfolio Management Portfolio Management in a Hostile in a Hostile

EnvironmentEnvironment

Portfolio Management InstitutePortfolio Management Institute

Atlanta, GeorgiaAtlanta, Georgia

April 22, 2010April 22, 2010