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1Q 2013 NIFCU$ Perspectives and Commentary


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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:

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1Q 2013 NIFCU$ Perspectives and Commentary

  1. 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, andwhen, Congress might resolve its ongoing battle over fiscal policy. As investors worried about theimpact of the tax and spending provisions the Budget Control Act of 2011 would have on an alreadyfragile economy, Congress showed little inclination to reach a bi-partisan compromise. The resultwas 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 MinorityLeader Mitch McConnell negotiated to avoid sequestration. Within seventy-two hours of their initialdiscussions, 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 threedays --- or was it?The ATRA of 2012 prolongs by two months the budget sequestration deadline established in the Actof 2011. Congress now has until the end of February 2013 (unless extended) to negotiate spendingcuts intended to lower the Federal deficit. Much now must be done in a short amount of time by agroup that has had little success reaching any sort of consensus over the past few years. Due to thisreality, uncertainty remains high which has not been lost on the financial markets. This thread ofuncertainty can be expected to weigh on investors, and caution will prevail until a detailed plan tolower deficit spending has been articulated. The sequestration established in the Act of 2011, ifallowed to prevail, could threaten the economy in 2013. A compromise would have less impact onthe economy, though what form any compromise might take is pure speculation. This uncertaintyshould dampen upside potential (especially in the equity markets) until a resolution is reached, andfailure 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 fourthquarter of 2012. Q3 GDP grew at a stronger-than-expected 3.1%, yet appears to have slowed tonear 2% in Q4 as both businesses and consumers remained reluctant to spend in anticipation ofpotential tax increases and further economic slowing. The ongoing recession in Europe and amodest slowing in emerging markets detracted from US growth as well. 1  
  2. 2. Despite slower growth in Q4, the US added 453,000 jobs over the quarter, keeping the rate ofunemployment at 7.8%, a number consistent with the end of Q3. Dominant areas supporting jobgrowth include health care, food services, construction and manufacturing.Though there is little doubt that fiscal drag at the federal government level will detract from economicgrowth in 2013, our base case scenario assumes a compromise will be reached that will allow theeconomy to expand over the year ahead. We expect any fiscal shock from the compromise will bemost apparent over the first six months of the year, subsiding in the second half as higher taxes andlower government spending become the established norm. Source: HighMark Capital estimates and Thomson DatastreamFixed Income Outlook On December 12, 2012, the Federal Open Market Committee (FOMC) announced they wouldexpand QE3 by over 200% (from $40 to $85 billion per month) following the end of Operation Twiston December 31st. They also moved away from their commitment to keep rates low through 2015 bypegging their timing for tightening monetary policy to the level of unemployment. We now expectaccommodative monetary policy will remain unchanged until the unemployment rate movessubstantially lower. Given that the FOMC forecasts unemployment to end 2014 at 7.05%, we expectvery low short-term interest rates throughout 2013. We believe this may not, however, be the casefor longer rates – despite the intentions behind QE3.During 2012, ten-year US Treasury yields ranged between 2.38% and 1.39%, and finished the yearat 1.76%. Peak yield was achieved in March following two months of better-than-expected growth innon-farm payroll (275k in January and 259k in February), suggesting an acceleration of economicgrowth. As it turned out, the economy was not accelerating. In fact, it was slowing, as evidenced byweak non-farm labor growth averaging only 67k over the second quarter of the year, and a drop inGDP from 2.0% in Q1 to 1.3% in Q2. Less-than-favorable news pushed the 10-year yield to 1.39% inJuly. Despite Operation Twist and the Fed’s desire to hold rates down, market forces continued todominate in the face of positive economic news. This suggests that Operation Twist, which hasessentially been extended as part of QE3, may not have the intended influence when the economy isshowing signs of improvement. Given our base scenario, which projects economic improvement overthe second half of 2013, we expect longer yields will move higher, with the 10-year near 2.5% atyear end, despite QE3.We believe the modest rise in longer Treasury rates over 2013 should not detract from investordesire to own yield. Economic fundamentals continue to support the ability for companies to servicedebt and concern over credit deterioration remains low. Yield spreads, meanwhile, remain modestly 2  
  3. 3. attractive, and the corporate bond component of the Barclay’s Aggregate Index returned 9.82% lastyear. As such, we believe investors should be reluctant to abandon the historically strongperformance 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 andthe near-term risk is that the program will end. We expect the program will continue untilunemployment moves much lower, inflation becomes problematic, or the Fed decides they can nolonger allow their balance sheet to expand. We view the last of these risks to be the initial catalysthelping longer rates to move higher. We expect the FOMC will draw a line on the maximum level ofdebt 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 hopefor 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   3  
  4. 4. Equity Outlook for Q1 2013 In the midst of election results and the fiscal cliff debate, the stock market spent the fourth quarterbehaving as if stronger growth was imminent. Cyclical firms, small companies and value plays allposted strong performance over the period, in contrast to the stable growth themes that hadprovided the most consistent returns over the previous three quarters.Looking forward to 2013, we feel the market is slightly overvalued on an absolute basis, yetcompetitively 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 marketvaluations. In response to sluggish domestic growth, many firms have been investing considerableresources into their offshore operations, where growth is higher and margins are better. Equitymarkets could respond positively to any rise in bond rates stemming from economic resurgence orthe 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 ofthe year was dominated by the same type of risk-on, risk-off volatility plaguing stock markets for thelast five years, the second half showed signs of stability reminiscent of less volatile markets, whichpreceded 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 4  
  5. 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 and Commentary is a publication of HighMark Capital Management, Inc. Thispublication is for general information only and is not intended to provide specific advice to anyindividual. Some information provided herein was obtained from third party sources deemed to bereliable. HighMark Capital Management, Inc. and its affiliates make no representations or warrantieswith respect to the timeliness, accuracy, or completeness of this publication and bear no liability forany loss arising from its use. All forward looking information and forecasts contained in thispublication, unless otherwise noted, are the opinion of HighMark Capital Management, Inc. andfuture market movements may differ significantly from our expectations. HighMark CapitalManagement, Inc., a registered investment adviser and subsidiary of Union Bank, N.A., serves asthe investment adviser for HighMark Funds. HighMark Funds are distributed by HighMark FundsDistributors, LLC, an affiliate of Foreside Distributors, LLC. Union Bank, N.A. provides certainservices for the HighMark Funds for which it is compensated. Shares in the HighMark Funds andinvestments in HighMark Capital Management, Inc. strategies are not deposits, obligations of orguaranteed by the adviser, its parent, or any affiliates. Index performance or any index related datais given for illustrative purposes only and is not indicative of the performance of any portfolio. Notethat an investment cannot be made directly in an index. Any performance data shown hereinrepresents returns, and is no guarantee of future results. Investment return and principal value willfluctuate, 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 bythe FDIC or any other agency. Mutual fund investing involves risk, including possible loss ofprincipal. Investors should consider the Funds investment objectives, risks, charges andexpenses carefully before investing. This and other information can be found in the Fundsprospectus, which may be obtained by calling 1.800.433.6884 or by Please read the prospectus carefully before investing. Entirepublication © HighMark Capital Management, Inc. 2013. All rights reserved.       5