Summary and Outlook

Our economy grew 1.7%, before inflation during 2011 compared to 3% in 2010 and headline inflation was up 2.9% versus 2.2%. Corporate profits were up 7.9% in 2011, compared to 32% in 2010 with the strongest gains in manufacturing and information technology. With a budget deficit equal to 8.6% of GDP and profit growth decelerating it is clear that a combination of pro-growth fiscal policies and spending restraint are needed to sustain a long term recovery.

We do not expect more quantitative easing from the Fed; however it is likely that operation “Twist” will be extended beyond its June 2012 deadline, which will keep a lid on longer term interest rates. We expect productivity growth to accelerate and inflationary pressures to recede.

Fiscal policy and regulation will be key campaign elements moving into the fall elections. Markets are already showing evidence of a “false prosperity” as investors accelerate income recognition in anticipation of higher taxes.

We are slowly shifting portfolio exposure to more growth and small cap businesses and adjusting exposures to certain industries based upon our policy expectations. However we have held portfolio equity allocations to neutral ranges, and will not expose client assets to greater market risk until fundamental developments become more clear.

We continue to believe that 2012 will be a pivotal year!

Economic Growth (Real GDP)

The US economy expanded at an annual rate of 3% during the fourth quarter, compared to 1.8% during the prior third quarter. Inventory expansion added 1.81% to fourth quarter GDP. Spending for autos (+20%) and computers (+21%), more than offset a 6.9% decline in government defense expenditures, a 2.2% decline in state and local government spending and a deceleration in business expenditures, which grew at a 5.2%, rate versus 16.1%.

For the entire year real GDP increased 1.7% in 2011, compared to 3.0% for 2010. The price index for domestic purchases increased 3.1% in 2011, versus 1.4% for 2010. Reduced investment in inventories and lower government spending were the primary factors contributing to slow growth in 2011.

Corporate profits increased $16.8 billion during the fourth quarter of 2011 compared to $32.5 billion for the prior period. Domestic profits for financial and Non-Financial corporations were up $29.9 billion and $28.4 billion respectively, and were partially offset by a $41.5 decline in profits from their foreign affiliates.

For the year corporate profits were up 7.9%, compared to 32.2% in 2010. Domestic profits were up 6.7% in 2011 and profits from foreign affiliates were up 12.4%. Financial corporate profits decreased in 2011 and non-financial corporate profits increased. Manufacturing and information technology were the strongest sectors, and utilities, retail & wholesale trades, transportation and warehousing were the weakest sectors.

Short term indicators were very strong during the first quarter of 2010 and we are seeing a repeat of this, albeit at a lower level so far this year. Productivity growth has declined from the 7% range to 1% and this seems to be supporting a modest increase in employment, primarily in the manufacturing sector. The unemployment rate declined from 9.4% to 8.5% during 2011. The consumer savings rate has declined from 8% to 5% and there is evidence of mild credit expansion.

Monetary Policy, Inflation, & Interest Rates

Credit and money markets have been closely manipulated by the Fed since the 2008 financial crisis. The Fed’s dual objective includes maintenance of low cost short term liquidity to support the banking system, and low cost long term money to stimulate the housing market and consumer spending. The global recession, and in particular the sovereign debt crisis in Europe increased demand for US Government debt as a safe haven and reserve currency, which allowed the Fed to issue over $2 trillion of low cost debt to support these objectives. In addition, last September the Fed initiated “Operation Twist”, whereby they issued short term bonds and used the proceeds to purchase long term government bonds. Twist has not increased the total amount of debt outstanding; however it has had the desired effect of holding down long term interest rates. When twist was initiated the interest rate on the ten year treasury bond declined from 3.17% to 1.92% in less than three weeks.

The increased probability of a longer term solution to the Euro-zone crisis during March resulted in an avalanche of government bond sales by hedge funds and other investors that were using US government as a safe haven to reduce portfolio risk. Yields for five and ten year government bonds ended the quarter at 1.04% and 2.21%, up .21% and .33% respectively. Operation Twist is scheduled to end during June and this will place additional upward pressure on long term rates.

Price inflation moderated during the first quarter. The CPI increased .6% during the fourth quarter and was up 2.9% for the 12-months ended February 2012. Finished goods and import prices were up .9% and .4% for the quarter and 3% and 5.5%, respectively for the year. Energy prices were up 1.7% for the quarter and ended the year up18.4%. Pricing pressures from higher food and energy costs are being tempered by lower prices for many services including utilities, communications and information technologies. Continued consumer deleveraging, reduced corporate earnings growth, and lower government spending will likely keep “demand pull” inflation at bay this year. Slower productivity growth means companies will need to add labor to increase production if growth rates do improve, and this does raise the prospect of “cost push” inflation if higher labor costs are passed on in the form of higher prices.

We think it is likely that the Fed will extend operation Twist beyond the June deadline and this will keep a lid on longer term interest rates, however we do not anticipate additional quantitative measures. Existing actions to cure the sovereign debt crisis will not be effective over the longer term, which will require additional quantitative easing in Europe and German acceptance of increasing inflation. Recent experience leads us to believe that Germany will not make this decision quickly and this increases the probability of a resumption of Euro-zone pressure and higher market volatility as the year progresses.

Fiscal Policy

Fiscal policy and regulation will be the primary economic battleground in the election process this year. President Obama has made it clear that he will use all power available to the executive branch to legislate, bypassing Congress and the Senate this year. As a result we expect a bevy of regulatory actions, increasing friction in the political process and little progress toward resolution of our budget deficit this year.

One certainty is the Bush tax cuts will expire at the end of this year, increasing tax rates paid for dividend, interest and ordinary income. If actions required to extend the Bush cuts are not forthcoming markets will continue to show the effects of “false prosperity”, as investors accelerate income recognition in anticipation of higher rates. Changes in tax rates will also affect the relative performance of various industry groups and capital structures, which in turn influences the investment outlook. We are already seeing these effects in performance of growth versus value stocks, small versus large cap stocks and on industries susceptible to higher tax and regulatory burdens.

Our federal budget deficit is currently $1.3 trillion and our annual GDP is $15.1 trillion, which translates to a deficit that is equal to 8.61% of our annual economic output. Therefore, reducing the deficit requires: 1) increasing our annual GDP growth to a level greater than 8.61%, 2) reducing the deficit by $785 billion (60%), or 3) some combination of these actions. Another popular GDP target is the 4% real growth rate proclaimed necessary to create job growth, which combined with the fourth quarter inflation rate of 2.9% equates to a GDP target of 6.9% Either GDP target rate (8.61%, or 6.9%) are well above the 2011 growth rate of 4.6% (1.7% GDP + 2.9% CPI). We must pursue policy measures that will stimulate GDP growth and control spending.

GEOPOLITICS

China

China is at a turning point, where they must transition from an export based economy to a more balanced economy with increased reliance on domestic demand. China is the world’s second largest economy and with a growing middle class and “managed” capitalism has the foundation required to surpass the United States as the world’s largest economy this century. In fact, many believe that this will occur within the next twenty years.

China has attracted vast amounts of investment capital and reduced the cost of goods for countries throughout the world. They have also invested heavily in US government securities supporting the low-interest rate environment in our country.

Going forward China will be viewed increasingly as a market for US products, versus a source of lower cost products.

Europe

Despite occasional shudders of fear that Portugal or Spain may need of fresh rounds of assistance from the rest of Europe, the worst of the European crisis seems to be behind us at present. There are two primary reasons that this seems to be the case:

1. Greece increasingly appears to be an isolated case, which means that the fear of an accelerating domino effect of defaults and bank implosions, starting with Greece and ending with Italy and the French banks, is unfounded. There is now the Greek situation and the rest of Europe. Now that the Greek debt exchange is complete, most of the uncertainty related to Greece has passed. This is a fragile hope, however, that could be dashed at the slightest fault of the remaining PIIGS.

2. The ECB three-year liquidity operation designed to support demand for government bonds among the huge European banks appears to have been a success, and is further evidence that the ECB will not remain idle in the face of crisis. We believe that this demonstrates that the ECB will act as the ultimate backstop of government debt and a lender of last resort, regardless of German concerns of increasing inflation pressures.

The Germans may be more inclined to support additional ECB action to support the PIIGS, because their economy will suffer if Europe continues to suffer. The Germans’ choice is either to support the ECB and tolerate rising inflation, or to remain tight-fisted and see their economy suffer as the rest of Europe sinks. Despite well-publicized criticism of the ECB during the quarter, the Germans appear to be more accommodative after last summer’s European crisis, and therefore, another full-blown crisis seems less likely.

Middle East

Violence in Syria continues and uncertainty related to Iran continues. The elimination of the Assad regime will completely isolate Iran in the Middle East, and should make Israel somewhat safer by cutting off a vital link to the Iranian-backed Lebanese terrorist group Hezbollah. The situation is no better in the Middle East than it was three months ago, although the upcoming elections in Egypt are an additional source of uncertainty in the region.

Nigeria

Violence in Nigeria continued through the quarter, with hundreds of dead at the hands of bombing attacks on Christians by the Islamist group Boko Haram.