Market Analysis / Fourth Quarter 2010

1. Market Analysis / Fourth Quarter 2010

2. Key Takeaways • A strong fourth quarter turned a mediocre year for stocks into a strong year • The broad high-quality bond market lost ground for the quarter as Treasury yields spiked higher, but still finished 2010 with a healthy 6.4% gain • Overseas, stocks from both developed and emerging markets closed with a strong fourth quarter and posted good full-year results • Emerging-markets bonds were mostly flat in Q4 but held on to mid-teen gains for the full year Market Analysis 4Q2010

3. Asset Class Returns Through 12/31/2010 Past performance may not be indicative of future returns. Market Analysis 4Q2010

4. Things Feel Better, but Our List of Worries Is Little Changed Household debt remains extremely high The job market is still very weak Housing is very stressed Each of these problems is a negative for spending, which is the main driver of the economy Government finances are in poor shape and will see further stress from lower tax revenues and higher pension and health care costs Market Analysis 4Q2010

5. Household Debt Has Bigger Cons than Pros Market Analysis 4Q2010

6. Though Household Debt Has Declined Sharply It Remains Historically High Market Analysis 4Q2010

7. With Rates Low and an Ebb in Fear, Investors Are Stretching for Return • Low interest rates have spurred risk taking, driving prices higher • As a result, few asset classes are priced to deliver exciting returns right now • Our scenario analysis provides us with return ranges for key asset classes under differing economic outcomes… Market Analysis 4Q2010

8. The Jobs Picture Has Improved but Remains Poor Market Analysis 4Q2010

9. There Is a Historically High Number of Unemployed Relative to Job Opening Market Analysis 4Q2010

10. The Housing Market Faces More Stress Market Analysis 4Q2010

11. Still, Things Are More Positive Than a Year Ago • The global economy saw decent growth in 2010 • Emerging markets are a bright spot • Corporations have lots of cash and will ramp up hiring and investing if things continue to improve • The recent tax bill will help replace the fading effects of the prior stimulus • This buys more time for the economy to gain momentum and will add to 2011 growth • It will also worsen our longer-term debt problems Market Analysis 4Q2010

12. We Expect Low Single-Digit Returns for Stocks in the Scenarios We Consider More Likely • Stocks are currently selling above our fair-value range • Considerable risks remain • Foreign stocks of developed countries are at similar valuations to the U.S. • Emerging-markets stocks should do better, but carry elevated risk • We now give more weight to the positive impact that stronger emerging-market nations have on earnings of developed market countries • As a result our return forecast for equities edged higher Market Analysis 4Q2010

13. Scenario Analysis: Asset Class Return Estimates Market Analysis 4Q2010

14. S&P 500 5-Year Return Estimates Under Each Scenario With the S&P at 1300, if earnings reach $88 and stocks trade at 15x earnings, and we add in dividends, we get this annualized return. Fair Value Range Market Analysis 4Q2010

15. Investment-Grade Bonds Are Unexciting But Some Bond Sectors Still Offer Reasonable Value • We do not think the idea of a “bond bubble” is accurate • Core fixed-income sectors are not attractively valued, but that results in low likely returns, not high downside risk • That downside risk protection remains important in the event of another recession • Some bond sectors do offer reasonable value and have better return potential • Overseas, emerging-markets local-currency bonds enjoy better yields and would benefit from ongoing weakening of the dollar Market Analysis 4Q2010

16. Muni Bonds Have Faced a Number of Stresses but Are Attractive for High Bracket Investors • Munis were barely positive in 2010 and lagged taxable bonds • Beyond the general rise in rates, munis were hurt by: • Credit fears due to weaker government finances • A rise in supply from new issuance • The ending of the Build America Bonds program, which will add more supply of munis • The tax bill, which delayed higher tax rates for several years • The result is that yields are now quite attractive • With major budget gaps to close, “headline risk” about these state/local finances will probably add to volatility in the shorter term • But over the longer-term, munis should do quite well and skilled managers should be able to avoid any problem areas Market Analysis 4Q2010

17. Is Our Concern Leading Us to Miss Out? • Though our macro concerns have largely been playing out, stocks have returned more than we thought • Looking ahead, we may lag in the shorter term if equities continue to rally • Longer term, we are confident we can do well by: • Remaining patient and disciplined as we wait for compelling asset class opportunities • Using alternative strategies that can do well without tailwinds from stocks and bonds • Using highly skilled stock and bond managers Market Analysis 4Q2010

18. Adding Value on the Fixed-Income Side • We use several flexible bond managers who we think can earn competitive returns but some have significantly higher risk than “core” bonds • Collectively these managers can mitigate the impact of rising rates and rising inflation • PIMCO Unconstrained has the flexibility to pursue strategies that would benefit from rising inflation, including having a negative duration • Fidelity Floating Rate High Income is focused on high-yield, variable rate bonds but with short maturities • Loomis Sayles Bond has significant exposure to countries with commodity-based economies, which should benefit in an inflationary environment • PIMCO Emerging Local Bond should do well against the dollar if U.S. inflation spikes Market Analysis 4Q2010

19. Investment Thesis: Emerging-Markets Local-Currency Bonds • We believe that a basket of emerging-markets (EM) currencies is the best way to protect our portfolios from a decline in the U.S. dollar • Other attractive attributes of emerging-markets local-currency bonds include relatively strong economic fundamentals for EM countries, higher bond yields, potential for currency appreciation over the long term • EM local-currency bonds could see significant short-term losses; in our worst-case recession scenario we would anticipate losses in the mid teens Market Analysis 4Q2010