Executive Summary

The economy:

• After giving vague guidance about when it might reverse course, the Federal Open Market Committee (FOMC) provided calendar-date projections as to when policy might change, and finally, in a form of radical transparency, it has provided specific unemployment and inflation triggers for policy changes. Although the Fed cannot take all the credit, its bond-buying program has aided the housing market by keeping mortgage rates low. Housing could provide a significant boost to growth in 2013.
• Another area that we believe could provide a lift is in the area of investment spending by businesses. Even if there is only a slightly positive growth rate to the economy, that could be enough for some to start thinking about growing their businesses.
• During the course of 2013, the dollar is likely to strengthen relative to the yen and euro but depreciate relative to some emerging markets currencies, like the Mexican peso.
• There are two big wild cards in 2013 for the eurozone: the February elections in Italy and the September/October elections in Germany.
• In emerging markets, there are country-specific factors that could favor areas like China, emerging Asia, and Central to South America in the coming year.

Equities:

• In our opinion, there has been a lingering consensus haunting Wall Street since the end of the last major bear market four years ago: Sooner or later, we are going to have to pay for the excesses of the past 25 years.
• In our opinion, one of the most important (but not the only) drivers of stock market performance is the stance and actions of the Federal Reserve.
• With Europe in a recession, and likely to stay that way throughout 2013, investors may be a bit too glum on European and emerging markets equities. We think Europe could be host to—and the source of—volatility, but with austerity becoming less austere, some emerging markets have slightly shifted away from export-dependent growth, and their economies—and markets—could advance nicely. We don’t encourage an overweight to Europe or emerging markets, but we do like a selective normal weight to both areas.

Fixed income:

• Our strategic position for 2013 remains the same as it has since 2010: It is still too early in this cycle for fixed-income investors to be overweight cash and cash equivalents. While no one can accurately predict the future path of growth, employment, or inflation, it is probably reasonable to assume that the Fed will keep the federal funds rate near zero and will remain a significant buyer of Treasuries and mortgage-backed securities (MBS) through 2013.
• A defining feature of this cycle is the collapse in borrowing in the private sector of the U.S. economy. Housing is a big user of borrowed money, and that sector is only now starting a slow recovery.
• We believe the current market environment is likely to prevail in 2013, and, as such, investors should continue to seek income rather than safety. Long-duration strategies that have been beneficial the past four years might not be as successful in 2013.

Asset allocation:

• For investors with an investment horizon of three years or longer, we recommend a strategic overweight to equities relative to fixed income.
• Short-term, over the next three months, we think investors can still be rewarded by looking at higheryielding fixed-income investments as well as growth-oriented equities.
• Within the equity portion of a portfolio, long-term, we think investors should look globally for opportunities.
• Based on our economic outlook, we believe that interest rates are likely to remain low for the next year, presenting an opportunity for investors to take on additional duration and credit risk.