Investment
Outlook
February 2011
John Maynard Keynes (1883–
1946) was a British economist
whose ideas have profoundly
affected the theory and
practice of modern
macroeconomics, as well as
the economic policies of
governments. While Keynes’s
views fell relatively out of
favor starting in the 1970s
with the U.S. economic
struggles and the rise of the
Monetarists like Milton
Friedman, the Great
Recession has inspired a
renaissance for his ideas.
E. William Stone, CFA, CMT
Chief Investment Strategist
Rebekah M. McCahan
Investment Strategist
Fred H. Senft, Jr., CFA
Director of Research
Nicholas M. Srmag
Fixed Income Analyst
Paul J. White, PhD, CAIA
Senior Investment Strategist
pnc.com
Great Expectations: Inflation
“By a continuing process of inflation, governments can confiscate,
secretly and unobserved, an important part of the wealth of their
citizens.”
—John Maynard Keynes
Executive Summary
This month we focus on inflation. Inflation is a source of concern for most
investors because it influences buying power in real terms. In our view, inflation
can be divided into two types:
expected inflation; and
unexpected inflation
The expected component of inflation does not qualify as risk; only the
unexpected component should be considered as risk. Expected inflation gets
priced into the market without shock, while unexpected inflation acts as a source
of volatility to the markets.
To hedge inflation an investor purchases inflation insurance, which may or may
not be cheap or effective. Our studies lead us to the following views.
Gold is an inflation hedge over the very long term.
Commodities are an inflation hedge with non-inflation exposures.
TIPS are an inflation hedge.
Private real estate is an ineffective inflation hedge.
This month’s Investment Outlook will focus on our inflation watch indicators,
expected versus unexpected inflation, and the above-mentioned inflation
hedges, with attention paid to the unintended exposures that accompany those
hedges. Unintended exposures in a hedge position may, in fact, expose an
investor’s portfolios to additional, unforeseen risks. That is the danger in adding
a hedge position that is not pure.
While we have devoted much of our February Investment Outlook to other
assets used in hedging inflation risks, we would be remiss not to discuss stocks
and bonds in this regard as well. Though high inflation historically has led to
poor short-term stock performance, equities historically have provided the
highest real return across stocks, bonds, and cash. Stocks adapt to inflation
because earnings eventually rise with the level of inflation and offset at least
some of the negative impact of inflation. Bonds paying a fixed coupon are
unable to adapt to unexpected inflation and suffer badly in comparison.
Our current recommended allocation attempts to balance the relative
attractiveness of stocks and other risk assets, given the transition to expansion
that we expect in the global economy. We remain vigilant in monitoring asset
valuations and the various factors affecting our views on the sustainability of the
economic recovery. There continue to be a number of sources of volatility and
downside risk, including European sovereign debt, emerging market inflation,
employment, and other geopolitical risks.
PNC’s six asset allocation models are shown on the back page of this outlook.
Investment Outlook

Great Expectations
Inflation is a source of concern for most investors because it influences buying power
in real terms. Higher inflation can lower an investor’s purchasing power; for that
reason, the convention that lower inflation is a positive for
Chart
Chart 1 equities typically holds. Inflation is usually measured by
Expected and Unexpected Inflation
Expected and Unexpected Inflation the consumer price index (CPI). The CPI is a price index
(shaded areas are recession periods)
(shaded areas are recession periods) calculated as the current cost of a fixed basket of goods
15
divided by the cost of the basket in the base period.
Inflation
Unexpected Inflation Chart 1 shows inflation as measured by the CPI. 1 Inflation
10 had three strong spikes–in 1974, 1979, and 1980. The
values exceeded 10%. This period is strongly associated
5
with soaring energy prices and recessions. Here, both
Percent

expected and unexpected inflation are shown. The

0
conventions of expected and unexpected inflation are
constructs.
-5
Expected inflation is the idea that an investor
-10 expects inflation to remain constant year
over year.
1970

1975

1980

1985

1990

1995

2000

2005

2010

Unexpected inflation is the change in the inflation

Source: Bureau of Labor Statistics, Bloomberg L.P., PNC rate year over year.
Although there isn’t a strict definition for unexpected
inflation, this separation reflects the idea that an investor is
biased neither higher nor lower with regard to next year’s value. Neither optimism
nor pessimism enters into a neutral point of view. The timeframe is important to
consider because we want to examine the effect of inflation over longer periods, that
is, years. These longer time periods are associated with investing, financial planning,
retirement, and the like. Inflation can be sampled on a shorter timescale, but higher-
frequency observations do not add to the message here.
The change itself in year-over-year inflation can occur over very short periods. To
that end, it would be practical to follow inflation proxies in the market. Market
indicators would have the advantage of immediacy versus the lag time associated
with publishing CPI numbers. A dramatic change in these values might alert an
investor to large values in unexpected inflation. Obviously, the negative scenario is
one of positive spikes in inflation.
At PNC, we use several inflation watch indicators2 to monitor the onset of inflation:
core inflation (inflation excluding food and energy) (Chart 2, page 3);
market expectations for future inflation (Chart 3, page 3);
commodity prices (Chart 4, page 3);
import prices (Chart 5, page 3);
labor costs (because this is what fed the wage/price spiral of the 1970s)
(Chart 6, page 3); and
the timeliness of the unwinding of central bank policy actions (Chart 7,
page 3).

1
Some people use the GDP deflator as a metric for inflation. CPI has known quality
adjustment and substitution biases. The choice does not affect our conclusions here.
2
These indicators were introduced in the July 2009 PNC Investment Outlook—Hold
‘em or Fold ‘em.

2 February 2011
 Great Expectations: Inflation

Chart
Chart 22 Chart
Chart 33
Headline andCore
Headline and CoreCPI
CPI 5-Year 5-Year-ForwardTIPS
5-Year 5-Year-Forward TIPS Spreads
Spreads
6.0 3.5
Total
Year-over-Year Percentage Change

5.0
Core: Total Excluding Food & Energy 3.0
4.0
2.5
3.0
2.0 2.0

Percent
1.0
1.5
0.0
1.0
-1.0
-2.0 0.5

-3.0 0.0
1/08

4/08

7/08

10/08

1/09

4/09

7/09

10/09

1/10

4/10

7/10

10/10

1/08

4/08

7/08

10/08

1/09

4/09

7/09

10/09

1/10

4/10

7/10

10/10

1/11
Source: Bureau of Labor Statistics, Bloomberg L.P., PNC Source: Bureau of Labor Statistics, Bloomberg L.P., PNC

Chart
Chart 44 Chart
Chart 55
DJ-UBS CommodityIndex
DJ-UBS Commodity Index Import PricesExcluding
Import Prices Excluding Petroleum
Petroleum
260 116
240 115
114
220
Index 1/2/1991 = 100

113
200
2000 = 100

112
180 111
160 110
109
140
108
120
107
100 106
1/08

5/08

9/08

1/09

5/09

9/09

1/10

5/10

9/10

1/11

1/08

5/08

9/08

1/09

5/09

9/09

1/10

5/10

9/10
Source: Dow Jones, UBS, Bloomberg L.P., PNC Source: Bureau of Labor Statistics, Bloomberg L.P., PNC

Chart
Chart 66 Chart 77
Chart
Average HourlyEarnings
Average Hourly Earnings M2
M2
4.0 12
Year-over-Year Percentage Change
Year-over-Year Percentage Change

10
3.5
8
3.0
6

2.5
4

2.0 2

1.5 0
1/08

4/08

7/08

10/08

1/09

4/09

7/09

10/09

1/10

4/10

7/10

10/10

1/11
1/08

5/08

9/08

1/09

5/09

9/09

1/10

5/10

9/10

Source: Bureau of Labor Statistics, Bloomberg L.P., PNC Source: Federal Reserve, Bloomberg L.P., PNC

3
Investment Outlook

Inflation is wealth entropy. It detracts from value in most circumstances and is a

hurdle to real purchasing power. In deciding what to spend or in estimating the final
value of an investment, inflation must be accounted for. In that sense, it is
straightforward enough to plan for expected inflation. It may be high or low, but
expected inflation fits into financial planning, for better or for worse. Unexpected
inflation is typically for the worse. Even if one is a debtor (where inflation reduces
one’s debt in real terms), unexpected inflation is a cost in terms of volatility.
Chart 8 shows the growth of one dollar invested in each of the S&P 500 ® and the
Barclays Aggregate bond index from 1989 to 2009. The values of each are presented
in both nominal and real terms. The real value is the
Chart
Chart 88 compound annual growth with inflation taken out. The
S&P
S&P 500 and
andBarclays
BarclaysAggregate
Aggregate Bond
Bond Index
Index difference is higher than most people think. For the
S&P 500, the end value of about 700% in nominal terms
900
S&P 500 becomes about 450% in real terms. The corresponding
800
S&P 500 Inflation Adjusted figures for the Barclays Aggregate are 470% in nominal
700 Barclays Aggregate
Bond Index
terms versus 270% in real terms. The difference of
600 nominal versus real becomes even clearer over longer
Barclays Aggregate
Percent

Inflation Adjusted
500 periods. The period from 1989 to 2009 was not the one of
400 the highest inflation; that would be the mid-70s, a time
300 when inflation peaked somewhere near 10% a year.
200 Regardless of the period chosen, it is clear that inflation
100 plays a destructive role in terms of purchasing power.
0 Unexpected inflation is a shock to financial planning. It
12/89

8/91

4/93

12/94

8/96

4/98

12/99

8/01

4/03

12/04

8/06

4/08

12/09

might be a negative or positive value. Both are not

favored, but clearly a large positive spike is the less
Source: Standard & Poor’s, Barclays Capital, Bureau of desired of the two outcomes. What is examined here is a
Labor Statistics, Bloomberg L.P., PNC way to hedge the unexpected positive shocks in inflation.
It is the PNC view that inflation should be moderate over
the near term. However, given the diversity of the client base, we recognize that
portfolios of different investors have different sensitivities to sharp increases in
inflation. To that end, the discussion here centers on methods to hedge unexpected
inflation in those specific portfolios.
Since one cannot accurately predict the short-term movement of stocks or infallibly
forecast the future, we primarily focus on what is knowable. When determining a
recommended asset allocation for our clients, we focus on their:
goals;
risk tolerance;
income needs;
investment holding period; and
personal situation.
In addition, when the Investment Policy Committee considers PNC’s general
recommended allocations, it concentrates on the intrinsic valuation of possible
investments and weighs the estimated risk versus reward.

Hedging: Expecting the Unexpected

Separating inflation into expected and unexpected components might seem academic
at first glance. However, inflation itself is not observable, meaning one can’t go into
the market and identify something on the exchange that is distinctly inflation. The
separation of something that is already invisible seems strange, but it is precisely the

4 February 2011
 Great Expectations: Inflation

unexpected versus the expected that drives changes in the market. Consider an
unexpected rate change from the Federal Open Market Committee as an analogy. In
this case, unexpected refers to a rate change between regularly scheduled meetings.
On October 8, 2008, the federal funds rate was lowered to 1.5% at an unscheduled
meeting and the S&P 500 swung more than 5% between the high and the low price
on that day. Unexpected inflation is also a source of volatility.

Gold3
Gold was covered in PNC’s November 2010 Investment Outlook: Road Trip to
Eldorado. The publication examined several investment aspects of gold, including its
ability to act as an inflation hedge. Gold was not an effective inflation hedge over
short or even sometimes multiple-decade investment holding periods. We will not
revisit details of the argument against inflation hedging. Instead, we want to examine
whether gold is an adequate hedge against unexpected inflation, which we defined as
the change in the year-over-year inflation rate.
To examine the possibility that gold is a hedge against inflation, we performed a
linear regression—
numerical analysis using linear regression. Linear regression is a way to look for
dependencies of certain variables contained inside another variable, in our case, the shows the
returns of gold. The idea is that the returns from gold are derived, in part, from relationship between
inflation. We know from previous work that gold is an inflation hedge over the very variables by fitting a
long term. By very long term, we mean literally decades. Our test in this work is to line to a group of
see whether investors should consider gold as a hedge for unexpected inflation over data points. (See
the very long term, as well. Recall that a steep rise in unexpected inflation can have Chart 9, page 6 for
adverse effects on financial planning.
an example.)
Assume for the moment that the returns of gold are driven solely by expected and
unexpected inflation. We can then model the effect with linear regression. In linear
regression, we can see how large a variable’s dependence is, namely, the size of the
regression coefficient; but more importantly, we can see whether the variable is
essential to the regression at all (this is commonly known as statistical significance).
Basically, we want to know what is important to the model and what is not.
The results of the regression are displayed in Table 1. We believe what is shown here
confirms our earlier result that gold is an inflation hedge in the long run, because the
t-statistic is 2 or higher in absolute value. This result does not surprise us. The result t-statistic—tells
for unexpected inflation shows that gold is not an effective hedge, neither long nor whether a variable is
short term. What is also statistically
Table
Table 11 interesting is how little of the significant or just
Linear
LinearRegression
RegressionResults
Results for
for Gold
Gold against
against variation in gold prices is
Inflation
noise.
Inflation and
and Unexpected
Unexpected Inflation
Inflation explained by either
Gold component of inflation. The
Intercept 16% R-squared is about 10%. If
T-Stat Intercept 1.88 only 10% of the return is R-squared—a value
Inflation Coefficient -5.01 captured by inflation, that between 0% and
T-Stat Inflation Coefficient -2.00 means another 90% of it is not 100%; 100% is a
Unexpected Inflation Coefficient -1.91 accounted for. This can take perfect linear fit.
T-Stat Unexpected Inflation Coefficient -0.85 the form of simple supply/
Adjusted R-Squared 10% demand dynamics, asset
Source: Bloomberg L.P., PNC bubbles, and so on. A hedge is
most effective when it is pure;

3
The November 2009 Investment Outlook: Time to Use the Philosopher’s Stone?
discusses in more detail PNC’s view on gold as an investment.

5
Investment Outlook

in other words, when much of the price variation of the hedge is explained by the
price variation of the risk that one is looking to hedge.
It is our view that gold is not an effective hedge against unexpected inflation. This
does not preclude the possibility that the price of gold may rise when inflation spikes
higher, but it does say that the price of gold and the rate of inflation do not have a
high probability of moving together.

Commodities4
Gold is not the only commodity. Contained within the S&P GSCI™ are anywhere
between 25 and 35 different commodities depending upon the year. Collections of
individual commodities may form complexes, such as the soybean complex, and
these may be part of larger constituents, such as the energy portions of the GSCI. Of
all the various commodity indexes, we chose the GSCI because it is based on world
production values of the commodities. 5
The GSCI is a commodity index with a long history and
Chart
Chart 9 well-documented methodology of composition. The
GSCI
GSCI Versus
Versus Unexpected Inflation
Unexpected Inflation analysis that we perform here might not be possible with
80 another commodity index. Leveraging the longer history
GSCI Excess Returns
60
of the GSCI, we can plot the GSCI versus unexpected
Linear (GSCI Excess Returns) inflation (Chart 9).
40
Immediately apparent is the linear relationship between the
Percent

20
two. The R-squared is around 50% and the F-value is
0
about 34 with a p-value much less than 0.00001.
-20
Disregarding the various statistics, the human eye tells us
y = 7.0996x + 0.0712
-40
R2 = 0.4791 that this is a good fit. On the surface, the GSCI appears
-60 like a good candidate for hedging unexpected inflation. As
-0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08 unexpected inflation spikes, the positive linear relationship
Inflation Rate Year-over-Year Percentage Change between the GSCI and unexpected inflation suggests that
they should move in concert.
Source: Bureau of Labor Statistics, Bloomberg L.P., PNC
We think it is fair to analyze the GSCI in much the same
way as gold, because they are both commodities.
However, it is important to keep in mind that the GSCI is a collection of different
commodities. It is possible that a commodity, like crude oil, does not share the same
inflation dependency as another commodity, say lean hogs. The claim has been made
F-value—value to that the GSCI is heavily weighted toward the energy commodities (crude oil,
determine whether gasoline, and heating oil). Performing a separate analysis on each commodity might
regression is shed more light on this. To this end, we can examine them individually to determine
statistically valid. whether the inflation hedging properties are consistent across the commodity index
constituents. We keep in mind that buying individual sets of commodities comes at a
cost to diversification and that the exercise serves to shine light on a well-known fact
that not all commodities behave alike.
The analysis looks at complexes first and then breaks them down into the
constituents. From the results of the regression, we see that the results are non-
uniform. The green numbers in the Unexpected Inflation T-Stat column are the
important ones. Copper, cattle, and heating oil seem to be the ones that provide
explicit hedging for unexpected inflation. At the complex level, this occurs for

4
Our October 2009 white paper, Natural Resources and Real Return: Gamma from
Managed Futures, discusses commodities in greater detail.
5
Standard & Poor’s Goldman Sachs Commodity Index Handbook.

6 February 2011
 Great Expectations: Inflation

Table
Table 22
Linear RegressionResults
Linear Regression Resultsfor
forVarious
Various Commodities
Commodities against
against Inflation
Inflation and Unexpected
and Unexpected Inflation
Inflation
T-St at Inflation Unexpected Inflation Adjusted
Intercept Intercept Coefficient T-Stat Coefficient T-Stat R-Squared
GSCI -16% -1.62 7.25 2.41 12.15 4.54 44%
Non-Energy -8% -1.14 2.88 1.42 5.07 2.81 21%
Energy -19% -0.94 10.15 1.58 18.70 3.79 36%
Livestock -24% -2.79 8.28 3.17 6.80 2.92 24%
Agriculture -6% -0.62 0.90 0.33 3.34 1.37 4%
Industrial Metals 7% 0.36 1.99 0.33 14.01 2.59 29%
Precious Metals 16% 1.98 -5.10 -2.06 -2.00 -0.91 11%
Heating Oil -11% -0.58 7.69 1.23 18.02 3.75 37%
Cattle -24% -2.79 8.28 3.17 6.80 2.92 24%
Hog -31% -2.29 9.33 2.28 6.67 1.83 11%
Wheat -12% -0.81 2.28 0.53 2.43 0.63 -6%
Corn -16% -1.24 3.44 0.86 3.79 1.06 -3%
Soybeans 13% 0.96 -3.12 -0.77 2.15 0.59 6%
Sugar 22% 1.22 -5.89 -1.09 4.49 0.93 19%
Coffee -7% -0.26 3.01 0.37 2.41 0.34 -7%
Cotton -1% -0.04 0.60 0.12 3.63 0.81 -3%
Gold 16% 1.88 -5.01 -2.00 -1.91 -0.85 10%
Silver 16% 1.27 -5.28 -1.38 -1.74 -0.51 2%
Copper 18% 0.79 0.54 0.08 15.57 2.56 32%
Source: Bloomberg L.P., PNC

energy, non-energy, livestock, and industrial metals. Although this does not hold
cross-sectionally, the weightings of the index, specifically toward energy, ensure that
the GSCI provides this hedging property.
The GSCI also provides hedging for inflation. As we said before, gold does give
some hedging property over the long term. This is followed by hogs and cattle. It is
interesting to note that energy is not as strong in this category. The R-squared values
of some of these categories are relatively high as well. These are the red numbers in
the Adjusted R-Squared column. This gives some reassurance that commodities
contain a significant inflation and unexpected inflation component of returns.
However, there are other drivers of the returns, which makes commodities an impure
hedge and subject to additional risks. To the extent that an investor can diversify the
additional idiosyncratic risks, PNC recommends a diversified basket of commodities
to perform the inflation hedging.

TIPS6
Treasury Inflation-Protected Securities (TIPS) provide pure hedging to inflation, both
expected and unexpected. In the October 2009 white paper Private Real Estate:
Inflation Hedging?, we outlined a mathematical argument based on cointegration for
why we believe TIPS make a good inflation hedge. In this case, TIPS hedged both
components of inflation, expected and unexpected. TIPS were constructed around the
CPI to adjust the principal repayment based on those changes.

6
Our June 2009 white paper, Neither Fish Nor Fowl: A TIPS Primer, discusses TIPs in
greater detail.

7
Investment Outlook

TIPS, although a purer hedge to inflation than other investments, are still regulated
by basic supply/demand forces in the market. If there is a great demand for that type
of security in the market, the price will rise. TIPS can become expensive like any
other type of insurance. The closer in time that protection is bought to an oncoming
market event, the more expensive it will likely be.

Chart 10
Chart 10 Private Real Estate
Private RealEstate
Private Real EstatePerformance
Performance and
and Inflation
Inflation Private real estate was shown in our October 2009 white
(rolling
(rolling1-year
1-yearreturns
returnsof
ofNCREIF
NCREIFand
andCPI)
CPI) paper, Private Real Estate: Inflation Hedging?, not to
30 have good hedging ability for inflation. Calling an
investment in private real estate an inflation hedge may
Year-over-Year Percentage Change

25
20 not be accurate. Private real estate probably does have
15 some exposure to inflation, but that is not the only
10
exposure it might have. What must not be neglected when
5
discussing its use as a hedge are its other components,
0
-5
which in the short run might drive returns sharply
-10 negative, as has been true recently, and which in the long
-15 run may still dominate any hedging efficacy it might have
-20 against inflation. Private real estate does have exposure to
NCREIF CPI Bubble Bubble
-25 inflation, but this exposure can be overwhelmed by asset
12/78

9/81

6/84

3/87

12/89

9/92

6/95

2/98

11/00

8/03

5/06

2/09

bubble behavior. This is the difference between using a

pure investment hedge and an impure investment hedge
Source: NCREIF, Bureau of Labor Statistics, such as private real estate.
Bloomberg L.P., PNC

Unexpected Inflation Hedges = TIPS and Commodities

TIPS and commodities form a hedge to unexpected inflation spikes. We have
outlined arguments that support this in a number of publications. It may give you
added confidence in our conclusion to know that our finding is corroborated by
another author.7 Using a different mathematical technique, the author found good
inflation hedging properties of TIPS, commodities, timber, and farmland. While the
PNC platform does not currently allow for farmland investment, there is a timber
option available. However, the illiquidity of the investment in timber, as well as other
idiosyncratic risks, discourage us from considering it as an equivalent investment to
TIPS or commodities.
Our recommendation for clients with acute inflation sensitivity is to consider the
portfolio constructed in our June 2009 white paper, Alternative Investments in Non-
Institutional Sized Accounts, as a way to guard against that particular risk. As with
any investment, this should be measured against the knowable aspects of a client’s
situation as listed in the bullets on page 4.
It is the view of the PNC Economics team, detailed in the January 2011 PNC
Economic Outlook, that inflation will remain contained in 2011, with annualized
changes forecasted to be 2.0% in the first quarter, 1.3% in the second, 1.7% in the
third, and 1.8% in the fourth.

7
George A. Martin, “The Long Horizon Benefits of Traditional and New Real Assets in
the Institutional Portfolio,” The Journal of Alternative Investments, Vol. 13, No. 1
(Summer 2010): 6-29.

8 February 2011
 Great Expectations: Inflation

Themes for 2011 Update

State of the States Revisited
In light of continued headlines describing the deterioration of state budgets and
painting a grim picture for holders of municipal debt, we want to comment again on
the issue that we added as a theme for 2011 in last month’s Investment Outlook—
Escape 2011: Outlook Part II. The main culprit of states’ fiscal problems continues
to be faltering revenues, with at least 46 states facing budget shortfalls in fiscal 2011.
Most recently, municipal market phobias have arisen from budget deficit issues in the
state of Illinois, as well as a significant increase in the cost of borrowing for issuers
of new debt. This has prompted many investors to question whether the states will be
able to adequately service their future debt burdens. When paired with a small
number of highly publicized municipal bankruptcies, these issues make the municipal
market appear to be quite a dangerous place. In reality, however, we believe this
market environment may provide an opportunity for investors.
While the list of potential problems is a concern, municipalities still enjoy a number
of advantages that corporations and others do not. It is these advantages that we
believe should provide investors with adequate comfort that the vast majority of
municipalities will meet their obligations, despite ever-increasing headline risk.
Below are some less-sensational facts about the municipal market that should help to
quell many investors’ concerns.
Because of balanced budget requirements, most states can not run budget
deficits for significant periods. This heightens the immediacy with which
states must address any budget shortfalls, including coverage of existing
general obligation debt. States are required to bring their budgets in line
by decreasing expenditures, increasing taxes, or both. The recent income
tax increase by the Illinois General Assembly is an example. Illinois
also illustrates that states are different from corporations in that few if
any corporations could pass along a price increase the size of Illinois’s
tax increase.
As a result of balanced budget requirements, the municipal bond market
enjoys much lower default rates than similarly rated investment-grade
corporate bonds. For example, Moody’s cites the average five-year historical
cumulative default rate for investment-grade municipal debt as 0.03%
compared with 0.97% for corporate issuers. In fact, between 1970 and 2009
there have been only 54 Moody’s-rated municipal defaults. Only three of
these carried a general obligation pledge. Further, of the recent municipal
defaults, most came the way of defunct non-essential service revenue bond
projects, rather than municipalities that carry the benefits of a full faith and
credit backing. Amidst continued difficult operating conditions, only six
municipal entities sought Chapter 9 protection in 2010.
The states have not had to endure the recent and current economy on their
own. Federal stimulus has helped states not only in closing budget gaps, but
it can be argued that federal aid is stimulative to the economy because it
prevents states from making additional spending cuts, tax hikes, or both. Of
the $160 billion state budget shortfall projected for fiscal 2011, at least
$59 billion will automatically be covered by Uncle Sam as part of the
American Recovery and Reinvestment Act of 2009. While we do not expect
future federal bailouts, the Federal Reserve maintains the ability to purchase
short-term municipal debt to provide liquidity to municipalities in the event
of extreme market dislocation.

9
Investment Outlook

Chart
Chart 11 Contrary to the inferences of recent headlines, third-
U.S.
U.S. State and Local
State and LocalGovernment
GovernmentFiscal
Fiscal Position
Position quarter 2010 marked the third consecutive quarter that
(current
(currentreceipts
receiptsless
lesscurrent
currentexpenditures)
expenditures) state tax receipts have increased on a year-over-year
80 basis, according to The Rockefeller Institute of
60 Government. In addition, third-quarter 2010 marked
40
the fourth consecutive quarter that current receipts
exceeded expenditures for state and local governments
Billions of Dollars

20
(Chart 11). The breadth of states showing
0
improvement was equally impressive, with 42 states
-20
reporting increases in tax collections. In terms of
-40
absolute dollars, California and New York
-60 experienced the largest personal income tax collection
-80 increases. Although still below prerecession values,
-100 this presents a positive sign for both state budgets and
1Q80

3Q82

1Q85

3Q87

1Q90

3Q92

1Q95

3Q97

1Q00

3Q02

1Q05

3Q07

1Q10
municipal investors.
The emergence of the Build America Bonds program
Source: Bureau of Economic Analysis, PNC had two significant positive effects for the municipal
market, especially near the end of 2010.
° The program allowed states to come to market at a low cost in a time
when liquidity was scarce.
° It can be argued that because the program offered taxable issuance, it
helped backstop the municipal market from additional pressures by
keeping tax-exempt supply low.
Although the program expired in 2010, a panel to discuss tax issues headed
by Treasury Secretary Timothy Geithner does allow for the possibility of a
program extension, especially if market conditions worsen further.
While Chapter 9 of the U.S. Bankruptcy Code specifically governs the debt
service agreements of municipalities, the 50 states are actually classified as
sovereign entities. Therefore, U.S. Bankruptcy Code does not apply to the
states. Stated differently, in the hypothetical situation in which a state
considers bankruptcy, there is currently no legal mechanism in place that
would allow for such an action. Prior to the advent of U.S. Bankruptcy laws,
the last time a state defaulted was in the early 1840s.
Additional focus recently centered on the municipal credit default swap
(CDS) market as investors watched Illinois 5-year CDS spreads rise to record
highs, which some alluded to as a sign of an imminent default. In its simplest
form, a CDS can be used as a gauge of credit risk in individual credits or the
market as a whole. For a number of reasons, however, it’s difficult to use a
municipal CDS as a perfect proxy for default probability. Unlike other asset
classes, there is no alternative way for municipal investors to express a short
position on the underlying assets other than a CDS, so spreads generally tend
to be biased upward. Furthermore, a CDS is used for a number of reasons
other than default speculation—including hedging certain exposures, taking a
directional view on credit, and exposing relative value among different
credits. Finally, the CDS market is young and, therefore, rather illiquid,
which can also place an upward bias on spreads. In fact, at the end of 2010,
net notional CDS outstanding was approximately 0.01% of the $2.8 trillion
municipal market. Given these facts, however, we do expect further
standardization and use of the municipal CDS market in the future. That
being said, we track CDS spreads as an additional market barometer in what
has traditionally been known as a less-than-transparent market. Even with
imperfect pricing, Illinois CDS spreads have decreased more than 20% since

10 February 2011
 Great Expectations: Inflation

the increase in the state income tax, indicating a fairly significant decrease in
credit risk.
Like many facets of the economy, state and local finances
Chart
Chart 12
12
are improving, though we believe they are still not out of
Municipal
Municipal Ratios
Ratios
the woods and one must be careful not to extrapolate the
(municipal
(municipalyields
yieldsrelative
relativeto
toTreasury
Treasuryyields)
yields)
general onto all specific state and local municipalities. Our
view is that the situation for state and local governments is 1.4

better than some of the alarmists might suggest. In 10-Year Ratio 5-Year Ratio
addition, the combination of worries about the fiscal 1.2
position of municipalities and the resultant volatility have
made valuations on municipal bonds relative to taxables

Ratio
1.0
much more attractive again (Chart 12).
While we would expect continued increased volatility due
0.8
to the structural changes in the municipal bond market and
worries about general fiscal health, we believe this should
provide interesting investment opportunities for the keen 0.6
investor. For client portfolios that use individual tax-

1/10

2/10

3/10

4/10

5/10

6/10

7/10

8/10

9/10

10/10

11/10

12/10

1/11
exempt securities, we continue to recommend using only
general obligation or essential service revenue bonds, such Source: Bloomberg L.P., PNC
as sewer and water bonds. This municipal market may also
provide significant opportunities for municipal bond
managers to add value via good credit research and taking advantage of the more
differentiated returns with monoline bond insurance much less a factor now.

PNC Current
PNC Current Recommendations
Recommendations
Our current recommended allocations continue to reflect the more positive
tone, while being mindful of the continued downside risks inherent in the market and
economic outlook:
a baseline allocation of stocks relative to bonds;
a baseline allocation to international relative to domestic stocks;
an allocation to emerging markets within the international component;
a preference for high-quality stocks;
a tactical allocation to leveraged loans within the bond allocation;
a tactical allocation to dividend-focused stocks within the U.S. large-cap
stock allocation; and
an allocation to alternative investments for qualified investors.

Baseline Allocation of Stocks Relative to Bonds

Since one cannot accurately determine the short-term movement of stocks, we argue
that investors should focus on what is knowable and controllable. The one thing an
investor can truly control is asset allocation. PNC’s six baseline asset allocation
models are shown on the back page of this outlook.

Preference for High-Quality Stocks

Any relapse to stressed capital markets or to another credit crunch from a financial
crisis poses a higher threat to lower-quality and highly leveraged companies.
Companies with weak balance sheets and less-robust business models have a much
higher risk to their survival. While this risk had seemingly receded as the world
economies stabilized, it has come back into focus with economic fears surrounding

11
Investment Outlook

the sovereign debt woes in Europe. We favor a preference for high-quality stocks as a
method of risk control against the possibility that the rebound may not be sustainable.

Allocation to Leveraged Loans within Bonds8

Chart 13
Chart 13
3-Month We believe an allocation to leveraged loans within the
3-Month LIBOR
LIBOR
bond portion of a portfolio should help defend against
0.59 higher interest rates. Since leveraged loans are adjustable-
0.54 rate instruments tied to short-term interest rates (typically
3-month LIBOR), we believe holders should benefit from
0.49
the rising rates (Chart 13). If longer-term interest rates rise,
the shorter duration of leveraged loans should result in
Percent

0.44

0.39
significantly better performance relative to longer-duration
fixed income, such as the Barclays Capital U.S. Aggregate
0.34 Index. As both the taxable and tax-exempt bond markets
0.29 stumbled in late-2010, this allocation continued to provide
positive results even in a rising rate environment.
0.24
10/10

11/10

12/10
1/10

2/10

3/10

4/10

5/10

6/10

7/10

8/10

9/10

1/11
In summary, this allocation could be characterized as
lowering the portfolios’ interest rate risk while raising the
Source: British Bankers’ Association, Bloomberg L.P., PNC
credit risk and correlation with equities. It accomplishes
this without a large impact on portfolio income.

Allocation to Dividend-Focused Stocks9

The allocation to dividend-focused large-cap U.S. equities is 10% of the large-cap
U.S. allocation taken from the large-cap value category. Companies continue to have
large and growing corporate cash holdings (Chart 14). Also, the payout ratio for the
S&P 500 remains low (Chart 15). Corporations in general have a significant stash of

Chart
Chart 14
14 Chart 15
Chart 15
Corporations’ Total Liquid
Corporations’ Total LiquidAssets
Assets S&P
S&P 500 Payout
PayoutRatio
Ratio
(shaded
(shadedareas
areasare
arerecession
recessionperiods)
periods) (shaded
(shadedareas
areasare
arerecession
recessionperiods)
periods)
65
2,000
1,800 60
1,600 55
Billions of Dollars

1,400
50
Percent

1,200
1,000 45

800 40
600
35
400
30
200
0 25
1961
1964
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
1980

1985

1990

1995

2000

2005

2010

Source: Federal Reserve, FactSet Research Systems, PNC Source: Standard & Poor’s, First Call, FactSet Research
Systems, PNC

8
The March 2010 Investment Outlook, Shakespeare for Primates, provides details
about leveraged loans.
9
The October 2010 Investment Outlook, Iceland: Lessons from the Front Line of the
Financial Meltdown, provides details about the dividend focus recommendation.

12 February 2011
 Great Expectations: Inflation

liquidity and level of earnings that give them flexibility to support the current
dividends and likely increase them.
While dividend stocks have lagged their more aggressive counterparts in the recent
strong market environment, we believe the focus on return of capital is likely to
remain with investors for some time as the financial crisis remains an overriding
memory. We believe dividend stocks remain attractive for investors seeking a
growing income stream and those attempting to lock in a larger amount of their
potential total return from stocks with dividends. In addition, the recent extension of
the Bush tax cuts with the lower dividend tax rate now removes another impediment
for investors. Dividend-focus stocks currently remain one of the better risk/reward
opportunities within our opportunity set, in our opinion.

Allocation to Alternative Investments

Alternative asset classes should also be considered for qualified investors, we
believe, because they may provide an effective risk management tool for portfolios.
The argument is that if alternative and traditional investments are put on even footing
with regard to expected returns, then solely by virtue of the two investments being
different, the risk of the overall portfolio is reduced without altering the portfolio’s
expected return. The risks may not be less, but they are in some ways different, so we
believe this diversification should help manage overall portfolio risk.
Every action (or even inaction) involves risk, and we firmly believe that investors
should think about risk when they consider alternative investments. However, our
research suggests that adding carefully selected alternative investments to a
diversified portfolio of traditional investments may materially reduce the overall risk
(as defined by the volatility of returns) of that portfolio without affecting expected
returns. We believe that alternative investments should be considered as a tool for
managing portfolio risk, not for adding risk to increase returns.
As an example of the possible value alternatives, in
particular hedge funds, can bring to a portfolio in the Chart 16
Chart 16
current environment, one can look at the correlation HFRX
HFRX Macro Indexand
Macro Index andS&P
S&P500
500 Correlations
Correlations
between the S&P 500 and the HFRX™ Macro Index 1.0
High: 0.9721
(Chart 16). Obviously, low correlation with stocks at times Latest: 0.8712
30-Day Rolling Correlations

when they are falling would be a distinct positive in terms

0.5
of reducing the downside. While at times these two very
different assets move nearly in unison, the hedge funds do
have exposure to other factors than solely stocks and also 0.0
might adapt to the environment by changing exposures.
Given the current market environment, which includes a -0.5
large number of factors (such as low returns on cash and
occasional spikes in macroeconomic concerns) that could -1.0
Low: -0.9407
continue to result in increased volatility, we believe
2007

2008

2009

2010

2011

alternative investments are worthy of consideration.10

Source: HFR Asset Management, LLC; Bloomberg L.P.;
PNC

10
For more details, see our October 2009 Investment Outlook, Alternative Medicine,
and our August 2009 white paper The Science of Alternative Investments.

13
Investment Outlook

Great
Great Expectations
Expectations in
in the
the Financial
Financial Markets
Markets
While we have devoted much of this outlook to other assets used in hedging inflation
risks, we would be remiss not to discuss stocks and bonds in this regard as well.
Studies have shown that high inflation historically has led to poor short-term stock
performance.11 However, in one of the most comprehensive studies of long-term
global stock market performance, Dimson, Marsh, and Staunton12 found that equities
provided the highest real return across the stock, bond, and cash returns of 16
countries and 101 years of data.
Though it is an extreme example, the German hyperinflation episode of the early
1920s can also serve as an interesting example of stock behavior. As one might
expect, all fixed cash flow assets (bonds, pensions, and so on) suffered horribly
during this period while real assets, stocks and many businesses fared much better.13
In fact, when looking at some of
the data during the episode, one
Table
Table 3
3 can see the performance of stocks
German HyperinflationComponents
German Hyperinflation Components during inflationary episodes, as
(change)
(change) well as some of reasons behind
Wholesale Deutschmark German what we monitor in the PNC
Money Price Versus U.S. Stock Inflation Watch Indicators
Year CPI Wages Supply Index Dollar FX Prices (Table 3).
1919 60% 80% 60% 230% -82% 40%
It is logical that businesses and
1920 105 105 90 80 -36 120
stocks adapt to inflation because
1921 70 80 70 140 -62 170
1922 3500 2700 1000 4100 -97 1100
earnings and future dividends
eventually start to rise with the
Source: ISI, Gerhard Bry, Bresciani-Turroni, PNC level of inflation and offset at
least some of the negative impact

Table
Table 4
Baseline AssetAllocation
Baseline Asset Allocationwith
withAlternative
Alternative Assets
Assets
Preservation Conservative Moderate Balanced Growth Aggressive
Strategic Allocation
Stocks 15 .0% 30 .0% 4 0 .0% 50. 0% 60 .0% 7 0.0 %
Bonds 30.0 60.0 45.0 30.0 15.0
Cash 55. 0 0. 0 0.0 0.0 0 .0
Alternative 1 0.0 15. 0 20 .0 25 .0 30 .0
Total 10 0 .0% 100.0% 1 00 .0% 1 00 .0% 1 00 .0 % 10 0.0 %
Alternative Assets
Hedge Funds 2.5 7.5 8.0 14.0 17.0
Private Equity 0.0 0.0 2.0 3.0 4.0
Private Real Estate 0.0 0.0 2.0 3.0 4.0
Natural Resources/Real Return 7.5 7.5 8.0 5.0 5.0
Total Alternative Assets 0.0% 10.0% 15.0% 20.0% 25.0% 30.0%
Source: PNC

11
Jeremy J. Siegel, Stocks for the Long Run (New York, McGraw Hill, 2002).
12
Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists: 101 Years of
Global Investment Returns (Princeton, NJ: Princeton University Press, 2002).
13
Adam Fergusson, When Money Dies: The Nightmare of the Weimar Collapse
(William Kimber & Co. Ltd., London, 1975).

14 February 2011
 Great Expectations: Inflation

of inflation. Bonds paying a fixed coupon are unable to adapt to unexpected inflation
and suffer badly in comparison.
As we have noted in the past, we believe that alternative investments can be used to
reduce some risks (likely including inflation risk) because they are exposed to some
different risks than are traditional investments. As illustrated in this outlook,
commodities and TIPS have the most direct inflation hedging ability. Hedge funds,
private equity, private real estate, and stocks probably all share some exposures that
should help guard against inflation in the long term, though there are other major
factors at work there as well. Table 4 on page 14 shows our recommended asset
allocation including alternative investments for qualified investors, which reflects our
current recommended allocations to many of the asset classes discussed in this
publication. For more information regarding these allocations please see our August
2009 white paper The Science of Alternative Investments.
PNC currently recommends a baseline allocation in our asset allocations in
terms of stocks versus bonds and cash, but we also recommend the following
tactical allocations.
In order to reduce interest-rate risk within portfolios, we recommend
leveraged loans within the bond allocation. This is an expression of our
baseline view that the recovery should continue, which will likely push
interest rates higher.
We believe dividend-focused stocks within the U.S. large-cap stock
allocation should effectively lower some volatility in the portfolio while
providing the opportunity to add some income and risk-adjusted performance
in this environment.
Our current recommended allocation attempts to balance the relative attractiveness of
stocks and other risk assets, given the transition to expansion that we expect in the
global economy, with the continued downside risks to our forecast. We remain
vigilant in monitoring asset valuations and the various factors affecting our views on
the sustainability of the economic recovery. There remain various sources of
volatility and downside risk, including European sovereign debt, emerging market,
inflation, employment, and other geopolitical risks.

15
Investment Outlook

As of market close, Monday, January 24, 2011:

S&P 500® DJIA 90-DAY T-BILL 10-YEAR T-NOTE

1290.84 11980.52 0.154% 3.408%

Asset Allocation Recommendations Equity Allocation

Capitalization: Baseline Style: Baseline
Current Tactical
Plus Dividend Focus Within Large-Cap

100 55%
55% 65% 50% 35% 20%
100%
100%
5% Small-Cap 50% Growth

10% Mid-Cap
80 80%
85% Large-Cap 50% Value
65%
60
50%
25%
40 30%
35%

20 20%
15%
(Baseline is 85/10/5) (Baseline is 50/50)
0
Preservation

Conservative

Moderate

Balanced

Growth

Aggressive

Global Positioning: Baseline

20% International

80% Domestic
Baseline

100 55% 65% 50% 35% 20% 100%

80 80%

(Baseline is 80/20)
65%
60
50% Fixed Income Allocation
40 30%
35% Credit Positioning: Core plus Leveraged Loans
20
15%
90% Core
0 10% High-Yield
Preservation

Conservative

Moderate

Balanced

Growth

Aggressive

Stocks Bonds Cash

100%

(Baseline is 100% Core)

For qualified investors, we recommend an allotment to alternative assets of 20% of a balanced allocation to
complement the traditional allocation.
The PNC Financial Services Group, Inc. (“PNC”) provides investment and wealth management, fiduciary services, FDIC-insured banking products and services and lending and borrowing of funds
through its subsidiary, PNC Bank, National Association, which is a Member FDIC, and provides certain fiduciary and agency services through PNC Delaware Trust Company. This report is furnished
for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation or
particular needs of any specific person. Use of this report is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client’s individual account
circumstances. Persons reading this report should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies
discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in this report was obtained from sources
deemed reliable. Such information is not guaranteed as to its accuracy, timeliness or completeness by PNC. The information contained in this report and the opinions expressed herein are subject
to change without notice. Past performance is no guarantee of future results. Neither the information in this report nor any opinion expressed herein constitutes an offer to buy or sell, nor a
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