Issuance and Investments in the Low-Rate “New Normal” Economy January 12, 2011 Presented by: Girard Miller, Senior Strategist PFM Asset Management LLC

Issuance and Investments inthe Low-Rate “New Normal”

Economy

January 12, 2011

Presented by:Girard Miller, Senior Strategist

PFM Asset Management LLC

PFM

Investment Advisors to the Public Sector

Agenda for This Session

• Economic fundamentals of the New Normal economy

• California’s unique challenges

• Debt issuance history and observations

• Treasury management considerations and strategies

2© 2011 PFM Asset Management LLC

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Economics of the New Normal Economy• Asset bubble in real estate has deflated

• Financial sector on shaky ground

– Requires steep yield curve to silently recapitalize banks

• Deflation risks outweigh inflation risks in short term

• Federal fiscal policy now stretched to the limit

– No support for more stimulus• BABs expired – just one example of new mood on Hill

– Tax relief will be the last major fiscal measure

• Fed has only one bullet left: Quantitative Easing

– Rates already effectively at zero


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Economic Outlook: Slow Recovery to Gain Momentum• Excesses of past decade must be washed out

– Significant excess capacity in U.S. economy– No inflationary pressure on the supply side except currency

• Weakness in aggregate demand in U.S.

– State and local spending a drag on economy– Businesses afraid to expand until they see demand revive

• Asian and Latin American economies booming

– Replacing the U.S. as engines of global growth– Global trade will continue to expand in 2011– Ports in So CA will benefit

• High unemployment will persist but decline slowly

• Confidence will strengthen, one step at a time


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California-Specific Challenges


• Real estate drag on statewide economy

– Rampant overbuilding and mortgage distress in many regions• 22% of U.S. homes underwater, some parts of CA are worse

– Even upscale markets have been clobbered– Until foreclosures abate, prices will lag and construction is

frozen• Negative impact on local government revenue base

• State’s budgetary problems weigh on Cali economy

– Huge structural deficits through 2015– Further drain on local governments– Hiring freezes to continue– Tax environment unfavorable to many businesses

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Likely Interest-Rate Outlook


• Low rates on short paper likely to persist in 2011 and into 2012

– Consensus outlook of Wall Street economists– Fed’s QE2 initiative certain thru mid-2011– Until unemployment declines, short rates are unlikely to rise– Fed will allow upward drift only when recovery is clearly

established and self-sustaining

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• Long-term rates could continue to drift higher on reflation fears and dollar-currency concerns over QE2

– Net result is a steeper yield curve on relative basis

• China, Australia and possibly India will raise rates in 2011

• When global economies begin synchronized in growth, rates will rise on inflation concerns, unwind of flight to quality, and demand for credit – But this is likely a 2H12 issue.

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Likely Interest-Rate Outlook

© 2011 PFM Asset Management LLC

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Classical Interest-Rate Spike History• Lessons from Schumpeter, Orange County and San Jose

• Rates will spike as economy shifts from recovery to expansion

– Then borrowing pressure mounts as growth strengthens and capacity utilization normalizes

– Credit must again be rationed– This could easily occur in 2012 and no later than 2013

• In this case, the QE2 must also be unwound, so there could be selling of T-bonds by the Fed if it cannot just let them mature

• Professional investors are leery of extending maturities too far into the yield curve, given the risks of higher rates in 2013 or possibly sooner

• BUT…..This time is different, really, and here’s what you need to watch:


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The New Normal: What’s Different (and What’s Not)• Excess housing will overhang this entire decade

• Homebuilding and residential construction will never reach 2006 peaks again

• Homes are no longer ATM machines

– Home equity has been wiped out

– Credit standards have been tightened for at least a half-decade

– HELOs cannot again fuel personal consumption

• Federal tax policy could dampen the home mortgage tax benefits of ownership

– And buyers who were never qualified will not get houses again

• Fannie Mae and Freddie Mac will never be the same

– U.S. guarantees may ultimately shift to GNMA and FHA paper, not theirs

• Conclusion: Housing sector may recover, but not to 2006-7 peaks

• Mortgage rates at 6% would throw us back into balance-sheet recession

• Home equity is not a source of personal wealth for many Americans

>10% of owners will remain underwater


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• Chastened Baby Boomers in private sector

– Their 401k became a 201k -- now a 301k

– A lesson of a lifetime on risk tolerance

– New awareness of need for more savings

– Growing awareness of need for retirement income, and thus bond demand will grow on demographic basis

• Result:

– More personal savings as consumers permanently restructure their balance sheets

– Generational shift from equities to bonds for 10% of portfolios, simply on age demographics

• Americans becoming more like Europeans in 2010s


The New Normal: What’s Different (and What’s Not)

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• BUT, some things won’t change!

• Expect to see luxury spending increase

– Wealth class will resume normal ways and be joined by huge ranks of noveau riche overseas

• Capital gains will return to HNW portfolios

– But Cali income tax receipts will be offset by 2008 tax losses until FY 2013

• The employed middle class will indulge in more spending on consumer discretionary

– Less in “housing as an investment”, more on clothes and cars, travel, personal enrichment

– Unemployed as a subclass will continue to retrench

• More Baby boomers semi-retiring at age 62 to get benefits


The New Normal: What’s Different (and What’s Not)

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New Normal Issuance Implications• A sour mood across the state

• Likely shrinkage of state and local government operations

• Tax increases may be proposed after recovery strengthens, but popular support remains weak, and tax rates in California are already high by national standards

• Pensions and OPEB obligations will gain visibility and dampen new hiring and salary increases

– A decade of modest or no pay raises for many public employees until retirement plans become sustainable

• 2011 could be the rock bottom year for municipal cash flow

– Revenue recovery more likely in 2012 and FY 2013

– Could be continued drain on municipal reserves

• May see general trend to increase TRANS borrowing to exploit cash-flow deficits, if positive arbitrage can be attained.


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California Debt Issuance Over Business Cycles


Source:1 California Debt and Investment Advisory Commission2 Federal Reserve Statistical Release (http://www.federalreserve.gov/releases/h15/data/Annual/H15_PRIME_NA.txt)

Comparison of the Percent of California Short-Term Issuance1

to Federal Short-Term Rates2

1990-2009

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Treasury Management Investment Themes: 2011• Don’t swing for the fences

• Don’t borrow from 2012-13 budgets by investing longer than today’s cash flow

• Know when to use LAIF and other pools, and when to invest in direct obligations

• Consider outsourcing of portfolio managers prudently if it can reduce costs and enhance returns

– Study carefully whether your investment horizon is favorable for this strategy

• Spreads will decompress from low-yield mode, when credit markets normalize


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Using LAIF and Other Liquid Pooled Investments


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LAIF vs Commercial Money Market Funds

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Source:1State Treasurer’s Office: Pooled Money Investment Account, PMIA Average Monthly Effective Yields (http://www.treasurer.ca.gov/pmia-laif/historical/avg_mn_ylds.asp)2iMoneyNet U.S. Prime Institutional Average Money Market Funds


Monthly LAIF Yields1 vs. Monthly Money Market Fund Net Yields2

October 2003 - November 2010

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LAIF vs Local Government Investment Pools

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Source:1State Treasurer’s Office: Pooled Money Investment Account, PMIA Average Monthly Effective Yields (http://www.treasurer.ca.gov/pmia-laif/historical/avg_mn_ylds.asp)2S&P LGIP Prime Index


Monthly LAIF Yields1 vs. Monthly S&P LGIP Prime Index2

March 1995 - November 2010

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LAIF vs Direct Investments:Understanding the Market Cycles

Source:1State Treasurer’s Office: Pooled Money Investment Account, PMIA Average Monthly Effective Yields (http://www.treasurer.ca.gov/pmia-laif/historical/avg_mn_ylds.asp)2Federal Reserve Statistical Release (http://www.federalreserve.gov/releases/h15/data/Monthly/H15_TCMNOM_Y1.txt)

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Comparison of Monthly LAIF Yields1 toMonthly Treasury 1-Year Constant Maturities Rates2

January 2000 - November 2010

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Underlying Composition of LAIF

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Source: State Treasurer’s Office: Pooled Money Investment Account (http://www.treasurer.ca.gov/pmia-laif/reports/maturity/20100930.pdf)

Key differences: Average maturity and maximum maturities are shorter for funds and pools complying with SEC Rule 2a7


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LAIF Diversification and Asset Categories

PMIA Portfolio Composition - 11/30/10(dollars in thousands)

$67.2 million

Source: State Treasurer’s Office: Pooled Money Investment Account (http://www.treasurer.ca.gov/graphs/pmia.asp)


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Pool Yields Lag

Average Monthly YieldsSeptember 2001 – September 2009

Source: Bloomberg and LAIF website


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When the Economy Is Expanding . . .




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When the Economy Is Contracting . . .




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Understanding the Pool Performance Cycle

Yields Compared to 24-Month Returns

Source: Bloomberg and LAIF website*Difference in return calculated as purchase yield of 2-year U.S. Treasury less LAIF’s average yield over next 24 months.

Return difference*


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Opportunity Cost of Excess Liquidity

Total Returns Periods Ended September 30, 2010

SectorPast

QuarterPastYear

Past 2 Years

Past 3 Years

Past 5 Years

S&P LGIP Index 0.04% 0.16% 0.45% 1.30% 2.66%

LAIF 0.13% 0.56% 1.13% 2.00% 3.08%

1-Year Treasury 0.25% 0.91% 1.62% 2.60% 3.46%

1-3 Year Treasury 0.62% 2.53% 3.00% 4.07% 4.35%

1-5 Year Treasury 1.32% 4.23% 4.41% 5.37% 5.13%



• Pools Have Historically Underperformed Diversified Portfolios— For those assets that can be invested longer

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Summary• The New Normal economy will likely see short rates suppressed in 2011

• Rates could rise meaningfully in 2H12 or 2013 if and as economy strengthens and confidence builds

• Risks to investing too long

• TRANS may remain popular in 2011

• Investment pools will remain popular in 2011 and likely to lag once economy regains momentum

– Spread between LAIF and commercial money market funds of JPA pools should narrow cyclically as rates tick upward.

• Total-return portfolio managers will face challenges if rates rise materially, so smart managers are avoiding duration risk

• Corporate credit risks should abate as 2011 brings sustained economic expansion, but not for all issuers


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Questions

Girard’s contact information:Cell 310.795.1354Email: [email protected]


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Disclaimer

This material is based on information obtained from sources generally believed to be reliable and available to the public, however PFM Asset Management LLC cannot guarantee its accuracy, completeness or suitability. This material is for general information purposes only and is not intended to provide specific advice or a specific recommendation. All statements as to what will or may happen under certain circumstances are based on assumptions, some but not all of which are noted in the presentation. Assumptions may or may not be proven correct as actual events occur, and results may depend on events outside of your or our control. Changes in assumptions may have a material effect on results. Past performance does not necessarily reflect and is not a guaranty of future results. The information contained in this presentation is not an offer to purchase or sell any securities.



Documents

Issuance and Investments in the Low-Rate “New Normal” Economy January 12, 2011 Presented by: Girard Miller, Senior Strategist PFM Asset Management LLC