Year End Investing

the slow and deliberate path

to normalization

“Fixed income markets in 2013 reached what we view as

an inflection point with the trend of declining interest

rates reversing during the year.”

Fiduciary Trust Company International 1

FINANCIAL MARKETS REVIEW—2013

2013 was a fascinating year in many respects, in some ways pleasantly surprising, in others misleading or, perhaps, simply baffling. We will attempt to shed some light on certain developments over the past year and consider them in the context of the breadth of the period following the Great Recession.

One of the more notable market features of the past year was the dispersion of returns across the broader capital markets. In the context of highly divergent global equity, fixed income, and cash returns, US equities were far and away the best performing category. Outside of the returns for developed equity markets, many asset classes failed to generate positive returns for the year, among them fixed income and most commodities, with oil being a notable exception. Even worse was the performance of gold, which experienced a dramatic decline of -28% during 2013. When viewed in the context of the broader global equity universe, the performance of US equities was not only impressive in the absolute but also on a relative basis. The US market produced substantial excess returns relative to broad international equity markets, with the performance differential relative to emerging markets even more dramatic. Emerging market equities not only performed poorly compared to developed markets but, in fact, also experienced disappointing returns in the absolute, declining -2.4% for the year (CHART 1). CHART 1: Wide Performance Dispersion between Asset Classes 2013 Total Returns

Source: Bloomberg.

AN INFLECTION POINT IN THE MARKETS

Fixed income markets in 2013 reached what we view as an inflection point with the trend of declining interest rates reversing during the year. The prior year’s uniformly positive absolute returns across all domestic fixed income asset classes were replaced by 2013’s largely negative ones, the first negative returns since 1999. While corporate credit remained in favor, investors shifted their preference along the yield curve, moving from long-end to short-end positioning. Long-dated assets, in a turnaround from 2012, weakened dramatically as global yields sharply rose in the months following introduction of Federal Reserve taper fears in May. On a global basis, the US fixed income markets experienced positive relative returns compared to International and Emerging Markets bonds, though all three were negative in the absolute.

As noted, corporate credit once again was the best performing fixed income sector. On a relative basis, investment grade corporate credit outperformed Treasuries, producing flat to slightly negative returns, while high yield corporate debt was the best overall sector performer with an absolute return of almost +7%. The broader tax-exempt municipal market, after experiencing dramatic outperformance in 2012, exhibited negative performance for the year and underperformed relative to the taxable market. The ‘taper fears’ manifested themselves in accelerated outflows from municipal mutual funds that continued unabated through year end. Compounding the outflow-driven pressure on the long end of the municipal yield curve were a rolling series of credit concerns over Puerto Rico and Detroit, which placed additional pressure on the municipal market.

A ROAD TO RECOVERY IN THE US

US equity markets rose +32.4% (including dividends) in 2013. Returns were broadly based across sectors and the market largely avoided prolonged corrections, generating positive returns in every month except May and August. Given the price movement over the past two years, investors are concerned that the market has come too far too fast, a natural conclusion when viewing 2013’s -20% 0% 20% 40% _32.4% 23.6% -2.0% -2.4% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

S&P 500 MSCI Europe, Australasia and Far East Index Barclays US Aggregate Bond Index MSCI Emerging Markets Index

Ronald Sanchez

Executive Vice President

CORPORATE PROFITS EXCEEDED PRE-CRISIS LEVELS

Ultimately, we believe domestic equity markets are a proxy for the overall health and profitability of corporate America. In 2013, the S&P 500 surpassed the previous pre-crisis market highs of 2007, reflecting the solid financial position and balance sheet strength of most companies. For the better part of the past five years, domestic equity market levels marched higher since hitting lows in March of 2009 (CHART 3). During this time, corporate revenues, earnings and valuation levels all returned to or exceeded pre-crisis levels. The first phase was a bounce in corporate revenues, followed by increasing earnings and, finally, dramatic improvements in valuations.

CHART 3: Profits Drove Recovery and Justify Valuations S&P 500 and Profit

Source: Bloomberg.

Today, valuations are, for the most part, in the realm of fair value as measured by the trailing earnings multiples of the S&P 500. Investors have become more comfortable with how much they are willing to pay for an expected unit of earnings. Investors appear to have shifted their focus from risk aversion to a more balanced view of risk and return. In hindsight, the normalization process took five years and only saw absolute market and valuation levels surpass their pre-crisis highs in 2013. Essentially, market valuations for the better part of the last five years have traded at a discount to their longer-term averages, reflecting investors’ caution regarding the economic and political landscape. This embedded risk premium moderated during 2012 and 2013. Thus, we believe the robust return experienced over the past two years should be viewed as a recovery robust equity returns through a lens of modest global

growth and the historical return experience. The year’s performance was the strongest since 1997.

While the S&P 500 has been gaining since the market lows of March 2009, it has exhibited a robust 45% rally since the middle of 2012. Given such an impressive return in a setting of modest economic and corporate revenue growth, many investors have become concerned about growing risks. Taking a step back and looking at equity returns in the context of the post-credit crisis period (2009–2013) we hope will provide some perspective. Certainly, this period of time can be fairly characterized as unprecedented in recent history; however there are two important features to the rally that we believe require consideration. First, the private sector of the economy appears to be slowly recovering and, second, the Federal Reserve altered the cost and return of capital for both borrowers and savers. Fiscal and, in particular, monetary policy was (and remains) unprecedented during this period and continues to influence the economy and markets even with the gradual diminution of those extraordinary policies. As a consequence of a loose fiscal policy bias transitioning to a tightening one, the rate of change for both federal and state spending varied significantly from year to year. The public versus private dynamic was particularly noteworthy in 2013. In fact, the shrinking federal government sector became a drag on overall economic growth, subtracting an estimated –1% from GDP. In contrast, the private side of the economy, which accounts for almost 80% of economic activity, continued to expand consistently, and in nominal terms is considerably higher than the period before the onset of the credit crisis (CHART 2).

CHART 2: Private Sector Growth Overcame Government Drag Contributions to GDP

Source: Bureau of Economic Analysis. -4% 0% -2% 2% 4% 2001 2003 2005 2007 2009 2011 2013 GDP Private Public 2006 2007 2008 2009 2010 2011 2012 2013 US Corporate Profits (Right Axis) S&P 500 (Left Axis)

800 600 1200 1000 1400 1600 1800 2000 1000 800 1400 1200 1600 1800 2000 2200 $ Billions Recovery Phase

Fiduciary Trust Company International 3 CHART 6: …and Gold Markets

Gold and US Consumer Price Index

Source: Bloomberg.

Given an environment of great uncertainty and elevated systemic risk, it was not surprising to see the price of Treasuries and gold jump immediately following the market events of 2008. Further, given the magnitude of global central bank intervention, many investors were concerned about a declining US dollar and the potential for rising inflation. This fear proved unfounded, as 2012 and 2013 saw falling rather than rising inflation as non-traditional monetary policy failed to fully filter through to the real economy.

Perhaps unsurprising given the recalibration of investor sentiment in favor of riskier assets, gold dramatically sold off in 2013. The 2011 peak in gold matched a dramatic spike in volatility, a proxy for systemic fears, centered on US political risk stemming from the debt ceiling crisis and attendant downgrade of the United States’ long-term credit rating. 2012 saw lower volatility as political crisis fatigue set in, along with weakening inflation. This perception of reduced risk paved the way for higher equity valuations (as measured by P/E multiple expansion) in 2012 and 2013. Reduced systemic risk and an improving perception of opportunity within equity markets heightened pressure on gold prices. 2013 also saw better economic data, muted inflationary pressures and an increased market indifference to government gridlock, along with no notable systemic shocks. These factors provided the fuel for risk assets to post stellar returns, while gold suffered a return of -28%, or almost 60% relative underperformance compared to the equity market.

or recapture phase and more reflective of today’s corporate fundamentals, both from a profitability and a valuation perspective (CHART 4).

CHART 4: US Equity Valuations Are within the Historic Average S&P 500—P/E vs. Historical Ten-Year Average

Source: Bloomberg.

RECALIBRATION OF RISK

At this point, some five years after the recession, investors are more comfortable assessing and pricing risk. It is not surprising to us to see a number of key markets signaling a similar central theme. We believe the market moves in stocks, interest rates and gold since the fall of 2012 reflect this dynamic.

While there are always causes for concern, when viewing today’s conditions relative to the previous five years it is no coincidence that risk premiums have moderated from elevated levels. During the peak of the crisis, Treasuries and gold, long considered safe havens during times of economic and political turbulence, were in high demand. The 10-Year Treasury note, which was hovering around 4% in October of 2008, declined for several years before bottoming near 1.5% in 2012 (CHART 5). Gold rose +24%, +30%, and +10% in the years from 2009 to 2011, respectively (CHART 6). CHART 5: Systemic Fear Dissipates in the Treasury Markets…. 10-Year Treasury Note

Source: Bloomberg. 2006 2007 2008 2009 2010 2011 2012 2013 6% Yield 0% 2% 4% Recovery Phase 2006 2007 2008 2009 2010 2011 2012 2013 Gold (Left Axis) US CPI (Right Axis)

800 400 0 1200 1600 2000 0% 2% 1% -3% -1% -2% 3% 4% 5% 6% Recovery Phase 0 10 5 15 20 25 2006 2007 2008 2009 2010 2011 2012 2013

Price/Earnings Ratio Historical Average

characteristics trade at a modest valuation premium during this normalization process. We continue to believe cash will have no associated return expectations until 2015 and perhaps not until 2016. All told, we feel confident that investors will have ultimately experienced at least six years of near zero short-term interest rates and maybe a decade of an exceptionally low Fed Funds rate before monetary policy fully normalizes. In this environment, stocks may evolve from originally trading at a risk premium to a price premium.

CHART 7: Monetary Policy Normalization to Progress in Sequential Phases

Phase 1: Tapering—2014?

Non-Traditional Policy (Asset Purchases) 10-Year Treasury Yield

Phase 2: Traditional Tightening—2015/2016? Traditional Policy (Short-Term Rates)

Yield on Short Treasuries

Source: Bloomberg.

Phase 3: Normalization—2017?

MONETARY POLICY

After much speculation, the Federal Reserve adopted a change to its asset purchase program, referred to as “quantitative easing,” in December, reducing the monthly rate of purchases of US Treasuries and mortgage-backed securities from $85 billion to $75 billion. We believe that over the next few years we will continue on a steady path toward normalization in economic growth, interest rates and ultimately monetary policy. Our expectation is that we will not experience a dramatic rise in the term structure of rates in this relatively short time period. Our investment thesis is that this expected steady rise in rates will unfold over several years and will impact different parts of the yield curve according to anticipated and actual shifts in policy by the Federal Reserve. Specifically, we want to differentiate policy action as it relates to non-traditional monetary policy (QE) and traditional monetary policy (Fed Funds rate). The point being that ‘tapering’ is not the same as ‘tightening’ and policy action is sequential not simultaneous. The adjustment in policy and interest rates will occur in phases and over an extended time frame. As of the end of 2013, we have seen a normalization occur in equity market valuations. However, the process of returning to some level of normalcy in interest rates, economic growth, monetary policy and valuations across the broader capital markets will occur over a number of years.

In a traditional asset allocation model of stocks, bonds and cash we view the latter two asset classes as being several years away from returning to “normal.” The yield environment has been considerably below historical levels for several years. For instance, in the decade preceding the crisis (1997 to 2007) the 10-Year Treasury note averaged approximately 4.8% and the 2-Year note averaged 4.0%. Even with the rise in rates in 2013, both the 10-Year note and 2-Year note still stand considerably below their historical average (CHART 7). The prospects for bonds as interest rates gradually normalize will be a return profile considerably below historical norms. In a low return environment it would not be particularly surprising to see risk assets which typically exhibit reasonable risk and return

0.0% -1.0% 2.0% 1.0% 3.0% 4.0% 5.0% 2008 2009 2010 2011 2012 2013

3-Month 2-Year 2-Year Average (’97–’07)

2008 2009 2010 2011 2012 2013 0.0% 2.0% 1.0% 3.0% 4.0% 5.0% 6.0%

Fiduciary Trust Company International 5 Despite persistent headline news regarding

unsustainable budget deficits, a dysfunctional political class, and the lack of long-term sound fiscal policy, there are improving trends in critical areas. Growth, fiscal discipline, housing, banking and the balance sheets of individuals and corporations all show notable, though modest, improvements. We believe these improvements are reflective of a slow but now steady recovery, still many years from normalization. In the interim, we believe the following short-term trends are favorable and will be supportive of equity returns:

• Improving global growth • Low global inflation

• Modest upward shift in interest rates

• Shift in investor positioning/‘Great Rotation’ • Stock buybacks and cash deployment

• Clarity surrounding monetary policy

Reflecting on events since the onset of the financial crisis, it has been demanding and even unsettling at times. We would like to thank you for allowing us to serve you through this extraordinary period in history.

2014 MARKET OUTLOOK

Our view is that we continue to see the US economy recover at a moderate pace while the rest of the

developed world shows moderate improvement over last year’s levels. Over the next year, the US should benefit from a declining drag from the government sector, improving growth outside the US, accommodative global monetary policy, low inflation and hopefully, private capital investment in labor, equipment and infrastructure. As this backdrop unfolds, we would expect to see a continuation of recent trends as they pertain to stocks, bonds and cash.

We anticipate a reasonable return environment for risk assets relative to the robust returns generated during the past two years, albeit with increasing market volatility. We continue to tilt portfolios toward an equity bias as investors are still compensated for the assumption of risk in relative terms. It is our expectation that global equity markets will generate excess returns over bonds and cash in 2014.

Looking back, it has been an extraordinarily challenging period for everyone, from investors to savers and

to policy makers. We have included a table which highlights some of the unusual events that have occurred during the road to recovery (CHART 8).

CHART 8: Drivers of Elevated Risk and Uncertainty during the Period (2008–2014)

• Great Recession

• Bank recapitalization and corporate bailouts • Staggering annual government budget deficits • Expansive global central bank monetary policy • European debt crisis

• Sovereign rating downgrades

• Increased taxes and heightened regulatory environment • Austerity measures, fiscal cliff and sequestration

Securities, mutual funds and other non-deposit investments:

Deposit products offered by Fiduciary Trust Company International, Member FDIC.

Fiduciary Trust Company International and subsidiaries (doing business as Fiduciary Trust International), and Fiduciary Trust Company of Canada are part of the Franklin Templeton Investments family of companies.

This communication is intended solely to provide general information. The information and opinions stated are as of December 31, 2013, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process.

Historical performance does not guarantee future results and results may differ over future time periods. NOT FDIC INSURED

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FIDUCIARY TRUST COMPANY INTERNATIONAL was founded in 1931 to specialize in investment management and administration of

assets for individuals and families. A bank charter permits Fiduciary Trust to act as executor and trustee, providing continuity of wealth management through multiple generations. Fiduciary Trust offers the following services to clients throughout the world:

• Investment Management • Manager Selection and Oversight • Master Custody

• Private Banking • Strategic Wealth Planning • Tax Reporting and Services

• Trust and Estate Administration

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