Potential portfolio impacts of a rising rate or inflationary environment — domestic equity

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D. Tysen Nutt Jr.

Senior Vice President, Senior Portfolio Manager, Team Leader — Large-Cap Value Equity

We believe we’re nicely positioned if inflation revives and interest rates finally rise because we’re overweight energy and underweight financials and utilities. Of course, much will depend on the details. If interest rates and inflation increase quickly and by a lot, all sectors could be affected and potentially hurt quite badly. But if a normalization of rates happens gradually — which is what the Federal Reserve is certainly attempting to engineer — we believe the market could come through fine, notwithstanding some valuation compression and sentiment deterioration.

Even within those sectors that overall might be hurt by elevated inflationary pressures or rising interest rates — financials, for example — there could be pockets of strength. Banks could actually benefit from a higher rate structure because it would improve their net interest margins, which have been suffering as of late. Insurance companies also could gain because they would finally squeeze some yield out of their fixed income portfolios. The main casualties of higher rates and inflation would be in the utility and consumer discretionary spaces, which are areas in which we currently maintain significantly underweight positions.

Christopher S. Beck, CFA

Senior Vice President, Chief Investment Officer — Small-Cap Value / Mid-Cap Value Equity

Don’t forget that the Fed has made it clear that it will not even contemplate raising benchmark interest rates until unemployment drops to 6.5%, which is still one full percentage point below the current level. Now, that may not seem like much, but with the real gross domestic product (a measure of all goods and services a country produces) continuing to exhibit modest growth of 1% – 3%, any significant progress on the labor front is expected to take time. And from an equity standpoint, the conditions that would cause the Fed to tighten policy would be good for corporate profits, because it would mean that economic growth is turning higher and the consumer is in better shape.

It is also important to note that many companies have locked in favorable financing terms for years to come, even if rates were to rise sooner and by more than is likely. The Fed has made transparency a major goal, and it has telegraphed every major move. There is no doubt in my mind that when the time comes to begin nudging rates higher, members of the Federal Open Market Committee (FOMC) will provide ample notice. No observers of the market should pick up the newspaper and get blindsided by Fed action, in our opinion. As a result, we feel that our portfolio has the potential to perform well due to the economic sensitivity of the overall portfolio, as long as rates rise gradually and the Fed does indeed act to prevent significant inflation.

Francis X. Morris

Senior Vice President, Chief Investment Officer — Core Equity

Under the most likely scenario, which, in our opinion, is a gradual and modest increase in rates and inflation, we believe small-cap stocks have the potential to perform very well. Historically, the “sweet spot” for small-caps is real economic growth of around 2.5% to 3.0%. This level of real gross domestic product growth has historically correlated with small-cap returns of close to 20%. (Source: Bloomberg.)

The U.S. economy is not there yet in terms of economic growth, but it is gradually improving, with housing being the most recent positive data point. In terms of inflation, a little more inflation would provide the type of pricing power that businesses need, in our opinion. All of this assumes that rates and inflation are rising for the “right” reasons, which would be improvements in economic activity.

The views expressed in each outlook represent the Manager’s assessment of the market environment as of January 2013, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager’s current views. The views expressed in each outlook are general in nature and do not relate to a particular mutual fund.

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