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Investment Strategies Group

Capital Market Outlook

Joseph P. Quinlan, Managing Director & Chief Market Strategist Harvey B. Hirschhorn, CFA, Managing Director & Chief Portfolio Strategist

HIGHLIGHTS

Banc of America Investment Advisors

Week of March 16, 2009

• Treasuries have become the U.S. assets of choice for foreigners during the current crisis.

• U.S. dependence on foreign capital continues to intensify as the government ramps up borrowing.

• Falling markets have changed the sector weightings of benchmark indexes.

ECONOMIC OUTLOOK

Joseph P. Quinlan

FOREIGN OWNERSHIP OF U.S. ASSETS — A SNAPSHOT

Chinese Premier Wen Jiabao recently claimed that he was “worried” about his nation’s roughly $1 trillion in U.S. debt holdings. As one of the largest investors in U.S. Treasuries, he has every right to be concerned — although airing these concerns in public is quite rare. Indeed, rare is the day that any world leader raises questions about the safety of U.S. Treasuries, considered to be among the world’s safest investments.

Against this backdrop, we thought it would be a good time to refresh and review the magnitude of foreign investment in U.S. securities.

Based on the latest Federal Reserve Flow Fund data, foreign ownership of U.S. financial assets —

Treasuries, government agency bonds, corporate bonds and equities — remains at or near record highs. However, during the past few quarters, foreign investors have become less enamored with U.S. government agency bonds and U.S. equities, a position

that is hardly surprising, given the turmoil in the U.S. financial markets

during the past year or so.

Foreign ownership of U.S. financial assets — Treasuries, government agency bonds, corporate bonds and equities — remains at or near record highs.

Exhibit 1 on the next page highlights some of the latest flow of funds data from the Federal Reserve.

This report, prepared by the Investment Strategies Group (ISG), is provided for informational purposes only and was not issued in connection with any proposed offering of securities. It was issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and does not contain investment recommendations. Bank of America and its affiliates do not accept any liability for any direct, indirect or consequential damages or losses arising from any use of this report or its contents. The information in this report was obtained from sources believed to be accurate, but we do not guarantee that it is accurate or complete. The opinions expressed herein are strictly those of IS G, are made as of the date of this material, and are subject to change without notice. There is no guarantee the views and opinions expressed in this communication will come to pass. ISG is part of the Global Wealth & Investment Management division of Bank of America and performs services through Banc of America Investment Advisors, Inc. (BAIA). BAIA is an SEC-registered investment adviser and wholly-owned subsidiary of Bank of America, N.A. The Investment Strategies Group provides strategic asset allocation advice as well as economic and market analysis to investment professionals servicing high-net- worth, institutional and brokerage relationships. Other affiliates may have opinions that are different from and/or inconsistent with the opinions expressed herein and may have banking, lending and/or other commercial relationships with the companies that are mentioned herein. Past performance is no guarantee of future results.

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Exhibit 1 — U.S. assets in demand overseas (Foreign ownership of U.S. securities, share of total ownership, percent)

60

50

40

30

20

10

0

Fourth quarter 2000 Fourth quarter 2008 50.3 30.4 28.8 19.8 16.2 14.5 9.4 8.0 U.S.
Fourth quarter 2000
Fourth quarter 2008
50.3
30.4
28.8
19.8
16.2
14.5
9.4
8.0
U.S. Treasuries
U.S. agency & GSE
bonds
U.S. corporate
U.S. equities
bonds

Sources: Federal Reserve Board; Investment Strategies Group Data through Dec. 31, 2008

We drew several key insights from this data:

U.S. Treasuries — Foreign ownership of U.S. Treasuries increased dramatically in the past decade and has never been higher. Foreign investors owned 50.3% of outstanding U.S. Treasuries at the end of 2008, up from a share of 47.7% in the final quarter of 2007. The share of U.S. Treasuries held by foreigners has more than doubled since the mid-1990s. China and Japan are today’s largest foreign holders.

U.S. government agency bonds — Given all the financial turmoil surrounding U.S. government agency bonds, there is little wonder that foreign appetite for them has diminished during the past few quarters. After steadily rising for most of this decade, the share of foreign ownership of U.S. government agency bonds slipped to 16.2% in the fourth quarter of last year, down from a peak of 21.2% the prior year. At the end of 2008, foreigner investors owned some $1.3 trillion in government agency bonds, down from $1.6 trillion in the fourth quarter of 2007.

U.S. corporate bonds — Foreign investors have never been as important to the U.S. corporate bond market as they are today. They owned roughly 29% of total outstanding U.S. corporate bonds in the fourth quarter of last year, up from a share of 25.6% in 2000. Foreign ownership of U.S. corporate bonds rose by a modest

1.2% between the fourth quarter of 2007 and the fourth quarter of 2008.

U.S. equities — Overseas investors’ holdings in U.S. stocks declined sharply, from $2.7 trillion from the fourth quarter of 2007 to $1.8 billion in the fourth quarter of 2008. The nearly 35% decline was precipitated, of course, by the U.S. global credit crisis of late 2008. The share of outstanding U.S. equities owned by foreign investors remains at or near record highs. In the fourth quarter of 2008, foreigners owned roughly 15% of total outstanding U.S. equities, up from a 9.4% share at the start of the decade.

MARKET COMMENTARY

Joseph P. Quinlan

FOREIGN OWNERSHIP OF U.S. ASSETS — TREASURIES TRUMP ALL

With the United States already one of the largest debtor nations and Washington burrowing deeper into debt, the foreign appetite for U.S. financial assets — Treasuries, government agency bonds, corporate bonds and equities — has never been as important as it is today. America’s soaring dependence on foreign capital remains one of the weakest links in the U.S. economy.

For years, the United States has spent more than it saved annually — drawing from overseas supplies of excess capital. This decade, U.S. net capital inflows have averaged nearly $700 billion annually, versus an annual average of just $139 billion during the 1990s.

This capital injection helped U.S. consumers purchase new cars and homes, U.S. businesses finance new investments, and the U.S. government enjoy both guns and butter — large military outlays and tax cuts. Foreign capital has been a key staple of U.S. economic expansion this decade.

Looking ahead, the role of foreign capital inflows is likely to become even more important as the United States digs deeper into debt to offset one of the worst recessions since the 1930s. Make no mistake about it — the U.S. government will have to underpin and underwrite a substantial share of its mega-borrowing with foreign capital.

Against this backdrop, the latest numbers from the Federal Reserve’s Flow Fund data are quite interesting. During the global flight to quality in the final quarter of 2008, U.S. Treasuries emerged as the favorite destination for foreign investors searching for relatively safe havens. Other assets were disposed of rather quickly. During the flight from risk triggered by the U.S.-led financial crisis, which reached a climax in September 2008, foreign investors bailed out or greatly reduced their purchases of U.S. government agency bonds, corporate bonds and equities.

While overseas investors shed other U.S. assets, foreign demand for U.S. Treasuries surged. Foreign ownership of Treasuries climbed to $3.2 trillion in the final quarter of last year — up from $2.9 trillion at the end of the third quarter of 2008 and a rise of one-third from the same period a year earlier.

THE LESSONS OF THE WORLD’S LOVE FOR TREASURIES

In times of global crisis and panic, U.S. Treasuries remain one of the most desired asset classes among investors around the world. When financial turmoil sets in, many foreign investors have more faith in Uncle Sam than leading financial institutions or their own governments. That is the good news.

The more discouraging news is this — the U.S. government’s era of big spending and big borrowing has foreign investors concerned, and for good reason. Their overriding fear, explicitly expressed by China last week, is that the deeper the U.S. government goes into debt, the greater the risk of inflation and the greater the odds of a collapse of the U.S. dollar at some point down the road. If the dollar collapsed, foreign investors would be left holding an empty or heavily devalued bag of Treasuries.

Clients often ask us whether a dollar collapse is imminent or inevitable. Our answer is “no,” as long as the U.S. government avoids the path of protectionism, the U.S. economy emerges from recession ahead of others by the end of the year, U.S. companies remain among the most competitive and attractive in the world, and the U.S. Federal Reserve maintains its anti- inflation credentials. The Fed will be put to a test some

time in 2010 — right now, we are more concerned about deflation than inflation.

THE BOTTOM LINE

We are worried about the swelling U.S. federal budget deficit, which is expected to top 12% of GDP in fiscal 2009, and its subsequent impact on U.S. capital inflows. The massive fiscal stimulus represents a bold gamble, one that will surely test the patience and nerves of foreign investors.

INVESTMENT STRATEGY 1

Orhan Imer, PhD., senior quantitative research analyst Harvey B. Hirschhorn, CFA

U.S. EQUITIES

After weeks of continual selling pressure, the stock market finally showed some life. Last week’s rally started with constructive comments from Citigroup regarding its corporate performance in early 2009. Retail sales news boosted the further upward trajectory. Sales slipped modestly, but higher transfer payments and strong tax refunds (compared to a year ago) kept them above expected levels.

Comments from Washington regarding the uptick rule and mark-to-market accounting also brought new money into the stock market, supporting prices. Both regulations may have influenced the breadth, depth and speed of the bear market. Congress may modify or adjust these regulations, which apparently pushed short-sellers to cover some of their negative bets.

For the week, the Dow Jones Industrial Average rose 9.0%, the S&P 500 gained 10.1%, and Nasdaq jumped 10.6%.

BENCHMARK SECTOR WEIGHTS

U.S. equities have slogged through a protracted bear market since the S&P 500 Index hit a record high of 1,565.15 on Oct. 9, 2007. While the majority of stocks have suffered significant losses since that peak, the downturn has affected economic sectors differently. By studying how equity benchmarks changed the

1 All sector and asset allocation recommendations must be considered in the context of an individual investor’s goals, time horizon and risk tolerance. Not all recommendations will be suitable for all investors. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. Investing in growth stocks incurs the possibility of losses because their prices are sensitive to changes in current or expected earnings. Value stocks are securities of companies that may have experienced adverse business or industry developments or may be subject to special risks that have caused the stocks to be out of favor. If the manager’s assessment of a company’s prospects is wrong, the price of its stock may not approach the value the manager has placed on it. Stocks of small- and mid- cap companies pose special risks, including possible illiquidity and greater price volatility than stocks of larger, more established companies.

proportion in which they represent sectors, we can shed some light on how stocks from different segments of the economy fared during this period.

Exhibits 2 and 3 on the next page show the sector compositions of the large-cap Russell 1000 Index and the small-cap Russell 2000 Index, respectively. The first two columns of each table show the weighting within each benchmark of the 10 Global Industry Classification Standard (GICS) economic sectors in October 2007 and February 2009. Weightings reflect the market capitalization of each sector as a share of total index market capitalization and are the average of all daily weightings in the given month.

The following insights are drawn from how the Russell 1000 Index composition changed, as seen in Exhibit 2:

• During the stock market peak of October 2007, financial companies made up the largest component of the Russell 1000 Index, at close to 20% of the benchmark’s total market capitalization. The Financials sector was also the hardest hit during the downturn, seeing its weight cut from 19.3% in October 2007 to 10.8% in February 2009 — almost in half.

• Consumer Discretionary companies, dependant on a healthy and expanding economy, also took a hit. The sector’s share of the benchmark declined from 10.2% in October 2007 to 8.8% in February 2009.

• While the Financials and Consumer Discretionary sectors fell out of favor, the Consumer Staples sector, which tends to be less sensitive to economic cycles, increased its share of the benchmark. The sector’s weight peaked at 12.5% in November 2008, but has since declined slightly, to 12.0%. It remains well above the October 2007 level of 8.8%.

• As of February 2009, the Energy and Materials sectors made up a larger percentage of the benchmark than in October 2007. However, their more recent weights are still well below July 2008 levels — when energy and commodity prices peaked.

• The Health Care, Utilities and Information Technology sector weights in the benchmark have increased. Companies in these sectors are perceived as relative safe havens with less economically sensitive cash flows.

• The Industrials sector’s benchmark weight declined from 11.8% in October 2007 to 10.4% in February 2009, while the Telecommunication Services sector remained relatively stable, with an unchanged weight of 3.6%.

As Exhibit 3 highlights, GICS sector weights within the small-cap Russell 2000 Index followed similar trends to their large-cap counterparts, with the exception of the Energy, Financials, Industrials and Information Technology sectors:

• Unlike large-cap Financials, small-cap Financials still accounted for more than 20% of the small-cap benchmark’s market capitalization as of February 2009, slightly up from 19.8% in October 2007.

• While the share of large-cap Energy companies increased, small-cap energy companies now make up only 4.5% of the small-cap benchmark, down from 6.4% in October 2007.

• Information Technology companies increased their weight in the large-cap benchmark but withdrew in small caps — their benchmark weight decreased from 18.6% in October 2007 to 17.0% in February 2009.

• The share of the Industrials in the small-cap benchmark slightly increased, from 15.2% in October 2007 to 16.2% in February 2009 — in contrast to a decreasing weight in the large-cap index.

As the above analysis shows, the sector compositions of equity benchmarks are

not static and may fluctuate, sometimes significantly, over time. We expect benchmark sector weights to continue evolving as the economic recovery slowly takes shape during the balance of the year.

We expect benchmark sector weights to continue evolving as the economic recovery slowly takes shape during the balance of the year.

BOND MARKET

The Treasury market fell under selling pressure as the stock market bounced higher, a slowing trade into relative safety and liquidity affected Treasuries and economic data marginally improved. For the week, the yield on the benchmark 10-year Treasury note 2 firmed

2 The 10-year Treasury note is used solely as a benchmark for long-term interest rates.

Exhibit 2 — Large-cap benchmark sector weightings (Russell 1000 Index)

* May not add up to 100% due to rounding. Sources: Bloomberg; Investment Strategies Group
*
May not add up
to 100% due to
rounding.
Sources:
Bloomberg;
Investment
Strategies Group
Data through Feb.
28, 2009
Refer to index
definitions at the
end of this report.

Exhibit 3 — Small-cap benchmark sector weightings (Russell 2000 Index)

Small-cap benchmark sector weightings (Russell 2000 Index) * May not add up to 100% due to
Small-cap benchmark sector weightings (Russell 2000 Index) * May not add up to 100% due to
Small-cap benchmark sector weightings (Russell 2000 Index) * May not add up to 100% due to
Small-cap benchmark sector weightings (Russell 2000 Index) * May not add up to 100% due to
* May not add up to 100% due to rounding. Sources: Bloomberg; Investment Strategies Group
*
May not add up
to 100% due to
rounding.
Sources:
Bloomberg;
Investment
Strategies Group
Data through Feb.
28, 2009
Refer to index
definitions at the
end of this report.

from 2.83% to 2.89%. Although investment grade bonds slipped modestly in price, high-yield 3 bonds firmed with the stock market.

INDEX DEFINITIONS The Dow Jones Industrial Average Index, the most widely used indicator of the overall condition of the stock market, is a price- weighted average of 30 actively traded blue-chip stocks as selected by the editors of The Wall Street Journal.

The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large capitalization U.S. stocks.

The Nasdaq Composite Index is a market capitalization price-only index that tracks the performance of domestic common stocks traded on the regular Nasdaq market as well as National Market System- traded foreign common stocks and American Depository Receipts.

The Russell 1000 Index is a capitalization-weighted index that measures the performance of the 1,000 largest market-capitalization companies in the U.S. equity market. The index represents approximately 92% of the U.S. equity market.

The Russell 2000 Index is a capitalization-weighted index that measures the performance of 2,000 companies in the U.S. equity market with small market capitalizations. The index represents approximately 8% of the U.S. equity market.

Indexes are unmanaged, and an investor cannot invest directly in an index.

3 Investments in high-yield bonds (sometimes referred to as “junk bonds”) offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a junk bond issuer’s ability to make principal and interest payments.

Tactical asset allocation (Weightings relative to strategic allocation targets)

 

Underweight

Neutral

Overweight

Underweight

Neutral

Overweight

Equities

Fixed income

Growth

Investment grade

Value

Non-investment grade

Large cap

Cash

Mid cap

 

Small cap

 

Developed international

 

All asset classes are not suitable for all investors. Each investor should select asset classes for investment based on his or her own goals, time horizon and risk tolerance.

UU.S. equity indexes (Price return, percent change)

 

Close

Last

Year-

Last

3/13/09

week

to-date

12 Months

Dow Jones Indstrl Avg.

7,223.98

9.01

-17.69

-40.52

S&P 500

756.55

10.71

-16.24

-42.49

S&P 400 MidCap

456.71

11.90

-15.15

-41.11

S&P 600 SmallCap

207.17

11.59

-22.91

-42.69

Nasdaq Composite

1,431.50

10.64

-9.23

-36.76

Russell 1000 Growth

336.03

8.92

-9.47

-38.44

Russell 1000 Value

380.22

12.94

-21.93

-47.02

Russell Midcap Growth

227.67

11.09

-8.75

-43.42

Russell Midcap Value

511.46

12.45

-21.23

-48.04

Russell 2000 Growth

216.13

11.00

-15.93

-40.27

Russell 2000 Value

543.29

12.99

-26.12

-44.26

International markets (Percent change)

Equity indexes

Close

Last

Year-

Last

(Price return)

3/13/09

week

to-date

12

Months

MSCI EAFE

980.53

5.90

-20.76

-51.36

MSCI Europe

864.75

7.69

-21.30

-54.57

MSCI Pacific

1,329.36

2.70

-19.74

-43.92

S&P/IFCI Emerging

359.28

7.97

-6.61

-52.18

Currency

Yen per dollar

97.95

-0.31

8.06

-2.68

Dollars per euro

1.2928

2.17

-7.47

-17.31

U.S. government bonds (Generic, percent change)

 
 

Yield

Last

Year-

Last

3/13/09

Week

to-date

12

months

90-day T-bill

0.20

-0.01

0.09

-1.15

Two-year Treasury

0.98

0.07

0.22

-0.65

Five-year Treasury

1.87

0.04

0.32

-0.66

10-year Treasury

2.89

0.06

0.64

-0.67

10-year TIPS (real)

1.84

-0.18

-0.25

0.84

Sources: Bloomberg; Investment Strategies Group Indexes are unmanaged, and an investor cannot invest directly in an index.

U.S. equity sectors (Price return, percent change)

10 economic sectors of the S&P 500 Index

Index

Last

Year-

Last

weight

week

to-date

12 months

Financials

10.37

33.85

-35.18

-67.05

Industrials

9.61

12.39

-27.56

-54.41

Consumer Discretionary

8.42

12.08

-15.78

-40.72

Materials

3.21

11.79

-10.62

-52.05

SS&P 500

100.00

10.71

-16.24

-42.49

Information Technology

17.69

9.77

-3.07

-35.55

Health Care

15.94

9.51

-9.55

-22.79

Telecommunications

4.01

7.35

-12.12

-27.25

Energy

13.54

6.70

-14.56

-42.22

Consumer Staples

13.13

4.57

-13.75

-25.18

Utilities

4.09

2.17

-19.40

-38.22

Bond indexes (Barclays Capital, total return, percent change)

 

Yield to

maturity

3/13/09

Last

week

Year-

to-date

Last

12 months

Corporate & government

4.09

-0.50

-2.50

1.15

Broad corporate

8.02

-1.08

-3.18

-7.29

Non-investment grade

19.59

1.99

1.26

-21.86

Treasury bills

3.97

0.02

1.41

7.24

Treasury notes & bonds

2.03

-0.25

-2.69

6.57

Agencies

2.47

-0.26

-0.90

5.89

Mortgages

4.26

0.32

1.48

8.55

Municipals

4.24

-0.26

3.38

1.62

Global gov’t., ex-U.S.

2.32

0.63

-7.44

-7.49

Source: Bloomberg Indexes are unmanaged, and an investor cannot invest directly in an index.

U.S. equity industries (Price return, percent change)

10 best and worst performing groups of the S&P 500 Index (of 123)

Last

Year-

Last

week

to-date

12 months

Commercial Banks

50.72

-48.95

-66.53

Diversified Financial Services

47.26

-40.78

-70.31

Automobiles

36.39

-17.42

-72.15

Consumer Finance

31.94

-41.15

-70.40

Capital Markets

30.74

-3.06

-56.51

Building Products

30.52

-54.27

-72.01

Paper & Forest Products

30.03

-30.45

-70.32

Industrial Conglomerates

28.34

-35.40

-67.62

Construction & Engineering

24.62

-13.26

-44.64

REITs

21.43

-33.16

-61.52

S&P 500

10.71

-16.24

-42.49

Internet Software & Services

5.84

3.96

-37.15

Health Care Technology

5.62

-18.14

-42.59

Food & Staples Retailing

4.42

-11.21

-20.35

Food Products

4.39

-11.49

-23.57

Beverages

4.29

-11.44

-23.58

Diversified Consumer Services

3.71

-13.54

9.69

Multi-Utilities

3.37

-15.35

-28.59

Household Products

3.10

-21.47

-28.78

Life Sciences

1.55

2.80

-31.44

Electric Utilities

0.26

-21.80

-38.44

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