2010 Annual Investment Plan by STRS Ohio

Fiscal 2010 INVESTMENT PLAN

June 18, 2009

60-118, 6/09/210

Table of Contents I. Purpose................................................................................................................................1

II. Investment Plan Overview .................................................................................................3 s &ORECAST IN "RIEF ...............................................................................................................3 s %CONOMIC /VERVIEW.........................................................................................................3 s 4OTAL &UND /UTLOOK ..........................................................................................................6 s )NVESTMENT 0LAN 4HEMES ..................................................................................................7 s /UTLOOK FOR THE !MORTIZATION 0ERIOD ...............................................................................7

III. Asset Allocation/Risk Budget ............................................................................................9 s !SSET #LASS 3UMMARIES ....................................................................................................9 s !SSET !LLOCATION .............................................................................................................10 s 2ISK "UDGET....................................................................................................................11

IV. Fiscal 2010 Economic Outlook........................................................................................15 s 5 3 %CONOMIC 'ROWTH AND )NmATION /UTLOOK ...............................................................15 s 5 3 %CONOMIC &ORECAST .................................................................................................22 s )NTERNATIONAL %CONOMIC 'ROWTH AND )NmATION /UTLOOK .................................................23 s )NTERNATIONAL &ORECASTS ...................................................................................................26

V. Fixed-Income Investments ...............................................................................................27 s /UTLOOK ..........................................................................................................................27 s 3TRATEGY ..........................................................................................................................29

VI. Domestic Equities Investments .......................................................................................33 s /UTLOOK ..........................................................................................................................33 s 3TRATEGY .........................................................................................................................36 VII. International Investments................................................................................................37 s /UTLOOK ..........................................................................................................................37 s 3TRATEGY ..........................................................................................................................42 VIII. Real Estate Investments ...................................................................................................45 s /UTLOOK ..........................................................................................................................45 s 3TRATEGY ..........................................................................................................................48 IX. Alternative Investments ...................................................................................................53

Fiscal 2010 Investment Plan

I. Purpose 4HE )NVESTMENT 0LAN PROVIDES STRATEGY FOR lSCAL BASED ON THE 3TATE 4EACHERS 2ETIREMENT "OARD S LONG TERM OBJECTIVES AND THE FORECASTED CLIMATE "ECAUSE THE STAFF FORECAST IS BASED ON ESTIMATES OF A FUTURE ECONOMIC CLIMATE MODIlCATIONS TO THE PLAN MAY BE NECESSARY -ODIlCATIONS WILL BE COMMUNICATED TO THE 2ETIREMENT "OARD IN MONTHLY REVIEWS OF THE PLAN AS NEEDED )N IMPLEMENTING THE PLAN THE STAFF WILL ENSURE THAT ALL POTENTIAL /HIO INVESTMENTS IN EACH ASSET CLASS RECEIVE A THOROUGH ANALYSIS ACCORDING TO POLICY

Fiscal 2010 Investment Plan

II. Investment Plan Overview FORECAST IN BRIEF Fiscal 2010 Projected Ranges

Fiscal 2009 Forecast

2EAL 'ROSS $OMESTIC 0RODUCT

2EAL 0ERSONAL #ONSUMPTION

2EAL "USINESS &IXED )NVESTMENT

#ONSUMER 0RICE )NDEX

3 0 %ARNINGS

n n

Fiscal 2010 Projected Ranges

May 2009

(OUSING 3TARTS MILLIONS 2EAL .ET %XPORTS BILLIONS

&EDERAL &UNDS 2ATE 9EAR 4REASURY .OTE

ECONOMIC OVERVIEW 4HERE ARE SIGNS FROM WEEKLY AND MONTHLY SURVEYS AND MACROECONOMIC MODELS THAT THE ECONOMY IS lNDING A BOTTOM TO ITS ROUGHLY COLLAPSE FROM PEAK ECONOMIC GROWTH MAKING THIS THE STEEPEST AND LONGEST DOWNTURN IN POST 7ORLD 7AR )) ECONOMIC HISTORY !FTER CONTINUED DECLINES IN ECONOMIC ACTIVITY OVER THE REMAINDER OF lSCAL SLUGGISH ECONOMIC GROWTH SHOULD RETURN IN THE lRST HALF OF lSCAL BEFORE GIVING WAY TO A MORE SUSTAINABLE GROWTH PATTERN IN THE SECOND HALF 2ESTORING CONlDENCE IN THE lNANCIAL MARKETS AND ECONOMY HAS BECOME THE PRIMARY MISSION OF lSCAL AND MONETARY POLICYMAKERS AFTER THEY HAVE SHOT NEARLY EVERY ARROW IN THEIR POLICY QUIVERS AT THIS 'REAT 2ECESSION OF n ! LITTLE OVER A YEAR AGO THE &EDERAL 2ESERVE ISSUED A BILLION LOAN TO *0-ORGAN #HASE TO COVER SOME OF "EAR 3TEARNS FAILING ASSETS 4HAT LOAN HERALDED WHAT WOULD BECOME A SERIES OF BAILOUTS AND EMERGENCY LENDING PROGRAMS THAT HAS CAUSED THE &EDERAL 2ESERVE TO MORE THAN DOUBLE ITS ASSETS TO MORE THAN TRILLION TODAY FROM LESS THAN BILLION &URTHERMORE ENORMOUS lSCAL POLICY STIMULUS AND RESCUE EFFORTS Â&#x2C6; PARTICULARLY THE NEARLY BILLION SPENDING AND TAX STIMULUS PACKAGE THE TRILLION JOINT EFFORT OF THE &EDERAL 2ESERVE AND THE 5 3 4REASURY TO UNFREEZE MARKETS FOR CONSUMER AND BUSINESS DEBT AND THE BILLION 4ROUBLED !SSET 2ELIEF 0ROGRAM Â&#x2C6; HAVE BEEN ADDED TO PRIOR MONETARY POLICY CHANGES IN AN ATTEMPT TO RIGHT THE ECONOMIC SHIP 4HE EXTRAORDINARY NUMBER AND SIZE OF POLICY INITIATIVES DIRECTED AT SUPPORTING THE lNANCIAL MARKETS AND ECONOMY HAVE NOT YET ENDED THE RECESSION BUT THEY HAVE HELPED TO SOFTEN THE COLLAPSE AND SHOULD SUPPORT POSITIVE ECONOMIC GROWTH IN lSCAL 4HERE ARE SOME hGREEN SHOOTSv OF IMPROVEMENT IN THE lNANCIAL MARKETS AND ECONOMY 4HE STOCK MARKET IS UP ROUGHLY FROM ITS -ARCH INTRADAY LOW WHILE CORPORATE BOND SPREADS TO 4REASURY SECURITIES HAVE NARROWED BASIS POINTS OVER THE SAME PERIOD AND SHORT TERM INTEREST RATE SPREADS

Fiscal 2010 Investment Plan

HAVE RETURNED TO THEIR lSCAL YEAR LOWS !UTO SALES IMPROVED BY NEARLY IN -ARCH FROM A VERY LOW LEVEL IN &EBRUARY BEFORE GIVING BACK SOME OF THAT GAIN IN !PRIL -ANUFACTURING SURVEYS THOUGH STILL HEAVILY NEGATIVE HAVE IMPROVED SINCE $ECEMBER AND OVERALL CONSUMER SPENDING AND CONlDENCE LEVELS HAVE TURNED MODESTLY UP -OST IMPORTANTLY NEW AND EXISTING HOME SALES APPEAR TO HAVE HIT A BOTTOM IN *ANUARY AND ARE MOVING MARGINALLY HIGHER 7HEN HOME PRICES lNALLY STABILIZE IT SHOULD SET IN MOTION A CHAIN OF EVENTS THAT COULD LEAD TO FURTHER EASING IN KEY INTEREST RATE SPREADS THAT THEN WOULD IMPROVE THE mOW OF CREDIT AND UNLEASH THE FULL FORCE OF THE lSCAL AND MONETARY POLICY STIMULUS /NCE A SLUGGISH RECOVERY LIKELY BEGINS IN lSCAL POLICYMAKERS WILL NEED TO ENSURE STIMULATIVE MONETARY AND lSCAL POLICY ACTIONS DO NOT CHANGE RADICALLY AND LEAD TO A RENEWED COLLAPSE OF THE lNANCIAL MARKETS AND ECONOMY !MONG OTHER COUNTRIES THE ECONOMIC CONTRACTION WILL LIKELY LAST AT LEAST THROUGH THE lRST HALF OF lSCAL $ESPITE SUPPORTIVE lSCAL AND MONETARY POLICIES ECONOMIC GROWTH IN DEVELOPED COUNTRIES IS GOING TO REMAIN SUBDUED AND THAT WILL CONTINUE TO AFFECT GROWTH IN MANY EMERGING COUNTRIES (OWEVER THOSE EMERGING COUNTRIES WITH COMFORTABLE FOREIGN EXCHANGE RESERVES LESS RELIANCE ON TRADE FEWER BANK SOLVENCY ISSUES AND EXPANSIONARY ECONOMIC POLICIES WILL FARE BETTER !S IN THE 5NITED 3TATES INmATION PRESSURES SHOULD REMAIN DORMANT IN MOST COUNTRIES )N SOME DEVELOPED COUNTRIES A SHORT BOUT OF DEmATION COULD OCCUR DURING THE lRST HALF OF lSCAL #ONSEQUENTLY THEIR CENTRAL BANKS SHOULD MAINTAIN HISTORICALLY LOW POLICY INTEREST RATES AS THEY CONTINUE VARIOUS FORMS OF QUANTITATIVE AND CREDIT EASING )N MANY EMERGING COUNTRIES MONETARY CONDITIONS WILL CONTINUE TO EASE &ISCAL SPENDING IN MOST COUNTRIES WILL BE USED TO NARROW THE SHORTFALL IN OUTPUT (ERE ARE THE HIGHLIGHTS OF OUR BASELINE FORECAST s The full force of past policy stimulus should begin to turn the economy around in the first half of fiscal 2010. 3LUGGISH GROWTH OF IN THE lRST HALF OF THE lSCAL YEAR IS EXPECTED BEFORE ECONOMIC ACTIVITY MOVES MODERATELY ABOVE POTENTIAL IN THE SECOND HALF AT AN AVERAGE 4HE lSCAL YEAR GROWTH RATE IS EXPECTED TO BE Â&#x2C6; SLIGHTLY BELOW THE ECONOMY S NEAR TERM POTENTIAL GROWTH RATE OF ROUGHLY s Consumer spending will turn positive, but remain relatively soft over most of fiscal 2010 as households rebuild savings. 2EAL CONSUMER SPENDING IN THE lRST HALF OF lSCAL FELL AN ANNUALIZED A NEARLY YEAR LOW FOR THE TWO QUARTER GROWTH RATE DESPITE AN ENORMOUS DROP IN THE PRICES OF GASOLINE AND OTHER ENERGY PRODUCTS 2ISING UNEMPLOYMENT HUGE WEALTH DECLINES AN INABILITY TO OBTAIN CREDIT AND THE FEAR OF LOSING A HOME HAVE TRUMPED THE BENElCIAL EFFECTS OF COLLAPSING ENERGY COSTS TO CONSUMERS .OT SURPRISINGLY CONSUMER CONlDENCE MEASURES SIT NEAR POST 7ORLD 7AR )) LOWS "ECAUSE THE STOCK MARKET HAS COLLAPSED TWICE OVER THE PAST EIGHT YEARS AND HOME PRICES CONTINUE TO FALL CONSUMERS WILL NOT BE ABLE TO DEPEND UPON WEALTH CREATION TO SUSTAIN CONSUMER SPENDING 0ERSONAL SAVING THAT IS THE AMOUNT OF AFTER TAX INCOME REMAINING AFTER CONSUMER SPENDING WILL HEAD HIGHER LIKELY RETURNING IN COMING QUARTERS TO A SAVING RATE IN THE TO RANGE FROM A YEAR AGO "ECAUSE THE UNEMPLOYMENT RATE SHOULD PEAK AROUND GROWTH IN AFTER TAX INCOME WILL REMAIN ONLY MODERATE AT BEST s A continued drawdown in the supply of new and existing homes should stop the home price decline and lead to a healthier housing market and overall economy in the second half of fiscal 2010. 4HE HOUSING COLLAPSE WAS AT THE ROOT OF THE lNANCIAL CRISIS AND ECONOMIC RECESSION FOR THE 5NITED 3TATES 5NTIL GREATER STABILITY IS INTRODUCED IN THAT SECTOR OF THE ECONOMY NO FORECASTER SHOULD EXPECT A SIGNIlCANT BOUNCE IN ECONOMIC ACTIVITY Â&#x2C6; EVEN WITH THE SUBSTANTIAL lNANCIAL AND ECONOMIC POLICY CHANGES THAT HAVE ALREADY BEEN INTRODUCED &ALLING HOME PRICES WIPED OUT MORE THAN TRILLION IN HOME EQUITY SINCE THE START OF lSCAL AND MORE THAN TRILLION IN EQUITY IN THE THREE YEARS ENDING WITH (OWEVER THE SEVERE DECLINE IN HOME PRICES AND INTEREST RATES HAS PUSHED HOME AFFORDABILITY TO NEW HIGHS (OME

Fiscal 2010 Investment Plan

AFFORDABILITY MEASURES THE ABILITY OF A FAMILY EARNING THE MEDIAN INCOME TO BUY A HOME AT THE MEDIAN PRICE USING CONSERVATIVE lNANCING AND A DOWN PAYMENT 4HE DECLINE IN HOUSING AFFORDABILITY THAT BEGAN IN MID PRECEDED THE HOUSING MARKET COLLAPSE BY ROUGHLY A YEAR AND A HALF )TS RECENT SURGE POINTS TO IMPROVED CONDITIONS DOWN THE ROAD /F COURSE AS LONG AS POTENTIAL HOMEBUYERS HAVE REASON TO BE AFRAID THAT HOME PRICES WILL FALL SUBSTANTIALLY FURTHER THEY ARE LIKELY TO PUT OFF THEIR HOME PURCHASES !S A RESULT INCREASED AFFORDABILITY IS NOT ENOUGH TO ARREST THE HOUSING SECTOR S DECLINE s Growth in real final sales (real gross domestic product [GDP] less inventory changes) will be substantially weaker at 0.2% in the first half of fiscal 2010 before hitting 2.4% in the second half, leading to a fiscal year growth rate of just 1.3%. 7HEN CONSUMER SPENDING COLLAPSES NONRESIDENTIAL INVESTMENT SOON FOLLOWS 4HE HUGE DROP IN BUSINESS lXED INVESTMENT DURING THE SECOND lSCAL QUARTER WILL CONTINUE INTO THE EARLY STAGES OF lSCAL AS ORDERS FOR NEW CAPITAL GOODS SEARCH FOR A BOTTOM /NE ECONOMIC POSITIVE THOUGH IS THAT INVENTORIES HAVE FALLEN DRAMATICALLY DURING lSCAL AND THAT WILL PUSH BUSINESSES TO REDUCE THE DEGREE OF DRAWDOWN BEFORE EVENTUALLY ADDING BACK INVENTORIES IN ANTICIPATION OF BETTER DEMAND FOR GOODS 4HEREFORE INVENTORY CHANGES WILL LIKELY CONTRIBUTE ROUGHLY ONE PERCENTAGE POINT TO THE EXPECTED lSCAL YEAR GROWTH OF REAL '$0 s The United States will not be able to rely upon strong exports to pull it out of the current crisis because of the dramatic slowdown in economic activity around the globe. )N RECENT YEARS WORLD TRADE HAS SIGNIlCANTLY SUPPORTED ECONOMIC GROWTH IN THE 5NITED 3TATES 4HE REAL NET EXPORTS BALANCE SHOULD SHOW CONTINUED IMPROVEMENT FOR THE REMAINDER OF lSCAL BECAUSE THE DROP IN 5 3 DEMAND FOR FOREIGN GOODS AND SERVICES SWAMPS THE DROP IN FOREIGN DEMAND FOR 5 3 GOODS AND SERVICES (OWEVER AS THE 5NITED 3TATES BEGINS A SLUGGISH RECOVERY IN lSCAL THE FOREIGN SECTOR WILL LAG BEHIND STEMMING THE IMPROVEMENT IN TRADE AND MODESTLY PUSHING REAL NET EXPORTS BACK DOWN s The baseline forecast expects inflation will remain contained in fiscal 2010. %NERGY COSTS WILL LIKELY MOVE IN A SOMEWHAT NARROW BAND COMPARED TO RECENT HISTORY WITH OIL PRICES EXPECTED WITHIN A TO RANGE FOR MUCH OF THE YEAR -OST INmATION MEASURES SHOULD RECORD GROWTH RATES IN THE LOWER PART OF THE &EDERAL 2ESERVE S TO ACCEPTABLE BAND AFTER THE NARROWER 0RODUCER 0RICE )NDEX 00) AND #ONSUMER 0RICE )NDEX #0) MEASURES FELL DURING lSCAL 4HE &EDERAL 2ESERVE WILL WANT TO REMOVE SOME OF ITS EXTRAORDINARY MONETARY STIMULUS ONCE THE ECONOMY STARTS TO SHOW SIGNS OF STABILITY BUT IT WILL NOT MAKE A DRASTIC COURSE CHANGE IN THE UPCOMING lSCAL YEAR 4HE FEDERAL FUNDS RATE CURRENTLY SET WITHIN A BAND OF TO WILL LIKELY REMAIN STEADY DURING MOST OF lSCAL (OWEVER LATE IN THE lSCAL YEAR MONETARY POLICYMAKERS WILL LIKELY SIGNAL FUTURE SHORT TERM INTEREST RATE INCREASES AND MIGHT EVEN HAVE RAISED THAT RATE BY TO BASIS POINTS s The baseline economic forecast shows stronger economic growth for fiscal 2010 than the consensus economic view. 4HE 3423 /HIO FORECAST FOR lSCAL EXPECTS lSCAL YEAR GROWTH IN REAL '$0 VERSUS THE Blue Chip Economic Indicators CONSENSUS ESTIMATE OF GROWTH 4HE CONSENSUS VIEW HAS CONSUMER PRICES GROWING AND THE '$0 PRICE INDEX ADVANCING OVER THE SAME PERIOD WHILE THE 3423 /HIO FORECAST SHOWS #0) GROWTH OF AND '$0 PRICE INDEX GROWTH OF &ISCAL NOMINAL '$0 GROWTH IN BOTH THE CONSENSUS FORECAST AND THE 3423 /HIO FORECAST WOULD BE ABOUT AFTER A ROUGHLY DECLINE IN NOMINAL '$0 DURING lSCAL Â&#x2C6; THE LARGEST DECLINE AND ONE OF THE FEW IN NOMINAL '$0 IN NEARLY YEARS 4HE MIX OF REAL GROWTH VERSUS INmATION IS MORE BENIGN IN THE 3423 /HIO FORECAST THAN IT IS IN THE CONSENSUS FORECAST

Fiscal 2010 Investment Plan

4HE PRIMARY ALTERNATIVE TO THE SLUGGISH BUT lNALLY GROWING ECONOMIC FORECAST WITH CONTAINED INmATION IS THAT ECONOMIC ACTIVITY SLIDES EVEN FURTHER IN lSCAL STOKING FEARS THAT THE 5 3 ECONOMY HAS ENTERED A *APANESE STYLE DEmATIONARY EPISODE (OWEVER IF THE RECENT SURGES IN THE lNANCIAL MARKETS CONTINUE THEN BUSINESS AND CONSUMER CONlDENCE SHOULD IMPROVE MORE RAPIDLY AND DRIVE THE ECONOMY HIGHER EARLIER IN lSCAL WHILE NON ENERGY INmATION REMAINS LARGELY CONTAINED %NERGY COSTS COULD MOVE ABOVE THE EXPECTED BASELINE RANGE IN THAT CASE AND PUSH HEADLINE INmATION MEASURES INTO THE TOP PART OF THE &EDERAL 2ESERVE S ACCEPTABLE RANGE Â&#x2C6; RATHER THAN THE LOWER PART OF THAT RANGE INCLUDED IN THE BASELINE FORECAST 7E WOULD ASSIGN MODERATE CONlDENCE TO THE PRIMARY ALTERNATIVE FORECAST AS OPPOSED TO THE HIGH CONlDENCE WE HAVE IN OUR BASELINE lSCAL FORECAST "ECAUSE WE ARE NOT EXPECTING THAT lNANCIAL CONDITIONS IN THE NEAR TERM WILL CONTINUE THE IMPROVEMENT THEY HAVE SHOWN OVER THE PAST COUPLE OF MONTHS WE WOULD ASSIGN ONLY LOW CONlDENCE TO THE IDEA THAT ECONOMIC GROWTH GREATLY EXCEEDS OUR BASELINE FORECAST WHILE HEATING UP ENERGY COSTS AND DRIVING OVERALL INmATION HIGHER THAN EXPECTED

TOTAL FUND OUTLOOK $URING lSCAL 3423 /HIO INVESTMENT ASSETS ARE PROJECTED TO GROW TO APPROXIMATELY BILLION AT MARKET VALUE FROM AN ESTIMATED BILLION IN *UNE 4HIS BILLION INCREASE CONSISTS OF INCOME AND MARKET APPRECIATION MINUS NET CONTRIBUTIONS 3INCE NET CONTRIBUTIONS WHICH ARE CONTRIBUTIONS LESS BENElTS AND OPERATING EXPENSES CONTINUE TO BE NEGATIVE MINUS BILLION ANNUALLY THE GROWTH IN ASSETS COMES TOTALLY FROM INVESTMENT RETURNS 4HE PROJECTED MARKET RETURN IN THIS MONTH PERIOD IS APPROXIMATELY WHICH IS CONSISTENT WITH THE RETURN OUTLOOK IN THE TABLE ON 0AGE #AUTION IS REQUIRED WHEN ESTIMATING FUTURE MARKET VALUES OF ASSETS BECAUSE OF THE POTENTIAL FOR MARKET mUCTUATIONS OVER SHORT TIME PERIODS 4HE TABLE ON 0AGE ILLUSTRATES THE EXPECTED ANNUAL MARKET RETURN FOR EACH ASSET CATEGORY FOR lSCAL RELATIVE TO THE 2ETIREMENT "OARD S POLICY FOR EXPECTED AVERAGE ANNUAL RETURNS !S DETAILED IN THE VARIOUS SECTIONS OF THIS PLAN WE PROJECT THIS PERIOD TO BE BELOW NORMAL FOR THE 3423 /HIO TOTAL FUND RETURN BASED UPON MARKET LEVELS IN -AY !FTER lSCAL S SEVERE DROP IN THE EQUITY MARKETS ONE WOULD NORMALLY EXPECT A SUBSTANTIAL RECOVERY (OWEVER THE EXTREME DETERIORATION SUFFERED IN THE CREDIT MARKETS MAY TAKE A LONGER PERIOD TO REACH hNORMALv TIMES 7E DO ANTICIPATE ANNUALIZED RETURNS OF OVER THE NEXT THREE lSCAL YEARS FOR 3423 /HIO YET lSCAL S RETURN WILL LIKELY LAG AS THE WORLDWIDE ECONOMIES ATTEMPT TO REESTABLISH A SOUND lNANCIAL SYSTEM 0REDICTING AN INDIVIDUAL YEAR S TOTAL FUND RETURN CAN BE HAZARDOUS AND IT HAS A LARGE CONlDENCE INTERVAL AROUND IT 5SING ONE STANDARD DEVIATION OF RETURNS ON THE TOTAL FUND THE ACTUAL RETURN COULD BE FROM n TO 4HE EQUITY MARKETS BOTH DOMESTIC AND INTERNATIONAL WHICH DECLINED SUBSTANTIALLY IN lSCAL ARE LIKELY TO BE POSITIVE IN lSCAL HOWEVER REAL ESTATE RETURNS ARE LIKELY TO OFFSET SOME OF THE GAIN 4HUS THE TOTAL FUND RETURN SHOULD BE BELOW NORMAL IN lSCAL

Fiscal 2010 Investment Plan

ANTICIPATED MARKET RETURNS Board Policy Expected Average Benchmark Annual Returns

Benchmark Annualized Return Expectation for Fiscal 2010*

,IQUIDITY 2ESERVES

3IGNIlCANTLY "ELOW .ORMAL

&IXED )NCOME

!BOVE .ORMAL

$OMESTIC %QUITIES

!BOVE .ORMAL

)NTERNATIONAL

.ORMAL

2EAL %STATE

3IGNIlCANTLY "ELOW .ORMAL

!LTERNATIVE )NVESTMENTS

"ELOW .ORMAL

Total Fund

7.7%

Below Normal

*Based upon market levels in mid-May 2009.

INVESTMENT PLAN THEMES )N ADDITION TO MEETING OR EXCEEDING THE 2ETIREMENT "OARD S GOAL OF BASIS POINTS OF NET VALUE ADDED FOR THE INVESTMENT PORTFOLIO IN lSCAL WE ANTICIPATE THE FOLLOWING ITEMS WILL BE ACCOMPLISHED s

%NHANCE THE OVERALL MANAGEMENT OF DOMESTIC EQUITIES BY INCORPORATING THE SUGGESTIONS FROM THE RECENT 2USSELL )NVESTMENT 'ROUP REVIEW AND BY REASSESSING 3423 /HIO S USE OF EXTERNAL CORE MANAGERS

2ESEARCH INVESTMENT OPPORTUNITIES IN OUR hNEWv SUB ASSET CLASS Â&#x2C6; h/PPORTUNISTIC $IVERSIlEDv Â&#x2C6; WITH THE GOAL OF FUNDING UP TO AN ADDITIONAL FOR A TOTAL OF OF TOTAL ASSETS DURING THE year.

!SSIST THE 2ETIREMENT "OARD IN COMPLETING THE SELECTION PROCESS FOR ITS NEW INVESTMENT CONSULTANT AND ENSURE A SEAMLESS TRANSFER FROM THE 2USSELL )NVESTMENT 'ROUP

%ARLY IN THE lSCAL YEAR WORK WITH 3423 /HIO S (UMAN 2ESOURCE 3ERVICES $EPARTMENT ON AN UPDATE TO THE COMPENSATION STUDY TO REmECT MARKET LEVELS TO ENSURE 3423 /HIO S COMPENSATION REMAINS COMPETITIVE OVER THE LONG TERM IN RETAINING OUR HIGH VALUE ADDED )NVESTMENT $EPARTMENT STAFF

OUTLOOK FOR THE AMORTIZATION PERIOD 7ITH A PROJECTED TOTAL FUND RETURN OF AROUND n FOR lSCAL THE AMORTIZATION PERIOD FOR THE UNFUNDED LIABILITY IS LIKELY TO INCREASE TO AN UNDETERMINED AMOUNT FOR *ULY FROM YEARS ON *ULY 7ITH lSCAL S EXPECTED RETURN OF AND EVEN THE PROJECTED ANNUALIZED RETURN OVER THE NEXT THREE lSCAL YEARS lSCAL TO lSCAL THE AMORTIZATION PERIOD SHOULD REMAIN AT AN UNDETERMINED AMOUNT 4HUS THE 2ETIREMENT "OARD S INTENSE FOCUS ON THE LONG TERM CONTINGENCY PLANNING PROCESS REMAINS PARAMOUNT

Fiscal 2010 Investment Plan

III. Asset Allocation/Risk Budget ASSET CLASS SUMMARIES Liquidity Reserves 7ITH THE UNPRECEDENTED DYSFUNCTIONAL STATE OF THE CREDIT MARKETS IN lSCAL THE LIQUIDITY NEEDS FOR MOST INSTITUTIONAL INVESTORS WERE STRETCHED TO THE LIMIT )T WILL BE IMPORTANT TO MAINTAIN HIGHER LIQUIDITY RESERVES UNTIL hNORMAL TIMESv RETURN )N lSCAL WE PLAN TO MAINTAIN AT LEAST A NORMAL WEIGHT DESPITE THE VERY LOW RETURN OUTLOOK )F EXPECTED RETURNS IN OTHER ASSETS MEET EXPECTATIONS EARLY IN THE lSCAL YEAR FUNDS MAY BE WITHDRAWN FROM THOSE ASSET CLASSES AND PLACED IN LIQUIDITY RESERVES TO PRESERVE CAPITAL

Fixed Income 4HE TOTAL DISARRAY THE CREDIT MARKETS EXPERIENCED FOR MOST OF lSCAL SHOULD CONTINUE TO DISSIPATE IN lSCAL %VEN THE MOST RELIABLE lXED INCOME MANAGERS SUFFERED GREATLY IN lSCAL AS CREDIT SPREADS ON NON 4REASURY ISSUES ROSE TO RECORD LEVELS 4HESE CREDIT SPREADS HAVE BEGUN TO NARROW AND WE EXPECT THEM TO CONTINUE TO IMPROVE IN THE COMING YEAR $ESPITE A PREDICTED RISE IN 4REASURY YIELDS OTHER lXED INCOME SECURITIES COULD DECLINE IN YIELD AS THE SPREADS NARROW 7E PLAN TO BE OVERWEIGHT CREDIT INSTRUMENTS AND UNDERWEIGHT 4REASURIES AS THIS REASSESSMENT OCCURS 4HE RETURN ON THE lXED INCOME BENCHMARK IS EXPECTED TO EXCEED ITS LONG TERM RETURN OBJECTIVE OF IN lSCAL HOWEVER IT IS UNLIKELY TO BE AS ROBUST AS THE EQUITY MARKETS

Domestic Equities )N lSCAL THE 5 3 EQUITY MARKET SUFFERED ITS BIGGEST DECLINE SINCE THE 'REAT $EPRESSION DUE TO THE SEVERE GLOBAL lNANCIAL CRISIS &ORTUNATELY IT APPEARS TO HAVE lNALLY RESPONDED FAVORABLY TO THE &EDERAL 2ESERVE AND THE FEDERAL GOVERNMENT S MULTIPLE ACTIONS AND HAS RISEN SUBSTANTIALLY FROM ITS LOW LEVEL IN -ARCH 7E ANTICIPATE THE MARKET RECOVERY WILL CONTINUE INTO lSCAL AS ECONOMIC GROWTH SHOULD RESUME IN FALL ,OW INmATION FAVORABLE ENERGY PRICES AND A RISE IN CORPORATE EARNINGS SHOULD PROVIDE A FAVORABLE ENVIRONMENT FOR 5 3 EQUITIES 7HILE THE LARGE RETURN OFF THE BOTTOM IS ALREADY BEHIND US WE EXPECT AN ABOVE AVERAGE YEAR FOR THE 5 3 STOCK MARKET

International Equities $URING MOST OF lSCAL INTERNATIONAL EQUITY MARKETS DECLINED SEVERELY REmECTING THE GLOBAL ECONOMIC AND CREDIT MELTDOWN ,ATE IN THE lSCAL YEAR THE MARKETS BEGAN RESPONDING TO THE WORLDWIDE CENTRAL BANKS AND GOVERNMENTS COORDINATED EFFORTS TO RESTORE LIQUIDITY AND CONlDENCE TO THE lNANCIAL SYSTEM 7ORLDWIDE ECONOMIES SHOULD MOVE OUT OF THE RECESSION DURING lSCAL BUT PROBABLY A QUARTER OR TWO AFTER THE 5NITED 3TATES 7E ARE FORECASTING THAT THE INTERNATIONAL EQUITY MARKETS WILL CONTINUE TO RISE AS THEY HAVE FROM -ARCH ALTHOUGH AT A MUCH SLOWER PLACE 7E ARE PROJECTING A NORMAL RETURN YEAR FOR INTERNATIONAL EQUITIES

Real Estate !FTER PRODUCING RETURNS OF NEARLY PER YEAR OVER THE PAST lVE YEARS REAL ESTATE HAD A TOUGH YEAR IN lSCAL 4HE ECONOMIC RECESSION AND THE GLOBAL CREDIT CRISIS CAUSED PROPERTY PRICES TO DECLINE FROM THEIR LOFTY LEVELS 7E ANTICIPATE THE CORRECTION WILL CONTINUE INTO lSCAL WITH REAL ESTATE LIKELY PRODUCING A NEGATIVE RETURN &ORTUNATELY THE 3423 /HIO PORTFOLIO CONSISTS OF VERY HIGH QUALITY ASSETS THAT SHOULD DECLINE LESS !LTHOUGH SLIGHTLY OVERWEIGHT IN THIS ASSET CLASS WE PLAN TO MAKE SOME LIMITED ACQUISITIONS DURING THE YEAR AT ATTRACTIVE LONG TERM PRICES

Fiscal 2010 Investment Plan

Alternative Investments 4HIS ASSET CLASS WAS NOT IMMUNE TO THE GLOBAL lNANCIAL CRISIS AS IT IS EXPECTED TO PRODUCE NEGATIVE RETURNS IN lSCAL 7E ARE PROJECTING THAT POSITIVE RETURNS WILL BE ACHIEVED IN lSCAL AS THE EQUITY MARKETS RISE YET PROBABLY NOT AT ITS NORMAL RATE OF 3423 /HIO HAS SUBSTANTIALLY INCREASED THIS ASSET CATEGORY OVER THE PAST FEW YEARS AND THE RECENT !SSET !LLOCATION 3TUDY RAISED THE TARGET NORMAL WEIGHT TO FROM )N lSCAL THE PRIMARY FOCUS WILL BE RESEARCHING INVESTMENTS FOR THE NEW SUBCATEGORY OF /PPORTUNISTIC $IVERSIlED 7E BELIEVE THIS MAY BE AN ATTRACTIVE PERIOD FOR THIS SEGMENT AS GOVERNMENT PROGRAMS AND CREDIT ISSUES MAY SET THE STAGE FOR EXCELLENT RISK ADJUSTED RETURNS

ASSET ALLOCATION AVERAGE LONG-TERM POLICY WEIGHT, ESTIMATED JUNE 2009 WEIGHT AND STRATEGY FOR FISCAL 2010 AS A PERCENTAGE OF TOTAL ASSETS AT MARKET

Average Long-Term Allocation ,IQUIDITY 2ESERVES &IXED )NCOME %QUITIES $OMESTIC International 4OTAL %QUITIES 2EAL %STATE !LTERNATIVE )NVESTMENTS 0RIVATE %QUITY /PPORTUNISTIC $IVERSIlED

4OTAL !LTERNATIVES Total

Estimated June 2009 Weight

100%

General Strategy for Fiscal 2010* ,IQUIDITY RESERVES ARE FORECASTED TO HAVE A VERY LOW RETURN AROUND IN lSCAL 3423 /HIO ANTICIPATES HAVING A MODEST WEIGHTING IN THIS ASSET CLASS UNLESS THE LONGER TERM lNANCIAL ASSETS BECOME OVERVALUED -AINTAIN A BELOW NEUTRAL WEIGHT AS EQUITIES HAVE A MORE FAVORABLE RETURN OUTLOOK 4HE RETURN OUTLOOK FOR EQUITIES IS FAVORABLE

-AINTAIN A SLIGHT OVERWEIGHT AS PROJECTED MONTH RETURNS EXCEED )NCREASE OVERWEIGHT POSITION SHOULD DOUBLE DIGIT RETURNS SEEM LIKELY )T IS VERY DIFlCULT TO ADJUST THIS WEIGHTING DUE TO THE INHERENT ILLIQUIDITY IN THE PROPERTY MARKETS 3423 /HIO WILL ALLOW THIS WEIGHTING TO DECREASE NATURALLY AS THE TOTAL FUND INCREASES !NTICIPATING A RECOVERY A FEW NEW ACQUISITIONS AT ATTRACTIVE PRICES ARE LIKELY TO BE MADE 4HE RECENT !SSET !LLOCATION 3TUDY HAS INCREASED THIS TARGET WEIGHTING SIGNIlCANTLY 3423 /HIO WILL AGGRESSIVELY SEEK INVESTMENTS IN THE NEW SUBCATEGORY OF h/PPORTUNISTIC $IVERSIlEDv DURING lSCAL

-ORE DETAILED ASSET WEIGHTINGS AND PROJECTIONS ARE PROVIDED QUARTERLY TO THE 2ETIREMENT "OARD 4HIS PROVIDES THE 2ETIREMENT "OARD MORE CURRENT UPDATES TO THE OVERALL STRATEGY RATHER THAN PLACING THEM IN THE )NVESTMENT 0LAN

/PPORTUNISTIC $IVERSIlED TARGET WEIGHT IS SCHEDULED TO INCREASE PER YEAR UNTIL A MAXIMUM TARGET WEIGHT IS OBTAINED EFFECTIVE *ULY

Fiscal 2010 Investment Plan

RISK BUDGET Investment Portfolio Risk Introduction 4HERE ARE TWO PRIMARY TYPES OF INVESTMENT RISK THAT THE 2ETIREMENT "OARD AND STAFF NEED TO MANAGE CAPITAL MARKET RISK AND ACTIVE MANAGEMENT RISK 4HE lRST DESCRIBES THE VOLATILITY OF THE POLICY RETURNS AND IS A RESULT OF THE PLAN ASSETS BEING INVESTED IN THE SELECTED ASSET CLASSES 4HE LAST ASSET LIABILITY STUDY DETERMINED AN ACCEPTABLE AMOUNT OF CAPITAL MARKET RISK AND ESTABLISHED APPROPRIATE ALLOCATIONS 3423 /HIO ACTIVELY MANAGES MOST OF ITS INVESTMENTS THEREFORE THE FUND WILL HAVE ACTIVE MANAGEMENT RISK 4HIS RISK REFERS TO THE RETURN mUCTUATIONS AROUND THE BENCHMARK RETURN THAT RESULT FROM ACTIVE MANAGEMENT DECISIONS 4HE AMOUNT OF ACTIVE MANAGEMENT RISK INDICATES HOW CLOSELY THE PORTFOLIO RETURNS WILL MATCH THE BENCHMARK RETURNS 4HE STAFF USES THE RISK BUDGET TO MANAGE THIS RISK !LTHOUGH ACTIVE MANAGEMENT IS A SOURCE OF VOLATILITY IT IS MUCH LOWER THAN AND UNCORRELATED WITH THE CAPITAL MARKET RISK 4HIS MEANS THAT ADDING ACTIVE MANAGEMENT RISK TO THE FUND WILL NOT CAUSE A LARGE INCREASE IN TOTAL FUND VOLATILITY 4HUS OVER THE LONG RUN THE ACTIONS OF THE STAFF ARE NOT EXPECTED TO CHANGE THE TOTAL VOLATILITY OF THE FUND MATERIALLY Asset Allocation and Capital Market Risk 4HE APPROPRIATE AMOUNT OF CAPITAL MARKET RISK FOR THE 3423 /HIO PORTFOLIO IS DETERMINED THROUGH AN ASSET LIABILITY STUDY 4HE STUDY ESTABLISHES AN OPTIMAL TARGET WEIGHT AND WEIGHT RANGE FOR EACH ASSET CLASS 4HIS MEANS THAT THERE IS NO OTHER COMBINATION OF ASSET CLASSES THAT HAS LOWER RISK WHILE ACHIEVING THE SAME EXPECTED RETURN WITHOUT VIOLATING THE CONSTRAINTS DECIDED UPON IN THE !SSET !LLOCATION 3TUDY 4HE FOLLOWING TABLE CONTAINS THE CURRENT AND TARGET ALLOCATIONS FOR EACH 3423 /HIO ASSET CLASS AND THE EXPECTED RETURN AND CAPITAL MARKET RISK Asset Class

Expected Return

Capital Market Target Rebalancing Risk Allocation Range

Current Allocation**

$OMESTIC %QUITIES

)NTERNATIONAL %QUITIES

&IXED )NCOME

2EAL %STATE

0RIVATE %QUITY

/PPORTUNISTIC $IVERSIlED

,IQUIDITY 2ESERVES

4OTAL &UND

$OES NOT INCLUDE ACTIVE MANAGEMENT RETURNS

!LLOCATION AS OF *UNE

4HE EXPECTED CAPITAL MARKET RISK FOR THE TOTAL INVESTMENT PORTFOLIO BENCHMARK IS WHICH MEANS THERE IS A PROBABILITY THAT THE INVESTMENT PORTFOLIO RETURNS WILL BE IN THE RANGE OF n TO !NOTHER WAY TO QUANTIFY THIS RISK IS THAT THERE IS ON AVERAGE A CHANCE UNDER THE TARGET ALLOCATION THAT THE FUND COULD LOSE BILLION OR MORE IN A SINGLE YEAR 4HE LOSS IN THE INVESTMENT PORTFOLIO WAS SUBSTANTIALLY MORE THAN THIS IN lSCAL &ROM A PURELY STATISTICAL PERSPECTIVE THE PROBABILITY OF SUCH A LOSS WAS LESS THAN 4HE lNANCIAL CRISIS THAT UNFOLDED IN lSCAL CAUSED ALL ASSET CLASSES TO DEVIATE FROM THEIR FORECASTED RISK RETURN DISTRIBUTIONS )N OTHER

Fiscal 2010 Investment Plan

WORDS THE RISK OF EACH ASSET CLASS SUDDENLY ROSE DRAMATICALLY AS DID THE CORRELATION AMONG THE ASSET CLASSES 4HE REPRICING OF RISK ACROSS ASSET CLASSES CAUSED A SPIKE IN THE VOLATILITY OF THE INVESTMENT PORTFOLIO !S THE lNANCIAL CRISIS UNWINDS WE EXPECT ALL ASSET CLASSES TO RETURN TO THEIR LONG TERM RISK RETURN DISTRIBUTIONS AS STATED IN THE !SSET !LLOCATION 3TUDY 3TAFF IS ALLOWED TO DEVIATE FROM THE ASSET CLASS TARGET WEIGHTS WITHIN THE ALLOWABLE REBALANCING RANGES 4HE INVESTMENT PORTFOLIO WILL BEGIN lSCAL WITH AN UNDERWEIGHT IN lXED INCOME 3INCE THIS ASSET CLASS HAS A LOWER VOLATILITY RELATIVE TO THE OTHER ASSET CLASSES THE CURRENT EXPECTED CAPITAL MARKET RISK OF THE INVESTMENT PORTFOLIO WILL BE SLIGHTLY HIGHER THAN THE EXPECTED AVERAGE Risk Budgeting and Active Management Risk !CTIVE MANAGEMENT RISK REFERS TO PORTFOLIO RETURN mUCTUATIONS AROUND THE BENCHMARK RETURN THAT RESULT FROM ACTIVE MANAGEMENT DECISIONS 2ISK BUDGETING IS A TOOL USED BY STAFF TO EFlCIENTLY ALLOCATE ACTIVE MANAGEMENT RISK AMONG THE ASSET CLASSES BY ASSIGNING ACTIVE MANAGEMENT RISK RANGES 4HE GOAL OF A RISK BUDGET IS TO MAXIMIZE THE ACTIVE MANAGEMENT RETURNS EARNED WITHIN A BOARD APPROVED ACTIVE MANAGEMENT RISK RANGE FOR THE TOTAL FUND %MPIRICAL EVIDENCE SHOWS THAT LESS EFlCIENT MARKETS SUCH AS REAL ESTATE AND EMERGING MARKETS OFFER GREATER OPPORTUNITIES FOR ACTIVE MANAGEMENT RETURNS COMPARED TO MORE EFlCIENT MARKETS SUCH AS DOMESTIC EQUITIES AND DOMESTIC lXED INCOME 4HEREFORE THE ESTIMATED ACTIVE MANAGEMENT RISK FOR REAL ESTATE AND INTERNATIONAL EQUITIES SHOULD BE HIGHER THAN THE OTHER ASSET CLASSES "ASED UPON QUANTITATIVE WORK DEVELOPED BY STAFF WE ESTIMATE THAT THE TOTAL FUND LEVEL OF ACTIVE MANAGEMENT RISK IS BASIS POINTS 4HE 3423 /HIO TOTAL FUND RETURN SHOULD TRACK WITHIN PLUS OR MINUS TWO TIMES THE EXPECTED ACTIVE MANAGEMENT RISK LEVEL RELATIVE TO THE TOTAL FUND COMPOSITE BENCHMARK 4HUS IF THE TOTAL FUND COMPOSITE BENCHMARK EARNS FOR THE YEAR THE 3423 /HIO RETURN IS EXPECTED TO BE WITHIN TWO TIMES OF THIS RETURN I E BETWEEN AND 3IMILARLY IN A YEAR WHEN THE BENCHMARK RETURN IS n THE 3423 /HIO RETURN IS EXPECTED TO BE BETWEEN n AND n 4HE POLICY RANGE OF ACTIVE MANAGEMENT RISK FOR THE TOTAL FUND IS ESTABLISHED TO ACHIEVE THE NET ACTIVE MANAGEMENT RETURN GOAL OF BASIS POINTS AS SPECIlED IN THE !SSET !LLOCATION STUDY 4HIS POLICY RANGE IS THE BASIS FOR THE POLICY RANGES OF THE INDIVIDUAL ASSET CLASSES %XPECTED OPERATING RANGES FOR THE ASSET CLASSES ARE CREATED BY STAFF EACH YEAR TO EFlCIENTLY ACHIEVE THE DESIRED LEVEL OF ACTIVE MANAGEMENT RISK FOR THE TOTAL FUND /PERATING RANGES MUST FALL WITHIN THE POLICY RANGES FOR EACH ASSET CLASS AND FOR THE TOTAL FUND 4HE TABLE ON 0AGE SHOWS THE *UNE ESTIMATE AND THE lSCAL EXPECTED OPERATING RANGE OF ACTIVE MANAGEMENT RISK FOR EACH ASSET CLASS 4HESE MEASURES ARE EXPECTED TO mUCTUATE SLIGHTLY OVER THE lSCAL YEAR HOWEVER NO MATERIAL DEVIATIONS FROM THESE MEASURES ARE ANTICIPATED 4HE ACTIVE MANAGEMENT RISK OF THE TOTAL FUND IS EXPECTED TO FALL IN THE RANGE OF TO BASIS POINTS DURING lSCAL 4HIS RANGE INCLUDES TACTICAL RISK DUE TO ASSET ALLOCATION BETS THAT DO NOT OCCUR WITHIN THE ASSET CLASS ACTIVE MANAGEMENT RISK ESTIMATES AND ARE LIKELY TO VARY THROUGHOUT THE YEAR

Fiscal 2010 Investment Plan

FISCAL 2010 ACTIVE MANAGEMENT RISK Estimated June 2009 Active Management Risk (basis points)

Fiscal 2010 Operating Range (basis points)

Policy Range (basis points)

,IQUIDITY 2ESERVES

. !

&IXED )NCOME

$OMESTIC %QUITIES

)NTERNATIONAL %QUITIES

2EAL %STATE

!LTERNATIVE )NVESTMENTS

. !

4ACTICAL !SSET !LLOCATION

. !

Total Fund

60â&#x20AC;&#x201C;95

20â&#x20AC;&#x201C;160

Asset Class

!S EXPLAINED IN THE PARAGRAPH BELOW THIS ESTIMATE IS STATIC UNLESS A SIGNIlCANT PORTFOLIO ADJUSTMENT OCCURS

5NLIKE OTHER ASSET CLASSES REAL ESTATE DOES NOT HAVE A MODEL THAT CAN BE USED TO ACCURATELY ESTIMATE ACTIVE MANAGEMENT RISK )NSTEAD THE ESTIMATE IS BASED ON HISTORICAL ACTIVE MANAGEMENT RETURNS THE AMOUNT OF LEVERAGE IN THE PORTFOLIO AND PAST REAL ESTATE MARKET VOLATILITY 4HESE FACTORS ARE UNLIKELY TO CHANGE MUCH OVER TIME WITHOUT A SIGNIlCANT CHANGE TO THE PORTFOLIO THEREFORE THE ESTIMATED ACTIVE MANAGEMENT RISK FOR REAL ESTATE WILL BE STATIC MOST YEARS 4HE CHART BELOW EXPLAINS WHERE THE ACTIVE MANAGEMENT RISK FOR THE TOTAL FUND IS GENERATED !S EXPECTED THE EFlCIENT ASSET CLASSES DOMESTIC EQUITIES AND lXED INCOME CONTRIBUTE DISPROPORTIONATELY LESS RELATIVE TO THEIR ASSET CLASS WEIGHT

CONTRIBUTION TO ACTIVE MANAGEMENT RISK 40%

36% 35%

30%

25%

24%

20%

17%

15%

12%

11%

10%

Alternative Investments

Liquidity Reserves

Domestic Equities

International Equities

Fixed Income

Real Estate

Tactical Asset Allocation

Fiscal 2010 Investment Plan

IV. Fiscal 2010 Economic Outlook U.S. ECONOMIC GROWTH AND INFLATION OUTLOOK %NTERING lSCAL THE 5 3 ECONOMY WAS IN TURMOIL %CONOMIC ACTIVITY WAS ADVANCING AT A MODEST PACE AT THE END OF lSCAL BUT MOST OF THE SUPPORT CAME FROM STRONG FOREIGN DEMAND FOR 5 3 GOODS AND SERVICES WHILE THE DOMESTIC ECONOMY WAS SLOWING ABRUPTLY )N FACT EXCLUDING INTERNATIONAL TRADE THE ECONOMY HAD STALLED IN THE SECOND HALF OF lSCAL "Y THE END OF THAT lSCAL YEAR THE STOCK MARKET WAS ALREADY DOWN FROM ITS DAILY CLOSING PEAK ON /CT AND BOTH SHORT AND LONG TERM CREDIT SPREADS HAD WIDENED TO ALARMING LEVELS 7HAT HAD STARTED AS A CRUSHING HOUSING DOWNTURN AT THE END OF lSCAL ONCE SUBPRIME MORTGAGES INCREASINGLY FELL INTO DEFAULT HAD NOW SPREAD THROUGHOUT THE lNANCIAL MARKETS AND ECONOMY CREATING WIDESPREAD UNCERTAINTY ABOUT FUTURE ECONOMIC AND lNANCIAL PROSPECTS 4HE WORST WAS YET TO COME 4HOUGH REAL ECONOMIC ACTIVITY FELL ONLY MODESTLY IN lSCAL S lRST QUARTER DOWN AT AN ANNUAL RATE ,EHMAN "ROTHERS WENT BANKRUPT IN 3EPTEMBER SETTING IN MOTION A lNANCIAL MARKET PANIC THAT CRUSHED THE STOCK AND CREDIT MARKETS !T ITS WORST CLOSE ON -ARCH THE 3 0 HAD FALLEN lSCAL YEAR TO DATE 4HAT DECLINE OVER BUSINESS DAYS WAS THE WORST DECLINE BY ROUGHLY OF ANY SUCH PERIOD GOING BACK TO !T THE SAME TIME CREDIT SPREADS FOR BOTH SHORT AND LONG TERM CREDIT SHOT UP TO UNHEARD OF LEVELS AND BANK CREDIT QUICKLY DRIED UP "USINESS ACTIVITY CAME TO A NEAR HALT PUSHING REAL '$0 GROWTH DOWN BY IN THE SECOND lSCAL QUARTER AND IN THE THIRD lSCAL QUARTER 4HE TWO QUARTER DECLINE IN ECONOMIC ACTIVITY WAS THE WORST IN YEARS AND EARNED THE RECESSION THAT BEGAN IN $ECEMBER THE TITLE h'REAT 2ECESSION v 4HE UNEMPLOYMENT RATE BEGAN THE lSCAL YEAR AT WITH MONTHLY JOB LOSSES DURING THE lRST SIX MONTHS OF THE RECESSION AVERAGING 4HAT PATTERN CONTINUED UP TO THE ,EHMAN "ROTHERS BANK RUPTCY WITH THE UNEMPLOYMENT RATE REACHING BEFORE AN ALL OUT ROUT OF THE LABOR MARKET BEGAN )N THE EIGHT MONTHS ENDING WITH !PRIL AVERAGE JOB LOSSES SOARED TO PER MONTH AND THE UNEMPLOYMENT RATE QUICKLY ROSE TO 7HILE MILLION JOBS WERE LOST DURING THE lRST EIGHT MONTHS OF THE RECESSION AN APPALLING MILLION WERE LOST DURING THE SECOND EIGHT MONTHS 2EAL CONSUMER SPENDING IN THE lRST HALF OF THE lSCAL YEAR FELL BY AN ANNUALIZED RATE Â&#x2C6; THE WORST RESULT FOR CONSUMER SPENDING WHICH MAKES UP ROUGHLY OF THE ECONOMY IN MORE THAN YEARS "USINESS SPENDING AND INVESTMENT SOON FOLLOWED WITH REAL NONRESIDENTIAL lXED INVESTMENT TUMBLING AN ANNUALIZED IN THE MIDDLE QUARTERS OF THE lSCAL YEAR AND INVENTORIES PLUNGING BY BILLION IN THE THIRD lSCAL QUARTER "OTH CHANGES WERE THE LARGEST IN POST 7ORLD 7AR )) ECONOMIC HISTORY 4HE REST OF THE WORLD HEAVILY DEPENDENT UPON 5 3 CONSUMPTION OF ITS GOODS AND SERVICES ALSO FELL INTO A DEEP RECESSION !S A RESULT REAL EXPORTS OF 5 3 ITEMS FELL AN ANNUALIZED IN THE MIDDLE QUARTERS OF THE lSCAL YEAR 2ESTORING CONlDENCE IN THE CRUSHED lNANCIAL MARKETS AND ECONOMY BECAME THE PRIMARY MISSION FOR MONETARY AND lSCAL POLICYMAKERS AFTER THEY CREATED A NEARLY UNCOUNTABLE NUMBER OF SUPPORT PROGRAMS 4HE MONETARY POLICY INTEREST RATE CONTROLLED BY THE &EDERAL 2ESERVE THE FEDERAL FUNDS RATE WAS LOWERED TO BASICALLY FROM AS RECENTLY AS 3EPTEMBER ! BILLION LOAN FROM THE &EDERAL 2ESERVE TO *0-ORGAN #HASE TO HELP IT PURCHASE BAD ASSETS FROM "EAR 3TEARNS IN -ARCH HERALDED WHAT WOULD BECOME A SERIES OF BAILOUTS AND EMERGENCY LENDING PROGRAMS 4HESE HAVE CAUSED THE &EDERAL 2ESERVE TO MORE THAN DOUBLE ITS ASSETS TO MORE THAN TRILLION TODAY FROM LESS THAN BILLION A YEAR AGO AS IT REMOVES TOXIC ASSETS FROM BANKS AND THE CREDIT MARKETS )N ADDITION ENORMOUS lSCAL POLICY STIMULUS AND RESCUE EFFORTS Â&#x2C6; PARTICULARLY WITH THE NEARLY BILLION SPENDING AND TAX STIMULUS PACKAGE THE TRILLION JOINT EFFORT OF THE &EDERAL 2ESERVE AND THE 5 3 4REASURY TO UNFREEZE MARKETS FOR CONSUMER AND BUSINESS DEBT AND THE BILLION 4ROUBLED !SSET 2ELIEF 0ROGRAM Â&#x2C6; HAVE BEEN ADDED TO PRIOR MONETARY POLICY CHANGES IN AN ATTEMPT TO RIGHT THE ECONOMIC SHIP 4HOUGH

Fiscal 2010 Investment Plan

THE EXTRAORDINARY NUMBER AND SIZE OF POLICY INITIATIVES DIRECTED AT SUPPORTING THE lNANCIAL MARKETS AND ECONOMY HAVE NOT YET ENDED THE RECESSION THEY HAVE HELPED TO SOFTEN THE ALREADY SHOCKING COLLAPSE AND SHOULD SUPPORT SLUGGISH ECONOMIC GROWTH IN lSCAL 2EAL '$0 GROWTH FELL AN ANNUALIZED THROUGH THE lRST THREE QUARTERS OF lSCAL AFTER GROWING A SOFT IN lSCAL 4HE 3423 /HIO 5 3 ECONOMIC FORECAST EXPECTS ECONOMIC ACTIVITY IN THE REMAINING QUARTER OF lSCAL TO SHOW ANOTHER DROP OF ROUGHLY PUTTING lSCAL REAL '$0 GROWTH AT n %CONOMIC GROWTH SHOULD RETURN TO POSITIVE TERRITORY IN lSCAL FROM THE DEEPLY NEGATIVE PATTERN OF THE LAST THREE QUARTERS PARTICULARLY BECAUSE OF THE MASSIVE AMOUNT OF ECONOMIC STIMULUS PROVIDED BY MONETARY AND lSCAL POLICY CHANGES IN lSCAL 7HILE CONSUMER DEMAND SHOULD IMPROVE MODESTLY AS THE lSCAL YEAR PROGRESSES BUSINESS AND FOREIGN DEMAND WILL LIKELY REMAIN SOFT UNTIL LATE IN THE lSCAL YEAR )N THE SECOND HALF OF THE lSCAL YEAR HOUSING ACTIVITY SHOULD lRST lND A BOTTOM AND lNALLY BEGIN TO MOVE HIGHER FROM VERY LOW LEVELS 'OVERNMENT SUPPORT FOR THE ECONOMY AND lNANCIAL MARKETS WILL REMAIN AN IMPORTANT THEME FOR lSCAL AS THE ECONOMY SLUGGISHLY ADVANCES OFF THE 'REAT 2ECESSION DEPTHS %CONOMIC GROWTH IN THE SECOND HALF OF THE lSCAL YEAR SHOULD BE MUCH STRONGER THAN IN THE lRST HALF THOUGH IT SHOULD BE REMEMBERED THAT MUCH OF THE IMPROVEMENT WILL LIKELY COME FROM A RAPID DECELERATION IN INVENTORY DRAWDOWNS AS BUSINESS ACTIVITY BEGINS TO RESPOND TO BETTER CONSUMER AND FOREIGN DEMAND FOR GOODS AND SERVICES /VERALL REAL '$0 SHOULD GROW BY IN lSCAL AFTER THE SEVERE PLUNGE IN lSCAL

REAL GROSS DOMESTIC PRODUCT (GDP) VERSUS ONE YEAR AGO lSCAL YEAR BASIS 10%

-2%

-4%

-6%

1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

'ROSS $OMESTIC 0RODUCT &ORECASTED '$0

.OTE 3HADED AREAS DENOTE RECESSION

Fiscal 2010 Investment Plan

4HERE ARE SOME hGREEN SHOOTSv OF IMPROVEMENT IN THE lNANCIAL MARKETS AND ECONOMY 4HE STOCK MARKET IS UP ROUGHLY FROM ITS -ARCH INTRADAY LOW WHILE CORPORATE BOND SPREADS TO 4REASURY SECURITIES HAVE NARROWED BASIS POINTS OVER THE SAME PERIOD AND SHORT TERM INTEREST RATE SPREADS HAVE RETURNED TO THEIR lSCAL YEAR LOWS !UTO SALES IMPROVED BY NEARLY IN -ARCH FROM A VERY LOW LEVEL IN &EBRUARY BEFORE GIVING BACK SOME OF THAT GAIN IN !PRIL -ANUFACTURING SURVEYS THOUGH STILL HEAVILY NEGATIVE HAVE IMPROVED SINCE $ECEMBER AND OVERALL CONSUMER SPENDING AND CONlDENCE LEVELS HAVE TURNED MODESTLY UP -OST IMPORTANTLY NEW AND EXISTING HOME SALES APPEAR TO HAVE HIT A BOTTOM IN *ANUARY AND ARE MOVING MARGINALLY HIGHER 7HEN HOME PRICES lNALLY STABILIZE IT SHOULD SET IN MOTION A CHAIN OF EVENTS THAT COULD LEAD TO FURTHER EASING IN KEY INTEREST RATE SPREADS THAT THEN WOULD IMPROVE THE mOW OF CREDIT AND UNLEASH THE FULL FORCE OF THE lSCAL AND MONETARY POLICY STIMULUS /NCE A SLUGGISH RECOVERY LIKELY BEGINS IN lSCAL POLICYMAKERS WILL NEED TO ENSURE STIMULATIVE MONETARY AND lSCAL POLICY ACTIONS DO NOT CHANGE RADICALLY AND LEAD TO A RENEWED COLLAPSE OF THE lNANCIAL MARKETS AND ECONOMY 2EAL CONSUMER SPENDING TURNED POSITIVE IN THE THIRD lSCAL QUARTER OF LED BY A SURGE IN AUTO SALES (OWEVER THAT TURNAROUND AFTER A SEVERE PLUNGE IN THE lRST HALF OF THE lSCAL YEAR WILL LIKELY HAVE BEEN TEMPORARY AS RETAIL SALES ACTIVITY STARTED POORLY IN THE lNAL lSCAL QUARTER .ONETHELESS LIKE MOST RECENT ECONOMIC SERIES CONSUMER CONlDENCE HAS MOVED OFF ITS WORST CONDITIONS THOUGH THERE IS A GREAT DEAL OF IMPROVEMENT STILL NEEDED BEFORE FORECASTERS CAN POINT TO AN UPCOMING ROBUST TURNAROUND IN ECONOMIC FORTUNES *OB LOSSES SHOULD CONTINUE INTO THE EARLY PART OF lSCAL S SECOND HALF THE UNEMPLOYMENT RATE WILL LIKELY PEAK AROUND FROM ITS LATEST READING OF 4AX CUTS WILL HELP MOVE REAL DISPOSABLE PERSONAL INCOME HIGHER BUT CONSUMERS WILL PUT A GREATER EMPHASIS ON SAVING OUT OF CURRENT INCOME THAN THEY HAVE DONE IN RECENT YEARS BECAUSE OF THE MASSIVE HOUSEHOLD WEALTH LOSS FROM THE REAL ESTATE COLLAPSE AND lNANCIAL MARKETS PLUNGE 4HEREFORE REAL CONSUMER SPENDING IS EXPECTED TO GROW DURING lSCAL AFTER A DROP IN lSCAL "Y THE SECOND HALF OF THE YEAR CONSUMER SPENDING GROWTH SHOULD ROUGHLY MATCH THE ECONOMY S NEARER TERM POTENTIAL GROWTH OF ROUGHLY A CLEAR IMPROVEMENT OF RECENT TRENDS 4HE HOUSING COLLAPSE WAS AT THE ROOT OF THE lNANCIAL CRISIS AND ECONOMIC RECESSION FOR THE 5NITED 3TATES 5NTIL GREATER STABILITY IS INTRODUCED IN THAT SECTOR OF THE ECONOMY NO FORECASTER SHOULD EXPECT A SIGNIlCANT BOUNCE IN ECONOMIC ACTIVITY Â&#x2C6; EVEN WITH THE SUBSTANTIAL lNANCIAL AND ECONOMIC POLICY CHANGES THAT HAVE ALREADY BEEN INTRODUCED &ALLING HOME PRICES WIPED OUT MORE THAN TRILLION IN HOME EQUITY SINCE THE START OF lSCAL AND MORE THAN TRILLION IN EQUITY IN THE THREE YEARS ENDING WITH (OWEVER THE SEVERE DECLINE IN HOME PRICES AND INTEREST RATES HAS PUSHED HOME AFFORDABILITY TO NEW HIGHS (OME AFFORDABILITY MEASURES THE ABILITY OF A FAMILY EARNING THE MEDIAN INCOME TO BUY A HOME AT THE MEDIAN PRICE USING CONSERVATIVE lNANCING AND A DOWN PAYMENT 4HE DECLINE IN HOUSING AFFORDABILITY THAT BEGAN IN MID PRECEDED THE HOUSING MARKET COLLAPSE BY ROUGHLY A YEAR AND A HALF )TS RECENT SURGE POINTS TO IMPROVED CONDITIONS DOWN THE ROAD /F COURSE AS LONG AS POTENTIAL HOMEBUYERS HAVE REASON TO BE AFRAID THAT HOME PRICES WILL FALL SUBSTANTIALLY FURTHER THEY ARE LIKELY TO PUT OFF THEIR HOME PURCHASES !S A RESULT INCREASED AFFORDABILITY IS NOT ENOUGH TO ARREST THE HOUSING SECTOR S DECLINE )NSTEAD IT WILL TAKE A CONTINUED DRAWDOWN IN THE SUPPLY OF NEW AND EXISTING HOMES TO STOP THE HOME PRICE DECLINE 4HIS WOULD THEN LEAD TO A HEALTHIER HOUSING MARKET AND OVERALL ECONOMY Â&#x2C6; AN EVENT WE EXPECT FOR THE SECOND HALF OF lSCAL 2EAL RESIDENTIAL INVESTMENT IS EXPECTED TO BE mAT DURING THE lRST HALF OF THE YEAR AFTER A NOSEDIVE IN lSCAL ! REBOUND OFF OF A VERY LOW LEVEL OF ACTIVITY SHOULD OCCUR IN THE SECOND HALF PUSHING BOTH RESIDENTIAL INVESTMENT AND NEW HOUSING STARTS HIGHER (OWEVER EVEN IF HOUSING STARTS lNISH THE YEAR AT UNITS AS FORECASTED THAT LEVEL OF ACTIVITY WOULD REMAIN ONLY MARGINALLY ABOVE THE RECORD LOWS OF THE PRIOR SIX QUARTERS "USINESS lXED INVESTMENT PLUMMETED IN THE MIDDLE QUARTERS OF lSCAL FALLING AN ANNUALIZED 4HE DOWNFALL WAS LED BY A SEVERE PULLBACK IN BUSINESS INVESTMENT IN EQUIPMENT AND SOFTWARE AFTER DOMESTIC DEMAND TUMBLED IN THE lRST lSCAL QUARTER "Y THE THIRD lSCAL QUARTER HOWEVER BUSINESS

Fiscal 2010 Investment Plan

INVESTMENT IN STRUCTURES JOINED THE PARADE FALLING AN ANNUALIZED .EW ORDERS FOR CAPITAL EQUIPMENT TURNED MARGINALLY HIGHER IN &EBRUARY AND -ARCH BUT THE TOTAL AMOUNT OF ACTIVITY REMAINS DEPRESSED 4HERE IS VERY LITTLE PROSPECT THAT INVESTMENT IN BUILDINGS AND STRUCTURES WILL IMPROVE IN THE UPCOMING lSCAL YEAR 4HEREFORE REAL NONRESIDENTIAL INVESTMENT IS EXPECTED TO CONTINUE FALLING IN lSCAL Â&#x2C6; DOWN DURING THE YEAR WITH A PLUNGE OF IN THE lRST HALF BEFORE A MODERATE BOUNCE LED BY BUSINESS INVESTMENT IN CAPITAL EQUIPMENT OF IN THE SECOND HALF /NE ECONOMIC POSITIVE THOUGH IS THAT INVENTORIES HAVE FALLEN DRAMATICALLY DURING lSCAL 4HIS WILL PUSH BUSINESSES TO REDUCE THE DEGREE OF DRAWDOWN BEFORE EVENTUALLY ADDING BACK INVENTORIES IN ANTICIPATION OF BETTER DEMAND FOR GOODS 4HE 3423 /HIO ECONOMIC FORECAST EXPECTS GROWTH IN REAL lNAL SALES REAL '$0 LESS INVENTORY CHANGES TO BE SUBSTANTIALLY WEAKER AT IN THE lRST HALF OF lSCAL BEFORE HITTING IN THE SECOND HALF LEADING TO lSCAL YEAR GROWTH RATE OF JUST 4HEREFORE INVENTORY CHANGES WILL LIKELY CONTRIBUTE ROUGHLY ONE PERCENTAGE POINT TO THE EXPECTED lSCAL YEAR GROWTH OF REAL '$0 /VER THE PAST THREE lSCAL YEARS INTERNATIONAL TRADE HAS HELPED TO OFFSET UNDERLYING DOMESTIC DEMAND WEAKNESS 7HILE REAL '$0 GREW JUST IN lSCAL REAL NET EXPORTS CONTRIBUTED PERCENTAGE POINTS TO THAT GAIN )N lSCAL REAL NET EXPORTS ACCOUNTED FOR ABOUT OF THE TOTAL GAIN IN REAL '$0 4HOUGH REAL '$0 FELL AN ANNUALIZED IN THE lRST THREE QUARTERS OF lSCAL REAL NET EXPORTS IMPROVED TO A DElCIT OF BILLION IN THE THIRD lSCAL QUARTER FROM A DElCIT OF BILLION BEFORE lSCAL Â&#x2C6; ADDING ROUGHLY A PERCENTAGE POINT TO ECONOMIC GROWTH OVER THAT PERIOD &OR MOST OF THOSE THREE YEARS THE DOLLAR HAD FALLEN AND MADE 5 3 GOODS AND SERVICES MORE AFFORDABLE TO FOREIGN CUSTOMERS WHILE FOREIGN GOODS AND SERVICES BECAME COMPARATIVELY MORE EXPENSIVE IN THE 5NITED 3TATES )N ADDITION FOREIGN DEMAND HELD UP LONGER THAN 5 3 DEMAND (OWEVER THE TABLES HAVE TURNED AS THE DOLLAR STEADILY STRENGTHENED IN lSCAL AND FOREIGN DEMAND PLUNGED FROM THE GLOBAL RECESSION !S THE 5NITED 3TATES BEGINS A SLUGGISH RECOVERY IN lSCAL THE FOREIGN SECTOR WILL LAG BEHIND STEMMING THE IMPROVEMENT IN TRADE AND MODESTLY PUSHING THE REAL NET EXPORTS FURTHER INTO DElCIT 4HE 3423 /HIO ECONOMIC FORECAST EXPECTS REAL NET EXPORTS WILL AVERAGE A DElCIT OF BILLION IN lSCAL 4HIS IS AFTER A NEARLY BILLION IMPROVEMENT IN lSCAL TO A DElCIT OF BILLION

CONSUMER PRICE INDEX (CPI) AND GDP PRICE INDEX VERSUS ONE YEAR AGO lSCAL YEAR BASIS 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4%

1961 1963 1965 1967 1969 1971 1973 1975 1977 1979

#0) '$0 0RICE )NDEX &ORECASTED '$0 0RICE )NDEX &ORECASTED #0)

.OTE 3HADED AREAS DENOTE RECESSION

1981 1983 1985 1987 1989 1991 1993 1995

1997 1999

2001 2003 2005 2007 2009

Fiscal 2010 Investment Plan

/N THE INmATION FRONT THE 3423 /HIO 5 3 ECONOMIC FORECAST EXPECTS PRICES TO MOVE FROM LARGELY A DEmATIONARY ENVIRONMENT TO A MODEST INmATIONARY ONE THAT FALLS INTO THE LOWER BOUND OF WHAT THE &EDERAL 2ESERVE CONSIDERS TO BE ACCEPTABLE &ISCAL WILL LIKELY CLOSE OUT WITH A THIRD STRAIGHT QUARTERLY DROP IN PRODUCER AND CONSUMER PRICES LARGELY DUE TO THE SIGNIlCANT PLUNGE IN ENERGY COSTS SINCE *ULY !S THE DOMESTIC ECONOMY BEGINS ITS SLUGGISH ADVANCE PRICES WILL LIKELY MOVE MARGINALLY HIGHER -UCH OF THAT INCREASE IN INmATION WILL COME FROM UPWARD MOVEMENT IN ENERGY COSTS WHILE CORE INmATION MEASURES PRICES EXCLUDING VOLATILE FOOD AND ENERGY COSTS REMAIN WELL CONTAINED 4HE 3423 /HIO ECONOMIC FORECAST PROJECTS THAT THE '$0 PRICE INDEX THE BROADEST MEASURE OF INmATION WILL GROW JUST IN lSCAL AFTER A WELL BEHAVED INCREASE IN lSCAL 'ROWTH IN CONSUMER PRICES SHOULD BE SIMILAR DURING THE YEAR AT AFTER HAVING FALLEN IN lSCAL

INTEREST RATES 4REASURY "OND AND &EDERAL &UNDS 2ATE lSCAL YEAR BASIS 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 1961 1963 1965 1967 1969 1971 1973

1975 1977 1979 1981 1983

1985

1987 1989 1991 1993 1995

1997 1999

2001 2003 2005 2007 2009

&EDERAL &UNDS 4REASURY "OND

.OTE 3HADED AREAS DENOTE RECESSION

!FTER A SLOW RESPONSE TO WHAT WOULD BECOME A DEEP CRISIS IN THE lNANCIAL MARKETS AND ECONOMY MONETARY AND lSCAL POLICIES HAVE MOVED INTO A HIGHLY STIMULATIVE STATE /NGOING STRUCTURAL ECONOMIC AND lNANCIAL MARKET PROBLEMS HAVE AND WILL CONTINUE TO LIMIT THE TRANSMISSION OF THAT STIMULUS THROUGH THE lNANCIAL MARKETS AND ECONOMY (OWEVER THE AMOUNT OF STIMULUS SHOULD HELP TO lNALLY RETURN ECONOMIC GROWTH ONTO HIGHER GROUND 4HE NORMAL MONETARY POLICY TOOL Â&#x2C6; LOWERING SHORT TERM INTEREST RATES THAT THEN INTRODUCE ADDITIONAL MONEY INTO THE ECONOMY Â&#x2C6; HAS REACHED A LIMIT 4HAT TOOL HAS LED TO RAPID MONEY SUPPLY GROWTH BUT BANKS HAVE BEEN RELUCTANT TO LEND THE ADDITIONAL MONEY DURING THE CURRENT CREDIT CRUNCH )N lSCAL THAT RELUCTANCE SHOULD BEGIN TO DISSIPATE AS BUSINESS CONDITIONS GRADUALLY RECOVER LEADING TO BETTER CREDIT CONDITIONS AND ECONOMIC EXPANSION )N ADDITION TO THE EXTRAORDINARY USAGE OF THE NORMAL MONETARY POLICY TOOL THE &EDERAL 2ESERVE HAS CREATED MANY FACILITIES TO THAW THE CREDIT FREEZE )T HAS MORE THAN DOUBLED THE ASSETS ON ITS BALANCE SHEET AS IT REMOVES TOXIC ASSETS FROM THE BANKING AND CREDIT SECTORS &ISCAL POLICY TOO HAS BECOME HIGHLY SUPPORTIVE IN FREEING

Fiscal 2010 Investment Plan

THE SEIZING UP OF CREDIT 4HE 3423 /HIO ECONOMIC FORECAST EXPECTS THAT THE FULL FORCE OF PAST POLICY STIMULUS SHOULD BEGIN TO TURN THE ECONOMY AROUND IN THE lRST HALF OF lSCAL WITH SLUGGISH GROWTH BEFORE ECONOMIC ACTIVITY MOVES MODERATELY ABOVE ITS NEARER TERM POTENTIAL IN THE SECOND HALF &EDERAL BUDGET DElCITS ARE ALREADY SOARING TO UNSEEN HEIGHTS "OTH THE /FlCE OF -ANAGEMENT AND "UDGET /-" FORECAST FROM THE /BAMA ADMINISTRATION AND THE #ONGRESSIONAL "UDGET /FlCE #"/ FORECAST EXPECT THE FEDERAL BUDGET DElCIT TO HIT ABOVE TRILLION IN FEDERAL lSCAL AFTER A BILLION DElCIT IN FEDERAL lSCAL )N FUTURE YEARS THE TWO BUDGET AGENCIES DIFFER SOMEWHAT ABOUT UPCOMING DElCITS BECAUSE THE /-" PROJECTION LIKELY INCLUDES UNREALISTIC ECONOMIC ASSUMPTIONS (OWEVER BOTH AGENCIES SHOW ENORMOUS DElCITS CONTINUING FOR AT LEAST THE NEXT DECADE %ACH AGENCY PROJECTS ABOUT A TRILLION DElCIT IN FEDERAL lSCAL WITHOUT ANY FURTHER CHANGES TO FEDERAL SPENDING PLANS Â&#x2C6; INCLUDING UPCOMING EXPANDED HEALTH CARE PLANS 4HE MORE RELIABLE #"/ ESTIMATES EXPECT THAT THE FEDERAL BUDGET DElCIT AS A SHARE OF NOMINAL '$0 WILL PEAK AT IN THE CURRENT FEDERAL lSCAL YEAR BUT REMAIN ABOVE PRIOR POST 7ORLD 7AR )) HIGHS THROUGH FEDERAL lSCAL 4HE STIMULUS FROM MONETARY AND lSCAL POLICY CHANGES DURING lSCAL IS PUTTING UPWARD PRESSURE ON INTEREST RATES EVEN AS THE ECONOMY mIRTS WITH DEmATION THAT TENDS TO KEEP INTEREST RATES LOWER THAN NORMAL 4HE &EDERAL 2ESERVE WILL LIKELY KEEP ITS POLICY RATE Â&#x2C6; THE FEDERAL FUNDS RATE Â&#x2C6; WITHIN THE TO BAND THAT IT IS CURRENTLY USING FOR MUCH OF lSCAL )T WILL WORRY THAT THE SLUGGISH START TO ECONOMIC RECOVERY WILL NECESSITATE THE CONTINUATION OF LOW SHORT TERM INTEREST RATES AND THE GOVERNMENT S SPECIAL LENDING FACILITIES .ONETHELESS IT WILL WANT TO REMOVE SOME OF ITS EXTRAORDINARY MONETARY STIMULUS ONCE THE ECONOMY STARTS TO SHOW SIGNS OF STABILITY 4HEREFORE LATE IN THE lSCAL YEAR MONETARY POLICYMAKERS WILL LIKELY SIGNAL THAT SHORT TERM INTEREST RATES WILL BE ADJUSTED HIGHER AND MIGHT EVEN HAVE ALREADY RAISED THE FEDERAL FUNDS RATE BY TO BASIS POINTS -EANWHILE 4REASURY YIELDS WILL FACE A CLASH OF FORCES FROM SLUGGISH GROWTH AND EXTRAORDINARY ISSUANCE TO FUND THE HUGE FEDERAL BUDGET DElCIT 7HEN MORE STABLE SIGNS OF ECONOMIC ACTIVITY APPEAR AROUND MID lSCAL YEAR THE UPWARD PRESSURE ON 4REASURY YIELDS WILL LIKELY WIN OUT Â&#x2C6; PUSHING YEAR 4REASURIES INTO THE UPPER HALF OF EXPECTED TO RANGE FOR lSCAL

Period

Federal Funds Rate

10-Year Treasury Yield

&ISCAL 2ANGES

.OTE 4HE RANGES LISTED ANTICIPATE CAPTURING OF THE DAILY CLOSES DURING THE PERIOD DESCRIBED "RIEF EXCURSIONS ABOVE OR BELOW THESE RANGES THAT ARE QUICKLY REVERSED SHOULD NOT BE CONSIDERED VIOLATIONS OF THE FORECAST

4HE BASELINE ECONOMIC FORECAST DIFFERS WITH THE Blue Chip Economic Indicators CONSENSUS OUTLOOK FOR lSCAL BY EXPECTING lSCAL YEAR GROWTH IN REAL '$0 VERSUS THE CONSENSUS ESTIMATE OF GROWTH 4HE CONSENSUS VIEW HAS CONSUMER PRICES GROWING AND THE '$0 PRICE INDEX ADVANCING OVER THE SAME PERIOD WHILE THE 3423 /HIO FORECAST SHOWS #0) GROWTH OF AND '$0 PRICE INDEX GROWTH OF &ISCAL NOMINAL '$0 GROWTH IN BOTH THE CONSENSUS FORECAST AND THE 3423 /HIO FORECAST WOULD BE ABOUT AFTER A ROUGHLY DECLINE IN NOMINAL '$0 DURING lSCAL Â&#x2C6; THE LARGEST DECLINE AND ONE OF THE FEW IN NOMINAL '$0 IN NEARLY YEARS 4HE MIX OF REAL GROWTH VERSUS INmATION IS MORE BENIGN IN THE 3423 /HIO FORECAST THAN IT IS IN THE CONSENSUS FORECAST 4HE PRIMARY ALTERNATIVE TO THE SLUGGISH BUT lNALLY GROWING ECONOMIC FORECAST WITH CONTAINED INmATION IS THAT ECONOMIC ACTIVITY SLIDES EVEN FURTHER IN lSCAL STOKING FEARS THAT THE 5 3 ECONOMY HAS ENTERED A *APANESE STYLE DEmATIONARY EPISODE (OWEVER IF THE RECENT SURGES IN THE lNANCIAL MARKETS

Fiscal 2010 Investment Plan

CONTINUE THEN BUSINESS AND CONSUMER CONlDENCE SHOULD IMPROVE MORE RAPIDLY AND DRIVE THE ECONOMY HIGHER EARLIER IN lSCAL WHILE NON ENERGY INmATION REMAINS LARGELY CONTAINED %NERGY COSTS COULD MOVE ABOVE THE EXPECTED BASELINE RANGE IN THAT CASE AND PUSH HEADLINE INmATION MEASURES INTO THE TOP PART OF THE &EDERAL 2ESERVE S ACCEPTABLE RANGE Â&#x2C6; RATHER THAN THE LOWER PART OF THAT RANGE INCLUDED IN THE BASELINE FORECAST 7E WOULD ASSIGN MODERATE CONlDENCE TO THE PRIMARY ALTERNATIVE FORECAST AS OPPOSED TO THE HIGH CONlDENCE WE HAVE IN OUR BASELINE lSCAL FORECAST "ECAUSE WE ARE NOT EXPECTING THAT lNANCIAL CONDITIONS IN THE NEAR TERM WILL CONTINUE THE IMPROVEMENT THEY HAVE SHOWN OVER THE PAST COUPLE OF MONTHS WE WOULD ASSIGN ONLY LOW CONlDENCE TO THE IDEA THAT ECONOMIC GROWTH GREATLY EXCEEDS OUR BASELINE FORECAST WHILE HEATING UP ENERGY COSTS AND DRIVING OVERALL INmATION HIGHER THAN EXPECTED

Fiscal 2010 Investment Plan

U.S. ECONOMIC FORECAST Fiscal Year Ranges

FY 2010

FY 2010 H1 H2

FY 2009

FY 2009 H1 H2

FY 2008

'ROSS $OMESTIC 0RODUCT

0ERSONAL #ONSUMPTION

.ONRESIDENTIAL )NVESTMENT

Composition of Real GDP

2ESIDENTIAL )NVESTMENT

%XPORTS OF 'OODS 3ERVICES

)MPORTS OF 'OODS 3ERVICES

&EDERAL #ONSUMPTION )NVESTMENT

3TATE ,OCAL #ONSUMPTION )NVESTMENT

&INAL 3ALES

$OMESTIC &INAL 3ALES

2EAL $ISPOSABLE 0ERSONAL )NCOME

.OMINAL '$0 #ORPORATE 0ROlTS

!FTER 4AX

0RODUCER 0RICE )NDEX

#ONSUMER 0RICE )NDEX

#HAIN 7EIGHTED '$0 0RICE )NDEX

'$0 )MPLICIT 0RICE $EmATOR

Incomes

Prices

Other Key Measures 2EAL .ET %XPORTS "

2EAL #HANGE IN "USINESS )NVENTORIES "

,IGHT 6EHICLE 3ALES -

.EW (OUSING 3TARTS -

5NEMPLOYMENT 2ATE

)NDUSTRIAL 0RODUCTION

Fiscal 2010 Investment Plan

INTERNATIONAL ECONOMIC GROWTH AND INFLATION OUTLOOK $EVELOPED COUNTRIES ABROAD ARE GOING TO BE IN RECESSION AT THE ONSET OF lSCAL 7ITH JOBLESSNESS RISING AND DOMESTIC DEMAND SHRINKING PROSPECTS OF FULL ECONOMIC RECOVERY DURING THE lSCAL YEAR ARE STILL TENTATIVE +EY EMERGING COUNTRIES ON THE OTHER HAND ARE GOING TO EXPAND GOING INTO lSCAL "UILT LARGELY ON DOMESTIC POLICY STIMULI THE EXPANSIONS RISK LOSING STEAM UNLESS GLOBAL DEMAND FOR THEIR GOODS AND SERVICES REVIVES DURING THE YEAR !S DEMAND SHRANK WORLDWIDE AND AS TRADE CREDIT DRIED UP EXPORTS SUFFERED VERY STEEP LOSSES DURING lSCAL 4HIS FORCED COUNTRIES TO TURN INWARD AND RELY HEAVILY ON PUBLIC STIMULUS TO INVIGORATE DOMESTIC ECONOMIC ACTIVITY (OWEVER ONLY FEW HAVE BEEN ABLE TO MUSTER STIMULUS PACKAGES LARGE ENOUGH FOR THAT TASK 4HE RUN UP IN THEIR lSCAL DElCITS HAS ADDED RAPIDLY TO SOVEREIGN DEBTS AND MANY OF THEM WILL BE UNABLE TO SPEND MORE WITHOUT RISKING LONGER TERM SOLVENCY 4HIS POTENTIAL INABILITY LOWERS THE CHANCES OF MORE lSCAL STIMULUS EVEN AS OUTPUT GAPS IN MANY COUNTRIES PERSIST OR WIDEN 4HEREFORE GLOBAL DEMAND COULD BE RUDDERLESS FOR SOME TIME 5NLIKE A RESURGING TIDE THAT LIFTS ALL BOATS DEMAND IS GOING TO mOW IN UNPREDICTABLE lTS AND STARTS 4HIS UNPREDICTABILITY IS INHERENT TO THE ARRAY OF lSCAL PACKAGES NOW UNDER WAY "ESIDES BEING INADEQUATE THEY HAVE BEEN TARGETED TO SPECIlC SECTORS RATHER THAN TO THE ECONOMY AS A WHOLE 4HIS WILL LIKELY SPUR NICHES OF ECONOMIC ACTIVITY AND AT DIFFERENT TIMES RATHER THAN STIMULATE OVERALL DEMAND AT THE SAME TIME -OREOVER THE SPENDING IS TRANSIENT AND ITS ECONOMIC EFFECTS MAY NOT LAST "EYOND A POINT ACTIVITY MAY RETURN TO A SUBDUED PATTERN AWAITING lRMER FUNDAMENTALS WORLDWIDE #ONSEQUENTLY DEmATION IS STILL THE MAIN SHORT TERM THREAT AND MONETARY POLICY IS GOING TO BE EXPANSIONARY IN MOST COUNTRIES #ENTRAL BANKS IN MOST DEVELOPED COUNTRIES HAVE CUT THEIR POLICY INTEREST RATES VERY CLOSE TO ZERO 3OME OF THEM HAVE BEEN EASING MONEY SUPPLY QUANTITATIVELY AND THE REST SHOULD FOLLOW THAT PATH SOON -ANY EMERGING MARKET CENTRAL BANKS ON THE OTHER HAND HAVE YET TO CUT THEIR POLICY INTEREST RATES ENOUGH 'IVEN THE LARGE UNCERTAINTY ABOUT GLOBAL DEMAND AND ABOUT THE EFFECTS OF lSCAL STIMULI THIS TIME MONETARY POLICYMAKERS ARE GOING TO HESITATE GIVING UP EXPANSIONARY POLICIES UNTIL SUSTAINED RECOVERY BEGINS TO SHOW UP IN PRICES )N PARTICULAR SHOULD PERCEPTION OF BETTER GLOBAL GROWTH LEAD EMERGING MARKET CURRENCIES TO APPRECIATE PREMATURELY THEIR CENTRAL BANKS WILL INTERVENE SO THAT INCIPIENT ECONOMIC RECOVERIES ARE UNHARMED 4HE ONGOING GLOBAL ECONOMIC SLUMP HAS BEEN THE DEEPEST AND THE MOST WIDESPREAD IN MANY DECADES -ONETARY AND lSCAL POLICIES HAVE BEEN DEPLOYED WORLDWIDE TO COMBAT IT (OWEVER POLICYMAKERS RISK RUNNING OUT OF POLICY TOOLS AS WELL AS RESOURCES FOR MORE STIMULUS #ONSEQUENTLY THE )NTERNATIONAL -ONETARY &UND )-& AND OTHER MULTILATERAL AGENCIES HAVE EXTENDED HELP TO COUNTRIES IN NEED "ESIDES DIRECT ASSISTANCE THE )-& HAS OPENED UP AN EMERGENCY FACILITY FOR WELL RUN GOVERNMENTS TO MEET SUDDEN LIQUIDITY SHORTFALLS -OREOVER COUNTRIES IN ,ATIN !MERICA AND IN !SIA HAVE PLEDGED TO POOL RESERVES ACCESSIBLE TO CONTRIBUTORS IF THEY RUN INTO TROUBLE 4HESE CAN POTENTIALLY PREVENT AN ACUTE PROBLEM FOR ANY ONE COUNTRY FROM BECOMING A CONTAGION TO ALL $ESPITE STIMULI AND ACCESS TO MULTILATERAL FUNDING NO REGION OR COUNTRY SEEMS TO BE IN A POSITION TO LEAD A GLOBAL RECOVERY /N THE ONE HAND PRIVATE SPENDING IN DEVELOPED COUNTRIES PARTICULARLY THE 5NITED 3TATES IS ADAPTING TO HIGHER CAPITAL COSTS AND SUBDUED INCOME GROWTH /N THE OTHER HAND THERE SEEMS TO BE NO COUNTRY WITH ENOUGH HEFT TO REPLACE THE LOST DEMAND FROM THE 5NITED 3TATES )N THIS CRISIS THE %UROPEAN 5NION HAS AMASSED MORE PROBLEMS THAN OTHER REGIONS AND HAS BEEN SLOW TO ADDRESS THEM -EANWHILE DOMESTIC DEMAND IN LARGE EMERGING COUNTRIES LIKE #HINA IS NOT YET PROMINENT ENOUGH TO COUNTER THE LOSS OF ITS OWN EXPORT INCOMES LET ALONE TO INVIGORATE THE REST OF THE WORLD 3O FAR THEY SEEM INSUFlCIENTLY SELF RELIANT TO GROW ROBUSTLY WITHOUT THE DEVELOPED WORLD DOING BETTER !MONG DEVELOPED COUNTRIES THE %UROZONE S ECONOMY IS IN RECESSION -OST COINCIDENT INDICATORS OF ECONOMIC ACTIVITY SHOW THAT THE DOWNTURN IS THE STEEPEST IN MANY DECADES AND LEADING INDICATORS

Fiscal 2010 Investment Plan

SUGGEST THAT THE WEAKNESS MAY PERSIST INTO THE lRST HALF OF lSCAL %CONOMIC ACTIVITY HAS CONTRACTED IN ALL MEMBER COUNTRIES 5NEMPLOYMENT IN PLACES SUCH AS 3PAIN IS NEARING AND EXPECTED TO RISE FURTHER 'ERMANY THE REGION S LARGEST ECONOMY IS AILING FROM A STEEP FALL IN EXPORTS THAT ACCOUNTS FOR NEARLY OF ITS '$0 0RIVATE BUSINESS INVESTMENT EVERYWHERE HAS FALLEN AS CREDIT SUPPLY HAS BEEN CUT #APITAL SPENDING IS EXPECTED TO BE ESSENTIALLY MUTED DURING lSCAL #ONSUMERS TOO IN MOST COUNTRIES HAVE CUT BACK 3INCE THE SOCIAL SAFETY NET IN THE EURO REGION IS MORE GENEROUS THAN ELSEWHERE CONSUMER SPENDING AHEAD SHOULD NOT LOSE AS MUCH AS IT DID IN lSCAL 4HEREFORE ECONOMIC LOSSES MAY DIMINISH DURING lSCAL (OWEVER PERVASIVE ECONOMIC GAINS ARE NOT ASSURED 4O DATE THE REGION S GOVERNMENTS HAVE BEEN UNABLE TO IMPLEMENT A UNIlED POLICY FOR THE AILING BANKING SECTOR "ESIDES TOXIC ASSETS Â&#x2C6; OF THE TYPE THAT AFFECTED 5 3 BANKS Â&#x2C6; %UROPEAN BANKS HAVE ALSO BEEN BESET BY EXTENSIVE LENDING TO %AST %UROPEAN AND "ALTIC COUNTRIES WHOSE ECONOMIES HAVE TUMBLED PRECIPITOUSLY 4HE REGION S FRAGMENTED POLICIES HAVE BEEN A HURDLE TO RESOLVING THE MANY CROSS BORDER BANKING WOES -OREOVER THE lSCAL STIMULUS PROGRAMS CAN ONLY PARTIALLY NARROW THE OUTPUT GAP -EANWHILE RATING AGENCIES HAVE DOWNGRADED SOVEREIGN DEBTS OF COUNTRIES WITH POORER lSCAL BALANCES AND SUBSTANTIAL SOVEREIGN OBLIGATIONS -ORE DOWNGRADES COULD FOLLOW BECAUSE TAX REVENUES MAY FALL WELL SHORT OF SPENDING PLANS AND GOVERNMENTS WILL LIKELY BE UNABLE TO NARROW THEIR lSCAL GAPS EVEN WITH MOUNTING SOVEREIGN DEBT 7ITHOUT BACKING FROM A UNIlED lSCAL AUTHORITY THE %UROPEAN #ENTRAL "ANK %#" BEGAN COMBATING THE CREDIT CRUNCH BY PROVIDING LIQUIDITY (OWEVER UNLIKE OTHER CENTRAL BANKS IT HAS BEEN RELUCTANT TO BUY PRIVATE SECTOR SECURITIES BECAUSE LOSSES TO ITS BALANCE SHEET ARE NOT INDEMNIlED BY ANY lSCAL AUTHORITY )T HAS ONLY RECENTLY AUGMENTED A HESITANT PROGRAM OF BUYING SAFE SECURITIES OF SHORT MATURITY MONTHS OR LESS -EANWHILE INmATION IN THE REGION HAS BEEN FALLING AND IS UNLIKELY TO BE A SOURCE OF CONCERN IN THE COMING MONTHS BECAUSE OVERALL DEMAND IS EXPECTED TO BE BELOW POTENTIAL 4HIS SHOULD LET THE %#" KEEP THE POLICY INTEREST RATE CLOSE TO THE CURRENT LEVEL OF AND MAINTAIN EXPANSIONARY MONETARY POLICY /VERALL THERE IS GOING TO BE SOME RECOVERY IN THE REGION BUT NOT SUFlCIENT TO MAKE UP FOR THE LOSSES ACCUMULATED THROUGH THE lRST HALF OF lSCAL %CONOMIC ACTIVITY MAY THEREFORE STRUGGLE TO REGAIN THE LEVEL IT HAD BEFORE THE DOWNTURN BEGAN !CROSS THE %NGLISH #HANNEL THE RECESSION IN THE 5NITED +INGDOM 5+ IS SEVERE 4HE DAMAGE HAS BEEN SO STEEP THAT INVESTORS EXPECT THAT SUBSEQUENT LOSSES CAN ONLY LESSEN (OWEVER THE DOMESTIC CREDIT CRUNCH STILL REMAINS INTENSE AND THE BANKING SECTOR S WOES PERSIST )N RESPONSE THE "ANK OF %NGLAND "O% HAS BEGUN QUANTITATIVE EASING AND LENDING CREDIT DIRECTLY TO THE PRIVATE SECTOR UNTIL THE COMMERCIAL BANKS ARE RESTORED TO HEALTH 3INCE THAT IS EXPECTED TO HAPPEN VERY GRADUALLY ECONOMIC GROWTH MAY REMAIN ELUSIVE FOR MANY QUARTERS 4HOUGH CONSUMER SPENDING APPEARS TO BE STIRRING IT HAS SO FAR BEEN ERRATIC AS ECONOMIC PROSPECTS ARE STILL FOGGY 4HE lSCAL DElCIT MEANWHILE HAS BECOME CUMBERSOME AND THE SOVEREIGN DEBT HAS MOUNTED 4HIS HAS SIGNIlCANTLY REDUCED THE CHANCES OF MORE lSCAL STIMULUS )F ANYTHING THE GOVERNMENT MAY BE FORCED TO CUT BACK ON DISCRETIONARY SPENDING TO PREVENT THE lSCAL BALANCES FROM BECOMING UNSUSTAINABLE 4HAT PROSPECT IN TURN SHOULD PREVENT THE "O% FROM CHANGING THE POLICY INTEREST RATE FROM THE CURRENT LEVEL OF FOR SOME TIME 7ITH LITTLE IF ANY AMMUNITION LEFT FOR POLICYMAKERS THE PRIVATE ECONOMY MAY HAVE TO INCH UP ON ITS OWN RELYING LARGELY ON THE TENTATIVE PROSPECTS IN CONTINENTAL %UROPE )N !SIA *APAN HAS BEEN HARD HIT BY A SHARP CONTRACTION OF EXPORTS %VEN BEFORE THE CRISIS BEGAN *APAN S ECONOMY WAS FRAGILE .OW IT IS SUFFERING MORE THAN OTHERS BECAUSE ITS DEmATIONARY STATE HAS WORSENED AND EXPORTS DO NOT OFFER A WAY OUT 0RICES THE EXCHANGE RATE AND DOMESTIC AND FOREIGN DEMAND LEAVE VERY LITTLE SCOPE FOR THE ECONOMY TO EKE OUT EVEN MODEST GROWTH &ISCAL STIMULUS IN *APAN HAS ABOUT A DECADE OF DISMAL RESULTS %XPECTED TO BE NO DIFFERENT THIS TIME IT WILL EVENTUALLY ADD TO SOVEREIGN DEBT WHICH IS NEARING OF '$0 AND MAY RISE FURTHER 4HE "ANK OF *APAN "O* TOO IS LEFT WITHOUT OPTIONS THE POLICY RATE HAS BEEN CUT TO NEAR ZERO THE LEVEL WHERE IT HAS BEEN FOR

Fiscal 2010 Investment Plan

ESSENTIALLY A DECADE 7ITH ANEMIC INTERNAL OPTIONS THE ECONOMY HAS A BETTER LIFELINE ACROSS THE 3EA OF *APAN IN #HINA 7HILE #HINA SUFFERED A SEVERE SETBACK TO ITS EXPORT INCOME ABOUT OF '$0 IT HAS BEEN QUICK TO ROLL OUT A HEFTY STIMULUS PLAN AMOUNTING TO ABOUT n OF ITS '$0 WITH MUCH OF IT BEING PUSHED DURING THE SECOND HALF OF lSCAL !S A RESULT ECONOMIC GROWTH IN #HINA IS LIKELY TO SURPRISE ON THE UPSIDE GOING INTO lSCAL )TS FOREIGN EXCHANGE RESERVES EQUIVALENT TO NEARLY TRILLION 5 3 DOLLARS ARE NEARLY FOUR TIMES THE AMOUNT OF THE CURRENT STIMULUS BEING INJECTED 5NLIKE DEVELOPED COUNTRIES #HINA IS IN A MORE COMFORTABLE POSITION TO CUSHION THE BLOW FROM FALLING EXPORTS 4HE STIMULUS WILL PROVIDE ONLY A TEMPORARY BOOST IF IT MERELY NARROWS THE SHORTFALL IN EXPORT INCOMES $OING SO DOES NOT BRING ABOUT LASTING INCREASES IN CONSUMER SPENDING REQUIRED TO RESTORE GLOBAL BALANCE 4O BRING ABOUT SUCH CHANGE #HINA NEEDS A MECHANISM THAT REDUCES THE HIGH PRECAUTIONARY SAVINGS RATE 4HIS CAN BE ACCOMPLISHED ONLY THROUGH PERMANENT PENSION MEDICAL AND EDUCATION PROGRAMS THAT LESSEN THE ECONOMIC INSECURITY AT THE ROOT OF THE PRECAUTIONARY SAVINGS )NTRODUCTION OF SUCH PROGRAMS OVER THE NEXT YEAR OR SO MAY SURPRISE INVESTORS BUT IT IS NOT BEYOND THE SCOPE OF #HINA S POLICYMAKERS CONCERNED ABOUT THE SUSTAINABLE WAY FORWARD 4HE LOOMING DEMOGRAPHIC SHIFT Â&#x2C6; RAPIDLY GRAYING POPULATION CAUSED BY THE LONG HELD ONE CHILD POLICY Â&#x2C6; WILL ONLY RAISE PRECAUTIONARY SAVINGS EXACERBATE THE GLOBAL IMBALANCE AND EVEN WORSEN DOMESTIC WOES 4O COUNTER THAT THE EXISTING CACHE OF RESERVES SEEMS ADEQUATE TO PROMOTE LASTING WAYS OF CONSUMING MORE NON TRADED GOODS DEPENDING LESS ON EXPORT INCOMES AND BECOMING LESS VULNERABLE TO DESTABILIZING EXTERNAL SHOCKS )N THE INTERIM #HINA S CYCLICAL BOOST IS LIKELY TO HELP NEIGHBORING EXPORTERS SUCH AS *APAN AND 3OUTH +OREA BUT ONLY TO THE EXTENT THEIR GOODS ARE FOR CONSUMERS IN #HINA AND NOT FOR ABROAD 4HE RAPID EASING OF MONETARY CONDITIONS TOGETHER WITH THE DEMAND GENERATED FROM THE STIMULUS WILL LIKELY ENSURE THE RETURN OF SOME INmATION DURING lSCAL (OWEVER WITHOUT POLICIES THAT LIFT CONSUMPTION OF NON TRADED DOMESTIC GOODS THE STIMULUS MAY LOSE STEAM AS IT MAY MERELY CREATE MORE CAPACITY IN GOODS WHOSE DEMAND AT HOME AND ABROAD IS INADEQUATE 4HIS IS THE KEY CYCLICAL RISK IN !SIA ,IKE #HINA EXPORTS OF MOST OTHER EMERGING COUNTRIES IN !SIA HAVE SUFFERED (OWEVER NEARLY ALL OF THEM RUN TRADE SURPLUSES AND HAVE FEW lNANCIAL SECTOR PROBLEMS LIKE THE DEVELOPED COUNTRIES .EARLY ALL HAVE SUFlCIENT RESERVES TO BOOST THEIR ECONOMIES IN THE NEAR TERM AND UNLIKE DEVELOPED COUNTRIES MAY NOT NECESSARILY HAVE TO STRAIN lSCAL BALANCES TO DO SO #ONSEQUENTLY THE RECOVERY IN EMERGING COUNTRIES CAN LOOK 6 SHAPED IN THE SHORT TERM (OWEVER SPENDING RESERVES GIVES ONLY A SHORT TERM IMPETUS AND MAY NOT SUBSTITUTE FOR THE REVIVAL OF FOREIGN DEMAND 4HE REBOUND MAY THUS BE UNSUSTAINABLE )N ,ATIN !MERICA "RAZIL IS ONE OF THE FEW EMERGING COUNTRIES THAT DEPENDS RELATIVELY LESS ON EXPORTS HAS MINIMAL BANKING DISTRESS AND HAS MORE ROOM THAN OTHERS TO CUT THE POLICY INTEREST RATE 4HE CENTRAL BANK HAS ALREADY CUT ITS POLICY RATE AGGRESSIVELY BRINGING IT DOWN FROM TO WITHIN A FEW MONTHS )T MAY BE SLASHED FURTHER TO ABOUT OR LESS THROUGH THE lRST HALF OF lSCAL -EANWHILE INmATION REMAINS WELL CONTAINED 0OLICYMAKERS ARE SURE TO INTERVENE AND PREVENT UNDESIRABLE EXCHANGE RATE VOLATILITY FROM AFFECTING INmATION EXPECTATIONS 7ITH FEWER DOMESTIC CREDIT PROBLEMS AND RELATIVELY LESS DEPENDENCE ON EXPORTS THAN OTHER COUNTRIES INTEREST RATE CUTS HAVE THE POTENTIAL TO STIMULATE THE DOMESTIC ECONOMY MORE IN "RAZIL THAN IS POSSIBLE ELSEWHERE -EXICO S ECONOMIC RECOVERY INEXTRICABLE FROM THAT OF THE 5 3 ECONOMY IS LIKELY TO BE VERY TENTATIVE AND MAY NOT APPEAR UNTIL THE SECOND HALF OF lSCAL )TS CENTRAL BANK HAS BEEN EASING POLICY RATES AGGRESSIVELY (OWEVER THE POTENTIAL STIMULUS FROM LOWERING INTEREST RATES IS LIKELY TO BE OFFSET BY THE DRAG FROM FALLEN EXTERNAL DEMAND FOR -EXICO S EXPORTS -EANWHILE #ANADA S ECONOMY REMAINS HITCHED TO THE 5 3 AS WELL 4HE CENTRAL BANK HAS CUT ITS POLICY RATES TO AND IS LIKELY TO LEAVE IT THERE UNTIL EXPORTS IMPROVE ,IKE -EXICO #ANADA S REAL '$0 GROWTH IS EXPECTED TO STRUGGLE THROUGH lSCAL

Fiscal 2010 Investment Plan

/VERALL THE SIZE OF ECONOMIC LOSSES MAY LESSEN AS THE YEAR PROGRESSES BUT FULL RECOVERY IS NOT ASSURED DURING lSCAL 4HE POSSIBILITY OF FURTHER DEmATION THEREFORE IS THE MAIN SHORT TERM THREAT -ONETARY AND lSCAL POLICIES ARE GOING TO STAY EXPANSIONARY BUT THERE IS DANGER OF POLICYMAKERS RUNNING OUT OF TOOLS TO RESTORE GLOBAL GROWTH -EANWHILE AS EACH COUNTRY STRUGGLES PROTECTIONISM COULD BECOME TEMPTING AND MAY HARM INTERNATIONAL TRADE OVER AND ABOVE THE LOSSES IT HAS ALREADY SUFFERED

INTERNATIONAL FORECASTS Real Gross Domestic Product Country/Region

Consumer Prices

FY 2010

FY 2009

FY 2010

FY 2009

United Kingdom

Eurozone

'ERMANY

&RANCE

)TALY

*APAN

#HINA

(ONG +ONG

)NDIA

3OUTH +OREA

"RAZIL

-EXICO

Canada

Asiaâ&#x20AC;&#x201C;Pacific

Latin America

Fiscal 2010 Investment Plan

V. Fixed-Income Investments TREASURY YIELD CURVE 5.00% 4.50%

0ERCENT 9IELD

4.00%

3.50%

3.00%

2.50% 2.00% 1.50%

1.00% 0.50%

0.00%

2yr

5yr

10yr

30yr

-ATURITY June 2008

May M 2009 d No

OUTLOOK Bond Market Returns 7E FORECAST RETURNS IN THE lXED INCOME MARKET TO BE ABOVE THE 3423 /HIO POLICY RETURN OF IN lSCAL 4OTAL RETURN IS A COMBINATION OF THE MARKET S COUPON INCOME PLUS THE CHANGE IN THE PRICE OF THE MARKET S SECURITIES 4HE MARKET S COUPON INCOME IS APPROXIMATELY AND PRICE INCREASES ARE FORECAST TO RAISE THE TOTAL RETURN TO 4HE ASSUMPTIONS THAT SUPPORT THIS FORECAST ARE A SLIGHT RISE IN 4REASURY YIELDS COMBINED WITH GENERALLY DECLINING YIELDS IN THE SPREAD SECTORS OF THE MARKET CONTRIBUTING TO AN OVERALL INCREASE IN PRICE FOR THE BENCHMARK AS OUTLINED IN MORE DETAIL IN THE FOLLOWING SECTIONS

Federal Reserve 4HE &EDERAL 2ESERVE HAS EMBARKED ON AN EMERGENCY POLICY TO SUPPORT THE lNANCIAL SYSTEM IN CONJUNCTION WITH THE &$)# AND THE 5 3 4REASURY !T THE CORE OF THIS ECONOMIC DOWNTURN IS THE WEAKNESS OF THE lNANCIAL SYSTEM 4HEREFORE A NECESSARY PRECONDITION TO STRONGER ECONOMIC ACTIVITY IS A HEALTHY lNANCIAL SYSTEM 4HE &EDERAL 2ESERVE RECENTLY COMPLETED STRESS TESTS TO EVALUATE THE QUALITY OF ASSETS ON THE BALANCE SHEETS OF lNANCIAL INSTITUTIONS INTENDING TO GUIDE REGULATORS AND INVESTORS AS TO THE

Fiscal 2010 Investment Plan

AMOUNT OF CAPITAL NEEDED TO STRENGTHEN THE lNANCIAL SYSTEM 4HIS PROCESS WILL PROVIDE A HIGH DEGREE OF TRANSPARENCY TO STRENGTHEN INVESTOR CONlDENCE 7HILE THIS PROCESS IS EVOLVING THE GOVERNMENT IS PROVIDING FUNDING AND CAPITAL TO KEY lNANCIAL INSTITUTIONS 4HE FULL DELEVERAGING OF lNANCIAL COMPANIES AND REBUILDING OF CAPITAL MAY TAKE SEVERAL YEARS TO ACCOMPLISH #LEARLY THE STRONGEST INSTITUTIONS WILL BE ABLE TO FUNCTION WITHOUT GOVERNMENT SUPPORT lRST (OWEVER FOR THE lNANCIAL SYSTEM TO BE REPAIRED THE &EDERAL 2ESERVE STATES THAT IT WILL LIKELY REQUIRE hEXCEPTIONALLY LOW LEVELS OF THE FEDERAL FUNDS RATE FOR AN EXTENDED PERIOD v 4OWARD THE END OF THE lSCAL YEAR IT IS FORECAST THAT THE MASSIVE AMOUNT OF LIQUIDITY PROVIDED BY THE &EDERAL 2ESERVE MAY BEGIN TO BE SLOWLY WITHDRAWN AS THE ECONOMY GAINS TRACTION 4HE &EDERAL 2ESERVE WILL MAINTAIN AN ACCOMMODATIVE MONETARY POLICY DURING lSCAL /UR FORECASTED RANGE FOR THE FEDERAL FUNDS RATE IS TO 4HE &EDERAL 2ESERVE IS DOING EVERYTHING POSSIBLE TO KEEP BOTH SHORT TERM AND LONG TERM INTEREST RATES LOW TO SUPPORT GROWTH AND PREVENT DEmATION )T IS SAFE TO SAY THAT THE CURRENT TARGETED FEDERAL FUNDS RATE OF TO IS AS LOW AS SHORT TERM RATES CAN GO (OWEVER IN ADDITION TO THESE LOW RATES THE &EDERAL 2ESERVE THROUGH ITS QUANTITATIVE EASING PROGRAM HAS GREATLY EXPANDED ITS BALANCE SHEET TO PURCHASE HIGH QUALITY ASSETS PROVIDING LIQUIDITY TO THE lNANCIAL SYSTEM )NVESTORS ARE BEGINNING TO WORRY THAT THE EXTRAORDINARY AMOUNT OF LIQUIDITY WILL LEAD TO AN INmATION PROBLEM 4HIS MAY BE A RISK IN A FEW YEARS BUT THE &EDERAL 2ESERVE HAS CONCLUDED THE NEAR TERM RISK IS SLOW ECONOMIC GROWTH 7HETHER THE &EDERAL 2ESERVE TARGETS THE FEDERAL FUNDS RATE AT BASIS POINTS OR EVEN BASIS POINTS AT THE END OF THE lSCAL YEAR SHORT TERM RATES WILL REMAIN LOW AND ANY MODEST RISE IS MORE SYMBOLIC OF THE &EDERAL 2ESERVE S EFFORTS TO BEGIN TO REDUCE LIQUIDITY IN THE lNANCIAL SYSTEM

Market Interest Rates /UR EXPECTED INTEREST RATE RANGE ON THE YEAR 4REASURY IS BASED ON THE 3423 /HIO ECONOMIC FORECAST OF A SLUGGISH RECOVERY WITH CONTAINED INmATION /UR FORECASTED RANGE FOR THE YIELD ON THE YEAR 4REASURY IS TO 4HERE ARE VERY STRONG OPPOSING FORCES THAT HELP TO DElNE OUR RANGES &ACTORS SUPPORTING OUR LOWER LIMIT ARE LOW SHORT TERM RATES RISK OF GROWTH BELOW EXPECTATIONS ACCOMPANIED BY LOW INmATION AND DIRECT GOVERNMENT PURCHASES OF 4REASURY SECURITIES BY THE &EDERAL 2ESERVE )T MAY BE POSSIBLE FOR INTEREST RATES TO TRADE NEAR THE LOWER LIMIT DURING THE lRST HALF OF lSCAL IF THE DELEVERAGING OF BUSINESSES AND INDIVIDUALS ACCELERATES 3UPPORTING OUR UPPER LIMIT ARE UNPRECEDENTED 4REASURY ISSUANCE REVERSAL OF mIGHT TO QUALITY FEARS AND INmATION CONCERNS FROM THE MASSIVE EXPANSION OF LIQUIDITY BY THE &EDERAL 2ESERVE )T IS HARD TO IMAGINE THAT A RISE IN RATES OF BASIS POINTS FROM CURRENT LEVELS WOULDN T BEGIN TO SLOW A FRAGILE ECONOMIC RECOVERY CONlRMING AN UPPER LIMIT OF AS APPROPRIATE 7E EXPECT THE YEAR 4REASURY TO END lSCAL YEAR NEAR THE UPPER LIMIT OF THE FORECASTED INTEREST RATE RANGE MODERATELY HIGHER THAN THE CURRENT LEVEL OF DISPLAYED ON THE 4REASURY YIELD CURVE GRAPH ON 0AGE

Credit Quality )NVESTMENT GRADE CREDIT QUALITY DETERIORATED RAPIDLY DURING lSCAL MOST NOTABLY IN THE lNANCIAL SECTOR 4HE DETERIORATION RESULTED FROM THE MASSIVE DELEVERAGING OF THE lNANCIAL SYSTEM THAT BEGAN WITH SECURITY WRITE DOWNS AND WAS SHARPLY ACCELERATED BY THE ,EHMAN "ROTHERS BANKRUPTCY 4HIS EVENT LED TO SERIOUS CONCERNS ABOUT lNANCIAL INSTITUTION SOLVENCY AND LIQUIDITY 4HESE CONCERNS COMBINED WITH A RAPID ECONOMIC DOWNTURN INTENSIlED THE ASSET QUALITY DETERIORATION THAT ALREADY EXISTED AND CULMINATED IN THE 5 3 GOVERNMENT PROVIDING CAPITAL AND LIQUIDITY SUPPORT TO THE lNANCIAL SYSTEM /UTSIDE OF THE lNANCIAL SECTOR COMPANIES REACTED TO THE WEAKER ECONOMY AND THE RESTRICTIVE CREDIT MARKETS BY DRAMATICALLY RESTRUCTURING THEIR BUSINESSES AND BUILDING lNANCIAL mEXIBILITY THROUGH COST CUTTING CAPITAL EXPENDITURE REDUCTIONS AND LOWER PAYMENTS TO SHAREHOLDERS

Fiscal 2010 Investment Plan

7E EXPECT lSCAL TO BE A YEAR OF TRANSITION FROM CREDIT QUALITY DETERIORATION TO CREDIT QUALITY REPAIR FOR ALL SEGMENTS OF THE CORPORATE BOND MARKET 7E EXPECT lNANCIAL INSTITUTION CREDIT QUALITY TO STABILIZE AS AN IMPROVING ECONOMIC ENVIRONMENT AND TIGHTER UNDERWRITING STANDARDS BEGIN TO STEADY ASSET QUALITY &INANCIAL INSTITUTIONS ARE KEENLY FOCUSED ON MAINTAINING STRONG BALANCE SHEETS AND HIGH LEVELS OF LIQUIDITY 3TRONGER INSTITUTIONS WILL REDUCE RELIANCE ON GOVERNMENT PROGRAMS THAT PROVIDE LIQUIDITY AND CAPITAL AND WILL LIKELY ACCESS THE CAPITAL MARKETS WITHOUT GOVERNMENT SUPPORT 4HE CAPITAL MARKETS SHOULD BECOME MORE RECEPTIVE TO THESE INSTITUTIONS GIVEN THEIR LOWER LEVERAGE INCREASED LIQUIDITY AND POTENTIAL FOR SOLID EARNINGS GROWTH IN THE FUTURE AS ASSET QUALITY DETERIORATION MODERATES !DDITIONALLY AN OVERHAUL OF THE lNANCIAL REGULATORY FRAMEWORK ON A GLOBAL BASIS SHOULD BE FAVORABLE TO SENIOR CREDITORS 7E EXPECT NON lNANCIAL COMPANY CREDIT QUALITY TO STABILIZE IN lSCAL 4HE FOCUS ON BALANCE SHEET REPAIR THAT BEGAN IN THE lNANCIAL SECTOR IS NOW PREVALENT THROUGHOUT NON lNANCIAL COMPANIES #OMPANIES WILL CONTINUE TO TAKE COSTS OUT OF THEIR BUSINESSES AND POSITION THEMSELVES FOR THE EVENTUAL UPTURN IN THE ECONOMY #OMPANIES WILL INCREASE LIQUIDITY AND lNANCIAL mEXIBILITY AND WILL BE HESITANT TO INCREASE PAYMENTS TO SHAREHOLDERS UNTIL THE ECONOMY REBOUNDS ,EVERAGE WILL LIKELY PEAK DURING THE lSCAL YEAR AS A RESULT OF LOWER EARNINGS BUT DEBT GROWTH SHOULD SLOW OR BECOME NEGATIVE (IGH YIELD CREDIT QUALITY WILL REACH A CYCLICAL LOW DURING THE YEAR WITH A BETTER TREND EMERGING BY lSCAL YEAR END %XTREMELY LOW NOMINAL ECONOMIC GROWTH COMBINED WITH TIGHT CREDIT MARKETS ARE DRIVING SALES AND PROlT MARGINS LOWER PROMPTING COMPANIES TO CUT COSTS AGGRESSIVELY TO COMPETE AND SURVIVE 4HE RESULT IS A DEFAULT RATE FOR THE HIGH YIELD MARKET RISING TO NEARLY CURRENTLY FROM A LOW LEVEL OF WITH CONSENSUS EXPECTATIONS PEAKING AROUND n BY THE MIDDLE OF lSCAL 7HILE DEBT SERVICE WILL BE CHALLENGING FOR MANY HIGHLY LEVERAGED COMPANIES IN THIS ENVIRONMENT THERE ARE SEVERAL POSITIVE FACTORS TO LIMIT A MORE SEVERE DOWNSIDE RISK 4HE COMPOSITE DATA IS CLEARLY REmECTING EFFORTS BY COMPANIES TO BUILD CASH RESERVES TO WEATHER THIS DIFlCULT PERIOD )N ADDITION ONLY ABOUT OF HIGH YIELD BONDS AND LOANS WILL NEED TO BE RElNANCED DURING THE NEXT TWO YEARS ALLOWING MOST COMPANIES TO FOCUS ON MEETING INTEREST PAYMENTS AND IMPROVING BALANCE SHEETS 7ITH A BETTER ECONOMIC BACKDROP BY THE END OF lSCAL MOST HIGH YIELD COMPANIES SHOULD BE DEMONSTRATING SOME EARLY SIGNS OF RECOVERY 4HE DECLINE IN ECONOMIC GROWTH AND DIFlCULT CREDIT CONDITIONS THAT ORIGINATED IN THE DEVELOPED COUNTRIES HAS BEEN GLOBAL IN ITS REACH BUT MANY EMERGING MARKET COUNTRIES HAVE DEMONSTRATED RESILIENCE COMPARED TO PREVIOUS lNANCIAL MARKET CRISES 4HE STRENGTHENED lNANCIAL POSITION OF EMERGING MARKET COUNTRIES EVIDENCED BY THE TREND OF LOWER EXTERNAL DEBT AND SUBSTANTIALLY HIGHER FOREIGN EXCHANGE RESERVES HAS HELPED TO BUFFER THE CREDIT RISK TO THESE COUNTRIES RESULTING FROM REDUCED WORLD TRADE AND CAUTIOUS mOW OF CAPITAL 4HIS POSITION HAS ENABLED THEM TO ENACT UNPRECEDENTED COUNTER CYCLICAL POLICIES TO COMBAT THIS CRISIS %XPANSIONARY lSCAL POLICIES ARE BEING ADOPTED WHERE APPROPRIATE AND POLICY INTEREST RATES ARE BEING REDUCED BY CENTRAL BANKS AS INmATIONARY PRESSURES DIMINISH &URTHER SUPPORTING THE CREDIT QUALITY OF EMERGING COUNTRIES THE ' RECENTLY ANNOUNCED PLANS TO ALLOCATE TRILLION TO ENTITIES SUCH AS THE )NTERNATIONAL -ONETARY &UND AND THE 7ORLD "ANK TO SUPPORT LIQUIDITY NEEDS AND TRADE lNANCE )NVESTORS EMBRACED THE ACTIONS AS FURTHER CONlRMATION THAT THE DOWNSIDE RISK IN EMERGING MARKET DEBT HAS DIMINISHED COMPARED TO PREVIOUS lNANCIAL CRISES

STRATEGY Overview. 4HE lXED INCOME PORTFOLIO WILL BEGIN lSCAL WITH AN ACTIVE MANAGEMENT RISK OF APPROXIMATELY BASIS POINTS AN INCREASE FROM BASIS POINTS ONE YEAR AGO 7E MOVED THE PORTFOLIO INTO THE UPPER END OF THE POLICY RANGE n BASIS POINTS DURING THE lRST HALF OF lSCAL AFTER DISLOCATIONS IN THE lXED INCOME MARKET REACHED UNPRECEDENTED LEVELS 4HE HOUSING INDUCED CREDIT CRUNCH THAT PERSISTED SINCE SUMMER EVOLVED INTO WIDESPREAD CONCERNS OF A lNANCIAL SYSTEM

Fiscal 2010 Investment Plan

MELTDOWN BY FALL 4HE RAPID REDUCTION AND CONSOLIDATION OF 7ALL 3TREET lRMS COMBINED WITH FEAR AND FORCED SELLING BY LEVERED INSTITUTIONS DROVE PRICES ON MANY HIGH QUALITY lXED INCOME SECURITIES WELL BELOW INTRINSIC VALUE 4HESE VALUATIONS WERE CONSISTENT WITH EXPECTATIONS OF AN ECONOMIC OUTCOME SIMILAR TO THE 'REAT $EPRESSION WHICH WE VIEWED AS HIGHLY UNLIKELY !S A CONSEQUENCE WE BELIEVE SELECTED SPREAD SECTORS OF THE lXED INCOME MARKET WILL GENERATE EXCELLENT RETURNS OVER THE NEXT SEVERAL YEARS FOR INVESTORS WHO ARE PATIENT AND WILLING TO WITHSTAND THE CURRENT MARKET CHARACTERISTICS OF HIGH VOLATILITY LOW LIQUIDITY AND PROLONGED ECONOMIC RECOVERY 4HE PRICE RECOVERY OF MANY OF THESE SECTORS COMMENCED DURING THE SECOND HALF OF lSCAL AND WE EXPECT THIS TO CONTINUE WITH AN UNEVEN TREND THROUGHOUT lSCAL /UR HIGHER ACTIVE MANAGEMENT RISK REmECTS THIS OUTLOOK EXPECTING THE POTENTIAL FOR ABOVE AVERAGE VALUE ADDED PERFORMANCE VERSUS THE BENCHMARK 4HE lXED INCOME PORTFOLIO HAS BEEN CONSTRUCTED WITH A SUBSTANTIAL UNDERWEIGHT TO THE 4REASURY AND GOVERNMENT RELATED SECTORS AND A CORRESPONDING OVERWEIGHT TO THE SPREAD SECTORS SEE 0ORTFOLIO 3TRUCTURE 4ABLE ON 0AGE 4HIS STRATEGY CURRENTLY PROVIDES THE BENElT OF A SUBSTANTIAL YIELD ADVANTAGE VERSUS THE BENCHMARK OF APPROXIMATELY BASIS POINTS 4HE YIELD ADVANTAGE IS DERIVED FROM OUR RELATIVE SECTOR WEIGHTINGS AND EXTRAORDINARILY WIDE YIELD SPREADS ON OUR CREDIT RELATED AND STRUCTURED PRODUCT SECTORS 7E EXPECT TO FURTHER ENHANCE RETURNS RELATIVE TO THE BENCHMARK AS THESE YIELD SPREADS TIGHTEN REmECTING AN IMPROVING ECONOMIC OUTLOOK AND HEALING IN THE lNANCIAL MARKETS 7E ARE ENCOURAGED BY A MORE FORCEFUL AND COMPREHENSIVE APPROACH TO SOLVE THE lNANCIAL CRISIS BY POLICYMAKERS DURING THE LAST SEVERAL MONTHS AS OPPOSED TO AD HOC AND SOMETIMES INCONSISTENT MEASURES DURING THE lRST HALF OF lSCAL 2ECENTLY ANNOUNCED PROGRAMS INTENDED TO VASTLY IMPROVE MARKET LIQUIDITY MANAGE THE EFFECTS OF DELEVERAGING AND PROMOTE NEW CREDIT CREATION SHOULD BENElT OUR PORTFOLIO !S OUR FORECAST IS REALIZED WE EXPECT TO LOWER OUR RELATIVE OVERWEIGHT TO THE SPREAD SECTORS AND ADD MORE LIQUIDITY TO THE PORTFOLIO 7E ALSO EXPECT THE RELATIVE DURATION OF THE PORTFOLIO TO CONTRIBUTE MARGINALLY TO OUR RETURNS VERSUS THE BENCHMARK IN lSCAL 7E BEGIN THE YEAR WITH A RELATIVE DURATION OF 7HILE THE OPPOSING FORCES WE OUTLINED IN THE MARKET INTEREST RATE OUTLOOK SECTION WILL CREATE INTEREST RATE VOLATILITY DURING THE YEAR WE EXPECT LONG TERM 4REASURY RATES TO END THE YEAR NEAR THE UPPER LIMIT OF OUR INTEREST RATE RANGE OF TO 4HE BURDEN OF NEW 4REASURY ISSUANCE AND THE EVENTUAL REMOVAL OF ACCOMMODATIVE MONETARY POLICY MAY PREVAIL AS THE DOMINANT FORCES PRESSURING 4REASURY RATES HIGHER FOR THE NEXT SEVERAL YEARS 4HEREFORE WE EXPECT TO TACTICALLY MANAGE OUR RELATIVE DURATION AT A LEVEL BELOW OR NEUTRAL TO THE INDEX DURING MOST OF lSCAL Treasuries. 7E BEGIN THE lSCAL YEAR WITH A LARGE UNDERWEIGHT TO 4REASURIES $URING THE PAST lSCAL YEAR EXTREMELY POOR ECONOMIC AND lNANCIAL MARKET CONDITIONS COMBINED TO CAUSE INVESTORS TO MAXIMIZE THEIR DEMAND FOR THE SAFETY AND LIQUIDITY OF 5 3 4REASURIES ! MOVE TOWARD THE NORMALIZATION OF THESE CONDITIONS TOGETHER WITH MASSIVE FEDERAL BUDGET DElCITS AND THE ACCOMPANYING INCREASE IN 4REASURY SUPPLY IS EXPECTED TO PUT UPWARD PRESSURE ON MARKET INTEREST RATES IN THE ABSENCE OF ACCELERATED &EDERAL 2ESERVE PURCHASES OF 4REASURIES !S INTEREST RATES MOVE HIGHER INTO OUR FORECASTED RANGE AND THE VALUATION OF SPREAD SECTORS IMPROVE WE WILL LIKELY ADD EXPOSURE TO 4REASURIES Government Related. 7E BEGIN THE lSCAL YEAR WITH A LARGE UNDERWEIGHT &ANNIE -AE AND &REDDIE -AC ARE THE PRIMARY ISSUERS IN THIS SECTOR )N FALL THEIR GOVERNMENT REGULATOR PLACED THEM IN CONSERVATORSHIP )N ADDITION THE 4REASURY ANNOUNCED SEVERAL MEASURES WHICH DIMINISHED LIQUIDITY AND SOLVENCY RISK TO SUPPORT THEIR DEBT 4HESE MEASURES HAD A SIGNIlCANT STABILIZING INmUENCE ON THEIR NEW ISSUES AND OUTSTANDING DEBT "ECAUSE OF THE LIQUIDITY AND HIGH QUALITY OF THIS SECTOR WE MAY SEEK TO OPPORTUNISTICALLY INCREASE OUR ALLOCATION TO THIS SECTOR DEPENDING ON THE PERFORMANCE OF THE OVERWEIGHT POSITIONS IN THE SPREAD SECTORS CMBS (Commercial Mortgage-Backed Securities) and ABS (Asset-Backed Securities). $URING lSCAL WE MAINTAINED OUR LARGE OVERWEIGHT POSITION IN !!! RATED #-"3 7E CONTINUE TO FAVOR OUR POSITION IN !!! RATED SECURITIES WHICH DRAW CREDIT SUPPORT FROM HIGH LEVELS OF CREDIT ENHANCE-

Fiscal 2010 Investment Plan

MENT 5 3 4REASURY DEFEASANCE AND THE UNDERLYING PROPERTY APPRECIATION OF WELL SEASONED VINTAGES 4HIS CREDIT SUPPORT SIGNIlCANTLY EXCEEDS THE DETERIORATION OF COMMERCIAL REAL ESTATE FUNDAMENTALS WE EXPECT !DDITIONALLY OUR SECURITY SELECTION BENElTS APPRECIABLY FROM THE EXPANDED GOVERNMENT PROGRAMS TARGETED TO SUPPORT THE #-"3 MARKET 4HE INITIAL RESPONSE TO THESE PROGRAMS HAVE BEEN POSITIVE 7E ANTICIPATE THE IMPLEMENTATION OF THESE PROGRAMS WILL CONTINUE TO MEANINGFULLY IMPROVE THE VALUATION OF THESE SECURITIES 7E FAVOR THE TOTAL RETURN POTENTIAL OF THESE ASSETS AND THE REDUCED RISK PROlLE RESULTING FROM THE EXPANDED EFFORTS OF RECENT GOVERNMENT PROGRAMS 7E EXPECT TO MAINTAIN AN OVERWEIGHT POSITION 7E BEGIN lSCAL OVERWEIGHT TO THE !"3 SECTOR 7E HAVE CHOSEN THE LARGEST CREDIT CARD MASTER TRUST ISSUERS AS THEY ARE BETTER ABLE TO MANAGE THE UNDERLYING COLLATERAL AND MAINTAIN A HIGH LEVEL OF CREDIT ENHANCEMENT 4HE COMMITMENT OF GOVERNMENT PROGRAMS TO SUPPORT CONSUMER lNANCE HELP TO IMPROVE THE LIQUIDITY AND VALUATION THEREFORE WE WILL MAINTAIN OUR OVERWEIGHT TO THIS SECTOR 7E MAY SELECTIVELY DIVERSIFY EXPOSURE TO OTHER CONSUMER !"3 COLLATERAL TYPES PROVIDED THE FUNDAMENTALS STABILIZE AND VALUATIONS ARE ATTRACTIVE Mortgages. 7E BEGIN lSCAL WITH AN OVERWEIGHT IN MORTGAGE BACKED SECURITIES (ISTORICALLY LOW MORTGAGE RATES AND POWERFUL BUY PROGRAMS FROM THE &EDERAL 2ESERVE AND THE 5 3 4REASURY HAVE AGENCY MORTGAGE VALUATIONS AT UNSUSTAINABLY HIGH LEVELS #URRENTLY THE MORTGAGE MARKET IS PREMIUM PRICED AT 4HIS WILL LEAD TO LARGE RElNANCE RELATED PREPAYMENTS EARLY IN lSCAL !S A RESULT THERE WILL BE A REDISTRIBUTION OF THE MORTGAGE UNIVERSE FROM LARGELY TO COUPON MORTGAGES TO A HIGHER CONCENTRATION OF AND MORTGAGES 4HE CURRENT PORTFOLIO IS CONCENTRATED IN SHORTER SEASONED LOANS WITH AN OVERWEIGHT TO LOWER COUPON MORTGAGES 2ELATIVE TO THE BENCHMARK THE PORTFOLIO IS WELL POSITIONED FOR THE PROJECTED RISE IN PREPAYMENTS ,ATER IN THE lSCAL YEAR AS GOVERNMENTAL BUY PROGRAMS ARE CONCLUDING INVESTORS WILL SHIFT THEIR CONCERNS FROM DURATION CONTRACTION RISK TO EXTENSION RISK 4HIS WILL PUT PRESSURE ON VALUATIONS AND CAUSE A SIGNIlCANT REPRICING OF THE MORTGAGE MARKET )N ANTICIPATION OF THIS SCENARIO WE WILL BE TRANSITIONING AGENCY MORTGAGES FROM AN OVERWEIGHT TO AN UNDERWEIGHT POSITION RELATIVE TO THE BENCHMARK DURING lSCAL 7E BEGIN THE YEAR WITH AN ALLOCATION TO NON AGENCY RESIDENTIAL MORTGAGE BACKED SECURITIES REPRESENTING APPROXIMATELY OF THE TOTAL RESIDENTIAL MORTGAGE SECTOR IN THE PORTFOLIO 4HESE ARE COMPRISED OF MORTGAGES MADE TO PRIME QUALITY BORROWERS WITH LOAN BALANCES EXCEEDING THE AGENCY CONFORMING LIMITS !LTHOUGH THE RESIDENTIAL HOME MARKET WILL FACE CHALLENGES WE EXPECT SOME SIGNS OF STABILIZATION LATER IN THE lSCAL YEAR -OREOVER THE EXPANDED GOVERNMENT PROGRAMS TARGETED AT THIS SECTOR HAVE HAD A POSITIVE INITIAL RESPONSE 7E ANTICIPATE HIGH RELATIVE RETURNS AS THE EXPANDED PROGRAMS ARE IMPLEMENTED 4HE ALLOCATION TO THIS SECTOR WILL BE MANAGED BASED ON THE VALUATIONS AND UNFOLDING FUNDAMENTALS Investment Grade Corporates. 7E BEGIN THE lSCAL YEAR WITH A LARGE OVERWEIGHT TO THE INVESTMENT GRADE CORPORATE CREDIT SECTOR 7E BELIEVE CURRENT CREDIT SPREADS THAT ARE NEAR HISTORIC WIDE LEVELS MORE THAN ADEQUATELY COMPENSATE FOR CREDIT RISK AND INCLUDE A SUBSTANTIAL LIQUIDITY PREMIUM #REDIT SPREADS ARE LIKELY TO TIGHTEN WHILE REMAINING VOLATILE AS CREDIT AND LIQUIDITY RISK PREMIUMS DECLINE /UR LARGEST OVERWEIGHT IS TO THE lNANCIAL SECTOR AS WE THINK IT HAS THE MOST SPREAD TIGHTENING POTENTIAL )N NONlNANCIALS WE ARE OVERWEIGHT """ RATED ISSUERS WHICH SHOULD OUTPERFORM HIGHER RATED SECURITIES AS CREDIT SPREADS TIGHTEN OVERALL 7E EXPECT TO MAINTAIN OUR OVERWEIGHT TO INVESTMENT GRADE CORPORATE CREDIT THROUGHOUT THE YEAR ADJUSTING OUR WEIGHT WITH CONSIDERATION TOWARD RELATIVE VALUE WITH OTHER SECTORS High Yield Corporates. 7E BEGIN lSCAL OVERWEIGHT TO THE HIGH YIELD SECTOR 4HIS SECTOR WILL PARTICULARLY BENElT FROM THE CONTINUED HEALING OF THE lNANCIAL SYSTEM AS ACCESS TO CAPITAL AND LIQUIDITY IS CRITICAL FOR HIGH YIELD COMPANIES 9IELD SPREADS ALREADY FULLY REmECT A MARKET EXPECTATION FOR DEFAULTS TO RISE TO APPROXIMATELY THREE TIMES THE LONG TERM AVERAGE DURING lSCAL 7E BELIEVE THESE VALUATIONS WILL COMPENSATE INVESTORS WELL FOR THE DIFlCULT CREDIT OUTLOOK FACING THE SECTOR EARLY IN lSCAL 7E ALSO EXPECT OUR HIGH YIELD PORTFOLIO WITH ITS HIGHER QUALITY BIAS TO AVOID THE FULL EXTENT OF

Fiscal 2010 Investment Plan

THE CREDIT PROBLEMS THAT WILL AFFECT THE BENCHMARK 7HILE WE MAY ADJUST THE LEVEL OF OUR OVERWEIGHT DEPENDING UPON OUTLOOK AND VALUATION WE EXPECT TO MAINTAIN AN OVERWEIGHT TO THE SECTOR DURING THE NEXT SEVERAL YEARS TO REALIZE ATTRACTIVE EXPECTED RETURNS Emerging Market Debt. 7E BEGIN THIS YEAR WITH AN OVERWEIGHT TO EMERGING MARKET DEBT 4HE SECTOR HAS HAD A STRONG RECOVERY IN PERFORMANCE DURING THE SECOND HALF OF lSCAL BUT WE BELIEVE YIELDS SPREADS ARE STILL ATTRACTIVE FOR THE CREDIT OUTLOOK 4HE NEW ISSUANCE MARKET HAS BEEN FAVORABLE RELATIVE TO MANY SEGMENTS OF THE lXED INCOME MARKET RECENTLY PERMITTING ACCESS TO CREDIT FOR SOVEREIGN ISSUERS AT REASONABLE RATES )F SPREADS CONTINUE TO TIGHTEN RELATIVE TO OTHER lXED INCOME SECTORS WE MAY REDUCE THE RELATIVE WEIGHTING BUT GENERALLY EXPECT TO MAINTAIN AN OVERWEIGHT DURING THE YEAR

PORTFOLIO STRUCTURE AS OF !PRIL

Portfolio Annualized Tracking Risk1 â&#x20AC;&#x201D; 120 basis points Portfolio Duration2 â&#x20AC;&#x201D; 3.73 Years Market Value ($ millions)

Sector Weights

Relative to Index â&#x20AC;&#x201D; 93% Percent of Portfolio

Yield

Relative to Index3

4REASURIES

'OVERNMENT 2ELATED4

-ORTGAGES5

#-"3 !"36

)NVESTMENT 'RADE #ORPORATES7

(IGH 9IELD #ORPORATES8

%MERGING -ARKET $EBT

4OTAL &IXED )NCOME

! STATISTICAL MODEL IS USED TO GENERATE TRACKING RISK WHICH IS AN ESTIMATE OF THE EXPECTED DIFFERENCE IN ANNUAL PERFORMANCE BETWEEN THE PORTFOLIO AND THE INDEX &OR EXAMPLE THE lXED INCOME PORTFOLIO CURRENTLY HAS A TRACKING RISK OF BASIS POINTS MEANING THE PERFORMANCE OF THE PORTFOLIO RELATIVE TO THE INDEX IS EXPECTED TO BE WITHIN BASIS POINTS FOR ONE STANDARD DEVIATION OF ALL MARKET OUTCOMES 2 ! MEASURE OF THE SENSITIVITY OF THE PRICE OF THE lXED INCOME PORTFOLIO TO A CHANGE IN INTEREST RATES EXPRESSED IN YEARS 4HE CURRENT PORTFOLIO DURATION OF YEARS IMPLIES THE AVERAGE PRICE OF THE PORTFOLIO IS EXPECTED TO RISE BY FOR A BASIS POINT DECLINE IN INTEREST RATES AND IS EXPECTED TO FALL BY FOR A BASIS POINT INCREASE IN INTEREST RATES 4HE PORTFOLIO DURATION RELATIVE TO THE INDEX CURRENTLY AT IS THE PORTFOLIO S DURATION DIVIDED BY THE DURATION OF THE INDEX ! NUMBER LESS THAN IMPLIES THE PORTFOLIO HAS A DURATION LESS THAN THAT OF THE INDEX AND REmECTS AN EXPECTATION OF RISING RATES 3 4HE RELATIVE EXPOSURE TO EACH SECTOR VERSUS THE INDEX ! NUMBER GREATER THAN X INDICATES AN OVERWEIGHT AND REmECTS A SECTOR THAT WE BELIEVE IS UNDERVALUED ! NUMBER LESS THAN X INDICATES AN UNDERWEIGHT AND A SECTOR WE BELIEVE IS OVERVALUED 4 )NCLUDES 5 3 'OVERNMENT 3PONSORED %NTERPRISE DEBT AND OTHER HIGHLY RATED NONCORPORATE DEBT 5 -ORTGAGES ARE SECURED BY A DIVERSIlED POOL OF LOANS ON RESIDENTIAL PROPERTIES -ORE THAN OF HOLDINGS HAVE PRINCIPAL AND INTEREST GUARANTEED BY 5 3 'OVERNMENT 3PONSORED %NTERPRISES 6 #OMMERCIAL -ORTGAGE "ACKED 3ECURITIES #-"3 ARE SECURED BY A DIVERSIlED POOL OF LOANS ON COMMERCIAL PROPERTY SUCH AS OFlCE BUILDINGS INDUSTRIAL COMPLEXES RETAIL CENTERS HOTELS AND MULTIFAMILY DEVELOPMENTS !SSET "ACKED 3ECURITIES !"3 ARE SECURED BY POOLS OF CONSUMER LOANS INCLUDING CREDIT CARD RECEIVABLES AND AUTO LOANS 7 )NCLUDES DEBT FROM INDUSTRIAL UTILITY AND lNANCIAL INSTITUTION ISSUERS THAT IS RATED INVESTMENT GRADE WHICH IS """ AND ABOVE 8 )NCLUDES DEBT FROM INDUSTRIAL UTILITY AND lNANCIAL INSTITUTION ISSUERS THAT IS RATED NON INVESTMENT GRADE WHICH IS "" AND BELOW 9 )NCLUDES BONDS BY COUNTRIES AND COMPANIES IN EMERGING MARKETS THAT ARE RATED """ AND BELOW 1

Fiscal 2010 Investment Plan

VI. Domestic Equities Investments OUTLOOK Summary &ISCAL WAS AN EXTREMELY DIFlCULT YEAR FOR THE 5 3 EQUITY MARKET WITH UNPRECEDENTED LEVELS OF VOLATILITY EARNINGS DECLINES AND RISK AVERSION &ROM THE BEGINNING OF THE lSCAL YEAR LEVEL OF THE 3 0 FELL ALMOST BEFORE ITS TROUGH ON -ARCH OF !S OF EARLY -AY THE 3 0 HAS REBOUNDED SHARPLY TO HOWEVER IT REMAINS DOWN APPROXIMATELY SINCE THE BEGINNING OF THE lSCAL YEAR 4HIS NEGATIVE RETURN IS SIGNIlCANTLY BELOW THE LONG TERM POLICY EXPECTATION FOR DOMESTIC EQUITIES OF

S&P 500 PRICE INDEX Avg. 1941â&#x20AC;&#x201C;43=10

Source: Financial Times

.OTE 3HADED AREAS DENOTE RECESSION

4HE DROP IN THE EQUITY INDEX COMES AMID A GLOBAL lNANCIAL CRISIS RESULTING IN GLOBAL ECONOMIC WEAKNESS THAT HAS LED TO DECLINES IN ALL ASSET CLASSES 4HE CATALYST FOR THE CRISIS WAS THE FALL IN THE 5 3 HOUSING MARKET AS MORTGAGE BACKED SECURITY LOSSES AND LACK OF CONlDENCE IN THE GLOBAL CREDIT MARKETS LED TO THE MALFUNCTIONING OF THE BOND MARKET 4HE CREDIT CRISIS GREW EXTREMELY DIRE IN FALL AND PRECIPITATED THE BANKRUPTCY OF ,EHMAN "ROTHERS AND THE UNPRECEDENTED GOVERNMENT BAILOUTS OF &REDDIE -AC &ANNIE -AE AND !)' 4HE GLOBAL CREDIT CRISIS CREATED A NEAR PANIC IN THE EQUITY MARKET AS 3EPTEMBER /CTOBER AND .OVEMBER SAW THE 3 0 SELL OFF WITH CONSECUTIVE DROPS OF AND 4HIS RANKS AMONG THE WORST THREEnMONTH PERFORMANCE IN HISTORY AND THE WORST SINCE THE STOCK MARKET CRASH )NVESTORS mED TO THE SAFETY OF 5 3 4REASURIES DRIVING YIELDS TO HISTORICAL LOW LEVELS

Fiscal 2010 Investment Plan

4HE MARKET DROP COUPLED WITH A DECLINE IN HOUSING VALUES CAUSED CONSUMER BALANCE SHEETS TO WEAKEN SUBSTANTIALLY LEADING TO SHARP DECLINES IN CONSUMER SPENDING "OTH THE CONSUMER CONlDENCE INDEX AND NEW HOME SALES FELL TO THEIR LOWEST LEVELS ON RECORD !UTO SALES FELL TO LEVELS NOT SEEN SINCE THE EARLY S PRECIPITATING THE BANKRUPTCY lLING BY #HRYSLER '- IS LIKELY TO FOLLOW SUIT 4HE UNEMPLOYMENT RATE NOW STANDS AT NEARLY A LEVEL NOT SEEN IN THE 5NITED 3TATES SINCE THE EARLY S 4O STABILIZE THE GLOBAL lNANCIAL SYSTEM THE 5 3 GOVERNMENT APPROVED A BILLION RESCUE PACKAGE FOR lNANCIAL lRMS 4HIS PACKAGE COUPLED WITH COORDINATED RATE CUTS BY CENTRAL BANKS IN .ORTH !MERICA %UROPE AND !SIA WERE IMPLEMENTED TO HELP UNLOCK THE CREDIT MARKETS 4HE &EDERAL 2ESERVE AGGRESSIVELY TOOK THE FEDERAL FUNDS RATE TO HISTORICAL LOW LEVELS TO AVERT A WIDER lNANCIAL CRISIS 4HE RATE NOW STANDS AT A TARGET RANGE OF n DOWN FROM AT THE BEGINNING OF THE lSCAL YEAR 7HILE lSCAL WAS A VERY POOR ENVIRONMENT FOR EQUITY PRICES THE 3 0 HAS RISEN MORE THAN SINCE ITS CLOSING LOW ON -ARCH &OR lSCAL A GRADUALLY IMPROVING ECONOMY SHOULD LEAD TO POSITIVE STOCK RETURNS 7E PROJECT A TARGET OF FOR THE 3 0 FOR lSCAL YEAR END RESULTING IN AN APPROXIMATE RETURN FROM THE CLOSE AT THE END OF !PRIL 4HIS FORECAST IS DERIVED BY PLACING A X PRICE TO EARNINGS 0 % MULTIPLE ON OUR POINT ESTIMATE FOR 3 0 EARNINGS OF 4HERE IS HOWEVER CONSIDERABLE UNCERTAINTY AROUND THIS PROJECTION BECAUSE OF HIGHLY VARIABLE ECONOMIC AND lNANCIAL CONDITIONS 7HILE IMPROVEMENTS IN THE lNANCIAL SECTOR COULD LEAD TO EARNINGS HIGHER THAN OUR CENTRAL ESTIMATE THAT IMPROVEMENT IS NOT A FOREGONE CONCLUSION )F THE CURRENT PROBLEMS CONTINUE TO BESET THE SECTOR WRITE OFFS OF BAD ASSETS COULD LEAD TO MUCH WEAKER EARNINGS THAN ANTICIPATED )N THAT CASE OUR PROJECTED ESTIMATE MAY TURN OUT TO BE TOO OPTIMISTIC

Economic Drivers 4HE 3423 /HIO 5 3 ECONOMIC FORECAST CALLS FOR SLUGGISH ECONOMIC GROWTH IN THE lRST HALF OF lSCAL WITH THE ECONOMY ACCELERATING AS THE YEAR PROGRESSES 2EAL '$0 GROWTH IS PROJECTED TO BE ONLY IN THE lRST HALF INCREASING TO IN THE SECOND HALF OF THE YEAR &OREIGN ECONOMIES WILL ALSO LIKELY SLOW WHICH COULD LEAD TO A STRONGER 5 3 DOLLAR VERSUS GLOBAL CURRENCIES ! STRONGER DOLLAR COUPLED WITH A WEAK GLOBAL ECONOMY WILL LIKELY LEAD TO CONTINUED WEAKNESS IN COMMODITY AND ENERGY PRICES Â&#x2C6; A SHARP REVERSAL FROM THE PAST FEW YEARS /IL NOW SELLS FOR UNDER PER BARREL WELL OFF ITS PER BARREL CLOSING PRICE OF EARLY *ULY 4HIS FAVORABLE BACKDROP FOR EARNINGS IS THE BASIS FOR OUR CENTRAL TARGET OF FOR THE 3 0

Fiscal 2010 Investment Plan

ECONOMIC DRIVERS â&#x2013;¼

Domestic Spot Market Price: West Texas Intermediate Crude Oil Federal Open Market Committee: Fed Funds Target Rate

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Sources: Wall Street Journal/Federal Reserve Board

.OTE 3HADED AREAS DENOTE RECESSION

Earnings 4HE SHARP DROP IN 3 0 EARNINGS WAS WIDESPREAD ACROSS ALL SECTORS IN lSCAL 4HE 3 0 IS EXPECTED TO EARN APPROXIMATELY IN lSCAL DOWN FROM IN lSCAL AND BELOW OUR ORIGINAL FORECAST OF AND THE CONSENSUS ESTIMATE OF MORE THAN 4HE NEAR COLLAPSE OF THE lNANCIAL SYSTEM WAS THE PRIMARY CAUSE OF OUR OVERESTIMATE /UR POINT ESTIMATE FOR 3 0 EARNINGS IS FOR lSCAL YEAR 4HIS WOULD RESULT IN AN EARNINGS GROWTH RATE OF NEARLY ALTHOUGH STILL SIGNIlCANTLY BELOW THE SEEN IN lSCAL 7HILE THIS IS CURRENTLY OUR BEST ESTIMATE WE RECOGNIZE THAT THERE IS A FAR GREATER THAN NORMAL DEGREE OF VARIABILITY AROUND OUR POINT ESTIMATE 4HE DISPERSION OF POTENTIAL ECONOMIC OUTCOMES MAKES THE FORECAST FOR THE COMING YEAR ESPECIALLY DIFlCULT 0ROJECTED EARNINGS ARE LIKELY TO FALL WITHIN A RANGE OF TO OR GROWTH VERSUS lSCAL )MPROVEMENTS IN THE lNANCIAL SECTOR COULD LEAD TO MUCH HIGHER EARNINGS RELATIVE TO OUR POINT ESTIMATE ,IKEWISE CONTINUED PROBLEMS IN THE SECTOR WOULD LIKELY LEAD TO FURTHER WRITE DOWNS AND INCREASE THE RISK OF A SIGNIlCANTLY SLOWER ECONOMY )N THIS SCENARIO OUR EARNINGS POINT ESTIMATE WOULD LIKELY BE TOO OPTIMISTIC 7ITH THE CONSIDERABLE UNCERTAINTY AHEAD WE WOULD NOT BE SURPRISED TO SEE THE MARKET TRADE IN A WIDE BAND WITH POSSIBLE DOWNSIDE TO X X AND UPSIDE BEYOND X X ALSO A POSSIBILITY 4HIS ARGUES FOR A NIMBLE STRATEGY SIMILAR TO THE ONE EMPLOYED OVER THE PAST FEW YEARS ADDING TO EQUITIES ON DECLINES AND LOWERING OUR EXPOSURE TO EQUITIES ON MARKET RALLIES

Fiscal 2010 Investment Plan

S&P 500 OPERATING EARNINGS â&#x2013;¼

S&P 500 Composite: Operating Earnings per share 4-qtr Moving Total

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S&P 500 Composite: Operating Earnings per share % Change â&#x20AC;&#x201D; Year to Year

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Source: Standard and Poorâ&#x20AC;&#x2122;s

.OTE 3HADED AREAS DENOTE RECESSION

Valuations 4HE 3 0 IS CURRENTLY TRADING AT TIMES TRAILING MONTH EARNINGS 7HILE THIS IS ABOVE THE HISTORICAL AVERAGE OF n TIMES CORPORATE EARNINGS LEVELS ARE AT EXTREMELY LOW LEVELS 7E EXPECT THE 0 % MULTIPLE FOR THE MARKET TO CONTRACT AS CORPORATE EARNINGS IMPROVE /UR lSCAL 3 0 TARGET OF IS BASED ON A 0 % OF TIMES OUR EARNINGS ESTIMATE

STRATEGY 7E REMAIN BALANCED IN BOTH STYLE AND MARKET CAPITALIZATION WITHIN THE EQUITY MARKET AND DO NOT PLAN TO MAKE DRAMATIC ALLOCATION CHANGES 4HE INTERNALLY MANAGED PORTFOLIOS FAVOR LARGE CAPITALIZATION COMPANIES ON A VALUATION BASIS BUT WE RECOGNIZE THAT SMALL CAP AND LOW QUALITY DISTRESSED COMPANIES MAY HAVE LARGE PRICE REBOUNDS IN AN IMPROVING ECONOMY !LTHOUGH OVERALL VOLATILITY HAS DECLINED RECENTLY THE UNCERTAIN ECONOMY WILL LIKELY PROVIDE PERIODS OF ELEVATED VOLATILITY IN lSCAL 7E PLAN TO TAKE ADVANTAGE OF THE VOLATILITY BY OPPORTUNISTICALLY INCREASING OUR EXPOSURE TO THE MARKET ON PULLBACKS AND DECREASING OUR EQUITY EXPOSURE ON MARKET RALLIES

Fiscal 2010 Investment Plan

VII. International Investments OUTLOOK !FTER A WEAK YEAR IN lSCAL THE INTERNATIONAL MARKETS EXPERIENCED A SHARPLY NEGATIVE YEAR IN lSCAL 4HE 7ORLD EX 53 )NDEX HEDGED FOR DEVELOPED MARKETS IS DOWN APPROXIMATELY THROUGH MID -AY DESPITE A SHARP RALLY IN THE lRST PART OF THE CALENDAR YEAR WHILE THE -3#) %-& )NDEX FOR EMERGING MARKETS IS DOWN !S A RESULT THE 3423 /HIO "LENDED "ENCHMARK CONSISTING OF OF THE 7ORLD EX 53 )NDEX HEDGED RETURN AND OF THE -3#) %-& )NDEX RETURN IS SHOWING A DECREASE OF 3TAFF EXPECTS AVERAGE OR NORMAL RETURNS FROM THE INTERNATIONAL ASSET CLASS IN lSCAL

Developed Markets 4HE DEVELOPED MARKETS SUFFERED LIKE OTHER WORLD MARKETS FALLING MORE THAN IN THE LAST MONTHS 0ERCENTAGE DECLINES IN THE MID S IN COUNTRY SPECIlC EQUITY MARKETS WERE COMPOUNDED BY LOW DOUBLE DIGIT APPRECIATION OF THE 5 3 DOLLAR AGAINST VARIOUS CURRENCIES FURTHER CONTRIBUTING TO LOSSES SUFFERED BY 5 3 DOLLAR BASED INVESTORS 4HE lNANCIAL TURMOIL INITIATED BY THE IMPLOSION OF 5 3 SUBPRIME HOUSING LOANS HAS LED TO A GLOBAL SYNCHRONIZED DOWNTURN UNMATCHED SINCE THE 'REAT $EPRESSION OF THE S 4HE DEBATE TAKING CENTER STAGE THIS YEAR IS WHETHER DEmATION OR INmATION REMAINS THE BIGGER THREAT TO GLOBAL MARKETS 6ARIOUS GOVERNMENTS AND CENTRAL BANKS HAVE UNDERTAKEN UNPRECEDENTED lSCAL AND MONETARY MEASURES TO ARREST THE DEmATIONARY FORCES HAMMERING THE GLOBAL ECONOMY 4HE INABILITY TO SLOW AND REVERSE THESE DEmATIONARY FORCES WOULD HAVE DIRE CONSEQUENCES E G MORE BANKRUPTCIES UNEMPLOYMENT AND FURTHER DECLINE IN lNANCIAL MARKETS IN THE NEAR TERM $EmATION REMAINS A NEAR TERM RISK (OWEVER THE CURRENT STIMULATIVE POLICIES EMPLOYED TO ARREST DEmATION MAY EVENTUALLY LEAD TO INmATION IF NOT PROPERLY MODIlED WHEN THE ECONOMY STARTS TO GAIN TRACTION AND GROW )F A POLICY MISHAP COMPOUNDS A POTENTIAL INmATION PROBLEM FOREIGN INVESTORS MAY SELL THEIR 5 3 ASSETS AND REPATRIATE THE FUNDS 4HIS FUNDS REPATRIATION PUTS DOWNWARD PRESSURE ON THE DOLLAR AND COULD SET OFF A NEGATIVE FEEDBACK LOOP WHICH CAN DRIVE ASSET VALUES DOWN FURTHER 4HEREFORE INmATION MAY BECOME A RISK AFTER A RECOVERY COMMENCES BUT THIS ISSUE IS LIKELY BEYOND THE TIME HORIZON OF THIS PLAN )NTERNATIONAL EQUITY MARKETS ARE FAIRLY VALUED WITH RETURNS LIKELY TO FALL IN THE NORMAL RANGE AT BEST 5SUALLY A LARGE MARKET DECLINE SUCH AS WE EXPERIENCED LAST YEAR WOULD LEAD TO AN UNDERVALUED SITUATION AND THE POSSIBILITY OF ABOVE AVERAGE FUTURE RETURNS (OWEVER WITH THE BENElT OF HINDSIGHT IT HAS BECOME CLEAR THAT A SUBSTANTIAL PORTION OF lNANCIAL EARNINGS GENERATED IN THE PAST lVE YEARS WAS UNSUSTAINABLE 4HEREFORE DESPITE FALLING MARKET PRICES EARNINGS HAVE ALSO HAD A STEEP DECLINE THAT DENY THE POSSIBILITY OF EXCESS RETURNS AND LEAD TO NORMAL RETURNS AT BEST -ARKET RETURNS THIS YEAR AND BEYOND WILL HINGE ON HOW QUICKLY PROlTS CAN RECOVER DESPITE AN IMPAIRED lNANCIAL SYSTEM AND HOW PRICE EARNINGS MULTIPLES mUCTUATE WITH INmATION EXPECTATIONS 'IVEN THE NEAR TERM UNCERTAINTY MARKETS SHOULD REMAIN VOLATILE 3423 /HIO IS SLIGHTLY MORE EXPOSED THAN THE BENCHMARK TO THE *APANESE AND 5+ EQUITY MARKETS AND SOME OF THE SMALLER COUNTRIES FOUND IN THE INDEX AND LESS EXPOSED TO THE 'ERMAN AND !USTRALIAN MARKETS Developed Asiaâ&#x20AC;&#x201C;Pacific 4HE *APANESE MARKET DECLINED THE LEAST OF THE LARGE DEVELOPED MARKETS IN THE PAST YEAR AND AN APPRECIATING YEN HELPED CUSHION THE DECLINE IN DOLLAR TERMS *APAN GOT A HEAD START IN THE ECONOMIC

-ORGAN 3TANLEY #APITAL )NTERNATIONAL %MERGING -ARKETS &REE )NDEX

Fiscal 2010 Investment Plan

DOWNTURN FROM A NUMBER OF SELF INmICTED REGULATORY AND POLITICAL MISSTEPS RESTRICTIONS ON CONDOMINIUM PERMITS STRICTER ENFORCEMENT OF lNANCIAL SERVICE PROVISIONS AND CURBS ON COMMERCIAL REAL ESTATE LENDING 7HILE AN APPRECIATING YEN HELPS DOLLAR BASED lNANCIAL RETURNS IT WREAKS HAVOC ON EXPORT ORIENTED MANUFACTURERS Â&#x2C6; THE HEART OF THE *APANESE ECONOMY 4HE COMBINATION OF A STRONGER CURRENCY AND THE DOWNTURN IN EXPORT DEMAND PROVED LETHAL FOR CORPORATE PROlTS THAT HAD BEEN RELATIVELY RESILIENT *APAN EXPERIENCED A SEVERE BANKING CRISIS NEARLY YEARS AGO AND THEREFORE ITS BANKS SHOULD BE SOMEWHAT INSULATED AS THE REST OF THE WORLD S BANKS TAKE THEIR LUMPS )NVESTORS MAY BE lNALLY REALIZING THAT AFTER NEARLY A DECADE OF CORPORATE RESTRUCTURING DEBT REPAYMENT AND GLOBALIZATION *APANESE COMPANIES MAY BE IN AN ENVIABLE POSITION AS INVESTMENT CANDIDATES Â&#x2C6; TRADING ON HISTORICAL LOW VALUATION MULTIPLES *APAN HAS A LARGE NUMBER OF WORLD CLASS COMPANIES AND THE MARKET DECLINE HAS PRODUCED A NUMBER OF ATTRACTIVE INVESTMENT OPPORTUNITIES )N THIS DOWNTURN IF *APANESE CORPORATIONS CAN SHOW BETTER THAN EXPECTED lNANCIAL RESULTS IT WILL DEMONSTRATE THE SUCCESS OF THE RESTRUCTURING MEASURES ALREADY TAKEN AND LEAD TO A lNANCIAL MARKET RE RATING ,OOKING LONGER TERM *APAN S ECONOMY FACES MANY TOUGH CHALLENGES &OR EXAMPLE IT IS AGING MORE RAPIDLY THAN ANY OTHER ADVANCED NATION THUS PLACING A SIGNIlCANT BURDEN ON THE SOCIAL SECURITY NETWORK *APAN S RESPONSE TO THIS ISSUE MAY SERVE AS A MODEL TO THE WORLD 7HAT MAY HELP *APAN MORE THAN OTHER DEVELOPED ECONOMIES IS THE FACT IT RESIDES IN THE REGION WITH THE MOST PROSPECTIVE GROWTH $ESPITE THE LONGER TERM CHALLENGES SUPERIOR EQUITY RETURNS ARE EXPECTED OVER THE NEXT MONTHS GIVEN THESE ATTRACTIVE COMPANY SPECIlC OPPORTUNITIES AND 3423 /HIO HOLDS AN OVERWEIGHTED POSITION !USTRALIA RESEMBLES AN INDIVIDUAL WITH A SPLIT PERSONALITY 4HE DOMESTIC SIDE IS SUFFERING LIKE OTHER COUNTRIES Â&#x2C6; WEAK HOUSING MARKET SLOW CONSUMER SPENDING AND BANKS FACING INCREASED PROVISIONS AND WRITE OFFS /N THE OTHER HAND THE EXPORT ECONOMY SUFFERED A TEMPORARY SETBACK THIS WINTER AND SPRING WHEN RESOURCE SHIPMENTS SLOWED (OWEVER IT APPEARS TO BE ON THE MEND WITH SIGNS OF LIFE IN THE #HINESE ECONOMY ITS CHIEF DESTINATION FOR RESOURCE EXPORTS /VER THE NEXT MONTHS THIS DICHOTOMY AND THE LACK OF ATTRACTIVE INVESTMENT OPPORTUNITIES WILL LIKELY PUT A LID ON ANY EXCESS RETURNS FROM !USTRALIAN EQUITIES &URTHERMORE SINCE !USTRALIA S CURRENCY IS NOT EXPECTED TO APPRECIATE SUBSTANTIALLY AGAINST THE 5 3 DOLLAR THE CURRENCY RELATED ADDITION TO THE TOTAL RETURN FROM !USTRALIA APPEARS TO BE LIMITED AS WELL 3423 /HIO IS UNDERWEIGHTED IN !USTRALIA Europe %UROPEAN EQUITIES HAVE TRENDED IN LOCKSTEP WITH THE 5 3 STOCK MARKET DURING THE lSCAL YEAR BUT WERE WORSE ON A DOLLAR BASIS SINCE THE 5 3 DOLLAR APPRECIATED AGAINST THE PRIMARY %UROPEAN CURRENCIES 7ITH THE POSSIBLE EXCEPTION OF THE 5+ THE %UROPEAN GOVERNMENTS lSCAL STIMULI AND THE %UROPEAN #ENTRAL "ANK S %#" MONETARY POLICY RESPONSE TO THE CURRENT CRISIS HAVE LAGGED THE 5NITED 3TATES ACTIONS 4HE %UROPEANS HAVE ADDITIONAL IMPEDIMENTS TO OVERCOME DUE TO HOW THE %#" AND %UROPEAN 5NION ARE CONlGURED WHICH SLOWS THEIR ABILITY TO RESPOND IN A CRISIS %UROPEAN BANKS HAVE ALSO BEEN SLOW TO RECOGNIZE LOSSES WHICH MAY HINDER THE ABILITY TO RECOVER ONCE THE BOTTOM HAS BEEN REACHED %XPORT ORIENTED COMPANIES LIKE THOSE FOUND IN 'ERMANY HAVE TAKEN A HIT RECENTLY GIVEN THE STEEP DECLINE IN DEMAND FOR INDUSTRIAL CAPITAL GOODS #YCLICAL SECTORS ARE IN THE PROCESS OF BOTTOMING VERSUS NONCYCLICAL SECTORS 4HIS IS AN IMPORTANT OBSERVATION IN THAT %UROPEAN EQUITY MARKETS ARE MORE HEAVILY TILTED TOWARD THE MANUFACTURING SECTOR THAN IS THE CASE FOR OTHER DEVELOPED REGIONS WORLDWIDE 4HIS LEAVES US WITH A MIXED BAG OF OPPORTUNITIES IN %UROPE 3INCE lNANCIAL MARKETS ACT AS A DISCOUNTING MECHANISM SOME CYCLICAL STOCKS HAVE ALREADY ANTICIPATED A RECOVERY AND MAY HAVE GOTTEN AHEAD OF THE FUNDAMENTALS -EANWHILE THE MORE DEFENSIVE ELEMENTS E G FOOD PHARMACEUTICALS AND CONSUMER STAPLES OF THE MARKET HAVE NOT GOTTEN CHEAP ENOUGH TO MAKE THEM ATTRACTIVE FROM AN INVESTMENT STANDPOINT 4HESE FACTORS AND THE FACT THAT %UROPE APPEARS TO BE LAGGING BEHIND THE 5NITED 3TATES

Fiscal 2010 Investment Plan

IN POLICY INITIATIVES DOES NOT GENERATE MUCH ENTHUSIASM FOR INVESTING HEAVILY IN THE REGION /VERALL 3423 /HIO IS CURRENTLY UNDERWEIGHT IN %UROPEAN EQUITIES BUT IS LOOKING FOR OPPORTUNITIES TO REDUCE THIS POSITION OVER THE NEXT YEAR )N MANY RESPECTS THE 5+ ECONOMY IS IN WORSE SHAPE THAN THE 5 3 ECONOMY 4HE HOUSING BUBBLE IN THE 5+ WAS INmATED TO A MUCH GREATER DEGREE THAN IN THE 5NITED 3TATES )TS lNANCIAL SYSTEM IS MORE CONCENTRATED WITH A GREATER PORTION OF BANKS LEANING ON GOVERNMENT RESOURCES TO REMAIN VIABLE $ESPITE THESE ISSUES THE 5+ IS HOME TO MANY MORE GLOBAL COMPANIES IN THE ENERGY PHARMACEUTICALS AND MINING INDUSTRIES WHICH APPEAR TO BE ATTRACTIVE ON A VALUATION BASIS ,IKE *APAN 3423 /HIO IS OVERWEIGHTED TO THE 5+ MARKET MORE BECAUSE OF THESE INDIVIDUAL COMPANIES PROSPECTS THAN THE ATTRACTIVENESS OF THE MARKET ITSELF

Emerging Markets %MERGING MARKET RETURNS HAVE BEEN ABYSMAL IN lSCAL FALLING MORE THAN THROUGH MID -AY 4HE ABSOLUTE RETURN FOR lSCAL IS THE lRST ONE SINCE lSCAL THAT HAS BEEN NEGATIVE 7E DISAGREED LAST YEAR WITH A POPULAR PREMISE CIRCULATING IN THE MARKETS THAT THE EMERGING WORLD COULD DECOUPLE FROM BEING STRONGLY INmUENCED BY THE 5 3 ECONOMY 7HEN THE lNANCIAL MARKETS IN THE 5NITED 3TATES WERE SEVERELY DISRUPTED IN 3EPTEMBER THE EMERGING MARKET RETURNS PLUMMETED IN BOTH 3EPTEMBER AND /CTOBER AT RATES THAT WERE THE WORST MONTHLY RETURNS SINCE !UGUST 4HEREFORE THE EMERGING MARKET RETURNS FOR THE CURRENT lSCAL YEAR ARE TRAILING THE DEVELOPED INTERNATIONAL MARKETS (OWEVER EMERGING MARKET RETURNS ARE SIGNIlCANTLY OUTPERFORMING IN THE CALENDAR YEAR AND HAVE RISEN BY MORE THAN THROUGH MID -AY 4HE MORE RECENT OUTPERFORMANCE IS DUE TO A SLOWING PACE IN THE RATE OF CONTRACTION IN ECONOMIC INDICATORS AND A RESULTING INCREASE IN RISK TOLERANCE IN THE EQUITY MARKETS 2ETURNS ON EQUITY IN EMERGING MARKETS REMAIN HIGHER THAN IN THE DEVELOPED WORLD WHILE VALUATIONS ON BOOK VALUE ARE AT A MINOR PREMIUM 6ALUATIONS ON TRAILING EARNINGS AND FORWARD EARNINGS ARE AT DOUBLE DIGIT PERCENTAGE DISCOUNTS TO THE DEVELOPED MARKETS BUT WE ARE SKEPTICAL OF THE ACCURACY OF CONSENSUS EARNINGS FORECASTS 4HE DIVIDEND YIELD IS SIMILAR TO THE DEVELOPED MARKETS 7E DO NOT lND OUTSTANDING RELATIVE VALUE IN THE EMERGING MARKETS THAT FULLY COMPENSATES FOR THE HIGHER RISKS %MERGING MARKET ECONOMIES WERE STRUCTURALLY BETTER PREPARED FOR THIS ECONOMIC DOWNTURN VERSUS PREVIOUS ONES #URRENT ACCOUNTS WERE IN BETTER BALANCE FOREIGN CURRENCY RESERVES WERE HIGHER AND FOREIGN DEBT EXPOSURES WERE BETTER MANAGED (OWEVER THE SEVERITY OF THE GLOBAL ECONOMIC RECESSION HAS OVERWHELMED THE CAPABILITY OF MANY OF THE EMERGING COUNTRIES TO INDEPENDENTLY TACKLE THEIR PROBLEMS -ONETARY ASSISTANCE HAS COME FROM )-& LENDING CROSS BORDER CURRENCY SWAPS AND OTHER MECHANISMS 4HE ECONOMIC PROBLEMS IN MOST OF THE EMERGING MARKETS AT THIS TIME APPEAR MANAGEABLE IF THE DEVELOPED WORLD ECONOMIES CAN BEGIN TO SUSTAIN AN ECONOMIC REBOUND BY EARLY (OWEVER HOW SOON THE DEVELOPED WORLD CAN REBOUND IS A BIG QUESTION MARK )N THE MEANTIME #HINA IS HELPING TO SOFTEN SOME OF THE GLOBAL DECLINE BY PUMP PRIMING ITS ECONOMY 4HIS HAS HELPED TO SUSTAIN A MODERATE LEVEL OF COMMODITY EXPORTS FROM THE EMERGING WORLD THAT ARE CRITICAL TO SEVERAL OF THE EMERGING ECONOMIES 0ORTFOLIO TRACKING RISK WILL REMAIN NEAR CURRENT LEVELS IF ELEVATED VOLATILITY IN THE MARKET PERSISTS ! SUMMARY OF OUR REGIONAL OUTLOOK FOR THE NEXT MONTHS FOLLOWS Asia 4HE GLOBAL ECONOMIC CRISIS HAS PUT #HINA S EXPORTS DRIVEN GROWTH MODEL UNDER SIGNIlCANT STRESS 4HE COUNTRY HAS SEEN ITS SUPERCHARGED GROWTH RATE SLOWING TO FROM THE RANGE IN A MATTER OF THREE QUARTERS !LTHOUGH THE GOVERNMENT HAS ADOPTED AN UNPRECEDENTED AGGRESSIVE STIMULUS PACKAGE TO SUPPORT THE ECONOMY THE SUSTAINABILITY OF SUCH MEASURES IS HIGHLY SUSPECT 4HIS AGGRESSIVE MONETARY

Fiscal 2010 Investment Plan

EXPANSION COULD RESULT IN HIGH INmATION IN THE MEDIUM TERM AND HAS SIGNIlCANT RAMIlCATIONS FOR ASSET QUALITY IN THE LONG TERM )T IS INEVITABLE THAT THE SUPERNORMAL MONETARY EXPANSION WILL SLOW AND AS A RESULT THE ECONOMIC GROWTH RATE MAY REVERT TO ITS DECELERATION TREND GOING INTO lSCAL 4HE HOPE IS FOR THE GLOBAL ECONOMIC CRISIS TO EASE AND EXTERNAL DEMAND TO IMPROVE (OWEVER THE REJUVENATION WILL LIKELY LACK BOTH STRENGTH AND LONGEVITY GIVEN THE SEVERE DELEVERAGING PROCESS THAT IS TAKING PLACE 4HE -3#) #HINA )NDEX HAS REBOUNDED MATERIALLY FROM ITS -ARCH LOW FOLLOWING BOTH THE SHORT TERM FAVORABLE DOMESTIC ECONOMIC NEWS AND A REBOUND IN GLOBAL INDICES DURING THE SAME TIME FRAME #HINA IS TRADING AT A MEANINGFUL PREMIUM ON A PRICE TO BOOK BASIS OVER THE EMERGING MARKETS AVERAGE WHILE THE EARNINGS GROWTH RATES FOR MANY CONSTITUENTS SEEM OVERLY OPTIMISTIC 4HE #HINESE MARKETS WILL LIKELY REMAIN VOLATILE IN lSCAL AND A MEANINGFUL CORRECTION CANNOT BE RULED OUT IN THE INTERIM 3IMILAR TO #HINA AND OTHER EXPORTS ORIENTED ECONOMIES 4AIWAN S ECONOMY HAS SUFFERED A SIGNIlCANT BLOW AMID THE GLOBAL ECONOMIC CRISIS )TS ECONOMY IS FORECASTED TO CONTRACT BY THIS YEAR &ISCAL AND MONETARY POLICIES WILL LIKELY CONTINUE TO BE STIMULATIVE 4HERE HAVE BEEN SOME POSITIVE SIGNS LATELY ON THE EXTERNAL FRONT WITH SEQUENTIAL EXPORTS AND ORDER GROWTH SEEMINGLY ON THE MEND 7HILE THE ECONOMIC ENVIRONMENT HAS BEEN CHALLENGING THE POLITICAL CLIMATE HAS WARMED UP SIGNIlCANTLY FOLLOWING #HINA -OBILE S ANNOUNCEMENT OF A ACQUISITION IN 4AIWAN S &AR %AS4ONE 4HIS IS THE lRST EVER DIRECT INVESTMENT MADE BY A #HINESE GOVERNMENT BACKED COMPANY INTO 4AIWAN IN SIX DECADES 3HOULD THE DEAL BE CARRIED OUT SUCCESSFULLY THEN THE REDUCTION IN THE RISK PREMIUM IN THE 4AIWAN MARKET WILL LIKELY BE SUSTAINED AND VALUATIONS SHOULD BE HIGHER ON A LONGER TERM BASIS (OWEVER AFTER A BOUNCE FROM ITS -ARCH LOW THE MARKET IS NO LONGER ATTRACTIVELY PRICED PARTICULARLY ON A FORWARD LOOKING PRICE TO EARNINGS BASIS /NE MAY ARGUE THAT EARNINGS FORECASTS HAVE BEEN MARKED DOWN SIGNIlCANTLY TO REmECT A CAUTIOUS OUTLOOK .EVERTHELESS THE 4AIWAN MARKET MAY GENERATE AN AVERAGE RETURN AT BEST AND IS SUSCEPTIBLE TO A SIGNIlCANT PULLBACK IF THE EXTERNAL ENVIRONMENT DOES NOT RECOVER AS QUICKLY AS THE MARKET ASSUMES NOW !S A HEAVILY EXPORT DEPENDENT ECONOMY IT WAS UNSURPRISING THAT +OREA WAS ONE OF THE WORST PERFORMING EMERGING MARKETS IN THE ONGOING GLOBAL DOWNTURN %ARLIER IN +OREAN EXPORTS TO EMERGING MARKETS ROSE SHARPLY HELPING TO OFFSET THE SLOWDOWN IN ITS EXPORTS TO DEVELOPED MARKETS (OWEVER DESPITE THE OPTIMISTIC FORECASTS BY SOME THAT EMERGING MARKET ECONOMIC GROWTH HAD DECOUPLED FROM DEVELOPED MARKETS EMERGING ECONOMIES ALSO DECELERATED SHARPLY AND LEAD TO A SHARP DECELERATION IN OVERALL +OREAN EXPORTS 5NFORTUNATELY FOR +OREA ITS DOMESTIC ECONOMY LACKED LEVERS TO OFFSET THIS SHARP DECELERATION IN GLOBAL GROWTH AS +OREAN CONSUMERS SUFFERED FROM HIGH DEBT 'OING FORWARD IT WILL BE CHALLENGING FOR +OREAN COMPANIES TO OUTPERFORM THE AVERAGE EMERGING MARKET PEER ON A CASH EARNINGS BASIS FOR AT LEAST THE NEXT MONTHS )NVESTORS WHO HAVE FAITH IN CONSENSUS FORECASTS CALLING FOR A SHARP TURNAROUND IN EARNINGS BY ARE LIKELY TO BE DISAPPOINTED 4HEREFORE IT IS EXPECTED THAT +OREAN EQUITIES WILL REMAIN VOLATILE OVER THE NEAR TERM 4HE SURPRISING MARGIN OF VICTORY IN THE RECENT )NDIA NATIONAL ELECTION BY THE #ONGRESS LED 50! COALITION HAS LED TO A SHARP RALLY IN THE )NDIAN MARKET &OR THE lRST TIME IN YEARS )NDIA WILL HAVE ONE PARTY DICTATING POLICY 4HIS SHOULD LEAD TO SIGNIlCANT REFORMS OF THE )NDIAN ECONOMY ALLOWING ENTERPRISING )NDIAN COMPANIES TO GROW EARNINGS AT A FASTER PACE AND ACCESS CAPITAL AT A LOWER COST )NVESTORS WILL NOW DISCOUNT FASTER EARNINGS GROWTH AT A LOWER RISK PREMIUM AND AT A HIGHER MULTIPLE !LTHOUGH VALUATIONS ARE REASONABLE EVEN AFTER THE RALLY INVESTORS EXPECTING A RAPID CHANGE IN REFORMS MAY BE DISAPPOINTED IF THE UPCOMING BUDGET DOES NOT MEET THEIR LOFTY EXPECTATIONS )N THE NEAR TERM ECONOMIC GROWTH WILL DECLINE SHARPLY TO APPROXIMATELY FROM EARLIER GROWTH RATES OF TO )NDIA S RELATIVELY CLOSED ECONOMY AND LARGE DOMESTIC MARKET WILL ALLOW IT TO ENJOY RELATIVELY HIGHER ECONOMIC GROWTH )N FACT IF GOOD RAINS OCCUR DURING MONSOON SEASON THEN ECONOMIC GROWTH COULD SURPRISE ON THE UPSIDE

Fiscal 2010 Investment Plan

Eastern Europe, Middle East and Africa 4HE #ZECH 2EPUBLIC (UNGARY AND 0OLAND ARE FACING SEVERE ECONOMIC DIFlCULTIES THAT WERE TRIGGERED BY THE GLOBAL RECESSION BUT HAVE BEEN EXACERBATED BY THEIR OWN SHAKY ECONOMIC FOUNDATIONS 4HE %ASTERN %UROPEAN REGION IS RECOGNIZED BY THE MARKETS TO BE THE MOST SUSCEPTIBLE REGION TO MAJOR ECONOMIC CRISES DUE TO CURRENT ACCOUNT DElCITS AND RELIANCE ON INTERNATIONAL FUND mOWS INTO ITS COUNTRIES !LTHOUGH A CRISIS IS MORE LIKELY TO HAPPEN IN A COUNTRY THAT 3423 /HIO DOES NOT DIRECTLY INVEST IN SUCH AS ,ATVIA OR 5KRAINE THERE WOULD VERY LIKELY BE PUNISHING CONTAGION EFFECTS ON ALL THE MARKETS IN THE REGION (UNGARY IS IN THE WORST ECONOMIC POSITION AMONG THE THREE LARGER %ASTERN %UROPEAN COUNTRIES BUT IT IS ALREADY RECEIVING MAJOR ECONOMIC ASSISTANCE FROM THE )-& %5 AND 7ORLD "ANK 4HE #ZECH 2EPUBLIC AND (UNGARY WILL BOTH HAVE TO SCHEDULE PARLIAMENTARY ELECTIONS BY THE END OF *UNE SO POLITICS COULD INTERFERE WITH NEEDED REFORMS 4HE GLOBAL lNANCIAL CRISIS HAS HAD A DISPROPORTIONATE EFFECT ON 2USSIA BECAUSE OF ITS DEPENDENCE ON EXPORTS OF ENERGY AND OTHER COMMODITIES AN IMMATURE DOMESTIC CREDIT MARKET AND MALFUNCTIONING GOVERNMENT INSTITUTIONS 2USSIA HAD BUILT UP ABUNDANT FOREIGN CURRENCY RESERVES DURING THE HIGH OIL PRICE PERIOD BUT FAILED TO MAKE NECESSARY REFORMS TO PREPARE FOR AN EVENTUAL DOWNTURN 4HE FOREIGN CURRENCY RESERVE POSITION HAS BEEN SIGNIlCANTLY DECREASED AS THE COUNTRY TRIED TO DEFEND THE RUBLE S VALUE !T THE CURRENT RATE 2USSIA S RESERVE FUND WILL BE DRAWN DOWN BY THE END OF 4HE LEADER SHIP S RESPONSE IN HANDLING THIS CRISIS OVER THIS CRUCIAL PERIOD WILL GO A LONG WAY IN DETERMINING 2USSIA S LONGER TERM SUCCESS )SRAEL S CENTRAL BANK HAS BEEN PROACTIVELY SLASHING INTEREST RATES BUYING LONGER MATURITY BONDS AND INTERVENING IN THE CURRENCY MARKETS TO HELP THE COUNTRY SOFTEN THE RECESSION 4HE CENTRAL BANK S ACTIONS CARRY SIGNIlCANT IMPORTANCE AS THE COUNTRY HAS NOT YET ENACTED A lSCAL BUDGET DUE TO ELECTIONS HELD EARLIER IN THE YEAR .OW THAT "ENJAMIN .ETANYAHU HAS FORMED A COALITION GOVERNMENT THE lSCAL AUTHORITIES CAN BEGIN TO FORMULATE A PLAN 5NFORTUNATELY THE GEOPOLITICAL RISKS THAT )SRAEL FACES HAVE NOT GREATLY SUBSIDED %GYPT ALSO HAS NOT IMPROVED FROM A GEOPOLITICAL RISK PERSPECTIVE AND NOW THE ECONOMY IS FACING VARIOUS HEADWINDS SUCH AS DECLINING TOURISM AND A REDUCTION IN 3UEZ #ANAL RECEIPTS DUE TO REDUCED INTERNATIONAL TRADE AND PIRATE ACTIVITY IN THE 'ULF OF !DEN 3OUTH !FRICA S ECONOMY IS DECELERATING SHARPLY WITH RECENT MANUFACTURING PRODUCTION STATISTICS SHOWING RECORD YEAR OVER YEAR DECLINES 4HE CENTRAL BANK IS CUTTING INTEREST RATES IN AN EFFORT TO BOOST THE ECONOMY 3OUTH !FRICA WAS LATE RELATIVE TO SOME OTHER COUNTRIES IN BEGINNING THEIR RATE CUTS DUE TO LINGERING INmATIONARY PRESSURES *ACOB :UMA FROM 4HE !FRICAN .ATIONAL #ONGRESS RECENTLY WON THE ELECTION FOR THE PRESIDENCY 4HE MARKET WILL BE DILIGENTLY WAITING TO SEE IF HE MOVES ECONOMIC POLICY TO A MORE SOCIALIST AGENDA 4HE VALUE OF THE RAND CURRENCY HAS BEEN STRONGER THAN ONE WOULD EXPECT GIVEN THE WEAK ECONOMY AND THE DEPENDENCE ON RESOURCE EXPORTS A CURRENT ACCOUNT DElCIT IN THE TO OF '$0 RANGE AND SOME POLITICAL UNCERTAINTY 4HE STOCK MARKET OVERALL LOOKS TO BE ATTRACTIVE STRICTLY ON A VALUATION BASIS BUT THE COUNTRY S OUTLOOK AT PRESENT IS LESS THAN FAVORABLE Latin America -EXICO S ECONOMY IS DECELERATING SHARPLY WITH RECENT MANUFACTURING PRODUCTION STATISTICS FALLING BY MORE THAN $UE TO THE CLOSE ECONOMIC TIES OF -EXICO WITH THE 5NITED 3TATES SUCH AREAS AS AUTOMOTIVE EXPORTS AND WORKER REMITTANCES ARE FACING MAJOR HEADWINDS 4HE RECENT ( . SWINE mU OUTBREAK IN -EXICO WILL PUT ADDITIONAL PRESSURE ON CONSUMPTION SPENDING )NmATION IN -EXICO IS FALLING BUT SINCE THE CURRENCY HAS BEEN WEAK THE PACE OF DECLINE IS SLOWER THAN IN SOME OTHER COUNTRIES /NE MAJOR POSITIVE ECONOMIC DEVELOPMENT IS THAT -EXICO WAS ABLE TO LOCK IN OIL PRICES AT PER

Fiscal 2010 Investment Plan

BARREL FOR -EXICO IS A BIG PRODUCER OF OIL AND THE OIL INDUSTRY IN -EXICO CONTRIBUTES TO OF GOVERNMENT REVENUES 0RESIDENT &ELIPE #ALDERON HAS AGGRESSIVELY GONE AFTER THE DRUG CARTELS SINCE TAKING OFlCE NEARLY THREE YEARS AGO WITH THE RESULT BEING INCREASED VIOLENCE DUE TO CARTELS lGHTING AGAINST EACH OTHER OR AGAINST THE -EXICAN POLICE 4HE -EXICAN MILITARY HAS BECOME HEAVILY INVOLVED IN THE lGHT BUT THE VIOLENCE WILL CONTINUE FOR SOME TIME 4HE EQUITY MARKET IN -EXICO IS OFF SHARPLY FROM ALL TIME HIGHS /N A STRICTLY VALUATION BASIS THE -EXICAN MARKET IS LOOKING ATTRACTIVE RELATIVE TO THE RECENT PAST 4HE OUTLOOK FOR "RAZIL WILL DEPEND ON COMMODITY PRICES AND VOLUMES AS A SIGNIlCANT PORTION OF THE "RAZILIAN MARKET IS COMPRISED OF COMMODITY COMPANIES 4HE DECLINE IN COMMODITY DEMAND HAS HAD A RIPPLE EFFECT ON INDUSTRIAL PRODUCTION AND CAPACITY UTILIZATION IN THE MANUFACTURING SECTOR 4HIS WAS COMPOUNDED WITH THE LACK OF AVAILABLE lNANCING FOR EXPORT ORIENTED COMPANIES AND IMPORTERS OF "RAZILIAN MANUFACTURED GOODS 4HE GOVERNMENT IS TRYING TO PROP UP THE ECONOMY USING BOTH lSCAL AND MONETARY MEASURES 4HE CENTRAL BANK ALSO HAS ROOM TO LOWER INTEREST RATES GIVEN THE HIGH NOMINAL AND REAL RATES IN THE COUNTRY 4HE lSCAL AND MONETARY SPENDING WILL HELP SOFTEN THE CONTRACTION BUT MOST ECONOMISTS NOW BELIEVE THAT "RAZIL S '$0 WILL CONTRACT SLIGHTLY IN

STRATEGY !S lSCAL DRAWS TO A CLOSE THE INTERNATIONAL PORTFOLIO IS APPROXIMATELY BILLION OR OF TOTAL ASSETS 4HIS REPRESENTS A MODEST OVERWEIGHT RELATIVE TO THE 2ETIREMENT "OARD S NEW AS OF *ULY AVERAGE LONG TERM WEIGHT OF 4HE INTERNATIONAL ASSET CLASS WAS UNDERWEIGHTED THROUGHOUT lSCAL FROM A HIGH OF IN *ULY TO A LOW OF IN /CTOBER AND REMAINED THERE UNTIL THE RALLY IN -ARCH MATERIALIZED !PPROXIMATELY MILLION WAS ADDED TO THE ASSET CLASS DURING THE SHARPEST PART OF THE DECLINE BETWEEN *ULY AND /CTOBER 4HE RANGE FOR EMERGING MARKETS HAS STAYED BETWEEN n FOR THE lSCAL YEAR RANGING FROM A LOW OF IN /CTOBER AND .OVEMBER BEFORE RISING TO MORE NEUTRAL LEVELS IN !PRIL 3TAFF IS PROJECTING A NORMAL RETURN FOR THE 3423 /HIO "LENDED "ENCHMARK FOR THE NEXT MONTHS WITH BOTH THE DEVELOPED AND EMERGING MARKETS RETURNING AT APPROXIMATELY THEIR LONG TERM EXPECTED AVERAGE OF n (OWEVER EVEN THESE RETURNS FOR INTERNATIONAL INVESTMENTS WILL PERFORM IN LINE OR BETTER THAN MOST OTHER MAJOR ASSET CLASSES THEREFORE THE INTERNATIONAL ASSET CLASS WILL LIKELY BE HELD CLOSE TO THE NEUTRAL POINT IN lSCAL ,OOKING AT THE PORTFOLIO FROM A RISK BUDGETING STANDPOINT THE HIGHEST AMOUNT OF RISK IS COMING FROM THE EXTERNAL MANAGERS 4HIS IS DUE IN LARGE PART TO THE LARGE COREn%!&% %UROPE !SIA &AR %AST PRODUCT BEING RUN INTERNALLY 3EVERAL OF THE OTHER INTERNAL PORTFOLIOS ARE BEING RUN VERY ACTIVELY 4HE STAFF DOES NOT ANTICIPATE MUCH OF A CHANGE IN THE ALLOCATION OF RISK ACROSS THE INTERNATIONAL PORTFOLIO IN lSCAL 4HE CHART ON 0AGE SHOWS ALLOCATIONS FOR INTERNALLY MANAGED EXTERNALLY MANAGED DEVELOPED COUNTRY AND EMERGING MARKETS INVESTMENTS !T lSCAL YEAR END WE WILL BE NEAR AN SPLIT BETWEEN THE DEVELOPED AND EMERGING MARKETS WHICH ARE AT THE NEUTRAL POINT SET FOR EACH 3TAFF ANTICIPATES KEEPING THE EMERGING MARKET WEIGHT NEAR THE TARGETED NEUTRAL WEIGHT OF OF TOTAL ASSETS IN lSCAL $EVELOPED MARKETS WILL ALSO BE KEPT NEAR THE NEW NORMAL WEIGHT OF OF TOTAL ASSETS WITH A SLIGHT BIAS TOWARD THE UPSIDE 4HE SPLIT BETWEEN EXTERNALLY AND INTERNALLY MANAGED FUNDS SHOULD CONTINUE TO BE APPROXIMATELY

Fiscal 2010 Investment Plan

FISCAL YEAR-END 2009 (estimated) $ Invested (at Market)

Percent of International Assets

%XTERNAL -ANAGERS

MILLION

)NTERNAL -ANAGERS

MILLION

$12,200 million

100%

$EVELOPED -ARKETS

MILLION

%MERGING -ARKETS

MILLION

$12,200 million

100%

Fiscal 2010 Investment Plan

VIII. Real Estate Investments OUTLOOK Overview !S lSCAL COMES TO A CLOSE THE COMMERCIAL REAL ESTATE MARKET IS IN THE MIDDLE OF A SIGNIlCANT REPRICING !FTER SEVERAL YEARS OF SUPER SIZED RETURNS PRICING REACHED LEVELS THAT WERE UNSUSTAINABLE Â&#x2C6; DUE IN LARGE PART TO THE EASY AND CHEAP AVAILABILITY OF DEBT lNANCING !T THIS TIME LAST YEAR STAFF INDICATED IT EXPECTED RETURNS TO BE SIGNIlCANTLY LOWER AND BELOW THE 2ETIREMENT "OARDgS LONG TERM EXPECTED POLICY AVERAGE (OWEVER THE BREADTH AND DEPTH OF THE lNANCIAL CRISIS WAS NOT YET CLEAR AND THE UNPRECEDENTED RAPIDITY OF DECLINE IN THE COMMERCIAL REAL ESTATE MARKETS WAS NOT ANTICIPATED 0RIVATE MARKET REAL ESTATE AS MEASURED BY THE .ATIONAL #OUNCIL OF 2EAL %STATE )NVESTMENT &IDUCIARIES .#2%)& 0ROPERTY )NDEX OR .0) PEAKED IN THE -ARCH QUARTER 4HE GENERAL CONSENSUS IS THAT THE PEAK TO TROUGH DECLINE WILL BE FROM n TO AS HIGH AS n )N THE LAST FOUR QUARTERS THROUGH -ARCH THE INDEX HAS EXPERIENCED A PRICE DECLINE OF )F AS ANTICIPATED THE COMMERCIAL REAL ESTATE MARKET BOTTOMS NEAR THE END OF lSCAL IT WILL HAVE TAKEN JUST NINE QUARTERS FOR THIS CORRECTION %VEN IF IT EXTENDS SLIGHTLY BEYOND THIS ITS DURATION WILL STILL BE UNPRECEDENTED &OR COMPARISON THE .0) )NDEX RECOGNIZED A DECLINE OVER THE COURSE OF THE S DOWNTURN (OWEVER IT TOOK QUARTERS FOR THAT PRICE CORRECTION TO BE RECOGNIZED -EANWHILE THE ECONOMY WAS IN ITS FOURTH YEAR OF EXPANSION AT THE TIME 4HE RAPID RECOGNITION OF REAL ESTATEgS REPRICING SPEAKS TO THE INCREASED TRANSPARENCY SOPHISTICATION AND BROAD ACCEPTANCE OF REAL ESTATE AS A COMPONENT OF A MULTIASSET CLASS PORTFOLIO OVER THE LAST YEARS )TS IMPROVED STATUS WILL ALLOW THE ASSET CLASS TO RECOVER MORE QUICKLY AS WELL !S WOULD BE EXPECTED PUBLIC MARKET REAL ESTATE 2EAL %STATE )NVESTMENT 4RUSTS OR 2%)4S HAS SEEN AN EVEN GREATER AND MORE RAPID CORRECTION 0EAK TO TROUGH 2%)4S DECLINED ALMOST /VER THE SHORT RUN 2%)4S ACT MORE LIKE EQUITIES AND UNUSUALLY SO OVER THE PAST n MONTHS 2%)4S HAVE THE UNFORTUNATE DISTINCTION OF BEING CONSIDERED PART OF THE TWO WORST SECTORS Â&#x2C6; lNANCIALS AND REAL ESTATE 4HE VOLATILITY EXPERIENCED IN 2%)4S OVER THE LAST YEAR HAS BEEN SIGNIlCANT /UT OF TRADING DAYS ENDING -ARCH THERE HAVE BEEN DAYS WITH PRICE SWINGS GREATER THAN AND DAYS WITH PRICE SWINGS EXCEEDING !S OF LATE -AY THE BENCHMARK RETURN STANDS AT APPROXIMATELY n 3INCE REAL ESTATE RETURNS IN BOTH THE PUBLIC AND PRIVATE MARKET HAVE BEEN DRIVEN MORE BY UPS AND DOWNS IN THE CAPITAL MARKETS RATHER THAN SPACE MARKET FUNDAMENTALS !FTER THIS PERIOD OF CORRECTION WE ANTICIPATE REAL ESTATE WILL RETURN TO ITS LONG TERM TREND OF ROUGHLY OF ITS RETURN ATTRIBUTABLE TO THE INCOME COMPONENT AND ATTRIBUTABLE TO THE CAPITAL PRICE COMPONENT 4RANSACTION VOLUME IN THE PRIVATE REAL ESTATE MARKETPLACE HAS CONTINUED TO PLUMMET FROM THE PEAK OF SALES IN TO SALES IN THEN DOWN TO AN ANNUALIZED RATE OF FOR BASED ON THE PALTRY SALES IN THE .0) IN THE -ARCH QUARTER 4HIS REPRESENTS AN DECLINE OVER THE AVERAGE ANNUAL SALES OF FROM TO 4YPICALLY SALES SLOW SIGNIlCANTLY WHEN THE MARKET IS GOING THROUGH A DOWNWARD ADJUSTMENT 3ELLERS ARE SLOW TO ACCEPT THE CHANGE IN THE CAPITAL MARKETS AND BUYERS ARE TESTING TO lND THE BOTTOM WHICH CREATES A WIDE PRICING GAP MAKING IT DIFlCULT FOR TRANSACTIONS TO TAKE PLACE (OWEVER THE CURRENT DECLINE IS ANYTHING BUT TYPICAL )N THE LAST BIG REAL ESTATE DOWNTURN OF THE EARLY S THE RATE OF DECLINE IN SALES WAS ONLY ABOUT FROM THE PREVIOUS THREE YEAR AVERAGE 4HIS DEMONSTRATES THE SIGNIlCANT IMPACT THE FREEZING OF THE CREDIT MARKETS OVER THE LAST YEAR HAS HAD ON REAL ESTATE AND WHY VALUATIONS HAVE DECLINED SO SWIFTLY AND DRAMATICALLY 2EAL ESTATE VALUES LAG CURRENT TRANSACTION PRICING EVEN IN TIMES OF HIGH TRANSACTION ACTIVITY 4HE DEARTH OF TRANSACTIONS IN THE MARKETPLACE TODAY WOULD NORMALLY MAKE AN APPRAISAL BASED INDEX SUCH AS .0) LESS RELIABLE !PPRAISERS RELY ON TRANSACTIONS ON WHICH TO BASE INPUTS TO THEIR VALUATION MODEL 7HEN SALES ARE SLOW IT TAKES QUITE AWHILE FOR CURRENT PORTFOLIOS TO REmECT THE REALITY OF THE MARKETPLACE AS WAS THE CASE IN THE S (OWEVER THE APPRAISAL COMMUNITY WANTS TO GET AHEAD OF THE CURVE THIS

Fiscal 2010 Investment Plan

TIME AND IS NOT WAITING FOR TRANSACTIONS TO OCCUR )T IS USING OTHER METHODS TO DEVELOP INPUTS TO VALUATION MODELS AND ERRING ON THE SIGN OF CONSERVATISM IF NECESSARY 'IVEN THE REPRICING OF RISK ACROSS ASSET CLASSES IT IS DIFlCULT TO ARGUE THAT REAL ESTATE WILL NOT BE REPRICED TO THE SAME DEGREE AS OTHER ASSETS HENCE THE ALMOST DECLINE OVER THE LAST MONTHS WITH MORE EXPECTED OVER THE NEXT YEAR !S TRANSACTIONS BEGIN TO OCCUR THIS WILL HELP TO BRING CLARITY TO VALUATIONS OF EXISTING ASSETS )N lSCAL STAFF ANTICIPATES A BLENDED BENCHMARK TOTAL RETURN BETWEEN n AND n WHICH REmECTS UP TO A PRICE DECLINE FOR PRIVATE MARKET REAL ESTATE (OWEVER WE EXPECT TRANSACTION PRICING ON NEW ACQUISITIONS TO BE ABOVE THE LONG TERM EXPECTED RETURN FOR THE ASSET CLASS OF

Property Markets 'IVEN THE EXTRAORDINARY JOB LOSSES AND RETRENCHMENT BY THE CONSUMER OVERALL DEMAND FOR SPACE ACROSS ALL PROPERTY TYPES IS DOWN 0ROPERTY FUNDAMENTALS WILL SEE FURTHER WEAKENING AS THE CONTRACTION CONTINUES OVER THE COURSE OF THE YEAR 6ACANCY RATES WILL CONTINUE TO RISE FORCING LANDLORDS TO REDUCE RENTAL RATES TO KEEP EXISTING TENANTS AND ATTRACT NEW ONES 4HIS WILL RESULT IN DECLINING REVENUE STREAMS ,ANDLORDS WILL FOCUS ON MANAGING THEIR RENT ROLLS TO GET THROUGH THE NEXT FEW YEARS WITH MINIMAL TURNOVER IN TENANCY WHICH IS COSTLY IN THIS KIND OF ENVIRONMENT 4O OFFSET THE DECLINING REVENUES THERE WILL BE A RENEWED FOCUS ON ASSET MANAGEMENT TO MAINTAIN TIGHT OPERATING BUDGETS AND REDUCE OR ELIMINATE NONCRITICAL CAPITAL IMPROVEMENTS /N THE SUPPLY SIDE MOST MAJOR MARKETS ARE NOT SIGNIlCANTLY OVERSUPPLIED WHICH IS A KEY DIFFERENCE FROM THE REAL ESTATE DOWNTURN OF THE S .EW SUPPLY HAS BEEN CONSTRAINED IN MOST MARKETS DUE TO SEVERAL YEARS OF HIGH CONSTRUCTION COSTS BEFORE THE RECESSION AS WELL AS THE MORE RECENT SHUTDOWN OF THE DEBT MARKETS )T IS EXPECTED THAT DEBT lNANCING WILL CONTINUE TO BE DIFlCULT TO OBTAIN 4HIS WILL IMPACT THE PIPELINE OF NEW SUPPLY FOR THE NEXT SEVERAL YEARS AND COULD LEAD TO DEMAND OUTSTRIPPING SUPPLY WHEN THE ECONOMY IMPROVES !NY IMBALANCE WILL LEAD TO A MORE RAPID IMPROVEMENT IN THE PROPERTY FUNDAMENTALS AND THUS THE OVERALL REAL ESTATE MARKET .OT SURPRISINGLY THE retail SECTOR HAS BEEN PARTICULARLY HARD HIT BY THE CURRENT RECESSION 4HE PERFECT STORM OF JOB LOSSES NEGATIVE WEALTH EFFECT IN THE EQUITY AND HOUSING MARKETS TIGHT CREDIT AND NEGATIVE SENTIMENT HAVE ALL CONTRIBUTED TO SHARPLY CONTRACTING CONSUMER SPENDING !S A RESULT TENANT BANKRUPTCIES OF WELL KNOWN NAMES AND BRANDS HAVE BEEN PLENTIFUL AND ARE EXPECTED TO CONTINUE AND PERHAPS ACCELERATE OVER THE COMING YEAR !DDITIONALLY MOST RETAILERS HAVE SIGNIlCANTLY CURTAILED OR CANCELLED STORE EXPANSION PLANS !CCORDING TO 2%)3 RESEARCH NEGATIVE ABSORPTION IN THE RETAIL SECTOR IN THE -ARCH QUARTER WAS THE WORST QUARTER SINCE IT BEGAN TRACKING IT IN !S A RESULT RETAIL SALES WILL CONTINUE TO BE WEAK IN lSCAL /F THE TENANTS THAT DO REMAIN IN BUSINESS MANY ARE TAKING ADVANTAGE OF THE ENVIRONMENT TO SEEK UNILATERAL REDUCTIONS IN RENT /WNERS FEARING LARGE HOLES IN THEIR CENTERS ARE RELENTING AND NEGOTIATING WITH TENANTS WHICH ALSO IMPACTS LEASING RATES FOR NEW TENANTS 4HE COMBINATION OF LOWER SALES RENT REDUCTIONS AND REDUCED CONSUMER SPENDING WILL REDUCE OPERATING INCOME IN THE RETAIL SECTOR !LTHOUGH NEW SUPPLY WAS ADDED IN THAT NEGATIVELY IMPACTED THE SECTOR NEW DEVELOPMENT IS EXPECTED TO REMAIN AT EXTREMELY LOW LEVELS FOR THE NEXT FEW YEARS 5NTIL THEN ANY DEMAND FOR THE FEW TENANTS THAT ARE GROWING CAN BE MET BY EXISTING VACANCIES OR BY OTHER RETAILERS LOOKING TO DOWNSIZE 4HIS WILL HELP TO BRING THE SUPPLY DEMAND EQUATION INTO BETTER BALANCE 3OME CATEGORIES WITHIN THE RETAIL SECTOR HAVE ACTUALLY BENElTTED FROM THE DOWNTURN OR ARE AT LEAST PERFORMING WELL ON A RELATIVE BASIS h6ALUEv IS IN hLUXURYv IS OUT 'OING FORWARD THE SAFEST AREA FOR INVESTMENT IS LIKELY TO BE WELL LOCATED NEIGHBORHOOD AND COMMUNITY CENTERS WITH A STRONG GROCER DRUG ANCHOR 4HE hNECESSITY BASEDv RETAIL THAT THESE CENTERS PROVIDE CONSUMERS SHOULD RESULT IN STRONGER OPERATIONAL PERFORMANCE OVER THE NEXT FEW YEARS 4HE office SECTOR FUNDAMENTALS HAVE DETERIORATED RAPIDLY IN THE WAKE OF THE lNANCIAL CRISIS #LEARLY THE SIGNIlCANT JOB LOSSES IN THE lNANCIAL SERVICES INDUSTRY HAVE HAD A TREMENDOUS IMPACT ON THIS SECTOR (OWEVER ALMOST NO INDUSTRY IS UNAFFECTED BY THIS DOWNTURN AND MANY BUSINESSES ARE REDUCING

Fiscal 2010 Investment Plan

HEADCOUNT AND DOWNSIZING THEIR SPACE REQUIREMENTS !S THE ECONOMY CONTINUES TO SHED JOBS OFlCE VACANCIES WILL CONTINUE TO RISE )T IS POSSIBLE VACANCY RATES COULD REACH AS HIGH AS THOSE EXPERIENCED IN THE S DOWNTURN 4HIS WILL LEAD TO FURTHER DETERIORATION IN RENTAL RATES /FlCES IN #ENTRAL "USINESS $ISTRICTS #"$ HAVE HISTORICALLY OUTPERFORMED THEIR SUBURBAN COUNTERPARTS 'IVEN THE HEAVY CONCENTRATION OF lNANCIAL lRMS IN #"$S WE WOULD EXPECT THESE MARKETS TO UNDERPERFORM IN lSCAL &ROM A DEMAND PERSPECTIVE THE OFlCE SECTOR WILL BE THE LAST TO RECOVER 7HILE THERE IS LITTLE NEW SUPPLY COMING ONLINE IN lSCAL THE SIGNIlCANT DROP OFF IN DEMAND AS WELL AS THE EXCESS SPACE BUSINESSES ARE PUTTING ON THE MARKET FOR SUBLEASE WILL FURTHER INCREASE THE DOWNWARD PRESSURE ON RENTAL RATES /NE MITIGATING FACTOR IS MANY LEASES THAT WILL BE COMING UP FOR RENEWAL WERE SIGNED BEFORE THE RAPID RUN UP IN RATES WHICH WILL HELP TO SOFTEN THE DECLINING INCOME FROM THESE ASSETS AS LEASES ROLL TO MARKET RATES 4HE apartment SECTOR IS DRIVEN BY JOB GROWTH AND HOUSEHOLD FORMATION 7ITH THE MOUNTING JOB LOSSES AND SLOWING HOUSEHOLD FORMATION DEMAND FOR APARTMENTS HAS FALLEN 4HERE IS ALSO COMPETITION FROM VACANT SINGLE FAMILY HOMES ALTHOUGH THIS IS PRIMARILY CONCENTRATED IN A FEW LARGE MARKETS THAT WERE THE MOST OVERBUILT !S A RESULT RENTAL RATES HAVE DECLINED AND LANDLORDS ARE FORCED TO OFFER MORE CONCESSIONS TO MAINTAIN OCCUPANCY )NCOME IN THE APARTMENT SECTOR TYPICALLY EXPERIENCES SHARPER DECLINES GIVEN THE SHORT TERM NATURE OF APARTMENT LEASES 4HIS IS EXPECTED TO CONTINUE INTO lSCAL #ONVERSELY APARTMENT REVENUES CAN TURN AROUND MORE QUICKLY IN A RECOVERY #ONSTRUCTION STARTS HAVE COLLAPSED AND lNANCING FOR NEW DEVELOPMENT IS ALMOST NONEXISTENT 4HIS WILL SHRINK NEW SUPPLY SHARPLY OVER THE NEXT SEVERAL YEARS 4OUGHER UNDERWRITING STANDARDS FOR HOMEOWNERSHIP AND NEW HOUSEHOLD FORMATIONS BY THE ECHO BOOMERS THAT ARE STILL ENTERING THEIR PRIME LEASING YEARS WILL HELP TO INCREASE DEMAND AS THE ECONOMY IMPROVES AND NEW JOBS ARE ADDED 4HERE CONTINUES TO BE SUPPORT FROM &ANNIE -AE AND &REDDIE -AC FOR lNANCING IN THIS SECTOR UNLIKE THE OTHER AREAS OF COMMERCIAL REAL ESTATE WHERE DEBT lNANCING IS DIFlCULT AT BEST 4HIS SHOULD HELP TRANSACTIONAL ACTIVITY TO RECOVER IN THE APARTMENT SECTOR MAKING IT THE lRST AREA OF COMMERCIAL REAL ESTATE TO REBOUND (OWEVER WE ANTICIPATE TRANSACTIONS WILL ALSO REMAIN SLOW IN THIS SECTOR THROUGH THE lRST HALF OF lSCAL 4HE industrial property SECTOR IS DEPENDENT ON ECONOMIC GROWTH THE PRODUCTION AND CONSUMPTION OF GOODS AND GLOBAL TRADE .OT SURPRISINGLY GIVEN THE DOWNWARD SPIRAL IN ALL THESE AREAS THIS SECTOR HAS SUFFERED SIGNIlCANTLY !CCORDING TO 4ORTO 7HEATON 2ESEARCH THE NATIONAL INDUSTRIAL VACANCY RATE HIT IN THE -ARCH QUARTER WHICH IS THE HIGHEST VACANCY SINCE THE lRM BEGAN TRACKING IT IN 4HE HARDEST HIT MARKETS ARE WHERE THE HOUSING CRISIS AND RATE OF FORECLOSURES HAVE BEEN THE MOST SEVERE (OWEVER THE DECLINE IN GLOBAL TRADE HAS HAD A SIGNIlCANT IMPACT ON THE COASTAL MARKETS AS WELL )NCREASES IN VACANCY ARE ALWAYS FOLLOWED BY REDUCTIONS IN RENTAL RATES ALTHOUGH THIS DECLINE DOES NOT SEEM TO BE AS PRECIPITOUS AS THE DECLINE IN THE DOWNTURN 4HIS IS LIKELY DUE TO THE RAPID REDUCTION OF NEW SUPPLY COMING ONLINE 3CHEDULED DELIVERIES FOR WERE LESS THAN OF THE EXISTING INVENTORY OF INDUSTRIAL SPACE WHICH IS LOW BY HISTORICAL STANDARDS /VERALL DEMAND FOR INDUSTRIAL SPACE WILL REMAIN WEAK IN THE NEAR TERM BUT OVER THE LONG RUN THIS SECTOR PROVIDES A RELATIVELY STEADY INCOME STREAM WITH LOWER OVERALL VOLATILITY

Returns 4HE CHART ON 0AGE DEMONSTRATES THE CHANGES IN PRIVATE REAL ESTATE RETURNS OVER THE LAST THREE YEARS &OR COMPARISON JUST LAST YEAR THE PRICE APPRECIATION COMPONENT WAS FOR ITS THREE YEAR AVERAGE 4HE PRICE DECLINE OVER THE LAST MONTHS IS UNPRECEDENTED RESULTING IN NEGATIVE PRICE APPRECIATION OF n FOR THE CURRENT THREE YEAR AVERAGE /VER THE LONG TERM INCOME ACCOUNTS FOR APPROXIMATELY OF THE TOTAL RETURN FOR REAL ESTATE !S THE MARKETS GET PAST THIS CURRENT CORRECTION WE WOULD EXPECT THE INCOME AND PRICE COMPONENTS TO RETURN TO THEIR LONG TERM HISTORICAL RELATIONSHIP 4HE .0) ACCOUNTS FOR OF THE REAL ESTATE BLENDED BENCHMARK

Fiscal 2010 Investment Plan

NCREIF Property Index (NPI) One Year Ending

Income

Price

Total

Three-Year Average Annual

5.6%

â&#x20AC;&#x201C;1.4%

4.16%

2EAL ESTATE RETURNS ARE DRIVEN BY BOTH THE UNDERLYING PROPERTY FUNDAMENTALS AND THE CAPITAL MARKETS !S HAS BEEN THE CASE FOR SEVERAL YEARS THE CAPITAL MARKETS HAVE BEEN THE PRIMARY DRIVER OF RETURNS 4HIS IS EXPECTED TO CONTINUE IN lSCAL 7HILE MUCH OF THE FOCUS TO DATE HAS BEEN ON THE CAPITAL SIDE THE CONTINUED WEAKNESS IN THE OPERATING FUNDAMENTALS WILL ALSO PUT DOWNWARD PRESSURE ON RETURNS OVER THE NEXT YEAR 2EAL ESTATE IS IN THE EARLY STAGE OF THE CONTRACTION PHASE OF ITS CYCLE AS THE SECTOR LAGS THE OVERALL ECONOMY 4HE SPACE MARKETS WILL CONTINUE TO FEEL THE IMPACT OF THE RECESSION OVER THE COURSE OF lSCAL EVEN AS THE OVERALL ECONOMY BEGINS TO IMPROVE 7E ANTICIPATE A BLENDED BENCHMARK TOTAL RETURN FOR THE ASSET CLASS BETWEEN n AND n IN lSCAL WHICH REmECTS UP TO A PRICE DECLINE FOR PRIVATE MARKET REAL ESTATE (OWEVER WE EXPECT TRANSACTION PRICING ON NEW ACQUISITIONS TO BE ABOVE THE LONG TERM EXPECTED RETURN FOR THE ASSET CLASS 4HE BEAR MARKET IN 2%)4S THAT BEGAN IN -ARCH HAD SHOWN SIGNS OF STABILIZING DURING SUMMER (OWEVER ,EHMAN S FAILURE IN 3EPTEMBER AND THE ENSUING CREDIT CRISIS LED TO THE NEXT LEG DOWN AND 2%)4S LOST NEARLY TWO THIRDS OF THEIR VALUE IN LESS THAN TWO MONTHS ! DOUBLE BOTTOM WAS PUT IN LAST FALL AND THIS -ARCH SETTING THE STAGE FOR A ROBUST RALLY IN THE STOCKS 7HILE THE STOCKS HAVE RECOVERED SOMEWHAT THE SLIDE IN PROPERTY FUNDAMENTALS IS JUST NOW HITTING THE PROPERTY SECTORS WITH LONGER LEASE TERMS LIKE OFlCE AND RETAIL 7E ANTICIPATE CONTINUED DETERIORATION IN EARNINGS OVER THE NEXT FEW QUARTERS AS LOWER TENANT DEMAND SHOWS UP IN THE FORM OF LOWER RENTS AND OCCUPANCIES #ONVERSELY THE SHORTER LEASE TERM SECTORS LIKE APARTMENTS MAY HAVE ALREADY BOTTOMED AND COULD ACTUALLY BEGIN TO IMPROVE MIDWAY THROUGH THE lSCAL YEAR )RRESPECTIVE OF EARNINGS THE 2%)4 INDUSTRY LIKE MANY OTHERS IS IN FOR AN EXTENDED PERIOD OF DELEVERAGING WHICH WILL RETURN THE SECTOR TO A MORE CONSERVATIVE BUSINESS MODEL !SSUMING A GRADUAL RECOVERY IN BOTH THE ECONOMY AND CREDIT MARKETS WE EXPECT 2%)4S TO GENERATE TOTAL RETURNS IN THE MID SINGLE DIGITS TO MID TEENS OVER THE NEXT MONTHS WITH THE SPLIT ROUGHLY EQUAL BETWEEN DIVIDENDS AND APPRECIATION )F THE ECONOMIC RECOVERY IS STRONGER THAN ANTICIPATED THE VERY LOW LEVEL OF NEW CONSTRUCTION OVER THE PAST TWO YEARS COULD CREATE A SUPPLY DEMAND IMBALANCE THAT WOULD GENERATE OUTSIZED POSITIVE RETURNS FOR THE STOCKS 4HIS COULD EVEN COME IN THE FACE OF SOME VERY NEGATIVE HEADLINE NEWS ABOUT OVERLEVERAGED REAL ESTATE OWNERS FORCED INTO DISTRESSED SALE SITUATIONS AS WELL AS BANKS TAKING WRITE DOWNS ON THEIR COMMERCIAL REAL ESTATE LOAN PORTFOLIOS

STRATEGY Allocation 3TAFF PROJECTS ENDING lSCAL WITH APPROXIMATELY BILLION IN REAL ESTATE 4HIS REmECTS A PROJECTED WEIGHTING WHICH IS THE NEUTRAL WEIGHT FOR THE ASSET CLASS !S STAFF EXPECTS CONTINUED NEGATIVE PRICE APPRECIATION OVER THE COURSE OF lSCAL THE PORTFOLIO IS PROJECTED TO BE APPROXIMATELY BILLION AT THE END OF lSCAL EXCLUDING ANY ACQUISITIONS OR DISPOSITIONS 4HIS IMPLIES A BELOW NEUTRAL WEIGHT OF APPROXIMATELY

Fiscal 2010 Investment Plan

!NTICIPATED GROWTH AT THE TOTAL FUND LEVEL INDICATES POTENTIAL CAPACITY OF UP TO MILLION IN NEW ALLOCATION TO REAL ESTATE FOR lSCAL TO MAINTAIN A NEUTRAL WEIGHTING n IN THE ASSET CLASS !S MENTIONED EARLIER PRICING IN lSCAL FOR NEW REAL ESTATE ACQUISITIONS IS ANTICIPATED TO BE ABOVE THE LONG TERM EXPECTED RETURN FOR THE ASSET CLASS 4RANSACTION ACTIVITY IS EXPECTED TO REMAIN EXTREMELY LOW DURING THE lRST HALF OF THE lSCAL YEAR (OWEVER WITH INCREASED ACTIVITY IN THE SECOND HALF STAFF ANTICIPATES ATTRACTIVE BUYING OPPORTUNITIES WILL EMERGE

Diversification Public Investment (REITs) 7ITH THE BIG DROP IN VALUES LAST FALL THE 2%)4 ALLOCATION IS LESS THAN OF TOTAL REAL ESTATE AS OF THE END OF -AY VERSUS ITS NEUTRAL WEIGHT !LTHOUGH STAFF EXPECTS 2%)4S TO OUTPERFORM PRIVATE REAL ESTATE IN lSCAL WITH THE ASSET CLASS AS A WHOLE AT ITS NEUTRAL WEIGHT WE EXPECT TO BE BELOW THE NEUTRAL WEIGHT IN 2%)4S FOR THE EARLY PART OF THE lSCAL YEAR !S ALLOCATION BECOMES AVAILABLE STAFF WOULD EXPECT TO MOVE TOWARD AT LEAST A NEUTRAL POSITION DURING THE lSCAL YEAR Private Investment Geographic !S SHOWN IN THE TABLE BELOW THE PORTFOLIO IS DIVERSIlED ACROSS THE FOUR REGIONS WITH THE -IDWEST HAVING A SIGNIlCANT OVERWEIGHT 4HE LAST ACQUISITION IN WAS A SIGNIlCANT ASSET IN #HICAGO THAT INCREASED THE ALLOCATION TO THE -IDWEST 4HE -IDWEST AND 3OUTH REGIONS INCREASED BOTH THEIR ABSOLUTE AND RELATIVE WEIGHTINGS WITH A DECREASE IN BOTH THE %AST AND 7EST REGIONS 4HE COASTAL REGIONS HAD THE LARGEST RUN UP IN PRICES OVER THE LAST SEVERAL YEARS SO IT IS NOT SURPRISING TO HAVE HIGHER DEPRECIATION IN THOSE REGIONS NOW 4HE -IDWEST REGION SHOWED A SIGNIlCANT INCREASE FROM LAST YEAR ON A RELATIVE BASIS WITH THE OTHER REGIONS HAVING ONLY SLIGHT CHANGES Geographic Diversification (Core Only) (estimate as of 06/30/09) STRS Ohio

STRS Ohio vs. NPI

%AST

-IDWEST

3OUTH

7EST

3TAFF WILL CONTINUE TO FOCUS PORTFOLIO HOLDINGS AND THUS ACQUISITIONS IN MAJOR METROPOLITAN MARKETS ACROSS THE COUNTRY TO PROVIDE FOR DIVERSIlCATION Â&#x2C6; BOTH GEOGRAPHIC AND ECONOMIC -AJOR MARKETS ARE EMPHASIZED GIVEN THE NEED TO HOLD A MIXED PORTFOLIO WITH CRITICAL MASS TO ENABLE EFlCIENT ASSET MANAGEMENT AS WELL AS TO BENElT FROM THE INCREASED LIQUIDITY TYPICALLY FOUND IN THESE MARKETS 3TAFF IS COMFORTABLE WITH THE UNDERWEIGHT IN THE 3OUTH HOWEVER WE WILL LOOK TO INCREASE OUR WEIGHTING IN THE 7EST THROUGH ACQUISITIONS IN THE REGION 7HILE NO DISPOSITIONS ARE SPECIlCALLY PLANNED WE MAY LOOK FOR OPPORTUNISTIC SALES LATE IN THE lSCAL YEAR ESPECIALLY IN THE -IDWEST AS A WAY TO REDUCE OUR EXPOSURE IN THE REGION

Fiscal 2010 Investment Plan

Property Type !CTIVE REBALANCING IS ACCOMPLISHED THROUGH BOTH ACQUISITIONS AND DISPOSITIONS (OWEVER GIVEN THE OVERWEIGHT IN THE ASSET CLASS OVER THE COURSE OF THE YEAR AND THE COMPLETE SHUTDOWN OF THE TRANSACTION MARKET THERE WAS NO OPPORTUNITY TO ACTIVELY REBALANCE THE PORTFOLIO IN lSCAL 4HE TABLE BELOW DETAILS 3423 /HIO S WEIGHTINGS IN THE FOUR PROPERTY SECTORS AS WELL AS THE COMPARISON TO THE BENCHMARK 4HE ABSOLUTE AND RELATIVE WEIGHTING OF BOTH THE APARTMENT AND INDUSTRIAL SECTORS IN 3423 /HIOgS PORTFOLIO INCREASED SINCE LAST YEAR AT THIS TIME 4HE INDUSTRIAL SECTOR IS NEUTRAL TO THE BENCHMARK APARTMENTS ARE OVERWEIGHT #ORRESPONDINGLY BOTH THE RETAIL AND OFlCE SECTORS FELL ON BOTH AN ABSOLUTE AND RELATIVE BASIS WITH RETAIL HAVING A SIGNIlCANT UNDERWEIGHT IN THE PORTFOLIO Property Type Diversification (Core Only) (estimate as of 06/30/09) STRS Ohio

STRS Ohio vs. NPI

!PARTMENT

)NDUSTRIAL

/FlCE

2ETAIL

4HE LARGEST ABSOLUTE AND RELATIVE OVERWEIGHT IN THE PORTFOLIO IS IN THE OFlCE SECTOR !S DISCUSSED LAST YEAR STAFF HAD BEEN PRUNING THE OFlCE PORTFOLIO DOWN TO WHAT IT BELIEVES ARE THE BEST PERFORMING OFlCE ASSETS OVER THE LONG TERM 7ITH A FEW EXCEPTIONS THIS GOAL WAS LARGELY ACCOMPLISHED BEFORE THE SHUTDOWN IN THE MARKETS 3TAFF ALSO INDICATED LAST YEAR THAT WITH JOB LOSSES AND A SLOWING ECONOMY THE OFlCE SECTOR WAS POISED FOR A PULLBACK GIVEN THE SIGNIlCANT RUN UP IN PRICES /BVIOUSLY THE EXTENT OF THE PULLBACK HAS BEEN MUCH GREATER THAN ANTICIPATED WHICH HAS BEEN A DRAG ON THE OVERALL PORTFOLIO RETURNS 4HE PORTFOLIO HAS BEEN IMPACTED BY THE JOB LOSSES IN THE lNANCIAL SECTOR BUT THE MAJORITY OF THESE ASSETS ARE LOCATED IN SUPPLY CONSTRAINED MARKETS 4HIS SHOULD ALLOW FOR A SHORTER RECOVERY TIME TO REACH EQUILIBRIUM VERSUS OTHER MARKETS ONCE THE JOB MARKET IMPROVES 7HILE WE ARE NOT LOOKING TO INCREASE THE NET ALLOCATION TO OFlCE WE WILL LOOK TO TRADE UP SOME OF THE ASSETS IN THE PORTFOLIO FOR HIGHER QUALITY ASSETS THAT MAY BE IN DISTRESS DUE TO THE SELLERgS CAPITAL STRUCTURE OR ARE OTHERWISE ATTRACTIVELY PRICED 7HILE THE INDUSTRIAL SECTOR IS WEIGHTED EQUALLY TO THE BENCHMARK WE WILL FOCUS EFFORTS ON INCREASING ITS TOTAL ALLOCATION AS OPPORTUNITIES ARISE )T IS DIFlCULT TO BUILD AN INDUSTRIAL PORTFOLIO AS THE INDIVIDUAL ASSET SIZES TEND TO BE SMALLER HOWEVER WE WILL CONCENTRATE ON ADDING TO THIS AREA ESPECIALLY IN THE 7EST REGION WHERE WE ARE SIGNIlCANTLY UNDERREPRESENTED 4HE PORTFOLIO IS OVERWEIGHT IN THE APARTMENT SECTOR HOWEVER WE ARE UNDERREPRESENTED IN THE %AST REGION OUTSIDE OF THE .EW 9ORK #ITY MARKET 7E WILL LOOK TO INCREASE INVESTMENT IN THE OTHER MAJOR %AST REGION MARKETS 4HE LARGEST BET IN THE PORTFOLIO IS THE SIGNIlCANT UNDERWEIGHT IN THE RETAIL SECTOR (OWEVER GIVEN THE OUTLOOK FOR CONSUMER SPENDING AND THE POOR HEALTH OF RETAILERS OVER THE NEAR TO MID TERM WE ARE NOT AS CONCERNED WITH THE LEVEL OF THE UNDERWEIGHT )T SHOULD BE NOTED RETAIL SECTOR PRICING DID NOT RUN UP AS HIGH AS THE OTHER PROPERTY TYPES SO IT HAS LESS TO FALL FROM A CAPITAL PRICE PERSPECTIVE 4HIS MAY HELP TO SOFTEN THE BLOW FOR POOR OPERATING RESULTS 7E WILL CONSIDER RETAIL THAT IS MORE DEFENSIVE IN NATURE SUCH AS GROCERY ANCHORED NEIGHBORHOOD CENTERS

Fiscal 2010 Investment Plan

Property Life Cycle !S THE CONTRACTION PHASE OF THE CYCLE IS EXPECTED TO CONTINUE THROUGHOUT lSCAL STAFF ANTICIPATES EMPHASIZING DEFENSIVE ORIENTED INVESTMENT OPPORTUNITIES I E HIGH QUALITY OPERATING PROPERTIES WITH STABLE RENT ROLL 4HIS WOULD EFFECTIVELY EXCLUDE INVESTMENT IN DEVELOPMENT ASSETS OR THOSE WITH SIGNIlCANT VACANCY OR LEASE ROLLOVER IN THE NEAR TERM (OWEVER IF PRICED ACCORDINGLY HIGH QUALITY ASSETS IN STRONG MARKETS WITH SOME TENANCY RISK MAY BE APPROPRIATE

Leverage !S OF -ARCH THE LEVERAGE RATIO IS APPROXIMATELY 4HIS WILL INCREASE SLIGHTLY BY THE END OF THE lSCAL YEAR AS WELL AS INTO THE lRST HALF OF lSCAL !PPROXIMATELY TWO THIRDS OF THE LEVERAGE IS RELATED TO JOINT VENTURE INVESTMENTS 4HE REMAINING ONE THIRD IS RELATED TO ASSETS WHOLLY OWNED BY 3423 /HIO AND IS SPLIT BETWEEN ASSET LEVEL lNANCING AND A CREDIT FACILITY MILLION )N -AY THE FACILITY WAS INCREASED MILLION AND EXTENDED FOR AN ADDITIONAL YEAR AT AN ATTRACTIVE INTEREST RATE 7E WILL CONTINUE TO MANAGE THE USE OF LEVERAGE IN THE PORTFOLIO BELOW THE POLICY LIMIT OF

International 4HE INTERNATIONAL PORTFOLIO CURRENTLY STANDS AT OF TOTAL REAL ESTATE !S OF THE END OF lSCAL THE PORTFOLIO WILL ENCOMPASS FUNDS WITH MANAGERS .INE FUNDS ARE IN THE INVESTMENT STAGE WHILE FUNDS HAVE COMPLETED THEIR INVESTMENT PROGRAMS AND ARE ACTIVELY POSITIONING THEIR PORTFOLIOS FOR SALE ONCE THE MARKETS RECOVER 7HILE SEVERAL INVESTMENTS WERE EXPLORED DURING THE YEAR INCLUDING OPPORTUNITIES IN "RAZIL AND %ASTERN %UROPE COMMITTING TO NEW MANAGERS AND NEW REGIONS AMID THE GLOBAL ECONOMIC UNCERTAINTY WAS NOT WARRANTED 4WO NEW COMMITMENTS TOTALING MILLION WERE MADE EARLY IN THE YEAR TO EXISTING MANAGERS WITH !SIA AND 7ESTERN #ENTRAL %UROPE MANDATES !T lSCAL YEAR END UNFUNDED COMMITMENTS WILL TOTAL MILLION 4HE LARGE BALANCE IS THE RESULT OF THE MANAGERS EXHIBITING CAUTION AND MAKING FEW INVESTMENTS THROUGHOUT THE TUMULTUOUS YEAR 4HIS HAS POSITIONED THE PORTFOLIO TO PARTICIPATE IN THE OPPORTUNITIES THAT ARE EXPECTED TO ARISE IN THE NEXT n MONTHS 4HE mOOD OF CAPITAL WHICH LEAD TO HISTORICAL LOW CAP RATES AND UNSUSTAINABLE PRICING MEANS THE RECEDING mOW WILL CAUSE CAP RATES TO RISE AND VALUES TO FALL TO A NEW SUSTAINABLE LEVEL 7HAT THE NEW LEVEL WILL BE REMAINS TO BE SEEN WITH THE UNDERLYING UNCERTAINTY DRIVING VOLATILITY 4HE DEPTH AND BREADTH OF THE CRISIS PRESENTS A CHALLENGING ENVIRONMENT IN WHICH TO UNDERWRITE NEW INVESTMENTS 4HE MANAGERS WITH WHOM WE HAVE INVESTED EXHIBITED STRONG ACUMEN BY INVESTING LESS THAN OF AVAILABLE CAPITAL DURING THE LAST lSCAL YEAR 4HE REDUCED lNANCIAL CAPACITY OF BUYERS MEANT THAT FUNDS WERE UNABLE TO EXIT FROM INVESTMENTS MADE IN THE PRIOR TWO TO THREE YEARS THUS INCREASING THE EXPOSURE OF THE PORTFOLIO TO THE CORRECTION IN PRICING 4HE RESULT HAS BEEN A DRAMATIC REDUCTION IN DISTRIBUTIONS AND ON AVERAGE INVESTMENTS DECLINES OF IN VALUE WITH FURTHER WRITE DOWNS ANTICIPATED IN THE NEAR TERM (OWEVER RECOVERY IN ASSET PRICING IS ANTICIPATED IN AND BEYOND AS FUNDAMENTALS AND LIQUIDITY IMPROVE 4HE PORTFOLIO IS WELL POSITIONED IN STRONG MARKETS IN DEVELOPED ECONOMIES AND lRST TIER CITIES OF EMERGING ECONOMIES $URING THE NEXT n MONTHS AS ECONOMIES STRUGGLE TO STABILIZE STRONG BANKING RELATIONSHIPS AND OPERATING SKILLS WILL BE PARAMOUNT TO NEGOTIATE WITH LENDERS TO RESTRUCTURE RElNANCE LOANS /UR MANAGERS POSSESS BOTH THESE ATTRIBUTES WHICH BETTER ENABLE THEM TO POSITION THE ASSETS TO PARTICIPATE IN THE RECOVERY ANTICIPATED IN THE MID TO LONG TERM

Fiscal 2010 Investment Plan

RETURN EXPECTATIONS FOR FISCAL 2010 ACQUISITIONS 10-Year HoldingPeriod Return

Overall Relative Risk

Property

Type

Strategy

Priority

Stabilized Yield

2ETAIL

#OMMUNITY #TR

3TABLE

,OW

-ODERATE TO (IGH

6ALUE !DD

,OW

(IGH

.EW $EVELOPMENT

,OW

(IGH

.EIGHBORHOOD #TR

3TABLE

-EDIUM

-ODERATE

6ALUE !DD

,OW

-ODERATE TO (IGH

.EW $EVELOPMENT

,OW

-ODERATE TO (IGH

-ULTIFAMILY

3TABLE

-EDIUM TO (IGH

,OW TO -ODERATE

6ALUE !DD

,OW

(IGH

.EW $EVELOPMENT

,OW

(IGH

)NDUSTRIAL

3TABLE

-EDIUM TO (IGH

-ODERATE

.EW $EVELOPMENT

,OW

(IGH

/FlCE

3TABLE

-EDIUM

-ODERATE

#ENTRAL "USINESS $ISTRICT #"$

6ALUE !DD

,OW

(IGH

.EW $EVELOPMENT

,OW

(IGH

3UBURBAN

3TABLE

,OW

(IGH

6ALUE !DD

,OW

(IGH

.EW $EVELOPMENT

,OW

(IGH

$ENOTES RETURN ON COST

Fiscal 2010 Investment Plan

IX. Alternative Investments &ISCAL REPRESENTS THE TH YEAR SINCE A STATUTE REVISION REMOVED A LIMITATION THAT RESTRICTED ALTERNATIVE INVESTMENTS SOLELY TO /HIO COMPANIES OR VENTURE CAPITAL lRMS HAVING AN OFlCE IN /HIO )N -AY THE 2ETIREMENT "OARD APPROVED A BROAD DOMESTIC AND GLOBAL INVESTMENT PLAN FOR ALTERNATIVE INVESTMENTS AND ESTABLISHED A ALLOCATION FOR THIS ASSET CLASS )N -AY A BOARD DIRECTED !SSET !LLOCATION 3TUDY INCREASED THE ALLOCATION TO $URING THE 2ETIREMENT "OARD CONDUCTED AN !SSET ,IABILITY 3TUDY AND ESTABLISHED A ALLOCATION FOR ALTERNATIVE INVESTMENTS EFFECTIVE *AN 4HE ALLOCATION WAS INCREASED TO EFFECTIVE /CT IN CONJUNCTION WITH A CHANGE IN THE REAL ESTATE WEIGHTING .OW AS PART OF THE COMPLETED !SSET !LLOCATION 3TUDY THE ALTERNATIVE INVESTMENT PORTFOLIO WILL BE SPLIT INTO TWO ALLOCATIONS TO PRIVATE EQUITY AND TO OPPORTUNISTIC DIVERSIlED 4HE INITIAL ALLOCATION TO OPPORTUNISTIC DIVERSIlED WILL BE FULlLLED WITH THE EXISTING INVESTMENTS FROM WITHIN THE ALTERNATIVE INVESTMENT OTHER CATEGORY 4HE ALLOCATION FOR OPPORTUNISTIC DIVERSIlED WILL INCREASE TO EFFECTIVE *ULY AND WILL GROW TO OVER THE FOLLOWING THREE lSCAL YEARS !S THE NAME IMPLIES THIS ALLOCATION WILL BE OPEN TO A WIDE VARIETY OF INVESTMENT TYPES SOURCED FROM ALL ASSET CLASSES 4HE FOLLOWING CHART SHOWS THE FUND COMMITMENT ACTIVITY IN THE ALTERNATIVE INVESTMENTS PORTFOLIO SINCE INCEPTION

ANNUAL SUMMARY OF CAPITAL COMMITMENTS Fiscal Year

$ Committed

New Managers

Existing Managers

AND 0RIOR

MILLION

Total

$8,461 million

PROJECTED

TO MILLION

Fiscal 2010 Investment Plan

,AST YEAR S )NVESTMENT 0LAN PROJECTED NEW COMMITMENTS RANGING FROM MILLION TO BILLION 4HE lRST HALF OF lSCAL HAD COMMITMENTS OF ALMOST MILLION SOME OF WHICH WERE DEFERRED FROM lSCAL AS A RESULT OF COMMITMENTS IN THAT YEAR EXCEEDING THE MILLION TO BILLION ALLOCATION RANGE /UR ACTIVITY IN THE SECOND HALF OF lSCAL DROPPED DRAMATICALLY Â&#x2C6; lRST DUE TO THE IMPACT OF THE CREDIT CRISIS ON MANAGERSg WILLINGNESS TO MARKET NEW FUNDS AND SECOND IN RESPONSE TO OUR OVERWEIGHT ALLOCATION TO THE ASSET CLASS &OR lSCAL WE ARE PROJECTING THAT NEW COMMITMENTS TO PRIVATE EQUITY WILL RANGE FROM MILLION TO MILLION 4HIS COMPARES TO AN AVERAGE OF MILLION PER YEAR OVER THE LAST YEARS AND AN AVERAGE OF BILLION OVER THE LAST FOUR YEARS INCLUDING COMMITMENTS THAT WILL NOW BE PART OF THE OPPORTUNISTIC DIVERSIlED ALLOCATION 4HE SEVERE DECLINE IN THE MARKET VALUE OF THE PUBLIC EQUITY PORTFOLIO HAS CAUSED A SIGNIlCANT OVERWEIGHT IN THE ALTERNATIVE INVESTMENT PORTFOLIO 4HIS WAS SUSTAINED BY THE RAPID PACE OF INVESTMENTS OVER THE LAST FEW YEARS ALONG WITH THE LACK OF EXIT OPPORTUNITIES 4HIS HAS CAUSED THE INVESTED LEVEL OF ALTERNATIVE INVESTMENTS TO MORE THAN DOUBLE THE TARGET ALLOCATION OF AT TIMES CURRENTLY AT AT THE END OF !PRIL !LTHOUGH IT IS DIFlCULT TO PROJECT THE PATTERN OF DISBURSEMENTS TO DISTRIBUTIONS FROM AND VALUATIONS OF OUR ALTERNATIVE INVESTMENTS THERE IS A DElNITE POSSIBILITY THAT WE WILL APPROACH AN ALLOCATION TO hPRIVATE EQUITYv OVER THE NEXT THREE lSCAL YEARS VERSUS THE NEW ALLOCATION ASSUMING THE TOTAL FUND GROWS TO BILLION 4HE NINE COMMITMENTS MADE IN lSCAL ARE DISTRIBUTED ON A DOLLAR WEIGHTED BASIS AMONG DOMESTIC PRIVATE EQUITY FUNDS Â&#x2C6; DOMESTIC VENTURE CAPITAL FUNDS Â&#x2C6; GLOBAL INTERNA TIONAL PRIVATE EQUITY FUNDS Â&#x2C6; AND hOTHERv Â&#x2C6; 4HE ACTIVITY IN THE LATTER CATEGORY INCLUDED AN ADDITIONAL COMMITMENT TO AN EXISTING DISTRESSED DEBT FUND !S MENTIONED ABOVE THE OTHER CATEGORY WILL BECOME THE OPPORTUNISTIC DIVERSIlED PORTFOLIO 4HE ALTERNATIVE INVESTMENT PLAN PROVIDES A FRAMEWORK FOR SELECTING APPROPRIATE INVESTMENTS 4HE CATEGORIES THAT WILL BE CONSIDERED FOR NEW INVESTMENTS DURING lSCAL ARE LISTED BELOW Domestic Private Equity Funds s 'ENERAL BUYOUT FUNDS s )NDUSTRY TARGETED BUYOUT FUNDS s 'ROWTH EQUITY FUNDS s -EZZANINE AND SUBORDINATED DEBT FUNDS Domestic Venture Capital Funds s 'ENERAL EARLY TO LATE STAGE VENTURE FUNDS s )NDUSTRY TARGETED EARLY TO LATE STAGE INVESTMENT FUNDS s 3TRUCTURED VENTURE lNANCE FUNDS Global/International Private Equity Funds s 0RIVATE EQUITY FUNDS IN ESTABLISHED AND OR EMERGING REGIONS s 6ENTURE CAPITAL AND OTHER TYPES OF PRIVATE CAPITAL

Fiscal 2010 Investment Plan

Other (Opportunistic/Diversified) s #OMMODITIES s )NFRASTRUCTURE s (EDGE FUNDS s $ISTRESSED DEBT s %NERGY NATURAL RESOURCES s #OMMERCIAL MORTGAGE BACKED SECURITIES s .ON AGENCY MORTGAGES s 0UBLIC 0RIVATE )NVESTMENT 0ROGRAM OPPORTUNITIES s %QUITY STRATEGIES E G LOW VOLATILITY DEFENSIVE EMERGING MARKETS MASTER LIMITED PARTNERSHIPS ETC s !LL OTHER OPPORTUNISTIC INVESTMENTS

4HE PRIMARY VEHICLE FOR PRIVATE EQUITY AND OPPORTUNISTIC DIVERSIlED INVESTMENTS WILL BE COMMINGLED PARTNERSHIP FUNDS )N THE CASE OF OPPORTUNISTIC DIVERSIlED DIRECT INVESTMENTS IN PUBLIC OR PRIVATE COMPANIES WILL ALSO BE CONSIDERED &OR PRIVATE EQUITY FUND OF FUNDS AND SEPARATE ACCOUNT RELATIONSHIPS WILL BE EXPLORED ON A MORE LIMITED BASIS DUE TO THE COST OF AN ADDITIONAL LAYER OF MANAGEMENT FEES $IRECT INVESTMENTS IN PRIVATE COMPANIES WILL NOT BE CONSIDERED DUE TO THE ADDITIONAL STAFlNG AND THE INDUSTRY FOCUSED EXPERTISE THAT IS REQUIRED #O INVESTMENT OPPORTUNITIES IN PRIVATE EQUITY PORTFOLIO COMPANIES ALONGSIDE EXISTING FUND MANAGERS WILL BE PURSUED ON A CASE BY CASE BASIS IN CONJUNCTION WITH THE TOP PERFORMING BUYOUT AND GROWTH EQUITY FUND MANAGERS IN OUR PORTFOLIO 4YPICALLY THIS WILL BE RESTRICTED TO VEHICLES PROVIDING THE GENERAL PARTNER WITH COMPLETE DISCRETION SINCE CO INVESTMENTS REQUIRING THE ACTIVE INVOLVEMENT OF THE LIMITED PARTNER ARE UNLIKELY TO BE COST EFFECTIVE DUE TO THE ADDITIONAL STAFlNG NEEDED TO PRUDENTLY EVALUATE SUCH INVESTMENT OPPORTUNITIES AND MAKE DECISIONS IN A VERY SHORT PERIOD OF TIME &OR OPPORTUNISTIC DIVERSIlED THE LIST OF POSSIBLE INVESTMENTS SHOWN ABOVE IS NOT INTENDED TO BE ALL INCLUSIVE OR LIMITING SINCE CHANGING MARKETS MAY CREATE NEW AND MORE ATTRACTIVE INVESTMENT OPPORTUNITIES AS THE YEAR GOES ON 3INCE IT IS NOT POSSIBLE TO ANTICIPATE WHAT TYPE OF INVESTMENTS MAY BE MADE IN THE OPPORTUNISTIC DIVERSIlED PORTFOLIO PROPOSED INVESTMENTS WILL BE SHOWN TO THE 2ETIREMENT "OARD BEFORE MAKING A BINDING COMMITMENT 3423 /HIO HAS MODEST HEDGE FUND EXPOSURE 7E CURRENTLY INVEST IN A LONG SHORT EQUITY HEDGE FUND MANAGED BY ONE OF OUR TOP PRIVATE EQUITY MANAGERS !DDITIONAL HEDGE FUND INVESTMENTS WILL BE EVALUATED PRIMARILY AS POTENTIAL INVESTMENTS IN THE OPPORTUNISTIC DIVERSIlED PORTFOLIO AND WILL BE APPROACHED CAUTIOUSLY DUE TO THE DIFlCULTY OF EXECUTING STRATEGIES WHEN TOO MUCH CAPITAL mOWS INTO HEDGE FUNDS THE RISK THAT REDEMPTION REQUESTS RELATED TO INVESTOR PANIC OR INVESTORSg NEED FOR LIQUIDITY WILL HURT PERFORMANCE DUE TO THE UNTIMELY SALE OF ASSETS AND CHALLENGES ASSOCIATED WITH THE LACK OF TRANSPARENT REPORTING !S IN THE PAST THE FOLLOWING INVESTMENT OPPORTUNITIES WILL NOT BE CONSIDERED FOR THE PRIVATE EQUITY PORTFOLIO MICRO CAP STOCK FUNDS SEED OR hANGELv FUNDS ECONOMICALLY TARGETED FUNDS OR COMMODITIES (OWEVER THE LATTER MAY BE CONSIDERED FOR THE OPPORTUNISTIC DIVERSIlED PORTFOLIO !LSO WE ARE UNLIKELY TO INVEST IN lRST TIME FUNDS BECAUSE OF OUR FOCUS ON THE PROVEN ABILITY OF THE ENTIRE INVESTMENT TEAM TO WORK TOGETHER TO PRODUCE ATTRACTIVE RETURNS

Fiscal 2010 Investment Plan

4HE PURCHASE OF SECONDARY INTERESTS IN EXISTING PARTNERSHIPS IS ANOTHER METHOD OF INVESTING IN ALTERNATIVE INVESTMENTS EITHER DIRECTLY OR THROUGH FUND OF FUNDS 4HE MARKET APPEARS TO BE IDEAL FOR SUCH INVESTMENTS AND 3423 /HIO MADE ITS lRST COMMITMENT TO A SECONDARY FUND OF FUNDS DURING lSCAL /UR CONCERN OVER PAYING ADDITIONAL FEES IS MITIGATED SOMEWHAT BY THE FACT THAT OF THE MANAGEMENT FEE WILL NOT BE CHARGED UNTIL THE CAPITAL IS ACTUALLY INVESTED $IRECT SECONDARIES WOULD REQUIRE ADDITIONAL STAFlNG AND WILL NOT BE CONSIDERED 3423 /HIO COULD ALSO PARTICIPATE IN THE SECONDARY MARKET AS A SELLER FOR TACTICAL REASONS (OWEVER WE WILL NOT CONSIDER SUCH TRANSACTIONS AS LONG AS IT CONTINUES TO BE A BUYERgS MARKET 3423 /HIO MAY SEEK APPROVAL TO PURCHASE ADDITIONAL INTERESTS IN THE EXISTING FUNDS OF OUR TOP MANAGERS WHEN OTHER LIMITED PARTNERS DECIDE TO TRANSFER THEIR INTERESTS 'AINING ACCESS TO LEGACY TOP TIER VENTURE CAPITAL FUNDS CONTINUES TO BE CHALLENGING 3UCH FUNDS ARE CONSISTENTLY OVERSUBSCRIBED AND THEY DENY ACCESS TO PUBLIC PENSION PLANS WHO ARE BURDENED WITH OPEN RECORDS LAWS 5NFORTUNATELY THE PROTECTION OF TRADE SECRETS AFFORDED BY THE /HIO STATUTES WAS NULLIlED BY ACTIONS TAKEN BY A PRIOR /HIO !TTORNEY 'ENERAL IN RESPONSE TO MAJOR PROBLEMS UNCOVERED IN THE /HIO "UREAU OF 7ORKERS #OMPENSATION S ALTERNATIVE INVESTMENT PROGRAM IN 4HIS RESULTED IN THE LOSS OF ONE OF 3423 /HIO S TOP VENTURE CAPITAL RELATIONSHIPS 7E CONTINUED TO MAINTAIN COMMUNICATIONS WITH THIS MANAGER AND DURING lSCAL WE WERE ABLE TO RENEW THIS RELATIONSHIP WHEN THE GENERAL PARTNERS ALLOWED US TO INVEST IN THEIR MOST RECENT FUND .EW CAPITAL COMMITMENTS PROJECTED FOR lSCAL WILL BE FOCUSED ON TOP PERFORMING OR POTENTIALLY TOP PERFORMING SUCCESSOR FUNDS FOR EXISTING MANAGERS AND MANAGERS THAT ARE NEW TO 3423 /HIO IN ALL CATEGORIES 4HE PORTFOLIO CONTINUES TO BE ADEQUATELY DIVERSIlED 4HE EMPHASIS ON DOMESTIC PRIVATE EQUITY FUNDS OVER THE PAST THREE YEARS HAS INCREASED THE PERCENTAGE OF TOTAL COMMITMENTS TO FROM AND HAS INCREASED THE MARKET VALUE TO OF ALTERNATIVE INVESTMENTS FROM -EANWHILE THE CURRENT MARKET VALUE OF THE VENTURE CAPITAL PORTFOLIO DROPPED TO FROM 4HE COMMITMENTS AS OF -AY ARE SHOWN BELOW CURRENT PERCENTAGES SHOWN IN PARENTHESES 7E ANTICIPATE THAT THE CATEGORY ALLOCATIONS DURING lSCAL WILL GENERALLY STAY WITHIN THE PERCENTAGE RANGES SHOWN EXCLUDING h/THER v #OMMITMENTS TO THE OTHER CATEGORY WHICH WILL NOW BE REFERRED TO AS THE OPPORTUNISTIC DIVERSIlED PORTFOLIO WILL BE SEPARATE FROM THE MILLION TO MILLION ALLOCATION TO PRIVATE EQUITY #OMMITMENTS TO OPPORTUNISTIC DIVERSIlED WILL BE MADE ON A PACE TO INCREASE INVESTMENTS IN THAT PORTFOLIO TO OF TOTAL FUND OVER THE NEXT FEW YEARS SUBJECT TO THE AVAILABILITY OF ATTRACTIVE INVESTMENT OPPORTUNITIES

CAPITAL COMMITMENTS BY CATEGORY Actual Commitments May 31, 2009

Projected Allocation Ranges Fiscal 2010

$OMESTIC 0RIVATE %QUITY &UNDS

MILLION

$OMESTIC 6ENTURE #APITAL &UNDS

MILLION

/THER /PPORTUNISTIC $IVERSIlED

MILLION

'LOBAL )NTERNATIONAL 0RIVATE %QUITY &UNDS

MILLION

$8,205 million

100%

TOTALS

Fiscal 2010 Investment Plan

-OST ALTERNATIVE INVESTMENT OPPORTUNITIES INVOLVE A LONG TERM INVESTMENT HORIZON ILLIQUIDITY AND HIGH VOLATILITY OF RETURNS &OR THESE REASONS EXPECTED lNANCIAL RETURNS SHOULD EXCEED THOSE OF THE OTHER ASSET CLASSES "ASED ON THE !SSET !LLOCATION 3TUDY ALTERNATIVE ASSET RETURNS ARE EXPECTED TO BE NET OF FEES OVER THE LONG TERM WITH A VOLATILITY OF !S COMPONENTS OF ALTERNATIVE INVESTMENTS PRIVATE EQUITY RETURNS ARE EXPECTED TO BE WITH A VOLATILITY OF AND OPPORTUNISTIC DIVERSIlED RETURNS ARE EXPECTED TO BE WITH AN ESTIMATED VOLATILITY OF )N PRIVATE EQUITY RETURNS ON INDIVIDUAL FUNDS GENERALLY FOLLOW A PATTERN REFERRED TO AS THE h* CURVE v WHICH ANTICIPATES NEGATIVE RETURNS DURING THE EARLY YEARS OF THE FUND FOLLOWED BY PROGRESSIVELY INCREASING POSITIVE RETURNS THEREAFTER /NE lFTH OF OUR EXISTING COMMITMENTS WERE MADE DURING THE LAST MONTHS 4HE * CURVE EFFECT FROM THESE INVESTMENTS WILL IMPACT NEAR TERM PERFORMANCE ALONG WITH INTERIM MARKS REmECTING UNREALIZED LOSSES RESULTING FROM THE IMPACT OF FROZEN CREDIT MARKETS ON LEVERAGED TRANSACTIONS AND THE IMPACT OF THE RECESSION ON PORTFOLIO COMPANIESg REVENUES AND EARNINGS 4HE LATTER HAS AFFECTED VALUATIONS MORE THAN IT WOULD HAVE IN PAST YEARS DUE TO THE MARK TO MARKET ACCOUNTING RULES &INANCIAL !CCOUNTING 3TANDARD THAT WERE FULLY IMPLEMENTED BY THE END OF LAST YEAR ESPECIALLY ON VALUATIONS THAT ARE BASED ON PUBLIC COMPANY MULTIPLES 4HE CREDIT CRISIS AND RECESSION HAVE REVERSED A PERIOD OF SEVERAL YEARS OF STRONG PERFORMANCE IN ALTERNATIVE INVESTMENTS CAUSING THE lSCAL YEAR TO DATE PERFORMANCE TO DROP TO n THROUGH !PRIL COMPARED TO THE 2USSELL )NDEX FOR PUBLIC STOCKS AT n FOR THE SAME PERIOD (OWEVER WE HAVE ESTIMATED THAT RETURNS FOR THE FULL lSCAL YEAR COULD WORSEN TO APPROXIMATELY n 4HE IMPACT OF THE RECESSION IS EXPECTED TO CAUSE ALTERNATIVE INVESTMENTS VALUATIONS TO LAG THE PUBLIC MARKETS SO WE ARE PROJECTING A hBELOW NORMALv RETURN OF FOR THE ASSET CLASS FOR lSCAL )N THE PAST MONTHS THE ALTERNATIVE INVESTMENTS STAFF MADE GOOD PROGRESS ON THE GENERAL GOALS OUTLINED IN LAST YEAR S ANNUAL PLAN INCLUDING ADDING THREE NEW TOP TIER MANAGERS TO THE PORTFOLIO AND REGAINING AN IMPORTANT RELATIONSHIP WITH A TOP VENTURE CAPITAL lRM $URING lSCAL THE ALTERNATIVE INVESTMENTS STAFF WILL s

#ONTINUE TO EVALUATE SUCCESSOR AND NEW FUND OPPORTUNITIES TO IMPROVE THE OVERALL RETURN POTENTIAL OF THE PORTFOLIO

#ONTINUE TO DECLINE COMMITMENTS TO THE FOLLOW UP FUNDS BEING RAISED BY EXISTING MANAGERS WHOSE TRACK RECORDS CAUSE US TO BELIEVE THAT THEIR NEXT FUND WILL NOT PRODUCE ATTRACTIVE RETURNS

#ONTINUE TO OPPORTUNISTICALLY SELL PUBLIC SHARES DISTRIBUTED TO US BY THE GENERAL PARTNERS AND

!CTIVELY SEEK PROSPECTIVE INVESTMENTS FOR THE OPPORTUNISTIC DIVERSIlED PORTFOLIO