Asset Allocation: Fall 2010: Olume Ctober

VOLUME 2.
17
OCTOBER 29, 2010
Asset Allocation: Fall 2010
One of the major determinants of investment success over the next decade will
be correctly anticipating the trend in general price inflation. How long the current
deflationary environment persists, and how well the exit from quantitative easing is
implemented will decide the relative performance of the three principal asset classes:
fixed income, precious metals and equities.
The divergence between the bond market and precious metal prices is extreme
at the moment, and it is likely to persist for the foreseeable future. Quantitative easing
drives down bond yields in the short term but if they are pushed below their natural or
equilibrium level, inflationary expectations will eventually rise and with them, long-term
bond yields. It is difficult to measure whether bond yields are below their equilibrium
level before inflation takes off, which is why the inflation/deflation debate rages.
Economic growth in the U.S. remains weak and bank lending subdued, thus
keeping a lid on consumer price inflation and a floor under unemployment. This in turn
encourages continued fiscal and monetary stimulus. Because virtually all developed
nations have allowed their finances to deteriorate, most can run with the herd with little
risk of fiscal crisis for the time being. A few of the weakest countries are obvious
exceptions.
© Boeckh Investment Letter., 1750-1002 Sherbrooke Street West, Montreal, Quebec. H3A 3L6 Tel. 514-904-0551, info@bccl.ca
International Disequilibrium
The international monetary game is intact. It is based on a fiat, floating dollar
system in which surplus countries buy (mainly) dollars to prevent their currencies from
rising toward equilibrium levels so as to continue subsidizing their exports. This creates
excess liquidity and inflation in those countries. The other side of the disequilibrium is
sustained deflation, high unemployment in the deficit countries and a very angry
electorate. This inevitably leads to a high degree of geopolitical tension. The result is
rising protectionism in one form or another leading to prospects of retaliation. However,
fear of tit-for-tat economic and financial warfare sustains the status quo, probably for
longer than most investors expect, despite how seemingly dangerous and unstable it is.
A global trade war is underway and currencies will be the primary battleground.
On one side we have the U.S. with an unlimited supply of ammunition: in theory it can
print as many dollars as it likes in the short term, which is an effective but dangerous
way to put pressure on the surplus countries. If they persist in trying to hold their
currencies down, they are forced to accelerate their accumulation of dollars as reserves
or in sovereign wealth funds. It should be noted that China’s third quarter reserve
purchases were equal to over half the value of US gold reserves at current prices!
As long as surplus nations prioritize their export sector, they will buy dollars in the
foreign exchange market to keep their own currency depressed. Despite attempts at
sterilizing the flood of dollars, massive reserve accumulation causes excess liquidity,
asset price inflation and/or general price inflation. Consumer price inflation in India is
high, although it has declined from a peak of 16% per annum early this year, to a little
THE
© BOECKH INVESTMENT LETTER WWW.BOECKHINVESTMENTLETTER.COM 2
over 10%. China, which has more sophisticated capital control mechanisms, has kept a
partial lid on CPI but it is worrisome at around 4% and rising. Chinese asset prices are
frothy and the central bank recently increased its key interest rate by ¼%. Capital
controls and interest rate hikes will have limited success and eventually China will have
to revalue the yuan to dampen inflationary pressure. The implication of this situation is
that the U.S. can continue to do as it pleases with its currency and the rest of the world
has little recourse but to adapt. Perhaps an effective international agreement can be
achieved, for example on quantitative limits for current account balances, but we
wouldn’t bet on it. The “balance of financial terror” is intact and one consequence is that
a dollar crisis is unlikely. Rather, it will weaken gradually, which is exactly what the U.S.
wants.
Bond investors can be fairly confident that a sudden spike in yields of the kind
that would result from a dollar crisis is unlikely. Thus, the key risk for fixed income
investors is in the longer run as ultimately higher general price inflation will erode the
purchasing power of longer-dated bonds. However, there are several factors that make
a significant rise in the CPI over the next few years a low probability event. The
massive amounts of liquidity created by the Federal Reserve has and will continue to
lead to frothy asset markets and other imbalances, but not necessarily general price
inflation. The financial system is broken and a self-sustaining cycle of investment and
consumption will not occur until the mechanism of credit creation is repaired.
Establishment of this virtuous cycle is a necessary precondition for high general price
inflation of the kind we saw in the 1970’s that drove gold and other commodities to peak
prices then. So, how long will it take for the global economy to heal?
THE
The historical experience with the aftermath of financial crises is generally limited
to isolated countries or regions, and almost without exception major currency
devaluation was an integral part of the recovery process. The only truly global financial
crisis that matches the depth of the recent one is the 1930’s, and this example is of
limited use because of the stark contrast in monetary, fiscal and trade policy between
the two eras. The Great Depression was exacerbated by attempts to maintain the gold
standard by raising taxes, tariffs, and interest rates, thus pushing the adjustment onto
the labor market. Policymakers are not currently suffering from such delusional policies.
So what does recovery from a financial crisis look like when a large relative
devaluation is not an option, monetary policy is unshackled from any semblance of
restraint and government debt ratios are spiralling out of control? The answer is that it
will probably be long, slow, uneven and prone to many false starts and setbacks. The
massive amount of liquidity sloshing around the system poses a danger of exacerbating
the imbalances that brought the global economy to this state in the first place. Larger
and more frequent asset bubbles are a likely threat, resulting in extreme volatility in
financial markets.
Asset Allocation: Gold
Over the last year, we have consistently encouraged investors to keep no more
than 5-10% of their assets in gold. We have made no secret of our opinion that gold will
likely be a terrible investment over the next 5-10 years, and that it should be held only
as insurance against the unlikely event of a huge surge in inflation and dollar collapse or
a major geopolitical event.
THE
This recommendation has met with resistance from some of our readers, and
there is certainly a group of investors who are true believers in gold. There have been a
number of arguments trotted out to support gold’s momentum. The two primary
arguments relate to supply & demand and inflation.
Supply Constraints
We often hear the argument that supply can’t keep up as a justification for
current prices. Mining production did peak in 2002, declining from about 2,604 tons a
year to 2,356 in 2008. However, in 2009 production surged to 2,572 and will likely
reach a new peak in 2010. It is true that bringing new supply online is expensive and
time consuming. Producers have been reluctant to invest substantially in new
production during most of the 2000’s. The bulk of production was hedged and these
hedges have only been unwound in the last few years, thus reducing supply
temporarily. That effect is basically over. Further, we are now seeing a great deal of
new investment in the field, production has turned around and could increase at a faster
rate.
Cash costs of production currently range from about U.S. $400-$500 per ounce.
However, this excludes G&A expenses, taxes etc., not to mention the cost of
exploration and adding new reserves. This year Kinross paid about $500/oz for Red
Back Mining. Whether Kinross paid a fair price will be revealed in time, but it does
indicate that total cost is a little over $1,000/oz. At current prices above $1,300/oz this
provides good incentives to increase mine production.
THE
It is important to keep in mind that the existing gold stock is huge compared to
the level of annual new supply. Consequently, recycling and re-sales can have a
disproportionate effect on the market. As a result, financial demand can have a large
impact on prices in both directions. It has increased sharply in recent years and has
been the main driver of the bull market. But, financial demand can turn around on a
dime, as it did in 1980 after which gold prices plunged from $1,000 to a low of $287.
Here are some facts worth noting:
 From the 2nd quarter of 2009 net retail investment demand for gold
increased 67% on a USD basis to $9.4 billion.
 Europe (particularly Germany) and China showed the largest increase,
with the U.S. not far behind. The total dollar amount purchased in Q2
2010 was $3.2 bn in Europe, $1.6 bn in India, $1.5 bn in China and $1.2
bn in the U.S.
 Since 2000, the dollar value of net retail investment plus ETF demand
increased from $1.5 bn, to $42 bn. This represented less than 5% of the
total in 2000; now it represents close to 40%
Central Banks
Another bullish argument is that central banks are becoming net buyers. Frankly,
their track record on gold is appalling. Central bank sales peaked precisely when gold
prices hit bottom in 2001. If history is to be our guide, we should do the opposite of
central banks.
THE
Inflation
We have made our position clear on the inflationary thesis supporting gold—we
don’t buy it, at least not over the next few years in developed countries. Inflation is a
concern in emerging markets due to lax U.S. monetary policy, and investors with assets
denominated, for example, in rupees or yuan would be advised to hold an above
average allocation in precious metals. However, a massive amount of gold demand for
investment comes from countries that have little to fear from inflation over the next few
years. Europe, and in particular Germany, is extremely sensitive to inflationary fears as
a consequence of past hyper-inflation. Given the uncertainty over sovereign debt
issues and the survival of the monetary union, these fears are understandable, although
we believe they are misplaced. Even if inflation does heat up in developed countries,
gold is already pricing in very high inflation expectations. Furthermore, China and other
emerging markets are taking steps to cool money and credit growth. China’s recent
¼% rate increase resulted in a $36 drop in the gold price in one day. When the U.S.
Federal Reserve indicated that QE2 wouldn’t be quite as dramatic as expected, gold
sold off sharply.
It is always hard to spot the top of a bubble before it bursts. Probably the
clearest perspective is provided by Charles Kindleberger1, who described the three
steps in the formation of a mania. First, a displacement is triggered by, among other
things, a shock to the macroeconomic system. Second, the expansion of bank credit
fuels an increase in the price of an asset. Finally, a positive feedback loop develops
where price gains attract new investment which maintains the upward trajectory. It
1
Kindleberger, Charles. Manias, Panics, and Crashes: A History of Financial Crises, rev. ed. (New York:
Basic Books, 1989).
THE
would be hard to imagine a scenario more ominously represented by Kindleberger’s
description of a mania than the current gold market. Gold prices have started to go
exponential which is reminiscent of the late 70’s. It’s hard to say how far this mania
could run, but it is possible that it is entering the late stages (Chart 1). Typically, the
biggest gains come right before a bubble pops and greed and temptation trump
rationality and valuation as the process of making a top is completed.
Chart 1: Gold – the winning combination: strong returns and uncorrelated with
stocks...but for how much longer?
The modest chance that we are actually headed for financial Armageddon or a
major geopolitical crisis in the short term continues to warrant some “gold insurance,”
which would include a maximum of 5-10% allocation to precious metals or their
producers. A greater allocation must be considered a speculative decision. At current
prices, it is expensive insurance at best and could be a poor investment in the long run
(Chart 2).
THE
Chart 2: Gold is expensive relative to a broad basket of commodities
We encourage investors to look at alternative forms of inflation protection. In a
mildly inflationary environment stocks are likely to do well, particularly those with pricing
power and prospects for dividend growth. After all, a little inflation in the near term
would likely be associated with an improvement in the economic outlook and profits.
Investing in industrial and agricultural commodities offers inflation protection, and we
can have greater confidence in the valuation of those commodities where demand is
predominantly for consumption rather than speculation. Beaten down real estate in the
U.S.is also a reasonable bet, particularly when there is a reliable income stream. Other
real estate markets, like Canada, have not sold off over the last few years and don’t
offer as attractive valuation, especially considering the high level of household debt.
THE
Fixed Income
A forecast of weak economic growth and deflation implies a need to invest in high
quality bonds. Yet one of the key determinants of long term investment success is the
valuation at the time of purchase. Bonds have two counts against them now. In the
U.S. Treasury market, yields are at historic lows and as our bond model is showing,
prices are extremely overvalued (Chart 3). The second issue is that the bond market
has been heavily distorted by government intervention, and there is a likelihood that
another round of longer-dated bond purchases by the Federal Reserve would continue
to depress bond yields below their fair market value. It is likely that the Fed will be able
to maintain its grip on bond yields for the foreseeable future, but this dynamic is a poor
justification for investment in the sector. Longer-dated bonds, even of the highest
quality, carry much more risk at the moment than is justified by their yields. Investors
Chart 3: Bonds are extremely over-valued at the moment.
THE
are faced with a difficult dilemma: accept a higher degree of inflation risk on longer-
dated bonds, or shorten duration and accept meagre yields. Neither option is attractive.
Either way, we expect Treasurys to underperform the stock market over the next few
years (Chart 4).
Chart 4: Bonds vs. stocks
THE
There are still good opportunities in Chart 5: Corporate bond spreads are widening again,
but probably not for long.
corporate bonds. Spreads have widened a
bit this year due to double-dip recession
fears (chart 5). We continue to believe that
a double dip is unlikely, and consequently
that corporate bond spreads will stay
narrow. Even though there is no
conclusive evidence at this point, we are
starting to raise the odds that the recovery in the U.S. may surprise on the upside over
the next few quarters.
The Hunt for Yield
Henry and Joan Turner from Garrison, NY recently wrote to us questioning
investment advisors’ fixation on the bonds‐stocks‐cash split as the primary method
of controlling risk. Their comments illustrate the need to re‐evaluate the distinction
between equity and fixed income investments in the current environment:
“My wife and I are 77 and 75, retired, and need income from our investments. 11%
of our liquid assets is in gold, half in coins and half in 7 junior miners, for insurance
purposes. 38% of our assets is in 19 Canadian income trusts and those already
converted to corporations, yielding an average of 9.4%. 32% is in 18 energy Master
Limited Partnerships (MLPs), yielding an average of 7.2%. 18% is in tanker and rural
telecom stocks, yielding an average of 8.9%. Our total of liquid assets is now well
ahead of where we were before the Great Recession began. So why don't you
recognize such investments?”
Response: The discussion of bonds‐stocks‐cash helps to provide overall risk
positioning. There are a wide range of equity investments, some of which have
properties similar to fixed income investments in some ways. Even though this
couple has the bulk of their assets in equities, we would consider their approach a
balanced and sensible allocation for the current environment.
THE
Given the extremely low yields available on investment grade bonds, and the
growing mania in precious metals, the risk reward trade-off is tilted in favour of equities.
From an income perspective utilities, royalty trusts and blue chip dividend paying stocks
are attractive at the moment, and investors who can afford to take a bit more risk on the
income side of their portfolio should consider tilting their portfolio away from longer-
dated bonds and towards these types of stocks. For those unwilling to accept the
additional risk, duration should be kept short. For all investors, cash should be
overweight given the uncertain and volatile outlook and the difficulty of finding low
correlated investments.
Equity Diversification
Correlations between most equity sectors and between various national and
regional indices are well above historical norms. There are several explanations for
this. Macroeconomic events have captured the attention of most investors over the last
few years, and even the most focused bottom-up investors have found it difficult to
ignore macro trends. Furthermore, there has been a dramatic increase in the proportion
of equity investment that occurs through various ETFs. Recently, up to 1/3 of daily
trading volume on the NYSE is linked to ETFs. This combination—a macro focus and
availability of products to implement related strategies—results in high correlations
within equity and commodity investments. The trend will eventually translate into
excellent opportunities for patient stock pickers, but the downside is that risk cannot
easily be reduced through diversification. The recent example of the sharp global sell-
off in risk assets triggered by the tiny Chinese interest rate hike is telling.
THE
Charts 6 to 12 show the return of various indices relative to the S&P 5002
benchmark, alongside the rolling 1-year correlation of quarterly returns. This correlation
measure is a suitable approach for investors who rebalance their portfolio annually.
The high degree of correlation between virtually all risk assets highlights the following
considerations:
 Overall portfolio risk is higher than normal because diversification will
provide little or no protection in the event of another major bear market;
 Buy and hold is a riskier strategy in the current environment than in
“normal” times when correlations are lower;
 The key determinant of investment success over the next 5-10 years will
likely be inflation positioning and getting the right mix of equities, fixed
income investments and precious metals.
Capitalization: does size matter?
Little diversification value can be achieved through capitalization weighting in a
portfolio. Charts 6 and 7 show the relative performance of small vs. large cap stocks in
the U.S. and Canada. In both cases, the correlations are very high. Therefore investors
should focus on setting their allocation to small cap stocks based on risk tolerance.
Small cap stocks, while they tend to outperform over the long run, are subject to higher
volatility. Investors should also note that small cap value stocks far outperform small
cap growth stocks and returns on illiquid stocks have produced even higher returns over
2
Relative return should not be considered exact due to the various methodologies of index construction
and measurement of total return.
THE
the longer run.3 Younger and more aggressive investors should overweight small value
and illiquid stocks vs. large cap stocks and seek diversification through geography, and
allocations to bonds, cash and precious metals.
Chart 6: Little diversification value in small cap stocks; however we expect the
sector to outperform large cap stocks over the coming years.
Chart 7: Canada: Small cap vs. large cap
3
SBBI 2010 Yearbook (Chicago: Ibbotson Associates, 2010).
THE
Emerging Markets
Besides the gold vs. bonds debate, there are few topics more controversial than
the relative merits of emerging vs. developed markets. In our previous letter, George
Magnus provided a detailed look at emerging markets and why institutional investors
are typically limiting EM exposure to 5-10% of their portfolios, well below the weightings
in global indices. There are a number of factors, outlined below:
Pros:
 Fast growth and high productivity

 Great historical returns on equities
 Demographics
 Government finances
 High savings
 Developed countries institutions under invested
 Undervalued currencies
Cons:
 Infrastructure problems
 Unbalanced economy
 Political instability
 Corruption
 Volatility
 Governance
 Institutional weakness
Chart 8 shows the strong relative performance of the MSCI BRIC index vs. the
S&P 500. China, the strongest, has outperformed Russia, India and Brazil since 2006
by a wide margin (chart 9). However, volatility can be extremely high and the
correlation with U.S. markets is close to 1. Accordingly, we recommend investors limit
EM exposure to 5-15% of their portfolio, and consider investments in commodities as a
somewhat less correlated play on emerging markets. The high degree of volatility and
THE
relatively high valuation of most emerging markets means that investors would be wise
to time their purchase carefully.
Chart 8: Brazil, Russia, India and China – closely correlated with U.S. equity markets.
Chart 9: China is outperforming the other BRICs
THE
Europe
European markets have not recovered their footing relative to the S&P 500 since
2008 (chart 10). Sovereign debt problems, instability relating to policy changes and
imbalances resulting from the wide range of current account balances for the various
nations sharing a common monetary regime will continue to weigh on these markets.
There are still deep-seated fears that the euro zone will ultimately fracture. The fall in
correlation to 0.6 simply indicates that Europe is missing out on the recent strength in
the U.S. markets. Investors should underweight Europe.
Chart 10: Europe, Australia and Far East. Little diversification value here.
Canada
Canada is a major beneficiary of the commodity super-cycle. This, combined
with strong government finances should continue to drive favorable relative
performance (chart 11). The two big negatives, however, are excessive household debt
THE
and inflated house prices. These and heavy exposure to commodities means that
Canada would be extremely vulnerable to another world recession.
Chart 11: Canada. Near perfect correlation with U.S. markets.
Commodities
Commodities have outperformed stocks over the last decade and the correlation
with stocks was low until 2007, providing a free lunch for investors (chart 12).
Correlations moved up dramatically since then as a consequence of several factors:
markets have moved broadly as a result of the risk on/risk off trade; and a proliferation
of ETFs have made commodity investing as accessible and inexpensive as buying
stocks. We expect commodities to continue to do well, although the returns relative to
stocks will likely not be as high as the 2000-2008 period. Inflation protection, exposure
to EM growth, and correlations in the 0.6-0.8 range warrant considerable exposure,
although we tend to favour producers, especially juniors with the potential to increase
THE
reserves substantially. Consequently, profitability can be sustained even if prices start
to level off.
Chart 12: Commodities. Strong correlation since mid 2008 - are ETFs changing
the nature of commodity investing?
Investment Conclusion
Summary of Macro Outlook
1. Recovery in the U.S. and most industrial countries has been weak, uneven and
job creation is slow. Excess liquidity will continue to act as a tailwind for equities,
commodities and non-dollar currencies well into 2011.
2. Deflation will dominate in the short term; the inflationary threat is probably further
away than most investors expect. Gold is expensive relative to the inflationary
outlook.
3. Fixed income markets are heavily influenced by government intervention. While
it is likely that continued intervention will succeed in depressing bond yields
below market levels, even a modest increase in inflationary expectations would
THE
undermine these actions. We recommend shortening duration. Furthermore,
extremely low yields relative to dividends tilts the risk-reward trade-off in favour of
dividend paying equities over bonds.
We are investing in the midst of an unprecedented reflation experiment with an
uncertain outcome. The traditional havens of investment grade bonds and precious
metals are overvalued. Thus investors must protect themselves by maintaining an
above average cash position, and investing in high quality, dividend paying companies,
and for the less risk averse, small cap and illiquid value stocks with strong balance
sheets. Commodity producers and/or direct investment in commodities is a sensible
approach to inflation protection in the current environment.
Although there is no solid evidence yet, we believe that U.S. growth may surprise on
the upside over the next few quarters. It is too soon to make any bets on this
perspective, but we will be watching closely for any signals.
Model Portfolio
In this letter, we introduce specific tactical asset allocation recommendations for two
general types of portfolios. Portfolio A represents a typical equity biased allocation
suitable for 30-35 year old investors with a higher risk tolerance. Portfolio B represents
a typical allocation suitable for 60-65 year olds, more conservative investors who are
seeking income and capital preservation. Those who fall somewhere in between can
interpolate between the two, and those outside the range, can extrapolate. Obviously,
there are many factors that must be considered in constructing an appropriate strategic
asset allocation and investors should seek professional help to develop a suitable
THE
framework that fits their needs. We offer these model portfolios to stimulate thinking
and planning.
For both types of investor, we recommend significantly underweighting bonds
and shortening duration, while overweighting cash and short term instruments (figure 1
and 2). Investors willing to take on a bit more risk would likely be rewarded by seeking
income from dividend paying equities and royalty trusts (and other similar high quality
vehicles), and should consider shifting some of their fixed income allocation into these
types of equities.
Figure 1 Figure 2
Portfolio A: Younger/ Portfolio B:
Aggressive Retired/Conservative
100% 100%
80% 80%
60% 60%
40% 40%
20% 20%
0% 0%
Strategic Tactical Strategic Tactical
Portfolio A: Portfolio B:
Younger/Aggressive Retired/Conservative
Cash & Short Cash & Short
5% 20% 5% 25%
Term Term
Gold 5% 5% Gold 10% 5%
Bonds 20% 15% Bonds 45% 35%
Equity 70% 60% Equity 40% 35%
Tony Boeckh / Rob Boeckh
Date: Oct 29, 2010
www.BoeckhInvestmentLetter.com
info@bccl.ca
THE
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VOLUME 2.

fixed income, precious metals and equities.

The international monetary game is intact. It is based on a fiat, floating dollar

rising protectionism in one form or another leading to prospects of retaliation. However,

to isolated countries or regions, and almost without exception major currency

devaluation is not an option, monetary policy is unshackled from any semblance of

a major geopolitical event.

arguments relate to supply & demand and inflation.

time consuming. Producers have been reluctant to invest substantially in new

provides good incentives to increase mine production.

Here are some facts worth noting:

increased 67% on a USD basis to $9.4 billion.

 Europe (particularly Germany) and China showed the largest increase,

total in 2000; now it represents close to 40%

denominated, for example, in rupees or yuan would be advised to hold an above

years. Europe, and in particular Germany, is extremely sensitive to inflationary fears as

a consequence of past hyper-inflation. Given the uncertainty over sovereign debt

sold off sharply.

clearest perspective is provided by Charles Kindleberger1, who described the three

rationality and valuation as the process of making a top is completed.

which would include a maximum of 5-10% allocation to precious metals or their

producers. A greater allocation must be considered a speculative decision. At current

We encourage investors to look at alternative forms of inflation protection. In a

Investing in industrial and agricultural commodities offers inflation protection, and we

Chart 3: Bonds are extremely over-valued at the moment.

years (Chart 4).

Chart 4: Bonds vs. stocks

corporate bonds. Spreads have widened a

bit this year due to double-dip recession

fears (chart 5). We continue to believe that

a double dip is unlikely, and consequently

that corporate bond spreads will stay

narrow. Even though there is no

conclusive evidence at this point, we are

the next few quarters.

availability of products to implement related strategies—results in high correlations

 Overall portfolio risk is higher than normal because diversification will

provide little or no protection in the event of another major bear market;

 Buy and hold is a riskier strategy in the current environment than in

“normal” times when correlations are lower;

income investments and precious metals.

Little diversification value can be achieved through capitalization weighting in a

allocations to bonds, cash and precious metals.

Chart 7: Canada: Small cap vs. large cap

in global indices. There are a number of factors, outlined below:

 Fast growth and high productivity

correlation with U.S. markets is close to 1. Accordingly, we recommend investors limit

EM exposure to 5-15% of their portfolio, and consider investments in commodities as a

to time their purchase carefully.

Chart 9: China is outperforming the other BRICs

the U.S. markets. Investors should underweight Europe.

Canada is a major beneficiary of the commodity super-cycle. This, combined

with strong government finances should continue to drive favorable relative

Canada would be extremely vulnerable to another world recession.

Chart 11: Canada. Near perfect correlation with U.S. markets.

Correlations moved up dramatically since then as a consequence of several factors:

of ETFs have made commodity investing as accessible and inexpensive as buying

stocks. We expect commodities to continue to do well, although the returns relative to

to EM growth, and correlations in the 0.6-0.8 range warrant considerable exposure,

commodities and non-dollar currencies well into 2011.

3. Fixed income markets are heavily influenced by government intervention. While

it is likely that continued intervention will succeed in depressing bond yields