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Investment Outlook March 2010 Quality is crucial →11 Brighter prospects ahead →14 China solving growth
Investment
Outlook
March 2010
Quality is crucial →11
Brighter prospects ahead →14
China solving growth puzzle →17
private banking • investment strategy

Contents

Investment Strategy

Contents Investment Strategy Introduction 5 Summary 6 Portfolio strategy 8 Theme: Quality is crucial

Introduction

5

Summary

6

Portfolio strategy

8

Theme: Quality is crucial

11

Theme: Brighter prospects ahead

14

Theme: China solving growth puzzle

17

Macro summary

19

asset CLasses

Equities

21

Fixed income

24

Hedge funds

26

Real estate

29

Private equity

32

Commodities

34

Currencies

36

Investment OutlOOk - maRCH 2010

3

Investment Strategy This report was published on March 9, 2010. Its contents are based on

Investment Strategy

This report was published on March 9, 2010. Its contents are based on information and analysis available before February 26, 2010.

Hans Peterson

Global Head of Investment Strategy

+ 46 8 763 69 21

hans.peterson@seb.se

Lars Gunnar Aspman

Global Head of Macro Strategy

+ 46 8 763 69 75

lars.aspman@seb.se

Rickard Lundquist

Portfolio Strategist

+ 46 8 763 69 27

rickard.lundquist@seb,se

Victor de Oliveira

Portfolio Manager and Head of IS Luxembourg

+ 352 26 23 62 37

victor.deoliveira@sebprivatebanking.com

Johan Hagbarth

Head of Retail Support + 46 8 763 69 58 johan.hagbart@seb.se

Carl Barnekow

Global Head of Advisory Team + 46 8 763 69 38 carl.barnekow@seb.se

Reine Kase

Economist +46 8 763 6973 reine.kase@seb.se

Liza Braaw

Communicator and Editor +46 8 763 6909 liza.braaw@seb.se

This document produced by SEB contains general marketing information about its investment products. Although the content is based on sources judged to be reliable, SEB will not be liable for any omissions or inaccuracies, or for any loss whatsoever which arises from reliance on it. If investment research is referred to, you should if possible read the full report and the disclosures contained within it, or read the disclosures relating to specific companies found on www.seb.se/dis- claimers. Information relating to taxes may become outdated and may not fit your individual circumstances. Investment products produce a return linked to risk. Their value may fall as well as rise, and historic returns are no guarantee of future returns; in some cases, losses can exceed the initial amount invested. Where either funds or you invest in securities denominated in a foreign currency, changes in exchange rates can impact the return. You alone are responsible for your investment decisions and you should always obtain detailed information before taking them. For more information please see inter alia the simplified prospectus for funds and information brochure for funds and for structured products, available at www.seb.se. If necessary you should seek advice tailored to your individual circumstances from your SEB advisor.

Information about taxation: As a customer of our International Private Banking offices in Luxembourg, Singapore and Switzerland you are obliged to keep informed of the tax rules applicable in the countries of your citizenship, residence or domicile with respect to bank accounts and financial transactions. SEB does not provide any tax reporting to foreign countries meaning that you must yourself provide concerned authorities with information as and when required.

4

Investment OutlOOk - maRCH 2010

Introduction
Introduction

In search of the best – amid chill winds

We are in a sort of holding pattern; selectivity pays, and thoughtfulness is becoming a virtue. The path towards better days is lined with various challenges, such as miserable govern- ment finances and worries about monetary tightening. We are moving from beta to alpha and seeking quality. This is the focus of the spring 2010 issue of Investment Outlook.

This year has begun with a new trend. The economic upturn has consolidated. Meanwhile the markets have been fretting about such things as the government finances of various European countries and an economic policy tightening in China. Market conditions have become more uncertain.

Later this year, growth rates in the OECD will slow as posi- tive inventory effects and fiscal stimulus packages fade. This means we are now focusing on assets that can perform well without strong cyclical support. In this phase, the wheat will be separated from the chaff. We must refine our investment strategy. Today there are still good potential investments. The global economy is continuing to grow − though rather slowly, which is nevertheless an advantage. As the market perceives the future as more predictable, risk appetite will climb. This, in turn, will lead to greater interest in alternative asset classes.

We Have mOveD intO reaL estate We have now taken our first steps into the real estate market in our portfolios. A rapid upswing in real estate transactions at good price levels − substantially better than prices at the end of the last economic expansion − is under way. There are parallels here with private equity, in which we also made an early investment that has yielded us good returns, especially compared to asset classes with similar risk exposure. In the long term, our attitude is that it is better to buy a little too early than too late.

Another investment area we are carefully evaluating and tak- ing action in is emerging markets (EM). In today’s financial cli- mate, investors are drawing a sharp distinction between high and low quality. In our opinion, many EM countries represent high quality in terms of growth and finances. Rapid growth will trigger interest rate hikes, but the combination of quality and potential currency gains is attractive. Stock markets in the EM sphere will probably yield good returns. Today’s worries about China’s monetary tightening measures may very well be fol- lowed by a realisation in the markets that it is to their advan- tage to keep inflation risks in check.

time tO FOCUs On QUaLity “From beta to alpha” is one of our main themes. In other words, we now need to find good returns with an emphasis on quality, following the first rapid market upturn phase. We have the advantage of being able to employ a broad spectrum of investment opportunities.

During recent quarters, our corporate bond market invest- ments have been very successful. We will remain exposed to corporate bonds, especially in the High Yield segment. Despite an already very good run in this segment, we foresee contin- ued fine potential returns. These returns are likely to end up being well above those of a global equities investment but at less risk in terms of volatility, creating the potential for good portfolio management.

There will be some challenges during the spring of 2010, but in a somewhat longer perspective the prospects for econo- mies and financial markets are bright. The key to this is a slow economic upturn, coupled with low inflation. But the upswing will take time, especially in the G3 countries. This will demand greater selectivity in our investments.

Hans Peterson CIO Private Banking and Global Head of Investment Strategy

Investment OutlOOk - maRCH 2010

5

Historical return

Historical return Summary   Expected 1-year   return risk Reasoning Equities 8% 17%

Summary

 

Expected 1-year

 

return

risk

Reasoning

Equities

8%

17%

positivE. Stock markets are past their very best period and in some places are now being subjected to conflicting forces. Yet the current phase is rather equity-friendly, and valuations are below historical averages. There is good stock market potential in the US, emerging markets (mainly Eastern Europe) and companies with financial stamina.

Fixed income

5%*

6%

WAit-AND-sEE/positivE. Corporate bonds remain appealing, and High Yield bonds in particular are more attractive than government bonds. Our exposure to convertible debt instruments remains favourable, and emerging market debt is increasingly attractive.

Hedge funds

7%

6%

positivE. The effect of initiatives to regulate the hedge fund industry remains unclear. Looking ahead, our focus will be on quality managers who have proven capacity, with an emphasis on Macro, CTA, Relative Value and Fixed Income strategies.

Real estate

4%

3%

WAit-AND-sEE/positivE. Access to lending is gradually improving, the number of transactions is rising, and yield is falling. All this indicates that the real estate market is on its way into a recovery phase. Various problems remain, however, and it will be important to stick to quality properties.

Private

positivE. The number of transactions is increasing, indicating that the gap between buyers and sellers is now beginning to narrow. The secondary market remains attractive. The risks concern quality in the economic cycle and possible risk aversion.

equity

15%

24%

Commodities

5%

15%

WAit-AND-sEE. A stronger USD, economic policy tightening measures in China, a dip in OECD economic growth and regulation of US commodities trading are risk factors that are lowering the prospects for this asset class as a whole. Industrial metals are the least attractive, while agri-commodities may rise due to poorer harvests and protectionism.

Currencies

5%

3%

WAit-AND-sEE/positivE. The USD will appreciate against the EUR in the next few years. Emerging market currencies should appreciate, while commodity-related currencies may lose some ground. Better risk appetite should lower the JPY and CHF somewhat further ahead.

* Expected return on corporate bonds that are weighted about 1/3 Investment Grade and 2/3 High Yield.

eXpeCteD risk anD retUrn (1 year HOriZOn)

CHange in OUr eXpeCteD retUrns

1 6 % 16% 1 4 % 14% Private equity 1 2 % 1 0
1 6
%
16%
1 4
%
14%
Private equity
1 2
%
1
0 %
12%
8
%
6
%
10%
4
%
2
%
8%
Hedge funds
Equities
0
%
-2
%
6%
Currencies
-4
%
Fixed income*
Commodities
4%
Real estate
2%
0%
Equities
Fixed income*
Hedge funds
Real estate
Private equity
Currencies
Commodities
-2%
Expectedreturn
2008-11
2009-02
2009-05
2009-08
2009-12
2010-02

0%

5%

10%

15%

20%

25%

30%

 

Expected volatility

 

HistOriCaL risk anD retUrn (FebrUary 29, 2000 tO JanUary 31, 2010)

8%

 

6%

   
 

Fixed Income

Real estate

Real estate

 

4%

 

2%

 
Hedge funds

Hedge funds

 

0%

0% Currencies

Currencies

0% Currencies

-2%

 

Commodities

 
Equities

Equities

-4%

 

-6%

-8%

-10%

 

Private equity

-10%   Private equity

0%

5%

10%

15%

20%

25%

30%

Historical volatility

HistOriCaL COrreLatiOn (FebrUary 29, 2000 tO JanUary 31, 2010)

Commodities

Fixed income

Hedge funds

Real estate

Currencies

Equities

Private

equity

Equities

1.00

Fixed income

-0.02

1.00

Hedge funds

0.35

0.24

1.00

Real estate

0.75

-0.10

0.23

1.00

Private

equity

0.83

-0.18

0.28

0.82

1.00

Commodities

0.27

-0.12

0.27

0.22

0.30

1.00

Currencies

0.17

0.65

0.51

-0.01

-0.06

-0.01

1.00

Historical values are based on the following indices: Equities = MSCI AC World. Fixed income = JP Morgan Global GBI Hedge. Hedge funds = HFRX Global Hedge Fund. Real estate = FTSE EPRA/NAREIT Developed. Private equity = LPX50. Commodities = S&P GSCI TR. Currencies = BarclayHedge Currency Trader.

6

Investment OutlOOk - maRCH 2010

Per cent

WeigHts in mODern prOteCtiOn

Equities

Fixed income

Hedge funds

Real estate

Private equity

Commodities

Currencies

Cash

0%

Real estate Private equity Commodities Currencies Cash 0% 0% 0% 10. 0% 1% 5% 0% 10%
Real estate Private equity Commodities Currencies Cash 0% 0% 0% 10. 0% 1% 5% 0% 10%

0%

0%

10.

0%

1%
1%

5%

0%

10%

5%

20% 30%

Currencies Cash 0% 0% 0% 10. 0% 1% 5% 0% 10% 5% 20% 30% 40% Previous

40%

Previous

50%

60% 70%

Current0% 10. 0% 1% 5% 0% 10% 5% 20% 30% 40% Previous 50% 60% 70% 80%

80%

83. 5%

90%

WeigHts in mODern grOWtH

Equities

Fixed income

Hedge funds

Real estate

Private equity

Commodities

Currencies

Cash

funds Real estate Private equity Commodities Currencies Cash 24% 27% 3% 2. 5% 5% 5% 3.

24%

27%
27%

27%

27%
estate Private equity Commodities Currencies Cash 24% 27% 3% 2. 5% 5% 5% 3. 5% 30%
3% 2. 5% 5% 5% 3. 5%
3%
2.
5%
5%
5%
3. 5%

30%

0%

10%

20%

30%

Cash 24% 27% 3% 2. 5% 5% 5% 3. 5% 30% 0% 10% 20% 30% Previous

Previous

27% 3% 2. 5% 5% 5% 3. 5% 30% 0% 10% 20% 30% Previous Current 40%

Current

40%

WeigHts in mODern aggressive

Equities

Fixed income

Hedge funds

Real estate

Private equity

Commodities

Currencies

Cash

funds Real estate Private equity Commodities Currencies Cash     29%     22. 5% 0%
   

29%

   

22.

5%

0%

 
5%
5%

10.

5%

0%

 
1%
1%

1%

0%

10%

 

20%

30%

5% 0%   1% 0% 10%   20% 30% Previous Current 32% 40% Summary rOLLing 36-mOntH

Previous

0%   1% 0% 10%   20% 30% Previous Current 32% 40% Summary rOLLing 36-mOntH COrreLatiOns

Current

32%

40%

Summary

10%   20% 30% Previous Current 32% 40% Summary rOLLing 36-mOntH COrreLatiOns vs. msCi WOrLD (eUr)

rOLLing 36-mOntH COrreLatiOns vs. msCi WOrLD (eUr)

1 0 . 8 0 . 6 0 . 4 0 . 2 0 -
1
0
. 8
0
. 6
0
. 4
0
. 2
0
- 0
. 2
- 0
. 4
- 0
. 6
2 0 0 2
2 0 0 3
2 0 0 4
2 0 0 5
2 0 0 6
2 0 0 7
2 0 0 8
2 0 0 9
Fixed income
Hedge funds
Real estate
Private equity
Commodities
Currencies

Quality is crucial: After the recovery, the focus is now shifting to flourishing countries and quality companies

brighter prospects ahead: The market should move from treading water to upturn − risk assets will benefit

China solving growth puzzle: Domestic demand should be able to take over as an economic engine

tHeme: QUaLity is CrUCiaL

1 6 0 0 1 . 6 5 1 5 0 0 1 . 6
1
6
0
0
1 . 6
5
1
5
0
0
1 . 6
0
1
4
0
0
1 . 5
5
1
3
0
0
1 . 5
0
1
2
0
0
1 . 4
5
1 1
0
0
1 . 4
0
1 0
0
0
1 . 3
5
9
0
0
1 . 3
0
8
0
0
1 . 2
5
7
0
0
1 . 2
0
M a r J u n Se p D e c
M a r J u n Se p D e c
2 0 0 8
2 0 0 9
2 0 1 0
EUR/USD [ma 5]
MSCI World [ma 5]
EUR/USD
MSCI

Source: Reuters EcoWin

Since late 2009, the USD has strengthened from 1.50 to 1.35 per EUR, while the stock market has lost only a few per cent. This indicates that the correlation between equities and the dollar has begun to loosen.

tHeme: CHina sOLving grOWtH pUZZLe 50 50 40 40 30 30 20 20 10 10
tHeme: CHina sOLving grOWtH pUZZLe
50
50
40
40
30
30
20
20
10
10
0
0
-10
-10
-20
-20
-30
-30
1996
1998
2000
2002
2004
2006
2008
China, Exports, Chg y/y
China,Investment in Fixed Assets, Urban, Chg Y/Y
Source: Reuters EcoWin

Both in 1998-99 and 2000-2002, when export growth fell, the pace of investments rose in China. We now discern a similar pattern for the period 2008 onward.

Investment OutlOOk - maRCH 2010

7

Portfolio strategy
Portfolio strategy

Portfolios for a new financial reality

Our Modern investment programmes have been adapted to the new market conditions. Our positive view of corporate bonds remains in place, but we are choosing to reduce interest rate sensitivity. Our convertible debt instruments show that we have found the desired cushion against a stock market downturn. We are keeping our weighting for equities unchanged. Our hedge fund holdings have performed well, and we are raising our return expectations in this asset class. The same applies to real estate, a new feature of our portfolios along with emerging market debt. We have lowered our return expectations for commodities and have consequently down-weighted this asset class.

mODern prOteCtiOn Even under the more turbulent market conditions of recent months, Modern Protection has proved stable and has deliv- ered positive returns. Despite such events as the government fiscal crisis in southern Europe, China’s monetary tightening measures and President Barack Obama’s proposal for stricter banking rules, all holdings except one are still showing a posi- tive return. Granted that market prices for our limited risk exposure in corporate bonds − both Investment Grade (IG) and High Yield (HY) − fell from their late January peaks, but they are still making a positive contribution to the portfolio. Our exposure to the foreign exchange market continues to be the weak link in the portfolio, with a marginal negative yield, but at present we see no major cause for concern. We regularly re-assess our investment decisions, however.

Our positive view of IG and HY bonds remains largely un- changed, but we are choosing to reduce the interest sensitivity of our IG bond holding. We are replacing our holding with one that has a similar strategy and manager, but with a signifi- cantly shorter duration. It may actually seem rather early to be worrying about rising market interest rates, but this reflects our cautious attitude towards all types of risks in the Modern Protection portfolio. The fixed income funds with “cash plus” and “total return” strategies that we have chosen to invest in have actually exceeded our expectations, not just matched them. It was highly reassuring to watch how their managers skilfully navigated through the latest market turbulence. Risk control is one of the most important components, and it is often a matter of avoiding losses rather than achieving large gains. We can note that this has worked.

8

Investment OutlOOk - maRCH 2010

The hedge fund portion of the portfolio is unchanged, focus- ing on market neutral strategies. This year began well for our holdings, and in this asset class we look forward to the com- ing year with confidence. After sharp recoveries during which most assets have gained value, there is now a clear trend:

market players that can separate the wheat from the chaff will be the winners. This can also be expressed in technical terms as separating alpha from beta, which is exactly what market neutral strategies are all about.

1% 5% 10.5% 83.5%
1% 5%
10.5%
83.5%

Cashwhich is exactly what market neutral strategies are all about. 1% 5% 10.5% 83.5% Currencies Hedge

Currenciesbeta, which is exactly what market neutral strategies are all about. 1% 5% 10.5% 83.5% Cash

Hedge fundsfrom beta, which is exactly what market neutral strategies are all about. 1% 5% 10.5% 83.5%

Fixed incomefrom beta, which is exactly what market neutral strategies are all about. 1% 5% 10.5% 83.5%

mODern grOWtH The financial world has now definitively left behind its most aggressive recovery period. The focus has shifted back to current economic realities, and perhaps a bit away from ex- pectations of future growth. Markets have seriously begun to question the high indebtedness of Western countries and their long-term capacity to generate growth. Movements in major currencies are creating concerns, and markets are doubtful about the value of the euro in the wake of government fiscal crises primarily in the currency union’s Mediterranean mem- ber nations. When China − a key “economic engine” among emerging market countries − also resorts to measures aimed at cooling off its economy, this leads inexorably to uncertainty and loss of risk appetite. Commodities, primarily metals and their producers, quickly suffered profit-taking and falling market prices. We regard our exposure to commodities in the Modern Growth portfolio as reasonably balanced. Even though it fell rather sharply in value in a relatively short time, we are thus still choosing to retain our position, since this ex- posure is well-diversified in nature.

Equities are naturally rather hard-hit as an asset class when market worries multiply, but since we did not let ourselves be persuaded to join the wild celebration and instead held off from increasing our holding of equities, we feel comfortable with our exposure, which is about 24 per cent. The equities portion of the Modern Growth portfolio is based on good ex- pected returns in relation to risk during the coming year, and market turbulence has not caused us to change that opinion. Our main scenario assumes that the problem economies in the EU will deal with their imbalances, although this process may take a bit longer than desirable, and that a new global financial crisis can be avoided. We essentially view China’s measures to cool off its economy as natural and logical steps that should lead to a more sustained, stable period of eco- nomic growth, though characterised by a marginally lower rate of expansion.

In the fixed income portion of the portfolio, we are doing the same as in Modern Protection: reducing our interest rate sensitivity in IG bonds. In the same way, we are replacing our holding with one that has a similar strategy and management, but with a significant shortening of duration. Although we are more risk-inclined in the Modern Growth portfolio, we believe that the same risk adjustment is justified considering our ex- pected returns on IG bonds. Our HY bond holdings will remain intact, however.

Our holding of convertible debt instruments has performed as expected. So far the result has been to provide us with the cushion against a stock market downturn that we were seek- ing, but with greater potential for a continued upturn than cor- porate bonds. The choice of two complementary investments proved wise, since the one that has a larger equities element has delivered a marginally negative yield, while the one focus-

Portfolio strategy

negative yield, while the one focus- Portfolio strategy ing on the bond market has yielded a

ing on the bond market has yielded a positive return. We are satisfied with our exposure to convertible debt.

Just as we were early in embracing listed private equity, we now foresee the potential for attractive risk-adjusted returns in real estate. In our judgement, the commercial real estate market will bottom out during the latter part of 2010. We are choosing to reduce our cash holding by three per cent of the portfolio by moving into a well-diversified real estate fund, which will invest mainly in open, direct-investment real estate funds. Our objective and expectation is to earn a yearly return of between 5-8 per cent via the yield on the underlying prop- erties. Since our last Investment Outlook (December 2009), we have raised our expected return on real estate.

Turning to private equity as an asset class, our ambition remains to broaden our portfolio, but at present we find it difficult to balance attractive investments with reasonable liquidity. Our search is continuing, and in the meantime we are choosing to retain our current position in listed private equity, which has continued to contribute positively to the portfolio.

Just as in Modern Protection, we have not received any posi- tive contribution in Modern Growth from foreign exchange exposure. We see no immediate cause for concern, but unlike in Modern Protection, we are willing to re-assess our decision in favour of an investment that carries higher risk and greater return potential.

Among the hedge funds that we recently added to the Modern Growth portfolio, we have been affected by a pleasant prob- lem for the hedge fund industry. Hedge funds that perform very well receive so much new money that they decide to close the funds to new deposits. The purpose of this is to avoid jeopardising the ability of the funds to generate continued good returns for existing investors. We recently invested in such a fund, and now we must search for complementary alternatives. The portfolio is robust and well-diversified, with strategies that we believe have good potential to contribute to good, stable returns. In this asset class, too, we have raised our expected return for the coming year.

3.5% 5% 24% 5% 2.5% 3% 30% 27%
3.5%
5%
24%
5%
2.5%
3%
30%
27%

Cashfor the coming year. 3.5% 5% 24% 5% 2.5% 3% 30% 27% Currencies Commodities Private equity

Currenciesthe coming year. 3.5% 5% 24% 5% 2.5% 3% 30% 27% Cash Commodities Private equity Real

Commoditiesyear. 3.5% 5% 24% 5% 2.5% 3% 30% 27% Cash Currencies Private equity Real estate Hedge

Private equity5% 24% 5% 2.5% 3% 30% 27% Cash Currencies Commodities Real estate Hedge funds Fixed income

Real estate3% 30% 27% Cash Currencies Commodities Private equity Hedge funds Fixed income Equities Investment OutlOOk -

Hedge funds30% 27% Cash Currencies Commodities Private equity Real estate Fixed income Equities Investment OutlOOk - maRCH

Fixed income3% 30% 27% Cash Currencies Commodities Private equity Real estate Hedge funds Equities Investment OutlOOk -

Equities30% 27% Cash Currencies Commodities Private equity Real estate Hedge funds Fixed income Investment OutlOOk -

Investment OutlOOk - maRCH 2010

9

Portfolio strategy mODern aggressive Although we are more inclined to take risks in the Modern

Portfolio strategy

mODern aggressive Although we are more inclined to take risks in the Modern Aggressive portfolio, late in 2009 we carried out some reallo- cations of risk in order to improve the balance and correlations between our holdings. Specific changes were made in equities in favour of greater exposure to HY, and a broader mandate in commodities was added to the portfolio.

We have now reduced our commodity exposure to metal and energy producers. This is the holding that has performed most spectacularly since the beginning almost a year ago, and sharp upturns unquestionably lead to lower expected future return. In the wake of China’s economic policy tightening measures, we have consequently lowered our return expectations for the commodities asset class, and we are thus also reducing our exposure. Instead we are increasing our private equity holding. This is at least equally “aggressive” in nature, but has different driving forces. We are also allocating part of our commodities exposure to emerging market debt (EMD), making this a new holding in the fixed income asset class.

The role of emerging markets in global growth is steadily in- creasing. The countries in the emerging markets (EM) sphere now account for about 32 per cent of global consumption. This means that they have surpassed the US, which accounts for around 28 per cent. Although the OECD countries still produce 65 per cent of the world’s total GDP, the growth rate in the EM sphere has been twice as high during the past five years. As their economic and political conditions improve, the credit ratings of EM countries are now being upgraded.

10

1% 5% 10.5% 32% 22.5%
1% 5%
10.5%
32%
22.5%

29%

Investment OutlOOk - maRCH 2010

Cash1% 5% 10.5% 32% 22.5% 29% Investment OutlOOk - maRCH 2010 Commodities Private equity Hedge funds

Commodities10.5% 32% 22.5% 29% Investment OutlOOk - maRCH 2010 Cash Private equity Hedge funds Fixed income

Private equity22.5% 29% Investment OutlOOk - maRCH 2010 Cash Commodities Hedge funds Fixed income Equities In addition

Hedge fundsOutlOOk - maRCH 2010 Cash Commodities Private equity Fixed income Equities In addition to high interest

Fixed income- maRCH 2010 Cash Commodities Private equity Hedge funds Equities In addition to high interest rates

EquitiesCash Commodities Private equity Hedge funds Fixed income In addition to high interest rates and positive

In addition to high interest rates and positive prospects, the EM currencies are increasingly attractive to investors, and these currencies are likely to appreciate further. From the standpoint of an asset manager, EMD has high return potential. It provides opportunities to work with yield curves, interest rates and local currencies, but also with bonds issued in hard currencies. Since 2001, EMD in local currencies has yielded an annual return of more than 15 per cent. We foresee continued good performance, although it will hardly be as strong as during the past nine years.

As in the Modern Growth portfolio, in Modern Aggressive we have also recently been affected by a pleasant problem for the hedge fund industry. Hedge funds that perform very well re- ceive so much new money that they decide to close the funds to new deposits. The purpose of this is to avoid jeopardising the ability of the funds to generate continued good returns for existing investors. We recently invested in such a fund, and now we must search for complementary alternatives. The portfolio is robust and well-diversified, with strategies that we believe have good potential to contribute to good, stable returns. In this asset class, too, we have raised our expected return for the coming year.

Here we are choosing not to invest in the same type of real estate as in Modern Growth, since its defensive nature does not fully contribute to the objectives of the Modern Aggressive portfolio.

theme: Quality is crucial
theme:
Quality is crucial

Only the best is good enough

This year, the focus of investors will be on quality…

…whether it concerns bonds, currencies or equities

The winners will be flourishing countries and quality companies

In recent years, market movements have taken investors on

a roller coaster ride. The period from 2005 to the summer of

2007 was dominated by high risk appetite and skyrocketing share prices. After that, investors fled from anything risky, but by the spring of 2009 they were again buying risk assets in large quantities.

The world economy survived the doomsday scenario painted by the media and forecasters, a fact that is priced into markets today. Share prices, commodity prices and returns on debt securities and other assets have rebounded from their 2009 lows. What climbed the most were assets that were priced during the most acute crisis phase on the assumption that bankruptcy was imminent − that is, low-quality assets.

After living through several years of markets where they were either flooring the accelerator or slamming both feet on the brake, today’s market players are increasingly distinguishing between investments based on good and bad risk. The period we are entering will thus not be as forgiving of “bad risk” as was the case last year. Instead we foresee that one theme of 2010 will be assessing the underlying quality of assets, regard- less of whether they are government securities, corporate bonds, currencies or equities.

One clear example of how the market has begun to focus on quality is today’s concern about Greek government finances.

It is not news that the “PIGS” countries (Portugal, Italy, Greece and Spain) are in shaky economic health. We wrote about this in Investment Outlook as far back as one year ago (March 2009). For weak euro zone member countries, the cost of bor- rowing was as high at that time as it is now.

viOLent stOCk market sWings 500 450 400 350 300 250 200 2005 2006 2007 2008
viOLent stOCk market sWings
500
450
400
350
300
250
200
2005
2006
2007
2008
2009
2010
In d e x

Source: Reuters EcoWin

In recent years, the stock market has behaved like a roller coaster. In our assessment, the market has now entered a phase where investors are increasingly evaluating the underlying quality of assets. Market players are thus not as likely as previously to be as unanimously positive or nega- tive towards risk assets.

The difference is that during the spring 2009, the market was glad just to be alive, and only now have investors begun look- ing more closely at quality.

COUntry risk Has an impaCt The financial situation of countries has begun to affect inves- tors’ decisions and is having a clear impact on various asset markets. It seems quite natural that the euro is losing ground when the euro system is creaking at the joints. Nor is it any surprise that Greek government bonds are losing value as the country inches closer to insolvency. Somewhat more sur- prising, however, is that shares and bonds of a company like Portugal Telecom have performed far worse than those of its competitor Deutsche Telekom, even though the two compa- nies have similar credit ratings and business models.

The same pattern is discernible if we view markets at the ag- gregate level. During the past three months, the Greek stock market has lost more than 20 percent and the Spanish stock market 15 per cent. But in Germany the stock market

Investment OutlOOk - maRCH 2010

11

Theme: Quality is crucial stOCk market trenDs in eUrOpe (3 mOntHs) 12.5 12.5 10.0 10.0
Theme: Quality is crucial
stOCk market trenDs in eUrOpe (3 mOntHs)
12.5
12.5
10.0
10.0
7.5
7.5
5.0
5.0
2.5
2.5
0.0
0.0
-2.5
-2.5
-5.0
-5.0
-7.5
-7.5
-10.0
-10.0
-12.5
-12.5
-15.0
-15.0
Finland
Sweden Germany
I taly
Portugal
Spain
Greece

Source: Reuters EcoWin

The performance of some European stock markets varies greatly, reflecting the influence of each country’s financial situation on investors’ decisions.

has fallen only about 4 per cent and in Sweden only 2 per cent. Borrowing costs of companies operating in weak euro zone countries have climbed substantially (rising interest rates on loans), while the borrowing costs of companies with operations in countries like Germany have remained stable.

Investors are thus distinguishing between economic condi- tions in different countries and assuming that companies that operate in weak economies will be adversely affected. Among other things, these companies will face lower demand and higher taxes than competitors based in economies that are on more stable ground. Euro zone countries with poor budg- etary discipline are not alone in grappling with severe deficit problems. The global economic slowdown and the launch of gigantic stimulus packages have dug deep holes in many Western government budgets. In searching for quality, inves- tors are thus more interested in countries that have managed their budgets well and can show solid cash balances and cur- rent account surpluses (such as Sweden, Norway, Canada and Germany). Asset classes connected to these countries are thus likely to be in heavier demand.

QUaLity UpsWing FOr emerging markets Historically, a negative gust of wind in the world economy has turned into a full-blown storm in the emerging markets sphere, but this time around the opposite is true. Most devel- oping countries have demonstrated impressive growth fig- ures, even though the global economy has suffered its worst cyclical slump in many decades. One repercussion of the financial and economic crisis is that most Western countries have seen their credit ratings downgraded by international rating agencies. For developing countries, however, the trend has been towards a larger number of positive ratings chang- es, even at a time when the global economy was down for the count. The main reason for this new order is that the econo- mies in the EM sphere have significantly more stable financial fundamentals than before. The EM sphere has escaped the brunt of the global economic slowdown, and this is reflected

12

Investment OutlOOk - maRCH 2010

in the trend of share prices. Overall, EM shares provided a return of 75 per cent during 2009, compared to “only” 25 per cent for the rest of the world (both in US dollar terms), but the massive rally on EM stock exchanges may also be viewed as a consequence of their having fallen − without justification − significantly further than Western stock exchanges when the financial crisis was raging at its worst. Investors have thus corrected their previous assumption that emerging markets were more vulnerable, which proved wrong.

In our assessment, assets in most emerging markets will re- main in demand among global investors, especially at a time when quality is a guiding principle. It is mainly OECD countries that face the biggest challenges. Their central government debts have skyrocketed, and in a number of industrialised countries such debt is higher than one year of GDP. In the emerging market countries, the growth of government debt has been more stable, and at an aggregate level it represents less than 50 per cent of GDP. The number of jobs in the EM sphere has increased during the past six months, while the current labour market situation and outlook in the OECD countries appear much gloomier. Finally, we expect the EM sphere to continue delivering growth figures well above those of the OECD countries. The difference in levels is striking. According to the IMF forecast for 2010 the EM sphere will grow by nearly 6.5 per cent, while the OECD countries are only pro- jected to grow by a bit below 2.5 per cent.

CHanges in em CreDit ratings

 

s&p

fITCH

Moody's

China

A+/Stbl

A+/Stbl

A1/Pos

Estonia

A-/Stbl

BBB+/Neg

A1/Neg

Mexico

BBB/Stbl

BBB/Stbl

Baa1/Stbl

Russia

BBB/Stbl

BBB/Stbl

Baa1/Stbl

Hungary

BBB-/Stbl

BBB/Neg

Baa1/Neg

Lithuania

BBB/Stbl

BBB/Neg

Baa1/Neg

Bulgaria

BBB/Stbl

BBB-/Neg

Baa3/Pos

Iceland

BBB-/Neg

BB+/Neg

Baa3/Stbl

Indonesia

BB-/Pos

BB+/Stbl

Ba2/Stbl

Turkey

BB/Pos

BB+/Stbl

Ba2/Stbl

Ukraine

CCC+/Stbl

B-/Neg

B2/Neg

Rating up

Outlook up

Rating down

Outlook

down

The past four months have been dominated by positive changes in credit ratings, as shown by the colours in the table. This applies both to the actual rating (letter combination) and the future outlook (positive/stable/negative).

tHe Us DOLLar – a sOUrCe OF COnCern Since the beginning of 2010, we have seen a sharp US dol- lar appreciation, and we expect this trend to continue. Historically, a strong dollar has generally been synonymous with weaker stock markets, especially in the EM sphere. So is the surging value of the dollar a threat to risk assets in general and EM assets in particular? There are several explanations for the connection between the dollar and the stock market. One is that the dollar often gains strength during periods when risk appetite is low. Investors sell their risk assets and buy US government securities, strengthening the dollar. Based on the conventional wisdom that EM countries are the most vulnerable to external shocks, stock market declines in these countries were sharper. This time, the strength of the dollar is primarily a consequence of a weak euro, since the euro system has turned out to be built on shaky ground. Part of the dollar’s upturn can also be ascribed to an unexpectedly strong US economy. Since the problems are thus specific to Europe, nei- ther US stock exchanges nor emerging market regions should suffer any major damage.

Another reason why emerging market countries have his- torically been especially hard hit by a strong dollar is that they have previously been known as commodity producers. Commodities are traded in dollars, and a strong US currency pushes down commodity prices. Today, however, the EM coun- tries as a whole have well-diversified stock markets, and the EM sphere is less dependent on commodity exports. For Latin America and Russia there may be a clear impact if the dollar remains strong, but so far this year commodity prices have shown low correlation with the dollar.

Overall, today the dollar does not pose the same threat to risk assets as during earlier periods of dollar appreciation. But although the correlation between the dollar and stock markets is no longer as strong, the dollar upswing still reflects a certain decline in investors’ risk appetite. Thus not all risk assets will perform strongly, and it is up to the investor to bet on the right horse. As mentioned earlier, in our assessment the quality of assets will be increasingly important in helping investors to make the proper choices.

tHe stOCk market is De-COUpLing FrOm tHe DOLLar

1600 1.65 1500 1.60 1400 1.55 1300 1.50 1200 1.45 1100 1.40 1000 1.35 900
1600
1.65
1500
1.60
1400
1.55
1300
1.50
1200
1.45
1100
1.40
1000
1.35
900
1.30
800
1.25
700
1.20
EUR/USD
MSCI

Mar Jun Sep Dec Mar Jun Sep Dec

700 1.20 EUR/USD MSCI Mar Jun Sep Dec Mar Jun Sep Dec 2008 EUR/USD [ma 5]

2008

EUR/USD [ma 5]

MSCI Mar Jun Sep Dec Mar Jun Sep Dec 2008 EUR/USD [ma 5] 2009 MSCI World

2009

MSCI World [ma 5]

2010

Source: Reuters EcoWin

Theme: Quality is crucial

QUaLity COmpanies WiLL be tHe Winners Aside from country-specific differences, the market will also take into account that companies show different quality levels. Compared to most governments − which face enormous eco- nomic challenges − companies that survived the financial and credit crisis are generally in good health. Today they typically have fewer employees, slimmed-down inventories and higher productivity. However, certain types of companies will cope better than others in the market climate that we foresee.

In an upward market cycle, in the first phase it is high-beta, low-quality shares that perform most strongly. The stock market curve is usually steep in this initial phase. After six to twelve months, the stock market trend normalises. In our assessment, it will be quality companies that drive the stock market in this phase (where we are now).

According to our criteria, quality companies are well-estab- lished companies that have a tried-and-tested, successful

business model. They must also be able to demonstrate good, uniform earnings growth regardless of market climate. Finally, they must have sound finances and strong balance sheets. In

a climate where quality is becoming increasingly important, in-

vestors will pay extra for companies with these characteristics.

One way of distinguishing high-quality stocks is to look at their potential for high dividends. A company that has historically paid high dividends to shareholders − regardless of market climate − ought to have a well-functioning business model,

a sound balance sheet and a strong cash flow. Since global

growth is expected to be low in 2010-2011 and the world has now entered the more mature phase of the recovery, the divi- dend in itself may also contribute a relatively large proportion of the total return on shares.

This year it will be extra important for investors to choose good risk assets. In our view, during 2010 good risks will be most EM countries (stock markets, currencies and bonds), the US (the dollar and US stock exchanges) and quality companies with high, stable dividends.

Since late 2009, the US dollar has appreciated

greatly against the euro (which has fallen from

USD 1.50 to USD 1.35). Meanwhile the stock market has lost only a few per cent. This indi-

cates that the correlation between the stock market and the dollar has begun to loosen.

Investment OutlOOk - maRCH 2010

cates that the correlation between the stock market and the dollar has begun to loosen. Investment

13

Per cent

Per cent

theme: Brighter prospects ahead
theme:
Brighter prospects
ahead

Slow upturn will benefit risk assets

14

Markets are now largely treading water…

…but there are good odds of improved performance a bit further ahead

The key is slow economic recovery and low inflation

firmed by current macroeconomic statistics during the second half of 2009, this further fuelled the upturn in risk asset val- ues. More recently, however, the picture has changed. A new phase has begun, including both positive and negative influ- ences, and the trend of asset prices has thus been significantly more mixed. Our first theme article (see page 11) discusses the characteristics of the phase that the market has now entered.

What happens to asset prices further ahead – late in 2010 and early in 2011 – will depend on numerous factors. Among the most important factors at the macro level will be economic and price trends as well as the direction of economic policy in both the OECD and the emerging market (EM) sphere, plus the prospects of market-moving surprises, either upside or downside.

At present, much of the world economy is characterised by strong cyclical momentum, with only portions of Eastern Europe lagging behind. The OECD countries are benefiting from continued powerful economic stimulus measures, a major shift in the inventory cycle from draw-down to build-up and a very strong surge in manufacturing. During the latter part of 2010, however, the OECD countries will lose a great

6

5

4

3

2

1

0

- 1

- 2

3

The environment for financial assets usually undergoes significant shifts in the course of an economic cycle. Since expectations ordinarily determine the current behaviour of the markets, these are usually ahead of the economic cycle. The most recent period of rising risk asset prices began late in the first quarter of 2009, in other words 4-5 months before the shift from recession to recovery in the industrialised countries of the OECD.

In this initial phase, markets began to discount an imminent economic upturn, with leading indicators as their compass − and this time a new indicator concept, “green shoots”, was coined. Risk appetite also benefited from low and occasionally falling market interest rates. When the recovery was also con-

1992 1995 1998 2001 2004 2007
1992
1995
1998
2001
2004
2007

stOCk market a step aHeaD OF tHe eCOnOmy

50

40

30

20

10

0

- 10

- 20

- 30

- 40

- 50

- It is historically well documented that the

4

- stock market is a leading economic indicator. This also applied during 2009, when share prices began climbing 4-5 months before the economy (measured here as US GDP).

US, GDP, Total, Constant Prices, AR, SA, USD, 2005 prices [c.o.p 261 obs] US, S&P 500 Composite, Index, Total Return, Close, USD [c.o.p 261 obs, ma 21] Source: Reuters EcoWin

Investment OutlOOk - maRCH 2010

Per cent

deal of their growth dynamic as the prevailing stimulus effects fade. In the EM sphere, expansion will meanwhile continue in high gear, with the fast-growing Asian economies in particular leading the way. China is expected to account for nearly 1/3 of global GDP growth of 4.5 per cent during 2010.

This dual-track global economic trend will create widely con- trasting economic policy conditions, especially since the gaps in growth rates will cause inflation prospects to appear very different. While the OECD countries are predicted to show consumer price inflation of about 1 per cent this year and only slightly above 0.5 per cent in 2011, price increases in the EM sphere seem set to end up at around 5 per cent both years. In itself this is not especially high in a historical perspective. While the OECD countries will be characterised by many price- depressing forces − large spare capacity, the slowest rate of pay increases in the post-war period, weak labour markets, high productivity − many EM countries will be confronted by certain overheating tendencies in the real economy, coupled with asset price bubble risks.

mOre rOOm FOr LOOse mOnetary pOLiCy The need for economic policy tightening will thus be sub- stantially greater in the EM sphere than in the OECD. But one complication in the OECD is that the financial problems of the governments in a number of countries will necessitate fiscal belt-tightening. This is something that in itself increases room for a continued loose monetary policy, however (see also page 24). In the EM sphere, on the other hand, public finances are in far better shape, so fiscal policy decisions will be different from those in the OECD. The bottom line is that the focus of economic tightening in the EM sphere will be on monetary policy, not fiscal policy.

Some countries, especially in Asia, have already begun to tighten their monetary policy. China’s two-stage increase in cash reserve requirements for banks since the beginning of 2010 has attracted the greatest attention. Eastern Europe is lagging behind in the economic cycle, as reflected in Russia’s recent cut in its key interest rate. So far there are no signs that the new monetary policy measures in the EM sphere will be forceful. This should be seen in light of the fact that the above-mentioned price and bubble risks do not appear to be so serious (see also page 18). Furthermore, there are many indications that EM currencies will continue to rise in value, cooling off their economies, especially if China resumes its appreciation of the yuan, as we have forecasted (see page 37). Another part of the picture is the prospect of rather stable commodity prices (see page 34).

Looking ahead about one year, monetary policy in the OECD is thus likely to be loose – short-term interest rates will remain historically low, while long-term yields will climb only modestly. Meanwhile tightening measures will be imposed in the EM sphere, but these seem unlikely to be of the aggressive kind.

Theme: Brighter prospects ahead

be of the aggressive kind. Theme: Brighter prospects ahead Overall, this should be a global environment

Overall, this should be a global environment that benefits risk assets. Reversals may occur at times, however, as the market focuses on and becomes concerned about moves towards tougher monetary policy, as illustrated by the negative reac- tion to the Federal Reserve’s announcement in mid-February that it was raising the discount rate on Fed lending to banks.

mODest interest rate Hikes in 2011 During 2011, by all indications there will be interest rate hikes on a fairly broad front in the OECD, but these appear likely to be modest since inflation prospects are not worrisome and many countries will be tightening their fiscal policies. Nor is there any reason to automatically equate higher interest rates with falling asset prices. Instead, history shows that during rather long periods, moderately rising interest rates have gone hand in hand with rising asset prices, especially if it has been possible to link an interest rate increase to higher economic growth (higher real interest rate), not to rising inflation expec- tations.

HigH interest rates aLOngsiDe bULL markets 5500 7 5000 6 4500 5 4000 4 3500
HigH interest rates aLOngsiDe bULL markets
5500
7
5000
6
4500
5
4000
4
3500
3
3000
2
2500
1
2000
0
2000
2002
2004
2006
2008
Index
2 2500 1 2000 0 2000 2002 2004 2006 2008 Index TreasuryBills, Bid, 3 Month, Yield

TreasuryBills, Bid, 3 Month, Yield Standard & Poors, 500 Composite, Index, Total Return

Source: Reuters EcoWin

Worries that interest rate hikes will kill the current stock mar- ket upturn are exaggerated. During 2004-2006, for example, the US stock market rose at the same time as the Fed was raising key rates.

The reasons behind a recession often leave their mark on the subsequent recovery. At the heart of the most recent recession was the American sub-prime mortgage crisis, followed by a financial and economic crisis in the US that quickly spread to the entire OECD. Burst real estate bubbles also characterised a number of European countries, for example the United Kingdom, Ireland and Spain.

The cyclical profile of the OECD during 2010 and 2011 that is visible in our crystal ball – a modest upturn with a GDP growth rate of about 2.5 per cent, reminiscent of the upturns in the early 1990s and 2000s – is consistent with the recovery pat- tern that has generally followed recessions caused by burst bubbles.

Investment OutlOOk - maRCH 2010

15

16 Theme: Brighter prospects ahead sLOW UptUrns aFter reaL estate Crises Since the early 1970s,

16

Theme: Brighter prospects ahead

sLOW UptUrns aFter reaL estate Crises Since the early 1970s, there have been more than 30 real es- tate crises in the OECD countries that have led to significant economic slumps. One common denominator of these crises has been that the subsequent cyclical upturns have been slow and rather lengthy. They have also been characterised by large spare production capacity, which has contributed to low infla- tion pressure and low interest rates. Furthermore, renewed cyclical reversals or “double dips” have been rare. Recoveries have instead continued, though in low gear and occasionally sputtering. The growth slump that we believe will occur in the OECD during the second half of 2010 is quite consistent with this historical pattern.

So how have risk assets usually performed during such mod- est cyclical upturns? During the first recovery years, equities have been among the assets that have risen rapidly in value, and have then entered a “treading water” phase for 6-12 months, with more or less sideways market price movements – as in 2004, for example (see Investment Outlook, December 2009). After that, stock markets have generally entered a phase characterised by renewed price upturns. Perhaps the main key for a slow economic upturn becoming a long one is low inflation. This, in turn, lays the groundwork for rather low interest rates and thus a favourable investment environment.

What, then, might disrupt our market scenario − in a nega- tive or positive direction? Clearly rising inflation and inflation expectations, accompanied by sharp interest rate hikes, would undoubtedly be very negative and would probably halt the increase in both risk asset prices and − somewhat later − the economic upturn. Another risk would be if government finan- cial problems escalate and, perhaps together with surprisingly large bank losses, trigger a wave of financial market turmoil. A third danger would be if monetary tightening in the emerging market sphere is significantly more aggressive than expected and that this also causes major damage to OECD financial markets.

CHanCe OF UpsiDe sUrprise If underlying demand in industrialised countries takes over as an economic engine as the prevailing stimulus measures disappear, the market would probably view this favourably − assuming that surprisingly good growth does not lead to widespread expectations of faster price increases. On the micro level, it would be positive if balance sheets and income statements of companies improve faster than expected, strengthening the equity/assets ratios and financial stamina of companies and making their stocks cheaper in terms of price/ equity ratios. This would benefit both the corporate bond and stock markets.

traDing-Water pHase FOLLOWeD by better grOWtH Overall, there is thus a good chance that the current “tread- ing water” phase in risk asset markets will be followed by a renewed improvement in growth towards the end of this year and early in 2011.

inFLatiOn is a key FaCtOr

3. 00 3. 00 2. 75 2. 75 2. 50 2. 50 2. 25 2.
3.
00
3.
00
2.
75
2.
75
2.
50
2.
50
2.
25
2.
25
2.
00
2.
00
1.
75
1.
75
1.
50
1.
50
1.
25
1.
25
1.
00
1.
00
0.
75
0.
75
2005
2006
2007
2008
2009
Per cent

Euro Zone, Consumer Prices, All-items ex energy and seasonal food, SA, 2005=100, Chg Y/Y

US, Consumer Prices, All items less food and energy, SA, 1982-1984=100, Chg Y/Y Source: Reuters EcoWin

Low inflation benefits risk assets, and we expect inflation to remain low on both sides of

the Atlantic for an extended period. The main factors behind this are large spare capac- ity, historically small pay increases and high productivity.

Investment OutlOOk - maRCH 2010

theme: China solving growth puzzle
theme:
China solving
growth puzzle

Potential greater than risks in China

Credit expansion and over-investments are worrisome…

…but domestic demand may take over as a driving force

China has good potential for sustainable long-term growth

Market sentiment has shifted towards short-term concerns about the stability and sustainability of China’s economic growth. Early this year, rapid official actions aimed primarily at lending by the banking sector took many investors by surprise and led to worries about how much the Chinese central bank will tighten its policies. Beyond these short-term worries, other obstacles to China’s long-term economic growth are looming. In the long term, China’s demographics appear skewed. In the medium term, the overall savings ratio must fall from today’s 50 per cent or so of GDP to make room for domestic con- sumption. And an inefficient capital market is systematically allocating private capital to the wrong investments. Today’s high investment level is causing worries about future bubbles. Due to a concentration of misplaced investments and a rising credit supply, inflation is a short-term threat. So how serious are these obstacles, and is China still attractive as an invest- ment target?

investments OFFsetting eXpOrt DeCLine 50 50 40 40 30 30 20 20 10 10 0
investments OFFsetting eXpOrt DeCLine
50
50
40
40
30
30
20
20
10
10
0
0
-10
-10
-20
-20
-30
-30
1996
1998
2000
2002
2004
2006
2008
China,Exports,Chgy/y
China,Investment in Fixed Assets, Urban, Chg Y/Y
Source:ReutersEcoWin
Per cent

LenDing gOes intO investments According to official statistics, fixed investments in China are equivalent to 42 per cent of GDP, an undoubtedly high and worrisome figure. Investments generally lead, among other things, to greater demand for commodities, which in turn contributes to economic growth. But production capacity is rapidly expanding, and over-investments risk causing both surplus capacity and inefficient use of tied-up capital. As fixed investments in China have risen as a proportion of GDP, more and more economists have thus expressed concerns about the negative impact of this high investment level.

To understand the Chinese investment phenomenon, it must be viewed in a cyclical perspective. During earlier economic downturns, as in 2008-2009, investments rose as a share of GDP when foreign demand fell. Investments are the govern- ment’s main tool for smoothing economic fluctuations and sustaining demand during slumps. So is there no risk of over- capacity? China has a continued large need for infrastructure expansion – for example, the length of China’s motorways per 100 inhabitants is 4.5 metres, compared to 2.5 kilome- tres in the US. Certainly not all the investments being made are efficiency-raising, but China has a fundamental need for better infrastructure, and this spending has improved the po- tential for increasing trade and labour mobility in the country. Instead, the risk is that the government may not succeed in cutting back its stimulus measures in time and with the right strength as external demand returns.

Both in 1998-99 and 2000-2002, when export growth fell, the pace of investments rose in China. We now discern a similar pattern for the period 2008 onward.

Investment OutlOOk - maRCH 2010

17

Theme: China solving growth puzzle Another source of concern is China’s strong credit expansion, reflected

Theme: China solving growth puzzle

Another source of concern is China’s strong credit expansion, reflected among other things in an M1 money supply increase of nearly 40 per cent in January compared to 12 months ear- lier. The explosion in credit supply is fuelling concerns about both asset bubbles and inflation. But this credit growth is also strongly tied to infrastructure spending. In China, banks are forced to participate in financing stimulus measures, and ac- cording to some observers at least one third of the increased credit supply is due to investment stimulus measures.

investments traCk LenDing 55 50 45 40 35 30 25 20 15 10 5 Per
investments traCk LenDing
55
50
45
40
35
30
25
20
15
10
5
Per cent

55

50

45

40

35

30

25

20

15

10

5

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Moneysupply, M2, growthrate, Chg Y/Y

Investment inFixed Assets, Urban, Chg Y/Y Source:ReutersEcoWin

The close parallels between changes in investments and money supply indicate that a large proportion of higher credit supply goes into investments. As China tightens its stimulus, credit growth and investment as a share of GDP should also decline.

So is there a risk of loan losses? Indeed, but many of the loans have gone to projects carried out by government-owned companies, and a large proportion can thus be viewed as gov- ernment-guaranteed loans. Considering China’s sizeable trade surplus and high savings ratio, there is no significant risk, as long as GDP growth stays at reasonable levels.

bUbbLing reaL estate priCes Given China’s large stimulus packages, investments and credit supply, asset price bubbles are a risk in the near future. Prices of private homes have gone up by more than 9 per cent in one year. Although this is a high figure, it should be viewed in relation to its absolute level. The price per square metre of homes in India is more than three times higher than in Beijing, and properties in China are far below the valuations that prevailed before the bubble burst in the US in 2007. The price increases are also mainly concentrated in major coastal cities like Shenzhen and Shanghai, as well as Beijing. As usual when it comes to economic statistics from China, information about home prices and vacancy rates is also flawed or inconsistent, and it is difficult to estimate the impact of urbanisation on property prices. It is quite clear that there is a risk of bubbles in these local markets, but it is more difficult to argue that this amounts to a national property bubble.

18

Investment OutlOOk - maRCH 2010

tHe neeD FOr DOmestiC DemanD China's recent expansion has mainly been export-driven. The country has invested heavily in its manufacturing sector, which today accounts for more than 40 per cent of GDP, but as China has become more industrialised there is also a need for serv- ices (today about 40 per cent of GDP) to expand. The service sector accounts for much more of GDP in other Asian econo- mies (about 90, 70 and 60 per cent in Hong Kong, Taiwan and South Korea, respectively).

The key is to get domestic demand moving, and China’s very

high gross savings ratio of around 50 per cent of GDP of-

fers the potential for this. There are various reasons why the

savings ratio is so exceptionally high: Demographic shifts,

resulting in more and more companies and middle-aged men

saving for retirement (life cycle theory); a lack of social safety

nets, which drives private buffer savings; strong profit growth

at companies; and the lack of an efficient capital market,

which means that companies save up to finance their own

investments. Family planning − which has resulted in gender

imbalances − has led to keener competition for marriageable women. Savings have become a competitive tool among men.

All these problems must be addressed in order to bring about greater domestic demand. This process has also begun. For example, the one-child policy has been further eased. A new social safety net system is now being tested in rural areas, and the equivalent of about USD 125 billion will be spent over the next three years to improve the health care system. These fac- tors point towards increased private consumption in China in the long term. We would also like to see a less regulated capi- tal market that allows more efficient financing for companies. This will enable companies to reduce their savings.

beyOnD tHe FinanCiaL Crisis As China’s population grows and moves upward in worldwide prosperity rankings, the demand for goods and services will also grow. The above-mentioned measures and effects will also lay the groundwork for an economic expansion driven by more efficient markets and a more balanced demand profile which – unless protectionism becomes a global theme in the future – should enable the country to achieve a new financial and political stature in the global arena. In the longer term, some of the key factors will be “green” growth, commodity expansion and labour mobility.

If China succeeds during the coming year in navigating through the existing inflation threats and the risk of overheat- ing by means of timely, well-balanced economic tightening measures, there will be potential for sustainable long-term growth. This will, however, depend on continued de-regulation of the capital market, a better social safety network and in- creased domestic demand.

% q/q i årstakt

macro summary
macro summary

Road to recovery lined with challenges

Emerging markets will account for most global expansion in 2010-2011

while

fading stimulus effects and trouble

spots will hamper OECD growth

Fiscal tightening and low inflation will persuade central banks to postpone rate hikes

The global recovery has gained strength in recent months. Emerging Asian economies are expanding rapidly, American growth was unexpectedly robust late in 2009, and in Europe the potential for a recovery has improved. Leading indicators are signalling an accelerated expansion during the first half of 2010. After that, the effects of fiscal stimulus and the swing in the inventory cycle in the OECD countries will fade, causing growth to level off or slow.

The road ahead is lined with various challenges and risks. China must cool off its economy, but worries about the conse- quences of this are showing that the world economy remains fragile and dependent on Chinese demand. Events in southern Europe illustrate how the growing financial problems of gov- ernments can lead to large-scale crises of confidence. Recent flare-ups in trouble spots indicate that the room for crafting economic policy exit strategies has narrowed.

We foresee GDP growth in the 30 countries of the Organisation for Economic Cooperation and Development (OECD) of about 2.5 per cent annually during the next couple of years. Thanks to far higher growth in the emerging markets (EM) sphere − more than 6 per cent − global GDP will climb by about 4.5 per cent both in 2010 and 2011.

Because of moderate economic growth in the OECD, resource utilisation will remain low. Unemployment will thus be stuck at high levels for some time to come, and inflation will remain low. There is little risk that the massive monetary stimulation being provided by central banks will eventually trigger infla- tion. Consumer prices in the OECD will increase by 1 per cent this year and just above 0.5 per cent in 2011.

ameriCan grOWtH sUrge

10.0

10.0

7.5

7.5

5.0

5.0

2.5

2.5

0.0

0.0

-2.5

-2.5

-5.0

-5.0

-7.5

-7.5

2000

0.0 -2.5 -2.5 -5.0 -5.0 -7.5 -7.5 2000 2002 ar ma 1 quarter 2004 2006 2008

2002

ar ma 1 quarter

2004

2006

2008

Source: Reuters EcoWin

GDP growth in the United States accelerated significantly during the final quarter of 2009, but this was essentially due to fiscal stimulus programmes and the effects of the shift in the inventory cycle.

FrOm UpsWing tO LOst mOmentUm in tHe Us The American economy took off in earnest during the fourth quarter of 2009, but a significant share of this growth was ex- plained by a shift in the inventory cycle. This will also contrib- ute positively to growth during the first half of 2010 but then fade as fiscal stimulus measures also ebb away. In addition, due to a rather listless labour market recovery and a continued rise in household saving, private consumption will grow unu- sually slowly for a recovery year. US GDP will grow by nearly 3.5 per cent this year and just above 2 per cent in 2011.

With unemployment stuck at high levels, along with very low capacity utilisation in businesses, low inflation is likely. The Federal Reserve is thus not in a hurry to raise its key interest rate, but will instead wait until December 2010.

DeFLatiOn WOrries in Japan Japan’s continued economic upturn will be slow. Large fiscal stimulus packages have not caused private consumption to take off, and household sentiment is again falling. However, businesses have become more optimistic, though this has not been enough to boost capital spending plans. A weakening of the yen and the global recovery − which will benefit Japanese exports − as well as some additional fiscal stimulus will ensure

Investment OutlOOk - maRCH 2010

19

Macro summary GDP growth of 1.5 per cent in 2010 and nearly 2 per cent

Macro summary

GDP growth of 1.5 per cent in 2010 and nearly 2 per cent in 2011. The biggest challenge in Japan is the risk of deflation. Consumer prices are currently falling by more than 1.5 per cent year-on-year. There is thus no reason for the Bank of Japan to raise its key interest rate for an extended period.

eUrOpe rOLLing again, bUt nOt espeCiaLLy Fast The United Kingdom was one of the last big economies to exit the recession, with GDP growing marginally again in the fourth quarter of 2009. There is clear optimism among businesses, which promises higher capital spending, while a weak pound and increased world trade will benefit exports. British private consumption is growing slowly, however. GDP will increase by less than 2 per cent this year and a bit more than 2.5 per cent in 2011. The Bank of England will keep its key rate unchanged until December 2010.

The euro zone economies have also begun to grow, but rather sluggishly. Various leading indicators are signalling accelera- tion, but the picture is not entirely clear. The instability trig- gered by the financial problems of the Greek government is a risk factor. Burgeoning budget deficits in most euro zone countries are raising some difficult questions about the prin- ciples and regulations governing the euro system. A relatively moderate recovery in the euro zone − GDP will grow by a bit more than 1.5 per cent this year and 2 per cent in 2011 − low inflation, government financial problems as well as concerns about the health of the banking system in the currency union will persuade the European Central Bank (ECB) to keep its key interest rate unchanged until late this year.

nO rapiD german UptUrn

115 100 110 75 105 50 100 25 95 0 90 -25 85 -50 80
115
100
110
75
105
50
100
25
95
0
90
-25
85
-50
80
-75
2000
2002
2004
2006
2008
Index
Index
85 -50 80 -75 2000 2002 2004 2006 2008 Index Index Germany, ZEW, economic expectations Germany,

Germany, ZEW, economic expectations Germany, IFO, business climate index

Source: Reuters EcoWin

Various indicators in Germany signal economic growth, but judging from the IFO business index and the ZEW financial market index, the upturn will be rather modest.

nOrDiCs enJOying strOng FUnDamentaLs The Nordic countries are benefiting from good fundamen- tals in the form of large current account surpluses and − in an international perspective − strong government finances.

20

Investment OutlOOk - maRCH 2010

Norway will enjoy high oil prices and extremely strong public finances. Sweden and Finland will benefit from the upswing in global demand for industrial products. In Denmark, however, the recovery will be more listless due to protracted adjustment problems in the construction and housing sector.

em spHere Driving tHe WOrLD eCOnOmy While the OECD countries are expected to contribute about 1.25 percentage points to global GDP growth this year, EM countries will account for more than 3.2 percentage points. Emerging economies, especially in Asia, will thus account for the lion’s share of global growth in 2010. Due to significantly lower government debt than in the OECD, the need for fiscal consolidation will be far smaller in the EM countries. Latin America − which noted a GDP decline last year − is now grow- ing again thanks to the global recovery and expansionary economic policies, as well as the influx of capital from other regions.

Even Eastern Europe, the region hardest hit by the global cri- sis, is now climbing out of its recession. In 2010 these econo- mies will grow again, with the exception of Latvia. In the three Baltic countries, the most acute crisis is over. These countries have taken advantage of the incipient recovery in global demand, and there is increased confidence in their strategy of maintaining their currency pegs to the euro with the help of “internal devaluations”. Estonia’s economy is in the best shape, and we predict that the country will join the currency union and introduce the euro in January 2011.

tHe Crisis Has mOveD sOUtH

800 800 700 700 600 600 500 500 400 400 300 300 200 200 100
800
800
700
700
600
600
500
500
400
400
300
300
200
200
100
100
Jan
Mar
May
Jul
Sep
Nov
Jan
2009
2010
Estonia,EUR
Greece,USD
Source:ReutersEcoWin
Basis points

While Estonia’s economy and finances have quickly recuper- ated, in Greece the situation has become acute. This is re- flected in the credit default swap (CDS) premiums to insure five-year government bonds from these countries.

asset class: Equities
asset class:
Equities

Positive and negative forces compete

Stock markets have passed their very best period…

…and have entered a phase dominated by more contradictory forces

Strong potential for the US, Eastern Europe and growth companies with financial stamina

Stock markets closed 2009 with a strong rally, largely due to a number of surprisingly good US macroeconomic reports, which boosted growth and profit expectations on the thresh- old of 2010. But only a week or so into the New Year a series of market shocks began. These included President Barack Obama’s proposal for stricter banking rules − no bank would be allowed to own or operate hedge funds, private equity funds or proprietary trading units, and the size of financial institutions would be curtailed − Chinese economic tightening by means of higher bank reserve requirements and an escalat- ing government financial crisis in Greece. These events caused share prices to fall sharply and volatility to climb dramatically on a few occasions.

gLObaL stOCk markets 350 350 325 325 300 300 275 275 250 250 225 225
gLObaL stOCk markets
350
350
325
325
300
300
275
275
250
250
225
225
200
200
Jan
Mar
May
Jul
Sep
Nov
Jan
2009
2010
Source: Reuters EcoWin
In d e x

Since the start of 2010, global stock markets have faced worries such as China’s economic tightening and a govern- ment financial crisis in Greece, leading to clear share price reversals, but the bull market that began in March 2009 is not over.

These market worries were further fuelled by greater un- certainty regarding the strength of economic growth in the OECD industrialised countries. Another joy-killer was Standard & Poor’s downgrading of Japan’s credit outlook due to the deflation risk in that country and a government debt mov- ing towards 200 per cent of GDP. More countries in the EM sphere − India and the Philippines − followed China’s example and enacted monetary tightening, while Brazil’s central bank signalled that an interest rate hike may be implemented within a couple of months.

Market concerns about economic exit policies also flared up when the Federal Reserve announced it was raising its dis- count rate − the interest rate that banks pay when borrowing from the Fed (see also page 24). Fed Chairman Ben Bernanke had indeed signalled in an earlier speech that such a change was coming, but the initial stock market reaction to the an- nouncement was still clearly negative.

market sHOCks aFFeCt regiOnaL eXCHanges The market shocks that dominated January and early February also had a clear impact on regional stock exchanges. While the US and Swedish stock markets, for example, performed better than the overall world index, other European markets − as well

as the euro − were weighed down by the drama unfolding on the Mediterranean. Emerging markets took an extra beating,

mainly due to China’s monetary tightening measures. Falling

commodity prices due to declining risk appetite pulled down commodity-heavy stock exchanges in Latin America.

Another reason why many European stock exchanges have performed more poorly than American ones since the begin- ning of 2010 is the gap in reports on economic growth. In many cases, macro statistics in the US have been better than the corresponding European ones. While the US economy grew by 1.6 per cent from the third to the fourth quarter of 2009, the figures in both the UK and the euro zone were only +0.1 per cent. In Germany, GDP stagnated. Furthermore, the ISM purchasing managers’ index in the US has climbed far more than its European equivalents in recent months.

Investment OutlOOk - maRCH 2010

21

Asset class: Equities Us stOCks beat WOrLD inDeX… 2.5 2.5 0.0 0.0 -2.5 -2.5 -5.0
Asset class: Equities
Us stOCks beat WOrLD inDeX…
2.5
2.5
0.0
0.0
-2.5
-2.5
-5.0
-5.0
The first phase was characterised by initially incorrect pricing
of risk assets, expectations of improving economic conditions
and rising profits, the fulfilment of these expectations, low or
falling interest rates and steeply positive yield curves. On the
whole, this offered the best possible conditions for equities
and other risk assets.
-7.5
-7.5
-10.0
-10.0
-12.5
-12.5
-15.0
-15.0
-17.5
-17.5
Feb Apr
Jun
Aug
Oct
Dec
Feb
2009
2010
S&P 500 Composite relative MSCIAC World, USD
S&P 500 Composite relative MSCI AC World, USD, 21 day moving average
Source: Reuters EcoWin
In recent months, the US has shown high economic growth
and strong leading indicators. This has helped US stock ex-
changes beat the world index.
…WHiLe eUrOpean Ones LOse grOUnD
The current phase is also equity-friendly, but not at all to
the same extent as the initial phase. What will be especially
important now are profits, profit estimates and valuations.
Expectations of profit trends are currently rather high − in
most countries the growth forecasts are +20-25 per cent in
2010 and 2011 − while share price declines in January and ear-
ly February led to falling valuations. On many exchanges, these
are now below their historical averages. This indicates that the
stock market has been affected by the negative events that
have occurred since the beginning of 2010 (see above), and
that the market is somewhat sceptical about the economic
and financial future.
20.0
20.0
17.5
17.5
15.0
15.0
12.5 sHares Have beCOme CHeaper
12.5
10.0
10.0
3
5
7.5
7.5
5.0
5.0
3
0
2.5
2.5
2
5
0.0
0.0
Source: Datastream
-2.5
-2.5
2
0
-5.0
-5.0
1
5
Feb Apr
Jun
Aug
Oct
Dec
Feb
2009
2010
1
0
EuroSTOXX 50 relative MSCI AC World, EUR, 21 day moving average
EuroSTOXX 50 relative MSCIAC World, EUR
5
Source: Reuters EcoWin
Government financial problems in southern Europe gener-
ally and Greece in particular pulled down European share
prices. Current macro data in Europe have also been much
weaker than US statistics.
Dow Jones Euro Stoxx 12MTH FWD P/E
MSCI EM 12MTH FWD P/E
OMX INDEX 12MTH FWD P/E
S & P 500 INDEX 12MTH FWD P/E
Stock exchanges in the euro zone are clearly vulnerable to
negative forces − rising borrowing costs and growth-crimping
fiscal tightening in the wake of the southern European crisis,
as well as slower economic growth momentum than the US.
The weakening of the euro, which has improved the interna-
tional competitiveness of the currency union, is only likely to
offset this only in part.
Share price declines since the beginning of 2010 have
resulted in lower valuations (P/E ratios). This means that to
some extent, stock markets are sceptical of profit forecasts.
By late February, the stock market mood had again improved
somewhat, when worries among financial market players
about southern European government debt eased to some
extent. Also worth noting is that the negative forces in January
and early February tended to obscure often surprisingly good
company earnings reports for the fourth quarter of 2009, es-
pecially in terms of profits. In any event, the trend of the past
couple of months shows that the stock market has left behind
its first sharp upturn phase, which began early in March 2009,
and has entered a phased characterised by other conditions,
opportunities and risks.
In light of this scepticism, evidence of a continued economic
upturn is a very important factor in stock market performance.
The momentum of economic growth is currently strong, and
positive growth surprises may very well occur in the short
term, both in the OECD and the EM sphere. Later this year,
however, the growth rate in industrialised countries risks
levelling off or slowing. Early signs of this − for example falling
purchasing managers’ index figures in the US and Europe − are
likely to have a negative impact on stock exchanges.
The risk picture still includes government financial problems,
Obama’s banking ideas and market concerns about imminent
exit policy. Worries regarding exit policies are mainly focus-
ing on what will happen in the monetary policy field, which
of course has a bearing on the supply of liquidity and inter-
est rates, which are important to the stock market. This time
around, exit measures will not only directly affect market inter-
22
Investment OutlOOk - maRCH 2010
Index
Index
Feb-00
Feb-01
Feb-02
Feb-03
Feb-04
Feb-05
Feb-06
Feb-07
Feb-08
Feb-09
Feb-10

est rates via key rate hikes, but probably also bond yields since many central banks have bought large quantities of bonds that they will gradually divest.

It is true that by most indications, exit policies will be delayed for a fairly long time in major industrialised countries, but as illustrated by the reaction to the Fed’s discount rate hike in February, there is obvious market nervousness. Another example is from 2004, when expectations of a hike in the US key interest rate − the federal funds rate − began to circulate as early as the first quarter, but the hike took place only in late June. The period when rate hike expectations were escalating otherwise coincided with the beginning of a period of “range trading” in stock markets, which characterised much of 2004.

market Was nOt Listening tO bernanke

7 7 6 6 5 5 4 4 3 3 2 2 1 1 0
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
0
2003
2004
2005
2006
2007
2008
2009
Source: Reuters EcoWin
Per cent

Chairman Ben Bernanke had clearly signalled that the US Federal Reserve’s discount rate would be raised and that this should not be regarded as a monetary tightening. Yet when the Fed acted, initial market reaction was clearly negative.

In some small OECD countries, such as Norway and Sweden, several key rate hikes are already in the cards during 2010, and Australia is likely to continue raising its key interest rate at a rather fast pace. But it is primarily in many EM countries that interest rates will be ratcheted up during 2010, though not in an aggressive way. Higher interest rates in influential Asian and Latin American countries may at times trigger irritated financial market reactions in both the US and Europe.

miX OF pOsitive anD negative FOrCes On the whole, stock markets will thus probably be exposed to a mix of positive and negative forces, while conditions will diverge greatly depending on geography and sector.

Stock markets in the OECD countries will benefit from low interest rates for another while, as well as rising profits and reasonable share valuations, but will be adversely affected by the prospects of economic policy tightening and an economic dip later in 2010. In the short term, the US economy will grow faster than that of Europe. Along with lower short-term inter- est rates, this gives the US an advantage. Share valuations are admittedly a bit higher across the Atlantic, but the adverse ef-

Asset class: Equities

the Atlantic, but the adverse ef- Asset class: Equities fects of this are less weighty than

fects of this are less weighty than the financial and credibility problems that the euro zone is grappling with. The dollar has appreciated so far this year, but this does not diminish the US advantage to any great extent, since the equilibrium exchange rate against the euro is somewhere around USD 1.20. The EM sphere will benefit from high economic growth, good financial stamina and − compared to the OECD − large profit increases and lower P/E ratios, but will be negatively affected by exist- ing and continuing monetary tightening measures and to some extent by rising exchange rates (which are nevertheless advantageous to “foreign” investors). In EM stock markets, our scenario is that growth and profits will thus offset higher inter- est rates by a wide margin.

interest rates being CUt in eastern eUrOpe 13.0 13.0 12.5 12.5 12.0 12.0 11.5 11.5
interest rates being CUt in eastern eUrOpe
13.0
13.0
12.5
12.5
12.0
12.0
11.5
11.5
11.0
11.0
10.5
10.5
10.0
10.0
9.5
9.5
9.0
9.0
8.5
8.5
2005
2006
2007
2008
2009
Per cent

Source:ReutersEcoWin

In most countries, interest rate cutting is over or rates have begun to be raised. Parts of Eastern Europe are an excep- tion. Russia recently lowered its key interest rate to 8.5 per cent, and further cuts are predicted.

A comparison of the arguments for investing in OECD coun-

tries and the EM sphere favours the latter, but conditions are not identical throughout the EM sphere. During 2010-2011, growth will be highest in Asia and inflation there will be lower than in Latin America, which will enjoy growth about half as fast as in Asia. Interest rate hikes will occur in many countries on both of these continents. Eastern Europe is in a different

situation. By all indications, further interest rate cuts are immi- nent there, mainly in Russia, Hungary and Romania, and with

a few exceptions the region will be characterised by accelerat-

ing GDP growth. Eastern Europe is thus the only region in the world that shows the conditions that usually apply during the first sharp upturn period in the stock market.

HigHer QUaLity anD seLeCtivity OECD stock markets have entered a period characterised by higher quality and selectivity – the shift “from beta to alpha”. This favours sectors and companies with stable earning pow- er, strong finances and limited cyclical sensitivity − a category that includes consumer goods, information technology and pharmaceutical companies. Since the world outside the OECD will offer much faster market growth than these companies’ home markets, it is an extra advantage if they operate globally.

Investment OutlOOk - maRCH 2010

23

asset class: Fixed income
asset class:
Fixed income

Corporate bonds still attractive

2010 will be a good year for corporate bonds

with

both macro and micro factors benefiting

this asset class

and

High Yield in particular much more

attractive than government bonds

Late in 2009, government bond yields rose significantly on both sides of the Atlantic, when strong US macro statistics caused the market to price in accelerated interest rate hikes by the Federal Reserve (Fed). Risk appetite generally rose as New Year approached, as reflected in a stock market rally, higher commodity prices and an upturn in corporate bond prices.

Shortly after New Year, these patterns were interrupted as risk appetite suffered a series of blows: President Obama’s proposal for stricter banking rules, the flare-up of government financial problems in southern Europe and China’s monetary tightening measures. In the fixed income market, the response was a fall in yields on government securities regarded as safe, higher yields on government securities from countries with large budget deficits and debts as well as declining corporate bond prices. Late in February, financial market worries faded to some extent and risk appetite returned.

The stronger world economic upturn, along with overheating risks in Asia and government financial collapses in southern Europe, demonstrate the need to launch economic policy exit strategies. Growing public sector deficits are forcing many countries to implement fiscal belt-tightening. In the G20 countries, fiscal policies are expected to shift from having a positive effect of about 2 per cent of GDP to a negative impact of about 1 per cent in 2011.

The support that fiscal policy has provided to the economy is thus disappearing. Meanwhile measures aimed at creating a more robust banking system (a degree of re-regulation, limits on the size of balance sheets, etc.) are on their way, which implies monetary tightening and higher costs of capital. This increases the room for continued loose monetary policy. The

24

Investment OutlOOk - maRCH 2010

prospects of persistent very low inflation − thanks to large spare capacity and falling unit labour costs − add to this room.

The major central banks − the Fed, the European Central Bank (ECB), the Bank of England (BoE) and the Bank of Japan (BoJ) − have also continued to emphasise the severity of the recent economic crisis and have underscored the fragility of the recovery. The Fed continues to repeat its mantra that the federal funds rate is likely to remain extremely low for an extended period. The recent US discount rate hike was not a monetary tightening either, but a step towards a normalisation of policy after earlier crisis − in other words, an indication that the financial market is functioning normally again. In light of this, it will probably be nearly a year before the Fed, the ECB and the BoE begin hiking their key rates. For the BoJ it will be even longer, since Japan is again experiencing deflation risks.

Stronger economic conditions, the prospect of interest rate hikes further ahead and rapidly growing budget deficits point towards rising government bond yields/falling bond prices during 2010. Because of continued very low inflation and strong confidence in the inflation-fighting policies of central banks, however, these yield increases will be moderate.

steeper yieLD CUrve in tHe Us tHis year

7 6 5 4 3 2 1 0 2000 2002 2004 2006 2008 Per cent
7
6
5
4
3
2
1
0
2000
2002
2004
2006
2008
Per cent

7

6

5

4

3

2

1

0

Government Benchmarks, Bid, 10 Year, Yield, Close

PolicyRates, Fed Funds Target Rate

Source:ReutersEcoWin

While the Fed is expected to leave its key interest rate unchanged at 0-0.25 per cent for nearly another year, US government bond yields will rise, though moderately. The consequence will be a steeper yield curve and the risk of lower prices on government bonds.

Asset class: Fixed income

Asset class: Fixed income

Rising government bond yields and the renewed focus on public sector deficits and debts – which has periodically caused the market to set higher credit default swap (CDS) pre- miums on the government bonds of certain countries than on some corporate bond segments − mean that government se- curities remain unattractive in the fixed income asset class. It is true that corporate bonds are not as attractive as before. Yet 2010 looks as if it will be a good corporate bond year, though not close to the record year 2009, when many High Yield (HY) bonds rose in value by 60-75 per cent and Investment Grade (IG) bonds by 15-20 per cent.

brigHter prOspeCts at miCrO LeveL, tOO Our crystal ball shows moderate economic growth and low inflation in the world during 2010, an environment that has historically been favourable for corporate bonds. Prospects look brighter at the microeconomic level as well. Many compa- nies weathered the financial and economic crisis surprisingly well, mainly due to aggressive cost-cutting measures. As the economy has recovered, their profits have increased and their balance sheets have strengthened. Companies improved their balance sheets by such means as bond issues, extended bond debt maturity, continued tough cost control and restrictive- ness with investments, which have increased their liquidity. Companies are thus healthier.

New bond issues − which were especially numerous last year − look set to continue at high volume this year as well. The consequence will be an increased supply of corporate bonds, but the demand is likely to remain large, among other things due to substantially higher effective yields on corporate bonds than on government bonds. Another reason is that European institutional investors are now including HY bonds as a strate- gic asset class in their fixed income portfolios. This has been true in the US for the past decade.

prOpOrtiOn OF bankrUptCies FaLLing steepLy In addition, bankruptcies in the HY segment recently passed their peak on both sides of the Atlantic. According to SEB’s forecast, bankruptcies in Europe will fall from a peak of just above 8 per cent of all HY issuers to only 2 per cent this au- tumn, while the corresponding US figures are about 11 per cent and just above 4 per cent. There is also a trend towards substantially larger asset recoveries after corporate bankrupt- cies, which will of course reduce investor losses.

Our forecast for 2010 indicates a return of more than 7 per cent on HY bonds and 3 per cent on IG bonds. In both cases, this is far lower than in 2009, yet significantly more than government bonds are expected to yield. The better expected return on HY bonds than on IG bonds is due to higher effective yield, and thus also greater remaining room for narrowing the spread above government bonds.

HigH yieLD bOnDs mOre attraCtive

1750 1500 1250 1000 750 500 250 0 Basis points
1750
1500
1250
1000
750
500
250
0
Basis points

1750

1500

1250

1000

750

500

250

0

Sep Dec M ar Jun Sep Dec M ar Jun Sep Dec M ar

2007

AAA Rated

2008

BBB Rated

2009

2010

CCC Rated and above

Source: Reuters EcoWin

Yields on HY bonds in the US (10-year CCC- rated industrial bonds) are far above those of 10-year government bonds, while the spread for Investment Grade bonds (AAA and BBB) is significantly narrower.

Investment OutlOOk - maRCH 2010

while the spread for Investment Grade bonds (AAA and BBB) is significantly narrower. Investment OutlOOk -

25

asset class: Hedge funds
asset class:
Hedge funds

From beta to alpha − time for hedge funds

Alpha-generating capacity increasingly vital

Obama and politics having an impact

Analysis especially important before investing

As we described in our last Investment Outlook (December 2009), last year was a relatively simple period for hedge fund managers. Once financial markets began to recuperate in earnest last March, a period characterised by easily earned money also began, making 2009 the best hedge fund year in a decade. Broad hedge fund indices rose more than 13 per cent, while some of the narrower indices gained nearly 20 per cent.

Directional hedge funds such as Equity Long/Short (L/S) gen- erated good returns during 2009, though they were soundly beaten by stock markets. Qualitative directional hedge funds noted an upturn roughly in line with broad indices (about 13 per cent). Hedge funds with a greater quantitative bias and more focus on downside protection had a bit of difficulty pro-

ducing satisfactory value and tended to generate below-index returns. One reason was that they underestimated the power of the world economic recovery. It was of course natural for managers to behave extra cautiously after one of the worst financial crises in history, especially considering that many directional hedge funds perform better over time than stock markets. This is because managers hedge their capital in trou- bled times, not because they beat stock markets when these climb sharply. For directional funds that we view as lower- quality, 2009 was a really good year. The recovery of the mar- kets enabled them to generate returns by following markets upward, what are called “beta returns”.

In the current situation − when a large part of market normali- sation has occurred − we expect that a different set of hedge funds will be successful. It is no longer possible to achieve easy beta returns, at least not to the same extent as in 2009. Looking ahead, it will be substantially more important for in- vestors to take advantage of qualitative funds that thoroughly

FUND

YTD*

INDEX VALUE

2009

2008

HFrX global Hedge Fund index

0.21 %

1159.61

13.40

%

-23.25 %

HFrX equal Weighted strategies index

0.55

%

1118.43

11.44

%

-21.90 %

HFrX absolute return index

0.30

%

987.25

-3.58 %

-13.09 %

HFrX market Directional index

0.27

%

1155.02

29.34

%

-29.70 %

HFrX aggregate index

 

-

-

13.34

%

-17.13 %

HFrX equity Hedge index

-0.73 %

1126.75

13.14

%

-25.45 %

HFrX equity market neutral index

0.91

%

993.88

-5.56 %

-1.16 %

HFrX event Driven index

0.79

%

1358.57

16.59

%

-22.11 %

HFrX Distressed securities index

2.16

%

967.64

-5.60 %

-30.69 %

HFrX merger arbitrage index

0.99

%

1457.85

8.14 %

3.69

%

HFrX macro index

-0.77 %

1237.77

-8.78 %

5.61

%

HFrX systematic Diversified index

-1.64 %

1550.60

-9.04 %

31.55 %

HFrX relative value arbitrage index

1.19

%

1104.85

38.47

%

-37.60 %

HFrX Convertible arbitrage index

-0.12 %

620.61

42.46

%

-58.37 %

26

Investment OutlOOk - maRCH 2010

*January 1-February 24, 2010. Source: Hedge Fund Research

hedge their downside and have very good control of their risk. This applies regardless of whether the funds are directional in nature or are more absolute return- or trading-oriented. The alpha generating capacity of hedge funds will determine whether we invest in them or not.

FrOm reCOvery tO FOCUs On QUaLity 1175 1175 1150 1150 1125 1125 1100 1100 1075
FrOm reCOvery tO FOCUs On QUaLity
1175
1175
1150
1150
1125
1125
1100
1100
1075
1075
1050
1050
1025
1025
1000
1000
Jan
Mar
May
Jul
Sep
Nov
Jan
2009
2010
Source: Reuters EcoWin
In d e x

Last year was very good for hedge funds, while 2010 began on a weak note. Quality will be important (HFRX Global Hedge Fund Index).

COmpetitiOn imprOves aLpHa pOtentiaL The repercussions of the financial crisis have created good market opportunities for hedge funds. Although the total quantity of assets under management remains around USD 2 trillion, the decreasing number of funds has benefited those that survived. There are no longer as many investors chasing the same deals. Another factor that plays a major part is less competition from the trading departments of the banks them- selves. Banks closed or downsized many of their proprietary trading departments during the financial crisis. Although some have been re-established, we foresee no major expansion in this portion of bank operations. One reason is uncertainty about what future rules of the game will apply.

tHe impaCt OF Obama anD pOLitiCs President Barack Obama and many other politicians have taken the opportunity to try to turn back the clock in order to strengthen their power. With regard to hedge funds, this has assumed various forms. The largest impact will probably be from changing political demands on banks. It will take some time before decisions are made on what rules will apply in the years ahead. But any rules prohibiting banks from own- ing hedge funds would obviously play a key role. The same is true of changes that would affect the ability and potential for banks to carry out trading for their own account, depending on capital adequacy rules and other factors.

As a consequence of the financial crisis, hedge funds may also very well have to factor in tighter regulation, even though the crisis was not the fault of these funds. UCITS III/IV rules (under the EU directive on Undertakings for Collective Investments in

Asset class: Hedge funds

for Collective Investments in Asset class: Hedge funds Transferable Securities) and political demands for more

Transferable Securities) and political demands for more regu- lation may put pressure on hedge funds to improve trading cy- cles, transparency and reporting. This is of course good for in- vestors, but there is also a flip side to the extent that this may limit the funds’ potential for generating really good returns. It is difficult to quantify by how much, though. Even today, some hedge funds that have only been traded over the counter

(OTC) and have been based in various tax havens have begun to set up UCITS III-compliant operations. Furthermore, some

of the largest and highest-profile hedge funds have recently

joined the Hedge Fund Standards Board (HFSB). These devel-

opments will be interesting to follow and have the potential

to fundamentally alter the way hedge funds operate. In other words, the hedge fund world seems inevitably headed towards

becoming more regulated. The only question is whether this

will occur at its own initiative, for example via the HFSB, or

through legislation. In any event, we are convinced that qual- ity management will not only survive but will also thrive in a

regulated future.

OUr searCH prOCess One very important factor to take into account in searching for hedge funds to invest in is to identify funds that can add desirable characteristics to our investment profiles that differ from those possessed by such asset classes as market-listed equities. Perhaps most important is that hedge funds should provide good protection in troubled times. In our opinion, following market downturns the full distance over time is the worst thing an asset manager can do. If fund assets are halved, it will take more than a decade just to climb back to the same level as initially, assuming normal stock market returns. Including the interest-on-interest effects during this decade, the investor’s situation is made even worse. If hedge funds can contribute downside protection, it is thus highly val- uable. In addition, hedge funds can generate returns as high as those of equities or better, provided they are quality funds with good risk control and institutional structures. Another important quality that we aim for is more uniform return flows, which good hedge funds can provide.

We begin our selection process by specifying desirable hedge fund characteristics. Then we start searching for funds that will add to our portfolios the characteristics we are aiming for. In practice, this is a matter of reviewing many hedge funds quantitatively to evaluate which ones have high enough re- turns and low enough risk to be considered. Also important here is that the flow of returns has the right characteristics. We want a good risk/reward ratio with asymmetry between risk and return. Downside protection must be there, but also the ability to generate positive returns with a larger upside than downside. Uniformity of returns is also important, with as many months of gains as possible. The number of loss-making months should be few, no more than two or three per year. We know that risk is, of course, required in order to achieve returns. But if hedge funds have good risk control systems,

Investment OutlOOk - maRCH 2010

27

28 Asset class: Hedge funds it is possible to generate returns with the characteristics we

28

Asset class: Hedge funds

it is possible to generate returns with the characteristics we want, given very high quality. Finally, it is important that the relatively large fees we pay should seem worth their cost. If the ratio of fees to returns is not acceptable, we sell the fund.

Once we complete the quantitative search process, we begin the qualitative process (in practice all of this occurs continu- ously). This means contacting the hedge fund in question to ensure that it has an adequate operating structure with a fo- cus on risk control, back office functions, compliance etc. Here we work together with Key Asset Management, which has long experience of analysing and investing in hedge funds.

After this, and on the basis of expected returns, risks etc. we put together suitable portfolios that reflect our objectives. We use a plausibility check and double risk controls to reduce the risk of mistakes in the process. The final step is naturally to monitor our investments and ensure that hedge funds have delivered what we have desired, as well as assessing whether they will continue to perform according to our requirements.

styLes We preFer at present Given our assessment that 2010 will be a year for alpha re- turns, we are focusing on finding hedge funds with the capac- ity to deliver high returns mainly due to the superior quality of their management and operation. Qualitative Macro hedge funds fit well into this set of requirements, since these funds are able to choose from the full range of potential investments such as equities, fixed income, commodities and currencies etc. This broad potential naturally also implies risks, which make quality crucial. During 2009 this was demonstrated with

great emphasis. The Macro index was in clearly negative terri- tory, while the best funds delivered enviable results.

On the systematic side of Macro we find CTA (Commodity Trading Advisors) funds, which use model-based management and offer good characteristics for portfolio-building since they tend to be long on volatility, thus providing good opportunities for satisfactory returns in times of crisis. In 2008 CTA gener- ated returns well above 20 per cent during a year when hedge funds as a group took a heavy beating, with 20 per cent down- turns for broad hedge fund indices. One disadvantage of hav- ing CTA in the portfolio is comparatively high volatility, with rather large fluctuations from month to month. In the hedge fund world, large fluctuations are classified as approximately five per cent up or down. Worth noting is that this is similar to stock markets.

We also have a positive view of Relative Value and some types of Fixed Income. Due to their borrowing, some of these funds may be highly leveraged. But we are choosing to be very cau- tious about funds that have more than low normal borrowing, since this may be dangerous, judging from the experiences of 2008. Our cautiousness costs us returns under normal condi- tions, but it is more vital to avoid ending up being trapped in case of sudden crisis.

In our judgement, given the good opportunities that exist in the hedge fund world we have high return expectations dur- ing 2010 and 2011, although the differences in results may be sizeable depending on fund quality.

QUaLititative (Cta) HeDge FUnDs WeatHereD tHe Crisis WeLL

1 7 0 1 6 0 1 5 0 1 4 0 1 3 0
1 7
0
1 6
0
1 5
0
1 4
0
1 3
0
1 2
0
1 1
0
1 0
0
9
0
Source: Datastream
8
0
HFRX SYSTEMATIC DIVERSIFIED - PRICE INDEX
HFRX GLOBAL HEDGE FUND U$ - PRICE INDEX
Feb-06
May-06
Aug-06
Nov-06
Feb-07
May-07
Aug-07
Nov-07
Feb-08
May-08
Aug-08
Nov-08
Feb-09
May-09
Aug-09
Nov-09

When the crisis was raging at its worst be- tween the second half of 2007 and early 2009, CTA funds offered precisely the protection that was expected, thanks to their ability to unsentimentally take advantage of existing market prices.

Investment OutlOOk - maRCH 2010

asset class: Real estate
asset class:
Real estate

Time to start cautiously investing in real estate

The sun is beginning to rise over the real estate market

Yield is starting to fall

Storm clouds in China and elsewhere

The sun is finally beginning to rise over the real estate mar- ket after the crisis. While caution still dominates the market, transactions have begun to increase, distressed property own- ers have revealed more upside than downside surprises, credit markets are recovering and rent levels as well as vacancy rates seem to have bottomed out in most sub-markets. These fac- tors indicate that the time has come to invest in the real estate market.

Many markets in Asia weathered the crisis relatively un- scathed. Combined with large government stimulus packages, this has led to a market where we see higher leasing activity. In addition, yield (percentage return) has begun to fall as a consequence of rising real estate prices. These positive effects have also been reflected in an increased number of transac- tions.

Europe is also showing rising transaction volume, though not

at all at the same pace as in Asia. The number of transactions

is back at roughly the same level as in 2002, after bottoming out during the first half of 2009.

In North America the picture is similar to Europe, although the crisis was deeper. Major coastal cities are demonstrating greater stability, while the picture elsewhere can be signifi- cantly worse. In spite of this, the total impression is positive.

The rising number of transactions indicates that real estate investments have begun to come into play for investors. Large financial assets that have been on the sidelines are now be- ginning to be activated, which is a sign that real estate prices will rise. We do not believe prices will climb rapidly, however. The upturn will probably be rather slow and steady. There are

naturally potential hazards. These include political factors and

a possible real estate bubble in China.

It is true that the level of transactions in the United States re- mains low, but in our judgement the bottom is past and there will be more real estate deals over the next few years. Looking at different segments, it appears that residential and retail property transactions will increase, while sales of industrial properties and office buildings still seem to be in the cellar, without any clear upward trend. Nor is it surprising that the recovery is uneven after such a major crisis. Our overall as- sessment is positive, although we will probably need to wait until the end of 2010 before certain segments show any clear improvement. Many property users are probably taking the opportunity to improve the efficiency of their space usage, which may adversely affect the market on the margin.

As for real estate prices, we find much anecdotal evidence that they have probably bottomed out and that price upturns should be imminent. The real estate market actually consists of numerous sub-markets that behave in different ways, but although some segments may lag behind, in our judgement real estate investments face a promising future.

tbi inDeX Has bOttOmeD OUt 300 250 200 150 100 50 Source: MIT/CRE 0 Price
tbi inDeX Has bOttOmeD OUt
300
250
200
150
100
50
Source: MIT/CRE
0
Price index
Demand index
Supply index
Mar-00
Mar-01
Mar-02
Mar-03
Mar-04
Mar-05
Mar-06
Mar-07
Mar-08
Mar-09

Prices of US commercial properties have stopped falling and have stabilised at a low level, though continuing to fluctuate. Further improvements are expected, but at an uneven pace.

Investment OutlOOk - maRCH 2010

29

30 Asset class: Real estate The MIT transaction-based index (TBI) of US commercial real estate

30

Asset class: Real estate

The MIT transaction-based index (TBI) of US commercial real estate prices is now bumping along the bottom after a major decline. A major decline does not automatically imply that there is great potential for rapid upturns, but this must be interpreted as a good long-term situation. Investors should be patient, though, especially after the real estate market rally of the preceding years. In reality, that upswing was abnormal. The market is now closer to its trend growth line. In any event, a normalisation is good news for real estate.

The American housing market is slowly on its way to recover- ing, as also evidenced by a larger number of housing starts

in January and by the National Association of Homebuilders

(NAHB) Index, which rose a bit more than expected in

February. We interpret these figures positively, especially

in light of disappointing figures in the preceding months.

A somewhat better labour market, economic growth, low

interest rates, cheap homes and an extended tax credit for first-time buyers are factors that are helping to improve the situation.

The S&P/Case-Shiller Index of 10 major U.S. cities is presumed to reflect what is happening in a large portion of the American market. According to this index, prices are still lower than a year ago, but the rate of price decline is quickly slowing. According to the Federal Housing Finance Agency (FHFA) Index, the picture is more uneven, with positive and negative figures.

Us HOme priCes are LeveLLing OFF… 25 20 15 10 5 0 -5 -10 -15
Us HOme priCes are LeveLLing OFF…
25
20
15
10
5
0
-5
-10
-15
-20
2000
2002
2004
2006
2008
Per cent

-5

-10

-15

-20

yieLD anD priCe inDiCate nOW is time tO bUy

The latest yield and price changes indicate that now is a good time to invest in real estate. When yield is low, properties are usually too expensive since investors will then simply not earn

a good return on their invested capital. On the other hand,

when yield is high, properties are often too cheap. In a number of European countries, yields have begun to fall again, signal- ling a good time to buy.

25

20 In Europe, yields fell during most of the 2000s decade and

15 bottomed out before the sub-prime crisis, which thus meant

10

5 that real estate prices were high. The low yield at that time

0 was apparently a result of excessive borrowing. We are now expecting yields to fall only moderately, promising a good − but not spectacular − return on real estate investments. What

is holding back the market to some extent is the downsizing of

lending that is now under way. It remains uncertain how much capital will be left in the system.

S&P Case-Shiller, Composite-10, 2000M1=100 [c.o.p 12 months]

FHFA, USA (Purchase-Only), 1991M1=100 [c.o.p 12 months] Source: Reuters EcoWin

US residential real estate prices are continuing to stabilise and will soon be climbing compared to one year earlier.

…bUiLDing permits anD HOUsing starts are Up 2.50 2.50 2.25 2.25 2.00 2.00 1.75 1.75
…bUiLDing permits anD HOUsing starts are Up
2.50
2.50
2.25
2.25
2.00
2.00
1.75
1.75
1.50
1.50
1.25
1.25
1.00
1.00
0.75
0.75
0.50
0.50
0.25
0.25
2000
2002
2004
2006
2008
Millions
Millions
0.25 0.25 2000 2002 2004 2006 2008 Millions Millions United States, Building Permits, Total, AR, SA

United States, Building Permits, Total, AR, SA United States, Housing Starts, Total, AR, SA

Source: Reuters EcoWin

The number of US building permits has risen, and although the number of housing starts has not yet increased much, there are many indications that the situation will improve in the coming months.

Another factor indicating that it is a good time to start invest- ing in real estate is the trend of office rents. They usually lag behind the general economic trend, but we can already dis- cern a trough that promises an upturn.

The world economic recovery is having a positive impact on

the demand for real estate. But how does the supply side look?

One effect of the earlier crisis is that there is less new con-

struction of office and industrial buildings. As a result, existing

buildings will become more attractive, which should provide

good potential for price increases over the next several years.

nOt OnLy pOsitive FaCtOrs

Real estate investments face not only positive factors at present, but also dangers. One concerns access to financing. The ability of banks to provide capital remains somewhat unclear, among other things due to uncertainty about what regulatory requirements will apply in the future. Loan-to-value ratios today − with around half of financing from banks − are well below those of 3-5 years ago, when the ratio in some cases could be 100 per cent. To be allowed to invest at a high loan-to-value ratio, it is a major advantage to be an investor that has been successful during the crisis and has good credit

Investment OutlOOk - maRCH 2010

Asset class: Real estate

history. Good real estate investors with outstanding track records thus offer good investment opportunities for us.

Some borrowers have ended up being squeezed, unable to handle their financial obligations. Banks do not want to leave these borrowers in the lurch, since this alternative is probably worse than helping them to survive financially and take good care of their properties. By working together actively to resolve the situation and make the transition to an economy with lower overall loan-to-value ratios, both banks and borrowers can generate value without affecting markets too much.

In the United States, loans of around USD 500 billion per year fall due in 2010-2012. Starting in 2013 the amount will decline significantly, to about USD 150 billion. This is a clear indica- tion of how much the overall lending market must shrink, and obviously it affects real estate markets. We should expect the process of lending normalisation to take at least another few years, but it is under way and will be good for real estate as time passes.

The number of unleased square metres in newly constructed properties in China is another source of concern that has the potential to hurt the Chinese market, with repercussions in the world economy. The monetary tightening that China has

begun will help cool down new real estate construction, but by how much is uncertain. On the plus side in China, there are forecasts showing higher real estate prices. Overall, we are not worried about China, but we still wish to single this out as a potential danger, though a small one.

There is evidence that quality pays for real estate investors. The easy money that was made by real estate investment trusts (REITs) in the second and third quarter of 2009 was largely a result of a general sense of relief after the financial crisis. Looking ahead, things will probably not be as easy. It will be more important to search for property managers that generate returns even though the market is not working quite optimally, and to invest in those portions of the market that are predicted to have an especially bright future. Our most likely scenario − a sideways but somewhat positive market with rising asset prices − favours residential properties and those portions of the real estate market with central and local governments and stable companies as tenants.

Since we now see the sun going up on the horizon, we are choosing to start investing in real estate via the less risky por- tion of the market. We expect to earn uniform return flows, which will provide stability in our portfolios at relatively low risk.

reit inDiCes WOrLDWiDe sHOW same UpWarD trenD

150 150 130 130 110 110 90 90 70 70 50 50 Jan M ar
150
150
130
130
110
110
90
90
70
70
50
50
Jan
M ar
M ay
Ju l
S ep
N o v
Jan
2009
2010
Europe, GPR, 250 REIT Index
United States, Dow Jones Wilshire, Specialty, REIT Index (Float Adj)
World, GPR, 250 REIT Index
Asia, GPR, 250 REIT Index
Source: Reuters EcoWin
Index

Indices of real estate investment trusts (REITs) clearly show the increase in risk appetite that reached the market in March 2009 and con- tinued for the rest of the year. Now the focus is shifting to a lasting upturn and underly- ing growth, where quality will be even more important.

Investment OutlOOk - maRCH 2010

to a lasting upturn and underly- ing growth, where quality will be even more important. Investment

31

asset class: Private equity
asset class:
Private equity

Challenging year − good business opportunities

The recovery will benefit private equity

Thawing credit market a key issue

Excellent situation for strong market players

Last year’s economic and market recovery benefited private equity (PE) investments. In our last Investment Outlook (December 2009), we argued that these improved conditions had laid the groundwork for positive growth, something that so far appears to have occurred. A number of PE transactions have been completed, while market prices of listed PE compa- nies have performed well. The SEB Listed Private Equity fund is up more than 5 per cent since the end of November 2009. PE companies themselves speak of recovery and brighter market prospects, although many point out that the situation is far from the best.

As always, there are arguments both for and against a positive trend for PE investments. The negative factors should not be neglected or underestimated, but on the whole our assess- ment is that the positive side outweighs them. Given that we are in the final phase of a deep crisis, however, selectivity is more important than usual − all that glitters is not gold.

eCOnOmiC anD CreDit Crisis a maJOr bUrDen The turbulence of recent years has hurt PE companies in vari- ous ways. Because of weak economic conditions, PE-owned companies − target companies − have performed below ex- pectations and/or have encountered problems. Since acquisi- tions are normally made with borrowed funds, PE companies are dependent on positive cash flow. When this is absent, they encounter financial problems, often because banks call in loans to protect their claims when PE-owned companies do not fulfil the covenants agreed for the loans.

The credit market crash worsened the situation, when lenders had a great need to reduce their risks and slim their balance sheets. Overall, this led to a market that was nearly frozen solid during the winter of 2008/2009. Values fell very sharply, and investors were very reluctant throughout 2009. The vol- ume of new transactions was thus at its lowest in 25 years.

32

Investment OutlOOk - maRCH 2010

Starting in the second quarter of last year, however, an im- provement was noticeable at all levels. The cyclical recovery and a credit market that slowly began functioning again led to sharp value increases, not only on stock exchanges but also for PE companies. The prospects of continued decent growth ahead gradually meant better conditions for target companies.

CreDit market is reaWakening Credit market developments are a factor whose effects are more difficult to assess. Bank lending to PE has gradually resumed. A number of transactions have recently been an- nounced in which it is clearly apparent that banks are again helping to finance PE companies, albeit at lower loan-to-value ratios than during the peak years. Activity is also increasing in the corporate bond market, where the companies can obtain financing, admittedly at high cost but without covenants. There are also new creative financing solutions, with certain pension funds among the players.

On the other hand, access to capital remains scarce. Banks re- main under pressure, and political initiatives are disrupting the picture. In particular, President Obama’s proposal not to allow banks to own PE companies or funds risks turning up pres- sure on the market. In addition, there is probably still a great need for many PE companies to divest holdings for financial reasons.

But, and this is important: These risks also represent oppor- tunities for those that have weathered the crisis well. For PE companies that have “dry powder” − money to invest − there should be good opportunities to buy secondaries (existing PE investments) at attractive prices when banks and others may sell them in the future. In this market, transactions are taking place today at a discount of up to 25-30 per cent of compa- nies’ net asset value (NAV). After a year with few transactions, we expect volume to triple in 2010.

Less COmpetitiOn FOr targets Most observers agree that the market for new PE funds will remain cautious this year, with significantly lower volume than during the record years 2006-2007. This is also good news for

Asset class: Private equity

those market players that are strong today, since fewer rivals will be competing for the good targets.

Among the various segments, we are most positive towards the potential for acquiring small and medium-sized companies

− in part because they do not attract as much capital in exter-

nal financing and partly because there is more often room for

a professional corporate governance model in order to make

a difference in the value of the company. Megafunds, which

raised enormous sums during the peak years to make specula- tive acquisitions of the largest companies in the stock market, are probably a phenomenon consigned to history.

prOper pOsitiOning impOrtant Overall, we foresee several key success factors for the near future. The PE companies that will succeed have:

• Operational resources to pursue the reform process in tar get companies

• Target companies that have captured market share during the crisis

• Few problem companies in their portfolio

• Long-term relationships with local lenders

• “Dry powder” for new investments

For those PE companies that are properly positioned, the pros- pects appear attractive. There are plenty of companies to buy, and sellers seem to be starting to accept the prevailing price levels. Target companies can now be bought at lower initial prices than before, and they probably have a greater need for operational reform. So even if a strained credit market means lower loan-to-value ratios − which means lower leveraging

of the investment − and more expensive borrowing, well- managed PE firms should be able to grow nicely in the future. History also shows that PE companies have generated good returns in the wake of recessions.

COntinUeD gOOD DisCOUnt tO nav At the bottom, PE companies were changing hands at ex- tremely high discounts on net asset value. Because of sharply rising market prices, discounts in relation to net asset value (NAV) have largely disappeared, but the discounts are still close to the lowest levels that prevailed at the bottom of the economic downturn just after the turn of the millennium. Actual discounts are probably somewhat larger than the re- ported ones. We estimate that they are at 30-40 percent. This promises good growth for PE companies ahead as the valua- tions normalise.

We have a generally positive view of the potential for PE. The very best potential is probably found in secondaries, but given that the risk appetite of the investor community has normalised, listed PE should also be able to perform well. The strained financing situation is more than outweighed by the good business opportunities in the wake of the crisis. Good growth potential is the engine, and big discounts are a further incentive.

We remain invested in listed PE in our portfolios and are working further to find attractive investment opportunities in secondaries. At the same time, we note that this asset class is highly volatile, and PE should thus not be a dominant element of the portfolio.

a LOng Way tO earLier peaks

275 250 225 200 175 150 125 100 75 50 2003 2004 2005 2006 2007
275
250
225
200
175
150
125
100
75
50
2003
2004
2005
2006
2007
2008
2009
Index

275

250

225

200

175

150

125

100

75

50

LPX, LPX 50 Index, Total Return, Close [rebase 01/01/2003 = 100.0]

MSCI, Index, Gross Total Return [rebase 01/01/2003 = 100.0]

Source: Reuters EcoWin

Due to the recession and credit crisis, listed pri- vate equity companies fell much further than the overall stock market. Since then, share prices of listed PE companies have recovered but remain far below their earlier peaks. Despite the upturn, the market is trading at a level near its low point in the previous reces- sion. Note that PE has weathered the stock market turbulence of recent months nicely.

Investment OutlOOk - maRCH 2010

sion. Note that PE has weathered the stock market turbulence of recent months nicely. Investment OutlOOk

33

asset class: Commodities
asset class:
Commodities

Pluses and minuses quite evenly balanced

34

After a strong 2009, commodity prices fell early this year

mainly

due to worries about China, Greece

and US policies

The 2010 outlook for commodities is mixed; we have lowered our expectations

Except for a dramatic slide late in 2008 after the Lehman Brothers bankruptcy, the first decade after the turn of the mil- lennium was very strong in the commodities market. For many years, there has also been a rather regular cyclical pattern for commodities, with bull markets for about 10 years followed by bear markets for about 20 years.

Strong periods for commodity prices have often coincided with weak ones for equities. One explanation is that rising commodity prices are usually coupled with high inflation, which is an unfavourable environment for equities − especially because interest rates are then high or rising. The commodity upturn of 2000-2008 was unique in this respect, since it was not accompanied by high inflation. Contributing factors be- hind the commodities boom during this period were, instead, expectations of appreciably faster growth in China, a signifi-

cant weakening of the US dollar (USD) and under-investments during the 1990s that led to bottlenecks in the supply of com- modities.

Last year commodities had a very strong year in 2009, with the UBS Bloomberg Constant Maturity Commodity Index (CMCI) gaining 43 per cent. Prices began to rise as early as February, or a month before the turnaround in the stock market began. This was contrary to historical patterns, according to which commodity prices have usually rebounded at about the same time as government bond yields, in other words significantly later than the stock market.

COmmODities aHeaD OF tHe CUrve This time commodities were reminiscent of a very early cyclical stock. They started climbing on prospects of strong Chinese growth − especially following the launch of an infrastructure- heavy stimulus package totalling 14 per cent of GDP − and as a hedge against a weaker USD and the risk of higher inflation. The extremely loose monetary policies launched during the autumn of 2008 also laid the groundwork for the commodities race. Other contributing factors were greater interest in com- modities among financial investors, resulting from both risk diversification ambitions and the rapid growth of new financial instruments; in 2009 investments in commodities set a new record of about USD 60 billion.

11000 10000 9000 8000 7000 6000 5000 4000 3000 Jan M ay S ep Jan
11000
10000
9000
8000
7000
6000
5000
4000
3000
Jan
M ay
S ep
Jan
M ay
S
ep
Jan
M ay
S ep
Jan
Index

3000

2750

2500

2250

2000

1750

1500

1250

1000

ep Jan Index 3000 2750 2500 2250 2000 1750 1500 1250 1000 2007 2008 2009 World

2007

2008 2009

World ex USA, MSCI, LOC Index (LOC), Net Total Return World, GSCI, Index, Total Return, USD

Source: Reuters EcoWin

COmmODity priCes Up beFOre

sHare priCes

Commodity prices have traditionally re-

bounded considerably later than the stock market, but in 2009 commodities were ahead

of the game. One reason was that the market expected higher commodity demand in China.

Investment OutlOOk - maRCH 2010

Soon after 2010 began, however, commodity prices turned downward. The main reasons were concerns related to mon- etary policy tightening in China, the risk of sovereign debt default in Europe (read: Greece) − which has pushed down the euro − and political initiatives in the United States, mainly President Obama’s proposal for measures to limit risk-taking by banks. The upturn for the USD that began late in 2009, and that has recently been further fuelled by the weakness of the euro, has also played an important role.

rising DOLLar a tHreat tO COmmODities 11000 1.7 10000 1.6 9000 1.5 8000 1.4 7000
rising DOLLar a tHreat tO COmmODities
11000
1.7
10000
1.6
9000
1.5
8000
1.4
7000
1.3
6000
1.2
5000
1.1
4000
1.0
3000
0.9
2000
0.8
2000
2002
2004
2006
2008
2010
United States, Spot Rates, EUR/USD
World, GSCI, Index, Total Return, USD
Source: Reuters EcoWin

A rising US dollar has usually gone hand in hand with falling commodity prices, and vice versa. The prospect of a further USD appreciation during 2010 is thus a negative factor for the commodities market.

Key factors for the commodities market during the remainder of 2010 will be what will happen with the storm clouds that gathered early in the year, as well as fundamental develop- ments in terms of economic growth in both the EM sphere and the industrialised OECD countries. Other central factors are how major currencies fare and what assets financial investors are interested in.

risks sHOULD nOt be eXaggerateD During 2010, China will continue to pursue its tightening poli- cies, including probable increases in the key interest rate and a gradual appreciation of the currency. But as a whole, these measures are not likely to slow economic expansion too much. The country’s demand for commodities will thus remain fairly high. The main risk when it comes to government financial problems in Europe is whether Greece will infect other coun- tries, but this is a very low-probability scenario. In addition, it will take a long time for Obama to pilot his proposal on stricter bank rules through Congress − a couple of years − but the market may occasionally fret about political perspectives.

While these storm clouds can be dissipated to a great extent, investor interest will probably remain rather strong and eco- nomic growth in emerging markets led by Asia will be high, the outlook is bleaker in the OECD. It is true that the economies of many industrialised countries are currently improving. But

Asset class: Commodities

are currently improving. But Asset class: Commodities their expansive energy will diminish later this year as

their expansive energy will diminish later this year as various stimulus effects fade (see page 19), which will hamper the de- mand for commodities. Our forecast that the USD will gradu- ally appreciate in 2010-2011 against the euro and yen, among other currencies, is another negative factor for commodities.

mOre Or Less siDeWays These positive and negative factors are quite evenly balanced. Our conclusion is thus that commodities are likely to move generally sideways during 2010 − but subject to rather large volatility. This means that compared to last autumn, we have lowered our return expectations on commodity investments.

As a consequence, we have down-weighted this asset class in

the Modern Aggressive portfolio (see page 10).

best OUtLOOk FOr preCiOUs metaLs anD agri 1800 1800 1700 1700 1600 1600 1500 1500
best OUtLOOk FOr preCiOUs metaLs anD agri
1800
1800
1700
1700
1600
1600
1500
1500
1400
1400
1300
1300
1200
1200
1100
1100
1000
1000
900
900
800
800
700
700
Index

Aug Dec Apr Aug Dec Apr Aug Dec Apr Aug Dec

2006

2007

Agricultural and Livestock Index

2008

Precious Metals Index

2009

Source: Reuters EcoWin

While we expect the prices of other commodities to move more or less sideways this year, there is a chance of higher prices for precious metals and agri-commodities.

While we predict that energy and industrial metals will follow the general price trend, there are certain upside chances for agri-commodities and precious metals. In particular, prices of wheat, maize (corn) and soya beans have fallen due to good harvests, but unfavourable weather during the spring of 2010 (El Niño) would result in price increases.

In a climate characterised by a decent risk appetite, a stronger USD and very low inflation, gold is not especially attractive, even though some central banks in the emerging markets sphere are buying it. However, other precious metals such as platinum and palladium will benefit from increased demand in the automotive industry.

Investment OutlOOk - maRCH 2010

35

asset class: Currencies
asset class:
Currencies

Separating the wheat from the chaff

More focus on the economic strength of countries/currencies

Greece will continue to weigh down the euro

Many indications that emerging market currencies will appreciate

Risk appetite previously played a crucial role in the foreign exchange (FX) market, but in recent months the fundamental statistics of countries and currencies have become a more influential driving force. We expect this new trend to become more evident during 2010. While most of the companies that have survived the crisis are on stable ground and have strong balance sheets, a number of central governments are close to financial insolvency. Global recession and gigantic stimulus packages have dug deep holes in national finances.

WOrries abOUt greeCe WeigH DOWn eUrO The market’s gaze is focused especially on Greece, but also on the other “PIGS” countries (Portugal, Italy and Spain). In an earlier Investment Outlook (March 2009), we mentioned that the euro system risks major strains that will push down the value of the currency, since the members of the euro zone are in such different economic condition.

eXpensive FOr greeCe tO bOrrOW

4.0 4.0 Greece 3.5 3.5 3.0 3.0 2.5 2.5 2.0 2.0 Ireland 1.5 1.5 Portugal
4.0
4.0
Greece
3.5
3.5
3.0
3.0
2.5
2.5
2.0
2.0
Ireland
1.5
1.5
Portugal
1.0
1.0
Italy
Spain
0.5
0.5
0.0
0.0
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
2008
2009
2010
Source:ReutersEcoWin
Percentage points

Market worries about Greece are reflected in the country’s bond yields. Today Greece must borrow at substantially higher yields than Germany.

36

Investment OutlOOk - maRCH 2010

Since then, these problems have escalated for the weakest links in the euro chain.

The path towards greater stability in the PIGS countries will likely be long and winding, since there are fundamental problems in these economies. Budget discipline has been conspicuously missing, debt levels are high and there is great dependence on foreign financing.

However, the risk that any of the PIGS countries will leave the euro system or be thrown out is minimal. All sides realise that the price of this would be too high. The weak euro countries have debts denominated in euros, and switching to a signifi- cantly weaker national currency would substantially increase their debt burden. In addition, the withdrawal of a euro zone country from the currency union would be a gigantic reversal for the whole project. Too much prestige has been invested to allow such a break-up. Finally, there is a significant risk of sec- ondary effects on other weak euro countries. But even if the system does not fall apart, the euro zone is likely to continue to face major challenges, which will weigh down the euro for a long time.

sWeDen best in CLass

1. 5 1 0. 5 0 -0. 5 -1 -1. 5 G r e I
1.
5
1
0.
5
0
-0.
5
-1
-1. 5
G
r e I e re c l e a Po n d U rt K u F g r a a n l c e I t Sp a B l y e N a l gi e i n A t u h u m e s r D t l r a ia en n Ge d ma s rm rk Fi a n n S l y a we n d d e n

Source: Reuters EcoWin

According to SEB’s country risk model, Sweden is the best in class, while Greece is the worst. The model is based, among other things, on government debt, budget deficits and econo- mic growth.

Asset class: Currencies

gOOD starting pOsitiOn FOr tHe sWeDisH krOna Because of concerns about budget problems in several euro zone countries, there is an increasing interest in the curren- cies of countries with sound government finances and cur- rent account surpluses. With Europe’s smallest budget deficit and largest current account surplus as a percentage of GDP, Sweden and the krona are in a strong position. Sweden’s robust economic health, together with improved export pros- pects and indications from the Riksbank of relatively early interest rate hikes, point towards a stronger Swedish krona. A year from now, we foresee an exchange rate of SEK 9.50 per euro, and at the end of 2011 about 9.20.

emerging market CUrrenCies LOOk prOmising The economies of the emerging market countries have largely changed character in recent years. Having previously been extremely sensitive to external shocks, the EM sphere is now stable as storm winds blow across the world economy. The main reason is that today these economies are based on significantly more solid fundamentals and are showing high growth rates.

Instead it is the OECD industrialised countries that face the biggest challenges: gigantic fiscal deficits, high unemploy- ment, low growth and so on. One source of concern in the market is the effects on economic growth when massive stimulus packages are withdrawn (exit policies). Our assess- ment is that global capital will continue to flow in the direc- tion of emerging markets, where growth rates are higher and financial stability is greater.

interest rate DiFFerentiaLs again a Driving FOrCe In the FX market climate that is likely to prevail in 2010, taking advantage of interest rate differentials will also be a strong driving force. In other words investors will borrow where inter- est rates are low and invest where they are high − a practice known as “carry trading”. The result is downward pressure on the currencies of low-interest countries, while the currencies of high-interest countries strengthen.

vOLatiLity On tHe Way DOWn

Today there are wide gaps between interest rates in different regions, and they will widen further. On the one hand, OECD countries were compelled to introduce ultra-loose monetary policies and will not tighten these policies right away. On the other hand, most EM countries are about to raise interest rates, which are already relatively high. Wider interest rate differentials are thus another reason why the demand for EM currencies will be large.

There is still heavy pressure on the Chinese authorities to allow an appreciation of the Chinese renminbin, or yuan (CNY). The last issue of Investment Outlook (December 2009) forecasted a strengthening of the CNY against the USD by 7 per cent in 2010 and by an equal percentage in 2011. We are sticking to that forecast. Since last autumn it has become increasingly clear that the Chinese economy has weathered the global economic deceleration admirably, so there is now reason to begin a currency appreciation − especially since there are now certain inflation risks in China. A stronger CNY would also reduce the country’s export dependence and in- stead stimulate domestic consumption. An appreciation of the yuan would also open the door for continued strengthening of other Asian currencies.

DOLLar WiLL retain its strengtH Since the beginning of 2010 the USD has strengthened notice- ably, especially against the hard-pressed euro. We predict that this trend will last for an extended period. One explanation for the strength of the dollar is euro weakness due to great concern about the budget crisis in Greece, a crisis that will not be solved overnight. In addition, fundamental factors are likely to be a powerful force in the FX market ahead, and the USD will benefit from this since the American economy is early in the economic cycle and in recent months has demonstrated far better growth than both the euro zone and the United Kingdom.

27.5 27.5 25.0 25.0 Lehman crisis 22.5 22.5 20.0 20.0 17.5 17.5 15.0 15.0 12.5
27.5
27.5
25.0
25.0
Lehman crisis
22.5
22.5
20.0
20.0
17.5
17.5
15.0
15.0
12.5
12.5
10.0
10.0
7.5
7.5
5.0
5.0
2005
2006
2007
2008
2009
Source: Reuters EcoWin
Per cent

After the Lehman crash, volatility has fallen in

the foreign exchange market, and we foresee a continued downward trend.

Investment OutlOOk - maRCH 2010

has fallen in the foreign exchange market, and we foresee a continued downward trend. Investment OutlOOk

37

SEB is a North European financial group serving 400,000 corporate customers and institutions and more than five million private individuals. One area with strong traditions in the SEB Group is private banking. From its founding in 1856, SEB offered financial services to wealthy private individuals. Today the Group has a leading position in Sweden and a strong presence in the other Nordic countries and elsewhere in Europe.

SEB Private Banking has a broad client base that includes corporate executives, business owners and private individuals of varying means, each with different levels of interest in economic issues. To SEB, private banking is all about offering a broad range of high-quality services in the financial field − tailored to the unique personal needs of each client and backed by the Group’s collective knowledge.

SEB Private Banking has some 350 employees working in Sweden, Denmark, Finland and Norway. Outside of Sweden, we take care of our clients via offices in Estonia, Geneva, Latvia, Lithuania, Luxembourg and Singapore as well as branches in London and Nice. On December 31, 2009, our managed assets totalled SEK 230 billion.

in London and Nice. On December 31, 2009, our managed assets totalled SEK 230 billion. www.sebgroup.com/privatebanking

www.sebgroup.com/privatebanking