Sie sind auf Seite 1von 40
Investment Outlook June 2011 navigating through risky waters private banking - investment strategy
Investment
Outlook
June 2011
navigating through risky waters
private banking - investment strategy

Contents

Investment Strategy

Contents Investment Strategy Introduction 5 Summary 6 Portfolio strategy 8 Theme: Identifying risks

Introduction

5

Summary

6

Portfolio strategy

8

Theme: Identifying risks

11

Theme: Navigating through risky waters

16

Themes: Tools for stock market choices

19

Macro summary

23

asset CLasses

Equities

25

Fixed income

28

Hedge funds

30

Real estate

32

Private equity

34

Commodities

36

Currencies

38

Investment OutlOOk - June 2011

3

Investment Strategy This report was published on May 31, 2011. Its contents are based on

Investment Strategy

This report was published on May 31, 2011. Its contents are based on information and analysis available before May 23, 2011.

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 Manager

+ 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

Investment Strategist

+ 46 8 763 69 58

johan.hagbarth@seb.se

esben Hanssen

Head of IS Norway

+ 47 22 82 67 44

esben.hanssen@seb.no

Carl barnekow

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

reine kase

Economist +352 26 23 63 50 reine.kase@sebprivatebanking.com

Daniel gecer

Economist +46 8 763 69 18 daniel.gecer@seb.se

Cecilia kohonen

Global Head of Communication Team +46 8 763 6995 cecilia.kohonen@seb.se

Liza braaw

Communicator and Editor +46 8 763 69 09 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 Information relating to taxes may become outdated and may not fit your individual circumstances.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 in- formed 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 - June 2011

introduction
introduction

A humble attitude in a moderate growth market

A period of rapid stock market gains and eco- nomic upturn is now being followed by a calmer trend in both cases. This is not so dramatic, but investors should lower their return expectations a bit. Those who properly assess and manage the prevailing market risks can earn a lot of returns.

Asset management is always a combination of long-term thinking and short-term tactical deliberations. The markets send continuous signals. It is thus a matter of determining when these signals are a forecast of future trends, and when they are a reaction to a specific event that only temporarily changes market sentiment.

As the summer approaches, we have a relatively optimistic

view of capital markets in general. The global economy is in

a period characterised by growth in most major countries, in

many cases solid growth. Many countries are pursuing sup- portive and accommodative monetary policies. The inflation outlook is fundamentally favourable in many places around the world. This lays the groundwork for a rather positive view of the capacity of the stock market − and other cyclically de- pendent markets − to generate higher value.

The economy now appears to have passed a point in the eco- nomic cycle that is attractive from an investment perspective. The upward journey of leading indicators has probably peaked and may have passed, which can be interpreted as the inter- ruption of a trend. These indicators are now levelling out, but this is occurring at a high level − signalling that companies foresee a bright future for the economy and their own opera- tions.

Stock markets rise fastest in the initial upturn phase, when

indicators are also moving rapidly upward. After peaking, there

is a period when they both transition to a calmer journey. It can be described as moving from a strong bull market to a more moderate growth market.

This is actually not such a dramatic process, yet it represents

a further progression in the economic cycle. It is normal to

see continued growth in stock market value, shrinking yield spreads between corporate and government bonds and good growth in various other capital market segments. So it does not represent any significant shift in direction, but investors should lower their return expectations a bit.

In addition to our customary review of opportunities in various asset classes, this issue of Investment Outlook also pays extra attention to a few specific questions: What are the risks that affect capital market pricing today? What characterises the current phase of the economic cycle from the perspective of returns? How do we build up a country allocation model for stock markets?

With some justification, we can draw the conclusion that most markets are not particularly expensive. One reason why markets are not overpriced may be the existence of a number of risk scenarios that adversely influence the desire to invest capital. In recent weeks, sovereign bond yields have again fallen substantially, a market reaction that is a sign of caution and perhaps a lack of faith in economic growth among inves- tors. This is why we consider it important to discuss the exist- ing economic and market risks. Those who assess and manage these risks properly can earn a lot of returns.

We have further refined the country model we launched in the last issue of Investment Outlook (February 2011). The justification for creating this type of model is a systematisa- tion of efforts to illustrate driving forces and risks in our asset management.

Market analysis is often described as an art form. But in reality,

it is mostly a matter of structured work and a humble attitude

towards a constantly changing and occasionally risky financial

world, which continuously generates business opportunities.

Hans Peterson CIO Private Banking and Global Head of Investment Strategy

Investment OutlOOk - June 2011

5

Historical return

Historical return Summary   expected, 1-2 years (annual averages)   return. risk reasoning

Summary

 

expected, 1-2 years (annual averages)

 

return.

risk

reasoning

equities

8%

16%

Positive. Risk appetite is increasing in the global stock market and the long-term trend still points upward. There is a risk of short-term downward revisions due to softer economic signals, but various risk factors are already priced into the market.

Fixed income

5%*

6%

Positive towards High Yield and EM Debt; negative towards government bonds. Various OECD countries will be financing large budget deficits, and government bond yields will rise. In EM countries, expect higher key inter- est rates and gradually less resolute tightening measures. The global economic upturn will continue to favour the High Yield segment.

Hedge funds

6%

5%

Positive. Normalisation of financial markets will open the way for a larger number of mergers and acquisi- tions, benefiting several strategies. The improved investment climate will create potential for good returns, without managers having to take unnecessary risks.

real estate

4%

4%

neutral/Positive. Rental levels are rising at an accelerating pace, and the number of unleased proper- ties is decreasing. Better borrowing opportunities will benefit the market. Some concerns about bubble tendencies in China, while the American housing market remains weak.

private

Positive. Today’s valuation levels are still attractive, but companies are no longer cheap. There is some financial instability, but strong economic and earnings growth is making this asset class appealing.

equity

10%

20%

Commodities

6.5%

18%

Positive/neutral. Somewhat greater worries about the world economic situation as well as recent USD appreciation have contributed to a downward correction after the commodities rally of the past year. More normal weather conditions may continue to push down agricultural prices. It should be possible for oil prices to fall when calm is restored in the Middle East and North Africa (MENA).

Currencies

3.5%

4%

neutral/ negative**. Taking advantage of interest rate spreads (the “carry trade”) and global imbalances are factors that are driving this asset class. The revaluation of the Chinese yuan is likely to continue.

* Expected return on corporate bonds that are weighted about 1/3 Investment Grade and 2/3 High Yield. ** This opinion refers to the alpha-generating capacity of a foreign exchange trading manager.

eXpeCteD risk anD retUrn (1-2 year HOriZOn, annUaL averages)

CHange in OUr eXpeCteD retUrn

12% 1 6 % 1 4 % Private equity 10% 1 2 % 1 0
12%
1 6
%
1 4
%
Private equity
10%
1 2
%
1 0 %
Equities
8
%
8%
6
%
4
%
Hedge funds
Commodities
6%
2
%
0
%
Fixed income*
Real estate
-2
%
4%
-4
%
Currencies
2%
0%
Equities
Fixed income*
Hedge funds
Real estate
0%
5%
10%
15%
20%
25%
30%
Private equity
Currencies
Commodities
Expected volatility
Expected return
2008-11
2009-02
2009-05
2009-08
2009-12
2010-02
2010-05
2010-09
2010-12
2011-02
2011-05

HistOriCaL risk anD retUrn (may 31, 2001 tO apriL 30, 2011)

8%

6%

4%

2%

0%

-2%

-4%

Fixed income

Hedge funds
Hedge funds

Real estate

Currencies

Commodities Fixed income Hedge funds Real estate Currencies Equities Private equity

EquitiesFixed income Hedge funds Real estate Currencies Commodities Private equity

Private equity

Fixed income Hedge funds Real estate Currencies Commodities Equities Private equity

0%

5%

10%

15%

20%

Historical volatility

25%

30%

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 = SEB PB Real Estate. Private equity = LPX50. Commodities = DJ UBS Commodities TR. Currencies = Barclay- Hedge Currency Trader.

6

Investment OutlOOk - June 2011

HistOriCaL COrreLatiOn (may 31, 2001 tO apriL 30, 2011)

Commodities

Fixed income

Hedge funds

Real estate

Currencies

Equities

Private

equity

Equities

1.0

Fixed income

-0.47

1.00

Hedge funds

0.52

-0.24

1.00

Real estate

-0.16

0.12

-0.07

1.00

Private

equity

0.85

-0.35

0.61

-0.18

1.00

Commodities

0.24

-0.16

0.65

-0.11

0.37

1.00

Currencies

-0.17

0.16

0.12

-0.12

-0.04

0.05

1.00

S&P 500 index

WeigHts in mODern prOteCtiOn

WeigHts in mODern aggressive

Summary

in mODern prOteCtiOn WeigHts in mODern aggressive Summary 40% 0% Equities Equities 25% 78. 0% Fixed
40% 0% Equities Equities 25% 78. 0% Fixed income Fixed income 13. 5% 19. 5%
40%
0%
Equities
Equities
25%
78.
0%
Fixed income
Fixed income
13.
5%
19.
5%
Hedge funds
Hedge funds
2.
0%
0%
Real estate
Real estate
0.
0%
9.
5%
Private equity
Private equity
0.
0%
5%
Commodities
Commodities
4.
5%
0%
Currencies
Currencies
2.
0%
1%
Cash
Cash
0%
10%
20% 30%
40%
50%
60% 70%
80%
90%
0%
10%
20%
30%
40%
50%
Previous
Current
Previous
Current
WeigHts in mODern grOWtH
rOLLing 36-mOntH COrreLatiOns vs. msCi WOrLD
(eUr)
29%
1
Equities
0
. 8
27%
Fixed income
0
. 6
24.
5%
Hedge funds
0
. 4
2.
5%
0
. 2
Real estate
0
5%
Private equity
- 0
. 2
5%
Commodities
- 0
. 4
4%
Currencies
- 0
. 6
3%
- 0
. 8
Cash
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
2 0 1 0
0%
10%
20%
30%
40%
Fixed income
Hedge
Real estate
Previous
Current
Private equity
Commodities
Currencies

identifying risks: The economic and stock market upturn may go on for another 2-3 years; there are risks but they are manageable

navigating through risky waters: The market is moving from a strong growth phase to a calmer expansion phase

tools for stock market choices: Factors we are focusing on in this phase are growth, inflation/monetary policy, valuations and currencies

tHeme: iDentiFying risks

1 7 .5 1 7 .5 1 5 .0 1 5 .0 1 2 .5
1
7
.5
1
7
.5
1
5
.0
1
5
.0
1
2
.5
1 2
.5
1
0
.0
1 0
.0
7
.5
7
.5
5
.0
5
.0
2
.5
2
.5
0
.0
0
.0
-
2
.5
-
2
.5
2 0 0 5
2 0 0 6
2 0 0 7
2 0 0 8
2 0 0 9
2 0 1 0 2 0 1 1
Russia, consumer prices
Source: Reuters EcoWin
Brazil, consumer prices
China, consumer prices
India, wholesale prices
Per cent, year-on-year

Inflation in the BRIC countries (Brazil, Russia, India and China) has ac- celerated significantly since the global recovery began in the autumn of 2009. Rapid growth, shortages of spare production resources and the commodity price rally are the main reasons, but the upturn has levelled off recently, due especially to tighter economic policies. Together with the prospect of lower food prices, this should mean gradually slower inflation ahead.

tHeme: tOOLs FOr stOCk market CHOiCes 1600 1600 1500 1500 1400 1400 1300 1300 Phase
tHeme: tOOLs FOr stOCk market CHOiCes
1600
1600
1500
1500
1400
1400
1300
1300
Phase 2
Phase 1
Phase 3
1200
1200
1100
1100
1000
1000
900
900
800
800
2003
2004
2005
2006
2007
Source: R euters EcoW in
US, S&P500, USD
A bull market can generally be divided into three phases. Our as-
sessment is that at present, the market is in phase 2, where investors
increasingly distinguish between asset classes and stock exchanges
based on their respective potential.
S&P500index

Investment OutlOOk - June 2011

7

portfolio strategy
portfolio strategy

Steady portfolios in a tumultuous market

Our portfolios have remained steady during a turbulent spring. Due to minor adjustments in our long-term market view, we have made some shifts within certain asset classes, but without a need for major re-allocations between them. Modern Growth and Modern Aggressive remain positioned towards global recovery, while Modern Protection is gaining a somewhat higher expected return.

mODern prOteCtiOn While the yield curve for American government securities remained largely unchanged during the February-April period, higher European/German short-term interest rates created a somewhat flatter yield curve. The movement in German inter- est rates is explained, among other things, by the European Central Bank’s key rate hike in April. Inflation accelerated somewhat in a number of countries due to rising commod- ity prices, and inflation worries are slowly creeping into the market.

In the fixed income market, we foresee risk rather than return in government bonds, and we are instead finding potential for returns in corporate bonds. Since February, we have gradually reduced the Modern Protection portfolio’s holdings of short- term fixed income funds and shifted to corporate bonds. To preserve the capital-protecting investment profile of the fixed income sub-portfolio, we are cautiously positioned in both Investment Grade and High Yield, attracted by higher coupons and possible price gains, but without thereby increasing inter- est rate risk. We have also increased the share of absolute/ total return funds, which now account for about half of the sub-portfolio. Each individual fund in this segment implies a somewhat higher risk, but the combination of managers’ dif- ferent investment strategies results in an acceptable risk level, which is on a par with the risk profile of the overall portfolio.

Looking ahead, we plan to further reduce holdings of short- term interest-bearing bonds in favour of senior secured lever- aged loans − loans issued to companies with low creditworthi- ness but with better underlying collateral and variable interest

8

Investment OutlOOk - June 2011

rates. This segment was hard hit during the financial crisis, but as the underlying companies show stronger balance sheets, the risk of bankruptcies has decreased. In addition, these loans have higher collateral than traditional bonds, and the risk level is quite suitable for Modern Protection. The variable interest rate component also means low interest rate risk.

The portfolio’s allocation to hedge funds increased, using a low-risk, market-neutral manager − the hedge fund sub- portfolio now accounts for about 14 per cent of Modern Protection. The portfolio’s currency managers succeeded in turning around the trend; this sub-portfolio rose about 1 per cent from February to April.

All asset classes in Modern Protection have made positive contributions so far in 2011, and the portfolio is well equipped for an environment of potentially rising interest rates.

2.0% 4.5%

2.0% 13.5% 78.0%
2.0%
13.5%
78.0%

Cashpotentially rising interest rates. 2 . 0 % 4.5% 2.0% 13.5% 78.0% Currencies Real estate Hedge

Currenciesof potentially rising interest rates. 2 . 0 % 4.5% 2.0% 13.5% 78.0% Cash Real estate

Real estateof potentially rising interest rates. 2 . 0 % 4.5% 2.0% 13.5% 78.0% Cash Currencies Hedge

Hedge fundsof potentially rising interest rates. 2 . 0 % 4.5% 2.0% 13.5% 78.0% Cash Currencies Real

Fixed incomeof potentially rising interest rates. 2 . 0 % 4.5% 2.0% 13.5% 78.0% Cash Currencies Real

mODern grOWtH During the first four months of 2011, financial markets have been difficult to navigate. Worries about sovereign debt on the periphery of Europe have caused ebbs and flows in the mar- kets for equities, fixed income and currencies. Unrest in North Africa paved the way for rising oil prices, and the earthquake/ tsunami disaster in Japan impacted the energy sector, among others. The market’s general view that there is an underlying global recovery nevertheless persists.

Environments like this really put our Modern Investment pro- grammes to the test. While global equities fell in euro terms between February and April, the Modern Growth strategy suc- ceeded in gaining more than 1 per cent − a result of our broad diversification philosophy. The equities sub-portfolio per- formed somewhat better than the world index, yet ended up in the red, while all the other asset classes contributed positively to the portfolio’s performance.

Our long-term view of the world economy and our as- set classes is generally unchanged. Emerging market (EM) countries are still growing at a rapid pace, while some OECD countries are struggling to regain control of sovereign debt. Since February, EM countries have performed better than OECD countries. This has benefited our equities sub-portfolio. Meanwhile our commodities sub-portfolio has risen by more than 5 per cent. An ever-weaker US dollar caused commodity prices to rise generally, and uncertainty about global monetary systems boosted the demand for gold. Uncertainty about the future of nuclear power and about global oil supplies in con- junction with unrest in Libya paved the way to rising oil prices, among other things.

During February, we increased our allocation to private equity in Modern Growth from 3 to 5 per cent. Since then, this sub- portfolio has climbed about 5 per cent measured in euros. Private equity companies are still trading at a discount larger than the historical average, and valuations are still good. The outlook remains positive, and at present we see no reason to change this allocation.

One major reason why Modern Growth has continued its stable performance during 2011 is our allocation to High Yield and Emerging Market debt in the fixed income sub-portfolio. Companies are continuing to improve their finances, and the bankruptcy risk is continuously decreasing, which is benefiting High Yield. Since February, we have allowed out positions in these segments to increase compared to other asset classes but have also made an active allocation to High Yield in par- ticular, since our assessment was that it could make a positive contribution amid prevailing short-term market uncertainty. The outlook also remains good for convertible bonds, but we are also seeing potential in senior secured leveraged loans − loans issued to companies with low creditworthiness but with better underlying collateral and variable interest rates. We

Portfolio strategy

and variable interest rates. We Portfolio strategy thus intend to replace our position in convertibles with

thus intend to replace our position in convertibles with these. The portfolio should thereby also achieve a somewhat lower correlation with the stock market.

In hedge funds, we are also continuing to strive for a sub- portfolio that better complements Modern Growth as a whole, while contributing potential returns. At this writing, we have begun the process of divesting one of our Global Macro funds while looking into adding a new strategy to the sub-portfolio:

Credit Long/Short. This strategy should benefit from tensions in the global credit market, and the strategy as such should contribute nicely to our risk diversification. Our overall alloca- tion to hedge funds decreased during the period, but this is primarily because we prefer to invest in such assets as High Yield bonds during the period while our search for new hedge fund managers is under way.

While the real estate sub-portfolio continued to chug along in good shape, our currency managers also succeeded in turn- ing around the trend and this asset class gained more than 1 per cent during February-April. From a portfolio strategy standpoint, we are satisfied with our position in currencies (about 2.5 per cent), but we are continuing to analyse the currency fund market and search for managers who may perhaps be able to further enhance the diversification of this sub-portfolio.

Given the planned adjustments in the fixed income sub-port- folio as well as in the hedge fund sub-portfolio, the risk/return profile of Modern Growth should improve, further positioning the portfolio to benefit from the global economic recovery.

3% 4% 5% 29% 5% 2.5% 24.5% 27%
3%
4%
5%
29%
5%
2.5%
24.5%
27%

Casheconomic recovery. 3% 4% 5% 29% 5% 2.5% 24.5% 27% Currencies Commodities Private equity Real estate

Currenciesrecovery. 3% 4% 5% 29% 5% 2.5% 24.5% 27% Cash Commodities Private equity Real estate Hedge

Commodities3% 4% 5% 29% 5% 2.5% 24.5% 27% Cash Currencies Private equity Real estate Hedge funds

Private equity5% 29% 5% 2.5% 24.5% 27% Cash Currencies Commodities Real estate Hedge funds Fixed income Equities

Real estate2.5% 24.5% 27% Cash Currencies Commodities Private equity Hedge funds Fixed income Equities Investment OutlOOk -

Hedge funds24.5% 27% Cash Currencies Commodities Private equity Real estate Fixed income Equities Investment OutlOOk - June

Fixed income24.5% 27% Cash Currencies Commodities Private equity Real estate Hedge funds Equities Investment OutlOOk - June

Equities27% Cash Currencies Commodities Private equity Real estate Hedge funds Fixed income Investment OutlOOk - June

Investment OutlOOk - June 2011

9

10 Portfolio strategy mODern aggressive In order to achieve the best possible risk-adjusted potential re-

10

Portfolio strategy

mODern aggressive In order to achieve the best possible risk-adjusted potential re- turns, without sacrificing our broad diversification philosophy, in Modern Aggressive we are currently investing in five asset classes: equities, commodities, hedge funds, private equity and fixed income. This strategy showed its strength, with the portfolio gaining more than 1 per cent during February-April, while world stock markets lost more than 1 per cent in euro terms.

In the equities asset class, emerging markets regained lost ground against the OECD countries between February and April, and the MSCI EM Net in euro lost a marginal 0.1 per cent, while the MSCI World Net in euro lost 1.3 per cent. For the equities sub-portfolio in Modern Aggressive, this meant a marginal downturn of 0.3 per cent, both because nearly 40 per cent of the equities sub-portfolio is invested in emerging markets and because both the EM and global equity sub- portfolios performed better than their respective benchmark indices.

Meanwhile the commodities sub-portfolio has risen more than 5 per cent. An ever-weaker US dollar caused commodity prices to rise generally, and uncertainty about global monetary systems boosted the demand for gold. Uncertainty about the future of nuclear power and about global oil supplies in con- junction with unrest in Libya paved the way to rising oil prices, among other things. The private equity sub-portfolio rose by 5 per cent. The total allocation to private equity today is about 9.5 per cent of Modern Aggressive, one percentage point lower than in February, which is actually because we chose to invest capital inflows mainly in High Yield funds during this turbulent period. The outlook for private equity remains good, however, and at present we see no reason to change this al- location.

The fixed income sub-portfolio is still focused on High Yield and Emerging Market Debt. The High Yield segment is contin- uing to benefit from stronger balance sheets and an increas- ingly positive underlying economic situation, which lowers the risk of bankruptcies. In Modern Aggressive we are also considering an increase in our allocation to Emerging Market Debt − at the margin, we foresee somewhat higher potential returns, but above all this should contribute to better risk di- versification from a portfolio standpoint.

The objective of Modern Aggressive is to generate a return that is higher than the stock market over en economic cycle, and this should also be reflected in the hedge fund sub-port- folio. This past winter and spring, the hedge fund sub-portfolio has gradually shifted towards funds and managers with higher potential returns. During April we began the process of phas- ing down Global Micro funds, which we believe have a profile that will not achieve the targeted return of the overall portfo- lio. We also plan to re-assess our Credit Long/Short-oriented holding; this strategy as such clearly contributes to risk di- versification in the hedge fund sub-portfolio, but it might be possible to boost potential returns. Hedge funds decreased as a proportion of the Modern Aggressive portfolio during the period, but this is primarily because we prefer to invest in such assets as High Yield bonds during the period while our search for new hedge fund managers is under way.

Despite a higher risk profile, Modern Aggressive has per- formed well during a turbulent 2011. We will largely retain the allocation of the portfolio between asset classes and will continue to seek the most attractive risk-adjusted returns in each asset class.

40%

1%

5%

9.5% 25%
9.5%
25%

19.5%

Cashreturns in each asset class. 40% 1 % 5% 9.5% 25% 19.5% Commodities Private equity Hedge

Commoditiesin each asset class. 40% 1 % 5% 9.5% 25% 19.5% Cash Private equity Hedge funds

Private equityasset class. 40% 1 % 5% 9.5% 25% 19.5% Cash Commodities Hedge funds Fixed income Equities

Hedge fundsclass. 40% 1 % 5% 9.5% 25% 19.5% Cash Commodities Private equity Fixed income Equities Investment

Fixed incomeclass. 40% 1 % 5% 9.5% 25% 19.5% Cash Commodities Private equity Hedge funds Equities Investment

Equitiesclass. 40% 1 % 5% 9.5% 25% 19.5% Cash Commodities Private equity Hedge funds Fixed income

Investment OutlOOk - June 2011

theme: identifying risks
theme:
identifying risks

The economic upturn is not in jeopardy

The economic and stock market upturn may go on for another 2-3 years

…unless some form of shock interrupts the upswing

The risks are manageable, and not too severe

Rising economic cycles are mostly paired with rising stock markets, and vice versa. As long as the economy is in an up- ward phase and is expected to remain so for another while, there is thus good potential for a bull market.

Over the past 50+ years, economic upturns in the United States, for example, have had an average length of five years. This coincides with the average length of equity bull markets during the same period. The length of these upturns has varied greatly, however, indicating that they have sometimes been interrupted by various shocks. If the current upswing is not affected by any kind of shock, according to historical ex- perience it should be capable of continuing for another two to three years (see also Theme: Navigating through risky waters).

But today’s crystal ball also contains a number of conceivable risks, which might interrupt the economic upturn early and shorten the prevailing equity bull market. Some of these have their origins in the historically deep financial and economic crisis during the latest recession − government financial problems, monetary exit policies, various tension-generating problem situations in developed market (DM) and emerging market (EM) countries. Others are related to the consequences of more recent geopolitical events: mainly a sharp rise in com- modity prices. In addition, there are conditions that favour the creation of speculative bubbles.

the government financial crisis − a lengthy drama

Immediately after the announcement of the Lehman Brothers bankruptcy on September 15, 2008, the economic system was brutally shaken to its foundations. In the DM countries, the economy went into free fall. The risk of a global financial meltdown was real. Against the background of this menac-

ing situation, the economic policy reaction was exceptionally powerful, characterised by heroic fiscal rescue measures and large budget packages that propped up faltering economies. Central banks also immediately implemented zero interest rate monetary policies, along with massive quantitative easing measures.

As a consequence of these fiscal emergency responses and

− in the wake of the economic crash − declining tax revenue

as well as the triggering of automatic stabilisers (such as higher expenditures as unemployment climbed), fiscal defi- cits in many DM countries rose and sovereign debts soared. Seemingly overnight, there was an escalation of the public sector debt problems that had been building up for the past three decades or so − the “debt super-cycle” − and for a number of European countries the financial situation became acute during 2010.

About a year ago, this forced the international community to extend an emergency bail-out loan of EUR 110 billion to

Greece and to create a financial safety net totalling EUR 750 billion based on the European crisis mechanism (EFSF/EFSM) and loans pledged by the International Monetary Fund (IMF).

It also led to stress tests of European banks; in June 2011 the

European Union (EU) will publish the results of a new round of such tests. In November 2010 the safety net had to be utilised when Ireland needed a bail-out loan amounting to EUR 85

billion. In April 2011 it became clear that Portugal also needed

a bail-out loan which ended up at nearly EUR 80 billion. In

return, these countries − along with Spain, which has not yet needed to apply for a fiscal bail-out − launched sizeable aus- terity programmes aimed at drastically reducing their budget deficits.

Well managed under the circumstances

So far, the difficult government financial problems in Europe have been managed comparatively well by the EU and the IMF, together with the European Central Bank (ECB). In recent months, however, the situation in Greece has again deterio- rated dramatically. It is difficult to see how the country will be able to avoid some form of public sector debt restructuring, but this risk is regarded as manageable.

Investment OutlOOk - June 2011

11

USD trillion

USD trillion

USD trillion USD trillion 12 Theme: Identifying risks Looking a little further ahead, it cannot be

12

Theme: Identifying risks

Looking a little further ahead, it cannot be ruled out that Ireland and Portugal may also face debt renegotiations. By then there will hopefully be larger lending resources as part of the newly created European Stability Mechanism (ESM) that will be sufficient to provide loans to Spain as well, if needed.

Fiscal austerity will hamper Dm growth

One consequence of fiscal deficits and debts will be multi- year, non-cyclically-related fiscal austerity, both in countries whose governments have ended up in an acute financial situa- tion − Portugal, Ireland, Greece and Spain (the PIGS countries)

− as well as the United States and the United Kingdom. In

itself, this is something that will hamper economic growth in the DM sphere for many years to come.

The pressure on the US to start trimming its huge budget defi- cits increased further when Standard & Poor’s recently low- ered its outlook on US sovereign debt to negative. President Barack Obama’s proposal to tighten the federal budget by USD 4 trillion during the period 2012-2023 thus became the focus of political discussion in Washington. If a bipartisan consensus can be reached − which is our basic scenario − the US government can achieve a tightening equivalent to an estimated 3.5 per cent of GDP during fiscal 2012. For the DM countries as a whole, the contractive effect attributable to fiscal austerity next year would be about 1.5 per cent of GDP (0.25 per cent this year).

sharp economic slide. Later this year and during 2012, it will be followed by accelerating growth related to restoration and reconstruction work after the natural disaster. The cost will be substantially larger than after the Kobe earthquake of 1995. This will leave a deep hole in government finances, and sover- eign debt may increase to 230-240 per cent of GDP by the end of next year.

The Japanese natural disaster initially posed an obvious threat to financial markets, with falling risk appetite and risk asset prices. Looking ahead, however, Japan will instead offer op- portunities to the global economy when its reconstruction increases world demand.

Conclusion: Government financial problems will not halt the upturn

Granted that for many years, government financial problems will be an occasional source of market worries. Budget tighten- ing in the wake of deficits will be a drag on economic growth in the DM countries for many years to come. There will also be major fiscal challenges during the next recession, when room for counter-cyclical policies will appear nonexistent. However, a government financial crisis of such calibre that it would cut short the economic upturn is unlikely, though the risk must be monitored very carefully.

sOaring DeFiCits neeD tO be reineD in

Central banks in different policy phases

At the same time as many DM countries are now tightening

their fiscal policies − with Sweden and Norway among the

exceptions − in most places, central banks will continue or

initiate their exit policies from an abnormal starting position,

0. 25 0. 00 - 0. 25 - 0. 50 - 0. 75 - 1.
0.
25
0.
00
- 0.
25
- 0.
50
- 0.
75
- 1.
00
- 1.
25
- 1.
50
1905
1920 1935
1950 1965
1980
1995

-

0.

0.

0.

0.

25

00

25

50

0. 75

Source: Reuters EcoWin

Mainly due to the financial and economic crisis, the US federal budget deficit has exploded in recent years. Austerity measures are imminent, however, shrinking the deficit from about USD 1.4 trillion in fiscal 2011 to USD 1.1 trillion in fiscal 2012. The chart shows budget outcomes until fiscal 2010.

- following the emergency management measures required by

- the financial and economic crisis. The Bank of Japan will hold

off for a long time, however.

- Key interest rates have been raised in parts of Europe as well

1.

00

-

1. 25

as in such commodity-producing countries as Canada and

Australia, and the ECB has cautiously begun its rate hiking

- cycle. The Bank of England is in less of a hurry but is likely to follow suit this autumn. The Federal Reserve (Fed) will com- plete its quantitative easing programme (QE2) − purchasing USD 600 billion worth of US government securities − but will probably allow its balance sheet (the monetary base) to shrink slightly this autumn and then carry out its first key rate hike early in 2012.

1.

50

Japan in a special situation

Japan’s sovereign credit rating and credit outlook have been downgraded this year, but no budget-tightening is in the cards

− on the contrary, due to the consequences of the March 11

earthquake and the subsequent tsunami and nuclear power plant failure. In the short term, the country has suffered a

The phase-out of QE2 should not lead to any significant effects on market interest rates, since the USD 600 billion increase in the Fed’s balance sheet since last autumn has not been accompanied by sharply rising money supply and lending. The ratio between the money supply and the mon- etary base − the credit multiplier − has instead fallen steeply, implying that the money has stayed within the walls of the banking system. In other words, QE2 has not stimulated the

Investment OutlOOk - June 2011

US economy via the domestic lending channel, but instead because the dollar has fallen. QE2 has strengthened the belief among market players that the Fed’s monetary policy will remain ultra-loose far longer than that of other major central banks, except for the Bank of Japan.

Dm exit policies − a balancing act

Generally speaking, central banks must now perform a care- ful balancing act. On the one hand, they must nurture the economic upturn, while bearing in mind that fiscal policies are tightening significantly in many places. On the other hand, they must take into account that total inflation − the target variable for many central banks − has increased significantly since last autumn, due to sharp increases in commodity prices.

The price outlook is not alarming, however. Assuming that the commodity price increase culminates and that later this year, certain prices − among them energy and food − fall somewhat, total consumer price inflation on both sides of the Atlantic in 2012 will be well below the 2011 level. Core inflation (excluding food and energy) will climb very modestly next year.

Conclusion: There will be no reason for DM central banks to sharply tighten their monetary policies

In recent months, central banks in the DM countries have faced more difficult decision-making problems as inflation has increased sharply, mainly due to more expensive commodities. But the price outlook is not alarming. The process of unwind- ing very accommodative interest rate policies can thus occur gently. Imminent monetary exit policies consequently pose no threat to the economic upturn.

Different cyclical positions have created tensions

While the DM sphere saw deep downturns in the last reces- sion, economic reversals for EM countries were substantially shallower. As a consequence of this, tensions have arisen in the global currency system. These have included what the EM countries regard as undesirably strong upward pressure on their currencies as well as overheating risks, also related to above-trend growth and commodity price increases. Some countries have responded by limiting the inflow of portfolio investments from DM countries; some have tightened their economic policies in order to slow economic growth.

The situation has cooled somewhat since China accelerated its revaluation of the yuan against the US dollar, but by all indications currency-related tensions will continue in the fore- seeable future. In any event, there is little likelihood of a wide- spread currency and trade war, especially since the outlook for the EM sphere now seems to be improving in important respects.

Theme: Identifying risks

be improving in important respects. Theme: Identifying risks efforts to ease overheating likely to bear fruit

efforts to ease overheating likely to bear fruit

Efforts by EM countries − especially in Asia − to reduce over- heating problems are soon likely to start bearing fruit. Growth

has decelerated as a result of interest rate hikes, bank lending restrictions and fiscal austerity, and price pressure is trending downward. Assuming a sizeable decline in food prices during the second half of this year (see below), conditions will im- prove further. In the EM countries, food accounts for between 25 and 50 per cent of the consumer price index, compared to an average of 15 per cent in the DM countries. Meanwhile, the EM sphere is less sensitive to oil price movements. The prospect of cheaper agricultural products later this year is thus especially important to the EM countries. As a result of these prospects, the need for tightening economic policies will fade

in some of the EM countries.

Conclusion: No economic hard landing in the EM sphere

A very shallow economic slump in the EM countries in 2008-

2009 and above-trend growth plus surging commodity prices have resulted in currency-related tensions and overheating in many of these countries. The overheating problem now seems to have decreased, and the prospect of cheaper food will ben- efit EM households in particular.

more expensive food a cause of dearer oil

One risk that is not based on the financial and economic crisis

is the big increase in commodity prices during the past year or

so. This can be explained by increased demand, a significant element of speculation in rising prices, a weakening of the US dollar and − in the case of food prices − supply-side disrup- tions due to the La Niña weather phenomenon.

OverHeating Has igniteD inFLatiOn

17.5 17.5 15.0 15.0 12.5 12.5 10.0 10.0 7.5 7.5 5.0 5.0 2.5 2.5 0.0
17.5
17.5
15.0
15.0
12.5
12.5
10.0
10.0
7.5
7.5
5.0
5.0
2.5
2.5
0.0
0.0
-
2.5
- 2.5
2005
2006
2007
2008
2009
2010 2011
Russia, consumer prices
Source: Reuters EcoWin
Brazil, consumer prices
China, consumer prices
India, wholesale prices
Per cent, year-on-year

Inflation in the BRIC countries has accelerated since the global recovery began in late 2009. Rapid growth, shortages of spare production resources and the commodity price rally are the main reasons, but the upturn has levelled off, especially due to tighter economic policies. Assuming lower food prices, this should mean gradually slower inflation ahead.

Investment OutlOOk - June 2011

13

Index

Per cent, y/y

Index Per cent, y/y 14 Theme: Identifying risks More expensive food was also the spark that

14

Theme: Identifying risks

More expensive food was also the spark that ignited social un- rest and violence in the Middle East and North Africa (MENA), which in turn further fuelled the oil price upturn. The risk is that oil prices may climb so much as to cause a sharp decel- eration in economic growth. So far, more expensive commodi- ties have had a certain cooling effect on the world economy, but without jeopardising the upturn.

rather minor inflationary effects in Dm countries

The inflationary effects of the price upturn to date are likely to be rather minor in the DM sphere. Oil and other com- modities account for only a small fraction of total company expenses − an overwhelming majority of these expenses consists of labour costs (about 70 per cent) − and in today’s macroeconomic environment it is also likely that companies will have difficulty passing on higher expenses to consumers. Meanwhile households/employees will find it hard to push through demands for higher wages and salaries as compensa- tion for more expensive energy.

Household energy consumption as a share of GDP has also fallen substantially during the past four decades, for example in the US from 17 per cent in 1970 to about 9 per cent today. It thus requires a significantly larger price increase now to have the same tightening effect on private consumption as before.

Furthermore, the correlation between American GDP growth and energy prices has changed signs. In the 1970s and early 1980s, the correlation was strongly negative: 80 per cent at the peak. In other words, rising oil prices went hand in hand with falling GDP. Since then it has gradually changed and has become positive. In the fourth quarter of last year, this positive correlation was about 75 per cent. Nowadays, rising GDP thus goes hand in hand with rising oil prices, as higher growth and demand from households and businesses lead to a greater need for energy and other commodities.

gDp CHanges anD OiL priCes gO HanD in HanD 12.5 10.0 7.5 5.0 2.5 0.0
gDp CHanges anD OiL priCes gO HanD in HanD
12.5
10.0
7.5
5.0
2.5
0.0
-2.5
-5.0
-7.5
Source: Reuters EcoWin
-10.0
1998
2000
2002
2004
2006
2008
2010
GDP, US
Brent crude oil
Per cent, q/q, annualised

150

125

100

50

25

-25

-50

-75

In the 1970s, GDP in the US usually grew more slowly or fell when oil prices rose, but in recent decades the correlation has become positive: Rising oil prices are associated with faster GDP growth and falling oil prices often coincide with weak US expansion.

Fading commodity price upturn

Last − but not least − a peak in the commodity price upturn is part of our forecast for the second half of 2011, since supply- side disruptions are likely to diminish by then. In the case of oil, for example, production in Libya should increase again, and that naughty weather girl La Niña will turn nice again, ac- cording to long-term meteorological forecasts: the weather will be far more favourable for production of agricultural com- modities.

LittLe WeatHer girL WitH big priCing pOWer 1100 6000 1000 5500 900 5000 800 4500
LittLe WeatHer girL WitH big priCing pOWer
1100
6000
1000
5500
900
5000
800
4500
700
4000
600
3500
500
3000
400
2500
300
2000
200
1500
100
1000
0
500
2006
2007
2008
2009
2010
2011
Soya beans
Wheat
Index, Agricultural products
Maize (corn)
Sugar
Source: Reuters EcoWin
Index

The price increases for agricultural products last autumn and winter were mainly due to the La Niña weather phenomenon, which caused flooding, droughts and more. Today forecasts point towards more normal weather and thus lower prices for various agricultural products.

Conclusion: More expensive commodities have slowed but not interrupted the upswing

So far, the increase in commodity prices has slowed but not in- terrupted the prevailing cyclical upswing in the DM countries, since their sensitivity to dearer oil in particular has gradually diminished since the 1970s. There is also potential for cheaper oil and − not least − agricultural products later this year. A de-

cline in food prices will especially benefit EM households.

management of bubbles has paved way for new ones
75

Among the factors behind the sub-prime mortgage crisis that

exploded in 2007-2008 − with dramatic financial and eco-

nomic consequences − was the Federal Reserve’s loose mon-

0 etary policy after the IT/telecom bubble burst early in the new millennium. The way that the consequences of a burst bubble are managed can thus pave the way for the next bubble.

Since 2008, DM monetary policies have been exceptionally accommodative. Not until this spring has one of the major central banks in these countries, the ECB, taken the first step towards a normalisation of its monetary policy. So is there rea- son to fear that new speculative bubbles are now inflating?

Investment OutlOOk - June 2011

Per cent

One obvious candidate since last autumn has been the com- modities market, but early in May 2011 there was a noticeable downward correction in many commodity prices. We also be- lieve that the upturns in commodity prices have culminated.

Dm sovereign bonds − a possible bubble candidate

Judging among other things from valuations, the stock market is not generally characterised by any bubble tendencies at the moment, but there is reason for some concern in the case of DM sovereign bonds. The yields on these bonds have trended downward since the early 1980s, with the accompanying in- creases in the market prices of these fixed income securities. Today it is difficult to foresee prospects of even lower yields/ higher market prices as monetary policies in the DM sphere gradually normalise. In some cases, gigantic budget deficits must be financed. But at present it seems a long way between our base scenario of gradually rising sovereign bond yields to a bubble-bursting process − dramatic increases in such yields.

In the real estate market, many bubbles have already burst in recent years, not only in the US but also in such countries as Spain and Ireland. The risk that the Chinese real estate market may currently be in a bubble has been hotly debated in recent years.

Theme: Identifying risks

Those who are worried point, for example, to excessive resi- dential construction in China, the fact that numerous house- holds in need of a larger home cannot afford one due to price increases, that many people have regarded homes as invest- ments and that interest rates are now rising while lending is being tightened. Those who are not worried instead empha- sise that decision makers at all levels want to avoid a decline in construction and home prices, that residential construction

is not excessive at all, since there are whole cities with dilapi- dated housing stock, and that housing demand will increase in the long term due to continued urbanisation in China.

The question of whether the Chinese real estate market is in

a bubble or not is thus very complex, and a genuinely solid

answer would require an in-depth analysis. So the final word is that “the jury is still out.”

Conclusion: there is no obvious bubble in sight, but there are some candidates

The economic policy response to a speculative bubble may prepare the way for the next one. But despite exceptionally ac- commodative monetary policies in the DM sphere in the past few years, no obvious bubble tendencies are currently in sight. DM sovereign bonds and the Chinese real estate market are possible candidates.

1 7

.5

1 5

.0

1 2

.5

1 0

.0

7

.5

5

.0

2

.5

0

.0

1 9 0 5

1 9 2 0

1 9 3 5

1 9 5 0

1 9 6 5

1 9 8 0

1 9 9 5

1 trenD sHiFt LikeLy FOr gOvernment bOnD yieLDs

7

.5

1

5 .0

Since the 1920s, government bond yield cycles in the
1

US (10-year Treasuries in the chart) have encompas-

2

.5

1

0

7

5

2

0

.0

.5

.0

.5

.0

sed periods of about 30 years. First there was a falling trend until the late 1940s, then a rising trend until the

early 1980s, followed by a period of gradually falling yields. If history repeats itself, the trend during the

coming decades will be upward. Looking ahead at least a few years, there are also various arguments for

rising government bond yields, which would adversely

affect bond prices. But it is unlikely that this market will now see a bursting bubble.

Source: Reuters EcoWin

Investment OutlOOk - June 2011

it is unlikely that this market will now see a bursting bubble. Source: Reuters EcoWin Investment

15

theme: navigating through risky waters
theme:
navigating through
risky waters

Capital investments in a calmer cyclical phase

From strong growth to calmer expansion

Greater stability will eventually mean greater risk appetite

Focus shifting to less cyclically dependent sectors

The economy is on its way into a part of the cycle where glo- bal leading indicators, especially in Japan, have peaked. In recent months they have shown somewhat lower values than previously. At the overall level, this means adjusting our fore- cast for the world economic growth rate slightly downward. Nevertheless, we see no reason to abandon our fundamentally positive view of the economy, which today includes expecta- tions that annual global growth will be around 4.5 per cent in 2011 and 2012. Fundamentally, this provides good conditions for risk-bearing assets such as equities.

Assuming that the economy is still in a growth phase, which is the case, the questions asked in macro-oriented analyses of the outlook should be: How long does the economic upturn appear capable of continuing without disruptions? What might interrupt the upturn “prematurely”? Are there signs of speculative bubbles in financial asset markets or in real es- tate? (See Theme: Identifying risks)

History provides excellent guidance

History gives us excellent guidance regarding the length of a “normal” cyclical upturn, what may interrupt such an upturn prematurely, and how frequently speculative market bubbles have occurred.

Between the late 1950s and the end of 2007, the United States had eight periods characterised by cyclical upturns, with an average length of 20 quarters. This entirely matches the aver- age length of equity bull markets during the same time span.

Cyclical upturns have nevertheless shown a wide range of durations; the shortest ran for only three quarters, the longest for 35 quarters. The average US recession since the mid-1950s has lasted just over ten months.

16

Investment OutlOOk - June 2011

price shocks and speculative bubbles more common

The upturns in the late 1950s and the 1960s were interrupted due to traditional cyclical reasons, while the upturns during the 1970s were interrupted prematurely when the economy was subjected to oil price shocks. The first upturn of the 1980s was interrupted after only three quarters when the Federal Reserve sharply tightened its monetary policy via interest rate hikes and money supply management in order to combat very high inflation.

The three subsequent cyclical upturns that occurred in the 1990s and 2000s all ended in ways that included elements of burst speculative bubbles.

The current cyclical upturn began in the US and many other industrialised countries (OECD = Developed Markets, DM) early in the second half of 2009 and has thus been under way for nearly two years. If the prevailing cyclical upswing is “left in peace” and is not subjected to any kind of shock, it should be able to continue for another two to three years. This, in turn, would fuel equities and other risk assets. But since we are in a phase with various possible sources of risk that may influence this favourable tendency, it is important to try to evaluate the various risks we have around us, and how they could poten- tially have an adverse effect on the positive trend.

We must weigh in certain risks − for example, that economic growth may be weaker than expected, or that one of the risk factors develops in a way that is unlikely today, yet might hap- pen − and make an assessment of how to invest capital in order to reduce the influence of these risks.

Our first observation is that we are moderating our view of what will drive capital markets in the near future. We are mov- ing from a period of accelerating growth to a calmer expansion phase. In itself, this will lead to different market behaviour. This type of calmer phase is a natural part of an economic cy- cle and is always accompanied by a certain slowdown in indi- cators, creating a sense of concern among investors. It is thus important to place this argument in its context and recall that underlying growth is the natural state of the economic cycle.

Growth,

Index

Theme: Navigating through risky waters

Genuine interruptions in the cyclical upturn are virtually al- ways driven by various kinds of tightening measures − which at present we are currently far from, in a total global perspec- tive.

Our overall assessment is that inflation risks are manageable and that we can return to a period driven by carefully nurtured growth and moderately accommodative monetary policies.

How do we generate returns in a phase like the current one?

We have identified some key trends that we believe will be of great importance in the near future:

• Fundamentally, public authorities are still making significant

efforts to nurture stable growth, since it will be necessary to increase employment in order to repair government finances around the world.

• The recovery from the financial crisis is continuing slowly

but surely, banks are recapitalising via profits and government financial risks are currently more or less under control.

• Commodity prices have cooled down a bit − a reflection of

a calmer economic trend − and the US dollar is showing some tendencies towards appreciating against other major curren- cies.

• Markets are moving from a cyclical focus to a more mixed

view of what assets one should own, a pattern that has been clear in stock markets during the past few months.

• Risk appetite is stabilising, and volatility is coming down

to sustainably low levels − an indication that capital markets have an increasingly homogeneous view of the future.

• Government bond yields are normalising more and more, and credit spreads are narrowing further.

What qualities characterise the investments we are focusing on? These qualities are low cyclical dependence, low volatility and increased risk appetite, high value added, increased finan- cial stability and high growth at reasonable valuations.

Low cyclical dependence

During the beginning of a cyclical upturn, there are rising valuations in those stock market sectors that first experience increased demand; this category includes commodity compa- nies. In later phases of the cycle, the focus moves to other sec- tors that are less cyclically dependent. Pharmaceutical compa- nies are an example of a sector with low cyclical dependence, often classified as late-cyclical. One interesting idea is to look at which sectors can show good earnings forecasts during 2011 and 2012. Also important is lower dependence on com- modity prices.

Low volatility and increased risk appetite

In the more mature phase of the economic cycle, capital mar- ket performance is often more uniform. We get lower volatility, and risk appetite thus often increases. We do not have the same wide market fluctuations.

Hedge fund management often thrives during phases of relatively stable growth. In addition, hedge fund managers are often skilful technicians who can take efficient advantage of small price differences. This works best when there is a certain degree of predictability in markets.

earnings FOreCasts by seCtOr

50.0% 40.0% 30.0% * electricity, gas and water Source: Factset 20.0% 10.0% 0.0% earnings/share Energy
50.0%
40.0%
30.0%
* electricity, gas and water
Source: Factset
20.0%
10.0%
0.0%
earnings/share
Energy
M aterials
Utilities*
Financials
Health care
Industrials
Information
technology
Telecom
services
Consumer
discretionary
Consumer
staples
T o tal
HeDge FUnDs tHrive in a stabLe envirOnment 2.5 110 0.0 100 -2.5 90 80 2011
HeDge FUnDs tHrive in a stabLe envirOnment
2.5
110
0.0
100
-2.5
90
80
2011 -5.0
70
2012 -7.5
-10.0
60
-12.5
50
-15.0
40
-17.5
30
-20.0
20
-22.5
10
-25.0
0
May Aug
Nov
Feb May Aug Nov
Feb
May Aug Nov
Feb May
2008 2009
2010 2011
World, HFR, Global Hedge Fund Index [increase %]
US, VIX-index
Source: Reuters EcoWin
Per cent

Forecasts indicate somewhat lower profit expectations in sectors with low cyclical dependence − such as health care, telecom services, con- sumer staples and utilities. The consumer discretionary sector may be regarded as late-cyclical in nature and will show uniform, high growth during 2011 and 2012.

There is a strong negative correlation between hedge fund perform- ance and stock market volatility. Hedge fund managers generally ben- efit from phases of relatively stable stock market performance.

Investment OutlOOk - June 2011

managers generally ben- efit from phases of relatively stable stock market performance. Investment OutlOOk - June

17

Growth, earnings/share

Growth, earnings/share 18 Theme: Navigating through risky waters The gradual increase in risk appetite also drives

18

Theme: Navigating through risky waters

The gradual increase in risk appetite also drives investors to accept investments with lower liquidity, and they look for as- sets that complement traditional markets. This means that private equity and more tailor-made investments come into focus.

We can also add currency strategies to this category. Today we have had major shifts in foreign exchange market trends and large interest rate spreads. These strategies are also relatively independent of economic cycles and can provide returns even if stock markets fall. They are attractive from a portfolio standpoint.

High value added

Because the markets will, to a great extent, be looking for as- sets that are not strictly dependent on the economic cycle, value added will be increasingly attractive. Here, too, private equity will attract attention since its business model makes it possible to optimise companies in a powerful way, operation-

ally but also financially. In stock markets, we have a number of sectors with high value added, including traditional industries.

increased financial stability

As the financial system becomes stronger, the financing of various businesses will be a factor that drives values. Today banks are showing relatively weak performance, but they may benefit if the healing process continues in the future. This will provide a helping hand to consumption and investments. Sectors that are dependent on financing will also benefit.

High growth at reasonable valuations

At present, the growth rate is different for different assets. It is higher in parts of the manufacturing sector and in emerging market countries. In a more stable phase, we will see a clearer differentiation between asset classes, and the importance of choosing properly will increase. The challenge lies in finding assets that have high, uniform returns but are not overpriced. This applies to sectors in the stock market as well as countries.

25.0%

20.0%

15.0%

10.0%

5.0%

0.0% 5.0 World
0.0%
5.0
World
7.0 9.0 Emerging markets
7.0
9.0
Emerging markets

Investment OutlOOk - June 2011

7.0 9.0 Emerging markets Investment OutlOOk - June 2011 Source: Factset 11.0 13.0 15.0 17.0 P/E

Source: Factset

11.0

13.0

15.0

17.0

P/E

US

2011 Source: Factset 11.0 13.0 15.0 17.0 P/E US Europe Japan Brazil India China grOWtH vs.

Europe

Factset 11.0 13.0 15.0 17.0 P/E US Europe Japan Brazil India China grOWtH vs. vaLUatiOn In

Japan

Factset 11.0 13.0 15.0 17.0 P/E US Europe Japan Brazil India China grOWtH vs. vaLUatiOn In

Brazil

11.0 13.0 15.0 17.0 P/E US Europe Japan Brazil India China grOWtH vs. vaLUatiOn In a

India

13.0 15.0 17.0 P/E US Europe Japan Brazil India China grOWtH vs. vaLUatiOn In a more

China

grOWtH vs. vaLUatiOn

In a more stable phase of the economic cycle, the valuation gap both between countries and between sectors will shrink. It will thus pay better to hold assets with high growth that, relatively speaking, are not overpriced.

theme: tools for stock market choices
theme:
tools for
stock market choices

New factors and new favourites

Large discrepancy in returns – important to choose properly

China and the US score the best in our modified model

Falling food prices will benefit EM stock markets

The market is a moving target. Factors that were of impor- tance one quarter ago may be completely out of date today, while new driving forces continuously move onstage. Markets are often driven by only one or a few factors at a time. As an investor, it is vital to try to identify what these are, how much impact they will have and how long they will last.

Where we are in the market cycle is of central importance in being able to predict how global risk willingness will change. Since share prices, commodity prices, returns on loans etc. bottomed out in the spring of 2009, we have experienced a bull market characterised by high risk appetite and rising asset prices.

Roughly speaking, a bull market can be divided into three different phases. In the first phase, asset prices surge on a broad front. This occurs because the market can write off the doomsday scenario often included in prices after a bubble bursts (the IT/dotcom crash, the financial crisis etc.). In the second phase, risk willingness is clearly more variable, and the discrepancy in returns between different asset classes and regions increases. By then the recovery has entered a more mature phase and company profits have stabilised. In the third and final phase, investors begin to disregard risks, after having experienced years of upward-trending asset prices and strong economic growth. This phase is often characterised by euphoric market players and exponentially rising asset prices. Our assessment is that at present, the market is in phase two, but that it will take some time before market players lose their risk perspective and believe that trees grow to heaven (phase three).

In an investment climate where risk willingness fluctuates and the differences in returns between assets may be large, it is especially important to identify tomorrow’s winners and los- ers. For this purpose, in the last issue of Investment Outlook (dated February 2011) we launched a quantitative stock mar- ket model for country allocation. We are now building further on this effort.

1600 1600 1500 1500 1400 1400 1300 1300 Phase 2 Phase 1 Phase 3 1200
1600
1600
1500
1500
1400
1400
1300
1300
Phase 2
Phase 1
Phase 3
1200
1200
1100
1100
1000
1000
900
900
800
800
2003
2004
2005
2006
2007
Source: Reuters EcoWin
US, S&P500, USD
S&P 500 index
S&P 500 index

bULL market DUring part OF tHe 2000s

A bull market can generally be divided into three

phases. Our assessment is that at present, the market

is in phase 2, where investors increasingly distinguish

between asset classes and stock exchanges, based on

their respective potential.

Investment OutlOOk - June 2011

19

Theme: Tools for stock market choices Using a quantitative model has a number of advantages.

Theme: Tools for stock market choices

Using a quantitative model has a number of advantages. It is a good tool for structuring the market and identifying the driving forces of the future. In addition, it is easy to fol- low the analytical process, both for those who work with the model and for those who view the results. One disadvantage, however, is that the model assigns figures to subjective as- sessments about what factors will drive developments and how these should be scored for different countries. A model is never better than the numbers that are put into it, and it will probably not capture all forces and scenarios. The model is consequently not an absolute truth, but is intended to de- scribe how we view the market and what we believe will drive it in the coming months.

The model is based on our selection of factors that we believe will affect the market in the future from a country standpoint. We have changed some factors compared to the previous model. The factors we are now focusing on are growth, infla- tion/monetary policy, valuations and currency. We score each factor based on its positive or negative contribution to the stock market in each respective country. The scale runs from -3 to +3. The model also enables us to weight these various factors on the basis of how large an impact we believe they will have, given the market climate we foresee. This time, how- ever, we have chosen not to use such weighting, since there are fewer factors than before and we find it difficult to rank their impact.

One important difference compared to the previous version of the model is that to a greater extent, we are now focusing on our view compared to the market consensus. One advantage of this new approach is that factors not yet priced in by the market are usually what will drive the market. One disad- vantage is that it is difficult to know exactly what the market consensus is.

GDP growth has historically had a fairly low co-variation with share price movements. One explanation for this weak con- nection is that most of the components that make up GDP growth are public information before the actual GDP figure

is published. The market thus has a rather clear perception

of what has happened by the time the figure is published, more than a month after the end of each quarter. During this period, quite a lot of new macroeconomic statistics have also had time to appear, reflecting a more current reading of the economic pulse. This is why there is rarely any excitement or major surprise when GDP growth is announced.

Changes in gDp forecasts, however, have historically had

a very large impact on share prices. A Goldman Sachs study,

for example, shows that a 1 percentage point change in ex- pected GDP growth looking ahead one year has resulted in a 10 per cent change in share prices (all else being equal). The countries in the model thus receive points especially when our growth expectations diverge from consensus forecasts.

inflation/monetary policy is a factor that can be approached from various angles. In our previous model, we weighed in only monetary policy, with an expansionary monetary policy being preferable for investors. At that time the world was divided in two, with policy tightening in the EM sphere and ultra-loose monetary policy in the OECD. The spread in interest rates remains wide, but interest rate hikes in the OECD countries are now beginning to be priced into the market, while most

EM countries will have ended their rate hiking cycles this year. Inflation is closely connected to monetary policy, and there

is a clear difference in inflation pressure between different

groups of countries. In this phase of the economic cycle, we

predict that changes in inflation expectations are likely to have

a major impact on asset prices.

OUr assessment mODeL FOr COUntries/grOUps OF COUntries

COuNTRy/

Growth

Inflation/

Valuations

Currency

Total

GROuP

monetary policy

em

2

2

1

2

7

Dm

1

1

0

0

2

China

2

2

1

1

6

United states

2

2

0

1

5

germany

2

1

0

1

4

eastern europe

1

0

0

2

3

russia

1

-1

1

2

3

nordic countries

1

0

1

1

3

sweden

1

-1

1

1

2

brazil

-1

0

1

0

0

pigs countries

-1

-1

0

0

-2

Japan

-1

0

2

-3

-2

20

Investment OutlOOk - June 2011

Theme: Tools for stock market choices

stock market valuations are generally in line with their 10- year average. Meanwhile share prices are only about 10-15 per cent below their peaks before the outbreak of the financial cri- sis. Compared to share prices, valuations are thus significantly lower in today’s bull market than before the financial crisis. In terms of valuations, most groups of countries are trading at about the historical average, but some markets may be re- garded as somewhat better bargains. These are Japan (due to post-disaster effects), the Nordic countries, Russia and China.

Currency movements are a factor with several dimensions from an investor standpoint. First, a weaker currency may be positive for the stock market, since it strengthens the com- petitiveness of a country’s export sector. In the past year, for example, there has been a very strong association between a weaker US dollar and rising prices on American stock ex- changes. Second, currency movements may have a direct impact on returns for an investor who buys foreign equities. For a Swedish investor, for instance, it has been difficult to generate a positive return on a global equity portfolio due to the strong performance of the Swedish krona during the past year (i.e. falling exchange rates for other currencies). Since in many cases today’s listed companies are so globalised that it is difficult to know where their production costs and sales are located, we are assigning the largest weight to the direct effect of currency movements on returns in the model.

advantage em

Dividing up stock markets into emerging market (EM) and de- veloped market (DM) countries is a very crude approach, since there are wide variations in conditions within each of these groups of countries. But although we prefer to view stock mar- kets from a country perspective, at present there are certain factors that justify comparing EM to DM countries.

EM countries receive more points for all factors in the model than DM countries, and the reason is as follows: Stock markets

in the EM sphere have been held back due to the tightening of key interest rates, which have been needed in order to ease high inflation pressure, mainly driven by sharply rising food prices (a large share of disposable income among EM consum- ers). The interest rate hiking cycle has not yet ended, but its effect is already priced into the stock market. Our assessment is that later this year, food prices will fall faster and further than current consensus expectations. Such a scenario would increase purchasing power and reduce the need for monetary policy tightening in the EM sphere.

Although the EM sphere is not likely to surpass today’s high GDP growth expectations, we believe that there will be a renewed focus on the growth gap between the DM and EM countries. Investors are likely to be attracted by the high growth that EM countries will offer, resulting in capital inflows and rising share prices. Another effect is that EM currencies will be in demand, and a large interest rate gap between EM and DM countries will further enhance this attraction. Most EM countries should have a positive attitude towards seeing their currencies appreciate, since this will reduce inflation pressure.

Finally, valuations on most EM stock exchanges look attractive. Traditionally, EM shares are traded with a discount to the world index. Given the currently prevailing two-speed economic situation in the world − with the EM sphere performing better than the DM sphere − this discount is not equally justified.

Within the EM sphere, the outlook is varied. We foresee the best potential for Asia, followed by Eastern Europe and finally Latin America. Compared to Asia, Latin America does not offer the same growth figures, inflation is less manageable and cur- rencies are not expected to appreciate to the same extent. In addition, a relatively powerful correction in commodity prices is under way, putting countries that are commodity consumers (Asia) in a better position than commodity producers (Latin America).

4

.0

%

3

.5

%

3

.0

%

2

.5

%

2

.0

%

1

.5

%

1

.0

%

0

.5

%

0

.0

%

US

SEB’s GDP forec.% 1 .0 % 0 .5 % 0 .0 % US Consensus Source: SEB, Consensus Forecasts

Consensus% 0 .5 % 0 .0 % US SEB’s GDP forec. Source: SEB, Consensus Forecasts Germany

Source: SEB, Consensus Forecasts

GDP forec. Consensus Source: SEB, Consensus Forecasts Germany strOnger grOWtH tHan COnsensUs The US and Germany
GDP forec. Consensus Source: SEB, Consensus Forecasts Germany strOnger grOWtH tHan COnsensUs The US and Germany
GDP forec. Consensus Source: SEB, Consensus Forecasts Germany strOnger grOWtH tHan COnsensUs The US and Germany
GDP forec. Consensus Source: SEB, Consensus Forecasts Germany strOnger grOWtH tHan COnsensUs The US and Germany

Germany

strOnger grOWtH tHan COnsensUs

The US and Germany score well in our model because we believe that their growth will be well above the 2012 consensus estimate. The EM sphere and China also earn high scores for the growth factor, since the growth gap between EM and DM countries is again likely to attract intensive market attention.

Investment OutlOOk - June 2011

gap between EM and DM countries is again likely to attract intensive market attention. Investment OutlOOk

21

Theme: Tools for stock market choices China – best in test From a country standpoint,

Theme: Tools for stock market choices

China – best in test

From a country standpoint, China, Germany and the United States look the most attractive, for varying reasons. China is the country that best coincides with the arguments we have presented for our positive view of EM countries in general. In the case of Germany, high growth than expected by the mar- ket is the main factor that pushes up the country’s score in the model. Germany’s recovery is progressing at a rapid pace, and it will probably remain the economic engine of the euro zone for a long time to come. Since there is one monetary policy for the entire single currency union, our assessment is that it is unjustifiably accommodative for Germany, since the European Central Bank (ECB) also takes into account the heavily in- debted PIGS countries (Portugal, Ireland, Greece and Spain). The value of the euro is also affected by the weaker links in the euro chain, and German exporters are thus able to benefit from a comparatively weak currency. The export sector is by far the most important engine of German industry.

We also predict that American economic growth will surpass expectations. The combination of a weak dollar, dynamic companies and high productivity has created a profitable manufacturing sector. For the first time in nearly four decades, the manufacturing sector has increased its share of American GDP. Markets are also concerned that risk assets, especially the US stock market, will be adversely affected when the Federal Reserve stops buying government bonds early in June (see the chart below). These bond purchases have pushed down interest rates to artificially low levels, stimulating eco-

3 .0 3 .0 2 .5 2 .5 2 .0 2 .0 1 .5 1
3
.0
3
.0
2
.5
2
.5
2
.0
2
.0
1
.5
1
.5
1
.0
1
.0
0
.5
0
.5
0
.0
0
.0
2 0 0 2
2 0 0 4
2 0 0 5
2 0 0 6
2 0 0 7
2 0 0 8
2 0 0 9
2 0 1 0 2 0 1 1
Source: Reuters EcoWin
22
Investment OutlOOk - June 2011
USD trillions
USD trillions

nomic growth and the stock market. In our assessment, such market worries are exaggerated and when these effects turn out to be negligible, this is likely to be reflected in share prices.

avoid Japan

The lowest scores in the model go to Japan and the PIGS countries. The Japanese economy and stock market have been disappointing for a number of years. It is true that reconstruc- tion work following the earthquake will contribute positively to GDP growth. But on the other hand, growth rates will remain low and the natural disaster may help make an already deli- cate recovery even more fragile. In addition, Japan’s zero inter- est rate policy and overvalued currency are indications that the yen may fall sharply in value, making a negative contribu- tion to total return for a foreign investor.

The outlook for the PIGS countries is anything but bright. The situation is the most acute in Greece, where sovereign debt is approaching 160 per cent of GDP, while economic growth is falling sharply and unemployment is skyrocketing. There has recently been talk of writing down Greek debts to private lend- ers, something that SEB believes will happen during 2012. The risk of contagious effects on the other PIGS countries is not negligible. On the other hand, the debt situation is no secret, so that if the situation improves there is potential for sizeable stock market gains. At present, however, we find it difficult to foresee any solution to these problems, and the PIGS coun- tries thus receive a low score in our model.

enD OF Qe2 sHOULD Have LittLe impaCt

This summer the US Federal Reserve is ending its purchases of government bonds (quantitative easing). These purchases,

under way since autumn 2008, have greatly enlarged the Fed’s balance sheet. The Fed’s ambition has been to increase

the money supply and lending, but since the money has remained within the banking system there is likely to be little impact when the second round of the programme (QE2) soon

ends. Interest rates have perhaps been somewhat lower due to the Fed’s government bond purchases, but overall interest

rate movements will probably be small when QE2 ceases. Once the market can leave this source of worries behind,

it should have a positive effect on the US stock market in particular.

macro summary
macro summary

World economy will continue its upturn

Despite new challenges, this year world economic growth will be well above its historical trend

and

next year the pace may increase, thanks

to accelerating OECD growth

Inflation is now a major source of concern, but price increases will ease significantly in 2012

In recent months, the global economy has faced a number of challenges: social unrest and violence in the Middle East and North Africa, a civil war in Libya, a natural disaster in Japan and a new wave of European sovereign debt crisis. As a result, the international economic pulse has not been as strong dur- ing the spring. This has created greater uncertainty about the sustainability of the recovery.

In our assessment, however, the world economy will overcome these new challenges. Emerging market (EM) economies will continue their rapid growth. The US upturn will become more self-sustaining and will soon pick up more speed after a pale first quarter. Post-disaster reconstruction work will stimulate the Japanese economy. Global GDP growth will thus accelerate in 2012, despite some tightening of economic policies.

Rapidly rising commodity prices have pushed up world infla- tion, leading to concerns about persistent high inflation. A cool-down in commodity prices, together with low underlying cost pressures in the OECD industrialised countries, will nev- ertheless lead to a substantial slowdown in consumer price increases next year.

Us economy poised for acceleration

By all indications, the first-quarter slump in the US economy was temporary, with severe winter weather and surging food and petrol prices hampering growth. Among indications of a rebound are prospects of a return to lower inflation, a gradual labour market improvement − which will benefit private con- sumption − and robust optimism among businesses, which are enjoying high earnings and strong balance sheets. The lat-

ter plus large capital spending needs will also be an economic driving force. We predict that GDP will increase by just below 3 per cent this year and nearly 4 per cent in 2012.

accentuated dualism in the euro zone

The euro zone economies are showing increasing dualism. German growth remains high, and optimism is at record levels according to the IFO business sentiment index. Germany’s GDP will climb about 3.5 per cent this year and more than 2.5 per cent in 2012. France and Italy are growing more slowly, roughly on a par with their historical trend (1.5-2 per cent). One reason is sluggish growth in domestic demand, while fast-growing exports are instrumental in Germany’s expansion. Spain was on the brink of a new recession late in 2010 but has since stabilised. Due to dramatic fiscal austerity in Greece, Ireland and Portugal, these countries will see a decline in GDP this year as well. We foresee overall euro zone growth of about 2 per cent both this year and next.

Obstacles to british economic growth

The British economy will be held back this year by fiscal tight- ening and high inflation, which will undermine household purchasing power. Offsetting this are the weak British pound and strong international demand, which will create good con- ditions for exporters. Together with prospects of rather strong capital spending, this will help prop up economic growth. We predict GDP increases of 1.5 per cent in 2011 and 2.5 per cent in 2012.

nordic countries reaping economic success

The Nordic countries will continue to reap macroeconomic success. These countries are characterised by strong eco- nomic fundamentals in the form of budget balances, public sector debt and current account balances. Meanwhile export- ers are well positioned to respond to growing global demand. Currency appreciation in Sweden and Norway − due among other things to strong fundamentals and early key interest rate hikes − will not slow the expansion to any great extent. We predict overall Nordic GDP increases of nearly 3.5 per cent this year and more than 2.5 per cent in 2012.

Investment OutlOOk - June 2011

23

Macro summary natural disaster will speed Japanese growth The natural disaster and its consequences are

Macro summary

natural disaster will speed Japanese growth

The natural disaster and its consequences are making all forecasts of Japanese economic trends unusually uncertain. In the short term, activity appears to have fallen more than expected. This time around, the impact will clearly be more se- vere than after the Kobe earthquake of 1995. The devastation is larger. In all, about 1 per cent of the country’s capital stock − worth 3-4 per cent of GDP − seems to have been destroyed. But developments will likely follow the pattern of earlier natu- ral disasters. Starting in the third quarter, the stimulus effects of reconstruction efforts will gradually take the upper hand. In 2011 as a whole, we foresee GDP growth of only 0.5 per cent. In 2012 growth will accelerate to about 2.5 per cent.

tightening will mean soft landing in em asia

Asian emerging markets are still leading the economic cycle and driving global growth, but overheating risks have become increasingly apparent in the past six months. Together with ris- ing commodity prices, this has justified significant economic policy tightening, with a focus on monetary policy. This will help ease price pressures and prepare the way for an econom- ic soft landing. We thus expect emerging Asian economies to continue expanding at a comparatively rapid pace (7.5-8 per cent) in 2011 and 2012.

We predict that China’s GDP will grow by nearly 9.5 per cent this year and 8.5 per cent in 2012. A combination of somewhat slower export expansion and a slightly less dynamic domestic market will help slow GDP growth compared to nearly 10.5 per cent in 2010, but growth will exceed the 7 per cent target stated in the new five-year plan. Inflation has largely been driven by food prices and will slow gradually from this sum- mer. In India, we forecast a slowdown in GDP growth to 7 per cent in 2012 after this year’s 8 per cent (8.5 per cent in 2010), but exports and industrial production will continue to perform strongly after last winter’s slump.

tightening will slow Latin american growth

The Latin American economies − which grew by 6.5 per cent last year − will decelerate to 4.5-5 per cent in 2011. Inflation was around 6.5 per cent in 2010 and rose further early this year, leading to widespread monetary policy tightening. For example, the Brazilian central bank’s benchmark SELIC rate has been raised several times in the past year. More hikes can be expected. Due to tighter economic policies, growth in Brazil and the region as a whole will slow to just over 4 per cent next year, but Latin America can still show far better figures than the OECD for both public sector finances and current account balances.

accelerating economies in eastern europe

The Eastern European economies will speed up in 2011- 2012, even though global growth will slow a bit and many countries − including Poland − will tighten their fiscal poli-

24

Investment OutlOOk - June 2011

cies. Competitive exports will remain a strong driving force. Meanwhile consumption and capital spending are awakening from their crisis-period hibernation. In the short term, rapid commodity-driven inflation has undermined purchasing power, but we predict that energy and agricultural commodity prices will fall in the second half of 2011. During the past year, better growth and improved control of public finances have strengthened the market’s confidence in Eastern Europe.

The gradual upturn in the Baltic countries is continuing, mainly thanks to strong export growth, but domestic demand is only slowly recuperating from the crisis. In 2011-2012 annual growth may reach 4-5 per cent, led by Estonia. There is little risk of a severe upturn in inflation. Baltic economic imbalances have greatly diminished, but major structural problems in the labour market plus budget deficits in Latvia and Lithuania pose continued challenges.

World economic growth above historical trend

We expect GDP in the emerging market sphere − which ac- counts for nearly 50 per cent of the world economy (adjusted for purchasing power parities) − to grow by 6.5 per cent in 2011 and a bit more slowly in 2012. Meanwhile we predict growth in the OECD countries of about 2.5 per cent this year and just above 3 per cent next year. Global economic growth may thus average nearly 4.5 per cent in 2011-2012, a pace well above its historical trend − despite all the new challenges.

sLigHtLy sLOWer grOWtH in CHina anD inDia

14 14 13 13 12 12 11 11 10 10 9 9 8 8 7
14
14
13
13
12
12
11
11
10
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
0
2005
2006
2007
2008
2009
2010
China, GDP change
India, GDP change
Source: Reuters EcoWin
Per cent, year-on-year

In both China and India, the slump during the 2008-2009 global recession was noticeably shallow, after which GDP growth accel- erated rapidly. Due to higher inflation in the wake of the upturn, monetary and other economic policies were tightened in both countries. This led to some cooling off last winter. Further decel- eration is likely in the coming year and we foresee soft landings.

equities

equities

Attractive valuations sustain stock markets

Numerous risk factors are already priced into markets

Stock exchange indices approaching pre-crisis levels − but with lower relative valuations

After a bad patch in March, volatility is back at more normal levels

Since we published the last Investment Outlook (February 2011), global equity markets have been affected by unusual, unexpected events as well as risks. Some of these risks will persist for years to come (for example the European/US debt situation), while others will weaken over time. But since today’s valuations are at or near their 10-year averages, there is room for a further bull market despite short-term turbulence.

markets taken by surprise

Markets were not prepared for the sudden unrest that hit Tunisia and Egypt early in 2011. Demonstrations then spread to other countries in North Africa and the Middle East. In light of these events, markets witnessed sharply rising oil prices. Equity markets became noticeably more nervous as a direct consequence of escalating unrest. The volatility of the S&P 500 index, measured by the VIX index, rose from 15 per cent to above 20 per cent.

Equity markets were thus already vulnerable when the earth- quake and the subsequent tsunami hit Japan on March 11 this year. Fears of an imminent nuclear power plant disaster drove equity markets to 2011 lows. The MSCI World Index fell more than 6 per cent during four trading days, and the VIX index rapidly surged by 10 percentage points to 30 per cent.

The Japanese stock market was naturally the most strongly affected, plunging by 18 per cent during the same period. Japan represents 9 per cent of the world economy but imports account for only 10 per cent of its GDP. Japanese imports thus only total 0.9 per cent of global GDP. Equity markets quickly concluded that a short-term reversal in Japanese growth will

have only a limited impact on global economic growth as a whole. Share prices recovered to pre-disaster levels by the end of March.

In April, the focus shifted from the situation in North Africa and Japan to the US and the European debt crisis, and some- what later to first-quarter 2011 company reports. Standard & Poor’s downgraded the US government’s AAA credit outlook to negative as a consequence of continuously growing budget deficits, but equity markets were only marginally affected by this announcement − perhaps because by means of economic growth, the US has greater potential to resolve its debt prob- lems than its European counterparts.

Although the crisis in parts of Europe, especially the so-called PIGS countries (Portugal, Ireland, Greece and Spain), could potentially lead to debt restructuring that would impact the global stock market, we should not underestimate the ability of markets to discount such possible changes over time.

Upward adjustments in earnings expectations

First-quarter corporate reports provided global stock exchang- es with positive surprises. A majority of US, Nordic and other European companies reported results that were above expec- tations. But while positive figures led to upward adjustments in global earnings expectations, the same is not true of certain major sectors and companies in the Nordic markets. Strong Nordic currencies relative to the USD have muted some of the expected impacts of good quarterly reports on future earnings estimates. European profit expectations have fallen marginally during the past three months.

Most equity markets have moved sideways in the past three months. US stock exchanges have led the way with their posi- tive performance, while the biggest laggards have been Japan (understandably), Brazil and India. At this writing, the VIX index is at around 15 per cent, indicating that global equity investors are quite comfortable with their current exposure.

Sector-wise, so far this year banks and other financial sector companies have gone from being the shining star (+15 per cent during first two months of 2011) to levelling out, while

Investment OutlOOk - June 2011

25

26

Equities

the travel and leisure sector has continued to struggle in the light of unrest in North Africa and the Middle East as well as rising fuel costs, a direct consequence of higher oil prices. In recent months, health care − historically a defensive sector − has emerged as the winner on a year-to-date basis, indicating more cautious investor sentiment.

increased global risk appetite

Looking ahead, our fundamental view of the global stock market is that risk appetite will keep increasing and that the bull market will continue. It is true that expectations regard- ing short-term global growth seem to be levelling out, and we might even see some downward revisions due to softer macroeconomic signals. We will also witness gradually less supportive fiscal and monetary conditions (the end of QE2). However, we believe that most of these challenges are well known and some of a temporary nature, while valuations will continue to support equities as an asset class. By way of com- parison, between 2004 and 2006 global equity indices rose despite falling purchasing managers’ indices in the US and flat ones in China. It is the absolute level rather than the short- term trend of these macroeconomic indicators that reveals investor demand for equities.

45

40

35

30

25

20

15

10

5

0

Us

1

1

1

1

1

800

600

400

200

0

800

600

400

200

000

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

3

2

2

1

1

0

5

0

5

0

5

0

Next 12m P/E

eUrOpe

Next 12m P/B

Next 12m RoE

Price

5

4

4

3

3

2

2

1

1

5

0

0 0

5 0

0 0

5 0

0 0

5 0

0 0

5

0

0

0

0

2 0 0 1 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 2 0 1 0 2 0 1 1

Next 12m P/E

Next 12m P/B

Next 12m RoE

Price

vaLUatiOns in DiFFerent stOCk markets

Looking at equities as an asset class, we find valuations to be of vital importance. During the past 12 months, equity markets have risen in response to increased earnings, while pricing multiples have remained flat. In a scenario where inflation is contained and markets are seeing only a moderate rise in long-term bond yields, we would argue that there is ample room for expansion in the world of equities. Our models show that most global equity markets are priced at or around their average for the past 10 years. Looking at both Price/Earnings, Price/Book and expected Return on Equity (ROE) for various markets, we find that although several equity indices are only 10-15 per cent away from their pre-financial crisis levels, their relative valuations are much lower this time around.

potential gains vs. risk

Valuations are always a consequence of the balance between potential for further gains and implicit risks. Over the past 12 months we have seen markets take on 1) the European/US debt crisis, 2) increasing inflation fears, 3) increasing currency volatility, 4) political unrest in North Africa and the Middle East, 5) the disaster in Japan and 6) sharply rising commodity prices. Yet most stock markets are up between 10-20 per cent during this period.

50

45

40

35

30

25

20

15

10

5

0

2006

2007

Next 12m P/E

CHina

3

2

2

000

500

000

1 500

1 000

 

500

0

2008

2009

2010

Next 12m P/B

Next 12m RoE

Price

40

35

30

25

20

15

10

5

0

Japan

20

18

16

14

12

10

8

6

4

2

0

000

000

000

000

000

000

000

000

000

000

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Next 12m P/E

Next 12m P/B

Next 12m RoE

Price

Source: Factset

The various key ratios can be read using the Y-axis on the left, while the Y-axis to the right is related to the underlying equity index. The Price/Book ratio is multiplied by 10 to make it compatible with Price/Earnings (absolute figures) and Return on Equity (figures in per cent).

Investment OutlOOk - June 2011

Since markets have already priced in high doses of risks during the past 12 months, coupled with a healthy first-quarter 2011 reporting season, we believe there is room for a further bull market in global equities.

The US equity market is showing short-term strength, having reached new highs this spring. Stock exchanges in Europe including the Nordics are trading at or around their previous highs from this upturn cycle. Most emerging markets (led by the BRICs) are showing short-term weakness, trading below both short- and long-term averages.

Below we have aggregated our valuation models into a simple matrix. Using the colours in a traditional traffic light, positive factors are indicated by green, neutral by yellow and nega- tive by red. As shown in the matrix, current valuations are in a positive to neutral range. Estimate revisions in the US have trended upwards this spring, while European estimates are marginally down. The Nordics have seen small changes to running earnings estimates, while Japan has of course expe- rienced large downward revisions due to the effects of the March 11 disaster.

Equities

due to the effects of the March 11 disaster. Equities room for upward valuations Over the

room for upward valuations

Over the past 12 months, financial markets have discounted multiple risk factors. We maintain that there is room for major upward valuations from present levels as some of the risks assume a more subdued nature. We continue to believe that the economic expansion will result in continued support for equities as an asset class, mostly based on sound valuations. We thus expect to see further strengthening in stock markets during the coming 3-6 months.

COuNTRy

P/E ABSOLuTE

P/E COmPAREd TO HISTORy

P/B COmPAREd

ROE COmPAREd TO HISTORy

EARNINGS ESTI-

TECHNICAL

/REGION

TO HISTORy

mATE REVISIONS

ANALySIS

Us

           

europe

           

Japan

           

China

           

india

           

brazil

           

russia

           

sweden

           

Denmark

           

norway

           

Investment OutlOOk - June 2011

27

Fixed income

Fixed income

High yield and Em debt remain best choices

Modestly rising OECD key interest rates and sovereign bond yields

Gradually less resolute monetary tightening in the EM sphere

High Yield and EM Debt still the best fixed income investment choices

Global fixed income perspectives remain highly varied, both geographically and with regard to different segments of the fixed income market. Behind this are such factors as divergent monetary policy directions, different macroeconomic condi- tions and events in the corporate world.

Many central banks in the OECD industrialised countries now find themselves in a somewhat tricky decision-making situation. Increased inflation − mainly due to more expensive commodities − is undermining household purchasing power, jeopardising the banks’ chances of meeting their inflation tar- gets and risking higher inflation expectations. At its monetary policy meeting in April, the European Central Bank (ECB)

Divergent mOnetary pOLiCies 8 7 6 5 4 3 2 1 0 2 0 0
Divergent mOnetary pOLiCies
8
7
6
5
4
3
2
1
0
2 0 0 0
2 0 0 2
2 0 0 4
2 0 0 6
2 0 0 8
2 0 1 0
Per cent

UK, bank rate

Euro zone, refi rate

China, one-year lending rate

US, federal funds rate

Sweden, repo rate

Source: Reuters EcoWin

8

7

6

5

4

3

2

1

0

Due to different cyclical phases and outlooks, the policies of ma- jor central banks diverge greatly. In most of the EM sphere and in fast-growing OECD countries, key interest rate hikes began in 2010. The ECB began such hikes in April, while the Bank of England and the Federal Reserve have held back so far.

28

Investment OutlOOk - June 2011

attached the greatest importance to the latter arguments and thus began its rate hiking cycle.

In recent months, the Bank of England (BoE) has been in a decision making situation similar to the ECB, but has not yet raised its key interest rate. More and more members of the BoE’s Monetary Policy Committee are leaning towards a hike, however. The US Federal Reserve (Fed), in contrast, seems to be in no hurry to begin key rate escalation. This applies even more to the Bank of Japan (BoJ), which must also take into ac- count the devastating economic consequences of this spring’s natural disaster.

At the other end of the scale are central banks in rapidly grow- ing OECD economies such as Sweden, Norway and Australia, as well as their colleagues in many parts of the emerging mar- kets (EM) sphere, which began interest rate hikes in 2010 in order to keep inflation in check.

The availability of spare production resources in the form of labour and production facilities remains quite large, especially in the US, but also in Europe. Inflation expectations have remained modest in spite of everything, and the commodity price upturn has culminated. Against this backdrop, there is no

reason for OECD central banks to quickly and ruthlessly use

their interest rate weapons.

In the EM sphere, mainly in Asia excluding Japan and in Latin

America, central banks have been ratcheting up their key rates

for more than a year. Some − such as the People’s Bank of

China (PBOC) − have supplemented higher interest rates with

measures to curb lending by banks. The reasons for the mon-

etary policy direction they have chosen have been overheating

problems in the wake of high economic growth and lack of spare production capacity, plus a commodity-driven accelera- tion in inflation.

Lower general price pressure

These measures now seem to be on their way towards having the intended effect. The growth rate is slowing. As a conse- quence, underlying inflation − excluding food and energy − will probably decline later this year, while falling prices for

agricultural products in particular will ease general price pres- sures. EM central banks could thus gradually begin to slow the pace of their tightening measures during the next six months. Government bond yields in the OECD countries rose clearly last winter and then fell a bit during the spring due to lower risk appetite in the wake of the unrest in North Africa and the Middle East, the Japanese natural disaster and a series of macroeconomic signals that were weaker than expected. Today there are many indications that bond yields will again head upward; central banks are raising their key interest rates (though modestly), many countries must finance very large budget deficits and risk appetite is expected to be healthy. Rising yields will be accompanied by negative effects on bond prices, and OECD government bonds are thus not attractive as fixed income investments.

renewed interest in em investments

Late in 2010 and early in 2011, global investors sold both EM equities and bonds on a large scale, with falling prices as a consequence. The background was mainly profit-taking after sharp price increases, overheating risks and monetary tighten- ing. Since then, investor interest has returned and prices have risen. The prospects for EM Debt also appear bright. Yields are higher than in the US and Europe, for example. Budget deficits and sovereign debt are well below OECD levels. The danger of inflation is fading, and central bank tightening measures will gradually become less resolute.

em Debt best in asset CLass

3 0 0 Equities, mature economies Bonds, US 2 5 0 Bonds, EM, local currencies
3
0 0
Equities, mature economies
Bonds, US
2
5 0
Bonds, EM, local currencies
2 0 0
1 5
0
1 0
0
5
0
2 0 0 3
2 0 0 5
2 0 0 7
2 0 0 9
2 0 1 1
Index 2003 = USD 100

Source: Bloomberg

3 0 0

2 5 0

2 0 0

1

1

5

0

0

0

5 0

Since 2003, EM Debt in local currencies has shown significantly better growth in value than both equities in OECD countries and American government bonds. Given our forecast of a cyclical soft landing, lower inflation and continued good economic funda- mentals in many countries, the outlook for EM Debt appears bright.

The prospects of stronger EM currencies during the coming year − partly because central banks are using currency appre- ciation to lower domestic inflation via cheaper imports − will also make this asset class attractive to many investors domi- ciled in OECD currency areas.

Fixed income

investors domi- ciled in OECD currency areas. Fixed income High yield continues to enjoy advantages Another

High yield continues to enjoy advantages

Another fixed interest investment alternative that remains at- tractive is corporate bonds. This applies especially to the High Yield segment, which in all essential respects has resisted the market instability of this spring and has thus delivered con- sistently good returns since the beginning of 2011. This asset class will continue to benefit from the global economic upturn, increasingly strong corporate finances and prospects of fine risk appetite, together with investors’ search for high yields. American High Yield bonds now offer an average effective return of nearly 7 per cent, compared to about 4.5 per cent for Investment Grade and around 3 per cent for government bonds (5-year).

OECD government bond yields − both short- and long-term − are indeed likely to rise, and the supply of corporate bonds will continue to increase during the coming year. The yield spread between corporate and government bonds remains wide, however. For example, for B-rated US corporate bonds it is about 1.75 percentage points more than in 2005-2006 (before the financial and economic crisis). Meanwhile the percentage of bankruptcies among High Yield debt-issuing companies is continuing to fall. In the US it was around 3 per cent and in Europe around 2 per cent at the end of March (on a 12-month basis). During the first quarter of 2011, only eight High Yield debt issuers went bankrupt at the global level. According to Moody’s crystal ball, such bankruptcies around the world will have fallen to 1.5 per cent of issuers by December 2011.

Higher ratings far more common than downgrading

Given a lower and lower percentage of bankruptcies and an

ever-larger positive ratio between the number of US High Yield companies that have received higher ratings (more than 140

since January 1) and the number that have been downgraded (fewer than 80 since January 1), the risks in this portion of the

fixed income market are falling. The upgrading of companies

is partly due to a large weighting for the liquidity in corporate balance sheets. Concurrently, recoveries are likely to be larger

for investors holding bonds issued by companies that never- theless go bankrupt.

Corporate bonds, first Investment Grade and then High Yield, have formed the base of our fixed income portfolios and our fixed income investment recommendations since early 2009. During this period, these portfolios and investments have pro- vided outstanding risk-adjusted returns. As indicated above, the outlook for the High Yield market also remains bright. As the cyclical upturn matures and yield spreads narrow, however, the expected return on this asset class will shrink. But it will be some time before any other interest-bearing alternative can seriously compete with High Yield.

Investment OutlOOk - June 2011

29

Hedge funds

Hedge funds

divergent world views good for hedge funds

Favourable scenario for hedge funds as an asset class

Increased number of mergers and acquisitions will benefit several strategies

Chances for good returns at reasonable risk

With their different strategies, hedge fund managers have the potential to generate good returns in virtually all market situ- ations, but generally speaking they thrive the very most when market assessments of future world developments diverge. They also benefit from the fact that the world is not so static, for example when key interest rates vary greatly around the world. Spreads in other interest rates and yields, as well as in estimates of which way these variables will move, also provide an excellent breeding ground for many hedge fund strategies. Falling or lower correlations, which we are also seeing at present, contribute positively to the good hedge fund climate.

In an environment where large portions of the emerging mar- ket (EM) sphere are fighting inflationary tendencies by hiking key interest rates, and the developed world is largely retaining low interest rates, hedge funds have good potential to gener- ate returns. When certain developed market (DM) economies have performed so well that they have started their interest rate hiking phase (for example Australia and Sweden, as well as the European Central Bank, which has also begun raising its refi rate), such potential increases further. This should mean that strategies like Fixed Income Relative Value will be able to deliver good returns at reasonable risk. These strategies are relatively liquid, and it is thus possible to gain access to good hedge funds that are traded daily if an investor wants short trading cycles. It is not necessary to move further out on the liquidity curve than monthly trading to invest in good Global Macro or Fixed Income Relative Value funds.

At present, Relative Value managers are quite naturally fo- cusing on the Fed’s expected termination of its quantitative easing programme (QE2). This is expected to occur shortly, and there are divergent views in the markets as to what this

30

Investment OutlOOk - June 2011

will mean to the price of loans, regardless of whether they are corporate loans or government loans. Fixed Income Relative Value and Credit Long/Short can benefit from such divergent views. These strategies can also take advantage of a projected further normalisation of credit markets, meaning that some loans are perceived as having become expensive. Risk pre- miums have decreased, new loans may be of poorer quality again and many observers will shift part of their attention to inflation. There will thus probably be an increase in the differ- ences between loans perceived as safer compared to those perceived as carrying higher risk. This is good news for Credit Long/Short, for example, which can thus make even greater use of both its long book and short book.

One sign of normalisation is that the market is opening up for more corporate mergers and acquisitions. Companies that have weathered the financial crisis better than others and have gained strength from a favourable cyclical trend are more aggressive than they have been for years and are beginning to look around for ways of improving their market position. This may be a matter of merging with another aggressive company, buying up a fledgling company that can contribute some good qualities, or simply buying up a competitor in order to have the market more to themselves. This may also involve pure restructurings or other types of special situations. Overall, this indicates that a Merger Arbitrage or other Event Driven strat- egy should generate good future returns.

mergers and acquisitions increasing

Mergers and acquisitions are likely to continue increasing, which benefits these strategies. It is also relatively easy and cheap to borrow capital for investments in the current market climate, thereby enabling hedge funds to take positions and generate value. The really big opportunities have probably already passed for hedge funds that focus on problem loans and companies, but there are still large enough opportunities to generate good returns, also at reasonable risk.

Over the past few years, the rally in the High Yield segment has led to this asset class being valued on the basis of gen- eralisations. Assuming a normalising market and bankruptcy levels close to zero, the next movement will include the differ-

Hedge funds

ences between better and worse High Yield instruments. This will also further improve the potential for Event Driven strate- gies, which will be able to take more constructive positions, further improving the quality of investment opportunities.

Equity Long/Short strategies are usually the easiest to under- stand and identify with. Buy shares you like and short those you don’t like. Rather simple, actually, but this of course re- quires that both the analysis and positioning are correct and disciplined. The prevailing market climate should permit ac- ceptable opportunities for this strategy as well, but we advo- cate some caution with Long Biased hedge funds, since most of the time these are invested in markets up to a high percent- age of capital. There will be some ups and downs in this type of funds, but less than for ordinary equity funds in general.

momentum is on the side of hedge funds

Although we are painting a very favourable scenario for hedge funds, the markets are of course not without some bumps in the road. A normalisation process takes time, and the pattern of movements tends to form plateaus, with large and small corrections along the way. Throughout the economic recovery, we have seen hedge funds as a group performing very well in some months, then losing a lot of value in other months. This has been repeated, with a correction about every four months. We believe that we can expect this pattern in the future as well. We saw this most recently in the first week of May, when we again experienced a genuine correction, which adversely affected many hedge funds. During the year, many hedge funds have built up positions based on a weaker USD and ris- ing oil prices. The market situation changed dramatically when the dollar quickly began to appreciate and oil prices dropped by around 15 per cent in a short period. Such sharp, rapid movements obviously affect hedge funds, especially those that build up positions that follow market trends. Such hedge fund strategies as CTA (systematic multi-asset management), Global Macro and Long Biased Equity L/S took a real beating, with downturns of around 2.5-4 per cent on index levels for a week.

These movements thus have the potential to wipe out a third or more of a year’s returns in as short a period as a week or so. This shows the importance of trying to keep track of such rap- id shifts, if not otherwise as an indication of the performance of other asset classes. We nevertheless currently have a very positive view of hedge funds as an asset class. Momentum is on the side of hedge funds, and we expect the overall invest- ment climate to improve even further. As always, quality plays an extra large role for hedge funds, but by way of summary, the investment climate is good.

key QUaLitative aspeCts in CHOOsing HeDge FUnDs

1 5 0 1 4 0 Dow Jones Credit Suisse Hedge Fund Index Dow Jones
1
5
0
1 4
0
Dow Jones Credit Suisse Hedge Fund Index
Dow Jones Credit Suisse Managed Futures Index
HFRX Global Hedge Fund Index
1 3
0
1 2
0
1 1
0
1
0
0
9
0
J
a n /1 1
8
0
Source: Bloomberg
S
e p /1 0
7
0
M
J
a y /1 0
a n /1 0
S
e p /0 9
M
J
a y /0 9
a n /0 9
S
e p /0 8
M
J
a y /0 8
a n /0 8
S
e p /0 7
M
J
a y /0 7
a n /0 7
Index

The returns of recent years in the hedge fund field have shown divergent natures, depending on what strategy investors have chosen, and also depending on whether the index includes a very large number of hedge funds across a broad spectrum (HFRX) or whether the index has a more qualitative focus (DJCS Index). The chart shows the importance of trying to se- lect hedge funds based on qualitative aspects. The table below shows what good characteristics CTA/Managed Futures had in the last crisis, but that this strategy has had a more difficult time since then.

Source: Dow Jones Credit Suisse

INdEx/STRATEGIES

yTd

2010

2009

(April 2011)

Dow Jones Credit suisse Core Hedge Fund index

2.62%

8.10%

13.12%

Convertible arbitrage

2.56%

11.16%

46.23%

emerging markets

3.50%

9.89%

26.86%

event Driven

2.33%

7.15%

20.84%

Fixed income arbitrage

2.20%

4.46%

3.25%

global macro

1.61%

8.29%

5.81%

Long/short equity

3.47%

6.84%

19.08%

Cta/managed Futures

2.97%

13.80%

-12.59%

sOme HeDge FUnD sUb-strategies

The table shows the performance of various common hedge fund strategies after the big 2008 downturn. Figures for 2011 are until the end of April and show good upturns, among other things due to fine figures during April itself.

Investment OutlOOk - June 2011

April and show good upturns, among other things due to fine figures during April itself. Investment

31

real estate

real estate

Continued normalisation, but with problems

Rent levels are rising ever faster and vacancies are falling

Better borrowing opportunities will lead to higher transaction volume

Main risks in China and the United States

The global economy is continuing to recover from its major crisis, and the real estate market is generally in better health today than before. In earlier issues of Investment Outlook, we have maintained that this normalisation process would occur in two phases − first an investor-led phase and then a broader, more economically prosperous phase. This is because econo- mies would be gaining momentum, with higher production and lower unemployment as contributing positive factors.

Except for certain portions of the global real estate market, we believe that the market is now firmly in phase two. Large portions of the market may even be normalised, in any case properties with good geographic locations. In its Global Market Perspectives for the first quarter of 2011, Jones Lang Lasalle writes that for the first time since the global financial crisis, downside risks are less than upside risks. They add that the global real estate market is the strongest in two years.

Change in rents

Hong Kong Singapore Moscow Sao Paulo Shanghai London Brussels San Francisco Washington DC Paris Toronto
Hong Kong
Singapore
Moscow
Sao Paulo
Shanghai
London
Brussels
San Francisco
Washington DC
Paris
Toronto
Sydney
Mumbai
Chicago
New York
Amsterdam
Tokyo
Frankfurt
Source: Jones Lang Lasalle
Los Angeles
Madrid
Change, per cent
Dubai
-40
-30
-20
-10
0
10
20
30
40

32

Investment OutlOOk - June 2011

This view coincides with that of a majority of global real estate analysts.

Clear signs of this improvement are that rent levels are climb- ing and vacancies are falling. The chart below shows the change in rent levels in selected cities during 2010.

Rent increases are also showing signs of accelerating, as the world economy improves. This trend is very clear in primary areas, whereas secondary and tertiary areas have not really taken off yet, but they are stable and will improve. Vacancies are falling as an effect of the better market climate. Combined with low levels of new construction in the Western world, this will fuel new rent increases and lower vacancy levels in sec- ondary and tertiary areas as well. If the current trend persists, this should be evident within a few quarters.

The picture is different in emerging market countries. In some places, especially China, authorities are choking off access to capital in order to keep real estate prices and inflation in check. During a recent trip to China, we saw that this has had an impact. It was evident that many large skyscraper projects had been halted in mid-construction. A relatively large num- bers of skyscrapers were only concrete skeletons, but no work was going on at the moment. The situation is consequently different from the Western world, although this was only a

rent LeveLs are mOving UpWarD

On the whole, rent levels rose sharply during 2010 and are continuing to rise in a growing number of cities.

Real estate

small glimpse of reality. Underlying growth in emerging market countries is nevertheless strong, and many real estate projects will undoubtedly be completed. The chart below shows trans- action volume, according to Jones Lang Lasalle.

increased supply of capital

This increase in transaction volume has been made possible partly because banks are healthier and there is a larger supply of capital for real estate investors. Better borrowing oppor- tunities, along with a stronger global economic situation and large numbers of investors who are more optimistic about the future, have together resulted in higher transaction volume, rising rents and falling vacancies, but also rising property prices (or falling return on capital). During the past year, many real estate investors have seen double-digit increases in value. One example is the rising value of real estate shares − meas- ured as the FTSE EPRA/NAREIT Global Net, which has gained about 20 per cent in USD terms this past year. Pure real estate investments that are not stock exchange listed have risen by around 8 per cent. The past year has generally been good for the real estate market.

The problem for us as financial investors is that it is not always so easy to invest in real estate that combines good returns and low risk. Either there is an equity risk if properties are traded via listed companies or it is often necessary to be invested for many years. Those who want their capital to be liquid have had fewer choices. Large German real estate funds have been one investment alternative, with German authorities currently reviewing how they will operate in the future. We will see what comes out of this examination.

What, then, are the risks in the real estate market? China again. Market players are once again beginning to talk about bubble tendencies in some parts of China − a problem that could have rather severe consequences. Construction projects halted in mid-course (especially apparent in the city of Chongqing) could potentially lead to the collapse of con- struction companies, which would cause further tensions in

the system. What is positive is that Chinese authorities have shown a skilful hand in economic management and have influenced markets in the right direction where there were previously bubble tendencies. The most probable scenario is that they will succeed this time around too, but it is a rather delicate balancing act.

The next problem remains the American housing market. The commercial real estate market looks better, and the problems are mainly in the residential market. The supply of capital is crucial, but the healing of the credit market is occurring slowly. We have seen positive indications in the labour market over the past few months, with minor reversals here and there, but mainly a decent pace of improvements. This will obviously benefit the housing market. Now we are also waiting for the banks to successfully get rid of a large proportion of their bad loans. If they can manage thus within the foreseeable future, it should be possible to improve the momentum of lending activity, at least to some extent. In that case the housing mar- ket − both in terms of prices and rents − should rather quickly bounce back from today’s low levels.

good market climate for real estate

Another positive development globally is that a number of prestige properties have changed owners during the past year. This strengthens the perception among investors that the real estate market is improving. We believe that the posi- tive factors in the real estate market will continue and even improve further. Property investors will increase the intensity of their activity when the credit supply gets better and as the world economy improves. The market climate, especially in the Western world, is increasingly advantageous to landlords due to shrinking vacancies, rising rents and the small number of new construction projects. Generally speaking, this is a good situation for the real estate market and long-term property investments, but there are some troublesome problems that need to be avoided.

100 90 80 70 60 50 40 30 20 10 0 USD billions 2007 Q1
100
90
80
70
60
50
40
30
20
10
0
USD billions
2007
Q1
2007
Q2
2007
2007
Q3
Q4
Source: Jones Lang Lasalle Americas EMEA Asia Pacific 2008 2008 Q1 Q2 2008 2008 Q3
Source: Jones Lang Lasalle
Americas
EMEA
Asia Pacific
2008
2008
Q1
Q2
2008
2008
Q3
Q4
2009
Q1
2009
2009
Q2
Q3
2009
Q4
2010
Q1
2010
Q2
2010
2010
Q3
Q4

gOOD mOmentUm in tHe reaL estate market

Better borrowing opportunities together with stronger global economic conditions have led to higher transaction volume, rising rents and falling vacancies, but also rising property prices.

Investment OutlOOk - June 2011

transaction volume, rising rents and falling vacancies, but also rising property prices. Investment OutlOOk - June

33

private equity

private equity

Economic growth will drive values

Favourable economic situation for PE

Prospects of rising company values and attractive valuations will benefit this asset class

Risks consist of weaker economic growth than expected and new financial worries

We are sticking to our generally positive view of the prospects for private equity (PE). So far this year, such a bright picture has not materialised in the form of significantly rising share prices, and this might be seen as a disappointment. For ex- ample, the SEB Listed Private Equity Fund has gained two per cent. Yet we believe this should be viewed as a sign of strength. The reason, of course, is that private equity has also been affected by all the major events this year that have con- tributed to a bumpy road for risky assets in general.

In recent months the tragedies in Japan, unrest in the Middle East, the debt crisis in Europe and inflation worries have creat- ed uncertainty about the general economic trend and have di- minished risk appetite. Meanwhile we have seen many signs of health from the corporate world and some from the financial markets. Among these signs of health, globally strong quar- terly reports from listed companies are especially noteworthy, along with the fact that mergers and acquisitions appear likely to start up again on a broad front. Meanwhile the funding situ- ation is easing more and more for PE companies, and banks are becoming more willing to provide financing.

When analysing an asset class, it is easy to get stuck in techni- cal factors and to assign great significance to the latest events, at the expense of key fundamental factors. It is thus important to remember what drives long-term value in private equity:

• PE is a cyclically sensitive asset class…

• …that provides an exposure to corporate profits − with leveraging

• To perform well, PE needs a stable financial situation

• Given risk, PE needs markets with good risk appetite

34

Investment OutlOOk - June 2011

Cyclical sensitivity, and thus exposure to corporate profits, appears to be an advantage in today’s situation. As indicated elsewhere in Investment Outlook, we have a positive fun- damental view of global economic growth during the next several years and are anticipating growth clearly above the long-term trend. As explained in earlier issues, this particular phase of the economic cycle is normally the best for PE com- panies. After the recession, the efforts of these companies to streamline their portfolio businesses have led to efficient operations with the potential for high margins. Right now, after the economic upturn has been under way for a while, demand is finally gathering steam, providing good chances of higher sales. The combination of high margins and increased sales means significant potential when it comes to corporate profits. This, in turn, will logically lead to rising net asset value (NAV) in PE companies. We are now also seeing the cyclical upturn spreading to more sectors. This benefits PE companies, which are often active across the entire economy.

good supply of credit

As for leveraging, internationally a growing number of PE companies are indicating that the supply of credit is good. The corporate bond market has been working smoothly for these companies for some time. What is new is that banks are now easing the terms of the covenants related to their lending and that they are willing to allow a larger element of leverag- ing in acquisitions of companies. Before the credit crisis, PE companies could borrow around 70 per cent of the purchase price, which meant providing 30 per cent equity. After a period when a significant higher equity percentage was required, the percentage is now on the way down, this time towards 40 per cent. A lower equity percentage means higher leveraging; return on equity will be higher if the transaction is successful − but risk also increases.

The world financial situation does not really seem as stable. The European credit crisis and large US deficits, which will sooner or later lead to the withdrawal of quantitative easing, are causing justifiable concern. But although public sector finances are weak in many places, the banking system is becoming more and more stable and well-capitalised. This is perhaps the hardest parameter to assess, with the potential

to send tremors through the financial system when worries mount. It would probably result in greater risk aversion, which is likely to hurt the share prices of PE companies.

Financial uncertainty aside, there are still good reasons to believe that risk appetite will be decent in the future. The growth-driven phase of the economic and stock market cycle is traditionally characterised by good financial stability, with growth driving profits and capital supply. This time around, uncertainty is admittedly perhaps greater, but this is offset by low interest rates. On the whole, good risk appetite should be possible, assuming that our economic scenario holds up.

Strong economic performance and earnings, and probably good risk appetite, should be more than enough to offset fi- nancial uncertainty. We continue to have an optimistic view of the external conditions for private equity.

merger and acquisition activity is up

More PE-specific factors also provide a fairly bright picture of the situation. Merger and acquisition activity is again fairly high, after essentially having been non-existent during the credit crisis. During the pre-crisis years 2006-2008, well over 2,000 transactions took place annually in the global PE uni- verse. During 2009, volume fell to around 900 transactions. Last year it rebounded to 1,500. Company valuations have approached a normal situation, both as regards PE companies and the businesses they invest in: their portfolio companies. As for the latter, we can note that during the same periods as above, the earning multiple measured as enterprise value/ earnings before interest, taxes, depreciation, and amortisation (EV/EBITDA, which works in roughly the same way as a price/ equity ratio) moved from 8.7 down to 7.2 and then up to 8.1 (Source: 2010 Preqin Global Private Equity Report). Current valuation levels still look relatively attractive, but it is no longer possible to say that the companies are cheap. Valuations are more attractive for small and medium-sized companies, while those in the large cap segment are beginning to look more strained. This is because many “mega cap” funds that started just before the financial crisis must now invest the remaining portions of the capital they raised.

If portfolio companies appear relatively attractive, the same is true of listed PE companies as such. During the spring, the discount to net asset value (NAV) has been comparatively sta- ble at an average of 20-25 per cent of NAV. This is somewhat more than the historical average level of 10-15 per cent. It may be regarded as justified, given the uncertain financial situa- tion and lower leverage. Over time, there should nevertheless be room for some narrowing of these discounts. All else be- ing equal, this will benefit share prices, but it is not a strong enough factor to drive them by itself.

Private equity

strong enough factor to drive them by itself. Private equity Discount to nav back at normal

Discount to nav back at normal levels

It is worth noting that the discount to NAV in the secondaries market − transactions that involve existing PE commitments − is back at normal levels, around 10 per cent. It means that some listed PE companies that have traded at relatively large discounts have been bought out by other PE investors, who thereby “earn” the larger discount. This trend may continue as long as listed companies are traded with larger discounts, something that in itself helps support share prices.

Assuming that our economic scenario holds up, PE invest- ments should be able to provide good returns during the next couple of years. Growth will drive up the values of portfolio companies, boosting NAV. However, there will probably be no easy profit-taking. The market players that generate the best returns are those that are successful in creating operational added value in portfolio companies.

The profits of listed PE companies are expected to rise by 10 per cent or a bit more in the next couple of years. PE portfolio companies should be able to deliver at least as much. Add higher financial leverage, and return on assets should prove very good. Since today’s valuations appear reasonable, or even attractive, it seems reasonable to imagine that the share prices of listed PE companies should be able to rise at least as much as the return figures. We forecast share price potential of around 15 per cent annually in the next 1-2 years, an as- sumption that does not appear aggressive if fundamental conditions live up to our forecasts.

2 0 1 1 -0 4 2 0 1 1 -0 2 2 0 1
2
0 1 1 -0 4
2
0 1 1 -0 2
2
0 1 0 -1 2
2
0 1 0 -1 0
2
2
2
0 1 0 -0 8
0 1 0 -0 6
0 1 0 -0 4
2
0 1 0 -0 2
2
0 0 9 -1 2
paUsing FOr breatH aFter tHe reCOvery
2
0 0 9 -1 0
2
0 0 9 -0 8
240
2
2
2
2
0 0 9 -0 6
220
200
0 0 9 -0 4
180
0 0 9 -0 2
160
0 0 8 -1 2
140
120
100
80
Source: Bloomberg
60
LPX50 Listed Private Equity TR
Index

After the crash, share prices of listed PE companies rose sharply. In recent months, market uncertainty has slowed their upturn. It should be viewed as a sign of underlying strength that prices of these companies have held up so well. We expect the positive trend to resume once economic growth is again driving market performance, but the upturns will be of a more normal nature.

Investment OutlOOk - June 2011

35

Commodities

Commodities

36

The commodity boom has hit a wall

The silver rally has collapsed

and

Oil prices will remain at high levels

There are a number of factors behind the sharp commodity price increases of the past year. The strong global economic recovery and expansive growth in Asia have created high demand pressure. The US dollar has trended downward in the past year. Since commodities are traded in dollars, there is a strong association between the dollar and commodity prices. When the dollar weakens, producers demand higher prices for their commodities in dollar terms, resulting in rising commod- ity prices, and vice versa. In addition, supply disruptions such as the La Niña weather phenomenon and escalating unrest in North Africa and the Middle East have left their mark on food and oil prices. In addition, there was a large portion of specu- lative positions in commodities generally and precious metals in particular.

The recent downward correction was mainly due to the un- winding of these speculative positions. The decline was largest for those commodities that had climbed the most in a short time. During a one-week period, the price of silver fell no less than 27 per cent, but oil and other industrial metals also lost substantial value. Increased worries about the world economy and the reversal of the dollar’s long weakening trend were the factors that triggered the price decline.

the silver bubble that burst

The trend of silver prices more closely resembled the burst- ing of a financial bubble than a healthy correction. During the months before the price slump, silver prices climbed almost vertically, indicating that investors had lost touch with the real value of this asset. In addition, silver exposure was a favourite of small investors − reflected, for example, in enormous posi-

tions in exchange-traded funds (ETFs). In the end, few inves-

tors had not already taken a position assuming continued price upturns. Exposure to silver normally occurs in the form of futures trading. Investors thus do not have to cover the entire position with their own capital; instead, about 5-10 per cent is enough. The death blow for the silver rally came when the leading metals exchange boosted its margin requirement on silver exposures.

gold may be next in line

Since the summer of 2010, we have seen a powerful rally in commodity prices, but this upturn suffered a major tumble early in May. Before the correction began, commodities as a whole had climbed by about 40 per cent. All sub-segments contributed to the upturn. In less than one year, Brent crude oil rose from USD 70 per barrel to more than USD 125. The prices of agricultural products also climbed quickly, because the El Niño and La Niña weather phenomena adversely affected harvests. During the same period, food prices climbed a full 55 per cent. Despite a slight recent decline, food prices are still above their previous highs from 2008. Industrial and precious metals also experienced sharp price increases, approaching 40 per cent.

a COrreCtiOn in COmmODity priCes

160 Industrial metals Precious metals 150 Energy 140 Food 130 120 110 100 90 Source:
160
Industrial metals
Precious metals
150
Energy
140
Food
130
120
110
100
90
Source: Bloomberg,
SEB Commodity Research
80
Index
J
F
a
n /1 0
b /1 0
M
A
a
e
r/1 0
p r/1 0
M
a
y /1 0
J
J
u
u l/1 0
n /1 0
A
u
g /1 0
S
e
O
p /1 0
k t/1 0
N
D
o
v /1 0
e
c /1 0
J
F
a
n /1 1
b /1 1
M
A
a
e
r/1 1
p r/1 1
M
a
y /1 1

After a year of rapidly rising prices, commodities lost ground early in May. A stronger US dollar and increased worries about the global economic recovery led investors to choose profit- taking in their commodity exposures.

Investment OutlOOk - June 2011

Since a larger proportion of the silver price upturn was driven by speculation, it is difficult to know how much value silver may lose. However, one rule of thumb in the financial market is that investors should avoid trying to catch “falling knives”, which is a good description of silver prices at present.

tHe rise anD FaLL OF siLver

50 50 45 45 40 40 35 35 30 30 25 25 20 20 15
50
50
45
45
40
40
35
35
30
30
25
25
20
20
15
15
10
10
5
5
0
0
1970
1975 1980
1985 1990
1995
2000 2005
2010
Source: Reuters EcoWin
Early in 2011 there was something of a silver hysteria among
small investors, but soaring silver prices abruptly peaked in May
and then fell 27 per cent in one week. Late in the 1970s, silver
prices underwent a similar exponential rise. If the subsequent
correction is as big this time around as it was then, silver still has
some distance to fall.
USD/Ounce (troy)

gold has done well, so far

Despite the sharp decline for silver, gold has more or less re- sisted the latest price corrections in the commodity segment. In earlier issues of Investment Outlook, we have argued that gold is also showing bubble tendencies and that there is a risk that the “gold bubble” may burst. Gold prices have climbed more or less without interruption throughout the 21st century. As with all bubbles, there are good arguments that explain the price upturn. In recent years, gold has been in demand regard- less of the prevailing market climate. Investors have been at- tracted by gold in periods of worries about deflation, inflation, the survival of the euro, quantitative easing and so on. Since the financial crisis, however, the ongoing currency war that has been the main reason for the increased attractiveness of gold. This precious metal is often viewed as an alternative currency. When countries compete to weaken their respective curren- cies − in an effort to improve their competitiveness − demand for gold increases.

The disadvantage of gold is that it offers no cash flow to the owner, unlike such assets as equities or bonds. This reality has been a minor worry in recent years, with the G7 countries es- sentially embracing a zero interest rate policy. As the recovery progresses, however, key interest rates are now being hiked in many parts of the world. This risks reducing the attractiveness of gold. Given our view of the market − including strong global growth, comparatively high risk appetite and gradually rising interest rates − there is a risk that gold prices will fall from today’s peaks. A chart of gold prices does not look as alarming

Commodities

A chart of gold prices does not look as alarming Commodities as a chart of silver

as a chart of silver prices, but gold may also be regarded as having risen too far during too short a period. There is thus a risk that the “bubble” will burst.

Cheaper food

According to recent weather forecasts, the La Niña phenom- enon is about to fade, and more normal weather conditions

can be expected by mid-year. If this proves correct, agricultural

prices should continue to fall, due to lower weather-related

risk premiums and prospects of higher agricultural produc-

tion. Historically, farmers worldwide also usually increase their

production substantially in response to market price increases.

The sharp price increases of the past year are also likely to

lead to profit-taking by investors. Overall, this indicates that

the price decline may be significant.

somewhat lower oil prices

Despite the recent price decline, oil is still being traded at historically high levels. At this writing, Brent crude costs more than USD 110 per barrel, while West Texas Intermediate is trading at around USD 100 per barrel. The situation in North Africa and the Middle East is still tense, and it will probably be some time before calm is restored in this region. Oil prices are thus likely to remain at high levels for another while. During the second half of 2011, however, we expect oil prices to fall due to more favourable supply conditions. Today the OPEC countries also have significantly higher reserve capacity than in 2008, when such capacity was very small and it was difficult to meet high demand.

Large risk premiUm in agriCULtUraL priCes

170 160 - Grain hoarding 150 - Floods 140 - Political unrest 130 120 110
170
160
- Grain hoarding
150
- Floods
140
- Political unrest
130
120
110
100
Source:
90
Bloomberg, SEB Commodity Research
80
Jan 2010
Apr 2010
Jun 2010
Oct 2010
Jan 2011
Apr 2011
Index

Due to exceptional weather conditions in the wake of El Niño and La Niña, agricultural prices have skyrocketed. In recent months, however, they have fallen a bit, and larger price de- clines can be expected if/when weather conditions normalise.

Investment OutlOOk - June 2011

37

Currencies

Currencies

Imbalances and interest rate spreads crucial

38

Yuan revaluation will continue

Dollar will strengthen against other G7 currencies in second half of 2011

Krona will keep gaining ground against euro

In the past three months, there have been large movements in the foreign exchange (FX) market. After a year of constant weakening, the US dollar gained a lot of ground during a few days in early May. Its renewed strength also triggered a sharp decline in most commodity prices. The euro fell from USD 1.48 to 1.41 and the Swedish krona weakened from SEK 6.00 to 6.38 per USD. This movement was, above all, an effect of signals from the European Central Bank (ECB) that its mon- etary policy would be less contractive than the market had expected. Interest rate policy is having a major impact, an indi- cation that the FX market is focusing on interest rate spreads − a driving force that the last issue of Investment Outlook predicted would be increasingly influential.

We believe that taking advantage of interest rate spreads will continue to determine much of what happens in the FX market. Investors do so by borrowing where interest rates are low and investing where they are high. This is called the

“carry trade”, since the investor has a positive net financing cost, or “carry” on such transactions. The result is downward pressure on the currencies of countries with low interest rates, whereas currencies in countries with high interest rates appre- ciate. During periods when the carry trade has been a market theme, the volatility of the FX market has been low, which is often synonymous with high risk appetite.

imbalances leave their mark

In addition to interest rate spreads, global imbalances are likely to leave their mark on the FX market. Historically, the US in particular has played the role of the world’s consumer, while emerging market (EM) countries − led by China − have been in charge of production. Over time, this relationship has led to the build-up of enormous imbalances, including Chinese trade surpluses and US trade deficits.

Rebalancing the world foreign exchange situation will, above all, require increasingly strong Asian currencies. Here the re- lationship between the US dollar and the Chinese yuan (CNY) plays a key role. Since the summer of 2010, Chinese authori- ties have allowed a gradual appreciation of the yuan, which has gained 5 per cent so far against the dollar. Not only would the world economy benefit from an adjustment in global trade, but continued yuan appreciation is also advantageous

0.50 8.25 0.25 8.00 0.00 7.75 -0.25 7.50 -0.50 7.25 -0.75 7.00 -1.00 6.75 -1.25
0.50
8.25
0.25
8.00
0.00
7.75
-0.25
7.50
-0.50
7.25
-0.75
7.00
-1.00
6.75
-1.25
6.50
-1.50
6.25
-1.75
6.00
Jan
Mar
Maj
Jul
Sep
Nov
Jan
Mar
Maj
10
11
Source: Reuters EcoWin
Sweden, Spot Rates, USD/SEK, Close
Key interest rate spread US/Sweden
Percentage points
U
S D / S E K

interest rate spreaDs Driving

eXCHange rates

The krona’s appreciation against the dollar has

kept pace with the widening of the key interest

rate gap between Sweden and the US. Interest rate spreads and expectations of future tightening

measures are likely to continue having a major

impact on exchange rate movements.

Investment OutlOOk - June 2011

EUR/SEK

for China. The country’s ambition is to shift from export-led to domestic consumption-led economic growth. In addition, in- flation is at uncomfortably high levels. A stronger currency will cause inflation pressure to ease, since foreign goods will be- come cheaper for Chinese consumers. We expect the revalua- tion of the yuan to continue, with the USD/CNY exchange rate reaching 6.20 at the end of 2011 and 5.85 at the end of 2012. This implies an overall revaluation of nearly 17 per cent from the summer of 2010.

CHina ratCHets Up tHe vaLUe OF tHe yUan 8 .5 8 7 .5 7 6
CHina ratCHets Up tHe vaLUe OF tHe yUan
8 .5
8
7 .5
7
6 .5
Source: Bloomberg
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 2 0 1 0 2 0 1 1
USD-CNY X-RATE

Since the summer of 2008, Chinese authorities have again al- lowed a gradual appreciation of the yuan. We expect this process to continue, with the USD/CNY exchange rate reaching 5.85 by the end of 2012. A stronger CNY is in the interest of both China and other countries.

Like China, most other Asian countries control the value of their currencies to ensure that their exports remain competi- tive. This occurs by means of interventions in the FX market by the respective central bank. The revaluation of the CNY also increases upward pressure on these other Asian currencies, since it is unlikely that other central banks can resist a market positioned for Asian currency appreciation. Furthermore, there is less incentive to keep currencies weak when purchasing power in China − the most important export market for these countries − increases via a stronger CNY. Leading EM countries have recently discussed a coordinated revaluation against the USD and other OECD currencies. This would accelerate the process of addressing global imbalances and would ease infla- tion pressures in the EM sphere.

a stronger dollar, but not yet

The US Federal Reserve (Fed) is the only central bank aside from the Bank of Japan that has still not begun to tighten its monetary policy. Our assessment is that the Fed will not be- gin to raise its key interest rate until 2012. Since the focus of the FX market today is on interest rate spreads, a continued expansionary monetary policy is likely to keep weighing down the dollar, which is also pulled down by large US budget and current account deficits. We expect the EUR/USD exchange rate to climb to 1.48 by mid-2011. As the Fed’s quantitative ea-

Currencies