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Investment Outlook

private banking - investment strategy

September 2011

a risky balancing act

Investment Strategy

Contents
Introduction..........................................................................................................................5 Summary...............................................................................................................................6 Macro summary ...................................................................................................................8 Portfolio strategy .............................................................................................................. 10 Portfolio commentary: Modern Investment Programmes.......................................... 12 Theme: Unusual economic pattern challenges investors........................................... 15 Theme: A nearly empty economic policy toolkit .......................................................... 18 Theme: Emerging markets The next generation ...................................................... 21 asset CLasses Equities............................................................................................................................... 23 Fixed income ..................................................................................................................... 26 Hedge funds ...................................................................................................................... 28 Real estate ......................................................................................................................... 30 Private equity .................................................................................................................... 32 Commodities ..................................................................................................................... 34 Currencies.......................................................................................................................... 36

Investment OutlOOk - sePtemBeR 2011

Investment Strategy

This report was published on September 13, 2011. Its contents are based on information and analysis available before September 6, 2011.

Hans peterson
Global Head of Investment Strategy + 46 8 763 69 21 hans.peterson@seb.se

roger trnkvist
Economist +46 8 763 69 43 roger.tornkvist@seb.se

Lars gunnar aspman


Global Head of Macro Strategy + 46 8 763 69 75 lars.aspman@seb.se

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

robert bergqvist
Chief Economist, SEB + 46 8 506 230 16 robert.bergqvist@seb.se

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

victor de Oliveira
Portfolio Manager and Head of IS Luxemburg + 352 26 23 62 37 victor.deoliveira@sebprivatebanking.com

Carl-Filip strmbck
Economist +46 8 763 69 83 carl-filip.stromback@seb.se

Johan Hagbarth
Investment Strategist + 46 8 763 69 58 johan.hagbarth@seb.se

Cecilia kohonen
Global Head of Communication Team +46 8 763 69 95 cecilia.kohonen@seb.se

esben Hanssen
Head of IS Norway + 47 22 82 67 44 esben.hanssen@seb.no

Liza braaw
Communicator and Editor +46 8 763 69 09 liza.braaw@seb.se

Carl barnekow
Global Head of Advisory Team + 46 8 763 69 38 carl.barnekow@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/disclaimers. Information relating to taxes may become outdated and may not fit your individual circumstances. Investment products produce a return linked to risk. Their value may fall as well as rise, and historic returns are no guarantee of future returns; in some cases, losses can exceed the initial amount invested. Where either funds or you invest in securities denominated in a foreign currency, changes in exchange rates can impact the return. You alone are responsible for your investment decisions and you should always obtain detailed information before taking them. For more information please see inter alia the simplified prospectus for funds and information brochure for funds and for structured products, available at www.seb.se. If necessary you should seek advice tailored to your individual circumstances from your SEB advisor. information about taxation: As a customer of our International Private Banking offices in Luxembourg, Singapore and Switzerland you are obliged to keep informed of the tax rules applicable in the countries of your citizenship, residence or domicile with respect to bank accounts and financial transactions. SEB does not provide any tax reporting to foreign countries meaning that you must yourself provide concerned authorities with information as and when required.

Investment OutlOOk - sePtemBeR 2011

introduction

Keeping your balance in wobbly markets


Imbalances and systemic risks will require forceful action. The market is concerned about lacklustre growth, and there are reasons to expect a bumpy ride. Overall, this underscores the importance of choosing a main investment strategy focus capital preservation or returns?
In Nordic Outlook (August 2011), our colleagues at SEB Economic Research write that the world economy is staggering under debt burdens. They quantify the recession risk in the OECD countries at 30 per cent, in a scenario of decent global growth and with a risk that the euro project may break down. This type of assessment is unusual and speaks volumes about the difficult situation the world economy is in. Meanwhile our task is to make the best of every situation and achieve returns on capital, given the market picture we see. The financial market, of which we ourselves are a part, is to some extent in the hands of political leaders around the world. There is potential for both the economy and risk assets to perform well, but decisions about European cooperation, debt management and reductions in budget deficits must be made in order to restore confidence and risk appetite. One key question today is thus: What can political leaders and central bankers achieve? Today we have an almost uniformly weak trend in most sentiment indicators, which measure how businesses and private individuals around the world view the future of the economy. In some cases actual economic outcomes are better, but the overall picture remains problematic. Capital markets adapt naturally to problematic conditions assigning prices to risks, protecting themselves by means of higher risk premiums and fleeing to safe investments like government bonds. This flight and the accompanying capital flow into the fixed income market are definitely among the reasons for the extremely low bond yields prevailing today. We are in a phase where sovereign debt problems on both sides of the Atlantic are hampering growth. Cyclically-driven investments such as equities consequently run the risk of becoming highly volatile. We are devoting a few extra pages in this Investment Outlook to the question of how we should view equity investments in this type of market climate. Given a relatively high recession risk and the question of how to forecast investment returns, some reflection is needed. Today preserving capital and maintaining low portfolio risk are the main priorities of many clients. Generating reasonable returns in an orderly way (with limited volatility), without taking excessive risks, is becoming more and more important. The solution is to diversify across a number of asset classes. By broadening our investments to include more kinds of instruments and by identifying high-earning assets in different market situations, we will be well equipped if the potential risks we see today should materialise. But worth adding is that it takes courage for a manager to dare turn down some of the opportunities the stock market offers. Successful capital preservation requires discipline, especially in times of uncertainty. During weaker growth phases, problems arise and become increasingly difficult to manage. This summers events speak for themselves, and not taking them into account in our management strategies would be wrong. We are living through an uneven economic cycle. Pauses during growth phases are a characteristic of the recovery we are in. This, in turn, affects capital markets and may try our patience. In the prevailing situation, we thus have to look at the patterns and mechanisms behind events. This issue of Investment Outlook includes a section that describes these risks and, to some extent, the related opportunities. Let us close with opportunities: some parts of the world economy are continuing to grow at a healthy pace for entirely natural reasons such as greater prosperity, productivity and rising demand. In the section entitled Emerging markets The next generation, you can read about which countries are next in line to become major economic powers and market players whose influence will be felt in the years ahead.

Hans Peterson CIO Private Banking and Global Head of Investment Strategy

Investment OutlOOk - sePtemBeR 2011

Summary

expected, 1-2 years (annual averages) return risk reasoning Neutral. Markets continue to be dominated by worries connected to negative headlines and speculation. Risk appetite will not revert to normal levels without solid support from macro indicators. While respecting the relatively high probability of a recession, our main scenario is a mid-cycle slowdown. Emerging market (EM) equities are the most attractive, with low valuations, continued high economic growth and room to ease economic policies as needed. Our assessment carries high risk. Negative towards government bonds in the OECD countries. The yield spread (gap) between government securities and corporate bonds has widened significantly. positive towards High Yield, where the gap is historically wide. Also good conditions for EM Debt, which should benefit after a period of economic policy tightening. positive. Hedge funds are generally in a significantly more stable situation, with greater preparedness to face an economic downturn. The prevailing market climate favours Global Macro strategies, among others. Neutral/Negative. Investors are searching for quality during this period of market turbulence, benefiting primary markets and hurting secondary ones. Good potential for favourable performance a bit further ahead. Neutral. If todays growth forecasts prove correct, PE companies generally seem attractively valued. In the short term, however, some caution should be observed. As long as uncertainty about both the economic cycle and financial stability remains, the PE sector is among the riskier investment alternatives. Neutral/positive. Continued strong demand for commodities from emerging markets should be able to defend todays price levels. Best outlook for base metals, gold and to some extent oil. Agricultural commodities are expected to move sideways. The choice of manager will be important. Neutral**. The USD and EUR will change leadership when the USD is questioned. EM currencies will benefit from interest rate differentials and continued high growth.

equities

13%

19%

Fixed income Hedge funds

7%* 6%

9% 7%

real estate private equity

3%

4%

19%

28%

Commodities Currencies

5% 4%

12% 4%

* 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)


20% 18% 16% 14% Equities Private equity

CHange in OUr eXpeCteD retUrn


25% 20% 15% 10% 5%

Expected return

12% 10% 8% 6% 4% 2% 0% 0% 5% 10% 15% Expected volatility Hedge funds Currencies Real estate Fixed income* Commodities

0% -5%

2008-11

2009-02

2009-05

2009-08

2009-12

2010-02

2010-05

2010-09

2010-12

2011-02

2011-05

Equities
20% 25% 30%

Fixed income* Currencies

Hedge funds Commodities

Real estate

Private equity

HistOriCaL risk anD retUrn (september 28, 2001 tO aUgUst 31, 2011)
8% 6% 4%
Historical return

HistOriCaL COrreLatiOn (september 28, 2001 tO aUgUst 31, 2011)


Commodities
1.00 0.06 1.00

Commodities

Fixed income

Hedge funds

Real estate

Equities

Fixed Income Real estate Currencies Hedge funds

2% 0% -2% -4% 0% 5%

Equities
Equities Private equity

1.00
-0.47 0.56 -0.15 0.86 0.24 -0.18

Fixed income Hedge funds Real estate

1.00
-0.27 0.09 -0.35 -0.16 0.17 1.00 -0.05 0.64 0.65 0.13 1.00 -0.17 -0,10 -0.11 1.00 0.37 -0.06

10% 15% Historical volatility

20%

25%

30%

Private equity Commodities Currencies

Historical values are based on the following indices: Equities = MSCI AC World EUR. Fixed income = JP Morgan Global GBI EUR Hedge. Hedge funds = HFRX Global Hedge Fund USD. Real estate = SEB PB Real Estate EUR. Private equity = LPX50 EUR. Commodities = DJ UBS Commodities TR EUR. Currencies = BarclayHedge Currency Trader USD.

Investment OutlOOk - sePtemBeR 2011

Currencies

Private equity

2011-09

Summary

WeigHts in mODern prOteCtiOn


Equities Fixed income Hedge funds Real estate 0% Private equity Commodities Currencies Cash 0% 0% 0% 2% 3% 20% 40%
Previous

WeigHts in mODern aggressive


Equities 20% 30% 18% 0% 0% 5% 0% 27% 0% 10% 20% Previous 30% Current 40% 50%

0% 80% 15%

Fixed income Hedge funds Real estate Private equity Commodities Currencies Cash

60%
Current

80%

100%

WeigHts in mODern grOWtH


Equities Fixed income Hedge funds Real estate Private equity Commodities Currencies Cash 0% 10% 20%
Previous Current

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


1
27.5%

10%

0.8 0.6 0.4 0.2 0 -0.2 -0.4 -0.6

26% 0.0% 0% 5% 4% 27.5% 30% 40%

-0.8 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Fixed income Private equity Hedge funds Commodities Real estate Currencies

perFOrmanCe OF DiFFerent asset CLasses sinCe 2000

60 40 20 0 -20 -40 -60 -80


2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Equities Private equity Fixed income Commodities Hedge funds Currencies Real estate

Source:SEB

Return in 2011 is until August 31. - Historical values are based on the following indices: Equities = MSCI AC World EUR. Fixed income = JP Morgan Global GBI EUR Hedge. Hedge funds = HFRX Global Hedge Fund USD. Real estate = SEB PB Real Estate EUR. Private equity = LPX50 EUR. Commodities = DJ UBS Commodities TR EUR. Currencies = BarclayHedge Currency Trader USD.

Investment OutlOOk - sePtemBeR 2011

macro summary

A multi-speed world economy in 2011-2013


Weak dynamism and the debt problems of some OECD countries ...will lead to a clear downshift in growth during 2012, and the recession risk in some countries should not be underestimated Offsetting this will be a stronger EM sphere and a slight OECD upswing in 2013
The world economic outlook has recently turned gloomier. Last springs slowdown does not seem to have been temporary. Instead, surprisingly weak economic data both from the United States and Europe along with sovereign debt problems, mainly in the euro zone indicate restrained growth in a longer perspective as well. The recession risk in the US and various European countries should not be underestimated. The emerging market (EM) sphere will also be affected, but to a lesser degree. Large intra-regional trade, especially in Asia, and if the need arises ample room for economic policy stimulus measures will allow a softer landing. In 2013 we expect the OECD industrialised countries to show slightly stronger economic growth. The forces that will decelerate the upturn during the coming year will ease to some extent, and debt adjustment will have made more progress. Economic policy makers are also likely to use the measures remaining in their toolkits. Meanwhile confidence in euro zone growth will gradually improve. The inflation outlook appears favourable OECD consumer price increases will slow noticeably in 2012 giving monetary policy makers more flexibility. ens, further quantitative easing by the Federal Reserve (Fed) is likely even though inflation is undesirably high today. The Fed should be willing to help sustain economic growth and try to prevent unemployment from climbing. We predict that GDP will increase by 1.5 per cent this year, 2 per cent in 2012 and more than 2.5 per cent in 2013.

Difficult political dilemmas in the euro zone


The sovereign debt crisis in parts of the euro zone is now dampening growth to a significant extent, and economic policy makers face difficult dilemmas. In many countries, budget-tightening is necessary in order to restore financial market confidence, but such measures then adversely impact budgets due to slower economic growth. Inflation is currently rather high, but it should fall significantly by early next year. The previously fast-growing German economy has been hurt by the US slowdown as well as by the problems of financially weak euro zone countries, but will continue to show growth well above the euro zone average. In the euro zone as a whole, we expect GDP to increase by more than 1.5 per cent this year, by 1 per cent next year and by 1.5 per cent in 2013.

british economy facing headwinds


The British economy is facing clear headwinds due to lowered global economic prospects and the governments tough fiscal austerity programme. Temporary factors have pushed inflation high above the Bank of Englands 2 per cent target, but we foresee a sizeable slowdown in price increases during 20122013. This opens the way for further quantitative easing by the BoE. We predict GDP growth of only 1 per cent this year, a bit over 1.5 per cent in 2012 and around 2 per cent in 2013.

nordic countries will perform fairly well


The Nordic countries have fairly good potential to withstand the chill economic winds from elsewhere in the world, thanks to relatively strong fundamentals in terms of budget balances, public sector debts and current account balances. In 2012, growth will nevertheless probably fall below trend in some of these countries. This applies especially to Sweden, whose growth rate will be squeezed by weaker exports, private consumption and comparatively tight fiscal policies. We forecast Nordic GDP growth of slightly over 2.5 per cent this year, less than 2 per cent in 2012 and about 2.5 per cent in 2013.

major economic challenges in the Us


The US economy is grappling with major difficulties. Temporary factors high energy prices and supply disruptions following the Japanese natural disaster explained some of the slowdown in the first half of 2011, but underlying economic growth dynamism was also unexpectedly weak. This, combined with the shift towards fiscal tightening as well as more and more doubts about US political resolve, has provided a reason to lower growth forecasts. As fiscal policy tight-

Investment OutlOOk - sePtemBeR 2011

Macro summary

Japans growth will soon return


The natural disaster had a clear impact on the Japanese economy. As a consequence, GDP has now shrunk for three quarters in a row. The rate of economic downturn was smaller in the second quarter of 2011, however, with post-disaster reconstruction work being reflected in higher public and private sector capital spending. Leading indicators such as the purchasing managers index now also point to a continued recovery. By all indications, GDP will begin growing again during the current quarter. Short-term risks include lingering energy supply problems and a difficult competitive situation for exports, due to the strong yen. In 2011 as a whole, we expect GDP to decline by more than 0.5 per cent, while we foresee growth of around 3 per cent in 2012 and more than 2 per cent in 2013.

eastern europe will be relatively resilient


Eastern (including Central) Europe will cope relatively well with the economic slump in the OECD countries, though exports will slow and currencies may suffer temporary shocks. Unlike most Western countries, Eastern Europe emerged from the 2008-2009 recession with rather low public sector debts. On the other hand, many countries in the region showed relatively large budget deficits, but these have shrunk due to significant austerity measures. Further cutbacks that might hamper growth are now not likely to be necessary. Trade with crisisplagued southern Europe and the US is also small. The US buys less than 5 per cent of total Eastern European exports. Slower growth in Germany which weighs especially heavily in the exports and GDP of Central European countries is a decelerating factor, however. Overall GDP growth during 20112013 will end up at 4-5 per cent annually in the three largest regional economies: Russia, Poland and Ukraine. The recovery in the Baltic countries (see chart) after their 2008-2010 recession is continuing, but prospects have become gloomier because the export boom is fading rather quickly. Their three domestic economies are gradually improving, however. This year we expect GDP increases of about 6.5 per cent in Estonia and Lithuania, and 4 per cent in Latvia. In 2012, growth will decelerate to 3.5-4 per cent in all three countries, followed by a slight acceleration in 2013. baLtiC UpsWing tempOrariLy LOses mOmentUm
14 11 8 5 2 -1 -4 -7

asias em economies will play a key role


The role of Asian emerging market countries as engines of the world economy is now becoming even more important as growth weakens in the industrialised countries. The regions export chances will worsen due to the OECD slowdown, but thanks to ever increasing intra-regional trade, over time the Asian EM countries have become less dependent on developments in the Western world. Domestic demand is also good, especially private consumption. There is room for economic policy stimulus measures if needed. A scenario of moderately slower growth in the region is thus still the most likely. Lower demand from the OECD countries will cool Chinas export expansion, but household purchasing power will rise as inflation falls. Greater room for private consumption at the expense of exports and capital spending is also in line with official economic strategy. We expect Chinas GDP to grow more than 9 per cent in 2011, about 8.5 per cent in 2012 and nearly 9 per cent in 2013. India is a large, rather closed economy and thus has good potential to cope well with a weaker industrialised world. Due to structural problems related to corruption and regulation, however, India is unlikely to achieve growth rates near 10 per cent. We expect GDP to climb about 8 per cent in 2011, about 7.5 per cent in 2012 and more than 8 per cent in 2013.

Per cent/year-on-year

-10 -13 -16 -19 -22 -25 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Estonia, change in real GDP compared to year-earlier quarter Lithuania, change in real GDP compared to year-earlier quarter Latvia, change in real GDP compared to year-earlier quarter

Source: Reuters EcoWin

Latin american growth will be lower


The Latin American economies will not remain unaffected by the slowdown in the OECD countries, but GDP growth in the region should end up at nearly 4.5 per cent this year, around 3.5 per cent in 2012 and somewhat higher in 2013. Last year, Latin American inflation exceeded 6.5 per cent. This years rate may average a smidgen higher, but all indications are that somewhat lower figures will then follow. This means that the need for monetary tightening will ease. Latin America will continue to show far better economic fundamentals in terms of public budget deficits and debts than the OECD countries.

a multi-speed world economy in 2011-2013


After last years 5 per cent figure, we expect global GDP (adjusted for purchasing power parities) to grow by 4 per cent in 2011, 3.5 per cent in 2012 and about 4 per cent in 2013. This still represents a fairly decent rate, despite all problems and risks (trend growth in the past decade has been 3.9 per cent), and is due to continued good momentum in the EM sphere. We predict that GDP will climb more than 6 per cent this year, 5.5 per cent in 2012 and nearly 6 per cent in 2013 in the EM countries. Our equivalent forecast for the OECD countries is somewhat above 1.5 per cent, a bit below 2 per cent and more than 2 per cent. This means that the EM countries will soon be producing more than half of total world GDP.

Investment OutlOOk - sePtemBeR 2011

portfolio strategy

Equity strategy a highly individual issue


Old truths do not apply in the 2010s Selectivity among regions and sectors is the key to success Time to buy? Yes! No! Maybe
During the past decade, stock markets have generally been a source of some returns, but at times also a source of many problems. We struggle every day to make assessments of stock markets from different perspectives. But one thing seems clear: the old buy and hold strategy in which equities were regarded as the only stable source of returns is no longer valid. Given todays volatile stock markets and the risks that fluctuations bring, we must be completely aware of why we own shares and what purpose they have in the portfolio we are managing. Stock markets are a barometer of a regions economic health. Fundamentally, equity investments are money we put into businesses for the purpose of earning returns on the work performed in these businesses. Companies are fundamentally dependent on the markets in which they operate. History has shown that equities are outstanding tools for achieving returns in times of high growth, especially shares in companies that operate in fast-growing sectors and in countries with good growth and development. During periods of low growth and in regions with low growth, the stock market is in a more vulnerable situation. Japan, for example, has had such problems for a long time. Another example is that in the industrialised countries as a whole, during the first decade of the 21st century the stock market has had great difficulty in generating returns. The MSCI World AC Index, measured in Swedish kronor (SEK), fell 22.77 per cent from the beginning of 2000 to the end of 2010. One conclusion from the above observations is that today we must be more selective in our equity investments. General truths for example that global equities always return 7-8 per cent annually are gross simplifications and to some extent pure lies. It often requires unreasonably long periods of time for such a statement to prove correct. In order to be successful with our equity strategies in todays hard-to-navigate market, we need a clear perception of the conditions in various regions and sectors. In the two previous editions of Investment Outlook (February and June 2011), we presented our country allocation model. The purpose of this analytical model is to use a number of parameters to identify the regions and sectors with the best potential to generate returns.

One question several answers


Is it time to buy? This is perhaps the most common question we hear as investment advisors. The question is extremely difficult to answer, for many reasons. We can identify market climates and trends that are better or worse for stock markets, but saying exactly when the stock market bottoms out (or, for that matter, when it peaks and it is time to sell) is an impossible task. The second and perhaps most important dimension of all is that the question has different answers depending on who the investor is. To a day trader, the right times to buy may come and go several times a day, while an investor such as an insurance company keeps a more or less constant proportion of equities in its portfolio. Everything depends on who you are. Factors like investment horizon, willingness to take risks, the purpose of the investment and the investors level of knowledge play a major role in answering the question of whether it is time to buy.

market climate is promising for equities, but


Assuming todays share valuations, and calculating future market capitalisation based on a stable economic scenario, there is reason to expect high returns from stock markets in general (read more in our Equities section on page 23). The problem is that today we cannot say there is a 100 per cent probability that economic performance and global growth will be stable. Granted that we are estimating global growth of about 4 per cent this year and 3.5 per cent in 2012, but this assessment includes a certain margin of error in terms of recession risk (which SEB quantifies at 30 per cent). Depending on how probable our main scenario is, an investor should thus have a slightly different view of forecasted returns. This, in turn, means that if asked whether it is time to buy, our answer must include the proviso that the underlying scenario

10

Investment OutlOOk - sePtemBeR 2011

Portfolio strategy

includes built-in uncertainty about recession risk. This uncertainty may, indeed, already be reflected in todays share prices. But we dont know to what extent these prices carry a certain margin of error as well, since they are based on assessments of what we know today. Today we also have the interesting situation that different regions and segments of the stock market show different potential. That may also result in different answers to the question of whether it is time to buy. Emerging markets, especially in Asia, have better growth potential than developed, industrialised countries. Companies based elsewhere in the world also have the opportunity to take advantage of this via their sales to fast-growing regions. Then we have an investment strategy dimension. Companies with different characteristics have varying potential during different periods and different parts of the economic cycle. During 2011 non-cyclical, defensive companies have performed better than others. This might imply that more cyclical companies may be in an attractive position, since expectations are low and thus easier to surpass. One stable pattern is that in volatile phases (like the present one), companies with stable dividends perform better than companies with weaker financial situations. Today it may very well make sense to buy stable dividend payers, provided our main growth scenario proves correct.

Today we are choosing to hold a low percentage of portfolio assets in equities, since we foresee better risk-adjusted returns in such investments as hedge funds and High Yield bonds. Here we are choosing to be very cautious about how we manage portfolio capital. When it comes to equities as an asset class, we factor in the existing recession risk and weigh it against potential returns from other asset classes. Our decision is to diversify away from some of the recession risk in the portfolio. In Modern Aggressive (a mandate in which we can accept more risk) we have chosen to assume a greater cyclical risk and are thus holding a higher percentage of equities. In addition, we are taking equity positions that more clearly reflect geographic exposure to regions and sectors in which we foresee a strong future. In practice, this means a focus on Asia and the Nordic countries. Modern Protection is not discussed here since it is not exposed to equities at all. More information about this mandate is found in under Portfolio commentary in this issue.

traditional mandates
We also manage traditional mandates that are primarily a combination of equities and bonds. These naturally include a higher proportion of equities, with the option of allocating up or down depending on market risk. Here we are closer to a neutral position today, but with some downward adjustment in response to the prevailing economic uncertainty and high market volatility. We are choosing to emphasise emerging markets and Asia relatively clearly, since we foresee the best potential in those countries.

role determines reasoning


During the past six months, stock markets have shown major fluctuations amid a downward trend. In many cases, todays investors are hardened veterans (with the financial crisis still a vivid memory). A few years ago, downturns of 15-20 per cent would have generated crisis headlines, whereas today they lead to questions about a suitable buy level. Where that level lies is a question that we as portfolio managers must think about, and whether it is the right time to invest depends greatly on a portfolios type of mandate and investment strategy obviously coupled with what market scenario we foresee.

When is it time to buy?


As we have tried to explain, the right time to act depends on the portfolio type, alternatives and risk appetite. Today, clients who are prepared to live with the prevailing uncertainty can buy equities more cheaply than two months ago. They can buy shares in companies with stable dividend-paying histories at good prices. It is possible to invest specifically in areas and currency regions with a somewhat higher probability of share price increases, so there are indeed buying opportunities. A general yes to the question of whether stock markets will rise from todays levels is difficult to state and carries a degree of uncertainty. In our Equities section, we describe todays valuations and how the market will perform given the main scenario stated in SEBs economic assessment. Investors with a long time horizon, an awareness of risk and solid experience can find good bargains in todays market situation, but with the knowledge that they will then be living with continued problems in Europe and economic uncertainty (recession risk). Although a recession is not our main scenario, the risk is nevertheless there.

modern investment programmes


Modern Growth is a management mandate in which we are careful with investor capital and seek to avoid excessive losses of value. In this type of portfolio, we currently have a cautious attitude towards risk assets. We have an opportunity to seek returns in all asset classes and have no need to hold positions in equities specifically. Our objective is to generate returns consistent with global stock markets over an economic cycle, but with lower volatility and a degree of cautiousness about investor capital. A portfolio like Modern Growth will admittedly always show some volatility, since it is invested in different types of assets, and by trying to take advantage of the ability of different assets to generate returns we decrease the fluctuations.

Investment OutlOOk - sePtemBeR 2011

11

portfolio commentary: modern investment programmes

Sailing clear of financial storms


Hurricane Irene recently roared through New Yorks Financial District without causing any major material damage there. At this writing, it is unclear whether the storm in the financial markets has passed there is a risk that we are in the eye of the storm. In our Modern Investment Programmes, we are choosing to prepare ourselves for continued rough weather by reducing risk positions in our portfolios.
mODern prOteCtiOn Market turbulence and the inability of political leaders to find solutions to debt problems on both sides of the Atlantic have made investors increasingly unhappy. Ten-year US Treasury bond yield, which stood at about 3.1 per cent late in May, fell sharply during the first half of August to below 2 per cent a sign that investors are lowering their American economic outlook. Similar patterns are found in Europe. In order to achieve its targeted return of a 1-2 per cent above risk-free yields (short-term government securities), Modern Protection has been conservatively positioned in riskier segments of fixed income securities, such as High Yield bonds and emerging market (EM) debt. Like so many other assets, these have been hurt by negative market sentiment. In the fixed income asset sub-portfolio, however, we foresee the greatest risk-adjusted return potential in High Yield. Corporate balance sheets are far stronger than before the 2008 crisis, and companies are thus well equipped to face any downturn in sales. If negative sentiment continues and investors become less inclined to take risks, however, there is a danger that liquidity in the bond market will shrink. In such a scenario, High Yield will be adversely affected first. During August, we thus chose to decrease our exposure to High Yield somewhat. Government bonds issued by emerging market (EM) countries have not been as hard hit as corporate credit instruments in the West. Comparing the financial situation of governments, EM bonds look more solid than American and continental European ones but still offer yields almost at the same level as High Yield bonds. They are also quoted in local currencies, providing an indirect exposure to EM currencies. Given the prevailing market situation, this hybrid nature fixed income and currency makes the segment more attractive than a pure currency exposure. We have thus chosen to reduce the share of Modern Protection being handled by currency managers in order to hold more EM bonds. In the hedge fund sub-portfolio, we have chosen to increase our CTA positions somewhat. CTA is the strategy that has the greatest potential to generate returns in a negative market trend. This strategy includes a number of styles featuring both high and low risk. We have chosen managers with low volatility and a good crisis-period track record. Our real estate-related holdings have been divested in order to improve the portfolios liquidity profile. Given these portfolio changes, we believe that Modern Protection can perform well despite a more lukewarm global economic trend and can preserve capital even if market sentiment remains negative.
3% 2% 15%

80%

Cash Currencies Hedge funds Fixed income

12

Investment OutlOOk - sePtemBeR 2011

Portfolio commentary: Modern Investment Programmes

mODern grOWtH Diversification is one of the slogans for our Modern Investment Programmes. But under circumstances like this summer, diversification is of little consolation when all asset classes are losing value. Although equities (-14 per cent) and private equity (-23 per cent) saw the largest declines between the end of May and August 26, as the table below indicates, all risk assets have fallen. Only government bonds noted an upturn (+3 per cent). The other important principle behind the word Modern is therefore also our concept of having a free investment mandate, which is not limited to a given over/underweighting against a reference weighting (benchmark index).
asset class
private equity equities real estate

portfolio. In the equities asset class, we foresee a larger downside risk for the OECD countries than for emerging markets. In the remaining equities sub-portfolio, we are thus increasing the share of emerging market managers marginally to 30 per cent from our earlier 25 per cent. We are also retaining our exposure to commodities, which still have potential to benefit from growth and new consumption patterns in emerging market countries. In the fixed income sub-portfolio, High Yield bonds in particular face headwinds, but we see that company balance sheets remain strong. After their cutbacks and restructuring during 2008/2009, companies are well equipped for weaker economic growth. Provided that we do not end up in a lengthy recession, corporate borrowing has good potential to continue generating returns. Emerging market bonds are also attractive, with high coupons and good diversification characteristics, and overall we are keeping our positions in this asset class. To create stability in the portfolio amid continued stormy weather, our intention is to gradually increase the role of the hedge fund sub-portfolio. Global Macro and CTA strategies in particular have the best potential to resist the prevailing downward market trend and even generate returns. Some of the proceeds from equities and private equity will therefore be invested with hedge fund managers specialising in these strategies and with good track records and risk control. We are also broadening the portfolio by increasing the percentage of High Yield bonds, EM debt and commodities. Our purpose is to be capable of achieving more uniform returns in more types of scenarios. If the global recovery nevertheless continues (which is our main scenario) we are likely to see a slow, lengthy upturn in risky assets. Even if we miss part of the initial upturn, we can still take part in a majority of the recovery. If we again end up in a recession (our risk assessment for this amounts to 30 per cent), prices are likely to fall quickly. Although an opportunist may see a buying situation today, we are choosing to try to preserve capital in keeping with the principles of the Modern Investment Programmes and are lowering our allocation to risk assets.
10% 27.5% Cash Currencies Commodities Hedge funds Fixed income Equities

performance index (5/31-8/26)


-23.4% -14.7% -12.9% LpX 50 tr eUr msCi aC WOrLD eUr Ftse epra/nareit Developed real estate index eUr HFrX global UsD DJ Ubs Commodities tr UsD Jpm gbi global eUr

Hedge funds Commodities Fixed income

-5.7% -3.2% +3.3%

With free investment mandates, we can move within and between asset classes, but above all we can reduce or eliminate exposure to risk when we deem this reasonable. In this way, we can avoid being tied to equity investments during a sharp downward trend, for example. We have now chosen to apply this principle to a greater extent than previously. In Modern Growth we have gradually increased our cash position since May. At the end of July it amounted to more than 8 per cent. Early in August we saw that the risk of a self-fulfilling recession prophecy was increasing rapidly, and by the middle of the month we saw negative market sentiment also beginning to creep into macroeconomic indicators. While both the stock and fixed income markets are now discounting a rather gloomy future scenario, certain macroeconomic hard data figures unaffected by the feelings of survey respondents are still indicating some growth ahead. Market players seem more pessimistic than macroeconomists, but economists have a tendency to be late with their downward revisions. As portfolio managers, right now we are navigating in a thick fog with the accompanying poor visibility. In light of this uncertainty, we are choosing to reduce our exposure to the most cyclical and risky asset classes. We have reduced equities from 26 per cent to about 10 per cent of the total portfolio, and we have sold off our entire private equity exposure of about 4 per cent. We have also sold our real estate-related holdings in order to improve the liquidity of the

27.5% 4% 5% 26%

Investment OutlOOk - sePtemBeR 2011

13

Portfolio commentary: Modern Investment Programmes

mODern aggressive Financial markets remained stable for most of June and July, despite worries about government debt on both sides of the Atlantic. Risk appetite received a sharp blow late in July, however, and the downgrading of the US sovereign credit rating in early August triggered further pessimism. Meanwhile both US and euro zone GDP for the first quarter was revised downward, showing that the economic recovery was not at all as strong as the market had thought. Political obstacles in both Europe and the US though different in nature are blocking the chances of solving debt problems, and this situation is impacting the economy. As a result, macroeconomists in general are now lowering their forecasts for global growth during the coming year. SEBs forecast is that global growth will reach 4 per cent in 2011 and 3.5 per cent in 2012. Risk appetite fell dramatically during August, and the VIX index also known as the fear index climbed from 16 in early July to above 45 in early August. In such an environment, all risk assets become depressed as investors flee to safe assets such as gold, government bonds and Swiss francs, which were essentially the only assets that rose during the period. These developments also hurt Modern Aggressive. All asset classes in the portfolio fell between May 31 and August 26, except that hedge funds rose marginally. As indicated by our analyses in this publication, our main scenario is that the world will not fall back into a recession. Our conclusion is thus that the movements we have seen during the summer should be regarded as a correction and that risk assets should benefit in the future. Meanwhile the uncertainty in the market as well as in economists forecasts is unusually large, and there is an imminent risk that a more negative scenario might unfold. The more aggressive nature of this portfolio justifies continued exposure to risk assets, but in mid-August we chose to utilise our free investment mandate to reduce downside risk in the portfolio and preserve capital. We reduced our exposure to equities from the previous 38 per cent to 20 per cent of the portfolio. Our private equity holdings (about 9 per cent) were divested entirely. In our equity strategy, we are focusing more clearly on regions that we believe have good potential, such as Asia and the Nordic countries. We are also increasing the percentage of commodity-based investments.

In the equities asset class, we foresee that downside risk is larger for the OECD countries than for emerging markets, and we are maintaining a 60/40 proportion between global managers and emerging market managers. We are also retaining our exposure to commodities, which still have potential to benefit from growth and new consumption patterns in emerging market countries. In the fixed income sub-portfolio, High Yield bonds in particular have encountered headwinds, but we see that company balance sheets remain strong. After their cutbacks and restructuring during 2008/2009, companies are well equipped for weaker economic growth. Provided that we do not end up in a lengthy recession, corporate borrowing has good potential to continue generating returns. Emerging market bonds are also attractive, with high coupons and good diversification characteristics, and overall we are keeping our positions in this asset class. To create stability in the portfolio amid continued stormy weather, our intention is to gradually increase the role of the hedge fund sub-portfolio. Global Macro and CTA strategies in particular have the best potential to resist the prevailing downward market trend and even generate returns. Some of the proceeds from equities and private equity will therefore be invested with hedge fund managers specialising in these strategies and with good track records and risk control. Although we have tightened the sails in the portfolio, we are prepared to increase risk again if the market outlook brightens, or if the financial market prices in an improbably negative future. At present, however, we have a wait-and-see attitude towards equity risk, in the absence of signs that future prospects have improved.

20%

27%

30% 18%

5%

Cash Commodities Hedge funds Fixed income Equities

14

Investment OutlOOk - sePtemBeR 2011

theme

Unusual economic pattern challenges investors


The upturn is slow and very choppy due to ...the latest recession, black swans, sovereign debt crises and special reasons Financial investors face new challenges
The current economic upturn began in the summer of 2009. The upswing was conspicuously strong that autumn and early in 2010. Then growth decelerated in the OECD industrialised countries, when the previous shift towards corporate inventory build-up slowed at the same time as the extremely stimulating effects of fiscal policy measures faded. Another factor was the outbreak of the European sovereign debt crisis. But during the second half of 2010, the US and other OECD economies regained strength as the shift to growth driven by household and business demand proved successful. Early in 2011, however, the positive mood was challenged by dramatic events in the Middle East and North Africa (MENA) with an accompanying sharp increase in oil prices and in mid-March by the natural disaster in Japan. Topping off market worries was Act 2 in the European sovereign debt drama, which unfolded this summer. Greece again played the leading role, but other actors were also forced up on the stage as markets aimed questioning spotlights at the economies and finances of Italy and Spain. Markets also expressed doubts as to whether the French government actually deserved its top credit rating after Standard & Poors had lowered the US sovereign debt rating from AAA to AA-. For these reasons, during spring and summer 2011 there was a new dip in the economic curve in the US and in various other OECD countries. The sharp stock market slide late in the summer was mainly due to heightened uncertainty about where the economy is headed. This nervousness was further fuelled by unforeseeable plot twists in the European debt drama. Whereas oil price increases due to the MENA events and the Japanese natural disaster are examples of shocks with a large and unpredictable economic impact called black swans (after the Australian bird) the sovereign debt mess in Europe and the US is a consequence of the 2008-2009 financial crisis. Of course there have been sovereign financial problems on both sides of the Atlantic for many years, but they have escalated dramatically in recent years. The reasons are: Countless fiscal policy programmes aimed at preventing the financial system from crashing after the Lehman Brothers collapse of September 15, 2008, which caused the public sector to take over acute debt problems from the private sector to an unprecedented extent. A shortfall in taxes and other revenue when the economy went into free fall between autumn 2008 and spring 2009. Massive budget stimulus measures in an effort to kick-start an economic recovery. UnUsUaLLy WObbLy eCOnOmiC perFOrmanCe
60.0 57.5 55.0 60.0 57.5 55.0 52.5 50.0 47.5 45.0 42.5 40.0 37.5 2006 2007 2008 2009 2010 2011 35.0

Purchasing managers index (global)

52.5 50.0 47.5 45.0 42.5 40.0 37.5 35.0

Global purchasing managers index JPMorgan Chase & Co.

Source: Reuters EcoWin

It is more the rule than the exception that a rapid initial economic upswing is followed by a deceleration, but the prevailing upturn which began in the summer of 2009 has been characterised by two conspicuous dips in the economic curve. Such a choppy performance is unusual.

Investment OutlOOk - sePtemBeR 2011

15

Theme: Unusual economic pattern challenges investors

The new dip in the OECD countries upward economic curve can partly by explained by the shocks of last winter and spring oil price hikes, the Japanese natural disaster and the sovereign debt crises but there are also many indications that the underlying growth dynamic is weaker than it often is during an economic recovery. The current upturn thus shows signs of being exceptionally choppy in nature. A slow growth rate, along with varying economic activity, undoubtedly increases the risk of recession (negative GDP for at least two consecutive quarters) in some OECD countries.

to restore fiscal order and strengthen balance sheets in the public sector has not been excessively large. However, the opposite is true this time around, due to dramatically escalating government financial problems. In the space of a few years, crisis-plagued euro zone countries and the UK will implement budget austerity measures in the range of 5-10 per cent of GDP. In the US, budget-tightening will escalate beginning in 2013. In the OECD countries as a whole, austerity will end up at 1-1.5 per cent of GDP both in 2012 and 2013 a sizeable drag on growth. Aside from being conspicuously slow, the OECD economic upturn since the summer of 2009 also seems to consist of various mini-cycles, which is rather unusual. It thus shows a pattern that can be described as two steps forward, one step back. What, then, is behind this economic wobbling?

slump leaving its imprint on upturn


The causes of a recession often leave their imprint on the subsequent economic upturn. At the epicentre of the latest precipitous recession during 2008 and early 2009 was the US sub-prime mortgage crisis, which quickly spread around the world through various financial and economic channels. During the past 40 years, OECD countries have experienced more than 30 real estate crises, resulting in deep economic slumps. The subsequent economic upturns have all been sluggish, and like the current one they have also been characterised by plenty of spare production capacity in terms of both labour and real capital (machinery, premises etc.). This, in turn, has led to low cost and price pressure. Such economic upturns have plodded along albeit slower than trend growth and have continued for a relatively long time thanks to the absence of overheating tendencies, paving the way for very low interest rates during a lengthy period. During recoveries after other types of recessions for example those caused by sharp interest rate hikes, more expensive commodities or large swings in the inventory cycle the housing market has usually been one of the strongest growth engines. When recessions have been caused by burst real estate bubbles, the housing market has instead hampered the upturn, which is the case today. The main reasons have been large surplus inventories of homes and tough credit approval processes by banks for both buyers and sellers/builders due to large credit losses during the preceding deep downturns.

the wobbly economy


One explanation is the wide gap between conditions in the OECD countries and the emerging markets (EM) sphere. Worries about the EM countries have mainly concerned their excessively rapid growth and the risk of economic overheating. While stronger global demand has benefited the weak OECD recovery, it has instead posed an overheating threat in the EM sphere, and while slower global growth has helped cool down the EM economies, it has instead worsened economic weakness and public deficits in the OECD countries. Meanwhile it is unusually difficult to pursue a carefully balanced stabilisation policy. In the OECD countries, the economic policy toolkit was largely emptied when budget deficits and government debts swelled. Balancing between stimulus needs and financial market demands for far-reaching budget tightening has been difficult. In the EM sphere, there has been a balancing act between efforts to decelerate growth enough to reduce overheating risks and to ensure that these economies do not risk a hard landing. HOUsing Can bOtH HeLp anD HinDer grOWtH
2.50 2.25 2.00 1.75 2.50 2.25 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25

increased saving hampers growth


Another reason why upturns after bubble recessions have been slow can be found in the financial behaviour of households and businesses. When their balance sheets rapidly shrink due to falling stock market and property values, their usual reaction is to boost their saving and reduce their debt. The result is weak expansion in private consumption and capital spending. This growth-hampering process has usually culminated a couple of years after recessions but has then often continued at diminished intensity for quite a long time. Sluggish economic recoveries mean slow labour market improvements. Uncertain job and income prospects, in turn, explain why long after recessions, households have abstained from buying splurges to the detriment of economic growth. After previous bubble recessions in OECD countries, the need
Millions of units

1.50 1.25 1.00 0.75 0.50 0.25 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Housing starts
Source: Reuters EcoWin

After US recessions caused, for example, by interest rate hikes aimed at combating excessive inflation, residential construction has often been a powerful recovery engine, as in 1991-1992. The main reason for the latest recession was the burst sub-prime mortgage bubble, which means that the countrys housing sector is instead still a drag on economic growth.

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Investment OutlOOk - sePtemBeR 2011

Millions of units

Theme: Unusual economic pattern challenges investors

In addition, limited production capacity in the commodities field meant that the dramatic MENA events caused oil prices to skyrocket. As a result, worries in 2009 and early 2010 that there might be deflation (generally falling prices) were replaced by fear of inflation in late 2010 and early 2011. Such large shifts in prices and expectations naturally have a clear impact on the financial markets, as well as on the actions of companies and households.

The adverse effects on growth earlier this year due to rising energy prices and the Japanese natural disaster are fading. While it is true that growth is slowing in the EM sphere, the deceleration seems to be rather gentle and the rate of price increases will gradually fall during the coming year. This will give EM central banks reasons to slow the pace of their monetary tightening as inflation slows. Cyclical sector activity in the OECD countries, which usually accounts for most of the decline in demand during recessions, is already running at low speed (especially in the US) and can hardly fall very much more. American households have already greatly lowered their debts, and the situation in the countrys banking and credit market is substantially better than in 2008. Corporate balance sheets and income statements remain strong. Profits a leading economic indicator usually fall substantially in the run-up to recessions, which is by no means the case today. In the US, the rate of profit increases peaked in late 2009. Historically, after a profit peak it usually takes more than four years before a recession begins. SEB estimates the risk of a recession in the OECD countries at 30 per cent, while a scenario of a renewed and more lasting acceleration in growth has a 15 per cent probability. Our main scenario which has a 55 per cent probability is that the coming year will be characterised by an economic slowdown, but not a recession.

economically vulnerable households


Slow economic upturns in the OECD countries, along with small labour market improvements, make households vulnerable to energy price increases. Such increases reduce their purchasing power income after inflation and taxes. This may be offset by tax cuts or expanded government subsidies, or by increases in household borrowing from banks. But during the prevailing upturn, the room for tax cuts is quite small and banks are very restrictive about lending. Thus, households have mainly squeezed or expanded their consumption like an accordion as energy prices have risen or fallen. Meanwhile their saving ambitions have been rather stable. Last but not least, major government financial problems have occasionally triggered financial market turmoil and falling share prices, darkening the mood among households and businesses as well as resulting in lower economic forecasts. Such vicious circles characterised the second quarter of 2010 and the summer of 2011. A fundamentally very slow economic upturn, coupled with a fluctuating growth rate, poses a risk that the upturn in the US and certain European countries may die out and a recession will thus follow.

automatic deceleration takes hold


In this context, the stall speed concept is vital. In the aviation sphere, it means that if an aircraft has slowed to a certain speed, it will automatically continue to lose speed and will finally crash. Translated to the economic sphere, if an economy has slowed to its stall speed, growth will gradually decelerate further and then finally turn into shrinking GDP the beginning of a recession. An analysis from the Federal Reserve (Jeremy Nalewaik, Forecasting Recessions Using Stall Speeds, April 14, 2011) about the US economy shows that when GDP growth has fallen a bit below 2 per cent (annualised), in nearly 50 per cent of cases since 1947 recessions have occurred within one year. In other G7 countries including Australia, the corresponding probabilities are smaller. During the second half of 2010, American GDP growth was about 2.5 per cent. During the first half of 2011 it decelerated to only 0.7 per cent. Judging from history, this signals a rather large risk of an impending recession. SEB nevertheless believes that the most likely trend is still a continued economic upturn in the US and the OECD countries as a whole, for several reasons:

Conclusions for financial investors: The economic upturn will continue but will slow during the coming year. The long-term trend for risk assets is still upward, but count on significantly slower growth in value than during the second half of 2009 and early 2010. The correlation between asset markets will be rather large, even well into the upturn. The wobbling growth rate pattern, with the accompanying abrupt expectations-driven ups and downs in markets, will give people reasons to follow their investments more actively and to diversify their assets in risk terms into various potential sources of returns not merely rely on the stock market. The role of outperforming region compared to world indices now seems to shift back and forth between the OECD and EM countries more often that previously. At this writing, this role is being held by the EM sphere.

Investment OutlOOk - sePtemBeR 2011

17

theme

A nearly empty economic policy toolkit


What will be the effects of the remaining economic policy tools? Where do we go from zero interest rate policies and synchronised global debt problems? Can the solution be found in unconventional monetary policy?
Before the global debt crisis broke out in 2007, governments, central banks and economists had underestimated the effects of the financial cycle on risk build-up, mainly in the Western world. They had also overestimated the growth dynamism and productivity of economies. Today economic policy makers face three main problems: 1) surplus capacity in the economy excessive unemployment in particular in the aftermath of global recession, 2) still-incomplete repairs to financial sector balance sheets and 3) necessary restructuring of sovereign and household debts. In Europe the situation is complicated by an unfinished economic and monetary union, which adds political problems.

Conventional and unconventional tools


The economic policy toolkit includes both conventional and unconventional ways of managing economic slowdowns. Fiscal policy can become more expansionary, either by means of automatic stabilisers (such as grants/expenditures that increase when growth slows) or discretionary decisions (active measures aimed at influencing the economic cycle). Monetary policy can help sustain economic growth; central banks lower their key interest rates (conventional monetary policy), or they expand or alter the structure of their balance sheets (unconventional policy). Under more normal economic conditions, the negative impact of a countrys fiscal tightening on growth is softened by a number of circumstances. Central banks usually have rather ample room to lower their key interest rates in order to stimulate consumption, capital spending and to some extent asset prices. A countrys currency is weakened as a result of this policy mix. A weaker currency, together with a global economy that is expected to show good growth, provides the export sector with an extra upward push.

11 10 9

3.00 2.75 2.50

Credit multiplier

8 7

USD trillion

2.25 2.00 1.75

a grOWing FeD baLanCe sHeet anD a sHrinking CreDit mULtipLier


The balance sheet of the US Federal Reserve is expected to swell further due to purchases of American government securities, but because of a weak credit multiplier the money supply in the economy is growing today by only one tenth of the corresponding expansion in the monetary base.

6 5 4 3 04

1.50 1.25 1.00 0.75

05

06

07

08

09

10

11

Federal Reserve balance sheet Credit multiplier (money supply/monetary base)

Source: Federal Reserve

18

Investment OutlOOk - sePtemBeR 2011

Theme: A nearly empty economic policy toolkit

Under prevailing conditions, with essentially zero interest rate policies in many countries and a global, synchronised debt problem in major Western economies, interest rates cannot be lowered and the global economy cannot help drive growth. Nor do currencies have room to weaken. In addition, a number of the worlds major economies have hard-pressed governments that are finding it difficult to push through their policies at home. Fiscal stimulus measures, for example in the form of direct aid to the neediest households and public sector investments, are the most effective tools for quickly reversing an economic slowdown and boosting growth. Given todays high government debt, there is naturally little chance of doing this. However, political leaders can increase their room for manoeuvre if new short-term stimulus packages are offset by tougher medium- and long-term cost-cutting, in order to avoid losing the confidence of the public and seeing the countrys credit rating downgraded by rating agencies. Announcements of future taxes on consumption, a step that for example the US is being urged to take, may also lead to higher growth in the near future if households accelerate consumption in order to avoid higher future prices. But the outcome of such a strategy is uncertain in light of already high government debts.

Other tools that remain at the Feds disposal are purchasing even more securities; so far its holdings of government securities have increased in two rounds by USD 300 billion and USD 600 billion. Purchases of government securities are continuing, however, as the Fed receives the proceeds of other maturing securities. The Feds target is for its total holdings of securities to remain stable at around USD 2.6 trillion. A new QE3 round will probably include purchases of US government securities totalling nearly USD 1 trillion. Additional options available to the Fed are to buy securities with longer maturities, offer long-term fixed interest loans, set and communicate a target figure for how much the monetary base should grow year-on-year, promise unlimited interventions at certain yield levels on government securities and weaken the dollar by purchasing foreign government securities.

Conventional monetary policy


For the Fed, the purpose of conventional monetary policy has changed character somewhat during the past 1-2 years. The need to bring down interest rates and/or improve the functioning of the credit market is no longer primary. Today US home mortgage rates are at their lowest in 50 years. The enormous growth of the monetary base also means that the fundamentals for lending and liquidity are already in place. However, due to a weak credit multiplier, the money supply in the economy is growing by only one tenth of monetary base expansion. This can probably be explained both by continued caution among banks and low credit demand in a weak economy. The Fed maintains that the effects of QE2 and other measures are equivalent to key interest rate cuts of 10-12 basis points, which (all else being equal) will boost growth and inflation and create about 700,000 news jobs during a two-year period. The element of surprise has been important in gaining a positive effect from QE1-QE2. Some observers maintain that their purpose is also to weaken the US dollar. This is wrong. Such a strategy would make the countrys chances of attracting about 40 per cent of the worlds total savings surplus more difficult and drive US interest rates higher. It would also encounter tough international criticism. The fact that a limited quantity of new dollars has left the system due to a weak credit multiplier also weakens that thesis, although psychological currency effects should not be underestimated.

Unconventional monetary policy


This is why central banks are now being given the heavy responsibility of using unconventional monetary policy to stimulate growth and avoid a new recession. The purpose of central banks unconventional monetary policy is to improve the functioning of the market and provide liquidity in order to strengthen the monetary policy transmission mechanism and thus the effectiveness of the interest rate weapon, stabilise inflation expectations at close to 2 per cent and reduce the risk of financial instability. To some extent, unconventional monetary policy may also be intended to stabilise the prices of assets, for example equities, during a certain period. The Federal Reserve (Fed) is the central bank that has gone furthest in applying unconventional monetary policy (quantitative easing or QE). In recent years, aside from lowering its key interest rate to essentially zero per cent, the US central bank has practiced expansionary monetary policy by letting the banks balance sheet grow by about 220 per cent and periodically also changing its structure. The Fed has done so, among other things, by purchasing mortgage and government securities (QE1 in November 2008 and March 2009 and QE2 in November 2010). In addition, the Fed has issued pledges to maintain its zero interest rate first for an extended period and most recently until a specified date: mid-2013.

Limited inflation risk and money supply growth


The disadvantages of unconventional monetary policy are not strong enough that central banks should abstain from using it. Of course zero interest rates and generous money supply can increase the risk of new financial imbalances. Low interest rates over a long period also mean a delay in balance sheet repairs in the financial sector and restructuring of government and household debt. In addition, the balance sheets of central banks become increasingly exposed to interest rate and credit

Investment OutlOOk - sePtemBeR 2011

19

Theme: A nearly empty economic policy toolkit

risk, as well as currency risk to the extent that these banks intervene in the foreign exchange market and build up large currency reserves. Central banks may also experience negative net interest income if the key rate rises, increasing the cost of the liquidityabsorbing operations that may become necessary while their holdings of securities generate low returns. Eventually winding down their gigantic portfolios will take time. If it sells securities before maturity, a central bank may also suffer capital losses. The risk of growing inflation pressure due to unconventional monetary policy is limited. The monetary expansion that has occurred so far has had a limited impact on money supply growth. This is explained by cautious lending and low demand for borrowing. Studies by the Bank for International Settlements (BIS) also confirm weak associations between changes in central bank balance sheets and money supply growth as well as inflation. The inflation risk is thus low. If the money supply should increase in an undesired way, central banks have the necessary tools for draining the banking system of surplus liquidity.

sibility of buying the government securities of crisis-hit countries, as the European Central Bank (ECB) is doing today. The ECBs purchases of government securities are market management tools and also inevitably a funding instrument for governments, even if the ECB acts only in secondary markets. Our conclusion is that the risk calculation that central banks make based on the above arguments should lead them to go ahead and maintain high activity when it comes to unconventional monetary policy, especially in a situation where there is limited manoeuvring room for fiscal policy. Finally: Within the framework of unconventional policy, but partly outside the remit of central banks, is the possibility of introducing various types of regulatory measures that imply direct monetary aid to various parts of the national economy. This tool is not only unconventional but also controversial. But we find ourselves in a world where the unique seems logical. For example, securities firms can be compelled to invest a certain percentage of their portfolios in various types of credit instruments (both government and private) and the interest rate can be set by regulatory authorities. Lending institutions can likewise be compelled to offer loans according to predetermined conditions to selected sectors of society all this to enable the world to return to a somewhat more normal state. ROBERT BERGQVIST

Limited fiscal policy manoeuvring room


Central banks undoubtedly have very large balance sheet capacities for implementing unconventional monetary policy, for example by purchasing securities. This also includes the pos-

Money supply determined by monetary base and credit multiplier Interest in the balance sheets of central banks has increased as more countries have chosen extraordinary measures in order to pursue unconventional monetary policy alongside traditional interest rate policy. Altering the structure and/or size of a central banks balance sheet affects the money supply in the economy. Ultimately, inflation may also be affected if the money supply exceeds the supply of goods. Put simply, the monetary base (MB) consists of two parts: the quantity of bank notes and coins in circulation plus the liquidity reserves that banks maintain with the central bank. The MB can be described as being the actual core element for creating money in an economy and is 100 per cent controlled by the central bank through its various market operations. But the money supply, or the available means of payment in an economy, is influenced not only by the economys need for

physical bank notes and coins, but also by how able and willing the banking system is to use its liquidity reserves with the central bank to expand deposits from and lending to the public. the credit multiplier (CM) measures how much money flows into the economy after the central bank has increased the MB, for example as one element in unconventional monetary policy. If the credit multiplier is 10, this means that if the central bank has taken steps to increase the liquidity reserves of the banking system by 100, the money supply in the economy increases by 1,000. The challenge that various central banks are facing today is that the CM is weak as a consequence of both weak demand for borrowing and caution on the part of banks. This means that the MB must increase by very large amounts to have the desired effect on the money supply. The CM will eventually normalise, leading to an increased money supply without a central bank changing the MB. In that situation, the central bank must reduce the MB in order not to increase the risk of future inflation. But the central bank has effective tools for this.

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Investment OutlOOk - sePtemBeR 2011

theme

Emerging markets The next generation


Emerging markets playing an ever-larger role in financial markets Rising consumption will provide extra fuel for economic growth Sensitive to declines in risk appetite
The four BRIC countries (Brazil, Russia, India and China) have become increasingly important players in the global financial arena. The financial crisis of recent years and the miserable government finances of many OECD countries have helped accelerate and reinforce the influence of the BRIC countries. There are many indications that in about 15 years, Chinas share of the world economy may be as large as that of the United States and that after another five years the BRIC countries, taken together, will catch up with the G7 countries. For some time, Brazil, India, and China have been tightening their economic policies to prevent overheating, with the aim of instead laying the groundwork for solid long-term development. China in particular is show signs that these efforts have a good chance of succeeding. In the emerging market (EM) sphere, however, there are other countries that somewhat overshadowed by the big four have made and are continuing to make major progress, both economically and structurally. They are sometimes called the Next 11, growth markets or frontier markets. At present they encompass some 30 countries (though the Next 11 obviously refers to eleven specific countries). Among their characteristics are greatly improved potential for growth, continued increases in share of global GDP and rising prosperity, especially increased consumption of goods higher up in the value chain (televisions, refrigerators, cars etc.). Some of these countries also have favourable demographics, with a large percentage of young people. This is positive both from a labour force and consumption standpoint. Let us take a brief look at some of the countries outside of the BRIC quartet in which we foresee extra opportunities.

Lots of muscles in asia


In Asia there are a number of countries that demonstrate good economic potential. South Korea is viewed by many observers as a developed country, not an EM country, since it is quite advanced in both its economic and structural development. Exports among them electronics, cars and chemicals are important to the countrys economy. This summers worries about the economy thus caused the Korean stock market to fall sharply early in August. However, the Korean economy is not overly sensitive to the global slowdown, since more than half of its exports go to EM countries. Domestic demand has accounted for an increasingly large share of GDP and is also showing continued strength. Vietnams economy has performed strongly in recent years, and in 2010 GDP grew by nearly 7 per cent. Among the forces that are driving this growth are stable domestic demand and good export momentum. Foreign direct investments have also successively increased. Due to rising wages in China, many companies are choosing to move production to other countries, including Vietnam. With its 230 million inhabitants, Indonesia is one of the most populous countries in Asia. Early this year, strong economic growth and a low budget deficit helped the country earn an upgrading of its credit rating from Moodys, the rating agency, and it is now just a tiny bit below Investment Grade status (BBB-), which is the threshold for Indonesia to be classified as a country with low credit risk. Stable domestic demand in the country serves as a buffer against increased global risks. Private consumption may strengthen further with the help of rising household income and a favourable demographic trend. Increased public sector spending for infrastructure and other development projects will also help bring about more direct investments. The balance between private consumption and capital spending is important, since one of the clear risks is rising inflation. The profit expectations for Indonesian companies are among the highest in the emerging market sphere.

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21

Theme: Emerging markets - The next generation

Latin america more than just brazil


After Brazil, Mexico is the largest economy in Latin America. The country is also the worlds eleventh largest economy. Since Mexico is one of the worlds largest oil exporters, the oil price situation is vital. About 80 per cent of Mexicos exports go to the United States, so US economic performance is important to Mexico. After a period of sluggish economic growth, the countrys prospects now look brighter, among other things due to greater foreign demand. Private consumption is still lagging, mainly because a relatively large percentage of the population are poor. For some time, President Felipe Caldern has been waging war against various drug cartels, which has led to increased violence in Mexico, but it has also resulted in some successes for the president in the battle against drugs. Two other interesting countries in Latin America are Peru and Chile. Peru is a large-scale exporter of silver, copper, gold and zinc. In recent years, Peru has made major development progress with high growth, low inflation, good macroeconomic stability, reduced foreign debt, budget surpluses and important social programmes. The country has also been upgraded to Investment Grade status. During four of the past ten years, the Peruvian stock market has been the best in Latin America. Recently the country elected a new president, Ollanta Humala. Before the election there was uncertainty as to whether he would change the direction of Perus economic policy if elected. After the election, Humala announced that he would like to improve income allocation, but he has underscored the importance of preserving growth and stability. This has calmed the market to some extent. Since its return to democracy in 1990, Chile has focused on promoting economic reforms, proactive social investments and open public administration. Its economy is now among the fastest growing in Latin America, very much thanks to strong domestic demand. The country has a large, welldiversified financial system compared to other countries in the region. The system is regarded as having solid regulation and oversight, as well as a capacity for resilience when faced by crises.

Other countries in the queue


Aside from the above-named markets, a number of other countries left the starting blocks some time ago and are dashing ahead at a fast pace in the economic development race. In Asia, Bangladesh with its 170 million inhabitants one of the worlds most densely populated countries as well as Pakistan (185 million inhabitants) are showing attractive economic development. Nigeria was once among the richest countries in Africa in terms of GDP per capita. The country is one of the worlds largest oil exporters, yet still poor since only a fraction of its oil income goes to the general population. In spite of this, Nigeria has shown strong GDP growth in recent years. There has been great political uncertainty in the country since democracy was reintroduced in 1999, however, which has so far caused some investors to be wary.

not without risks


Although the above-mentioned countries, and other emerging markets, appear attractive in the long term, there are a number of risks that must be taken into account, since they may adversely affect development: Rapid economic development will probably lead to inflation pressure, and inflation management may have undesired effects in various countries. Reduced risk appetite in financial markets such as we are experiencing right now may also lead to large capital outflows from these regions. These may squeeze their stock markets, which are small in a global perspective and thus sensitive to capital movements. There are also high hopes that companies in these countries will deliver good profits, and profit disappointments thus have large adverse effects. Another risk factor that must be highlighted is the political situation, which is far from stable in a number of EM countries. This risk is higher in countries with a large proportion of statecontrolled companies. Finally, it should be pointed out that fears regarding continuity and possible political upheavals in these countries have diminished in the past 20-30 years.

South Korea

United States

Western Europe

Vietnam

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Investment OutlOOk - sePtemBeR 2011

Indonesia

Nigeria

Mexico

Japan

50 45 40 35 30 25 20 15 10 5 0

Median age in years

Source: Goldman Sachs

yOUng pOpULatiOn in many em COUntries


The chart shows the median age in a number of countries and in Western Europe. Many emerging market countries have relatively young populations.

equities

Low valuations coupled with greater risk


Equities have fallen sharply from already low price levels Are global growth and current risks correctly priced? Valuations are approaching 10-year lows
What a diffrence a week makes. A paraphrase of rhythm and blues singer Dinah Washingtons Grammy-winning 1959 title is what springs to mind when trying to describe financial markets in early August this year. Having already priced in mixed economic indicators and troubling bond yields in southern Europe, markets suddenly reacted dramatically to what they had in fact been witnessing for well over a year: Growing debt, and the struggle to reduce it without jeopardising future growth in most Western nations. During the first eight trading days of August the S&P 500 index fell 13 per cent and the Nordic VINX30 lost 17 per cent. Markets were not impressed by the summers dismal political battle in Washington over the debt ceiling and the federal budget culminating in S&Ps downgrading of its US sovereign credit rating. Having previously viewed Greece, Ireland and Portugal as the main examples of indebted nations facing acute challenges, they began focusing on the widening credit spreads in Italy and Spain, until the European Central Bank (ECB) finally revealed itself on the buy side of bonds issued by the two latter nations. Markets then shifted to rumours of a downgrading of French debt and sold down European, especially French banks quite dramatically (equities and corporate bonds). Meanwhile revised data revealed that growth in both US and the euro zone during the first half of 2011 had been much lower than previously thought. Future indicators such as the Philadelphia Federal Reserve business outlook survey started pointing at a deteriorating growth picture from already weak levels. Hence the R word (Recession) has once again entered our daily vocabulary. Todays investors have the events of 2008 fresh in mind, and increasing worries that we might be heading for another systemic crisis driven by a liquidity squeeze have found some footing in the market. Equity markets tumbled (see chart) as a consequence of all of the above factors, and further dramatic movements may have occurred between this writing in late August and the date when you read the article. vOLatiLe perFOrmanCe sO Far tHis year
110 110

100

100

90

90

80

80

Source: Factset
70
2011

70 Jan Feb Mar Apr May Jun Jul


Aug 2011

Euro STOXX Fixed China Fixed OMX Copenhagen (DK) India BSE30 Sensex Fixed

S&P 500 Index Fixed OMX Stockholm 30 Norway OSE Benchmark Russia Fixed

World stock markets (index 100 = January 1, 2011) have been wobbly, to say the least. Since July they have lost 15-20 per cent. The US market has done best, while the OMX Copenhagen has performed worst.

Looking at equity performance in different global regions and markets, it is fair to conclude that the current downturn has hit all major stock markets. In the broad US indices, all of the Nordic exchanges and most emerging market (EM) exchanges, we are seeing downturns of 15-25 per cent. There have also been big downturns for other asset classes. Hence we can fairly assume that investor behaviour is largely related to fear of a slowdown in global growth. This applies to some regions more than others. GDP growth is indeed decelerating. Both the euro zone and the US are already in a slower growth scenario. In major Asian emerging economies, which have served as the main engine of global economic expansion, the number one risk factor for

Investment OutlOOk - sePtemBeR 2011

23

Equities

reduced GDP growth until this summer was economic policy tightening aimed at fighting inflation and economic overheating. This risk has now decreased notably.

two key questions


Coordinated policy interventions might initiate a rebound from fairly depressed current levels, but data that demonstrates growth in the real economy is needed in order to ease underlying risk aversion and bring riskier assets such as equities back into positive year-to-date territory. Two questions therefore remain: 1. Going forward, what will global growth be? 2. How much global growth is priced into the market at current asset prices? It is very important to keep both questions in mind when assessing the composition of investment portfolios. Fears of slower global GDP growth seem sensible in the current economic climate, but it is quite another thing to make changes in your portfolio based on these assumptions alone. Before making portfolio decisions, it is necessary to find out what investors as a group expect future GDP growth to be. And how much growth is priced into the current market? So let us try to answer these questions, starting with the first one. What will global growth be, going forward? It is fair to assume that the answer lies somewhere between AC/DCs legendary rock song "Highway to Hell" (released in 1979), indicating a full- fledged recession, and the more mellow "Bridge Over Troubled Waters" by Simon & Garfunkel (released in 1969), indicating a milder scenario.

Both are great pieces of music, but they leave you in quite different moods. Leading economists foresee global GDP growth of around 3.5 per cent in 2011 and 2012. This estimate seems a lot closer to our friends Simon & Garfunkel than to the gloomier members of AC/DC. Moving on to the second question: How much global growth is priced into the market at current levels? The higher the answer to this question, the riskier equity investments are likely to be. At this point we introduce a simple model showing the trend of equities and earnings in relation to the S&P 500 index during post-war recessions. The model describes the relationship between lower earnings and share price movements during recessions. It also compares valuations in US equity markets to US bond yields during recessions. The latter provides an indication of how pricy equities are, as opposed to an alternative 10-year bond. The difference between the yields on equities and bonds in the current situation seems to give a solid advantage to equities. Although equities have much lower valuations this time around than during the downturns of 2001 and 2008, a lot of this advantage is due to low current bond yields. In trying to define how much of a recession the stock market has already discounted, a simple approach would be to divide the current market decline of 18 per cent by the average decline of 26 per cent during a recession. The market is currently pricing in a 69 per cent probability of an average recession scenario.

Final year of downturn


1949 1953 1957 1960 1970 1974 1980 1982 1990 2001 2009 average Current

Highest valuation, p/e ratio*


9.0 11.0 14.1 17.5 18.5 18.1 7.6 9.2 17.0 28.0 21.0 15.5 15.5

inverted p/e ratio (e/p)


11.1 9.1 7.1 5.7 5.4 5.5 13.2 10.9 5.9 3.6 4.8 7.5% 6.5%

10-year govt bond 2.5% 2.7% 3.8% 4.4% 5.6% 6.6% 12.5% 12.6% 8.5% 5.8% 4.2% 6.3% 2.2%

Fed model** 8.6% 6.4% 3.3% 1.3% -0.2% -1.1% 0.7% -1.7% -2.6% -2.2% 0.6% 1.2% 4.3%

Share price downturn -17.0% -11.0% -17.0% -13.0% -34.0% -46.0% -15.0% -27.0% -16.0% -37.0% -56.0% -26% -18%

Earnings downturn -3% -12% -22% -12% -13% -15% -5% -19% -26% -23% -45% -18%

* Moving earnings per share. ** Fed model = Inverted P/E ratio minus 10-year government bond yield. The Fed model shows underlying value in the stock market vs. the bond market.

Source: Factset, Yale, SEB

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Investment OutlOOk - sePtemBeR 2011

Equities

Bringing the decline in earnings into the equation, one could argue that since average earnings in a recession decline by 18 per cent and average share prices fall by 26 per cent, then 69 per cent of the share price reaction could be explained through the fall in earnings. With stock prices currently down 18 per cent from their peak, we can deduce that markets expect an earnings downgrade of 12.5 per cent (18 per cent X 0.69). In calculating what global GDP growth scenario an earnings downgrade of 12.5 per cent implies, it is useful to look at the correlation between GDP growth and earnings. gDp anD earnings grOWtH gO HanD in HanD
y = 0.0377x + 3.1034 R = 0.4598
2

Looking at valuations in relation to both price/earnings ratios (while fully aware that earnings will be revised downward) and price/book ratios, we find that the current pricing relationships are close to 10-year historical lows. This is in strong contrast to the pricing scenario of the previous two major equity market downturns in 2001 and 2008. We therefore believe there is good value in current equity market pricing. Attractive valuations alone may not lure investors back to the marketplace, but they have certainly proved a good factor in attempting to identify underlying risk throughout history. Uncertainty has definitely increased since early August. It is very challenging to analyse the current market situation, but no matter how much intraday volatility we continue to face, our approach will always be fundamentally based on valuations. It is not the time for big sudden moves rather cautious observations are warranted during the coming weeks and months.

6 5 4 3

GDP Growth

2 1 0
Source: SEB Enskilda

-40

-20

-1

20

40

60

All dramatic market reactions create new opportunities. What these opportunities will be this time around is too early to tell. attraCtive ameriCan vaLUatiOns...
45 40 35 30 25 20 2 200 2 000 1 800 1 600

Change in operating income

The measurement points show the change in global GDP compared to the change in operating income at 118 Nordic large cap companies. According to historical observation, global GDP growth of just above 3 per cent is required to generate growth in the operating income of these companies.

Source: Factset

1 400 1 200 1 000 800 600

The correlation indicates that assuming GDP growth of 3.1 per cent, earnings revisions can be expected to be neutral (0). An earnings downgrade of 12.5 per cent (the current market expectations according to our above calculation) corresponds to world GDP growth of 2.6 per cent. It should be noted that the SEB Enskilda model only refers to earnings in the Nordic countries, while the previous chart is based on US historical figures. Nonetheless, applied together, they provide us with a good indication of the answer to question number two. Combining the answers to our two questions it is fair to assume that, at current levels, stock markets are pricing in a more negative global scenario than economists anticipate. This scenario may not be exactly 2.6 per cent GDP growth, but it is certainly much lower than the 3.5-4.0 per cent consensus among economists. The market is definitely not pricing in a full fledged global recession, but this exercise should provide some comfort as to what expectations current market valuations imply. We will have to wait for further economic data before we see the final outcome of this saga. Whether or not the average investor, as opposed to the average economist, leans towards AC/DC or Simon & Garfunkel will therefore remain an open question.

15 10 5

2009

2010

1996

1997

2001

2005

1998

1999

2000

2002

2003

2004

2006

P/E ratio 12 months ahead


Price

P/E 12 months ahead P/B

...anD attraCtive eUrOpean Ones


35 30 25 700 600 500

2007

20 15 10 5

2008

Source: Factset
400 300 200 100

2001

2002

2003

1996

1997

1998

1999

2000

2004

2005

2006

2008

2009

2007

Price

P/E 12 months ahead

P/B 12 months ahead P/B

The charts illustrate prices and expected valuations for Americas S&P 500 index in USD and Europes Stoxx in EUR. Compared to the stock market declines of 2001 and 2008, todays share price valuations appear attractive.

Investment OutlOOk - sePtemBeR 2011

2010

2011

2011

25

Fixed income

High Yield well-positioned once the fog lifts


This summers debt and economic worries have hurt risk assets... ...paving the way for historically low yields and more monetary stimulus Once the economic outlook becomes clearer, High Yield will benefit
The summer of 2011 was anything but peaceful in the fixed income market. The market was dominated by the European sovereign debt saga, lengthy budget negotiations in the United States, signs of economic slowdown in most industrialised countries and risks of overheating and economic hard landings in parts of the emerging market (EM) sphere. But whereas share prices fell steeply in July as a result of these mounting problems, the trend in corporate bond markets was still positive on both sides of the Atlantic. In July, some progress was gradually achieved in managing the sovereign financial problems in Europe. Budget discussions in Washington resulted in a negotiated compromise just before federal finances were about to hit the debt ceiling on August 2, yet we saw a dramatic stock market slide in early August. After a few days the High Yield market also suffered a clear decline in prices as risk appetite fell appreciably. Meanwhile investors fled to what they perceived as safe assets, causing the prices of government securities to rise (and their yields to fall). This was also true in the US, despite Standard & Poors downgrading of the countrys credit rating on August 5. The main reasons for the financial market drama during part of August were heightened concerns about the economic outlook, with accompanying downward revisions in growth forecasts, as well as continued worries about European sovereign debts and their management. Risks in the EM sphere, however, were perceived as having decreased somewhat. Reactions from central banks were not long in coming. After its August 9 Federal Open Market Committee meeting, the Federal Reserve announced that its key interest rate was likely to remain exceptionally low at least until mid- 2013. Its previous wording on this issue was for an extended period. The Fed also hinted that it was prepared to launch further rounds of quantitative easing if the risk of a US recession should increase. The European Central Bank (ECB) resumed purchases of government bonds issued by such countries as Portugal and Ireland. The ECB also began buying Italian and Spanish government bonds. Among smaller central banks, those in Norway and South Korea abstained from widely predicted key rate hikes also obviously in response to the market drama. Let us assume 1) a downshift in global growth during 2012, mainly caused by a weaker growth dynamic in sizeable portions of the OECD industrialised countries, and 2) prospects of substantially lower inflation, once the effects of earlier commodity price increases disappear from the statistics next year. In that case, there is reason to expect that the period of ultraloose monetary policy in the OECD countries will be lengthier than we had previously predicted and that further monetary stimulus measures will be launched. UnpreCeDenteD stimULUs by tHe FeDeraL reserve
3.00 2.75 2.50 2.25 2.00 8 7 6 5 4

USD trillion

1.50 1.25 1.00 0.75 0.50 2003 2004 2005 2006 2007 2008 2009 2010 2011

2 1 0 -1 -2

Fed balance sheet

Federal funds rate


Source: Reuters EcoWin

The US Federal Reserve has launched two main rounds of quantitative easing to help sustain the financial system and the economy. The Feds key interest rate is close to zero, and massive bond purchases have swelled the banks balance sheet.

Major central banks the Fed, ECB, Bank of England (BoE) and Bank of Japan (BoJ) are now expected to let their key

26

Investment OutlOOk - sePtemBeR 2011

Per cent

1.75

Fixed income

interest rates remain historically low until the end of 2013 or longer. Both the Fed and the BoE will also probably launch new quantitative easing by purchasing more government bonds. In the Feds case this will perhaps be in the range of USD 1 trillion (the previous round, QE2, totalled USD 600 million). In the BoEs case, new purchases may total around GBP 50 billion; the ceiling on such purchases had remained unchanged at GBP 200 million for some time. Meanwhile the ECB will probably continue to buy government bonds issued by financially weak euro zone countries. The BoJ may well expand its loan facility for companies and its programme for purchases of financial assets; these currently total JPY 15 trillion. Such monetary policy strategies by influential central banks, along with a lower inflation rate, will favour government bonds in the largest OECD countries. Thus, in itself, this indicates that yields on such bonds will remain very low. But there is also another side to the story, including very large public sector financial needs even taking into account possible actions by central banks and prospects of somewhat better risk appetite once the economic outlook becomes clearer. This might lead to some reallocation from government bonds towards traditional risk assets: equities, corporate bonds etc. If the latter occurs, it will lead to somewhat higher yields (lower prices) for government bonds.

2003 and autumn 2008-summer 2009. During both of these periods, corporate balance sheets weakened, and the second included the Lehman Brothers crash (September 15, 2008) followed by an unprecedented financial and economic crisis. In other words, the current situation among these companies is much better than it was then. A yield gap of more than 6 percentage points indicates that the market is pricing in a 7 per cent bankruptcy rate among the highest rated HY-issuing companies. This can be compared with the latest bankruptcy statistic, about 2.5 per cent (12-month figure) and forecasts from the rating agency Moodys and others of about 2 per cent at the end of 2011. This is an indication that todays yield spread may well shrink significantly. If the lower figure in the yield spread government bond yields is fairly stable or rises only slightly, this points towards price increases for HY bonds. We are assuming that the yield on such bonds will fall more than government bond yields rise, which seems likely.

risk appetite will determine High yield performance


What ultimately determines how HY bond investments like other risk assets will perform is risk appetite, which depends on the economic outlook. This is uncertain, but once the fog lifts our crystal ball reveals a scenario in which global growth slows noticeably in the coming year, yet keeps growing at a decent pace and accelerates in 2013. We thus believe that severe government financial problems will not abort the economic upturn, although investors will have to expect these problems to have a definite decelerating effect on growth for a long time and to continue occasionally causing significant market worries. Hy mOre attraCtive aFter WiDer yieLD gap
2250 2000 1750 1500 2250 2000 1750 1500 1250 1000 750 500 250 2000 2002 2004 2006 2008 2010
Source: Reuters EcoWin

Continued focus on High yield


Despite the financial market drama during the late summer, we have essentially chosen to retain our exposure to corporate bonds, with a focus on the High Yield (HY) segment. Among key factors determining how the value of High Yield bonds will change in the future are: 1) the health of each company in terms of balance sheets and income statements, 2) the yield gap (spread) between corporate and government bonds and 3) the general risk appetite among investors. The health of companies mainly in the US is still very good, as reflected in their earnings reports for the second quarter. Especially important among companies that issue HY bonds is the trend towards reduced debt (better equity/asset ratios) and a growing share of cash in their balance sheets. These companies have also extended the duration of their bond portfolios, which means their need for financing has been postponed significantly. The risk that financial distress might lead to corporate bankruptcies has thus diminished.

Basis points

1250 1000 750 500 250 0 1996

Worries have widened yield gaps


This summers large-scale economic and financial worries have caused yield gaps between corporate and government bonds to widen. For example, in the BB/B segment in the US which consists of highly rated HY bonds the gap increased to more than 6 percentage points in August. Since the year 2000 this has only occurred on two occasions: autumn 2002-spring

Yield gap between High Yield bonds and US Treasury bonds

Due to dramatically escalating market worries in August, with the accompanying flight from risk assets to government bonds, yield gaps between US High Yield bonds and Treasury bonds have widened greatly. Given more predictable and decent economic prospects, the yields on HY bonds are likely to fall again, with rising market prices as a consequence.

Investment OutlOOk - sePtemBeR 2011

27

Hedge funds

Prepared for an economic slowdown


The actions of political leaders and central bank governors on both sides of the Atlantic will determine risk appetite Strategies based on fundamentals are at a disadvantage Revenge for CTA and Global Macro/ Trading
Since the last issue of Investment Outlook (June 2011), hedge fund performance has been weak. Measured as the HFRX Global Hedge Fund Index in EUR, this asset class lost 2.5 per cent during the second quarter of 2011. Because of recent market turbulence, bottom-up analyses based on fundamentals are falling short. Assessments have been based more on interpretations of macroeconomic statistics and major political moves. Whether the focus has been on the debt problems of Europe and the US, inflation fears in China or especially general worries about American macro statistics, the result has been violent fluctuations in risk appetite. This is making life easier for some hedge funds and significantly more challenging for others. Below we have chosen to divide the hedge fund market into four main strategies: Equity Long/Short Relative Value Event Driven and Distressed Macro and Trading What these strategies have in common is that the shaky market climate has generally led hedge fund managers to balance their portfolios. These actions are aimed at improving their preparedness for an economic slowdown (in the worst case, a new recession). Volatility is historically high and will probably remain high in the foreseeable future. Managers are thus likely to reduce their total exposure, then gradually increase it as volatility falls again. Such a procedure carries the risk of missing out on a considerable proportion of the upturn once analysis based on fundamentals begins to work again. In Equity L/S, sub-strategies whose managers act quickly in response to short-term market movements (trading) are likely to do relatively well, though at the moment they are somewhat hampered by low trading volume (common during summer months and at times of great turbulence, a wait-and-see market). We have a cautious attitude towards Equity Long/Short and believe that strategies focusing on the fixed income market have better potential during the coming quarter.

relative value
Relative Value managers in fixed income performed somewhat better than their equity-oriented colleagues in the second quarter, since worries about the global macro scenario did not affect sentiment in corporate bond markets until June. In June, large outflows and lower issues of new bonds hurt the High Yield segment, resulting in major sell-offs. Those managers who acted quickly in response to short-term market movements were nevertheless able to benefit from the flight to safer government securities and thus performed better than more long-term-oriented managers. Meanwhile we reached the end of Americas QE2 stimulus package, removing a large buy-side player in US financial markets. This withdrawal will create disruptions in liquidity and in flows, which Relative Value managers can take advantage of. Many observers believe that the recession risk in the OECD countries is 50 per cent (SEBs estimate is 30 per cent). If these more pessimistic market players should prove correct in their forecasts, strategies with a degree of built-in protection will probably benefit. For example, such protection consists of rising effective yields, which act as a buffer against a possible continued decline in bond prices.

equity Long/short
The worlds stock markets have had a tough time recently. In Equity Long/Short, managers (most of them with long positions in equities) have turned in a weak performance: -5.4 per cent during the second quarter.

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Investment OutlOOk - sePtemBeR 2011

Hedge funds

For the Credit Long/Short sub-strategy, major fluctuations in market risk appetite create opportunities to identify undervalued fixed income securities that are undeservedly pulled into downturns that are more or less caused by poorer liquidity. Speculation about further quantitative easing measures from the Federal Reserve (and possibly from other central banks) is propping up volume at a somewhat artificial level, and thus the opportunity to find fixed income securities that are suitable short-sale candidates. The risk-adjusted returns of these strategies should be capable of surpassing risk-free interest in the coming quarters. We prefer Relative Value to Equity Long/Short and are cautiously positive towards this strategy during the next quarter.

Macro/Trading strategies in the fixed income area, which have not delivered good earnings this year either, succeeded in turning around this trend and showing double-digit positive earnings this summer until early August. However, the choice of manager is still a crucial factor, even if we choose the right strategy. Todays market climate has a little wait-and-see feeling. As the phase that we are in matures, managers are preparing to act. The most proficient, experienced managers will probably make more correct impact assessments of major political moves and benefit from the violent fluctuations in risk appetite and asset prices that these events may lead to. CTA has shown tendencies similar to Macro/Trading. Over a two-year period, many managers have shown zero earnings, but during the worst turbulence in July and August, this strategy delivered earnings equivalent to our return ambition for 12 months. There have been large movements in currencies, commodities, equities and bonds, and some managers have occasionally held aggressive positions. We have witnessed significant portfolio turnover aimed at balancing assets. Holdings of bonds as well as short-term securities (such as Treasury bills) have been built up. Equity positions have been reduced, and in some cases even shorted. Commodities remain in portfolios but no longer have the same clear focus on energy. Currency positions in portfolios have not changed to any great extent, but remain focused on emerging market and commodity-producer currencies plus short USD positions. On the whole, this results in more balanced portfolios and better potential to navigate through still-volatile, uncertain markets. Macro and Trading are our first choices among hedge fund strategies in the near future.

event Driven and Distressed


Event Driven strategies such as Merger Arbitrage and Broad Event Driven had a tough second quarter. The number of acquisitions and mergers decreased, even companies still have large cash reserves and generally healthy balance sheets. The cost of capital remains at comfortable levels, and in some sectors such as pharmaceuticals it will thus be possible for consolidation to continue. But in our assessment, poorer risk appetite in the market will adversely affect the number of deals, and managers will probably reduce their total exposure. Because of continued low interest rates, forecasts defaults on American loans and corporate bonds will remain below 2 per cent until 2013. Distressed strategies will thus focus on very few, complex situations that require high specialised knowledge (and are often very time-consuming). The returns are there for those with patience, but liquidity and trading cycles may be difficult for many investors to manage. Event Driven and Distressed are not strategies we recommend at present.

Conclusion:
Compared to 2008-2009, hedge funds are generally in a much more stable situation, with substantially better portfolio balance and preparedness to face an economic slowdown (or at worst, a new recession). Solutions to the unusually large sovereign debt problems must be devised. This may naturally lead to weaker global GDP growth, but for high-quality hedge funds, the outcome is likely to be business as usual.

macro and trading


Global Macro strategies have generally found it difficult to deliver good earnings throughout 2011, but there are major differences between managers and their specific working areas. Some earned good money on the April rebound but failed to take profits before the turbulence of May and June.
STRATEGY INDEX

PERFORMANCE % Jul-Aug Q2 -2.51 -5.42 0.09 -0.95 -3.56 2011 YTD (Aug 26) -6.18 -15.19 -2.51 -3.89 -0.93 2010 5.19 8.92 7.65 1.98 -1.73

global Hedge equity Hedge relative value event Driven macro

HFrX global Hedge Fund HFrX equity Hedge HFrX relative value arbitrage HFrX event Driven HFrX macro

-4.15 -7.49 -3.85 -5.26 1.24

Investment OutlOOk - sePtemBeR 2011

29

real estate

Demand for quality in troubled times


North America is behind the surge in activity, but subdued risk appetite is slowing the global growth rate The search for assets that pay returns is benefiting primary markets Given continued market turbulence, recent market trends are likely to persist
As in other financial markets, recent turbulence has adversely affected the real estate market even though it has shown good resilience in relative terms. Partly due to delays in major business deals, however, the number of large transactions fell sharply during the second quarter. This must be viewed as the main reason why the rate of growth in activity has recently begun to fall. Aside from uncertainty about the world economy, prevailing foreign exchange market volatility is now creating friction in the real estate market. Put differently, one major consequence is that it is taking longer to close large business deals, since investor enthusiasm has cooled.

the markets yield requirements are stabilising


Current yield stabilised in all markets during the second quarter. If we break down yield into its two main components, capital growth and rental income, it is clear that the rental market is showing continued high activity in Asia and Latin America, but significantly lower activity in Europe and especially in the US. Overall, rent levels seem to be stabilising both in the US and in parts of Europe, with rental levels in primary markets climbing. In financially weak European countries, however, there are continuing problems. Meanwhile rent levels keep rising in Asia, due to strong demand in the region. As for capital growth, today it is best in Asia as well as in primary markets in Europe and the US.

north america lifting market activity


According to Jones Lang Lasalles latest quarterly report on the real estate market, the second quarter showed growth in the global volume of direct property investment transactions in the commercial market. This was true both year-on-year and quarter-on-quarter. The engine of this growth in activity was clearly the lagging recovery we are seeing in North America, with US volume nearly doubling compared to the preceding quarter.

100 90 80 70
USD billion

60 50 40 30 20 10 0
Source: Jones Lang Lasalle

sHarpLy HigHer interest in COmmerCiaL prOperties in nOrtH ameriCa


The volume of direct investments transactions related to commercial properties rose 82 per cent in the United States and a full 206 per cent in Canada during the second quarter, but the global growth rate is slowing.

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Investment OutlOOk - sePtemBeR 2011

2007 Q1 2007 Q2 2007 Q3 2007 Q4 2008 Q1 2008 Q2 2008 Q3 2008 Q4 2009 Q1 2009 Q2 2009 Q3 2009 Q4 2010 Q1 2010 Q2 2010 Q3 2010 Q4 2011 Q1 2011 Q2
Americas EMEA Asia Pacific

Real estate

Waiting for a better outlook


In the wake of the recent global stock market slide, the indirect real estate market (listed real estate companies) has fallen just as sharply. The EPRA/NAREIT global price index illustrates the trend in this sector. As in the broader stock market, during late summer nearly two thirds of the positive growth we have seen in the past year was wiped out. Given todays valuation, relatively large discounts on net asset value (NAV) and in many cases attractive direct yields, we view this sector as being of long-term interest from an investment standpoint. But a deteriorating market outlook will probably keep investors away until the prevailing market turbulence has subsided. maJOr DeCLine FOr ListeD reaL estate COmpanies

to continue delaying major transactions, but the fact that these deals are taking longer but are not being cancelled indicates that uncertainty will not necessary interrupt the positive trend we are experiencing in the real estate market.

the future outlook remains positive


If we look a bit further ahead, past the current market turbulence, various positive factors favour real estate as an asset class. Markets with decent economic growth and a pronounced supply shortage among them parts of Europe, Asia and core US regions should be capable of showing continued good growth in rent levels. Japans recovery phase and the countrys cyclical lag due to the natural disaster in March should fuel the market. We are also seeing that large emerging markets such as China seem to be coping well with a period of economic policy tightening without showing tendencies towards the hard landing that was previously feared. Generally speaking, stable yield requirements in the real estate market are followed by rising capital value in line with rent levels. But as we have stated in earlier editions of Investment Outlook, the second phase in the real estate cycle is dependent on growth and prosperity in the broader economy. This implies that good economic growth is essential if phase two is to continue unfolding. If it should turn out that the economy is already declining, we will have to revise our current view, but we are not there yet.

Per cent

Oct
EPRA/NAREIT [perf %] MSCI [perf %] Source: Reuters EcoWin

From peak to trough, during July and August the world index for listed property companies fell nearly 20 per cent. This meant that nearly two thirds of gains during the past year were wiped out.

The prevailing market turbulence is leading us to be somewhat cautious about this asset class in the immediate future. Looking a bit further ahead, however, we remain positive towards investments in the global real estate market.

investors risk aversion favouring quality properties


Because of recent volatility in the fixed income market, institutional investors have sought alternatives in the real estate market. Given the debt problems in parts of the Western world and the risk of economic overheating in some emerging market regions, this heightened risk aversion has had a positive impact on quality properties. In primary markets in the United States, the United Kingdom, Germany, France and Japan, demand for trophy properties is driving up prices to the levels we saw before the 2008 crash. Investors seem to be fleeing risky markets and putting their money into what they regard as safe harbours. This has driven prices so high that in some places, yields hardly exceed inflation.

Current trends will persist


Worries about world economic developments will probably persist in the near future, and markets will remain shaky. Having said this, we can expect the current trend to remain in place at least in a short-term perspective. Investors search for assets with good yields should continue to benefit trophy properties. Primary markets will be more attractive than secondary ones. Increased risk aversion among investors is likely

Investment OutlOOk - sePtemBeR 2011

31

private equity

Depressed values due to uncertainty


Materialising risks, debt problems and worries about growth are depressing values of PE companies Companies are again trading at big discounts, with a lot of worries priced in Their dependence on stability is obvious along with their potential if the picture normalises
In the last Investment Outlook (June 2011), we painted a fundamentally bright picture for private equity (PE), with a favourable economic situation and partly as a result of this prospects for rising PE company values. We also pointed out that there are risks in the form of weaker-than-expected economic growth and renewed financial turmoil. These risks have dominated the scene recently in a way that has triggered declines in the value of virtually all risk assets, not least private equity. Since PE can be simply described as (usually) leveraged investments in unlisted companies, the sensitivity of PE companies to both an uncertain economic outlook and a shaky financial market is greater than that of the broad stock market. This is especially true in a slightly shorter perspective. Looking further ahead, it is possible to argue that the potential for PE companies to carry out active ownership can generate value even in situations where economic growth does not provide so much help. transactions has again dried up and uncertainty has dominated the market. On the other hand, the funding situation looks stable, at least for the time being, but continued instability in financial markets risks changing that picture quickly. After the recent decline in share prices, PE companies are now trading for significant discounts to net asset value (NAV). From levels of just over 20 per cent, discounts now average more than 35 per cent. A number of well-run PE companies are trading for nearly 50 per cent discounts. In itself, it is natural for these discounts to increase. Most observers are now adjusting their growth forecasts downward, and so are we. This will probably lead to lower earnings forecasts, which will affect valuation models. One of the crucial parameters in calculating NAV is also what valuation multiple to assign to earnings forecasts. These multiples are now likely to be adjusted downward, too, thus also pulling down valuations. There is a clear and rather obvious correlation between falling NAV and falling share prices, but historical studies show that beta responsiveness to market swings varies sharply. At the bottom of the 2009 crash, the discount was more than 70 per cent, so there is still plenty of potential downside if the situation gets worse. On the other hand, over the past two years PE companies have not only seen shrinking discounts but also sharply rising NAV, among other things due to successful divestments of companies and the rising value of listed holdings. This has greatly strengthened the financial situation of PE companies. Today most such companies have net cash positions and good capacity to handle their obligations.

Depending on stable finances


PE companies are indeed more dependent on a stable financial world, for two different reasons. Aside from their greater need for external funding, PE companies are also dependent on a functioning exit market: opportunities to sell their portfolio companies onward, either by launching them on the stock exchange, selling to a player in the same industry as the company being divested or selling to another PE company. During the deep 2008/2009 slump, this market froze solid, then gradually thawed out in 2010. The last market players to come back to life, in practice early this year, were industrial buyers. Amid the monumental uncertainty of recent weeks, the flow of

Listed companies have taken a beating


An easy and liquid way of investing in PE is to buy listed PE companies or a fund that invests in such companies. The SEB Listed Private Equity Fund invests most of its capital in traditional PE companies and funds, but also has some of its assets invested in management companies as well as a small proportion in listed companies owned by PE companies. Management companies (KKR and Blackstone are two of the better known ones) are companies that own and run PE funds or portfolios and earn their money on management fees and performance fees compensation in connection with suc-

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Private equity

cessful divestments. These are among the companies that have taken the biggest beating during the recent downturn. They are now priced in a way that they will essentially receive no more performance fees. In other words, they will never be able to sell a portfolio company at a profit. There is naturally room here for upward revaluations in a more stable market. Yet assuming that the world economy will still grow decently during the next few years, reasonable earnings growth should be included in forecasts. It is also important to point out that portfolio businesses owned by PE companies were more resilient than expected in the last recession, thanks to active ownership. Given todays discounts, in our opinion the market has more than priced in slower growth. If todays growth forecasts prove correct, PE companies generally appear attractively valued. In addition, if the funding situation does not deteriorate, in the future PE companies will have access to both cheap funding and investable capital for acquisitions, in a market where prices appear attractive. In the best of worlds, this would create the potential for rising NAV, even if underlying

growth is sluggish. Combined with shrinking discounts, this might result in significant value increases for PE companies, with rising share prices as a consequence.

Worries keeping values down


However, it seems too optimistic to fully discount this bright scenario. As long as there is lingering uncertainty about both the economy and financial stability, the PE sector is among the riskier investment alternatives. At present, PE investments are comparable to investments in listed financial sector companies such as banks. Given this choice, however, we prefer PE companies, thanks to their potential to generate value via active ownership and attractive valuations. And as soon as the economic situation turns brighter and financial markets stabilise, PE has the potential to be among the winners. In the short term, some caution should be observed. There is an obvious risk that things will get worse before they get better.

200 180 160 140 120 100 80 60 40 20 0


2005 2006 2007 2008 2009 2010 2011

pe Like tHe FinanCiaL seCtOr, bUt better


PE companies tend to fluctuate more than the stock market generally. Their behaviour is reminiscent of companies in the financial sector, presumably because they are highly dependent on both funding and a functioning financial market. At present, however, we foresee greater potential for PE companies to generate value, even if economic growth is subdued. Low valuations and good opportunities for generating value in portfolio companies make this asset class attractive, provided that a recession can be avoided.

Source: Reuters EcoWin

World, MSCI, Index, Open, USD World, LPX, LPX 50 Index, Total Return, Close, USD World, Standard & Poors, Global 1200 Sector, Financials, Index, Total

Investment OutlOOk - sePtemBeR 2011

33

Commodities

Supply squeeze will keep prices up


Lower growth forecasts are restraining commodity prices Risk of weather disruptions in agriculture, supply squeeze on base metals and oil producers will keep prices up If our growth scenario holds up, so will commodity prices
Despite the recent drama in financial markets and substantial write-downs of growth forecasts, commodity prices have held up rather well. Granted that we have seen some downturns for certain agricultural commodities and metals, but given international developments these modest downturns must be regarded as signs of strength. As for future price trends, the economic growth trend will naturally play an important role. Provided that our main scenario of decent world economic growth proves correct, we expect demand for commodities to remain relatively good. This scenario assumes that the United States is not plunged into a new recession and that the Chinese economy will experience a soft landing. A full-blown US recession would obviously upset this scenario, especially since it would hurt Chinas growth (and demand for commodities) via lower exports. Fundamentally, and long term, commodity prices are determined by the balance between supply and demand. Unlike other financial assets, commodities are physical products. Which factors, in turn, drive supply and demand will vary between commodity categories. In some cases supply varies more, and in others demand. be implemented, however. Lower growth forecasts have recently led to some price downturns. In several cases, prices are now beginning to approach production cost levels. This provides strong incentives to keep prices up, if not otherwise via temporary production cutbacks. Above all, we foresee room for rising copper and aluminium prices. In both cases, prices have fallen to levels near production cost, the supply situation is relatively tight and production costs are on their way up. In the case of copper, China has also drawn down its reserves so far this year. Sooner or later, China will need to replenish its reserves, and this may very well result in copper prices above USD 10,000 per tonne, compared to USD 9,057 at this writing. Assuming downward revisions in global growth forecasts, it is reasonable to lower our price expectations for metals generally, yet continued decent global demand, rising cost levels and a tight supply situation are pointing towards certain price increases. An American recession and/or a Chinese hard landing would naturally squeeze base metal prices. In such a scenario, aluminium will probably be the most resilient, thanks to its production cost trend.

room for rising oil prices


Oil, the most pivotal energy commodity, has also experienced price downturns in the wake of lower economic growth forecasts. A price of around USD 100 per barrel (slightly higher for Brent crude and lower for West Texas Intermediate) appears manageable for both producers and consumers, but we foresee a certain upside for oil prices from todays levels, again assuming that growth does not fall more than we have forecasted. Continued good demand, coupled with falling OECD reserves and shrinking spare capacity in the Organisation of Petroleum Exporting Countries (OPEC) will sustain prices. Also important is that Saudi Arabia which serves as a kind of central bank for the global oil market raised its oil price break-even levels this year. About a year ago, oil prices of USD 75-95/barrel were needed in order to balance the countrys budget. Due to unrest in the region during 2011, Saudi Arabia has undertaken large fiscal spending for the purpose of preserving political stability, a

growth will drive demand for metals


World economic growth naturally has a direct influence on demand in many cases. This connection is clearest for base metals, where the supply situation is also very sluggish. It takes a long time to build up production capacity (open-cast mines, smelters etc.). Temporary cutbacks in capacity can naturally

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Commodites

strategy that has been successful so far, but this has pushed up break-even levels for oil prices to around USD 90/barrel this year and nearly USD 115 by 2015. We expect Brent oil to be traded at levels just above USD 100/barrel, with a slow rising trend over the next few years. So far the success of the rebel side in the Libyan civil war has not had any major impact on oil prices. To some extent, its effects may already be discounted, and there is uncertainty about how quickly Libyan production will resume. Todays historically wide price differential between Brent oil and Americas WTI oil nevertheless indicates that Brent may have been traded with a certain risk premium, which might now be reduced. This would point towards a better relative increase for WTI.

heaven. Sooner or later, of course, the upturn will end. Late in August, the price of gold also fell quite substantially, from more than USD 1,900/ounce to below USD 1,800. In a short to medium-term perspective, however, there are factors that will sustain gold prices. Aside from the obvious continued financial and economic uncertainty we also see that governments around the world are again net buyers of gold today, after having drawn down their gold reserves since 1988. And although gold prices have climbed sharply, they have a long way to go before reaching historical highs in real terms. Continued low interest rates and a weak US dollar are other arguments in favour of gold. We expect marginal price upturns during the coming year. Some of the above arguments pointing towards rising gold prices a bit further ahead low interest rates and the weak dollar also provide support for other commodity prices. Low interest rates create access to liquidity, benefiting commodities as financial investments. Since most commodities are priced in dollars, a weaker dollar can be compensated for through rising commodity prices. Together with the relatively good demand that follows from our growth scenario, this should enable commodities to easily defend todays price levels, with some room for upturns in the case of industrial metals, oil and possibly gold, but the risks in this forecast are clearly on the downside. Forecasts of weaker growth than in our main scenario are a risk that must definitely be taken into account. Such a development would mainly hurt cyclical commodities such as base metals (but would affect gold positively). Likewise, continued shaky financial markets would adversely affect risk appetite, which is also likely to push down relatively volatile commodity prices. agriCULtUraL COmmODities WiLL LeveL OFF
250 225 200 175 150 125 100 75 50 25 250 225 200 175 150 125 100 75 50 25

agricultural commodity prices will level out


For agricultural commodities, conditions are in some respects the opposite of those affecting base metals. Demand is relatively stable, but supply tends to vary more. This is partly because farmers can vary their production in response to price changes, and partly because of the weather situation. In the June issue of Investment Outlook, we expected lower food prices, driven among other things by the fading effects of the La Nia weather phenomenon, which had disrupted harvests. This has indeed occurred, and prices have come down for most agricultural commodities. However, we are now revising our earlier forecast of continued price declines during the rest of 2011, since meteorologists now warn of a new La Nia, with disruptions over the coming months. During the summer, there has also been a drought in large parts of the US. Oklahoma experienced its hottest July ever, with average temperatures of around 31.5 degrees C. This has led to smaller harvests and thus less build-up of reserves for such crops as maize (corn) and soya beans, which is positive for prices. Offsetting this are still relatively high prices in historical terms, the prospect of somewhat lower demand and a risk that next year the US Congress will decide to cut back federal subsidies for ethanol production. Overall, we expect sideways price movements for most agricultural commodities during the coming year. In the last major commodity category, precious metals, gold is dominant. Gold prices have been in an upward trend for many years. Among the fundamental factors worth noting are that rapidly rising prosperity in India, China and other countries is increasing the demand for gold used in making jewellery. However, a large proportion of the demand that has driven up prices has come from financial investors, who have wanted to protect themselves from market uncertainty. Both during the Lehman Brothers crisis of 2008 and so far this year, we have seen dramatic price increases.

Index

2007
Maize (corn) Agricultural index Cotton Soya beans

2008

2009

2010

2011

Source: Reuters EcoWin

gold at high levels


These sharp upturns raise the question of whether what we are seeing is a price bubble. No tree grows all the way to

After sharp upturns, prices of agri-commodities turned downward around the beginning of 2011, but weak harvests this year (drought in the US) combined with the risk of new weather disruptions in the form of La Nia are likely to stabilise prices ahead.

Investment OutlOOk - sePtemBeR 2011

Index

35

Currencies

Fundamentals the main key to currencies


The market favours currencies that are sustained by strong economic fundamentals The US dollar is on its way towards losing safe harbour status In the EM sphere, Asian currencies are winners
Since the economic upturn began in the summer of 2009, one central theme in the foreign exchange (FX) market has been the search for attractive economic fundamentals. Countries with good growth, low debt ratios, rising key interest rates and current account surpluses have often seen their currencies appreciate. Within this category are the Scandinavian currencies and currencies of various major commodity producers such as Australia and Canada. Many countries in the emerging market (EM) sphere have also fulfilled the requirements for attractive economic fundamentals and have thus seen rising exchange rates. In some cases, such currency appreciation has been undesirably large and countries have taken steps to reduce their attractiveness. For example, Brazil has imposed taxes on foreign investments in the countrys equities and bonds. interpreted as indicating that the USD is on its way towards relinquishing its previous safe harbour status. The main reasons for a changed FX market view of the USD may be: Greater political uncertainty and growing doubts about the abilities of US elected officials. Efforts to reduce the American current account and budget deficits may include a weaker USD. The Federal Reserves monetary policy, pledging a zero key interest rate at least until mid- 2013, and a greater likelihood that a further round of quantitative easing (QE3) will be launched. In June, international investors reduced their long-term holdings of US securities for the first time since January 2009. Asian countries with large surpluses led by China thus have a diminishing appetite for such assets as American government securities. Our forecast is that the USD will continue to weaken. If the financial market mood improves a bit further ahead which is our assessment this is an additional argument for a weaker USD. Meanwhile the outlook for the euro (EUR) is not so bright either. Uncertainty about the management of/solution to the European sovereign debt crisis is conspicuous. But although this has resulted in a high risk premium for the EUR, the economic fundamentals actually look somewhat better in the euro zone than in the US.

safe currencies appealing in troubled times


During the summer of 2011, financial markets have been very nervous. To some extent this has been detrimental to EM currencies, with investors occasionally seeking safe, highly liquid currencies, which are mainly found in the OECD industrialised countries. In recent months, it has essentially been the Swiss franc (CHF) and to some extent the Japanese yen (JPY) that have appealed to worried investors. Among the EM countries, however, Asian currencies have continued to maintain their positions well. As the worlds largest and most liquid currency, the American dollar (USD) previously appreciated during periods of market turmoil. But during the summer of 2011, this has not been the case. The USD has instead lost value in trade-weighted terms and has been traded at close to historical lows. This may be

eUr less bad than UsD


The euro zone as a whole has a lower debt ratio than the US and a current account balance that is almost at zero. Current account movements which show currency flows resulting from trade in goods and services, interest payments, loans and principal payments, portfolio and direct investments etc. also indicate that portfolio flows are more favourable for the

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Currencies

EUR than the USD. For these reasons, the USD appears to be the weaker of the two large weak currencies, and we forecast that the EUR/USD exchange rate will be 1.50 in December 2012 (1.44 on August 31 this year). This summers dramatically escalated financial market turmoil, in the wake of sovereign debt problems in Europe and uncertainty about the global economic outlook, clearly showed that only one currency the CHF remained a genuine safe harbour for nervous financial capital flows. According to most yardsticks, the CHF is overvalued by 20-40 per cent, and concern about the negative impact of this situation on the Swiss economy is now spreading. It is true that Switzerlands exports will be hurt by a high CHF, but at the same time these exports are relatively price-insensitive. As early as 2010, however, the Swiss National Bank intervened in the FX market in an effort to limit the appreciation of the CHF. On September 6, the SNB announced that the CHF is being pegged to the EUR, with EUR/CHF 1.20 as the strongest permitted exchange rate for the Swiss currency. Assuming that financial market turmoil will continue for a while, the SNB will probably need to buy sizeable amounts of foreign currencies to prevent this ceiling from being breached. Due to the drama and uncertainty of recent months, valuations of many assets have become extreme both high and low and this is also true of the FX market. Fundamentally strong countries such as Switzerland and Australia, and to some extent Japan, have noted large currency appreciations. Meanwhile countries battling with dual financial deficits and pursuing very expansionary fiscal policies, for example the US and the UK, have seen their currencies weaken sharply.

asian currencies in an attractive position


Many Asian currencies are also in an attractive position, sustained by very strong economic fundamentals. High interest rates compared with the OECD countries may also eventually fuel their appreciation. Stronger currencies in the region may also be politically justified. In August, China speeded up the rate of yuan (CNY) appreciation against the USD, an indication that the country is taking global financial market and economic worries seriously. This action is not enough to resolve global imbalances, but it helps by making Chinas imports cheaper in local currency thus benefiting exporters in other countries. There are also domestic reasons for a stronger CNY. Cheaper imports will also promote the efforts of the Chinese authorities to ease inflation pressure and benefit the process of shifting the growth dynamic towards private consumption one explicit objective of Chinas latest five-year plan. If commodity prices rise somewhat during the coming year, which is our forecast, this will benefit Latin American currencies. The prerequisites for Eastern European currencies have worsened, however, due to the many economic links between these countries and the shaky euro zone, as well as shortcoming in some of the economic fundamentals in certain countries. For example, Hungary has a large public sector debt, banks in Romania have strong ties with Greece, Turkey is reporting negative current account figures and Poland is being forced to show growing current account deficits. tWin DeFiCits tHreaten tHe DOLLar
0.25 0.00 -0.25 0.25 0.00 -0.25 -0.50 -0.75 -1.00 -1.25 -1.50

Most indications are that the main features of this FX market pattern will persist for the time being. Investors are more inclined to seek safety than to aspire for high returns, and quality is thus extra important. Of the worlds ten largest currencies, the Swedish krona (SEK) is consequently a good alternative. This summers financial market turmoil has not weakened the SEK as much as normally in such a market environment. Swedens strength with regard to government finances and the current account balance might help lead to a changed view of the SEK, from a currency that is a winner only in good economic times to one that also has less cyclically sensitive (defensive) qualities. It is, however, still too early to draw this conclusion too far. Nevertheless, the SEK and the Norwegian krone (NOK) are two currencies that are not hurt by high valuations, and reduced uncertainty about the economic outlook a bit further ahead might help vault them higher.

-0.50

USD trillion

-1.00 -1.25 -1.50 1950

1960

1970

1980

1990

2000

2010

Government budget balance, fiscal year Current account balance, calendar year

Source: Reuters EcoWin

The gigantic twin deficits in the US current account and federal budget occasionally pull down the dollar. These deficits reflect a savings shortage in the federal sector and in the country as a whole. While the budget deficit will be reduced by means of sizeable spending cuts in the coming decade, a weaker dollar may help shrink the current account deficit.

Investment OutlOOk - sePtemBeR 2011

USD trillion

-0.75

37

SEB is a North European financial group serving 400,000 corporate customers and institutions and more than five million private individuals. One area with strong traditions in the SEB Group is private banking. From its founding in 1856, SEB offered financial services to wealthy private individuals. Today the Group has a leading position in Sweden and a strong presence in the other Nordic countries and elsewhere in Europe. SEB Private Banking has a broad client base that includes corporate executives, business owners and private individuals of varying means, each with different levels of interest in economic issues. To SEB, private banking is all about offering a broad range of high-quality services in the financial field tailored to the unique personal needs of each client and backed by the Groups collective knowledge. SEB Private Banking has some 350 employees working in Sweden, Denmark, Finland and Norway. Outside of Sweden, we take care of our clients via offices in Estonia, Latvia, Lithuania, Luxembourg, Switzerland and Singapore. On June 30, 2011, our managed assets totalled SEK 276 billion.

www.sebgroup.com/privatebanking