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InvestmentOutlook May 2010private banking - investment strategy

the debt burden – can the world handle the pressure?

3Investment OutlOOk - may 2010

Contents

Introduction ____________________________________________________________5Summary ______________________________________________________________6Portfolio strategy _______________________________________________________8Theme: The debt burden – can the world handle the pressure? _______________ 11Theme: Redrawing the investment map ___________________________________ 14Theme: Market pause – more rule than exception __________________________ 17Macro summary ______________________________________________________ 20

asset CLassesEquities ______________________________________________________________ 22Fixed income _________________________________________________________ 24Hedge funds _________________________________________________________ 26Real estate ___________________________________________________________ 28Private equity _________________________________________________________ 30Commodities _________________________________________________________ 32Currencies ___________________________________________________________ 34

Investment Strategy

4 Investment OutlOOk - may 2010

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Hans PetersonGlobal Head of Investment Strategy + 46 8 763 69 [email protected]

Lars Gunnar AspmanGlobal Head of Macro Strategy+ 46 8 763 69 [email protected]

Rickard LundquistPortfolio Strategist+ 46 8 763 69 [email protected]

Victor de OliveiraPortfolio Manager and Head of IS Luxembourg+ 352 26 23 62 [email protected]

Johan HagbarthInvestment Strategist+ 46 8 763 69 [email protected]

Carl BarnekowGlobal Head of Advisory Team+ 46 8 763 69 [email protected]

Reine KaseEconomist+46 8 763 [email protected]

Liza BraawCommunicator and Editor+46 8 763 [email protected]

This report was published on May 18, 2010.Its contents are based on information and analysis available before May 10, 2010.

Investment Strategy


The debt problems of industrialised countries will affect the risk perceptions of markets for a long time. The concepts of high and low risk will gain new meanings. Knowledge, a compre-hensive view and understanding are essential, now that traditional truths about risk must be questioned.

The fiscal crisis in Greece has focused attention on gigantic budget deficits and massive government debt mountains, mainly in Europe. This will affect the way markets view risk for many years to come.

For a long time, the norm for a low-risk investment has been an equity portfolio composed of shares mainly from North America, Europe and Japan. Nowadays, in practice such a portfolio primarily encompasses a group of highly indebted countries that will be forced to deal somehow with their debt problems. Regardless of what debt resolution strategy they choose, it will affect economic growth. Together with low inflation and low interest rates, this implies downside risks for the currencies of many industrialised countries − adding to the risk picture. What used to be a low-risk investment is thus actually associated with rather high risk. A paradigm shift has occurred. Changing conditionsIn today’s new financial and economic world – characterised by debt problems and slow economic growth in the indus-trialised OECD countries, coupled with substantially better fi-nancial stamina and high growth in the emerging market (EM) sphere – the conditions determining what is high risk and what is low risk are changing. Meanwhile emerging markets naturally do not offer everything that an investor is looking for.

Our ambition is to build well-diversified portfolios that have good characteristics and can provide stable returns in all financial climates. One relevant question that an investor should ask is whether the tax base of a country is a more

stable source of revenue for covering interest and principal payments than the sales of a global corporation in a mature industry. The answer may well be that some corporate bonds are perhaps more attractive than some government bonds from a risk standpoint. Thus it is more important than ever to diversify properly and to have the right analytical approach.

What is low risk? The answer to that question actually has to do with us as investors. It is about having knowledge and control, as well as a comprehensive view of the factors we can understand that affect our investments. For example, today it is more important to eliminate leveraging in various portfolio assets than to apply traditional diversification between geo-graphic areas. Analysis of underlying driving forces is more important than it has been for a long time. Paradoxically, to-day an investment in a well-analysed, correctly priced private equity fund may be less risky than a global equities fund with the wrong currency exposure.

Focusing on risk and indebtednessFor good reasons, we are devoting a lot of space in this issue of Investment Outlook to questions about risk and indebted-ness. Today these are pivotal issues in asset management. Debt problems in industrialised countries will affect numerous assets that traditionally occupy a lot of space in securities portfolios. The risk issue is vital because we believe that the role of risks and the way they are handled by portfolio manag-ers must be reassessed. The traditional allocation method − employing correlations between assets that are based on long time series − do not provide the whole answer today. Instead a more in-depth understanding is needed to enable us to build good portfolios. The driving forces behind market price trends must be exposed. Traditional truths must be questioned. These are undoubtedly exciting new times − times that require a new approach to risk. Hans Peterson CIO Private Banking and Global Head of Investment Strategy

introduction

New times – new approach to risk


Summary

expected 1-year

reasoningreturn risk

equities 9% 17%

POSITIVE. There is a short-term risk of corrections due to fiscal worries and as macroeconomic indicators stop providing upside surprises. But further along, low inflation and moderate growth may drive OECD markets. Eastern Europe and Asia will continue to benefit from higher economic growth. The euro zone is least attractive, with the worst growth potential.

Fixed income 6%* 6%

POSITIVE for High Yield, NEgaTIVE for government securities. Company profits will strengthen and bankruptcy risk will decrease – corporate bonds remain attractive. High Yield bonds with large spreads over government securities are the most appealing. Government bonds in emerging markets, with their high yields, are also attrac-tive. Swedish government securities will continue to provide minimal returns and continue to risk interest rate hikes.

Hedge funds 8% 6%

POSITIVE. The prevailing tensions between and within asset classes provide continued good potential for hedge funds. We will continue to focus on quality managers in the Macro, CTA, Relative Value and Fixed Income strategies, while Event Driven is becoming increasingly attractive.

real estate 5% 3%

WaIT-aND-SEE/POSITIVE. Capital is seeking out quality properties. Better general economic conditions and lower unemployment will benefit this asset class. Monetary tightening and possible bubbles in China constitute risks.

private equity 15% 22%

POSITIVE. The number of private equity (PE) transactions will continue to increase in an environment of low valuations. The secondary market is attractive when financially pressed investors are forced to sell at discounts. Listed PE still has room for sizeable upturns.

Commodities 5% 18%

WaIT-aND-SEE. Lower growth ahead in the OECD countries will reduce demand for industrial metals, while low real interest rates will keep demand for gold up. Agri-commodities will be squeezed in the short term, but higher ethanol production may boost the price of maize (corn) and other crops further ahead.

Currencies 5% 3%

WaIT-aND-SEE/POSITIVE. Interest rate differentials will continue to drive currencies. Export countries such as Sweden and emerging market countries will see their currencies appreciate, while the euro will be pushed down by large government debts. China will begin allowing its currency to appreciate during 2010.

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

eXpeCteD risk anD retUrn (1 year HOriZOn)

HistOriCaL risk anD retUrn(may 31, 2000 tO apriL 30, 2010)

CHange in OUr eXpeCteD retUrns

Equities

Fixed income*

Hedge funds

Real estate

Private equity

Currencies

Commodities

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

0% 5% 10% 15% 20% 25% 30%Expected volatility

Expe

cted

retu

rn

-4%-2%0%2%4%6%8%

10%12%14%16%

2008

-11

2009

-02

2009

-05

2009

-08

2009

-12

2010

-02

2010

-05

Equities Fixed income* Hedge funds Real estate

Private equity Currencies Commodities

Fixed Income

Equities

Private equity

Commodities

Real estate

Hedge funds

Currencies

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

0% 5% 10% 15% 20% 25% 30%Historical volatility

Hist

oric

al re

turn

HistOriCaL COrreLatiOn (may 31, 2000 tO apriL 30, 2010)

Equi

ties

Fixe

d in

com

e

Hed

ge fu

nds

Real

est

ate

Priv

ate

equi

ty

Com

mod

ities

Cur

renc

ies

Equities 1.00

Fixed income -0.04 1.00

Hedge funds 0.37 0.27 1.00

Real estate 0.76 -0.13 0.28 1.00

Private equity

0.85 -0.17 0.26 0.86 1.00

Commodities 0.28 -0.11 0.29 0.23 0.31 1.00

Currencies 0.18 0.67 0.57 -0.01 -0.03 -0.02 1.00

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


Summary

WeigHts in mODern prOteCtiOn

WeigHts in mODern grOWtH

1%

5%

0%

0%

2%

10.5%

81.5%

0%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Cash

Currencies

Commodities

Private equity

Real estate

Hedge funds

Fixed income

Equities

Previous Current

1.5%

4.5%

4.5%

3%

3%

30%

28.5%

25%

0% 10% 20% 30% 40%

Cash

Currencies

Commodities

Private equity

Real estate

Hedge funds

Fixed income

Equities

Previous Current

WeigHts in mODern aggressive

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

0.5%

0%

4.5%

11%

0%

23%

26%

35%

0% 10% 20% 30% 40%

Cash

Currencies

Commodities

Private equity

Real estate

Hedge funds

Fixed income

Equities

Previous Current

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

2002 2003 2004 2005 2006 2007 2008 2009

Fixed income Hedge funds Real estatePrivate equity Commodities Currencies

tHeme: tHe Debt bUrDen − Can tHe WOrLD HanDLe tHe pressUre?

Norway

CanadaFranceUS

Italy

Greece

FinlandDenmark

Australia

SwedenGermany

NetherlandsSpain

Ireland UK

Japan

-15

-10

-5

0

5

10

15

0 50 100 150 200

Public debt (% of GDP)

Publ

ic s

urpl

us/d

efic

it(%

of G

DP)

tHeme: reDraWing tHe investment map

US (50%)

Japan (10%)

UK (10%)Other (30%)

For countries with large government debts and public sector defi-cits − such as the US, Greece, Italy and Japan − tough years of debt resolution lie ahead.

The MSCI World index is often used as a benchmark for global equity funds, but 70 per cent of its exposure is to three countries and the EM sphere is missing.

the debt burden – can the world handle the pressure? The debt mountain in the West strengthens arguments for emerging market exposure

redrawing the investment map: What was a high risk investment yesterday may be low risk tomorrow, for example in emerging markets

market pause – more rule than exception: The weaker period in markets is probably just a pause during the bull market to catch our breath


portfolio strategy

MODERN PROTECTION Despite occasionally volatile markets, this portfolio performed well during the first few months of 2010. Since the primary purpose of Modern Protection is to preserve the value of capital, its return of nearly one per cent during the first three months must be considered satisfactory, given the market cli-mate. We also note that practically all holdings contributed to the portfolio’s positive return and that no holding fell outside this framework. Broader fixed income mandates (“cash plus” or “total return”) are continuing to deliver good returns, along with our small corporate bond fund holdings, both Investment Grade (IG) and High Yield (HY). Our currency mandate investment also began to contribute to our performance. In the hedge fund portion of the portfolio, however, those funds that adhere to the Equity Market Neutral strategy have not really met expec-tations, and these holdings may be reconsidered.

New during the period is that we are choosing to begin invest-ing in real estate. In our judgement, this asset class should be able to start contributing positively to our returns, while intro-ducing another type of risk and return source to the portfolio. We also foresee that the low risk profile of this asset class will fit well into the Modern Protection investment philosophy.

On the whole, our existing mix of investments is satisfactory. The portfolio is delivering a reasonable return at low, con-trolled risk. Especially in risk-adjusted terms, we are satisfied with its performance.

Portfolios for shifting financial winds

2%

81.5%

1% 5%

10.5%

CashCurrenciesReal estateHedge fundsFixed income

In our Modern Investment programmes, we apply our approach to markets and asset classes in practice. The turbulence surrounding the fiscal crisis illustrates the value of the guiding principles governing our asset management: diversification among several asset classes and the ambition to capture long-term trends in economies and markets. Despite extreme market fluctuations, long-term conditions have not fundamentally changed. We are thus sticking to our balanced investment tactics, holding decent proportions of risky asset classes such as equities and private equity, com-bined with more stable investments such as real estate, corporate bonds and hedge funds. Among minor portfolio adjustments worth noting are a small risk increase in our Modern Aggressive portfo-lio as well as the expansion of our real estate and emerging market debt holdings.


mODern grOWtHAs the world economy continued to recover, the Modern Growth portfolio rose by more than three per cent during the first quarter of 2010. This positive trend also continued in April. Its holdings are not unaffected by the storm clouds that have influenced the financial market in recent months, but given its good risk diversification and its so far successful choice of investments, the portfolio has performed well. The asset classes that have contributed most to its returns are equity and fixed income investments, together with private equity and hedge funds. Commodities and currencies have performed less satisfactorily to date. In the long term, we expect the world economy to recover largely as planned, but in the short term storm clouds will al-low room for disappointments. In the Modern Growth portfolio we are well prepared for short-term reversals, while seeking investments that can perform satisfactorily in times of positive markets. In the tug-of-war between short-term concerns and long-term potential, we see risks in both a clearly positive at-titude and an exaggerated pessimism.

We are retaining our current exposure to equities, which includes holdings in both traditional global funds and in a number of broad emerging market funds. In the fixed income portion of the portfolio, our exposure to credit risk instru-ments will remain in place, but we are making a small change by replacing Investment Grade Libor (short duration) with Emerging Market Debt.

The hedge fund portion of Modern Growth is delivering good returns, and its stabilising effect on the portfolio gives us good opportunities to take risks in other asset classes. We foresee continued world tensions in many asset classes, both between asset classes and regions. This should provide good oppor-tunities for many hedge funds. Global Macro, CTA and Equity L/S are strategies that should be able to perform well in the future, so we are choosing to retain these holdings. The good market also provides good potential for Multistrategy, and we are also choosing to keep such investments. We are making a marginal upward adjustment in our return expectations for hedge funds.

Real estate is a relatively new asset class for us in Modern Growth. We expect it to be able to deliver good risk-adjusted returns ahead and to provide a stabilising effect in the portfo-lio. Here we are focusing on more stable property investments with an emphasis on cash flow. Certain high-risk property investment projects might also be attractive, but are not suit-able in this portfolio for both risk and liquidity reasons.

Our current position in listed private equity, which we are choosing to retain, has contributed good returns so far. We are searching for complementary investments in this asset class, but this is difficult because of limited liquidity.

Portfolio strategy

3%3%

1.5%

28.5%

25%

4.5%4.5%

30%

CashCurrenciesCommoditiesPrivate equityReal estateHedge fundsFixed incomeEquities


Portfolio strategy

mODern aggressiveAs the normalisation of markets and economies has pro-gressed, we have successively escalated the risk in the Modern Aggressive portfolio. Our intention is to gradually increase risk when we regard this as suitable.

We are making a small change at the moment: replacing a convertible debenture holding with equities. Since the dis-count that we saw existed in the convertible holding when we bought it has disappeared, we are replacing it with equities since the risk is largely the same, but the potential is better. This approach also permeates the management of the Modern Investment programmes. We focus on investments with the potential for the best risk-adjusted return – while seeking to take advantage of somewhat larger market shifts.

In the equities asset class, a large proportion of the portfolio’s investments consists of emerging markets. This has worked out nicely, both in investment and currency terms. One fourth of the gains on our EM funds are attributable to currencies. We can see that the existing growth in the world economy is coming mainly from emerging markets, and it is natural to be invested in these markets.

Although there is room to increase the risk level in the portfo-lio, these decisions are easier if there is smoothly functioning risk diversification. A relatively large proportion of investments in the Modern Aggressive Portfolio is in fixed income; how-ever, these are investments that have almost equity-like return expectations, but at lower risk. This provides us with a good cushion in the portfolio, but looking a bit further ahead we foresee that we should lower this proportion to enable us to generate the returns we are aiming at over a business

cycle. Among corporate bonds, our High Yield holdings are still performing outstandingly; they are, incidentally, good invest-ments in most market situations. We have kept some convert-ible debentures, since these are expected to have continued good return potential.

In the hedge fund field, we have chosen funds that are a bit more aggressive. We also have some holdings in hedge funds of a more stable nature and expect to cut the size of these holdings in the coming quarters while buying more lively hedge funds. We are facing a delicate problem, since one of our hedge funds has chosen to stop accepting new deposits. This is naturally good, since the managers foresee a small risk that its size could adversely affect performance. Since the fund is successful, we are retaining our holding and have mean-while found a fully qualified alternative for future investments.

The real estate investments we have made in the other Modern Investment programmes do not live up to the return expectations that govern Modern Aggressive, which is why we have no real estate investments in this portfolio. There are in-deed well-managed opportunistic real estate investments that have good return potential, but their liquidity is generally too poor for this portfolio.

Pure commodity investments have not contributed anything this year. Instead it has mainly been commodity shares that have recorded gains, and we eliminated our commodity share investment some months ago. In retrospect, we did so a bit too early. There will undoubtedly be new opportunities to invest in commodity shares again, but at the moment we are holding off.

23%

11%

26%

35%

0.5% 4.5%

CashCommoditiesPrivate equityHedge fundsFixed incomeEquities


theme:the debt burden − can the world handle the pressure?

•Beyond Greece, massive government debt mountains loom

•While the Western world grapples with its debts......

• ... economies in the emerging markets sphere are running in high gear

With a government debt of more than 115 per cent of GDP and a budget deficit of nearly 15 per cent, Greece scared the daylights out of the stock, fixed income and foreign exchange markets. Early in May, Greece reached an agreement with its fellow euro zone countries and the International Monetary Fund (IMF) on a loan totalling EUR 110 billion. The country seems to have narrowly escaped defaulting. The path to this agreement was long and winding for both political and financial reasons. At their peak, two-year Greek sovereign bond yields climbed to nearly 20 per cent. Nor is it possible to declare an end to the emergency, although the EUR 750 billion financial package later unveiled by the European Union and the IMF avoided a liquidity crisis in Europe.

This tale of fiscal woes illustrates the challenges that many Western countries face. As a result of massive fiscal stimulus policies launched immediately after the Lehman Brothers shock in September 2008 and during the deep financial and economic crisis that followed, the G7 countries will collectively have increased their central government debts to a record-high 120 per cent of GDP by the end of 2010. What, then, will be the implications of this debt problem? How will it impact the global economy and the asset markets?

government debt a natural feature of the economy For governments to be in debt is nothing more unusual than for companies to finance their activities by borrowing. Just as companies smooth their liquidity needs and reduce their tied-up capital through debt financing, governments can smooth their current and future capital flow requirements. One of the reasons behind today’s government debt problem is that structural debts have gradually grown.

After the world had undergone a depression and a world war – including major economic fluctuations that resulted in enormous social consequences – the ideas of economist John Maynard Keynes gained ground. He advocated an active role for government in smoothing economic cycles; the fundamen-tal concept was that a government should set aside savings in good times that enabled it to pursue an expansionary fiscal policy in tough times. In this way, the government could ease the adverse economic and social consequences of fluctuating economic conditions.

Periodic surpluses and deficits in government finances are related to the cyclical nature of the economy. During boom periods, tax revenue rises and unemployment falls, while economic downturns lead to higher unemployment, lower tax revenue and high social welfare expenditures. These cyclical surpluses and deficits contribute to decreases and increases in total government debt as the economy fluctuates.

However, the political incentives to reduce expenditures dur-ing an economic boom are smaller than the incentives to boost expenditures in tough times. In the run-up to elections, for natural reasons there is also an unwillingness to raise taxes and trim government subsidies. Before social stabilisers such as unemployment insurance were introduced, surpluses and deficits more or less offset each other during an economic cycle, and government debt tended to be fairly stable as a per-centage of GDP. But as the welfare state expanded, the cyclical portion of government debt did not fully vanish during eco-nomic upturns. Structural debt − the part that persists through the entire cycle − has thus successively expanded.

excessive government debt creates problems Excessively large central government debt leads to many problems. It reduces confidence among investors that a coun-try will be able to meet its payment obligations, which leads to lower creditworthiness and higher interest rates or bond yields. Banks encounter higher funding costs, and the supply of liquidity shrinks for both private individuals and businesses. Ultimately this hampers private consumption and business-related capital spending, thereby slowing economic growth. One study (Reinhart and Rogoff) shows that GDP growth falls

In the shadow of the debt mountains


by one percentage point when government debt reaches 90 per cent of GDP.

What, then, is a “good” level of government debt? The lit-erature offers no simple, straightforward methodology for calculating the optimal debt level. Depending on the model and parameters, for example, optimal US debt can be esti-mated at anywhere from 5 to 66 per cent of GDP. According to the Stability Pact, EU countries are supposed to ensure that government debt is below 60 per cent of GDP, which the IMF and the World Bank also regard as the upper limit for sound government finances.

However, there are theoretical guidelines for what a sound level of government debt means:

1. A sustainable long-term fiscal policy − future tax revenue should be capable of funding future interest and principal payments. If long-term government finances are expected to end up imbalanced, the private sector risks a reduction in its consumption and will save more, in anticipation of a higher future tax burden.

2. Room for counter-cyclical fiscal measures − as mentioned above, debt as a share of GDP rises during cyclical downturns. If a country has high initial debt levels, an economic downturn will result in even higher indebtedness and leave less room for fiscal stimulus. In such a situation, if the government increases its debts, this has adverse consequences including lower long-term growth.

3. Contributing to economic expansion − reasonable levels of government debt benefit growth because a larger number of high-return projects can obtain funding when market interest rates are low. But excessively high debt, with the accompany-ing higher government bond yields, will cause capital to seek better fixed income alternatives to government securities. This will “crowd out” efficiency-raising private investments.

initial situation affects final outcomeFor the above-mentioned reasons, countries with low initial government debt burdens can launch more powerful fiscal stimulus measures that have a greater impact on their econo-mies than countries with high initial government debts. As a group, before the financial crisis the industrialised countries had government debt totalling about 65 per cent of GDP. Large government-financed bail-out and stimulus measures, as well as lower revenue and higher expenditures during the financial and economic crisis, have led to exploding govern-ment budget deficits. According to IMF forecasts, government debt in the OECD countries as a whole will reach 100 per cent of GDP within five years.

Even if stimulus measures in the Western world were with-drawn, public expenditures would only fall by about 1.5 per cent of GDP. Looking ahead, vigorous and credible action plans to reduce public deficits will thus be important in order to create confidence − both in the financial market so capital will seek the right investments and at companies so they dare to begin hiring new employees.

In many contexts, Sweden is held up as an example of a coun-try that has practised good crisis management. In the wake of the Swedish banking crisis of the early 1990s, the government initially launched large aid packages. Over a six year period, government debt rose by about 35 percentage points to more than 75 per cent of GDP. After that, the government imple-mented dramatic belt-tightening measures which helped its budget balance swing from -11 per cent of GDP to nearly +4 per cent in the space of seven years, but economic growth was very low during this period.

For the emerging market (EM) sphere, the picture is entirely different. As a group, EM countries entered the crisis with a government debt of only about 30 per cent of GDP. The IMF estimates that these countries will soon be back at the same

Theme: The debt burden − can the world handle the pressure?

Norway

CanadaFranceUS

Italy

Greece

FinlandDenmark

Australia

SwedenGermany

NetherlandsSpain

Ireland UK

Japan

-15

-10

-5

0

5

10

15

0 50 100 150 200

Public debt (% of GDP)

Publ

ic s

urpl

us/d

efic

it(%

of G

DP)

Debt-bUrDeneD COUntries FaCe beLt-tigHtening

For countries with large government debts and public sector deficits −such as the US, Greece, Italy and Japan − tough years of belt-tighten-ing lie ahead.


The debt burden - can the world handle the pressure?

relative debt level. The financial crisis had a milder impact on these economies than on the OECD countries, and their low indebtedness allowed room for larger stimulus measures.

tough budget austerity will hamper growth Countries that must overcome debt mountains have three main alternatives: inflation, currency depreciation and budget austerity.

High inflation causes the value of money to shrink. In other words, the real cost of loans becomes lower − borrowers bene-fit at the expense of lenders. Inflation can be created by print-ing money, but such a monetary policy strategy presupposes a well-functioning banking system and high economic capacity utilisation in order to have an impact. An inflation effect can also be achieved by means of currency depreciation − if a loan is denominated in the country’s currency and the value of this currency falls, inflation is imported and the cost of the loan falls in real terms. Greece, Spain and other euro zone countries cannot apply these two alternatives, however, since their key interest rate is set by the European Central Bank and their currency is trans-national. For these countries, all that remains for as long as they belong to the euro system is the third alternative − budget austerity.

Budget austerity is the hard way. It means that a government begins to repay its debt when it has achieved a budget surplus − the result of tough cost-cutting and tax hikes. Studies from the World Bank and elsewhere show that growth is clearly more sustainable when budget austerity occurs mainly via reductions in public expenditures, as compared to increases in tax revenue. For example, by cutting subsidies and raising the retirement age, a country boosts its productivity while improv-ing its government finances. Such measures lead to major political challenges, however, especially in countries with a sizeable public sector.

Our conclusion is that countries that have sound finances to-day will enjoy a higher growth rate in the future than countries with dreadful finances. The Western world thus faces many years of below-potential growth and the gigantic challenge of restoring order to their government finances. Among the best-positioned Western countries are Sweden, Norway and Canada, while nations on the periphery of the euro zone will face the biggest strains.

Globally speaking, Asian economies will enjoy the highest growth for many years to come, followed by Latin American economies. Eastern Europe will gradually pick up speed. This difference in growth rates − which will thus be amplified by OECD debt problems − will cause a continued flow of capital to the EM sphere, where the growth outlook is best. Assets in these countries will rise in value, and both fiscal and monetary

policy tightening will be implemented mainly in Asia and Latin America to offset overheating. The currencies of EM countries will thus appreciate relative to those of Western countries. This will help reduce export dependence in EM countries and en-courage growth that is driven by domestic demand.

OECD countries that follow the responsible path to fiscal bal-ance − budget austerity − and that have low capacity utilisa-tion and high unemployment will show low interest rates and low inflation. If they also have moderate economic growth, the stock markets in these countries may benefit. Countries that choose the inflation alternative or are unable to get a handle on their government finances, however, will see high inflation coupled with rising bond yields − a clearly less favourable al-ternative for equities.

The shadow of the Western debt mountains thus reinforces arguments in favour of EM exposure in various forms − real estate, equities, currencies − both medium- and long-term.

-6-4-202468

1012

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

World Industrialised countriesEuro zone Central and Eastern EuropeAsia ex Japan, Korea Middle East and North Africa

asia in HigHer gear

According to IMF forecasts, real GDP growth will be highest in Asia, at more than 8 per cent annually during the next several years, compared to less than 2 per cent in the OECD countries.

14

theme: redrawing the investment map

•Traditional risk-spreading falls short

•Emerging markets no longer so risky

•Currency movements will play a major role

Until the early 1980s, the main available investment alterna-tives were equities on domestic stock exchanges and fixed income investments in local currency. Since then, the pace of development in the financial field has been explosive. Today’s investors have a nearly unlimited range of alternative places to put their money.

These new alternatives provide better potential for generating good returns. But at the same time they are more complex, re-quiring new knowledge and insights into the risks and oppor-tunities of these investments. To some extent, conventional assumptions about risk, quality and potential return on assets can be considered somewhat outdated. Our assessment is that in the near future, we will face something of a paradigm shift, where old truths will be reassessed. Such a shift would redraw the investment map and lead to changes in the pricing of numerous investments.

broad equity funds not so broad One conventional assumption is that a traditional broad glo-bal equity fund provides the best risk-spreading in an equity portfolio. This idea assumes that a broad equity fund includes exposure to various markets that do not have the same patterns of returns (have low correlation). It thus achieves diversification, which may reduce risk without decreasing the potential returns to the same extent. There is no doubt that diversification is a powerful tool for lowering portfolio risk, but what we can be sceptical about is whether a global fund, for example, is actually the best way of achieving risk-spreading in an equity portfolio.

Equity fund managers generally tend not to diverge to an over-ly great extent from their benchmark indices. Consequently a global equity fund often has an allocation similar to a global index, which in turn is based on the market capitalisation on various stock exchanges. The global index most frequently

used as a benchmark is the MSCI World Index. The three coun-tries representing the largest exposure in this index are the United States (50 per cent), Japan (10 per cent) and the United Kingdom (9.5 per cent). Emerging market (EM) countries are not represented at all. As an investor, one should be sceptical as to whether this actually represents good risk-spreading, since 70 per cent of exposure is to only three countries and the EM sphere is missing.

The question is highly relevant, especially in today’s market climate characterised by a greater focus on country risk. The economic solvency of countries has become a very important risk parameter in investment decisions. This is demonstrated, in particular, by prevailing market concerns about Greek government finances. At present, most countries must bor-row at higher interest rates than creditworthy companies pay. Investors thus regard corporate bonds as more reliable than many government bonds. The fact that country risk is higher in some cases than credit risk shows that the market has reas-sessed its view of risk. What, then, is the status of the coun-tries that investors tend to be exposed to via a global fund?

safe securities becoming risky exposuresGreece is far from alone in grappling with profound deficit problems. Most Western countries are characterised by dwin-

Old truths mean big risks

US (50%)

Japan (10%)

UK (10%)Other (30%)

big OeCD COUntries DOminate msCi WOrLD

The MSCI World Index is often used as a benchmark in tradi-tional broad equity funds. The index is 70 per cent exposed to three countries, and the EM sphere is missing.

Investment OutlOOk - may 2010


dling cash reserves due to the expensive global recession and gigantic stimulus packages of recent years. Among the coun-tries with the absolutely weakest government finances are the US, Japan and the UK. Their budget deficits are at, or near, 10 per cent of GDP (Greece 13 per cent). Central government debt stands at 230 per cent of GDP in Japan, more than 90 per cent in the US and 65 per cent in the UK (115 per cent in Greece). In the UK, the private debt burden of businesses and households is also among the highest in the world.

The financial situation of countries has begun to influence investors’ decisions and is thus having an impact on various asset markets. In Europe, for example, there is a clear and noticeable connection between a country’s economic health and the performance of its stock market. Investors distinguish between the economic potential of different countries and believe that companies operating in weak economies will be adversely affected.

The return on shares is determined in the long term by company profits and expectations about the future trend of profits. But profits are, in turn, dependent on the underlying economic performance of the markets where companies operate. Companies in debt-ridden countries risk encounter-ing less demand and higher taxes than competitors based on economies that are on more stable ground. It is important, however, to point out that this primarily applies to companies that sell in the domestic market. Export companies that sell their products in markets where demand is high may perform better. Low economic growth holds down labour costs, and a country’s weak finances may cause its currency to lose value, creating competitive advantages for exporters.

It is clear that the gigantic government debts that have ac-cumulated are threatening to hamper GDP growth in debt-

ridden countries for many years to come (see pages 11-13). There is thus reason to assume that the stock markets in these countries will also be weighted down in the long term. An equities portfolio allocated on the basis of the market capitali-sation on stock exchanges thus appears to be a relatively high risk investment. Diversification largely occurs between three countries that will face enormous economic challenges for many years. In spite of this, an equities portfolio composed of shares in North America, Europe and Japan is regarded as an investment with low equity risk.

reassessing our approach to emerging marketsAnother clear disadvantage is that the rapidly growing EM sphere has little or no weight at all in most global equity funds. A majority of EM countries have demonstrated impressive growth figures, even though the global economy has suffered its worst economic slump in living memory. In addition, the growth of government debt in EM countries has been consid-erably slower than in the OECD countries. At an aggregated level, EM sovereign debt is equivalent to less than 50 per cent of GDP.

The EM sphere has historically been categorised as a high risk investment, but today’s investors should question this old truth. There are still a number of EM countries that are char-acterised by corrupt governance, non-existent educational opportunities and economies on the brink of ruin. But these countries are becoming fewer and fewer, and generally speak-ing the EM sphere is on substantially more stable ground than previously.

The most common measure of risk in financial theory is volatility, in other words the variation in return over time. High volatility leads to greater uncertainty about what return an investment will provide, which means that it is a high risk investment. Historically, EM stock exchanges have had a con-siderably higher volatility than OECD stock exchanges. But in recent years, volatility in the EM sphere has fallen to the same level as in the OECD. The risk of equity investments in the EM countries has thus diminished.

The improved solvency of many EM countries is also reflected in the credit ratings from international agencies. During the past six months, the trend has been towards more and more rating upgrades, at a time when the global economy has been in deep recession. However, many Western countries have seen their credit ratings downgraded in the aftermath of the financial crisis.

There are various reasons to wonder about the classification of EM investments as extremely high risk. When investors reassess this view, the attractiveness of EM assets will increase − with rising asset prices as a consequence. Investors should, however, be aware that political risk is still higher in the EM

Theme: Redrawing the investment map

Government debt as a percentage of GDP

Developed economies Emerging economies Nordic countriesSource: OECD, SEB

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

30

40

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SEB forecast

Large Debt bUrDen in tHe OeCD

Due to the global economic slowdown and the launching of gigantic stimulus packages, central government debt as a percentage of GDP has increased dramatically in the OECD countries. In the EM sphere, however, indebtedness is low.


countries than in developed Western democracies. In addition, investors tend to avoid peripheral markets when cold winds blow, and the EM sphere is still regarded as being a dash of spice in many portfolios.

Currency an important parameter Currency movements are something that many investors do not attach such great importance to when choosing where to put their money, but as the investment universe has gained an increasingly global dispersion, this factor has become increas-ingly important to bear in mind.

Since fund managers and other investors do not generally currency-hedge their positions, a large proportion of risk and return will depend on what happens in the foreign exchange market. Historically, share prices move about twice as much as exchange rates. In other words, the stock market has about twice the volatility of the foreign exchange market. Thus one third of the return on an equity investment in a country with another currency is determined by currency movements.

In our judgement, the fundamental strengths of countries will become an increasingly influential driving force in the foreign exchange market during the next few years. Capital will avoid countries in financial difficulties and move, especially, to EM countries where growth is higher and profitability larger.

We also predict that taking advantage of interest rate dif-ferences will be a strong driving force; investors will borrow where interest rates are low and invest where they are high. The result will be downward pressure on low-interest curren-cies, whereas the currencies of countries with high interest rates will appreciate. Today the interest rate differentials between categories of countries are large, and they will widen further. On the one side are the OECD countries, where the tightening of interest rates is being postponed. On the other

side are many EM countries, where interest rates have been raised from already fairly high levels. Our picture of future trends in the foreign exchange market thus provides another reason to reassess equity portfolios with large exposure to debt-ridden countries.

As an investor, one should also bear in mind that currency movements may influence the prerequisites for a country’s competitiveness. For example, the weaker euro has enabled the already strong German export sector to benefit from newly gained competitive advantages (see pages 34-35).

Diversify between good risks In this theme article, we have challenged conventional as-sumptions that are often regarded as absolute truths. For example, a traditional global equity portfolio need not provide good risk-spreading, but rather the opposite. We have also examined factors that are important in making well-founded investment decisions.

Fundamentally, it is a matter of being aware as an investor of what risks one is exposed to and then allocating one’s funds to achieve the best risk-adjusted returns. However, the market is a living being, so something that was high risk yesterday may be low risk tomorrow (for example EM assets).

Diversification remains the best tool for achieving high risk-adjusted returns. But the choice of investments for achieving risk-spreading is very important. The assets that attract us in our world are the ones we are familiar with and that have high value appreciation and good profitability. We currently believe that good risk means quality companies, EM sovereign bonds, High Yield bonds and the secondary pri-vate equity market.

Theme: Redrawing the investment map

J.P. Morgan G7 currency volatility index VIX volatility index for US equities

Source: Reuters EcoWin

2005 2006 2007 2008 2009 20100

10

20

30

40

50

60

70

80

90

Per c

ent

0

10

20

30

40

50

60

70

80

90

Equity market

FX market

CUrrenCy Has an impaCt

The volatility of the stock market is about twice as large as that of the foreign exchange market. Thus one third of the return on an equity invest-ment in another country is determined by currency movements.


• It is easy to be blinded by a positive market mood and macro statistics…

•…and view the world with excessive optimism

•Risk asset markets enter a calmer phase

Right at the beginning of 2009, the pessimism among both investors and forecasters was unrelenting. Many drew parallels with the depression of the 1930s, and anyone who dared to predict a bright future for markets and the overall economy was regarded as frivolous and naïve. But as so many times be-fore, those who dared at that time to challenge conventional views and analyses turned out to be right. A price rally for risk assets − equities, corporate bonds, hedge funds, private equity and so on − began during the second quarter of 2009.

Just as the textbook says, the economy stabilised fairly soon thereafter. In various countries − for example the United States − a cyclical recovery ensued during the third quarter. The economy thus rebounded 5-6 months after the stock market, as it was supposed to.

The economic upturn was later confirmed by statistics to-wards the end of 2009. Together with significant cost-cutting, this enabled corporate profits to rise as well, while interest rates in most industrialised countries remained historically low. As a result of this favourable economic environment, prices of risk assets continued their upward journey. Granted that the curves briefly turned downward just after the begin-ning of 2010 when the fiscal mess in Greece was revealed and China took steps to tighten its economic policies, yet investors did not allow themselves to be scared for a long time. Instead the spring of 2010 was dominated by a strong rally in risk as-set markets − despite volcanic ash clouds and an increasingly worrisome fiscal situation in Greece.

Well-fuelled spring rally The main fuel for the spring rally was surprisingly good cor-porate earnings and higher growth expectations, both among macro forecasters and market players. For the first time in this upturn cycle, the market ran faster than the economists when it came to revising the future upward. Statistics for March and April also supported the picture of accelerated growth in many parts of the world economy, after growth had slowed early in 2010 partly related to weather.

The time has come to catch our breath

theme: market pause − more rule than exception

UK, PMI Manufacturing Eurozone, PMI Manufacturing

US, PMI Manufacturing China, PMI Manufacturing


2005 2006 2007 2008 2009 201030

35

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55

60

65

Inde

x

30

35

40

45

50

55

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65

springtime FOr pUrCHasing managers

In many parts of the world, purchasing manag-ers in the manufacturing sector indicate that the wheels of industry are turning faster. The biggest upswing is in the US, but in Europe and China the expansion has also gained strength.


Among others, purchasing managers in the US, Asia and Europe indicated improved conditions. Exporters in the European Union’s core countries gained global competitive-ness when the euro fell as a reaction to the Greek crisis. Countries like China, Singapore and India reported accelerat-ing GDP growth. American consumers defied predictions that their savings ratio would rise. Instead they broke into their pig-gy banks so they could increase their consumption more than their income permitted. The mood of households improved in the US, Japan and the euro zone. Statistics awakened some hopes that the deeply depressed American housing market − which largely triggered the financial and economic crisis − is at least on its way towards stabilising.

However, it is easy to be blinded by cheery markets and posi-tive macro statistics and thus view the future with excessive optimism (the exact opposite of early 2009). It is easy to forget that there are mechanisms that usually cause the economy to change gears with rather short notice. The same applies to the fact that accelerating economic growth may also actually have negative aspects.

special factors behind growthOne key question is how much of this economic growth is due to the turnaround in the inventory cycle and fiscal stimulus measures, and how much is a consequence of increased un-derlying demand from households and businesses. For exam-ple, in the US the shift from an inventory cutback of USD -160 billion in the second quarter of 2009 to an inventory build-up of USD +31 billion in the first quarter of 2010 provided a posi-tive GDP contribution of nearly 6.5 percentage points. That factor together with the contribution from President Obama’s stimulus package explained more than the entire American GDP growth during the second half of 2009 − underlying demand thus fell − and during the first quarter of this year the contribution from these two factors added up to more than 2.5 percentage points of GDP growth, which totalled 3.2 per cent. In other words, underlying demand indeed rose early in 2010, but only by around 0.5 per cent.

Inventories and fiscal stimulus are propping up American growth during the current quarter as well, and by most indica-tions the total contribution will be somewhat larger than in the first quarter. These particular factors are an important reason behind stronger recent American economic statistics. But it is not only in the US that these forces have an impact. Positive growth effects from a turnaround in the inventory cycle are noticeable in large portions of the world economy, and budget stimulus is also still propping up growth in many places − es-pecially in the industrialised OECD countries.

These cyclically beneficial effects will fade during the sec-ond half of 2010, however. In the US, probably around three fourths of the positive impact of the inventory cycle has already occurred, and later this year the contribution of inven-

tory to GDP may well be negative for a period, when the pace of build-up slows; that is, the second derivative − the change in the rate of change − becomes negative. Meanwhile the growth impulse from fiscal stimulus measures will also shift from plus to minus.

This could admittedly be offset by a corresponding accelera-tion in underlying businesses and household demand. But although the most recent macro data reflects such improve-ments, it is unlikely that they will be large enough − a conclu-sion essentially true of the OECD countries as a whole.

Downturn in ism manufacturing index usually comes During the spring, the ISM purchasing managers’ index for the US manufacturing sector has climbed above 60, a level usually associated with high growth. Historically, however, this phase has been fairly brief and has often been followed by a down-turn in both the ISM index and GDP growth. For example, this occurred during the recoveries of the early 1970s, mid-1980s and early 2000s. Here, too − as in other parts of the business sector − inventories naturally play an important role, since a swing from cutback to build-up ordinarily causes the orders-to-inventory ratio to fall. This, in turn, is a signal to businesses to slow down their production rate.

It is true that there has been a strong association between the ISM index, which is dominated by large companies, and American GDP, but in retrospect the correlation between the National Federation of Independent Business (NFIB) small business index and GDP is even stronger. In itself, this is a warning signal, since during the spring the gap between the NFIB and ISM index was the widest since small business sur-veys began in 1974. Behind the low figure are the difficulties experienced by small businesses in getting bank loans and the large role of the still-depressed construction industry in the NFIB index.

Theme: Market pause − more rule than exception

FisCaL stimULUs anD inventOries are beHinD Us grOWtH

During the latter part of 2009, more than all US growth in GDP was due to fiscal stimulus and a turnaround in the inventory cycle. Looking ahead, the economy will have to be more self-sustaining when these effects fade.

Annualised

Inventory contribution Net effect of stimulus

GDP growth

Source: CBO, Recovery.gov, SEB

Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q409 10 11

-2

-1

0

1

2

3

4

5

6

-2

-1

0

1

2

3

4

5

6SEB forecast


Theme: Market pause − more rule than exception

One key factor behind household demand is the trend of income, which in turn is dependent on what happens in the la-bour market. In many industrialised countries, the labour mar-ket weakened perceptibly during the financial and economic crisis. There are many indications that employment will not grow fast enough in the next two years to push down unem-ployment much. Overall this will result in slow income growth, which will presumably hamper private consumption.

There are thus many reasons to predict that the prevailing OECD upswing will be followed by a deceleration later in 2010. But such a course of events does not seem to be part of the forecasts of market players and thus constitutes a market risk in the coming months, on top of worries about government finances − especially in Europe.

High growth may have negative aspectsAt present, market players have reason to be pleased with the strong macroeconomic data. But it cannot be ruled out that they will gradually begin to worry that high growth may lay the groundwork for inflation risks a bit further ahead − though not justified according to our assessment − and that expectations of accelerated key interest rate hikes in influential countries will thus gain a foothold.

Developments in China since the autumn of 2009 − when the stock market there began to lose ground compared to world indices − show what can happen when the market shifts from liking to disliking strong macro figures. When the Chinese then implemented their first economic tightening measures early in 2010, this not only adversely affected the stock market in China but also shook other stock markets. Another example is from 1975, when expectations of US interest rate hikes caused Wall Street share prices to fall nearly 15 per cent. Worries about the negative aspects of accelerating economic growth − inflation dangers and accompanying economic policy tighten-ing − are thus also a risk factor to bear in mind.

Our basic forecast is that the current OECD acceleration − for the reasons discussed above − will not continue long enough for inflation expectations to spread significantly. A moderate deceleration for a couple of quarters is also, by all indications, a smaller market risk than escalating price and interest rate expectations, but a slump is likely to have an impact on asset prices and increase uncertainty for a time.

It is more of a rule than an exception that upturns in risk asset markets occasionally pause for breath. Since the current bull market began in March 2009 and until this spring, for exam-ple, stock markets have gone through three temporary dips: one around mid-2009, one early in 2010 and one early in May. Looking further back in history shows that since 1975, equi-ties, corporate bonds, hedge funds, private equity funds and commodities have ordinarily entered a weaker phase when the cyclical recovery has been under way for several quarters. When the economy has unrelentingly continued to grow, after a while risk asset prices have begun a new upturn phase that has lasted for a long time. One US exception was in the early 1980s, when a cyclical double dip occurred due to sharp inter-est rate hikes aimed at combating high inflation. Assuming that the OECD growth slump later this year that is visible in our crystal ball will be mild and brief, with continued low inflation, no interest rate worries will get a foothold and fiscal problems do not escalate dramatically, a weaker period in risk asset markets will only be a pause for breath in a bull market that may persist for another couple of years.

OECD weighted leading indicators MSCI World Net index, change y/y


1980 1990 2000

Indi

cato

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85.0

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105.0

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-50

-30

-10

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CLOse Link betWeen stOCk market anD eCOnOmy

It is a well-known fact that the stock market is usually a step ahead of the economy during both upturns and downturns. This connection is underscored by the largely simultane-ous turnarounds in the World Index and leading economic indicators in the OECD countries. History also shows that the initial strong rebound is ordinarily followed by something of a pause, which in turn is followed by strong periods for both the stock market and the economy.

Index of Small Business Optimism PMI ManufacturingSource: Reuters EcoWin

1995 2000 2005

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Happy big Firms, gLOOmy smaLL Firms

The American ISM index, which has climbed sharply since last autumn, is dominated by large companies while the NFIB small business index has recently fallen from a low level. Difficulties in obtaining bank loans are one reason.


macro summary

•Economic upturn with EM countries in the driver’s seat

•Small rate hikes in major OECD countries, larger hikes in small countries and EM

•Growing public sector imbalances and postponed economic burdens

The world economic upturn has gained strength and is now on firmer ground. Global GDP will increase by more than 4.5 per cent both this year and in 2011. The Asian economies will con-tinue to be an important driving force, and the emerging mar-kets (EM) sphere as a whole will grow at a 6.5-7 per cent pace in 2010-2011. The upturn in the US is beginning to pick up support from a labour market that is showing less weakness. Europe is plagued by government fiscal problems − especially in southern Europe and the UK − but expansionary forces are still decent. Exporters in Germany and the UK are benefiting from weak currencies. Growth in the 30-country Organisation for Economic Cooperation and Development (OECD) will end up at around 2.5 per cent in both years.

Low inflation for a long timeInflation will remain low in the industrialised countries for an extended period, as large spare capacity and high unemploy-ment push down wages and prices. There is little risk that higher commodity prices will threaten this low-inflation envi-ronment. Due to limited inflation pressures and to concerns about the resilience of the financial system, leading central banks will proceed very cautiously with their key interest rate hikes.

However, key interest rates will be raised on a larger scale in the EM countries and less export-dependent OECD countries. Despite low inflation and cautious central banks, sovereign bond yields will rise somewhat due to sizeable borrowing re-quirements and stronger economic conditions.

The relatively bright growth outlook does not mean that the world is nearing a normal economic situation. The banking

system is still damaged, and its healing process is continuing. Ultra-low interest rates and growing public sector debts have led to the postponement of many adjustment burdens.

The US economic recovery has gradually broadened. GDP growth will reach more than 3.5 per cent this year and nearly 3 per cent next year. The growth contribution from inven-tory build-up and fiscal stimulus is slowing, but this is being offset to a decent extent by stronger final domestic demand. Employment is moving towards improvement, but the job-less rate will fall slowly to just below 9 per cent at the end of 2011. This, combined with a continued decline in core infla-tion (price increases excluding food and energy), will help persuade the Federal Reserve to hold off on hiking its key rate until December this year.

rest of asia gives Japan a helping handJapanese exports are growing rapidly, thanks to higher de-mand from China and other Asian countries − a shot in the arm for the Japanese economy. GDP growth will reach 2-2.5 per cent annually in 2010-2011. Deflation pressure will persist in the economy but will be somewhat less powerful. The gov-ernment’s many stimulus packages have contributed to the

Global recovery on firmer ground

USA GDP, quarterly change annualisedSource: Reuters EcoWin

2000 2002 2004 2006 2008-7.5

-5.0

-2.5

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gOOD paCe OF eXpansiOn in Us eCOnOmy

After a deep recession late in 2008 and early in 2009, American GDP grew for three consecutive quarters, but this expansion was entirely dependent on a turnaround in the inventory cycle and fiscal stimulus measures.


Macro summary

economic turnaround but have further exacerbated govern-ment finances, which are showing a deficit of 10 per cent of GDP. There is no urgency about interest rate hikes − the Bank of Japan can wait until late 2011 − and we predict that the yen will weaken in value during the next couple of years.

The economic situation in the euro zone has not been impres-sive during early 2010. The fiscal crisis in the “PIIGS” countries (Portugal, Ireland, Italy, Greece, Spain) − especially in Greece − is creating great uncertainty. Meanwhile there are signs that the recovery will continue, though at a leisurely pace. Various leading indicators are moving upward, and the export sector is being fuelled by the weakness of the euro. This year GDP growth will be 1.5 per cent, and next year nearly 2 per cent. The serious problems in Greece, slow growth and low inflation are reasons for the European Central Bank to let its refi rate remain at 1 per cent until the spring of 2011.

The British economy is on its way up. GDP will grow by 1.5 per cent this year and 2 per cent in 2011. The new government faces very big challenges. The country is plagued by deeper imbalance problems than other leading economies; the budg-et deficit exceeds 11 per cent of GDP. Unless the government is able to produce a credible plan for restoring fiscal order, the UK’s sovereign debt rating risks being downgraded. The Bank of England will not raise its key rate until December 2010.

nordics will grow a bit slower than OeCDAnnual GDP growth in the Nordic countries will end up aver-aging less than 2.5 per cent in 2010-2011, a bit slower than the OECD countries as a whole. Swedish and Finnish GDP will in-crease the fastest, in both cases with exports as an important engine. In Norway the main source of growth will be private consumption, largely thanks to sizeable income increases. The Danish recovery is quite fragile, among other things due to earlier declines in home prices and construction.

em sphere playing in its own division

There are good prospects that China − the engine of the world economy − will perform well. Thanks to a tightening of eco-nomic policy and currency appreciation, growth will decelerate from 10.5 per cent this year to 9 per cent in 2011, a pace better compatible with lower inflation. India also has good growth potential, although public budget deficits have reached about 10 per cent of GDP and inflation has climbed above 10 per cent. Further rate hikes plus fiscal tightening measures to strengthen the budget and ease price pressures will bring India’s GDP growth down from 8.0 per cent this year to 7.0 per cent next year.

silver medal for Latin america With a growth rate of 4.5-5 per cent in 2010-2011, Latin America is in second place after Asia. Brazil, Mexico and Chile are the fastest-growing large economies. At 6-7 per cent, infla-tion in the region is on the high side, but unlike many OECD countries both budget deficits and public sector debts are small. Nor do percentages of foreign loans and external bal-ances provide cause for concern.

In the past six months, Eastern Europe has begun a gradual economic upturn, but most economies in the region are continuing to display dual tendencies. The recovery is be-ing driven by competitive exporters, while consumption and investments will be weighed down for another while by rising unemployment, fiscal tightening and low capacity utilisation. Among Eastern European economies Poland is at the head of the class and was the only EU country with positive GDP growth last year.

Today the three Baltic countries are also characterised by a gradual export-led recovery. Earlier extreme current account deficits have been replaced by surpluses. The recession has also helped to dampen inflation dramatically in the Baltics. Smaller economic imbalances further support the assessment that there will be no devaluations in the region.

China, Reserve Requirement Ratio India, Key Rate China, Key Rate


2002 2004 2006 2008 2010

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ent

2.5

5.0

7.5

10.0

12.5

15.0

17.5

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2.5

5.0

7.5

10.0

12.5

15.0

17.5

WeLL-JUstiFieD tigHtening measUres

Since early 2010, China’s central bank has raised the reserve requirement for banks in three steps and India has hiked its key interest rate twice. High growth in China and inflation worries in India are good reasons for these measures.


2000 2002 2004 2006 20080

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signiFiCant grOWtH aCCeLeratiOn in CHina

At the bottom of its economic slowdown in the first quarter of 2009, China recorded a GDP growth rate of more than 6 per cent. Since then the growth rate has climbed to nearly 12 per cent. In the short term, it may accelerate even further.


asset class: equities

•Strategically, the fundamental driving forces are in place

•The extraordinary loan package will create new opportunities for European equities

•Emerging markets again in focus

The market shocks that dominated January and early February − Chinese economic tightening measures, the fiscal problems of Greece and President Obama’s proposals on stricter bank-ing rules − caused share prices to fall sharply, but after that the stock market rally resumed during the spring. Fuelling this rally was a clear preponderance of positive surprises in both macro statistics and the flow of earnings reports. Equities also bene-fited from a continued highly expansionary fiscal environment, especially the exceptionally low key interest rates prevailing in the OECD countries.

The strength of this spring’s stock market rally could not re-ally match last year’s strongest upswing. But this was entirely compatible with the transition from the earlier phase of strong market hopes − strongly driven by expectations of a shift from losses and declining profits to rising profits − to the growth phase that the stock market has been in since early 2010, with confirmations of rising corporate profits serving as a powerful engine. Early in this growth phase, it is not at all unusual for share valuations to fall, a phenomenon that also characterised the first quarter of 2010 and further fuelled the stock market.

Some weeks into the second quarter, however, stock markets again encountered headwinds. These were in the form of a rapidly escalating Greek fiscal crisis, clouds of Icelandic vol-canic ash that paralysed most air traffic in Western Europe − resulting in sharp share price declines for airlines in particular − and a civil fraud suit filed by the US Securities and Exchange Commission against Goldman Sachs, adversely affecting the share prices of many banks and other financial institutions. And although the volcanic ash is mostly gone for the moment, Greece has received a loan totalling EUR 110 billion from the euro zone and the IMF, and the EU/IMF approved an emer-

gency package of EUR 750 billion, there is reason to have a somewhat cautiously optimistic attitude towards equities. The problems of mounting government debts remain and eco-nomic expectations appear a bit too cheery.

During the spring, stock market players became spoiled by numerous positive macro surprises and the clear preponder-ance of unexpectedly good earnings in company reports, both in the OECD countries and the EM sphere. As a consequence, cyclical expectations in the stock market changed shape from a U to a V. At the same time, the mood became increasingly cheerful. For example, US optimism about world economic performance in April was the highest since the boom years 2005-2006, and the percentage of pessimists was the lowest in 25 years. Meanwhile American mutual funds that invest in equities cut their liquid assets to the lowest level since the turn of the millennium, and stock market holdings by US house-holds rose dramatically.

Given a background dominated by growing government debts and a clearer predominance of unexpectedly good macro figures − which boosted market expectations about the

Short-term risks – long-term opportunities


Jan2009

Apr Jul Oct Jan2010

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From their turnaround in March 2009 until early May 2010, world stock markets rose about 60 per cent. The upward ride was not a straight line but was instead rather bumpy, the usual pattern during a bull market.

23

economic upswing − as well as both optimistic stock market players and households, by all indications it will require very positive surprises at the micro and/or macro level to trigger further share price rallies.

The first quarter 2010 report season is over, so events at company level are likely to play a less prominent role for some time. Meanwhile the stock market seems to have discounted a faster economic recovery than most economic forecasts are predicting. This is a downside risk for the stock market, together with the risk that OECD macro data will first turn more mixed and then probably present negative surprises (see pages 17-19). At the same time, this risk is limited by reason-able valuations in most stock markets − price/earnings ratios in the US are just above 12 and in Sweden just above 15, for example − as well as profit forecasts for 2010 and 2011 of a solid 20-25 per cent. Weaker economic news will slow stock markets During the spring, stock exchanges in Sweden and the US performed more strongly than those of the euro zone. This was due to clearly positive Swedish and American economic news, while the government debt mountain in the euro cur-rency union was under scrutiny. EM stock markets as a whole lagged behind the world index, mainly due to sagging Chinese share prices in the wake of economic policy tightening. Cyclical sectors such as industrials and commodity companies performed more strongly than defensive ones like health care. If the OECD economies soon enter a calmer phase after their

first strong upturn phase, sectors that are not so cyclical will become more attractive − but not the purely defensive ones, since growth still looks set to be decent.

em sphere appealing The emerging market sphere remains appealing, especially Eastern Europe including Russia − which is beginning its eco-nomic upswing this year − and China, where the stock market has taken quite a beating due to economic tightening meas-ures. The US is somewhat more attractive than Europe, with exporters in the euro zone core countries − mainly Germany − as positive exceptions due to the weak euro. This is especially true if these exporters have their most important markets in the EM sphere.

Although it thus seems likely that stock market performance will be a little mixed this summer, our assessment is that this does not signal the beginning of a bear market, but is instead a new phase of a continued bull market.

Strategically − in roughly a two-year perspective − stock mar-ket conditions seem good in the OECD countries thanks to improving economic conditions and profits, low inflation and very modest interest rate hikes. EM stock markets will benefit from high economic growth and large profit increases, which will offset larger interest rate hikes in these countries. As part of their calculations, investors who are based in an OECD country should also bear in mind the chances of currency rate gains on their investments in EM equities.


Asset class: Equities

Relative performance MSCI Emerging Markets vs MSCI AC World Moving average 20 days


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em eQUities a bit better tHan WOrLD inDeX…

Although the Chinese stock market took quite a beating due to the government’s economic tightening measures, equities in the EM sphere as a whole performed relatively well dur-ing January-April 2010 thanks to good stock market gains in Latin America and Eastern Europe.

Relative performance EuroSTOXX50 vs MSCI AC World Moving average 20 days


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As the Greek fiscal crisis escalated, euro zone stock markets performed significantly worse than the World Index, but German exporters did well.


asset class: Fixed income

•Central banks are following divergent interest rate paths…

• ...which affect the trend of government bond yields

• ...High Yield still the best fixed income choice

After falling risk appetite early in 2010, US sovereign bond yields rose again when investors sold government securities to buy risk assets such as equities and corporate bonds. But in the core countries of Europe, government bond yields con-tinued downward. One reason was that the Greek fiscal crisis caused investors to avoid sovereign bonds in the periphery of the currency union and instead buy safe German government bonds. The yield spread between 10-year Greek and German government bonds widened dramatically at the end of April − despite the EUR 110 billion loan package for Greece. When the EU/IMF package totalling EUR 750 billion was delivered later, however, the gap shrank significantly.

Looking ahead, how government bond yields move in vari-ous countries will primarily be determined by the actions of central banks, the degree of economic strength, inflation risks and what happens with public sector finances, especially in Europe.

Because of very low inflation pressure and lingering worries about the health of the financial system, the most influential OECD central banks are being notably cautious about deploy-ing their interest rate weapons. In our assessment, the US Federal Reserve will start its rate hiking cycle in December 2010, and the Fed will not begin selling off bonds until next year at the earliest. The Bank of England must pay heed to large financial imbalances but is meanwhile confronted with rather high inflation. It is reasonable to assume that British key rate hikes will begin about the same time as those of the Fed.

eCb faces debt mountain and sluggish economiesThe environment that the European Central Bank faces is dominated by growing public sector debt mountains, a rather sluggish economic upturn and below-target inflation. The first ECB refi rate hike will thus not occur until the spring of 2011. The Bank of Japan (BoJ) will be the last of the major central banks to make its move. Because of moderate economic growth and continued deflation, the BoJ will keep its interest rate weapon unused until the second half of 2011.

In some industrialised countries − especially commodity- and export-dependent countries that show higher growth and larger inflation risks than the OECD average − interest rates will nevertheless soon be raised. This has already happened in Australia and Norway, for example, and soon the Bank of Canada and Sweden’s Riksbank will follow suit.

Interest rates and yields a complicated mix

US UK Japan GermanySource: Reuters EcoWin

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reCOrD-LOW key rates FOr sOme time tO COme

The deep financial and economic crisis per-suaded the world’s most influential central banks to cut their key interest rates to record-low levels. There is no rush to begin hiking these rates, since inflation risks are minimal, the financial system has not been restored to health and government debts are cause for concern.


Asset class: Fixed income

Due to stronger economic dynamism, greater inflation dan-gers, significantly better financial balance than in the OECD and risks of asset bubbles, central banks especially in Asia − but also in Latin America − have begun policy tightening, a trend that will dominate 2010-2011. In Eastern Europe, howev-er, several Russian interest rate cuts are in the cards. Poland’s central bank will be the only one in the region that will begin ratcheting up its key interest rate later this year.

The Greek tragedy that unfolded this winter and spring un-derscored the association between public sector finances and sovereign bond yields. The dramatically growing spread be-tween Greek and German government bond yields this spring (see chart below) reflected the fiscal problems of Greece.

But even under more normal circumstances, there is an as-sociation between the savings level in a country − public and private, adding up to the current account balance − and sovereign bond yields. For example, 10-year government bond yields in Japan are 1.3 per cent and the corresponding yields in the US are 3.5 per cent, even though both countries have government budget deficits of about 10 per cent of GDP. The explanation is substantially larger private saving in Japan, which means that the country has a current account surplus of about 2 per cent of GDP as opposed to the US current account deficit of about 3 per cent of GDP.

Our conclusion is that government bond yields in the US and the core countries of Europe will remain low during much of 2010, thanks to insignificant inflation pressure and the fact that central banks will not begin to unsheathe their interest rate weapons before the end of 2010 at the earliest. While awaiting persuasive progress in the management of fiscal defi-cits, the government bond yields on the periphery of the euro zone will, by all indications, remain high. Meanwhile strong economic conditions and key interest rate hikes will contribute

to rising government bond yields in countries like Sweden and Norway. Partly for the same reasons, higher bond yields are also imminent in large portions of the EM sphere. Yields in the corporate bond market − which rose early in 2010 as investors’ risk appetite waned − later resumed their decline, pushing up the price of these bonds. Early in May, however, corporate bonds suffered a temporary price setback as finan-cial worries mounted. The outlook is nevertheless good in vari-ous respects. Although the best period for corporate bonds was during 2009, this asset class will benefit from a continued economic upturn and low inflation. Historically speaking, cor-porate bonds have also usually provided better returns than other bonds during the first phase of interest rate hikes, which implies that this asset class has a chance of maintaining its at-tractiveness until early 2011 as well.

Due to earlier tough cost-cutting along with now-returning top line growth, companies around the world have increased their profits more than forecasted. Along with steps that have improved their debt structure − extending the maturities of bonds outstanding, issuing new shares and building up emer-gency liquidity − this has increased equity/asset ratios and thus the ability of the corporate sector to cope with economic strains. Better corporate financial health is reflected, among other things, in a rapid decline in bankruptcies among compa-nies in the High Yield segment and a rapid increase in corpo-rate credit rating upgrades.

Returns on corporate bonds are primarily determined by the prevailing yield gap against government bonds and how the yields on the latter are moving. Given significantly higher re-turns on High Yield (HY) bonds than on Investment Grade (IG) bonds and the prospect of continued low government bond yields in the US and the core countries of Europe, HY invest-ments still appear attractive. IG bonds are less appealing, however. Government securities remain least attractive.

Greece GermanySource: Reuters EcoWin

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varying interest in greek gOvernment bOnDs

The financial and economic crisis in Greece forced the euro zone and the IMF to provide the country with a large emer-gency loan. The severity of the crisis was reflected in the record-high yield spread between Greek and German 10-year government bonds. After the subsequent EU/IMF pack-age was approved, this yield spread narrowed substantially.

AAA BBB CCC and above B BBSource: Reuters EcoWin

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Early in May, there was a temporary setback in the corpo-rate bond market due to the ongoing fiscal drama. In the US, for example, the yield spread between industrial and government bonds widened at that time. Since then, how-ever, conditions have again improved for corporate bonds.


asset class: Hedge funds

•2010 somewhat better than a normal year

•Quality more important

•Short Biased has had a tough time this year

Hedge funds are continuing to perform well. So far this year, broad hedge fund indices have delivered a return of around 10 per cent year-on-year. Not everything has been hunky dory, as the turbulence in late January and early February emphatically showed. It is also hardly astonishing that hedge funds may get knocked around a bit in the short term when unexpected events occur in the markets. At times of surprising events, however, ordinary markets are often harder hit than hedge funds, whose investment flexibility also enable them to quickly readjust their assets and thereby take advantage of the new market situation. In addition, certain strategies perform espe-cially well in times of turbulent markets. March results − which were the best during the past six months or so − showed that hedge funds collectively were successful in the market climate that prevailed in the spring of 2010.

Event Driven is the strategy that has performed the best so far this year, thanks to a variety of reasons. Many corporate merg-ers and acquisitions have taken place, from which managers of these funds have been able to generate value. In March alone, M & A transactions totalling more than USD 200 billion were announced − an indication that the market is genuinely beginning to reawaken. Event Driven managers have also benefited from various themes such as health care, which they have succeeded in exploiting. These managers have also been successful in credit investments. Event Driven is a strategy well worth a close look, and also worth investing in during the next couple of years. One negative factor, however, is that liquidity in this part of the hedge fund market is often not the best.

For the Global Macro strategy, 2010 to date has been a bit more challenging, though there have been many different themes and markets with good potential returns. So far this year, unexpected changes in the yield curve for government bonds, especially on the short end of the curve, have been costly in terms of lost returns. Here the flare-up of the Greek

fiscal crisis has played an important role. There have also been reversals − trends that have suddenly turned around − in foreign exchange administration, something that is usually difficult for foreign exchange dealers to correct for in the short term. Competent Global Macro managers should nevertheless have good potential to deliver good risk-adjusted returns dur-ing the remainder of this year.

The problem of reversals and how they adversely affect certain types of hedge funds is worth examining before commenting on other strategies. Reversals impact not only Global Macro management, but also perhaps to an even greater degree CTA (Commodity Trading Advisors) funds. Both styles involve many different asset classes. But one difference is that CTA uses computer models and automatic trading, while Global Macro is based on fundamental trading. The chart below shows an example from 2009 that explains the difficulties these manag-ers can encounter in markets where trends reverse.

This year CTA has good potential to deliver fine results after a difficult 2009, but there are major quality differences, so it is important to invest in the right hedge fund. CTA can generally deliver a good return over time, but especially important will be the “contrarian” attributes that this strategy has in troubled

Continued good prospects for hedge funds

EUR/USD Brent oilSource: Reuters EcoWin

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Although the long-term trend was upward, 2009 was filled with short trend reversals. This made the CTA and Macro strategies more difficult.

27

times. One example is 2008, when nearly all financial invest-ments had a disastrous year, while CTA provided a positive return. We value these attributes. In our assessment, CTA may be able to deliver good returns this year as well, when markets are expected to be characterised by stabilisation. The trend follower tactic may be suitable during 2010, but development such as new fiscal trouble spots may naturally change the picture.

Quality differences are important when it comes to hedge funds, as the chart below shows.

In March CTA, or Managed Futures, showed returns ranging from -6 per cent at worst to +22 per cent at best. Most hedge funds provided returns of between -1 per cent and about +8 per cent. Emerging Market funds noted especially large dif-ferentials, with a range from -16 per cent to +18 per cent. It is thus very important to choose the right hedge fund, and most important of all to avoid the worst losers, which can be very costly.

In previous issues of Investment Outlook, we have under-scored the need for very thorough analyses of hedge funds

and hedge fund companies, and an investor often needs to get help with this, since it is an extensive task. We work together with Key Asset Management, which SEB acquired in 2007. Key Asset Management manages hedge funds of funds and has a solid analytical capacity in hedge funds, which we use.

Equity Long/Short (L/S) has worked well so far this year, returning about the same as hedge fund indices in general. March was a really good month for this strategy when stock markets were performing strongly. Equity L/S still has fairly low net exposure, and managers have chosen to be cautiously positioned since there are many uncertainties in the markets. Equity L/S should also be able to provide good returns during 2010, with good resilience on the downside if fiscal worries should escalate.

The Equity Market Neutral strategy has had a slightly difficult time so far during 2010, with a negative return at the index level since the turn of the year. However, these are alpha-gen-erating funds that add good attributes to an investor’s overall portfolio, so we appreciate their benefits.

Another strategy that has run into adversity is Equity Short Biased, which is more or less always short in the market. When stock markets fall, these hedge funds generate value, but when stock markets go up − as they did in March, for exam-ple − these funds take a beating. Their March setback of more than 6 per cent conveys this clearly.

good potential for hedge funds this yearGiven the prevailing market situation, our assessment is that hedge funds that can generate returns on the basis of ten-sions within or between different asset classes this year have good potential to deliver good results. We predict that 2010 will be a somewhat better year for hedge funds than a normal year. We are choosing to keep most of our hedge fund invest-ments with Equity L/S, Global Macro, CTA and Multistrategy managers. We are investing in Event Driven funds via Multistrategy, but Event Driven is such an attractive strategy that we may very well add it to our portfolio within one or two quarters. We expect hedge funds to contribute to its stability.


Asset class: Hedge funds

Distressed Securities, 2008-01-01 = 100 Macro, 2008-01-01 = 100 Equity Market Neutral, 2008-01-01 = 100 Market Directional, 2008-01-01 = 100


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aDvantage: DireCtiOnaL strategies

Directional strategies have been able to benefit from rising markets, while neutral strategies have had more difficulty in holding their own.

FUND APRIL 2010 MARCH 2010 yTD 2009 2008

HFrX global Hedge Fund index 0.80% 1.38% 2.45% 13.40% -23.25%

HFrX equity Hedge index 1.04% 1.13% 1.37% 13.14% -25.45%

HFrX equity market neutral index -0.38% -0.04% 0.63% -5.56% -1.16%

HFrX event Driven index 0.82% 1.75% 3.12% 16.59% -22.11%

HFrX macro index -0.70% 1.07% -0.10% -8.78% 5.61%

HFrX systematic Diversified index 0.85% 2.54% 1.95% -9.04% 31.55%

HFrX relative value arbitrage index

1.34% 1.22% 4.02% 38.47% -37.60%

Hedge funds will deliver good earnings this year, except for Short Biased, but this strategy may benefit from market crises. Among hedge fund indices, the CS/Tremont index is up 3.09%, the HFRI is up 3.79% and Eureka Hedge is up 3.33% to the end of April. Hedge funds are thus on track, but their path may be curvy when crises arise.Source: Hedgefund Research


asset class: real estate

•Real estate is recovering, but fiscal dangers a threat

• Interest rates are falling, prices are rising

•Bubble tendencies in China

Real estate as an asset class has moved further in the right direction during the past few months but is not entirely out of the woods. In the last Investment Outlook (March 2010), we wrote that it was “time to start cautiously investing in real estate”. We also did so in some of our portfolios. This illus-trates that financial investors have begun to view real estate with different eyes than during the dramatic financial crisis. The banking system is functioning much better again, which is attracting real estate investors. Funding opportunities are improving, and total risk is lower both for property companies and those who make financial investments in this asset class, but a reversal for the financial system would adversely impact this asset class.

Real estate values have also climbed in many markets since the beginning of 2010. The consequence has been an easier world for property companies, which no longer have to worry about their survival and can instead concentrate on the task of generating returns. Real estate investment trusts (REITs) and shares of real estate companies have also performed well. Property transactions are also showing strength by involving more countries, which confirms the strength of the upturn.

surging single-family home sales in the UsIn the United States, sales of new single-family homes climbed 27 per cent month-on-month in March, the largest such in-crease in 47 years. The main reason for the surge in sales was probably the tax credit of up to USD 8,000 for first-time buy-ers, provided they signed a contract by April 30 and the whole transaction closes by June 30. The change from severe winter weather in February to spring weather in March may also have benefited sales during the month. Even taking these special reasons into account, the American single-family home market seems to be moving towards stabilisation, though at a very low level of activity.

Reacting to these sales figures, construction-related shares took off in US stock exchanges. We should not read too much into the figures themselves, but the fact that they greatly surpassed forecasts is a source of hope that the recovery is stronger than most analysts expect. Granted that 90 per cent of the US single-family home market consists of existing homes, but in this sub-market too, March statistics showed a clear sales increase − the first in four months.

The number of real estate transactions is continuing to increase from low levels, confirming the more positive real estate landscape which began to emerge during the second half of 2009.

Aside from increasing transaction volume, prices are also rising. The interest that investors could earn in the wake of the crisis has previously been very high (and prices thus low), which was natural. For the past quarter or so, however, various parts of the market have begun pricing real estate in a new, higher way. This has resulted in lower interest income for in-vestors. In practice, this means prices have gone up, and they are expected to continue rising.

Continued positive signals, but there are dangers

Existing home sales New home salesSource: Reuters EcoWin

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The market for new and existing single-family homes in the US is beginning to recuperate, as sales figures are showing. Two main factors have contributed to this: the economic recovery and the temporary tax credit.

29

government finances the greatest riskBut not everything is positive in the real estate market. There are also dangers. One of these is the risk that countries will default on their debts. Greece is the country with the big-gest problems at the moment. If these fiscal worries were to spread, it would also be negative, probably influencing the supply of credit via banks or the bond market. Renewed eco-nomic setbacks would also be negative for real estate. The same applies to the existing inflation risks, especially in parts of Asia. Also on the negative side, there is uncertainty about how big the economic consequences will be when major cen-tral banks begin tightening their monetary policies, something that the central banks in such countries as Australia, Norway and India have already begun to do. In many countries, inter-est rate hikes will presumably not begin until late in 2010 or

early 2011, but it is important to keep an especially watchful eye on interest rate trends.

In addition, there are clear price-bubble tendencies in certain parts of the real estate market in China. The Chinese govern-ment has begun to tighten its economic policies, for example by boosting the reserve requirements for banks and taking various other steps to raise market interest rates. The authori-ties are also conveying the message that Chinese state-owned companies − which are not real estate companies − should not build new properties. It remains to be seen how much effect these measures will have, but if the price trend in portions of the Chinese real estate market continues at its current pace, the measures carried out so far will not be enough. Singapore has introduced a stamp duty, an example of another method to try to keep the price trend in the real estate market under control. mixed market is reawakeningMany asset classes have gradually recovered, and this is now also true in portions of real estate as an asset class. The proc-ess has been driven by investors who want returns on their capital. To a growing extent, they have regarded real estate investments as a good way to generate low-risk returns. Well-managed properties in good locations have been the focus of this first investor-led recovery phase, with the result that the prices and loan-to-value ratios for these properties are similar to what we previously became accustomed to. For well-man-aged properties, the situation can thus be largely considered as normalised.

The situation is different for properties that are not well-man-aged, and in order for this market to normalise, the next phase of the upturn will need to begin. The world economy must improve further, and what we want to see above all is that many countries get unemployment under control. The first signs of this have also come, but the process may be lengthy and complex.

In the short term, there are risks when central banks withdraw their stimulus measures (activate their exit policy), but the downside for the real estate market is likely to be limited for investors with a time horizon of a year or longer. In the next few years, we expect returns that are roughly equal to a nor-mal long-term return: risk-free interest plus 3-5 per cent.

We have real estate investments that represent a few per cent of some of our management mandates. We expect to be able to increase this percentage little by little as the world econom-ic recovery continues, but considering fiscal uncertainties and bubble tendencies in China, we are hurrying slowly.

Asset class: Real estate


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vOLUme is reCOvering WOrLDWiDe...

Measured in volume terms, commercial real estate invest-ments are rising, though from a low level. Financial investors have changed their view of real estate and are now daring to enter the market.

010

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Inve

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Europe UK France Germany

...anD eUrOpean markets are piCking Up

Major European markets are showing largely the same trend for commercial real estate investments. Ongoing worries about Greece may, however, affect the credit supply ahead.

Source: Jones Lang LaSalle

Source: PMA Property Market Analysis


asset class: private equity

•The private equity (PE) market is functioning again

• Increasing supply and attractive prices are providing good business opportunities

•Despite uncertainty about regulations and funding, we have a positive view of PE, given good quality selection

The world’s financial markets are continuing to normalise. The existence of the economic recovery is also unquestionable, al-though its strength − growth dynamic − is open to discussion. This is good news for the private equity (PE) industry and is reflected, among other things, in a good index trend for listed PE companies.

The overall picture in the underlying businesses is also brighter, but at the same time more complex. Parts of the PE industry are still grappling with major problems. Many of the funds/companies that made aggressive, highly leveraged in-vestments late in the economic expansion are still confronting difficulties. Meanwhile business opportunities are unusually good for those investors whose portfolio companies are in good shape and who have money to invest.

Large obligations in the private equity marketThe underlying mathematics is specific to PE investments. As most people know, PE companies (or funds) make their actual investments over a period of years. Investors who participate from the start undertake to deliver money as the fund buys companies. A fund that started during the peak years 2008-2009 perhaps had time to make only one or a few company investments before the crisis hit. This means that many inves-tors still have large remaining obligations to PE funds.

During the 2009 crisis, large portions of the PE market froze completely. Almost no new funds were started, and in the secondary market (trading in existing holdings in and obliga-tions to PE funds), worldwide volume fell from USD 20 billion in 2008 to USD 8 billion. It can hardly surprise anyone that the

primary market died out. The sluggishness of the secondary market was not as self-evident, but it was largely because sell-ers and buyers stood far apart regarding reasonable prices. Meanwhile not so many investors were under pressure to sell, since the funds that started in the years just before the crash, and thus were not yet fully invested, were not active in buying companies. This meant that they were not collecting more capital from their investors.

various factors behind the brighter outlookToday the market is rapidly thawing. The funding situation has brightened considerably. Granted that a larger percentage of equity is now required, but there is still a lot of “business as usual” for PE companies. The more positive general economic picture is another contributing factor behind a resumption of acquisitions by PE companies and funds. As a result, more funds are drawing capital from their investors, forcing finan-cially weak investors to give up previously invested money when they are not capable of meeting new demands for capital. This creates a golden opportunity for those who have capital to invest, assuming good talent for identifying quality investments. In these cases it is also an advantage to be well-connected in the PE industry, since some of these holdings do not reach the broad market.

Favourable situation for good private equity

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The secondary market for private equity froze during the 2009 crisis. An unexpectedly rapid recovery is leading to new record volume, creating good business opportunities.

31

We pointed out in the last Investment Outlook (March 2010) that good PE companies often have their best period after a recession. The same is also true this time around, and perhaps to a greater extent than usual considering the depth of the downturn. Listed companies are now carrying out major cost-cutting on a broad front, which will lead to good operational leverage once demand takes off, and higher margins will lead to large profit increases. This also applies to many of the PE companies’ portfolio firms.

Widespread questions are being raised about company debts, and this “wall of debt” worries some observers. A record number of corporate bonds and credits will fall due during the next few years. Many PE companies have responded to this with loan extensions, corporate restructuring and other measures to reduce their sensitivity. In our judgement, the PE industry is easily capable of handling the situation.

Another storm cloud concerns regulation. Discussions are underway on both sides of the Atlantic about tightening the rules for the financial sector, including the PE industry. Not all proposals will be implemented, but the US government’s intention to prohibit banks from owning PE investments may very well become a reality. Since banks own nearly 10 per cent of American PE investments, this would create supply pressure that would hurt prices in the secondary market, but it would also create good buying opportunities for those with capital to invest.

As we wrote in the last Investment Outlook, it is important to distinguish between good and bad PE. We are still focusing on investments that fulfil certain criteria that, in our judgement, reflect good PE in the prevailing market situation:

• Operational resources to pursue the reform process in target companies• Target companies that have captured market share during the crisis• Few problem companies in their portfolio• "Dry powder” for new investments

“Long-term relationships with local lenders” were previously another important factor, but this now appears less important since the credit market has normalised.

As for listed PE, we can state that its price performance has consistently been good. The LPE50 index has continued its recovery but has a long way to go before approaching its old peaks. Meanwhile these companies are continuing to trade at discounts in relation to their net asset value (NAV). The average discount is around 30 per cent. This is a substantially smaller discount than the low point a year ago, but still on a par with the lowest levels from the previous recession. The historical average is a discount of less than 10 per cent. It should also be noted here that the discounts – according to the companies – are calculated very conservatively. Among other things, there are often adjustments for any illiquidity.

Large discounts to nav should shrinkOne reason for the continued large discounts may be that investors mistrust net asset values. As transactions have now resumed, we see that companies tend to be sold at prices above the stated (conservative) NAVs. If this trend persists, NAVs should be accorded greater confidence, which should justify a smaller discount. Add to this that NAVs should be able to increase in today’s more positive economic environment. Our conclusion is thus that there is room for sizeable price in-creases on listed PE, though with great volatility depending on the flow of news about possible regulation and other matters.

We also foresee continued very good business opportunities in the secondary market. As mentioned above, the supply is likely to grow as PE companies resume their investments and thus request more capital from investors who in some case are financially pressed. We are continuing our effort to identify attractive investment alternatives in this segment while re-taining and, in a few cases, enlarging our listed private equity holdings.


Asset class: Private equity

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Listed PE company indices have climbed sharply since bottoming out last autumn, but during the crash PE companies fell more than the stock market as a whole. These companies have a long way to go before reaching their previous peaks.


•Price setback early in 2010 then spring rally

•Strong association between change in growth rate and commodity prices

•Market forces pulling in different directions

This year began with sizeable commodity price setbacks due to concerns related to Greek government finances, economic tightening measures in China and President Obama’s propos-als on stricter rules for banks. But during the spring, commodi-ties again became more expensive, thanks to a strengthening world economy, supply restrictions in some commodity segments and higher risk appetite among financial investors. The price rally was led by industrial metals, especially nickel, aluminium and copper.

In the short term, both OECD and EM spere growth will ac-celerate. In itself, this is likely to mean a continued rise in commodity prices, since history shows that the co-variance between changes in the growth rate (second derivative) and commodity prices is strong. During the past decade, this factor has explained about 40 per cent of commodity price, while the growth level (first derivative) has been much less important, with only a 15 per cent explanatory value.

At times of faster economic growth, the most cyclical com-modities – energy and industrial metals – have risen the most in price, and they have also fallen the most during economic slumps. Since the turn of the millennium, the standard de-viation for these commodities has been nearly 40 per cent, compared to only about 15 per cent for precious metals and agricultural commodities. So it was not surprising that the spring price rally was led by a number of industrial metals and that oil also became considerably more expensive.

Demand for commodities by China − the engine of the world economy − is currently also continuing to grow. Reflecting this, the country’s crude oil imports are close to record-sized and its purchases of copper are growing at a doubled-digit rate. In the US, the shift to inventory-building will continue for another while, benefiting the commodities market, and when this fades the European inventory cycle will also kick in for a while. Commodities also have a lengthier inventory cycle than the general cycle, so commodity purchases for stockpiling may persist for longer.

Chinese tightening measures among risksOur crystal ball for the commodities market is also showing risks. High Chinese growth and the accompanying overheating risks have caused authorities in China to halt various infra-structure projects and begin tightening economic policies. There is also concern that growth in the OECD countries will decelerate as the positive effects of the inventory turnaround and stimulus measures fade. In addition, the fiscal problems that are now flaring up risk slamming the brakes effectively on growth and persuading financial investors to seek less risky assets. Finally, there are fears that more expensive oil and petrol will undermine purchasing power, spoil the mood of businesses and households and lead to inflation worries in the fixed income market and among central banks.

These risks do not seem too large, however. Not allowing the Chinese economy to rush into overheating is positive, and a revaluation of the renminbin (yuan) − as one step in China’s cooling-off policy − would in itself also be positive for com-modities, since imported commodities would then become cheaper for the Chinese. Judging from the upbeat messages

Many forces affecting commodities

asset class: Commodities


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This spring was characterised by a price rally for industrial metals, with nickel as the winner, but in late April there was a reversal as risk appetite in the markets dwindled.

33

from many leading indicators and the higher forecasts of GDP growth in various OECD countries (see pages 20-21), the odds against anything resembling a “double-dip” recession are very high, although a deceleration in the expansion rate is in the cards later this year. Gigantic budget deficits and runaway government debts are indeed a source of significant concerns, but the harmful effects on OECD growth that these financial imbalances will cause will mainly occur a bit later.

In the short term, oil prices may very well climb in response to continued high Chinese demand, the approaching high season for driving in the US and the closure of some produc-tion capacity in the North Sea due to maintenance work. During the second half of 2010, prices are likely to be in the USD 70-80 per barrel range. Factors pointing in this direction include a minor slowdown in growth and commodity demand in the OECD countries and high oil production as well as re-serve capacity and large oil stockpiles. An unexpectedly rapid increase in Iraq’s oil production would constitute a downside risk. Within the energy mix, natural gas prices are likely to fall substantially as a consequence of sharply increased supply in the US.

price rally for industrial metals interruptedDuring the spring, industrial metals benefited from strong demand from end-users both in the OECD countries and the EM sphere, as well as shrinking metal stocks and strikes and operational problems at mines. Late in April, however, there was a sharp correction. Decelerating growth in the OECD is one reason to argue that industrial metal prices will not climb during the second half of 2010. There is an upside chance for copper and a downside risk for nickel.

Low real interest rates, Chinese demand, the Indian wed-ding season, global financial risks and central bank demand

will prop up demand for gold. In order for the price to climb further, however, it will probably be necessary for the yuan to undergo a revaluation (probable) and/or for the US dollar to weaken (less probable). Platinum and palladium, which are mainly produced in South Africa − where competition for en-ergy will increase this June and July due to the football World’s Cup, which may disrupt metal production − continue to have the best outlook. Meanwhile demand for these metals from the automotive industry will continue to increase.

Prices of agri-commodities may fall further this summer and early autumn, and it is difficult to be optimistic about maize (corn), wheat and soya beans, despite currently low price lev-els. But in a slightly longer time frame, prospects will improve somewhat, due among other things to increased ethanol pro-duction from maize and greater demand for meat as well as animal feed as a consequence of global economic recovery.


Asset class: Commodities


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In April, oil prices rose to around USD 85 per barrel. After a decline in May, they may rebound due to such factors as the American driving season. In a longer perspective, prices will probably be in the USD 70-80 range.

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Many commodities have risen in price during the past year, mainly thanks to the global economic recovery, the need for inventory-building and very high demand from China. While precious metals, energy and industrial metals have performed strongly, prices of agri-cultural commodities have not kept pace. A bit further ahead, however, the agri-commodities sector may do better.


asset class: Currencies

•Greece’s financial problems continue to weigh down the euro

•German exports are benefiting from the weaker euro

•Asian currencies are on their way up

In the last issue of Investment Outlook (March 2010), we predicted that the fundamental strengths of countries and currencies as well as market players’ utilisation of interest rate differentials would become more influential driving forces in the foreign exchange market. Since then, developments have been consistent with this forecast. Currencies connected to countries with weak government finances and where interest rate hikes are not imminent have continued to weaken, while we have seen an upswing for currencies in well-managed countries where interest rates are about to be raised. At present, there is no reason to believe that these trends will be reversed. krona will remain strong The prevailing foreign exchange market climate benefits the Swedish krona. The Swedish economy is in good health and Sweden can boast the smallest budget deficit and the largest current account surplus as a percentage of GDP in the European Union. The krona is also benefiting from the global recovery, which is boosting demand in other countries for Swedish goods and services and thus also demand for Swedish kronor. Exports are equivalent to more than 50 per cent of Sweden’s GDP. The Riksbank is also expected to hike its key interest rate at a faster pace than most other central banks, and this also adds to the attractiveness of the krona. The krona should appreciate substantially against the euro due to the systemic crisis in the euro zone. Our forecast is that the krona will strengthen to SEK 9.00 per euro by year-end and to SEK 7.20 against the US dollar by year-end.

greek crisis weighing down the euroThe first week of May was dominated by a financial panic unlike anything we have seen since the worst phase of the

credit crisis. The market totally lost confidence in Greek crisis management. Meanwhile there were major concerns about contagious effects on other southern European countries. In response, the EU and the IMF approved an emergency package totalling EUR 750 billion. This is about twice as large as Sweden’s annual GDP. The European Central Bank also approved supportive purchases of government securities in countries that the market mistrusts.

Although an acute crisis has been avoided, Greece remains in the same difficult situation. The country is facing painful economic austerity measures, and the path towards financial balance will be long, winding and arduous. The market is scep-tical as to whether Greece will be capable of implementing the necessary belt-tightening and reforms. Making the task of reform more difficult is massive discontent among the general public, manifested in numerous strikes. The final act of the Greek drama is far from being written, and the country’s prob-lems will have a long-term impact on market risk appetite, interest rates and the euro.

Fundamentals determining exchange rates


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Weak euro fuelling german stock market

While Greece is hovering on the edge of bankruptcy, Germany has sound government finances and a current account sur-plus. A well-equipped Germany can take advantage of the favourable conditions resulting from a weak euro. The falling currency makes German goods and services cheaper for non-euro zone consumers and businesses, benefiting German ex-ports. The export sector is equivalent to about 45 per cent of Germany’s GDP, and about 60 per cent of this is sold outside the euro zone. The positive impact on the German economy is thus sizeable. Another consequence of the declining euro is that German companies have become cheap in the eyes of non-euro zone investors. This may attract foreign capital, which would benefit the German stock market.

Even though the euro system has begun to sputter, so far this year the German stock market has yielded good returns that have been clearly better than in stock markets in many other euro zone countries. A Greek collapse would decrease overall risk appetite and hurt stock markets worldwide – including Germany. But if the budget crisis only results in a weak euro and helps keep the ECB’s key interest rate at a low level for a long time, this scenario will also continue to benefit Germany exporters and − ultimately − the German stock market.

Chinese currency will be revalued Today it is not a question of whether but of when Chinese authorities decide to begin their revaluation of the renminbin, or yuan (CNY). In the last two issues of Investment Outlook, we argued that there are both global and domestic Chinese reasons for the CNY to appreciate. For the world economy, it is a matter of reducing global trade imbalances, and for China of reducing export dependence and instead stimulating the domestic economy. A revaluation of the CNY will occur on China’s terms, however, since it is clear that Chinese authori-ties strongly resent the opinions of other countries about their currency policies. At the G20 meeting in Washington in April,

there was total silence on the infected currency issue, itself an indication that the date when a gradual appreciation of the CNY will begin is drawing closer. Our forecast is that the CNY will appreciate 5 per cent against the US dollar by year-end and an additional 10 per cent during 2011.

Like China, most other Asian countries control the value of their currencies to ensure that their exports remain competi-tive. This occurs by means of foreign exchange market inter-ventions by the respective central bank. A revaluation of the CNY would also increase revaluation pressure on these other Asian currencies, since it is unlikely that other central banks will be able to resist a foreign exchange market positioned for Asian currency appreciations. There is also less incentive to keep their currencies weak when the purchasing power in China − the most important export market for these countries − rises due to a stronger CNY.


Asset class: Currencies


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Germany’s DAX stock market index is roughly unchanged since the beginning of 2010, but in US dollar terms German companies have become significantly cheaper.

www.sebgroup.com/privatebanking

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 countri-es 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 − tailo-red to the unique personal needs of each client and backed by the Group’s collective knowledge.

SEB Private Banking has some 350 employees working in Sweden, Denmark, Finland and Norway. Outside of Sweden, we take care of our clients via offices in Estonia, Geneva, Latvia, Lithuania, Luxembourg and Singapore as well as branches in London and Nice. On March 31, 2010, our managed assets totalled SEK 245 billion.

investment the debt burden – outlook can the world …...2010/05/18 · investment outlook - may...

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