Global Tactical Asset Allocation

GLOBAL TACTICAL ASSET ALLOCATION September 2007 SUMMARY Financial markets are very much in turmoil, as the problems in the US sub-prime housing market have spread to other markets and also seem to be impacting the real economy. We remain optimistic that these sub-prime problems will not trigger a global recession. Although central banks have stressed that they will not bail out over-leveraged investors and mortgage holders, we believe that they will recognise that the current liquidity crunch could turn into a credit crunch and thus endanger economic growth. As a result, we expect central banks to continue to inject liquidity into financial markets and, in the US, to cut rates, even if that creates moral hazard problems. Eventually, the conviction that central banks will operate as lenders of last resort should help to prevent the financial crisis from turning into a full-blown economic crisis. If the US housing market problems can be contained, the global economy is unlikely to end up in a recession. In this environment, we continue to believe that an overweight position in equities is justified, due to companies’ solid balance sheets, central banks’ willingness to prevent a credit crunch, the robustness of the global economy outside the US, the solid profit outlook and the reasonableness of valuations. Within equities, we remain overweight in emerging markets, due to the economies’ solid growth and the valuation cushion versus developed markets. Barring a recession, bond yields are unlikely to fall much from current levels. We have thus left our underweight position in bonds unchanged. MACROECONOMIC SITUATION United States The distress in the US sub-prime mortgage market has intensified. Not only have the sub-prime problems— and those in related derivatives— spread to other markets, but the real economy also seems to have been affected. The financial markets problems have the potential to develop into a general credit crunch and have an impact on the real economy. The Federal Reserve was initially criticised by some market participants for its inactivity in the current liquidity crisis. But after the ECB led the way in providing liquidity, the Fed followed suit. Although the Fed initially provided less support than the ECB, money market rates in the US were pushed below the official rate. Money market rates have even been below 5%. The Fed has thus effectively eased monetary policy, albeit in a way that can be reversed quickly. On 17 August, the Fed took centre stage by cutting its discount rate. This is not the official money market target rate, but a penalty rate through which the Fed performs its function as lender of last resort. The positive market reactions (equity prices and bond yields rose) showed that the Fed’s psychologically important step was helping. Banks were actively encouraged to borrow through the discount window and the terms of these loans were eased. Several large banks borrowed through the discount window. The move revealed the Fed’s willingness to calm the markets and prevent the liquidity crunch from developing into a general credit crunch. Nonetheless, money market rates have not settled. Overnight rates continue to have a large spread over the Fed funds rate. The problems in financial markets have developed against a backdrop of a softening economy. The housing market is experiencing a double dip, confidence is waning and the number of jobs shrunk in August. Meanwhile, inflation, which scared investors as recently as June, has become a non-issue. Bad news has predominated in the US housing market. US builders’ confidence is back at levels last seen just after the savings & loan crisis of 1990-1991. Housing activity is 40% off its peak in late 2006. In July, pending homes sales dropped by more than 12% mom. It should not have come as a surprise when home prices fell by more than 3% yoy in the second quarter. The bad news is that there is no end in sight. Consumer and producer confidence levels are waning, though they are substantially above recession levels. In the current circumstances of a cooling economy, we think that inflation fears will fade rapidly, despite relatively strong increases in materials prices and unit labour costs. The economic circumstances have cooled so much that the three most important criteria for a Fed rate cut are satisfied. First, the economy has been growing below trend for Page 1 GLOBAL TACTICAL ASSET ALLOCATION the last four quarters. Second, inflation is within the Fed’s comfort zone and is unlikely to increase. Third, employment is falling, while unemployment is rising. The question is no longer whether the Fed will cut, but rather by how much. The current situation has similarities with the financial crises of 1998 and in 2001. In 1998, a financial crisis broke out after Russia defaulted on its debt and the LTCM hedge fund collapsed. The current financial crisis looks more serious than the LTCM crisis. Back in 1998, it was known where the risks were and the Fed could broker a deal to save the financial system. Today, it is not known who holds the sub-primemortgage-related assets. Moreover, there are widespread concerns that large holdings of these products are owned by less-regulated financial institutions, such as hedge funds. Moreover, the credit risks are not limited to the US but are spread around the globe. The current economic weakness has similarities with the recession of 2000-2001, when an over-leveraged corporate America got into trouble after the dotcom bubble burst and the Fed cut rates aggressively to save the US from a severe recession. Today, corporate balance sheets are sound, while the problems centre on an over-leveraged consumer. Since consumption makes up roughly two thirds of the economy, the potential downside for the economy is thus substantial. In our view, the Fed will cut rates. The extent of the cuts will depend on both financial-market developments and the softening of the economy. If the financial-market turmoil suddenly intensifies, we expect the Fed to take large steps to prevent a credit crunch that would paralyse the economy. But we believe that the Fed’s cuts will reflect the cooling of the US economy. Given the negative news from the labour and housing markets, we now expect the Fed to cut by at least 50 bp this year. Eurozone The eurozone economy is in good shape. Although leading indicators seem to be showing that eurozone economies have passed their peaks, growth is still robust. Improved profitability has been a favourable factor for investment and employment growth. Capacity utilisation has accelerated sharply and the utilisation rate, which declined slightly in the second quarter, is now higher than the most recent peak in 2000. Employment is rising robustly and unemployment is at 6.9%, which is a multi-year low. Enhanced job security and a less indebted consumer than in the US should contribute to consumption growth in the region. Although export growth may decline somewhat due to the strong euro and decelerating global trade, we expect the eurozone economy to expand above trend both this year and next. The turmoil in financial markets turned out to be stronger than the fears about inflation. In the past few months, the ECB had hinted that it would hike rates. The economy has been growing above trend for a while and money growth re-accelerated to 11.6% yoy in July, far above the 4.5% that the ECB has as the upper end of its comfort zone. Inflation was 1.8% in July but is likely to shoot through the 2% threshold in the coming months when favourable base effects disappear. The ECB has therefore not dropped its tightening bias. But it would be strange for the bank to flood the market with liquidity at the same time that it was raising the cost of finance. As a result, we expect the ECB to remain on hold for the rest of this year. Japan The latest data seems to show that the Japanese economy has still not escaped from deflation. In the second quarter, growth fell by 0.3% qoq. Headline inflation was flat in July, while core inflation ex-energy fell by 0.5% yoy. But there are also some pockets of strength. Unemployment is at a multi-year low, and the prospects for employment growth look promising. Profits are growing at one of the highest rates in the developed world and Japan is benefiting from strength in neighbouring Asia––China in particular––which is partly offsetting the recent appreciation of the yen. In August, the Bank of Japan (BoJ) injected funds into money markets but then drained money from the financial system after overnight call rates fell (in the opinion of officials) too far. This can be interpreted as a sign that the BoJ is eager to raise rates. But we believe that the BoJ will be forced to shelve its plans for a rate hike, first because of the recent turmoil in financial markets, and second because of the cooling of both the Japanese and US economies. Emerging markets With the global credit market under serious pressure and economic growth momentum slowing in the US, Europe and Japan, the outlook for global trade has deteriorated in recent months. Emerging Asia—the world’s manufacturing centre—is likely to be affected by a global economic slowdown. The magnitude of the Asian slowdown will depend on the buoyancy of the US financial system. For the time being, we are assuming that global trade growth will start declining in the next few months, which will have a negative impact on GDP growth in the open Asian economies. We have thus reduced our 2008 GDP growth forecast for the region by a full percentage point to 7%. A sharper growth adjustment is not justified at this stage, first because China will probably continue to gain market share in global import markets, and second because of the typical increase in public investment throughout Asia in periods of declining external demand. With credit markets likely to remain tight for a while and global trade growth likely to start slowing, we expect a more challenging environment for Brazil in the next few quarters—perhaps even years. Page 2 GLOBAL TACTICAL ASSET ALLOCATION As the country’s fiscal accounts, debt ratios and external financing needs are in much better shape than five years ago, when Brazil was confronted with its last financial crisis, we assess the likelihood of another crisis to be very low. But we do believe that the increased headwinds from the global environment will bite into growth. The real is likely to weaken further due to lower export revenues and falling portfolio capital inflows. As a result, domestic interest rates are unlikely to be cut as much as originally expected. Depending on the magnitude of the currency depreciation, interest rates might even have to be raised. Lower export growth and higher domestic interest rates should reduce overall economic growth. We have reduced our 2008 GDP growth forecast from 5% to 4%. BONDS Ten-year bonds have rallied as the troubles in financial markets have triggered safe-haven flows. US Treasury yields fell from 5.3% on 12 June to 4.4% on 13 September. A similar pattern was visible for tenyear Bunds and Japanese government bonds. Through the summer months, the spreads on riskier bonds widened as investors fled from riskier products, while shorter-term money market rates continue to have an unusually large spread over central bank rates. US Our overall view on US bonds is neutral. The macroeconomic backdrop has improved in the light of the weak jobs data and lower inflation numbers. In addition, improvements in labour productivity, lower unit labour costs, gradually rising unemployment and declining commodity prices (ex-oil) were bond friendly. Although most inflation measures are at the higher end of the Fed’s comfort zone—or even outside it—we do not think that inflation will be a problem. The recent cut in the discount rate was driven by the Fed’s desire to calm the market and keep credit liquid. The statement accompanying the reduction indicated an implicit easing bias. Against the background of a flight to quality, the Treasury market rallied and valuations now look expensive. Nevertheless, we are expecting the sub-prime problems to remain a factor in the market, which should continue to support government bonds. At the time of writing, the market is pricing in 75 bp of rate cuts in the US. As a result, the potential for ten-year Treasury yields to move down seems limited. Market risks would be greater if the Fed does not cut rates than if it does. The market is likely to remain choppy in the near term, so forecasting developments is difficult. The front end of the yield curve has led the recent market rallies. If the Fed does cut rates, as expected, this should offer further support to the front end of the curve. When markets calm down, we believe that the longer end will take the impact. We expect to see further steepening of the yield curve, as well as wider breakeven inflation on rising risk premiums/mortgage-contagion fears. In the current volatile environment, we have low conviction about the quality of investment opportunities. Eurozone The macroeconomic outlook for the eurozone is less positive for bonds than in the US. Although leading indicators are coming off their peaks, we expect third-quarter economic data to be more robust. Unemployment has come down to levels considered close to the natural rate. This suggests that growth is still above trend, which would induce further inflationary pressures. But the recent pressures in the money markets make it unlikely that the ECB will hike rates. Ten-year Bund valuations look neutral, with recent gains underpinned by the flight-to-quality theme. We are expecting some modest curve steepening over the next three months. Japan The latest macro data has been bullish for bonds. GDP shrank in the second quarter, sentiment indicators and leading indicators deteriorated, and inflation is at zero at best. Nonetheless, we are expecting a turnaround in 2008, based on labour market shortages spilling over into higher wages and thus higher inflation expectations. Economic growth is forecast to be above trend and land prices are rising. After recent rallies, JGB valuations look slightly stretched and our overall view on JGBs is neutral to bearish. The BoJ was widely expected to hike interest rates in September, but did not do so, in part because of the market turmoil and in part because of the adverse data flow. If financial markets calm down and economic data bounces back from the secondquarter setbacks, the BoJ may reconsider a rate hike, though it is unlikely to take place in 2007. Bond allocation Spreads on riskier bonds and corporates have widened over the summer, due to the turmoil in financial markets. As a result, our overweight government bonds position has worked out well. We believe that spreads have not widened enough to justify considering overweight positions in the riskier bond categories. We therefore remain overweight in government bonds and underweight in corporates, high yield and emerging markets bonds. The problems with sub-prime mortgages intensified in late July and in August. Problems that first seemed to be limited to the US spread into other financial markets. The second-biggest European bank, BNP Paribas, froze access to three funds and a couple of German banks were hit by losses on what at first seemed relatively risk-free mortgage-backed securities portfolios. On 9 August, the ECB pumped EUR 95 bln into the market after interbank liquidity started to dry up. Later, the Fed and the BoJ followed the ECB’s example. Since then, money markets have not calmed down. Further liquidity injections by the central banks followed and money market rates Page 3 GLOBAL TACTICAL ASSET ALLOCATION are still widely above central bank target rates, indicating that financial parties do not trust each other. Banks and other financial institutions are currently going through their books, which should help to clarify where the risks are located. But this will probably be a time-consuming process. We therefore expect nervousness in financial markets to persist and volatility to remain high. In such as environment, riskier bonds are likely to underperform. And now that markets are growing more concerned about the possibility of a US recession, the outlook for risky assets has become even more complicated. We believe that a loosening of monetary (and fiscal) policy may prevent the US economy from landing up in a recession. Nonetheless, recession fears will not disappear in the short term, thereby limiting the upside potential for riskier markets for some time. CURRENCIES We forecast no major changes for the US dollar either in the shorter term or in the longer term. We believe the downside risk for US interest rates is limited because the market has already priced in 75 bp of cuts. As we expect the ECB to remain on hold for the next few meetings, the expected interest-rate differential should remain stable. This could change, of course, if the US slips into a recession––when the US dollar could weaken substantially––but that is not our main scenario. As we also expect the BoJ to postpone rate hikes, a similar line of reasoning applies to the yen/dollar rate. Our forecasts for the coming three months are 1.38 for the euro/US dollar and 112 for the yen/dollar. In the longer term, we expect some softening of eurozone growth, while the US may emerge from its housing-market-related problems in 2008. This could lead to a higher interest-rate differential with Europe and upward pressure on the currency. On the other hand, we also expect the large current-account deficit to keep the dollar in check. As a result, we have a 1.40 forecast for the euro/dollar rate in twelve months, which is close to the current position. If the Japanese economy claws its way out of the current deflationary period, the BoJ is likely to resume hiking rates again in 2008, which should lead to an appreciation of the yen. We are forecasting that the yen will appreciate to 110 against the US dollar over the next twelve months. But the uncertainties surrounding this forecast are substantial. If investors suddenly become more risk averse, the yen could appreciate swiftly. On the other hand, if the economy remains in the doldrums for a longer period, markets may anticipate a return to the zerointerest rate policy. In such a case, the carry trade may be implemented again, making it likely that the yen would depreciate significantly against both the euro and the US dollar. EQUITIES The outlook for equities remains positive, although there are significant risks. First, the market has remained volatile since the problems in financial markets developed. The MSCI World index dropped by more than 10% from mid-July but recouped half of its loss between mid-August and early September. The volatility is also evident in the VIX index. Before the sub-prime related problems began, the VIX had been stable at 13-14 levels; by mid-August, it had soared to above 30. At the time of writing (mid-September), the VIX is still at 25. If we are right that a recession can be avoided, the downside for equity markets should not be too big; in 1987 and 1998, equity markets fell by some 20% and quickly recovered in both years. Twelve months after the respective declines, the MSCI World index was up by 23% from the 1987 trough and 38% up from the 1998 trough. Nonetheless, if there is a recession in the US, the downside is substantial. At the time of the savings & loan crisis 1990-1991, the MSCI World fell by 22%, while equity prices halved in the 2001-2003 bear market. There are a number of positive factors for equities at present. First, corporate balance sheets are in good shape. Indeed, the current subprime problems may actually prevent corporates from over-leveraging themselves. Moreover, even fiscal measures may be taken to prop up the economy. Second, central banks seem to be willing to cut interest rates and flood markets with liquidity to prevent a credit crunch. Reflation has been a powerful driver for equities in the past, and we expect low interest rates to support liquidity. Third, inflation is relatively high in the central banks’ tolerance zones, but is likely to be a non-issue if the US economy slows. Fourth, outside the US, the rest of the world seems to be in a good shape. European growth is above trend and China is recording double-digit growth numbers. Fifth, valuations are not overstretched, as was the case in previous recessions. One could argue, of course, that valuations are stretched on the basis of cyclically adjusted earnings, but we believe that the prospects for earnings growth in the coming period are relatively favourable, due to globalisation, low labour costs, deregulation and the implementation of productivity-enhancing IT. Regional allocation US and Europe In local currency terms, the performance of US equities has mirrored that of European equities. It is difficult to indicate a preference between the two regions. First, the softening of the US dollar worked to the benefit of US exporters and helped to boost US profits. On the other hand, a weaker dollar makes US investments less attractive for eurozone-based investors. Although the economic risks in the US are greater due to the sub-prime problems, interest-rate risks in the eurozone are more significant. The ECB is still on hold but has a clear tightening bias, while the Fed seems to be on the verge of cutting interest rates. The US has a lower beta and would normally be the preferred market for safe-haven flows, but in Page 4 GLOBAL TACTICAL ASSET ALLOCATION the current economic circumstances, Europe and emerging markets are likely to safeguard global growth. Japan The situation for Japanese equities is less favourable than for eurozone and US equities. First, the economy seems to be in the doldrums. Growth contracted in the second quarter and inflation is at 0% or, for some inflation indicators, even below zero. Second, the yen has appreciated as investors became more risk averse and unwound the carry trade. A more expensive yen is hurting profits and could be an additional negative now that domestic demand is softening. Third, there are no direct triggers for the equity market to thrive. The political situation is a mess, after the LDP lost the Upper House elections and Shinzo Abe resigned as prime minister. There is no great flow of M&A deals, particularly those involving foreigners, in the pipeline, and wages keep falling on a yoy basis. Emerging markets We remain sanguine about emerging markets, even though they have recouped a good part of their losses since 23 July. First, global economic growth remains healthy. Although the situation may be less favourable than in 2006 and early 2007, there is a good chance the emerging markets will grow at high rates. Chinese growth is still at double-digit levels, which is propping up materials prices. This in turn is a stimulus to commodity-rich countries. Emerging markets still have a valuation cushion versus developed markets, although we admit that the margin between the P/Es in developed and emerging markets is diminishing. But we believe that emerging markets are likely to be the least influenced by the US housing market troubles, and that a loosening of monetary policy by the Fed will have a positive impact on emerging markets. Sectors In our sector policy, we take the stance that global growth will be robust, albeit at lower levels than in the last few years. We therefore continue to favour cyclical sectors that are not directly exposed to the consumer (such as IT and materials) and commodity-related sectors (such as energy and materials). As the US consumer is at the heart of the current problems, we remain underweight in consumer discretionary and consumer staples. We continue to favour the healthcare and telecom sectors, because of their large-cap bias and because they can function as a defensive hedge. We maintain our small underweight in utilities, as we are expecting long-term interest rates to rise from current levels. We considered trimming our underweight in financials, which typically outperforms after a Fed rate cut. But due to the ongoing turmoil in financial markets, we think such a move would be premature. It is possible that not all the bad news has been priced in and that there will be more earnings disappointments as financial institutions go through their books. PROPERTY Now that liquidity in the US debt market is drying up, private equity deals are in jeopardy, although it is likely that the Hilton and Archstone deals will be finalised. There is some concern about the large number of adjustable-rate mortgages that are to be reset within the next year, as these residential mortgage issues could start to affect the commercial sector. Defaults have increased and lenders have tightened their underwriting standards. Valuations look enticing. We prefer to position ourselves within sectors that are subject to longer lease terms, such as malls and offices, and with companies that have strong balance sheets. Smaller companies with debt concerns are the ones to avoid in this environment. There is a feeling that the European market is bottoming out and sentiment will reverse in the coming months. Again, as in the US, yields in the UK are expected to increase. In fact, current valuations reflect an up-tick in yields by 50-100 bp. The German economy remains in good shape, although some German banks have recently got into trouble due to their US sub-prime exposure. Rents are increasing sooner than expected, even in Berlin. Within the Asia Pacific region, Hong Kong has great upside potential. Chinese investors are now allowed to invest in Hong Kong, which should push prices higher. In Japan, however, we expect opportunities to be more limited in the near future, as the Japanese are the end-holders of a significant amount of US sub-prime debt. We are shifting property assets out of Asia and Europe into the Americas. We are currently modestly overweight in Europe and the US, and underweight in Asia. We have some concern over the level of Japanese exposure to US sub-prime loans, and about a reduction in US consumer spending that could potentially slow Chinese growth. In addition, in the event of a worldwide growth slowdown, the US would provide the best defence. Furthermore, if the global economy stabilises, the Americas offer the best relative valuations. ASSET ALLOCATION Despite the volatility in markets, we have made no changes to our asset allocation. We maintain our overweight in equities and our underweight in bonds. We remain neutral in both cash and property. Even in the light of the current financial-market turmoil, we continue to believe that an overweight equity position is justified, albeit that such a position is not without risks. The US economy may slow further, but global growth is likely to be substantial, particularly in emerging markets and Europe. Profit growth is likely to benefit from global growth and IT implementation, deregulation and globalisation. The Fed rate cuts that seem to be in the offing should also help to support liquidity, keeping interest-rate risk low. Given that 75 bp of rate cuts by the Fed are priced in by the markets, we Page 5 GLOBAL TACTICAL ASSET ALLOCATION do not expect Treasury yields to fall by much. As a result, we are not changing our underweight position, as a US recession is not our main scenario. We acknowledge that the turmoil in financial markets is likely to continue as financial institutions go through their books. We therefore remain underweight in the riskier bond categories. We remain neutral in property, as the positives on the asset class are offset by some negatives. On the one hand, valuation has improved, given that property has underperformed equities so significantly since March. In addition, property is also being supporting structural factors, such as the implementation of REIT legislation in Germany and the UK, and pension funds’ structural underweight in the asset class. On the other hand, property benefited significantly from the leveraged environment, which now seems to have vanished. Finally, the correlation between property and equities has shot up from 30% two years ago to 63%, making property a less-attractive diversifier in a multi-asset portfolio. Important information This material is provided to you for information purposes only. Before investing in any product of ABN AMRO Asset Management (Netherlands) B.V., you should inform yourself about various consequences that you may encounter under the laws of your country. ABN AMRO Asset Management (Netherlands) B.V. has taken all reasonable care to ensure that the information contained in this document is correct but does not accept liability for any misprints. ABN AMRO Asset Management (Netherlands) B.V. reserves the right to make amendments to this material. Page 6