Climbing a wall of worry.ppt

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					„„Heading off-piste‟‟
    Some food for thought



    MCT Wealth Management
 Investment Views for 2006
As we enter another challenging year, we would like to share with our clients our way of approaching the
investment markets in 2006.
Obviously, we do not know what the future is made of and there are plenty of “unknowns” going into the new
year. But we know that there is always an asset class that will do well in the future investment environment. Our
aim is identify this asset class, although it‟s never easy.
This annual report consists of four main parts:
Reviewing the last investment year (pages 3 to 11)
The world economy is behaving abnormally by past historical standards and we continue investing money in an
un-balanced investment world. The lesson of 2005, however, is that long-term adjustments may not occur for a
long time. In the meantime, there may well be money to be made.
Searching for better understanding (pages 12 to 20)
Last year was full of economic and investment surprises, and we try to focus on some of them in the hope that
pushing our investment understanding way past conventional thinking will lead to a successful performance in
the future. In our search we use various independent research sources to supplement our own in-house approach
and we strongly believe that reflecting on some out-of-the-box analytical ideas is time well spent.
Visiting the global investment village (pages 21 to 32)
We travel through various markets and asset classes of the global universe of investment choices to see 2006 in
the bigger context of long-term opportunities and vulnerabilities.
Looking into the future (pages 33 to 46)
We don‟t really do forecasts and we don‟t attach a time or any specific number to our future expectations, but
we wish to present our views on different possible investment scenarios developing over the next 12 months.
Our main investment theme for 2006 is an opportunistic optimism with a huge dose of flexibility, and you would
be better advised to watch what we will be doing during this year instead of holding us tightly to what we write
in this presentation in early January.

Enjoy your reading,
                                                                           MCT Wealth Management Team
Reviewing the last investment year …
      Global economy in 2005 – “as good as you could ask for”

•   Economic developments during 2005 were similar to the previous year in that stability was maintained
    despite many of the risks highlighted at the start of the year actually being manifested.
•   The global economy had still been flying on two engines: the Chinese producers and the American
    consumers, but 2005 has been a different year.
•   The global growth was more balanced and remarkably robust, and remained above its long-term trend, in
    spite of the substantial increase in cost of capital and much higher prices of commodities; companies almost
    everywhere are making more money than ever before.
•   The US economy proved resilient enough to keep the worst fears at bay; consumers continued to spend, the
    housing market did not collapse, and productivity and growth have been robust (GDP growth 3.5% after
    4.4% in 2004).
•   The pulse of the euro zone‟s economies has quickened, especially during the second half or the year;
    Euroland is observing a positive shift in consumer and business sentiment surveys, and its economic growth
    in 2006 is expected to be its best in 6 years.
•   The Japanese economy is in its longest expansion since the bubble burst a decade ago and China‟s trade
    continued to boom, up 23% from the previous year.
•   Declining volatility of the global economy (sub-trends in Emerging Markets are less clear), combined with
    stronger trend growth, was positive for risky assets.
•   Unfortunately, some countries continue to prefer an export-driven growth model for their economies
    (including China) by neglecting their domestic consumption; one of them is Germany, which usually
    dominates the European economic cycle.
•   Japan and Europe are still very dependent on the rest or the world for most of their growth; if one strips out
    exports and government spending from the GDP numbers of either Japan or the European three largest
    economies (Germany, Franvce and Italy), there is very little growth left.


      As we move into 2006, it’s likely that we’re going to see economic resources starting to get tight.
      Equities: the best & the worst markets (in local currencies)

AMERICAS                              AMERICAS
Mexico                        37.8%   Chile                           9.1%
Brazil                        27.7%   US                              0.6%
Canada                        21.9%   Venezuela                      31.9%


EUROPE & AFRICA                       EUROPE & AFRICA
Norwey                        52.2%   UK                         16.7%
Austria                       50.8%   Italy                      15.5%
South Africa                  43.0%   Portugal                    3.4%


ASIA                                  ASIA
South Korea                   54.0%   Hong Kong                   4.5%
Pakistan                      53.7%   Malaysia                    0.8%
India                         42.3%   China Shanghai              8.2%
Japan                         40.2%   China Shenzhen             11.8%


EMERGING EUROPE                       EMERGING EUROPE
Romania                       64.5%   Czech Republic                 28.6%
Russia                        50.9%   Hungary                        21.5%
Bulgaria                      50.5%   Croatia                        16.8%
                       2005: a good year for the equity bulls
•   With conditions nearly ideal, world equity markets surged and they enjoyed one of the broadest rallies in
    recent memory, but only outside the US; U.S. equities delivered subpar results (they remain relatively
    cheap, probably because they have to compensate for the USD risk), despite corporate-profit growth
    steadily outpacing forecasts (profit margins are close to 35-year highs).
•   The real action was in share buybacks (companies in the S&P500 index spent an estimated $ 315bn, up
    60% from the year before, a sum that was also a record) and small cap stocks.
•   Quoted companies in Euroland have found a way of not suffering from the ongoing continental stagnation;
    in other words, a growing share of the profits of European companies does not originate in Europe, but
    somewhere else (if one discounts strong profits made abroad, with long rates made in Euroland, one could
    be less surprised by the strong continental markets).
•   A rally, driven primarily by overseas institutions and domestic retail investors, has propelled the Nikkei 225
    index to five-year highs of about 16.000.
•   Asia benefited from strong economic growth and a large expansion in multiples, while Latin American
    commodity producers capitalised on rising prices for natural resources.
•   The usual correlation between various Asian markets totally broke down last year (three markets really
    stood out: South Korea, India and Japan, but most other markets had a rather lacklustre year with Taiwan
    and Thailand trully disappointing); Asia has also witnessed a clear lack of breath (most markets powered
    ahead on a limited number of large caps).
•   The Chinese equity markets have been one of the worst performers in the world despite massive economic
    growth; the main reason: Chinese companies are not operating under free-market conditions.
•   Global investors increased their exposure to the developing equity world, which has been steadily
    outperforming developed equity markets (but they still trade at a sizeable discount), and this is probably a
    more structural change; the significant increase in dedicated EM funds signals a strategic shift in the
    thinking of market participants for all things emerging.
•   Many markets, especially in the Middle East, were strongly lifted by a huge tide of oil money, going around
    and chasing any existing investment opportunities.
•   2005 was a record year for foreign-stock purchases by American investors with net purchases exceeding $
    100 billion (another reason why their own shares are lagging).
      International Bond Markets in 2005

US Treasury                                3.2%
US Corporate                               2.4%
US High Yield                              3.0%
US Mortgage                                2.9%
EM Debt                                    12.0%
EM Latin                                   12.5%
EM EMA                                     10.2%
EM Asia                                    17.3%
Poland                                     9.9%
                  A surprisingly consistent “valuation anchor”

•   Nothing is ever perfect, but macroeconomic conditions in the global bond market came pretty close last
    year; however, the search for yield that characterised so much market activity in 2005 will no doubt be
    more difficult and less successful this year.
•   Movements in short-term interest rates prove to be an unreliable guide to bond yields; yield curves are
    much flatter everywhere or even inverting (the Japanese yield curve is amongst the steepest).
•   The flattening of the yield curve, with short-term interest rates rising to the level of long bond rates, failed
    to disturb international bond investors; many economists urged investors to ignore the recesionary threat of
    the inverting yield curve due to unique global economic and investment circumstances, including a foreign
    strong bias towards the USD and long-dated US treasuries.
•   Investment grade spreads in the US and Europe remained close to last February‟s record lows, while high-
    yield spreads have widened only modestly (high-yield default rates are at an 8-year low).
•   Some of the most striking changes have occured in Emerging Markets; EM sovereign bond spreads have
    continued to fall last year even as other credit spreads have widened.
•   2005 has not been a kind year for Asian fixed income investors and the Japanese bond market.
•   The Japanese private savers have been huge buyers of US and European bonds, much more important than
    central banks (the biggest purchase of foreign stocks and bonds since 1989, the year that the government
    first started compiling this data).
•   The big question is if and when they will discover better returns at home and repatriate funds to the local
    equity market (90% correlation between the Tokyo stock market and the US bond yield on a daily basis
    since 1990).
•   With government spending on the rise everywhere and low real interest rates, government bonds are
    attractive neither structurally nor on valuations.
•   Corporate activity is becoming less bond-friendly as companies gear up again, and merger and acquisition
    activity is increasing; corporate profits could also be challenged by the cyclical deceleration.
Performance of different hedge fund strategies in 2005

            STRATEGY             Performance in   Performance in
                                      2005             2004
   Dedicated Short                   19.3%            7.7%
   Emerging Markets                  14.6%            12.5%
   Distressed Debt                   9.8%             15.6%
   Global Macro                      7.6%             8.5%
   Event Driven                      7.4%             14.5%
   Long/Short Equity                 6.7%             11.6%
   All Funds                         5.9%             9.6%
   Event Driven Multi-Strategy       5.9%             14.0%
   Multi-Strategy                    5.5%             7.5%
   Equity Market Neutral             4.6%             6.5%
   Managed Futures                   2.5%             6.0%
   Risk Arbitrage                    2.2%             5.5%
   Fixed Income Arbitrage            0.2%             6.9%
   Convertible Arbitrage             3.5%             2.0%
        Hedge funds: an “alternatively traditional” asset class?



•   Hedge fund investors have changed from mainly HNWI to mostly pension funds (institutionalisation of the
    hedge fund industry) and, with this change, the risk-reward equation in the hedge fund segment has
    changed dramatically, effecting its average performance numbers.
•   For all their popularity and prominence, most hedge funds are no longer delivering double-digit annual
    returns, raising questions about their future investment profile and suggesting a potential shake-out in the
    industry; their popularity among private wealthy investors is already declining.
•   The hedge fund field also gets ever more crowded; many hedge fund strategies still beat many other
    traditional investment choices, but their most recent performances didn‟t match past years; the over-
    abudance of efficiency capital means that hedge funds are now chasing very small inefficiencies.
•   At the same time, 2005 was a very good year for hedge fund investors who were prepared to take more
    directional risk and who wanted to benefit from alternative betas; these types of funds, however, do not
    make money every month and their absolute returns are much more volatile.
•   Over the past 12 months the correlation between Merrill Lynch‟s diversified HF index and the S&P500
    index was 0.8%; in other words, 80 % of the performance of the HF sector could be explained by the
    movements of the US equity markets! (probably also because managers have chased risk in order to
    enhance their returns).
•   Investors seeking to diversify away from equities or bonds need to make sure that they know why they are
    doing it and they have to be careful with their strategy and fund selection in order to avoid any major
    performance disappointments.
                            2005: “the dogs that didn‟t bark ”

Many economic relationships and investment asset classes have not behaved in the way that the markets
   anticipated before the begining of the year:

•   The continuation of the conundrum in the US bond market and its international widening
•   The level and sustainability of oil price
•   A lack of any strong visible pressure on the core inflation despite much higher headline numbers
•   The ability of the US to cover its huge current account deficit
•   The resilience of the credit market
•   The performance of the US dollar, its best in four years (market forecasts haven‟t been that wrong about the
    direction of a major currency since 1999)
•   The subpar performance of the US equities
•   The remarkable success of Germany‟s export sector, despite high domestic costs and a relatively strong
    currency
•   China‟s willingness and ability to run a profitless economy by absorbing higher material and labour costs
•   The Yen‟s weakness, despite massive purchases of the Japanese equities by foreigners
•   Asia‟s outperformance in the face of rising commodity prices and tightening global liquidity conditions
•   The collapse of Asian currencies

•   No sustainable disruption in capital flows to riskier asset classes despite declining attractions or the carry
    trade
•   Housing markets failing to fall (rather they have levelled off)
Searching for better understanding …
 Global economic transformation: “an amazing period of history”

Since China‟s shift towards economic openness and the end of the Cold War, the world economy has been going
through a massive transformation with a substantial impact on the global economic cycle and the behaviours of
all the economic players, including the financial investors.

Western economies are moving away from being industrial based economies to being service economies (this is
where wealth is being created today) with a less volatile economic cycle (industrial jobs are more cyclical and
not as secure as service jobs); meanwhile, a number of Asian economies are moving away from being
agriculture based and are becoming industrial economies, with higher and less cyclical growth.

This means that the most volatile parts of the international production process have been outsourced to newly
emerging industrial economies, with huge macroeconomic implications for investors (far less volatile developed
economies with milder swings in employment, higher and more stable profits, and potentially structurally
stronger productivity); unfortunately, the volatility has not disappeared from the global system; it has simply
been transferred, through imports and outsourcing, to Emerging Markets.

The globalisation threat has had the effect of depressing wages and increasing inequality in numerous countries,
both rich and poor; but it has also had dumping effects on inflation and interest rates.

Only the future will tell us whether the West‟s loss of competitiveness, not just in the goods produced by the
industry but also increasingly in services (as a percentage of GDP in the US the trade surplus in services has
actually begun to decline) will have a negative impact on living standards in the US and in the West.

Another important change is that international companies, banking organisations and financial markets are
increasingly efficient; greater market and business efficiency leads to higher confidence and it also encourages
companies and consumers (unfortunately, also those left behind and trying to preserve their traditional life style)
to take on more debt
        Plutonomy: “it has never been so expensive to be rich …
The world is dividing into two blocks: the beneficiaries of globalisation (the plutonomy) and the rest of us, with
plutonomies (areas of economic activities, where growth is powered by and largely consumed by the wealthy)
having an increasing impact on the structure and the dynamics of the global economy.
In plutonomies the wealthy absorb a disproportionate chunk of the economy and have a massive influence on
reported economic statistics like savings rates, current account deficits, consumption and debt levels, etc.; this
growing imbalance in wealth inequality expresses itself through aggregate numbers in the commonly recognised
global imbalances.
Sources of wealth generation, exploited best by the wealthy, educated and creative (entrepreneur-plutocrats),
include the development of new technologies and new products, the opening of new markets, an access to a new
supply of labour, new business processes and productivity improvements, financial engineering and capital
leveraging (in summary: the current wave of globalisation with its tectonic shifts in politics and society,
combined with an undisrupted inheritance process).
There is no average consumer in the plutonomies and our traditional consensus analysis, focusing on the average
economic players, is deeply flawed; there is compelling evidence that the wealthy account for a surprisingly
growing and disproportionately large portion of the national and the global economic pie.
We talk about the massive improvement in the standard of living of the rich 1% of the population, but by
contrast, for the typical household in the West real wages have been declining; so the vast majority of people are
not living better than they did 20 years ago, and if they do live better – if – it is only because emerging
economies now produce goods that are more affordable and the financial system allows for the leveraging of
historical individual economic success to finance current consumption.
This deepening plutonomy of a few and the uneqal equality of others, or the imbalances in inequality across
nations and continents, correspond with the global imbalances: debt loads, savings rates and asset inflation.
All the things rich people like to buy (things that you can‟t mass produce), and that includes certain segments of
real estate, commodity market and equities, are being priced out of the market; however, in these segments,
affordability is not an issue and this could be a structural change and a long term trend.
Threatening global imbalances are therefore pretty understandable and sustainable, and applying an excessive
risk premium to them is a flawed approach to bond and equity investing.

              … but neither has it ever been so cheap to be poor! There is a lot of truth in that”
       Walking the global path of “dis-inflationary equilibrium”
It seems to us that the day of reckoning over the world‟s huge economic and financial imbalances could be
postponed as long as both the US and China keep doing what they have been doing over the last few years:
China generating its deflationary pressures and the US reflating through a necessary dose of liquidity to create a
kind of global dis-inflationary equilibrium (the US deficit has also played a key part in taming economic cycles
and supporting global growth, as much as Chinese buying in global bond markets).
As the consumer (demand stability) and borrower of last resort, the US allows the world to avoid deflation and
to work itself out of any major economic or financial crisis; on the other hand, the Chinese government‟s goal -
as the “global profit loser of the first resort” – is to employ every single Chinese worker by promoting the
Chinese market share strategy and by supporting the expansion of local production capacity irrespectively of
existing demand.
Investors today believe that the global economy is successfully reflating in the face of the largest capacity
expansion in the global economy in our lifetimes, at the time when most industries have no significant pricing
power; therefore, the interest rates have been lowered for a number of logical secular reasons that are likely to
persist for some time.
We think that the deflationary forces of globalisation, and with them the ongoing implications for strong
investment growth in the emerging world and low labour pricing power in the developed world, remain as strong
as ever and that they are likely to continue through 2006. If the globalisation process is allowed to run, we will
not have an all-out massive redirection of global imbalances.
It will be very important, however, to observe how these structural trends could persist in the context of a series
of delayed inflationary effects of high commodity prices and of a full impact on economic growth of previous
monetary tightening; we recognise however, that the above cited factors have a probable longevity that exceeds
a normal business cycle.
In summary, we probably live in an under-appreciated and misunderstood world of high growth, low inflation,
greater productivity, accelerating competition and very challenging economic polarisation.
                          The affordability of “bad deflation”

These days, there are a lot of prices that are falling (good deflation), and falling very hard (technology products);
and then, there are other prices that are rising, and rising a fair amount (services like medical care and
education).
One cannot state, per se, that deflation is always bad; we all experience various forms of a deflationary pull on
the global economy (with sale volumes rising faster than prices fall), because of the manufacturing in China and
because of the services coming out of India (just to use these two countries as some of the biggest structural
drivers of the globalisation process).
If one assumes that the global deflationary forces will not disappear over night, maybe one should also allow for
asset inflation and service price inflation as a way to reduce the overall deflationary pressure and to avoid the
risk of a painful shift from a deflationary boom to an outright deflation and deflationary bust.
The only time when one really has a serious problem with deflation is when total credit market debt is very high
and this is when when deflation really hits: your debts don‟t go down, but your asset prices do.
The West (mainly the US) - having created the asset inflation over the last 20 years or so as a result of
expansionary monetary policies and excessive credit growth - cannot afford deflation; therefore, some central
banks simply keep printing money and avoid targeting asset prices, because they would be taking a risk of
deflationary bust.
The real question is that once the central banks decide to target asset prices on the downside (as they do by
aertificially dropping interest rates), if they should not target them also on the upside; currently, they offer an
asymmetrical policy, which encourages asset speculation and leads to a potentially unstable and unbalanced
economic environment.
Instead, the central banks should at least target credit expansion and make sure that credit creation doesn‟t got
out of hand; it would also help if they redirected credit funding towards capital investment (real wealth creation)
rather than financial speculation (more illusionary wealth).
                           The US current account deficit:
                      a widely misunderstood global stabiliser?

In order to trade, the world needs a reserve currency. The US current account deficit represents working capital
needs of world trade, plus changes in foreign private investment and changes in foreign central bank reserves.
Over the recent years we have witnessed an impressive boom in world tarde combined with a big rise in
commodity and freight prices. The world‟s working capital needs have been growing up markedly (by more than
USD 600bn in just the last two years).
Over the coming years, we should witness a continued rapid acceleration in global trade and in turn, this growth
will imply a growing need for USD reserves. In a world with expanding trade flows, the only way to reconcile
the central banks‟ needs for reserves, and the trade‟s needs for USD, is for the US to accept to run a perpetual
current account deficit.
Those who call for this imbalance to be redressed, and for the US current account deficit to improve, are in fact
calling for a financial crisis, or at least, severe value dislocation. Illustrating this point is the fact that in the past
every significant improvement in the US current account deficit has led to an international financial crisis.
Foreigners typically do not buy USD, they earn them through trade. Today, they can still earn USD by selling
goods to the US consumers, but the ex oil and China deficit numbers are already declining (by some 20% since
February last year).
The size of the trade deficit is not a problem as long as Americans are willing to satisfy the foreign natural
demand for US assets.
Bearishness towards the USD is also contradicted by the fact that the US runs a positive cash-flow with the
outside world. Despite all the talk about over-indebtedness, the USD runs a positive carry.
Inherent in the current account is the assumption that basic profit margins are the same everywhere, but China
produces goods for no profit. If one calculated the current account on profits, and not on sales, it‟s likely that the
current account in the US would be massively positive, not negative as is the case today.
           The US household debt: “a gravity-defying experience”

       Negative savings? Maybe YES …                                           … or maybe NO?
Continued asset inflation creates a situation where people    Servicing of debt remains near a record low and is still
don‟t save anymore, which is a pre-condition for a            affordable.
healthy economic environment (growth becomes purely           Interest rates would have to rise a lot before the
driven by asset allocation, which is driven by easy credit    servicing of the debt started to really hit the consumer‟s
standards, which is driven by excessive monetary              overall financial health.
growth).                                                      US real estate prices have so far powered ahead,
One of the biggest developments in the US economy over        regardless of the rise in mortgage rates.
the past year was that the personal-savings rate went         Job growth and real disposable income have been very
negative (Americans spent more money than they made           solid in the past year, and none of them appear to be
last year!).                                                  rolling over this year.
The financial deficit of US households currently runs at      Adjusted for the cost of borrowing, US real estate
an all-time record of more than 7% of GDP, with debt          remains very attractive, especially in relation to other
service payments of 14% of the disposable income.             asset classes, such as bonds or equities.
Most of the growth in the US consumer debt over the past      Today, more savings are put aside tthrought business
five years has been mortgage debt and there is little doubt   ownership and these savings are not captured by
that some areas of the property market are experiencing a     national accounts (“moving from a nation of employees
real estate bubble.                                           to the nation of entrepreneurs”).
Savings that are entirely tied to asset market valuations     Americans, despite their negative savings rate,
with no effective means of exit are not quite safe            contributed over USD650bn (9% of incomes) into
(liquidity is a very important aspect of savings).            various savings products last year.
Companies use deep discounts and generous financing to        In a country where more people have a lot of capital and
keep debt-laden consumers in a buying mood, but their         more income is coming from capital gains or from
own profitability is expected to be challenged.               income thrown off by capital, and not just from income
It‟s time for the American consumers to stop spending!        from work, than the savings rate is maybe becoming a
                                                              less meaningful number.
  The power of the money flow - a short history of “carry-trade”

Between 1995 and 1998 many investors participated in the great Yen carry trade (whatever one bought with
borrowed Yens, one made money). However, the unwinding of the leveraged positions was both violent and
painful for most involved in it.
From 2001 to 2004, we experienced the great USD carry trade. A large number of investors borrowed USD on
the premise that the USD could only go down and that the cheap dollar would likely stay that way for a very
long time.
The USD carry trade is no longer working, borrowing is no longer so cheap and the future direction of the USD
is much more debatable. The continued unwinding of the USD carry trade may potentially lead to some short-
term dislocations in the financial markets (most investors are still positive on their short USD trades, meanwhile
bearishness on the USD remains prevalent).
Some investors believe that the USD carry trade is in the process of being replaced by the Euro carry trade (“the
most overvalued liquid currency, whose interest rates would have to go down again pretty soon due to Europe‟s
structural economic underperformance”). The Euro carry trade could potentially address the global liquidity
squeeze resulting from the declining availability of dollars.
The missing ingredient for a global Euro carry-trade has been a clear currency trend and confusing interest rate
situation, but with the EMU politics deteriorating, the markets may one day see the Euro as the weakest, as well
as the cheapest, funding currency in the world. So far, borrowed Euros have gone mainly to real estate, Eastern
Europe (both bonds and equities), private equity and publicly listed companies, but money still does not go to
finance consumption or capital spending.
In the meantime, one may observe a very popular return to the Yen carry trade. The Japanese investors (who
control the largest pool of savings in the world) borrow cheap Yen at home to chase higher returns overseas and
foreign investors leverage their exposure to the promising Japanese equity market by borrowing local currency.
                             “Con(tango) with commodities”
The commodity cycle was a great lure for new investment in the asset class in general, driving up index assets
across the board; it‟s expected that the demand for strategic commodity investments will stay high.

International investors spent USD 6bn on the commodity-linked funds last year (after watching four straight
years of double-digit performance delivered by the commodity indices) in the hope that they could participate in
the commodities super-cycle; financial buyers have come rushing in on top of the natural buyers.

Commodity returns have three sources: movements in the underlying spot price, interest earned on the margin
held as collateral on futures contracts, and the roll yield (risk premium); the latter derives from buying cheaper
longer-dated futures and waiting for the price to rise as the delivery date nears (a long position in futures is
expected to earn positive returns as long as the future price is set below the expected future spot price).

This works when forward curves are downward sloping (roll yield generated almost half the annual return from
Deutsche Bank‟s crude oil index between 1989 and 2004).

In 2005, however, roll yields turned sharply negative, as fears of supply shortages pushed the near-end of the
forward curve into contango (upward sloping).

It‟s estimated that – due to the contango – oil indices might require a 2006 spot price of $77 a barrel, ca. 26%
above the January‟s opening price of $61, just to break even this year.

One has to agree that massive speculative and asset allocation driven buying of the commodity index products
changes the fundamental market dynamics; it leads to an increasing volatility and it pushes the prices to record
levels, often despite fully sifficient supply and rising stocks.

One must also conclude that investors should be fully aware of the current market situation and they have to
consider potentially significantly reduced benefits from their investments, due to much higher costs of rolling
their index positions.
Visiting the global investment village …
             Global liquidity: “now you see it, now you don‟t”

•   Global economic activities have been lubricated by a very loose monetary policy and easy credit since
    2001; the question is, how do you take this huge liquidity out of the economy without introducing too much
    stress.
•   Over the past 18 months, central banks have been tightening their monetary policy (New Zealand,
    Euroland, Indonesia, Korea, Canada, the US), but none of them has been acting really aggressively; on the
    other hand, what has muted the effect of the monetary tightening has been the easing of lending standards
    because of increasing market competition (in the West) or because of lack of proper risk management
    measures (China).
•   The U.S. Federal Reserve has pushed its benchmark rate to 4.25% in 13 consecutive quarter-point increases
    (measured manaer), the European Central Bank raised intereset rates in November for the first time since
    2000 (from 2.0% to 2.25%) and is likely to lift them again; the Bank of Japan is also expected to embark on
    a cautious tightening policy (maybe not necessarily by lifting rates, at least initially, but by cutting back on
    its purchases of government bonds from Japanese banks, which pump Yen into the market).
•   These moves (the global money supply indicator is already in negative territory) will probably have far
    reaching consequences for the world economy as well as for international capital markets (with less money
    floating around, the market‟s willingness to take risk could be abating).
•   There is little doubt that, thanks to low USD interest rates, there has been a big pile up in USD debt in
    recent years (total credit market debt at the present time in the US is growing at about 4 times the rate of
    nominal GDP growth); some of that debt has occurred in the US, but a lot of it has taken place outside of
    the US.
•   The list of areas mostly exposed to the risk of deleveraging include China (capital mis-allocation), the USA
    (consumer boom and growth in property prices), Europe (rise in government spending allowing for a large
    expansion of the welfare state), international trade (funding for accelerating global economic growth) and
    highly leveraged financial instruments.
              Interest rates: “ the conundrum is going global ”

•   There are signs that the US no longer has a monopoly on the conundrum (the US bond yields are now lower
    than when the Fed started to raise official interest rates a year and a half ago); in recent months, the yield
    curves in Japan and Germany have been flattening, while Britain‟s yield curve has already inverted (long-
    term interest rates are even lower in Europe and Japan than they are in the US).

•   The same factors that are influencing the interest rate climate in the US are having similar effects on
    overseas bond markets, and thus, are helping to keep interest rates low in these countries; increasingly,
    sovereign debt markets in the largest economies trade as if they were in a single global market, determined
    by global savings and investment information (Japanese private investors and institutions - the asset-
    liability matching of Japanese savers - have been one of the main drivers behind the compression in global
    bond yields).

•   There is a debate going on about the appropriate monetary policy to pursue from here; core inflation is
    surprisingly stable and headline inflation is converging down, which proves that we still live in a
    disinflationary environment with global supply structurally higher than demand (low interest rates not only
    stimulate consumption in the local economies, but capacity expansion abroad even more, with investment
    in capacity looking like normal market demand).

•   Due to highly divided opinions and expectations regarding present and future inflationary / deflationary
    dynamics and the most suitable interest rate policies (the US and Europe), the investment environment for
    fixed-income investors could become much more difficult and volatile this year (in Japan, the bond market
    investors have accepted that a rise in interest rates is a certainty).


            “It’s only human nature to believe that the Fed’s maestro has called it exactly right.”
    The US: “economy operating as a huge global hedge fund”?

•   The world‟s largest economy is riding a massive wave of productivity gains and the visibility on the US
    growth outlook is probably the best of any country; however, it is still too early to suggest that higher
    commodity prices and monetary tightening have suddenly lost their inflationary or growth depressing
    power.
•   The US corporate profits have increased very sharply because of financial profits and because of
    operational profits generated by growing overseas subsidiaries, but they haven‟t increased much at all in the
    non-financial sectors in the US and the financial gains are highly dependent on asset inflation.
•   However, in the US, the cheap and easy money has financed an expansion in consumption far more than an
    expansion in capital spending; this means that the US corporate sector is relatively sheltered from the
    negative effects of the tightening liquidity environment and more expensive materials.
•   Corporate America is on course for the longest unbroken stretch (10 quarters) of double-digit earnings
    growth; the longevity of earnings growth comes at a time when profit margin and profits, as a proportion of
    US GDP, are at 30 and 50 year highs respectively.
•   US manufacturers are operating with less spare factory capacity than at any time in the past 5 years,
    pushing up prices of products in short supply.
•   Unfortunately, many businesses appear surprisingly reluctant to invest; this may suggest more pessimistic
    expectations about future economic conditions, but it could also reflect the existence of still unexploited,
    capex-free opportunities to boost productivity.
•   Most of the growth in the US consumer debt over the past few years has been mortgage debt; house prices
    and home sales may still be relatively strong, but many experts who are close to this market are getting
    distinctly less bullish.
•   We are witnessing the law of comparative advantages at work across the world; with this in mind, it seems
    that Americans are better capital allocators then foreigners (as far as the China-US relationship goes, that
    looks broadly right) and that is why foreigners save and Americans spend (is it truly unsustainable?).
•   When foreigners invest mainly in US Treasuries, then the US financial system transforms this risk-adverse
    capital into risk-friendly capital, invested in various high-yielding riskier assets and capital ventures around
    the world (the US knows how to do this better than anyone else in the world).
                     Europe: problems outlasting one cycle?

•   Europe is full of its own internal imbalances: negative export growth in France, huge current account
    deficits in Spain and Portugal, or worring budget deficits (Germany, Italy, France); it‟s liberalisation of
    market policies and financial regulations is also seen as too little done too late.
•   European governments have been a major beneficiary of the global period of easy money, expanding their
    operations and rising debt; much tighter monetary conditions could make markets worried about the
    repayment of capital on European debt.
•   European exporters have been much more successful in China than US companies; this is mainly a function
    of industrial specialisation in capital equipment and luxury goods, but also a more China-friendly foreign
    policy; in the future, this export-led regional growth model could be potentially challenged by slowing
    global economic activity and the end of China‟s investment boom (the negative impact could be greater on
    European than on US growth).
•   With employment relatively stagnant, real wages rather falling and taxes rising, household borrowing could
    be the only possible source of domestic consumption growth and it could be fuelled by leveraging property
    assets through accelerating mortgage borrowing.
•   It would, however, required the ECB to follow Britain and Sweden in an easier monetary policy (much
    lower than the current 2.25%) and to jump-start an Anglo-Saxon-style spiral of rising house prices, higher
    consumer borrowing and job creation, leading to still more house price growth.
•   The other scenario is that Euroland economies continue to stagnate, triggering potential public finance
    crises in at least a few member countries; as global growth decelerates, the situation in Europe could start
    looking rather critical, leading to possible capital flights.
•   The new German coalition government agreed that the way to stimulate an economy which is suffering
    from mass unemployment and stagnantnt consumption is to increase consumption tax (?) at the time of
    monetary tightening.
•   It seems that no-one in Europe has an incentive to talk the Euro up and many believe that to survive, the
    Euro needs to be a weak currency.
        Japan: “is the bearish case getting weaker and weaker?”
A number of economic signs seem to indicate that Japan is leaving its deflationary bust behind:
bad debts have been written off - banks no longer face the risk of bankruptcy - property prices are no
longer falling - profit growth is strong - companies are once again hiring - the economy is looking
more robust than ever - growth is more driven by domestic demand
Japan‟s Prime Minister Junichiro Koizumi‟s election victory in September was widely viewed by the markets as
a mandate for accelerating economic and political reforms.
However, popular optimism about the economy - still very strong among many private and institutional
investors - doesn‟t have to automatically translate into another year of substantial stock-market gains:
• Japanese companies continue to restructure (by applying technology, cost-cutting, plant closure and
outsourcing) and their profits have grown in 2005 more rapidly than in the US, but they will probably find it
harder from now on to boost their profits through additional restructuring; the Japanese industrial model is not a
flawless one.
• Japan is typically a very cyclical market (in most industries, Japanese companies are the marginal producers)
and its dependency on export makes Japan vulnerable to any significant slowdown in its main markets – the US
and China.
• The growth of the Japanese money supply is decelerating; annual reserve growth is nearly back to negative
territory and as a result, the Bank of Japan no longer needs to print the Yen as aggressively as in the past.
• Fiscal policy is expected to be tightened in order to reduce huge government debt (the biggest in any
developed economy, but, in the case of Japan, consisting mainly of local liabilities).
• Ending quantitative easing (an unprecendented exercise of sucking about $ 250bn of excess reserves out of
the banking system) could prove to be unsettling for the bond market.
• Strong and sustainable domestic demand is still on young and shaky legs; Japan‟s demographic structure
also represents a serious concern for future growth.
• Japanese banks, which have been underperforming lately (usually bad news for local equities), are pointing
towards renewed deflation; the operational leverage in the economy and corporate profits are rather
underestimated.
                 Asia: “a continent with great growth promise”

A number of Asian economies are rapidly moving away from being agriculture based and becoming industrial or
service economies with stronger and less cyclical growth.
In the future, one should expect a continued acceleration in Asian economic activities through multiplication of
the many critical sructural factors:
widening globalisation - increasing free trade - massive market scale - higher quality of the labour
force - new business processes - strong productivity gains - growing domestic consumer spending
- improving infrastructure - deflationary pricing of technology - access to global luiquidity and
financial leverage - urban migration and expansion of living space - greater regional co-operation
and intraregional trade - improving political environment - growing respect for the law
We should also anticipate a second wave of creative destruction throughout much wider and more efficient
employment of local talent and throughout the inventive activities of a growing class of local successful
entrepreneurs.
• Most economists expect the region to expand by more than 7% this year and many analysts reckon that at
the current attractive valuations, Asia could withstand global monetary tightening and a consumption slowdown
in the US (only 18% of Asian sales goes to the US) well above other economic regions. That could only happen
if domestic demand in the region picks up the slack (likely to be left by falling exports), but the monetary policy
in the biggest Asian economies is relatively loose, leaving consumers and companies with enough liquidity to
buy and invest.
• It looks as if the markets are already pricing some “decoupling” of domestic economies from the US; the
Tokyo and Seoul bourses outperformed their US peer by more than 30% last year and the yield curves in both
Japan and Korea are significantly steeper than in the US.
• Unfortunately, China‟s pivotal role in the region‟s economy is also the biggest threat to the decoupling
theory. With exports accounting for almost 40% of GDP, China would get hurt if the US stopped buying its
products.
         China: “a promised land with collapsing profitability”
•   Without a doubt, China maintains its status of the world‟s fastest growing economy; yet, for all the Chinese
    growth, the Chinese equity market has been one of the worst performers in the world.
•   It is also suprising that one of the best performing asset classes in China in recent years have been
    government bonds; last year long dated Chinese bond yields collapsed by more then a third to the level
    below the cost of borrowing for the US government (could it be another sign that the Chinese economy is
    slowing more than most have expected?).
•   China is experiencing a huge capex boom (probably one of the potential weak-spots in the global
    economy); but its structural bias towards capacity expansion and too low cost of capital have led to
    collapsing profit margins (China is growing GDP at almost 10% nominal, while corporate profits are falling
    by 5% a year).
•   The Chinese real estate market was booming in the past, financed with cheap USD mortgages; as USD
    interest rates rise and rental yields fall, real estate becomes a negative carry and the leveraged speculators
    are leaving the market (a sharp slowdown in Chinese RE activity has been observed in the recent months).
•   The leadership still faces a delicate social, economic and political balancing act to sustain the country‟s
    break-neck growth pace; a real political time bomb is ticking in rural China, where seizure of land by the
    government represents the most disturbing form of social and economic polarisation behind the Asian
    Dragon‟s fabulous growth since the 1980s.
•   China‟s rapid industrialisation has been at the environment‟s expense, making a mandatory cleanup for
    central economic planing; the deteriorating birth rates could also lead to a drop in Chinese growth in the
    coming years.
•   Labour costs in China have been rising and most of China‟s booming provinces are suffering from an acute
    shortage of labour, indicating a structural problem and suggesting a drift higher in manufacturing costs
•   China‟s banks carry bad loans on their books probably above 40% of GDP; in China, banks are an
    extension of the government (many projects are driven by local political imperatives rather than sound
    economic fundamentals) and the end-owner of all the bad loans and weak assets is the government - the
    “global loser of the first resort”.
•   A pause in China‟s growth would have huge implications for all commodity prices, global inflation rates,
    productivity trends and capital flows.
        Emerging Markets: islands of “investment tranquility”?
•   Emerging Market fundamentals (political, legal, fiscal and monetary) have massively improved; the
    prevailing global environment of strong growth, high commodity prices and low interest rates was also very
    supportive for emerging economies last year and they enjoyed a very robust performance in both equity and
    bond markets (even in the face of surging commodity prices and higher global interest rates).
•   The strong returns in EM, though, have likely surpassed levels that better economic performance can
    explain; the most recent returns may reflect the desperation of the global liquidity chasing the most
    attractive investment opportunities and the absence of a crisis in any major emerging market over the last
    few years.
•   Emerging Markets remain very sensitive to changes in the global liquidity environment, which is getting
    more challenging by the day; an overall tightening by the global providers of liquidity (Asia, Europe, China
    and oil producers) may reduce the leverage and risk appetite.
•   Everyone today is very excited about the structural growth behind the emerging markets, but come the
    downside of the cycle, that structural growth could prove to be far more cyclical than many people expect;
    one of the reasons is that they have absorbed the most volatile part of the Western world‟s cycle:
    manufacturing and keeping stock.
•   The inefficiencies to be squeezed out in the next global slowdown are not in the West but in China and in
    other emerging economies that have expanded too fast, given their underlying infrastructure.
•   In a tightening of global liquidity, the emerging markets, due to their relatively more cyclical nature
    (rapidly developing economies go through wider business cycles than established economies), could have a
    meaningful setback.
•   The future dynamics of oil price will probably generate divergent performances among emerging
    economies: commodity exporters vs. manufactured goods exporters and oil producers vs. oil consumers.
•   A number of emerging economies, including Mexico and Brazil, will hold national elections this year; at
    this point, it does not appear that major changes in economic policcy are at risk, but that could change.
•   The search for higher returns led to record inflows of cash into dedicated EM bonds ($ 10.1bn – against $
    3.2bn in 2004) and equity ($ 20.5bn - 5 times more than last year) funds in 2005.
•   The CEE region represents a leverage play on Western Europe, but even there the EM forex party could end
    one day, especially for those currencies with large current account deficits.
        Currency market: “thrashing around for a fresh theme”

•   If one looks at the currency market in 2005 and if one was to encapsulate last year in two words, those
    words wouldn‟t be “strong dollar”, but they would actually be “weak yen”; the USD has not been strong
    across the board (it‟s actually weakened against quite a lot of Emerging Market currencies and against the
    Canadian dollar), whereas the yen has practically weakened against virtually every single currency.
•   With the Chinese revaluing the RMB, with the Japanese economy emerging from its deflationary bust, with
    large scale buying of Japanese equities by foreigners and with the Yen being the most sensitive currency to
    changes in international liquidity, most people expected the Yen to rise; this time the headwind probably
    came from the Japanese investors selling their leveraged currency to acquire higher-yielding assets abroad.
•   The USD‟s yield advantage on the Euro will probably remain, but many currency players believe that
    altering interest rate differentials are prompting a renewed focus on growth differentials and current account
    concerns; some specific events in 2005 bolstered demand for the USD, such as repatriation of corporate
    foreign profits and the reinvestment of petrodollars.
•   The Asian currencies are massively undervalued despite the fact that the great Asian currency revaluation
    has been, and still is, everyone‟s favourite long-term trade, but in the short term it has not been working so
    well; the underperformance of Asian currencies is all the more surprising in the face of solid equity markets
    and large foreign buying (higher cost of commodities?, interest rate differentials?, the end of the USD carry
    trade?).
•   Chinese policymakers announced their intention to diversify the currency structure of the official foreign
    exchange reserves; the markets think that at some point diversification will happen and that any marginal
    supply of the USD from diversification will come to the market.
•   Currency speculators who have been piling into the country on a bet that Beijing would sharply strengthen
    the currency began a significant pullback as it became clear that China favours a very slow approach to
    currency appreciation (half as much money has been flowing lately as a year ago); it reduces the pressure
    for China to revalue and helps to bring inflation down so sharply that deflation is beginning to be a serious
    concern again.
         Those, who missed the gain of the USD last year believe that they were not wrong, just early:
                  “These gains will prove little more than a blip in the dollar’s decline.”
                          “Hot, hotter … and commodities”

There are many sound structural reasons to be bullish about commodities in 2006 …

•   As the globalisation process widens and the world gets richer, the demand for commodities is bound to
    continue rising, and the physical markets will remain vulnerable to potential supply shocks.
•   Over many years, investment into commodity production and transformation have been minimal, due to
    depressed market prices and the mis-allocation of capital towards non-hard-asset industries.
•   The most conservative institutional investors have only just started to look at commodities as an asset class
    (investments in funds tracking commodity indexes, already huge by any historical standards, are forecasted
    to increase by almost 40% this year, to $110bn).


… But there are aso plenty of sensible cyclical reasons why we should be careful with their current
   pricing!

•   Commodities from gold to oil to copper have already soared over the last few years, and they have been
    amongst the best performing asset classes.
•   The prices of commodities will no longer be able to rise in the vacuum of massive monetary stimulus, due
    to more synchronised and accelerating tightening; global supplieres of commodities are also increasing
    their production volume to benefit from the booming markets.
•   The current rise in oil prices represents a period of panic (Katrina) and speculative buying, rather than a
    smooth up tick in demand from new important market players like China (it took China 10 years to move
    from consuming 2 million barrels per day to 5 or more today).

                    “The best way to benefit from globalisation is to own the suppliers.“
    Gold (is back): “perfect insurance for the complexities of 2006”?
Gold is seen by different market players as an alternative currency or just as another commodity, and both
    groups claim to be able to justify the recent parabolic rise in gold price (recently, it has broken $550/oz to
    set 24-year highs).
The most popular arguments behind gold as a currency:
•     It is an essential barometer in the grand battle between hard and financial assets, which has strongly favoured commodities
      and real estate over the past 3 years.
•     Gold has shrugged off tight correleation to the USD/EUR exchange rate, which dominated discourse throughout 2003/2004,
      and it has outperformed the price of oil by 15% in the past 3 months.
•     The price of gold seems to be indicating that the market does not trust the future value or the USD; since 2000/2001,
      everything in the US has lost value against the price of gold (therefore, investors diversifying out of USD-denominated assets
      strongly favoured the metal over the gold equities!).
•     Investors are also hedging against some other risks such as avian flu or terrorism.

                 “ The hedge to have when you are not quite sure what you are hedging against ”
Arguments usually presented by supporters of gold as a commodity:
•     Usually, when gold goes up because it is a currency (hedge against inflation), bond markets tank and TIPs go through the
      roof, but we have not noticed any of that
•     Gold has truly underperformed most commodities (even oil!) and gold equities lagged the metal itself last year (were equities
      anticipating a lower gold price ahead?); gold and the S&P500 index have not moved very far apart since September 2002.
•     The real proof of a bull market in gold will come when, or if, it resumes an ascent that is impressive not only when measured
      in paper currency, but also when measured against alternative investments.
•     We are now simply in the seasonably favourable period for gold (Diwali, Christmas, Hannukah, Chinese New Year, etc.); the
      Middle East has always been a big client of gold, and it is getting richer for obvious reasons.
•     As long as India and China maintain exchange controls and those countries get richer, that demand for gold will be sustained.
•     Speculators are simply massively extended in gold!; if investors are feeling so risk-averse, why are the equity markets so
      expensive, and, if they are so worried about future inflation, why are the yields in the bond markets so low?
•     Come late January, we should have the answer on whether gold is truly in a long term bull market, or whether the latest
      uptrend is linked, once again, to seasonal patterns.

                                        “Even at $500, it’s still a barbarous relic.”
Looking into the future …
    Questions ahead: looking beyond January‟s early performance

•   Are we moving away from the disinflationary / deflationary environment that has held sway in the West
    basically since the fall of the Berlin Wall, and into a more inflationary world? Do we live in an environment
    in which money, or paper assets, will lose out to real assets and in which inflation will accelerate?
•   Should we base our expectations on the previous economic cycles or rather extrapolate into the future the
    most recent numbers? Will the current incoming economic statistics – pretty positive in many economies –
    prove sustainable or rather temporary and misleading?
•   Is the global economy actually in far worse or far better shape than official statistics show and how strong
    will the global economic growth be this year? Should we expect that the higher interest rates and energy
    prices, and apparent slowdown in housing activities to have little or no effect on the future level of
    economic activities?
•   How far will the central banks go with their desire to tighten liquidity? How strong will the investors‟
    appetite for risk be? Where will the investment capital flow? Will the markets focus more on the US
    deficits, due to perceived trend changes in the interest rate differentials, or on Europe‟s internal imbalances?
•   How sustainable is Chinese growth? Will Chinese capital spending prove to be more structural than just
    cyclical and will it accelerate despite tighter global liquidity conditions? Are markets correctly discounting
    China‟s future? Or are they just projecting its recent past?
•   What is a reasonable level of pricing of financial assets? Are the Western corporate profits and the Chinese
    corporate losses sustainable? Are local equity markets telling us that either China, or the US, are facing a
    serious slowdown? Should we buy into the European recovery story?
•   How should investors be allocating their assets as we move into 2006? Are markets pricing the right
    investment scenario?

              Without perfect foresight, no one knows the right answers to all these questions!
The investment Puzzle of 2005/2006 – “The known unknowns”
The delayed effects of                                                                            Pricing power of
monetary tightening                                                                               public
and higher commodity                                                                              corporations?
prices?

                                                                          Headline                 higher prices in
                                                           Still higher   Inflation               financial assets and
• limited negotiating power of   • no major increases in       than                               booming property
                                                                          this is what we pay
the labour force due to          real wages (Wage           interest                              markets - Asset
                                                                          Consumer (CPI) &        Inflation
accelerating globalisation       Inflation) despite           rates
                                                                          Producer (PPI)          • rise in price of gold
                                 much higher cost of
                                                                          Price Inflation
                                 living

• willingness of the Chinese     • no passing through                     Core Inflation
and other low cost producers     of higher production      Apparently     this is what Central    • global imbalances
to absorb additional costs       costs (Commodity            under        Banks look at           • status of USD
and to give up their profit      Inflation) to final        control                               (reserve currency and
margin                           customer                                                         price of commodities)
                                                                          • no food
                                 • record high corporate                                          • flow of investment
                                 profits!                                 • no commodities
                                                                                                  capital
                                                                          • no real estate
                                                                          • no financial assets

A re-emergence of                                                                                 Conundrum in
deflationary forces in                                                                            the international
China and Japan?                                                                                  bond markets?
              Macro-economics in 2006 – a year of transition?

•      This is the year the world‟s economies will have to live without easy money: the cost of capital is
       going up, liquidity is drying up and the investment in capacity is slowing down; the global monetary
       policy is still tightening while, at the same time, consumption decelerates and a lot of new capcity
       comes on stream.
•      Rising house prices and mortgage equity release have been the biggest drivers of US consumption,
       which in turn has been the fuel for global economic growth; the patern of house price gains has now
       moved into clearly overbought teritory and an end to equity release seems inevitable with a negative
       impact on US consumption growth.
•      It is very difficult – despite much greater energy efficiency – to believe that the well-proven
       relationship between increases in energy prices and economic activity is simply not working
       anymore; at the end of the day, higher oil prices are like an additional tax, which shifts funds from
       private and business consumers to oil producing states.
•      China‟s investment boom is fading and China‟s health, like that of the United States, is a matter of
       uncertainty and of a potential concern to everybody; in China, the driver of growth is first and
       foremost capital spending with almost no respect for corporate profitability, and with the excess
       capacity put into place in recent years, China is rapidly evolving from being a buyer to being a very
       competitive supplier.
•      The levels of consumer and business confidence in the U.S. look pretty feeble compared with the
       previous periods; business surveys in Europe have been surprisingly strong since the summer, also in
       Germany (probably driven by hopes for continuation of export-led growth), despite expectations of
       increasing interest rates, compromised labour and product reforms, and higher taxes promised by the
       new government (no practical stimulation of domestic consumption).


    “It’s a crazy kind of world and it’s not going to get less crazy. It might get even more crazy in 2006.”
        Investing in 2006: “as January goes, so goes the year”?

•   Bulls have got new year‟s trade off to a flying start, but there are plenty of unknows going into the rest or
    2006 and we prepare ourselves for sharper ups and downs in different markets than we have seen lately.
•   Either the bond market is right and we are in a non-inflationary environement and commodity
    market prices will respond, or the commodity markets are correct and we are in an inflationary
    environment and interest rates will go up substantially; the only connecting and explaining factors
    would be a much weaker dollar, excessive liquidity leading to speculation or the consequences of
    massive deflationary forces.
•   If we are in a continuing disinflationary environemnt, it would be totally unrealistic to expect that US
    corporate profits will continue to expand at double-digits forever, because in the long run, corporate profits
    expand at approximately the same rate as nominal GDP growth.
•   Therefore, the consensus expectations for global economic growth and corporate earnings are probably too
    high (another year of double digit acceleration would be hard to deliver).
•   Europe‟s growth performance could disappoint unless there is a further boost from exports or a greater
    willingness among consumers to take on more debt.
•   Even a marginal slowdown in Chinese capex could lead a number of companies into dumping excess
    inventories unto the market, hereby depressing prices and forcing others to do the same.
•   The unpredictabilty of the global economic situation could lead to sharp moves in the FX markets.
•   The bull market in equities and commodities continues, and even though these markets look technically
    overbought at this stage, there is still too much money flowing around to let them crash.
    Recognising the danger: “small” accidents can always happen

Some totally unexpected events could transform our understanding of today‟s economics completely, because
    economics can never be an exact science like physics and we must always keep an open mind towards any
    outside possibility. Or perhaps the biggest investment risks for 2006 are political rather than economic.
The list of things that might go wrong (or potential negative surprises) is truly impressive this year:
•   Mr. Bernanke taking over from Mr. Grennspan (it‟s a very tricky time, and he will come in to quite an
    inheritance!; the market worries that he could be acting in a much too reactive way).
•   Terrorism – also incidents involving weapons of mass destruction - remains a risk almost everywhere.
•   A pandemic of avian flu, interfering with the movement of individuals both within and across borders (we
    will continue to monitor the development progress without altering our investment strategies, but the risk is
    real and we hope to be neither too late nor too early on this subject).
•   The war in Irak going wrong.
•   Policymakers doing the wrong things and continuing their populistic and protectionist rhetorics ( the long-
    term health of the economy is sacrificed for short-term political gains).
•   Iran‟s nuclear crisis.
•   An accelerating Middle East conflict.
•   Anti-capitalist political language in Europe with little political legitimacy of the EU leaders.
•   Energy blackmailing by President Putin and his oil-pipeline imperialism.
•   The threat of a partial re-nationalisation of the oil industry by communist and Islamic states, unfriendly
    towards some Western democracies.
•   Rampant bullishness in some investment areas (India, Middle East, Japan)
•   Social disconnection and the breakdown of civil order in Europe.
           The hazards of tightening the liquidity environment:
                  “Who has done something stupid?”

During credit bull markets there are parts of a financial system that boom almost unnoticed, and as we go from a
    period of easy money into one of tight money we always discover some interesting surprises.

Although the current situation may appear sound it remains too early to conclude that the Fed will succeed in
    removing accommodation without inducing a sharp slowdown and/or market dislocation (there has never
    been a Fed tightening cycle without unintended negative consequences in the financial markets).


The following is a short list of a few the most obvious possibilities:

•   This time, trade finance has been one of the major beneficiaries of the global period of easy money and the
    trade credit could now dry up with the drain in liquidity (watch for unprofitable companies chasing growing
    volumes and bigger market share!).

•   It seems implausible that the new credit derivatives market could have grown at such an astonishing rate
    without risking being mis-priced; we are in unknown territory here, but last year‟s downgrade of GM
    proved how a single borrower‟s problems can be magnified through credit derivatives (watch the
    performance of all those collateralised debt obligations and synthetic collateralised debt obligations).

•   The explosion of unregulated hedge funds and the widespread use of derivatives (such as credit default
    swaps) pose risks that are simply impossible to calibrate until the system is truly stress-tested.

•   Other potential candidates: the US auto industry and the mortgage agencies (Freddie Mac and Fannie Mae).
                 The beauty of consensus: “eyes wide shut”?

There are some observable extremes in market thinking at this moment; some of them are truly scary and are
    forcing everyone to approach 2006 with a finger near to the panic button.
But the consensus believes that there are few reasons to be seriously worried and it guides the market
    along the following lines:

•   Continued and broadening global economic growth with strongly rising capital investment.
•   A less pricy outlook for oil and other industrial commodities, but with some potential short-term spikes.
•   Still growing (maybe in the single digits) corporate profits and the US still outperforming other developed
    economies.
•   More tempered, but still positive, consumer spending in the US (the Fed will soon stop raising rates!).
•   The recovery in Euroland driven more by domestic consumptions.
•   Japan holding on to its anti-deflationary expansion.
•   A higher demand from oil and commodity exporters reducing the impact of a potential slowdown in the US
    consumption and in the Chinese investment growth
•   The continued rise of Asia and other emerging economies with huge and diverse benefits for the global
    economy.
•   Core inflation remaining under control and tempering any rise in bond yields.
•   Equities outperforming other asset classes.
•   The USD resuming its downtrend, reaching a new trade-weighted low and underppining precious metal and
    commodity prices
•   Some limited but healthy rebalancing in the global economy.

      Consensus thinking always comes with the warning: “The conventional wisdom is no sure bet.”
The beast of unknown: the violent unwinding of global balances?

We‟re going to get many surprises in 2006, just as we got some big surprises in 2005. However, it is sometimes
   hard to see the triggers for changes in the markets‟ mood, but many experienced investors are smelling
   something fishy and they talk more bearishly than general consensus.

We find four potential headwinds for financial markets and for the prevailing consensus thinking (alternative
   investment scenarios) in the capital markets:

1. A lower pace in economic activity (the biggest risk to the growth outlook remains the prospective
   behaviours of the US consumers – roughly 20% of the global economy – and disappointing earnings (a
   lack of growth and business cycle contraction).

2. Accelerating inflationary pressures (too little tightening too late, as well as too consistently and too high
   commodity prices)

3. The return of a deflationary threat (an underestimation of the deflationary forces in the global economy,
   which could possibly accelerate at the same time: over-capacity explosion in China, collapse in commodity
   prices, crashing property prices in the US).

4. Continued negative changes in the liquidity environment (liquidity crisis and a financial system shock).

Therefore, we are prepared to review our basic scenario and to change our position a lot more this year to
   capture opportunity as we see it evolving.


    The positive consensus could be right, but even in the best of times, it is prudent to ponder the worst.
   Alternative scenarios: “perceptions can change very quickly”

DISAPPOINTING GROWTH                                  RETURN OF INFLATION

Reduce exposure to more cyclical assets like          Buy gold and some commodities
commodities and Emerging Markets                      Increase your equity exposure
Increase weightings in government bonds               Keep Emerging Markets
Focus on large companies with pricing power           Sell bonds, but not TIPs
Trim down the overall leverage



LIQUIDITY CRISES                                      RE-EMERGENCE OF DEFLATION


Overweight US equities (especially large cap growth   Respect your cash
companies), underweight Emerging Markets
                                                      Invest in quality government bonds (medium and long-
Overweight USD, underweight Euro                      term durations)
Overweight US government bonds, underweight           Avoid credit risk and TIPs
EMU government bonds and corporate bonds
                                                      Re-consider your USD exposure
Underweight commodities
                                                      Select shares in companies able to manage the
                                                      declining price environment
           Our approach for 2006: “Readiness to observe … ”
•   It is anybody‟s guess what 2006 will offer to us as investors, but we have little doubt that making money in
    the coming year could potentially be harder and more emetionally challenging than in the last 2-3 years.
•   The inflationary / deflationary outlook will determine performance of all asset classes this year and we will
    be exposed to frequent releases of economic data, which may appeal to both pessimsts and optimists, and
    which could lead to some sharp reversal in risk appetite (we will be watching these data, assuming that it
    will be volatile and confusing); but, everything we seem to observe these days leads to a conclusion that the
    dis-inflationary forces, driven by technology, globalisation and China, will probably dominate and that they
    will be able to absorb any inflationary pressures created by higher commodity prices and aggressive
    monetary accommodation (at least for a while).
•   The recent rallies have left many asset prices stretched by conventional valuation standards and current
    prices for a range of assets may not fully reflect potential investment risks, but it would be too easy to
    underestimate the capacity of the global economy to muddle through its vulnerable imbalances; however,
    we fully acknowledge that the monetary policy tightening (or rather its normalisation after a long period of
    aggressive accommodation) could be a challenge for more risky and pricy assets.
•   We believe that it could prove rather difficult to be too bearish on government bonds (although we should
    see some yield divergence this year) in major developed and developing markets, because maybe the
    current yields are not as low as commonly believed; we maintain our dis-inflationary expectations and we
    trust the link between the inverting yield curve and the risk or recession, which should influence the Fed‟s
    decisions.
•   Equity markets are by and large structurally attractive and neither too cheap nor too expensive; the only
    problem is that, cyclically, equity markets are rather unattractive (tightening monetary base, flat yield
    curves, high commodity prices) and that in the short-term a wave of risk aversion may well take over from
    the unconditional enthusiasm of the past few months (therefore, we plan to wait patiently for market
    correcting wake-up calls, especially when prices are over-extended, and then accelerate the buying of our
    selected equity stories with a certain level of scepticism and with an exit strategy in mind).

            “A butterfly batting its wings in the Chinese forest or in a sunny condo in California
                                      can trigger a storm at Wall Street”
                                  “ … and extreme flexibility”
•     We see the first few days of this year in the currency market as a forecaster for the next 12 months, and we
      expect the currency markets to be pretty volatile in 2006.
•     We maintain our conceptual courtious bullishness on the USD (maybe the structural headwinds facing the
      American currency will not re-assert themselves, plus the USD retains a higher-yielding status than Europe
      and Japan), but we recognise that the yield patterns are changing and that it has a strong and justifiable
      market momentum going against it (it‟s not just the differential in interest rates but how much the
      differentials are changing); another risk is that, due to dynamism of the US monetary policy, we could see
      the rates falling potentially faster than everywhere else if there are any more dramatic developments.
•     We expect structural appreciation of Asian currencies as a result of improving economic fundamentals in
      the region; we also support commodities and emerging markets currencies, but we assume that some
      periods of weakness might be ahead of us.
•     We agree in favouring Emerging Markets assets (an increasingly obsolete description) and we remain
      positive on Japan with its economic revival looking to be well entranched; Chinese domestic stocks could
      be one of the black horses in 2006, reflecting growing confidence in the reforms being undertaken by the
      government in a number or areas.
•     We remain positive on the long-term prospects of the commodity sector and although other commodities
      look hotter today, the biggest play this year may be in agriculture products (non-correlated assets), where
      prices have been lagging behind; we will continue buying gold and industrial commodities on medium-term
      dips, but at the same time we believe this sector is much more cyclical than investors realize today (an
      overlay of cyclical and speculative demand on top of fundamental supply/demand market dynamics).
•     Common sense suggests that the following equity themes could offer an above-average return potential:
      continued re-rating of mining companies, selective alternative energies and oil related services (years of
      infrastructure underinvestment), additional restructuring of mid-cap European companies (including
      Germany and Switzerland), geographical and product expansion of successful technologies, certain public
      players in the gambling sector and selected special valuation / business situations (we recognize that some
      of our calls are part of the current consensus view)

    “There is little margin for error, so overweight flexibility, avoid inflexibility and be wary of complacency.”
                       Initial Investment Guidelines for 2006
           Regions                                              Commodity            Emerging
                      US      Eurozone   Switzerland    Japan                 Asia
Assets                                                          Economies             Markets


Cash                   +        o/+          o/+         o/+        +          X         +

Bonds ST               o         o            o           -         o          x         +

Bonds LT              o/+       o/+           o           -        o/+         x         O

Equities              o/+       o/+          o/+         ++         ++        -/+       +/++

HF- Non                                                  o/+
directional
HF - Directional                                         +

Commodities          Energy              Pres. Metals           Ind. Metals          Agriculture
                       +                       +                     o                  o/+


Currencies             x        o/+           +          +          +          +         ++

Convertible Bonds      +         +            +          ++         +          x         +


Real Estate            -        -/+          o/+         o/+        o          x         +
                       Initial Asset Allocation for 2006


           Portfolio   “Comfortable Wealth”   “Prudent Opportunism”   “Dynamic Prosperity”

  Assets                   Conservative             Balanced                Growth



Cash & Bonds                  50 %                   25 %                     0%


Equities                      15 %                   35 %                    50 %


Commodities                   10 %                   15 %                    20 %


Hedge Funds                   25 %                   20 %                    20%


Others                         0%                     5%                     10 %

				
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