investment outlook - seb · 6 investment outlook - december 2011 summary expectations* next 12...

InvestmentOutlook December 2011private banking - investment strategy

a global search for returns

3Investment OutlOOk - december 2011

Contents

Investment Strategy

Introduction..........................................................................................................................5Summary ...............................................................................................................................6Macro summary ...................................................................................................................8Portfolio commentary: Modern Investment Programmes .......................................... 10Theme: A global search for returns ................................................................................ 13Theme: Finding gold that doesn’t glitter ....................................................................... 16Theme: Macro environment the key to returns ............................................................ 19

asset CLassesEquities............................................................................................................................... 22 Fixed income ..................................................................................................................... 26Hedge funds ...................................................................................................................... 28Real estate ......................................................................................................................... 30Private equity .................................................................................................................... 32Commodities ..................................................................................................................... 34Currencies .......................................................................................................................... 36

4 Investment OutlOOk - december 2011

This document produced by SEB contains general marketing information about its investment products. Although the content is based on sources judged to be reliable, SEB will not be liable for any omissions or inaccuracies, or for any loss whatsoever which arises from reliance on it. If investment research is referred to, you should if possible read the full report and the disclosures contained within it, or read the disclosures relating to specific companies found on www.seb.se/disclaimers. Information relating to taxes may become outdated and may not fit your individual circumstances. Investment Strategy tracks and monitors various companies continuously and applies no fixed periodicity to its investment recommendations. Disclosures of previous recommendation history may be obtained upon request. Analysts employed by SEB may hold positions in equities or equity-related instruments of companies for which they provide a recom-mendation. More information about SEB’s investment recommendations and its management of conflicts of interest etc. can be found at http://www.seb.se/upplysningar.se (in Swedish). Historic returns on funds and other financial instruments are no guarantee of future returns. The value of your fund units or other financial instruments may either rise or fall, and it is not certain that you will get back your invested capital. In some cases, losses can exceed the initial amount invested. Where either funds or you invest in securities denominated in a foreign currency, changes in exchange rates can impact the return. You alone are fully responsible for your investment decisions and you should always obtain detailed information before taking them. For more information please see inter alia the simplified prospectus for funds and information brochure for funds and for structured products, available at www.seb.se. If necessary you should seek advice tailored to your individual circumstances from your SEB advisor.

information about taxation: As a customer of our International Private Banking offices in Luxembourg, Singapore and Switzerland you are obliged to keep in-formed of the tax rules applicable in the countries of your citizenship, residence or domicile with respect to bank accounts and financial transactions. SEB does not provide any tax reporting to foreign countries meaning that you must yourself provide concerned authorities with information as and when required.

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

Lars gunnar aspmanGlobal Head of Macro Strategy+ 46 8 763 69 [email protected]

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

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

esben Hanssen Head of IS Norway+ 47 22 82 67 [email protected]

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

Jonas evaldssonEconomist+46 8 763 69 43 [email protected]

reine kaseEconomist+352 26 23 63 [email protected]

Daniel gecerEconomist+46 8 763 69 18 [email protected]

Carl-Filip strömbäckEconomist+46 8 763 69 83 [email protected]

Cecilia kohonenGlobal Head of Communication Team +46 8 763 69 [email protected]

Liza braawCommunicator and Editor+46 8 763 69 [email protected]

This report was published on November 29, 2011.Its contents are based on information and analysis available before November 18, 2011.

Investment Strategy


We live in a changeable world, where previous truths and natural associations no longer apply. There is little predictability and investors are very concerned, which has created a need for fresh strategic thinking in the investment field. These and many other questions are discussed in this issue of Investment Outlook.

We are living in unusual times. The world is partly out of joint. Natural assumptions such as the safety of government bonds no longer apply to the same extent as before. Apparently in some cases it is better to own corporate bonds issued by com-panies with stable sales than government bonds issued by countries with weak tax bases and rising expenditures.

Never before has a period of financial turmoil been as stub-bornly persistent as today. We must go back to the 1970s oil crisis to find anything that can be regarded as equivalent. In phases like the current one, patterns become self-reinforcing. Bad news creates uncertainty, causing investment decisions to be postponed and market pricing to include an uncertainty premium. In some cases this leads to pure mispricing, since in-vestors lack the energy, determination or patience to maintain risks when markets are jumping up and down in value for no apparent reason. The flip side of the coin is that opportuni-ties are also being born in today’s volatile markets. One of our theme articles in this issue of Investment Outlook discusses these particular opportunities.

Another theme article provides some basic reflections about how to build up one’s investment strategy in a structured way in today’s unusual times. What de facto forces are moving the markets? Because of volatility in the past decade, essentially a whole generation of investors (who began their careers in the 1990s) have never earned a good return on equity invest-ments.

What is annoying about phases like the one we are now in is the co-variance among assets; they are all being lumped to-gether. In more normal periods of greater market predictabil-ity, there are bigger differences between how various assets perform, and valuations occur more on merit. In the present situation, our management strategy is a mixture of trying to minimise the damage from weak markets and identifying where we see potential, despite high volatility.

Of course there are opportunities in this world, too, but our investment methods need to be adjusted. Yesterday it was important to zero in on peaks and troughs; today it is largely a matter of generating returns with good risk control. In a theme article, we examine some alternative investment strate-gies and put greater emphasis on such variables as dividends and current return. This is a “gentler” way of investing and will probably remain in the spotlight as long as extremely low interest rates and yields prevail, and they will do so for a long time to come. It is also important to realise that a new phase will come after the one we are going through. At some point, Europe will be headed in the right direction, either via an even more active European Central Bank and/or more resolute debt manage-ment policies. From an investor’s standpoint, the problems do not actually need to be solved. It suffices that the path towards a solution is credible. The markets also have a few lifelines today: the economic picture in Asia provides hope of gentler monetary policies, and American economic growth is actually beginning to provide upside surprises. This may of course be temporary, but it is still a bright spot. In valuation terms, there are various opportunities. If confidence increases, there is room for higher valuations. Ultimately, economic growth is still the best way out of today’s problems. Political leaders know this, and that realisation will hopefully lead their actions in a positive direction.

Hans Peterson CIO Private Banking

and Global Head of Investment Strategy

introduction

When the financial world is out of joint


Summary

expectations*next 12 months

reasoning *Forecasts are taken from the seb House view and are based on our economic growth scenario (see page 19)return risk

equities 1 10% 18%

Neutral outlook in the short term, POSITIVE in the long term. Globally no strained valuations, provided that growth does not fall further. A decent macro scenario in the US, significantly weaker in Europe. Emerging market (EM) economies will show continued robust growth after a period of inflation-fighting. Strong performance in Russia, encouraging news headlines from China. Confidence in the EM sphere seems to be returning, though somewhat cautiously.

Fixed income 2 6% 7%

Negative towards government bonds in the OECD countries because of today’s very low yields and prospects of some yield increases/risk of price declines. POSITIVE towards High Yield bonds, which based on fundamentals – in terms of company health and bankruptcy risk – have unjustifiably wide yield gaps to government securities. Given somewhat better risk appetite, EM Debt will also appeal to investors, due to the potential for lower yields/price increases and stronger currencies compared to the developed market (DM) sphere.

Hedge funds 4% 5%

positive. Still cautious about Equity L/S and Distressed strategies, but the actions of central banks will create attractive opportunities for Credit L/S managers. From a portfolio standpoint, we view Macro and Trading strate-gies as good diversification mandates.

real estate 3% 4%

Neutral. Comparatively stable market performance. World economic uncertainty and volatile foreign exchange markets are contributing to delays in major real estate transactions. Continued heavy demand for less risky quality properties.

privateequity 15% 27%

Neutral. Market turmoil has continued to depress share prices of PE companies; this has resulted in large discounts to NAV. The market has already priced in continued problems. Fundamentals provide good support for today’s prices.

Commodities 3 3% 12%

Neutral. The weak outlook for the OECD countries is hampering good performance. At present, upturns in the commodities market are more indicative of greater risk appetite than of an improved growth outlook. Limited downside for base metals. Gold prices will benefit from the prevailing environment. Diminishing worries about weather developments will lead to falling prices for agricultural commodities.

Currencies 4 3% 4%

Neutral. In fundamental terms, EM currencies will benefit from interest rate differentials and continued high growth, but greater risk appetite will be needed for appreciation. The USD will strengthen in a bumpy market that will also be sceptical to the EUR. The yen is regarded as overvalued.

1The forecast refers to the global stock market. 2 The forecast refers to a basket of ½ Investment Grade and ½ High Yield. 3 The forecast refers to a basket in which the energy, industrial metals, precious metal and agricultural commodity categories are equally weighted. 4 This opinion refers to the alpha-generating capacity of a foreign exchange trading manager.

eXpeCteD risk anD retUrn (neXt 12 mOntHs)

HistOriCaL risk anD retUrn(nOvember 30, 2001 tO OCtOber 31, 2011)

CHange in OUr eXpeCteD retUrn

Equities

Fixed income*

Hedge funds

Real estate

Private equity

CurrenciesCommodities

0%

2%

4%

6%

8%

10%

12%

14%

16%

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

Expe

cted

retu

rn

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

-5%

0%

5%

10%

15%

20%

25%

2008

-11

2009

-02

2009

-05

2009

-08

2009

-12

2010

-02

2010

-05

2010

-09

2010

-12

2011

-02

2011

-05

2011

-09

2011

-12

Equities Fixed income* Hedge funds Real estate

Private equity Currencies Commodities

Fixed Income

Equities

Private equity

Commodities

Real estate

Hedge funds

Currencies

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

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

His

toric

al re

turn

HistOriCaL COrreLatiOn (2001-11-30 tO 2011-10-31)

Equi

ties

Fixe

d in

com

e

Hed

ge fu

nds

Real

est

ate

Priv

ate

equi

ty

Com

mod

ities

Cur

renc

ies

Equities 1.00

Fixed income -0.50 1.00

Hedge funds 0.57 -0.30 1.00

Real estate -0.12 0.06 -0.05 1.00

Private equity 0.85 -0.38 0.66 -0.14 1.00

Commodities 0.25 -0.17 0.68 -0.05 0.38 1.00

Currencies -0.19 0.19 0.14 -0.09 -0.07 0.02 1.00


Summary

WeigHts in mODern prOteCtiOn

WeigHts in mODern grOWtH

WeigHts in mODern aggressive

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

-80

-60

-40

-20

0

20

40

60

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Equities Fixed income Hedge Real estatePrivate equity Commodities Currencies

perFOrmanCe OF DiFFerent asset CLasses sinCe 2000

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

Source:SEB

-0.8-0.6

-0.4-0.2

0

0.20.40.6

0.81

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Fixed income Hedge Real estatePrivate equity Commodities Currencies

6%

0%

7.5%

0%

0%

20%

30.5%

36%

0% 10% 20% 30% 40%

Cash

Currencies

Commodities

Private equity

Real estate

Hedge funds

Fixed income

Equities

Previous Current

1.5%

2%

0%

0%

0%

17%

79.5%

0%

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

Cash

Currencies

Commodities

Private equity

Real estate

Hedge funds

Fixed income

Equities

Previous Current

10.5%

4%

4.5%

0%

0%

30%

34%

17%

0% 10% 20% 30% 40%

Cash

Currencies

Commodities

Private equity

Real estate

Hedge funds

Fixed income

Equities

Previous Current

8

macro summary

•Worse outlook for the world economy in 2012

•Euro zone in recession, but US will cope better

•EM sphere will keep growing much faster than OECD countries

In recent months, the world economic outlook has become gloomier. The sovereign debt crisis in Europe has escalated, spreading both financial and economic uncertainty. This has primarily been reflected in a deteriorating mood among households and businesses in many parts of the world, but has also been visible in certain “hard” macroeconomic sta-tistics, for example order bookings and industrial production. The largest negative change compared to a few months ago is that the euro zone will probably end up in a recession in 2012, while the US economy has performed better than expected.

The differences between the OECD countries and the emerg-ing market (EM) sphere in terms of growth dynamic will remain sizeable, although the EM countries will also be affected by negative economic forces and thus lose some momentum. Global economic growth next year will be well below trend.

Late in 2012, the economic situation in the OECD countries may improve somewhat. By then, political leaders should have a better handle on resolving sovereign debt problems. Lower inflation will enable central banks in many OECD countries to continue their zero interest rate policies for an extended period. Major industrialised countries will probably also launch more monetary quantitative easing.

Deceleration but no recession in the Us The US economy has performed better than expected in recent months, thanks to reduced household saving, cheaper energy and stronger manufacturing activity now that deliver-ies of Japanese intermediate goods are again normal after disruptions caused by the natural disasters of last spring. As earlier, we believe GDP growth will decelerate in the first half of 2012 without sliding into recession. Among sources of con-cern are tight financial conditions, question marks about what will happen to federal fiscal policy, the euro zone recession and gloomy sentiment among Americans. Unemployment will

creep upward next year, and inflation will be lower. We foresee GDP growth of nearly 2 per cent this year, about 1.5 per cent in 2012 and less than 2.5 per cent in 2013.

euro zone recession The growth outlook in the euro zone has recently turned sub-stantially worse. The sovereign debt crisis and financial market turmoil have intensified, further austerity programmes are set to be launched in many countries, and macro indicators predict noticeably slower growth. Even in Germany – which resisted the downturn for a long time – the deceleration will become more apparent. We believe that all the GIIPS countries (Greece, Ireland, Italy, Portugal and Spain) except Ireland will end up in recession next year, while the German economy will grow very slowly. No long-term solution to the sovereign debt crisis is discernible. Meanwhile inflation will be far lower than in recent years. We expect euro zone GDP to grow by a bit above 1.5 per cent this year, then fall nearly 0.5 per cent next year and grow by less than 1 per cent in 2013.

Debt crisis hurting the british economy The euro zone crisis is hurting the United Kingdom via lower exports and adverse effects on household and business con-fidence. Rising unemployment, budget austerity and a high inflation rate – more than 5 per cent in September – is also hampering British private consumption, which will decrease this year and stagnate in 2012. Next year, however, inflation will fall steeply, which in itself points towards further quantita-tive easing by the Bank of England. We expect the UK to avoid a recession, with GDP growth in the 1 per cent range both this year and in 2012, and a bit below 2 per cent in 2013.

nordic dependence on europe will lower growthThe Nordic countries continue to show considerably better economic fundamentals – budget balances, public sector debts and current account balances – than many other re-gions. They can thus manage fairly well in 2012, even though world economic growth will decelerate and a number of European economies will end up in recession. Since the Nordic countries have extensive trade with the euro zone, however, their growth will be noticeably slower next year. We forecast that overall Nordic GDP will increase by 2.5 per cent this year, less than 1.5 per cent in 2012 and 2 per cent in 2013.

Global growth slowdown – but no recession

Investment OutlOOk - december 2011

9

Japanese reconstruction boosting activity

The Japanese economy will be affected by the global slow-down, but in the short term, reconstruction following the natu-ral disasters will sustain economic activity. There will be plenty of idle production resources, so deflation (a general decline in prices) will persist. Because of this and an undesirably strong currency, the Bank of Japan is likely to continue selling yen in the foreign exchange market. At 220 per cent of GDP, the country’s public sector debt is by far the largest in the OECD, but thanks to a large surplus of private savings this will not lead to higher interest rates. In 2011 we expect Japan’s GDP to decline by less than 0.5 per cent, while predicted growth is 2 per cent in 2012 and a bit above 1 per cent in 2013.

soft landing and lower inflation in emerging asia Asian emerging countries are continuing to help sustain the global economy, although their growth will cool a bit more next year. The euro zone crisis and slow US economic growth will lower exports from Asia, but this effect will be eased by the increasingly important role of intra-regional trade. Open economies like Malaysia will be affected more than economies where the domestic market plays a larger role in growth, like Indonesia. Inflation has culminated in most Asian countries, and lower inflation during 2012 will stimulate household con-sumption and give central banks room to lower key rates.

The Chinese economy is now slowing due to weaker export expansion, while high growth in domestic demand will persist. Falling prices for food and other commodities together with more sedate economic growth will lead to lower inflation ahead. We believe that China’s GDP will grow by slightly more than 9 per cent this year and by some 8 per cent annually in 2012 and 2013. Exports account for a rather small percentage of India’s GDP, so that country has good potential to shrug off a weaker glo-bal economy. So far, inflation has been stubbornly high – now around 9.5 per cent – but our forecast is that it will decelerate during 2012. We predict GDP growth of around 7.5 per cent both in 2011 and 2012 and 8.0 per cent in 2013.

Latin america will feel colder global winds Despite great progress during the past decade in terms of domestic growth conditions, Latin American economies are still very sensitive to shifting global economic winds. The slow-down in the OECD countries will thus have a clear impact. We foresee GDP growth of nearly 4.5 per cent in the region this year, about 3.5 per cent in 2012 and only a bit higher in 2013. This year inflation in Latin America may approach 7 per cent and then slow to about 6 per cent in 2012. Together with an economic cooling, this means the need for monetary tighten-ing will diminish.

a gentler slowdown in eastern europe In the past year, growing domestic demand in Eastern (includ-

ing Central) Europe has emerged alongside exports as an eco-nomic engine, but the region’s expansion is about to weaken as slower growth in global demand hampers its exports. Highly export-dependent Hungary, the Czech Republic and Slovakia (with exports equivalent to 70-80 per cent of GDP) are espe-cially vulnerable. To some extent, growth will also decelerate due to lower capital spending by businesses, but the decelera-tion in GDP growth will be far gentler than in the euro zone.

Except for Hungary, public sector debt is moderate. As a re-sult, the need for austerity measures will be smaller than in Western Europe, and this will benefit domestic demand. In 2012 Poland, Latvia and Ukraine will continue their moder-ate budget tightening, while fiscal policy will become slightly stimulative in Russia, Estonia and Lithuania. Consumption and capital spending can thus hold up relatively well as ex-port growth slows. Inflation will remain low in most Eastern European countries, mainly due to large output gaps.

slow pace of world growth in 2012-2013 We forecast global GDP growth (adjusted for purchasing power parities) of 4 per cent this year, just over 3 per cent in 2012 and less than 4 per cent in 2013. In the next couple of years, the growth rate will thus remain below trend (growth has averaged 3.9 per cent since 2000), but the world economy will not end up in a new recession. Expansion in the EM sphere will remain by far the fastest – with GDP increasing by more than 6 per cent this year, a bit above 5 per cent in 2012 and just over 5.5 per cent in 2013. The corresponding forecast figures for the OECD countries are only slightly above 1.5 per cent, just over 1 per cent and less than 2 per cent.

Macro summary


China, GDP volume growth India, GDP volume growth Source: Reuters EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q12005 2006 2007 2008 2009 2010 2011

Yea

r-on

-yea

r pe

rcen

tage

cha

nge

0123456789

1011121314

sOFt LanDing FOr maJOr asian em eCOnOmies

GDP growth has trended lower in both China and India since early 2010, but so far this deceleration is moderate. The growth rate remains above 9 per cent in China and 7.5 per cent in India. Although the risks of a harder landing in 2012 have increased, mainly due to European economic and sovereign debt problems, our main scenario is still that both economies will experience a soft landing next year and then accelerate somewhat in 2013.


mODern prOteCtiOnGreece has remained at the centre of the euro zone drama, but is gradually getting more competition for attention from Italy. A lack of domestic political firmness pushed Italian sovereign bond yields above 7 per cent, which was the level at which Ireland and other countries were forced to apply for bail-out loans from the European Union (EU) and the International Monetary Fund (IMF). US 10-year Treasuries fell to a record-low 1.7 per cent in September when the euro zone outlook was at its gloomiest. Since then, Treasury yields have recovered and at this writing they are around 2 per cent. German 10-year bonds, which were trading at just below 1.7 per cent, are once again above 1.8 per cent – a sign that bond market players are more worried about the growth outlook in Europe than in the United States.

In Modern Protection, we try to preserve capital by allocating it to asset classes and managers that can generate returns regardless of economic events. Market worries are unusually large, however, and given a somewhat faltering interbank mar-ket this puts pressure on all asset classes, even less risky ones.

Since September we have only made minor adjustments. In the fixed income sub-portfolio, we have adjusted the share of absolute return fixed income funds downward to 34.5 per cent from 36.3. We have left our cautious positions in High Yield and emerging market (EM) debt untouched.

In the hedge fund universe, we foresee that credit market-ori-ented managers have good potential to generate returns, both because various central banks are now resorting to unconven-tional methods and because loan pricing is outside of normal limits right now. We have thus allocated 2 per cent to Credit Long/Short by replacing one of our Global Macro managers

and by adding the proceeds from our re-weighting in the fixed income sub-portfolio.

In the currencies sub-portfolio, we have previously allocated capital to managers with free investment mandates in the for-eign exchange market, but they have not succeeded in gener-ating satisfactory returns in the past few quarters. This is why, consistent with our view of currencies, we are now choosing to take a more active investment approach by seeking exposure to Asian currencies. Late in October we replaced our currency managers in favour of an Asian fixed income fund that invests in short maturities (1-3 years) and in local currencies (to gain currency exposure at limited interest rate risk). This position is generally more sensitive to risk appetite in the market, how-ever, and we have thus reduced the currency asset class to 2 per cent from the earlier 4 per cent.

As an effect of dysfunctional markets, Modern Protection has also lost some ground since August-September, but the port-folio should be able to recover at a rapid pace as risk appetite and liquidity improve.

Setting our sights on growth

Major market worries and a dose of systemic risk are pointing towards continued turbulent markets. In our portfolios we will generally maintain our cautious approach to risks, but we are choosing selective growth-oriented exposures. In Modern Protection this implies only minor adjustments, but in Modern Growth and Modern Aggressive it will mean a larger role for equities, including exposure to Asia and the Nordic countries.

17%

2%1.5%

79.5%

CashCurrenciesHedge fundsFixed income

portfolio commentary:modern investment programmes


mODern grOWtHThe euro zone issue has been the main controlling element in financial markets throughout 2011 – including this quarter. Although stock markets are largely at the same level at this writing as they were in late August, it has been a dramatic ride in recent months. Meanwhile the risk map has been redrawn to some extent.

Although the VIX volatility index, also called the “fear index”, has mostly remained above the 30 mark, the index has been in a downward trend since the turbulence of August. The US dollar, which is another indicator of market volatility, rose more than 8 per cent against EM currencies in September, but has fallen somewhat since then, though it has been trading aimlessly since mid-October. Asian currencies have performed well, however, with a modest decline of about 2 per cent since August. In Modern Growth we have had a defensive attitude since August, with equity holdings of 10 per cent and cash hold-ings of more than 20 per cent, motivated by great uncertainty and the lack of visibility in 2012. Although there are still many elements of uncertainty, the general mood about the future of Europe is more upbeat than one quarter ago. And above all, a number of assets have fallen to clearly attractive levels. Forward-looking price/earnings (P/E) ratios for equities at the global level are reasonable, and the spread between High Yield bonds and government securities is again above 700 basis points.

In the prevailing climate, we prefer to invest in asset classes that can generate returns regardless of market climate. Most forecasters predict less than a 3 per cent rate of company bankruptcies next year, while the bond market is pricing in more than 15 per cent. Corporate balance sheets are histori-cally strong, however, and High Yield bonds look clearly under-valued. Emerging market bonds continue to be attractive with their high coupons, and in some EM countries this is also po-tential for falling yields (= price gains). After the strong appre-ciation in the dollar, there is also great potential for exchange rate gains. We have thus gradually increased our fixed income holdings from 27.5 to 34 per cent of the overall portfolio, in-cluding 4.5 per cent High Yield and 2 per cent EM debt.

In the equities sub-portfolio, we have selectively bought ex-posure to markets with the best potential for growth – Asia (4.5 per cent) and the Nordic countries (2 per cent). Although these regions tend to be more volatile than global equities, they have shown other good characteristics compared to EM countries generally. Although risk appetite will determine the performance of these markets in the short term, their poten-tial viewed over 1-2 years is strong, provided we do not end up in a global recession. Total exposure to equities in Modern Growth is less than 17 per cent, which can be regarded as a continued defensive position.

To improve the ability of the portfolio to weather sharp down-turns in the markets, we have increased the share of CTA hedge funds to 9 per cent. We also foresee that credit market-oriented managers have good potential to generate returns, both because a number of central banks are now resorting to unconventional methods and because loan pricing is outside of normal limits right now. We are also increasing our alloca-tion to Credit Long/Short by replacing one of our Global Macro managers. In all, we have increased the hedge fund sub-port-folio to 30 per cent of Modern Growth from 26 per cent earlier.

In the currencies sub-portfolio, we have previously allocated capital to managers with free investment mandates in the for-eign exchange market, but they have not succeeded in gener-ating satisfactory returns in the past few quarters. This is why, consistent with our view of currencies, we are now choosing to take a more active investment approach by seeking exposure to Asian currencies. Late in October we replaced our currency managers in favour of an Asian fixed income fund that invests in short maturities (1-3 years) and in local currencies (to gain currency exposure at limited interest rate risk).

On the whole, our positions are not so dependent on stock market performance (and thus global growth) – the portfolio should be able to generate returns as long as we do not end up in a global recession. Short-term performance is, however, likely to fluctuate in response to the moves of political leaders and the ebb and flow of risk appetite. Further ahead, we nev-ertheless expect relatively stable portfolio performance.

Portfolio commentary: Modern Investment Programmes

10.5%

34%

17%4%4.5%

30%

CashCurrenciesCommoditiesHedge fundsFixed incomeEquities


Portfolio commentary: Modern Investment Programmes

mODern aggressiveAfter their big downturn in August, equities continued to fall during September. Share prices recovered slowly in October, however, amid hopes that euro zone leaders were moving towards finding a credible solution to the euro crisis. Late in October, they finally unveiled a plan that was positive on the surface, but lacked details. The plan could be regarded as more of a common declaration of will and a political roadmap than a final plan for a solution. Risk appetite – and thus the performance of various stock markets and asset classes – changes daily in response to political statements. In today’s market situation, asset prices are mainly being driven by the political advances and reversals occurring in Europe.

Since August, most economists have revised their global growth forecasts for 2012 downward. Meanwhile corporate earnings expectations for 2012 have been lowered. These revisions have been larger in the EM sphere (about 13 per cent since the end of July compared to 7.5 per cent for Western countries). Expectations for Asian companies have been lowered by about 12 per cent. Meanwhile, US macroeconomic indicators have provided upside surprises, and China is ap-parently moving towards an economic soft landing. Taken together, this is a scenario that points to continued global growth next year.

In Modern Aggressive, as in Modern Growth, in late August we had a defensive attitude with equity holdings of 20 per cent and cash holdings of more than 20 per cent, motivated by great uncertainty and the lack of visibility in 2012. Although there are still many elements of uncertainty, the general mood about the future of Europe is more upbeat than one quarter ago. And above all, a number of assets have fallen to clearly attractive levels. Forward-looking price/earnings (P/E) ratios for equities at the global level are reasonable, and the spread between High Yield bonds and government securities is again above 700 basis points.

As the markets began to stabilise, we gradually began to increase our exposure to markets with the best potential for growth – Asia (9.5 per cent) and the Nordic countries (5 per cent). Although these regions tend to be more volatile than global equities, they have generally shown other good char-acteristics compared to EM countries generally. Although risk appetite will determine the performance of these markets in the short term, their potential viewed over 1-2 years is strong, provided we do not end up in a global recession. Total expo-sure to equities in Modern Aggressive is 36 per cent.

High Yield bonds make up about two thirds of the fixed in-come sub-portfolio, which accounts for 30 per cent of Modern Aggressive. Most forecasters predict less than a 3 per cent rate of company bankruptcies next year, while the bond mar-ket is pricing in 7-10 per cent. Corporate balance sheets are historically strong, however, and High Yield bonds look clearly

undervalued. The remaining one third of the sub-portfolio consists of emerging market bonds, which continue to be at-tractive with their high coupons, and in some EM countries this is also potential for falling yields (= price gains). After the strong appreciation in the dollar, there is also great potential for exchange rate gains. We are maintaining our fixed income positions.

To improve the ability of the portfolio to weather sharp down-turns in the markets, we have increased the share of CTA hedge funds to 7 per cent. In this hedge fund strategy, returns vary significantly from one manager to another, and we have thus chosen to supplement our existing CTA portfolio with another manager who takes sufficiently high risks to fit into Modern Aggressive’s risk profile, but who still has a good track record and risk control.

Global risks and the volatility of the financial system in Europe are continuing to hamper highly-leveraged business models, especially private equity. Although discounts to net asset value are again at high levels, we are choosing to remain on the sidelines due to generally high risk driven by uncertainty about the balance sheets and funding ability of banks and the liquid-ity situation in the market.

Altogether, the Modern Aggressive portfolio is again exposed to market risk, but more selectively targeted to regions that are expected to drive global growth in the future. Return flows are, however, still spread across fixed income, hedge funds and commodities to ensure stable performance.

7.5%

6%

36%

30.5%

20%

CashCommoditiesHedge fundsFixed incomeEquities

13

theme

•Reduced cyclicality due to debt reduction needs

•Greater focus on selectiveness and direct returns on assets

•Bond markets are changing investment conditions

The global debt crisis gives us reasons to ponder how invest-ment strategies should look in the future. One of the theses that may become a reality over the next few years is that eco-nomic patterns will look a little different than we have been accustomed to during the past three decades. Likely effects of the continued need to reduce the debts in government and private balance sheets are continued high savings levels, an unwillingness to finance consumption with loans and probably somewhat reduced cyclicality.

We can summarise the past 20 years in terms of three phases:• Until2000–debtbuild-upandcapitalmarketappreciation.• 2000to2006–continueddebtbuild-up,butchangesinvaluations = greater volatility. • 2008(autumn)–debtreductionandlowermarketvalua-tions.

Today we are moving through a phase of debt reduction, with continued very large imbalances that affect the markets. The volatility that we have seen originates from changes in valu-ations, liquidity and debt reductions. This volatility has also caused many people to become tired of the stock market as an investment. We are on our way towards the emergence of a generation of investors who do not view stock markets as a source of returns.

We have lived in a world where powerful cycles have driven stock markets up and down. Monetary policy and other fac-tors have served as engines of the economic cycle. Low inter-est rates have encouraged loan financing and consumption, adding momentum to cycles that in turn have generated large stock market movements. This has meant that the most important analytical parameter has been to identify the turn-

ing points of cycles; once this has been done, the investor community has moved symmetrically. Macro-driven market analysis was the recipe for success. Another factor that has driven returns during the past three decades is that bond yields have basically fallen throughout the period. This has probably driven both the economy and markets in a positive direction. Because yields have become lower and lower, this has driven capital into investments (cheap to borrow) and risk assets (search for higher returns). In the future, the investment climate will be different. Interest rates are extremely low. Monetary policy muscle is not as ef-fective. Stimulus mechanisms via low interest rates do not have the same impact. Stock markets will probably not have the same predictable cyclicality to work in. This means that we will need to be much more selective in our future investment strategies.

Recession risks in the OECD countries will be part of everyday life ahead, since demand will not be as powerful as previously, saving will weaken the impact of consumption, unemployment will be at high levels and we will have somewhat more “boring” economic performance. It used to be sufficient to say “buy equities” and the result was good growth. Given the current trend, we need to be significantly more selective in identifying the genuine growth themes that still exist and that generate value. This means that more questions besides identifying cyclical shifts will be important to market players.

Low bond yields will change many thingsHaving bond yields as low as today’s will change many things. Bonds have been a simple, stable generator of returns, with falling yields as an extra driving force. In portfolios, the strat-egy of using bonds as a risk buffer has been comparatively simple. Bonds have contributed good returns, while shares have provided growth. Looking ahead, this will change. Given today’s low yields, returns from bond holdings will not be as good. Stagnating yields will pay 2-3 per cent. Rising yields, which will materialise sooner or later, will provide a negative return. This also means that the search for stable sources of returns will become increasingly important. These should pref-erably have low volatility in their underlying value, or at least one that can be forecasted.

A global search for returns


14

investing for returns more important aheadToday we have an investment climate where traditional cy-clically driven growth will not be the same basic source of returns. Volatility is high, and as a result the price of returns has risen. Based on these conditions, we reach the conclusion that we must give ever-higher priority to the ability of various assets to de facto generate current returns. By this, we mean returns in the form of dividends, coupons and pure cash flow. Given a large cash flow and good dividends, we can build up capital and also live with a degree of market fluctuations.

Most investment processes are designed to deal with the chal-lenges of identifying turning points in cycles and assessing how a cycle will affect the value of assets. Given the size of its economy and the large quantity of data that it generates, the United States has naturally been in the spotlight. If we put more energy into generating returns than into capturing cycles, the focus will naturally shift to the underlying asset, regardless of region or which part of the cycle we are in. so in the investment process, we take into account:1. The return-generating capacity of a specific asset: dividends etc.2. The stability of this dividend, its cyclical sensitivity etc.3. Various risk factors that may affect returns and the value of the asset, currency risks etc.4. Risk assessment in relation to expected returns (risk/reward ratio). 5. Role in the portfolio, correlations, diversification between sources of returns.

How shall we view various assets given this perspective?

equitiesEquities will remain attractive as an asset class in portfolios. Such factors as the growth of the underlying market, good pricing (low valuations), productivity increases and stable or preferably slightly rising prices are important.

But in a climate of smaller economic fluctuations, selection will become more important. Because we will be living for a long period in a world that will still be dealing with large debt problems, it will become even more vital to identify where real growth is. Regions and economic sectors with good potential will generate better returns. The currencies of debt-burdened regions will also eventually be a challenge. It is conceivable to divide sectors and regions into three categories: • Thosewithrapidgrowthindemand,currencieswithgood potential and rising productivity.• ThosethatwillbasicallygrowatthepaceofglobalGDP.• Thosewithmajordebtproblemsthatwillaffectdemand.

This analysis leads us in roughly the right direction, but if we wish to continue to genuine return-based investing, we must study the characteristics of the various equities. We must then select companies that have good balance sheets, stable sales and preferably a limited dependence on economic cycles. These companies should also have a stable dividend history. As an illustration, we asked SEB Enskilda to rank Stockholm-listed companies for us. The table below shows companies in which cyclical effects on dividends can be regarded as limited.

Theme: A global search for returns


COMPANY Direct return (%)

2011*

Historical return (%) Market

capitalisation

(SEK m)*2010 2009 2008

tele2 11.9 19.3 5.3 7.2 56,307

teliasonera 6.7 5.2 4.4 4.7 193,468

skanska 5.9 9.0 5.1 6.8 41,998

astraZeneca 6.2 5.5 4.9 5.0 401,309

securitas 4.9 3.8 4.3 4.5 22,287

Hennes & mauritz 4.6 4.2 4.0 5.1 340,945

sCa 4.1 3.8 3.9 5.2 68,986

Holmen 3.9 3.2 3.8 4.7 15,069

HigH anD prObabLe DireCt retUrn

First, we made a list of companies on the OMX Stockholm exchange with positive recommenda-tions plus high, resilient dividend levels. Next, we added the criterion of a 3.9 per cent minimum expected dividend. We eliminated companies that have cancelled dividends within the past three years. Finally, we kept only companies with a mar-ket capitalisation above SEK 10 billion. * Market capitalisations on November 18, 2011. Source: SEB Enskilda

15

In another ranking, we looked at companies that have gener-ated a direct return of at least 3 per cent annually over the past decade (see the chart below). The chart also shows the beta value of these companies and indicates that the share price of this type of company moves less than the stock mar-ket as a whole, one of the criteria we specify for a good return-based investment.

bond marketsBonds are the classic return-based instrument, but govern-ment bonds have lost much of their attractiveness as yields have fallen. Nevertheless, corporate bond markets have now moved into the spotlight for various reasons.

One of the big changes in Europe today is that more and more banks must trim their balance sheets. This means that com-panies will increase their borrowing directly via bond markets. The European corporate bond market will evolve exactly like the North American one. Our current view of corporate bonds is presented in the “Fixed income” section later in Investment Outlook. Here we will only focus on the structural change that will make corporate bonds a worthwhile form of investment for many years to come. We have recently invested quite a lot in corporate bonds, especially in the High Yield segment. This has given us valuable experience on how this asset class works. Our assessment is that corporate bonds have good risk characteristics, provided we practice healthy diversification.

structured bond investmentsWe are seeing more and more investments in which bond structures are placed in different baskets in order to reduce company-specific risk in the investment. This will be a com-mon form of investment in the future, with the various types of structures having different liquidities and some of them requiring longer lock-in periods. Putting together a basket of bonds is one way of reducing risks. It is an attractive invest-ment in some cases. The portfolio designer can add a mecha-nism for financing the holdings in order to increase exposure at the expense of liquidity. Investors must then be prepared to lock in their capital for a given period.

real estate investmentsReal estate can be an excellent way of obtaining stable re-turns in a portfolio, which may also include some inflation compensation. In principle, there is always the problem of liquidity here, and investors must expect to lock in their capital for some time. But in exchange, they gain good asset charac-teristics. Real estate is a market into which large institutional investors put much of their capital in order to ensure the value of their portfolios. It is important to note that residential prop-erties generally provide more stable returns than commercial properties. One challenge in this market is that the number of funds is rather limited, and those that exist are often fully subscribed relatively fast.

Theme: A global search for returns


COmpanies WitH HigH DireCt retUrns Have FLUCtUateD Less tHan tHe market

0%

3%

5%

8%

10%

13%

15%

18%

20%

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ns

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ilä

NC

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M

Min Avg Max

Dir

ect

retu

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%)

0.280.35 0.36 0.37 0.39

0.46 0.48 0.48 0.51 0.530.59 0.59 0.6

0.64 0.650.74

0.5

1

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0.2

0.4

0.6

0.8

1

1.2

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When we list those companies that have provided yearly direct returns of at least 3 per cent during the past decade (right-hand chart) we see that virtually all of them have had a beta value below 1, i.e. their share prices have fluctuated less than the exchange as a whole. This is a good example of exactly the combination we want to achieve in return-based investments: stable income flows at low risk.

Source: Reuters EcoWin, SEB


16

theme

•Great uncertainty and sharp price movements mean good potential for those who dare to leave the herd

• Investors seek assets they perceive as safe; this creates buying opportunities in turnaround situations

•Undeserved price declines create value pockets with attractive risk/return ratios

In genuinely uncertain times like these, stability is the first victim of the market. Volatility – price fluctuations – increases when the future seems more and more difficult to assess. Globalisation also contributes to these fluctuations, since it has caused all economies and markets to be woven more tightly together, for better or worse. In recent years, the term “risk on/risk off” has become a common way of describing the behaviour of financial market players. Investors move in herds, either into or out of all types of investments that carry various kinds of risks. Prices of risk assets fall, partly because it is rea-sonable to set a risk premium on less certain future income, but sometimes also because the doorway gets crowded when everyone is trying to exit at the same time. This creates capital flows that are sometimes not soundly based on fundamentals. Valuations thus tend to become attractive in many places. This behaviour also means good potential for those who dare to separate themselves from the herd and go against the current. Here we will study some of the reasons for these sometimes exaggerated price movements and try to identify investments for which the risk-return ratio appears extra attractive, despite the uncertain situation.

two explanations for downturns The opportunities that occur in the wake of risk aversion and rising uncertainty have two main explanations. First, certain types of assets tend to perform better in times of uncertainty and others worse, due to differences in liquidity – how easy it is to sell a security, stability (financial) and the predictability of earnings growth/future capital flows. Here relative price trends

arise, which tend to correct themselves over time. Second, some market segments may be undeservedly affected by a price slide; these may be stock markets, sectors, asset classes or companies. One reason may be that amid the stress born out of the desire to quickly cut down on risk, prices are set on the basis of old characteristics, without taking into account that fundamentals may have changed. Another may be that analytic capacity is simply insufficient to separate the wheat from the chaff. This leads to the emergence of what we call “value pockets” – investments that have undeservedly low valuations. Note the word “undeservedly”. In many cases, a low valuation may be justified. A successful investor is able to identify the difference between what is undeserved and what is not.

If we first focus on common patterns in volatile times, it is clear that among other things, investors tend to repatriate capital. They sell off holdings in peripheral markets in favour of what they regard as home markets. This tends to benefit larger financial markets, such as North American ones, since larger markets – as exporters of capital – naturally represent a larger share of smaller markets than vice versa. (For example, American investors generally own a larger percentage of the OMX Stockholm exchange than Swedes own in US stock mar-kets.) We see clear evidence of this pattern from the fact that the US dollar tends to strengthen when volatility rises and that American exchanges are top performers among the world’s stock markets this year.

Another pattern is that investments are concentrated in more stable holdings, often in larger markets as well, but also in investments with a more stable history. Countries like Switzerland and assets like gold are direct associations in these cases. Japan also tends to benefit, along with more sta-ble shares, generally known as “value companies”.

In order to take the best advantage of these trends, we not only need to identify which assets fall the most in uncertain times and that thus have the greatest potential to rise when risk appetite returns. We must also think about when risk ap-petite can return. Predicting turning points in trends is always

Finding gold that doesn’t glitter


17

tricky. At present, credible long-term solutions to Europe’s debt problems appear to be the most important catalyst for such a peripeteia, as the turning point is called in a Greek drama.

The second way of identifying opportunities amid the prevail-ing uncertainty is to analyse which of the assets that have fallen have done so for fundamental reasons, as conditions actually deteriorated, and which ones have merely been swept along in the price decline. Among the latter, the greatest po-tential may be found.

One such example is Nordic equities, especially compared to equities elsewhere in Europe. It is not surprising that non-Nordic European equities have generally been hurt, consider-ing the problems in parts of the region. Non-Nordic Europe will be struggling for a long time with the effects of large debts and deficits, and a large proportion of its weak performance is definitely justified. And obviously the problems of these countries will affect the more strongly performing economies of the Nordic countries, just as weaker non-Nordic European demand will hurt exports from Nordic companies. But bearing in mind that the share of Nordic exports destined for emerging markets has steadily increased, and exports from non-Nordic European companies have been affected at least as severely, it is difficult to see fundamental reasons why Nordic companies as a category have fallen more than a broad European index (see chart). There is some justification for arguing that on the whole, Nordic stock markets have a larger element of cycli-cal companies that are likely to be more severely affected by increased uncertainty about growth. But it is also possible to suspect that the Nordic region is being punished because of the relatively small size of its stock exchanges (investors are selling off holdings in small peripheral markets).

Larger-than-average price declines have also affected stock markets in the world’s emerging economies, especially in Asia, even though these countries seem to have the fastest growth and stable economies. The simple explanation for the relative weakness of Asian stock markets is these countries’ historical track record of instability and volatility, combined with the small size of many of their stock markets. This argument is beginning to sound threadbare, however. Another explanation may be that in uncertain times, markets do not seem to want to pay “extra” for growth, which may be a common explanation for value pockets – that certain market segments are battered unfairly in turbulent times.

growth doesn’t pay at presentA Goldman Sachs study shows that those European compa-nies that have the highest expected earnings growth in the next few years are, in principle, being traded today without a premium compared to the rest of the market. Historically, companies that are expected to show earnings growth of more than 15 per cent over the next three years (including the current year) have been valued at a premium of 4-5 units com-pared to the rest of the market in terms of price/earnings ratio. When the market has traded at P/E ratios of 13, these compa-nies have traded at P/E ratios of 17-18. Today these companies are trading at P/E ratios of just over 9, in line with the market average and close to a historical low. Reasonable explana-tions are that reduced risk appetite tends to lower the value of (uncertain) future excess profits and that the market has little confidence in analysts’ forecasts. This valuation anomaly may, of course, be normalised either when the shares of these companies perform better than average or their earnings forecasts turn worse. It may also be true that the predictability of forecasts is worse than for a long time (risk is greater), so in some cases the relatively weak price performance of these

Theme: Finding gold that doesn’t glitter


USA, CBOE, Volatility Index (VIX) Nordic countries, OMX, VINX, 30 Index Emerging Markets, MSCI, USD Index US, Standard & Poors, 500 Composite Index Source: Reuters EcoWin

Dec2010 2011

Feb Mar Apr May Jun Jul Aug Sep Oct

Pe

r ce

nt

15.017.520.022.525.027.530.032.535.037.5

Index

707580859095

100105110

UnCertainty HUrts smaLLer markets mOre

Repatriation of capital has benefited the larger American stock market and created outflows from the smaller stock exchanges of the Nordic countries and Asia.

Europe, STOXX, Financials, Index, EUR Nordic Countries, OMX, Financials, Index, EUR World, MSCI, All Countries Index (LOC) Source: Reuters EcoWin

Dec2010 2011

Feb Mar Apr May Jun Jul Aug Sep Oct Nov60

70

80

90

100

110

120

Index

60

70

80

90

100

110

120

eUrOpean banks Have been LUmpeD tOgetHer

Companies in the Nordic financial sector (mainly banks) have seen their share prices fall almost as much as those of their colleagues elsewhere in Europe – despite clearly lower exposure to crisis-plagued countries and more stable financial positions.

18

Theme: Finding gold that doesn’t glitter

shares may be justified. But when an entire category of poten-tial growth companies is valued as if their earnings will be no higher than the market in general, there must be exceptions – cases of undeserved share price declines. Some examples might be companies with fundamental support for their earn-ings forecasts, such as larger exposure to emerging markets or proven stability in generating earnings.

The same reasoning (to close a large circle) can be applied to the markets in Asia. Smaller fluctuations in growth due to reduced export dependence and a higher share of domestic consumption, coupled with greater financial stability, indicate that as a group these markets might be assigned higher cred-ibility and thus higher valuations compared to other countries than was previously justified.

Other examples of assets for which the market has perhaps not succeeded in separating the wheat from the chaff may be Nordic banks, whose shares have fallen as much as those of their non-Nordic European colleagues, even though they are affected to a much smaller extent by the European debt crisis (see chart) and better capitalised than their non-Nordic European colleagues – an appealing combination. Listed private equity (PE) companies have also been hard hit by the prevailing financial market uncertainty. They are being traded at larger discounts to net asset value (NAV) than during previ-ous crises, except in the midst of the turbulence following the Lehman Brothers crash. Although the financial situation seems about equally uncertain, there are very few indications that there will be as deep a recession as three years ago. The financial stability of PE companies is also substantially higher, which may also indicate that discounts to NAV may be exag-gerated, at least as soon as more stable risk appetite returns (see also the “Private equity” section).

High yield better than the stock marketFinally, ever since the Lehman Brothers crash, we have had a more or less positive attitude towards corporate bonds, espe-cially in the High Yield segment. One argument has been that

over time, these investments have paid returns in the same range as the stock market, but at lower risk. This combina-tion usually means that their market prices fall less during downturns and rise less during upturns. Lower risk does not necessarily mean that High Yield funds gain less ground than equities during all upturn phases. We have studied how the prices of different assets have tended to move during the past two decades following periods when the VIX volatility index has climbed above 30 or 40. Such high volatility levels usually indicate great market uncertainty and coincide with large sell-offs, which often also represent buying opportunities (tradi-tionally for equities). Our studies also show that stock markets as a group, twelve months after an upturn in volatility, have in fact performed well, but also that High Yield investments have delivered a return that exceeds most other asset classes, both in terms of average return and stability.

value pockets offer market price potentialThese value pockets do not close by themselves, and even the prices of low-valued assets can fall, of course, if uncertainty persists. But an undeservedly low valuation reasonably repre-sents some form of cushion against future downturns, while the price potential should be good. Especially attractive is the fact that some degree of stabilisation should reasonably suffice to enable these investments to provide relatively good returns.

Conclusion: Those who believe that the market will eventually return to a more normal scenario should take a look at Nordic equities generally, Asian equity funds and – perhaps above all – High Yield bond funds. American equities and gold po-tentially appear less attractive – all else being equal. For those who are seeking value pockets in markets where the ratio between risk and expected return is extra favourable, Nordic bank shares, private equity companies and equities with fore-casted high growth coupled with large exposure to emerging markets or historically stable earnings appear to be especially attractive.


DATES SINCE THE 1990S WHEN

THE VIX BROKE THE 40 LEVEL

Equities Government

bonds

Corporate bonds with

lower credit ratings (HY)

Commodities

september 4, 1998 31.7% 5.1% 5.0% 5.2%

september, 21 2001 -13% -7.4% -2.8% 9.8%

august 2, 2002 7.3% -5.0% 25.7% 21.9%

October 3, 2008 -6.8% 13.9% 23.7% -21.7%

January 9, 2009 25.7% -7.4% 52.0% 20.6%

may 7, 2010 15.3% -10.3% 14.7% 24.1%

average retUrn 10.1% -1.8% 19.7% 10.0%

When volatility has risen, it has usually been accompanied by positive market performance – not so surprising in itself. Worth noting, however, is that High Yield bonds exceeded both equities and commodities in the recovery phases, both on average and in terms of the best/worst period.

19

theme

•The most likely scenario is a continued slow, choppy upturn in the OECD countries...

• ...which will bring modest growth in the value of risk assets

• In a worse or better scenario, the outlook for returns will be substantially different The latest global recession was precipitous and was coupled with the worst financial crisis in generations. The recovery that started in mid-2009 was initially rapid – partly a reflec-tion of the previous steep slide – but the economic upturn since then has been both slow and choppy. The reasons for this sluggishness were discussed in detail in the last Invest-ment Outlook (published September 13, 2011). Our most important conclusions were:

• Duringthepast40years,upturnsthatfollowedrecessionsin the OECD countries caused by burst speculative bubbles have generally been sluggish. Underlying the 2008-early 2009 recession was the sub-prime real estate crisis in the US.

• Commonfactorsbehindsuchsluggishnesshavebeen1)the weakness of the housing market, 2) that households and businesses have increased their savings level/reduced their indebtedness and 3) uncertain job prospects that have ham-pered consumption. This time around, there has also been a great need for budget-tightening in many countries.

• Theupturnshavebeencharacterisedbyampleproductioncapacity in terms of both labour and real capital. This has led to low cost and price pressure, paving the way for low interest rates. The upturns have thus often continued for long periods.

Judging from history and current trends, there are many indications that the most likely macro scenario for the next few years is a continued slow, choppy economic upturn in the OECD countries as a whole (but a recession in the euro zone during 2012), with low inflation. We are assigning a 60 per cent probability to this main scenario.

A pattern of economic growth well below the trend level – slightly less than 4 per cent annually for the global economy – is actually not especially unusual. More than 90 such periods can be identified in various parts of the world since the break-through of industrialisation in the late 19th century (Robert Barro & José Ursua, “Macroeconomic Crises since 1870”, Brookings Papers on Economic Activity, 2008).

many features in common Common macroeconomic features in these “growth reces-sions” have been 1) more stable growth than the historical average, 2) low inflation, 3) weak labour markets, often with rising unemployment and 4) low or somewhat declining home prices. Another common factor has been the existence of financial crises of various kinds – in the stock market, in the banking sector, in the foreign exchange market – which sup-ports the assessment that the last deep financial crisis will also leave its imprint on the economy for many years to come. History also clearly shows that during periods of economic growth which is significantly slower than trend, returns on eq-uity investments have been lower and returns on bonds have been higher than their historical averages. During the post-war period, equities globally have returned about 5 per cent annually in low-growth phases, compared to about 11 per cent on average. Corresponding figures for bond investments have been around 4 per cent and 2.5 per cent. However, some factors create nuances in this picture of invest-ment returns. The existence of inflation is one such factor. Low growth coupled with rising inflation has been an especially unfavourable combination for financial assets, resulting in 1) much lower returns on equity investments than normal, 2) lower returns on bonds than normal and 3) negative returns on money market securities.

US statistics since the mid-1960s show that in periods when the macro environment has been characterised by a combina-tion of low growth and high inflation, equities have paid aver-age annual returns of -1 per cent, but in periods of high growth and low inflation more than 15 per cent.

Macro environment the key to returns


20

important to distinguish between OeCD and em

Considering the wide gap between conditions in the OECD countries and the emerging markets (EM) sphere, it is now also important to distinguish between their prospects both in terms of growth and investment returns. While many OECD countries – such as Italy, Spain, France and Japan – are strug-gling with major growth problems that appear to be long-term, there is a far better growth outlook in such EM countries as China, India, Indonesia, Argentina and Russia. Historically, too, the OECD countries – especially in Western Europe – have seen periods of very slow growth more often than the EM sphere. The picture of a “two-speed world econo-my” may thus become even clearer during the next 5-10 years.

Conclusion: Our main scenario implies slow, choppy growth and very low inflation in the OeCD countries with far higher growth and moderate inflation in the em sphere.

History shows that periods of low growth preceded by reces-sions caused by financial crises – like the current one – have usually been characterised by lower returns on equity invest-ments than the historical average, while during such periods bonds have provided above-average returns. Another factor that should be taken into account is that equities (and other risk assets) have usually delivered higher returns in a low-inflation macro environment than in a high-inflation one. For an investor, it is also essential to pay heed to the far better macroeconomic conditions and prospects in the EM sphere than in the OECD countries.

alternative scenarios

Given the high level of economic and financial uncertainty now prevailing, there is also reason to consider how alternative scenarios might look.

a significantly more negative scenario than the one we view as most probable includes a deeper, lengthier recession in the euro zone and a more severe financial crisis that has global contagious effects, with both the OECD countries and the world economy slipping into recession. According to the International Monetary Fund (IMF) definition, a global reces-sion occurs when world economic growth drops below 3 per cent. The risk of deflation, especially in the OECD countries, also increases significantly in this scenario, to which we are as-signing a 25 per cent probability.

If, on the other hand, the management of European govern-ment financial problems proves unexpectedly resolute, at the same time as the American and Chinese economies exceed expectations, this might lead to far more favourable perfor-mance than in our main scenario, with gradually accelerating GDP growth both globally and in the OECD countries over the next couple of years. Probability: 15 per cent.

Uncertainty in the starring roleWhat, then, might be the rhythm of these alternative econo-mic scenarios? The degree of uncertainty would play a major role, and in the financial market one of the best measures of uncertainty is the VIX volatility index (option prices for the S&P 500 equities index in the US).

During upturns characterised by slow economic growth fol-lowing recessions caused by financial crises – like the current upturn, which began in mid-2009 – the VIX index has usually fallen gradually. But that has not been true this time around. Both in the spring of 2010 and in late summer 2011, the VIX index soared. It has also showed major fluctuations from week to week – a kind of volatility amid the volatility, so to speak.

The main causes have been the sovereign debt crisis in Europe, including its effects on banks, question marks about US fiscal policy and choppy economic performance. One recent example of a major negative drama occurred in August-September, when worries about European and US government finances, a US recession and a hard landing in China escalated at the same time. The VIX index soared to 48 – its highest level since the unprecedented financial market year 2008.

the viX both reflects and affects When the VIX index rises, this indicates greater economic and financial worries. The upturn in the index ordinarily coincides with falling prices for equities and other risk assets, which also impact growth through various channels.


Theme: Macro environment the key to returns

UnUsUaLLy vOLatiLe

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The VIX volatility index – which reflects financial market instability – has usually fallen during economic upturns, but this pattern has not applied during the current recovery. Instead the index climbed sharply both in the spring of 2010 and in the late summer of 2011. The main reason is recurring worries about European government finances.

21

Increased uncertainty usually causes households to hold off on buying capital goods and causes businesses to post-pone capital spending decisions, thereby lowering growth. Mounting concerns about the economy – or European govern-ment finances or US fiscal policy – may thus easily become self-fulfilling. In the next stage, lower growth would worsen government financial conditions, thus creating more worries, causing households and businesses to reduce their consump-tion and capital spending, and so on.

It is therefore an obvious risk to the economy if increased uncertainty about government finances and/or the economy recurs frequently over the next couple of years – reflected in a rising or constantly fluctuating VIX index – since this would reinforce the vicious circle described above and lead to a trend consistent with our negative alternative scenario.

virtuous circle as driving forceIn the same way – though in the opposite direction – positive events related to government finances and/or the economy might reduce uncertainty and cause the VIX index to gradu-ally fall. The mood among households and businesses would thus improve, consumption would increase and more capital spending would occur. This would boost growth and improve government finances, fuel more optimism and drive up de-mand, and so on. A virtuous circle would thus become the driving force in our more favourable alternative scenario.

As financial markets around the world are globalised and wo-ven together, both negative and positive events are instantly transmitted worldwide via financial channels. This means that an escalating drama in the Greek economy and politics im-mediately affects not only financial markets, households and businesses in Europe, but also those in many other parts of the world. In the same way, surprisingly strong American econom-ic figures can immediately have a positive impact in financial markets on the other side of the globe, causing households and businesses there to experience an improvement. returns in alternative scenariosA negative scenario of global recession and severe financial crisis would – in our judgement – have an impact on asset markets reminiscent of the period from 2008 to early 2009: steeply falling risk asset prices and rising government bond prices. There are some important differences, however. First, a global recession is unlikely to be as deep as the last one (world GDP fell 0.5 per cent in 2009), even if the economic policy toolkit is nearly empty in parts of the OECD. Second, there is now significantly less room for higher government bond prices. In addition, the bonds of many problem countries have been re-labelled as risk assets. The conditions for High Yield bonds (see the “Fixed income” section) are also significantly better today than in 2008, so in this scenario such bonds should perform fairly well compared to many other risk assets.

A more favourable scenario, with gradually accelerating growth, would lead to a favourable period for risk investments. Annual returns on equity investments, for example, should end up at least on a par with the post-war average (11 per cent), while returns on bonds in core countries would probably be lower than the historical average (2.5 per cent). High Yield bonds would provide both a high absolute and – not least – risk-adjusted return, while investments in the sovereign bonds of some problem countries (such as Ireland) may perhaps result in upside surprises.

Conclusion: recurring uncertainty will trigger a worse sce-nario; greater predictability will lead to a better scenario.

In a worse scenario, the pattern in asset markets would be reminiscent of the last financial crisis. Risk assets are not, how-ever, likely to fall as much in value as then, especially not High Yield bonds, and the room for price increases on government bonds in core countries is now clearly smaller.

In a better scenario, risk assets would benefit and in many cases should be able to provide returns equal or higher than historical averages. In this scenario, too, High Yield bonds ap-pear attractive in both absolute and relative terms. Bonds of certain problem countries may prove to be jokers in the pack.

Theme: Macro environment the key to returns


US, GDP volume growth, year-on-year US, Dow Jones industrial shares US, Merrill Lynch, High Yield index, USD World, Dow Jones Commodity Price Index, USD US, yields on 10-year Treasuries US, consumer prices, year-on-year Source: Reuters EcoWin

71 74 77 80 83 86 89 92 95 98 01 04 07 10

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10.012.515.017.5

maCrO – tHe key tO retUrns On assets

Economic fluctuations and other changes in the macro envi-ronment – for example the trend towards lower inflation since the early 1980s – strongly influence returns on assets. Govern-ment bonds have been favoured by falling inflation, reflected in gradually lower yields/rising market prices, but such risk as-sets as equities and High Yield bonds also benefit from lower inflation. Commodities were a fairly “boring” investment for a long time, but over the past decade they have occasionally offered excellent returns. High Yield bonds usually lose less value during recessions than do equities and commodities.

22

•Asian and Nordic stock markets should recover lost ground

•No strained valuations in historical terms, despite stock market rally

•While sticking to our long-term positive view of equities, we are more defensive in the short term

According to Wikipedia, a thriller is a story that “uses sus-pense, tension and excitement as the main elements,” stimulates “moods such as a high level of anticipation, ultra-heightened expectation, uncertainty, anxiety, suspense (and) excitement” and uses such devices as the “cover-up of impor-tant information.”

The observant reader will already have spotted the similarity between the thriller genre and the current world of financial markets. Recently, whenever we think we might be close to a “normalised” market and “out of the woods”, there has been a tendency towards continued surprises, leading the market in all kinds of directions. Economic, financial and political turmoil has been the norm rather than the exception during the past few quarters.

In our latest Investment Outlook (published September 13, 2011) we argued in favour of investors holding on to their equity exposure after heavy market declines during late sum-mer. Markets had fallen dramatically both on the notion of decreased global growth and a growing fear of systemic risk (bankruptcies in financial institutions followed by a liquidity squeeze). According to our models, markets were discounting fairly bearish growth in world GDP of about 2.5 per cent, while economists on average were expecting a more optimistic growth scenario of 3.5-4.0 per cent for the coming 12 months. As a consequence of this discrepancy, we stated that risk/re-ward ratios favoured maintaining current equity exposure and that policy interventions, preferably global, would hopefully initiate a rebound from fairly depressed levels. By the end of September an increasing belief in an upcoming package solu-tion from European politicians started to get a foothold in the

market. At the “mother of all EU summits” on October 26-27, politicians agreed to expand the European Financial Stability Facility (EFSF) and take steps to recapitalise European banks and restructure Greek debt. Markets reacted quite strongly and most major equity indices ended October up 12-15 per cent for the month. As a consequence of rising equity markets, current implicit ex-pectations of growth in world GDP are at 3.0 per cent (with the S&P 500 at 1285). In the meantime economists have lowered their expectations, thereby narrowing the gap. We are now left with a more traditional approach to equity market valuation, where future growth is the most relevant issue. In this scenario we find it prudent not to increase risk, as we fear that it is too early to write off the ongoing situation in Europe and that the growth outlook is quite uncertain.

A thriller unfolds

equities


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One factor that favours equities is today’s historically low market valuations. The chart illustrates the ratio of Swedish market capi-talisation to expected earnings (P/E) and to book value (P/BV). At present these are well below their 10-year historical averages. We see similar tendencies in Norway and in Europe generally, but the picture is more neutral in the US, where the ratios are currently close to their historical averages.

Source: Factset

23

Stock markets and bond markets currently reflect divergent views on the future path of financial markets. While stocks have rallied since early October, one of the most critical risk parameters in the current EU turbulence – Italian government bond yields – have risen sharply and are currently well above 7 per cent. This is not a sustainable level and will require action by the European Central Bank (ECB) and EFSF to bring yields down.

Factors that favour equities include price/book value (P/BV) ratios and price/earnings (P/E) ratios well below 10-year historical averages. This is in strong contrast to the pric-ing scenario in the last two major equity market downturns in 2001 and 2008. The corporate sector is also in a strong posi-tion, with healthy balance sheets and decent flexibility, making it well equipped for unexpected events. Third quarter reports have generally led to a sense of relief, with 41 per cent of Nordic companies having exceeded SEB Enskilda’s estimates of earnings before interest and taxes (EBIT) by more than 5 per cent. At this writing, the Q3 positive/negative surprise ratio has so far been at 2.2, the highest since the third quarter of 2010.

Financial markets are currently behaving in a very “risk on / risk off” mode. The fact that most equity markets have moved in a synchronised manner makes it more challenging for inves-tors to diversify their equity exposure. The market’s total focus on the European sovereign debt crisis has overshadowed fundamental factors that create different conditions from a country perspective, such as growth, indebtedness and monetary policy. There is no quick solution to the euro zone crisis, and worries about sovereign debt in Europe are likely to rattle financial markets from time to time. However, our main scenario is that the global recovery will continue and that the euro project will survive the challenges it now faces. Eventually today’s market climate – characterised by either flooring the accelerator or putting both feet on the brake pedal – is likely to shift to a climate where investors increasingly focus on fun-damental distinctions between the stock markets of different countries.

Our stock market model a recurrent featureIn recent issues of Investment Outlook, we have created a quantitative model aimed at capturing the premises of dif-ferent stock markets. Because the model makes our analysis transparent and hopefully easier to follow, we have now cho-sen to turn this model into a recurrent feature of Investment Outlook. It is important to point out, however, that a model is a radical simplification of reality and will never capture all forces and scenarios. It should consequently not be regarded as an absolute truth, but be viewed as a tool for describing how we see the market and what we believe will drive it.

The framework of the model is that we select factors that we believe will set the tone, based on the market climate we see before us. Each factor will be assigned a score based on its positive or negative contribution to the stock market in each respective country. The scores will vary from -3 to +3. This time around, we believe that the following factors can generate different potential for various stock markets: gDp growth, monetary policy, fiscal policy, financial stability, valuations and currency.

gDp growth forecasts in the world have gradually been low-ered, and SEB’s forecast is no exception. We foresee moderate global growth during the coming year of just above 3 per cent. This is lower than the 3.5 per cent consensus assessment that prevailed in October. However, the growth gap between emerging market (EM) and developed market (DM) countries is still expected to be wide, and this is something we believe the market will pay attention to.

monetary policy varies significantly between regions. The world appears to be divided in two, with relatively high inter-est rates in the EM sphere and ultra-loose monetary policy in the OECD countries. For the stock market, an expansionary monetary policy is preferable, but it also depends on where you come from. In the OECD countries, key interest rates are likely to remain at today’s extremely low levels during the foreseeable future. This in itself will probably stimulate the

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In the West, gigantic debt mountains are likely to weigh down GDP growth for many years to come. In emerging market (EM) countries, especially in Asia, the prospects are brighter. Investors will probably pay attention to this growth gap.

Source: Reuters

EcoWin/SEB

24

economy and fuel risk appetite, but at the same time there is no ammunition left in the interest rate weapon. The market is unlikely to be positively surprised by key interest rates that are parked around zero, since this is already taken for granted, and further interest rate cuts are impossible. However, there is room for further quantitative easing (QE) rounds. For ex-ample, we believe that the US Federal Reserve will launch its third such round (QE3) in mid-2012, which is likely to fuel the stock market. In most emerging market countries, however, the interest rate weapon is fully loaded with real ammunition. Reduced inflation pressure in the EM sphere is now also laying the groundwork for central banks to pursue more stimulus-oriented monetary policies with a good conscience. The ability of certain countries to sharply lower the price of money is likely to be vital, especially in a climate where global economic growth is well below trend.

The potential for economic stimulus via fiscal policy also var-ies significantly between different parts of the world. In many debt-burdened Western countries, governments are being forced to tighten their fiscal policies to prevent already soar-ing deficits from growing even faster. They have delivered far-reaching austerity packages in rapid succession, and measures aimed at bringing debt under control are likely to hamper economic growth for many years to come. Especially in emerging Asia, however, the situation is the opposite; gov-ernments are ready to flex enormous fiscal muscle if economic activity fades.

Financial stability is a factor that is likely to attract investors more and more. It is no secret that debt burdens vary signifi-cantly between countries, but meanwhile we do not believe that this is being reflected in today’s asset prices. When the market’s “risk on/risk off” behaviour fades, the finances of the US, Japan and the UK – which are in tatters to say the least – are likely to end up being more closely examined by investors, and financial stability will help guide their allocation by region.

Currency movements are a variable with several dimen-sions from an investment standpoint. Among other things, a weaker currency may strengthen a country’s competitiveness and vice versa. But in many cases, today’s companies are so globalised that it is difficult to know where their production costs and sales are located. Thus the scoring system in the model instead takes into account the direct effect on returns for those who invest in foreign equities. A stronger currency thereby contributes positively to total return, while a weaker currency contributes negatively. In today’s turbulent market climate, investors demand high-volume, liquid currencies such as the US dollar, Japanese yen and Swiss franc. Assuming that there will be no quick solution to European problems, the liquidity aspect is likely to continue dominating the foreign exchange market. Once the acute situation in southern Europe eventually calms down, more fundamental factors will set the agenda. This will probably benefit commodity-dominated, EM and Nordic currencies. advantage asia and the nordicsOur model indicates that Asian stock markets have good po-tential to perform well in a long-term perspective. The region is unlikely to exceed high growth expectations, but the growth gap between Asia and the DM countries should again come into focus. Investments are likely to be attracted by the rela-tively high growth that Asia offers, leading to capital inflows and rising share prices. Furthermore, mainly as a result of falling food prices and key interest rate hikes, earlier high infla-tion pressure in Asia has now begun to ease. If the inflation trend continues along its current path, purchasing power will increase in the region and these countries will also have an op-portunity to pursue more accommodative monetary policies. In addition Asia, led by China, can demonstrate the world’s largest trade surpluses; debt is generally low and there is room to launch large financial stimulus packages.

Equities


Russia Brazil Chna Source: Reuters EcoWin

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inFLatiOn pressUre WiLL ease in tHe em spHere

Inflation is about to fall in many EM countries, giving their central banks room to cut key interest rates and thus probably stimulate growth and equity prices in the EM sphere.

25

There are also many indications that Asian currencies will appreciate in the future. Among other things, stronger Asian currencies will be an important tool for dealing with the enor-mous trade imbalances that have built up between West and East. A number of Asian countries should also have a positive attitude towards seeing their currency appreciate, since this will help ease inflation pressure. In our model, Asia is rep-resented by China and India, and China wins the contest in terms of its score. The Nordic countries have various similarities with Asia. Their growth rate is admittedly at a much lower level, but their financial stability is good. They also have some room for mon-etary and fiscal stimulus policies. Another similarity between Asia and the Nordic countries is that major investors still view these regions as peripheral markets. The turbulent stock mar-ket movements of the past six months have caused market players to sell their holdings in distant markets and instead shift their demand to highly liquid stock markets. A number of EM stock markets as well as the Nordic markets thus show larger share price downturns than fundamentals would justify (in the range of 15-20 per cent), while US stock exchanges have hovered around zero. Nor are the EM or Nordic countries plagued by minimal growth figures and gigantic debt moun-tains. In a market climate where investors are increasingly examining the fundamental differences between countries, a number of unjustifiably depressed stock markets are likely to regain some lost ground.

euro zone faces painful austerity measuresThe euro zone scores the lowest number of points in our model. Although the prospects are different in the southern and northern parts of the euro zone, our main scenario is that the region as a whole is headed for a recession (falling GDP). A combination of political instability, fiscal tightening and a stricter credit environment will benefit neither economic growth nor the stock market. No quick fix is at hand either. Recent political commitments have not succeeded in calming worried markets. Instead they have revealed the weakness of a common currency union without strong political coordination.

Looking ahead, the euro zone drama is likely to be dominated by political moves that sometimes please and sometimes upset the markets, but it will probably be some time before a credible and comprehensive plan is implemented. At present there are too many conflicting interests, leading to blockages in the crisis management process. As a result, firm and coordi-nated action by political leaders is conspicuously missing. The euro project is desperately searching for firm ground to stand on, and there will probably be many difficult challenges ahead. From an equities perspective, the euro zone thus does not ap-pear to be a region to invest in.

Equities


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China 2 2 2 3 0 1 10

russia 1 0 1 2 2 1 7

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brazil 1 2 1 0 -1 1 4

Japan 0 0 -1 -1 2 1 1

Us 1 1 -2 -1 0 1 0

india 2 0 0 -1 -1 0 0

euro zone -2 1 -2 -1 2 0 -2

OUr regiOnaL assessment mODeL

26

HY still tempting if risk appetite improves

•Different monetary policy tactics in OECD and EM spheres...

• ...and divergent outlooks for their government bond yields

•Risk appetite will continue to steer High Yield prices

The world’s central banks can be divided into two teams. The OECD team is characterised by record-low key interest rates, and in some cases massive quantitative easing (QE) pro-grammes. Since early 2010, the emerging market (EM) team has been engaging in gradual monetary tightening – such as hiking key interest rates curbing bank lending – but has more or less reached the end of its tightening cycle.

These widely divergent policy directions reflect widely diver-gent macroeconomic environments. In the OECD countries, recession risks and sovereign debt problems have dominated, while the EM sphere has been characterised by high economic activity, overheating risks and better government finances than the OECD countries. Looking in our crystal ball today, we foresee certain changes in monetary policy tactics: less in the OECD team than in the EM team.

We believe that central banks in major industrialised countries – the United States, Japan and the United Kingdom – will stick to their zero interest rate policies until at least early 2014. The European Central Bank (ECB) – which raised its key rate in two steps this year and then cut it again in early November – is li-kely to deliver at least one more rate cut this winter. The ECB’s use of its interest rate weapon will be determined both by the risk of recession and clearly lower inflation and by the conti-nued unfolding of the European sovereign debt drama.

The fragile economic performance of many OECD countries may also justify more quantitative easing, mainly in the form of government and (in some cases) mortgage bond purchases. For central banks, the purpose of QE is to try to achieve low bond yields and thereby also help sustain economic growth.

The US Federal Reserve (Fed) launched its first round of quantitative easing (QE1) immediately after the collapse of Lehman Brothers in September 2008. Round two (QE2) ran from autumn 2010 until this past summer. Right now the Fed is engaged in “Operation Twist”, which involves selling USD 400 billion worth of short-term government securities in its balance sheet while buying an equal amount of long-term government bonds (with 6-30 year maturities). We cannot rule out the possibility that once it has stopped “twisting” at the end of June 2012, the Fed will launch QE3 and then buy mort-gage bonds in order to help sustain the housing market. In October the Bank of England (BoE) decided to raise the ceiling on its bond purchases by GBP 75 billion to GBP 275 billion. About a month ago, the Bank of Japan (BoJ) increased its securities purchases by JPY 5 trillion, and the total amount of such purchases together with lending to the Japanese business sector now adds up to JPY 55 trillion. Both of these central banks can be expected to take further QE actions in

Fixed income


em interest rates CULminating

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Key interest rate hikes in the BRIC countries (Brazil, Russia, India and China) appear to be ending, and Brazil’s central bank has already lowered its rate twice this year. In both China and Russia, the next step is likely to be a rate cut, while there is greater un-certainty about how the Reserve Bank of India will use its interest rate weapon.

27

Fixed income

the coming year. In the case of the ECB, QE efforts – mainly purchases of sovereign bonds from troubled countries – will be affected by such factors as the future capacity of the European Financial Stability Facility (EFSF).

While central banks in the OECD countries are digging ever-deeper into their kits to find tools, the time will soon be ripe for a shift to traditional monetary policy easing (key interest rate cuts) in many EM countries. The reason is that previously overheated economies are now gradually cooling and that cost and price pressures will soon ease. Among the BRIC coun-tries, Brazil has already lowered its key interest rate twice this year. India hiked its key rate in October, but signalled that this may mark the end of its hiking cycle. Our basic prediction is that during 2012, many EM central banks will follow the exam-ple of Brazil and cut interest rates.

The outlook for government bond yields in the OECD coun-tries and the EM sphere is also divergent. OECD inflation will indeed be lower and a number of central banks are large buyers of government bonds, but on the other hand public sector funding needs are enormous. Together with the pros-pect of gradually rising risk appetite in markets this coming year – which usually decreases investors’ interest in govern-ment bonds – this ultimately points towards somewhat higher OECD government bond yields in 2012. In the EM countries, public sector deficits are far smaller, money market rates are actually falling, inflation is slowing and government bonds are tempting to investors if risk appetite increases. Conclusion: EM Debt is a far more attractive fixed income investment than OECD government bonds.

High yield (Hy) still appealingCorporate bonds – primarily High Yield – remain an attractive fixed income alternative, especially since their yields have climbed (prices have fallen) due to the big financial market drama in August-September. Although corporate bond yields have subsequently fallen somewhat, they are still highly ap-pealing. Key factors that will determine the performance of the corporate bond market are 1) yield gap (spread) against gov-ernment bonds, 2) the health of the bond-issuing company and 3) general risk appetite in financial markets.

Third quarter financial turmoil caused the yield gaps between corporate and government bonds to widen. For example in the US, spreads for HY bonds went from 5 percentage points to more than 9. Since then the gap has narrowed to about 7.5 points but still implies that the market is pricing in much worse corporate finances than those now prevailing.

Pricing in the High Yield segment also assumes that about 7-10 per cent of HY-issuing companies will go bankrupt. But such a bankruptcy level is consistent with a scenario in which the US and the world quickly slide into a new recession, which of course is not our assessment. During the economic and

financial crisis of 2008 and the first half of 2009, the bank-ruptcy rate reached about 13 per cent. If – contrary to our as-sumption – a recession occurs in 2012, it would nevertheless be far milder than the unusually deep one of 2-3 years ago. Meanwhile HY-issuing companies around the world are in far better financial shape now than during that recession.

The latest global bankruptcy statistic for High Yield-issuing companies is 1.8 per cent (12-month figure), and current forecasts from the rating agency Moody’s for the coming 12 months are 1.4-2.1 per cent (the average since 1983 is 4.9 per cent). Since the beginning of 2011, only 17 HY-issuing com-panies included in the global index (1,291 issuers) have gone bankrupt, equivalent to 1.3 per cent.

As for the health of companies in the High Yield sector, the positive picture presented in the issue of Investment Outlook published on September 13, 2011 is unchanged: a good earn-ings trend, substantially lower indebtedness, a considerably higher percentage of liquid assets in balance sheets and ex-tended maturities on company bond loan portfolios.

We thus conclude that general risk appetite will remain the primary factor affecting HY market performance. If the prevail-ing deceleration is a temporary mid-cycle slowdown, and if global growth gradually strengthens during late 2012 and in 2013 in keeping with our main scenario, investments in HY bonds and other risk assets will probably perform better than investments in OECD government bonds. And this would be consistent with the market pattern since March 2009.


HigH yieLD bOnDs OUtperFOrming eQUities

Standard & Poors, 500 Composite, Index, CBOT, Dow Jones CBOT Treasury Index Merrill Lynch, High Yield Master Index


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Last spring the financial market mood was decent. US equities and High Yield bonds thus beat government bond investments. But since then there have been major shifts, with dramatic price declines on risk assets in August-September followed by a strongly positive October rebound. Since then choppiness has predominated. Investment ranking so far in 2011: 1st Government bonds, 2nd High Yield and 3rd equities.

28

•Tough market for hedge funds generally...

• ...but fixed income mandates in an interesting position

•Macro/Trading still a good diversification

Since the last issue of Investment Outlook (published September 13, 2011), hedge fund performance has remained weak. Mainly due to the euro zone crisis, but also mixed macro statistics from the United States and fears of a hard landing in China, the HFRX Global Hedge Fund Index in EUR lost 6.45 per cent during the third quarter and has lost 7.82 per cent so far during 2011.

All major strategies are showing negative results since the beginning of the year, with Macro and CTA doing the best in relative terms, with a downturn of 3 per cent. The per-formance of the Equity Hedge strategy has been the worst, down 18.4 per cent in the past nine months. Although some important decisions on matters of principle have been made by euro zone political leaders with the aim of stabilising and eventually resolving the roots of the crisis, the next few months are likely to be characterised by uncertainty and turbulence.

Exactly as in the previous Investment Outlook, we are choosing to divide the hedge fund market into four main strategies:

• EquityLong/Short• RelativeValue• EventDrivenandDistressed• MacroandTrading

equity Long/shortMarket conditions for Equity Long/Short have remained exceptionally difficult. Correctly gauging the direction of the market would have required correctly predicting the moves of political leaders and the market’s reactions to them, which is an impossible task. Not even market-neutral strategies did especially well; the downturn was 6.1 per cent for the quarter.

Uncertainty and high volatility are likely to continue dominat-ing the market, although there are major fundamental qualita-tive differences between companies. Quality companies may become genuinely attractive from a valuation perspective, while companies dependent on economic growth may be more severely affected, which in itself creates opportunities for Long/Short managers. But since overall uncertainty will lead to less net exposure, not even skilful stock pickers are likely to achieve meaningful results. We continue to have a cautious attitude towards Equity L/S during the current and coming quarters.

relative valueRelative Value managers in fixed income investments got a rather good start in July, while August and September provid-ed a more mixed picture. Flight to safe government securities and huge fluctuations in risk appetite characterised the pe-riod. Managers with a negative outlook performed somewhat better, and managers who traded actively between long and short positions were able to generate positive results by deal-ing with flows, macroeconomic news and technical behaviours in a skilful way.

The actions of central banks during the quarter and in the future will create attractive investment opportunities for fixed income strategies. In the US, Operation Twist began in September for the purpose of keeping long-term yields down. This may drive investors towards the short end of the yield curve, which could make bank loans and High Yield bonds especially attractive. Some valuations were extreme during the quarter; for example, CDS spreads priced in a bankruptcy level of 20 per cent for senior bank bonds in September. Looking ahead, there will probably be major upturn potential for bonds when there is favourable news about the euro crisis. We are positive towards Relative Value during the next quarter.

event Driven and DistressedFor Event Driven strategies, the third quarter was one of the worst to date. The HFRX Distressed lost 8.4 per cent and HFRX Event Driven lost 6.8 per cent, while Merger Arbitrage “only” fell 4.2 per cent. Overall, it was the worst quarter since the 1998 Asian financial crisis.

“Operation Twist” benefiting Relative Value

Hedge funds


29

Although the number of corporate events continued to de-crease, as we predicted in the last Investment Outlook, it was write-downs to current market prices that caused most of the losses. Distressed showed decent resilience to the stock market during July, but could not withstand the continued pressure during August and September. As managers lowered the risks in their portfolios, popular holdings in particular were subjected to disproportionately large downturns.

Companies continue to have high cash reserves and generally strong balance sheets. During an economic downturn, various companies will probably seek higher revenues through cor-porate deals. This is likely to lead to a reasonable investment climate for Event Driven strategies in the future, but today’s turbulence in the euro zone will probably hamper activity in the near future. Event Driven and Distressed are not strategies we recommend at present.

macro and tradingOn the whole, Macro and CTA were the best-performing strategies during the third quarter, with a downturn of 0.9 per cent. As during prior quarters, there were major differences between managers and their specific working areas. More structurally negative managers succeeded the best in the task of earning money during the quarter, especially those who had the euro zone as their theme during the risk aversion in August.

On the whole, CTA and Systematic Macro showed positive results during the quarter, but here too the differences were noticeable. Asset allocation was crucial, with fixed income holdings accounting for the largest contribution when risk as-sets were sold off in the markets.

At present, the risk/opportunity ratio looks somewhat different from the beginning of the quarter. Structurally negative man-agers will presumably tone down their conviction that markets will move in their direction, while more optimistic ones will see an increased probability of being right. Great uncertainty and significantly different market perceptions should create good potential for generating returns.

CTA and Systematic Macro are viewed by most observers as a tool for portfolio diversification that is expected to perform well when other asset classes are having difficulty. Holdings in fixed income securities are the single largest position of most managers, which in itself signifies a risk of substantial losses if the market situation improves in the long term, but since man-agers are now positioned a little more cautiously they can be a little faster in their reactions. Macro and Trading remain our first choices among hedge fund strategies in the near future.


Hedge funds

STRATEGY INDEX PERFORMANCE %

Oct-Nov Q3 2011 YTD

(Nov 10)

2010

global Hedge HFrX global Hedge Fund 0.67 -6.45 -7.82 5.19

equity Hedge HFrX equity Hedge 0.92 -10.97 -17.63 8.92

relative value HFrX relative value arbitrage 0.61 -5.42 -3.51 7.65

event Driven HFrX event Driven 1.57 -6.78 -3.94 1.98

macro HFrX macro -0.76 -0.85 -3.72 -1.73


•Stable activity in a cautious environment

•Flight to quality remains a theme

•Continued uncertainty, not a good time for illiquid investments

The global real estate market has held up well during the autumn’s financial market drama, although a turbulent ride through the third quarter of 2011 – to say the least – caused real estate investors to become somewhat more cautious.

In the last issue of Investment Outlook (published September 13, 2011), we pointed to a number of trends that were signal-ling this increased market caution. During the late summer, we saw both a clear trend towards flight to “safe harbours” – as demand for quality properties rose while riskier secondary markets lost favour – and the friction in the real estate market that was emerging as a result of great world economic uncer-tainty and a significantly more volatile foreign exchange mar-ket. Real estate deals simply took more time to close. Based on these trends, there was every reason to be somewhat more cautious towards this asset class during the second quarter.

However, the third quarter turned out somewhat better than feared, and data now show that the trend was relatively stable not only on both sides of the Atlantic but also in the East. real estate deals continue in europe despite crisisThe volume of direct investment transactions in the global real estate market rose by 36 per cent during the third quarter compared to the same period of last year. Jones Lang Lasalle’s latest real estate market report showed that on a quarter-to-quarter basis, activity fell in the United States after very strong growth in the second quarter. Meanwhile transaction volume rose in both Europe and Asia. Year-on-year, activity rose in all regions.

Europe showed sustained activity despite escalating sovereign debt problems, partly due to delayed transactions from the second quarter, but it was encouraging to learn that growth was still positive compared to both the last quarter and a year earlier. In Asia, market developments were mixed; in the wake of its natural disaster earlier this year, Japan accounted for a large proportion of positive growth. China also showed a continued expansion in activity, despite the tightening meas-ures undertaken during the year. In Australia there was lower activity, however, and Singapore witnessed a sharp decline in transaction volume during the third quarter.

Real estate market holding up well

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reaL estate investments inCreaseD in eUrOpe

Europe recorded greater activity in the real estate market during the third quarter of 2011. Activity remained high despite escalating sovereign debt problems, partly because a number of delayed transactions from the second quarter closed in the third. One positive surprise was that volume never-theless rose both quarter-on-quarter and year-on-year. EMEA = Europe, Middle East and Africa.

Source: Jones Lang Lasalle

31

stable rental market in most places

The rental market has also been resilient during the autumn. Both activity and rent levels have generally been stable. We find the strongest market performance in Asia, where demand for office buildings in particular continued to grow, which also pushed up rent levels in many places. However, there were tendencies towards a slowdown in demand in the financial districts of Hong Kong and Singapore, where rents fell some-what. In Europe, both leasing activity and rents moved side-ways. The demand for leases in major German cities remained strong. In the UK, London recovered after a weak first half. The worst activity was noted in the US, where demand for leases continued to fall during the third quarter. Rents, however, held up well despite falling demand. Some places, such as San Francisco and New York, also reported higher rent levels.

Continued cautious attitude towards riskAlthough the global real estate market as a whole held up well during the autumn, it has obviously been adversely affected by recent market turbulence. The risk aversion that market play-ers showed during the late summer is still in place. Investors are seeking less risky quality properties and are still not en-tirely satisfied with the risk premium in the rest of the market, although there are local exceptions. Instead, the focus is on what risk an investor is willing to take, rather than on what returns it is possible to achieve.

As for the trend towards transactions taking a longer time to complete, we can report that it is continuing. Continued vola-tility in the foreign exchange market and worsening opportuni-ties for loan financing – which may also very well deteriorate further in the current climate – are reasons why real estate investments continue to take longer to complete, at least ma-jor deals.

But we would like to point out that real estate transactions, despite the delays, are still being concluded. An optimist can find a further bright spot: the nearly panic-stricken flight to quality that we saw earlier in the autumn has eased off. This is reflected in the fact that yield requirements for quality proper-ties are no longer shrinking as much. Meanwhile we are seeing some decline in the risk premium in somewhat riskier markets, including the US. This is a signal that some investors have be-gun to move upward on the risk scale in the real estate market, but it is still too early to determine whether this will be a short-term trend or the beginning of a turnaround.

not the time for an illiquid investmentEconomic fundamentals have clearly weakened during the autumn, but there are still various arguments in favour of real estate as an asset class. Countries and regions with a pronounced supply shortage that meanwhile have decent economic growth, such as Asia but also parts of the US and Europe, should be able to show a continued favourable trend in rent levels. As long as yield requirements in the market remain stable at current levels, valuations of existing proper-ties should rise along with rental income. But as we have mentioned previously, there are still a lot of question marks about the performance and health of the broader economy. In particular, answers to questions related to the political agenda will have an impact on the economy. The direct property market is significantly more illiquid than the market for equities, fixed income investments and com-modities. Fund managers specialising in the real estate market thus often ask investors to commit their capital for a long peri-od. For this reason, and because we are still in a very uncertain financial market situation, it is difficult to justify this type of investment. At present, we are thus choosing to remain on the sidelines until the picture has become clearer.

Real estate


32

• Financial turmoil and economic uncertainty keeping PE company market prices depressed

•Continued decent earnings growth in portfolio companies, stronger finances = stable NAV

• Large discounts to NAV indicate that the market is pricing in continued problems, good support for share prices from fundamentals

As we know, since the last Investment Outlook (published September 13, 2011), financial turbulence has continued. European debt and confidence problems have become in-creasingly apparent. Meanwhile the global economic trend has actually delivered upside surprises. Although Europe is in – or is moving towards – a recession, signals of relatively stable growth are coming from the United States, and the Chinese economy seems to be decelerating in an orderly fashion. After dramatic price declines for risk assets during August, their prices have moved sideways or in some cases slightly upward.

Private equity (PE) has performed relatively well in recent months. Since the last Investment Outlook, the SEB Listed Private Equity Fund has risen by 3.5 per cent, with large fluc-tuations along the way. However, private equity has fallen by more than 22 per cent this year, making it one of the asset classes with the largest declines. The question is whether this downturn is justified, insufficient or exaggerated. In our assessment it is exaggerated, provided that the world (read Europe) is not on its way towards a major financial meltdown and/or a period of marked recession.

Large discounts to navThis year’s price declines for private equity do not correspond to downturns in the net asset value (NAV) of PE companies. On the contrary, NAV rose during the first half. The third quar-ter reports of recent weeks are also signalling stable NAV for these companies. Falling share prices and stable NAV means increasing discounts to NAV. Preliminary estimates indicate that the average discount to NAV is now around 40 per cent. With the exception of a few months right after the Lehman Brothers crash, these are the highest discount levels we have seen – even including the stock market crash of the early 2000s.

It is not so remarkable that the discounts are increasing in this phase. The market is expecting PE companies to write down the value of their portfolio companies in the wake of recent general downward revisions of growth and earnings forecasts. Based on these lower growth assumptions, PE companies boost the return requirements in their valuation models, which also lowers NAV. The market discounts this, with falling share prices as a consequence.

However, there are reasons to believe that the price decline (which has led to the rising discounts) may be exaggerated. NAV remained satisfactory during the past quarter partly because the underlying businesses generally performed well. Reports from American companies in particular show continued good activity in their operations and largely stable earnings expectations. Reported NAV for European companies is also largely stable, but we are seeing some slowdown in earnings growth.

private equity


Risk aversion creates overreaction

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Equities: MSCI World IndexPrivate equity: LPX 50 IndexS&P Global 1200 Financials

It seems reasonable that the shares of listed PE companies have performed worse than the stock market average, given their higher leveraging and larger dependence on financial stability. But price declines as large as the hard-pressed financial sector seem like an overreaction.


33

In some cases, NAV has remained satisfactory because earlier reported NAV was set too conservatively. Many PE companies have reported their portfolio companies at cost, even though in many cases rising profits justified revising their valuations upward. Together with generous premiums for low liquidity (some companies have reported large portions of their hold-ings at 75 per cent of estimated NAV), this has provided a large valuation cushion. Also illustrating this is the fact that many of the portfolio company divestments that occurred late in 2010 and early in 2011 occurred at premiums of up to 30 per cent on reported NAV. This may at least partly offset the effects of falling company values.

Harder times are built into share pricesThe market has thus discounted harder times and falling NAV. We estimate that the market has priced in profit downturns in the range of 25 per cent. There is a clear correlation between falling share prices and falling NAV. They move in the same di-rection, but their mutual relationship and the size of the move-ment have varied dramatically. The great uncertainty that prevails about future economic growth (which of course also affects the value of companies, profit multipliers and so on) makes it difficult, if not impossible, to draw exact conclusions. But in our assessment, the share price declines are somewhat exaggerated. Also making assessments difficult is that PE companies are dependent on both functioning financial markets (stock mar-kets in order to sell portfolio companies) and funding markets (banks for borrowing and bond markets for other funding). When these markets are weak, the stock market tends to lower PE company valuations. This may partly explain the large share price declines.

As for the funding situation, it is important to note that PE companies have been working actively with their debts since the last financial crash. They have lowered their total borrow-ing and largely extended the maturities of their outstanding

debt. Put simply, the “wall of debt” problem that companies faced a year or so ago – due to gigantic debts that were falling due – has essentially been resolved, although stock market turbulence has limited their ability to sell portfolio companies (exit). If the exit market ceases to function and divestments are postponed, the market also tends to adjust its valuations of PE companies accordingly. This is not unreasonable in itself, but there is a risk of exaggeration. The present value of the proceeds from a divestment indeed becomes smaller the longer it is postponed, but since growth is decent this may at least partially be offset by rising value generated by company profits. Another factor to take into account is whether the market may have exaggerated the risk in PE companies. The quality of their portfolio companies is generally higher than many observers seem to believe. Despite high leveraging in many cases, the previous very deep recession and the related financial crash claimed few victims – only about 1.5 per cent of portfolio com-panies went bankrupt at that time. The major challenges that the global economy and financial system are facing naturally have an adverse impact on the PE sector. Because of financial market turbulence, short-term forecasts of valuation trends are out of date before they have a chance to reach their recipi-ents. This also makes long-term forecasts unusually uncertain. It is clear, however, that much of the risks have already been priced in.

Since PE companies are significantly better equipped today, with more stable finances and conservative valuations, the risk-return ratio appears attractive. In all scenarios except the most pessimistic of all, the danger of further declines appears more limited than in other high-risk investments, while the po-tential for recovery should be rather good. There is, however, a potential for weaker performance in the short term, given the turbulence and risk of more long-term effects from the dam-age that is affecting the European financial system.


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Discounts to NAV have widened as prices of listed PE companies have fallen. Preliminary estimates show discounts of around 40-45 per cent, on a par with earlier records (except for a few quarters after the Lehman Brothers crash). The discounts on secondaries are significantly smaller; the most value can be found among listed companies.

Source: Thompson Financial, JPMorgan, SEB


•World economy will provide support for prices

•Limited downside for metal prices

•Falling agri-commodity prices as worries about production disruptions recede

During much of last summer, commodity prices held up relatively well in spite of great uncertainty and worries about economic growth. In late summer and early autumn, however, a number of commodities led by base metals suffered falling prices. Oil prices nevertheless remained at levels above USD 100 per barrel (Brent).

energyDespite recently escalating concerns about developments in southern Europe and their impact on global economic growth, oil prices have remained at levels of around USD 110/barrel. A tight supply/demand situation for both diesel and heating oil is keeping prices up. This situation will probably not ease, now that the Americans are entering their heating season – with increased demand for energy. In addition, China has been hit by drought, leading to a shortage of hydroelectric power that is being offset by running diesel generator sets. Low European oil stocks, currently at levels close to nine-year lows, are pro-viding further support for oil prices.

Developments in the Middle East and North Africa (MENA) this past year signify that the region now has many years of change ahead. This will probably not be an entirely painless process; instead, from time to time events will occur that in-crease the risk premium for oil.

Speculation about whether Iran is developing nuclear weap-ons has created market concerns. If this is true, it risks leading to deteriorating relations between Iran and the Western world, which in turn may create difficulties in exporting oil from that country, with rising prices as a consequence.

On the other hand, total US oil demand has shown signs of weakness this autumn – likewise Asian demand for plastics. Another restraining factor for oil prices is concern about growth in the OECD countries, but its effect on the price trend should not be crucial. We are also assuming that even if the OECD countries end up in a recession, or if worries about a hard landing in China should increase, Brent crude is unlikely to be traded below USD 90/barrel except during brief periods. One strong reason for this is that Saudi Arabia, which has the world’s largest oil reserves, now needs an oil price of USD 90 in order to balance its budget and thus has stronger incentives to defend high oil prices today than in 2008, for example. We expect somewhat higher average oil prices during 2012 than in 2011.

China an important factor for commodity prices

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Oil stocks in Europe are currently lower than at any time in the past five years for the corresponding period, which is providing support for oil prices.

Source: IEA


industrial metalsThis autumn, players in the market for industrial metals have primarily been concerned about weaker demand due to lower economic growth, rather than restricted supply. Developments in China are a crucial factor in the trend of industrial metal prices, since China accounts for about 40 per cent of global consumption of these metals. A hard landing in the Chinese economy would thus have a major impact. We expect China to avoid this and to loosen its monetary policy in the near future, which will provide support for metal prices.

After price declines in late summer and early autumn, prices of some metals are now below their marginal cost. Obviously production costs higher than the price of a metal is a situation that is not sustainable long term and that will support price increases ahead. Copper is one exception, with the metal be-ing traded with a margin above production cost; it is also the metal that is most sensitive to developments in China.

Justifying lower metal prices than today requires a higher risk of a Chinese hard landing. Weaker economic growth in the OECD countries will probably have only a marginal negative effect on prices. This is because demand never recovered after the 2008 crisis and there is thus limited room for further de-cline. We expect somewhat higher metal prices in the coming year, driven mainly by demand from China and the fact that a number of metals are currently not profitable to produce.

agri-commoditiesIt is no easy task to predict whether agricultural commodity prices will rise or fall. Forecasting the future supply/demand situation and thus world price trends requires – aside from some idea of global growth and current stock levels – an as-sessment of how weather conditions and thus future harvests will turn out.

We believe that prices of agricultural commodities will remain high in the medium term, since there is fundamentally good demand for most types of grains. The La Niña weather phe-nomenon is not expected to be as powerful as it was in 2010, but it will still create some uncertainty, especially since com-modity stocks are low. If it takes a long time before rain falls, this may lead to further drought in already hard-hit areas of the US. Another scenario linked to La Niña is too much rain. If this should occur, there is a risk of damage to harvests in Australia, for example.

As long as the risk of production disruptions haunts the market, agricultural commodity prices are likely to remain at high levels. When uncertainty decreases, prices should fall again. We are thus anticipating relatively unchanged prices in the short term, but falling prices in a longer perspective.

For cotton in particular, we view price increases as probable. The main arguments for this are globally low stock levels and the fact that after last spring’s decline the price of cotton is now low, at least compared to other agricultural commodities. Since there is competition for arable land, more producers will choose to cultivate other products, thereby decreasing the supply of cotton.

precious metalsGold is continuing to perform well in the prevailing environ-ment of extremely low interest rates and great uncertainty about economic growth. Volatile stock markets and low risk appetite have historically favoured gold, which is viewed as a safe harbour. After a sharp upturn during the second half of the summer, this trend was temporarily interrupted and gold prices fell by about 15 per cent in September. Now gold has resumed its rising trend, which has been under way since late 2008. High and possibly increased market liquidity, negative real interest rates and systemic risks will be underlying forces that drive gold prices in the future. Government are currently net buyers of gold, thus providing further support. We expect somewhat higher gold prices during 2012.

China will set the agendaGlobal economic growth is the main driver of demand for commodities. Since emerging markets – mainly China – are expected to be the engine that propels the world economy at a healthy pace, EM countries are the places to look in order to estimate the trend of commodity prices. The greatest concern, which has largely dominated commodity markets recently, is whether developments in Europe will affect China and thus increase the risk that its economy will undergo a hard landing. Our assessment is that China will experience a soft landing, and we also believe that the US economy will continue recov-ering at a healthy pace.

In addition, we foresee low interest rates, high liquidity and healthy global economic growth, which will provide support for commodity prices. On the other hand, developments in the OECD countries – mainly in the euro zone – will restrain price increases. Our assessment that China will not experience a hard landing and the OECD countries as a whole will not enter a recession should lead to commodity prices remaining rela-tively unchanged one year from now, but count on a volatile journey.

Commodities


•Liquidity important in the short term, fundamentals in the long term

•EM currencies will benefit from greater risk appetite

• In the long term, the yen is overvalued

The extreme market movements of recent months reflect an investor community that is largely fumbling in the dark. The strength of the global recovery seems uncertain, and market players are in the hands of political leaders who are practicing an advanced balancing act. On the one hand, elected officials want to show determination and initiative. On the other hand, it is difficult to push through the necessary reforms and still retain the goodwill of voters. The uncertain political and eco-nomic situation has created a market that behaves digitally: by either flooring the accelerator or slamming on the brake with both feet. These sudden contrasts lead to major price fluctua-tions for all asset classes, and currencies are no exception.

During periods when investors flee from risk, the liquidity of a currency is by far its most important feature. Large curren-

cies such as the US dollar, Japanese yen and Swiss franc gain ground at such times. Meanwhile smaller peripheral curren-cies – such as the Swedish krona, Norwegian krone and many emerging market (EM) currencies – lose value.

When risk appetite increases, the market shifts its attention to more fundamental factors, like GDP growth, government debt and current account balance. There is a clear dividing line here between OECD and EM countries. As a rule, the EM sphere is showing high growth, low debt and current account surpluses, whereas the opposite is often true of various OECD countries.

When risk appetite is high, interest rate spreads play a sig-nificant role. When investors take advantage of interest rate spreads, they borrow where interest rates are low and invest where they are high (the carry trade). There is thus downward pressure on the currencies of countries with low interest rates, while currencies of high interest rate countries appreciate.

A final, detailed solution to the European debt crisis is far from being in place. Some important steps in the right direction have been taken, but there are still many question marks. The process is not likely to be painless, but will probably occur ac-cording to the “two steps forward, one step back” principle. Fluctuating risk appetite is thus likely to continue dominating markets, which will occasionally favour larger currencies with “safe harbour” status. Cyclical currencies like Scandinavian and commodity-based ones will face a tough environment during the next six months or so, with fluctuating risk appetite and weak growth. Generally, however, these countries are characterised by fundamentally strong economies and good public finances. Once the acute situation in southern Europe calms down, cyclical currencies are likely to become more att-ractive as the market focuses more on fundamentals.

eUr will lose battle against UsD in the short termThe most heavily traded currency pair is the euro against the US dollar, and the choice between the world’s two largest cur-rencies is likely to continue being a matter of identifying the less bad alternative. It seems natural that the euro should be traded with a risk premium, given that the euro project is be-ing shaken to its foundations and its future is uncertain.

Risk appetite takes charge

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37

In addition, the European Central Bank (ECB) recently lowered its refi rate unexpectedly to 1.25 per cent, narrowing the inter-est rate spread compared to the dollar. There are also many in-dications that the ECB will carry out another rate cut to 1.0 per cent at its next monetary policy meeting in December. On the other hand, the dollar is weighed down by a sizeable current account deficit. It is also an election year in 2012 and the out-come is uncertain, to say the least. President Barack Obama’s popularity has fallen and it seems to be extremely difficult to create a broad consensus on US fiscal policy. Despite an even match, in the near future the USD will seem to be the less bad alternative. We expect the EUR/USD exchange rate to move towards 1.25 (today about 1.35).

slower appreciation rate for the yuanFor more than a year, Chinese authorities have allowed a grad-ual strengthening of the yuan (CNY) against the US dollar, and there are many indications that this appreciation will continue. In China, inflation remains undesirably high, but a stronger yuan will make imported good cheaper and help ease price pressure in the country. A stronger CNY may also be an impor-tant tool for shifting the country’s growth dynamic from ex-ports to domestic consumption (one goal of the latest 5-year plan). A stronger currency will undermine the competitiveness of China’s exports, while boosting the purchasing power of domestic consumers. The appreciation of the yuan would also make life easier for beleaguered competitors in the US and Europe. In light of China’s sizeable investments in the US – but also European – government securities, it is also in China’s in-terest to ensure that these economies do not collapse.

Recent events indicate, however, that Chinese authorities are easing up on the pace of yuan appreciation. In October, Chinese exports grew by “only” 16 per cent, while imports grew by 29 per cent. Lower export growth reflects the slow-down in global demand, and if customers outside China

continue to buy less and less, the authorities are likely to be cautious about letting the yuan rise too fast. In addition, infla-tion pressure in China has eased somewhat in the past month and the dollar has strengthened on a broad front. Due to the yuan’s connection to the USD, this has also caused the value of the CNY to increase. We expect the Chinese currency to continue appreciating, with a USD/CNY exchange rate of 6.10 in December 2012. The USD/CNY rate is around 6.35 today.

the yen will be too expensive in the long term Since 2007 the yen has appreciated by 58 per cent in trade-weighted terms. It has gone from being an undervalued cur-rency to one that can be regarded today as clearly overvalued. The strong yen is creating headaches for the Japanese govern-ment, since an excessive strong currency is not desirable from a trade standpoint. To make things easier for the export sector, the Japanese authorities have intervened a few times in the foreign exchange market, selling large quantities of JPY for the purpose of keeping the value of the currency down.

In a wobbly market, demand for the yen is likely to remain high, since it is generally regarded as a safe harbour. Looking further ahead, however, investors are likely to question wheth-er the yen appreciation of recent years has been justified, considering Japan’s large debt burden as well as a key inter-est rate that will probably be parked close to zero during the foreseeable future. Historically, the value of the yen has been closely connected to the interest rate spread between Japan and other countries. It is likely to be some time before other countries again adjust their key interest rates upward, but when this happens the attractiveness of the yen will diminish. Japan has been pursuing a zero interest rate policy for more than 15 years, and there is no indication of a new monetary policy direction. In the long term, the attractiveness of yen is thus likely to fade, but its defensive characteristics will prob-ably keep it in demand for another year or so.


Currencies

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Chinese authorities are likely to continue letting the yuan appre-ciate in value against the USD, but due to lower global growth, decreased inflation and a stronger dollar, the pace may slow.

yen in DemanD, bUt FOr HOW mUCH LOnger?

Japan, Nominal Effective Exchange Rate Index, JPYSource: Reuters EcoWin

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Since 2007 the value of the yen has steadily increased, but a key interest rate parked close to zero and a large debt burden in Japan are likely to be negative factors in the yen's future.

1

www.sebgroup.com/privatebanking

SEB is a North European financial group serving 400,000 corporate customers and institutions and more than five million private individuals. One area with strong traditions in the SEB Group is private banking. From its founding in 1856, SEB offered financial services to wealthy private individuals. Today the Group has a leading position in Sweden and a strong presence in the other Nordic coun-tries and elsewhere in Europe.

SEB Private Banking has a broad client base that includes corporate executives, business owners and private individuals of varying means, each with different levels of interest in economic issues. To SEB, private banking is all about offering a broad range of high-quality services in the financial field − tai-lored to the unique personal needs of each client and backed by the Group’s collective knowledge.

SEB Private Banking has some 350 employees working in Sweden, Denmark, Finland and Norway.Outside of the Nordic countries, we take care of our clients via offices in Estonia, Latvia, Lithuania, Switzerland, Luxembourg and Singapore as well as a branch in London. On September 30, 2011, our managed assets totalled SEK 240 billion.

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