Investment The debt burden –

Outlook
can the world handle the
May 2010 pressure?
private banking - investment strategy
 Investment Strategy

Contents
Introduction_____________________________________________________________5
Summary_ ______________________________________________________________6
Portfolio strategy ________________________________________________________8
Theme: The debt burden – can the world handle the pressure?________________ 11
Theme: Redrawing the investment map____________________________________ 14
Theme: Market pause – more rule than exception_ __________________________ 17
Macro summary _______________________________________________________ 20

ASSET CLASSES
Equities_______________________________________________________________ 22
Fixed income__________________________________________________________ 24
Hedge funds __________________________________________________________ 26
Real estate____________________________________________________________ 28
Private equity__________________________________________________________ 30
Commodities__________________________________________________________ 32
Currencies_ ___________________________________________________________ 34

Investment Outlook - may 2010 3

 Investment Strategy

This report was published on May 18, 2010.

Its contents are based on information and analysis available before May 10, 2010.

Hans Peterson Johan Hagbarth

Global Head of Investment Strategy Investment Strategist
+ 46 8 763 69 21 + 46 8 763 69 58
hans.peterson@seb.se johan.hagbarth@seb.se

Lars Gunnar Aspman Carl Barnekow

Global Head of Macro Strategy Global Head of Advisory Team
+ 46 8 763 69 75 + 46 8 763 69 38
lars.aspman@seb.se carl.barnekow@seb.se

Rickard Lundquist Reine Kase

Portfolio Strategist Economist
+ 46 8 763 69 27 +46 8 763 6973
rickard.lundquist@seb.se reine.kase@seb.se

Victor de Oliveira Liza Braaw

Portfolio Manager and Head of IS Luxembourg Communicator and Editor
+ 352 26 23 62 37 +46 8 763 6909
victor.deoliveira@sebprivatebanking.com liza.braaw@seb.se

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4 Investment Outlook - MAy 2010

Introduction

New times – new approach to risk

The debt problems of industrialised countries stable source of revenue for covering interest and principal
will affect the risk perceptions of markets for payments than the sales of a global corporation in a mature
industry. The answer may well be that some corporate bonds
a long time. The concepts of high and low risk are perhaps more attractive than some government bonds
will gain new meanings. Knowledge, a compre- from a risk standpoint. Thus it is more important than ever to
hensive view and understanding are essential, diversify properly and to have the right analytical approach.
now that traditional truths about risk must be
What is low risk? The answer to that question actually has
questioned. to do with us as investors. It is about having knowledge and
control, as well as a comprehensive view of the factors we can
understand that affect our investments. For example, today it
The fiscal crisis in Greece has focused attention on gigantic
is more important to eliminate leveraging in various portfolio
budget deficits and massive government debt mountains,
assets than to apply traditional diversification between geo-
mainly in Europe. This will affect the way markets view risk for
graphic areas. Analysis of underlying driving forces is more
many years to come.
important than it has been for a long time. Paradoxically, to-
day an investment in a well-analysed, correctly priced private
For a long time, the norm for a low-risk investment has been
equity fund may be less risky than a global equities fund with
an equity portfolio composed of shares mainly from North
the wrong currency exposure.
America, Europe and Japan. Nowadays, in practice such a
portfolio primarily encompasses a group of highly indebted Focusing on risk and indebtedness
countries that will be forced to deal somehow with their debt
For good reasons, we are devoting a lot of space in this issue
problems. Regardless of what debt resolution strategy they
of Investment Outlook to questions about risk and indebted-
choose, it will affect economic growth. Together with low
ness. Today these are pivotal issues in asset management.
inflation and low interest rates, this implies downside risks for
Debt problems in industrialised countries will affect numerous
the currencies of many industrialised countries − adding to
assets that traditionally occupy a lot of space in securities
the risk picture. What used to be a low-risk investment is thus
portfolios. The risk issue is vital because we believe that the
actually associated with rather high risk. A paradigm shift has
role of risks and the way they are handled by portfolio manag-
occurred.
ers must be reassessed. The traditional allocation method −
Changing conditions employing correlations between assets that are based on long
time series − do not provide the whole answer today. Instead a
In today’s new financial and economic world – characterised
more in-depth understanding is needed to enable us to build
by debt problems and slow economic growth in the indus-
good portfolios. The driving forces behind market price trends
trialised OECD countries, coupled with substantially better fi-
must be exposed. Traditional truths must be questioned.
nancial stamina and high growth in the emerging market (EM)
These are undoubtedly exciting new times − times that require
sphere – the conditions determining what is high risk and
a new approach to risk.
what is low risk are changing. Meanwhile emerging markets
naturally do not offer everything that an investor is looking for.
Hans Peterson
CIO Private Banking and Global Head of
Our ambition is to build well-diversified portfolios that have
Investment Strategy
good characteristics and can provide stable returns in all
financial climates. One relevant question that an investor
should ask is whether the tax base of a country is a more

Investment Outlook - MAy 2010 5

 Summary

Expected 1-year
return risk Reasoning

POSITIVE. There is a short-term risk of corrections due to fiscal worries and as macroeconomic indicators
stop providing upside surprises. But further along, low inflation and moderate growth may drive OECD
markets. Eastern Europe and Asia will continue to benefit from higher economic growth. The euro zone is
Equities 9% 17% least attractive, with the worst growth potential.
POSITIVE for High Yield, Negative for government securities. Company profits will strengthen and bankruptcy
risk will decrease – corporate bonds remain attractive. High Yield bonds with large spreads over government
securities are the most appealing. Government bonds in emerging markets, with their high yields, are also attrac-
tive. Swedish government securities will continue to provide minimal returns and continue to risk interest rate
Fixed income 6%* 6% hikes.

PositivE. The prevailing tensions between and within asset classes provide continued good potential for
hedge funds. We will continue to focus on quality managers in the Macro, CTA, Relative Value and Fixed
Hedge funds 8% 6% Income strategies, while Event Driven is becoming increasingly attractive.
WAIT-AND-SEE/POSITIVE. Capital is seeking out quality properties. Better general economic conditions
and lower unemployment will benefit this asset class. Monetary tightening and possible bubbles in China
Real estate 5% 3% constitute risks.
pOSITIVE. The number of private equity (PE) transactions will continue to increase in an environment of
Private low valuations. The secondary market is attractive when financially pressed investors are forced to sell at
equity 15% 22% discounts. Listed PE still has room for sizeable upturns.
WAIT-AND-SEE. Lower growth ahead in the OECD countries will reduce demand for industrial metals, while
low real interest rates will keep demand for gold up. Agri-commodities will be squeezed in the short term,
Commodities 5% 18% but higher ethanol production may boost the price of maize (corn) and other crops further ahead.
WAIT-AND-SEE/POSITIVE. Interest rate differentials will continue to drive currencies. Export countries such
as Sweden and emerging market countries will see their currencies appreciate, while the euro will be pushed
Currencies 5% 3% down by large government debts. China will begin allowing its currency to appreciate during 2010.
* Expected return on corporate bonds that are weighted about 1/3 Investment Grade and 2/3 High Yield.

EXPECTED RISK AND RETURN (1 YEAR HORIZON) CHANGE IN OUR EXPECTED RETURNS
16%
16%
Private equity
14% 14%
12%
12% 10%
8%
10% 6%
Hedge funds
Equities 4%
Expected return

8%
2%
Fixed income* 0%
6%
-2%
Commodities
4% -4%
Currencies
2008-11

2009-02

2009-05

2009-08

2009-12

2010-02

2010-05
Real estate
2%

0%
Equities Fixed income* Hedge funds Real estate
-2%
Private equity Currencies Commodities
0% 5% 10% 15% 20% 25% 30%
Expected volatility

HISTORICAL RISK AND RETURN HISTORICAL CORRELATION

(MAY 31, 2000 TO APRIL 30, 2010) (MAY 31, 2000 TO APRIL 30, 2010)
8%
Private equity

Commodities
Fixed income

Hedge funds

Real estate
Real estate

Currencies

6%
Equities

4%
Fixed Income Hedge funds
2%
Historical return

0%
Currencies Commodities Equities 1.00
-2%
Equities
-4% Fixed income -0.04 1.00
-6% Hedge funds 0.37 0.27 1.00
Private equity
-8%
Real estate 0.76 -0.13 0.28 1.00
-10%
0% 5% 10% 15% 20% 25% 30% Private
Historical volatility 0.85 -0.17 0.26 0.86 1.00
equity

Commodities 0.28 -0.11 0.29 0.23 0.31 1.00

Historical values are based on the following indices: Equities = MSCI AC World. Fixed
income = JP Morgan Global GBI Hedge. Hedge funds = HFRX Global Hedge Fund. Real
estate = FTSE EPRA/NAREIT Developed. Private equity = LPX50. Commodities = S&P GSCI
Currencies 0.18 0.67 0.57 -0.01 -0.03 -0.02 1.00
TR. Currencies = BarclayHedge Currency Trader.

6 Investment Outlook - May 2010

 Summary

WEIGHTS IN MODERN PROTECTION WEIGHTS IN MODERN AGGRESSIVE

0% 35%
Equities Equities

81.5% 26%
Fixed income Fixed income

10.5% 23%
Hedge funds Hedge funds

2% 0%
Real estate Real estate

0% 11%
Private equity Private equity

0% 4.5%
Commodities Commodities

Currencies 5% Currencies
0%

Cash 1% Cash
0.5%

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

Previous Current Previous Current

WEIGHTS IN MODERN GROWTH ROLLING 36-MONTH CORRELATIONS VS. MSCI WORLD

(EUR)
Equities 25% 1

28.5% 0.8
Fixed income

30% 0.6
Hedge funds
0.4
3%
Real estate
0.2
Private equity 3%
0
Commodities 4.5%
-0.2
4.5%
Currencies -0.4
1.5% -0.6
Cash
2002 2003 2004 2005 2006 2007 2008 2009
0% 10% 20% 30% 40%
Fixed income Hedge funds Real estate
Previous Current Private equity Commodities Currencies

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

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

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

THEME: THE DEBT BURDEN − CAN THE WORLD HANDLE THEME: REDRAWING THE INVESTMENT MAP
the pressure?
15
Public surplus/deficit

10 Norway

5
(% of GDP)

Sweden
0 Germany
Finland
0 50
Denmark 100
Canada 150 200 US (50%)
-5 Australia Netherlands Italy Japan (10%)
France
-10 Spain Japan UK (10%)
US
Ireland UK Greece Other (30%)
-15
Public debt (% of GDP)

For countries with large government debts and public sector defi- The MSCI World index is often used as a benchmark for global
cits − such as the US, Greece, Italy and Japan − tough years of debt equity funds, but 70 per cent of its exposure is to three countries
resolution lie ahead. and the EM sphere is missing.

Investment Outlook - MAY 2010 7

 Portfolio strategy

Portfolios for shifting financial winds

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

MODERN PROTECTION
Despite occasionally volatile markets, this portfolio performed On the whole, our existing mix of investments is satisfactory.
well during the first few months of 2010. Since the primary The portfolio is delivering a reasonable return at low, con-
purpose of Modern Protection is to preserve the value of trolled risk. Especially in risk-adjusted terms, we are satisfied
capital, its return of nearly one per cent during the first three with its performance.
months must be considered satisfactory, given the market cli-
mate. We also note that practically all holdings contributed to
1% 5%
the portfolio’s positive return and that no holding fell outside 2%
this framework. 10.5%

Broader fixed income mandates (“cash plus” or “total return”)

are continuing to deliver good returns, along with our small Cash
corporate bond fund holdings, both Investment Grade (IG) Currencies
and High Yield (HY). Our currency mandate investment also Real estate
began to contribute to our performance. In the hedge fund Hedge funds
portion of the portfolio, however, those funds that adhere to 81.5% Fixed income
the Equity Market Neutral strategy have not really met expec-
tations, and these holdings may be reconsidered.

New during the period is that we are choosing to begin invest-

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

8 Investment Outlook - MAY 2010


MODERN GROWTH
As the world economy continued to recover, the Modern
Growth portfolio rose by more than three per cent during
the first quarter of 2010. This positive trend also continued
in April. Its holdings are not unaffected by the storm clouds
that have influenced the financial market in recent months,
but given its good risk diversification and its so far successful
choice of investments, the portfolio has performed well. The
asset classes that have contributed most to its returns are
equity and fixed income investments, together with private
equity and hedge funds. Commodities and currencies have
performed less satisfactorily to date.
In the long term, we expect the world economy to recover
largely as planned, but in the short term storm clouds will al-
low room for disappointments. In the Modern Growth portfolio
we are well prepared for short-term reversals, while seeking
investments that can perform satisfactorily in times of positive
markets. In the tug-of-war between short-term concerns and
long-term potential, we see risks in both a clearly positive at-
titude and an exaggerated pessimism.
We are retaining our current exposure to equities, which
includes holdings in both traditional global funds and in a
number of broad emerging market funds. In the fixed income
portion of the portfolio, our exposure to credit risk instru-
ments will remain in place, but we are making a small change
by replacing Investment Grade Libor (short duration) with
Emerging Market Debt.
1.5% 4.5%
4.5%
25% 3%
3%
30%
28.5%
Portfolio strategy
The hedge fund portion of Modern Growth is delivering good
returns, and its stabilising effect on the portfolio gives us good
opportunities to take risks in other asset classes. We foresee
continued world tensions in many asset classes, both between
asset classes and regions. This should provide good oppor-
tunities for many hedge funds. Global Macro, CTA and Equity
L/S are strategies that should be able to perform well in the
future, so we are choosing to retain these holdings. The good
market also provides good potential for Multistrategy, and we
are also choosing to keep such investments. We are making
a marginal upward adjustment in our return expectations for
hedge funds.
Real estate is a relatively new asset class for us in Modern
Growth. We expect it to be able to deliver good risk-adjusted
returns ahead and to provide a stabilising effect in the portfo-
lio. Here we are focusing on more stable property investments
with an emphasis on cash flow. Certain high-risk property
investment projects might also be attractive, but are not suit-
able in this portfolio for both risk and liquidity reasons.
Our current position in listed private equity, which we are
choosing to retain, has contributed good returns so far. We are
searching for complementary investments in this asset class,
but this is difficult because of limited liquidity.
Cash
Currencies
Commodities
Private equity
Real estate
Hedge funds
Fixed income
Equities
Investment Outlook - MAy 2010 9
 Portfolio strategy
MODERN AGGRESSIVE
As the normalisation of markets and economies has pro-
gressed, we have successively escalated the risk in the Modern
Aggressive portfolio. Our intention is to gradually increase risk
when we regard this as suitable.
We are making a small change at the moment: replacing a
convertible debenture holding with equities. Since the dis-
count that we saw existed in the convertible holding when we
bought it has disappeared, we are replacing it with equities
since the risk is largely the same, but the potential is better.
This approach also permeates the management of the Modern
Investment programmes. We focus on investments with the
potential for the best risk-adjusted return – while seeking to
take advantage of somewhat larger market shifts.
In the equities asset class, a large proportion of the portfolio’s
investments consists of emerging markets. This has worked
out nicely, both in investment and currency terms. One fourth
of the gains on our EM funds are attributable to currencies.
We can see that the existing growth in the world economy is
coming mainly from emerging markets, and it is natural to be
invested in these markets.
Although there is room to increase the risk level in the portfo-
lio, these decisions are easier if there is smoothly functioning
risk diversification. A relatively large proportion of investments
in the Modern Aggressive Portfolio is in fixed income; how-
ever, these are investments that have almost equity-like return
expectations, but at lower risk. This provides us with a good
cushion in the portfolio, but looking a bit further ahead we
foresee that we should lower this proportion to enable us to
generate the returns we are aiming at over a business
0.5% 4.5%
11%
35%
23%
26%
10 Investment Outlook - MAY 2010
cycle. Among corporate bonds, our High Yield holdings are still
performing outstandingly; they are, incidentally, good invest-
ments in most market situations. We have kept some convert-
ible debentures, since these are expected to have continued
good return potential.
In the hedge fund field, we have chosen funds that are a bit
more aggressive. We also have some holdings in hedge funds
of a more stable nature and expect to cut the size of these
holdings in the coming quarters while buying more lively
hedge funds. We are facing a delicate problem, since one of
our hedge funds has chosen to stop accepting new deposits.
This is naturally good, since the managers foresee a small risk
that its size could adversely affect performance. Since the fund
is successful, we are retaining our holding and have mean-
while found a fully qualified alternative for future investments.
The real estate investments we have made in the other
Modern Investment programmes do not live up to the return
expectations that govern Modern Aggressive, which is why we
have no real estate investments in this portfolio. There are in-
deed well-managed opportunistic real estate investments that
have good return potential, but their liquidity is generally too
poor for this portfolio.
Pure commodity investments have not contributed anything
this year. Instead it has mainly been commodity shares that
have recorded gains, and we eliminated our commodity share
investment some months ago. In retrospect, we did so a bit
too early. There will undoubtedly be new opportunities to
invest in commodity shares again, but at the moment we are
holding off.
Cash
Commodities
Private equity
Hedge funds
Fixed income
Equities
Theme:
The debt burden −
can the world
handle the pressure?
In the shadow of the debt mountains
• Beyond Greece, massive government debt After the world had undergone a depression and a world
mountains loom
• While the Western world grapples with its Maynard Keynes gained ground. He advocated an active role
debts......
• ... economies in the emerging markets sphere in good times that enabled it to pursue an expansionary fiscal
are running in high gear
With a government debt of more than 115 per cent of GDP
and a budget deficit of nearly 15 per cent, Greece scared the
daylights out of the stock, fixed income and foreign exchange
markets. Early in May, Greece reached an agreement with its
fellow euro zone countries and the International Monetary
Fund (IMF) on a loan totalling EUR 110 billion. The country
seems to have narrowly escaped defaulting. The path to
this agreement was long and winding for both political and
financial reasons. At their peak, two-year Greek sovereign
bond yields climbed to nearly 20 per cent. Nor is it possible to
declare an end to the emergency, although the EUR 750 billion
financial package later unveiled by the European Union and
the IMF avoided a liquidity crisis in Europe.
This tale of fiscal woes illustrates the challenges that many
Western countries face. As a result of massive fiscal stimulus
policies launched immediately after the Lehman Brothers
shock in September 2008 and during the deep financial and
economic crisis that followed, the G7 countries will collectively
have increased their central government debts to a record-
high 120 per cent of GDP by the end of 2010. What, then, will
be the implications of this debt problem? How will it impact
the global economy and the asset markets?
Government debt a natural feature of the economy
For governments to be in debt is nothing more unusual than
for companies to finance their activities by borrowing. Just as
companies smooth their liquidity needs and reduce their tied-
up capital through debt financing, governments can smooth
their current and future capital flow requirements. One of
the reasons behind today’s government debt problem is that
structural debts have gradually grown.
war – including major economic fluctuations that resulted in
enormous social consequences – the ideas of economist John
for government in smoothing economic cycles; the fundamen-
tal concept was that a government should set aside savings
policy in tough times. In this way, the government could ease
the adverse economic and social consequences of fluctuating
economic conditions.
Periodic surpluses and deficits in government finances are
related to the cyclical nature of the economy. During boom
periods, tax revenue rises and unemployment falls, while
economic downturns lead to higher unemployment, lower tax
revenue and high social welfare expenditures. These cyclical
surpluses and deficits contribute to decreases and increases in
total government debt as the economy fluctuates.
However, the political incentives to reduce expenditures dur-
ing an economic boom are smaller than the incentives to
boost expenditures in tough times. In the run-up to elections,
for natural reasons there is also an unwillingness to raise taxes
and trim government subsidies. Before social stabilisers such
as unemployment insurance were introduced, surpluses and
deficits more or less offset each other during an economic
cycle, and government debt tended to be fairly stable as a per-
centage of GDP. But as the welfare state expanded, the cyclical
portion of government debt did not fully vanish during eco-
nomic upturns. Structural debt − the part that persists through
the entire cycle − has thus successively expanded.
Excessive government debt creates problems
Excessively large central government debt leads to many
problems. It reduces confidence among investors that a coun-
try will be able to meet its payment obligations, which leads
to lower creditworthiness and higher interest rates or bond
yields. Banks encounter higher funding costs, and the supply
of liquidity shrinks for both private individuals and businesses.
Ultimately this hampers private consumption and business-
related capital spending, thereby slowing economic growth.
One study (Reinhart and Rogoff) shows that GDP growth falls
Investment Outlook - MAY 2010 11
 Theme: The debt burden − can the world handle the pressure?
by one percentage point when government debt reaches 90
per cent of GDP.
What, then, is a “good” level of government debt? The lit-
erature offers no simple, straightforward methodology for
calculating the optimal debt level. Depending on the model
and parameters, for example, optimal US debt can be esti-
mated at anywhere from 5 to 66 per cent of GDP. According
to the Stability Pact, EU countries are supposed to ensure that
government debt is below 60 per cent of GDP, which the IMF
and the World Bank also regard as the upper limit for sound
government finances.
However, there are theoretical guidelines for what a sound
level of government debt means:
1. A sustainable long-term fiscal policy − future tax revenue
should be capable of funding future interest and principal
payments. If long-term government finances are expected to
end up imbalanced, the private sector risks a reduction in its
consumption and will save more, in anticipation of a higher
future tax burden.
2. Room for counter-cyclical fiscal measures − as mentioned
above, debt as a share of GDP rises during cyclical downturns.
If a country has high initial debt levels, an economic downturn
will result in even higher indebtedness and leave less room for
fiscal stimulus. In such a situation, if the government increases
its debts, this has adverse consequences including lower long-
term growth.
3. Contributing to economic expansion − reasonable levels of
government debt benefit growth because a larger number of
high-return projects can obtain funding when market interest
rates are low. But excessively high debt, with the accompany-
ing higher government bond yields, will cause capital to seek
better fixed income alternatives to government securities. This
will “crowd out” efficiency-raising private investments.
DEBT-BURDENED COUNTRIES FACE BELT-TIGHTENING
15
Public surplus/deficit
10 Norway
5
(% of GDP)
Sweden
0 Germany
Finland
0 50 100
-5 AustraliaDenmark Canada
Netherlands
France
-10 Spain
US
Ireland UK
-15
Public debt (% of GDP)
12 Investment Outlook - MAY 2010
Initial situation affects final outcome
For the above-mentioned reasons, countries with low initial
government debt burdens can launch more powerful fiscal
stimulus measures that have a greater impact on their econo-
mies than countries with high initial government debts. As a
group, before the financial crisis the industrialised countries
had government debt totalling about 65 per cent of GDP.
Large government-financed bail-out and stimulus measures,
as well as lower revenue and higher expenditures during the
financial and economic crisis, have led to exploding govern-
ment budget deficits. According to IMF forecasts, government
debt in the OECD countries as a whole will reach 100 per cent
of GDP within five years.
Even if stimulus measures in the Western world were with-
drawn, public expenditures would only fall by about 1.5 per
cent of GDP. Looking ahead, vigorous and credible action
plans to reduce public deficits will thus be important in order
to create confidence − both in the financial market so capital
will seek the right investments and at companies so they dare
to begin hiring new employees.
In many contexts, Sweden is held up as an example of a coun-
try that has practised good crisis management. In the wake of
the Swedish banking crisis of the early 1990s, the government
initially launched large aid packages. Over a six year period,
government debt rose by about 35 percentage points to more
than 75 per cent of GDP. After that, the government imple-
mented dramatic belt-tightening measures which helped its
budget balance swing from -11 per cent of GDP to nearly +4
per cent in the space of seven years, but economic growth was
very low during this period.
For the emerging market (EM) sphere, the picture is entirely
different. As a group, EM countries entered the crisis with a
government debt of only about 30 per cent of GDP. The IMF
estimates that these countries will soon be back at the same
150 200
Italy
For countries with large government debts and
Japan public sector deficits −such as the US, Greece,
Greece Italy and Japan − tough years of belt-tighten-
ing lie ahead.

relative debt level. The financial crisis had a milder impact on
these economies than on the OECD countries, and their low
indebtedness allowed room for larger stimulus measures.
Tough budget austerity will hamper growth
Countries that must overcome debt mountains have three
main alternatives: inflation, currency depreciation and budget
austerity.
High inflation causes the value of money to shrink. In other
words, the real cost of loans becomes lower − borrowers bene-
fit at the expense of lenders. Inflation can be created by print-
ing money, but such a monetary policy strategy presupposes a
well-functioning banking system and high economic capacity
utilisation in order to have an impact. An inflation effect can
also be achieved by means of currency depreciation − if a loan
is denominated in the country’s currency and the value of this
currency falls, inflation is imported and the cost of the loan
falls in real terms.
Greece, Spain and other euro zone countries cannot apply
these two alternatives, however, since their key interest rate
is set by the European Central Bank and their currency is
trans-national. For these countries, all that remains for as long
as they belong to the euro system is the third alternative −
budget austerity.
Budget austerity is the hard way. It means that a government
begins to repay its debt when it has achieved a budget surplus
− the result of tough cost-cutting and tax hikes. Studies from
the World Bank and elsewhere show that growth is clearly
more sustainable when budget austerity occurs mainly via
reductions in public expenditures, as compared to increases in
tax revenue. For example, by cutting subsidies and raising the
retirement age, a country boosts its productivity while improv-
ing its government finances. Such measures lead to major
political challenges, however, especially in countries with a
sizeable public sector.
Our conclusion is that countries that have sound finances to-
day will enjoy a higher growth rate in the future than countries
with dreadful finances. The Western world thus faces many
years of below-potential growth and the gigantic challenge
of restoring order to their government finances. Among the
best-positioned Western countries are Sweden, Norway and
Canada, while nations on the periphery of the euro zone will
face the biggest strains.
Globally speaking, Asian economies will enjoy the highest
growth for many years to come, followed by Latin American
economies. Eastern Europe will gradually pick up speed. This
difference in growth rates − which will thus be amplified by
OECD debt problems − will cause a continued flow of capital
to the EM sphere, where the growth outlook is best. Assets in
these countries will rise in value, and both fiscal and monetary
The debt burden - can the world handle the pressure?
policy tightening will be implemented mainly in Asia and Latin
America to offset overheating. The currencies of EM countries
will thus appreciate relative to those of Western countries. This
will help reduce export dependence in EM countries and en-
courage growth that is driven by domestic demand.
OECD countries that follow the responsible path to fiscal bal-
ance − budget austerity − and that have low capacity utilisa-
tion and high unemployment will show low interest rates and
low inflation. If they also have moderate economic growth, the
stock markets in these countries may benefit. Countries that
choose the inflation alternative or are unable to get a handle
on their government finances, however, will see high inflation
coupled with rising bond yields − a clearly less favourable al-
ternative for equities.
The shadow of the Western debt mountains thus reinforces
arguments in favour of EM exposure in various forms − real
estate, equities, currencies − both medium- and long-term.
ASIA IN HIGHER GEAR
12
10
8
6
4
2
0
-2
-4
-6
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
World Industrialised countries
Euro zone Central and Eastern Europe
Asia ex Japan, Korea Middle East and North Africa
According to IMF forecasts, real GDP growth will be highest
in Asia, at more than 8 per cent annually during the next
several years, compared to less than 2 per cent in the OECD
countries.
Investment Outlook - maY 2010 13
 Theme: Redrawing
the investment map
Old truths mean big risks
• Traditional risk-spreading falls short
• Emerging markets no longer so risky
• Currency movements will play a major role
Until the early 1980s, the main available investment alterna-
tives were equities on domestic stock exchanges and fixed
income investments in local currency. Since then, the pace of
development in the financial field has been explosive. Today’s
investors have a nearly unlimited range of alternative places to
put their money.
These new alternatives provide better potential for generating
good returns. But at the same time they are more complex, re-
quiring new knowledge and insights into the risks and oppor-
tunities of these investments. To some extent, conventional
assumptions about risk, quality and potential return on assets
can be considered somewhat outdated. Our assessment is
that in the near future, we will face something of a paradigm
shift, where old truths will be reassessed. Such a shift would
redraw the investment map and lead to changes in the pricing
of numerous investments.
Broad equity funds not so broad
One conventional assumption is that a traditional broad glo-
bal equity fund provides the best risk-spreading in an equity
portfolio. This idea assumes that a broad equity fund includes
exposure to various markets that do not have the same
patterns of returns (have low correlation). It thus achieves
diversification, which may reduce risk without decreasing the
potential returns to the same extent. There is no doubt that
diversification is a powerful tool for lowering portfolio risk, but
what we can be sceptical about is whether a global fund, for
example, is actually the best way of achieving risk-spreading in
an equity portfolio.
Equity fund managers generally tend not to diverge to an over-
ly great extent from their benchmark indices. Consequently a
global equity fund often has an allocation similar to a global
index, which in turn is based on the market capitalisation on
various stock exchanges. The global index most frequently
14 Investment Outlook - MAY 2010
used as a benchmark is the MSCI World Index. The three coun-
tries representing the largest exposure in this index are the
United States (50 per cent), Japan (10 per cent) and the United
Kingdom (9.5 per cent). Emerging market (EM) countries are
not represented at all. As an investor, one should be sceptical
as to whether this actually represents good risk-spreading,
since 70 per cent of exposure is to only three countries and the
EM sphere is missing.
BIG OECD COUNTRIES DOMINATE MSCI WORLD
US (50%)
Japan (10%)
UK (10%)
Other (30%)
The MSCI World Index is often used as a benchmark in tradi-
tional broad equity funds. The index is 70 per cent exposed
to three countries, and the EM sphere is missing.
The question is highly relevant, especially in today’s market
climate characterised by a greater focus on country risk. The
economic solvency of countries has become a very important
risk parameter in investment decisions. This is demonstrated,
in particular, by prevailing market concerns about Greek
government finances. At present, most countries must bor-
row at higher interest rates than creditworthy companies pay.
Investors thus regard corporate bonds as more reliable than
many government bonds. The fact that country risk is higher
in some cases than credit risk shows that the market has reas-
sessed its view of risk. What, then, is the status of the coun-
tries that investors tend to be exposed to via a global fund?
Safe securities becoming risky exposures
Greece is far from alone in grappling with profound deficit
problems. Most Western countries are characterised by dwin-

dling cash reserves due to the expensive global recession and
gigantic stimulus packages of recent years. Among the coun-
tries with the absolutely weakest government finances are
the US, Japan and the UK. Their budget deficits are at, or near,
10 per cent of GDP (Greece 13 per cent). Central government
debt stands at 230 per cent of GDP in Japan, more than 90
per cent in the US and 65 per cent in the UK (115 per cent in
Greece). In the UK, the private debt burden of businesses and
households is also among the highest in the world.
The financial situation of countries has begun to influence
investors’ decisions and is thus having an impact on various
asset markets. In Europe, for example, there is a clear and
noticeable connection between a country’s economic health
and the performance of its stock market. Investors distinguish
between the economic potential of different countries and
believe that companies operating in weak economies will be
adversely affected.
The return on shares is determined in the long term by
company profits and expectations about the future trend of
profits. But profits are, in turn, dependent on the underlying
economic performance of the markets where companies
operate. Companies in debt-ridden countries risk encounter-
ing less demand and higher taxes than competitors based on
economies that are on more stable ground. It is important,
however, to point out that this primarily applies to companies
that sell in the domestic market. Export companies that sell
their products in markets where demand is high may perform
better. Low economic growth holds down labour costs, and a
country’s weak finances may cause its currency to lose value,
creating competitive advantages for exporters.
LARGE DEBT BURDEN IN THE OECD
Government debt as a percentage of GDP
110
100
90 SEB forecast
80
70
60
50
40
30
00 01 02 03 04 05 06 07 08 09 10 11 12
Developed economies Emerging economies
Due to the global economic slowdown and the launching of
gigantic stimulus packages, central government debt as a
percentage of GDP has increased dramatically in the OECD
countries. In the EM sphere, however, indebtedness is low.
It is clear that the gigantic government debts that have ac-
cumulated are threatening to hamper GDP growth in debt-
Theme: Redrawing the investment map
ridden countries for many years to come (see pages 11-13).
There is thus reason to assume that the stock markets in these
countries will also be weighted down in the long term. An
equities portfolio allocated on the basis of the market capitali-
sation on stock exchanges thus appears to be a relatively high
risk investment. Diversification largely occurs between three
countries that will face enormous economic challenges for
many years. In spite of this, an equities portfolio composed of
shares in North America, Europe and Japan is regarded as an
investment with low equity risk.
Reassessing our approach to emerging markets
Another clear disadvantage is that the rapidly growing EM
sphere has little or no weight at all in most global equity funds.
A majority of EM countries have demonstrated impressive
growth figures, even though the global economy has suffered
its worst economic slump in living memory. In addition, the
growth of government debt in EM countries has been consid-
erably slower than in the OECD countries. At an aggregated
level, EM sovereign debt is equivalent to less than 50 per cent
of GDP.
The EM sphere has historically been categorised as a high
risk investment, but today’s investors should question this old
truth. There are still a number of EM countries that are char-
acterised by corrupt governance, non-existent educational
opportunities and economies on the brink of ruin. But these
countries are becoming fewer and fewer, and generally speak-
ing the EM sphere is on substantially more stable ground than
previously.
The most common measure of risk in financial theory is
volatility, in other words the variation in return over time.
High volatility leads to greater uncertainty about what return
an investment will provide, which means that it is a high risk
110 investment. Historically, EM stock exchanges have had a con-
100 siderably higher volatility than OECD stock exchanges. But in
90
recent years, volatility in the EM sphere has fallen to the same
80
level as in the OECD. The risk of equity investments in the EM
70
countries has thus diminished.
60
50
The improved solvency of many EM countries is also reflected
in the credit ratings from international agencies. During the
40
past six months, the trend has been towards more and more
30
13 14 rating upgrades, at a time when the global economy has been
Nordic countries
Source: OECD, SEB
in deep recession. However, many Western countries have
seen their credit ratings downgraded in the aftermath of the
financial crisis.
There are various reasons to wonder about the classification
of EM investments as extremely high risk. When investors
reassess this view, the attractiveness of EM assets will increase
− with rising asset prices as a consequence. Investors should,
however, be aware that political risk is still higher in the EM
Investment Outlook - maY 2010 15
 Theme: Redrawing the investment map
countries than in developed Western democracies. In addition,
investors tend to avoid peripheral markets when cold winds
blow, and the EM sphere is still regarded as being a dash of
spice in many portfolios.
Currency an important parameter
Currency movements are something that many investors do
not attach such great importance to when choosing where to
put their money, but as the investment universe has gained an
increasingly global dispersion, this factor has become increas-
ingly important to bear in mind.
Since fund managers and other investors do not generally
currency-hedge their positions, a large proportion of risk and
return will depend on what happens in the foreign exchange
market. Historically, share prices move about twice as much
as exchange rates. In other words, the stock market has about
twice the volatility of the foreign exchange market. Thus one
third of the return on an equity investment in a country with
another currency is determined by currency movements.
In our judgement, the fundamental strengths of countries will
become an increasingly influential driving force in the foreign
exchange market during the next few years. Capital will avoid
countries in financial difficulties and move, especially, to EM
countries where growth is higher and profitability larger.
We also predict that taking advantage of interest rate dif-
ferences will be a strong driving force; investors will borrow
where interest rates are low and invest where they are high.
The result will be downward pressure on low-interest curren-
cies, whereas the currencies of countries with high interest
rates will appreciate. Today the interest rate differentials
between categories of countries are large, and they will widen
further. On the one side are the OECD countries, where the
tightening of interest rates is being postponed. On the other
CURRENCY HAS AN IMPACT
90
80
70
60
Per cent
50 Equity market
40
30
20
10
FX market
0 0
2005 2006 2007 2008
J.P. Morgan G7 currency volatility index
VIX volatility index for US equities
16 Investment Outlook - MAY 2010
side are many EM countries, where interest rates have been
raised from already fairly high levels. Our picture of future
trends in the foreign exchange market thus provides another
reason to reassess equity portfolios with large exposure to
debt-ridden countries.
As an investor, one should also bear in mind that currency
movements may influence the prerequisites for a country’s
competitiveness. For example, the weaker euro has enabled
the already strong German export sector to benefit from newly
gained competitive advantages (see pages 34-35).
Diversify between good risks
In this theme article, we have challenged conventional as-
sumptions that are often regarded as absolute truths. For
example, a traditional global equity portfolio need not provide
good risk-spreading, but rather the opposite. We have also
examined factors that are important in making well-founded
investment decisions.
Fundamentally, it is a matter of being aware as an investor of
what risks one is exposed to and then allocating one’s funds to
achieve the best risk-adjusted returns. However, the market is
a living being, so something that was high risk yesterday may
be low risk tomorrow (for example EM assets).
Diversification remains the best tool for achieving high risk-
adjusted returns. But the choice of investments for achieving
risk-spreading is very important. The assets that attract us in
our world are the ones we are familiar with and that have high
value appreciation and good profitability.
We currently believe that good risk means quality companies,
EM sovereign bonds, High Yield bonds and the secondary pri-
vate equity market.
90
80
70
60
50
40
30
20
The volatility of the stock market is about twice
10
as large as that of the foreign exchange market.
2009 2010 Thus one third of the return on an equity invest-
ment in another country is determined by currency
movements.
Source: Reuters EcoWin
Theme: Market
pause − more rule
than exception

The time has come to catch our breath

• It is easy to be blinded by a positive market The economic upturn was later confirmed by statistics to-
mood and macro statistics…
• …and view the world with excessive optimism
• Risk asset markets enter a calmer phase
Right at the beginning of 2009, the pessimism among both
investors and forecasters was unrelenting. Many drew parallels
with the depression of the 1930s, and anyone who dared to
predict a bright future for markets and the overall economy
was regarded as frivolous and naïve. But as so many times be-
fore, those who dared at that time to challenge conventional
views and analyses turned out to be right. A price rally for risk
assets − equities, corporate bonds, hedge funds, private equity
and so on − began during the second quarter of 2009.
Just as the textbook says, the economy stabilised fairly soon
thereafter. In various countries − for example the United
States − a cyclical recovery ensued during the third quarter.
The economy thus rebounded 5-6 months after the stock
market, as it was supposed to.
wards the end of 2009. Together with significant cost-cutting,
this enabled corporate profits to rise as well, while interest
rates in most industrialised countries remained historically
low. As a result of this favourable economic environment,
prices of risk assets continued their upward journey. Granted
that the curves briefly turned downward just after the begin-
ning of 2010 when the fiscal mess in Greece was revealed and
China took steps to tighten its economic policies, yet investors
did not allow themselves to be scared for a long time. Instead
the spring of 2010 was dominated by a strong rally in risk as-
set markets − despite volcanic ash clouds and an increasingly
worrisome fiscal situation in Greece.
Well-fuelled spring rally
The main fuel for the spring rally was surprisingly good cor-
porate earnings and higher growth expectations, both among
macro forecasters and market players. For the first time in this
upturn cycle, the market ran faster than the economists when
it came to revising the future upward. Statistics for March and
April also supported the picture of accelerated growth in many
parts of the world economy, after growth had slowed early in
2010 partly related to weather.

SPRINGTIME FOR PURCHASING MANAGERS

65 65

60 60

55 55

50 50
Index

45 45

40 40

35 35 In many parts of the world, purchasing manag-

30 30 ers in the manufacturing sector indicate that the
2005 2006 2007 2008 2009 2010 wheels of industry are turning faster. The biggest
upswing is in the US, but in Europe and China the
UK, PMI Manufacturing US, PMI Manufacturing
Eurozone, PMI Manufacturing China, PMI Manufacturing expansion has also gained strength.
Source: Reuters EcoWin

Investment Outlook - maY 2010 17

 Theme: Market pause − more rule than exception
Among others, purchasing managers in the US, Asia and
Europe indicated improved conditions. Exporters in the
European Union’s core countries gained global competitive-
ness when the euro fell as a reaction to the Greek crisis.
Countries like China, Singapore and India reported accelerat-
ing GDP growth. American consumers defied predictions that
their savings ratio would rise. Instead they broke into their pig-
gy banks so they could increase their consumption more than
their income permitted. The mood of households improved
in the US, Japan and the euro zone. Statistics awakened some
hopes that the deeply depressed American housing market −
which largely triggered the financial and economic crisis − is at
least on its way towards stabilising.
However, it is easy to be blinded by cheery markets and posi-
tive macro statistics and thus view the future with excessive
optimism (the exact opposite of early 2009). It is easy to forget
that there are mechanisms that usually cause the economy to
change gears with rather short notice. The same applies to the
fact that accelerating economic growth may also actually have
negative aspects.
Special factors behind growth
One key question is how much of this economic growth is due
to the turnaround in the inventory cycle and fiscal stimulus
measures, and how much is a consequence of increased un-
derlying demand from households and businesses. For exam-
ple, in the US the shift from an inventory cutback of USD -160
billion in the second quarter of 2009 to an inventory build-up
of USD +31 billion in the first quarter of 2010 provided a posi-
tive GDP contribution of nearly 6.5 percentage points. That
factor together with the contribution from President Obama’s
stimulus package explained more than the entire American
GDP growth during the second half of 2009 − underlying
demand thus fell − and during the first quarter of this year the
contribution from these two factors added up to more than
2.5 percentage points of GDP growth, which totalled 3.2 per
cent. In other words, underlying demand indeed rose early in
2010, but only by around 0.5 per cent.
Inventories and fiscal stimulus are propping up American
growth during the current quarter as well, and by most indica-
tions the total contribution will be somewhat larger than in the
first quarter. These particular factors are an important reason
behind stronger recent American economic statistics. But it is
not only in the US that these forces have an impact. Positive
growth effects from a turnaround in the inventory cycle are
noticeable in large portions of the world economy, and budget
stimulus is also still propping up growth in many places − es-
pecially in the industrialised OECD countries.
These cyclically beneficial effects will fade during the sec-
ond half of 2010, however. In the US, probably around three
fourths of the positive impact of the inventory cycle has
already occurred, and later this year the contribution of inven-
18 Investment Outlook - maY 2010
tory to GDP may well be negative for a period, when the pace
of build-up slows; that is, the second derivative − the change
in the rate of change − becomes negative. Meanwhile the
growth impulse from fiscal stimulus measures will also shift
from plus to minus.
FISCAL STIMULUS AND INVENTORIES ARE BEHIND US
GROWTH
Annualised
6 6
SEB forecast
5 5
4 4
3 3
2 2
1 1
0 0
-1 -1
-2 -2
Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
09 10 11
Inventory contribution GDP growth
Net effect of stimulus
Source: CBO, Recovery.gov, SEB
During the latter part of 2009, more than all US growth
in GDP was due to fiscal stimulus and a turnaround in the
inventory cycle. Looking ahead, the economy will have to be
more self-sustaining when these effects fade.
This could admittedly be offset by a corresponding accelera-
tion in underlying businesses and household demand. But
although the most recent macro data reflects such improve-
ments, it is unlikely that they will be large enough − a conclu-
sion essentially true of the OECD countries as a whole.
Downturn in ISM manufacturing index usually comes
During the spring, the ISM purchasing managers’ index for the
US manufacturing sector has climbed above 60, a level usually
associated with high growth. Historically, however, this phase
has been fairly brief and has often been followed by a down-
turn in both the ISM index and GDP growth. For example, this
occurred during the recoveries of the early 1970s, mid-1980s
and early 2000s. Here, too − as in other parts of the business
sector − inventories naturally play an important role, since a
swing from cutback to build-up ordinarily causes the orders-
to-inventory ratio to fall. This, in turn, is a signal to businesses
to slow down their production rate.
It is true that there has been a strong association between
the ISM index, which is dominated by large companies, and
American GDP, but in retrospect the correlation between the
National Federation of Independent Business (NFIB) small
business index and GDP is even stronger. In itself, this is a
warning signal, since during the spring the gap between the
NFIB and ISM index was the widest since small business sur-
veys began in 1974. Behind the low figure are the difficulties
experienced by small businesses in getting bank loans and the
large role of the still-depressed construction industry in the
NFIB index.

HAPPY BIG FIRMS, GLOOMY SMALL FIRMS
65
60
55
50
Index
45
40
35
30
1995 2000 2005
Index of Small Business Optimism PMI Manufacturing
Source: Reuters EcoWin
The American ISM index, which has climbed sharply since
last autumn, is dominated by large companies while the
NFIB small business index has recently fallen from a low
level. Difficulties in obtaining bank loans are one reason.
One key factor behind household demand is the trend of
income, which in turn is dependent on what happens in the la-
bour market. In many industrialised countries, the labour mar-
ket weakened perceptibly during the financial and economic
crisis. There are many indications that employment will not
grow fast enough in the next two years to push down unem-
ployment much. Overall this will result in slow income growth,
which will presumably hamper private consumption.
There are thus many reasons to predict that the prevailing
OECD upswing will be followed by a deceleration later in 2010.
But such a course of events does not seem to be part of the
forecasts of market players and thus constitutes a market risk
in the coming months, on top of worries about government
finances − especially in Europe.
High growth may have negative aspects
At present, market players have reason to be pleased with the
strong macroeconomic data. But it cannot be ruled out that
they will gradually begin to worry that high growth may lay the
groundwork for inflation risks a bit further ahead − though not
justified according to our assessment − and that expectations
of accelerated key interest rate hikes in influential countries
will thus gain a foothold.
Developments in China since the autumn of 2009 − when the
stock market there began to lose ground compared to world
indices − show what can happen when the market shifts from
liking to disliking strong macro figures. When the Chinese then
implemented their first economic tightening measures early
in 2010, this not only adversely affected the stock market in
China but also shook other stock markets. Another example is
from 1975, when expectations of US interest rate hikes caused
Wall Street share prices to fall nearly 15 per cent. Worries
about the negative aspects of accelerating economic growth −
inflation dangers and accompanying economic policy tighten-
ing − are thus also a risk factor to bear in mind.
Theme: Market pause − more rule than exception
Our basic forecast is that the current OECD acceleration − for
115 the reasons discussed above − will not continue long enough
110
for inflation expectations to spread significantly. A moderate
deceleration for a couple of quarters is also, by all indications,
105
a smaller market risk than escalating price and interest rate
100 expectations, but a slump is likely to have an impact on asset
Index
95 prices and increase uncertainty for a time.
90
It is more of a rule than an exception that upturns in risk asset
85
markets occasionally pause for breath. Since the current bull
80 market began in March 2009 and until this spring, for exam-
ple, stock markets have gone through three temporary dips:
one around mid-2009, one early in 2010 and one early in May.
Looking further back in history shows that since 1975, equi-
ties, corporate bonds, hedge funds, private equity funds and
commodities have ordinarily entered a weaker phase when
the cyclical recovery has been under way for several quarters.
When the economy has unrelentingly continued to grow, after
a while risk asset prices have begun a new upturn phase that
has lasted for a long time. One US exception was in the early
1980s, when a cyclical double dip occurred due to sharp inter-
est rate hikes aimed at combating high inflation.
Assuming that the OECD growth slump later this year that is
visible in our crystal ball will be mild and brief, with continued
low inflation, no interest rate worries will get a foothold and
fiscal problems do not escalate dramatically, a weaker period
in risk asset markets will only be a pause for breath in a bull
market that may persist for another couple of years.
CLOSE LINK BETWEEN STOCK MARKET AND ECONOMY
50 110.0
30 105.0
10 100.0
Indicator
Per cent
-10 95.0
-30 90.0
-50 85.0
1980 1990 2000
OECD weighted leading indicators
MSCI World Net index, change y/y
Source: Reuters EcoWin
It is a well-known fact that the stock market is usually a step
ahead of the economy during both upturns and downturns.
This connection is underscored by the largely simultane-
ous turnarounds in the World Index and leading economic
indicators in the OECD countries. History also shows that the
initial strong rebound is ordinarily followed by something of
a pause, which in turn is followed by strong periods for both
the stock market and the economy.
Investment Outlook - may 2010 19
 Macro summary
Global recovery on firmer ground
• Economic upturn with EM countries in the system is still damaged, and its healing process is continuing.
driver’s seat
• Small rate hikes in major OECD countries,
larger hikes in small countries and EM
• Growing public sector imbalances and
postponed economic burdens
The world economic upturn has gained strength and is now on
firmer ground. Global GDP will increase by more than 4.5 per
cent both this year and in 2011. The Asian economies will con-
tinue to be an important driving force, and the emerging mar-
kets (EM) sphere as a whole will grow at a 6.5-7 per cent pace
in 2010-2011. The upturn in the US is beginning to pick up
support from a labour market that is showing less weakness.
Europe is plagued by government fiscal problems − especially
in southern Europe and the UK − but expansionary forces are
still decent. Exporters in Germany and the UK are benefiting
from weak currencies. Growth in the 30-country Organisation
for Economic Cooperation and Development (OECD) will end
up at around 2.5 per cent in both years.
Low inflation for a long time
Inflation will remain low in the industrialised countries for an
extended period, as large spare capacity and high unemploy-
ment push down wages and prices. There is little risk that
higher commodity prices will threaten this low-inflation envi-
ronment. Due to limited inflation pressures and to concerns
about the resilience of the financial system, leading central
banks will proceed very cautiously with their key interest rate
hikes.
However, key interest rates will be raised on a larger scale in
the EM countries and less export-dependent OECD countries.
Despite low inflation and cautious central banks, sovereign
bond yields will rise somewhat due to sizeable borrowing re-
quirements and stronger economic conditions.
The relatively bright growth outlook does not mean that the
world is nearing a normal economic situation. The banking
20 Investment Outlook - may 2010
Ultra-low interest rates and growing public sector debts have
led to the postponement of many adjustment burdens.
The US economic recovery has gradually broadened. GDP
growth will reach more than 3.5 per cent this year and nearly
3 per cent next year. The growth contribution from inven-
tory build-up and fiscal stimulus is slowing, but this is being
offset to a decent extent by stronger final domestic demand.
Employment is moving towards improvement, but the job-
less rate will fall slowly to just below 9 per cent at the end of
2011. This, combined with a continued decline in core infla-
tion (price increases excluding food and energy), will help
persuade the Federal Reserve to hold off on hiking its key rate
until December this year.
GOOD PACE OF EXPANSION IN US ECONOMY
10.0 10.0
7.5 7.5
Per cent q/q annualised
5.0 5.0
2.5 2.5
0.0 0.0
-2.5 -2.5
-5.0 -5.0
-7.5 -7.5
2000 2002 2004 2006 2008
USA GDP, quarterly change annualised
Source: Reuters EcoWin
After a deep recession late in 2008 and early in 2009,
American GDP grew for three consecutive quarters, but this
expansion was entirely dependent on a turnaround in the
inventory cycle and fiscal stimulus measures.
Rest of Asia gives Japan a helping hand
Japanese exports are growing rapidly, thanks to higher de-
mand from China and other Asian countries − a shot in the
arm for the Japanese economy. GDP growth will reach 2-2.5
per cent annually in 2010-2011. Deflation pressure will persist
in the economy but will be somewhat less powerful. The gov-
ernment’s many stimulus packages have contributed to the

economic turnaround but have further exacerbated govern-
ment finances, which are showing a deficit of 10 per cent of
GDP. There is no urgency about interest rate hikes − the Bank
of Japan can wait until late 2011 − and we predict that the yen
will weaken in value during the next couple of years.
The economic situation in the euro zone has not been impres-
sive during early 2010. The fiscal crisis in the “PIIGS” countries
(Portugal, Ireland, Italy, Greece, Spain) − especially in Greece
− is creating great uncertainty. Meanwhile there are signs that
the recovery will continue, though at a leisurely pace. Various
leading indicators are moving upward, and the export sector
is being fuelled by the weakness of the euro. This year GDP
growth will be 1.5 per cent, and next year nearly 2 per cent.
The serious problems in Greece, slow growth and low inflation
are reasons for the European Central Bank to let its refi rate
remain at 1 per cent until the spring of 2011.
The British economy is on its way up. GDP will grow by 1.5 per
cent this year and 2 per cent in 2011. The new government
faces very big challenges. The country is plagued by deeper
imbalance problems than other leading economies; the budg-
et deficit exceeds 11 per cent of GDP. Unless the government
is able to produce a credible plan for restoring fiscal order, the
UK’s sovereign debt rating risks being downgraded. The Bank
of England will not raise its key rate until December 2010.
Nordics will grow a bit slower than OECD
Annual GDP growth in the Nordic countries will end up aver-
aging less than 2.5 per cent in 2010-2011, a bit slower than the
OECD countries as a whole. Swedish and Finnish GDP will in-
crease the fastest, in both cases with exports as an important
engine. In Norway the main source of growth will be private
consumption, largely thanks to sizeable income increases. The
Danish recovery is quite fragile, among other things due to
earlier declines in home prices and construction.
SIGNIFICANT GROWTH ACCELERATION IN CHINA
14 14
12 12
10 10
Per cent y/y
8 8
6 6
4 4
2 2
0 0
2000 2002 2004 2006 2008
Source: Reuters EcoWin
At the bottom of its economic slowdown in the first quarter
of 2009, China recorded a GDP growth rate of more than 6
per cent. Since then the growth rate has climbed to nearly
12 per cent. In the short term, it may accelerate even further.
Macro summary
EM sphere playing in its own division
There are good prospects that China − the engine of the world
economy − will perform well. Thanks to a tightening of eco-
nomic policy and currency appreciation, growth will decelerate
from 10.5 per cent this year to 9 per cent in 2011, a pace better
compatible with lower inflation. India also has good growth
potential, although public budget deficits have reached about
10 per cent of GDP and inflation has climbed above 10 per
cent. Further rate hikes plus fiscal tightening measures to
strengthen the budget and ease price pressures will bring
India’s GDP growth down from 8.0 per cent this year to 7.0 per
cent next year.
Silver medal for Latin America
With a growth rate of 4.5-5 per cent in 2010-2011, Latin
America is in second place after Asia. Brazil, Mexico and Chile
are the fastest-growing large economies. At 6-7 per cent, infla-
tion in the region is on the high side, but unlike many OECD
countries both budget deficits and public sector debts are
small. Nor do percentages of foreign loans and external bal-
ances provide cause for concern.
In the past six months, Eastern Europe has begun a gradual
economic upturn, but most economies in the region are
continuing to display dual tendencies. The recovery is be-
ing driven by competitive exporters, while consumption and
investments will be weighed down for another while by rising
unemployment, fiscal tightening and low capacity utilisation.
Among Eastern European economies Poland is at the head
of the class and was the only EU country with positive GDP
growth last year.
Today the three Baltic countries are also characterised by a
gradual export-led recovery. Earlier extreme current account
deficits have been replaced by surpluses. The recession has
also helped to dampen inflation dramatically in the Baltics.
Smaller economic imbalances further support the assessment
that there will be no devaluations in the region.
WELL-JUSTIFIED TIGHTENING MEASURES
17.5 17.5
15.0 15.0
12.5 12.5
Per cent
Per cent
10.0 10.0
7.5 7.5
5.0 5.0
2.5 2.5
2002 2004 2006 2008 2010
China, Reserve Requirement Ratio
India, Key Rate
China, Key Rate
Source: Reuters EcoWin
Since early 2010, China’s central bank has raised the reserve
requirement for banks in three steps and India has hiked its
key interest rate twice. High growth in China and inflation
worries in India are good reasons for these measures.
Investment Outlook - maY 2010 21
 Asset class:
Equities

Short-term risks – long-term opportunities

• Strategically, the fundamental driving forces gency package of EUR 750 billion, there is reason to have a
are in place somewhat cautiously optimistic attitude towards equities. The
problems of mounting government debts remain and eco-
• The extraordinary loan package will create nomic expectations appear a bit too cheery.
new opportunities for European equities BULL MARKET A BUMPY RIDE
• Emerging markets again in focus
350 350

325 325
The market shocks that dominated January and early February
− Chinese economic tightening measures, the fiscal problems 300 300
of Greece and President Obama’s proposals on stricter bank-
Index

275 275
ing rules − caused share prices to fall sharply, but after that the
stock market rally resumed during the spring. Fuelling this rally 250 250
was a clear preponderance of positive surprises in both macro
statistics and the flow of earnings reports. Equities also bene- 225 225

fited from a continued highly expansionary fiscal environment, 200 200

especially the exceptionally low key interest rates prevailing in Jan Apr Jul Oct Jan Apr
the OECD countries. 2009 2010
Source: Reuters EcoWin

The strength of this spring’s stock market rally could not re- From their turnaround in March 2009 until early May 2010,
ally match last year’s strongest upswing. But this was entirely world stock markets rose about 60 per cent. The upward
compatible with the transition from the earlier phase of strong ride was not a straight line but was instead rather bumpy,
market hopes − strongly driven by expectations of a shift from the usual pattern during a bull market.
losses and declining profits to rising profits − to the growth
During the spring, stock market players became spoiled by
phase that the stock market has been in since early 2010, with
numerous positive macro surprises and the clear preponder-
confirmations of rising corporate profits serving as a powerful
ance of unexpectedly good earnings in company reports, both
engine. Early in this growth phase, it is not at all unusual for
in the OECD countries and the EM sphere. As a consequence,
share valuations to fall, a phenomenon that also characterised
cyclical expectations in the stock market changed shape from
the first quarter of 2010 and further fuelled the stock market.
a U to a V. At the same time, the mood became increasingly
cheerful. For example, US optimism about world economic
Some weeks into the second quarter, however, stock markets
performance in April was the highest since the boom years
again encountered headwinds. These were in the form of a
2005-2006, and the percentage of pessimists was the lowest
rapidly escalating Greek fiscal crisis, clouds of Icelandic vol-
in 25 years. Meanwhile American mutual funds that invest in
canic ash that paralysed most air traffic in Western Europe −
equities cut their liquid assets to the lowest level since the turn
resulting in sharp share price declines for airlines in particular
of the millennium, and stock market holdings by US house-
− and a civil fraud suit filed by the US Securities and Exchange
holds rose dramatically.
Commission against Goldman Sachs, adversely affecting the
share prices of many banks and other financial institutions.
Given a background dominated by growing government debts
And although the volcanic ash is mostly gone for the moment,
and a clearer predominance of unexpectedly good macro
Greece has received a loan totalling EUR 110 billion from the
figures − which boosted market expectations about the
euro zone and the IMF, and the EU/IMF approved an emer-

22 Investment Outlook - maY 2010

 Asset class: Equities

economic upswing − as well as both optimistic stock market
players and households, by all indications it will require very
positive surprises at the micro and/or macro level to trigger
further share price rallies.
The first quarter 2010 report season is over, so events at
company level are likely to play a less prominent role for some
time. Meanwhile the stock market seems to have discounted
a faster economic recovery than most economic forecasts
are predicting. This is a downside risk for the stock market,
together with the risk that OECD macro data will first turn
more mixed and then probably present negative surprises (see
pages 17-19). At the same time, this risk is limited by reason-
able valuations in most stock markets − price/earnings ratios
in the US are just above 12 and in Sweden just above 15, for
example − as well as profit forecasts for 2010 and 2011 of a
solid 20-25 per cent.
Weaker economic news will slow stock markets
During the spring, stock exchanges in Sweden and the US
performed more strongly than those of the euro zone. This
was due to clearly positive Swedish and American economic
news, while the government debt mountain in the euro cur-
rency union was under scrutiny. EM stock markets as a whole
lagged behind the world index, mainly due to sagging Chinese
share prices in the wake of economic policy tightening.
Cyclical sectors such as industrials and commodity companies
performed more strongly than defensive ones like health care.
If the OECD economies soon enter a calmer phase after their
first strong upturn phase, sectors that are not so cyclical will
become more attractive − but not the purely defensive ones,
since growth still looks set to be decent.
EM sphere appealing
The emerging market sphere remains appealing, especially
Eastern Europe including Russia − which is beginning its eco-
nomic upswing this year − and China, where the stock market
has taken quite a beating due to economic tightening meas-
ures. The US is somewhat more attractive than Europe, with
exporters in the euro zone core countries − mainly Germany −
as positive exceptions due to the weak euro. This is especially
true if these exporters have their most important markets in
the EM sphere.
Although it thus seems likely that stock market performance
will be a little mixed this summer, our assessment is that this
does not signal the beginning of a bear market, but is instead
a new phase of a continued bull market.
Strategically − in roughly a two-year perspective − stock mar-
ket conditions seem good in the OECD countries thanks to
improving economic conditions and profits, low inflation and
very modest interest rate hikes. EM stock markets will benefit
from high economic growth and large profit increases, which
will offset larger interest rate hikes in these countries. As part
of their calculations, investors who are based in an OECD
country should also bear in mind the chances of currency rate
gains on their investments in EM equities.

EM EQUITIES A BIT BETTER THAN WORLD INDEX… …WHILE THE EURO ZONE LAGGED SIGNIFICANTLY

12.5 12.5 10 10

10.0 10.0 5 5
0 0
7.5 7.5
Per cent

-5 -5
Percent

5.0 5.0
-10 -10
2.5 2.5
-15 -15
0.0 0.0 -20 -20
-2.5 -2.5 -25 -25
May Jul Sep Nov Jan Mar May May Jul Sep Nov Jan Mar May
2009 2010 2009 2010
Relative performance MSCI Emerging Markets vs MSCI AC World Relative performance EuroSTOXX50 vs MSCI AC World
Moving average 20 days Moving average 20 days
Source: Reuters EcoWin Source: Reuters EcoWin

Although the Chinese stock market took quite a beating due
to the government’s economic tightening measures, equities
in the EM sphere as a whole performed relatively well dur-
ing January-April 2010 thanks to good stock market gains in
Latin America and Eastern Europe.
As the Greek fiscal crisis escalated, euro zone stock markets
performed significantly worse than the World Index, but
German exporters did well.

Investment Outlook - may 2010 23

 Asset class:
Fixed income

Interest rates and yields a complicated mix

• Central banks are following divergent interest Because of very low inflation pressure and lingering worries
rate paths… about the health of the financial system, the most influential
OECD central banks are being notably cautious about deploy-
• ...which affect the trend of government bond ing their interest rate weapons. In our assessment, the US
yields Federal Reserve will start its rate hiking cycle in December
2010, and the Fed will not begin selling off bonds until next
• ...High Yield still the best fixed income choice year at the earliest. The Bank of England must pay heed to
large financial imbalances but is meanwhile confronted with
rather high inflation. It is reasonable to assume that British key
After falling risk appetite early in 2010, US sovereign bond
rate hikes will begin about the same time as those of the Fed.
yields rose again when investors sold government securities
to buy risk assets such as equities and corporate bonds. But ECB faces debt mountain and sluggish economies
in the core countries of Europe, government bond yields con-
The environment that the European Central Bank faces is
tinued downward. One reason was that the Greek fiscal crisis
dominated by growing public sector debt mountains, a rather
caused investors to avoid sovereign bonds in the periphery of
sluggish economic upturn and below-target inflation. The first
the currency union and instead buy safe German government
ECB refi rate hike will thus not occur until the spring of 2011.
bonds. The yield spread between 10-year Greek and German
The Bank of Japan (BoJ) will be the last of the major central
government bonds widened dramatically at the end of April −
banks to make its move. Because of moderate economic
despite the EUR 110 billion loan package for Greece. When the
growth and continued deflation, the BoJ will keep its interest
EU/IMF package totalling EUR 750 billion was delivered later,
rate weapon unused until the second half of 2011.
however, the gap shrank significantly.
In some industrialised countries − especially commodity- and
Looking ahead, how government bond yields move in vari-
export-dependent countries that show higher growth and
ous countries will primarily be determined by the actions of
larger inflation risks than the OECD average − interest rates
central banks, the degree of economic strength, inflation risks
will nevertheless soon be raised. This has already happened
and what happens with public sector finances, especially in
in Australia and Norway, for example, and soon the Bank of
Europe.
Canada and Sweden’s Riksbank will follow suit.
RECORD-LOW KEY RATES FOR SOME TIME TO COME
7 7

6 6

5 5

4 4
Per cent

3 3 The deep financial and economic crisis per-

2 2
suaded the world’s most influential central
banks to cut their key interest rates to record-
1 1
low levels. There is no rush to begin hiking
0 0 these rates, since inflation risks are minimal,
-1 -1 the financial system has not been restored to
2000 2002 2004 2006 2008 2010 health and government debts are cause for
US UK Japan Germany concern.
Source: Reuters EcoWin

24 Investment Outlook - MAY 2010


Due to stronger economic dynamism, greater inflation dan-
gers, significantly better financial balance than in the OECD
and risks of asset bubbles, central banks especially in Asia
− but also in Latin America − have begun policy tightening, a
trend that will dominate 2010-2011. In Eastern Europe, howev-
er, several Russian interest rate cuts are in the cards. Poland’s
central bank will be the only one in the region that will begin
ratcheting up its key interest rate later this year.
The Greek tragedy that unfolded this winter and spring un-
derscored the association between public sector finances and
sovereign bond yields. The dramatically growing spread be-
tween Greek and German government bond yields this spring
(see chart below) reflected the fiscal problems of Greece.
VARYING INTEREST IN GREEK GOVERNMENT BONDS
12
10
Per cent
8 8
6 6
4 4
2 2
2005 2006 2007 2008 2009
Greece Germany
Source: Reuters EcoWin
The financial and economic crisis in Greece forced the euro
zone and the IMF to provide the country with a large emer-
gency loan. The severity of the crisis was reflected in the
record-high yield spread between Greek and German 10-
year government bonds. After the subsequent EU/IMF pack-
age was approved, this yield spread narrowed substantially.
But even under more normal circumstances, there is an as-
sociation between the savings level in a country − public
and private, adding up to the current account balance − and
sovereign bond yields. For example, 10-year government bond
yields in Japan are 1.3 per cent and the corresponding yields
in the US are 3.5 per cent, even though both countries have
government budget deficits of about 10 per cent of GDP. The
explanation is substantially larger private saving in Japan,
which means that the country has a current account surplus of
about 2 per cent of GDP as opposed to the US current account
deficit of about 3 per cent of GDP.
Our conclusion is that government bond yields in the US and
the core countries of Europe will remain low during much of
2010, thanks to insignificant inflation pressure and the fact
that central banks will not begin to unsheathe their interest
rate weapons before the end of 2010 at the earliest. While
awaiting persuasive progress in the management of fiscal defi-
cits, the government bond yields on the periphery of the euro
zone will, by all indications, remain high. Meanwhile strong
economic conditions and key interest rate hikes will contribute
Asset class: Fixed income
to rising government bond yields in countries like Sweden and
Norway. Partly for the same reasons, higher bond yields are
also imminent in large portions of the EM sphere.
Yields in the corporate bond market − which rose early in 2010
as investors’ risk appetite waned − later resumed their decline,
pushing up the price of these bonds. Early in May, however,
corporate bonds suffered a temporary price setback as finan-
cial worries mounted. The outlook is nevertheless good in vari-
ous respects. Although the best period for corporate bonds
was during 2009, this asset class will benefit from a continued
economic upturn and low inflation. Historically speaking, cor-
porate bonds have also usually provided better returns than
other bonds during the first phase of interest rate hikes, which
implies that this asset class has a chance of maintaining its at-
tractiveness until early 2011 as well.
12
Due to earlier tough cost-cutting along with now-returning
10
top line growth, companies around the world have increased
their profits more than forecasted. Along with steps that have
improved their debt structure − extending the maturities of
bonds outstanding, issuing new shares and building up emer-
gency liquidity − this has increased equity/asset ratios and
thus the ability of the corporate sector to cope with economic
strains. Better corporate financial health is reflected, among
other things, in a rapid decline in bankruptcies among compa-
nies in the High Yield segment and a rapid increase in corpo-
rate credit rating upgrades.
Returns on corporate bonds are primarily determined by the
prevailing yield gap against government bonds and how the
yields on the latter are moving. Given significantly higher re-
turns on High Yield (HY) bonds than on Investment Grade (IG)
bonds and the prospect of continued low government bond
yields in the US and the core countries of Europe, HY invest-
ments still appear attractive. IG bonds are less appealing,
however. Government securities remain least attractive.
CORPORATE BONDS ARE ATTRACTIVE
1750 1750
1500 1500
1250 1250
Basis points
1000 1000
750 750
500 500
250 250
0 0
Jan Apr Jul Oct Jan Apr
2009 2010
AAA BBB CCC and above B BB
Source: Reuters EcoWin
Early in May, there was a temporary setback in the corpo-
rate bond market due to the ongoing fiscal drama. In the
US, for example, the yield spread between industrial and
government bonds widened at that time. Since then, how-
ever, conditions have again improved for corporate bonds.
Investment Outlook - MAY 2010 25
 Asset class:
Hedge funds

Continued good prospects for hedge funds

• 2010 somewhat better than a normal year
• Quality more important
• Short Biased has had a tough time this year
Hedge funds are continuing to perform well. So far this year,
broad hedge fund indices have delivered a return of around 10
per cent year-on-year. Not everything has been hunky dory, as
the turbulence in late January and early February emphatically
showed. It is also hardly astonishing that hedge funds may
get knocked around a bit in the short term when unexpected
events occur in the markets. At times of surprising events,
however, ordinary markets are often harder hit than hedge
funds, whose investment flexibility also enable them to quickly
readjust their assets and thereby take advantage of the new
market situation. In addition, certain strategies perform espe-
cially well in times of turbulent markets. March results − which
were the best during the past six months or so − showed that
hedge funds collectively were successful in the market climate
that prevailed in the spring of 2010.
fiscal crisis has played an important role. There have also
been reversals − trends that have suddenly turned around − in
foreign exchange administration, something that is usually
difficult for foreign exchange dealers to correct for in the short
term. Competent Global Macro managers should nevertheless
have good potential to deliver good risk-adjusted returns dur-
ing the remainder of this year.
The problem of reversals and how they adversely affect certain
types of hedge funds is worth examining before commenting
on other strategies. Reversals impact not only Global Macro
management, but also perhaps to an even greater degree CTA
(Commodity Trading Advisors) funds. Both styles involve many
different asset classes. But one difference is that CTA uses
computer models and automatic trading, while Global Macro
is based on fundamental trading. The chart below shows an
example from 2009 that explains the difficulties these manag-
ers can encounter in markets where trends reverse.
TREND REVERSALS HARD TO CAPTURE
90 1.55

Event Driven is the strategy that has performed the best so far 80 1.50
this year, thanks to a variety of reasons. Many corporate merg- 70 1.45
USD/Barrel

ers and acquisitions have taken place, from which managers

EUR/USD

of these funds have been able to generate value. In March 60 1.40

alone, M & A transactions totalling more than USD 200 billion 50 1.35
were announced − an indication that the market is genuinely
40 1.30
beginning to reawaken. Event Driven managers have also
benefited from various themes such as health care, which they 30 1.25
have succeeded in exploiting. These managers have also been Jan Apr Jul Oct Jan Apr
2009 2010
successful in credit investments. Event Driven is a strategy well EUR/USD Brent oil
Source: Reuters EcoWin
worth a close look, and also worth investing in during the next
couple of years. One negative factor, however, is that liquidity Although the long-term trend was upward, 2009 was filled
in this part of the hedge fund market is often not the best. with short trend reversals. This made the CTA and Macro
strategies more difficult.
For the Global Macro strategy, 2010 to date has been a bit
more challenging, though there have been many different This year CTA has good potential to deliver fine results after a
themes and markets with good potential returns. So far this difficult 2009, but there are major quality differences, so it is
year, unexpected changes in the yield curve for government important to invest in the right hedge fund. CTA can generally
bonds, especially on the short end of the curve, have been deliver a good return over time, but especially important will
costly in terms of lost returns. Here the flare-up of the Greek be the “contrarian” attributes that this strategy has in troubled

26 Investment Outlook - may 2010

 Asset class: Hedge funds

times. One example is 2008, when nearly all financial invest-
ments had a disastrous year, while CTA provided a positive
return. We value these attributes. In our assessment, CTA may
be able to deliver good returns this year as well, when markets
are expected to be characterised by stabilisation. The trend
follower tactic may be suitable during 2010, but development
such as new fiscal trouble spots may naturally change the
picture.
Quality differences are important when it comes to hedge
funds, as the chart below shows.
ADVANTAGE: DIRECTIONAL STRATEGIES
120
110
100
Index
and hedge fund companies, and an investor often needs
to get help with this, since it is an extensive task. We work
together with Key Asset Management, which SEB acquired in
2007. Key Asset Management manages hedge funds of funds
and has a solid analytical capacity in hedge funds, which we
use.
Equity Long/Short (L/S) has worked well so far this year,
returning about the same as hedge fund indices in general.
March was a really good month for this strategy when stock
markets were performing strongly. Equity L/S still has fairly
low net exposure, and managers have chosen to be cautiously
positioned since there are many uncertainties in the markets.
120 Equity L/S should also be able to provide good returns during
2010, with good resilience on the downside if fiscal worries
110
should escalate.
100

90 90 The Equity Market Neutral strategy has had a slightly difficult

80 80 time so far during 2010, with a negative return at the index
70 70
level since the turn of the year. However, these are alpha-gen-
erating funds that add good attributes to an investor’s overall
60 60
Dec Aug Dec Apr Aug Dec Apr
portfolio, so we appreciate their benefits.
2007 2008 2009 2010
Distressed Securities, 2008-01-01 = 100
Macro, 2008-01-01 = 100 Another strategy that has run into adversity is Equity Short
Equity Market Neutral, 2008-01-01 = 100
Market Directional, 2008-01-01 = 100 Biased, which is more or less always short in the market. When
Source: Reuters EcoWin
stock markets fall, these hedge funds generate value, but
Directional strategies have been able to benefit from rising when stock markets go up − as they did in March, for exam-
markets, while neutral strategies have had more difficulty in ple − these funds take a beating. Their March setback of more
holding their own. than 6 per cent conveys this clearly.

In March CTA, or Managed Futures, showed returns ranging
from -6 per cent at worst to +22 per cent at best. Most hedge
funds provided returns of between -1 per cent and about +8
per cent. Emerging Market funds noted especially large dif-
ferentials, with a range from -16 per cent to +18 per cent. It is
thus very important to choose the right hedge fund, and most
important of all to avoid the worst losers, which can be very
costly.
In previous issues of Investment Outlook, we have under-
scored the need for very thorough analyses of hedge funds
Good potential for hedge funds this year
Given the prevailing market situation, our assessment is that
hedge funds that can generate returns on the basis of ten-
sions within or between different asset classes this year have
good potential to deliver good results. We predict that 2010
will be a somewhat better year for hedge funds than a normal
year. We are choosing to keep most of our hedge fund invest-
ments with Equity L/S, Global Macro, CTA and Multistrategy
managers. We are investing in Event Driven funds via
Multistrategy, but Event Driven is such an attractive strategy
that we may very well add it to our portfolio within one or two
quarters. We expect hedge funds to contribute to its stability.

FUND April 2010 march 2010 ytd 2009 2008 Hedge funds will deliver
HFRX Global Hedge Fund Index 0.80% 1.38% 2.45% 13.40% -23.25% good earnings this year,
except for Short Biased, but
HFRX Equity Hedge Index 1.04% 1.13% 1.37% 13.14% -25.45%
this strategy may benefit
HFRX Equity Market Neutral Index -0.38% -0.04% 0.63% -5.56% -1.16% from market crises. Among
HFRX Event Driven Index 0.82% 1.75% 3.12% 16.59% -22.11% hedge fund indices, the CS/
Tremont index is up 3.09%,
HFRX Macro Index -0.70% 1.07% -0.10% -8.78% 5.61% the HFRI is up 3.79% and
HFRX Systematic Diversified Index 0.85% 2.54% 1.95% -9.04% 31.55% Eureka Hedge is up 3.33%
to the end of April. Hedge
HFRX Relative Value Arbitrage 1.34% 1.22% 4.02% 38.47% -37.60%
funds are thus on track, but
Index
their path may be curvy
Source: Hedgefund Research when crises arise.

Investment Outlook - MAY 2010 27

 Asset class:
Real estate

Continued positive signals, but there are

dangers
• Real estate is recovering, but fiscal dangers a Reacting to these sales figures, construction-related shares
threat
• Interest rates are falling, prices are rising
• Bubble tendencies in China
Real estate as an asset class has moved further in the right
direction during the past few months but is not entirely out
of the woods. In the last Investment Outlook (March 2010),
we wrote that it was “time to start cautiously investing in real
estate”. We also did so in some of our portfolios. This illus-
trates that financial investors have begun to view real estate
with different eyes than during the dramatic financial crisis.
took off in US stock exchanges. We should not read too much
into the figures themselves, but the fact that they greatly
surpassed forecasts is a source of hope that the recovery
is stronger than most analysts expect. Granted that 90 per
cent of the US single-family home market consists of existing
homes, but in this sub-market too, March statistics showed a
clear sales increase − the first in four months.
US SINGLE-FAMILY HOME SALES STOP FALLING
1.3 7.5
1.1 6.5
Millions

Millions
0.9 5.5
The banking system is functioning much better again, which
is attracting real estate investors. Funding opportunities are 0.7 4.5
improving, and total risk is lower both for property companies
and those who make financial investments in this asset class, 0.5 3.5
but a reversal for the financial system would adversely impact 0.3 2.5
this asset class. 1990 1995 2000 2005
Existing home sales New home sales
Real estate values have also climbed in many markets since Source: Reuters EcoWin

the beginning of 2010. The consequence has been an easier
world for property companies, which no longer have to worry
about their survival and can instead concentrate on the task
of generating returns. Real estate investment trusts (REITs)
and shares of real estate companies have also performed well.
Property transactions are also showing strength by involving
more countries, which confirms the strength of the upturn.
Surging single-family home sales in the US
In the United States, sales of new single-family homes climbed
27 per cent month-on-month in March, the largest such in-
crease in 47 years. The main reason for the surge in sales was
probably the tax credit of up to USD 8,000 for first-time buy-
ers, provided they signed a contract by April 30 and the whole
transaction closes by June 30. The change from severe winter
weather in February to spring weather in March may also have
benefited sales during the month. Even taking these special
reasons into account, the American single-family home market
seems to be moving towards stabilisation, though at a very
low level of activity.
The market for new and existing single-family homes in the
US is beginning to recuperate, as sales figures are showing.
Two main factors have contributed to this: the economic
recovery and the temporary tax credit.
The number of real estate transactions is continuing to
increase from low levels, confirming the more positive real
estate landscape which began to emerge during the second
half of 2009.
Aside from increasing transaction volume, prices are also
rising. The interest that investors could earn in the wake of
the crisis has previously been very high (and prices thus low),
which was natural. For the past quarter or so, however, various
parts of the market have begun pricing real estate in a new,
higher way. This has resulted in lower interest income for in-
vestors. In practice, this means prices have gone up, and they
are expected to continue rising.

28 Investment Outlook - mAY 2010

 Asset class: Real estate

VOLUME IS RECOVERING WORLDWIDE... early 2011, but it is important to keep an especially watchful
350 eye on interest rate trends.
300
250 In addition, there are clear price-bubble tendencies in certain
USD Billion

parts of the real estate market in China. The Chinese govern-

200
Source: Jones Lang LaSalle
ment has begun to tighten its economic policies, for example
150 by boosting the reserve requirements for banks and taking
100 various other steps to raise market interest rates. The authori-
50 ties are also conveying the message that Chinese state-owned
0 companies − which are not real estate companies − should not
North America Europe Asia build new properties. It remains to be seen how much effect
these measures will have, but if the price trend in portions of
2005 2006 2007 2008 2009 2010*
the Chinese real estate market continues at its current pace,
Measured in volume terms, commercial real estate invest- the measures carried out so far will not be enough. Singapore
ments are rising, though from a low level. Financial investors has introduced a stamp duty, an example of another method
have changed their view of real estate and are now daring to try to keep the price trend in the real estate market under
to enter the market. control.

...AND EUROPEAN MARKETS ARE PICKING UP Mixed market is reawakening

70 Many asset classes have gradually recovered, and this is now
Investments (EUR billion)

60 also true in portions of real estate as an asset class. The proc-

50 ess has been driven by investors who want returns on their
40 capital. To a growing extent, they have regarded real estate
Source: PMA Property Market Analysis
30 investments as a good way to generate low-risk returns. Well-
20 managed properties in good locations have been the focus of
this first investor-led recovery phase, with the result that the
10
prices and loan-to-value ratios for these properties are similar
0
2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 2010
to what we previously became accustomed to. For well-man-
Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 aged properties, the situation can thus be largely considered
as normalised.
Europe UK France Germany

Major European markets are showing largely the same
trend for commercial real estate investments. Ongoing
worries about Greece may, however, affect the credit supply
ahead.
Government finances the greatest risk
But not everything is positive in the real estate market. There
are also dangers. One of these is the risk that countries will
default on their debts. Greece is the country with the big-
gest problems at the moment. If these fiscal worries were to
spread, it would also be negative, probably influencing the
supply of credit via banks or the bond market. Renewed eco-
nomic setbacks would also be negative for real estate. The
same applies to the existing inflation risks, especially in parts
of Asia. Also on the negative side, there is uncertainty about
how big the economic consequences will be when major cen-
tral banks begin tightening their monetary policies, something
that the central banks in such countries as Australia, Norway
and India have already begun to do. In many countries, inter-
est rate hikes will presumably not begin until late in 2010 or
The situation is different for properties that are not well-man-
aged, and in order for this market to normalise, the next phase
of the upturn will need to begin. The world economy must
improve further, and what we want to see above all is that
many countries get unemployment under control. The first
signs of this have also come, but the process may be lengthy
and complex.
In the short term, there are risks when central banks withdraw
their stimulus measures (activate their exit policy), but the
downside for the real estate market is likely to be limited for
investors with a time horizon of a year or longer. In the next
few years, we expect returns that are roughly equal to a nor-
mal long-term return: risk-free interest plus 3-5 per cent.
We have real estate investments that represent a few per cent
of some of our management mandates. We expect to be able
to increase this percentage little by little as the world econom-
ic recovery continues, but considering fiscal uncertainties and
bubble tendencies in China, we are hurrying slowly.

Investment Outlook - MAY 2010 29

 Asset class:
Private equity
Favourable situation for good private equity
• The private equity (PE) market is functioning primary market died out. The sluggishness of the secondary
again
• Increasing supply and attractive prices are
providing good business opportunities
• Despite uncertainty about regulations and
funding, we have a positive view of PE, given capital from their investors.
good quality selection
The world’s financial markets are continuing to normalise. The
existence of the economic recovery is also unquestionable, al-
though its strength − growth dynamic − is open to discussion.
This is good news for the private equity (PE) industry and is
reflected, among other things, in a good index trend for listed
PE companies.
The overall picture in the underlying businesses is also
brighter, but at the same time more complex. Parts of the PE
industry are still grappling with major problems. Many of the
funds/companies that made aggressive, highly leveraged in-
vestments late in the economic expansion are still confronting
difficulties. Meanwhile business opportunities are unusually
good for those investors whose portfolio companies are in
good shape and who have money to invest.
Large obligations in the private equity market
The underlying mathematics is specific to PE investments. As
most people know, PE companies (or funds) make their actual
investments over a period of years. Investors who participate
from the start undertake to deliver money as the fund buys
companies. A fund that started during the peak years 2008-
2009 perhaps had time to make only one or a few company
investments before the crisis hit. This means that many inves-
tors still have large remaining obligations to PE funds.
During the 2009 crisis, large portions of the PE market froze
completely. Almost no new funds were started, and in the
secondary market (trading in existing holdings in and obliga-
tions to PE funds), worldwide volume fell from USD 20 billion
in 2008 to USD 8 billion. It can hardly surprise anyone that the
30 Investment Outlook - MAy 2010
market was not as self-evident, but it was largely because sell-
ers and buyers stood far apart regarding reasonable prices.
Meanwhile not so many investors were under pressure to sell,
since the funds that started in the years just before the crash,
and thus were not yet fully invested, were not active in buying
companies. This meant that they were not collecting more
Various factors behind the brighter outlook
Today the market is rapidly thawing. The funding situation has
brightened considerably. Granted that a larger percentage of
equity is now required, but there is still a lot of “business as
usual” for PE companies. The more positive general economic
picture is another contributing factor behind a resumption
of acquisitions by PE companies and funds. As a result, more
funds are drawing capital from their investors, forcing finan-
cially weak investors to give up previously invested money
when they are not capable of meeting new demands for
capital. This creates a golden opportunity for those who have
capital to invest, assuming good talent for identifying quality
investments. In these cases it is also an advantage to be well-
connected in the PE industry, since some of these holdings do
not reach the broad market.
SECONDARY MARKET TAKING OFF
(billion)
30
25
20
15
10
5
0
2005 2006 2007 2008 2009 2010E 2011E
The secondary market for private equity froze during the
2009 crisis. An unexpectedly rapid recovery is leading to
new record volume, creating good business opportunities.

We pointed out in the last Investment Outlook (March 2010)
that good PE companies often have their best period after a
recession. The same is also true this time around, and perhaps
to a greater extent than usual considering the depth of the
downturn. Listed companies are now carrying out major cost-
cutting on a broad front, which will lead to good operational
leverage once demand takes off, and higher margins will lead
to large profit increases. This also applies to many of the PE
companies’ portfolio firms.
Widespread questions are being raised about company debts,
and this “wall of debt” worries some observers. A record
number of corporate bonds and credits will fall due during
the next few years. Many PE companies have responded to
this with loan extensions, corporate restructuring and other
measures to reduce their sensitivity. In our judgement, the PE
industry is easily capable of handling the situation.
Another storm cloud concerns regulation. Discussions are
underway on both sides of the Atlantic about tightening the
rules for the financial sector, including the PE industry. Not
all proposals will be implemented, but the US government’s
intention to prohibit banks from owning PE investments may
very well become a reality. Since banks own nearly 10 per cent
of American PE investments, this would create supply pressure
that would hurt prices in the secondary market, but it would
also create good buying opportunities for those with capital
to invest.
As we wrote in the last Investment Outlook, it is important to
distinguish between good and bad PE. We are still focusing on
investments that fulfil certain criteria that, in our judgement,
reflect good PE in the prevailing market situation:
• Operational resources to pursue the reform process in attractive investment alternatives in this segment while re-
target companies
• Target companies that have captured market share during
the crisis
• Few problem companies in their portfolio
• "Dry powder” for new investments
SHARP PRICE UPTURNS FOR PE COMPANIES
275
250
225
200
175
Index
150
125
100
75
50
2003 2004 2005 2006 2007 2008
LPX50 TR Index, 2003-01-01 = 100
MSCI World Gross Index, 2003-01-01 = 100
Source: Reuters EcoWin
Asset class: Private equity
“Long-term relationships with local lenders” were previously
another important factor, but this now appears less important
since the credit market has normalised.
As for listed PE, we can state that its price performance has
consistently been good. The LPE50 index has continued its
recovery but has a long way to go before approaching its old
peaks. Meanwhile these companies are continuing to trade
at discounts in relation to their net asset value (NAV). The
average discount is around 30 per cent. This is a substantially
smaller discount than the low point a year ago, but still on a
par with the lowest levels from the previous recession. The
historical average is a discount of less than 10 per cent. It
should also be noted here that the discounts – according to
the companies – are calculated very conservatively. Among
other things, there are often adjustments for any illiquidity.
Large discounts to NAV should shrink
One reason for the continued large discounts may be that
investors mistrust net asset values. As transactions have now
resumed, we see that companies tend to be sold at prices
above the stated (conservative) NAVs. If this trend persists,
NAVs should be accorded greater confidence, which should
justify a smaller discount. Add to this that NAVs should be able
to increase in today’s more positive economic environment.
Our conclusion is thus that there is room for sizeable price in-
creases on listed PE, though with great volatility depending on
the flow of news about possible regulation and other matters.
We also foresee continued very good business opportunities
in the secondary market. As mentioned above, the supply is
likely to grow as PE companies resume their investments and
thus request more capital from investors who in some case
are financially pressed. We are continuing our effort to identify
taining and, in a few cases, enlarging our listed private equity
holdings.
275
250
225
200 Listed PE company indices have climbed
175 sharply since bottoming out last autumn, but
150
during the crash PE companies fell more than
125
the stock market as a whole. These companies
100
have a long way to go before reaching their
75
previous peaks.
50
2009
Investment Outlook - MAy 2010 31
 Asset class:
Commodities

Many forces affecting commodities

• Price setback early in 2010 then spring rally
• Strong association between change in growth in price, and they have also fallen the most during economic
rate and commodity prices
• Market forces pulling in different directions
This year began with sizeable commodity price setbacks due
to concerns related to Greek government finances, economic
tightening measures in China and President Obama’s propos-
als on stricter rules for banks. But during the spring, commodi-
ties again became more expensive, thanks to a strengthening
world economy, supply restrictions in some commodity
segments and higher risk appetite among financial investors.
The price rally was led by industrial metals, especially nickel,
aluminium and copper.
In the short term, both OECD and EM spere growth will ac-
celerate. In itself, this is likely to mean a continued rise in
commodity prices, since history shows that the co-variance
between changes in the growth rate (second derivative) and
commodity prices is strong. During the past decade, this factor
has explained about 40 per cent of commodity price, while the
growth level (first derivative) has been much less important,
with only a 15 per cent explanatory value.
NICKEL the WINNing INDUSTRIAL METAL
800 800
750 750
700 700
650 650
Index
At times of faster economic growth, the most cyclical com-
modities – energy and industrial metals – have risen the most
slumps. Since the turn of the millennium, the standard de-
viation for these commodities has been nearly 40 per cent,
compared to only about 15 per cent for precious metals and
agricultural commodities. So it was not surprising that the
spring price rally was led by a number of industrial metals and
that oil also became considerably more expensive.
Demand for commodities by China − the engine of the world
economy − is currently also continuing to grow. Reflecting
this, the country’s crude oil imports are close to record-sized
and its purchases of copper are growing at a doubled-digit
rate. In the US, the shift to inventory-building will continue for
another while, benefiting the commodities market, and when
this fades the European inventory cycle will also kick in for a
while. Commodities also have a lengthier inventory cycle than
the general cycle, so commodity purchases for stockpiling may
persist for longer.
Chinese tightening measures among risks
Our crystal ball for the commodities market is also showing
risks. High Chinese growth and the accompanying overheating
risks have caused authorities in China to halt various infra-
structure projects and begin tightening economic policies.
There is also concern that growth in the OECD countries will
decelerate as the positive effects of the inventory turnaround
and stimulus measures fade. In addition, the fiscal problems
that are now flaring up risk slamming the brakes effectively on
growth and persuading financial investors to seek less risky
assets. Finally, there are fears that more expensive oil and

600 600
petrol will undermine purchasing power, spoil the mood of
businesses and households and lead to inflation worries in the
550 550
fixed income market and among central banks.
500 500

450 450 These risks do not seem too large, however. Not allowing the
Jan Feb Mar Apr May Chinese economy to rush into overheating is positive, and a
2010 revaluation of the renminbin (yuan) − as one step in China’s
Source: Reuters EcoWin

This spring was characterised by a price rally for industrial cooling-off policy − would in itself also be positive for com-
metals, with nickel as the winner, but in late April there was modities, since imported commodities would then become
a reversal as risk appetite in the markets dwindled. cheaper for the Chinese. Judging from the upbeat messages

32 Investment Outlook - MAY 2010

 Asset class: Commodities

from many leading indicators and the higher forecasts of GDP
growth in various OECD countries (see pages 20-21), the odds
against anything resembling a “double-dip” recession are very
high, although a deceleration in the expansion rate is in the
cards later this year. Gigantic budget deficits and runaway
government debts are indeed a source of significant concerns,
but the harmful effects on OECD growth that these financial
imbalances will cause will mainly occur a bit later.
In the short term, oil prices may very well climb in response
to continued high Chinese demand, the approaching high
season for driving in the US and the closure of some produc-
tion capacity in the North Sea due to maintenance work.
During the second half of 2010, prices are likely to be in the
USD 70-80 per barrel range. Factors pointing in this direction
include a minor slowdown in growth and commodity demand
in the OECD countries and high oil production as well as re-
serve capacity and large oil stockpiles. An unexpectedly rapid
increase in Iraq’s oil production would constitute a downside
risk. Within the energy mix, natural gas prices are likely to fall
substantially as a consequence of sharply increased supply in
the US.
will prop up demand for gold. In order for the price to climb
further, however, it will probably be necessary for the yuan to
undergo a revaluation (probable) and/or for the US dollar to
weaken (less probable). Platinum and palladium, which are
mainly produced in South Africa − where competition for en-
ergy will increase this June and July due to the football World’s
Cup, which may disrupt metal production − continue to have
the best outlook. Meanwhile demand for these metals from
the automotive industry will continue to increase.
Prices of agri-commodities may fall further this summer and
early autumn, and it is difficult to be optimistic about maize
(corn), wheat and soya beans, despite currently low price lev-
els. But in a slightly longer time frame, prospects will improve
somewhat, due among other things to increased ethanol pro-
duction from maize and greater demand for meat as well as
animal feed as a consequence of global economic recovery.
A WELL-LUBRICATED OIL MARKET
150 150
125 125
100 100
USD/Barrel

Price rally for industrial metals interrupted

During the spring, industrial metals benefited from strong 75 75

demand from end-users both in the OECD countries and the 50 50

EM sphere, as well as shrinking metal stocks and strikes and
operational problems at mines. Late in April, however, there 25 25
was a sharp correction. Decelerating growth in the OECD is 0 0
one reason to argue that industrial metal prices will not climb 2000 2002 2004 2006 2008 2010
during the second half of 2010. There is an upside chance for Source: Reuters EcoWin

copper and a downside risk for nickel. In April, oil prices rose to around USD 85 per barrel. After a
decline in May, they may rebound due to such factors as the
Low real interest rates, Chinese demand, the Indian wed- American driving season. In a longer perspective, prices will
ding season, global financial risks and central bank demand probably be in the USD 70-80 range.

AGRI-COMMODITIES LAGGING BEHIND

3500 3500

3000 3000

2500 2500

2000 2000
Index

1500 1500 Many commodities have risen in price during

the past year, mainly thanks to the global
1000 1000
economic recovery, the need for inventory-
500 500 building and very high demand from China.
While precious metals, energy and industrial
0 0
2000 2002 2004 2006 2008 2010 metals have performed strongly, prices of agri-
cultural commodities have not kept pace. A bit
S&P/GSCI Agricultural TR S&P/GSCI Energy TR
S&P/GSCI Precious Metals TR further ahead, however, the agri-commodities
S&P/GSCI Industrial Metals TR
Source: Reuters EcoWin sector may do better.

Investment Outlook - maY 2010 33

 Asset class:
Currencies

Fundamentals determining exchange rates

• Greece’s financial problems continue to weigh credit crisis. The market totally lost confidence in Greek crisis
down the euro
• German exports are benefiting from the
weaker euro
• Asian currencies are on their way up
In the last issue of Investment Outlook (March 2010), we
predicted that the fundamental strengths of countries and
currencies as well as market players’ utilisation of interest rate
differentials would become more influential driving forces in
the foreign exchange market. Since then, developments have
been consistent with this forecast. Currencies connected to
countries with weak government finances and where interest
rate hikes are not imminent have continued to weaken, while
we have seen an upswing for currencies in well-managed
countries where interest rates are about to be raised. At
present, there is no reason to believe that these trends will be
reversed.
Krona will remain strong
The prevailing foreign exchange market climate benefits
the Swedish krona. The Swedish economy is in good health
and Sweden can boast the smallest budget deficit and the
largest current account surplus as a percentage of GDP in
management. Meanwhile there were major concerns about
contagious effects on other southern European countries.
In response, the EU and the IMF approved an emergency
package totalling EUR 750 billion. This is about twice as large
as Sweden’s annual GDP. The European Central Bank also
approved supportive purchases of government securities in
countries that the market mistrusts.
Although an acute crisis has been avoided, Greece remains
in the same difficult situation. The country is facing painful
economic austerity measures, and the path towards financial
balance will be long, winding and arduous. The market is scep-
tical as to whether Greece will be capable of implementing
the necessary belt-tightening and reforms. Making the task of
reform more difficult is massive discontent among the general
public, manifested in numerous strikes. The final act of the
Greek drama is far from being written, and the country’s prob-
lems will have a long-term impact on market risk appetite,
interest rates and the euro.
DWINDLING CONFIDENCE IN GREECE
13 13
12 12
11 11
10 10
9 9
Per cent

the European Union. The krona is also benefiting from the 8 8

global recovery, which is boosting demand in other countries 7 7
for Swedish goods and services and thus also demand for 6 6
Swedish kronor. Exports are equivalent to more than 50 per 5 5
cent of Sweden’s GDP. The Riksbank is also expected to hike 4 4
3 3
its key interest rate at a faster pace than most other central
1998 2001 2004 2007
banks, and this also adds to the attractiveness of the krona.
The krona should appreciate substantially against the euro Source: Reuters EcoWin

The Greek government’s borrowing costs remain high, but

due to the systemic crisis in the euro zone. Our forecast is that
its bond yields have fallen drastically since the recent EUR
the krona will strengthen to SEK 9.00 per euro by year-end
750 billion emergency package was announced. The chart
and to SEK 7.20 against the US dollar by year-end.
shows yields on 10-year Greek government bonds.
Greek crisis weighing down the euro
The first week of May was dominated by a financial panic
unlike anything we have seen since the worst phase of the

34 Investment Outlook - may 2010


Weak euro fuelling German stock market
While Greece is hovering on the edge of bankruptcy, Germany
has sound government finances and a current account sur-
plus. A well-equipped Germany can take advantage of the
favourable conditions resulting from a weak euro. The falling
currency makes German goods and services cheaper for non-
euro zone consumers and businesses, benefiting German ex-
ports. The export sector is equivalent to about 45 per cent of
Germany’s GDP, and about 60 per cent of this is sold outside
the euro zone. The positive impact on the German economy
is thus sizeable. Another consequence of the declining euro
is that German companies have become cheap in the eyes
of non-euro zone investors. This may attract foreign capital,
which would benefit the German stock market.
DAX IS CHEAP FOR AN AMERICAN
107.5
105.0
102.5
100.0
97.5
95.0
92.5
90.0
87.5
85.0
Jan Feb Mar Apr May
2010
DAX index in EUR (2010-01-01 = 100)
DAX index in USD (2010-01-01 = 100)
Source: Reuters EcoWin
Germany’s DAX stock market index is roughly unchanged
since the beginning of 2010, but in US dollar terms German
companies have become significantly cheaper.
Even though the euro system has begun to sputter, so far this
year the German stock market has yielded good returns that
have been clearly better than in stock markets in many other
euro zone countries. A Greek collapse would decrease overall
risk appetite and hurt stock markets worldwide – including
Germany. But if the budget crisis only results in a weak euro
and helps keep the ECB’s key interest rate at a low level for a
long time, this scenario will also continue to benefit Germany
exporters and − ultimately − the German stock market.
Chinese currency will be revalued
Today it is not a question of whether but of when Chinese
authorities decide to begin their revaluation of the renminbin,
or yuan (CNY). In the last two issues of Investment Outlook,
we argued that there are both global and domestic Chinese
reasons for the CNY to appreciate. For the world economy, it
is a matter of reducing global trade imbalances, and for China
of reducing export dependence and instead stimulating the
domestic economy. A revaluation of the CNY will occur on
China’s terms, however, since it is clear that Chinese authori-
ties strongly resent the opinions of other countries about their
currency policies. At the G20 meeting in Washington in April,
Asset class: Currencies
there was total silence on the infected currency issue, itself an
indication that the date when a gradual appreciation of the
CNY will begin is drawing closer. Our forecast is that the CNY
will appreciate 5 per cent against the US dollar by year-end
and an additional 10 per cent during 2011.
Like China, most other Asian countries control the value of
their currencies to ensure that their exports remain competi-
tive. This occurs by means of foreign exchange market inter-
ventions by the respective central bank. A revaluation of the
CNY would also increase revaluation pressure on these other
Asian currencies, since it is unlikely that other central banks
will be able to resist a foreign exchange market positioned
for Asian currency appreciations. There is also less incentive
to keep their currencies weak when the purchasing power in
China − the most important export market for these countries
− rises due to a stronger CNY.
107.5
105.0 CNY REVALUATION WILL BEGIN SOON
102.5
100.0 9 9
97.5 8 8
95.0 8 8
92.5 8 8
90.0 8 8
USD/CNY
87.5 7 7
85.0 7 7
7 7
7 7
6 6
6 6
2004 2006 2008 2010
Source: Reuters EcoWin
A revaluation of the Chinese renminbin or yuan (CNY) is
drawing ever closer. A stronger CNY would help cool off the
overheated Chinese economy and ease global trade imbal-
ances.
Investment Outlook - maY 2010 35
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