Global Investing: Where We Are and How We Got Here June 11, 2007
Page 1
The Long and the Short of It • It is different this time. There have been fundamental changes in economies • This has driven profound shifts in investor behavior • Markets and valuations reflect this • What can you do about it?
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It is Different This Time • The Great Moderation • Globalization and the spread of economic liberalism • Demographics • Technology
Page 3
The Great Moderation: Growth and Inflation Economic volatility plunged at the start of the 1980s
Volatilty of Real GDP Growth and Inflation (rolling 20 quarter standard deviation) 3.0 2.5 2.0 1.5 1.0 0.5 0.0 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 Inflation (GDP deflator)
1. Data as of April 2007. Page 4
Real GDP
Source: Reuters EcoWin
Structural Changes in Emerging Markets Increased Current Account and Lower Debt
3.0
7.0
45
2.0
6.0
40
1.0
5.0
35
0.0
4.0
-1.0
3.0
-2.0
2.0
20
-3.0
1.0
15
-4.0
0.0 2001
2002
2003
2004
2005
Fiscal Balance (Rhs)
25
2000
2001
2002
2003
Foreign debt (% of GDP)
2004
2005
2006E
2007F
2008F
External debt-service ratio (% of exports)
Real GDP growth
Source: Central Banks, Ministries of Finance
Source: International Monetary Fund, World Economic Outlook
Domestic Public Debt and Inflation
Investable Universe: Local Yield Curves
85
7.5
75
6.5
11.0 10.5 10.0
65 5.5 55 4.5
9.5
45 3.5
Percent
Percent of GDP
30
2006E 2007F 2008F
35
9.0 8.5 8.0 7.5 7.0
25
2.5 2002 2003 2004 2005 Domestic Share in Public Debt
2006E 2007F Public Debt
2008F
Inflation (Rhs)
Source: IMF, World Economic Outlook 1. Data as of December 29, 2006. Weighted average of 25 emerging economies. Page 5
Percent
50
Percent
8.0
2000
Increase is not just at the aggregate level but is consistent at the country level too
External Performance
4.0
Percent
Stricter monetary and fiscal policies, and robust trade flows in a commodity driven environment have led to strong current account surpluses and foreign – exchange reserves
Real GDP Growth and Fiscal Policy
Percent of GDP
Emerging Markets are in much stronger economic health than a decade ago
6.5 6.0 1Y
3Y Mexico
5Y
7Y South Africa
Source: IMF, World Economic Outlook
10Y Indonesia
20Y
How Investing Has Changed • The internationalization of portfolios • The rise of the official investor • Derivatives and financial engineering • New approaches to investing – Shifting from accounting-based to risk-based investment guidelines – Liability-driven mandates – Absolute return strategies
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Cross-Border Financial Flows Have Surged Increased gross flows are a strong sign of increased market integration
Gross U.S. Capital Flows as a Percent of GDP (sum of inflows and outflows) 22.5 20.0 17.5 15.0 12.5 10.0 7.5 5.0 2.5 0.0 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 Source: Reuters EcoWin
1. Data as of April 2007. Page 7
The Cash Piles Up at Central Banks Foreign Exchange Reserves in Asia (China, Hong Kong, India, Japan, South Korea, Taiwan, Thailand)
Reserves also are growing rapidly in commodity exporting countries
3.00 2.75
Investment of these funds remains very conservative
2.50 $ Trillion (thousand billions)
2.25 2.00 1.75 1.50 1.25 1.00 0.75 0.50 96
97
98
99
00
01
02
03
04
05
06
07
Source: Reuters EcoWin 1. Data as of April 2007. Page 8
The Inexorable Advance of Derivatives New types of derivative, and broader use, are driving volumes higher Credit default swaps are the latest drivers of growth
Gross Notional Value of OTC Derivative Contracts ($ bil.) 400000
350000
300000
250000
200000
150000
100000
6
5
0 0 .2 n
J u
D e
c
.2
0
0 0
5
4 .2 0 n J u
D e
c
.2
0
0 0
4
3 .2 0 n J u
c
D e
n J u
.2
0
0 0
3
2 .2 0
0
.2 c
D e
n J u
1. Source: Bank for International Settlements. Data as of December 2006. Page 9
0 0
2
1 .2 0
0
.2 c
.2 0
D e
n J u
0 0
1
0 0 0
0
c .2
n J u
D e
.2 0
9
0
9 9
9 9
.1
.1 9 n
J u
D e c
8
9 9
9
.1 c
n J u
D e
.1 9
0
8
50000
Uses and Misuses of Derivatives • Financial derivatives can allow more efficient management of risk • Financial derivatives can be used to concentrate risk and avoid regulation • Financial derivatives can diversify risk and enhance stability • The resilience of the financial system to large shocks is untested • Investors not allowing derivatives are penalized
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An Expanding Menu of Investment Choices There is a varied assortment of alternatives that fit the bill Asset Class
Strategy / Universe
Implementation
Commodities
Broad universe including energy, metals, agriculture
Futures
Emerging Markets Debt
Bonds issued by governments and corporates in developing economies
Funds
Private Equity
Direct equity stakes in private companies (venture capital, buyouts, distressed)
Funds
Hedge Funds
Generally unconstrained investment funds
Funds
High Yield Debt
Non-investment grade bonds (ratings BB+ and below)
Funds
Real Estate
Both direct listed real estate investments (e.g., REITS)
Funds
Senior Loans
Purchase of companies’ senior debt (through syndication, securitization)
Funds
Currency
Long/Short strategy seeking absolute return through currency trading
Funds
Long/Short Strategies
Market Neutral / GTAA
Funds
Volatility
VIX Index – priced off volatility in equity index derivatives
Futures and Swaps
Infrastructure
Investment in public goods and services (e.g., toll roads, water, communication systems)
Funds
Emissions
Investment in newly established EU carbon dioxide emissions permits
Futures
Freight
Investment in freight capacity for worldwide shipping
Futures and Swaps
Convertible Bonds
Hybrid equity/bond asset
Funds
Others...
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Relaxing Traditional Guidelines • Traditional portfolio guidelines have been based on accounting measures of risk and tight style boxes. Examples: – No high yield bonds – No negative currency exposures • The “new mainstream” relaxes accounting constraints and puts limits on overall risk: VaR 200, or 100 basis points tracking error • Limited hedging/short positions are allowed (130/30 strategies) • This should work – but will it?
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Liability Driven Investing: Why • The surplus of a pension plan equals its assets less the present value of its liabilities • The value of liabilities is inversely related to interest rates and positively related to inflation • Regulators and corporate Treasurers want to minimize shortfalls and volatility in fund surpluses
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Liability Driven Investing: How • The plan invests in a portfolio designed to earn a high absolute return, holding equities, cash, and various alternatives • The plan “buys” exposure to long term interest rates or inflation through a swap or other derivative contract • The result is a portfolio that will track the value of plan liabilities as interest rates and inflation vary • Ideally, the portfolio will earn enough to exceed the cost of the swap, and limit contributions from the plan sponsor
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Absolute Return Investing • What do you do if you don’t have explicit liabilities? • Throw the benchmark away. Buy illiquid, private, non-traditional securities • A successful approach that has gone too far?
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Implications for Markets and Prices
• The carry trade in foreign exchange • The bubble in bonds • Equities appear relatively cheap • The collapse in volatility and risk premiums • Correlations increase: the myth of diversification
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Euro/Yen Driven to Unprecedented Levels The real Yen/Euro relationship has moved beyond historic ranges
Real Euro versus Yen
1. Data as of March 2007 Page 17
The Bubble in Bonds: Real Yields Below Growth Real bond yields are unusually low relative to global growth
Real Bond Yields and Global Growth This means attractive terms for borrowers and poor returns for lenders
8 7 6 5 4 3 2 1
Global Real GDP Growth (IMF-PPP)
20 08
20 06
20 04
Global Real GDP Growth (IMF-Mkt)
Real US 10-yr Treasury Yield
1. Source: IMF, Reuters/EcoWin, and Morgan Stanley Investment Management. Data as of April 2007. Page 18
20 02
20 00
19 98
19 96
19 94
19 92
19 90
19 88
19 86
19 84
19 82
19 80
0
The Bubble in Bonds: Equities Yield More Earnings Yield and Government Bond Yield It’s unusual for equities to yield more than bonds
17.5
Earnings should grow with the economy; bond coupons are static
15.0 12.5
Percent
The implied equity risk premium is wide
10.0 7.5 5.0 2.5 0.0 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 Earnings yield - S&P500 United States, Government Benchmarks, Bid, 10 Year, Yield, End of Period, USD Source: Reuters EcoWin 1. Source: IMF, Reuters/EcoWin, and Morgan Stanley Investment Management. Data as of April 2007.
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Interest Rates Vanishing Volatility 10-Year Basis Point Volatility1 Data as of March 30, 2007
Interest rate volatility is extremely low and vulnerable to a rebound
118
104
91
Source: Citigroup Global Markets and Morgan Stanley Investment Management 1. Annualized implied volatility of a three-year option on a ten-year interest-rate swap. Orange lines denote a one standard deviation band. Page 20
High Yield: Spreads vs. US Treasury Bonds High yield credit spreads are very tight as compared to historical levels
STW, CSFB High Yield Index Data as of March 31, 2007
March 31, 2007 = 316
Source: CS First Boston
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Hedge Funds – Too Popular? The amount of money flowing into hedge funds is causing concern that it will lead to lower returns.
Annualized Alpha Hedge Fund Index vs MSCI World
35.0% 30.0%
Over the last ten years we have indeed seen some alpha erosion for the hedge fund universe as a whole, but there is still positive alpha to be found
25.0% 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% -15.0% Jul-94
12-Month Rolling
Jul-96
Source: MSIM. Data through December 2006.
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24-Month Rolling
Jul-98
Jul-00
60-Month Rolling
Jul-02
Since Inception
Jul-04
Jul-06
Higher Correlation in Hedge Fund Returns It is not so much the alpha, but rather the higher correlations that are the problem for the hedge fund universe overall.
Annualized Correlation Hedge Fund Index vs MSCI World
1.00 0.90 0.80
Recent observations put correlations at or near all-time highs.
0.70 0.60
This means that it is very important to find the right kinds of hedge funds!
0.50 0.40 0.30 0.20 0.10 0.00 Jul-94
Jul-96
12-Month Rolling
Jul-98
Source: MSIM. Data through December 2006.
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Jul-00
24-Month Rolling
Jul-02
60-Month Rolling
Jul-04
Since Inception
Jul-06
What Investors Can Do • KISS • Recognize that fundamentals are good and expected returns are low • Don’t try to forecast the turning point • Protect your liabilities and search for genuine diversification
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