Paul O'Brien June 1007

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?

Page 2

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

Page 6

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

Page 10

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...

Page 11

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?

Page 12

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

Page 13

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

Page 14

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?

Page 15

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

Page 16

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.

Page 19

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

Page 21

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.

Page 22

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.

Page 23

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

Page 24