Investment Outlook - SEB

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PRIVATE BANKING • INVESTMENT STRATEGY

Investment Outlook Anatomy of the recovery Market view and portfolio strategy December 2009

Contents

Introduction..................................................................................................................................................3 Summary.......................................................................................................................................................4 Portfolio strategy.........................................................................................................................................6 Theme: Anatomy of the recovery...............................................................................................................9 Theme: The influence of exchange rates on investments....................................................................12 Theme: Commodity producers vs. commodities................................................................................... 14 Macro summary.........................................................................................................................................16 Asset classes: Equities........................................................................................................................................................18 Fixed income.............................................................................................................................................. 21 Hedge funds...............................................................................................................................................24 Real estate..................................................................................................................................................26 Private equity..............................................................................................................................................28 Commodities..............................................................................................................................................30 Currencies...................................................................................................................................................33

1

Investment Strategy

This report was published on December 8, 2009. Its contents are based on information and analysis available before November 23, 2009. Hans Peterson Global Head of Investment Strategy

+ 46 8 763 69 21

[email protected]

Lars Gunnar Aspman Global Head of Macro Strategy

+ 46 8 763 69 75

[email protected]

Rickard Lundquist Portfolio Strategist

+ 46 8 763 69 27

[email protected]

Victor de Oliveira Portfolio Manager and Head of IS Luxembourg

+ 352 26 23 62 37

[email protected]

Carl Barnekow Global Head of Advisory Team

+ 46 8 763 69 38

[email protected]

Reine Kase Economist

+46 8 763 6973

[email protected]

Liza Braaw Communication

+46 8 763 6909

[email protected]

This document produced by SEB contains general marketing information about its investment products. Although the content is based on sources judged to be reliable, SEB will not be liable for any omissions or inaccuracies, or for any loss whatsoever which arises from reliance on it. If investment research is referred to, you should if possible read the full report and the disclosures contained within it, or read the disclosures relating to specific companies found on www.seb.se/disclaimers. Information relating to taxes may become outdated and may not fit your individual circumstances. Investment products produce a return linked to risk. Their value may fall as well as rise, and historic returns are no guarantee of future returns; in some cases, losses can exceed the initial amount invested. Where either funds or you invest in securities denominated in a foreign currency, changes in exchange rates can impact the return. You alone are responsible for your investment decisions and you should always obtain detailed information before taking them. For more information please see inter alia the simplified prospectus for funds and information brochure for funds and for structured products, available at www.seb.se. If necessary you should seek advice tailored to your individual circumstances from your SEB advisor. Information about taxation As a customer of our International Private Banking offices in Luxembourg, Singapore and Switzerland you are obliged to keep informed of the tax rules applicable in the countries of your citizenship, residence or domicile with respect to bank accounts and financial transactions. SEB does not provide any tax reporting to foreign countries meaning that you must yourself provide concerned authorities with information as and when required.

2

Introduction

2010 a year of growth – with old and new trends After a traditional cyclical upturn over the next few quarters, economic acceleration risks faltering, yet many investors are likely to find risky market segments attractive. The weaker dollar may give US exporters an unexpected boost, and further surprises await. Share prices may be approaching a point where the upturns that began last spring will be followed by a period of sideways “range trading”. Valuations in most stock markets are consistent with economic growth expectations and are thus reasonable, but we cannot rule out that macroeconomic forecasts will be revised a bit further upward.

Positive changes in the economy, together with good liquidity, can do wonders for the prices of various assets. During 2009 the value of equities, certain commodities and corporate bonds have undergone a vigorous upswing. Hedge funds and private equity have also benefited greatly from the new economic climate. This market trend is now continuing, supported by government stimulus measures.

Government bond yields have hit bottom. They will trend upward in the coming months, but this will not happen quickly. Since last spring, corporate bonds have been fantastic investments. There are many indications that High Yield bonds in particular will continue to generate good returns as yield spreads between government and corporate bonds shrink further.

The change in the momentum of the economy – not its level – determines market trends. Indeed, the United States is struggling with major economic problems, and parts of Europe face their own troubles. This will affect markets for a long period, but their direction is positive. Most indicators are past their lows, and the strengthening of global industrial production is having a favourable impact on markets. Powerful stimulus policies are helping drive both economies and markets, but in a longer perspective they may increase worries about financial bubbles. At present, there is little such risk – asset valuations are not alarming – except in semi-isolated economies such as Hong Kong.

Potential surprise factors Tensions are rising in the foreign exchange market. Due to “carry trading” (low-interest borrowing in the US and investments in high-interest countries), the US dollar is falling in value even though saving is increasing in the US and the country’s foreign trade balance is improving. An undervalued dollar will give American companies an excellent international competitive position, which may turn out to be a surprise factor during 2010.

Fairly good market climate The world will probably experience a more or less traditional cyclical upturn in the next few quarters, characterised by gradually better growth. After that economic acceleration risks faltering, among other things when governments launch their exit policies, which means that their massive bail-out and stimulus measures will start fading into the sunset. The market climate nevertheless looks set to be fairly good.

There are many indications that we are on the threshold of an interesting year. Surprises are likely to happen. Although we do not foresee any danger of inflation, inflation expectations may rise, altering the scenario now visible in our crystal ball. But not all surprises need to be negative… Hans Peterson, CIO Private Banking and Global Head of Investment Strategy

In 2010 both old and new trends will unfold. Growth rates will of course vary between countries and regions, but the global economy will continue to recover. For many investors, this means that putting money into risky market segments will appear attractive. 3

Summary

Expected 1-yr

Reasoning

return

risk

8%

20%

Wait-and-see/Positive. GDP forecasts are being revised upward, which should soon become visible in corporate sales (“top-line growth”). Risk of sideways trading when the market focuses on worries about exit policy, perhaps as soon as this spring.

Fixed income

5.5%*

8%

Wait-and-see/Positive. Central banks are balancing between economic stimulus and the risk of financial bubbles. In emerging markets, central banks will raise key interest rates as early as this winter, well before most OECD countries. The room for price increases on Investment Grade bonds has greatly decreased, but there is still potential for High Yield bonds.

Hedge funds

6%

5%

Positive. Continued favourable conditions for hedge funds in terms of market normalisation and better liquidity. We are positive towards Macro, Distressed and Fixed Income strategies, more neutral towards Equity Long/Short and Event Driven ones. Continued emphasis on high-quality managers.

Real estate

2%

3%

Wait-and-see. Bright spots include somewhat rising volume, slowing price declines on commercial properties and high returns. But problems remain, including a large number of unsold and unrented homes. Risk is still greater than potential.

Private equity

15%

22%

Wait-and-see/Positive. As the economy continues to recover, this asset class makes increasing sense. The secondary market is still the most attractive, but the discount has narrowed. Financing remains a problem for both sellers and buyers.

Equities

Commodities

10%

20%

Wait-and-see/Positive. Continued USD weakness will cause commodity prices to rise. Further ahead, global imbalances between supply and demand are arguments in favour of this asset class. Commodities offer an attractive element of inflation protection, but under today’s conditions they should provide good returns regardless of inflation.

Currencies

5%

3%

Positive. The USD is being squeezed by low interest rates and good risk appetite, while currencies of emerging market and commodity-producing countries should benefit. Pressure from other countries will probably persuade China to let the yuan rise in the coming year.

* Expected return on corporate bonds that are weighted 1/3 Investment Grade and 2/3 High Yield. Change in our expected returns

Real estate

0%

5%

10% 15% Expected volatility

20%

25%

30%

Hedge funds

Currencies

Commodities

8% 6%

Real estate Fixed income

4%

Hedge funds

Historical return

2%

Commodities

0%

Real estate

Historical correlation (December 31, 1999 to October 31, 2009) Equities

Historical risk and return (December 31, 1999 to October 31, 2009)

Fixed income*

Private equity

Currencies

Equities

1.00

Fixed income

-0.02

1.00

Hedge funds

0.36

0.23

1.00

Currencies

0%

Equities

Commodities

-2%

Private equity

2%

Fixed income*

Real estates

Currencies

4%

2009/12

Equities

Hedge funds

6%

2009-08

Commodities

8%

Hedge funds

Expected return

10%

2009-05

12%

2009-02

Private equity

14%

2008-11

16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4%

16%

Fixed income

Expected risk and return (1 year horizon)

-2% Equities

-4% -6%

Private equity

-8% -10% 0%

5%

10%

15% 20% Historical volatility

25%

30%

Real estates

0.74

-0.09

0.23

1.00

Private equity

0.82

-0.18

0.31

0.80

1.00

Commodities

0.27

-0.10

0.28

0.21

0.31

1.00

Currencies

0.14

0.68

0.49

-0.02

-0.07

0.00

35%

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 Global. Private equity = LPX50. Commodities = S&P GSCI TR. Currencies = BarclayHedge Currency Trader (last observation September 2009, for October data we have used the SEB Multi-Manager Currency Fund).

4

Summary

Weightings in the Modern Aggressive portfolio

Weightings in the Modern Protection portfolio Equities

0%

Real estate

0%

Private equity

0%

Commodities

0%

22.5%

Hedge funds Real estate

0% 7.5%

Private equity

9%

Commodities

5%

Currencies

Currencies

2%

Cash 0%

10%

20%

30%

40%

50%

1%

60%

70%

80%

90%

0%

10%

30%

40%

Current

Rolling correlations (36 months vs. MSCI World)

22.5%

Equities

20% Previous

Current

Weightings in the Modern Growth portfolio

Source: Bloomberg/EcoWin

1

Fixed income

30%

0.8

Hedge funds

30%

0.6 0.4

0%

0.2

2.5%

Private equity

0%

Cash

Previous

Real estate

30%

Fixed income

10%

Hedge funds

30%

Equities

83%

Fixed income

0

Commodities

5%

-0.2

Currencies

5%

-0.4

Cash

5%

-0.6

0%

2002 10%

20% Previous

30%

40%

2003

2004

Fixed income Private equity

Current

2005

2006

Hedge Commodities

2007

2008

2009

Real estate Currencies

The chart shows how equities correlate with other asset classes over time, on a rolling 36 month basis.

In the spotlight •

Anatomy of the recovery – A continued cyclical upswing this winter will provide a favourable financial investment environment for another while. After that, be prepared for somewhat choppier markets as accelerating growth levels off, due to the launch of exit policies and the fading positive impact of the inventory cycle.



USD performance – The dollar is affected by both risk appetite and global liquidity flows. A weak dollar should benefit the global recovery and American exporters can take advantage of the situation.



Commodities vs. commodity producer shares – Long-term global imbalance between commodity supply and demand will benefit this asset class. In some cases, commodity shares may be a better form of exposure than futures. There is also currently a leveraging mechanism for commodity producers: after major cost-cutting there is room for potentially strong profits even on marginal recovery in demand.

Theme: USD will help rescue US economy 40

-15

350

350

-10

300

300

250

250

200

200

150

150

100

100

50

50

-5

30 20

0

10

5

0

10

-10

0

15

-20 -30

Index

Percentage change y/y

50

Percentage change y/y

60

Theme: Commodity producers interesting

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

20

2005

2006

2007

2008

2009

0

GSCI, Energy Index, Total Return [rebase 2005-01-01 = 100.0] Standard & Poors, Global 1200 Industry, Energy Equipment & Services, Index, Total Return [rebase 2005-01-01 = 100.0] GSCI, Energy Index, Spot Return [rebase 2005-01-01 = 100.0] Source: Reuters EcoWin

Earnings for exporters (LHS) Trade-weighted USD (RHS, inverted) Source: BEA, Federal Reserve

For certain commodities, shares of commodity companies may provide better exposure to actual price changes in the underlying commodity (page 14).

A weaker dollar benefits American exports, making US export companies attractive (page 12).

5

Tema: 1 strategy Portfolio

Preparing for a slightly bumpier road Corporate bonds still have room to generate good returns. Meanwhile convertible debt instruments provide an attractive option on potential continued share price increases. We are keeping the same weighting for equities in our portfolios but are lowering their risk level. We expect commodities to make a positive contribution, while our view of government bonds remains negative due to the prospects of rising government yields. For the time being, we are holding off on investments in the real estate market. We have chosen to replace portions of our IG holdings in the Growth portfolio and the entire IG holding in the Aggressive portfolio with convertible debt instruments, which deliver only slightly lower underlying interest rates and provide an attractive option on potential continued increases in share prices. In HY bonds, we foresee good opportunities for further narrowing of yield spreads, and the underlying interest rates remain high. On the margin, we are increasing the proportion of HY bonds in our Aggressive portfolio at the expense of IG bonds.

So far, the strategy in our Modern investment programmes has been based on projections of a gradual improvement in macroeconomic conditions, as well as a normalisation of the corporate bond market. Our holdings of Investment Grade (IG) bonds and High Yield (HY) bonds have continued to deliver very high risk-adjusted returns, and these assets have made a respectable contribution to the good performance of our portfolios. In the IG segment, however, we are now adjusting our expected return downward, since room for continued declines in yield spreads (yields compared to those of government bonds) on IG bonds has rapidly narrowed, while underlying effective interest rates have fallen to a level that is less attractive when adjusted for risks.

There is a risk that the current acceleration in the world economy will be followed by more or less level growth, starting in the latter part of 2010. To reflect this, we have made certain changes within the equities asset class in our growth-oriented portfolios.

Modern Protection This portfolio has the explicitly stated aim of delivering a return that exceeds risk-free interest with very limited risktaking. This requires that the portfolio should consist predominantly of fixed income investments. The problem with the shortest-term, safest fixed income securities is their historically low nominal interest rates. Our view of government bonds remains negative, and we avoid climbing too far out on the yield curve − in order not to suffer falling prices on bonds with long maturities, which are the most sensitive to changes in inflation expectations.

our limited exposure in these segments of the bond market, since other alternatives with greater potential do not match our risk and return ambitions. We are making no changes in the hedge fund portion of the portfolio but are sticking to our market neutral strategies, which together have delivered a positive return at very low risk. Our exposure to foreign exchange markets is still having difficulty in delivering high returns, but the risk level in our investment has not increased and the correlation with our other holdings is low. The total volatility of the portfolio thus benefits from our currency holding, which we are choosing to keep intact.

IG and HY corporate bonds still offer the best protection in such a scenario, in the form of higher yields than the equivalent government bonds and potential for continued declining spreads, mainly in HY bonds. We are retaining 6

Portfolio strategy

As the liquidity situation in financial markets normalises, there is reason to increase the proportion of fixed income funds with “cash plus” and “total return” strategies. This is a way for us to assign limited risk mandates to recognised managers with strong track records. Products offered by new managers have met the criteria in our selection process and will supplement our earlier holdings, which have delivered satisfactory benchmark-beating returns.

2% 5% 10%

83%

Cash Currencies Hedge funds Fixed income

Modern Growth We are also making various changes in the hedge fund portion of the portfolio. We are increasing the total element of hedge funds in the portfolio and funding this by reducing exposure to IG bonds. We are also adding new funds. We are reducing the role of Market Neutral and Equity Long/Short in favour of a broader portfolio consisting of Multi Strategy, CTA, Macro and Fixed Income. We are thus reducing overall correlation with the stock market.

If our ambition is to deliver equity-like returns over time, but with lower risks, it is a clear advantage not to use a traditional benchmark index. This increases our chances of continually looking for returns outside the stock market. We have benefited greatly from the fact that last spring, corporate bonds as an asset class were incorrectly priced, which was due to a liquidity shortage rather than fundamental factors. Our investment decision was based on the fact that effective yields when we launched our Modern investment programmes were approaching 18 per cent, rather than on a strong conviction about shrinking yield spreads triggering a surge in corporate bond prices. Even if yield spreads had not moved, our annual returns would still have ended up at levels far exceeding the historical return in stock markets.

We are still holding off from investing in the real estate market. Although portions of this market are showing signs of healing, the overall picture is still not good enough for financial investments in real estate. Other asset classes offer better potential returns in relation to risk.

Continued positive contribution from commodities

We are continuing to evaluate expected returns in our seven asset classes and are now reviewing our IG corporate bond holdings. The market has normalised, and yield spreads have shrunk to the levels prevailing before the Lehman Brothers bankruptcy in September 2008. The yields remain attractive compared to those of government bonds, but since we are seeking equity-like returns we foresee considerably larger yield potential in convertible debt instruments. Their underlying interest rates are not much lower than on IG bonds, and convertible instruments have a substantially larger upside potential in case of a continued stock market rally. We are thus choosing to reduce our IG bond holdings in favour of global convertible securities funds and stepped-up exposure to the HY segment.

As an asset class, commodities are continuing to contribute positively to the total portfolio. The alpha-generating nature of our holdings has delivered positive returns, both in relation to the commodities market and in absolute numbers. We are keeping our current exposure. In the private equity and currency asset classes, we are keeping our current weightings of 2.5 and 5 per cent, respectively, while intensifying our search for supplementary investments. In private equity, we are looking for less volatile investments in the secondary market, and in currencies we are looking for something with a slightly higher expected return – even if this implies a tad higher risk. The correlation with other asset classes is low and thus does not raise the total risk in the portfolio.

Increased exposure to mature markets Since our risk has increased somewhat in the fixed income portion of the portfolio, we are also making some adjustments in the equities portion. We foresee a risk that the acceleration in the global economy may be followed by a levelling off of growth. We are thus choosing to reduce our large exposure to emerging markets in favour of mature markets. At present, we are not increasing the overall risk level in the portfolio.

5% 22.5%

5%

5% 2.5%

30% 30%

7

Cash Currencies Commodities Private equity Hedge funds Fixed income Equities

Portföljstrategi Portfolio strategy

Modern Aggressive In the Modern Aggressive portfolio, too, the biggest changes are occurring in the fixed income portion. As in the Growth portfolio, we are focusing on the extremely strong IG bond trend, which has resulted in a sharp drop in underlying interest rates. Unlike the Growth portfolio − where we have reduced our IG bond holdings − IG bonds are completely disappearing from the Aggressive portfolio. We are thus investing twice as much in convertible debt instruments as in our Growth portfolio. We are also bringing in a new HY manager, while reducing our most defensive HY strategy. Our exposure is thus becoming larger and more aggressive, but with more diversified manager risk.

In addition, we are making certain changes in the equities portion of the Aggressive portfolio. We are maintaining the same proportion of emerging markets but are removing our specifically Nordic exposure. Our higher relative risk has benefited us, while a strengthening of the underlying currencies has also helped boost returns. We are choosing to reallocate this part of the portfolio among our global holdings.

Adding new strategies In the hedge fund portion of the portfolio, we are reducing our Equity Long/Short holdings in mature markets, while adding new Fixed Income and Macro strategies. We are raising the risk level in CTA (Commodity Trading Advisor) funds. Overall, we are retaining the same weighting for alternative investments but have greatly reduced their correlation with the stock market. This will help reduce total portfolio risk.

We are also using the reduction in our IG bond holding to increase our commodity holdings, thereby boosting our protection against rising inflation expectations and continued decline in the US dollar. The characteristics of our alpha-generating commodities strategy also benefit the overall risk in the portfolio.

1%

9% 7.5%

30%

22.5%

30%

Cash Commodities Private equity Hedge funds Fixed income Equities

8

Theme: Anatomy of the recovery

Risk assets still have more to give • A continued cyclical upswing this winter and spring... • ...will initially provide favourable conditions for financial investments in 2010... • ...but after that, be prepared for somewhat choppier markets

The financial and economic crisis during the autumn of 2008 and the following winter was characterised by freefalling prices for assets associated with risk: mainly equities, corporate bonds, hedge funds and private equity investments. Only government securities attracted panic-stricken investors. These dramatic events triggered extraordinary economic policy responses. Key interest rates were slashed towards zero, central banks undertook massive quantitative easing programmes − including purchases of mortgage bonds − and political leaders approved unprecedented measures to sustain the financial sector. These were matched by massive budget packages aimed at stimulating the economy.

extremely low-priced risk assets accelerated. In the second week of March, a strong stock market upturn began. A little later that month, corporate bonds and hedge funds joined the upturn, while the trend in private equity was more hesitant.

Last spring the positive impact of these policies began to be noticeable. More and more economic “green shoots” appeared, and the situation in the financial sector stabilised. Risk appetite returned to markets, and investor demand for

The best period ever

Late spring and summer witnessed a normalisation of asset markets as earlier price anomalies were gradually corrected. In the real economy, last winter’s dramatic GDP decline was followed during the summer by stabilisation, and in the third quarter of 2009 more and more economies again began showing positive growth. The green shoots had opened. The global recession was over.

One result of investor interest in risk assets was that the period April-May was the best ever for corporate bonds. The stock market was unusually strong during the summer of 2009. Contributing to this were many positive surprises in both macroeconomic statistics and corporate earnings reports. The normalisation of financial investment conditions continued during the autumn. As during the summer, this was fuelled mainly by a combination of unexpectedly favourable macro- and microeconomic signals. These signals, in turn, have led to upward revisions in both economic and profit forecasts. So how do the economic prospects for 2010 look?

Per cent

Normalised markets 90

90

80

80

70

70

60

60

50

50

40

40

30

30

20

20

10

10

0

2001

2004

2007

According to the current signals from leading indicators, in many parts of the world the economy will exhibit strong upward momentum this coming winter and spring. After minor dips in various indicator curves early this autumn, most manufacturing sector indices have rebounded, among them the JP Morgan Global Manufacturing PMI, the ISM in the

0

Source: Reuters EcoWin

The VIX volatility index rose to unprecedented levels after the Lehman Brothers bankruptcy in September 2008, a sign of panic-stricken financial markets. This autumn, the index returned to normal levels.

9

Portföljstrategi Theme: Anatomy of the recovery

United States and the British PMI. For several months these indices, which are based on surveys of purchasing managers in the manufacturing sector, have shown clear improvements in order bookings, thereby promising a continued recovery in company output and capacity utilisation. It would be remarkable if this well-documented industrial upswing did not have a positive impact on corporate sales (”top line growth”) in the near future.

Large interest rate gap for another while

Growing activity in US manufacturing

7

7

6

6

5

5

4

4

3

3

2

2

1

1

0

2001

60

While the Fed’s key rate is expected to remain historically low until late 2010, US government bond yields are likely to rise somewhat, mainly due to larger federal budget deficits.

55

Index

0

2007

Policy Rates, Fed Funds Target Rate Government Benchmarks, Bid, 10 Year, Yield, Close Source: Reuters EcoWin

65

50 45

er than risking a repetition of earlier policy mistakes. This means that it will be some time before the underlying forces of the current recovery are challenged.

40 35 30 1995

2004

2000

2005

The 30 industrialised countries of the Organisation for Economic Cooperation and Development (OECD) will thus benefit from stimulus policies for another while. The result will be continued very low short-term interest rates, but somewhat higher government bond yields due to growing budget deficits. The latter is a consequence of the delay in the fiscal stimulus policy exit, as well as mounting − though according to our analysis unjustified − inflation worries. The yield curves in the industrialised countries should thus assume an even more positive slope during the next six months or so.

Source: Reuters EcoWin

The ISM purchasing managers’ index in manufacturing rebounded above 50 in August and has climbed further this autumn, signalling an improvement in US manufacturing.

Judging from historical associations, global industrial activity may accelerate for at least another couple of quarters, then enter a period characterised by growth at varying speeds. There are also other reasons why a strong first half of 2010 will be followed by more sedate economic growth. Companies all over the world dramatically reduced their inventories during last winter’s economic crisis. As optimism has risen in recent months, the de-stocking rate has slowed, and by a few months into 2010 more and more companies will have begun rebuilding their inventories. This shift in the inventory cycle will contribute positively to economic growth in late 2009 and the first 6-8 months of 2010.

Different for emerging markets and commodity producers In the emerging markets (EM) sphere, and among commodity-producing countries, conditions are different. In many places, the economy and the financial sector have almost completely escaped the crisis situation that has plagued the OECD, and − except in Eastern Europe − economic recovery is occurring rapidly, starting in much higher gear. Capacity

A very important question At present, economic growth and risk appetite are also benefiting from powerful stimulus policies. So a very important question on the threshold of 2010 is: How, and at what pace, should these policies be phased out? How will monetary and fiscal policy exit strategies look? The strategy choices made in different parts of the world will greatly affect the environment for various asset classes. Worries about new speculative bubbles and inflation point towards a rapid launch in exit policies. On the other hand, experiences from the 1930s and Japan in the 1990s indicate the risks attached to a rapid, vigorous exit from stimulus measures.

Accelerating growth in Korea 40

110

30

105

20

100

10

95

0

90

-10

85

-20

80

-30 2000

The discussions at the annual meetings of the International Monetary Fund (IMF) and the World Bank in October 2009 and the statements of the Group of 20 (G20) meeting and European Union finance and budget ministers in November indicate that the global community would prefer to wait a little longer than optimal before initiating a policy shift, rath-

2002

2004

2006

2008

75

Operation Ratio, Manufacturing, SA Exports, Volume, total [c.o.p 12 months] Source: Reuters EcoWin

Accelerating economic expansion in South Korea and many other emerging markets will justify monetary tightening fairly soon.

10

Portföljstrategi Theme: Anatomy of the recovery

utilisation is higher as well. This is why monetary policy tightening is imminent in many countries. Commodity producers Australia and Norway have already begun to raise their key interest rates. This will mean higher short-term interest rates and probably also higher government bond yields due to the key rate hikes and rapid growth. In the EM sphere, however, yield curves will most likely tend to become flatter (short-term interest rates will rise more than long-term ones).

In many respects, the economic outlook for 2010 is reminiscent of the outlook on the threshold of 2004. At that time, too, the crystal ball showed a cyclical expansion that risked a loss of momentum, fading fiscal stimulus measures and interest rate hikes. As in 2009, risk assets during 2003 were characterised by sharp increases in value; from a low in early March until December 2003, the S&P 500 share price index rose by 40 per cent. The stock market rally then culminated early in 2004. After that, the index showed a volatile and more or less sideways trend until late autumn, when a new rally began.

The upswing in the OECD countries will probably lose momentum in the second half of 2010. The acceleration in manufacturing will turn into more moderate growth, and the positive impact of the inventory cycle will fade. The most influential central banks will then also start hiking their key interest rates − shifting the entire yield curve upward − and phasing out their quantitative easing programmes. In 2011, at least the euro zone countries and the United Kingdom will take steps to withdraw their fiscal stimulus measures, in order to avoid jeopardising the credibility of their long-term balance in public finances. This implies that the overall Gross Domestic Product (GDP) of the OECD countries – which will recover from a decline of 3.5 per cent in 2009 to an increase of about 2.5 per cent in 2010 – will not accelerate further in 2011. Instead, growth will level off at about the same rate as in 2010.

Index

A repeat of 2003–2004?

3.50

1500

3.25

1400

3.00

1300

2.75

1200

2.50

1100

2.25

1000

2.00

900

1.75

800

2001

2004

2007

3500

3250

3250

3000

3000

2750

2750

2500

2500

May Sep 2003

2250 May Sep 2004 Source: Reuters EcoWin

Jan

Private equity will benefit from the gradual reduction in risk premiums. The current decline in volatility − which also characterised 2004, when the VIX index fell all the way to 12 − will help hedge funds. Government bonds will remain unattractive in our 2010 scenario, as runaway budget deficits and expected interest rate hikes, followed by actual hikes later in the year, push up bond yields. The attractiveness of Investment Grade corporate bonds will decrease due to narrower yield spreads against government securities. High Yield bonds, however, will have considerably higher running yield and will offer the potential for attractive returns. Convertible debt instruments will also be attractive in the market climate that we believe will prevail in 2010.

USD/BRL

USD/KRW

3.75

3500

Reduced risk premiums beneficial

Foreign currency market winners 1600

3750

Today our conclusion is that the environment for financial investments will initially remain favourable in 2010. Meanwhile the lessons of 2004 give us reason to be prepared for a somewhat more volatile “range trading” trend in the stock market some months into next year. But this is not incompatible with good price growth for many asset classes by the time the 2010 financial year wraps up more than 12 months from now.

The overall effect is that we expect global GDP growth to be around 4 per cent both in 2010 and 2011.

4.00

3750

The outlook for 2010 has a number of features in common with events in 2004. For example, during that year Wall Street transitioned to “range trading”.

In emerging markets, economic growth will greatly strengthen during the coming year, with GDP climbing from just over 2 per cent growth in 2009 to more than 5.5 per cent in 2010, then accelerating a bit further in 2011. There will be continuing capital inflows from the OECD countries, which will fund real investments and boost productivity. Interest rate hikes, diminished fiscal stimulus, ever-stronger currencies and weak help from OECD imports will nevertheless have a certain restraining effect on the expansion.

1700

4000

2250 Jan

Accelerating growth in emerging markets

1800

4000

1.50

Brazil, USD/BRL South Korea, USD/KRW Source: Reuters EcoWin

Rapid economic growth and higher interest rates than in the developed countries are attracting capital to countries like Brazil and South Korea, thus strengthening their currencies.

11

Tema: 1 The influence of exchange rates on investments Theme:

USD will help rescue US economy • Weak dollar stimulates American exports • Tough going for euro zone exporters • Emerging market assets still in demand The weakening of the dollar is also making American equities seem cheaper to foreign investors. For an investor based in the euro zone, the US stock market has become 20 per cent cheaper in the past year, since the euro has appreciated from USD 1.25 to about USD 1.50.

Recent exchange rate movements have created new conditions for different regions, but the market has not yet priced in the new exchange rate perspectives. Instead, asset prices have responded mainly to greater risk appetite and surplus liquidity. This means there are opportunities for investors to benefit from these conditions. When the financial storm was blowing at its worst, the US dollar was regarded as one of the few safe havens. It was thus in demand from the whole investor community. But as investors have become more willing to take risks, many of them have abandoned the dollar and moved their money to wherever the return expectations are highest. The result has been a sharp decline in the dollar, while emerging market currencies in particular have strengthened.

It is both in the American and global interest to increase US exports. For the US, it is a matter of finding a new economic engine, since the country can no longer rely on freespending, overly leveraged consumers. This principle has also received support from leading political circles. For example Lawrence Summers, President Barack Obama’s top economic advisor, has declared that the American economy must become more export-oriented and less dependent on private consumption.

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The dollar decline is mainly advantageous to the US economy. A weaker currency makes American goods and services cheaper to foreign consumers and companies, benefiting the US export sector. Increased foreign demand for American products is now leaving a clear positive mark on the statistics. During the third quarter, exports rose by 17 per cent, making this the second fastest growing sector in the US economy. The positive contributions from exports are likely to remain large as the wheels of the global economy roll ever faster.

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Earnings for exporters (LHS) Trade-weighted USD (RHS, inverted) Source: BEA, Federal Reserve

The dollar decline also benefits American companies that focus on the domestic market. They have a competitive advantage over foreign exporters, whose goods and services become more expensive to Americans. However, US household purchasing power is currently very weak.

A weaker dollar benefits the export sector, since it makes American goods and services cheaper to foreign consumers and companies.

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Theme: The influence of exchange rates on investments

Old arrangements being challenged

February, euro zone exports have become about 7 per cent more expensive from the standpoint of the currency union’s external trading partners. The economic outlook for the euro zone seems brighter, but there is a risk that weak exports will hamper the recovery. The outlook is similar in a number of major commodity-exporting countries such as Canada, Australia and – to some extent – Norway.

From a global perspective, it is important to correct today’s gigantic financial imbalances. American households have historically assumed the role of perfect consumers, leading to record-sized US trade deficits. Emerging markets – with China in the lead – have played the role of perfect producers, resulting in sizeable trade surpluses. These old arrangements are now being challenged, and the weak dollar is playing a key role in creating better global balance.

Since last spring, a lot of foreign capital has poured into Asia and Latin America, resulting in escalating commodity prices and stronger currencies. Numerous emerging market (EM) countries have expressed concern that continued exchange rate appreciation may hamper their exports. Another risk is that speculative bubbles will build up in these regions. To cool the interest of foreign investors, for example, Brazil has imposed a new tax on portfolio investments − foreign purchases of equities and fixed income securities − and several other countries seem poised to take similar action.

In order to achieve a full rebalancing, China will have to abandon its fixed exchange rate against the dollar. This currency peg means that China’s export sector is “doped” because of the dollar decline. Pressure from other countries to revalue the yuan is growing ever stronger. It now also appears as if Chinese authorities accept the concept of again allowing a gradual appreciation against the dollar, with the aim of reducing their dependence on exports and instead stimulating domestic consumption. Since the financial crisis, China has become aware of the risk of relying exclusively on eager foreign consumers. In recent months, there have also been official signals from China indicating that a revaluation of the yuan is relatively imminent.

Emerging markets remain attractive Despite increased risks, we still have a positive attitude towards investing in emerging markets. Monetary policy in the OECD countries will remain very expansionary for a long time to come in order not to risk economic reversals, adding to global liquidity. Capital is attracted to EM countries because they are in considerably better economic shape than the industrialised countries. While we foresee overall GDP in the OECD countries growing by a modest 2.5 per cent in 2010, GDP in emerging market countries will increase by over 5.5 per cent.

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In light of their stronger economies, a number of EM countries are ready to raise their key interest rates soon. This will create a widening gap between interest rates in the OECD and the EM sphere. In an environment of high risk appetite, investors like to take advantage of interest rate differences, borrowing where interest rates are low and investing where they are high (“carry trades”). Overall, these factors point towards a continued increase in demand for emerging market assets and currencies.

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United States, SA, Current prices, SA Source: Reuters EcoWin

Global imbalances have decreased somewhat, but before a major shift can occur, Chinese authorities will have to eliminate their currency peg against the dollar.

EM countries remain attractive

A stronger Chinese currency would benefit other emerging economies in Asia. This is because a stronger yuan would increase Chinese purchasing power, enabling exports to China from neighbouring and other countries to increase. A reduced competitive advantage for China would also enable other emerging market countries to perform better in the global export market.

Index

MSCI EM vs. MSCI World

Stronger currency weighs down euro zone Countries whose currencies have appreciated sharply are in the opposite situation from the US. Their export sectors have found conditions increasingly tough, since their international competitiveness has deteriorated. In the euro zone, it has gradually become more difficult for the export sector to sell goods and services in the world market. Since

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As long as monetary policy is ultra-loose and risk appetite is good, capital will flow to emerging market countries. This is because growth prospects and interest rates are far higher in the EM sphere than in the OECD countries.

13

Tema: 1 Commodity producers vs. commodities Theme:

Commodity producers attractive to investors • Commodity producers may gain value faster than commodities • Early recovery cycle an argument for buying commodity shares • Investors thereby avoid problems related to physical commodities The shares of commodity producers have characteristics distinct from those of the underlying commodities. They behave differently in the various phases of the economic cycle. As the chart below indicates, shares of commodity producers perform better early in the expansion cycle, while the underlying commodities often do better later in the upturn phase. The world economy is now in the early recovery phase, which reasonably implies that these shares still have a long way to rise. Thus it is currently most advantageous to invest in commodities via equities.

If we examine this year’s commodity market performance and compare it to share price movements, we see that there are strong associations between them. Commodity sub-indices (see the table on page 32) have gone up at least as much as equities, and even in broader commodity indices we see changes almost as large as those in the shares of commodity-producing companies. Pricing also seems to differ between underlying commodities. When we follow daily (spot) prices, we see a striking similarity with the performance of commodity producers, but when we compare total return including rollover costs, which are explained below, we get a different picture. The chart below shows this situation.

However, this picture may vary somewhat between different commodity and commodity-producer sectors. In addition, commodity investments via exchange-traded commodities also play a role. The reason for this is that nowadays, commodities seem to react in ways similar to equities in relation to economic developments. Investors thus have to do their homework carefully at all times. The chart below shows how the real return profile usually looks during different phases of the economic cycle over a long period.

Index

Energy shares and energy commodities

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To understand the difference between commodity investments via equities or direct via commodities, there are two difficult but important concepts to keep track of: contango and backwardation. These terms describe the slope of the price curve for commodity futures. Contango means the

Late expansion Commodities

Pay-off curves vary depending on what stage of the economic cycle we are in. Correctly assessed, this can make a big difference in returns over time.

14

Theme: Commodity producers vs. commodities

An examination of commodity producer valuations, especially in the mining industry, shows that based on expected 2010 profits their share valuations are at normal levels, with a price/earnings (P/E) ratio of around 15. Given higher profits, which we are assuming, these companies would instead appear rather undervalued in the future. This is yet another current argument in favour of producers rather than commodities.

market believes that the price of a commodity will rise (the curve has a positive slope), while backwardation means that the price will fall (the curve has a negative slope). Physical commodities are often bought via futures contracts, with a specified future delivery date. Since the commodity needs to be stored in the meantime and the buyer of the commodity contract will not receive the product until later, the futures curve normally has a positive slope (contango) − since storage and financing costs need to be taken into account. If someone buys a commodity contract for investment purposes only, that person does not wish to accept a physical delivery, for example a lorry full of meat, but well before the expiration of the futures contract the investor will need to buy a new contract with a later expiration date. Selling the old contract and buying a new one is called “rollover”. One challenge here is to find the right timing for entering into and getting out of contracts; another is that this action in itself involves a “rollover risk” − given rising prices, the buyer continuously pays more for each new contract.

Another factor that favours producers is that investments aimed at expanding production capacity have been low or entirely absent during the crisis, and before prospecting of various kinds resumes, there is potential for continued price increases. One reason is that the bottlenecks that emerge before new capacity investments have had an impact will benefit both commodity prices and producers. Bottlenecks result in expectations of future profits, which should favour share investments. So is it always better to invest in commodity producers than in commodities? The answer is obviously no. Aside from referring to the above economic cycle argument, the chart below shows that there are situations when it is probably better to invest directly in a commodity − simply because commodity companies have already taken off in the stock market, and due to the contango and backwardation phenomenon described earlier. Commodities have had a tendency to catch up with the share price trend for producers. For example, in the agricultural sector we thus currently favour commodities to food-production companies.

An investment in an energy commodity producer may mean earning a good return compared to the spot market for the commodity, without needing to assume storage costs and rollover risk. In theory it would be optimal to invest in commodity companies when the price curve shows contango, and in the underlying commodity when the price curve points towards backwardation, but in practice this is difficult to achieve.

Other factors to take into account

Commodities have lagged behind

Index

For mining companies and certain other commodity producers, there is an additional factor to include in the calculations, and that is a possible revaluation of the Chinese yuan (CNY). If the large growth gaps between China and the OECD countries persist, there are many indications that China will need to cool off its economy. One way − which many observers regard as probable − is to once again revalue the CNY against the US dollar (USD). Calculations for mining companies show that many of them would actually benefit from an increase in the value of the CNY.

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GSCI, Agricultural Index [rebase 2005-01-01 = 100.0] Standard & Poors, Global 1200 Industry, Food Products, Index [rebase 2005-01-01 = 100.0] Source: Reuters EcoWin

Another circumstance to be taken into account is the USD, which affects both commodities and commodity companies. Most commodity prices are quoted in dollars. The thesis here is that commodity companies have a greater ability to withstand a possible future strengthening of the dollar by then widening profit margins. This should be possible in good times and thus ought to be an argument in favour of commodity producers. The other side of the coin is that if it is possible to raise the prices charged to consumers, it is often also possible to raise the price earlier in the chain.

Food producing companies’ shares have climbed on expectations of agri-commodity price increases, not so much on the basis of actual price trends.

How can you take advantage of this in your investments? When building a portfolio, there is reason to include both commodity producers and underlying commodities. This will enable you to boost returns and even lower your risk – if these investments are combined.

15

Tema: Macro1 summary

Good global growth during the coming year • There have been upside surprises in the world economy... • ...and the upturn is now accelerating • Growth will level off as exit policies are launched The world economy has continued to recuperate in recent months. Exceptional government economic policy measures have both sustained financial markets and given the economy a powerful helping hand. This, in turn, has increased risk appetite among financial market players and has contributed to rising optimism among households and businesses.

was steeper than in the US and the UK. But in the recovery phase, there is reason to expect good fundamentals to pay off to a greater extent. In countries with traumatised banking systems and sizeable public and private sector financial consolidation needs, economic growth will be hampered for years to come. In the fast-growing emerging market (EM) sphere, we do foresee faster GDP growth in 2011 (+6 per cent), but the difference compared to 2010 (+5.6 per cent) will not be especially large. This is because fading fiscal stimulus measures, monetary tightening and rising currencies will hurt the international competitiveness of the EM sphere.

These developments have laid the groundwork for growing economic activity. Company order books are admittedly still somewhat meagre, but production curves are now pointing ever more clearly upward. As long as stimulus policies remain in place, risk appetite will probably remain good in financial markets, and this will also help fuel the economy.

Taken together, our forecasts for the OECD and EM sphere mean that global GDP – which will fall by roughly 1 per cent this year − will grow by around 4 per cent both in 2010 and 2011.

However, lingering bail-out and stimulus policies will also mean that adjustments in the financial imbalances that triggered the crisis will be postponed in some respects. Only once economic policy exit strategies − interest rate hikes, budget-tightening etc. − are launched in earnest will the underlying strength of the recovery be put to the test.

Per cent

When this happens later in 2010 and during 2011, economic acceleration risks being succeeded by a levellingoff of growth. This is reflected in our GDP forecasts for the OECD industrialised countries. After this year’s GDP decline of 3.5 per cent, these countries will recover to an average of about 2.5 per cent growth in 2010 and about the same rate in 2011, which is close to the trend growth rate.

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The pattern in the OECD is that countries that are heavily dependent on manufacturing and exports have suffered larger GDP declines than the countries where the financial crisis has been centred. For example, the downturn in Japan, Germany and Sweden during the winter of 2008/2009

Leading indicators in the OECD have climbed sharply since early 2009. A few months later, industrial production also surged.

16

Macro summary

Nordic growth near OECD average

Although the economic outlook is brighter, for many years there will be a lot of spare production capacity in the form of high unemployment and low capacity utilisation by companies. Price and cost pressures will thus remain unusually low. We estimate that consumer prices in the OECD will increase by less than 1 per cent both next year and in 2011.

GDP growth in the Nordic countries will be at about the OECD average in the next couple of years. Norway will benefit from high oil prices and extremely strong public finances. Sweden will take advantage of the upswing in global demand via its weak krona and favourable industrial structure. Further, a large proportion of households in both countries have adjustable mortgage loans and are thus benefiting from extremely low short-term interest rates. Home prices have also resisted the downturn. We predict that Nordic GDP will increase by more than 2 per cent in 2010 and 2.5 per cent in 2011.

The US economy is growing again The bottom of the US economic downturn is past. After four straight quarters of falling GDP, the economy grew by 2.8 per cent in the third quarter of 2009. Continued support from fiscal and monetary policies for another while, together with a rebound in manufacturing and a shift to inventory build-up at companies, will provide good contributions to GDP growth during the next six months.

Emerging markets pave the way Growth in rapidly expanding Asian economies has greatly contributed to stabilising the world economy and paving the way for a recovery. Large trade surpluses and relatively little exposure to the banking problems in the West have been sources of strength. During the next couple of years, Asia will continue its rapid growth, serving as an important engine of the entire global economy.

But once the positive effects of fiscal policy and the inventory cycle fade later next year, the growth impulse will weaken again. One important reason is that household demand − which has historically served as a strong engine of recovery − will not take off in earnest this time around, since Americans are continuing to restore their savings in the wake of the financial and housing crisis, and due to the weak labour market. GDP will grow by 3 per cent in 2010 and just above 2 per cent in 2011.

Latin America is on its way up from the deepest economic slump for years, and next year both Brazil and Argentina will show GDP growth of 4-5 per cent. The region will benefit from increased world trade and rising commodity prices. International investors are also attracted by improving economic policy stability.

Positive surprises in Japan Last spring’s major stimulus package has contributed to the Japanese economic recovery. GDP grew both in the second and third quarters, and pessimism in the business community and among households has diminished. The housing and construction outlook remains gloomy. Positive surprises predominate, however, and GDP may grow by about 2 per cent annually in 2010-2011. A strong yen and large spare capacity indicate that this year’s consumer price decline will be repeated next year.

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Chinese GDP trough still high

UK and euro zone moving towards 2 per cent Numerous indicators are signalling that British economic growth is now positive. After a decline of 4.5 per cent this year, we foresee GDP growth approaching 2 per cent in 2010 and less than 1.5 per cent in 2011. The prospect of major fiscal belt-tightening explains the growth slowdown in 2011.

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Chinese economic growth bottomed out in the first quarter of 2009, when the GDP growth rate was about 6 per cent. Since then, it has accelerated to nearly 9 per cent.

Eastern Europe has been hardest hit by the global credit crisis, because its earlier rapid economic growth was largely financed by foreign currency borrowing. But even in this region, bright spots are now visible, especially in manufacturing. Poland and the Czech Republic are best positioned to benefit from the world economic upturn. Russia will also recuperate at a decent pace, while recovery will be slow in Ukraine and the Baltic countries following this year’s sharp GDP declines. Ukraine and Russia are also plagued by high inflation.

In the euro zone, however, GDP growth will speed up somewhat − from just below 2 per cent next year to somewhat above that in 2011. There are currently many signs of a broad-based recovery, reflected by a return to positive GDP growth during the third quarter of 2009. Germany in particular is benefiting as world trade regains ground, and the French economy is also performing fairly well. Italy and especially Spain are in worse shape, with the latter economy being hobbled by a real estate market that remains in free fall.

17

Tema: Asset1class: Equities

Up for another while – then sideways • In the short term, stock markets have the potential to climb further... • ...but after that the bull market risks losing momentum • The US market may show positive surprises The accelerating plunge in stock markets during the financial and economic crisis was followed by a strong share price rebound − a new bull market. At the global level this began on March 10, 2009 (coincidentally, the previous World Index upturn phase began on the same date in 2003). Since last spring the market has rapidly gone north − the MSCI AC World Index in local currencies rose 53 per cent from March 9 to November 27 − but the journey has been rocky. In late June and early July there was a significant reversal due to a flare-up of worries that the “green shoots” in the economy would not open, and concerns about what picture the upcoming quarterly report season would paint at individual company level. In both cases, however, investors were calmed by positive late summer surprises, though unexpectedly good company earnings were essentially a consequence of cost savings.

The July-August share price rally was followed by a more volatile trend, primarily based on renewed concerns about the underlying strength of the economy and corporate prospects as third quarter reports approached. Speculations about what would happen to growth when the exceptional government economic stimulus measures are eventually phased out, “exit policy”, also occasionally contributed to shifts in the stock market mood. The upward stock market trend is, however, intact. Important factors behind market trends in the months ahead will be the strength and predictability of the economic cycle, the economic policy agenda and share valuations. Developments in these areas will, in turn, have a particularly strong impact on the willingness of investors to take risks, which in the last analysis will determine stock market performance.

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After four quarters of negative growth, the US economy expanded in the third quarter of 2009. Many other industrialised countries have also left recession behind.

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Asset class: Equities

In recent months, valuations have levelled off or fallen somewhat due to higher profit forecasts and/or slightly lower share prices. Since further upward revisions of macro projections are in the cards, profit estimates are also set to be raised a bit more this winter, which would benefit the stock market. Signals in fourth quarter earnings reports that order bookings are rising − which seem likely − would in themselves also fuel a stock market upturn. In particular, it is psychologically important that sales, or “top-line growth”, should show an upward trend.

July 1. The US, Japan and the euro zone all noted growing GDP during the third quarter. In China’s case, growth accelerated to nearly 9 per cent (annualised). Judging from the strong signals that leading indicators are now sending, the risk of macroeconomic disappointments in the next few months has diminished. There is also an improved chance that the growth impulse may shift from the inventory cycle to final demand. The global economic outlook for 2010 has thus brightened, while predictability has increased. If anything, growth next year may be a tad higher than current forecasts predict.

Positive slope for the stock market

Recent economic and stock market developments actually bear many similarities to a typical recovery phase. Who would have dared to promise such a scenario early in 2009, when everything seemed so dismal in the financial world?

The current steeply positive yield curves in the fixed income market likewise favour stock markets, since history shows that periods characterised by such a sloping curve have coincided with stock market upturns (see the chart below). The normalisation of volatility since this past summer is yet another sign of stock market optimism.

Soothing pronouncements

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During periods of steeply positive yield curves – with short-term interest rates much lower than long-term yields – the stock market has usually climbed.

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As for the exit policy agenda, the current pronouncements of the central banks and political leaders are soothing (see also page 10). This means that economies and stock markets can count on massive economic policy support for at least another couple of quarters. Only after mid-year 2010 will the European Central Bank begin its key interest rate hikes, while the Bank of England and the US Federal Reserve will wait until late in the year. Although the major central banks will then gradually continue ratcheting up their interest rates, at the end of 2011 key rates will still be at levels (around 2.5 per cent) that imply a prolonged expansionary monetary policy. Clearer government budgettightening will begin in 2011 at the earliest, although austerity programmes are due to be unveiled soon.

What is worth reflecting on, however, is the stock market trend for small companies compared to large companies. After a period of market upturn, small companies traditionally see faster gains than major corporations, something that has not happened this time around. From the bottom of the US stock market on March 9 until November 27, the Russell Small Cap Index rose 73 per cent, while the S&P 500 was up 88 per cent. One interpretation of this is that the investor community feels somewhat worried about the continued strength of the recovery. Another factor may be the gap in new borrowing potential. Large companies can use the “revived” corporate bond market, while small companies in both the US and Europe are essentially at the mercy of the banks, which are currently imposing very strict lending standards. In the US, lending to small companies has fallen dramatically in the past year. Nor is the future of stock markets entirely rosy.

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ECB Main refinancing, Fixed Rate United Kingdom, Policy Rates, Bank Rate United States, Fed Funds Target Rate Source: Reuters EcoWin

The signals from the ECB, Bank of England and Federal Reserve are clear: the first interest rate hikes will not come for a long time.

Stock market valuations are currently not out of line. In the US, for example, P/E ratios are only a bit above their historical averages. They are also clearly lower than at the end of 2003, when the previous bull market had been under way for 9-10 months. Today no markets seem overpriced. One of the few stock markets with a P/E ratio above 20 is the Japanese market. In Sweden, the P/E ratio is parked above the global average.

Looking ahead, the economic recovery will be hampered by the launch of exit policies and by the need to repair balance sheets following the financial excesses early in the new millennium, especially in the US. The banking sector is under pressure and still needs a lot of additional risk 19

Asset class: Equities

capital. According to the IMF, more than half of the banks’ write-downs still lie ahead. These two circumstances in particular will hobble growth in late 2010 and during 2011. As a result, it will be a long time until the world economy reaches the growth figures recorded before the latest crisis. We have limited experience of analysing what occurs when unprecedented stimulus policies are normalised, so there is unusually great uncertainty about what will happen to the economy further ahead.

In geographic terms, emerging market (EM) and European stock exchanges − including Sweden − have risen faster than the world index since the turnaround last March, while the markets in Japan and the US have lagged behind. This is also reflected in the allocations of global equity fund managers, which are characterised by pronounced overweighting in the EM sphere, small overweighting in Europe, slight underweighting in the US and large underweighting in Japan.

While both the economic cycle and stock markets have thus performed about as usual during a recovery, there is a risk that the next phase will be a little more atypical. Since stock markets are constantly looking ahead, a growing concern about what lies around the corner may suffice to lower risk appetite. This is illustrated by the brief panic attack in the stock market last summer − when the need for exit policies first appeared on the public agenda − and by bouts of stock market uncertainty during the autumn in the run-up to policy announcements by influential industrialised countries.

In itself, this massive EM overweighting by fund managers will limit the future potential for emerging markets to beat the world index. Meanwhile EM economies will increase their growth rate a bit further in 2011, and the profit outlook is favourable.

US stock market will benefit Given a weak – perhaps even weaker – dollar, major US export companies will become even more competitive, especially in relation to emerging market and commodityproducing countries. This would benefit the US stock market (see also page 12). Much of Europe is likely to have a tougher time, while the Nordic stock markets will take advantage of economic growth in line with the OECD average, rising commodity prices (primarily Norway) and increased world trade (especially Sweden). The Japanese stock market remains an unknown quantity, although the large underweighting by global fund managers provides potential.

Worries may return In other words, next spring markets may begin fretting about imminent interest rate hikes and other exit steps. Inflation worries may also resurface when 12-month consumer price figures change from negative to positive (mainly because commodity prices fell dramatically a year earlier). Given steadily falling underlying inflation due to large idle production capacity, however, in our opinion these worries are unwarranted.

...but US stock market has lagged

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Weighing together the contents of our crystal ball on the threshold of 2010 leads us to the conclusion that the global stock market upturn may lose momentum this spring, then begin a period of sideways or “range trading”.

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While EM stock exchanges have beat the world index for the past year, Wall Street has lagged behind.

In terms of sectors, those with cyclical characteristics – consumer capital goods, commodities, industrials – have tended to be the best performers on stock exchanges since last summer, and information technology (IT) has also done nicely. Financial shares have roughly kept pace with indices, while pharmaceuticals and consumer nondurables have lagged behind. In the short term, cyclical sectors will continue to steam ahead, but a subsequent stock market scenario of sideways “range trading” will instead benefit less cyclically sensitive sectors, such as consumer non-durables and pharmaceuticals.

0 0 Dec Feb Apr Jun Aug Oct Dec 2009 2008 MSCI Emerging Markets relative to MSCI AC World 20 day moving average Source: Reuters EcoWin

In 2009, stock markets in the emerging markets sphere attracted investors on a large scale and thus performed strongly compared to the world stock market index.

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Asset class: Fixed income

Time to reshuffle the fixed income portfolio • Both short- and long-term government yields will climb somewhat in 2010 • With smaller yield spreads, Investment Grade will become less attractive... • ...while High Yield and convertibles will look better to investors Small central banks lead the way

Per cent

Last spring’s highly eventful developments in the bond market − characterised by clearly rising government bond yields and dramatically falling corporate bond yields − were followed by a far calmer trend after mid-year. Government bond yields on both sides of the Atlantic have more or less moved sideways, while the differences in yields (spreads) between corporate and government bonds narrowed at a considerably slower pace than before, then nearly levelled off during the fourth quarter.

10

10

9 8

9 8

7 6

7 6

5

5

4 3

4 3

2 1

2 1

0 2002

The world’s money markets have also been rather calm during the past few months. It is true that a few smaller central banks have raised their key interest rates. Israel’s central bank took the lead last summer, followed by the Reserve Bank of Australia and Norges Bank in Norway, and several Asian central banks have meanwhile unsheathed their interest rate weapons. The rate hikes carried out to date have been modest, however, and have been accompanied by comments aimed at guiding the market’s (overly aggressive) interest rate expectations downward. Other central banks, such as Bank of Canada, have also taken the opportunity at recent interest rate policy meetings to tone down their future need for monetary tightening.

2004

2006

2008

0

Israel, Bank of Israel Headline Rate, ILS Norway, Sight Deposit Rate, NOK Australia, Cash Target Rate, End of Period, AUD Source: Reuters EcoWin

A few central banks have begun raising their key interest rates, led by Israel, Australia and Norway. No rapid rate hikes appear likely in the near future.

Nevertheless, the central banks also need to begin factoring in the risk that financial bubbles will form and expand. The breeding ground of the latest financial crisis − a prolonged period of low interest rate policy, mainly in the US, which led eventually to the “sub-prime crash” − should provide food for thought. The shaping of monetary policy exit strategies is thus under way today.

The world’s most influential central banks − the Federal Reserve (Fed), the European Central Bank (ECB) the Bank of England (BoE) and the Bank of Japan (BoJ) − have all recently emphasised the severity of the past year’s crisis as well as the fragility of the economic recovery. Their top priority has been to try to persuade financial markets that extremely low interest rates and quantitative easing, including central bank purchases of bonds in the market, will not be removed for a long time. The BoE, for example, recently even raised the ceiling on its quantitative measures from GBP 175 to 200 billion.

Assuming that the global economic recovery continues during 2010 and that the newly regained stability of the financial system is not jeopardised, there is reason to expect that the leading central banks − with the BoJ as an exception − will launch their exit strategies next year. The ECB will probably take the lead, followed by the BoE and the Fed. A decent cyclical upturn, low inflation and clear fiscal belt-tightening are arguments for moderate increases in key interest rates over the next couple of years.

21

Asset class: Fixed income

The combination of higher economic growth, monetary tightening, burgeoning budget deficits and the potential for continued good risk appetite among investors points towards rising government bond yields/falling bond prices during 2010. But the prospect of continued very low inflation means that yields will rise only modestly.

Government bond yields are nevertheless rising somewhat, making them unattractive within the fixed income asset class. Nor are corporate bonds as attractive as they were last spring. Because of the corporate bond market rally of the past eight months or so, yield spreads − the differentials between yields on corporate and government bonds − have rapidly narrowed and are approaching the levels that prevailed before the financial crisis began during 2007.

Per cent

Falling prices, then weakly rising prices 17.5

17.5

15.0

15.0

12.5

12.5

10.0

10.0

7.5

7.5

5.0

5.0

2.5

2.5

0.0 -2.5 1980

The spread for top-rated corporate bonds (AAA) in the US is already back at spring 2007 levels, while there is still a way to go in the B to BBB segments and especially for corporate bonds with the low CCC rating (see chart at bottom left). In Europe the narrowing of spreads has not progressed as far as in the US, since the rally in the Europe corporate bond market began a little later than in the US market.

0.0 1990

2000

-2.5

c.o.p 12 months c.o.p 12 months Source: Reuters EcoWin

Corporate yields in Europe may fall further

Consumer prices in the OECD are currently falling. Next year they will rise, but due to such factors as large spare capacity the upturns will be small.

600

Source: Markit, SEB

500 400

The Fed has pumped enormous quantities of liquidity into the American banking system − the monetary base has greatly increased − but because of tough credit conditions and very limited demand for lending by households and businesses, this liquidity has stayed in the banks.

300 200 100 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Before there is a risk of higher inflation due to monetary reasons, bank lending must expand − the “credit multiplier” will need to increase − and the money will have to be used for corporate capital spending and private consumption. But only when higher demand in the economy causes actual production to approach potential production, leading to bottlenecks, will inflation risks be accentuated. Today capacity utilisation at companies is nearly at a record low, and firms can thus increase production for a long time before bottlenecks appear. In addition, starting next year the Fed and other central banks will gradually withdraw liquidity from the banking system, which will limit the lending capacity of the banks.

iBoxx Corporate Investment Grade

There is more room for declines in corporate bond yields in Europe than in the US. The chart shows the gap between yields on a 5-year IG bond and a German government bond with the same maturity.

In other words, the previous extreme undervaluation of corporate bonds has disappeared and the room for price gains has decreased substantially. How much room there is will depend on the strength of the cyclical recovery − the stronger the economic situation, the narrower the spreads, since high growth stimulates risk appetite and reduces the number of corporate bankruptcies − as well as on what happens to government bond yields, the base from which the spreads are measured.

Less distance for corporate yields to fall 1750

Assuming continued economic recovery in the coming year, yield spreads may approach their historical average relatively soon. In Europe (5-year bonds) this is about 140 basis points for Investment Grade (IG) and 580 basis points for High Yield (HY) bonds. Also pointing towards a narrower spread is that the number of bankruptcies in the HY segment has been falling since its peak in March.

Basis points

1500 1250 1000 750 500 250 0 Jul

Nov Mar Jul Nov Mar Jul Nov 2007 2008 2009 AAA Rated BBB Rated CCC Rated and above B Rated BB Rated Source: Reuters EcoWin

Measured on a 12-month basis (compared to the same month one year earlier), however, HY bankruptcies have kept climbing in 2009. But according to many observers they will soon peak, even measured in this way. SEB predicts that US bankruptcies in the HY universe will peak at about 13.5 per cent this month, in December 2009.

Yield spreads against government bonds for top-rated US corporate bonds are down to pre-crisis levels. High Yield bonds, however, still have quite a distance to fall.

22

Asset class: Fixed income

Our forecast for Europe is a peak bankruptcy figure of just below 12 per cent during the first quarter of 2010. By summer, we expect the proportion of HY failures to fall to around 6 per cent in the US and a bit above 4 per cent in Europe.

to about -7.5 per cent in the industrialised countries. And while the OECD as a whole will show savings (current account balances) of about -1 per cent of GDP (about USD -350 billion), the EM sphere will have an overall savings surplus of more than 3 per cent of GDP (just over USD +400 billion).

Another positive factor is that the ratio between possible downgrades (corporate credits receiving a negative change in rating) and possible upgrades (corporate credits receiving a positive change in rating) has continued to fall in the US, while in Europe it has remained at about the same level as in early 2009.

Many EM currencies also look set to rise in value during the coming year, which is another plus for an American or European investor when translating to dollars or euros.

Convertible debt now attractive Convertible debt instruments are also attractive. Convertibles combine the advantages of stocks and bonds. Historically, the increase in the value of convertibles has been equivalent to roughly 2/3 that of shares, but with far lower volatility. The option of converting them to shares means that the investor has a potential shareholding, and when the share price rises the value of the convertible increases. If the share price falls, however, the convertible will not fall below its underlying bond value. A convertible thus has some features in common with equity-linked bonds (capital-protected investments).

There are still various factors that favour corporate bonds and thus indicate that spreads will narrow even further. But meanwhile we expect government bond yields in the US and Europe to rise somewhat during the coming year. At least in the US, this will cause yields on many IG bonds to rise, leading to a price decline. This portion of the corporate bond market will thus become less attractive. HY bonds, however, will continue to look good to investors. In several rating categories, there is still rather large remaining room for spreads to shrink. This investment segment will also benefit from the incipient economic upturn, from increased risk appetite and from the prospects of a rapidly falling bankruptcy rate on both sides of the Atlantic.

During the autumn 2008 financial crisis, investors sold convertibles on a large scale, but interest in this asset class returned by early 2009. This year their prices have risen and yields have fallen. Convertibles currently offer a combination of potential increase in value connected to a possible rise in the stock market. The yield is also still positive and stands at around 2.5 per cent. Actually the yield should be negative, considering the pricing that normally occurs in the option market. Fairly short duration is another advantage of convertible debt instruments today, since the forecast is for gradually rising interest rates.

Government bonds issued by fast-growing emerging market (EM) countries are also potentially attractive, and although we have not yet invested in such bonds, they are on our radar. EM bonds offer yields that are higher than government bond yields in the OECD countries. Growth rates (see page 16) as well as economic fundamentals are stronger in the EM sphere. Public sector finances are in better shape than in the OECD. The total budget deficit is equivalent to a bit more than -4 per cent of GDP, compared

Index

Convertibles combine advantages 3000

3000

2750

2750

2500

2500

2250

2250

2000

2000

1750

1750

1500

1500

1250

1250

1000

1000

750

1998

2001

2004

750

2007

Source: Reuters EcoWin

23

Convertible debt instruments combine the advantages of equities and bonds. When European stock markets fell about 60 per cent from summer 2007 to spring 2009, the European convertible index lost 25 per cent. Since March, convertibles have gained a good 20 per cent (stock markets over 55 per cent).

Tema: Asset1class: Hedge funds

Perhaps it was too easy • The recovery is continuing… • …although there are risks • But conditions are better than normal After more than six months of genuinely good returns and a comparatively easy market for nearly all hedge fund strategies, a change may occur as normalisation continues and corrections take place. In one-way markets − like the steady rise so far this year − less qualified hedge fund managers unfortunately take many long positions. Even though these managers are not so skilled at handling portfolio hedges, they have still been able to report good value appreciation. The question is whether the recovery has been too easy.

Hedge funds continued to rise sharply in value during the third quarter of 2009, but early in the fourth quarter they showed a small decline in overall returns, according to the HFRX Global Hedge Index. In contrast, the Credit Suisse/ Tremont Index rose marginally (see table below). The second half of October was a little tougher, with downturns almost across the board as market worries mounted. Volatility as measured by the VIX index rebounded towards 30, making it generally harder for hedge funds to perform well. Since early November, volatility has again subsided, with the VIX dropping to a low of around 20. This index is thus close to its long-term average, and very far from its peak of around 80 during the crisis of last autumn and winter.

For less skilled managers, our assessment is that the hedge fund market has been too easy. They should instead have

Credit Suisse/Tremont Hedge Fund Index Performance Index/Sub Strategies

Value

Oct 09

Source: Credit Suisse/Tremont YTD

1 Year

Annl*

Std Dev*

Sharpe*

Credit Suisse/Tremont Hedge Fund Index

404.13

0.13%

15.11%

10.30%

9.22%

7.84%

0.71

Convertible Arbitrage

316.90

2.16%

42.99%

38.93%

7.56%

7.25%

0.54

71.80

4.79%

-19.27%

-18.21%

-2.07%

16.99%

-0.33

Emerging Markets

Dedicated Short Bias

332.70

0.90%

25.79%

23.70%

7.89%

15.63%

0.27

Equity Market Neutral

236.50

-0.35%

4.89%

-37.28%

5.59%

10.89%

0.18

Event Driven

455.65

0.43%

15.20%

10.10%

10.05%

6.08%

1.06

Distressed

522.69

0.71%

15.59%

7.03%

11.01%

6.71%

1.10

Multi-Strategy

426.10

0.21%

14.84%

11.80%

9.59%

6.45%

0.93

Risk Arbitrage

306.59

0.16%

10.43%

12.18%

7.33%

4.23%

0.88

Fixed Income Arbitrage

207.35

1.94%

24.32%

16.42%

4.71%

6.09%

0.18

Global Macro

636.99

0.21%

9.32%

12.23%

12.41%

10.32%

0.85

Long/Short Equity

463.35

-1.21%

15.27%

14.84%

10.17%

10.09%

0.65

Managed Futures

266.33

-2.17%

-6.28%

-0.98%

6.38%

11.72%

0.24

Multi-Strategy

336.48

1.12%

22.01%

14.59%

8.10%

5.53%

0.81

* Average Annual Index data begin in January 1994. Monthly Standard Deviation annualised. Sharpe ratio calculated using rolling 90 day T-bill rate.

24

Asset class: Hedge funds

quarter or so, we can upgrade these strategies to a positive view. If this is to happen, though, the world economy and company transactions will have to live up to today’s consensus, a continued and steady recovery in both cases.

been forced out of the market (the very worst are already gone, however). Genuinely skilful managers, however, have good potential ahead. They have continued to hedge the downside. There is consequently a risk that these managers may have achieved relatively poor value appreciation this year. Yet history shows that high-quality managers come out as winners in tougher times. Last year’s crash illustrates this with dramatic clarity.

Those CTA (Commodity Trading Advisors) funds that focus mainly on long commodity positions performed best during the rough patch in October. This was because volatility has been relatively unchanged in commodities, unlike other asset classes that CTA funds use: fixed income management, equity index, equities and foreign exchange management. The managers’ good earnings in commodities did not suffice to offset the downturns in other asset classes, however. Overall, we have a positive view of CTA. Trends began to be established during the second quarter, and these have continued. If nothing unforeseen happens, CTA should have good potential ahead.

Good opportunities for hedge funds The large adjustments that have occurred during 2009 in order to normalise prices have been extraordinary, and they should also be viewed as such. It is now time to lift our gaze and look beyond the present, focusing instead on more long-term, reasonable trends. Although the first lucrative recovery phase is over, hedge funds should have several years of better than normal returns ahead − especially the high-quality funds.

We are also positive towards Macro strategies. The technique of investing across several different asset classes provides good opportunities for future returns, we believe. Examples of recent transactions by Macro managers are buying the S&P 500 and selling Nasdaq. There is a trend towards investing in large companies again instead of small ones. We can also see that many Macro funds are still selling US dollars, but this position is showing a tendency towards becoming over-established, and there is a risk of corrections. This needs to be monitored, since a broad market shift in attitude towards the dollar would change the attitude towards many other asset classes as well.

We have a neutral view of Equity Long/Short (L/S) as a whole. Funds with genuinely high-quality managers remain attractive, however. We are choosing to try to focus on managers who possess knowledge and common sense and do not follow the herd. Those who merely go along with the majority will eventually have a rough time. There are special reasons to comment on Emerging Markets L/S, since it is important to be aware that in some cases hedging is hard to achieve, and in most cases it is rather expensive. This category is thus more similar to ordinary equity investments than are other Equity L/S funds. These investments may still be attractive, however, but we must not forget their different characteristics.

A normalised world will bring a positive change in opportunities for Macro managers to generate returns. It is no longer merely a matter of central bank-directed stimulus. Instead, there will be additional driving forces for Macro managers to take advantage of.

As for Fixed Income, we favour Credit L/S and Fixed Income directional plays, while we are currently trying to avoid Relative Value. The Convertible Arbitrage strategy has had a fantastic 2009, recouping virtually its entire loss of value from last year. But prices have essentially been normalised, which means that we now have a neutral view of Convertible Arbitrage.

On the whole, the good times for hedge funds will continue. At the main strategy level, we prefer Macro, Distressed and Fixed Income and are more neutral towards Equity L/S and Event Driven strategies, but at the sub-strategy level the picture is more varied.

In Distressed strategies, we also foresee good opportunities for L/S, but we are more neutral towards long-term strategies. Yield spreads in High Yield have narrowed greatly during 2009. As a result, certain individual investments (companies) have followed the trend towards narrower yield spreads without having genuinely qualified for this at the company level. Those managers who can manoeuvre properly with long positions against hedged short positions have good potential to generate fine returns ahead.

Index

Different strategies follow different patterns 1600

1600

1500

1500

1400

1400

1300

1300

1200

1200

1100

1100

1000

1000

900

900

800

800

700

Event Driven and Merger Arbitrage are becoming attractive, since a growing number of structurally motivated company transactions are being announced. It is still rather early to favour these strategies, but we are montoring this area more intensively and expect that within one

2003

2004

Global Hedge Fund Index Macro Index

2005

2006 Equity Hedge Index Event Driven Index

2007

2008

2009

700

Relative Value Arbitrage Index Source: Reuters EcoWin

The chart shows last year’s dramatic crash and this year’s recovery curves for several hedge fund strategies.

25

Tema: Asset1class: Real estate

Still an uncertain situation for real estate • Major problems persist… • …but there are bright spots • We are maintaining a wait-and-see attitude towards real estate investments The real estate market still has major problems due to tight credit following the financial and economic crisis, but there are signs of recovery. In our last Investment Outlook (September 2009), we mentioned that prices of private homes in Florida and elsewhere had increased. In recent months there have been further signals that real estate as an asset class is slowly healing. The recovery is still at an early stage, but to achieve genuinely good earnings on real estate investments it is necessary to buy early.

homes have already shown signs of recovery, and this is now also true of commercial properties. Early in November, the Massachusetts Institute of Technology’s Center for Real Estate (MIT/CRE) published a report showing that institutionally owned commercial properties in the US had risen in price by 4.4 per cent since bottoming out. The low point thus seems to have passed. As the chart below indicates, according to the TransactionBased Index (TBI), commercial property prices have rebounded concurrently with a sizeable increase in demand, but supply is continuing to shrink. The pace of this decline has slowed, however, and there are many indications that the index will show a growing supply when it is published the next time.

For investors interested in the real estate market and with access to long-term capital, now may be a good time to invest directly in properties. The location and quality of properties are normally key factors, and in the current situation this is even more valid. For financial investors the picture is a little different, as we will explain later. Private

Greater demand for commercial properties 220 200

Source: MIT/CRE

180 160 140

The transaction-based price index (TBI) has rebounded, while demand has risen substantially. Supply is still shrinking, however.

120 100

D

ec -0 Ju 0 n D -01 ec -0 Ju 1 n D -02 ec -0 Ju 2 nD 03 ec -0 Ju 3 nD 04 ec -0 Ju 4 nD 05 ec -0 Ju 5 nD 06 ec -0 Ju 6 nD 07 ec -0 Ju 7 n D -08 ec -0 Ju 8 n09

80

Price Index

Demand Index

Supply Index

26

Asset class: Real estate

The research and consulting company Real Capital Analytics (RCA) has gathered global data on commercial properties that also indicate an improved situation in recent months. This is visible, among other things, in higher real estate market sales volume, with China and other parts of Asia leading the way.

One central factor behind the slow pace of normalisation is that the banking system is not lending as much capital to property investors as previously. Large loans have been reduced in the wake of the financial crisis, while there has been intensive public debate and great uncertainty about future bank regulation. It is thus natural that banks are extra cautious about granting new loans, which is lengthening the time it will take for the real estate market to normalise. This means that renegotiated contracts become financially problematic for property investors and new projects are being delayed and becoming more difficult to carry out. As financial investors, we notice this clearly; many more real estate market players are contacting us seeking investment capital.

Higher overall volume

Inflows to real estate funds

In contrast to MIT/CRE, however, the Moody’s/REAL Commercial Property Price Indices (CPPI) fell by 3.9 per cent in September. According to Moody’s, prices of American commercial properties have fallen by more than 40 per cent since their peak in October 2007. The Moody’s index is broader than that of MIT/CRE, which only measures institutionally owned properties.

Flows of financial investments in properties have begun to take off. According to Jones Lang LaSalle, US real estate investment trusts (REITs) have attracted USD 30 billion so far this year, which is a sign that financially strong property investors have again begun buying. This is also evident from yield trends. German real estate funds have also reported inflows of around EUR 3 billion since the beginning of 2009, and RCA is reporting that direct property investments have increased in the UK, France, Germany and the Netherlands. The UK, in particular, has attracted many foreign speculative buyers, and this has set the market in motion. The French market is showing signs of being able to follow the British example. In North America, we generally prefer the Canadian real estate market to the US market, though the Washington, D.C. and Philadelphia regions also look attractive.

160 140 120 100 80 60 40 20

20 07

Q 20 1 07 Q 20 2 07 Q 20 3 07 Q 20 4 08 Q 20 1 08 Q 20 2 08 Q 20 3 08 Q 20 4 09 Q 20 1 09 Q 20 2 09 Q 3

0

Americas

EMEA

Asia Pac. (ex China)

China

Source RCA Overall volume in the commercial real estate market has risen, especially in China and other Asian countries.

Especially encouraging – aside from higher volume – is that returns have also risen. Today investors earn yields of around 7 per cent when buying a property with a conservative risk profile, which is an attractive level. Looking at the S&P/Case-Shiller Index of 10 major American cities, measured as a 12-month change, we are now seeing a clear slowdown in the rate of price decline. Compared to last summer, prices are climbing. This is a bright spot in the American property market.

In the Asian market, China, Hong Kong, Seoul and Singapore have set the pace. We expect that the strong economic growth under way in Asia will continue to sustain the real estate market. As for financial real estate investments, we still generally foresee difficulties for broad-based real estate funds to generate good returns. However, risks of capital losses or obstacles to withdrawal from funds are substantially smaller today than only one quarter ago. Indications and assessments of return levels over the next 1-2 years show that these will be lower than normal. Meanwhile there are still risks, which − if anything − are higher than normal.

Sharp decline in housing construction However, recent statistics on US housing starts and building permits have been noticeably weak, with sharp declines in both. This was contrary to market expectations and clearly demonstrates that there are still problems in the real estate sector − even though there are bright spots. One important reason behind the negative figures is the sizeable number of unsold and unrented homes. The National Association of Homebuilders (NAHB) Index in the US has also suffered a downswing.

Since there are still numerous reasons not to invest in real estate, we choose to maintain our wait-and-see attitude towards financial real estate investments. We are abstaining from real estate investments, since our current assessment is that expected return in relation to risk-taking is better in other asset classes.

It will take time before the real estate market has completely normalised, but the large stimulus packages launched by governments and central banks have naturally been very helpful in putting the market back on more or less firm ground. 27

Tema: Asset1class: Private equity

Private equity faces a brighter future • World economic recovery is stimulating private equity • The secondary market offers good access to fine projects • Financing is a key issue were good − actually above expectations − but companies’ guidance for the future was still somewhat cautious. This is understandable, since corporate executives do not have especially much to gain by counting their chickens before they hatch, especially those at listed companies. Meanwhile valuations have got a bit out of hand since their incredible rally earlier this year, causing investors to focus even more on how the future will look.

Banks worldwide are continuing to recuperate and are moving closer to normal conditions each passing day. Along with the overall economic recovery from the worst financial and cyclical crisis in generations, this is laying the groundwork for a climate beneficial to both listed and unlisted companies. The second quarter of 2009 was an epoch-making period, when the financial world transitioned from crash to stabilisation and then to recovery. This is illustrated clearly by the trend for listed private equity, measured by the LPX50 Index, which has been turning in a fantastic performance since last spring.

Macro statistics and revised forecasts of GDP, for example, are generally showing a clear improvement in optimism among a great majority of observers. Now they are waiting for companies, both listed and unlisted, to show greater explicit confidence in the future. We expected improved conditions over the next few years, which should benefit private equity investments, although brief downswings may naturally occur.

Index

LPX 50 – Listed private equity 1750

1750

1500

1500

1250

1250

1000

1000

750

750

500

500

250

As always, it is necessary to be very selective in choosing investments. We are still somewhat cautious about primary investments in private equity. If the right primary project appears, we may invest in such a project, but at present we are mainly analysing secondary market investments. One reason is that there is an ample supply of good projects to invest in, since there are many investors who need to reduce their exposure to private equity for various reasons.

250 2005

2006

2007

2008

2009 Source: Reuters EcoWin

The chart shows the performance of listed private equity firms in recent years, including a spectacular upturn in 2009.

What happened was that access to financing for private equity began to improve, both from banks and investors. This eased the worst distress from last autumn, when the flow of credit was cut off. Since then the situation has gradually improved, as the price chart clearly shows. October was a month of minor reversals, when most asset classes took a break because the earnings reporting season for the third quarter was drawing to a close. Earnings

This naturally creates opportunities, in the sense that investors with plenty of available capital are in a good negotiating position in relation to sellers who need to free up capital. Taking advantage of other people’s misfortunes may seem a little unfair, but at the same time it means that projects will replace an uncertain investor for an investor with capital who is far more financially stable. In the final 28

Asset class: Private equity

Other aspects to take advantage of as a buyer, especially in the secondary market, are:

analysis, this should be positive for private equity as a whole, with fewer bankruptcies as a consequence. We are focusing on the good characteristics of the asset class. Meanwhile we believe that private equity represents fine investments for our customers.

- The market is inefficient, creating good opportunities for well-informed buyers. As mentioned above, sellers are often knowledgeable and it is thus especially important for sellers to be knowledgeable as well.

What was revealed after the deep crisis was that many existing investors had committed too much capital to various illiquid assets, for example in private equity projects or real estate. The consequences of these commitments were that many people had to sell off all or parts of their investments. This process is continuing today and will do so for some time to come.

- The potential for gaining access is important, since approval is often required from private equity funds. - The market will probably rise. The reason is large portfolio allocations to private equity during 2005-2008; in our assessment, portions of these holdings will pass into the secondary market.

Last summer, a rather large number of projects were put up for sale, and it was obvious that desperate sellers needed to get rid of some of their investments to be able to keep others. For numerous investors, it was simply a matter of survival. Selling assets enabled them to shrink their balance sheets significantly. After all, it is generally better to trim one’s balance sheet than to completely disappear from the game.

- The market is offering good pricing, with levels more than 50 per cent below net asset value (NAV). This raises the question of how relevant NAV actually is. The market focuses on the discount, but we think it is more relevant to assess future potential. There are various reasons why private equity investments have come out into the secondary market. One obvious reason is that many investors ended up overweighted in illiquid asset classes when nearly all investments fell in value during the crisis. This has resulted in pressure to sell private equity investments. Another factor is that the financial situation of investors has deteriorated so much that they have been forced to sell. The value of many investments has again increased during 2009, reducing the pressure to sell as the overall financial health of investors improves. This means they are increasingly well placed to survive the crisis. There are naturally other reasons, but those mentioned here are among the most common. As buyers, we can also take advantage of these.

A staring match between sellers and buyers We have now reached a situation that resembles a staring match between sellers and buyers, and the question is which category will blink first. One widespread belief is that it will be the sellers, but as the global economic recovery progresses, their situation will improve too. Our assessment is that buyers will try to invest capital they have parked on the sidelines in order not to risk missing out on good business opportunities. The result is likely to be an increased number of transactions over the next few quarters. Although discounts are gradually decreasing, there will probably be good business opportunities for buyers of private equity, both today and for another year or so. The likelihood of buying a pig in a poke has greatly diminished. Actually so have potential returns, but the risk/return ratio is still considerably better today than only six months ago.

Potential sellers of private equity are those who have been hardest hit by the crisis and the subsequent credit crunch, which affected the world economy generally and the financial industry in particular. These may include US or global foundation funds, pension funds and banks, but also wealthy private individuals.

The offers that investors receive are obviously of varying quality, among other things because sellers − who are generally knowledgeable − want to divest what they regard as their worst assets first. It is thus important that we as buyers make well-informed assessments of which offers are worth investing in. What we are especially looking for is:

Improvement potential for private equity There is structural improvement potential both in the world economy and in the private equity market. Because of this, along with the extraordinary opportunities available primarily in the secondary market, we are now buyers of private equity. This view is reflected in the portfolios of our Modern investment programme.

- Sound business concepts with good future potential. - Strong and stable owners. - Projects with good potential to obtain future financing.

29

Tema: Asset1class: Commodities

Commodities showing continued strength • Continued weak US dollar is pushing commodity prices up • A growing middle class in emerging market countries is a long-term key... • …and now China is building roads in Africa So far during 2009, the S&P 500 share price index is up about 25 per cent in USD terms, while the S&P GSCI commodities index has climbed less than half as much. During the autumn, however, commodities have been very strong and since early October the GSCI Index has risen substantially faster than the S&P 500: by more than 6 per cent, compared to less than 5 per cent (see table on page 32). It thus appears as if commodities are trying hard to catch up with the stock market.

One reason why maize has recently risen in price is the delay in American harvests. This year’s harvest is the latest since 1985. Only 20 per cent of the crop had been brought in by the end of October, compared to a five-year average of nearly 60 per cent. Rain during planting season followed by rain at harvest time has undoubtedly created problems for American farmers. Finally, precious metals have had a good year, since many investors have chosen to buy gold as a form of protection against inflation and also to diversify their portfolios. The price of precious metals rose 8.3 per cent in the third quarter and 31.6 per cent for the year to date. The price of gold has clearly established itself at above USD 1,000 per ounce. Looking a little further back in time, over the past decade the price of gold has gone up by about 250 per cent, making it the commodity that has climbed the most in price. During the same period, the USD has fallen in value by 25 per cent, so this is not the entire explanation. In our assessment, part

Base metals have been the stand-out segment in 2009, with a fantastic gain of 69 per cent. Copper, lead and zinc have been the best assets in the segment. This is due, among other things, to the major infrastructure packages that China, the US and other countries launched during last winter’s deep crisis, since these commodities are used to a great extent in various kinds of construction projects. Copper is being priced at close to the levels prevailing at the end of 2007, and the 2008 price slide has thus largely been reversed.

Changed investor behaviour

Index

The worst performer this year has been livestock, at -15 per cent. Hogs have recovered a bit during the current quarter, enabling livestock as a whole to show an upturn of nearly 2 per cent. The market for feeder cattle remains tough, however. In agri-commodities, the picture is highly mixed, with large price increases especially for sugar, but also cotton and soya beans. Wheat and maize (corn), however, have had a rather miserable year, but have got their revenge in the past few months. For agri-commodities as a whole, the outcome is a price increase of 9.3 per cent in the latest quarter but an upturn of only 1.9 per cent since January 1.

350

350

300

300

250

250

200

200

150

150

100

100

50

2004

2005

GSCI TR Index Agricultural Index Energy Index

2006

2007

2008

2009

50

Industrial Metals Index Livestock Index Source: Reuters EcoWin

The US economy and the USD have played a major role in the good returns on commodities this year. Many investors have also chosen to buy gold as protection against inflation.

30

Asset class: Commodities

Although we cannot yet fully summarise the outcome of the deep crisis, it appears as if the commodities asset class has fundamentally changed − resulting in both good and bad effects. One good effect is that it has become easier for investors to use this asset class in their portfolios. One bad effect is that diversification opportunities are not available in the same way as before. With more prospective buyers, commodities have become more like equities in nature and commodity prices react more quickly. In share valuation, we look into the future and expect certain trends. This characteristic now seems to have become part of the commodities market as well, naturally combined with the connections between commodities and the general economic situation.

of the explanation lies in changed investor behaviour. Due to globalisation effects, the potential for diversification in fixed income and equity investments has gradually diminished. As a result, there has been greater interest in investments that can be used to spread risks in portfolios, among them gold.

What has happened with commodities and why The US economy and currency have played a major role in the good returns on commodities this year. As the USD has lost value, physical commodities have risen in price. Another factor is that low US interest rates have made USD fixed income investments uncompetitive. This has given commodities a good opportunity to rise in price, among other things due to a favourable capital flow situation. A third reason for the rising prices of certain commodities is heavy precipitation in regions like North America and drought in certain other parts of the world. The El Niño phenomenon (warming of equatorial waters every few years), which controls rainfall around the Pacific Ocean, has caused divergences from normal weather patterns.

Five-year correlations, commodities/equities 0.6 0.5 0.4 0.3 0.2 0,1 0 -0.1 -0.2 -0.3 -0.4

Commodities will have a good chance of delivering good returns as long as the USD remains weak and US interest rates are kept low. Aside from these short-term factors, many other factors favour commodities in the longer term.

Source: EcoWin

1974 1979 1984 1989 1994 1999 2004 2009 Five year correlations MSCI AC World vs. GSCI Total Return

The correlation between global equities and commodities has increased, but the future trend is unclear.

One such factor is the growing middle class in the emerging markets (EM) sphere, which appears likely to match 50-70 years of Western economic growth in perhaps 20 years. This makes it easy to understand that the changes will come fast. In China alone, 700-800 million people will make the transition from relative poverty to middle class status. Adding countries like India, Malaysia, Indonesia, Bangladesh and many more, the situation becomes even clearer. In addition, the population of the earth is also increasing. Today there are about 6.5 billion people. In 40 years there will be more than 9 billion. This will create problems in a world where humans are already pushing the limits of many resources.

Taking into account the price trends of this year and last, along with our thoughts about the future − such as the emerging middle class and growing world population − it is difficult not to be optimistic about commodities as an asset class. We expect prices to continue climbing, not in a straight line but instead with some reversals. One underlying factor pointing towards a continued rise in prices is the change in balance between supply and demand, with supply lagging. In principle, only new technology could alter this situation. Commodities have traditionally provided outstanding returns in times of inflation, but given the prevailing supply and demand situation today, there is good potential for commodities to generate fine returns regardless of whether inflation is imminent or not.

It is worth noting that political leaders have understood the vital importance of natural resources and have acted accordingly. For many years, the US has been careful to safeguard its oil supplies, and this year it has become apparent that China is thinking − and acting − along similar lines. China is investing a lot of capital all over the world, but with a special focus on Asia and Africa. In Africa, for example, China is building roads and buying mines to ensure its supply of the commodities that are abundant on that continent.

In a one-year perspective, we are optimistic about precious metals, base metals and agricultural products. We are somewhat more reserved about energy. We are choosing to retain the existing commodities allocation in our Growth strategy and to expand it further in the Aggressive portfolio. The positive underlying picture for commodities strengthens our conviction that they will provide fine contributions to our future portfolio returns, as well as good risk diversification characteristics − though not as good as previously.

Aside from demand for commodities for real consumption, nowadays financial investors and speculators also have substantial influence on prices. The asset class has partly changed character due to the introduction of new investment instruments and the fact that many investors in the world − not only the US − have begun using commodities as part of a diversified portfolio. 31

Asset class: Commodities

Changes in commodity prices during 2009 November 20, 2009

Index level

1 Day

MTD Change

QTD Change

YTD Change

S&P 500 TR

1 794.65

-0.3%

5.53%

3.57%

23.52%

S&P GSCI TR

4 460.90

-0.39%

0.75%

6.66%

11.65%

Energy

1 004.18

-0,63%

-0,95%

6.03%

9.9%

Crude Oil

1 487.42

-0.74%

-0.21%

8.15%

7.44%

823.15

-0.6%

1.62%

9.5%

29.37%

Brent Crude Unleaded Petrol

2 691.53

0.21%

0.67%

11.68%

75.04%

Heating Oil

1 126.84

-1.02%

-1.38%

6.36%

18.8%

703.66

-1.74%

-3.28%

7.82%

21.37%

Natural Gas

2.04

0.91%

-13.01%

-22.52%

-61.39%

Petroleum

2 178.69

-0.73%

-0.07%

8.52%

18.58%

Non-Energy

2 261.50

0.18%

4.96%

8.17%

13.84%

Industrial Metals

1 580.14

0.78%

4.26%

7.68%

68.87%

87.79

1.44%

7.59%

7.85%

24.32%

Gas Oil

Aluminium

4 184.26

0.74%

5.5%

10.75%

119.35%

Lead

Copper

443.40

0.62%

1.31%

1.83%

123.91%

Nickel

463.39

-2.21%

-9.2%

-7.44%

39.17%

Zinc

136.52

1.8%

4.08%

13.63%

75.62%

1 498.91

0.37%

10.57%

13.3%

31.64%

Gold

Precious Metals

640.76

0.42%

10.23%

13.63%

28.68%

Silver

689.47

-0.08%

13.44%

10.7%

61.93%

Agriculture

604.28

-0.32%

6.07%

9.31%

1.91%

Wheat

247.58

-0.56%

13.13%

22.22%

-20.66%

69.51

-0.65%

11.38%

16.64%

-18.64%

116.66

-0.91%

7.14%

14.01%

-11.77%

3 155.27

0.67%

7.12%

12.5%

23.63%

Kansas Wheat Corn Soya Beans Cotton

212.26

1.47%

3.6%

11.52%

27.44%

Sugar

199.81

-1.19%

-1.49%

-11.49%

55.29%

Coffee

107.80

- 0.95%

-2.04%

3.87%

10.13%

Cocoa

47.04

3.19%

-1.61%

3.31%

18.89%

2 019.65

0.68%

-1.49%

1.56%

-15.28%

110.31

0.93%

-2.52%

-4.99%

-8.15%

Live Cattle

3 346.79

0.06%

-2.29%

-2.79%

-10.59%

Lean Hogs

218.08

1.74%

0.28%

14.65%

-23.89%

80.35

-0.16%

-0.41%

-3.4%

35.27%

Livestock Feeder Cattle

Softs

Source: S&P GSCI The table shows price changes for various commodities during the year to date (YTD) but also in the latest quarter (QTD) and month (MTD). It thus shows changes in trends. For comparative purposes it also includes the US stock market, as measured by the S&P 500 index.

32

Asset class: Currencies

Focus on interest rate differentials • The US dollar remains under pressure • Good prospects for emerging markets and commodity-related currencies • China will eliminate its currency peg In the foreign exchange (FX) market climate that we foresee, risk appetite will still play a key role. Taking advantage of interest rate differentials will also be an ever-stronger driving force. These factors point towards continued heavy demand for both emerging market (EM) and commodityrelated currencies. Meanwhile the US dollar (USD) will continue to weaken.

There are many indications that the current optimism will last another while. Risk appetite will thus remain a central driving force in the FX market. The most serious blockages in the financial system have been removed, substantially improving the odds of global economic recovery. Fiscal policies around the world are expansionary, to say the least, and interest rates in the OECD countries are recordlow. The international community has signalled that stimulus programmes will remain in place for a long time, in order not to risk economic reversals. Due to stimulus measures and normalisation of the financial market, economic activity has revived. The world economy is on a path towards better times, which encourages risk appetite.

Rising stock markets mean weaker USD Source: Reuters EcoWin

1.600

1300

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1200

1.500

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1.450

1000

1.400

900

1.350

800

1.300

700 Sep

Dec Mar 08 EUR/USD

Jun Sep 09 MSCI World

MSCI

EUR/USD

1400

Given a greater willingness to take risks, coupled with less volatility in the FX market, investors are increasingly taking advantage of existing interest rate differentials. They borrow where interest rates are low and invest where they are high − a practice known as “carry trading”. The result is downward pressure on the currencies of low-interest countries, while the attractiveness and currency rates of high-interest countries increase.

1.250

For more than six months, risk appetite has been the main driving force in the foreign exchange market. This is reflected by the strong correlation between stock markets and the US dollar. When risk appetite is high, investors borrow dollars and exchange them for currencies that offer the highest expected return.

The gap between interest rates in different regions is also expanding. On the one hand, most OECD countries are currently maintaining ultra-loose monetary policies. They will not be tightening their interest rates soon. On the other hand, in countries that have survived the crisis relatively unscathed, interest rates are now on their way up from already fairly high levels (primarily in Asian emerging economies and commodity-producing countries). Even bigger interest rate differentials thus make it even more likely that monetary flows will continue moving from the OECD towards emerging markets and commodity producers.

Greater risk appetite has had a sizeable impact on the foreign exchange market during the past six months, as reflected by the dollar exchange rate in particular. Having been regarded as one of the few safe havens after the Lehman Brothers crash, the USD is now used primarily as a currency for financing investments in regions with the highest potential returns. This change in risk appetite has led to a major weakening of the dollar, while the demand for EM and commodity-related currencies has increased. 33

Asset class: Currencies

Krona regaining lost ground

dominated currency reserves. For example, India recently bought 200 tonnes of gold from the IMF.

The prevailing market climate also favours the Swedish krona (SEK), which has gained about 13 per cent measured by the trade-weighted TCW index since March. When risk appetite is high, small peripheral currencies like the SEK benefit. The global economic upturn will also bring growing international trade, which will help the export-dependent Swedish economy. Sweden’s strong current account surplus and forecasts of relatively early interest rate hikes by the Riksbank make it even more likely that the krona will regain lost ground.

However, we disagree with those who fear an imminent dollar collapse. The US current account deficit is rapidly shrinking, due to weak domestic demand and the role of the weak USD in stimulating exports. The USD is already trading at well below its long-term trend level and is clearly undervalued in terms of purchasing power-adjusted exchange rates. Nor is it likely that any asset class other than the USD will become the first choice of central bank foreign currency reserves in the near future. India’s gold purchase was equivalent to about 8 per cent of annual gold production and cost USD 6.7 billion. By way of comparison, total global foreign currency reserves grew by no less than USD 200 billion during October alone, or thirty times more than India’s gold purchase. The gold market is thus too small to absorb a major diversification away from the USD.

The economic crisis in the Baltic countries remains a source of uncertainty for the krona, but the risk of reversals is decreasing as the global economy improves. Looking a year ahead, we expect the krona to strengthen to SEK 9.70 per euro (EUR). Even if it reaches this level, it will still be undervalued in a historical perspective.

China likely to ratchet up yuan

It is also unlikely that any other currency could take the place of the USD in the foreseeable future. China is growing fast, but its economy is still far smaller than that of the US. The CNY is also not completely liquid or convertible. The Japanese yen is not an alternative either, since it is hardly traded outside Asia. The most realistic alternative would be the EUR, but some observers question whether the euro currency union project will actually survive in the very long term.

Perhaps the most important question in the foreign exchange market right now is how China’s currency policy will unfold. The Chinese authorities have let the yuan (CNY) remain largely stable against the USD since the summer of 2008. They now seem to accept the need to again allow a gradual currency appreciation against the dollar, aimed at reducing their export dependence and instead stimulating domestic consumption. Our assessment is that China will begin to implement this currency policy in the first quarter of 2010. We predict that the CNY will strengthen by 7 per cent against the USD both next year and in 2011.

By way of summary, we believe that the USD has now undergone most of its weakening. In the short term and while risk appetite persists, it will nevertheless remain an attractive financing currency and continue to lose value.

Stronger yuan ahead

Better current account will strengthen USD

8.50 8.25 8.00

7.25 7.00 6.75 6.50 6.25 6.00

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: Reuters EcoWin

Both global and domestic motives will persuade Chinese authorities to revaluate the yuan against the dollar. We believe this new currency policy will be implemented early in 2010.

2

170

1

160

0

150

-1

Current account

140

-2

130

-3

120

-4

110

-5

100

USD-index (BIS)

-6 -7

USD-index (BIS, trade-weighted)

7.50

Current account % of GDP (4Q,MA)

USD/CNY

Current account and USD

USD/CNY

7.75

90 75

80

85

90

95

00

05

80

Source: Reuters EcoWin

A gradually shrinking US current account balance will eventually benefit the dollar. At present, however, “carry trading” is causing sizeable capital outflows from the US − which are reported in the capital account − and is weighing down the dollar in the short term.

No dollar collapse around the corner The prevailing FX market climate, with high risk appetite and a focus on interest rate differentials, is thus unfavourable to the USD. If China also revaluates the CNY, the USD will come under further pressure. Due to the sharp decline in the dollar, central banks in many fast-growing economies have shown greater interest in diversifying their USD34

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