Tuesday, May 10, 2011


Worries persist… now the Fed looks to reduce liquidity

We prefer emerging markets over developed markets

Federal reserve moves to reduce support for the US economy

Japanese earth quake impact on growth worse than expected

Macro hedge funds struggle to make money out of the volatility

Local markets helped by money supply growth


Economists dream of a world of sustainable good economic growth, with low inflation. Sadly in
the 1990s just as the global economy achieved such a phenomenon, governments, consumers
and investors leveraged it and the rest is history. Ever since the financial crisis the financial
markets have managed to put the problems of the future to one side. A mountain of support
from central banks and governments has managed to overcome fears as to the impact of the
huge burden of debt saddled on Japan, the United States and Europe. However governments
can no longer provide the same support, witness the Eurozone problems and the downgrade to
US credit rating. And central banks cannot provide ever-lasting liquidity in the face of a sharp
increase in inflation. The ECB has raised rates and the US Federal Reserve last week started
its process of winding down its unprecedented support for the economy.

Last week we decided to cut our exposure to developed markets in favour of the emerging
markets. In essence we are moving back to our long held view that emerging markets will
outperform developed markets- a view we now hold on both a tactical and strategic view. We
advise clients to cut their exposure to developed markets particularly the Eurozone and Japan.
We believe the Euro and Yen to be overvalued versus the dollar and that over time investors
could suffer losses on their equity holdings from currency weakness.

Last week in the U.S., the Federal Reserve Open Markets Committee (FOMC) decided to start
to ease back on all the support it has provided the markets since the financial crisis. The Fed’s
hand has been forced by the pick-up inflation, the improved outlook for growth and the need to
withdraw financial measures that were clearly designed for emergency conditions. The fact that
much of the profit of the US financial sector has been due to the very easy monetary conditions
given to them by the Federal Reserve is an often-missed point. Next up is the US government
who urgently need to address their debt problem. One measure of the scale of the structural
problems is the size of the entitlement programs. These programs (that cover things such as
Social Security and Medicaid) have grown 11x since the 1960’s whilst GDP has grown only
3.0x. The problem is that typically in front of a Presidential election (in 2012) there is little
government action to reduce spending and increase taxes. However these are not normal
times. The pressure to cut spending is even greater due to the waning credibility of the US in
debt markets. The downgrade to negative watch by S&P of US sovereign credit rating was but
one measure of the problem. Last week, New Jersey was yet another US State to be

Private Banking - CIO Office. PBIGD020511U1899 - May 2011



MAY 2, 2011

downgraded by the rating agencies. The more that parts of the machinery of US government
get shut out of the credit markets the more the pressure to reduce debt.

We are getting the first signs of the weakness of Japan post the earth quake. Industrial
production fell 15.3% month-on-month in March nearly five times the impact of the Kobe earth-
quake in January 1995. Encouragingly there is more talk and action to bring the manufacturing
sector back to health. In some sectors such as energy, there are signs that the repairs are
proceeding faster than expected. The impact on the rest of the world will still be meaningful as
Japanese exports fell 8% month-on-month in March prompting supply disruption problems to
many industries around the world. Car and electronic industries are particularly hit.

Global equities have now reversed their losses of early in April. A combination of the
persistence of low interest rates, good corporate profits and relatively low valuations has
prompted retail buying of equities. Our hesitancy to chase the markets is based on our fears
that there may be an acceleration of monetary tightening, geopolitical problems and ongoing
issues in the Eurozone. On the charts indices such as the S&P 500 have broken out to the
upside pushing through the recent peak of 1340 to close at 1363 last week. The next technical
target is 1426 the previous peak dating back to May 2008.

Hedge fund returns have been muted so far this year for the large heavyweight macro funds.
The HFR index of macro hedge funds is up just 2.2% since the start of the year. The low
returns reflect the general hesitation of the portfolio managers to commit to markets with so
many concerns. Also many of the market moves have been counter intuitive or outsize. The
remarkable fall in the dollar, the relative strength of the Euro and Swiss franc are examples of
the extraordinary market movements this year that were forecast with confidence by very few.
The absolute strength of the gold price as well as equities is also rather remarkable. Gold is
normally rallying when equities are struggling.

Local markets equities consolidated after recent gains last week. Strong money supply
numbers from Saudi Arabia (+13.8% year-on-year) and the UAE +3.3% month-on-month


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