investment strategy private banking

www.lombardodier.com

INVESTMENT STRATEGYPRIVATE BANKING

3rd quarter 2009

Quarterly publication of the Private Banking

Investment Services of Lombard Odier Darier Hentsch

IMPORTANT INFORMATIONPlease see important information at the end of this document.

Data as of July 13, 2009

Edition 2/3

Investment conclusions

The crisis which began in 2007 is still far from

complete and we have positioned our portfolios

comparatively defensively in recent weeks to

refl ect this observation. Within the context of

a positive strategic but more cautious tactical

view of risk taking, we anticipate adding

exposure to risky assets in coming months as

the risk return trade-off becomes more attractive

against the backdrop of a clearer sense of reality

amongst market participants.

The US equity market has recovered to •

almost 11* trailing peak reported earnings and

approximately 15* trend earnings, both at the

very long-run median level and indicative of a

market which must be considered fair value

at best. In aggregate, we are strategically

positive on global developed equity markets

but tactically more cautious.

Massive liquidity injections have leaked into •

Emerging Market Equity (EME), through

hugely expanded bank lending, into infl ation

in monetary assets in China in particular. At

a near 10% premium to developed equity in

aggregate, EME may be vulnerable at current

elevated valuation and depressed risk premia

levels.

There is little or no demand for credit •

and little or no appetite to lend amongst

banks. As a consequence, banks are awash

with liquidity, at almost zero cost, and are

purchasing government bonds aggressively to

take advantage of the almost free profi t from

the spread between the cost of cash and the

yield on government bonds. We anticipate

government bond yields remaining depressed

for some considerable period of time.

Please see important information at the end of this document.

2 Lombard Odier · Investment Strategy – Private Banking · 3rd quarter 2009

The injection of large amounts of liquid-

ity, intended to stabilize the deposit

base of the banking system, alongside

the provision of ample additional capi-

tal by governments seeking to at least

preserve some sense of solvency, has

been both necessary and suffi cient to

remove the threat perceived in the mar-

ket earlier in the year of total economic

and fi nancial systemic failure. As the

system was assured of resuscitation,

if not revival, the “Armageddon” risk

premia refl ected in the pricing of risky

assets was removed and with it the po-

tential for a depression-like collapse in

economic activity. Accordingly, subse-

quent economic data have been unde-

niably weak but clearly an improvement

relative to previously dire expectations.

This spate of positive economic sur-

prises (things could have been so much

worse) was enough for asset prices to

correct from oversold levels. To this ex-

tent, Geithner is correct in suggesting

that pulling the US economy back from

the brink and normalizing conditions is

necessary for an improvement in global

economic activity.

However, whilst market participants

are actively seeking evidence of fabled

“green shoots”, it is well worth bear-

ing in mind that from one quarter to

the next or from one year to the next

there is no correlation between eco-

nomic growth and either earnings per

share growth or equity market total

returns. That is to say, if you knew ex-

actly where and when the green shoots

of economic recovery would appear, it

would be useless to you as an investor!

The chart I (page 3) illustrates our point

perfectly: periods of strong economic

activity are not indicative of great fu-

ture returns. In eff ect what determines

future asset returns is the current level

of valuation, not a hypothetical growth

rate. Similarly, it is simply not the case that faster-growing economies produce better returns than slower-growing economies (if anything, the opposite is

more consistent with observed empiri-

cal facts).

Periods of strong economic

activity are not indicative

of great future returns.

In short, investors who express their

risk-taking views on the basis of arbi-

trary forecasts for economic growth,

or the appearance of “green shoots”,

are likely to be severely disappointed!

Economies expand and contract, com-

panies expand and contract their sales,

but it is simply incorrect to believe that

this process is the driver of investment

returns (in fact, ranking S&P500 com-

panies by 5-year trailing sales growth in

the post-war period produces the coun-

terintuitive result that the slowest-

growing companies delivered the best

returns to investors). In truth, the eco-

nomic growth forecasts of economists

are of no use to investors.

On the basis, however, that developed

country banking systems (which we

believe to be largely insolvent still

and with insuffi cient capital at risk

to withstand further inevitable asset

writedowns) are vulnerable to the

consequences of persistent economic

weakness, it is useful to ask one ques-

tion. If recovery comes, where will it come from?

The straightforward answer is: not consumption. Although representing

the largest portion of GDP in the

United States, the United Kingdom

and developed economies, its contri-

bution to the volatility or cyclicality

of economic growth is comparatively

modest. Economic cycles, recessions,

recoveries, booms and busts are not

triggered or propagated by consumers

but by the extreme cyclicality in the

far smaller component of GDP that is

investment (in inventories and capital

goods by businesses and homes by the

household sector). Given that these

components of GDP are most likely to

be fi nanced with leverage, you can see

that any view that the United States

and global economies can recover even

to sustain long-run trend-like growth

is entirely dependent on the health of

banks and the ability to intermediate

credit. Looking at the US data, in agree-

ment with Tim Geithner, the chart II

(page 3) shows the annual change in

the private sector fi nancial balance

(think of this as the budget defi cit for

the private sector) against the annual

growth in gross investment. Since the

change in the private sector defi cit

represents the leverage cycle as it in-

creases and decreases net savings, we can only see a meaningful recovery in investment spending, to drive the economy overall, if we believe that the savings rate in the private sector is go-ing to fall sharply and / or households and businesses become net borrowers again.

“The rest of the world needs

the US economy and fi nancial

system to recover in order for

it to revive. We remain at the

centre of the global economic

activity with fi nancial and

trade ties to every region of

the globe.”

US Treasury Secretary

Timothy Geithner, speech to

the Economic Club, Washington,

22nd April 2009

Investors, who express their risk taking views on the appearance of “green shoots”, are likely to be severely disappointed


Lombard Odier · Investment Strategy – Private Banking · 3rd quarter 2009 3

-20

-15

-10

-5

0

5

10

15

20

Q1 1985 Q3 1989 Q1 1994 Q3 1998 Q1 2003 Q3 2007 Q1 2012

-4

-2

0

2

4

6

8

-10

-5

0

5

10

15

20

1900s 1910s 1920s 1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s

I. Annualized change in equity index level vs annualized nominal GDP growth by decade

II. Year / year change in private sector balance as a percent of GDP vs US gross investment

Source: Crestmont Research, Lombard Odier calculation

Sources: Datastream, Lombard Odier calculation

Dow

Nom GDP

Investment (% y / y, l.h.s.)

Change in private balance (% points, r.h.s. inverted)

Our analysis on chart III, based upon the

fact that two-thirds of Adjustable Rate

Mortgage (ARM) resets remain ahead

of us, with two or three predictable

waves looming, and that existing weak-

ness in activity and rising unemploy-

ment will worsen the outlook for debt

delinquency rates, suggests that US banks alone still have almost two-thirds of all likely losses to come (total-ing in excess of an additional USD 2.0 trillion based on our estimates). To-

gether with the low prevailing level of

capacity utilization and massive wealth

destruction, this continuing pressure

on banks and the likelihood that credit

remains scarce for quite some time

as the economy deleverages renders

the possibility of a return to defi cits

and / or a reduction in savings rates in

the private sector implausible.

Whilst we have long argued that liquid-

ity and solvency measures were entire-

ly appropriate, our confi dence that the

US banking system can be resuscitated

and not simply revived has been dent-

ed by increasingly politically motivated

policy actions.

any risk is the common equity com-

ponent. Analysts who argue that the

banks are well capitalized appear not

to have recognized this consequence

of government action or are perfectly

happy to count the tax base as part

of the capital structure of the banking

system. As a bank bond debt buyer,

what disincentive do you face when

supplying capital for bad lending prac-

tices and excess when you know you

will be made good by the taxpayer?

Consolidated accounting, much lower

leverage ratios, the potential exposure

of bond holders to losses and capital

requirements proportional to total as-

set levels are preferable to more layers

of politically motivated and ultimately

unenforceable bureaucracy. Moreover,

central banks must include monetary infl ation in their target objective and not just focus on real economy infl a-tion as they currently do: the mainte-

nance of unsustainably low levels of

interest rates in response to a positive

real economy supply shock (China sup-

plying masses of cheap goods to the

world and depressing prices) fuelled as-

The US banking system has been resuscitated

but revival requires more decisive policy actions.

Recent reform proposals by Treasury

Secretary Geithner and Lawrence Sum-

mers assume that more regulation is

superior to better and rigorously imple-

mented regulation: we favor a return to the days when banks were forced to take “haircuts” on assets and hold capi-tal accordingly rather than rely on the

statistical “witchcraft” that passes for

modern banking supervision, changes

to securities laws that allow bank bond

holders to realize losses in accordance

with their place in the capital structure

without triggering default clauses on

all debt in the capital hierarchy, an em-

phasis on debt / equity swaps to halt

the tidal wave of mortgage delinquen-

cies that is likely to stem from two to

three years of continuous ARM resets.

Moreover, we simply cannot accept

that a leverage ratio of 30-35 times is

acceptable in an environment where

the only capital that appears to face

set infl ation in the monetary economy

and contributed to poor and excessive

lending. Positive supply shocks are a

feature of capitalism, they have hap-

pened before and will happen again,

and if the consequences are not to

be the same next time then central

bankers need to drop the excuses and

start to monitor asset price infl ation. It

should not be beyond them to measure

premia and identify bubbles.

Our analysis suggests that whilst we

have successfully avoided a systemic

collapse, measures to sustainably re-

structure the banking system are still

not evident nor is the fi nancial system

“out of the woods” yet given the waves

of losses that loom and far exceed the

capital at risk in the system.

Turning to markets, if the fi nancial

system still faces headwinds and eco-

0

10

20

30

40

50

60

70

11.2008 09.2009 07.2010 05.2011 03.2012 01.2013 11.2013 09.2014

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

III. United States, next reset peaks driven by option ARMs

* Option ARMs show estimated recast schedule based on current negam rate.

Sources: Credit Suisse (US Mortgage Strategy), LoanPerformance, FH / FN / GN

Agency (l.h.s.)

Alt-A (l.h.s.)

Option ARM* (l.h.s.)

Estimated cumulative amount (USD bn, r.h.s.)Subprime (l.h.s.)

Unsecuritized ARMs (estimated) (l.h.s.)Prime (l.h.s.)

Amount in USD bn Estimated cumulative reset amount in USD bn

Months to fi rst reset


4 Lombard Odier · Investment Strategy – Private Banking · 3rd quarter 2009

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

01.1999 01.2001 01.2003 01.2005 01.2007 01.2009 01.2011 01.2013 01.2015

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

01.1975 01.1980 01.1985 01.1990 01.1995 01.2000 01.2005 01.2010 01.2015

-10%

-8%-7%

-5%

-6%

-4%-3%

-2%-1%

3%

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

1st(Worst)

2nd 3rd 4th 5th 6th 7th 8th 9th 10th(Best)

IV. Minimum annualized 10 year S&P500 holding period return ranked by implied 10 year risk premium deciles

VI. MSCI China equity index projected 10 year holding period annualized return

V. World equity index ex United States projected 10 year holding period return with trend 6% EPS growth




Trailing maximum (19 * peak earnings)

Assuming normalized 2% per annum EPS growth and reversion

to given terminal price / trailing peak earnings level

nomic growth is not the driver of equity

market returns, what is? As if investors

(as opposed to speculators, traders and

trend chasers) needed a reminder, from

a decade of rampant global growth

that delivered desperately poor equity

market returns, the only two variables that we consider important are valu-ation and the implied risk premium.

The former because it gives us an indi-

cation of the bias in the direction of re-

turns and the latter because it gives us

an indication of the potential for losses

if things go wrong: the chart IV shows

the US implied equity risk premium

ranked by decile over the last century

and the worst case annualized 10-year

return associated with each decile.

As expected, higher risk premia give

meaningfully lower downside! Given

that the gains necessary to recover

losses are exponential (a 50% loss re-

quires a 100% gain to break even and a

trades at a near 10% premium to devel-oped equity in aggregate, that markets

may be vulnerable at current elevated

valuation and depressed risk premia

levels. The chart VI shows the Chinese

market’s implied risk premium at wafer-

thin levels: investors have forgotten

that growth does not drive returns

and seem happy again to take risk

with little or no compensation (the

same applies to the market in India).

With China at the heart of all things

emerging, we would be very cautious

at these levels, especially when domes-

tic demand simply cannot grow quickly

enough to off set the lack of demand

for exports that is evident in the shrink-

age of the US defi cit as US savings rise.

Emerging market investors, many of

whom came to the asset class in recent

years, need to learn that recent growth

rates were fuelled by US leverage as the

chart VII (page 5) shows.

1st decile = smallest / worst risk premium, 10th decile = largest / best risk premium: 1874 – 2009

Trailing minimum (2.5 * peak earnings)

Trailing median (6.0 * peak earnings)

Central banks must include monetary infl ation

in their target objective and not just focus

on real economy infl ation as they currently do.

70% loss requires a 300% gain to break

even), avoiding large losses is more

important that chasing large gains.

The US equity market has recovered to almost 11* trailing peak reported earnings and approximately 15* trend

earnings, both at the very long-run

median level and indicative of a market

which must be considered fair value at

best. The global market ex the United

States has recovered to 9* trailing peak

earnings from 7* at the March 2009

low, as the chart V shows, consistent

with an attractive risk / return profi le

over the course of the next cycle (al-

though with near-term vulnerabilities

along the lines outlined earlier). In ag-gregate, we are strategically positive on global developed equity markets but tactically more cautious.

Looking at Emerging Market Equity

(EME), massive liquidity injections

which have leaked, through hugely

expanded bank lending, into infl ation

in monetary assets in China in particu-

lar suggest to us, given that EME still

Turning to bond markets, fi scal stimu-

lus measures to boost growth and the

insertion of taxpayers into the capital

structure of banks to take losses for

which they are not responsible have

resulted in signifi cantly larger budget

defi cits in many countries. As the pro-

vider of the reserve currency, concern

seems particularly focussed upon the

United States. It seems a common

view that larger budget defi cits will

drive government bond yields higher:

however, a quick look at the data in

the chart VIII (page 5) of the change in

the budget balance versus changes in

bond yields shows that over the last 60

years, spanning infl ation, disinfl ation,

the Vietnam War and Cold War periods,

there is no correlation between defi -cits and yields. It is simply not the case

that large budget defi cits will force

government yields higher. Again, like

the perceived link between economic

growth and equity returns it is a com-

monly held view that is divorced from

empirical fact. One reason for the lack

of relationship is the fact that defi cits

Trailing maximum (= 32.9*)

Trailing minimum (= 7.1*)Trailing median P / peak E

Given dividend yield and specifi ed terminal P / peak E ratio

Actual


Lombard Odier · Investment Strategy – Private Banking · 3rd quarter 2009 5

8%

10%

12%

14%

16%

18%

20%

22%

24%

01.1973 01.1979 01.1985 01.1991 01.1997 01.2003 01.2009

5

6

7

8

9

10

11

12

13

14

09.1999 09.2001 09.2003 09.2005 09.2007 03.2009

-7.0

-6.5

-6.0

-5.5

-5.0

-4.5

-4.0

-3.5

-3.0

-2.5

-2.0

tend to be cyclical, they rise when activ-

ity weakens and infl ation expectations

decline: the decline in infl ation expecta-

tions and real interest rates off sets any

upward pressure on rates from a rise in

the risk premium. We are often asked

“who will buy all of these government bonds?” The answer remains “the banks”. In the United States (and the

United Kingdom), budget defi cits are

rising and current account defi cits are

shrinking, implying that the private sec-

tor is increasing its saving faster than

the government is reducing its saving.

At the same time, there is little or no

demand for credit and little or no appe-

tite to lend amongst banks. As a conse-

quence, banks are awash with liquidity,

at almost zero cost, and are purchasing

government bonds aggressively to take

advantage of the almost free profi t

from the spread between the cost

of cash and the yield on government

bonds. Lower-risk government bonds

are replacing higher-risk private sector

loans on the balance sheet of banks.

The chart IX shows the increase in US

bank holdings of Treasury debt in the

last year or more, with ample room for

further expansion there and elsewhere.

We anticipate government bond yields remaining depressed for some consid-erable period of time.

In conclusion, we will continue to focus

upon valuations of assets measured

on a normalized basis and risk premia

to measure our shortfall risk, taking

risk when it is well rewarded (typi-

cally when valuations are attractive

and most investors are compelled to

want to sell). The crisis which began in 2007 is still far from complete and we have positioned our portfolios com-paratively defensively in recent weeks to refl ect this observation. Within the

context of a positive strategic but more

cautious tactical view of risk-taking, we

anticipate adding exposure to risky as-

sets in the coming months as the risk

return trade-off becomes more attrac-

tive against the backdrop of a clearer

sense of reality amongst market par-

ticipants.

Paul Marson, CIO

VII. Chinese real GDP growth vs US current account as a percent of US real GDP

VIII. Annual change in US government bond yield (vert. axis) vs annnual change in US federal budget defi cit (as a % of GDP, horiz. axis): 1953 – 2009

IX. US government securities / total assets (%): US domestic commercial banks




Chinese GDP (% y / y, l.h.s.)

US current account (r.h.s. inverted)

-4

-3

-2

-1

0

1

2

3

4

-4 -3 -2 -1 0 1 2 3 4

IMPORTANT INFORMATIONThis document refl ects the opinion of Lombard Odier Darier Hentsch & Cie or an entity of the Group (hereinafter “Lombard Odier”) as of the date of issue. This document is not intended for distribution, publication, or use in any jurisdiction where such distribution,

publication, or use would be unlawful, nor it is directed to any person or entity to which it would be unlawful to direct such a document.

This document is furnished for information purposes only and does not constitute an off er or a recommendation to purchase or sell any security. The opinions herein do not take into account individual clients’ circumstances, objectives, or needs. Each client must

make his own independent decisions regarding any securities or fi nancial instruments mentioned herein. Before entering into any transaction, each client is urged to consider the suitability of the transaction to his particular circumstances and to independently

review, with professional advisors as necessary, the specifi c risks incurred, in particular at the fi nancial, regulatory, and tax levels.

The information and analysis contained herein have been based on sources believed to be reliable. However, Lombard Odier does not guarantee their timeliness, accuracy, or completeness, nor does it accept any liability for any loss or damage resulting from their

use. All information and opinions as well as the prices indicated are subject to change without notice. Past performance is no guarantee of current or future returns and the client may consequently get back less than he invested. Performance data of mutual funds

do not take into account the commissions and fees charged on the issue and redemption of the units or shares.

The investments mentioned herein may be subject to risks that are diffi cult to quantify and to integrate into the valuation of investments. Generally speaking, products with a high degree of risk, such as derivatives, structured products, or alternative / non-traditional

investments (Hedge Funds, private equity, real estate funds, etc.) are suitable only for sophisticated investors who are capable of understanding and assuming the risks involved. Upon request, Lombard Odier is available to provide more information to clients on

risks associated with specifi c investments.

If opinions from fi nancial analysts are contained herein, such analysts attest that all of the opinions expressed accurately refl ect their personal views about any and all of the subject securities or issuers. In order to ensure their independence, fi nancial analysts are

expressly prohibited from owning any securities that belong to the research universe they cover. The description of the rating system used by Lombard Odier for its fi nancial research is available on www.lombardodier.com.

This document may not be reproduced (in whole or in part), transmitted, modifi ed, or used for any public or commercial purpose without the prior written permission of Lombard Odier.

© 2009 Lombard Odier Darier Hentsch & Cie – all rights reserved.

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