paul o'brien june 1007
DESCRIPTION
June 11, 2007 Page 1 •What can you do about it? •This has driven profound shifts in investor behavior •Markets and valuations reflect this Page 2 •Globalization and the spread of economic liberalism •Demographics •Technology Page 3 Economic volatility plunged at the start of the 1980s 0.0 0.5 1.0 1.5 2.0 2.5 3.0 Page 1.Data as of April 2007. 4TRANSCRIPT
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Global Investing: Where We Are and How We Got HereJune 11, 2007
2Page
The Long and the Short of It
• It is different this time. There have been fundamental changes in economies
• This has driven profound shifts in investor behavior
• Markets and valuations reflect this
• What can you do about it?
3Page
It is Different This Time
• The Great Moderation
• Globalization and the spread of economic liberalism
• Demographics
• Technology
4Page
The Great Moderation: Growth and Inflation
1. Data as of April 2007.
Economic volatility plunged at the start of the 1980s
(rolling 20 quarter standard deviation)Volatilty of Real GDP Growth and Inflation
Inflation (GDP deflator) Real GDPSource: Reuters EcoWin
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 060.0
0.5
1.0
1.5
2.0
2.5
3.0
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Real GDP Growth and Fiscal Policy
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
2000 2001 2002 2003 2004 2005 2006E 2007F 2008F
Perc
ent o
f GD
P
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
Perc
ent
Fiscal Balance (Rhs) Real GDP growth
External Performance
15
20
25
30
35
40
45
50
2000 2001 2002 2003 2004 2005 2006E 2007F 2008F
Perc
ent
Foreign debt (% of GDP) External debt-service ratio (% of exports)
Domestic Public Debt and Inflation
25
35
45
55
65
75
85
2002 2003 2004 2005 2006E 2007F 2008F
Perc
ent o
f GD
P
2.5
3.5
4.5
5.5
6.5
7.5
Perc
ent
Domestic Share in Public Debt Public DebtInflation (Rhs)
Investable Universe: Local Yield Curves
6.0
6.5
7.0
7.5
8.0
8.5
9.0
9.5
10.0
10.5
11.0
1Y 3Y 5Y 7Y 10Y 20YPe
rcen
tMexico South Africa Indonesia
Structural Changes in Emerging MarketsIncreased Current Account and Lower Debt
Emerging Markets are in much stronger economic health than a decade ago
Stricter monetary and fiscal policies, and robust trade flows in a commodity driven environment have led to strong current account surpluses and foreign – exchange reserves
Increase is not just at the aggregate level but is consistent at the country level too
1. Data as of December 29, 2006. Weighted average of 25 emerging economies.
Source: IMF, World Economic Outlook Source: IMF, World Economic Outlook
Source: Central Banks, Ministries of Finance Source: International Monetary Fund, World Economic Outlook
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How Investing Has Changed
• The internationalization of portfolios
• The rise of the official investor
• Derivatives and financial engineering
• New approaches to investing– Shifting from accounting-based to risk-based investment guidelines– Liability-driven mandates– Absolute return strategies
7Page
Cross-Border Financial Flows Have Surged
1. Data as of April 2007.
Increased gross flows are a strong sign of increased market integration (sum of inflows and outflows)
Gross U.S. Capital Flows as a Percent of GDP
Source: Reuters EcoWin
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 060.0
2.5
5.0
7.5
10.0
12.5
15.0
17.5
20.0
22.5
8Page
The Cash Piles Up at Central Banks
1. Data as of April 2007.
Reserves also are growing rapidly in commodity exporting countries
Investment of these funds remains very conservative
(China, Hong Kong, India, Japan, South Korea, Taiwan, Thailand)Foreign Exchange Reserves in Asia
Source: Reuters EcoWin
96 97 98 99 00 01 02 03 04 05 06 07
$ Trillion (thousand billions)
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
3.00
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The Inexorable Advance of Derivatives
1. Source: Bank for International Settlements. Data as of December 2006.
New types of derivative, and broader use, are driving volumes higher
Credit default swaps are the latest drivers of growth
Gross Notional Value of OTC Derivative Contracts ($ bil.)
0
50000
100000
150000
200000
250000
300000
350000
400000
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Uses and Misuses of Derivatives
• Financial derivatives can allow more efficient management of risk
• Financial derivatives can be used to concentrate risk and avoid regulation
• Financial derivatives can diversify risk and enhance stability
• The resilience of the financial system to large shocks is untested
• Investors not allowing derivatives are penalized
11Page
An Expanding Menu of Investment Choices
There is a varied assortment of alternatives that fit the bill
Asset Class Strategy / Universe Implementation
Commodities Broad universe including energy, metals, agriculture Futures
Emerging Markets Debt Bonds issued by governments and corporates in developing economies Funds
Private Equity Direct equity stakes in private companies (venture capital, buyouts, distressed) Funds
Hedge Funds Generally unconstrained investment funds Funds
High Yield Debt Non-investment grade bonds (ratings BB+ and below) Funds
Real Estate Both direct listed real estate investments (e.g., REITS) Funds
Senior Loans Purchase of companies’ senior debt (through syndication, securitization) Funds
Currency Long/Short strategy seeking absolute return through currency trading Funds
Long/Short Strategies Market Neutral / GTAA Funds
Volatility VIX Index – priced off volatility in equity index derivatives Futures and Swaps
Infrastructure Investment in public goods and services (e.g., toll roads, water, communication systems) Funds
Emissions Investment in newly established EU carbon dioxide emissions permits Futures
Freight Investment in freight capacity for worldwide shipping Futures and Swaps
Convertible Bonds Hybrid equity/bond asset Funds
Others...
12Page
Relaxing Traditional Guidelines
• Traditional portfolio guidelines have been based on accounting measures of risk and tight style boxes. Examples:– No high yield bonds– No negative currency exposures
• The “new mainstream” relaxes accounting constraints and puts limits on overall risk: VaR 200, or 100 basis points tracking error
• Limited hedging/short positions are allowed (130/30 strategies)
• This should work – but will it?
13Page
Liability Driven Investing: Why
• The surplus of a pension plan equals its assets less the present value of its liabilities
• The value of liabilities is inversely related to interest rates and positively related to inflation
• Regulators and corporate Treasurers want to minimize shortfalls and volatility in fund surpluses
14Page
Liability Driven Investing: How
• The plan invests in a portfolio designed to earn a high absolute return, holding equities, cash, and various alternatives
• The plan “buys” exposure to long term interest rates or inflation through a swap or other derivative contract
• The result is a portfolio that will track the value of plan liabilities as interest rates and inflation vary
• Ideally, the portfolio will earn enough to exceed the cost of the swap, and limit contributions from the plan sponsor
15Page
Absolute Return Investing
• What do you do if you don’t have explicit liabilities?
• Throw the benchmark away. Buy illiquid, private, non-traditional securities
• A successful approach that has gone too far?
16Page
Implications for Markets and Prices
• The carry trade in foreign exchange
• The bubble in bonds
• Equities appear relatively cheap
• The collapse in volatility and risk premiums
• Correlations increase: the myth of diversification
17Page
Euro/Yen Driven to Unprecedented Levels
Real Euro versus Yen
1. Data as of March 2007
Real Exchange Rate, deflated by Producer Prices Average (1981-Date)
Source: Reuters EcoWin
81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
Inde
x (A
vera
ge=
100)
70
80
90
100
110
120
130
140
150
160
The real Yen/Euro relationship has moved beyond historic ranges
18Page
The Bubble in Bonds: Real Yields Below Growth
1. Source: IMF, Reuters/EcoWin, and Morgan Stanley Investment Management. Data as of April 2007.
Real bond yields are unusually low relative to global growth
This means attractive terms for borrowers and poor returns for lenders
Real Bond Yields and Global Growth
012345678
Global Real GDP Growth (IMF-PPP) Global Real GDP Growth (IMF-Mkt)Real US 10-yr Treasury Yield
19Page
The Bubble in Bonds: Equities Yield More
1. Source: IMF, Reuters/EcoWin, and Morgan Stanley Investment Management. Data as of April 2007.
It’s unusual for equities to yield more than bonds
Earnings should grow with the economy; bond coupons are static
The implied equity risk premium is wide
Earnings Yield and Government Bond Yield
Earnings yield - S&P500 United States, Government Benchmarks, Bid, 10 Year, Yield, End of Period, USD
Source: Reuters EcoWin
58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08
Percent
0.0
2.5
5.0
7.5
10.0
12.5
15.0
17.5
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Interest Rates Vanishing Volatility
1. Annualized implied volatility of a three-year option on a ten-year interest-rate swap. Orange lines denote a one standard deviation band.
Source: Citigroup Global Markets and Morgan Stanley Investment Management
Interest rate volatility is extremely low and vulnerable to a rebound
10-Year Basis Point Volatility1
Data as of March 30, 2007
118
104
91
21Page
High Yield: Spreads vs. US Treasury Bonds
High yield credit spreads are very tight as compared tohistorical levels
STW, CSFB High Yield IndexData as of March 31, 2007
Source: CS First Boston
March 31, 2007 = 316
22Page
Hedge Funds – Too Popular?
Annualized Alpha Hedge Fund Index vs MSCI World
-15.0%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
Jul-94 Jul-96 Jul-98 Jul-00 Jul-02 Jul-04 Jul-0612-Month Rolling 24-Month Rolling 60-Month Rolling Since Inception
The amount of money flowing into hedge funds is causing concern that it will lead to lower returns.
Over the last ten years we have indeed seen some alpha erosion for the hedge fund universe as a whole, but there is still positive alpha to be found
Source: MSIM. Data through December 2006.
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Higher Correlation in Hedge Fund Returns
It is not so much the alpha, but rather the higher correlations that are the problem for the hedge fund universe overall.
Recent observations put correlations at or near all-time highs.
This means that it is very important to find the right kinds of hedge funds!
Annualized Correlation Hedge Fund Index vs MSCI World
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
Jul-94 Jul-96 Jul-98 Jul-00 Jul-02 Jul-04 Jul-0612-Month Rolling 24-Month Rolling 60-Month Rolling Since Inception
Source: MSIM. Data through December 2006.
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What Investors Can Do
• KISS
• Recognize that fundamentals are good and expected returns are low
• Don’t try to forecast the turning point
• Protect your liabilities and search for genuine diversification