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Global Investing: Where We Are and How We Got HereJune 11, 2007

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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?

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It is Different This Time

• The Great Moderation

• Globalization and the spread of economic liberalism

• Demographics

• Technology

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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

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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

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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

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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...

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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?

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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

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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

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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?

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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

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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

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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

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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

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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

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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