Market volatility to continue

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1 How much more? Renewed speculation that financial institutions may report increased US subprime-related losses has sent equity markets tumbling. How much more bad news can investors expect going forward? Performance of regional equity markets (In USD terms) Equity 31 st Oct 31 st Oct markets 26 th Nov 30 th Nov Global -7.9% -4.6% US -9.2% -4.4% Europe -8.4% -3.1% Japan -9.5% -1.8% Asia ex Jap v -10.6% -8.4%. As of 26 November The respective markets are represented by the following indices: Global by MSCI AC World, US by S&P 500, Europe by DJ Stoxx 600, Japan by Topix and Asia by MSCI Asia ex Japan. Taking the bad news into perspective Market volatility to continue The month of November to date is the worst month in 2007 for the equity markets (See table). Losses for key markets ranged between 2-8% in USD terms, although the declines would have been greater (See table for returns as of 26 th November) if not for a late rally during the month. Markets had gained in the last few trading days of November on expectation that the Federal Reserve would cut interest rates again to revive the flagging US economy. Citi analysts expect market volatility to continue until there is greater clarity over the extent of the US subprime losses. So far, banks and other financial institutions have written off about US$50billion 1 of sub-prime-related losses. Citi analysts estimate that total sub prime losses may amount to US$170billion. Therefore, it appears that investors can expect more bad news in the months ahead. On the other hand, even if sub-prime losses reach US$170billion, it would amount to about 9% of total US and European banks Tier 1 capital 2 ; 0.4% of global Gross Domestic Product ( GDP ) or 0.2% of total US household wealth. So, while the economy and especially the global financial sector are likely to undergo some pain going forward, Citi analysts believe that the global economy still has pockets of resilience. The combination of strong profit growth and restrained spending in the last couple of years has given many global and US companies strong balance sheets, which may make them more resilient in the coming economic slowdown. In addition, the sustained expansion seen in the emerging economies also appears likely to help support the global economy in Expecting support from rate cuts Key to Citi analysts soft landing scenario for the global economy is their assumption that the US Federal Reserve ( Fed ) will cut interest rates further by at least 100bp by 2Q08. The Fed s action is expected to buffer the healthier segments of the US economy and buoy investor confidence. Citi analysts also expect the European Central Bank and the Bank of England to ease rates in 2008 as well. As a result, this would help corporate earnings to grow, albeit at a slower pace. This, together with still reasonable market valuations lead Citi analysts to remain positive on the outlook of equities (versus other asset classes) in In particular, Citi analysts favour Europe and the emerging markets to Japan and the United States. 1. as of 26 November Tier 1 capital is a measure of a bank s financial strength and is typically comprised of common and preferred shares as well as retained earnings.

2 UNITED STATES Housing weakness and tighter financial conditions threaten to undermine expansion Chart 1: S&P Overall growth appears to have remained on a healthy track thus far in 2007, given resiliency in consumer spending and as corporate finances stayed robust. Citi analysts believe that GDP growth could likely stabilize at 2.3% in 2008, as fundamentals appear likely to remain intact. However, intensifying weakness in the housing sector and significant tightening in credit conditions continue to pose downside risks to the US outlook. Inflation is expected to remain moderate and could lend the Federal Reserve (Fed) flexibility to maneuver monetary policy as conditions warrant. Citi analysts believe that the Fed funds rate could potentially decline into a 3.5% range or lower as the Fed attempts to secure a more neutral financial setting in Recent performance data has led Citi analysts to be positive on Banks as valuations appear compelling, while depressed earnings revision data and poor investor sentiment may be a sign that losses have gone too far. On the other hand, given the outperformance in the Energy sector, Citi analysts are now more cautious, reflecting less than compelling valuation, cautious earnings revision and rising oil prices.

3 EURO-AREA Chart 2: DJ Stoxx 600 Index Moderate slowdown with downside risks Citi analysts believe that economic growth in the euro area could potentially moderate to 1.9% in 2008, reflecting the lagged impact of tightening financial conditions. However with economic fundamentals expected to remain sound, a rebound to trend growth in 2009 remains likely. Nonetheless, risks to the outlook are appearing to the downside given that tightening bank lending standards could dampen private consumption while euro appreciation may potentially dent export growth. Inflation could likely remain above 2% until mid 2008 on the back of higher food and energy prices although upside risks remain limited. Against this backdrop, the European Central Bank could potentially continue to keep interest rates on hold at 4% although an eventual cut in 2008 remains a likelihood. Citi analysts are retaining their long held positive stance on European equities and believe that the prospects for the Health Care sector could be improving given its underperformance to date, its relatively stronger earnings momentum and expected dividends going forward. However, downside risks to overall corporate earnings appear to be on the rise. Nonetheless, Citi analysts believe that profit margins would only moderate and not collapse as long as global growth continues at a decent rate.

4 JAPAN Trend growth amid modest domestic demand Chart 3: Topix Citi analysts expect the economy to grow at a near trend pace of 1.4% in 2008 buoyed by external and domestic demand. While overall export growth could likely moderate, the resilience in the Asian economies could potentially provide some buffer in the event of a US economic slowdown. Business investment may slow down, in the view of Citi analysts, as small firms are appearing less willing to invest given more difficult business conditions, the lack of pricing power, surging input prices and renewed weakness in consumer spending. However, solid profit growth and capacity shortages at large firms could potentially continue to sustain an upward trend in business investment. Despite surging energy prices, inflation appears likely to remain low this year and in 2008, on the back of persistent declines in unit labour costs. Citi analysts also believe that the next interest rate hike by the Bank of Japan may be delayed till the fourth quarter of 2008 given the global financial market turbulence and the uncertainties that continue to surround the US economy. Overall, Citi analysts are turning positive on the banking sector, in response to news of a potential tieup between Aozora Bank and Sumitomo Trust & Banking, and are maintaining the view that sub-prime related concerns seem over inflated and valuations appear compelling. However, potential rate hikes by the Bank of Japan as well as low levels of loan growth continue to pose as risks.

5 ASIA-PACIFIC Chart 4: MSCI Asia ex Japan Stable growth trend despite upside risks to inflation outlook Citi analysts continue to expect Asian economies to grow at a relatively stable rate of 8.7% in both 2007 and 2008 with China and India likely to lead the pack. Aggressive easing by the Fed could in turn also lead to lower short-term rates in Hong Kong, Singapore and the Philippines while increasing the probability of rate cuts in India and Indonesia. In China, Taiwan and Vietnam, however, the central banks appear more likely to hike rates to fight inflation. While overall inflationary pressure remains benign across Asia, Citi analysts expect modestly higher inflation across the region in the coming year on the back of increasing food prices, energy cost, booming asset markets and robust consumption. Overall, given growing uncertainties, rising volatility and falling liquidity, Citi analysts believe that value investing appears likely to persist and continue to favour large caps and North Asia, as valuations remain relatively attractive. Citi analysts believe that retail investors have become an important force in the Asian markets. Historically, high retail interest has been associated with peak valuations. According to Citi analysts, the level of participation from retail investors in the Asian markets (excluding China and India) is now beyond the peaks seen in 1993.

6 EMERGING MARKETS Inflation likely to peak next year at 5.6% Chart 5: MSCI Emerging Markets Citi analysts overall growth forecast remains relatively robust, with GDP growth expected at 7.1% in 2007 and 6.9% in However, Citi analysts anticipate a slowdown in central Europe, which remain vulnerable to weak G3 growth and lower growth in Latin American. Inflation pressures could potentially peak next year at 5.6% with higher food and fuel prices likely to be the main drivers. However Citi analysts believe that it is unlikely to persist as tighter monetary policy and currency appreciation may possibly keep inflation in rein, and it could potentially abate to 5% in Citi analysts continue to remain positive on Latin American and Emerging Europe equities on the back of supportive fundamentals over the medium to long term, buoyant commodity prices, weakness in US dollar and positive earnings momentum. Additionally, Citi analysts also favour the Middle East and North Africa equities as supportive economies, reasonable valuations, alongside steps towards capital markets liberalization make these markets attractive. However, key risks most worth monitoring are likely to include rising inflation pressures and geopolitical uncertainty.

7 = Bond Market GLOBAL Yield curve likely to remain steep US Treasuries: The yield curve is likely to remain steep, given Citi analysts view that the Federal Reserve may cut rates by another 100bp by 2Q08. US Corporates: Citi analysts favour intermediate term (seven to ten years) issues, with a preference for liquid, high-quality names with strong fundamentals. On the other hand, the High Yield bond sector still appears expensive. Given concerns of rising default rates, Citi analysts prefer to focus on quality names while keeping duration short. Euro Bonds: In the view of Citi analysts, European bonds could likely underperform their US counterparts until the Fed s easing cycle is finished. Emerging Market Debt (EMD): Historically tight spreads continue to reflect downside risk and investors desiring exposure may wish to consider sovereign nations with stable to improving economies and minimal political turmoil. Disclaimer Citibank N.A. provides no independent research or analysis in the substance or preparation of this report. The information in this report has been obtained from reports issued by Citigroup Global Markets. Such information is based upon sources Citigroup Global Markets (CGM) believes to be reliable. CGM, however, does not guarantee its accuracy and it may be incomplete or condensed. All opinions and estimates constitute CGM's judgment as of the date of the report and are subject to change without notice. This report is for general informational purposes only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security or currency. Any person considering an investment should seek independent advice on the suitability or otherwise of a particular investment. Investments are not deposits or other obligations of, guaranteed or insured by Citibank N.A., Citigroup Inc., or any of their affiliates or subsidiaries, or by any local government or insurance agency, and are subject to investment risk, including the possible loss of the principal amount invested. Investors investing in funds denominated in non-local currency should be aware of the risk of exchange rate fluctuations that may cause a loss of principal. Past performance is not indicative of future performance, prices can go up or down. Some investment products (including mutual funds) are not available to US persons and may not be available in all jurisdictions.