Financial Forecast. Issue No. 3 February Inside this issue. Indices / FX Rate. Key Investment Thoughts 2. Equity Markets 3.

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1 Issue No. 3 February 2010 Financial Forecast Inside this issue Key Investment Thoughts 2 Equity Markets 3 Fixed Income 6 Currencies 8 Commodities 10 Conclusion 11 Indices / FX Rate Price (prices as at 17 th February 2010) FTSE 100 5, DJ Eurostoxx 50 2, S&P 500 1, / $ Crude Oil Gold 1, This report is written to place global financial markets into perspective and to draw together the future themes that we are formulating and subsequent trade ideas. Our sister publication, the weekly report, will pick up on specific trade ideas. RMG Wealth Management LLP 13 Austin Friars London EC2N 2HE Tel: Fax: info@rmgwealth.com Website: Stewart Richardson Chief Investment Officer RMG Wealth management LLP RMG Wealth Management LLP is authorised and regulated by the Financial Services Authority Registered in England No. OC Registered office is at 13 Austin Friars, London, EC2N 2HE

Key Investment Thoughts Stock Markets Last month, I said that the developed markets were vulnerable to a correction. Between mid January and early February the MSCI World index decline by 9.

2 Key Investment Thoughts Stock Markets Last month, I said that the developed markets were vulnerable to a correction. Between mid January and early February the MSCI World index decline by 9.5% with emerging markets and periphery Europe enduring more significant declines. Markets became oversold on a near term basis and have since rallied. I view the rise over the last week as a counter-trend move and expect the markets to continue their declines from current levels. Anyone who is nervous should be selling now. Interest Rates Bond markets have been both a safe haven from the sell-off in risky markets (Germany and U.S. Government Bonds) and also the focal point for the developing Sovereign debt crisis. It appears that the Greek Tragedy that is spreading through the periphery of Europe will not end until more pain has been inflicted and real change is set in motion. Currencies The U.S. Dollar continues to reign supreme. Short-term corrections, notwithstanding, I expect the Dollar rally to continue in the months ahead. Sterling has broken below important support against the Dollar and may be particularly vulnerable. Commodities Precious and base metals declined in line with equity markets and the Dollar as predicted. The rally over the last week is likely to peter out shortly with the larger downtrend still the dominant force. Conclusion The character of the markets has changed from bullish to bearish and we will be positioning client portfolios accordingly. The rebound over the last week in risky assets (from what was an oversold condition) is nearly over and I expect markets to move lower during the next few months. I have shown on the above S&P 500 chart how the uptrend since last March appears to have been broken. The red line on the chart is the 75 day moving average which has acted as a good trend indicator. This has now been broken and this together with a number of other factors lead me to expect any rally to end now and the market to move lower from here. 2

3 Equity Markets Equity markets have been on a bit of a rollercoaster since last month. The unfolding Sovereign debt crisis, together with Chinese monetary tightening, talk of exit strategies in the U.S. and Europe and impending regulatory changes have combined to spook investors. These events have illustrated to investors how 2010 is likely to be a more difficult year than 2009, and in my view, investors are still under-appreciating the risks that lay ahead. Add to the above mix concerns that European growth stalled in Q and U.S. growth flattered to deceive, and investors may have to lower earnings expectations. Of the three main inputs into our analysis, I believe that, at best, developed equity markets are fair value and never reached truly cheap levels at last year s lows. The technical inputs are now flashing strong warning signals and the sentiment picture appears to have changed during the recent market decline. The chart above shows the price to earnings ratio for the US equity market (blue line) and the S&P 500 Index (green line). To help smooth out both the cyclicality of earnings and also the accounting gimmicks that are prevalent today, the earnings data is the average for the last 10 years compared to the current price. What can be clearly seen is the extreme overvaluation in 1901, 1929, 1966 and in particular Each time the market began a long term corrective process from an extreme overvaluation, the process lasted for a number of years and over that time the market valuation became much more compelling as measured by the cyclically adjusted P/E ratio that declined well below 10. The roadmap that I am using here is that although the equity market has failed to perform for the last 10 years, the P/E ratio never got to truly cheap levels, and I believe that it should have to do so after the bursting of a credit bubble. The fact that this ratio is back at 20 either discounts a never seen before improvement in corporate 3

4 earnings, or more likely, a market that is not good value in light of the fact that western economies are still in the early stages of balance sheet repair in the wake of the bursting of the credit bubble. Previous notes have highlighted some of the technical inputs I use, such as momentum. One input that seasoned market professionals will say is important is the volume of trading. Essentially, volume should be in sync with the market trend if the market trend is to be seen as real. Why should this be? If we think about a market or stock that is in a bull market. If volume is increasing during the rise, that shows that investors are committing more capital at higher prices which is a sign of confidence. If, however, volume contracts during a bull market, that shows an increasing lack of conviction in the bull market on that part of investors, and that is not healthy. The chart below is of the Exchange Traded Fund that follows a widely followed group of financial companies in the U.S. With financials being at the epicentre of the bear market and then the poster child of the rally since March 2009, the health of the financials is important for the market as a whole (in fact the price and volume relationship for the broad market is very similar). Simply put, the declining volume seen during the post March 09 rally is a very unhealthy technical sign that big money investors have a low conviction in buying financials. The fact that volume has increased this year as price has declined is a worrying sign indeed. The sentiment picture has also changed quite dramatically during the recent sell-off. The chart below illustrates the S&P 500 on a daily basis since early 2007 together with the bullish sentiment of small traders. I have shown this chart a number of times before, and although there is no exact science here, the theory is that small traders tend to be wrong at market turning points. I have highlighted a divergence between the S&P 500 and sentiment apparent at the recent high. This was another hint that all was not well with the market in January. During the recent sell-off, bullish sentiment evaporated quickly, and was lower than at any time since May I have also highlighted how sentiment quickly found support during small corrections late last year, and how this support was recently broken. It is clear from this picture that sentiment has changed character during the recent sell-off. 4

5 The last week or so has seen equity markets try and recover their poise, and with that, sentiment is also recovering. I noted above how I believe that the S&P 500 is going to fail at resistance in the 1,100 area and it will be interesting to see if sentiment will fail in the mid 60 s where it found support late last year. If price and sentiment turn lower from these resistance areas, the downside argument become more powerful. It is worth noting here that some of the more optimistic forecasts for improving corporate earnings may well be too optimistic. With the Eurozone economy growing by an actual 0.1% in Q4 2009, UK by 0.1% and the U.S. flattering to deceive with 5.7% annualised growth (boosted by inventories and exports), there is little momentum for the whole year. Consensus estimates show earnings growth for the full year approximately +30% for Europe and the U.S. and with economic growth set to be in the 2% to 3% range, there is [both] room for disappointment. If costs are cut dramatically, there is a chance that earnings could grow this fast, but with employment being the major floating costs for most businesses, dramatically lower costs through lower wages will not be good news for the wider economy where unemployment remains high, wage growth anaemic and sentiment low by historic comparisons. Furthermore, the developing sovereign debt crisis could become a major headache for equity markets. As I set out in the fixed income commentary below, rather than inflation concerns, it is solvency concerns that are pushing up bond yields in some countries. When bond yields rise, all other inputs being equal, the market must fall as the current value of future cash flows (the dividend discount model) is less because of the higher discount rate. Also, in real life, the cost of financing for companies is likely to rise if bond yields rise, thereby suppressing future earnings power. For equity markets, the future of bond yields may be the biggest factor in determining performance this year. 5

6 Fixed Income Markets Government With the Greek tragedy unfolding, Government bond markets have suddenly become exciting. Any country whose fiscal position is in any doubt has suddenly become the focus of attention, with Greece at the centre. What has really happened is that investors seem to have woken up the fact that reported debt levels are heading towards unsustainable levels in these countries and current and future deficits make for grim reading. The particular flash point is in the Eurozone as the periphery countries have become very uncompetitive compared with Germany in particular and with no way of improving this through currency depreciation, the only viable option is for fiscal and wage restraint. Until this happens, the bond market will push yield higher in order to force change. At the same time, safe haven buying benefitted some bond markets (Germany in particular) and I suspect that the markets will continue to reward those who act responsibly (think Germany and Scandinavia) and punish those profligate countries (think anyone else who has not enacted serious austerity plans such as Ireland). At the time of writing, the Greek situation appears to be slightly on the back-burner. However, I believe that the sovereign debt story is one that will percolate on and off for quite some time. What is beginning to be discussed is the off balance sheet liabilities of western Governments, which according to a recent article in the Financial Times would take UK net debt relative to GDP from about 55% (as at March 2009) to over 400%. US net debt relative to GDP would not be 70% as is currently reported but actually over 500%. Furthermore, with a good portion of Government spending in Western countries going on Pensions and healthcare, and populations getting older and living for longer, fiscal issues are unlikely to disappear and the markets are likely to focus Governments on the need for drastic remedies. The UK is an interesting case at the moment. It is easy to argue that our fiscal position is pretty dire at the moment, and with an election due in May, there will be no change to the current tax and spending plans. Furthermore, with the Bank of England halting Gilt purchases the private sector will have to fund the expected budget deficit of 175 billion on its own. The above chart is the weekly chart of the 5 year Gilt Yield. It is apparent how the yield (and therefore price, which moves inversely to the yield) is trapped between converging trend lines. At some point, the yield will break out of this triangle pattern, I just cannot say for sure which way. 6

7 The 10 year, shown above in a weekly chart, is similar to the 5 year yield with arguably more of a rising yield (falling price) bias than the 5 year Gilt. The yield here is nudging up against resistance in the 4.1% area, and the battle lines in the Gilt market are becoming quite clear. I can make both a bullish and a bearish case for Gilts at the moment. Although inflation has risen above 3%, requiring the Governor of the Bank to write a letter to the Chancellor, extraordinarily low base effects from a year ago (remember when the world was about to end?) can easily explain this away. In fact, most indicators indicate that inflation will be falling quickly by the Summer. At the same time, commercial banks need to improve the quality of their balance sheets and individuals need to start saving more, and so demand for Gilts from the private sector should increase at a time when the Bank of England stops buying. The bearish case for Gilts (i.e. yields rising) I believe will occur if bond investors lose faith in the public finances and demand a higher yield for holding Gilts. This would have negative implications not only for Gilts but for UK asset prices in general. For the moment, without know which way the market will tip its hand, I am closely watching 4.10% for the 10 year Gilt and 3.05% for the 5 year Gilt. If yield rise smartly above these levels, it is likely that the bearish case for Gilts is unfolding. Corporate Bonds Corporate bonds, like other risky assets, suffered during the recent sell-off. As measured by spreads versus Government bonds, corporate bonds are beginning to underperform which is a trend that I expect to continue. Investors should focus on the highest quality companies only and debt with a maximum maturity of two to three years. 7

8 Currencies When I wrote our first monthly newsletter at the beginning of December, the EUR/USD exchange rate was trading at 1.50 and the bullish sentiment index was 90% bullish in favour of the Euro. In fact, it was pretty hard work to find anyone who was bullish on the Dollar. Fast foward 2 ½ months, the Euro is trading at 1.69 (a decline of decline of 10%) and bullish sentiment is only 10% bullish in favour of the Euro. Of course, with all of the problems in Greece seeping into the currency markets, it is easy to understand why traders are now so bearish on the Euro, and indeed, I share this bearish view for the months ahead. That said, with sentiment now so one sided, I would wait for a bounce in the Euro before selling. As can be seen from the above chart, the time to have turned bearish on the Euro was in December last year. The Euro could well rally in the days ahead to alleviate the current near term oversold condition. Any reasonable bounce is likely to then give way to further selling. The picture for Sterling against the U.S. Dollar is similar to that of the Euro, although sentiment is not quite as bearish as can been seen in the chart below. That said, Sterling is trading below what looks like important support in the 1.57 area and the risk is that Sterling could move quite quickly towards What I also think is interesting is, whereas peripheral European countries are not able to weaken their currencies to try and become more competitive, there is nothing to stop the U.K. employing tactics to try and weaken Sterling. Indeed, late last year, Mervyn King, the Governor of the Bank of England, said he welcomed a weaker currency. I remain bearish on Sterling, not just against the U.S. Dollar, but also against currencies of fundamentally stronger countries such as Norway and Denmark. 8

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10 Commodities The main commodity markets have continued to trade lock step with the currency markets and inversely to the U.S. Dollar. I expect this to continue for the foreseeable future, and as such expect prices to remain under pressure in the months ahead. Oil continues to edge higher as shown in the chart above, but with momentum in a declining pattern, the conviction behind supporting this uptrend appears to be weak. The risk here is that the bullish channel gives way at some point to a new downtrend for oil. 10

11 The Gold market has followed the fate of currencies closely. The chart below with Bullish Sentiment shows how both are rising from a near term oversold condition. I expect this bounce to end shortly and strength is to be sold in the Gold market. Conclusion Since my last monthly newsletter, risky assets suffered their worst decline since March This action, and the subsequent rally over the last week, augur for further declines in the months ahead, or at best, a sideways trading environment. Investors will need to overcome a sovereign debt crisis that is unlikely to go away, the unwinding of the extraordinary monetary and liquidity stimulus from central banks, a changing (for the worse) regulatory environment and slow economic growth. Currency markets were the first market to reverse the uptrend that began in March 2009, and they remain the weakest today which does not augur well for risky markets in general. Recent action in Government bond markets illustrates what can (and likely will) happen to profligate countries. The message here is to stay away from poor quality issuers and concentrate on high quality short duration issues. Overall, 2010 is shaping up to be a very different year than I am positioning client portfolios to benefit from a lacklustre equity market performance and a weaker Sterling. In particular, I believe that the Greek tragedy is just the start of a very difficult year for some sovereign bond markets and we will be looking to take advantage of this for our clients. Disclaimer RMG Wealth Management LLP is authorised and regulated by the Financial Services Authority (FSA). This report is for general information purposes only and does not take into account the specific investment objectives, financial situation or particular needs of any particular person. It is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it. This report is based upon public information that RMG considers reliable but RMG does not represent that the information contained herein is accurate or complete. The price and value of investments mentioned in this report and income arising from them may fluctuate. Past performance is not a guide to future performance and future returns are not guaranteed. 11

Financial Forecast. Issue No. 1 December Inside this issue. Indices / FX Rate. Key Investment Thoughts 2. Macro Thoughts 3.

Financial Forecast. Issue No. 1 December Inside this issue. Indices / FX Rate. Key Investment Thoughts 2. Macro Thoughts 3. Issue No. 1 December 2009 Financial Forecast Inside this issue Key Investment Thoughts 2 Macro Thoughts 3 Equity Markets 5 Fixed Income 7 Currencies 9 Commodities 11 Conclusion 12 Indices / FX Rate Price