Welcome to the Twilight Zone. May 2009 May 2009

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1 May 2009 May 2009 Welcome to the Twilight Zone This is the phase in a global earnings recession where share prices start to rise despite further falls in corporate earnings. Indeed, the latest equity market rebound has occurred against a backdrop of cheap valuations, stabilising lead economic indicators and tightening credit spreads. But Citi analysts caution that the fundamental outlook for profits remains dire and it may take another 12 months before the earnings cycle bottoms out.

2 Welcome to the Twilight Zone Surging stock markets and falling company profits do not appear likely bedfellows. But this seeming contradiction has been gripping investors the world over, with global equities about as far away from March s lows as they were at the start of the year. It appears that the Twilight Zone is upon us a period towards the end of a slowdown where share prices stabilise even as earnings are still falling. On one hand, falling company earnings suggest continued caution. The fundamental outlook for profits remains dire and it may take another 12 months before the earnings cycle bottoms out and at a level 3 lower than now. Yet valuations appear to have got so cheap to have already discounted these further profit falls and are even able to start looking towards an Chart 1: MSCI World Prices And Earnings (Log), Grey Bars Mark Twilight Zones Source: Citi Investment Research and Analysis, MSCI, Datastream As at 29 April 2009 eventual recovery. Indeed, the current strength in equity markets suggests that a more aggressive strategy is appropriate. This decoupling between share prices and earnings could well continue over the next 12 months. But history provides some pointers for navigating these confusing times. Indications of the Twilight Zone - Cheap valuations: The Twilight Zone begins at the moment that share prices have fallen far enough to discount the ongoing earnings collapse, which suggests that valuations should be cheap in the zone. The MSCI trailing PE ratio hit a low of 9x back in March. This is well below the levels reached at the beginning of the two 1990s Twilight Zones and consistent with the early 1980s. Only the 1970s was lower at 7x. - Macro green shoots : A turn in lead macro indicators seems to be a key characteristic of all previous Twilight Zones. This helps to improve investor risk appetites even though contemporary profitability suggests continued caution. It helps share prices decouple from falling earnings. Indeed, the US ISM index has stabilised, albeit at very low levels. Citi analysts expect the OECD composite leading index to do so soon. - Falling interest rates and bond yields: While previous Twilight Zones were associated with falling borrowing costs, already low rates this time round mean that there is limited room for them to decline further. Indeed, low interest rates make equities look very cheap against bonds. Also, Citi analysts argue that in non-inflationary Twilight Zones, like the current on, bond yields may rise. This is because having fallen earlier when investors rushed for safety, bond yields should rise in the Twilight Zone as investors head back into riskier assets in search of higher returns. This is exactly what happened in the late 1990s Twilight Zone and is also occurring right now. Strategy for the Twilight Zone - The Twilight Zone is a strange period towards the end of Chart 2: Global Equity Market Performance During Twilight Zones most (but not all) earnings recessions, here low share prices (% Perf From Start) reflect so much revulsion that investors become harder to disappoint. - A combination of cheap valuations, improving macroeconomic lead indicators and stabilising credit markets drive a recovery in share prices despite the protestations of bottom-up analysts who can see nothing but more bad news. - Global equities have bounced harder than at the beginning of previous Twilight Zones, perhaps reflecting that they had fallen that much further beforehand. - Previous experience suggests that there could be some consolidation from here, but that the equity market may rally again towards the end of the Twilight Zone (defined as the point when earnings finally turn upwards). - Assuming earnings turnaround 12 months later, there is no rush to buy now but that investors should be positioned for a Source: Citi Investment Research and Analysis, MSCI further burst of performance around the end of the year. As at 29 April Those waiting for a chance to buy at recent March lows could be disappointed. Even in the very long drawn-out Twilight Zone of the 1990s, the global equity market only gave back around a half of its initial rally. - There are risks that any improvement in the economic backdrop will prove stillborn, but cheap valuations should probably allow equities to at least hold recent lows. - Any sell-off over the summer should be seen as a buying opportunity ahead of the global earnings trough expected in 1H Source: Citi Investment Research

3 Chart 3: S&P 500 Index % -3.37% % Chart 4: Dow Jones Stoxx 600 Index % 0.94% % % United States Policy stabilization efforts gaining traction Euro-Area ECB likely to focus on quantitative measures Policy stabilization efforts have been gaining traction in the past month as credit and equity markets staged rallies on the back of indications that the pace of economic slowing may be easing. Inventories are falling into line and consumer spending has stopped dropping steeply. Historically low business sentiment readings suggest that the recession is not likely to end soon. However, recent improvement in some leading indicators suggests that the contraction in GDP will probably moderate in coming quarters, according to Citi analysts However, Citi analysts believe that lagged effects of massive wealth losses and rising joblessness are likely to continue to check any rebound. Going forward, Citi analysts expect economic activity to stabilise at the end of the year, when fiscal packages in many member states are fully implemented. However, the fiscal boosts, in combination with automatic Meanwhile, fiscal measures just legislated are expected to steady activity later this year along with a flattening out of homebuilding. But strains on state and local budgets, and weakness in commercial stabilisers and capital injections to the banking sector, are likely to lead to a strong increase in the debt-to-gdp ratio from 7 in 2008 to 79% in construction may offset some of that boost for me this statement does not fit with the flattening out of homebuilding above. Citi analysts think the European Central Bank (ECB) is unlikely to finish its easing cycle with the widely expected 25bp rate cut in May, which would The Fed s move to buy Treasuries and further expand its balance sheet are primarily directed at bolstering broad financial conditions, but confidence in the longer-term health of financial firms remains vulnerable. Citi analysts baseline scenario does not foresee an bring the main refinancing rate down to 1%. Instead, they expect the ECB to focus primarily on expanding open market operations and believe that private asset purchases may be used only when other measures fail to improve financing conditions. unwinding of accommodation any time over the next two years. Looking at the number of stocks trading above their 50-day moving Citi analysts expect US equity market strength to be supported by improving investor sentiment, attractive valuation, already low earnings expectations, and likely reduced volatility based on lead indicators. However, they caution that markets may still remain volatile. average suggests the market may be due for some consolidation in the short term. However, on a longer term basis, Citi analysts see equities as offering good value. Earnings expectations have fallen far and fast, as have share prices. This provides a good long-term entry point. Citi analysts continue to prefer high dividend-yielding companies with strong balance sheets and positive earnings trends.

4 Chart 5: MSCI Asia ex Japan Index Chart 6: MSCI Emerging Markets Index % 14.15% % 16.88% % % Japan Economic activity may stabilize in 2H Emerging Markets Favourable response to IMF s aid % Economic activity likely will stabilise in the second half of 2009, thanks to progress in inventory adjustment and a new economic stimulus package. However, prospects for private domestic demand remain bleak amid falling profits and worsening labour market conditions. Indeed, deterioration in corporate profits, along with declines in operating rates, is very likely to depress business investment in coming quarters. As a result, Citi analysts expect the economy to show renewed weakness in the first half of 2010, as the effect of the economic stimulus package wanes. The main focus of monetary policy has shifted to supporting dysfunctional financial intermediation by purchasing commercial paper and corporate bonds, providing longer-term funding to banks, and relaxing bank balance sheet constraints. Asia Pacific Signs of real turnaround remain elusive Regional activity is expected to bottom during the first half of with China leading the way. However, prospects for a renewed recovery continue to hinge on the G3 outlook, which remains fragile. Korea, Taiwan and Malaysia have probably ended their rate cuts, while China may be the first to tighten policy, according to Citi analysts. Bigger cuts to earnings estimates, better than-expected economic data and large amounts of liquidity may suggest to some that the bull market is back. But Citi analysts believe that the current upturn may well prove to be a bear market rally. They observe that export prices continue to tumble, and more steeply than in 1997/98. Volumes are also falling and faster than commodity input costs. Coupled with a less supportive credit environment, it is unlikely that current earnings estimates will be met. Markets have responded favourably to the G20 s commitment of International Monetary Fund (IMF) resources to emerging markets, and concerns about external liquidity have fallen significantly. Indeed, in order to reduce any risk associated with their external financing needs, as well as provide an incentive to minimise exchange rate volatility, Mexico, Poland and Colombia have signed up for the Flexible Credit Line (FCL). Going forward, Citi s guess is that the Czech Republic and South Africa are most likely to qualify for the FCL within CEEMEA. On the other hand, Latin America s need for the FCL seems more or less sated for now, with Uruguay being the only potential candidate. Citi analysts expect improved risk appetite, attractive carry, and higher commodity prices to support most Latin American currencies. In CEEMEA, the Polish Zloty could strengthen further due to access to the new IMF FCL, while the South African Rand and Russian Rouble should benefit from higher commodity prices. In Latin America, Citi analysts remain underweight Mexico (US-driven, lesser policy flexibility, earnings risks and looks overbought). Instead, they prefer a more defensive strategy and are overweight Colombia (relatively well diversified and attractively valued), alongside Chile. In CEEMEA, although valuations are at compelling levels, significant risks of further weakness exist as structural factors remain challenging. Citi analysts are overweight in Russia, Turkey, Czech Republic and Egypt; neutral in Israel and Poland; and underweight in South Africa and Hungary.

5 Currencies Chart 7: Currencies Favour high-grade corporate bonds 2,0 1,5 1,3 1,59% US Treasuries Citi analysts remain underweight US treasuries, as historically low interest 1,0 rates offer investors with little opportunity for significant returns. For those 0,5 looking to invest, Citi analysts prefer the 2 to 10-year portion of the curve. 0,0-0,5-1,0-0,62% Eur vs USD GBP vs USD Yen vs USD Lower volatility expected Euro Citi analysts estimate that EUR/USD is probably the exchange rate most vulnerable to the buffeting of conflicting concerns about excessive monetary ease versus belief that this policy stimulus may bring faster and earlier recovery. There are still concerns about banking exposures of West European banks to East and Central Europe and our economists think that there are further ECB could launch quantitative policies in the coming weeks. All this contributes to a weaker EUR but longer term worries about removing monetary accommodation in the US may still weaken the USD at times. British Pound Our analysts observe that the Sterling has been somewhat stronger than forecast over the past month although there has been little in the way of major new UK economic news over the past month, but there were some small chinks of light in rising mortgage approvals and a higher PMI. In general, they think sterling has already made its biggest move for this cycle. This still allows GBP/USD to stabilize just below 1.50 over the medium term. Yen Japanese economic fundamentals remain amongst the weakest globally with the 2009Q1 output loss likely to have been bigger even than the % SAAR of 2008Q4. However, as in other countries, Citi analysts observe that there are some grounds for optimism that the worst might be over. Most importantly, the Japanese government announced a major new fiscal stimulus package, which was a larger-than-expected yen 15.4 trillion, and which may add around 1pp to Japanese GDP over the next year, according to our analysts. Their medium term guide pins USD/JPY fair value at around 90 in the absence of other strong drivers. Corporate Bonds Risk-taking and liquidity have improved, bolstering expectations that highgrade corporate spreads are unlikely to retest recent highs. At current spreads, these securities are more attractive than government debt but investors are still wary of financial sector credits. On the other hand, they are cautious on the high-yield sector, favouring to wait on the sidelines until volatility subsides, as defaults are likely to increase given the weak economic outlook. Euro Bonds Weak economic fundamentals as well as declining inflation could push bond yields lower and prices higher. Citi analysts expect a steepening of the Euro zone government bond market, with yields in the short end of the curve falling more than yields in the long end. Emerging Market Debt Citi analysts remain cautious on emerging-market bonds. For investors seeking exposure, Citi analysts favour countries with sound economic fundamentals and minimal amount of political risk. General Disclosure Citi analysts refers to investment professionals within Citi Investment Research and Citi Global Markets (CGM) and voting members of the Global Investment Committee of Global Wealth Management. Citibank N.A. and its affiliates / subsidiaries provide no independent research or analysis in the substance or preparation of this document. The information in this document has been obtained from reports issued by CGM. Such information is based on sources CGM believes to be reliable. CGM, however, does not guarantee its accuracy and it may be incomplete or condensed. 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