Double Dip? The Investment World: Yesterday, Today & Tomorrow Don Rich Head of Tactical Asset Allocation November 10, 2010
Investment Landscape Has Changed Outsourcing is causal to business cycles, around the world, becoming more and more synchronized, resulting in elevated financial market correlations (as shown below) Expect the current risk on / risk off environment to continue in response to this secular shift in correlations (secular shift=globalization) The introduction and proliferation of ETFs may also be raising correlations 60% Key in 01: Asset Class Diversification Average Correlation of 24 Individual Asset Class Returns (average of 276=24*23/2 daily correlations) Key in 10: Risk Factor Diversification 55% 50% 45% Correlations are 70% higher than 10 Correlations are 70% higher than 10 years ago years ago! 40% 35% Risk management needs to adapt to reflect change 30% 25% 08-Jan-01 08-Apr-01 08-Jul-01 08-Oct-01 08-Jan-02 08-Apr-02 08-Jul-02 08-Oct-02 08-Jan-03 08-Apr-03 08-Jul-03 08-Oct-03 08-Jan-04 08-Apr-04 08-Jul-04 08-Oct-04 08-Jan-05 08-Apr-05 08-Jul-05 08-Oct-05 08-Jan-06 08-Apr-06 08-Jul-06 08-Oct-06 08-Jan-07 08-Apr-07 08-Jul-07 08-Oct-07 08-Jan-08 08-Apr-08 08-Jul-08 08-Oct-08 08-Jan-09 08-Apr-09 08-Jul-09 08-Oct-09 08-Jan-10 08-Apr-10 08-Jul-10 2
The Global Macro Risk Factor Is The Most Important Risk Factor THE BOSS below is our composite proxy of the global macro risk factor, based on output measures from 28 countries +1 to -1 Standardized Oscillator 1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00-0.10-0.20-0.30-0.40-0.50-0.60-0.70-0.80-0.90-1.00 THE BOSS: MFC's Global Composite Cyclical Indicator Upward slope is indicative of global economic expansion, downward is deceleration/contraction Current Signal: Down Cycle Jan-80 Jan-81 Jan-82 Jan-83 Jan-84 Jan-85 Jan-86 Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Last Update: Jan-08 Sep-10 Jan-09 Jan-10 3
Observations From THE BOSS We are currently in the global down cycle: it started in Nov. 09 based on our estimate Down cycles tend to last 12-16 months, but each is unique We are currently entering the depths of the current down cycle. It is projected to last until sometime between Feb and Apr 11 Deep into down cycles, things can get concerning: maximum market dislocation expected between Nov 10 Feb 11 Risk budgets should be up- and down-cycle dependent (to manage tail events) Pullbacks during up-cycles are shorter and milder, therefore risk budgets should be expanded during up-cycles (& contracted in down) Large adverse investor returns result during down-cycle pullbacks that escalate into tail events 4
5 300 Disagreeing With THE BOSS Can Free Up Your Career Opportunities Cumulative Performance From Different Strategies Trading "The Boss" = 100% equities (SPX) in up-cycles, 100% fixed income in down-cycles 250 200 150 100 50 Dec-99 Mar-00 Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Base = 100 Trading the Boss S&P500 Total Returns 50/50 S&P500, Lehman Agg Clearly, the global macro risk factor is an important driver of portfolio returns!
THE BOSS Says To Expect Continued Slowing Global Growth: Implications For US Double-Dip US Double-Dip Category Likelihood Manufacturing Recession Housing Recession Highly Likely Highly Likely (5 out of 6 already) Consumer Recession Unlikely GDP Recession Growth Around 1% 6
7 Manufacturing Double-Dip 60 Relationship Between Philadelphia Fed General Business Outlook and ISM 75 Phillie Fed, lhs ISM, rhs 70 40 65 20 60 55 0 50 45-20 40-40 35 30-60 25 Jan-80 Jan-81 Jan-82 Jan-83 Jan-84 Jan-85 Jan-86 Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 80 ISM New Orders-to- Inventory ratio as a leading indicator of ISM Manufacturing 70 60 50 40 30 20 1.8 1.6 1.4 1.2 1.0 0.8 0.6 Jan-09 Jan-80 Jan-81 Jan-82 Jan-83 Jan-84 Jan-85 Jan-86 Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-10 Some of the regional manufacturing surveys are already in contraction ISM Manufacturing, LHS ISM New Orders / Inventories, Adv 3m, 3mth MA, RHS and our ISM leading indicators suggest coming manufacturing contraction.
8 Housing Double-Dip 25 20 US Home Prices, YoY 15 10 5 0-5 -10-15 -20-25 01-Jan-00 01-Apr-00 01-Jul-00 01-Oct-00 01-Jan-01 01-Apr-01 01-Jul-01 01-Oct-01 01-Jan-02 01-Apr-02 01-Jul-02 01-Oct-02 01-Jan-03 01-Apr-03 01-Jul-03 01-Oct-03 01-Jan-04 01-Apr-04 01-Jul-04 01-Oct-04 01-Jan-05 01-Apr-05 01-Jul-05 01-Oct-05 01-Jan-06 01-Apr-06 01-Jul-06 01-Oct-06 01-Jan-07 01-Apr-07 01-Jul-07 01-Oct-07 01-Jan-08 01-Apr-08 01-Jul-08 01-Oct-08 01-Jan-09 01-Apr-09 01-Jul-09 01-Oct-09 01-Jan-10 01-Apr-10 01-Jul-10 Case-Shiller US New One Family Houses Sold: Avg Price FHFA US Home Price Index Existing One Family Home Sale Median Price (no new homes; accnts for 85% of all houses sold) Existing One Family Home Sale Avg Price (no new homes; accnts for 85% of all houses sold) 5 of 6 US house price indices are already in double dip
9 US Consumer Is Not In Recession 1.05 US Railroad Weekly Activity Index (Freight Carloads) Upward slope is indicative of increased rail activity 0.90 0.75 0.60 0.45 0.30 0.15 0.00 Huge relief compared to 07-08: US consumer is cautious but consuming! -0.15-0.30-0.45-0.60-0.75-0.90-1.05 Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Source: Bloomberg, Association of American Railroads, MFC Activity Index
10 Canada Faces Contagion Risk From South On a relative basis, Canada is better positioned than most countries, but it will not be immune 90% Percentage of Canada's Exports Going to US 85% 80% 75% 70% Some evidence of export diversification but roughly 3/4's still go to the US Canada's economy is too closely tied to the US to have divergent monetary policies! 65% 60% 55% 50% Jan-90 Jul-90 Jan-91 Jul-91 Jan-92 Jul-92 Jan-93 Jul-93 Jan-94 Jul-94 Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10
Canada Goes As Commodities Go 6 Canada Trade Balance x-energy 4 Trade ex Energy Balance C$bn LHS 2 0-2 The Loss of Manufacturing: Non-Energy Sector Used To Be A Net Positive But Is Now A Growing Net Negative on Growth -4-6 -8 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 11
12 Commodity Outlook Commodity prices will be under pressure as global growth slows 15 G7 Industrial Production Vs JOC Commodity Index G7 IP, YoY JOC, YoY, rhs 10 5 0-5 -10-15 100 80 60 40 20 0-20 -40-60 -80 Jan-86 Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
Implications of Low Interest Rates Basic economic principles say: Expected Ret = Risk-free Rate + Risk Premium 2.5% 10y UST yield combined with 2.0-3.0% risk premium says we should expect US equities to return around 5% in future...far below historical averages We think low interest rates could last 2-5 years as unprecedented levels of global imbalances correct 2-5 years of depressed equity returns could result in a structural shift in the money management industry Considerable consolidation of participants Margin compression 13
QE2 Implications To Consider First Round Effects: Liquidity Injection Second Round Effects: Low Borrowing Costs Third Round Effects: Weak Currency 14
Coming Head Winds Weak global expansion during unwinding of the tremendous expansion in fiscal & monetary policies Increased regulation / gov t intervention Increased taxation Reduced personal consumption (particularly US) Shifting/Aging demographics Growing budget deficits Sustained levels of above average unemployment Reduced current account recycling In sum, coming head winds suggest to expect choppy equity market performance in the future, with value added by actively managing risk around cyclical turns. 15