Market Update as of 31 Aug (Eng)

8/3/2019 Market Update as of 31 Aug (Eng)

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Market Review & Perspectives: August 2011Recessionary Fears Rise: Aggressive early-month sell-off cushioned by QE3 hope

It was a terrible month for risk assets. Risk sold off aggressively as global recession fears mounted and Europe

struggled to find a solution to its problems. Global economic surprises remained in negative territory barring Asia(both Japan and China surprised positively). While Japans recovery from the Tohoku earthquake remained ontrack with a further rebound in industrial production, Chinas August PMI of 50.9 was better than last months50.7 and the first time since March that it expanded sequentially. In the US, data was initially very negative withsharp downward revisions to 1Q11 and 2Q11 GDP data, but it seemed to get better towards the end of themonth, with stronger than expected readings for durable goods orders, home prices, consumer spending andAugust ISM Manufacturing Index (50.6 vs expectations of 48.5). Europe, which had been leading the developedworld, came under pressure as 2Q11 GDP came below expectations and its August Manufacturing PMI slippedinto contraction zone with a reading of 49 (Germany just managed to hold its head above water with a reading of50.9).

Chart1: JulyPMIs:Softerbutbetterthanexpected Chart2: OverallEconomicSurprisesstillNegative

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Source:Bloomberg/InternalMarkets carried on from where they had left July. The equity sell-off intensified further, credit spreads expanded(with high yields underperforming investment grade) and treasury yields declined sharply (10-yr USTs declined57bps, the most since declining 103bps in Nov08). Equity volatility rose across regions. Gold/Silver ralliedstrongly; oil and base metals declined in a typical risk-off play. The greenback reversed its recent weakeningtrend, though the extent of reversal was mild relative to the sell-off in equities and spread assets. Risk assetsrecovered somewhat in the last 10 days, giving S&P500 its best 8 day gain since 2009, on slightly bettereconomic data, expectations of QE3 in September and some signs of progress in the Eurozone (Merkelscabinet endorsed the expansion of EFSF to tackle the crisis). However, markets still closed deeply in the red,with MSCI AC World losing 7%, MSCI EM -9%, MSCI Asia -8% and S&P -6% (its worst month since May10 andits worst August since 2001).

Chart3:ExportOrientedAsianMarketsunderperformed Chart4:SentimentrecoveredtowardstheEndoftheMonth

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Source:Bloomberg/InternalIn Europe, ECB resumed its Securities Market Program and bought Spanish and Italian bonds that helped pushyields lower and restore some confidence in peripheral bond markets. German cabinet approved the revised


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rescue package. There is finally the prospect of each of France, Italy and Spain introducing constitutionalamendments to ensure much tougher underlying fiscal discipline. Not all is positive, however. Inter-bank spreadsare rising in Europe, indicating a rising fear-factor. Banks are trading at steep discount to book value, reflectingconcerns on capital adequacy. Greek bonds formed an orbit of their own, trading sharply lower amidst realization

that write-offs will ultimately be much larger than announced in last months funding package. The Finnishdemand for collateral before making further loans to Greece can open a can of worms. In Germany, thereremains considerable hostility to the notion of anything more in terms of German financial aid for the morechallenged Euro Area members. And, France seems to be the focus of renewed speculative interest, with itsbanks and sovereign CDS spreads coming under pressure in recent weeks.

Chart5:ECBsBondbuyshelpedItalianandSpanishBonds Chart6:InterbankspreadsshotupinEurope

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Chart7:GreekBonds:Plummetingmarketconfidence Chart8:FrenchCDSs:Undersustainedpressure

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Source:Bloomberg/InternalMLs fund flow data showed that long-only Equity funds continued to bleed in August. Theyve now recordedoutflows in 7 out of the past 8 weeks, the last week of August providing the exception. DM inflows of $25bn YTDhave been overshadowed by EM outflows of -$20bn. On the other hand, Bonds have had inflows of $50bn,Commodity funds +$4bn and Money Market Funds -$187bn. Within bonds, the last few weeks saw outflows fromspread/high-yield funds into the safety of treasuries. This risk-reduction sentiment was also captured in BoFAMLs Global Fund Manager August survey, as cash holdings increased almost to 2008 levels, accompanied by abig reduction in equity over-weights. However, US retail sentiment wasnt as bearish, with AAIIs bull-bearindicator still some distance from panic territory.

Chart9:GlobalFundFlows:RiskOffenvironment Chart10:RetailInvestorSentiment: WeakbutnotPanicky

Global Asset Allocation YTD'2011 ($ Mn)Equities 5,882

Bonds 50,423

Money Market Funds 186,680

Commodity Funds 3,930

Net Fund Flows to Global Equities YTD'2011 ($ Mn)

Long-only Funds (49,187)

ETFs 55,069

Develoed Market Funds 25,557

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I. EQUITIES

Change Change Change Change Change Change Change Change ChangeChange

HK/China 31-Aug-11 Month Q3'11 Q2'11 Q1'11 YTD'11 Q4'10 Q3'10 Last1yr 2010 2009

Hang Seng HK$ 20,535 -8% -8% -5% 2% -11% 3% 11% 0% 5% 52%

H-Shares HK$ 10,943 -12% -13% -6% 5% -14% 2% 8% -4% -1% 62%

Shanghai Comp CNY 2,567 -5% -7% -6% 4% -9% 6% 11% -3% -14% 80%

Shenzhen Comp CNY 1,143 -3% -1% -8% -3% -11% 10% 24% -2% 7% 117%

MSCI China USD 341 -9% -10% -2% 3% -9% 1% 11% 0% 5% 62%

Developed

S&P500-US USD 1,219 -6% -8% 0% 5% -3% 10% 11% 16% 13% 23%

Dow Jones-US USD 11,614 -4% -6% 1% 6% 0% 7% 10% 16% 11% 19%

Russell 2000-US USD 727 -9% -12% -2% 8% -7% 16% 11% 21% 25% 25%

DAX-Germany EUR 5,785 -19% -22% 5% 2% -16% 11% 4% -2% 16% 24%

FTSE100-UK GBP 5,395 -7% -9% 1% 0% -9% 6% 13% 3% 9% 22%

CAC 40-France EUR 3,257 -11% -18% 0% 5% -14% 2% 8% -7% -3% 22%

ASX 200-Australia AUD 4,297 -3% -7% -5% 2% -9% 4% 7% -2% -3% 31%

Nikkei 225-Japan JPY 8,955 -9% -9% 1% -5% -12% 9% 0% 1% -3% 19%

VIX Index % 32 6 5 2 5 14 -3 -11 6 -4 -18

Asia/Other EM

India-Sensex INR 16,677 -8% -12% -3% -5% -19% 2% 13% -7% 17% 81%

Thai-SET Index THB 1,070 -6% 3% -1% 1% 4% 6% 22% 17% 41% 63%

Singapore-STI SGD 2,885 -10% -8% 0% -3% -10% 3% 9% -2% 10% 64%

Korea-KOSPI KRW 1,880 -12% -11% 0% 3% -8% 10% 10% 8% 22% 50%

Taiwan-TWSI TWD 7,741 -10% -11% 0% -3% -14% 9% 12% 2% 10% 78%

Malaysia-KLCI MYR 1,447 -7% -8% 2% 2% -5% 4% 11% 2% 19% 45%

Brazil-BOVESPA BRL 56,495 -4% -9% -9% -1% -18% 0% 14% -13% 1% 83%Russia-RTSI$ USD 1,702 -13% -11% -7% 15% -4% 17% 13% 20% 23% 129%

MSCI: TR Net

MSCI FE xJ USD 307 -10% -8% 0% 2% -6% 7% 17% 12% 19% 69%

MSCI AsiaPac xJ USD 331 -8% -8% 0% 2% -6% 8% 18% 13% 18% 73%

MSCI Europe USD 4,271 -10% -13% 2% 6% -5% 5% 19% 10% 4% 36%

MSCI AC World USD 131 -7% -9% 0% 4% -5% 9% 14% 14% 13% 35%

MSCI EM USD 400 -9% -9% -1% 2% -9% 7% 18% 9% 19% 79%

MSCI BRIC USD 457 -10% -11% -3% 3% -11% 4% 15% 1% 10% 93%

Source:Bloomberg/InternalEquities had a terrible month. Every single market that we track closed in the red, in a repeat of October 2008.While markets did recover in the last 10 days, it wasnt enough to compensate for massive losses in the first 20.Correlations were high and volatilities rose as risk was taken off at alarming pace. Typical risk-on indicators likecrude, copper, cyclical equities, small-cap and beta all sold off aggressively. Risk-off indicators like gold, longsovereign bonds, defensive and large cap equities did well. In line with a cut in global growth forecasts, bottom-up earnings forecasts were also cut by sell side analysts. Barring Japan (where recovery from the Tohokuearthquake helped) and USA (a strong earnings season for 2Q11), revision rations for all other regionsremained below 1 (more downgrades than upgrades) for both 1-month and 3-month periods. The ratio stood at0.70 for Asia-ex-Japan and Emerging Market equities while it dipped rather sharply for Europe (down to 0.44 for1-month period as earnings delivery was well below expectations). Banks and Financials came under furtherstress in both US and Europe as a threat of recession, capital concerns (mainly in Europe) and litigation costs


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(mainly US) took heavy toll of investor sentiment. MSCI US Banking sector is down 19% YTD (the worstperforming sector in US) while MSCI Europe Banking sector is down 27% YTD. Both sectors are now tradingbelow book (more so in the case of MSCI Europe where the P/B has shrunk to just 0.60).

Regionally, DM equities outperformed EM equities for the fourth time in five months. Germany, (DAX -19%) hadits worst month since September02 when it had fallen 25%. US dropped a relatively modest 6% (S&P 500) and4% (Dow). The smaller cap Russell 2000 dropped 9%. Japan, despite a stronger economic undertone, couldntstem the tide, as Nikkei dropped 9%. MSCI EM fell 9%, its worst performance since October08. Within EM, LatinAmerica suffered the least damage as monetary policy easing expectations helped sentiment in both Brazil(Bovespa -4%) and Mexico (Bolsa -1%). Asian markets July outperformance was reversed quickly as indiceswere down 8% to 10% in $ terms. Export oriented markets like Korea, Taiwan and Singapore came underincreased pressure as global growth forecasts faced the chopping board. The domestic consumption economiesof Thailand, Philippines, Malaysia and India fared relatively better.

Sectorally, leadership was retained by defensives (Utilities, Telcos and Staples) in the US. Financials andEnergy stocks lagged the most. Small-caps lagged Large-caps. In Europe, Staples, IT and Health Care faredbetter than Financials, Cons Disc and Materials. Value underperformed Growth. In Japan too, defensives like

Utilities, Health Care and Staples did better than Cons Disc and Materials. But Small-caps outperformed Large-caps. In Asia, Small-caps underperformed Large-Caps. Best performing sectors were Telcos, Staples andUtilities while Industrials and Materials fared the worst.

II. FIXED INCOME & CREDITS


Key Policy Rates (%) 31-Aug-11 Month Q3'11 Q2'11 Q1'11 YTD'11 Q4'10 Q3'10 Last1yr 2010 2009

US-Fed Funds USD 0.25 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

UK Bank Rate GBP 0.50 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 -1.50

ECB Ref Rate EUR 1.50 0.00 0.25 0.25 0.00 0.50 0.00 0.00 0.50 0.00 -1.50

Australia Cash Rate AUD 4.75 0.00 0.00 0.00 0.00 0.00 0.25 0.00 0 .25 1.00 -0.50China 1y Dep Rate CNY 3.50 0.00 0.25 0.25 0.25 0.75 0.50 0.00 1.25 0.50 0.00

China 1y Lend Rate CNY 6.56 0.00 0.25 0.25 0.25 0.75 0.50 0.00 1.25 0.50 0.00

Treasuries (%)

USA-10y USD 2.22 -0.57 -0.94 -0.31 0.2 -1.1 0.8 -0.4 -0.2 -0.5 1.6

UK-10y GBP 2.60 -0.26 -0.78 -0.31 0.3 -0.8 0.4 -0.4 -0.2 -0.6 1.0

GER-10y EUR 2.22 -0.32 -0.81 -0.33 0.4 -0.7 0.7 -0.3 0.1 -0.4 0.4

Australia-10Y AUD 4.37 -0.43 -0.84 -0.28 -0.1 -1.2 0.6 -0.1 -0.4 -0.1 1.7

Japan-10y JPY 1.03 -0.05 -0.11 -0.12 0.1 -0.1 0.2 -0.2 0.1 -0.2 0.1

Hong Kong-10 EFN HKD 1.74 -0.54 -0.53 -0.41 -0.2 -1.1 0.9 -0.3 -0.2 0.3 1.4

China-10y CNY 4.12 0.03 0.23 -0.02 0.0 0.2 0.6 0.0 0.9 0.3 0.9

Singapore-10y SGD 1.64 -0.42 -0.67 -0.17 -0.2 -1.1 0.7 -0.4 -0.4 0.0 0.6

Korea-10y KRW 3.86 -0.34 -0.43 -0.19 0.0 -0.7 0.4 -0.8 -0.5 -0.9 1.2Credits (bps)

3m $ LIBOR-OIS USD 24 11 11 -5 5 12 1 -23 13 3 -112

NA CDX 5y IG CDS USD 115 19 23 -4 11 30 -22 -16 0 -1 -120

Europe 5y IG CDS USD 153 37 47 4 -3 48 -6 -18 35 29 -102

Asia 5y IG CDS USD 148 32 34 10 0 45 -14 -27 11 1 -266

JPM EMBI Index USD 367 66 79 -10 10 78 -16 -54 41 -6 -430

Source:Bloomberg/Internal


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Policy rate was cut by Switzerland (-25bps to zero) in a desperate attempt to stem flows into Swiss Franc as asafe haven currency. In fact, short-term rates were pushed into ve territory through excess liquidity creation todissuade speculative long positions. Others to cut rates were Brazil (a very surprising 50bp cut to 12% asdomestic economic conditions had deteriorated rapidly) and Turkey (-50bps to 5.75%). Rate hikers included

India (a surprising +50bp move at the start of the month), China (+25bps) and Thailand (+25bps). Chinatightened its monetary conditions further by imposing reserves on customer deposits against commercialfinancing commitments. However, the balance of monetary policy seems to be silently tilting towards easing inEmerging markets and could reflect in the form of prolonged tolerance of negative real rates, especially in Asia.Going forward, these Central banks are likely to use macro-prudential measures to impact certain sections of theeconomy rather than making broad-based interest rate changes in an environment of slowing global growth.

Government Bond Yields ended sharply lower across the board. Sovereign 10s touched multi-year lows in US,UK and Germany. They declined 57bps in US, 26bps in UK, 32bps in Germany and 54bps in HK. 2-yr InterestRate Swaps declined across the board as well, reflecting reduced expectations of rate increases, especially inEurope. Feds commitment to keep rates very low till at least 2013 had a big role to play in shaping this view.Also, while Bernankes much awaited Jackson-hole speech did not talk mention asset purchases, it did affirmthat the Fed will discuss further easing steps at its September FOMC, expanded to two days (Sep 20-21) to

facilitate discussions. In line with declining growth expectations, longer term US Inflation expectations alsodeclined sharply during the month. All measures of inflation expectation (5 & 10-year break-even rates derivedfrom corresponding maturity TIPS and fixed rate bonds, 10-yr CPI swaps) declined sharply. Term spreads endedsharply lower as long-end yields came off significantly, pushing 2/10s down 42bps to 202bps. In Europe,resumption of bond buying by ECB helped sentiment in Italy and Spain, pushing their 10-yr bond yields into the5-handle from the 6-handle. Irish and Portuguese yields declined as well in a positive sign. However, Greekyields continued to rise, implying a much larger haircut than that envisaged in its revised debt deal (at 21%).France seems to be focus of renewed speculative interest, with its banks and sovereign CDS spreads comingunder pressure. The consistent increase in net outstanding of French CDSs probably reflects the next pressurepoint in Europe. In Asia, 10-yr yields fell in every single market, except for China where they hardened a tad. InLatAm, benchmark yields dropped a whopping 144bps in Brazil while softening 50bps in Mexico.

Chart11:EmergingMarketRateHikes:Almostdone Chart12:InflationExpectationsdroppedsharply

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Source:Bloomberg/InternalCredit spreads widened sharply for both investment grade and high-yield bonds. Quality outperformed yet again.Based on MLs indices, US Investment Grade credit spread closed 55bps wider at 221bps (2011 high) while

Global Large Cap Corporate spread widened to 236bps. US & Global High Yield spread jumped 162bps &174bps to 720bps and 741bps respectively (both at 2011 highs). The average of 5 big US banks (GS, Citi, BoFA,JPM, MS) 5-yr CDSs moved up 65ps to 216bps. JPMs EMBI Bond spread widened 66bps to 367bps. MLs USTreasury and Inv Grade Corporate Bond Indices returned +2.6% and +0.1% respectively (theyre up 6.7% and5.8% YTD), its Global Govt Bond Index +2.1% and its Global Large Cap Corporate Index -0.6%. High Yieldreturns lagged substantially, with returns of -4% in US and -4.4% globally.


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III. CURRENCIES


CURRENCIES 31-Aug-11 Month Q3'11 Q2'11 Q1'11 YTD'11 Q4'10 Q3'10 Last1yr 2010 2009DXY (Dev Mkts $ Index) 74.15 0.3% -0.2% -2% -4% -6% 0% -8% -11% 2% -4%

BB JPM Asia $ Index 119.65 0.3% -0.7% -1% -1% -3% -2% -3% -7% -5% -3%

BB JPM LatAm $ Index 117.21 2.7% 2.3% -3% -2% -2% -1% -5% -6% -4% -13%

USD/EURO 1.44 0.2% 0.9% -2% -5% -7% 2% -10% -12% 7% -2%

USD/GBP 1.63 1.1% -1.2% 0% -3% -4% 1% -5% -6% 4% -10%

USD/AUD 1.07 2.7% 0.1% -4% -1% -4% -5% -13% -17% -12% -22%

Yen/USD 76.66 -0.1% -4.8% -3% 2% -5% -3% -6% -9% -13% 3%

HKD/USD 7.79 -0.1% 0.1% 0% 0% 0% 0% 0% 0% 0% 0%

CNY/USD 6.38 -0.9% -1.3% -1% -1% -3% -1% -1% -6% -3% 0%

HKD/USD 12M Fwd -0.42% -0.1% -0.1% 0% 0% 0% 0% 0% 0% 0% 0%

CNY/USD 12M NDF -1.59% -0.7% -0.3% 1% 1% 1% 0% -1% 0% 0% -5%

Source:Bloomberg/Internal(+venumberindicatesUSDappreciation)US$ appreciated against most global currencies, reversing its recent weakening trend. However, moves weresmall relative to the big risk-off moves in equities and credits. Especially noticeable was the meager (+0.3%)appreciation in $/Asia despite a sizeable decline in Asian equities, breaking a strong historical correlation. TheDXY index closed at 74.15 with USD appreciating against all except JPY (+0.1%). It strengthened the mostagainst NZD (+3%) and Swiss Franc (+2.6%, as Swiss authorities pushed short-term rates into negative territoryto dissuade long positions in CHF; there were talks of a CHF/EUR peg as well as Switzerland fought hard toprevent its currency from appreciating to absurd levels). In Asia, China let CNY appreciate at a faster pacerelative to USD (+0.9%). Other prominent moves in $ were against INR (+4.3%) and KRW (+1.2%). Japans MoFannounced a $100 billion facility aimed at checking the currencys advance. While the impact will be limited atbest, the move indicates a strong political will to resist appreciation. In the event of further gains, the could jointhe MoF by adding another 10 trillion to its Asset Purchase Program bringing the total to 60 trilliontogether with 4 trillion of currency intervention. In LatAm, $s biggest moves was against MXN (+5%) and BRL

(+2.6%). It seems like the Brazilians, after almost a year of constant struggle, can finally relax in their fightagainst a stronger currency. In the EMEA region, $ posted gains across the board, with big moves comingagainst South African Rand (+4.4%) and Russian Ruble (+4.4%). Market Fx positioning that had remainedsteadfastly in favor of long EUR/USD, finally seemed to reverse course last month. Simultaneously, shortpositions in JPY/USD reduced considerably. The main support for long EUR/USD i.e. positive interest ratedifferentials, suffered a knock. It is almost certain now that ECB is done with this mini-hike cycle. In fact, someare even calling for them to reverse the two hikes that theyve done in the last 3 months.

Chart13:Divergingpositioning:EURandJPY Chart14:AsianCurrencies:StrongdespiteweakEquities

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IV. COMMODITIES


Commodities 31-Aug-11 Month Q3'11 Q2'11 Q1'11 YTD'11 Q4'10 Q3'10 Last1yr 2010 2009RJ CRB Index USD 342.6 0% 1% -6% 8% 3% 16% 11% 30% 17% 23%

Baltic Dry Index USD 1,619 28% 15% -8% -14% -9% -28% 2% -40% -41% 288%

Nymex Crude USD/bl 88.8 -7% -7% -11% 17% -3% 14% 6% 23% 15% 78%

Brent Crude USD/bl 114.9 -2% 2% -4% 24% 21% 15% 10% 54% 22% 71%

Gold USD/toz 1,829.3 12% 22% 4% 1% 29% 9% 5% 46% 30% 24%

Silver USD/toz 41.7 4% 20% -8% 23% 35% 42% 17% 115% 84% 49%

Copper USD/T 9,269.8 -6% -2% 0% -2% -4% 20% 23% 25% 31% 141%

Aluminum USD/T 2,452.3 -6% -3% -4% 7% 0% 5% 19% 20% 11% 45%

Corn USc/bu 757.5 14% 20% -9% 10% 20% 27% 40% 78% 52% 2%

Soybean USc/bu 1,449.0 7% 11% -7% 1% 4% 26% 17% 44% 34% 7%

Wheat USc/bu 745.3 11% 27% -23% -4% -6% 18% 45% 14% 47% -11%

Sugar USc/lb 29.7 0% 5% 5% -16% -8% 27% 40% 50% 19% 128%Source:Bloomberg/InternalCommodities had a mixed month. Precious metals were clear outperformers in an extreme risk-off environment.The big move in gold prices wasnt just due to investment positioning, it was also influenced by strong physicaldemand from Asia (jewelry, coins), increased coin demand in US/Europe and potentially net Central bank buying.An increase in trading margins on both Comex and Shanghai did help in pulling prices down from an intra-monthhigh above $1900/toz but the yellow metal still finished 12% stronger (+22% in Q311 so far). In the Oil complex,WTI dipped far more than Brent and Asian grades, which showed their resilience despite lower growthexpectations and higher OPEC output. Even a near-victory for the rebels in Libya (which evoked expectations ofresumption of its production sometime in 4Q11) couldnt dent the Brent price much. It is possible that some EMpolicy makers are building higher levels of strategic oil reserves in an environment where the fiat currencysystem is under scrutiny. The average Brent price for August fell to $110/bl, down 5% relative to previousmonths $117/bl. While average WTI crude dropped 11% during August, average US retail gasoline price wasalmost unchanged, providing little relief to American consumers. Retail gasoline prices seem to be breaking outof their strong historical correlation with WTI and linking stronger with Brent instead. Price correlation betweenWTI-Retail gasoline has declined recently while it has picked up for Brent-Retail gasoline. Had that not been thecase, US retail gasoline prices would have dropped far more than they have this year. Base metals were weakwithout exceptions, both on LME and in Shanghai, in an environment of heightened macro uncertainty.Agricultural commodities made a smart recovery as uncertain weather patterns and low stocks kept investorsinterested. Expectations for the US corn harvest, the worlds largest, were lowered further, providing a boost toprices, not just of corn, but also wheat, soya and rough rice.

Chart15:Brent,WTIcrude&RetailGasoline Chart16:RetailUSGasolinedelinkingfromWTI?

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BrentCrude$/Bl(RHS)USRetail Gasoline Price$/GnWTICrude$/Bl(RHS)

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3mPriceCorrelation:WTIRetail Gasoline

3mPriceCorrelation:BrentRetail Gasoline



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Looking Ahead

The world economy is surely going through a period of lower growth, hit by macro concerns and consumerpockets strained by high food and energy prices. Odds of a recession have increased with some data points i.e.

extremely weak Philadephia Feds purchasing manager survey readings, Consumer Boards Consumerconfidence at levels associated with past recessions and two quarters of anemic GDP growth in US pointingtowards that. Simultaneously, there are data points (strong money supply growth, positive payrolls, risingindustrial production, positive retail sales, steep yield curve etc.) that point against a recession. While our owneconomic think tank has cut its US and Global GDP growth targets, theyre not in the recessionary camp yet. Wefeel much the same way, though further policy mistakes in US and Europe could easily push us into one. Forone, European policy makers need to take more structural steps to find a solution to Europes debt problemsinstead of continuing with the patchwork approach that theyve largely used since the crisis broke out. Whilesome progress was made last month with efforts to introduce constitutional amendments to ensure muchtougher underlying fiscal discipline; a lot more needs to be done urgently, else the Euro risks a breakdown!European banks seem to be in a denial mode regarding the need for more capital. Stock markets seem to thinkotherwise, with banking P/B ratios dropping alarmingly in the last 3-4 months. Christine Lagarde, the new IMFhead, hit the nail on its head at the Fed symposium last week, warning that the fragile recovery could be derailed

and specifically called for urgent recapitalization of the European banking sector in order to withstand a slowrecovery and weakness in European sovereign balance sheets. In the US, while the Fed has kept monetarypolicy very easy which has undoubtedly helped borrowers, it has also played a role in pushing up food andcommodity prices, which have hurt consumers real disposable incomes. We doubt if monetary policy can bemade more accommodative than it already is. The real issue to address growth woes probably lies elsewhere. AtJackson-hole, Chairman Bernanke himself focused on longer-run issues, including fiscal policy. He discussedthe role of fiscal policy in promoting stability and growth and stressed the balancing act fiscal policy-makers face.To us, what seems to be missing currently is an incentive for American businesses to reinvest in creating newcapacity in US. That would not just help in creating jobs but also help in improving the current account deficit, ineffect reducing the transfer of wealth from America to its exporting nations. As it is, job cut announcements seemto be outnumbering job addition ones, according to Challenger. We hope that President Obama outlinesconcrete policy steps to reinvigorate entrepreneurship in the country through a simpler tax code and animmediate fiscal consolidation plan, when he addresses the nation later this month.

Chart17:Steepcutsinglobalgrowthexpectations Chart18:Jobcuttingexceedjobhiringannouncements

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EuroArea2011MedianRealGDPGrowthForecast %yoy

Germany2011 MedianReal GDPGrowthForecast %yoy

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Japan2011MedianReal GDPGrowthForecast %yoy

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CHALLENGERJobCutAnnouncements

CHALLENGERJobHireAnnouncements


Our market risk indicators have been pointing towards an uncertain market environment since March11. Therehave been several short bouts of risk-on/risk-off periods, driven by macro concerns on Europe/US and aweakening growth outlook. The short-term trend has turned towards a risk-off environment, but is still somedistance from entering levels which signify high probabilities of contrarian bounce-back. Equity market returnshave indeed turned negative in most regions as a result of the August rout; macro uncertainty will keep the risk-environment uncertain and volatile.

Earnings and Valuations: Bottom-up factors, as we stated in the Equities section, are painting a mixed picture.Earnings revision breadth remains weak in all regions except USA and Japan. Valuations, however, have gottencheaper since the start the year and should provide support, unless policy mistakes push us into another global


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crisis and/or a deep recession. On trailing 12m earnings, MSCI AC World is now at 12.8x and MSCI EM at a12% discount at 11.3x. On Next 12m earnings, the multiples are 10.5x and 9.4x respectively; admittedly muchcheaper than historical averages. But the risk is for some earnings downgrades in coming months that willreduce the E factor in the P/E equation. The extent to which E is cut is the critical point. At this stage, we dont

believe that it will be cut drastically.

Chart19:MSCI ACWorld:Price/Last12MonthEPS Chart20:MSCIEM:Price/Last12MonthEPS

07 08 09 10 11

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MSCI AC WorldPrice to Earnings - LTM High: 27.1Aug 31, 2006 - Aug 31, 2011 Low: 9.4

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EM (Emerging Markets)

MSCI EM (Emerging Markets)Price to Earnings - LTM High: 20.6Aug 31, 2006 - Aug 31, 2011 Low: 7.9

Last: 11.3

Chart21:MSCI ACWorld:Price/Next12MonthEPS Chart22:MSCIEM:Price/Next12MonthEPS

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MSCI AC WorldPrice to Earnings - NTM High: 14.9Aug 31, 2006 - Aug 31, 2011 Low: 9.0

Last: 10.5

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EM(Emerging Markets)

MSCI EM (Emerging Markets)Price to Earnings - NTM High: 15.0Aug 31, 2006 - Aug 31, 2011 Low: 6.9

Last: 9.4

Source:FactsetOur basic view that 2011 will provide solid yet unspectacular returns to equity investors is being tested. It willlikely be tested further this month with a series of important data and policy decisions. While the developed worldcontinues to struggle with debt problems, the emerging world is likely to get some relief on the inflation front, asa positive base effect starts kicking in from 4Q11. The key for such an outcome to come good lies in incrementalinflation being lower than the rate last year as also during 1Q11. Indeed, if commodity prices do not riseanymore, we could gradually slip into a range of acceptable inflation that allows emerging market centralbankers to take their feet off the tightening pedal.

Nominal Sovereign Bond Yields, especially in leading DM economies like US, Germany and Japan are at verylow levels. Theyve become even more unattractive from a nominal-return seeking asset allocation perspective,but are more relevant than ever before, as barometers of the risk-on, risk-off syndrome. We continue to thinkthat sovereign bond yields should head higher from a fundamental perspective. However, we do realize the safe

haven status they enjoy, which is ironical, given that the primary source of the current macro volatility is weakGovt. balance sheets!

Weve always recommended long-term investors to use market volatility to scale back to desired weights inasset classes that have underperformed. Weve also urged them to keep diversified exposure across regionsand geographies to reduce overall portfolio volatility, even as we recognize that market correlations tend to rise(as indeed they have, in this fall) during periods of macro stress. Finally, we hope that policy makers do takeconcrete steps in coming weeks to find a sensible solution to the current set of problems, instead of deliveringmock impressions!


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BinayChandgothia

ManagingDirectorPortfolioManager

PrincipalGlobalInvestors(HongKong)Ltd

02September2011This material contains general information only on investment matters; it should not be considered as a comprehensive statement on anymatter and should not be relied upon as such. The information it contains does not take account of any investors investment objective,particular need or financial situation. You should consider whether an investment fits your investment objectives, particular needs andfinancial situation. This material is given in good faith and has been derived from sources believed to be accurate upon publicly availableinformation at the time of publication and is subject to change without notice. Subject to any contrary provisions of applicable law, nocompany in the Principal Financial Group nor any of their employees or directors gives any warranty of reliability or accuracy not accepts anyresponsibility arising in any other way (including by reason of negligence) for errors or omissions herein. Past performance is not a reliableindicator of future performance. You should not rely on past performance to make investment decision. The value of investments and theincome from them may fall as well as rise.

Market Update as of 31 Aug (Eng)

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