The Future Ain’t What It Used to Be: Investing In A World of Volatility

The Future Ain’t What It Used to Be: Investing In A World of Volatility January 2012 George Feiger CCA0112-0003

Why Ain’t It? • Investing now requires global thinking • Big global problems imply years more volatility • Prudent investment strategies must work with this reality

Investing now requires global thinking • Big global problems imply years more volatility • Prudent investment strategies must work with this reality

Once Upon a Time, It Made Sense to Think Locally 1970s: Controlled and fenced-off financial world • Controlled interest rates • Limited capital flows • Small savings pools • Heavy wealth taxation

Then We Connected Everything 1970s: Controlled and fenced-off financial world 30 years of demolition MORGAN STANLEY GOLDMAN SACHS • Deregulation of interest rates • Free international capital movements • Explosion of institutional and individual pension assets • Securitization and trading of all forms of debt • Collapse of socialism/explosive growth in emerging markets • Options on everything • Controlled interest rates • Limited capital flows • Small savings pools • Heavy wealth taxation

To Invest You Now Need to Work with the Big Picture Euro Zone Issues US Issues Your Investments! Resource Suppliers Issues Emerging Markets Issues

It’s Not a Very Happy Picture Euro Zone Issues US Issues • Excessive debt • Financial crisis to come • Recession • Structural flaws • Drowning in debt • Little real growth • Speculative bubbles • Inflation • Unsustainable growth structure Resource Suppliers Issues Emerging Markets Issues The tail on all these dogs!

But It’s Not Equally Bad Everywhere! • Euro Zone: choosing between bad and worse • Emerging markets: big bumps but big prospects • US: least bad place to be for the next few years

Euro Zone is most troubled and most troubling • Emerging markets have cyclical and structural issues • US not so bad, really, but socio-political risks

Euro Bank Crisis Is Most Pressing,But Bigger Problems Underlie It Bank Capital Crisis Exploding Government Debt Crisis Structural Competitiveness Crisis

Current And Proposed Actions Offer Life Support, Not a Cure Actions Likely Outcomes • Private capital & liquidity flight from banks and credit contraction • Greek debt haircuts and more required bank capital • Keeps banks alive but encourages massive purchase of “bad” government debt • 3-year bank repo lines • Draconian austerity • Deep recessions in peripheral economies, recession elsewhere, further credit losses, more government funding problems A decade of stagnation, financial flare-ups and popular discontent in Euro Zone

Why? Look at the Tab for a Real Fix ItemPossible Cost ($ Billion!) Bank recapitalization 200-500 Sovereign debt forgiveness 1000-2000 Supporting restructuring of Euro Zone 2000-3000 Break-up Even more (Hotel California)

An Italian, a Spaniard and a Greek Go Into a Bar … • Internal cost deflation won’t work: riots result • Euro Zone survival requires: • ECB bond buying on a grand scale, for the Southern countries • Lower taxes, more consumption and higher inflation in the North • Overall significant devaluation of the Euro • So allowing freezing nominal wages in the South to restore competitiveness • Will the Germans vote for it?

Emerging Markets Will Lead World Economic Growth Change in Industrial Production 250% 250% 200% 200% 150% 150% 100% 100% 50% 50% 0% 0% - 50% - 50% 1991 1993 1995 1997 1999 2002 2004 2006 2008 2010 Emerging Economies Developed Economies Source: Netherlands Bureau for Economic Policy Analysis

But Unpleasant Things Still Happen There • Real estate and credit bubbles • Attempts to control inflation • Need to rebalance from exports to consumption

China Is on the Edge of a Significant Slowdown Source: BCA Research, 2011

Followed by Dramatic Credit Issues SHARE PRICES OF REAL ESTATE DEVELOPERS CHINESE CORPORATE SPREADS CHINESE CORPORATE SPREADS 50% Drop BANKS 45% Drop Source: JP Morgan Chase; BCA Research, 2011 Source: MSCI Inc.; BCA Research, 2011

Structural Problems to Overcome • Excessive export dependence: China • Inadequate infrastructure investment: India, Indonesia, Brazil, Turkey • Susceptibility to destabilizing “hot money”: all the small economies • Gross corruption: everyone

The US Is Drowning in Debt Total Credit Market Debt as a % of GDP 380 380 345 345 305 305 265 265 225 225 185 185 145 145 1925 35 45 55 65 75 85 95 05 Source: Ned Davis Research, 2011

As an Investment, a House Is No Better Than a Treasury Bill Current Boom Inflation-adjusted US Home Price Index Value Index 100 100 PROJECTION 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Sources: Ritholtz.com; The Big Picture; NYT; Prof. Robert J. Shiller

And Houses Will Keep Getting Cheaper For a Couple More Years US Home Foreclosure Starts per Quarter Total Number of Homes for Sale (millions, annually) Median new home costs 34% more than median existing home (‘000) 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 800 Forecast …. 1983-2004 Average 600 400 200 0 Mar 14 Mar 15 Mar 12 Mar 2006 Mar 10 87 91 95 99 03 07 11 Mar 08 Source: Credit Suisse, 2011 Source: Thomson Datastream; Capital Economics, 2011

As Will Commercial Real Estate Moody’s/Real CPPI Index (National All Property) And those loans roll in 2013-2017! 60% LTV here % Change in Value 120% LTV here Dec Aug Mar Nov Jul Feb Sep 00 02 04 05 07 09 10 Source: Bloomberg, LP

But There Is “Good News” Here • Loan growth in every area but real estate • Continuing private sector job creation • Stabilized financial sector (but watch the big broker/dealer firms) • Ongoing investment in innovation • Massive potential energy supplies • Emerging rescue of housing/mortgages • Principal forgiveness • Covered bonds/private mortgage market

We Have Different Structural Problems • Technology decouples output growth from employment growth • Productivity growth has been slowing for years as education system deteriorates • And the political system cannot deal with this

Technology Decouples Output from Employment Industrial Production and Employment, 2009 Industrial Production Industrial Workers 40 million 30 million 20 million 10 million $2.4 trillion $1.8 trillion $1.2 trillion $600 billion Industrial Production * Industrial Workers ** US Japan Italy Russia Brazil China Germany France UK Canada Source: Ritholz, 10/14/11 * US dollars, 2009 ** Total workers, 2009

Productivity Growth Has Been Slowing for Years US real GDP per head $’000 US multi-factor productivity 60 50 40 30 20 10 6.0 5.5 5.0 4.5 Exponential trend 1947-1973 Real GDP per head (2005 prices) 1947-73 trend 1974-95 trend 1947 60 70 80 90 2000 11 1947 50 60 70 80 90 2000 11 Sources: Jonathan Huebner; Haver Analytics; David Beckworth; Robert Gordon

We Have, in Our Public (and Private!) Expenditures, Failed to Live Within Our Means Source: White House Office of Management and Budget; Congressional Budget Office; Ritholz, 2011

The Investor Needs to Deal with Two Environments • Appealing Longer Term: • Investment Prospects • Emerging market equities • Natural resources • Energy/alternative energy • Emerging market debt • “Northern Europe” assets • Global blue chips • Infrastructure • Difficult Near Term • (2, 3, 4, ? years) • Periodic financial crisis • Ongoing financial suppression and manipulation • Sluggish growth in US, recession in Euro Zone, bust/boom in emerging markets • Inflation?

So Follow a Personal Financial Plan That Addresses These Environments Think through future financial sources and uses Near-term needs portfolio Long-term needs portfolio – Capital preserving – Core diversified strategy – Accept the implied yield – Active management Rolling 5-10 years Rolling 3 years

A Portfolio from September 2010 Long-term portfolio Near-term needs portfolio Intermediate - Term Emerging Markets Debt, Domestic Fixed Income, 1.5% 3.0% Alternatives, 15.0% Total Return Fixed Income, 9.0% Real Estate, 1.9% Natural Resources, 3.8% Inflation Protected Short - Term Domestic Securities, 1.9% Fixed Income, 16.5% Cash, Near - term needs, Emerging Markets 2.5% 19.0% Equities, 4.5% International Equities, 7.9% Domestic Equities, 32.6%

But Don’t Stay There: Move with Opportunities and Threats • Accelerating Asian growth? Overweight industrial raw materials and energy • Slow domestic growth? Overweight global blue chips • Looming euro crisis? Reduce % of assets denominated in euro • Exploding nuclear plants? Invest in natural gas

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The Future Ain’t What It Used to Be: Investing In A World of Volatility