Is the ‘New Normal’ here? Presentation by Dr. V. Anantha Nageswaran Chief Investment Officer Bank Julius Baer Indian Association of Investment Professionals Speaker Event, May 7, 2010, Mumbai

2 Agenda  Introduction  Trends observed between 1982 and 2002  Trends observed from 2003 onwards  Crisis  The new financial normal  Conclusion

: The golden era for financial assets. Why?

4 Gold prices, 1982 – 2002 As of April 06, 2010 in USD Source: World Gold Council (2010) Chart: Gold price, dollar per ounce, London PM fix

5 Long-term interest rates, 1982 – 2002 As of April Source: Bloomberg Chart: US ten year government bond yields

6 Global commodity index, 1982 – 2002 As of April Source: Bloomberg Chart: Reuters/Jefferies CRB index

7 Oil prices, 1983 – 2002 As of April Source: Bloomberg and US Bureau of Labor Statistics (2010) Chart: West Texas Intermediate (WTI) cushing crude oil spot price

8 Government public debt and fiscal balance As of February Source: Cecchetti (2010)

9 Population structure and age-related spending As of February Source: Cecchetti (2010)

10 Source: Philippon T, Reshef A, Wages and human capital in the US financial industry: , December 2008 Wage and education

11 Financial wage and deregulation Source: Philippon T, Reshef A, Wages and human capital in the US financial industry: , December 2008

12 Actual and benchmark relative wages Source: Philippon T, Reshef A, Wages and human capital in the US financial industry: , December 2008

13 Response to ultra low real rates – delayed the inevitable

Post-2003: Markets begin to respond to fiat money debasement and lower funding costs

15 Gold prices, 2003 onwards As of April 06, 2010 in USD Source: World Gold Council (2010) Chart: Gold price, dollar per ounce, London PM fix

16 Long-term interest rates, 2003 onwards As of April Source: Bloomberg Chart: US ten year government bond yields

17 Global commodity index, 2003 onwards As of April Source: Bloomberg Chart: Reuters/Jefferies CRB index

18 Oil prices, 2003 onwards As of April Source: Bloomberg and US Bureau of Labor Statistics (2010) Chart: West Texas Intermediate (WTI) cushing crude oil spot price

19 Leverage Source: Haldane (2009), Chart: LCFIs’ trading portfolios and financial leverage

20 Leverage  The previous chart suggests that “efforts to expand balance sheets through higher leverage were focussed on trading assets. In the first part of this decade, rising asset prices delivered mark-to-market gains on banks’ expanding trading assets. This boosted their profitability and returns on equity. As long as asset prices rose, this created an Alice in Wonderland world in which everybody had won and all had prizes.” Source: Haldane and Alessandri (2009),

21 Consequence of low cost of debt

22 It was not just a US sub-prime problem – German banks expanded their balance-sheets Source: Germany: 2010 Article IV Consultation—Staff Report, IMF, March 2010

23 An experienced investor saw this  Global fundamental economic conditions are nearly perfect and have been for some time.  Availability of global credit is generous and cheap and has been for some time.  Animal spirits and optimism are therefore high and feed on themselves through reinforcing results and through being universally shared.  All global assets reflect this and are overpriced and show, probably for the first time, a negative return to risk taking.  The correlation in global economic fundamentals is at a new high, reflected in the steadily increasing correlation in asset price movements.  Global credit is more extended and more complicated than ever before so that no one is sure where all the increased risk has ended up.  Every bubble has always burst.  The bursting of the bubble will be across all countries and all assets, with the probable exception of high-grade bonds. Risk premiums in particular will widen.  Since no similar global event has occurred before, the stresses to the system are likely to be unexpected.  All of this is likely to depress confidence and lower economic activity. Source: It’s Everywhere, In Everything: The First Truly Global Bubble (Observations following a 6-week Round-the-World Trip), GMO Quarterly Letter, April 2007, Jeremy Grantham

24 Peak valuation in 2007 even higher than in 1999 in Asia MSCI Asia ex-Japan price-to-book ratio Source: Bloomberg.

Consequences of the crisis, in brief

26 General government financial balances, 2003 onwards As of March Note: IMF estimates since 2007 for Japan and since 2008 for UK and US Source: IMF Chart: General government balance as a percent of GDP

27 Central bank balance sheets Source: BIS (2009)

28 Government public debt and fiscal balance As of February Source: Cecchetti (2010)

29 Population structure and age-related spending As of February Source: Cecchetti (2010)

30 What needs to change?  Spending habits  Executive Compensation  Importance of Finance  Attitudes to investing  Long-term thinking in public policy  Acceptance of limitations of human brain

31 Scale of household de-leveraging needed As of January Source: GlobalEconomic Paper No 178, Goldman Sachs, 22 January 2009

32 US income excluding government transfer As of March Source: BEA (2010) Chart: Real personal income excluding current transfer receipts

33 US personal spending As of March Notes: Adjusted using implicit price index for personal consumption expenditure nominal personal outlays are adjusted using 2008 index Source: BEA (2010) Chart: Real personal outlays

34 US income inequality As of April Source: BEA (2009) Chart: CEO pay vs. Average wage income, 1970 – 2006

35 The ascent of finance – the damage it did  “Highly leveraged financial firms became a dominant part of the economy. Their profits allowed the firms to recruit many of the country’s most sought- after employees — mathematicians, scientists, top college graduates and top former government officials. Yet many of those profits turned out to be ephemeral. So some of the best minds were devoted to devising ever-more- complex means of creating money out of thin air, the proceeds of which then drew in even more talent.”  “It is worth remembering that Wall Street’s long boom has not exactly been shared by much of the rest of the American economy. Wage growth for most workers has been painfully slow over the past three decades. Economic growth over the last decade was slower than in any decade since World War II. Surely, one goal of re-regulation should be to loosen Wall Street’s grip on the country’s resources, both financial and human, in the hope that they might be put to more productive use.” Source:The New York Times, “Heading off the next financial crisis“, 22 March 2010,

36 Attitudes to investing  Investment portfolio:  Need to accept time-lags – lengthening holding periods  Need to optimise decisions over longer time periods (delayed gratification)  “JPMorgan Chase holds $3 billion of “model-uncertainty reserves” to cover mishaps caused by quants who have been too clever by half. If you can make provisions for bad loans, why not bad maths too?”  RBI treatment of securitization profits  Election cycle vs. economic-sense cycle Partial Source: Economist, “The gods strike back“, February. 13, 2010,

37 Evolution of human brain happened during the Stone Age  Evolution has not stopped, but most of the ‘modern’ areas of the human brain, like the prefrontal cortex, developed largely during the Stone Age.  Our brains are deeply rooted in the primeval environments in which our earlier ancestors evolved, long before the Homo Sapiens arose.  Formal markets with regular trading of stocks and bonds date back only about four centuries. It took our ancestors more than 6 million years to progress to that point;  if you imagine all of hominid history inscribed on a scroll one mile long, the first stock exchange would not show up until four inches from the end”. Source: ‘Your money and your brain‘, Jason Zweig

What is the evidence so far?

39 US saving rates As of March Source: BEA (2010) Chart: Personal saving as a percentage of disposable personal income

40 S&P 500 valuations As of April Source: Shiller (2005), Chart: S&P 500 price-earning ratio

41 Singapore property price index – a “V-shaped” recovery As of April Source: :Bloomberg Chart: Singapore residential price index (central)

42 Hong Kong property price index As of April Source: Bloomberg Chart: Hong Kong Colliers international luxury residential price index peak

43 What have shareholders learnt? – very low pain threshold  “It has cost a lot to learn how little we really knew,” says a senior central banker. Another lesson was that managing risk is as much about judgment as about numbers. Trying ever harder to capture risk in mathematical formulae can be counterproductive if such a degree of accuracy is intrinsically unattainable.”  “Performance is usually judged relative to rivals or to an industry benchmark, encouraging banks to mimic each other’s risk-taking, even if in the long run it benefits no one. In mortgages, bad lenders drove out good ones, keeping up with aggressive competitors for fear of losing market share. A few held back, but it was not easy: when JPMorgan sacrificed five percentage points of return on equity in the short run, it was lambasted by shareholders who wanted it to “catch up” with zippier-looking rivals.” Source: Economist, “The gods strike back“, February. 13, 2010,

44 Petrol tax  “Raising the federal petrol tax (which has remained at just 18.4 cents per gallon since 1993) would spur conservation and reduce imports even if the world oil price dropped.”  “Unfortunately, any politician bold enough to try that is liable to be driven from office. Americans may be getting used to expensive petrol, but that does not mean they are grateful for it.” Source: Economist, “A special report on American‘s economy: energetic progress“ 31 March 2010,

45 This is not good news Source: Bureau of Economic Analysis, USA and Bloomberg

46 The missing key word - humility  “I am inclined to think that, provided we do not become complacent and we continue to work on the reform of the financial regulation, the answer may be positive.”  “The more we convince ourselves that we have mastered risk and uncertainty and the more confident we are that we have learned the lessons of the past, the more vulnerable we become to lethal overconfidence and the probability that things will again go unimaginably wrong.”  “So the best way to ensure that the next time really will be different is to strengthen the financial system and remain vigilant, so as to avoid, at all costs, the thought that this time is different.” Source: Mr Jaime Caruana, General Manager of the BIS, at the 50th Anniversary Symposium of the Reserve Bank of Australia, Sydney, 9 February 2010,

47 Therefore, this has a long way to go Spot price of gold in USD per ounce. Source: Bloomberg

48 What if there is a new normal? – Investment implications  Emphasis on Income-generating assets: stocks with dividend yields  Weakening of global correlations  Rising interest rates  Importance of real assets  Less leverage – and hence better performance of non-financials over financials

49 Thank you very much for your attention "If contact between people is based on trust and absolute integrity, then it is of benefit for both sides." Contact: Dr. V. Anantha Nageswaran +41 (0)

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