The $2.5 Trillion Repair Job Geithner’S Plan to Fix the Geithner Needs to Put It to Work, Treasury, Federal Reserve and Other Financial System Is a Good One

investment outlook MARCH 2009

• Lessons from a bear market page 4

• Bond investors get choosy page 6

• Nine Signposts for 2009: an update page 9

• Sharpening our advice page 10

• Hedge funds make small gains page 12

• The cult of equity under attack page 14

CITIGROUP GLOBAL MARKETS INC.

The $2.5 Trillion Repair Job Geithner’s plan to fix the Geithner needs to put it to work, Treasury, Federal Reserve and other financial system is a good one. which is what we—and the mar- agencies are committed to making Now he needs to execute. kets, somewhat more tentatively— sure banks have the capital and By Jeff Applegate and expect to see in the weeks ahead. liquidity necessary to make credit Charles Reinhard STRESS TEST. The first element available. A vital aspect of the first Moments after US Trea- of the FSP is a comprehensive reg- piece of the FSP is that the govern- sury Secretary Timothy ulatory stress test for major banks. ment will provide a temporary Geithner unveiled the The aims of this test are to make capital buffer to recapitalize banks Obama administration’s much- sure the banks could still lend even that need it and take convertible anticipated Financial Stability if they suffer further losses and to preferred shares in exchange. The Plan (FSP) on Feb. 10, the stock recapitalize banks that fall short. budget released Feb. 26 includes market began sinking. Curiously The exam looks at a bank under $750 billion for the financial rescue enough, the credit markets barely worsening economic conditions—a plan as needed to be carried on the budged—a sign, perhaps, that the 3.3% contraction in GDP in 2009, books as a $250 billion loss. What fixed income players were willing to an average 10.3% unemployment if the banks need more? That will give the $2.5 trillion plan a chance. rate in 2010 and another 25% depend on the extent of further In our view, the FSP has the decline in home prices. losses, which the next part of the features needed to get bank lending After the review, banks needing FSP, the Public-Private Investment and securitized markets function- more capital will be encouraged to Fund, is designed to address. ing in a more normal fashion. Now seek private sources. Still, the US (continued on inside cover) Cover Story

The $2.5 Trillion Repair Job (continued from cover)

This investment fund, which is to acquire this is a further extension of the Fed’s credit bad assets from banks, is crucial. The govern- easing, as the central bank will now become a ment will lend money to private investors such market maker in securitized credit card, auto, as hedge funds to buy these assets, thereby student, commercial and residential loans. The letting the market set the price. The difference Fed’s initial foray into credit easing in the com- between that price and whatever values banks mercial paper market last autumn succeeded in By Jeff Applegate Chief Investment Officer are carrying on their books would have to be getting that market working again with lower Citi Global Wealth Management absorbed as additional bank losses. Since the absolute yields and spreads. The subsequent private-sector cost of borrowing will be low and venture into the mortgage market achieved the loan is nonrecourse, demand for these assets positive results as well. We think the TALF will could be quite robust; by extension, potential work, too. This should also mean the Federal bank write-downs and additional recapitaliza- Reserve’s balance sheet, which had recently tion needs will be commensurately lower. dropped back below $2 trillion as some of its LEVERAGING UP. The third part of the commercial paper holdings matured, will rise By Charles Reinhard FSP is the expansion, up to $1 trillion, of the again—potentially to $3 trillion—as the TALF Senior Investment Strategist Citi Global Wealth Management Federal Reserve’s previously announced Term ramps up (see chart). Asset-Backed Securities Loan Facility (TALF). While the FSP may fall short of what The plan calls for using $100 billion of ultimately will be required, in our view it is an Troubled Asset Relief Program funds, and then innovative initiative. Combined with the $787 leveraging them by a factor of 10. In essence, billion stimulus package signed by President Obama on Feb. 17 and the $275 billion Homeowner Affordability and Stability Plan Temporary Dip The Federal Reserve’s balance sheet is introduced by the president on Feb. 18, the expected to climb to $3 trillion as the Term Asset-Backed Securities Loan Facility starts acquiring loans. FSP is another element that should lead to a recovery in economic growth in the second half of 2009. This recovery should be anticipated $2.5 first in US and global equity markets. More- ) 2.3 over, this steady flow of initiatives from the Obama White House confirms our view that 2.1 this administration will be much more activist 1.9 than its predecessor.

nding ($ trillions ta 1.7 BEYOND THE US. Developed-country central banks, such as those in the UK, Japan and 1.5

edit Outs edit Canada, are moving toward a Fed-type ZIRP 1.3 (Zero Interest Rate Policy) or deploying credit

1.1 easing to keep local credit markets function- e Bank Cr ing. Unfortunately, the European Central Bank 0.9 rv ese

R hasn’t been aggressive enough on rates, though 0.7 we expect that it will move closer to ZIRP this Jan ‘08 Apr ‘08 Jul ‘08 Oct ‘08 Dec ‘08 Feb ‘09 summer. Developing-country central banks, such as those of China and Brazil, continue to Data Source: Federal Reserve as of 18 February 2009 reduce interest rates—albeit from much higher

2 MARCH 2009 • Citi Private Bank

Investment Products: Not FDIC Insured • No Bank Guarantee • May Lose Value levels—to stimulate their local economies. toward more-normalized valuations in the Finally, global fiscal policy stimulus is at work, months and quarters ahead. In addition, mar- too. Including the US, our economists estimate ket recoveries usually take place in a favorable fiscal stimulus will be more than 5% of global liquidity environment—and that liquidity is in GDP across 2009 and 2010 (see table). place. Moreover, while the credit markets have As long as an adequate global policy not returned to normal, they are moving in response is forthcoming, the US and global fi- that direction—and borrowing costs are low. nancial markets and economy should complete REAL YIELD. The US equity market also its bottoming process. Almost across the board, looks promising in terms of real yield, or the that policy mix seems appropriate, in our view. yield on risk-free Treasury bonds less the infla- However, there remain concerns over the risk tion rate. In the 1950 through 2008 period, of protectionism. The “Buy American” provi- any time real yields were below 3%, as they are sion in the US fiscal stimulus package is one now, stocks were up an average of 13.5% in the example; fortunately, it was mostly gutted after next 12 months. That is significantly greater the White House opposed it. than the 5.1% afforded to Treasury bonds or PROTECTIONIST RISKS. In some circles, 3.1% to cash in the same environment. That it’s considered “financial protectionism” when history is yet another reason for investors to global banks reduce lending or sell assets stay resolute through these difficult times. outside their markets. In our view, such ac- tions are more a corporate response to the downturn. Similarly, we disagree that backing Global Fiscal Stimulus The US and China have the biggest programs underway to stimulate their economies. All together, the various plans add up to some 5% of world GDP. US automakers is “industrial protectionism.” Canada and Germany, for example, have been Country Comment supportive of American auto companies in US $787 billion plan, 65% spending and 35% tax relief. Lower withholding taxes should those nations just as the US has been. So, while start in mid March. Infrastructure spending should be felt later on. protectionism remains a risk to markets, it is a China Rmb 4 trillion with 75%+ for infrastructure development, earthquake fairly low-level threat, given the globalization reconstruction and other projects. Provincial governments have added another of labor and capital extant today. Rmb 25 trillion in proposals. Early signs stimulus is already being felt. ROUND TRIP. US and global equities have Euro Zone Targeting households and businesses via tax and subsidy changes, plus some investment. round-tripped back to their November lows, Japan Direct subsidies to households, tax incentives for business investment and security as consensus earnings estimates and valuation investment, and subsidies for industries hit by higher input costs in 2008. reflect the deeper recession. US and global ex- UK Cut in the Value Added Tax (VAT). pected earnings for 2009 are now $64 and $17, Australia Fiscal stimulus to families, pensioners, first-home buyers, increased payments to respectively, versus $87 and $24 in November, the states and a focus on infrastructure. while forward price/earnings ratios are 12 and Canada Infrastructure spending, tax cuts, increased unemployment benefits and 11, respectively, versus nine and eight previously. backstopping of key industries, including the autos, telecommunications, forestry Historically, prospective equity returns have and aerospace. depended quite a bit on the characteristics Korea 35.6 trillion won total fiscal package was approved last year. Households and firms will receive tax cuts, while construction firms will gain from higher direct subsidies defining the starting point. Currently, P/E and infrastructure spending. ratios are below their long-term historical aver- Mexico If development bank lending is included, total stimulus is closer to 1% of GDP. ages. Earnings are also below trend. As a result, equities would stand to benefit if markets move Data Source: Citi Economic & Market Analysis as of 18 February 2009

MARCH 2009 • Citi Private Bank 3 Equities

Lessons From a Bear Market

With global equity markets off to a stock that similarly may be out of style. 50% from the late-2007 high and a We call this “thesis drift,” and it can have a likelihood of further bad news on the meaningful negative impact on performance. If economy and earnings over the next few quar- an investor’s original investment thesis is dam- ters, we thought it appropriate to step back aged, quite possibly the market’s view is, too. and assess what we have learned from this dif- This can lead to rapid downward share-price by Marshall Kaplan Senior Equity Strategist ficult period. Bear markets are very effective in movements when the market comes around Smith Barney Private Client Investment Strategy exposing problems, exploiting weaknesses and to recognizing the flaw. Swift, thorough and punishing hubris. We believe it is important realistic reassessment—in combination with to use the experience to learn from mistakes emotional detachment—are all key to avoid- and find ways to improve investments, so as to ing thesis drift and the damage it can inflict on prosper in an eventual upturn. your portfolio. 1. A Sell Discipline Trumps Convic- 2. Cash Is King, Balance Sheet tion. Selling stocks is a “negative art.” Most Strength Is Paramount. We have long investors find it easier to identify the positive focused on the importance of a company’s By William Mann traits of a company than to recognize and act financial flexibility—characterized by a strong European Equity Strategist Smith Barney Private Client upon an investment decision gone wrong. Said balance sheet and the ability to generate signifi- Investment Strategy differently, most of us are quicker to buy new cant free cash flow—in our stock selection pro- clothing than to discard an old favorite, no cess. During the last year, companies that rely matter how worn or out of style it may be. on outside financing, friendly capital markets Investors often justify a plummeting share or rising asset values to support their business price by deriving ever-new reasons to hold on models have found that they are no longer in control of their destiny. Cash Counts In a recession, companies with more cash on Over the past several weeks, there has been their balance sheets do better than those that have less. a resurgence of capital-raising, especially in

0% Europe, which has led to higher stock prices. Such results tend to be short-lived as the un-

-10 derlying weaknesses in the firms remain. -11.5% The market recognizes these differences. For

-20 instance, we took the Standard & Poor’s 500 stocks, excluded the financial stocks and sorted

-30 -28.4% the remainder based on the ratio of net cash as

eturn a percentage of market capitalization on Sept. al R t -40 30, 2008. Then we tracked the returns through To -40.2% Feb. 23, 2009. The top quartile of companies

-50 experienced an average loss of -11.5%, while the bottom quartile posted -60.3%.

-60 Furthermore, financial flexibility is a major Returns of S&P 500 Stocks (ex ﬁnancials) -60.3% Ranked by Net Cash as a Percentage of driver of dividends, something that is at the Market Capitalization, Sept. 30, 2008–Feb. 23, 2009 -70 top of the list when evaluating investments. Quartile 1 Quartile 2Quartile 3Quartile 4 In the current high-dividend-yield environment, it is important to separate companies Data Source: FactSet as of 23 February 2009

4 MARCH 2009 • Citi Private Bank with sustainable dividends from those with current market volatility requires a willingness dividend yields that only appear high because to act quickly on investor misperceptions—as the stock price has fallen and the earnings are emotionally charged markets are often driven suspect, creating a temporary high ratio of by fear and greed, rather than by the careful dividend to stock price. In this latter case, the analysis of fundamentals. Often, the right port- market must anticipate that the dividend will folio action to take is also the most difficult be cut soon to conserve precious cash. Stock- one to take. price performances have shown meaningful 5. Avoid Narrow Focus and Scan divergence between companies maintaining (or the Horizon. Investors tend to focus on the even increasing) dividends and those that can’t. ongoing themes—say, the collapse of financial We expect this theme to deepen over coming stocks or the expected increase in infrastructure quarters. Consequently, we caution investors to spending. It is equally important to keep an maintain a watchful eye over dividend payout eye out for emerging themes, which may exert ratios and forecast earnings growth as a health as much influence on share prices as existing check on dividend sustainability and growth. forces. For instance, while the market’s atten- 3. Avoid “Mental Accounting.” Inves- tion was focused on the unfolding financial tors have a tendency to perform “mental crisis in Western Europe, it was slow to recog- accounting.” This is a theory, developed in the nize the rapid deterioration of Eastern Europe. 1980s, positing that individuals tend to divide This opened up a second front, potentially just their assets into separate categories or “mind- as damaging as existing pressures that first sur- sets” and account for them differently. Es- faced in the west. Identification of new themes sentially, it says that people value some dollars can have a meaningful, positive impact on more than others. For instance, $1,000 won portfolio performance, if acted upon quickly. with a lottery ticket may be treated as “fun 6. Bear Markets Don’t Last Forever. money” and spent on something frivolous, While hindsight affords us the luxury of see- while the same amount that is earmarked for ing things through a rearview mirror, it is the a retirement-account contribution is treated road ahead that provides promise. Indeed, as indispensable. However, in fact, a dollar is cash levels at nonfinancial firms are at histori- a dollar. cally high levels, and the S&P 500 trades at Likewise, with investment portfolios, we approximately 15 times our current forecast have been guilty of congratulating ourselves of $51 for 2009 operating earnings. Our when dodging one potential pitfall while proprietary sentiment indicators are at levels another company already in our portfolio is that have historically proven to be attractive subjected to the same forces as the company entry points for equity investors, and tradi- we avoided. tional valuation metrics such as price/sales 4. Fear Is Often Inversely Correlat- ratio and price/book value are at 20-year lows. ed With Buying Opportunities. Opportu- However, until we have greater clarity on the nities exist in the current market, but it takes economic outlook, focusing on companies a willingness to go against the current negative with strong financials, organic growth op- sentiment to invest in them. It also takes a lot portunities and reasonable valuations should of patience to hold them while waiting for prove to be a prudent strategy. the market to recognize their true value. The

MARCH 2009 • Citi Private Bank 5 Fixed Income

Bond Market: Better, but With Choosy Investors

The economic data continues to be issue. Additionally, the 30-year bond will now dismal and uncertainty remains high, be sold eight times a year. As the size and but conditions in the bond market are frequency of bond auctions have increased, we improving. Although price performance has now expect a 20% jump in borrowing in the been mixed, fixed income spreads have largely current fiscal year to about $2 trillion. contracted across the board since December Not surprisingly, government yields have by Michael Brandes Senior Fixed Income Strategist when the Federal Reserve cut the overnight rate backed up from record lows in December. Smith Barney Private Client Investment Strategy to zero. Yields peaked during the fourth quarter The recent rise correlates with the increase in and are likely to remain range-bound or decline inflation expectations. For instance, since the further as the year progresses, in our view. beginning of the year, TIPS (Treasury Inflation- Much of the positive momentum can be Protected Securities) break-even rates have risen attributed to government efforts. The Fed’s sharply. The five-year forward TIPS break-even agency mortgage purchase program, which threshold is up to nearly 200 basis points, from started last month, has led to a 50-basis-point less than 50 basis points in early January. decline in long-term rates. Policymakers are We expect deflation to ultimately trump By Steve reich Economic Research expected to spend $500 billion by June 30. concerns about higher inflation. Thus, the Citi Global Wealth Management MORE GOVERNMENT FINANCING. Govern- backup in Treasury yields appears to be self- ment officials recently made important changes limiting, unless it was largely driven by lower risk to the auction calendar. Of note, the seven- aversion. Also, investors should keep in mind year Treasury security will return to monthly that Fed officials have stated that they would auctions. What’s more, the Treasury said it purchase Treasurys outright if higher yields were is considering adding a four-year or 20-year to push up consumer borrowing costs. IMPRESSIVE ISSUANCE. Another big plus Spreading Out Credit markets are easing, but the gap has been the corporate primary-issue market. between yields on higher- and lower-rated bonds is greater. With the exception of FDIC-backed securities, the new-issue market was essentially shut down 800 during the final months of 2008. In contrast,

Corporate Index some $150 billion has been launched year

s) 700 AA-Rated Corporates to date. That is about 25% higher compared BBB-Rated Corporates with the same period in 2008. About 35% of 600 investment-grade supply has been issued under

500 a government-sponsored program. Even some ead (basis point (basis ead high yield issuers have tapped the market, 400

d Spr te mainly higher-rated issuers in defensive sectors,

djus such as health care and cable. A 300 Long-term investors are benefiting from

200 spreads that more than compensate for default Option- risks, in our view. Notably, average yields in 100 the corporate market have declined substan- Apr ‘08 Jun ‘08 Aug ‘08 Oct ‘08 Dec ‘08 Feb ‘09 tially since December—falling this month below 7%, from more than 9%—in Citi’s BIG Data Source: The Yield Book as of 19 February 2009 Credit Index.

6 MARCH 2009 • Citi Private Bank PICKY PURCHASERS. Still, even as buyers LOWER YIELDS IN EUROPE. While events come back to the corporate market, they are in the US have been a key determinant of Euro getting choosier. Look at the chart, which Zone bond yields, the markets decoupled in shows spreads for the Citi High Grade Cor- mid February as investors became increasingly porate Index, and two components of it, the concerned about the health of European banks. AA-rated and BBB-rated companies. Until last Because of investor demand, German bond fall, the difference between the AA and BBB prices rose and the yields headed back toward was about 100 basis points. Spreads converged their 3% cyclical lows. Concern about sover- in the aftermath of the Lehman Brothers bank- eign credit quality kept many national bond ruptcy, and have since widened. Now, because yields above their recent lows, as investors investors prefer higher-rated bonds, BBBs yield have also become concerned about the abil- about 300 basis points more than AAs. ity of the market to absorb new government We continue to be defensive and are wary bond issuance. Nonetheless, poor economic about reaching for yield by sacrificing credit fundamentals and falling risk appetite should quality or liquidity. After all, neither the stimu- continue to support European government lus package nor the policy initiatives are going bonds. Although the European Central Bank to prevent consumer delinquency or corporate kept rates steady at 2% at their Feb. 5 meeting, default rates from accelerating in the near term we think the policy rate will be cut to 0.5% by as economic conditions worsen. mid year. With inflation contained, Euro Zone QUALITY COUNTS. Long-term investors government bond yields could fall further, in should focus on opportunities in the high- our view. grade corporate market, which we expect will BRITAIN’S LINGERING INFLATION. UK be the best-performing fixed income sector this government bonds have taken a slightly year. Investors need to seek out government- different path, as investors worry that linger- guaranteed financial company bonds and ing inflation may keep the Bank of England longer-maturity bonds of high-quality issuers (BOE) from stimulating the economy as much selling at low dollar prices. US investors it should. Recent inflation reports show that should also consider the municipal market, prices have not stabilized, as expected. Still, where lower liquidity and limited institutional we believe that there is little risk of inflation demand has generated a historically steep yield because the labor market has turned decidedly curve and returns that are high relative to tax- weaker. In fact, much of the current inflation- able Treasurys. ary pressure is external, as the weak pound Although the high yield market may con- keeps import prices high. The BOE lowered its tinue to be supported by strong mutual fund policy rate to 1% at its Feb. 5 meeting, and we inflows and a dearth of new supply, we advise expect rates to fall to 0.5% by mid year. investors to limit exposure to fairly short- LOW PROSPECTS FOR JAPAN. With the duration securities rated at least BB. Tight Japanese policy rate at 0.1%, and 10-year bond lending conditions and poor earnings pros- yields at just 1.3%, there is little more that pects are apt to generate increased defaults monetary policy can do to stimulate the econ- this year. What’s more, we believe that recov- omy. With Japanese equities at 20-year lows, ery rates on those defaults will be much lower we think that Japanese bond yields will remain than in past cycles. low, too, as investors remain risk averse.

MARCH 2009 • Citi Private Bank 7 Chart Book

Earnings Erosion Forecasting Volatility

Citi’s S&P 500 Earnings Growth Forecast Yield Curve Shown as a Leading Indicator of the VIX

S&P 500 Total 60 Yield Curve (right scale, inverted) -2% VIX (left scale, three-month

Energy moving average) )

50 -1 Y

ield Curv

Consumer Staples age

2008E er Health Care 2009E 40 0

e (perc av Information Technology ving

Utilities 30

1 ent

Industrials age point

Telecommunications Services mo ee-month 20 2 thr

Materials s)

10 3 VIX ( VIX Consumer Discretionary

Financials* 0 4 -125%-100 -75 -50 -25025% 1999 2001 2003 2005 2007 2009 Year-Over-Year Change 2001 2003 2005 2007 2009 *Financial earnings for 2009 going from negative to zero Note: Yield Curve shown from 1999, VIX since 2001 Data Source: Citi Economic & Market Analysis as of 20 February 2009 Data Source: Bloomberg as of 30 January 2009

The sharpest global quarter, and thus still have Today’s high stock- yield curve. As the chart downturn of the post-World far to fall. The materials market volatility, as shows, market volatility shot War II era will wreak havoc sector, for instance, which measured by the VIX, is up in 2007 and 2008 and on corporate profits, writes is highly sensitive to the unnerving to many inves- remains relatively high. Steven Wieting of Citi Eco- economic cycle, declined an tors. But those who study Conversely, when the nomic & Market Analysis estimated 7% in earnings in the yield curve, as mea- Fed is adding liquidity to the in a Feb. 20 report. Wiet- 2008; Wieting forecasts a sured by the difference in financial system by lower- ing slashed his forecast for 65% decline in 2009. Sec- yield between the 10-year ing the fed-funds rate, as 2009 S&P 500 operating tors that still managed to Treasury note and the it did in 2001 and 2002, earnings to $51 from his make gains in 2008, such as fed-funds rate, could have short-term rates typically previous forecast of $62, a energy, up 19%, and infor- anticipated it. fall relative to longer-term 17.7% decline. He also cut mation technology, up 4%, There is a lead-lag rates. The Fed action made his 2010 forecast to $54 are projected to go negative relationship between the the yield curve steeper, and from $65. Operating profits, this year, down 55% and yield curve and market the stock market response or profits before write-offs, 30%, respectively. volatility, with the yield was a lower VIX in the mid- were $84.46 in 2007, just The only sectors that curve leading the VIX dle part of the decade. 4% off their $88.08 peak Wieting thinks will be posi- by about two years. For Now, we note that the in 2006. tive in both 2008 and 2009 instance, when the Fed is Fed has been pumping up While much of the are consumer staples, draining liquidity from the liquidity for nearly two years; attention for the last year health care and utilities. financial system by raising it follows that volatility could has been on the finan- Those sectors usually do the fed-funds rate, as it did start subsiding soon. cial sector, Wieting says best in recessions and, for in the 2003 to 2006 period, profits for nonfinancial that reason, are considered short-term rates typically companies only started defensive investments. rise relative to longer-term their decline in the fourth rates, leading to a flatter

8 MARCH 2009 • Citi Private Bank No Tools Required NINE SIGNPOSTS FOR 2009 Japan Machine Tool Order Index 160 In January, we 12000 140 introduced “Nine 10000 8000 120 Signposts for 2009,” indicators to watch for 6000 100 improvements in the 4000 markets and the econ- 2000 80 omy. The table below 0 shows there has been 1999 2001 2003 2005 2007 2009 60 recent improvement. Data Source: Bloomberg as of 27 40 One of the big gain- February 2009 ers is the Baltic Dry 20 Index, a measure of shipping rates for commodities, which is 1950 (see chart), 0 1989 1993 1997 2001 2005 2009 up from 774 in December. Recent reports suggest China’s Data Source: Japan Machine Tool Builders’ Assn. as of 31 January 2009 stimulus plan is already creating demand for the raw materials these vessels carry. To obtain the most recent copy of “Nine Signposts for For most of last year, developing markets of Asia. 2009,” contact your FinancialPrivate Banker. Advisor. Japan seemed fairly insu- The index fell 71% in the lated from the direct impact early 1990s, but that decline Signpost Starting Current Reading of the global financial cri- played out over several Level Level sis, as its banks were not years, not months. S&P 500 Advance- -7271 -9000 D weighed down by the same Business investment is Decline Line level of bad assets as were falling because the financial Korean Composite Stock 1118 1063 SD those of the US and Europe. crisis is making it more dif- Price Index But with the financial crisis ficult and more expensive LIBOR-OIS Spread 126 bps 101 bps I having spawned a broader to obtain credit for expan- Spreads on Citigroup 563/ 511/ I economic crisis, Japan is sion. Also, with weakening High-Grade and High 1846 1675 now feeling the full brunt of consumer demand and ris- Yield Indexes bps bps the slowdown. ing economic uncertainty, Supply of US Existing 11.2 mos. 9.6 mos. I There’s no better manufacturers are canceling Homes for Sale example of this trend that projects or delaying major Univ. of Mich. Consumer 55.3 56.3 SI the plight of the Japanese capital investments. Sentiment Machine Tool Order index, Baltic Dry Index 774 1950 I which fell 83% during the Citi Financial Conditions -3.9 -1.7 I past four months. Orders Index std. dev. std. dev. dropped at nearly the same US Leading Economic -5.4% -3.7% I pace for both domestic and Indicators (six-month foreign buyers, as capital change) investment in manufac- I = Improvement, SI = Slight Improvement, turing evaporated in both D=Deterioration, SD=Slight Deterioration Japan and throughout Data Source: Bloomberg, The Yield Book, Citi Economic & Market Analysis, The Conference Board as of 27 February 2009 or latest possible date

MARCH 2009 • Citi Private Bank 9 Portfolios

Slicing Sectors to Sharpen Our Advice

Each month, the Investment Outlook the bond universe into smaller, more homo- section on the At a Glance page sum- geneous sectors for those investors wishing to marizes the Global Investment Com- capitalize on what we view as an opportunity mittee’s (GIC) tactical, or short-term, asset al- arising from the market turmoil of the past location recommendations. Although we have several months. not changed these recommendations in recent INTRODUCING COMMODITIES. Second, by Douglas Schindewolf months, we have made changes to the table to starting this month, we have added commodi- Director of Tactical Asset Allocation sharpen the GIC’s investment guidance. ties to the Investment Outlook table. However, Citi Global Wealth Management BREAKING BONDS. First, under the we note that unlike the other asset classes heading “Global Investment-Grade” in the that we follow, we do not view commodities bonds section, we now break out “Agencies & as a strategic asset class that should be a core Government-Related” securities as a separate holding for most portfolios. That’s because our subasset class. This category includes bonds studies show that over longer horizons, we ex- from such issuers as Fannie Mae, Freddie pect commodities to deliver modest returns, on Mac and Government National Mortgage average. Investment returns in actual commod- Association—the securities known as “Gin- ities tend to track broad inflation; investments nie Maes.” Though we approach investing on in a collateralized, futures-based commodity a global basis, this sector is made up almost index, such as the Dow Jones-AIG Commod- entirely of US agencies. Few securities issued ity Index, tend to earn a little more than the outside the US fit under this category. inflation rate. Those returns, in our view, are Previously, these securities were part of the not attractive enough to offset the considerable broader “Government” category. The addi- volatility commodities bring to portfolios, even tional granularity enables us to highlight the though commodities’ correlation with other extent of the flight to quality and liquidity over asset classes is generally low. the past several months. These “plain vanilla” Nevertheless, we believe that commodities government securities, such as US Treasury can add significant value over relatively short notes and bonds, have become very expensive horizons. As such, we will endeavor to identify and not particularly attractive as a long-term those times when an allocation to a broad-based investment, in our judgment. commodity vehicle seems appropriate. We will As we see it, more-attractive opportunities then reflect that opportunity with an over- exist in other sectors of the investment-grade weight recommendation in the table. Our sense bond market—such as agencies and corporate is that this is not one of those times, given the bonds, which investors have shunned amid likelihood of sluggish global economic activity a sharp increase in risk aversion. We reflect for the next several months—hence, we keep this view in our “underweight” recommen- our underweight recommendation for now. dation for the government bond sector and “overweight” recommendation for the agency and corporate sectors. This differentiation is difficult to reflect in our model portfolios because Treasurys, agencies and investment- grade corporate bonds are aggregated into a core subasset class. Nevertheless, we are slicing

10 MARCH 2009 • Citi Private Bank At a Glance at a glance Base Case Investment Outlook Below is a summary of The following table summarizes our tactical (short-term) adjustments to our strategic portfolios, which the Global Investment represent the blend of asset classes we believe are best suited, over the long run, for achieving maximum return Committee’s base case for world for various levels of risk tolerance. In our tactical recommendations, we identify which subasset economies. Unless noted, esti- classes to overweight or underweight within each global asset class. mates are for 2009. Vis-à-vis the strategic allocation: Overweight means up to 10% greater; Neutral: no change to the strategic allocation; Underweight: up to 10% below. GDP Growth RELATIVE WEIGHT benchmark index US: -2.7%, from 1.2% in 2008 Global Equities OVERWEIGHT MSCI All Country World UNDERWEIGHT Euro Zone: -2.5%, from 0.8% Global Bonds Barclays Capital Multiverse (hedged) in 2008 Hedge Funds & Managed Futures NEUTRAL HFRX Global Hedge Fund Japan: -6.7%, from -0.7% Cash NEUTRAL Three-Month LIBOR in 2008 RELATIVE WEIGHT Equities WITHIN EQUITIES benchmark index UK: -3.4%, from 0.7% in 2008 Developed Market Large & Mid Cap UNDERWEIGHT MSCI World Large Cap Developing economies: 1.6%, from 5.3% in 2008 United States overWEIGHT S&P 500 Europe ex UK UNDERWEIGHT MSCI Europe ex UK Large Cap Inflation United Kingdom UNDERWEIGHT MSCI UK Large Cap US: -1.0%, from 3.8% in 2008 Japan UNDERWEIGHT MSCI Japan Large Cap Asia Pacific ex Japan NEUTRAL MSCI Pacific ex Japan Large Cap Euro Zone: 0.3%, from 3.3% in 2008 Developed Market Small Cap OVERWEIGHT MSCI World Small Cap Japan: -1.4%, from 1.4% in 2008 Emerging Markets OVERWEIGHT MSCI Emerging Markets UK: 1.0%, from 3.6% in 2008 RELATIVE WEIGHT Bonds WITHIN BONDS benchmark index Global Investment-Grade OVERWEIGHT Barclays Capital Global Aggregate Monetary Policy Government UNDERWEIGHT Barclays Capital Global Government US Federal Reserve: Agencies & Government-Related overWEIGHT Barclays Capital Multiverse–Govt.-Related likely to remain steady at 0.0% to 0.25% through 2009 Corporate overWEIGHT Barclays Capital Global Corporate Securitized NEUTRAL Barclays Capital Global Securitized European Central Bank: likely to lower rate 150 basis points to High Yield UNDERWEIGHT Barclays Capital Global High Yield 0.5% by mid 2009 Emerging Markets UNDERWEIGHT Barclays Capital Global Emg. Mkts. Bank of Japan: Inflation Protected NEUTRAL Barclays Capital Global Inflation-Linked likely to remain steady at 0.1% RELATIVE WEIGHT through 2009 Hedge Funds & Managed Futures WITHIN HEDGE FUNDS benchmark index Bank of England: Relative Value/Event Driven NEUTRAL HFRX Blend* likely to lower rate 100 basis Equity Long/Short NEUTRAL HFRX Equity Hedge points to 0.25% by mid 2009 Managed Futures/Macro NEUTRAL HFRX Macro and CISDM CTA

Commodities RELATIVE WEIGHT benchmark index Commodities UNDERWEIGHT Dow Jones-AIG Commodity Index * Consists of: Convertible Arbitrage, Distressed Securities, Merger Arbitrage, Fixed Income-Corporate and Equity Market Neutral indexes. Arrows indicate change from previous month. Currencies vs. US vs. Japan vs. Euro vs. Canada vs. Australia vs. UK vs. China vs. Brazil vs. Mexico US $ Japan ¥ Euro ¤ Canada Australia UK £ China Brazil Mexico Based on 6-to-12-month horizon. o = +/- 5% change from current level; + = greater than 5% expected appreciation; – = greater than 5% expected depreciation. Arrows indicate change from previous month.

DECMARCHEMBER 20082009 • Citi Private Bank 11 Hedge Funds

A Fresh Start—or 2008 All Over Again?

Will hedge funds repeat last year’s aw- shares established late last year to deal with de- ful performance or will this asset class mand for redemptions. As the markets recover, stage a turnaround? The HFRX Global and as the prices for these securities improve, Hedge Fund Index, a broad-based measure managers will start selling these locked-up as- of industry returns, posted its first monthly sets so they can return the capital to investors. increase in some time, with a gain of 1.1%, LOWER RISK LEVELS. Risk levels at most BY Ray Nolte Chief Executive Officer versus an 8.56% loss for the Standard & Poor’s funds remain low. Net and gross exposures are Hedge Fund Management Group Citi Alternative Investments 500 Index. Almost all the substrategies finished especially low for the long-short equity funds; in positive territory; the two that were negative leverage levels remain low in the relative value were only modestly so (see chart). and event-driven fund groups. The lower risk THIN TRADING. In our view, it is still too levels were most noticeable in the long-short soon to declare that last year’s big losers have equity sector, which tends to have a long bias made a bottom and are now in their recovery and a higher correlation to the equity markets phase. In fact, the trading volume is sparse in than most other strategies. On the other hand, many of the securities owned by these groups; systematic macro funds stood out because of as such, much of the gains may have come a slight increase in leverage. This strategy has from marking up the securities in the portfolio been running counter to the industry; last year, based on few transactions. Still, these gains it was up 18.3%. may indicate that selling pressure has abated. A turnaround for hedge funds also requires Even so, many hedge funds hold significant restoration of investor confidence and a stabi- amounts of securities that need to be liqui- lization of assets under management. To that dated. These positions are now in the liquidat- end, we still expect to see redemptions through ing share classes and/or special-purpose-vehicle the first quarter. Barring another shock to the system, we expect redemptions to slow down Coming Back The Standard & Poor’s 500 sank 8.56% in for the mid-year-notice period. January, but hedge funds eked out a slightly positive return. A NEW PLAY. As a result of the disloca-

s tions—industry consolidation, trading desk xe Market Directional +1.71% Equal-Weighted Strategies +1.37% shutdowns and skittish investors—we expect Global Hedge +1.10% attractive opportunities to emerge. Perhaps X Global Inde Absolute Return +0.29% the biggest opportunity lies in the Public- HFR Private Investment Fund, part of the Obama Convertible Arbitrage +5.90% s

xe Relative Value Arbitrage +2.33% administration’s Financial Stability Plan. In this Event Driven +1.47% program, the government will lend money to

egy Inde Merger Arbitrage +0.32%

t ra private investors to buy bad assets from banks, Equity Market Neutral +0.01% X St X thereby letting the market set the price. Since Equity Hedge -0.15% HFR Distressed Securities -0.46% the private-sector cost of borrowing will be low and the loans will be nonrecourse, it is es Fund of Funds +0.81% expected to attract hedge fund managers. Still, Fund-Weighted Composite -0.04% Systematic Macro -0.42% returns are likely to be volatile, at least in the HFRI Ind ex near term. To take advantage of these new op- -1 0+1+2+3+4+5+6 Total Return (%) portunities, investors need a long time horizon

Data Source: Hedge Fund Research as of 31 January 2009 and a lot of patience.

12 MARCH 2009 • Citi Private Bank Q & A

Reasons to Be Optimistic

Milton Ezrati is the senior economist, While consumer spending has been ex- market strategist and a partner at tremely disappointing, there is a silver lining Lord, Abbett & Co., an investment here, and I don’t think we should underrate firm with some $70 billion in assets under it. US consumers’ savings rate is at over 3% management (as of Dec. 31, 2008). He is now, up from zero last June. That’s an almost responsible for providing economic research $300 billion annual rate, which is a signifi- MILTON EZRATI Senior Economist, Market and strategy to clients that enable them to cant number because it is also about 2% of Strategist and Partner Lord, Abbett & Co. gain context and a framework for under- outstanding liabilities. standing the economy and the markets, both It does suggest that deleveraging is pro- locally and at the global level. Jeff Applegate, ceeding; and of course, the further it goes the chief investment officer of Citi Global Wealth more consumers are going to feel comfortable Management, spoke with Ezrati on a Feb. 18 about spending—not spending the way they client call. What follows are excerpts from that once did during the boom, but at least spend- conversation. ing in tandem with income growth. APPLEGATE: Do you see anything positive APPLEGATE: How do you assess the em- in the financial indicators? ployment picture? EZRATI: We’re seeing signs of a financial EZRATI: Although we have seen tremen- thaw. Look at the TED (Treasury bill to dous layoffs in the last few months, two things Eurodollar lending rate) spread. In November, suggest that unemployment may not get as at the worst of this crisis, the spread was 460 bad as the market fears. The first of these is basis points; now it’s only 100 basis points. that, outside of autos and the financial sec- The banks are lending, too. At first, the tor, balance sheets are not in bad shape. Yes, Federal Reserve created all these reserves. earnings have come down. But the pressure to While the monetary base was larger, the lay people off is not nearly as great as it might money supply wasn’t, because the banks have been. In fact, corporate America went weren’t lending. But now, the money supply into this recession in better financial shape is growing. The M1 number has increased in than it has gone into previous recessions. excess of 20%, at an annual rate. The other significant thing is the jump in APPLEGATE: And are there some bright productivity that we saw in the fourth quarter. spots in the economy? It indicates that business was laying off at a EZRATI: The area that’s most significant is much faster rate than it was cutting production. housing. The supply of unsold houses dropped This doesn’t suggest that we will avoid further from more than a 12-month supply to under layoffs, but rather that layoffs will not proceed 10 months’ worth—in large part because at the breakneck pace of the last few months. the builders have cut back. We also see that people are taking advantage of low mortgage rates. By our calculations, the supply of unsold houses could come down to about four or five months’ worth by June or July. That would probably end the steepest slide, or maybe even end the slide altogether, in housing.

MARCH 2009 • Citi Private Bank 13 Perspectives

The Cult of Equity Under Attack

Global equities have returned -29% bull market pushed dividend yields below bond this decade, compared with 80% from yields, a situation that must have driven US government bonds. There have been equity strategists to distraction (see chart). All two 50% equity bear markets in just five years. their valuation models would have screamed This mix of miserable returns and extreme “sell.” As the chart shows, they would have volatility has led some to pronounce that, had to wait until November 2008 for dividend by Robert Buckland Chief Global Equity Strategist after 50 years, the “cult of equity” is dead. The yields to once again rise above Treasury yields. Citi Investment Research & Analysis phrase refers to the belief—a widely accepted There’s still a long way to go before US divi- view—that stocks are the most desirable asset dend yields cross over corporate bond yields. class. Indeed, there is evidence that investors This structural valuation shift occurred in the may be reappraising the role of the asset class UK and Japan, too. and the long-term implications for valuations. WHY DID THIS HAPPEN? Most obviously, A HISTORY LESSON. The cult of equity the 1950s marked the start of a period of began in the late 1950s. Before that, US equi- relative peace and prosperity. It came on the ties traded with a higher yield than that of heels of a tumultuous 50 years that included Treasurys and corporate bonds. Presumably, two world wars and an economic depression. investors demanded a high prospective return In hindsight, the case for equities over bonds to compensate for the risk inherent in holding was especially compelling in the early 1950s. stocks. This aspect overwhelmed the more posi- In 1951, US equities yielded 7%, versus 2% tive attributes of equities, such as their poten- on Treasurys and 3% on Baa corporate bonds. tial for capital gains and inflation hedging. Equities appeared to be a better asset match for That all changed in the late 1950s. A long any defined benefit pension plan trying to earn the 8% return generally required to keep up Crossing Yields The dividend yield on US equities exceeds with growth in liabilities. The yield crossover that on Treasurys, leading some analysts to wonder if it sig- coincided with economist Harry Markow- nals the end of investors’ 60-year love affair with stocks. itz’s first considerations of Modern Portfolio

18 US Corporate Bond Yield (Baa) Theory. This premise promoted the idea that a US Treasury Bond Yield well-diversified equity portfolio could achieve 16 US Equity Dividend Yield superior returns while helping to reduce risk. 14 Equity Yield CHASING PERFORMANCE. Perhaps the Back Above 12 Treasury Yield most convincing argument for equities was their performance. Pension funds bought more 10 Equity Yield Drops Below Bond Yields and more equities because they were rewarded 8 again and again for doing so. A $100 invest- 6 ment in US equities in 1950 would have been

4 worth $58,380 at the end of 1999, versus $1,768 for the same principal amount invested 2 in bonds. Those two numbers probably reveal 0 more about the cult of equity than any aca- '20 '28 '36 '44 '52 '60 '68 '76 '84 '92 '00 '08 demic study could illuminate with many pages. THE ATTACK ON EQUITIES. Why is the Data Source: Global Financial Data, Datastream, Citi Investment Research & Analysis as of 31 December 2008 equity culture coming under attack now—and,

14 MARCH 2009 • Citi Private Bank more importantly, why not sooner? Many ele- times gilts back then. Still, UK equities are not ments had to come together. The causes go well yet yielding twice the level of gilts—and that beyond the current depressed equity values, would imply another 25% still must come off but that steep decline is the catalyst that is share prices, given the current dividend base. prompting the reevaluation. At the same time, Perhaps this analysis suggests that the asset academics have come to question many of the class with the best value right now is corporate underpinnings of the cult of equity. Increasing- bonds. While the current 8% yield on US ly, pension funds switch to bonds as more of Baa-rated corporate bonds might not look high their beneficiaries approach retirement. What’s relative to the 18% of the early 1980s, spreads more, most of today’s workers are in defined against US Treasurys are now at early 1930s contribution plans in which they, not their levels. US Baa-rated bonds currently yield employers, bear the investment risk. Workers about six percentage points more than equities, could become increasingly wary of equities. in line with their post-1960s experience. So we VALUATION IMPLICATIONS. What does have yet to see any sign of reversal in the cult it mean if the cult of equity is reversing? The of equity in this valuation relationship. current yield of 3.7% is still a long way from This makes it clear why many investors— the pre-1960 level of 5.4%. Going back to that and our credit strategists—are now embracing level points to an S&P 500 about 30% lower. the cult of the investment-grade corporate On this basis, the UK looks less worrying, bond. Well-documented liquidity problems since the dividend yield is now approaching mean that corporate bond spreads against Trea- pre-1960 levels. At 3%, the Japanese dividend surys are now the highest ever seen. While cor- yield is already well past its post-1960 average porate bonds look fairly valued against equities of 2%; but it has a long way to go before hit- on a post-1960 basis, they are very attractive if ting the pre-1960 average of 6.9%. we return to a pre-1960 valuation. YIELDS AGAINST BONDS. We can also look Of course, many equity investors will be at equity valuations against bonds. US equities rankled to learn the asset class that did the yielded twice that of government bonds prior most to get us into the current mess might to 1960. At current Treasury rates, that would eventually gain the most from it. Those of us imply an equity market yield of nearly 6%. in the equity world have had it easy for most of The S&P would need to fall by another 37% the past half-century. We need to accept that to deliver that yield on the current dividend just as the rise of the equity culture drew capi- base. Such a move would be less intimidating tal from bonds into equities, so its reappraisal for Japanese equities, which, at 3%, already may be shifting capital back the other way. yield more than twice that of government Right now, with government bond yields bonds, at 1.3%. At the top of the bull market already so low, higher-quality investment grade in 1990, Japanese equities yielded 0.5% versus corporate bonds appear likely to be the key 5% for government bonds. It seems that a 20- beneficiaries of further outflows of equities. year bear market may have finally killed off the Recent high-quality corporate bond issues have cult of equity in Japan. The UK sits somewhere been heavily oversubscribed. Investment grade between the US and Japan. It has already seen seems to be the asset class of choice among equity valuations return to their pre-1960s re- most investors we meet. lationship with gilts—UK equities yielded 1.5

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For archives of The View, The View Online and The View Up Close, please visit the Citi Private Bank client Web site at www.citiprivatebank.com. If you have questions or comments, please write to [email protected]. All expressions of opinion are subject to change without notice and are not intended to be a guarantee of future events. This document is for information only and does not constitute a solicitation to buy or sell securities. Opinions expressed herein may differ from the opinions expressed by other businesses of Citigroup Inc., are not intended to be a forecast of future events or a guarantee of future results or investment advice and are subject to change based on market and other conditions. Past performance is not a guarantee of future results. Although information in this document has been obtained from sources believed to be reliable, Citigroup Inc. and its affiliates do not guarantee its accuracy or completeness and accept no liability for any direct or consequential losses arising from its use. Throughout this publication where charts indicate that a third party (parties) is the source, please note that the source references the raw data received from such parties. Citi Private Bank is a business of Citigroup Inc. (“Citigroup”), which provides its clients access to a broad array of products and services available through bank and nonbank affiliates of Citigroup Inc. Not all products and services are provided by all affiliates or are available at all locations. In the US, brokerage products and services are provided by Citigroup Global Markets Inc. (“CGMI”), Member SIPC. CGMI and Citibank, N.A. are affiliated companies under the common control of Citigroup Inc. Outside the US, brokerage services may be provided by other Citigroup Inc. affiliates. Citi and Citi with Arc Design are trademarks and service marks of Citigroup Inc. and its affiliates and are used and registered throughout the world. In the UK, certain services are available through Citibank, N.A. (“Citibank”) and Citibank International PLC, 33 Canada Square, Canary Wharf, London E14 5LB, which is authorized and regulated by the Financial Services Authority for the conduct of investment business in the UK and is a subsidiary of Citigroup Inc., USA. Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made. Alternative investments referenced in this report are speculative and entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in the fund, potential lack of diversification, absence of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds and advisor risk. © Copyright 2009, Citigroup Inc.

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