March 2009

March 2009

Deflation/Reflation strategies The global economy is set to flirt with deflation this year while many large economies like the US, Japan and China are forecasted to experience outright deflation. Yet, the aggressive policy responses seen so far points to reflation next year. Here we look at the implications for investors and highlight some strategies that investors may wish to employ. Deflation/Reflation strategies The deflation threat Just as commodity prices were behind accelerating inflation concerns less than 12 months ago, they are amongst the main contributors to lower price increases now. Citi analysts believe that the threat of deflation could likely intensify as global economic activity slows in the first half of 2009. While many economies around the globe are at risk of experiencing falling consumer prices, developed world consumer prices could see their slowest increase in 60 years. At this juncture, Citi analysts are forecasting outright deflation in the US, Japan and China.

Although the economy tends to be more vulnerable to negative shocks during deflationary periods, history shows that equity market performance during past episodes have not been as dismal as many would anticipate. While performance was dire during the Great Depression and Japanese equities performed poorly during the 1990s, equity markets performed well during the deflationary 1920s, and also in the late 1990s and early 2000s against a backdrop of falling consumer prices in Hong Kong.

Citi analysts observe that equity market performance during deflationary episodes appear to be driven by the strength of the real economy/earnings and valuations, with strong earnings and cheap valuations supporting stock prices. With global equity markets currently trading at cheaper levels than before the Great Depression or Japanese equities in the early 1990s, Citi analysts believe that the ingredients are not in place to see a further collapse in global stock prices, even as they expect corporate earnings to fall by 30% this year. But neither are the ingredients in place to see equities rally through the coming weakness they expect in consumer prices. Signs of a stabilisation in demand and corporate profits may be needed before that can happen.

Deflation strategies During times of sustained deflation, Citi analysts believe that equity investors should focus on three distinguishing features: pricing power, volume growth and strong balance sheets. These generally point to large caps and the defensive sectors.

> Pricing power: Look to sectors where demand is less elastic, competition is not as acute, consolidated sectors which are typically more resilient to falling prices and demand, companies that sell a broad range of products, as well as those that may see margin expansion as costs fall faster than output prices i.e. from food cost deflation, lower media rates and benign overheads (labour, energy).

> Volume growth: Past deflationary episodes have shown that companies are capable of dealing with the lack of pricing power as long as volumes remain solid. Volume growth is likely to be found in sectors with inelastic demand and those which are exposed to stronger structural drivers. Even if volume remains stable, companies could counter the lack of pricing power through the innovation of higher-margin products and aggressively managing costs through consolidation and benefiting from greater economies of scale.

> Strong balance sheets: An environment of falling prices does not bode well for leveraged companies as the real cost of servicing debt grows as deflation intensifies. Companies that have the ability to fund their business internally are likely to perform relatively better during periods of sustained deflation than those that are excessively geared. Highly-leveraged private equity owned companies may likely feel the most pain, given that the financial leverage on the LBO deals especially during the final days of boom was far in excess of the leverage seen in the equity market.

Reflation strategies Then again, while investors are concerned about deflation now, they should not stop thinking about inflation in the future. Unlike some previous deflationary periods, the current threat of falling consumer prices is being met by aggressive policy stimulus on a number of fronts. Following are some strategies that, according to Citi analysts, investors may wish to consider should inflation make a comeback.

> Do not ignore the natural hedges of inflation: i.e. Gold, Equities, Index-linked bonds, Cash deposits, Property & Infrastructure.

> Invest in the causes of inflation: Consider investments that are operating in the sectors or markets that have caused the rise in inflation. These would include investing in soft (e.g. agriculture) and hard commodities (e.g. metals), energy, as well as in the emerging markets.

> Seek exposure in sectors with resilient demand: Investors may also want to seek exposure to industries that face inelastic demand – demand that tends not to be significantly affected by price increases. These include manufacturers of nondiscretionary consumer staples as well as food and beverage manufacturers and retailers, which are more likely to be able to pass through higher prices to consumers.

> Consider regulated industries such as infrastructure and utilities: Output prices for these industries are set by law and typically incorporate an inflation index, these industries are better placed to pass through price increases to consumers. Chart 1: Chart 2: S&P 500 Index Dow Jones Stoxx 600 Index 0% 0% -5% -5% -10% -10% -10.99% -9.57% -15% -15% -12.83% -20% -20% -18.62% -25% -25% -30% -30% -35% -35% -40% -40% -45% -42.60% -45% -44.76% -45.78% -50% -50% -47.26% 1-Mth YTD 1-Yr 3-Yr* 1-Mth YTD 1-Yr 3-Yr* *Denotes cumulative performance *Denotes cumulative performance Performance data as of 27 February 2009 Performance data as of 27 February 2009 Source: Bloomberg Source: Bloomberg

United States Euro-Area Severe recessionary forces continue to challenge ECB likely to employ more unconventional monetary policy efforts measures

ƒ Investors have displayed greater appetite for credit risk but overall ƒ The credit crunch is broadening as banks report further tightening in financial conditions remain an impediment to economic activity. In Citi’s lending conditions and credit growth to households and businesses eases opinion, a sustained economic recovery awaits a lift in investor markedly. This suggests a further substantial fall in gross domestic product confidence and diminishing worries about financial firms. (GDP) in the current quarter. Citi analysts are as such revising down their forecast for 2009 GDP from -2.7% to -2.9%. ƒ Indeed, worries about income, declines in household wealth and rising joblessness so far are outweighing policy efforts. Citi analysts consider ƒ Nevertheless, the implementation of the fiscal stimulus packages in many that although fiscal measures just legislated are expected to steady countries may support some stabilization in economic activity in the activity later this year, strains on state and local budgets may offset second half of the year and could contribute to a modest recovery in 2010. some of that boost. ƒ That said, Citi analysts still expect the European Central Bank (ECB) to cut ƒ At the same time, amid widespread economic weakness and rapid interest rates to 0.5% in mid 2009 and to use unconventional measures to declines in inflation, Fed officials are likely to keep policy easing efforts ease financing conditions. at full throttle. Measures now are focused on easing credit through mortgage-backed securities (MBS) purchases and expanded lending ƒ Citi analysts observe that almost all stocks have been de-rated in absolute facilities. Citi’s baseline does not foresee an unwinding of terms since mid 2007 and are now trading on single digit Price-to-Earnings accommodation any time over the two-year forecast horizon. (P/E) multiples. But there is evidence of valuation divergence within the market. Indeed, the spread between the cheapest and the most expensive ƒ While investors perceive little hope and assume that only difficult sectors is back only to average levels. conditions can ensue, Citi analysts argue for a more constructive equity market in the next 6 to 12 months as valuations based on the earnings- ƒ In Citi’s opinion, this is likely to be positive for growth investing as further yield gap appear supportive, as do implied long-term earnings divergence will likely support outperformance of high dividend yielding expectations and sentiment readings. companies with strong balance sheets and positive earnings trends. In particular, Citi analysts are overweight defensive sectors such as Health Care, Food & Beverage and Telecoms while underweight Industrials, Construction and Utilities. Chart 3: Chart 4: MSCI Asia Pacific (Incl. Japan) MSCI Emerging Markets Index

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-10% -10,00% -5.71% -9,54% -11.95% -20% -20,00% -16,06% -30% -30,00% -40% -36.16% -40,00% -50% -41,61% -50,00% -60% -49,04% -57.24% -70% -60,00% 1-mth YTD 1 Year 3 Years* 1-Mth YTD 1-Yr 3-Yr* *Denotes cumulative performance *Denotes cumulative performance Performance data as of 27 February 2009 Performance data as of 27 February 2009 Source: Bloomberg Source: Bloomberg Japan Emerging Markets Potential for turnaround between April and June FX reserves likely to face downward pressures

ƒ Japan’s GDP contracted by 12.7% annualized in the fourth quarter of ƒ Emerging economies had previously built up substantial stocks of net 2008, marking the largest drop since the first quarter of 1974. This was foreign assets during the course of this decade, thanks to two forces: due to a severe downturn in Japan’s trading partners, resulting in a large current account surpluses and high levels of net capital inflows. historic nosedive in exports. The Bank of Japan (BoJ) is likely to maintain policy rates at 0.1% going forward, according to Citi analysts. ƒ However, Citi analysts estimate that going forward, current account Policymakers appear unwilling to return to the same quantitative easing balances are likely to come under pressure in emerging markets due to (QE) that was implemented from 2001 to 2006. Instead, the main focus lower commodity prices and weaker external demand; while net capital of monetary policy will probably be to support dysfunctional financial flows may stay weak due to the collapse in risk appetite. markets by purchasing assets with credit risk and to push down interest rates longer than the overnight call rate. ƒ In Citi’s opinion, this is likely to continue to put downward strain on FX reserves, a trend reinforced by policymakers’ desire in an increasing ƒ Citi analysts believe that Japanese markets may continue to experience number of countries to spend FX reserves to support domestic weakness through to March 2009 due to continued yen strength and the economic activity. global economic downturn.

Asia Pacific ƒ In Latin America, stretched valuations and collapsing growth lead Citi Near term growth outlook remains grim analysts to downgrade Brazil to neutral in the near term. Instead, they are adopting a more defensive strategy and have now raised Colombia ƒ The near term growth outlook remains grim as recession in the (relatively well diversified and attractively valued) to overweight, developed world deepens. In view of a worse than expected alongside Chile. manufacturing/export slump and a deepening spillover to domestic demand, Citi analysts have downgraded their 2009 and 2010 growth ƒ In CEEMEA1, Citi analysts estimate earnings may need to decline 55% forecasts for the region to 3.9% and 6.5% from 4.6% and 6.6% from levels at the end of 2007 in order for profitability to reach “trough” respectively. levels. As such, they prefer markets that are likely to show greater earnings resilience, especially Israel, Czech Republic and Turkey. The ƒ Despite meaningfully sized fiscal stimulus for a number of countries, Citi same goes for sectors: they prefer health care, consumer staples and analysts think the structural adjustments in US-led global demand will mobile telecoms. continue to weigh on Asia’s growth outlook. The sharp decline in export 1. CEEMEA is the collective term for Central and Eastern Europe, Middle East prices does not auger well for Asian companies, which may see an and Africa. even bleaker earnings outlook in 2009 than in 2008. Citi analysts as such believe that Asian stocks could potentially test the lows of October 2008. Currencies

Chart 5: Favour high-grade corporate bonds Currencies 0,00 % US Treasuries -1,00 % Citi analysts remain underweight treasuries, as historically low interest -2,00 % -1,86 % -2,12% -3,00 % rates offer investors with little opportunity for significant returns. For those

-4,00 % looking to invest, Citi analysts prefer the 2 to 10-year portion of the curve.

-5,00 %

-6,00 % Corporate

-7,00 % Citi analysts prefer high-grade corporate bonds given that the risk/reward

-8,00 % -7,80% trade-off seems more attractive and valuations appear compelling. On the -9,00 % other hand, they are cautious on the high-yield sector, favouring to wait on Eur vs. USD GBP vs. US D JP Y vs. USD

*Denotes cumulative performance the sidelines until volatility subsides, as defaults are likely to increase Monthly Performance data as of 27 February 2009 given the weak economic outlook. For investors seeking exposure, Citi Source: Bloomberg analysts prefer the shorter duration (1 to 3-year) given that extending out on the curve provides minimal yield pickup for increased risk. Pause before US Dollar weakening Euro Bonds Euro Weak economic fundamentals as well as declining inflation could push Global currency moves continued to be dominated by the swings in risk bond yields lower and prices higher. Citi analysts expect a bull steepening appetite, capital and trade flows, and gyrating terms of trade stemming of the Euro zone government bond market, with yields in the short end of from the worsening global recession. Policy responses — monetary the curve falling more than yields in the long end. easing, FX intervention, capital controls — have also added to FX volatility. Citi analysts expect the EUR to stabilize against the USD in the Emerging Market Debt near term before strengthening at the end of the year on the back of Citi analysts remain cautious on emerging-market bonds. For investors growing risk appetite. Citi analysts expect the EUR to trade at around 1.30 seeking exposure, Citi analysts favour countries with sound economic versus the USD by the end of the year. fundamentals and minimal amount of political risk. General Disclosure British Pound “Citi analysts” refers to investment professionals within Citi Investment Research and Citi Global Markets (CGM) and voting members of the Global Our analysts’ base case is that the pound will rise a little against the euro Investment Committee of Global Wealth Management. Citibank N.A. and its affiliates / subsidiaries provide no independent research or and the USD in the near term after having weakened sharply in recent analysis in the substance or preparation of this document. The information in this document has been obtained from reports issued by CGM. Such information is months in response to UK economic weakness and worries over the UK based on sources CGM believes to be reliable. CGM, however, does not guarantee its accuracy and it may be incomplete or condensed. All opinions and estimates authorities’ commitment to economic stability. However, the Sterling is constitute CGM's judgment as of the date of the report and are subject to change without notice. This document is for general information purposes only and is not likely to remain weak well into 2009, reflecting the United Kingdom's intended as a recommendation or an offer or solicitation for the purchase or sale of any security or currency. No part of this document may be reproduced in any severe recession, ballooning fiscal deficit, and falling policy rates. Citi manner without the written consent of Citibank N.A. Information in this document has analysts expect the Sterling to trade at around 1.50 versus de USD and been prepared without taking account of the objectives, financial situation, or needs of any particular investor. Any person considering an investment should consider the 0.9 versus the Euro by the end of the year. appropriateness of the investment having regard to their objectives, financial situation, or needs, and should seek independent advice on the suitability or otherwise of a particular investment. Investments are not deposits or other Yen obligations of, guaranteed or insured by Citibank N.A., Citigroup Inc., or any of their affiliates or subsidiaries, or by any local government or insurance agency, and are Citi analysts consider that the Japanese yen reached the end of its subject to investment risk, including the possible loss of the principal amount invested. Investors investing in funds denominated in non-local currency should be strength period against other major currencies and should remain stable in aware of the risk of exchange rate fluctuations that may cause a loss of principal. Past performance is not indicative of future performance, prices can go up or down. the coming months. A rise in risk appetite and hopes of exports recovery in Some investment products (including mutual funds) are not available to US persons and may not be available in all jurisdictions. Investors should be aware that it is the wake of Japan’s trade partner’s economic stimulus plans should his/her responsibility to seek legal and/or tax advice regarding the legal and tax consequences of his/her investment transactions. 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