Global Fixed Income Currency Commentary

Brandywine Global Investment Management Topical Insight | March 14, 2008

Our basic investment approach emphasizes the potential profit opportunity created by valuation anomalies. Typically, a chain reaction of economic/ policy/financial initiatives are set in motion once the price of an asset deviates far enough away from its underlying notional value. This chain reaction of events, in turn, sets in motion the process which causes the asset price to revert back to its notional value. The Dollar and the U.S. Financial System Crisis The U.S. financial crisis has touched off a period of weakening economic growth and risk aversion driven by a contraction in housing starts, falling house prices and an ensuing credit crunch as financial firms and investors re-price risk. The Federal Reserve (Fed) has eased and the dollar, along with government interest rates, has fallen. David F. Hoffman, CFA Managing Director & Portfolio Manager Historically, lower Fed funds and bond yields act as automatic stabilizers of growth by encouraging • Joined the firm in 1995, bringing 20 years of investment experience the demand for credit and spending. This time around, however, disruptions in the operation of the financial system have neutralized the positive growth-enhancing influence of lower • Williams College, B.A., Art History government bond yields. Credit spreads have blown out more than risk-free returns have fallen. Stephen S. Smith Consequently, the dollar has borne the burden of adjustment in acting as a counter-weight to Managing Director & Portfolio Manager the slowdown unfolding in the U.S. economy and has probably fallen much further than might • Joined the firm in 1991, bringing 23 years of investment experience otherwise have been the case had credit markets been functioning more normally. • Xavier University, B.S., Economics and The Fed has appeared unable or unwilling to get ahead of the factors which have neutralized Business Administration the potency of lower short-term policy interest rates. Instead, day-after-day reports of contagion in the financial system in combination with the unyielding stance of the European Jack P. McIntyre, CFA Associate Portfolio Manager, Central Bank (ECB) have produced relentless upward pressure on the euro. Senior Research Analyst Developments are reaching some sort of extreme. For the first time in this crisis, the Federal • Joined the firm in 1998, bringing 11 years of investment experience Reserve has stepped in to support the liabilities of Bear Stearns. Shareholders in the Wall • New York University, M.B.A., Finance Street firm have lost almost everything but the Fed has acted to avoid a systemic breakdown • University of Massachusetts, Amherst, related to counter-party risk by protecting the investment bank’s portfolio of liabilities. B.B.A., Finance The Tipping Point?

Conditions now have reached the tipping point. The prospect of a major U.S. investment bank running out of capital obviously creates counter-party risk and leaves investors wondering who is next. For the Fed, the time has come to forget about inflation risks for a time. Stabilization of the financial system is paramount at this juncture; excess liquidity can be drained once things have quieted down.

The ultimate barometer of stability in the U.S. is the stock market. It has been in a bear market Global Fixed Income Currency Commentary | p2 Brandywine Global Investment Management Topical Insight | March 14, 2008

since it peaked last year. If the Fed acts to guarantee the functioning of the banking and non-deposit taking banking system, as we think it should and will, the degradation in risk aversion should come to a halt. Gradually, in time, investors would come to see these initiatives as massively reflationary, a plus for the stock market and a plus for a heavily oversold U.S. dollar and the beginning of a major change in the key macro trends.

The Euro Objective and anecdotal evidence show that the currency is trading well above any sustainable long-term value; and that a chain reaction of economic/policy and financial initiatives are unfolding in a way which will cause it to revert lower. The unique nature of the U.S. financial crisis adds to uncertainty and to the potential extreme in euro overvaluation but it does not alter the eventuality/probability of mean reversion.

Valuation

A host of factors highlight significant overvaluation in the euro.

Organisation for Economic Co-operation and

Development (OECD) measures of purchasing Figure 1 Brandywine Global’s Measure of Figure 2 Euroland: JP Morgan Trade Weighted power parity (PPP) along with our own Purchasing Power Parity (PPP) for the Euro1 Index, Real, Broad Basis1 proprietary measures show that the currency USD/Euro is more expensive relative to this benchmark 1.6 140 than any time in the past. The dotted line 1.4 130 in this chart shows our estimate of PPP. The 1.2 120 line in the lower panel is the difference 1.0 110 between the actual level of the euro and the 0.8 100 fitted level. The currency has not been this 0.6 90 US$ Per Euro BGIM PPP high relative to the fitted line since 1996 Difference as Percentage of BGIM PPP Level Deviation from 5Y MA 40% 30 which was an all time high (see Figure 1). Expensive 20% 15 The next chart shows the real effective 0% 0 trade-weighted exchange rate for the euro tabulated by JPMorgan. The top panel -20% -15 shows the actual index is at an all-time high -40% -30 1981 1988 1995 2002 2009 (see Figure 2). 1970 1975 1980 1985 1990 1995 2000 2005

Another way of assessing currency valuation is through the preferences of consumers revealed in the trade balance. In this regard, recent developments in European trade are Figure 3 Euroland: Extra-EMU Exports, Annual % Figure 4 Euroland: Extra-EMU Trade Balance, Change, Current Prices, Seasonally Adjusted2 € Millions, Current Prices, Seasonally Adjusted2 consistent with the notion that the currency 30% 12000 has reached some sort of valuation extreme. 8000 The next chart shows how European 20% 4000 Monetary Union (EMU) export growth to 10% the rest of the world has fallen sharply (see 0 0% Figure 3). -4000 -10% -8000 Correspondingly, there has been a sudden 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 sharp drop in Europe’s external balance (see Figure 4). Global Fixed Income Currency Commentary | p3 Brandywine Global Investment Management Topical Insight | March 14, 2008

Economic Reaction

The overvaluation in the euro coupled with the deterioration in trade is beginning to influence overall economic growth. Business confidence is often a good leading indicator of corporate profitability and has been falling steadily since early 2006, the beginning of the euro’s latest surge higher. Correspondingly, production growth is beginning to weaken (see Figure 5).

Third-party research firms such as BCA Research have also identified how this slowing trend is spreading across other sectors of the economy (see Figures 6, 7 & 8).

Anecdotal developments support the case Figure 5 Belgian Business Confidence and Euro IP1 Figure 6 Real Private Final Consumption3 built from these more objective bits of data. 20% 10% 5% German car companies are looking to build 4% production facilities in North America, a 10% 5% 3% testimonial to the strength in the currency 0% 0% and the impact it will have on domestic 2% -10% -5% European growth. Retail vendors in New Belgian Business Euroland Industrial 1% Con dence* (L) Production (R) © BCA Research 2008 -20% -10% 0% York City are quoting prices on merchandise 1987 1994 2001 2008 1998 2000 2002 2004 2006 2008 in a variety of foreign currencies. European *Shown as a deviation from trend tourism to the U.S. is booming. The pinch on European business is reflected in growing Figure 7 Real Gross Private Non-Residential Figure 8 Volume of Imports Excluding Oil3 Fixed Capital Information4 demands from Europe’s politicians for the U.S. to 20% 9% support the dollar. 16% 12% 6% Policy 8% 3% 4% 0% To date, the ECB has been unwilling to react 0% -4% © BCA Research 2008 © BCA Research 2008 to the strength in the euro with lower interest -8% -3% 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 rates. The central bank’s main concerns are *Shown as a 3-month moving average the level of inflation in the economy along with the rapid growth in broad money supply. Figure 9 Euroland CPI - Overall Index, Ex-Energy, Figure 10 Euroland Money Supply: M1 (EP), Food, Alcohol & Tobacco, Annual Percentage Annual Percentage Change, Current Prices, Headline European inflation is over 3% and Change, Price Index, Not Seasonally Adjusted2 Seasonally Adjusted5 40% rising, a consequence of the food and energy 20% 35% price boom around the world. But core 15% inflation is much lower at about 1.8% and 30% 10% seems stable if not weak (see Figure 9). 25% 20% 5% Moreover, the unyielding stance of the ECB 15% 0% is reflected in narrow money growth which is 2000Q1 2002Q1 2004Q1 2006Q1 2008Q1 1983 1988 1993 1998 2003 2008 beginning to decelerate rapidly (see Figure 10). Figure 11 Pressure Slowly Builds on ECB: Euro Pressure is clearly building on the ECB. Area Policy Rate and ECB Monitor3 BCA calculates an index that conveniently 5% 2% ECB Monitor (R) Policy Rate (L) summarize the various factors which seem 4% 1% Tight Money to precede shifts in short-term euro interest Required 3% 0% rates. This index shows that an easing in Easy Money policy conditions is imminent (see Figure 11). 2% Required -1% © BCA Research 2008 1% -2% 1998 2000 2002 2004 2006 2008 Brandywine Global Investment Management Topical Insight | March 14, 2008

Bottom Line: The euro is expensive/ the dollar is cheap. U.S. financial system distress in Figure 12 Yen: Bearish Leading Indicator Trends3 combination with hawkish ECB policy has produced an unusual overshoot in the euro relative to 80 100% USD/JPY (L, Inverted) Leading Diffusion Index* (R) typical benchmarks of value. Historically, these kinds of overshoots have proven to be attractive 100 75% profit making opportunities. The key to a trend change is capitulation on the part of the ECB to 120 50% the need for monetary support as well as an initiative from the Fed that acts to underwrite risk, for a prolonged time period. Both developments seem imminent. The first development to look 140 25% © BCA Research 2008 for should be stabilization in the U.S. stock market. If we are wrong, it will be because the Fed 160 0% 1992 1996 2000 2004 2008 makes a major policy mistake and the U.S. economy plunges into a recession far deeper and *Shown as a 6-month moving average and advanced by 3 months longer than we forecast.

Figure 13 Yen: Bearish Consumer Confidence The Japanese Yen Trends6 80 30% Consumer Con dence (R) The recent rally in the Japanese yen runs contrary to the normal patterns of historical USD/JPY (L, Inverted) 100 15% correlation. 120 0% Normally, the yen is pro-cyclic: it tends to rally as the economy gathers strength, and then falls 140 -15% as the economy weakens. The next four charts show this pro-cyclic behavior and they also show © BCA Research 2008 160 -30% how anomalous the yen’s rally has been since last summer. 1993 1996 1999 2002 2005 2008

•The first chart shows that yen rallies are normally preceded by a pick-up in the leading economic indicator. This time, however, the indicator has fallen to recession levels while the yen has surged. Figure 14 Yen: Bearish Business Trends3 80 6% Overall Tertiary Index* (R) •The second chart shows the tight correlation between the yen and Japanese consumer USD/JPY (L, Inverted) confidence since 1993. However, the recent surge in the yen has coincided with a complete 110 3% collapse in confidence. 140 0% •Similarly, the third and fourth charts show how the rally in the yen is out of character with © BCA Research 2008 170 -3% past correlations with indicators of the corporate sector (see Figures 12, 13, 14 & 15). 1993 1996 1999 2002 2005 2008 *Shown smoothed except for last data point The unusual behavior of the yen reflected in these charts is consistent with the general tendency towards deflation or de-leveraging trades, or trades that reflect risk aversion. The Japanese currency was generally viewed as a funding currency for various leveraged carry Figure 15 Yen: Bearish Machinery Order trades. It thus tends to go up as risk aversion builds along with de-leveraging pressure. Trends7 80 30% USD/JPY Private Sector The funding-currency aspect of the yen offers an important insight into the future behavior of (L, Inverted) Machinery Orders* (R) this currency. The yen is driven by capital flows like other currencies. What makes it different 110 10% is a history dominated by the inability or unwillingness of Japan to recycle its current account surpluses in the form of capital outflows. Historically, this has been due to a combination of 140 -10% factors, the most significant being regulatory restrictions on domestic investors purchases of © BCA Research 2008 170 -30% foreign securities. As a consequence, the currency tends to be artificially supported (the OECD 1993 1996 1999 2002 2005 2008 has found the yen to be overvalued for the past 30 years) which leads to deflationary tendencies *Shown smoothed except for last data point and very low interest rates…none of which are compelling reasons for the global bond investor to buy Japanese bonds. In the meantime, Japanese industry remains competitive through chronic domestic deflation. Brandywine Global Investment Management Topical Insight | March 14, 2008

What the charts on the previous page clearly predict is a future restoration of the relationship Figure 16 Would Break of 100Y Spur 8 between economic growth in Japan and the yen. Our expectation is that the yen is due for a Intervention? major correction which will allow the economy to recover. Once this renormalization has taken USD/JPY (Inverted) 80 place, the more predictable pattern should emerge again.

In the meantime, Japanese officials have started to comment about the disturbing speed of the 110 ascent in the yen. Intervention may not be far off. The chart below shows that the currency 140 has exceeded exporter break-even levels as calculated by the Ministry of Finance. Intervention Spot Rate Exporters’ Break-Even Rate should be expected based on past behavior (see Figure 16). 170 Bottom Line: From Japan’s perspective, the yen’s rally is overdone and due for a significant Bn Y BoJ Total Monthly Yen Interventions 8000 reprieve. The Nikkei is an excellent leading indicator of the Japanese economy which suggests that it is already in recession. In this respect, the economic drag from a strong currency is 6000 more advanced in Japan than in Europe. However, like the euro, the key necessary condition 4000 for a reversal in the yen is action by the Federal Reserve to underwrite risk in the U.S. financial 2000 system and restore investor confidence. As noted earlier, we feel that the Fed’s action this week in supporting Bear Stearns is indicative of a broader and imminent effort to avoid systemic risk 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 in the U.S. financial system. © BCA Research 2008

Note: Shaded areas represent periods when USD/JPY spot rate was above the exporters’ break-even exchange rate. Bars denote periods when the Bank of Japan sold yen against the U.S. dollar and the euro. 1 Source: Thomson DataStream 2 Sources: Thomson DataStream, EUROSTAT 3 Source: BCA Research 4 Sources: BCA Research, OECD, includes forecasts 5 Sources: Thomson DataStream, ECB 6 Sources: BCA Research, Japan Economic Planning Agency 7 Sources: BCA Research, Japan’s Cabinet Office 8 Sources: BCA Research, Japan’s Cabinet Office Survey, Japan’s Ministry of Finance

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