Focus

Summary
Investors are continuing to contend with high political and economic risks. We now find ourselves in a new world and deeper international cooperation is the only way to get things back on the track. Given the varying interests of the different countries, this will be a long-winded process, with one small step being taken at a time. That new world is most evident in the fixed income markets. Not so long ago there was a definite distinction between the bonds of OECD countries and those of emerging markets (higher risk!), but now that distinction has clearly become blurred. The European government bond market is a good example (Ireland, Portugal etc). In the economic arena, policy makers can no longer draw solely on their traditional arsenal of measures with known effects. An example is the programme that the Federal Reserve initiated in early November to buy $600 billions worth of US government bonds (quantitative easing). In our base scenario (60% chance), we see good opportunities for equities, real estate stocks and commodities. We also see good opportunities for high-yield corporate bonds and emerging market debt in hard and local currencies. Our three investment themes are: search for yield (high dividend stocks, spread products), emerging markets (emerging market equities and bonds) and corporate expenditure (share buybacks, dividend hikes, M&A). The way in which large corporates use their abundant cash will have a substantial effect on financial markets.

November 2010

High risks do not need to discourage investment opportunities in 2011

The global economy is in a transition phase. The developed economies are still busy reducing debt, which has resulted in below-average growth in most of those countries. Germany is the major exception. That country is showing solid growth, partly thanks to exports to China and other Asian countries. The emerging economies, not so long ago very dependent on the economic cycle in the mature economies, are showing high structural growth. The belowaverage growth in the developed economies and the high structural growth in the emerging economies have resulted in reasonable global growth, but also in considerable global imbalances. These centre on the relationship between the US (largest deficits) and China (largest surpluses).

Geo-political relations have changed sharply

High political risks in a transition phase
The imbalances can only be pushed in the direction of a solution by more global collaboration. Given the varying interests, this will be a long-winded process of one small step at a time. That means investors will regularly have to contend with tension in the currency markets. We do not expect a trade war (large scale protectionism), assuming politicians keep a cool head. The problems in European government bond markets will not go away for the time being, either. And whereas until not long ago Europeans could look at the US to see where the European economy was heading, that pointer no longer exists. Economic figures for China, one of the major engines of the global economy, are now certainly so important that they give an indication of the course of the European and global economies.

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The economic risks are also higher than usual

The world must be rediscovered. Traditional solutions like a cut in key interest rates by the central banks and rising budget deficits being allowed by governments to rise are exhausted. The developed economies have even taken steps to reduce their deficits, while economic growth in the majority of those countries is still below the long-term average. This situation calls for an unconventional policy, such as the decision of the US Federal Reserve to buy up US$ 600 billions worth of government bonds (quantitative easing 2). Policy makers have little experience of the effects of this tactic, but we feel it is necessary in order to reduce the risk of a growth relapse (double dip).

emerging market currencies expected to appreciate sharply in the longer term

Furthermore a country like China, which acts as an example for many emerging countries, has built up large surpluses on the current account of its balance of payments. That provided the scope for the country to significantly stimulate its economy during the credit crisis. We expect that China will use its surpluses, which have enabled it to pursue an independent policy, to buoy up economic growth during any future crises. We know from past experience (e.g. Japan in the 1960s and 1970s) that structural rises in productivity lead to a sharp appreciation of the currency of the country concerned. Although China is keeping to its own policy, it may be expected that the renminbi will be unable to avoid a structural appreciation in the long run. Tensions between the US and China are expected to persist for the time being, sometimes in the foreground and at other times in the background of the economic picture.

We estimate there is a 60% chance of our base scenario becoming reality

We have translated our expectations into three scenarios, our base scenario (muddling on), the downward risk and the scenario with a strong global momentum. As the table shows, there are wide differences between the various investment categories as regards expected return. Depending on the risks that the investor is prepared to run, it seems wise not to focus the portfolio entirely on the outcomes of the base scenario, but to take another outcome into account through diversifying to a greater or lesser extent. Be that as it may, the wide differences in the outcomes of the three scenarios indicate the need to actively track developments.

Global economic outlook base scenario

real GDP growth (%) 2010 World Developed economies US Eurozone Japan UK 4.8 2.2 2.6 1.5 2.9 1.4 8.1 10.1 2011 3.8 1.6 1.8 1.7 1.1 1.5 6.5 8.5 Inflation (%) 2010 2.9 1.2 1.5 1.3 -1.0 3.1 5.1 2.8 2011 2.7 1.0 0.9 1.6 -0.6 2.5 4.9 3.6 0.45 0.13 1.0 0.10 0.50 0.53 0.13 1.25 0.10 0.50 Policy rates (%, year-end) 2010 2011

Three scenarios
environment Probability Equities Fixed income Real estate equities Commodities Source: ing im muddle on 60% 8-12% 2-5% 9-14% 9-14% Downward risk 25% -15% +7% -20% -25% Strong momentum 15% +15% -5% +20% +20%

Emerging economies China Source: ing im

economic strength lies with emerging markets and large corporates

Economic strength is mainly to be found in the emerging markets on which the credit crisis has little overall impact. At company level, strength can be found at the large corporates, which have managed to repair their balance sheets in a relatively short time. Whats more, large US and European companies are now very cash-rich. Taking account of the relatively high risks and high volatility, this environment offers opportunities to investors who are prepared to pragmatically exploit the opportunities in both the fixed income and the equity market.

Fixed income: government bond yields remain low for the time being
Core of the fixed income portfolio
We are in an environment of low nominal economic growth in the developed economies, ample liquidity and an extremely accommodative monetary policy. This will, in our view, put structural pressure on government bond yields (US, Germany, Netherlands) for some time. Yields of 4% and above are therefore hard to find. Investors have to search for returns like these. Pension funds and other institutional investors have to realise a certain return on invested assets in order to be able to meet their liabilities. This search for yield is one of our investment themes in 2011, as it was in 2010. Depending on the risk that the investor is prepared to accept, government bonds can to a greater or lesser extent form the core of the fixed income portfolio. It is clear, however, that a reasonable return will be unachievable if investment is solely in government bonds (US, Germany, Netherlands).

Growth in developed economies and in emerging economies continues to diverge

World with two speeds
Growth in the emerging economies is expected to be structurally higher than in developed economies in the years ahead. The factors here include the low debt, strong population growth, structural productivity growth and enormous potential for domestic growth in the emerging countries.

Spread products necessary in order to realise a reasonable return

In order to increase the yield, the remainder of the fixed income portfolio should comprise fixed income instruments with a higher risk, but also with a higher expected yield. Consideration should be given to high yield corporate bonds and emerging markets debt in hard and local currency. Global and European high yield bonds currently have yields of respectively

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7.3% and 6.6% (benchmark hedged to the euro). Emerging markets debt in hard currency currently has a yield of around 5.3%. Emerging market debt in local currency (money market) is yielding 2.2% and bonds in local currency 6.2% (all figures as of 17 November 2010). Given the high growth rates and healthy fundamentals (low debt), bonds of emerging markets are attractive in both hard and local currency. In the case of debt instruments in local currency investors benefit from the structural upward pressure on the currencies of emerging markets due partly to higher growth, but primarily to the sharp rises in productivity in those countries (compared to developed economies) for several years in succession. These factors encourage us to expect attractive returns in the longer term.

In the case of the search for yield the accent in mature markets is on the high dividend yield (versus the low interest rate) and on expected dividend growth. In Europe the gap between earnings growth and dividend growth is now the widest it has been for almost 40 years. Emerging markets remain a theme, given their superior fundamentals and valuation. The latter is close to that of the mature markets, while there are arguments (e.g. higher earnings growth) that advocate a premium. Corporate expenditure is a new theme, owing to the substantial cash positions companies have built up. The manner in which these resources are deployed (share buybacks, higher dividends, takeovers and hopefully higher investment) will give a significant boost to the global economy and to financial markets worldwide.

everything in place to make 2011 a good year for equities

earnings could grow significantly
Despite the modest economic outlook for the mature economies, corporate earnings could grow significantly in 2011. But companies in emerging economies (+20%) will leave US and European companies behind (+10%). Earnings growth, valuations and disposable cash will, in our view, be the main drivers of the equity trend in 2011.

Significant price rises on the horizon

In the longer term (up to and including December 2011), we think that the expected earnings growth, relatively low valuations and ample liquidity could push up share prices considerably. In the developed markets, we estimate an average price rise of 10% to 15% and in the emerging markets around 20%. That is purely on the basis of not-yet-discounted earnings growth in 2010 and expected earnings growth in 2011. We have kept price/earnings ratios unchanged.

Sources of earnings growth

The first source will be revenue growth of 4.5% to 5.5% due to the positive (albeit below average) economic growth in mature markets, but particularly because of the considerable expansion in emerging markets. Revenue growth is boosting operating margins because fixed costs per product unit are shrinking. Also, companies are benefiting from very low interest rates, which make it cheaper to finance their activities. Moreover, they are using the low interest rates to attractively refinance their loans. Hence, they are assured of low financing costs for a longer period. Share buybacks are also having a favourable effect on earnings per share, particularly in the US. The banking sector is an exception. The sector will have to issue more shares owing to the more stringent requirements of the regulators.

Currencies offer good opportunities for generating alpha

In our estimation there is only a small risk that the so-called currency war will end in a trade war. Our feeling is that in 2011 there will indeed be a clearer distinction between currencies that appreciate and those that lose value. We anticipate a constructive approach to the global currency pressure and foresee the currencies of emerging markets appreciating further against those of the developed markets. It is important to realise that the currency markets show many different trends and divergent patterns. We think that investors would do well to pay more attention to the currency markets as a separate asset class. These markets offer great and relatively uncorrelated opportunities for generating alpha and thus substantial returns.

Attractive valuation
Equities are attractively valued globally, compared with both their historical averages and the low bond yields. Because share prices have so far this year not risen in line with the surprisingly strong growth in profits, price/ earnings ratios are below the long-term average. What investors fail to notice is the positive effect of low or even negative real interest rates on equity valuations. Lower interest rates mean that a companys future cash flows are discounted by a lower interest rate, which in itself pushes up price/earnings ratios.

real estate equities: good fundamentals and appreciable dividend yields

The outperformance of real estate equities should continue in 2011. There are several factors that support us in this conviction, particularly the fact that many real estate companies have refinanced their debts and the fact that the underlying commercial real estate has turned the corner as regards vacancy and rentals. Moreover, dividend yields in developed markets are attractive.

Where are the best opportunities to be found? our investment themes in 2011
The search for yield and emerging markets, this years themes, will be carried over to 2011. A new theme is the rise in corporate expenditure.

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Commodities rely on high growth in emerging markets

Demand for raw materials should continue in 2011. We believe that precious metals will gain the most next year, followed by industrial metals. Gold continues to benefit from several factors: the flight to quality, central banks have become net buyers of gold, and the limited output of gold mines. A couple of risks are entailed. The (high) growth in global industrial production and global trade is slowing. Another risk is that China will make political errors or tighten its economy more sharply and so growth will be squeezed too hard. Should a currency war inadvertently culminate in a trade war, commodities would be hit harder than other asset classes.

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