Issue 29 | June 2011

Asset Allocation Report

foreword

Ithasntyetbeenopenlyacknowledgedbyeurozoneleadersbut,tous,therealityis clear:Greecewillnotbeabletorepayitsdebts.Inourview,someformofdebtdefault isinevitable,butdoesnotseemimminent.

Whyinevitable?Greecesdebtburdenisballooningtowards150%ofGDPandthe budgetdeficitremainsstubbornlyhigh.ThedynamicsoftheGreekeconomymeanthat bothstronggrowthandsustainedbudgetsurplusesarehighlyunlikely.Although privatisationsandassetsalesarenowontheagenda,inthecurrentclimatetheymay onlyfetchfire-saleprices.

Whynotimminent?Whenitcomes,debtrestructuringcouldcauseturmoil.TheGreek bankingsystemfacesbankruptcy,andtheEuropeanCentralBankwillsufferheavy losses.IrelandandPortugalandpossiblyalsoSpain,ItalyandBelgiummaybecaughtup inthefallout.ManyGerman,FrenchandUKbankswillneedmorecapitalandfurther publicsupportwhileconfidenceinthefinancialsystemmayevaporate.

Fornow,policymakersseemcommittedtoavoidingsuchacrisisandwetherefore expectafurtherbailouttobegrantedtoGreece.Weexpecttoseemore compromisesandmuddlingthroughinthemonthsahead,asliquiditymeasuresareused todelayaddressingasolvencyproblem. Againstthatbackdrop,wemaintainouroveralldefensivepositioningbutbelieveitistoo earlytogointocrisismode.

Dirk Wiedmann Head of Investments Rothschild Private Banking & Trust

Cover: Walking Past Two Chairs | Apri detail (lithograph and screenprint) by David Hockney 2008. David Hockney.

2011 Rothschild Private Banking & Trust Publication date: June 2011 Values:All data as at 27th May 2011 Sources of charts and tables: Rothschild and Bloomberg unless otherwise stated.

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Overallassetallocation
Wearestillconcernedaboutasetbackinmarketsandarepositioningourselvesmoredefensivelybyreducing ourexposuretocommoditiesandaddingtoourholdingsinAAA-ratedgovernmentbondsinsafehaven currencies.Wealsomaintainlargepositionsingoldandaslightunderweightpositioninequities.

Bonds and cash Werecommendalowallocationtobonds,withafocuson higher-qualityandshort-durationsecurities. Despitetherecentrally,weseelittlevalueinmostmajor governmentbondsandcontinuetofavourbondsissuedby companies.Thatsaid,wedolikeAAA-ratedgovernmentbonds issuedbycountriessuchasSweden,NorwayandSwitzerland asweexpectthesesecuritiestoperformverywellifthecrisis intheeurozoneescalates. Equities Equitieshavebeenremarkablyresilientbutweremaincautious ontheshort-termoutlook. Valuationsaregenerallyfairandequitiesremainattractive when comparedwithbothgovernmentandcorporatebonds. However,risingwages,taxesandinputcostswillputpressure onprofitswhilethereareanumberofbroaderrisksto investor sentiment. Wemaintainourslightunderweightpositioninequities,witha biastowardsdefensivestocksandsectors.

Hedge funds Wemaintainapositiveoutlookonhedgefunds.Equity Long/Shortfundsareanattractivealternativetoconventional longonlyinvestmentinequities.GlobalMacro/Trading managersshouldalsoperformwellatatimeofongoing uncertaintyandofferusefuldiversificationwithinaportfolio. Commodities and gold Weakpapercurrenciesandunresolveddebtproblemsinthe USandEuropecontinuetobesupportivefactorsforgold,and weholdlargepositionsinthepreciousmetalasahedge against turmoil. Bycontrast,thecloudiereconomicoutlookandsignsofa slowdowninglobalmanufacturingmayweighoncommodity pricesoverthesummerandwehaverecentlymoveddown fromanoverweighttoaneutralposition. Real estate Lowinterestratesandgrowingfearsofinflationshouldbe good newsforpropertyinvestments,buttheoutlookvaries greatlybymarket.Overall,werecommendaneutralpositionin thisassetclass.

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Macroeconomicoverview
WhileMaysfallintheoilpriceisgoodnewsforgrowth,mostrecenteconomicnumbershavebeen disappointing.Overall,westillexpectthemodestrecoverytocontinue,withsubduedgrowthinthe developedworld.

Modest macro. IntheUS,jobcreationremainsslow,housepricesarefalling andgovernmentcutsarenowstartingtobefelt.TheISM servicesindexdroppedsharplyinMay,followingnewsof sluggishgrowthinthefirstthreemonthsoftheyear. TheJapaneseeconomy,hithardbytheearthquakeand tsunami,hasplungedbackintorecession:GDPshrankatan annualisedrateof3.7%inthefirstquarter,andthesecond quarterlookslikelytobejustasbad.Bycontrast,theGerman economyhascontinuedtogrowstrongly,withGDPrisingby 4.9%overtheyeartoQ1. Mixed news on inflation. HeadlineandcoreinflationratesintheUS,UKandeurozone havebeenrisingnoticeably.USCPIincreasedby3.2%overthe yeartoApril,upfromarateofjust1.6%inNovemberlastyear whileintheUK,theBankofEnglandforecaststhatCPIwill reachapeakof5%inthefourthquarter. Thatsaid,oilpriceshavefallenbyaround10%inMay,which shouldhelpreduceinflationarypressureintheshorttermas wellaseasingconcernsabouttheoutlookforbothUS consumptionandgrowthinemergingmarkets.Inflation expectations(asmeasuredbyinflation-linkedbondmarkets) havealsofallenoverthepastsixweeksandlonger-term expectationsappearwellanchored.

Where next for China? RecentdatahaveshowedcontinuedstronggrowthinChina, althoughtherehavebeensomesignsofaslowdowninthe economicmomentum.Inflationhasbeenuncomfortablyhigh,at anannualrateof5.3%inApril,whilerapidgrowthhasleftthe economyshortofenergyproduction,withsupplyconstraints addingtotheupwardpressureonprices.However,the monetaryauthoritieshavebeenveryactiveinseekingto preventtheeconomyfromoverheatingandwebelievethey willbeabletoengineerasoftlandingfortheeconomy. ReserverequirementsforChinasbankshavebeenraisedeight timessincetheautumnandcurrencyappreciationmaynowbe allowedtoplayalargerroleinloweringinflationarypressures. Rate hikes delayed. Theeraofextraordinarilylowinterestratesisslowlycomingto anend,butsomeweakeconomicnumbersmeaninterestrate hikesarenowforecasttocomelaterthanhadbeenthought. Currently,theUSFederalReserveisexpectedtoleaverates onholduntilMaynextyear,whileUKinterestratesarenot expectedtoriseuntilthisNovember.Swissinflationwas surprisinglyweakinAprilandtheSwissNationalBankmayalso delayraisingratesuntiltheendoftheyear. Bycontrast,theEuropeanCentralBankremainsconcerned thatrealratesaretoolowandlookslikelytoraiseinterest ratesinJuly,followingonfromitsmoveinApril.

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Bondsandcurrencies
Theoutlookforthemajorcurrenciesiscloudyandwerecommendavoidinglargetacticalpositions. Given theriskofhigherinflation,webelievemostbondslookovervalued.

We see little value among government bonds. MajorgovernmentbondmarketsperformedwellinMay,as thereweresignsofaslowdowninglobalgrowth.However,we believethesesecuritiesareexpensiveandovervalued:the creditworthinessofgovernmentsisincreasinglyinthespotlight andhigherinflationremainsaconcern.Inourview,thereisstilla credibleriskofinvestorslosingconfidenceinsovereign borrowers,triggeringasharpfallinbondprices. Allthatsaid,wewouldexpectlong-datedUSTreasuriestorally stronglyintheeventofadebtdefaultintheeurozone,despite theUSeconomyspoorfundamentals.WebelieveAAA-rated governmentbondsissuedbycountriessuchasSweden,Norway andSwitzerlandwouldalsoperformwellinthisenvironment, benefitingfromstrongflowsintothesecurrenciesaswellasa rallyinthesecuritiesthemselves. Hunt for income supporting corporate bonds. Withcashratesandgovernmentbondyieldsstillverylow, investorscontinuetohuntformorelucrativealternatives elsewhere,andthistrendisboostingdemandforcorporate bonds.Overall,thespreadorriskpremiumisstillatfairly normallevels,butabsoluteyieldsarenowfairlylow,particularly whencomparedwiththerateofinflation. Importantly,therehavebeennosignsofpanicinthemarketfor financialbonds,despitethetensionsintheeurozone.

US dollar begins to recover. Onatrade-weightedbasis,theUScurrencyhititslowestlevel inadecadeinearlyMay,beforerallyingasinvestorsbecame moreriskaverse.Intheweeksahead,thisnervousnessamong investorsmaycontinuetosupportthedollar,butthecurrencys fundamentalsarepoor.Interestratesseemsettoremainlow forsometimeandtheUSlacksacredibleplantotackleits hugebudgetdeficit,withthedebtceilingbeingbreachedand the(loomingbuthighlyunlikely)prospectofadefaultonUS Treasuries.Therealsoremainsasuspicionthataweakdollaris welcomedbytheUSadministration,althoughofficialshave gonetogreatlengthstosuggestotherwise. Contagion fears to weigh on euro. AstensionswithintheeurozoneroseinMay,andthedebt situationinGreecereturnedtothespotlight,thesingle currencycameunderpressure,fallingbackbelow$1.40 towardstheendofthemonth.Whileexpectationsofhigher interestrateshavesupportedtheeuro,webelievethe growing divergencewithintheeurozonebothintermsof economicperformance,andoverhowbesttotacklethedebt crisismeanssentimenttowardsthesinglecurrencyislikely to remainfragile. Anescalationofthecrisisintheeurozone,particularlyin Ireland,wouldalsodamagesentimenttowardssterling,as UK bankswouldbehithardbyanyrestructuringofdebt.

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Equities
Weremaincautiousontheoutlookforequitiesintheweeksahead.

Equities move sideways. Globalequitymarketsareshowingsignsofconsolidationbut, despiteallthevolatility,remainwellwithintherecenttighttrading ranges.Forexample,theMSCIWorldindexinUSdollarsisup around3%sincethebeginningoftheyear,andisonlysome4% belowthepeaklevelreachedatthebeginningofMay. Overthepastsixweeks,defensiveareassuchasConsumer Staples,HealthcareandUtilitieshaveoutperformedthecyclical sectorssuchasMaterialsandTechnology. Caution warranted. Onapositivenote,marketvaluationsaregenerallyfairand equitiesremainattractivewhencomparedwithboth governmentandcorporatebonds.However,risingwages,taxes andinputcostswillputpressureoncorporatemarginswhilea reboundintheUSdollarwouldalsodamagetheprofitabilityof manyUSfirms. WiththenextearningsseasonnotstartinguntilJuly,investors willbefocusedontheeconomicnewsandthereareanumber ofbroaderriskstosentiment,includinganescalationofthe debtcrisisintheeurozone,afurtherincreaseininflationand theimminentendofthecurrentroundofquantitativeeasingin theUS,withagreatdealofuncertaintyoverwhatfollows. Againstthatbackdrop,wearecomfortablewithourslight underweightpositioninequitiesandmaintainourbiastowards defensivestocksandsectors.

Slowdown in earnings. Overall,consensusestimatessuggestthatearningsgrowthwill remainhealthy,butthepaceofthisgrowthisforecastto deceleratesharplycomparedwiththepasttwoyears,to between15%and18%intheUSoverthenextthreequarters. Thisslowdowninearningsgrowthistobeexpectedas the recoverymatures:year-on-yearcomparisonsbecome harder,andcompanieshavelessscopeformorecostcutting. In addition,overallprofitmarginsinmanymarketsarenow approachingorhaveexceededthepeaklevelsbefore the financialcrisis,suggestingfurthergainsmightbeharder to achieve. Tighter monetary conditions weigh on emerging markets. Emergingmarketequitieshavecontinuedtounderperform developedmarkets,byaround5%sincemid-April.Thenews fromemergingmarketshasnotchangeddramaticallyoflate, withhigherinflationandrisinginterestratesstillkeyconcerns. However,thedivergenceinmonetarypolicywiththe developedworldisbecominglesspronounced:theEuropean CentralBankisnowalsoraisinginterestratesandthecurrent roundofUSquantitativeeasingiscomingtoanend. Thisnarrowinggapshouldsupportemergingmarketequities andmayencouragerenewedinflowsofinvestmentsinto these markets.Valuationsarealsobroadlyneutraland investor positioningissendingnostrongsignals,eitherpositive ornegative.

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Alternatives

Webelievegrowingnervousnessamonginvestorswillweighoncommoditiesbutbegoodnewsforgold.

Macro risks cloud commodity outlook. Afteraverystrongrun,commoditypricesfellsharplyinearly Mayaftersomeweakeconomicdatadamagedinvestor sentimentandledspeculatorstoliquidatetheirlongpositions. Lookingforward,signsofaslowdowningrowth,particularlyin manufacturing,mayputmorepressureoncommodities: US industrialproductionhasdeceleratedsharply,Chinese commodity-relatedimportsareweakeningandtheearthquake inJapanhasdisruptedsupplychainsworldwide. Amongspecificcommodities,webelievethereispotentialfor furtherincreasesingrainpricesinthemonthsahead,asweather ishinderingplanting.Morebroadly,globaldemandfor agriculturalproductsisoutstrippingsupply,inventorieshave beenrundownanditwouldtakeseveralyearsofperfect productiontorestorepreviousstockpiles.Manyagricultural marketsareveryfinelybalanced,meaningthatanydisruptionto supplywouldleadtoasharpspikeinprices. Good environment for gold. Weakpapercurrenciesandunresolveddebtproblemsinthe USandEuropecontinuetobesupportivefactorsforgold,and weholdlargepositionsinportfoliosasasafehavenandhedge againstturmoil. DespitethevolatilityinMay,webelievethefundamental investmentcaseisunchangedandthatthereareanumberof factorsthatcouldpushgoldpricesmuchhigher.TheWorld GoldCouncilrecentlyhighlightedthestrengthofgoldjewellery demand,particularlyfromIndiaandChina,whiledemandfor goldbarsandcoinsremainssolid.

We continue to back talented hedge fund managers. Afterasolidstarttotheyear,hedgefundsstruggledinMarch whenaseriesofshockstomarketsandsharpswingsinasset pricesmadeforamuchmoredifficulttradingenvironment. MosthedgefundsrecoveredgroundinApriland,sincethen, manymanagershavestartedtotakeriskoutoftheirportfolios: accordingtoourprimebrokersources,netmarketexposure forEquityLong/Shortfundsisnowhoveringaround60%. Despitethemixedperformance,hedgefundscontinueto attractnewcapitalfrominvestorsand,oncurrentpredictions, totalassetsundermanagementinthehedgefundindustry shouldreach$2.3trillionbytheendofthisyear. Whereclientredemptionsaretakingplace,itseemsthatmuch ofthemoneyisbeingre-allocatedtobetter-performinghedge fundswithsimilarstrategies,ratherthanflowingoutofhedge fundsentirely. The investment environment should support property. Againstabackdropofloosemonetarypolicy,government indebtednessandlingeringfearsofinflation,propertyshouldbe attractiveasatangibleassetwithfairlypredictablecashflows. Forlong-terminvestors,webelievepropertyisanincreasingly attractivealternativetobonds. Inmanywesterneconomies,capitalgrowthislikelytobe limitedthisyearandpropertyownersandmanagersare focusedoncostcontrolandimprovingspaceutilisation.By contrast,mostemergingmarketshavegoodpotentialforboth rentalgrowthandcapitalappreciation.

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ChartBook
Thechartsbelowprovideanoverviewofkeytrendsinfinancialmarketsoverthepast12months. The table providesasnapshotofkeyeconomicindicators.

Equity market performance 12 months to date

% 30
26.6 19.6 16.9 20.5

10 Year bond yields

25 20 15

%
5 4 3 2 1 0

7.6

10 5 0

-1.6
US Europe ex-UK Japan Pacific ex-Japan UK Switzerland

May

Aug

Sep

Oct

Nov

Feb

June

Dec

US

UK

Eurozone

Japan

Switzerland

Volatility
50 40 30

Trade weighted currencies (indexed)

May

Mar

Apr

July

Jan

-5

% 120

110

100 20 10 0
Aug Sep Oct Nov Feb Apr Dec May Mar Jul Jan Aug Sep Oct Nov Feb Apr Jul Dec May Mar Jun Jan Jun Jun

90

80
GBP USD Euro Yen CHF
Jun

Interest rates % US Eurozone Switzerland UK Japan China 0.25 1.25 0.25 0.50 0.10 2.85

Government bond yields 10 year % 2 year % 0.5 1.6 0.5 0.9 0.2 3.2 3.1 3.0 1.8 3.3 1.1 3.9

Inflation % 3.2 2.8 0.3 4.5 0.3 5.3

Unemployment % 9.0 9.9 3.1 7.7 4.6 4.1

GDP growth % 2.3 2.5 3.2 1.8 -1.0 9.7

SourceBloomberg.Alldataasat 27/05/2011. EquitymarketindicesareMSCI;figuresareforTotalReturns,netdividends,inlocalcurrency.Volatilityismeasured by VIXIndex.GDPandinflationfiguresareannual andlatestavailable.Chineseinterestratesasmeasuredbythe3monthdepositrate . Issue 29 | June 2011 | Rothschild Asset Allocation Report | page 7

ContactInformation

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Tokyo 20F Kamiyacho MT Bldg 4-3-20, Minato-ku Tokyo 105-0001 Japan Tel.: +81 3 5408 8045 Singapore One Raffles Quay, North Tower 1 Raffles Quay #10-02 Singapore 048583 Telephone: + 65 6532 0866

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Disclaimers

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