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The End of the Equity Cult?

The End of the Equity Cult?. Duncan Gwyther Chief Investment Officer October 2010. The End of the Equity Cult. Two significant bear markets and continuing high volatility Uncertainty over economic growth prospects Regulation designed to make ‘the world a safer place’ - Solvency 2 etc Mean

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The End of the Equity Cult?

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  1. The End of the Equity Cult? Duncan Gwyther Chief Investment Officer October 2010

  2. The End of the Equity Cult • Two significant bear markets and continuing high volatility • Uncertainty over economic growth prospects • Regulation designed to make ‘the world a safer place’ - Solvency 2 etc Mean • Global bond yields have fallen to multi-decade lows, and • Insurance sector’s equity allocation just 4% (net of policyholder participation) • Bond fund flows are now greater than equity flows were in 2000 But • Sovereign debt crisis is real and ongoing • Inflation isn’t dead, so is there a ‘real’ problem meeting future liabilities? Source: Investment Company Institute, Morgan Stanley European Strategy 27 September 2010

  3. Association of British Insurers Long-Term and General Insurance Holdings Cash and Other UK Public Sector Securities, Investments, 8% 12% Property, 6% Overseas Public Sector Securities, 6% Unit Trusts, 13% UK Ordinary Stocks and Shares, 15% Other Overseas Company Securities, 14% Overseas Ordinary Stocks Other UK Company Stocks and Shares, 15% and Shares, 11% Equity exposure - UK insurance companies Source: Association of British Insurers 31 August 2010

  4. Morgan Stanley Research Estimate of Net Policyholder Participation Cash, 5% Equities, 4% Other, 10% Govt Bonds, 30% Loans, 8% Str Credit, 11% Cov Bonds, 5% Corp Bonds, 27% Equity exposure - UK insurance companies Source: Company data, Morgan Stanley European Strategy 27 September 2010

  5. Fund flows - Solvency 2, equities not capital efficient

  6. Fund flows - pension funds structural sellers Source: WM Pension Funds 31 Dec 2009

  7. Net Fund Flows to Equity Funds Relative to Global Equity Performance 40 50 40 30 30 20 20 10 10 Billions of Dollars % Total Return on Equities 0 0 -10 -10 -20 -20 -30 -30 -40 -40 -50 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Net new cash flow % Total return on equities Fund flows - US equity mutual fund flow v performance Source: Investment Company Institute and Morgan Stanley Capital International 2010

  8. Net Fund Flows to Bond Funds Relative to Bonds Returns 2.5 20 2.0 15 1.5 1.0 10 0.5 Billions of Dollars % Total Return on Bonds 0.0 5 -0.5 -1.0 0 -1.5 -2.0 -5 1995 1996 1996 1997 1997 1998 1999 1999 2000 2000 2001 2001 2002 2003 2003 2004 2004 2005 2006 2006 2007 2007 2008 2008 2009 Net new cash flow Total return on bonds Fund flows - US bond mutual fund flow v performance Source: Investment Company Institute and Morgan Stanley Capital International 2010

  9. European Commission Forecasts for Budget Deficit v General Government Debt in 2010 14% United Kingdom 12% Ireland 10% Spain Greece Portugal Budget Deficit, % GDP 8% France EU Euro Area 6% Italy Germany 4% Sweden 2% 0% 20% 40% 60% 80% 100% 120% 140% General Government Debt, % GDP Government debt - debt swap now a public ‘problem’ Source: European Commission

  10. Government debt - initial debt is not the whole story % of GDP Source: EU commission, Eurostat, CBO, IMF, Morgan Stanley Research 25 Aug 2010

  11. Government debt - revenue available to repay debt matters Source: Eurostat, CBO, Morgan Stanley 25 Aug 2010

  12. Government debt - so how safe are sovereign bonds really? • Sovereign debt crisis is global • Private to public debt swap has to be ‘paid for’ • Increased taxes will raise sufficient revenue to cover the bill • Default • UK/English government has not defaulted on debt since 1594 • Other countries have • Gilts rank senior to all other government debt • ‘Financial oppression’ • Reneging on ‘unsustainable promises’ - pensions are an obvious target • Repaying debt in devalued money e.g. through unexpected inflation • Regulating institutions to purchase government debt at uneconomic prices • No insurance against financial oppression at current yields

  13. 14/10/10 18 16 14 12 10 8 6 4 2 0 -2 O N D J F M A M J J A S O N D J F M A M J J A S O UK MONEY SUPPLY M4 - 12 MONTH CHANGE SADJ Source: DATASTREAM UK 12M GROWTH RATE OF MFI STERLING NET LENDING EXCL.SECURITIS Inflation - money supply in ‘real’ economy contracting

  14. 14/10/10 5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 2006 2007 2008 2009 2010 UK YOUGOV/CITIGROUP-INFLATION EXPECTATIONS FOR THE NEXT 12 MONTHS Source: DATASTREAM UK YOUGOV/CITIGROUP-INFLATION EXPECTATIONS, NEXT 5-10 YEARS Inflation - UK long-term expectations still well anchored

  15. Rolling rates of real return - bonds and equities Source: Quilter, DataStream

  16. 14/10/10 80 10 8 60 6 40 4 20 2 0 0 -2 -20 -4 -40 -6 -60 -8 -80 -10 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 EXCESS UK EQUITY RETURN OVER 6M ROLLING PERIODS Source: DATASTREAM OECD LEADING INDICATOR,6M CHANGE R/H SCALE Equities - excess equity return determined by dataflow

  17. Equities - unlike governments, companies have plenty of cash European companies have plenty of cash Source: MSCI, Worldscope 900,000 20 Cash on balance sheet Cash as % market cap - rhs 800,000 18 Cash as % total assets - rhs : 700,000 : 16 600,000 14 500,000 12 Cash as % of Market Cap/Total Assets (%) Cash on Balance Sheet (€m) 400,000 10 300,000 8 200,000 6 100,000 0 4 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: Morgan Stanley European Chartbook 7 October 2010

  18. Cash flows are cheap to buy 10.0 Source: FactSet, Datastream, MSCI, Worldscope, IBES, Morgan Stanley Research 8.0 6.0 4.0 2.0 FCF Yield for MSCI Europe (%) 0.0 -2.0 -4.0 -6.0 -8.0 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010e Equities - company cash flow is strong Source: Morgan Stanley European Chartbook 7 October 2010

  19. Corporate balance sheets are strong 2.4 75 Source: FactSet, Datastream, MSCI, Worldscope, IBES, Morgan Stanley 2.2 70 Net debt to equity - rhs 2.0 65 1.8 60 1.6 55 Net debt to equity Net debt to EBITDA 1.4 50 Net debt to EBITDA 1.2 45 1.0 40 0.8 35 0.6 30 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010e Equities - company balance sheets are strong Source: Morgan Stanley European Chartbook 7 October 2010

  20. Equities - companies ready to ‘splash the cash’? Source: Morgan Stanley European Chartbook 7 October 2010

  21. Equities - UK dividend/corporate bond yield ratio Source: Citi Research European Portfolio Strategist 19 August 2010

  22. Equities - UK equity earnings/gilt yield ratio Source: Citi Research European Portfolio Strategist 19 August 2010

  23. 14/10/10 13 12 11 10 9 8 7 6 5 4 3 2 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 GILT YIELD CORP BOND AAA Source: DATASTREAM FTA 500 IND EARNINGS YLD CORP BOND BBB Equities - cheaper than corporate debt = M&A?

  24. 30% 20% 10% 0% -10% -20% -30% 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 20 YTD YRS ANN Income return Capital growth Equities - components of UK total return Source: FTSE All Share, DataStream, to end 21 September 2010

  25. The End of the Equity Cult - maybe not • Governments will grow their way out of the unsustainable debt position • Default unlikely, ‘Financial oppression’ almost a certainty • Regulation mean institutions set up to be the ‘fall guys’ • Inflation may be tame short-term, but it is NOT dead longer term • Structural investor selling will continue to dampen equity returns • Equity valuations provide a large risk premium for future uncertainty • Companies will take advantage of the valuation anomalies through M&A • Dividends provide shorter-term ‘reward’ for ‘carrying’ the risk

  26. Disclaimer This communication has been prepared only for the recipient and date shown on the front page. It is not intended for any other persons and should not be relied upon by other persons. This presentation has been prepared for information purposes only and is not a solicitation or an offer to buy or sell any security. It does not purport to be a complete description of our investment policy, markets or any securities referred to in the material. The information on which the presentation is based is deemed to be reliable, but we have not independently verified such information and we do not guarantee its accuracy or completeness. All expressions of opinion are subject to change without notice. Any reference to the Quilter model portfolio, which is used for internal purposes, is purely illustrative and should not be relied upon. All figures correct to 30 September 2010 unless otherwise noted. Investors should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return. You may not recover what you invest. Changes in exchange rates may have an adverse effect on the value, price or income of foreign currency denominated securities. Levels and bases of taxation can change. Investments or investment services referred to may not be suitable for all recipients. Quilter is the trading name of Quilter & Co. Limited. A member of the London Stock Exchange and authorised and regulated by the Financial Services Authority. Quilter is a private limited company that is registered in England No. 01923571. The registered office is at 20 Bank Street, Canary Wharf, London E14 4AD. Quilter is a wholly owned subsidiary of Morgan Stanley Smith Barney.  “Quilter” and the “Quilter” logo are registered Community Trade Marks and remain the exclusive property of Quilter & Co. Ltd. You are prohibited from using the Quilter marks for any purpose without the prior written authority of Quilter. Messages and telephone calls to and from Quilter may be monitored to ensure compliance with internal policies.

  27. The End of the Equity Cult? October 2010

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