lyxor strategy q1_2012 final

Quarterly Strategy

- First Quarter 2012 -

T O W A R D S N O R M A L I Z A T I O N

Business Cycle Asset Classes Alternative Strategies

Reflation is slowly gaining ground

The ECB’s new policy is a game changer

L/S Credit a key convictionground

US policy mix remains supportive in 2012

is a game changer

Deleveraging providing risks and opportunities

Adding risk selectively

Correlations still elevated, but declining quickly for now

No straightforward solution to the Euro crisis

Not all havens seem safe anymore

Lionel Erdely Jean-Marc Stenger

A global slowdown in inflation

Opportunities from pricing dislocations preferred

Corporate health not reflected in US High Yield

C R O S S A S S E T R E S E A R C H

yHead of Alternative InvestmentsLyxor Asset Management

gDeputy Head Alternative InvestmentsLyxor Asset Management

Scott MixonStrategy - Fund ManagementLyxor Asset Management

Jeanne Asseraf-BittonStrategy - Fund ManagementLyxor Asset Management

Florence BarjouStrategy - Fund ManagementLyxor Asset Management

– C R O S S A S S E T R E S E A R C H –

A l te rna t i ve Inves tments S t ra tegy

Lyxor AM Strategy views – 1st quarter 2012

Completed February 6, 2012

Any opinions contained in this document are those of the authors and are not given or endorsed by the company. This document does not constitute an offer or aninvitation to invest or purchase any financial instrument. The products herein mentioned are subject to various legal or regulatory restrictions. Lyxor Asset Managementand/or the authors of such opinions assume no fiduciary responsibility or liability for any consequences financial or otherwise arising from the subscription or acquisition ofthese products.

INVESTMENT STRATEGY

INVESTMENT STRATEGY 1st quarter 2012

Alternative Investments

Lionel Erdely Head of Alternative Investments +1-212-205-4010 [email protected]

Jean-Marc Stenger Deputy Head of Alternative Investments +33-1-42-13-70-08 [email protected]

Jeanne Asseraf-Bitton Strategy – Fund Management +33-1-58-98-10-98 [email protected]

Florence Barjou Strategy – Fund Management +33-1-42-13-71-82 [email protected]

Scott Mixon Strategy – Fund Management +1-212-205-4012 [email protected]

STRATEGY VIEWS Q1 2012

Business Cycle: Our central scenario remains that of a structural debt deflationary backdrop. Deleveraging is ongoing, and growth rates should remain below potential. Nevertheless, reflationary forces have recently gained ground, and progress has been made on the path to normalization. The improvement is striking in the US, where credit is again expanding. With elections looming in November, we expect fiscal tightening to be delayed until 2013. Economic momentum should thus remain supportive in 2012. Housing could offer a welcome positive surprise. In Europe, we do not expect any straightforward solution to the sovereign debt crisis. Many hurdles remain, and downbeat activity is one of them. Nevertheless, now that the ECB is de facto monetizing debt behind the scene, systemic risk has declined. More globally, we expect a synchronized slowdown in inflation. In developed countries, this will mean higher real rates. In developing ones, it will allow dovish monetary policies.

Asset Classes: Markets are likely to remain caught between the structural debt-deflationary backdrop in developed countries, central banks’ massive reflationary efforts and the recessionary impact of fiscal consolidation. We believe reflation should gradually gain ground. The major downside risk lies in the Eurozone where banks’ deleveraging could worsen the ongoing recession. However, the ECB’s backdoor quantitative easing has capped systemic risk, triggering a turnaround in market sentiment. The sharp relief rally has corrected extreme undervaluation but risk premiums remain attractive. We are shifting to a more constructive view and are selectively adding exposure. The road towards normalization should be detrimental to overvalued safe havens such as high grade sovereign bonds. We think U.S. corporate health is not yet reflected in credit markets that offer an attractive risk reward profile. We favor U.S. equity amid improving fundamentals. Yet, we are less cautious on Europe as the deep valuation gap with the U.S. should start to close. In particular, a better policy mix should support UK equities. Positive long term growth prospects, further monetary easing and undemanding valuation keep us positive on Emerging markets.

Alternative Strategies: We continue to see significant opportunities for managers in the L/S Credit space and for managers on the lookout for valuation mispricings and hard catalyst opportunities. Correlation and volatility are at lower levels than they were at the highs of 2011, which is currently benefitting hedge fund managers. Thoughtful managers recognize this good tone to the markets might not last forever – markets rarely move in a straight line - and manage their portfolios accordingly. We downgrade L/S Equity Quant managers to a Slight Underweight ranking.

Note: Black signals an unchanged view, Blue signals an upgrade, Red signals a downgrade.

Underweight Overweight

EUR Japan Equities CASH EM Equities US HY CreditGerman Bonds TIPS Commodities US IG Credit

Yen US Bonds Precious metalsEurozone Equities UK Equities US Equities

USDEU Credit

Underweight Overweight

Distressed CTAs Short Term Equity Neutral FI ArbCTAs Long Term L/S Equity Variable Global Macro

Stat Arb Merger ArbCB Arb L/S Credit

L/S Equity Long Bias Special SitsQuant Arb

2


ALTERNATIVE INVESTMENTS

TABLE OF CONTENTS

BUSINESS CYCLE ............................................................................................................................................ 3

REFLATION SLOWLY GAINS GROUND ................................................................................................................................. 3

Politics & policy dominate economics ........................................................................................................................... 3

Europe. A recession followed by chronic weakness ..................................................................................................... 4

No straightforward solution to the Euro Crisis, but receding systemic risk ................................................................... 4

Queuing up at the hairdresser. Is Portugal the next candidate for a haircut? ............................................................... 5

The credit crunch is unfolding in Europe ....................................................................................................................... 6

Europe. A supportive currency, at last? ........................................................................................................................ 6

US. Reflation progressively gains ground ..................................................................................................................... 7

US. No recession in 2012 ............................................................................................................................................. 7

Will housing be 2012’s positive surprise? ..................................................................................................................... 8

Emerging markets: supportive policy yet has to kick in ................................................................................................ 9

Inflation re-coupling across the globe ......................................................................................................................... 10

ASSET CLASSES ........................................................................................................................................... 11

TOWARDS NORMALIZATION ............................................................................................................................................... 11

Coming out from 2011, rescued by central banks ...................................................................................................... 11

How sustainable is the liquidity driven rally? ............................................................................................................... 12

All in all, we are becoming more constructive as the balance of risk is shifting .......................................................... 15

Not all havens seem safe anymore ............................................................................................................................. 16

Gold, a bet on monetary reflation ................................................................................................................................ 17

US high yield, a top conviction .................................................................................................................................... 17

Strategic and Quant views also agree on a neutral stance on Equity ......................................................................... 19

More upside left in U.S. Equity .................................................................................................................................... 19

A cautious upgrade on European markets .................................................................................................................. 20

Emerging equity: positive drivers ................................................................................................................................ 21

Oil and industrial commodities. Waiting for a short term catalyst ............................................................................... 21

Currencies under central banks’ influence .................................................................................................................. 22

ALTERNATIVE STRATEGIES ........................................................................................................................ 23

THE RETURN OF ALPHA? .................................................................................................................................................... 23

Correlation: High, but moving in the right direction for now ........................................................................................ 23

Convertible & Volatility Arbitrage ................................................................................................................................ 25

CTAs, Global Macro, and Fixed Income Arb .............................................................................................................. 27

Event Driven ............................................................................................................................................................... 29

L/S Credit .................................................................................................................................................................... 31

L/S Equity .................................................................................................................................................................... 33

DISCLAIMER ................................................................................................................................................... 35

3



BUSINESS CYCLE REFLATION SLOWLY GAINS GROUND

Our central scenario remains that of a structural debt deflationary

backdrop. Deleveraging is ongoing, and growth rates should remain

below potential. Nevertheless, reflationary forces have recently

gained ground, and progress has been made on the path to

normalization. The improvement is striking in the US, where credit is

again expanding. With elections looming in November, we expect

fiscal tightening to be delayed until 2013. Economic momentum

should thus remain supportive in 2012. Housing could offer a

welcome positive surprise. In Europe, we do not expect any

straightforward solution to the sovereign debt crisis. Many hurdles

remain, and downbeat activity is one of them. Nevertheless, now that

the ECB is de facto monetizing debt behind the scene, systemic risk

has declined.

More globally, we expect a synchronized slowdown in inflation. In

developed countries, this will mean higher real rates. In developing

ones, it will allow dovish monetary policies.

Politics & policy dominate economics

In 2011, political uncertainty has been a major hurdle on the path to economic recovery. The spiraling European debt crisis showed how detrimental the combined lack of governance and proactive political action could be. In the United States, the fiscal stalemate was at the root of the loss of the AAA credit rating.

In 2012, again, politics and policy will remain key to the economic outlook. 2012 will see a heavy agenda of elections both in the United States, with the presidential election coming up in November, and in Europe, with elections looming in several countries (including France, and Greece). In China, the 18th National Congress of the Communist Party will undergo a leadership change this autumn.

In our view, reflationary forces have recently been gaining some ground. However, the battle against structural debt deflationary forces has not yet been won. In such a context, policy and politics will set the trend. In the end, it is the commitment to reflation which will make the difference.

In Europe, we do not expect any straightforward solution to the sovereign debt crisis. Policy makers retain all their market disappointment potential and austerity is triggering a vicious and negative economic cycle. At the current stage, most deficit targets are out of reach. Yet, the ECB’s LTROs have offered significant breathing space to the banking system and are nothing else that quantitative policy in disguise. As for politicians, there is increasing awareness that restoring growth is paramount to restoring fiscal soundness. Even though we are far from positive on Europe’s economic growth perspective, we think systemic risk – which was reflected in last year’s extreme risk premiums in European equity

markets – has declined and that the worst has probably been averted. We remain of the view that the scenario of a Euro zone breakup has a very low probability. We think that Europe will (painfully) have to learn to live with fiscal austerity, depressed consumption and high interest rates. The central scenario is thus one of a painful and chronic muddle through. Yet, for investors, the absence of a full euro meltdown is positive in itself. A structurally downbeat macro environment can thus be consistent with some normalization in risk premiums (see our asset class section for our views on European equities).

In the United States, beyond the positive impact of short term factors, reflation is slowly gaining ground. The Fed remains committed to supporting the economy and will not hesitate to move if growth disappoints. Fiscal discipline will have to kick in at some point, but elections have never been won with recessions and we believe the fiscal retrenchment will come rather later than sooner. The US housing sector remains a wildcard, and, after nearly six years of contraction, a recovery would be a welcome upside surprise, putting the US on the path to a more sustainable recovery.

The recent recovery in economic momentum …

Source : Thomson Reuters

… has been broad based


03 04 05 06 07 08 09 10 11-125

-100

-75

-50

-25

0

25

50

75

Economic Surprise Index, G10

Jan08

May Sep Jan09

May Sep Jan10

May Sep Jan11

May Sep Jan12

-200

-150

-100

-50

0

50

100

150

Eurozone United States Japan Emerging Markets

4



Lastly, we think Emerging markets will not remain immune to the European growth slowdown. However, we continue to expect a soft landing and no hard crash. Inflation across the globe will recouple on the downside in 2012, and this trend change should be particularly visible in developing countries. In such a context, policy easing should gain momentum.

Europe. A recession followed by chronic weakness

Europe remains faced with many hurdles. Most of them will probably not be overcome in 2012. The sharp decline in industrial output and the plunge in leading indicators at the end of 2011 both underscored that the region probably fell back into recession during the fourth quarter of 2011.

Going forward, recent data has seen main leading indices, such as the European Commission’s business cycle and economic sentiment indicators bottom out, buoyed by a stronger momentum in the United States. In Germany, both the IFO and the ZEW have increased. As shown by the uptick in the Citigroup economic surprise index, the Euro zone has recently surprised to the upside. In our view, these “positive surprises” are linked, not so much to a strong underlying economic momentum, but to very downbeat forecasters!

Fiscal austerity, the high uncertainty generated by the sovereign debt crisis, a steep interest rate curve south of France and the credit crunch that will go hand in hand with the balance sheet adjustments in the banking sector, should all significantly dampen growth. Chronic weakness lies ahead for the Euro zone.

No straightforward solution to the Euro Crisis, but receding systemic risk

Ahead of last year’s October Eurogroup meeting, hopes were high for a decisive solution combining fiscal solidarity, credible medium and long term fiscal solutions, and official ECB monetization of sovereign debt. The Euro package fell short of these hopes. Chancellor Merkel and the ECB made it clear that there would be no “bazooka“ solution for the Euro zone. As disappointing as this was, we had to acknowledge that there would be no straightforward “Fed-like” solution to the European crisis.

Since then, we have nevertheless seen policy moves which, in our view, have contributed to an improvement in systemic risk.

First, funding strains in the euro area banking sector have, to a large extent, been addressed. The ECB’s three year LTRO which was massively subscribed by European banks (around EUR 480 bn for the January allotment) is nothing else but quantitative easing in disguise. This unconventional ECB move simultaneously targets sovereign debt markets and the banking sector’s profitability. The hope is that banks will use the funds to purchase sovereign debt and thus put an end to the

snowball effect of rising sovereign yields. At the same time, the LTRO offers banks an opportunity to prop up revenues. In our view, financing 3Y Italian debt yielding around 4.5% with a 1% funding seems an attractive, and, at the current stage, low risk opportunity. As for the US dollar funding squeeze, it has been alleviated by a coordinated world central bank move, which helped the Euro-USD basis swap spread recover from -160bps end November to a current -68bps.

The economic situation is improving only in Germany…


… and this is reflected is still strongly diverging economic confidence indices


The ECB implements quantitative easing after all


00 01 02 03 04 05 06 07 08 09 10 112.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

22.5

25.0

Spain Greece Portugal France Italy Germany

Harmonized unemployment rates, %

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

01 02 03 04 05 06 07 08 09 10 11 12

Dispersion in economic sentiment,all Europe

Excluding Greece

07 08 09 10 11 12

thou

san

d bi

llion

s

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3 Lending to Euro Area credit institutions (incl. LTRO) SMP Program Covered Bonds

5



Then, technocratic governments, especially in Italy, are working hard to push forward structural reforms putting the country on a sustainable growth and public finances path.

Lastly, there seems to be progressive recognition among European policy makers that pure austerity does not work. In the GIPSI countries, the cure has been worse than the disease. Austerity has contributed to pushing these countries in an even deeper recession, generating a massive contraction in fiscal receipts and a significant miss in deficit targets In January, for the first time since the start of the Euro zone debt crisis, “growth” has been discussed at a European summit. We know that governments have their hands tied by the weak economic backdrop. But the recognition that growth matters is a radical change of tone.

These positive developments have started to be reflected in long-term yields. In Italy and in Spain, long term rates remain high – too high for the current debt path to be sustainable – but have shown an improvement relative to last year’s peak levels. All this has helped issuance progress relatively smoothly, which, given the heavy calendar for 2012, and, in particular in Q1, is crucial to support confidence.

It is however too early to call the onset of a virtuous cycle, where restored market confidence would enable a sharp decline in yields, and per se put European public finances back on a sustainable track. Modest growth in Germany will not be sufficient to offset recession in other countries. Synchronized fiscal tightening; policy uncertainty and downbeat expectations should all weigh on growth, and thus fiscal perspectives. We see a high probability of additional sovereign downgrades, so that the path to lower sovereign rates in GIPSI countries should remain a volatile one.

Queuing up at the hairdresser. Is Portugal the next candidate for a haircut?

While spreads on Italian and Spanish debt have come off from their peak levels, Portugal has been in the spotlight since the start of the year. Ten year yields surged to nearly 16% end of January, pushing spreads on the German Bund to a high 1 400 bps.

The fiscal situation in Portugal is far from being as catastrophic as in Greece. Still, with a debt to GDP ratio that should move above 110% by 2012 (IMF and European Commission forecasts), the current level of interest rates implies a just as unsustainable debt path for the country.

Now, after a first bailout package in 2011, Portugal is meant to return to markets in 2013, to fund an estimated gap of around EUR 10bn (Bloomberg data). In our view, given the current prohibitive level of interest rates, Portugal’s return to the market as soon as 2013, seems out of reach. The country’s sovereign debt is now rated below investment grade by all three major rating agencies, while the weak economic backdrop (GDP is set

to contract by around 3.5% according to official forecasts) implies that current deficit targets should not be met. In our view, a second bailout package will have to be put up for Portugal.

However, the real question is if Portugal will follow Greece and if there will be a haircut with another significant Private Sector Involvement (PSI) on the country’s debt. We tend to attach a low probability to this outcome.

Contrary to Greece, Portugal has made progress on the path to fiscal sustainability. This has clearly been acknowledged by the IMF’s December review, where

Receding funding strains, even on USD markets


Euro LT rates: reversing the snow ball effect


First quarter gross bond issuance in the Euro Zone


-140

-120

-100

-80

-60

-40

-20

0

20

01/06 10/06 07/07 04/08 01/09 10/09 07/10 04/11 01/12

USD to EUR 1 Year Basis Swap

0110

04 07 10 0111

04 07 10 0112

5

10

15

20

25

30

35

40

Spain Italy Portugal

Greece

2.5

5.0

7.5

10.0

12.5

15.0

17.510 YR sovereign bond yields

50

58

64

24 23

711

0

10

20

30

40

50

60

70

GER FR IT SP NLD AUS BEL

6



another financing tranche was easily released1. The IMF underlined that Portugal was making “good progress”, while “renewed efforts and bold measures should ensure 2012 fiscal targets [were] met”. Even if the economy will contract sharply and suffer in 2012, the fiscal adjustment is way more balanced than in Greece. In Greece, revenue increases were meant to account for 60% of the adjustment, while in Portugal, two-thirds are to be driven by spending cuts. Austerity thus has a less recessionary impact. At the same time, structural reforms, such as the reform of the social security system have already been undertaken, and should deliver over the longer term. Fiscal credibility is therefore much higher for Portugal than for Greece.

Then, Europe’s credibility is at stake. The PSI in Greece was meant to be unique and exceptional. A bis repetita for Portugal could entail contagion to other European countries. Compared with the very limited amount needed by Portugal in 2013 (around EUR10bn), spill-over costs are asymmetrically too high.

All in all, we do not believe in a debt restructuring involving PSI for Portugal. The country will be kept under the IMF/EMU lifeline and make use of the ESM’s firing power.

The credit crunch is unfolding in Europe

Reduced credit availability is another hurdle the Euro Zone will find difficult to overcome. Contrary to the United States, where reflation seems to be progressively gaining ground, the regulator is crushing the nascent recovery in bank credit growth (see chart on the right hand side). The recapitalization requirements of the European Banking Authority are not only significant (estimated recapitalization needs are of EUR 115 bn), but, in addition, banks have very little time to comply with them, as the target is by end of June.

The Italian experiences show how difficult it is to directly tap the market for funding at current equity valuation levels. Retained earnings will not be sufficient to fill the funding gap. If banks indeed want to comply with the EBA’s requirements, they will have to shrink their balance sheet. This procyclical deleveraging will sharply undermine credit growth, result in a credit crunch, and put additional downward pressure on economic activity.

Europe. A supportive currency, at last?

Recent growth dynamics in the euro zone have been driven by a slight firming in domestic demand (consumer spending and investment). Not only is this quite unusual – on average, euro area recoveries have been driven by stronger exports – but it very much reflects Germany’s dominant weight in the region. In peripheral countries, domestic demand is, and will continue to be constrained by

1 Portugal currently benefits from a EUR78bn international rescue package with the troika (EU, IMF, ECB). The IMF accounts for EUR26bn of this package.

the sharp austerity measures taken to consolidate public finances.

A weaker currency, which would stimulate export competitiveness, would thus be very good news for all of Europe, as it would alleviate some of the negative pressure linked to a very downbeat domestic demand environment.

For most of 2011, the Euro has been surprisingly resilient. From August throughout October, in the midst of the

Portuguese public finances

Source : Thomson Reuters, European Commission

No reflation in Europe


A more supportive currency for European exports


96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13-12

-11

-10

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

0

10

20

30

40

50

60

70

80

90

100

110

120

Public debt, % GDP, lhsPublic deficit, % GDP, rhs

Forecast

92 94 96 98 00 02 04 06 08 10 12-8

-6

-4

-2

0

2

4

6

8

10

12

14

16

-1

0

1

2

3

4

5

6

7

8

9

10

11

12US, total bank credit, rhs

Euro Zone, credit to private sector, lhs

% YoY

02 03 04 05 06 07 08 09 10 11 12 0130

40

50

60

70

80

90

100

110

120

130

140

150

160

1.25

1.27

1.30

1.33

1.35

1.38

1.40

1.43

1.45

1.48

1.50

EUR/USD, rhs

Spread between 3mth EUR and USD money market futures

7



European debt crisis, the Euro still traded at an average 1.39 USD, before eventually falling to a (not so low) 1.26 mid January. As stated in our asset class section, we think these currency movements reflect a balance sheet tug of war between the ECB and the FED.

At the current stage, we tend to think that weak long term fundamentals and the latent sovereign debt crisis will warrant additional easing from the ECB. This will come through lower refi rates, additional sovereign bond purchases, and further significant liquidity provisions to banks. At the same time, the Fed has committed to zero interest rates until the end of 2014, but QE3 has clearly been delayed by the current strong macro data. This militates for USD strength vs. EUR weakness.

US. Reflation progressively gains ground

The recent newsflow continued to be positive in the United States, confirming that last summer’s recession fears were overdone. Our central scenario of a positive, but below potential, economic growth remains valid. Reflation seems to be progressively gaining ground, but the now structurally high unemployment rate acts like a dampener on activity. This is reflected in the Fed’s long term economic forecasts, where the central expectation for the 2014 unemployment rate still stands above 7%, a high level for US standards.

Key to our positive GDP growth expectation for 2012 is the contribution of fiscal policy and government spending. Although already slightly negative, we expect budget adjustments to be delayed until 2013, once the presidential election is out of the way. Deleveraging has been limited to the private sector, and, just as elsewhere, public finances have significantly deteriorated. For now, measures such as the extension of the payroll tax cut are alleviating some of the fiscal pressure, but the fiscal drag, and thus recessionary risks, should be higher in 2013.

US. No recession in 2012

The recent improvement in US macro statistics has partly been linked to the reversal of the same short term factors which had dampened activity during the summer, raising fears of a double dip recession. The industrial sector got a boost from a catch-up following the Fukushima supply side shock, while from a domestic perspective, the expanded tax deduction buoyed corporate investment. As these short term elements fade, growth generation will have to be driven by consumption.

On that front, disposable income trends will be crucial this year. In 2011, we have seen consumption increase even though personal income declined. For now, savings have filled the gap. However, in a context of historically low consumer confidence, high economic uncertainty, and a badly functioning labor market, the savings ratio is probably now close to a floor. Clearly, an acceleration in disposable income is now required. As fiscal policy will progressively be getting less and less supportive, it will be

up to the labor market to generate these additional income gains.

On that front, after some puzzling summer statistics, we have seen encouraging signs. The unemployment rate is down to 8.3%, a three year low, the four week average of jobless claims has consistently been below the 400K mark

Public finances are an issue in the US too

Source : OECD

Declining savings cannot finance consumption for ever


Federal Reserve economic and interest rate forecasts

2012 2013 2014 Long run

Real GDP

November ‘11 2.5-2.9 3.0-3.5 3.0-3.9 2.4-2.7

January ‘12 2.2-2.7 2.8-3.2 3.2-4.0 2.3-2.6

Unemployment

November ‘11 8.5-8.7 7.8-8.2 6.8-7.7 5.2-6.0

January ‘12 8.2-8.7 7.4-8.1 6.7-7.6 5.2-6.0

PCE inflation

November ‘11 1.4-2.0 1.5-2.0 1.5-2.0 1.7-2.0

January ‘12 1.4-1.8 1.4-2.0 1.6-2.0 2.0

Core inflation

November ‘11 1.5-2.0 1.4-1.9 1.5-2.0 n.a.

January ‘12 1.5-1.8 1.5-2.0 1.6-2.0 n.a.

Fed Funds

January ‘12 0.00-0.00 0.00-0.75 0.00-2.50 4.00-4.50

Source: Federal Reserve

04 05 06 07 08 09 10 11 12-13

-12

-11

-10

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

Euro Zone United Kingdom United States

Government net lending, % GDP

Forecast

92 94 96 98 00 02 04 06 08 10 120

2

4

6

8 Savings rate

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0Personal Income

Personal outlays

% YoY, 3mma

8



since mid November, and, since September, the US economy has added over 900K. Admittedly part of these supportive figures, and, in particular, the significant decline in the unemployment rate, is linked to a sharp drop in the participation rate. Clearly, the situation of the US labor market is far from rosy, and indicators such as the long term unemployment rate remain close to historical highs. But job creation has been improving and we expect it to remain on a positive trend.

It is a euphemism to say that corporations operate on very lean payrolls. Simultaneously, they are in very good shape and very cash rich. Hiring decisions have probably been postponed by 2011’s extreme uncertainty. Decision makers had to face a Tsunami, a debt crisis in Europe, and a political tussle around domestic public finances which eventually led to the loss of the domestic AAA credit rating. With the economy continuing to expand in 2012, hiring decisions will probably continue to materialize.

At the same time, still high excess capacities in the labor market imply that wage dynamics should remain quite tame. While this is supportive for corporate profitability, it conversely means less upside for household purchasing power. On that front, declining inflation (see below) should be helpful, offering a welcome support to real income.

In this context, oil remains a major risk. The January surprise decline in consumer confidence shows how sensitive spending will be to any drag on household budgets.

Will housing be 2012’s positive surprise?

Housing has now been in deep crisis for nearly six years. Since the 2006 peak, prices have lost approximately 35% (Case Shiller home price index), while the share of residential investment in overall GDP has dropped from over 30% beginning of 2006 to just 10% end of last year. The sector, either through employment, construction activity or wealth effects, has been a massive drag on the economy.

Symmetrically, a recovery in housing would be extremely supportive and put the US economy on a sustainable growth path. In particular, if housing does recover by 2013, this could offer a growth buffer to the new administration, so that a fiscal adjustment could be completed without risking a recession.

From a pure statistical perspective, the average duration of the current down cycle in the US housing market is already above average, which, by itself would argue for a progressive normalization. More importantly however, recent indicators have started to show signs of stabilization.

Foreclosures remain stuck at a high level, but seem to be very progressively coming off their historical peak. This has had a positive impact on the supply of both new and existing home sales. These have come down from a crisis high of nearly 13 months, to a “mere” 6 months. In fact, the

current level of excess supply is close to the series’ long term historical average. We are thus moving away from an extremely oversupplied market to a normally oversupplied one.

Building permits have shown a timid improvement, but, if excess supply remains on its normalization trend, then we would expect both permits and housing starts to stage a much stronger recovery. Thanks to both low prices and low interest rates, affordability stands at record highs. Contrary to Europe, bank lending standards remain in supportive

The US economy is adding jobs


Excess supply back from extreme to just being a drag


Low house prices and low interest = extreme levels in housing affordability


98 99 00 01 02 03 04 05 06 07 08 09 10 1115.0

17.5

20.0

22.5

25.0

27.5

30.0

thou

san

ds

-800

-700

-600

-500

-400

-300

-200

-100

0

100

200

300

400

ISM employment index (weighted average manufacturing and services index)

Change in Non-Farm Payrolls

88 90 92 94 96 98 00 02 04 06 08 10 12-10

0

10

20

30

40

50

60

70

80

903

4

5

6

7

8

9

10

11

12

13

NAHB housing market index

Existing home sales, months of supply (lhs, reversed)

76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 1260

85

110

135

160

185

Housing affordability

9



ranges (even though the latest Senior Bank Lending Survey showed a slight tightening in credit standards for non-traditional mortgages).

For now, recovery signals have been modest. But if these signals gain momentum and house prices start to improve again, then the US recovery would be on a much more sustainable footing. The combination of job creations in the construction sector, of positive wealth effects for households, and of a heightened profitability for the banking sector (as defaults decline and as the value of foreclosed homes sitting on the balance sheet increases), would be extremely supportive.

Emerging markets: supportive policy yet has to kick in

De-coupling has not taken place. Emerging markets have obviously suffered from the Euro Zone crisis. For instance, it is often forgotten that, after inter-Asian trade, Europe is China’s main export partner. Europe’s growth slowdown has thus had a very direct impact on activity in the developing world.

The trade channel has not been the only weak link between developing countries and Europe. As always, when fear increases, the region has been hit by short term outflows. As for FDI, the slowdown initiated mid-2010 gained momentum.

All in all, there is little reason to expect Emerging economies to decouple from the weak growth environment experienced by the developed world. And indeed, industrial output has sharply slowed in BRIC countries, while China’s PMI even fell below 50 in November. Emerging economies are thus obviously cooling.

However, we remain of the view that fears of a hard landing are overstated. In China, where authorities actively engineered a cooling in a bubbling housing market, the policy stance has shifted to easing. Authorities clearly stated that they have now become more sensitive to growth than to inflation. In Brazil, monetary policy rates have been cut by 200bps since last summer.

As underscored just below, this transition between a restrictive and a more dovish monetary policy has been allowed by a marked slowdown in inflation. Now that price slippage is not a risk anymore, authorities can indeed focus on growth.

For the moment, easier monetary conditions have not yet filtered through to hard data. Industrial output for instance, remains on a downward path in most developing countries. This, however, should come as no surprise, as the usual lags between a change in policy rates and activity are of six months on average.

Going forward, we expect more constructive news from EM economies. Supportive policy will start to kick in – witness the Chinese PMI rebounding back above the 50 mark – and the slight improvement in Euro zone leading

indicators should also have a positive impact. Simultaneously, we keep in mind that structural fundamentals remain extremely sound both on an absolute level and from a relative perspective (compared with developed market peers). China’s debt to GDP ratio currently stands at slightly below 20%, offering sufficient leeway to deal with non-performing loans and local government’s finances.

Obvious trade links between China and Europe


FDI flows are on a much softer trend


Industrial sector could be close to its cyclical trough


98 99 00 01 02 03 04 05 06 07 08 09 10 11-5

-4

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-2

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-30

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China, total exports % YoY, lhs

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03 04 05 06 07 08 09 10 11-100

-75

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Joint ventures Foreign enterprises Manufacturing Real estate

China, FDI by sector, % YoY

00 01 02 03 04 05 06 07 08 09 10 11-25

-20

-15

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0

5

10

15

20

Brazil Russia India China

Industrial ouput, % YoY, 3MMA

10



Inflation re-coupling across the globe

We have had a long standing view that, in an environment characterized by ongoing deleveraging and below potential growth, inflation would remain extremely tame. As the world recovered from 2008’s brutal crisis, Emerging markets were the one exception. Stronger fundamentals allowed the new economies to rapidly close the output gap, so that the growth generated in 2009 had an inflationary touch. In Brazil and China, inflation rapidly came back to the 6%-7% range.

Today, the focus has shifted away from inflation risks to growth risks. Emerging markets have also felt the impact of Europe’s debt crisis. Trade slowed, and financing partly dried up. Inflation in emerging markets has thus clearly peaked and is set to drop further.

The decline in inflation, which had already been recorded in developed countries (inflation should drop below 2% in Europe and in the US), has thus started to spread to emerging countries. 2012 will be a year of synchronized deceleration in inflation.

This generalized decline in inflation has two major consequences.

The first one is that across the globe, monetary policies will be dedicated to reflation and growth, while continuing to contain systemic risk. As underlined in our asset class section, this would, theoretically, be a perfect environment to create a new bubble in risky assets.

The second one is that, with monetary policy rates already at near extreme lows in most developed countries, the drop in inflation will mechanically push up real interest rates. This will not be the case in emerging countries, where we expect real yields to decline as additional monetary easing is implemented.

Box 1: Synchronized monetary expansion to continue. Our

expectations for major world central banks.

- In the US, QE3 has been delayed by more supportive data, but the

Fed will not hesitate to step in if required. If QE3 is implemented, we

expect it to address the housing situation, and to be centered on MBS

purchases

- The European Central Bank cuts rates as Euro Zone falls back into

recession and continues to “unofficially” purchase sovereign debt,

offering a systemic backstop to Euro zone banks

- The Bank of England steps up its asset purchase program

- EM central banks engage in additional easing as growth worries now

outweigh inflation fears

World manufacturing prices are plunging…


… directly impacting inflation in EM countries


World monetary policy is turning dovish


90 92 94 96 98 00 02 04 06 08 10 12-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

15.0

World, manufacturing prices, % YoY

98 99 00 01 02 03 04 05 06 07 08 09 10 11-2.5

0.0

2.5

5.0

7.5

10.0

12.5

15.0

China

Brazil

Jan10

Apr Jul Oct Jan11

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Apr Jul0

1

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3

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Brazil Russia India China Hungary Chili Poland Colombia Peru Thailand South Korea Taiwan

Central banks policy rates

11



ASSET CLASSES

TOWARDS NORMALIZATION

Markets are likely to remain caught between the structural debt-

deflationary backdrop in developed countries, central banks’ massive

reflationary efforts and the recessionary impact of fiscal consolidation.

We believe reflation should gradually gain ground. The major

downside risk lies in the Eurozone where banks’ deleveraging could

worsen the ongoing recession. However, the ECB’s backdoor

quantitative easing has capped systemic risk, triggering a turnaround

in market sentiment. The sharp relief rally has corrected extreme

undervaluation but risk premiums remain attractive. We are shifting to

a more constructive view and are selectively adding exposure. The

road towards normalization should be detrimental to overvalued safe

havens such as high grade sovereign bonds. We think U.S. corporate

health is not yet reflected in credit markets that offer an attractive risk

reward profile. We favor U.S. equity amid improving fundamentals.

Yet, we are less cautious on Europe as the deep valuation gap with

the U.S. should start to close. In particular, a better policy mix should

support UK equities. Positive long term growth prospects, further

monetary easing and undemanding valuation keep us positive on

Emerging markets.

Coming out from 2011, rescued by central banks

2011 stands out as one of the most volatile years for financial assets. Over the first half, markets resisted the Arab Spring that overthrew governments in the Middle-East as well as Japan’s nuclear disaster and continued to rally, buoyed by both positive economic momentum and the abundant liquidity provided by the Fed’s aggressive easing. Then, weaker growth prospects and policy failures precipitated a market dislocation over the summer.

The U.S. Congress failed to organize the fiscal consolidation needed to stabilize public indebtedness while Europe let the Greek crisis escalate into a euro debt crisis. As the ECB stayed vocal about its policy of not monetizing sovereign debt (contrary to the Fed or the BoE), markets focused on the structural flaws of the Monetary Union.

European leaders failed to overcome the lack of unified governance and once the principle of a soft restructuring for Greek debt was adopted, no credible alternative for Italy or Spain was agreed upon. Under German influence, European policymakers concerned by moral hazard and reluctant to engage into debt solidarity, urged troubled countries to accentuate austerity programs, further damaging their growth outlook, which in turn was compromising their debt stabilization efforts. The crisis of confidence spread to Italy and to the banking sector, a major holder of sovereign debt.

We took down risk as the contagion from the debt crisis hit core euro countries but kept some exposure (concentrated

on U.S. assets) as we remained convinced that mounting financial stress would force a decisive policy response.

In late 2011, European leaders disappointed again, only achieving a fiscal compact that reinforces the architecture and the governance of the Union.

But fortunately, central banks have come to rescue.

2011: no return for risk and return for no risk

Source : Bloomberg, Thomson Reuters, Lyxor AM

The ECB’s “no monetary financing” of EMU member nations…

Source : Thomson Reuters, Lyxor AM

... has meant no protection against a debt crisis

Source : Thomson Reuters, Lyxor AM

Dec10 11

Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec70

80

90

100

110

120

130

140Total Return in local currency

US Govies >10Y

US Credit 5Y

Japan Topix 150

World Stoxx 1800

US S&P 500

Gold ($/ounce)

Europe Stoxx 600

07 08 09 10 11 12 13 1475

100

125

150

175

200

225

250

275

300

325

350

Eurosystem(ECB + members' central banks)

Bank of England

(100 = June 2008) Federal ReserveCentral Bank Balance Sheet

Bank of Japanpushed forward 11 years

Jan10

Apr Jul Oct Jan11

Apr Jul Oct Jan12

Apr1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0EMU 10Y yield % (weighted average with GG Debt)

U.S. 10Y yield %U.K. 10Y yield %

12



A coordinated move has alleviated European banks’ dollar funding issues. Chinese authorities have cut the reserve requirement ratios. Moreover, without departing openly from its dogmatic stance, the ECB has finally decided unprecedented operations to secure banks’ medium term financing needs.

Monetary accommodation has triggered a rebound in investors’ confidence and 2012 is opening with a sharp rally in risky assets. Markets have been climbing a wall of worry, easily absorbing large issuances of euro area sovereign debt and overlooking the latest round of rating downgrades.

Mid-January, considering that policy initiatives had thus far not “produced a breakthrough of sufficient size and scope to fully address the Eurozone's financial problems”, Standard & Poor’s cut the credit rating of most Eurozone nations. Italy, Portugal and Spain were downgraded by two notches and contrary to Germany, France and Austria lost their AAA. Portugal’s debt rating, as speculative, pushed up yields to new highs but neither the cut of France’s rating, nor the related downgrade of the EFSF had a material and lasting impact on markets. Moody’s and Fitch’s confirmation of France’s top rating probably reassured investors while markets were fuelled by central bank liquidity.

Indicators of liquidity strain (euro basis swap, TED, LIBOR-OIS spreads …) eased, market based measures of risk (VIX and credit spreads among others) dropped and equity (MSCI world index) gained 4.2% over January. Extreme risk aversion has now reversed, stock markets are no longer in oversold territory but valuation remains attractive.

How sustainable is the liquidity driven rally?

Restoring market confidence is in itself a sizeable achievement and it could continue to support the rally in the very short term. Also comforting, for once the recovery is not restricted to defensive assets but benefiting cyclical assets the most: Emerging markets performed better than developed ones, the German DAX outshined the Euro Stoxx 50, NASDAQ outperformed S&P 500, mid-caps beat large caps etc....Looking forward, we believe a number of issues will likely drive asset performance.

1) First and foremost, major central banks are not done with their unprecedented reflationary measures.

Starting with Europe, we think the latest ECB’s initiative is a game changer. To be sure, the ECB is not giving up on its adherence to EU treaties that ban the central bank from lending to governments. Its SMP program stagnates just above €200 billion of sovereign debt carefully sterilized by weekly collections of fixed-term deposits from banks. However, the introduction of the three year long term refinancing operations (LTRO) to shore up the banking system represents a significant breakthrough, which we believe, reduces systemic risk substantially.

The first operation, conducted on 21 December 2011, awarded to 523 credit institutions €489 billion, of which about €200 billion was additional lending, the rest being a shift from previously allotted lending of shorter maturity. Total lending to banks now stands at about €800 billion while banks’ recourse to the ECB’s overnight deposit facility has jumped to close to €500 billion. The central bank’s analysis of the bidding behavior at this operation shows that the large amount of liquidity obtained by banks can be viewed as a reflection of their refinancing needs over the coming three years.

Dollar funding pressures are receding

Source : Bloomberg, Thomson Reuters

Risk appetite is returning

Source: Bloomberg, Thomson Reuters

The ECB keeps sterilizing its SMP program...

Source: Bloomberg, Thomson Reuters, Lyxor AM

Jan08

May Sep Jan09

May Sep Jan10

May Sep Jan11

May Sep Jan12

-300

-250

-200

-150

-100

-50

00

50

100

150

200

250

300

350

400

450

500

USD to EUR Basis swap 3M (inverted RHS)

TED Spread 3M (LHS)

Jan08

May Sep Jan09

May Sep Jan10

May Sep Jan11

May Sep Jan12

0

50

100

150

200

250

300

350

400

10

20

30

40

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90CDS Spreads on European Financials (RHS)

Volatility index VIX (LHS)

w31 w33 w35 w37 w39 w41 w43 w45 w47 w49 w51 w1 w311 12

50

75

100

125

150

175

200

225

Fixed-term deposits from Banks (€ billion)

The liquidity providedthrough the SMP is absorbed by weekly collections of fixed-term deposits

ECB Securities Markets Program (€ billion)

13



Indeed, about €1500 billion of bank debt is due to mature before 2015. In 2012 alone, banks have to pay back €560 billion, of which €210 billion will fall due in the first quarter. They will have to borrow fresh money to service that debt but so far this year, only highly rated northern European banks have been able to sell covered bonds and senior unsecured debt. The ECB had already addressed part of the problem with its second €40 billion Covered Bond Purchase Program that has come on top of the €60 billion purchased through the first program. The ECB is reviving that segment of the debt market but it is insufficient to place bank funding on a stable footing.

The LTROs with full allotment and the dramatic change in collateral rules should do it. Some institutions may not be able to access central bank refinancing as they are running short of high quality collateral while others need to keep quality collateral for use in the private market. So the ECB has eased its collateral rules. Lower rated asset backed securities are accepted and the constraints on non-marketable securities (mainly bank loans) are loosened. The later change concerns funding by national central banks as the ECB does not want to bear the additional risk on its balance sheet. It seems the relaxed rules on bank loans were not yet effective for the December LTRO but they should apply for the second LTRO on 29 February 2012.

Mario Draghi, the ECB’s president, has suggested that the take-up for February’s LTRO could be slightly lower than for the first tranche. Incentives are high for most banks to borrow large amounts to cover their needs, while some should be tempted to play a “carry trade” by tapping the ECB’s cheap loan facility to invest in more rewarding short-dated sovereign debt in their home markets. Barclays Capital forecasts that apart from the rolling of existing operations, new borrowing for funding reasons and carry trade purposes could add up to €375 billion. We believe the second LTRO will surprise on the upside.

Clearly, the ECB’s move is a massive quantitative easing program. The vast amount of free reserves deposited at the ECB’s overnight facility will help banks fend off any liquidation pressures from depositors or creditors. True, the program does not solve banks’ capital adequacy problems but it buys time for institutions to raise capital, thus limiting a deleveraging process that could turn into a severe credit crunch for the Eurozone economy.

Across the channel as well, monetary policy remains biased towards more quantitative easing. In a recent speech, Bank of England Governor Mervyn King said “with inflation falling back and wage growth subdued, there is scope for interest rates to remain low, and, if necessary, for further asset purchases, to prevent inflation from falling below the 2% target."

The U.S. Federal Reserve is not outdone. As announced after the FOMC held on 25 January, the Fed pledged to keep rates exceptionally low at least through late 2014 (versus mid-2013, as previously indicated). Also it decided

to continue its program to extend the average maturity of its holdings of securities. It is not QE3, but in our view the commitment to keeping short term rates low for longer should count as easing. Interestingly, data published alongside show that 11 board members would begin raising rates before the end of 2014. The inconsistency with the dovish statement leads us to think that Chairman Bernanke is clearly dominating Fed’s policy.

The major central banks, including the ECB, keep showing their determination to fight debt deflationary pressures, which we believe, is a positive for financial markets.

…but has started its own form of quantitative easing

Source: Thomson Reuter, Lyxor AM

A hefty debt maturing schedule for Eurozone banks

Source: ECB, Lyxor AM

Chairman Bernanke defeats FOMC dissent

Source : Federal Reserve, Lyxor AM

02 03 04 05 06 07 08 09 10 110

100

200

300

400

500

600

700

800

900

ECB Lending to Banks

Deposit Facility

0

50

100

150

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1Q12 3Q12 1Q13 3Q13 1Q14 3Q14

Covered bonds & others Senior unsecured debt

0

0.5

1

1.5

2

2.5

3

3.5

4

2012 2013 2014

Target Fed Funds Rate at year-end

Estimates from FOMC participantsGuidance from FOMC statement

14



2) Lots of negatives about world growth are already priced in

The IMF has just released an update of its world economic outlook. Clearly, prospects are dim with a global expansion being revised down to 3.3% in 2012 and 3.9% in 2013. The Eurozone is now seen as entering a mild recession as a result of banks’ deleveraging and fiscal consolidation, and the U.K. is facing quasi-stagnation. The pace of activity in new economies is expected to slow amid the worsening external environment and weakening internal demand. U.S. growth is expected to stay sluggish. Though the Fed is forecasting slightly higher numbers for the U.S. economy, it has also revised down its projections and believes the expansion will remain modest.

But those negatives are old news. Conversely, the January surveys recently published (IFO or PMI in Europe and Asia, ISM manufacturing in the U.S. …) surprised on the upside, suggesting that confidence is bottoming, which is a good omen for activity.

At this stage we consider that three issues related to growth are likely to significantly impact markets’ behavior:

- A revival in the U.S. housing market would be supportive. Reflationary policies seem to bear fruit in the U.S. where the labor market is improving and credit growth is returning. The public sector is unlikely to contribute much to growth for many years but an upside could come from the housing sector (see Business Cycle section). Bold policy measures are needed to unlock the refinancing logjam and the coming elections could be a trigger for the Obama administration.

- The major downside risk lies with the Eurozone. Austerity is taking its toll on southern economies and the euro depreciation is not sufficient to boost export competitiveness. Credit is stalling in the Euro area and bank lending surveys show that credit standards could tighten further in the coming months. Obviously, the banks’ deleveraging necessary to reach the new capital requirement by 30 June could severely worsen the credit decline and deepen the ongoing recession. As discussed above, the ECB’s new policy should alleviate that risk. However, we believe it remains a major tail risk as it would not only hit Europe but also endanger the emerging economies that could not be immune to a deep European recession.

- Whether China stays on a soft landing path will also be critical. Markets’ consensus view is that authorities are capable of perfectly managing the economy and we tend to agree. While keeping credit in check to avoid reigniting the housing bubble, policy is starting to ease to promote internal demand. However, we do not want to be complacent as risks remain, especially as we perceive a change in the central bank behavior which let the Yuan appreciate despite weakening export growth. Will the PBoC stay behind the curve? Inflationary pressures hold the key.

3) Disinflation will help

CPI inflation has already peaked and we believe the general decline in inflation will continue across the globe, supporting consumer purchasing power (see Business Cycle section). It does comfort developed countries monetary authorities in their fight against debt deflationary pressures. But it is most important for emerging economies that are not confronted with debt deflation issues, as it should allow their central banks to engage in additional easing without compromising their main objective of keeping inflation under control.

4) Geopolitical and policy issues have not disappeared and will bring their share of uncertainty

Escalating tensions between Iran and the West are worrisome. Washington and the European Union imposed tough sanctions to force Iran to provide more information on its nuclear program. In response to EU's decision to stop importing crude from Iran from July 1, Tehran is threatening to cut off oil supplies to the EU immediately.

Though the EU accounts for about 25% of Iranian crude oil sales, the global oil market should not be overly disrupted as Saudis have made it clear that they'll step in to fill the void. This soft scenario is priced in current and future oil prices. But an escalation into military conflict triggered

Real yields are discounting major growth worries


Equity markets overly pessimistic on the economy?


96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11-1

0

1

2

3

4

5

United States United Kingdom

Implicit Real 10Y Yield

07 08 09 10 11 12-125

-100

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25

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20

30

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50G10 Economic Surprise Index(Citigroup, RHS)

World MSCI Index(6M %, LHS)

15



by the closing of the vital Strait of Hormuz shipping lane should be more disruptive for both the economy and the financial markets. We believe such a risk should not be disregarded.

EU policy has yet to address sovereign financing decisively. Progress is being made regarding the Greek debt swap deal. Private investors, that hold about 60% of Greece’s €350 billion debt, would reportedly accept an average coupon of as low as 3.6% on new 30-year bonds, which equates to a loss of more than 70% on the net-present value of Greek debt.

However an accord with bondholders is tied to a second bailout from Europe and the IMF. Greece is said to require now €145 billion, which is €15 billion more than was agreed in October whereas the IMF wants Greece to go further in overhauling its economy. As IMF Managing Director Christine Lagarde put it, the rescuers “are not terribly positive about what has been done”. European policy makers are considering a possible condition of the bailout that includes a direct intervention in Greek budget decisions, an option obviously rejected by Athens as being contrary to national sovereignty.

We have been accustomed to policy failures when it comes to solving the Greek crisis. This time, a failure would mean a disorderly default on 20 March, when Greece will face a €14.5 billion bond payment. We believe such an outcome should be avoided but we do not think it is a negligible risk. As discussed in the Business Cycle section, other issues regarding Portugal in particular, and more generally the EFSF / ESM sizing and mechanism will most certainly remain a source of volatility.

Also, we keep in mind that 2012 will potentially see major political transitions. Presidential elections are due in Russia in March, in France in May and in the United States in November while China is electing a new Central Committee in the second half of the year. In election years, challenged incumbents may make unexpected decisions and we don’t rule out undesirable moves.

All in all, we are becoming more constructive as the balance of risk is shifting

We believe that central bank supportive stance around the world is reducing systemic risk conclusively and that odds are higher that reflation will progressively gain ground. This should help a gradual normalization in financial markets and allow assets to trade somewhat closer to their fundamentals. However, we think the process may prove arduous as major tail risks remain on policy challenges facing the Eurozone, on European growth and on the geopolitical front. We are strategically adding risk in a cautious and selective way. In the present environment, the search for yield and the search for growth will likely prevail. We keep our overweight stance on credit and

2 Lyxor Quant Research contacts: Karl Eychenne, [email protected].

move to a neutral position on equity at the expense of high quality government bonds.

Interestingly, Lyxor Quant Research proprietary macro signals are progressively building a case for equities against bonds. The message contrasts with the past three quarters when views embodied in signals were very positive on bonds against equities. This move from elevated risk aversion to limited risk appetite is consistent with abating downside economic risks but not with a firm recovery.

A rise in oil price is equivalent to an additional tax

Source: IMF, Lyxor AM

Eurozone. No solution so far for sovereign financing

Source: Thomson Reuters, Lyxor AM

Lyxor Quant signals start to favor equity over bonds

Source: Lyxor Quant Research2

0%

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8%

9%

72 76 80 84 88 92 96 00 04 08 12 E

110

Oil pricein 2012$ barrel

World oil expenditure % GDP

130

90

Sep09

Dec10

Mar Jun Sep Dec11

Mar Jun Sep Dec12

0

5

10

15

20

25

30

35

Greece Portugal Ireland Italy Spain France Germany

10Y Government Bond Yield

16



Not all havens seem safe anymore

The structural debt deflationary backdrop in developed countries with sub-par growth and low inflation argues for continued low bond yields. However, risk aversion has pushed high quality government bonds into extreme overvaluation. To be sure, U.S. Treasuries will continue to benefit from major flights-to-quality usually triggered by unexpected shocks or geopolitical tensions. Such events could include a bank failure, Greece’s outright default or an escalation of the conflict between Iran and the West. In such cases, yields could probably fall back to their 2011 lows, below 1.75% for the 10Y yield.

Presently, U.S. 10 year government bonds are yielding less than 2%, much below the current nominal 3.7% growth rate of the economy. Looking ahead, activity will likely stay moderate but nominal growth should persistently exceed 4%, further stretching bond valuations. As risk aversion recedes, improving momentum on the U.S. economy should push yields back up towards their long term trend to at least 2.5%.

However, we believe that the downside on U.S. Treasuries is more modest than suggested by economic fundamentals. The Federal Reserve is particularly concerned by the housing situation and ideas about federal policies capable of reviving the sector have been the subject of more than one speech from FOMC members. Besides calling for a decisive move from the administration, the Fed keeps targeting long term rates by anchoring very low expectations on short term rates until late 2014 and pursuing its “twist” policy which extends the average maturity of its holdings. As the saying goes “Don’t fight the Fed”. We won’t and keep a close to neutral exposure on U.S. Treasuries.

German Bunds are a different story. So far they have been investors’ favored asset whenever the euro debt crisis was worsening and it could continue to be the case in the short term. However, their risk profile seems quite asymmetric to us. They would offer value if the euro were to breakdown, but we don’t attach a high probability to that outcome. On the contrary we believe there is a significant chance that Germany will finally be called into some form of solidarity to solve the euro debt crisis, which is not reflected in current Bunds’ valuation. Policymakers still have many obstacles to overcome before they find a credible solution to sovereign financing in the Eurozone but market pressure should help. The spread between Italian and German yields will likely continue to narrow as progress is made.

Views on bonds have been downgraded by Lyxor Quant signals from very positive over the summer to slightly negative now. Details of the proprietary signals show that both reassuring economic data and unfavorable market sentiment explain the downgrade. For the coming weeks, the signals suggest that the bond rally is over. However, the asset class is not expected to underperform

significantly. In other words, bond yields should post a limited increase from their historically low levels.

In terms of countries, contrary to our strategic views, the quant signals favor German over U.S. bonds. During 2011, Treasuries and Bunds signals exhibited a similar profile. Both were strongly positive over the summer, thanks to the surge in risk aversion and rising downside risks on the economy.

Since the beginning of the year, U.S. views were downgraded the most, from positive to negative, whereas views on German bunds only became quasi-neutral. These

US 10 year yield in a long bottoming phase?


The return of risk appetite, a threat for bonds


Bonds downgraded by Lyxor Quant signals

Source: Lyxor Quant Research

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 120.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

US 10Y yield & Trend

Jan08

May Sep Jan09

May Sep Jan10

May Sep Jan11

May Sep Jan12

50

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US 10Y Yield (detrended %, RHS)

Volatility Index VIX (reversed LHS)

17



changes are consistent with signs that the U.S. expansion was firming while data on the Eurozone remained mixed.

Gold, a bet on monetary reflation

Industrial demand for gold, mostly from the electronics sector, should stay fragile in a weak economic backdrop, particularly if China’s slowdown is set to continue. Demand for jewelry which is known for being price sensitive could also be strained. However, the decrease in inflation in emerging countries and in particular in India, a large buyer of gold, should be favorable through its impact on both disposable income and consumer sentiment. Beyond those factors of influence, we believe the main determinant of gold prices will remain investment demand.

Gold is often thought of as a safe haven when it comes to hedging against event risk. It did provide an excellent protection against the market dislocation over the summer 2011 but its price dropped like a stone in September and seemed to have become correlated with risky assets. This change in behavior coincided with the Fed’s “operation twist” announced on 21 September which disappointed hopes of a “quantitative easing” n°3. This comforts us in the view that investment demand in gold is mostly driven by central banks’ unprecedented reflation efforts.

Clearly, there is no opportunity cost of holding gold when real interest rates are zero or negative. Also, as monetary authorities keep printing money to fight deflationary pressures, the risk of a comeback in inflation down the road increases, making gold attractive as an inflation hedge. Last but not least, the unorthodox quantitative easing programs have damaged the quality of central banks’ balance sheets, thereby weakening the strength of the major fiat currencies.

The reserve status of the dollar and the euro is being challenged. While industrial countries are no longer selling gold, emerging economies are building their gold reserves which have surged by more than 30% since 2008 after stagnating during the previous two decades. And the stockpiling is likely to last; the tonnage of gold reserves held in new economies is still dwarfed by that owned in developed countries. Continued central banks’ purchases will bite into the supply of gold to the market.

The ECB will continue to grow its balance sheet through its second three year LTRO whereas the Bank of England has alluded to expanding its asset purchase program to promote the ailing U.K. economy. Though it remains an option, the Fed has chosen to postpone QE3. We think it is worth keeping a position in gold as long as further monetary reflation lies ahead. Tactically, the recent run up leaves the market exposed to a correction.

US high yield, a top conviction

The start of the year rally has benefited to all credit markets. Spreads tightened markedly on both the investment grade and speculative segments, in cash and

CDS markets. The squeeze was more intense in Europe where financials were boosted by the return in risk appetite. Total returns on Eurozone credit (iBoxx overall corporate index) as well as U.S. credit (Dow Jones corporate composite 5Y) came close to 3% in January.

Our central scenario for the world economy of sluggish growth, low inflation and easy money remains constructive for the overall credit asset class. Yet, we differentiate our rankings by region and ratings as we find valuation and risk-profile disparities.

Structural forces are backing gold price


More central banks purchases to come


Credit markets start of the year rally (spread changes over January)


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18



We have upgraded U.S. high yield credit from a slight to a strong overweight. The high yield segment is known to exhibit a seasonal pattern. According to Barclays Capital, January has produced an average excess return greater than 1% over the past 20 years (with a 95% confidence level). Clearly, we are not extrapolating last month performance for the rest of the year. But we do believe that U.S. high yield corporate bonds offer an attractive risk return profile.

The U.S. economy is set to expand at a moderate pace and there are signs that the Q4 strong patch is coming to an end. As discussed above, Fed’s policy is still biased towards easing and the withdrawal of monetary accommodation will not be an issue before long. The Fed is managing long rates expectations, thereby limiting the basis risk for credit yields. In addition, this abnormally low rate backdrop will continue to feed the search for yield and benefit to the asset class.

U.S. corporate health should also remain supportive. Business is keen to reduce risk and strengthen balance sheets in the face of a modest expansion. Profits margins have surged to new highs and the erosion we foresee in 2012 should stay marginal as long as economic growth is sustained. Balance sheets are extremely liquid as evidenced the high level of liquid assets. However, at this stage of the economic cycle, we think it is important to carefully monitor early signals of a possible change, such as credit rating transitions that have often led default rates.

According to Bank of America Merrill Lynch, default rates on U.S. high yield should gradually increase from 1.9% at the end of 2011 to an average of 3% this year. Assuming no change in the present 30% recovery rate, the net default loss would amount to 2.1%. With current spreads still hovering above 650 bps (Merrill Lynch HY OAS index), valuation looks very attractive.

U.S. investment grade should be less rewarding on this matrix. Spreads have already fallen back close to their spring 2011 levels and they offer less protection against the risk of a negative basis effect of firming Treasury yields. That being said, we are still comfortable with a slight overweight, contrary to European credit on which we remain cautious.

The ECB’s innovative program combined with signs that sentiment was bottoming have led the recent rally but the fundamental backdrop is challenging to say the least. Corporate profitability is vulnerable to the poor economic prospects. Risks are high that fiscal consolidation and banks’ deleveraging deepen the ongoing recession, which weighs on the risk-return profile of European credit.

Lyxor Quant signals do favor credit over government bonds. The past few months saw a progressive upgrade of quant credit views from negative up to positive in January 2012. The move was consistent with the upgrade of equity versus bonds views during the same period, but was much more pronounced.

For the weeks to come, quant signals indicate that credit products should outperform sovereign issues. Moreover, this positive call for credit is stronger than the call for equities versus bonds.

Within credit, US High Yield quant signals are now in very positive territory. Views have shifted from negative on average during 2011 to very positive since the beginning of the year. Again, the upgrade was much more pronounced than for equities, which is consistent with a higher potential upside in terms of valuation.

U.S. corporate balance sheet liquidity is great


U.S. credit spreads at odds with corporate health


Lyxor Quant signals favor US High Yield


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Strategic and Quant views also agree on a neutral stance on Equity

As we mentioned earlier, we believe the ECB and other major central banks’ aggressive easing has shifted the balance of risk, increasing chances that reflation will progressively win over debt deflationary forces. While acknowledging the many tail risks on the economic and policy fronts, we are cautiously increasing risk, raising our ranking on equity from underweight to neutral.

There again, Lyxor Quant signals reached the same conclusion. During the last quarter, quant equity signals have improved gradually from negative to quasi-neutral. An in-depth analysis of contributions shows that the move is mainly explained by reassuring economic news flow across regions while market sentiment declined. Looking ahead, quasi-neutral signals suggest equity should stay range bound. However, the dynamic seems positive.

Quant equity signals clearly preferred U.S. over Europe from 2010 until the summer 2011, which was coherent with the economic and earnings growth differentials. Now, despite large swings in the euro dollar exchange rate and more supportive US economic data, equity signals have become indifferent between US and European markets.

We have not. We have scaled up European equity a notch from a strong to a slight underweight but we continue to favor U.S. equity, ranking it a slightly overweight.

More upside left in U.S. Equity

The Q4 earnings season is well advanced with more than half of the S&P 500 companies having reported. Negative preannouncements had depressed expectations, allowing less disappointment as weak results were published. So far, about 60% of companies have beaten expectations, which is well below past quarters. Also earnings growth has lagged the advance in revenues, highlighting a slight contraction in corporate margins.

Historically high margins have indeed reached an inflexion point and worries are mounting. However, we believe margin compression will stay modest in 2012. Inflationary pressures are abating, compensation costs are unlikely to accelerate while unemployment stays elevated. Low interest rates and solid balance sheets should prevent debt servicing from rising. Our central scenario of moderate activity should allow a 5% top line growth, with some upside if the housing sector recovers. Bottom-up consensus estimates for the S&P 500 show 11.4% EPS growth over the next 12 months, which seems to us overly optimistic. We are not of the view that corporate profits will fall but rather that they will grow in 2012 at a slower one-digit pace, as the cycle matures.

Multiple’s expansion is not out of reach. Adjusting PE ratios for peak earnings shows that valuation is not cheap. Our calculation gives a PE above 20 times 2011 earnings rather than the non-adjusted 14. Yet it is not expensive given the low yield environment. Other fundamental

Lyxor Quant Equity signals have turned neutral


Not much risk on U.S. earnings


U.S. Equity. Adjusted PE ratio looks less cheap…


…but valuation remains undemanding


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measures such as the Tobin’s Q ratio show that valuation is undemanding. Extremely low valuation measures relative to bonds or cash are obviously distorted by the structural debt deflationary backdrop. However, they could fuel positive flows into equity markets. Equity mutual funds have suffered continued withdrawals mainly to the benefit of bond funds. Should market stress ease further or at least not rebound, the process is likely to revert with a gradual shift back into equity. Evidence does suggest that equities are still under-owned.

The broad based rally will probably morph into a more selective uptrend. Our constructive views remain intact, backed by the sustained economic expansion. In that regard, 2013 should be more challenging as policy tightening will be hard to avoid. This issue may focus investors’ attention later this year. It casts a shadow on our long term view on U.S. Equity.

A cautious upgrade on European markets

The euro debt crisis is not over and sovereign funding is still an issue. True, Italy and Spain can sustain their current borrowing costs, even assuming that yields return to their recent strained levels. The compounded net rise in their debt service costs over the next 5 years would bring interest payments to about 6.5% GDP for Italy and close to 3% for Spain. Obviously, it would cripple both economies but odds of a default would stay low. This leaves policy with the responsibility of avoiding a crisis of confidence and the associated spiraling effects. So far, policymakers have failed but the ECB has stepped in successfully. Yet, time is running out for Greece that will soon face a large redemption and pressures keep mounting on Portugal.

Beyond policy risks, Eurozone equities are threatened by poor growth prospects, amid continued fiscal restraint. The ongoing recession is hurting companies, as shown by the disappointing start of the Q4 earnings season. Credit is contracting and Q1 bank lending survey shows a sharp tightening of credit standards that endangers the economy.

Tail risks keep us cautious on Eurozone equity. However we have upgraded our ranking to a slight underweight on both risk and valuation grounds.

We have described at length why we think the ECB has secured credit institutions’ funding, thus putting a floor under banks’ valuation and capping systemic risk. It should help Eurozone stocks escape the deflationary path they were following and emerge from value traps.

The valuation gap with the U.S. has become compelling. The Euro Stoxx index trades at 10.2 times 2012 estimated earnings versus 12.7 for the S&P 500, which represents a 20% discount. We agree that Eurozone earnings are more at risk given the bleak economic outlook but we do not think they deserve such a high risk premium.

UK stocks are valued like Eurozone equities, the PE ratio on the FTSE 100 index being 10.3 times 2012 earnings.

The UK economic backdrop is hardly better with GDP contracting in Q4 and below 1% expected growth in 2012.

However, U.K equities should benefit from one of the best policy mix. There is no doubt about the BoE’s pro-growth stance and additional asset purchases lie ahead, should the economy falter. Correlatively, sterling will stay weak, thus supporting British companies’ competitiveness.

The BoE is efficiently buying the time required for policy to restore public finances. Importantly, UK policymakers have already designed a credible solution to put public finances on the right track. The public deficit is projected to fall

The ECB should help escape the deflationary path

Source: Bloomberg, Lyxor AM

The sector behavior reflects an optimistic scenario


United Kingdom, a favorable policy mix


Jan09

Apr Jul Oct Jan10

Apr Jul Oct Jan11

Apr Jul Oct Jan12

70

80

90

100

110

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150 Stoxx 600 Euro Cyclicals Stoxx 600 Euro Defensives

Feb11

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S&P 500 Euro Stoxx Broad UK FTSE 350

Equity price return - Banks relative performance

21



gradually from 8.4% GDP this year to 2.9% in 2015-16. The cuts are rather back-end loaded to protect the fragile activity of the next quarters. Bond markets are reassured and show no sign of stress but equity valuation has yet to reflect those positive fundamentals. We think UK equities deserve to be considered separately from the Eurozone and we rank them a notch higher with a neutral rating.

Emerging equity: positive drivers

We emphasized in late 2011 that emerging markets (“EM”) had been too severely punished by the spike in risk aversion. Unsurprisingly, the return in risk appetite has benefited EM the most. Since the beginning of the year and as of February 2nd, the MSCI Emerging markets index has gained 9% in local currencies, to be compared with a gain of 5.6% for the MSCI World index that only covers developed countries. The nice outperformance is not driven only by the recovery in investors’ sentiment.

The economic data news flow on EM has kept surprising to the upside, staging a significant advance over G10 countries. Asia has stopped disappointing and Latin America is providing its share of good news. The January purchasing managers indices recently released suggest that manufacturing activity could be bottoming as business sentiment recovers. China’s export sector is still vulnerable and real estate development, targeted by policy tightening, has deteriorated dramatically. Yet, China’s economy appears more resilient that anticipated and risks of a hard landing are fading.

Compared to previous downturns, Chinese policy may appear behind the curve. Authorities remain eager to contain the credit expansion and prevent a renewed surge in housing prices but they have also shown their dedication to preserve growth. We stick to our central scenario of a soft landing in China. Elsewhere in Asia and Latin America, policy seems also less willing to ease aggressively. We believe there is a gradual shift in focus from devaluing the currency to support exports towards boosting internal demand. It should be favorable to both local currencies and equities.

We stay constructive on EM, especially Asia & Latin America. Valuation is in check. Asian equities are trading at a discount of about 10% to developed markets, while the gap reaches 17% for Latam markets.

Emerging equity remains a high beta play on world growth. The tail risks we identified for the Eurozone economy explain why we keep a slight overweight and do not move yet to a strong overweight.

Oil and industrial commodities. Waiting for a short term catalyst

Long term fundamentals remain supportive for commodities but short term prospects are mixed. Base metals have rallied on more liquidity from central banks and higher growth expectations. Physical demand has yet

to catch up in particular in China where there is little sign of increased consumption. We keep a neutral stance on industrial metals, awaiting confirmation that growth has bottomed in China.

We believe the worsening geopolitical backdrop is not priced into futures oil prices and represents upside potential for the months to come. For the short term however, we prefer to maintain a neutral stance. The end of the winter season in the Northern Hemisphere should weigh on demand while a faster than expected return of Libyan oil exports could boost supply.

Emerging markets: back to fundamentals


Commodities dependent on EM demand


Oil markets seem to overlook geopolitical risks


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CRB Raw IndustrialsSub-Index (LHS)

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1 February 2012

Oil Curve Brent Futures

31 Dec 2007

15 Sept 2008

Feb11

Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan12

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Economic Surprise SpreadG10 versus Emerging (LHS)

MSCI World / MSCI Emerging (RHS)

22



Lyxor Quant signals on commodities have turned negative during Q2 2011. They bottomed last September, recovered somewhat in October and since then have stagnated in moderately negative territory. Details of the signals show that the negative views are mostly driven by downside risks to the world economy.

Currencies under central banks’ influence

Foreign exchange markets should stay dominated by relative change in monetary policies. The coordinated move from central banks has eased the USD liquidity crisis facing European banks, removing a technical support for the dollar against euro. The Fed’s pledge to keep zero interest rates until late 2014 went in the same direction.

Looking ahead, the ECB should take over with its next initiatives. We have argued that the second LTRO could surprise on the upside, which should weaken the euro. Moreover, with the refi rate at 1%, the ECB has more leeway to cut policy rates and is likely to use it as growth in the euro area remains depressed. We are not in the view that the euro will depreciate sharply in the near future, unless a major event risk such as a failed Greek PSI occurs, pushing the dollar higher. Overall, we find the risk reward of holding the euro versus dollar remains negative and we maintain an underweight ranking on the euro.

Lyxor Quant signals have turned quasi-neutral on the euro-dollar late last year, after being very negative in Q2 and Q3 2011. The adverse influence of the euro political crisis on the currency seems to have faded away, even though uncertainties stayed elevated. A close examination of the contributions to the signals, suggests that activity variables continue to disadvantage the euro but are offset by the improvement in market sentiment. The Quant signals are more discriminating when it comes to the yen dollar, with a strong negative view on the yen. After being quasi-neutral during the summer, the views became negative over Q4 2011. The downgrade was consistent with disappointing data on the Japanese economy, while market sentiment contributed positively, owing to the yen’s defensive status in a period of worldwide uncertainty.

The elimination of Japan’s trade surplus in 2011 supports a bearish view on the yen. Japan intends to phase out nuclear power and develop alternative energies. For the quarters to come, it means boosting its oil imports, thus sustaining a trade deficit. This fundamental shift could be sufficient to reverse the multi-decade uptrend in the yen versus dollar. Nevertheless, powerful structural forces are at stake, as evidenced by the many failed attempts of the BoJ to depreciate the currency. The nominal effective exchange rate of the yen shows the currency at a historical high against the currencies of Japan’s main trading partners. The picture is quite different when looking at the real effective exchange rate that takes into accounts the relative changes in CPI inflation. Clearly, Japan’s deflation is fuelling the yen’s nominal appreciation. All in all, we upgraded the yen to a slight underweight.

Lyxor Quant views on commodities stay negative


Further weakness ahead for the EURUSD


Lyxor Quant views short yen versus dollar


Japan’s deflation mitigates the outlook on yen


May10

Jul Sep Nov Jan11

Mar May Jul Sep Nov Jan12

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EURUSD spot rate (RHS)

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23



ALTERNATIVE STRATEGIES

THE RETURN OF ALPHA?

We continue to see significant opportunities for managers in the L/S

Credit space and for managers on the lookout for valuation

mispricings and hard catalyst opportunities. Correlation and volatility

are at lower levels than they were at the highs of 2011, which is

currently benefitting hedge fund managers. Thoughtful managers

recognize this good tone to the markets might not last forever –

markets rarely move in a straight line - and manage their portfolios

accordingly. We downgrade L/S Equity Quant managers to a Slight

Underweight ranking.

Correlation: High, but moving in the right direction for now

The beginning of 2012 has been explosive (in a good way) for equity markets. Commodities are broadly up and credit spreads have declined. Macroeconomic data has been broadly supportive. In Europe, for example, the concern was whether the downturn would be sharp and protracted or short and shallow; the data suggests it might be the latter. The result is a better tone to markets, in many respects, and one key result is a decline in correlations among asset prices. This is hugely beneficial to hedge fund managers, who suffer when markets are shocked and correlations all go to one. Hedge funds have had a very good January.

Of course, this positive tone to markets and the ancillary benefit of lower correlation have a bigger context. Correlations are still very high by historical standards, despite being well below the highs of 2011. We calculate that the correlation among stocks in the S&P 500, for example, is nearly as high as it was during the shocks of 2008 and 2010. And markets are still beholden to policy makers and voters. The Greek debt situation, and the Italian, Spanish, Portuguese, Irish, etc. etc. situations could still hold substantial surprises. The clever thinking behind the three year LTRO in Europe was very welcome, but it served to lower tail risk, not to eliminate risk. We saw correlations decline in early 2011 when markets rallied, and the good times came to an end quickly.

There is, of course, no simple solution to the European situation, and the background radiation of a deleveraging financial system (and world) is still with us. We expect a choppy environment that requires active management on our part.

We see significant opportunities for alternative investments in 2012. In a very practical sense, the difficulties of 2011 have created the opportunities for 2012, as indiscriminate selling has pushed down the prices of all assets, irrespective of the individual merits of a given asset.

We believe the opportunities might best be captured by managers who are able to deploy cash on an opportunistic

basis and are mindful of the volatility they still face in the markets. Correlations are bound to remain elevated until far more clarity is found regarding European debt issues. The causes and effects of the high correlation environment, in turn, open up opportunities for patient investors who can be active when the timing is right.

Developed countries are still confronted with the debt deflationary structural backdrop while growth is slowing down in emerging markets, easing inflationary pressures. Policymakers around the world will likely fight such an environment by continuing or intensifying monetary

CHANGES TO STRATEGY VIEWS

L/S Equity Quantitative Arbitrage: Downgrade to Slight Underweight

Alternative Strategy Returns1

Strategy Latest 3

Months (%) Year-to-Date

(%)

Convertible Arbitrage 2.0% 2.2%

CTA – Long Term 2.3% 0.4%

CTA – Short Term -1.7% -0.9%

Distressed 1.1% 1.4%

Merger Arbitrage 0.9% 1.1%

Special Situations 0.0% 3.6%

Fixed Income 2.3% 2.6%

Global Macro 0.0% 1.3%

L/S Credit 1.9% 2.1%

L/S Equity Long Bias 2.5% 3.0%

L/S Equity Variable Bias -2.1% 1.2%

L/S Equity Market Neutral -0.1% -0.4%

L/S Equity Statistical Arb 0.1% 0.2%

Source: Lyxor AM, Bloomberg.

1Data reflect Lyxor index returns to 31 January 2012 since 30 December 2011 for Year-to-Date

returns and since 31 October 2011 for three month returns.

Correlations: Extremely high by historical standards, but improving

Source : Bloomberg, Lyxor AM

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24



reflation. We believe financial markets will still be caught in this tug of war. In particular, the euro debt crisis should remain a main driver of markets’ performance.

At the same time, we acknowledge that, beyond the many tail risks, sentiment is rather bearish and that a lot of negatives already seem discounted. Even though volatility should stay high, we think that, over the year, reflation should gradually gain ground, promoting a normalisation in the economic and financial situation.

We continue to concentrate the risk budget on our convictions. In a risk on / risk off environment, we continue to focus on well-identified market mispricings and hard catalyst opportunities. Valuation and security selection opportunities, along with significant carry opportunities, are available across the globe in pockets of the credit markets. We prefer managers able to hedge themselves and take relative value plays with potential convexities across various states of the world over broad or passive plays into this space. We believe that these managers can also navigate the current illiquid market environment.

Hedge Fund Performance (% per year)1

%-ile 2008 2009 2010 2011

All Funds

95th 21.5 77.8 27.5 11.9

75th 1.4 33.4 14.4 2.0

50th -11.3 16.1 8.0 -2.5

25th -26.5 4.9 2.8 -10.2

5th -49.1 -8.3 -5.4 -23.7

L/S Equity

95th 12.3 73.0 27.4 8.0

75th -2.9 34.5 15.4 1.4

50th -14.3 18.5 8.2 -3.5

25th -29.1 8.1 2.7 -10.3

5th -52.1 -5.1 -5.9 -24.4Source: Morgan Stanley Prime Brokerage

Our cautiously optimistic outlook on the big picture is not so different from the one we held at the end of 2011, and therefore we are not significantly rotating our preferred alternative strategies in this report. We downgrade L/S Equity Quant managers to a Slight Underweight ranking, but the other rankings stay the same.

Correlation spikes = Alpha declines, and vice versa


Alpha has historically rebounded after declines

Source : Barclays, Lyxor AM

Broad equity market returns explaining less and less of the returns to L/S Equity


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Q3 2011

Q4 2011

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LS Equity - Market Neutral

25



Convertible & Volatility Arbitrage

Convertible Arbitrage: Slight Underweight

Volatility Arbitrage: Slight Underweight

Convertible Arbitrage. In our December 2011/January 2012 Strategy Views report, we upgraded Convertible and Volatility Arbitrage by one notch to Slight Underweight. These strategies had been at the bottom ranking since the substantial mispricing of 2008 was corrected.

Our logic was that the sharp sell-off in risk assets in the late summer and fall of 2011 had reduced the market prices of convertibles well below the appropriate market value, given the value of the various components of convertible bonds. This underpricing contrasted with the overpricing we observed during the first part of the year. As yield-hungry investors piled into the convertible bond market, prices had become a bit frothy. Corporates in need of cash were not issuing convertibles because they could issue High Yield straight bonds, and the extra demand was not met with extra supply. We were comforted because convertible arbitrage mangers were running portfolios with far less leverage than they had been using in prior years.

The underpricing of convertibles has resolved itself in some areas of the market, but not in all of them. In particular, we are a bit less impressed with the theoretical mispricing opportunities in the higher grade or larger cap convertibles, although opportunities still appear to exist there. The convertibles that are more credit-oriented and tend to be High Yield in nature are the ones that interest us. We like credit as an asset class (given our outlook for modest growth and low inflation), and convertibles appear to offer at least as good a value as straight bonds offer.

The table shown nearby (“Distribution of Cheapness to Theoretical Value”) illustrates the change in the global opportunity set for convertible managers since the end of 2010. The table shows the percentage of bonds that were rich (compared to theoretical models), fairly priced, and cheap. For the US small cap market, the “cheap” bonds increased from 31% to 48% of the market. The shift was less pronounced, but still significant, for large cap bonds: cheap bonds went from 24% of the market to 39%.

Distribution of Cheapness to Theoretical Value (Percentage

of Market)

December 2010 USA Large Cap USA Small Cap

> 1% Rich 38 43

1% Rich to 1% Cheap 38 26

> 1% Cheap 24 31

Total 100 100

February 2012

> 1% Rich 29 30

1% Rich to 1% Cheap 32 22

> 1% Cheap 39 48

Total 100 100

Source: Bank of America Merrill Lynch

The convertible markets in Europe and Asia also provide significant opportunities, in our view. Valuations there seem interesting. We note that the deleveraging of bank balance sheets may actually provide a boost, at the margin, for convertible arbitrage in these markets. If corporates in Europe and Asia turn to capital markets for their funding requirements, the High Yield market may finally get saturated and we might see convertible issuance rebound. New supply of convertible paper would be a good

High gamma convertibles normalized versus listed options

Source : Barclays

Credit-oriented convertibles: Still cheap versus straight bonds

Source : Barclays, Lyxor AM

Convertibles: Not a market of one


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IG Convertible Implied Vol

Option Implied Vol

(250)

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Spread

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26



thing for hedge fund managers, and they have been waiting for several years for it to occur.

Risks. We also examine two of the risks that concern us about all markets these days. First, we find that liquidity appears to be getting no worse for convertibles. It is not particularly good for reasons we have enumerated elsewhere. Nonetheless, leverage remains low and managers recognize the environment for what it is.

Second, we are concerned about correlations within markets. We constructed a measure of correlation in the convertible market by using advance/decline ratios, and this variable is charted nearby. While co-movement according to this measure was as high in late 2011 as it was during the convertible disaster of 2008, it has declined sharply since then. Convertibles are not moving together in unison, and this is comforting.

We continue to see value in the convertible arbitrage strategy as a credit-oriented play. This is true both within the US and across the globe.

Volatility Arbitrage

Volatility Arbitrage appears to be a very manager-specific space. The broad outlook of choppy markets with substantial political risks and consequently gappy markets, would seem to be a dream for managers attempting to monetize volatility. In practice, the theory needs some work.

We note that convertible arbitrage managers who attempt to gamma trade are probably hampered by the extremely high stock/corporate bond correlations we have seen in recent years. If convertible bond floors were hard, and stock price movements did not correlate so highly with bond prices, gamma trading convertibles might be a winner in this environment. But the correlation has been trending upward in recent years (see the nearby correlation chart), and this correlation has not eased significantly in recent periods. Bond floors are therefore “squishy” (a technical term we hear from our managers) and it lowers the potential returns from gamma trading.

More broadly, volatility arbitrage encompasses managers who do more than gamma trade convertibles. We also monitor the Newedge volatility arbitrage index of hedge funds. We have found that the index returns are highly correlated with a systematic strategy of going short the implied volatility term structure. When volatility spikes and the term structure inverts, the index tends to lose money. It makes a little as long as the term structure is upward sloping.

Our simple model has tracked the actual index returns reasonably well during the past few years. During the past few months, the model and the index have had modest gains. For us, the key insight from the model is that the strategy makes money when markets are not choppy, and it loses money in turbulent markets prone to shocks (which is not the same as a high volatility environment).

Therefore, we keep the strategy ranked as a Slight Underweight despite the intuition that this might be a good environment for volatility-oriented managers.

Stock, High Yield bond correlation damages gamma trading prospects


SPX volatility term structure steepening on falling volatility


Newedge Volatility Trading Index and model returns


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CTAs, Global Macro, and Fixed Income Arb

Medium & Long-Term CTAs: Slight Underweight

Short-Term CTAs: Slight Underweight

Global Macro: Strong Overweight

Fixed Income Arbitrage: Strong Overweight

Long-Term CTAs. We view CTAs as a core part of our portfolios, but we do not view them as a significant return generator on a stand-alone basis. As a hedge in the portfolio, they provided substantial benefit during several months in 2011. However, the positioning of the typical CTA portfolio is expected to provide less of a cushion in 2012 than in 2011.

We do not expect strong trends to persist in 2012, although we have already seen equity markets exhibit a substantial one during January 2012. Perhaps a better way to say this is that we do not yet see persistent trends that will not be punctuated by noticeable reversals. We reserve the right to change our minds, but the current outlook does not provide the most promising environment for trend-following CTAs on a stand-alone basis.

The nearby table shows month-to-month performance of CTAs side-by-side with performance by the S&P 500 Total Return Index, the total return to the 7-10 year U.S. Treasury ETF (ticker IEF), and the HFR Hedge Fund Index. Long-Term CTAs appear to have added value in August and September. The CTA Index was flattish in those months while equities plunged and many hedge funds suffered. The CTA Index rose nicely in December, even as many hedge funds kept reduced exposures and missed out on the equity rally during the latter part of the month. They similarly diversified portfolios in January 2012 as they lagged their more directional peers.

CTA performance in context, August2011 to January 2012

Lyxor CTA

Long-Term Index

S&P 500 Total

Return

US Treasury

ETF

HFR Hedge Fund Index

January +0.4% +4.5 +0.9 +1.7

December +1.3 +1.0 +2.0 -0.4

November +0.7 -0.2 +0.6 +0.6

October -3.0 +10.9 -1.3 +2.7

September +0.1 -7.0 +2.2 -3.7

August -0.4 -5.4 +4.6 -3.2

Source: Bloomberg

Of course, the broad positioning of CTAs can explain this performance reasonably well. CTAs have been quite defensive and have been net long Treasury bond futures for months. They were short equities during the protracted sell-off in late summer, but they have turned long equities in the past month or two. This equity exposure is key to

understanding why they might not be as good an insurance policy as they were over the past year.

The nearby charts provide a deep dive into Long-Term CTA positioning that utilizes the transparency of the Lyxor Platform. The first chart displays the margin-to-equity for Long-Term CTAs with respect to the net equity exposure of the portfolio. It shows the positioning of the fund with the median exposure on the platform (i.e., the 50th percentile). It also shows the positioning of the funds at the 25th and 75% percentile. Hence, we can show the evolution of the positioning across the entire Platform and not just for a single representative fund.

Long-Term CTAs: Now long equity

Source : Lyxor AM

CTAs have managed exposure levels

Source : Lyxor AM

Deep dive: Long-Term CTA equity net exposure

Source : Lyxor AM

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The charts clearly show the equity exposure being typically long going into 2011, declining into the middle of the year and turning negative by September. The trend is clearly toward more equity positioning, with the median fund trending that way and the more aggressive funds sharply moving in that direction.

The chart also highlights how some funds do exhibit non-trend-following components, as the positioning of funds with the lowest net equity exposure were very light or negative on equities throughout the entire year and not just mid-year. These funds generally experienced a poor first quarter and then rebounded when European risks flared up and roiled markets.

An analogous chart for margin-to-equity of net bond positioning is also shown here. CTAs spent much of 2011 long bonds, in the face of many fundamental analysts (ourselves included) who believed the next move for interest rates was upward. This defensive positioning has not wavered and, if anything, has been strengthened in the first part of 2012.

The broad indicators also suggest that Long-Term CTAs are now long energy, which, as part of the broad risk-on trade, have been highly correlated with equities. This long positioning reinforces our conclusion about the diminished capacity of CTAs to hedge broader portfolios of hedge funds in coming months.

Our hedge fund analyst covering CTAs suggests that portfolio managers favour programs that have some non-trend-following components (i.e., some contrarian positions) and favour some broad diversification across managers. Some of the managers who are heavily focused on fixed income might be a risk, and so portfolio managers should keep an eye on this when they choose diversified exposures to CTAs.

Short-Term CTAs. Short-Term CTAs continue as a Slight Underweight in our ranking scheme. CTA programs that are focused on a very short time frame appear to be a good complement to Long-Term CTAs. However, we note that many of them have had difficulty in the current environment and do not expect this to change imminently.

These managers are very difficult to “time”, and we refrain from making snap decisions about when a program might be broken. Managers in this space can snap back sharply and unpredictably from drawdowns, and anticipating this is not readily done. It is easy to point to examples of Short-Term CTA managers who performed quite poorly in 2010 and then experienced fantastic performance in 2011, and it is equally easy to find outperformers in 2010 who fizzled in 2011. This space is probably a very poor one for thinking about performance momentum.

Our analyst covering CTAs notes that the market environment in which policy expectations and actions can trump traditional market dynamics is a dangerous one for Short-Term CTAs. Central bank interventions such as the LTRO action in Europe and the coordinated swap lines to

ease liquidity constraints in Europe can negatively impact performance of these programs.

We continue to find comfort in having a basket of Short-Term CTAs, given the weaknesses of the strategy as outlined above.

Global Macro. The opportunity set for Global Macro managers remains promising. Hedge fund managers have noted that the opportunity set looks particularly promising in Emerging Markets rates and volatility trades. A rapidly evolving situation in Europe means that the word “tactical” keeps coming up when managers talk about their positioning. We have heard from managers regarding trading opportunities (long and short) in European sovereigns, in gold, in emerging currencies, and in crude oil, among others. With managers who claim skill at such tactical trading, the proof of the pudding, as always, is in the eating.

The recent shifts in correlation, such as the easing of correlations across some risk asset classes, should provide some opportunities that were not attractive a few months ago. In theory, the shifting correlations such as the SPX/Euro correlation, which is generally positive on a day-to-day basis but was not at all positive over the month of December, sounds like an interesting trade opportunity for

Deep dive: Long-Term CTA bond futures net exposure

Source : Lyxor AM

Fixed Income Arbitrage managers increasing leverage in recent weeks


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a global macro manager. In practice, such moves may be a performance detractor for global macro managers.

Fixed Income Arbitrage. Fixed Income Arbitrage continues to be a very attractive strategy to us. Central banks across the world continually devise new plans to intervene in sovereign markets as they counteract private sector deleveraging with public sector releveraging. Managers with an eye toward the various auctions and the participants in them should be able to anticipate interactions that should lead to opportunities. With such a policy heavy, sovereign debt heavy situation, these managers should find interesting trades in which to put money to work.

Managers with a mortgage-backed asset arbitrage portfolio generally did well in 2011. Participants in this space have experience now with illiquidity and are not as levered as they could be. There is still policy uncertainty regarding potential government action to affect the terms of existing mortgage backed securities collateral, but nothing substantial has occurred yet. President Obama has been pushing mortgage relief efforts more vigorously lately, with the highest profile effort showing up in the 2012 State of The Union speech. I have reminded my colleagues that President George Bush (the first one, not the second one) used the State of The Union address to outline a plan back in the early 1990s to send American astronauts to Mars. Obama’s mortgage relief plan might have a higher probability of success than Bush’s plan did.

Finally, we note that fixed income arbitrage managers, broadly speaking, generally took down leverage levels as 2011 progressed. The nearby chart is constructed by normalizing the time series of leverage for several funds in this space and then averaging. This average z-score for Gross Exposure moved up sharply in recent months as volatility declined (the implied volatility of the US long bond ETF is plotted on the same chart for convenience). Given the decline in volatility, this should not be perceived as a re-risking of portfolios, but as an almost mechanical shift in response to volatility changes.

Event Driven

Distressed: Strong Underweight

Merger Arbitrage: Strong Overweight

Special Situations: Strong Overweight

Event Driven remains a core position in our portfolios. The catalyst-driven nature of the trades is attractive and diversifies us away from the risk premiums that the broad market piles into, or out of, on a daily basis.

Merger Arbitrage

We ranked Merger Arbitrage as a Strong Overweight in 2011 because we viewed it as a low volatility strategy with a positive trajectory. We still view it that way, but we worry about the opportunity cost of the strategy at times.

Surveys from the sell-side project that merger and acquisitions activity in the U.S. will decline about 10% in 2012.3 Until sustained equity market performance exists, M&A activity will struggle to turn upward. Specialists in the space forecast that cash deals will dominate and that premiums will be moderate. Competing bids will not be at high levels. Deals that will occur will be predominately in the small- to mid-sized company space.

3 Barclay’s Capital Risk Arbitrage 2012 M&A Outlook, January 10, 2012, Evren Ergin and Terry Ma.

Deal spreads plateaued for the moment?

Source : Barclays

Comparison with June 2010: Average spread the same, but the distribution of spreads is worse now

Source : Barclays

Comparison with June 2010: Term structure of deals

Source : Barclays

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30



Spreads for currently pending deals remain on the high side compared to the very tight spreads observed over much of the past two years. The average annualized spread for U.S. deals, as reported by Barclay’s, is hovering around 10%. This is lower than the 15% number seen during the late summer sell-off, but it is still high.

The worries are suggested by drilling down further into the data. If we compare the distribution of deal data for January 2012 with the data for June 2010, when the average was similar, we get more insight. Compared to June 2010, there is a much lower fraction of deals with juicy 10-20% spreads and there is a much higher fraction of deals with tight 0-5% spreads. The difference is that, in the current period, there are some deals with very high spreads (e.g., in the 40% range) that bring up the average.

There are nearby deals with very tight spreads these days, and managers are playing them. The more attractive deals are several months away or have some complication arising from, for example, the harsher antitrust environment these days. The spreads are higher, but they are not as safe.

Our analyst covering this space also suggests that the archetypal dynamics of deals spreads – closing progressively as the completion date nears – is not playing out as expected these days. Deal spreads are staying modest until they close, with the bulk of the change occurring right at the completion. This suggests that there might not be as much steady “carry” from the strategy while we wait for the longer-dated deals to complete.

What does this mean for portfolio construction? First, smaller managers playing announced deals are preferred to portfolios with unannounced deals being played in anticipation. Second, the strategy does have the risk that the returns will be quite lumpy, with a significant portion of returns coming several months out. The risk is that the opportunity cost may be high if other strategies provide a better carry meanwhile.

The conclusion for now is that merger arbitrage managers still have opportunities with attractive spreads. The strategy is not riskless, and it does have a diminished outlook as 2012 progresses, given that M&A activity is projected to decline from the already modest levels for 2011. Yet we are not ready to downgrade the strategy, which has been a reliable, steady earner.

Special Situations

Special Situations managers remain a Strong Overweight for us, although we remain cautious about their prospects.

Special Situations managers generally impressed us last year, as they cut exposures much more aggressively than one might have supposed a priori. Nonetheless, we did see these managers suffer as their financials, energy, and materials exposures were hammered during the sell-offs.

Our Event-Driven analyst notes that the potential for equity reorganizations was not at all fully tapped in 2011. The

main trend for the year, in the Special Situations arena, was for splits and spin-offs. We have seen some announcements so far in 2012 for share buybacks as a way to return to shareholders some of the large cash balances sitting on company balance sheets.

Activist funds, the analyst further notes, should be key in pushing firms to make corporate actions in 2012. Looking at the data, one might note that proxy fights and other aggressive campaigns by activists have declined, but this does not mean they are not interested in making changes to firms. Rather, the threat of a proxy fight has been

Deal flow likely to improve from here

Source : Bloomberg

Special Situations: Typical Equity and Credit Allocations

Source : Lyxor AM

U.S. Credit: A quick tightening so far in 2012

Source : Bank of America Merrill Lynch, Bloomberg, Edward Altman/New York University

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effective in making management listen in some cases. Or, firms have an interest in settling these disputes quickly and with a minimum of fuss. (Some high profile recent examples suggest that not all board think this way.)

Given our strong preference for credit-oriented managers, this obviously suggests that we prefer Special Situations managers who deploy capital into the credit space. We see value there, and we are attracted to funds that also see value there.

Distressed

Distressed managers were downgraded to a Strong Underweight in the December 2011/January 2012 Strategy Views report.

We recognize that there will probably be rising defaults in the next year or two as growth remains tepid in the U.S. and Europe. Banks are obviously trying to pare down their non-core assets, and competition to sell will undoubtedly bring modest prices for the assets. Distressed managers will be there to take advantage of such situations. They will not choose the first distressed investment they see and use up their risk budget immediately.

On the other hand, we are not in a hurry to commit capital to managers focused on the distressed space. Given the long timeframe required for Distressed opportunities to come to fruition, we are comfortable downgrading them to a Strong Underweight in light of the opportunities provided by other strategies.

L/S Credit

L/S Credit: Strong Overweight

L/S Credit managers merit a Strong Overweight ranking, in our view. We believe the pricing has become rich in some parts of the world, relative to the economic reality we expect. We recognize that there will be defaults in the future, but we believe that the default rate required to rationalize the spreads we have been seeing is far too high to be realistic.

We conclude that managers in the L/S Credit space can add value through several potential avenues:

Carry Spread Normalization/Valuation Credit selection Deploying cash at opportune moments (i.e.,

timing)

We are not corporate credit specialists, but we do find some interesting suggestions from credit strategists. They note that, under realistic scenarios, long/short credit trades within the High Yield space can generate convexity in returns (with respect to the economic environment). For example, if BB and lower grade bonds have similar appreciation in upside scenarios, but BB bonds might have much less downside if a modest recession scenario arises. Lower grades would have significantly higher losses. This

convexity appears quite powerful unless a severe recession or yield spread widening occurred. Given the benefits of moving beyond a simple directional bet on credit spreads narrowing, this example highlights the significant benefits we believe that L/S Credit managers can bring to a portfolio in 2012.

L/S Credit is one of our most favoured strategies, but we recognize some risks. The credit markets are clearly the place where illiquidity has taken hold. Dealer positions are very low (see the chart nearby), because prop trading

Massive inflows into credit ETFs


Dealer holdings of corporate bonds

Source : Bloomberg

Co-Movement among High Yield bonds: Far below 2011 highs


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desks at sell-side banks have shut and trading desks are not willing to hold inventory.

Further, we recognize that spreads have tightened dramatically since the end of 2011. High Yield spreads have come in some 200 basis points as risk assets have rallied. While spreads remained high even as significant amounts of money were put to work in credit markets in late 2011, the tightening of 2012 has corresponded with an accelerated inflow of cash into the space.

We estimate that over USD 4 billion has moved into High Yield bonds in January 2012, looking at the largest US-listed ETFs alone. The largest of the ETFs had net assets of approximately USD 10.6 billion at the end of December and was well over USD 13 billion by the end of January. This inflow roughly corresponds in size to the inflow we saw for the entire year of 2011, using the same data and methodology.

However, one fear that we have regarding these flows is that the market will be overwhelmed by the flows and correlations will rocket upward. (Note that ETFs and mutual funds have daily redemptions to meet without imposing gates.) This will not only hinder trading, but it would mean that credit managers would have no ability to differentiate High Yield credit A from High Yield credit B because the fundamentals would not matter. This would be the loss of a serious source of alpha generation for the managers. Any benefit of providing liquidity on the short side to alpha-oriented managers (as opposed to beta-oriented ones) would likely be swamped by this effect.

However, the co-movement index we have constructed from advance/decline data in the corporate bond market does not suggest this is a problem. While the indicator does suggest that correlations were extremely high during the late summer sell-off, it also suggests that the co-movement is now back to roughly average levels. While it has trended upward in recent weeks, this is minor in relation to the magnitude of co-movement seen during stress periods. Therefore, we find no evidence that correlations among High Yield bonds are at “stress” levels. This is quite comforting, given the massive inflows into the ETFs, which represent the broad market for us.

Similarly, we construct a co-movement indicator for investment grade bonds and we find that the co-movement is at average levels. We observe the same upward trend in the indicator over recent weeks that we observed in the High Yield market, but the magnitude of the change is not yet worrying.

The portfolio implication of all this, to us, is that we cannot look at L/S Credit managers as short-term, liquid return generators only. They are not the best vehicle for active, tactical trading, and portfolios with a credit tilt should account for this friction. L/S Credit funds do offer exceptional opportunities, we believe, for investors.

Co-Movement among Investment Grade bonds: Approximately average levels

Source : Bloomberg, Lyxor AMk

Varying spreads = credit selection opportunity

Source : Bank of America Merrill Lynch

Stocks widely owned by hedge funds: Outperforming in 2012


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L/S Equity

L/S Equity Long Bias: Slight Underweight

L/S Equity Variable Bias: Slight Overweight

Market Neutral: Slight Overweight

Quant Arb: Downgrade to Slight Underweight

Statistical Arbitrage: Slight Underweight

L/S Equity managers, as a group, did not live up to expectations in 2011. Active managers were routinely whipsawed, and more passive managers who looked beyond the short-term volatility were handed losses. The politically driven environment and the high correlations that went along with it can explain some of the facts, but it does not excuse them.

January 2012 was a good start for L/S Equity. Most managers made money, and most of them appear to have increased exposure in order to take better advantage of the upturn. The correlation heights of 2011 are also behind us, at least for the moment. As noted in the beginning of this section, correlations are well off the 2011 highs, but they are still quite elevated. This is true at the market level, and it is true for stocks within a given sector (see the sector-level chart on this page).

L/S Equity Exposures by Region (Changes in percentage

points)

Gross January Change

Net January Change

U.S.A. 153% +11% 51% +5%

Europe 207% +20% 25% -8%

Asia 124% +9% 42% +9%

Source: Morgan Stanley Prime Brokerage

We do see some signs that are positive for L/S Equity managers that go beyond the observation that they had one good month. In particular, we note that fundamentals have been feeding through into the cross-section of stocks in some ways. We note that Value stocks have been beating Growth stocks for several months, and we note that lower quality stocks have been beating higher quality stocks since the last portion of 2011.

L/S Equity Exposures by Manager Type

Variable

Bias Long Bias

Market Neutral

December 2010 43% 68% 10%

March 2011 49% 71% 21%

June 2011 30% 75% 22%

September 2011 9% 75% 12%

December 2011 25% 74% 15%

Average 31% 73% 16%

2009 Average 21% 42% 8%

Source: Lyxor AM

Nonetheless, managers will no doubt see a difficult 2012. Some managers have taken the position that we are in a trading range, and they plan to add and reduce risk based on that assumption. Other managers are looking at the very long term and note that equities are quite cheap based on a variety of measures (e.g., the equity risk premium). These value-oriented managers figure that the market (or at least the subset of good stocks in the market) is attractive and the volatility is just something we need to

Correlation of stocks within sectors: Not yet at 2011 lows, but well below the 2011 highs


Stock Fundamentals: Value beating Growth


Stock Fundamentals: The Flight to Quality has reversed a bit in recent months


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deal with in the short-term while we wait for the value to be unlocked.

We view the elevated correlations in the market as a characteristic that will persist, but hopefully not at the upper end of the range that we saw in 2011. January obviously saw buoyant equities and declining correlation, but this might not be a persistent trend. Most managers to whom we have spoken recently seem to fall in this cap, as well.

Given the outlook of the mangers, as we understand them, it appears that L/S Equity managers will generally be managing their volatility and risks on a fairly tight basis. This might lead to a self-fulfilling prophesy on the correlation side. As we noted in an earlier Strategy Views report, the Bank of America Merrill Lynch Hedge Fund Generals Index, which is comprised of popular hedge fund holdings, severely underperformed during the sell-off in August 2011. Interestingly, the Index sharply outperformed the S&P 500 in January 2012 (see the chart on the prior page). This type of dynamic might continue in a very trading-oriented, volatility-sensitive marketplace. Irony.

We maintain our rankings for Long Bias and Variable Bias L/S Equity managers in this report (Slight Underweight and Slight Overweight, respectively). We currently have a preference for credit over equities, but we do see value in L/S Equity funds. We recognize that skilled traders can add value, but we also believe that the risk premium on equities is quite large given the modest growth, low inflation outlook we have. Eventually, the prices of equities should rise to reflect a more typical risk premium, but we note this could take a very long time (recall the long run of single digit P/E ratios during the 1970s).

Statistical Arbitrage mangers continue facing headwinds from declining trading activity and from elevated correlations. Some managers focused on very high frequency reversals appear to have gained traction, but the traditional approach has not worked as well recently. Quant models have faced some difficulties, especially in Europe. Most troubling to us are the ad hoc “fixes” to models that managers are tempted to make when returns are poor. We continue to believe in specific managers, but we are downgrading the L/S Equity Quant Arb strategy to a Slight Underweight in this report.

L/S Equity Market Neutral managers, focused on the fundamentals that have slowly been reasserting themselves, retain their Slight Overweight ranking.

Managers trading more single names (not baskets) as correlations declining


L/S Equity Net Exposures: Trending upward in US, not so much in Europe

Source : Morgan Stanley

L/S Equity Gross Exposures

Source : Morgan Stanley

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

0%

10%

20%

30%

40%


correlation among stock returns (Right Scale)

SPY share volume / S&P 500 cash volume

0%

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30%

40%

50%

60%

US Europe Asia

Net

Exp

osu

re (

% o

f N

AV

)

Aug 11 Sep 11 Oct 11 Nov 11 Dec 11 Jan 12

0%

50%

100%

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200%

250%

US Europe Asia

Gro

ss E

xpo

sure

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of

NA

V)

Aug 11 Sep 11 Oct 11 Nov 11 Dec 11 Jan 12

35



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