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solving

for 2012

Market Insights and Outlooks from Senior Investors at Neuberger Berman

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Neuberger BermanWe are an independent, employee-controlled investment managerin service to our clients. We partner with institutions, advisors and

individuals throughout the world to customize solutions that address

their needs or income, growth and capital preservation. With more

than 1,700 proessionals ocused exclusively on asset management,

we are deeply grounded in original, undamental research and oeran investment culture o independent thinking. Founded in 1939,

Neuberger Berman today provides solutions across equities, fxed

income and alternative investments.

7/31/2019 Solving for 2012

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The past year has been nothing i not unpredictable or investors. Even the most ardent

bears would have been unlikely to anticipate many o the unolding events that caused

markets to gyrate, sometimes spectacularly; meanwhile, many bulls were probably

caught o-guard by the continued earnings health o blue and near-blue chip com-

panies and the pockets o return strength that emerged in the ace o turbulence and

aura o global crisis.

How then, can one seek to opine on the outlook or 2012? To begin with, one needs

a dose o humility. Dicult as it once was to anticipate the ebb and fow o the capital

markets, the task has become harder as countries have traded closer together, econo-

mies have intertwined and the array o investment strategies has escalated. Investment

conclusions must emerge rom disciplined researchyou cant be a ortune teller, but

you can certainly assess conditions analytically and determine what you think may

happen and what may work rom an investment perspective.

At Neuberger Berman, we have been actively observing and investing in the markets

or more than 70 years, with a mission o working with clients to achieve their unique

investment objectives. Rather than impose a house view on our portolio managers,

we provide them with resources and let them make the decisions. It is an approach

that has seen great success over time. This leads to another guideline on investment

outlooks: respect divergent views and understand, to paraphrase Roy Neuberger, our

ounder, that there is more than one way to skin a cat.

With these ideas in mind, I present to you Solving for 2012, with opinions on the

upcoming year rom some o Neuberger Bermans most seasoned investors, and

covering a range o topics including global equities, ed income, alternatives and

multi-asset strategies. Whether investing on your own behal, or working to address

other individual or institutional needs, I believe you will nd this material to be useul

in considering investment positioning and strategy in this turbulent time.

A Look Ahead, With Humility

Sincerely,

Joseph V. Amato

President and Chie Investment Ocer

Neuberger Berman

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Contents Introduction lJoseph V. Amato, President and Chie Investment Ocer ....................................... iSraegi Perspeives

Old Dogmas, New Dharmas lAlan H. Dorsey, CFA, Head o Investment Strategy and Risk;Juliana Hadas, CFA, Vice President ........................................................................................4

Multi-Asset Class Portolios lWai Lee, PhD, Chie Investment Ocer andDirector o Research Quantitative Investment Group ................................................................7

Asset Allocation View lNeuberger Berman Asset Allocation Committee .................................10

Gba Equiies

Overview lJoseph V. Amato, President and Chie Investment Ocer.........................................14

U.S. Equities lLeah Modigliani, Multi-Asset Class Strategist ....................................................15

2012 Election lMatthew L. Rubin, Director o Investment Strategy...........................................19

International lBenjamin Segal, CFA, Portolio Manager and Head o Global Equity Team ...............20

Emerging Markets lConrad A. Saldanha, CFA, Portolio Manager Global Equity Team...............22

Greater China lFrank Yao, Senior Portolio Manager Greater China Equity Team.......................24

Gba Fie Ie

Overview l Brad Tank, Chie Investment Ocer Fied Income ...............................................28

U.S. Economy, Rates and Sectors

lAndrew A. Johnson, Chie Investment Ocer

Investment Grade Fied Income ..........................................................................................29

High Yield Bonds and Bank Loans l Ann H. Benjamin, Chie Investment Ocer Leveraged Asset Management ...........................................................................................31

Municipal Bonds l James L. Iselin, Head o Municipal Fied Income .........................................32

Eurozone and Asia Fied Income, Global Currency l Ugo Lancioni, Portolio Manager Global Fied Income and Currency; Thanos Bardas, PhD, Portolio Manager and Global Head o

Sovereigns and Interest Rates.............................................................................................33

Emerging Market Debt l Bobby T. Pornrojnangkool, PhD, Portolio Manager Emerging Market Debt .....................................................................................................34

Aeraives

Private Equity l Anthony D. Tutrone, Global Head o Alternatives.............................................38

Fund o Hedge Funds l Eric Weinstein, Chie Investment Ocer Fund o Hedge Funds.......................................................................................................43

About the Authors l...................................................................................................48

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STRATEGIC PERSPECTIVES

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A long-term view is complemented by

a combination o shorter-term views

rom systematic models and medium-

term views rom a multidisciplinary

asset allocation committee. This meldsthe concepts o strategic and tactical

asset allocation in a responsive and

adaptive approach. (For eample, see

the display, which depicts a strategic

asset allocation that is comprised o

risk-weighted asset classes and is

dynamic, changing over time depend-

ing on the volatility and correlations o

the underlying asset classes.) The

alternativerebalancing to a static

strategic benchmarkis not unlike

rebalancing to an arbitrary asset

allocation. A risk-balanced approach

can also be employed in single

asset-class mandates. In equities, or

eample, lower-beta managers who

are likely to hold more cash and ed

income and ocus on more deensive

sectors would get higher allocations

than their higher-beta peers. In credit,

the portolio manager may toggle

between credit risk and duration risk

in dierent market environments.

lIquIdITy and TaIl rIsk

managemenT

In addition to seeking overall volatil-

ity reduction, investors are particu-

larly attuned to mitigating the risko etreme tail events, in terms o

both asset class returns and liquid-

ity. Options and swaps are one way

to manage tail risks; however, they

can be costly, particularly in todays

high-volatility environment. Alterna-

tive ways to achieve tail risk mitiga-

tion include epanding or contracting

liquidity based on rich or cheap risk

premia, and allocating assets to man-

agers who can hold cash and vary itsamount dynamically based on market

conditions. Long-only equity strate-

gies with the feibility to hold cash

and ed income instruments when

the manager deems prudent have

the potential to achieve results similar

to other strategies that seek uncon-

strained global-equity eposure, such

as long/short hedge unds, but with

lower ees, higher liquidity and less

tail risk than hedge unds that may

use shorting and leverage. Dierent

hedge und strategies have dierent

sensitivity to equity illiquidity shocks,

however. Strategies such as equity

long/short, convertible arbitrage and

event-driven have historically seenreturn deterioration during times o

illiquidity shocks in the equity

markets. On the other hand, strate-

gies such as statistical arbitrage and

macro have seen little to no return

deterioration, and CTA (commodity

trading advisor) strategies have actu-

ally seen their returns improve in such

environments. Incorporating the latter

in the portolio can help mitigate tail

and illiquidity risk.

InFlaTIonary Hedge

With sovereign debt levels grow-

ing across the globe and signicant

resistance to scal austerity coming

rom both politicians and the general

populace, concern occurs about

uture infation. While commodities

and infation-linked bonds oer a

degree o hedging against infation

and currency depreciation, a risk is

that their beta-to-infation can turn

negative when infation reaches

certain levels, and that perormance

o the asset classes will likely begin to

diverge as signicant changes emerge

in infation estimates. An equal

duration-risked multi-asset portolio

can account or this by adjusting its

monthly sensitivity to infation. This

approach to risk allocates to vari-

ous assets in such a way that each

contributes similarly to the sensitivityo the overall portolio to changes

in infation. The strategy is feible in

that it can adjust to changing betas to

infation and changing orecasts or

infation. Numerous asset classes can

be included, such as high yield bonds,

infation-linked bonds, commodities,

leveraged loans, real estate invest-

ment trusts (REITs), and high-dividend

ExAmPlE: RISk-BAlAncEd StR AtEGIc ASSEt AllocAtIon

Percentage o Sample Allocation Over Time

Source: Neuberger Berman. For illustrative purposes only. The percentages reect the dynamic asset class/indexallocations o a hypothetical risk parity portolio, rebalanced monthly. The inormation shown is hypothetical and isnot representative o any investment product. Indexes are unmanaged and are not available or direct investment.Investing entails risks, including possible loss o principal.

0

10

20

30

40

50

60

70

80

90

100%

EM Equity

EAFE

R2000

R1000

TIPS

Global Agg

U.S. Agg

201120072003199919951991


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equities in sectors such as materials

and energy.

lIaBIlITy rIsk managemenT

Generally, lower interest rates havecaused liabilities to rise, while risk asset

prices have allen. This has led to a

decrease in many pension plans

unded status. Plans that are consider-

ing removing liability hedges are

considering whether now is the time

to do so. One tactic is to make this

decision in the contet o a liability-

driven investing (LDI) ramework.

While basic LDI strategies typically

ocus on investment-grade edincome or liability matching, more

advanced strategies also incorporate

high yield bonds and high-dividend-

paying stocks, such as utilities and

REITs. This LDI++ approach consid-

ers both liability hedging and return

generation, and seeks to add value

through sector research, issue selec-

tion and duration management,while controlling risk.

ouTsourced alTernaTIves

Investors are increasingly seeking

non-discretionary help in their hedge

und and private equity und selec-

tion, due diligence and portolio

construction. The rationale is based

in wanting to create completion

portolios o underlying managers

that are complementary to eitherdirect und commitments that the

investor has made or broad und o

unds commitments that have been

done. In other cases, unds o unds

can be employed to provide non-

discretionary assistance. Although

limited in scope, such implementation

can be a cost-eective solution or

certain large investors who are look-ing or skills to complement their own

internal investment processes.

We hope we have provided insights

into approaches that could prove useul

in seeking to solve or issues that may

concern our readers. And as our 16th

President posited about his own situa-

tion, Determine that the thing can and

shall be done, and then [together] we

shall nd the way.2

2. Abraham Lincolns speech in the House o Representatives (June 20, 1848).

This material is provided or inormational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold asecurity. Investing entails risks, including possible loss o principal. Investments in hedge unds and private equity are speculative and involve a higher degree o risk than moretraditional investments. Investments in hedge unds and private equity are intended or sophisticated investors only. Indexes are unmanaged and are not available or directinvestment. Past perormance is no guarantee o uture results.

Please see disclosures at the end o this publication, which are an important part o this article.

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assumptions about risk are all being

reevaluated. Risk parity, or eample,

has moved into the spotlight. And

while some o the buzz around this

approach to asset allocation is likelyjust that, we do believe it serves an

important role in certain portolios.

So, where will the dust settle in 2012

and how should investors think about

asset allocation?

Although it is common to dene asset

allocation in strict terms o strategic

and tactical (with time horizons

such as three to ve years or strate-

gic, or signicantly less than this or

tactical), we believe this one-size-ts-all approach actually ts very ew

investors objectives successully. For

instance, the process o rebalancing a

portolio periodically back to

a strategic 60/40 mi may require

trading more requently than a three-

to ve-year investment horizon. How

this process is designed and whetherthese trades should be considered

tactical are up or debate. We think it

is more useul or investors to consider

the degree o uncertainty associated

with their particular time horizons, and

to adjust their investment approach

and diversiy accordingly.

To be sure, diversication is one o

the most basic terms in investing, but

its meaning and application are not

always clear. Based on our etensiveresearch, we believe that investors

should diversiy to the degree they

are uncertain about something.

In other words, i you had perect

orecasting ability, there would be no

need to diversiy at allyou could

simply invest in the assets that would

do well and avoid the others. On theother hand, where you do not have

perect orecasting ability or you

have conditionssuch as etended

time horizonsthat make you less

certain about your epectations, then

it makes sense to adopt an approach

that does not rely so heavily on these

orecasts as inputs.

In the contet o asset allocation, this

is what we believe separates tactical

rom strategic asset allocation deci-sions and is a guide that we believe

investors should consider utilizing

more etensively. Although there is

FInAncIAl cRISIS ShockEd coRRElAtIonS

Roll ing Two-Year Correlation o Stock Market and Currency Returns Within a Given Region

Source: Bloomberg, Neuberger Berman Quantitative Investment Group.

2011

-100

-80

-60

-40

-20

0

20

40

60

80

100%

Switzerland

Canada

Australia

U.K.

Europe

LTCMGlobal

Financial Crisis

Japan

U.S.

2010200820062004200220001998199619941992199019881986

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a high degree o uncertainty in

orecasting ar into the uture,

our research has shown that, over

longer investment horizons, risk-

adjusted rewards o risky assets aremore comparable to one another

than they are in the shorter term.

Given that insight, we believe a

portolio constructed using a risk-

balanced approachor one that

selects assets based on their epected

contribution to the portolios risk,

rather than one that is constructed

based on return orecastsmay be

more robust over time. Moreover,

i investors are able to rela certainguidelines, such as those around the

use o leverage, a leveraged risk par-

ity portolio with equal contributions

to risk rom all assets may be able to

generate returns on par with tradi-

tional 60/40 type portolios, but at a

lower volatility and with less tail risk.

With the compounding eect in the

investors avor, lower risk over time

could mean higher returns. Given

the uncertainties we ace going into

2012, such an approach may make

even more sense to consider.

For similar reasons, we believe that

shorter-term tactical asset allocation

also remains essential to achieving

investment success. Such an approach

actors in shorter-term return ore-

casts, including analysis o market

trends and interrelationships among

asset prices. In the period since the

nancial crisis o the late 2000s, we

have witnessed some o the most

dramatic shits in these relationshipsin over a decade. For eample, both

within and across asset categories

including stocks, bonds and curren-

cies, correlations are at historically

etreme levels. Our research has

shown that, increasingly, investor risk

appetitewhether in a risk on or

a risk o periodis driving these

correlations. As such, we believe the

success o a shorter-term asset alloca-

tion approach is determined in part

by the ability to assess, and eectively

manage, these interrelationships.

lookIng aHead

Putting it all together and looking

ahead to 2012, we believe that

investors will remain highly ocused

on asset allocation. Whether one

believes that it accounts or a small

or large part o long-term portolio

return, in our view asset allocation

should not be dictated by passive,

possibly antiquated, assumptions.Factors ranging rom the time

horizon, to both short-term and

long-term asset price and market

behavior, to, o course, the investors

own ability to assess and manage

all o these dynamics will be impor-

tant considerations or multi-asset

class allocation in 2012 and beyond.

This material is provided or inormational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold asecurity. Investing entails risks, including possible loss o principal. Indexes are unmanaged and are not available or direct investment. Past perormance is no guaranteeo uture results.



7/31/2019 Solving for 2012

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Asset Allocation View:Positioning Portfolios for the Coming Yearnb B at ati citt

basis to consider the outlooks or a

range o asset classes. For 2012, we

generally avor equities, although

we see a number o potential value

opportunities in ed income andother areas as well. Below, we

present some o our key viewpoints.

Within equiies, the committee

avors U.S. large capitalization stocks

over small-cap, developed interna-

tional and emerging market equi-

ties, due to what we consider solid

earnings growth, attractive valuations

and abundant liquidity. Given the

epectation or continued market

turbulence, we are also avoringincome-oriented securities such as

high-dividend-paying equities, which

tend to dampen portolio volatility in

times o economic distress.

Among fe ie securities, we

preer credit sectors (like corporate

bonds) relative to government issues.

However, we see strong valuation

opportunities or asset-backed and

commercial mortgage-backed securi-

ties ollowing epanding spreads this

past summer.

The committee has an overweight

viewpoint on U.S. ig yie fe

ie securities, based on what we

believe to be attractive valuations

rom both a spread and yield per-

spective. While European debt-market

worries are infuencing high yield

prices, we believe the deault rate or

U.S. high yield bond issuers should

remain low, thanks to robust corpo-

rate balance sheets and cash fows.

Even in the ace o a more signicanteconomic slowdown, stronger cash

fows at companies should ade-

quately cover coupon payments.

In the aeraive asse asses,

the committee avors an overweight

to lower volatility and macro hedge

unds, while noting potential long-

term opportunities in commodities.

volaTIlITy presenTs

opporTunITIes

hege us may be unique in

todays landscape in that both their

short- and long-term prospects maybenet rom, rather than be disrupted

by, macro-related volatility. In the

class o macro-driven unds, the

epected backdrop o market turmoil

actually creates opportunities in both

directional and geographic bets

among global equities, bonds,

currencies and commodities. Lower-

volatility hedge unds may be an

attractive option in volatile markets

or their low correlation to equityand credit beta.

ciies are an area or which

the short-term outlook could di-

er signicantly rom longer-term

prospects. The perormance o most

commodities is tied to the strength

o the global economy. Considering

the wide anticipation o a moderate

pullback in economic growth in both

Asset allocation is a crucial part o the investment process that has become ever more relevant as inves-tors have sought to limit risk in volatile markets, in part by exploring new approaches to diversication

and broadening asset class exposures. At Neuberger Berman, our Asset Allocation Committee is a group

o senior strategists and portolio managers rom across investment disciplines who meet on a regular

7/31/2019 Solving for 2012

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emerging and developed economies,

this should mean lower demand

growth or commodities, at least in

the short term. Additionally, develop-

ing economies are ghting againstdomestic infation, which could cut

into commodity demand as well. Over

the longer term, however, a broader

pullback in economic growth would

likely tame some o that infation and

allow policymakers to ease up on the

brakeswhich could, in turn, provide

a boost to commodity perormance.

conclusIonIn summary, the committee holds

a relatively avorable view on the

prospects or equities relative to other

asset classes, based largely on the

sound undamental condition and

reasonable market valuations o many

companies. Overall, the investment

environment will likely continue to be

aected by ongoing risk relating tothe global economy, sovereign debt

and geopolitics, reinorcing the merits

o broadly diversied portolios.

mARkEt VIEwS BASEd on 1-YEAR REtURn oUtlook FoR EAch ASSEt clASS

This material is provided or inormational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold asecurity. Investing entails risks, including possible loss o principal. Indexes are unmanaged and are not available or direct investment. Past perormance is no guarantee outure results. The views expressed herein are generally those o Neuberger Bermans Asset Allocation Committee which comprises nine proessionals across multiple disciplinesincluding equity and fxed income strategists and portolio managers. The Asset Allocation Committee reviews and sets long-term asset allocation models, establishes preerrednear-term tactical asset class allocations and, upon request, reviews asset allocations or large diversifed mandates and makes client-specifc asset allocation recommendations.The views and recommendations o the Asset Allocation Committee may not reect the views o the frm as a whole, and Neuberger Berman advisors and portolio managers mayrecommend or take contrary positions to the views and recommendation o the Asset Allocation Committee. The Asset Allocation Committee views do not constitute a predictionor projection o uture events or uture market behavior. Due to a variety o actors, actual events or market behavior may dier signifcantly rom any views expressed. This mate-rial may include estimates, outlooks, projections and other orward-looking statements. Due to a variety o actors, actual events may dier signifcantly rom those presented.


ASSET CLASS Below-Normal Return Outlook

Long-Term (10-Yr.+)

Annual Return Outlook Above-Normal Return Outlook

Fixed Income

Investment Grade Fixed Income

U.S. TIPS

High Yield Corporates

Developed International Fixed Income

Emerging Market Fixed Income

Equity

U.S. All Cap Core

U.S. Large Cap

U.S. Small Cap

Master Limited Partnerships

Developed International Equities

Emerging Market EquitiesPublic Real Estate

Real and Alternative Assets

Commodities

Lower Volatility Hedge Funds

Macro Hedge Funds

Private Equity


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GLOBAL EQUITIES

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Overview: Beneath the Surface,Opportunities AwaitJh v. at, pit chi Itt of

the Japan earthquake, the U.S.

Treasury downgrade or the ongo-

ing drama in Europe, these actors

coalesced to heighten market turbu-

lence and reinorce the notion that

markets are truly interconnected as

never beore.

Looking ahead to 2012, we see little

sign that such issues are abating.

European nations, despite ongo-

ing dialogue, continue to struggle

to achieve a credible solution to the

debt crisis. The region, in our opinion,

requires concrete steps toward scal

consolidation ollowed by meaningul

intervention by the European CentralBank. The political process has been

taking much longer than markets de-

mand. While this is understandable,

given the compleities o the political

process, nancial markets may yet

orce the political leadership to move

more quickly.

In the U.S., Congress has postponed

hard decisions about budget cuts un-

til ater the November elections. This

will likely result in important policy

initiatives going into suspended

animation. The world is also watch-

ing closely as to whether China can

successully achieve a sot landing or

its infuential economy. In short, it

seems like heightened volatility, tight

correlations and near-term ocus on

high-level investment choicessuch

as asset class, region and sector

will continue to predominate in the

short term.

Despite this, as evident in our outlookpieces on the U.S., Europe, Emerg-

ing and China equities, we believe

there are eceptional opportunities

or bottom-up investors. For eample,

i you look past the general gloom

in Europe, you nd that there are

numerous high-quality companies

domiciled there with broad global

eposure that are providing strong

earnings at reasonable multiples.

Elsewhere, despite a dicult 2011,

emerging markets continue toprovide secular advantages over

developed counterparts. Economic

growth is much aster, governments

and individuals carry less debt, and

demographics are avorable, as

young and growing populations raise

their living standards and increase

consumption. Among stocks, the

sell-o o 2011 has provided ample

opportunities or bargain hunters.

As or the U.S., individual companies

are actually doing better than the

sluggish economy would suggest.

Many continue to generate healthy

earnings and boast cash-rich bal-

ance sheets, low nancing costs

and limited wage pressures. Overall,

Over the past year, the most commonly used words in relation to the markets were probably macro,volatilityand contagion. The least uttered? Id say fundamentals, as in what dierentiates individual

companies at any given time. Clearly, the big picture was ront and center in 2011, as investors grap-

pled with an array o unanticipated, signicant events oten simultaneously. Whether the Arab Spring,

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they seem well-positioned to ride

out a downturn and perorm well

should the economy maintain modest

growth (our epectation) or surprise

on the upside.

In all likelihood, 2012 is going to be

another eventul year. But i, like us,

you think o current volatility and

pessimism as opening and not just

shutting doors, then you may also

see this as a good time to capitalize

on the attractive opportunities thatawait, especially given that many

stocks have seen lower valuations in

the wake o undierentiated market

turbulence. In our view, the key in this

environment is to eert patience and

maintain investment discipline, while

waiting out the structural, big-picture

issues that continue to heighten ani-ety around the world.

This material is presented solely or inormational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or holda security. Any views or opinions expressed may not reect those o the frm as a whole. Third-party economic or market estimates discussed herein may or may not be realizedand no opinion or representation is being given regarding such estimates. This material may include estimates, outlooks, projections and other orward-looking statements.Due to a variety o actors, actual events may dier signifcantly rom those presented. Investing entails risks, including possible loss o principal. Past perormance is noguarantee o uture results.


GLOBAL EQUITIES

Uncertainty abounds as we enter

2012or equities and ed income,

in the U.S. and globally. It could be

another trying year. We epect a

barrage o macro issues, including

questions about the ongoing Euro-

pean sovereign debt crisis, whetherChina can avoid a hard landing, the

health o the U.S. economy and the

November elections, to continue to

shape investor sentiment. Against this

backdrop, strong corporate unda-

mentals, which are usually a orceul

driver o equity returns, continue to

take a back seat to daily headlines

and the periods o heightened volatil-

ity that oten ollow. While investors

could be in or a bumpy ride, we are

generally positive on the prospects

or the U.S. equity market and the

eventual return o undamentals-

driven perormance.

2011: rIsk aversIon surged as

THe year progressed

The U.S. equity market, which began

the year with much promise, was

soon hampered by a confuence

o events that resulted in a signi-

cant fight to quality and, at times,

indiscriminate selling. The shit rom

robust risk appetite (risk on) to

risk aversion (risk o) began in the

late spring. Ater a period o resil-iency in the wake o the uprisings in

the Middle East and the devastating

earthquake in Japan, investor senti-

ment started to sour. Data pointed to

moderating economic growth, and

ears o Greece deaulting on its debt

obligations again took center stage.

Risk aversion gained momentum in

the third quarter due largely to the

downgrade o U.S. Treasuries by Stan-

dard & Poors. Mied economic data,

ears o contagion rom the European

sovereign debt crisis, and growing

epectations or a double-dip reces-

sion compounded investor concerns.

At times, investors were willing to

park their money in Treasuries earning

minimal returns as they took shelter

in the rising storm. Despite a strong

rally or stocks in October, inves-

tor goodwill soon aded with new

concerns in Europe, including ears

about Italian debt and a surge in the

countrys borrowing costs. Political

gridlock in Washington also came to

a head as the debt-reduction super

committee ailed to reach a compro-mise to meet budgetary targets by

the agreed-upon deadline.

economy, FronT and cenTer

As we look ahead to 2012, the

economy, as usual, will be central

to the health o the stock market.

Unortunately, economic data have

been less than conclusive in gauging

a clear course or recovery. Consumer

and business spending, manuactur-ing activity and other metrics have

fuctuated rom month to month,

leading to shiting epectations by

turn rom epansion to contrac-

tion and back again. However, two

constants remain: elevated unemploy-

mentrecently at nearly 9%and

weakness in the housing market,

which has had little momentum ater

U.S. Equities:In the Back Seat Now, Fundamentals Should Eventually Drive Resultslh miii, mti-at c sttit

7/31/2019 Solving for 2012


dramatic declines in volume and pric-

ing. These actors, combined with wor-

ries about global macro developments,

have in turn negatively impacted

condence and consumption.

Still, we think the U.S. economy has

enough momentum to avoid a dou-

ble-dip recession in 2012, and grow

at a positive, even i subpar, pace.

Among the actors that could poten-

tially support growth are the sizable

cash holdings o many companies

that have been hesitant to deploycapital in an uncertain environment.

I condence improves, the increased

use o this cash could augment

GDPas could a positive change in

spending by consumers, who have

been relatively conservative in their

spending over the past several years.

Even i the U.S. alls back into reces-

sionwhich we see as the less likely

scenariowe think it would probably

be relatively shallow, due to what

we consider to be a lack o ecesses

in the economy. In the housing

sector, or eample, construction

starts, residential sales and home

prices all declined dramatically or

several years, and appear to have

little room to all urther rom todays

depressed levels. Corporations, hav-

ing cut costs during the depths o the

economic crisis, are operating leanly,aided by healthy balance sheets and

inepensive nancing. We believe

deault rates on company debt are

likely to come in below average net

year. Indeed, given modest infation

numbers and ears about the econ-

omy, the Federal Reserves monetary

policy is likely to remain accommoda-

tive. This monetary stimulus may be

particularly important given that U.S.

budgetary pressures and political

gridlock suggest that meaningulscal stimulus is unlikely to be put

into place in the coming year.

european deBT saga

conTInues

With unprecedented connectiv-

ity among businesses across global

markets, U.S. economic health will

depend in part on whats happening

elsewherewhether in Berlin, Hong

Kong or Tehran, or that matter. Atthis point, sovereign debtin the

U.S., but particularly in Europecon-

tinues to have an enormous impact

(at least psychologically) on business

and consumer condence as well as

market perormance.

As we write this report, the Euro-

pean situation continues to shit

rapidly. A late October agreement by

European Union members to reduce

Greeces debt by 50% and substan-tially increase the European Financial

Stability Facility (EFSF), designed to

support euro-area member states,

was initially viewed by investors as

a signicant step in quelling the

escalating crisis. However, it soon

became clear that the various players

remain at loggerheads on how to

deal eectively with major issues o

implementation, timing and unding.

Indebted nations bridle under pres-sure to implement austerity mea-

sures and reduce ependitures while

core countries (Germany and France)

have shown reluctance to bear the

brunt o potential bailouts, and the

European Central Bank seems cau-

tious about taking on a larger role in

quelling the crisis.

wIll REBoUnd In mARkEt VolAtIlItY contInUE In 2012?

Number o Trading Days with Intraday Swings Above 3% or S&P 500

0

10

20

30

40

50

60

70

80

11*1009080706050403020100

Source: FactSet. *As o November 30,2011.

coRPoRAtE BAlAncE ShEEtS REmAIn hEAlthY

Percentage o Assets in Cash: S&P 500 Companies (ex Financials)

10%

8

6

4

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: FactSet, through September 30, 2011.

7/31/2019 Solving for 2012

18/51Solving or 201

GLOBAL EQUITIES

France and Germany have called or

reworking the European Union (EU)

as a whole and amending Euro-

pean treaties to include centralized

oversight o national budgets andautomatic sanctions against countries

in violation o new stricter rules, at

least or the 17 eurozone countries.

But the U.K. has so ar vetoed the

proposed EU-wide agreement, and

some European voters are voic-

ing complaints as well. Meanwhile,

the prolonged inability to come up

with a decisive to its debt woes

appears to threaten the credit ratings

o even core eurozone countries. All

told, the ongoing uncertainty and

hobbled banking system will likely

impact economic activity in the near

termsomething that new European

Central Bank President Mario Draghi

acknowledged in noting the potential

or a mild European recession by

the end o 2011.

oTHer Issues:

cHInese Hard landIng

Beyond the maneuverings in Europe,

we are keeping a close eye on devel-

opments in China, which have signi-

cant implications or global growth

and the equity markets in 2012. Much

has been written about whether

China has the ability to orchestrate a

sot landing or its economy by end-

ing a two-year tightening cycle that

has included numerous interest rate

increases and higher bank reserve

requirements. Indeed, the countryseconomy has decelerated somewhat,

rom 10.4% GDP growth in 2010, to

around 9.2% or 2011.

I the Chinese governments mea-

sures to cool the property market

and tame infation turn out to have

been too heavy-handedespecially

with economic pressures mounting in

the developed worldthe resulting

slowdown could substantially impact

global business activity. From ourperspective, although Chinas eco-

nomic epansion is likely to urther

moderate in 2012, we dont believe

the country will eperience anything

too severe. Chinas infation rate now

appears to be at, or near, a peak

while its property market has shown

signs o cooling. As a result, we think

that Chinese policymakers have the

feibility to stop or potentially reverse

course on their tightening measures

in pursuit o the elusive sot landing.

elecTIon grIdlock?

Finally, one issue that is a bit harder

to handicap is the potential impact

o election politics in 2012, when

the U.S. will choose its President and

both the House and Senate have

the potential to change hands. (See

2012 Election on page 19.) Despite

etensive wrangling, little progress

has been made toward reducing the

ederal budget decit and level o

ederal debt, which has now reached

a staggering $15 trillion. Moreover,

should the economy soten, as noted,

it seems unlikely that there would be

agreement on any major stimulus.

Indeed, given the political games-

manship displayed during the debt

ceiling crisis and with the ailure o

the Congressional super committee

to reach budgetary compromise, we

think that the run-up to the election

will only intensiy current polarization

and etend gridlock. This, in turn,

could infuence Standard & Poors and

other rating agencies as they consider

a potential urther downgrade o U.S.

Treasuries, as well as the willingness

o businesses to make major invest-ments in equipment or hiring in an

uncertain environment. Although

there may be some movement on ta

reorm, it seems that the most impor-

tant policy initiatives will probably

have to wait until ater November.

WHaTs aHead For sTocks

Many o the key issues acing the

worlds governments and economies

will likely take time to play out. Assuch, we think that the short-term

movements o the U.S. equity market

in 2012 will continue to hinge on

UncERtAIntY, mAcRo FocUS hEIGhtEnEd coRRElAtIon AmonG StockS

S&P 500 Industry Groups: 30-day Roll ing Correlation

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

20112010200920082007200620052004

Source: FactSet, through November 30, 2011.

7/31/2019 Solving for 2012

19/51

7/31/2019 Solving for 2012

20/51

Politicians have long recognized therelationship between voter approval

and the state o the nancial markets

and economy. This is most evident in

U.S. presidential election years, when

campaign promises and stimulus

packages become the norm and tend

to benet stocks. In 2012, however,

things could be a bit dierent. Histori-

cally, presidential cycles and U.S. stock

markets have ehibited some recurring

trends, with equity market returnstending to be stronger in the third and

ourth years o presidential administra-

tions, as incumbents have pumped

stimulus into the economy in hopes

o urthering their reelection chances.

Since 1926, the S&P 500 total return

has averaged 8.2%, 9.0%, 19.4% and

11.0% in years 1, 2, 3 and 4, respec-

tively, o each presidential term.

Under President Obama, however,

equity returns have been ront-loaded,with the S&P 500 returning 26.5%

and 15.1% in his rst (2009) and

second (2010) years as President, andonly 1.1% year-to-date as o Novem-

ber 30, 2011. To be air, the market

environment throughout Obamas

tenure to date has been tumultuous

early gains refect the rebound rom

the depths o the March 2009 market

lows, while more recently the Euro-

pean debt crisis and economic ears

have had a dampening market impact.

an ausTerITy elecTIonLooking toward 2012, we do not

epect major stimulus measures to

be enacted by the ederal govern-

ment, as has oten been the case

in an election year. Fears over debt

levels and the vast political divide in

Congress have simply changed the

debate. Instead o proposing ta cuts

and spending increases, politicians are

generally contemplating ta increases

and spending cuts. All things beingequal, such austerity measures will

likely be a drag on economic growth.

As some will observe, the economyis not the stock market and the stock

market is not the economy. We agree,

but the 2012 elections are particularly

uncertain, with the President appearing

to be hanging on by a thread and the

major political parties deending slim

margins in the House and Senate.

Moreover, ta reorm, health care

regulation, international trade and

many other issues are still up in the

air and may not be decided until aterNovember 6. This will likely prompt

businesses and individuals to take a

cautious approach until greater

clarity emerges.

As a result, we anticipate the elec-

tions to have a dampening eect on

both the economy and stock market

in 2012i we do happen to reach

the 11.0% average S&P 500 return or

year 4 o the election cycle, I highly

doubt it would be a result o govern-ment largesse.

oBAmA And thE Stock mARkEt

S&P 50 0 Total Return by Presidential Year

Source: FactSet. Year 3 Obama data through November 30, 2011.

Historical Average Obama

0

5

10

15

20

25

30%

Year 4Year 3Year 2Year 1

2012 Election: An Exercise in Austeritymtthw l. rbi, dit Itt stt

This material is provided or inormational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold asecurity. The views expressed herein are generally those o Neuberger Bermans Investment Strategy Group (ISG), which analyzes market and economic indicators to developasset allocation strategies. ISG consists o fve investment proessionals who consult regularly with portolio managers and investment ofcers across the frm. This materialmay include estimates, outlooks, projections and other orward-looking statements. Due to a variety o actors, actual events may dier signifcantly rom those presented.Any views or opinions expressed may not reect those o the frm as a whole. Investing entails risks, including possible loss o principal. Indexes are unmanaged and are notavailable or direct investment. Past perormance is no guarantee o uture results.


7/31/2019 Solving for 2012


With so much uncertainty in the

past years global equity markets,

courtesy o the eurozone sovereign

debt crisis, investors may wonder

how much appeal an international

equity allocation holdsespecially as

the crisis and related concerns remain

an ongoing risk. In our opinion,

plenty. We think a global perspective,

along with a bottom-up, quality-

and valuations-ocused investment

approach, can continue to uncoverattractive long-term opportunities or

both appreciation and diversication,

and help mitigate many o the

risks associated with a tougher

macroeconomic backdrop.

From a regional perspective, we think

its critically important or investors

to dierentiate between sources o

opportunity and sources o aniety

in the developed international arena.

The weak perormance o the MSCI

EAFE Inde in 2011 was clearly driven

by the eurozone, with its news o

downgrades, potential deaults and

bailout-related political concerns.

The eurozone continues to garner

attention, as the debt accumulated

by the weaker GIIPS economies1

strains stronger nations such as

Germany, and taes the capabilities

o the European Financial Stabil-

ity Facility and commitment o itsmember states. Additionally, austerity

programs and higher taes aimed at

reducing large decits, while neces-

sary or the longer term, will likely

continue to impede growth and

weaken consumer and business

sentiment in the near term. This

suggests that serious challenges

remain as the region works toward

economic stability.

While the U.K. is not part o the euro-

zone, the outlook there seems airly

unappealing or many o the same

reasons. The U.K. has high levels o

consumer and government debt, as

well as large government decits.

Attempts to cut government spend-

ing have met with signicant resis-tance and have acted as a drag on an

already slowing economy. This con-

trasts with other non-eurozone coun-

tries like Switzerland and the Nordic

region that oer more economic

and scal stability. On the other side

o the globe, Japan struggles with

an aging demographic prole, high

public debt levels, and an eport sec-

tor eposed to an appreciating yen

and slowing global economylikely

a recipe or continued anemic growth

going orward. Elsewhere in Asia, and

more broadly in emerging markets,

new middle class consumers and

corporations oer opportunity or

growth and investment.

navIgaTIng Weaker markeTs

With most mature economies seeking

to reduce scal decits, we believe

economic growth in the developed

world is likely to remain weak. As a

result, infation should stay subdued,

and interest rates can remain at low

levels. We believe that spending

will remain weak, and thereore see

little appeal in companies that rely

on a buoyant consumer in Europe or

Japansuch as auto manuacturers

and more appeal in companies with a

more deensive customer prole. We

also believe that prospects or multi-

national businesses with established

operations in North America and

Emerging Markets are more attractive

than those with operations ocused onEurope or Japan. A number o Europe-

based companies have many decades

Developed International Markets: Looking Beyond the EurozoneBji s, cFa, pti m H gb eit T

EURozonE lIkElY to lAG, whIlE Em ShoUld lEAd GloBAl GRowth

% Year-over-Year Economic Growth

pjti

2010 2011 2012

Eurozone 1.8 1.6 1.1

United Kingdom 1.4 1.1 1.6

United States 3 1.5 1.8

Canada 3.2 2.1 1.9

Japan 4 -0.5 2.3

Emerging Markets 7.3 6.4 6.1

World Output 5.1 4 4

Source: IMF World Economic Outlook, September 2011.

1. Greece, Italy, Ireland, Portugal and Spain.

7/31/2019 Solving for 2012

22/51Solving or 201


Investing in oreign securities involves greater risks than investing in securities o U.S. issuers, including currency uctuations, interest rates, potential political instability,restrictions on oreign investors, less regulation and less market liquidity. Investing in emerging market countries involves risks in addition to those generally associated withinvesting in developed oreign countries. Securities o issuers in emerging market countries may be more volatile and less liquid than securities o issuers in oreign countrieswith more developed economies or markets.


o eperience operating in emerging

markets, oer strong corporate gover-

nance and transparency, and trade at

attractive valuation levels today.

Within Europe and Japan, we believe

deensive sectors like health care

and consumer staples hold appeal.

We also nd certain segments o the

consumer discretionary sectors attrac-

tivesuch as cable TV and satellite

broadcastingwhere many compa-

nies maintain a recurring stream o

revenue that tends to be insensitive to

the economic backdrop. We also view

parts o the inormation technology

and industrial sectors in the samelight, as many companies in these

areas derive most o their prots rom

maintenance or service revenue.

Even in mature markets, we believe

that telecommunications spending will

continue to rise, as consumers adopt

more data-intensive devices and appli-

cations. Within this area, we believe

that cellular operators and equipment

suppliers are likely to benet rom

greater volumes and capital spending.

In contrast, we are generally pes-

simistic about the nancial sector, as

we believe that the developed world

is in a prolonged period o deleverag-

ing. Credit markets globally remainvulnerable to policy in Europe, which

represents an area o potential risk

that it seems prudent to avoid.

IdenTIFyIng areas oF sTrengTH

In Europe, once one steps outside

the markets at the center o the debt

issue, we believe there are attractive

investment opportunities. Countries

such as Norway and Switzerland are

good eamples. Norway has retainedits own currency, has limited public

debt, and maintains signicant oil

reserves. Switzerland has also re-

tained its currency and is home to

several world-class global health care

and consumer staples companies that

operate in a variety o developed and

emerging markets. Similarly, while we

epect the U.K. economy to remain

lackluster, there are solid companies

in Britain that appear well-positionedwith global brands and operations.

From our perspective, a well-rounded

approach to international equity

investing should also consider non-

EAFE inde eposure. The Canadian

economy ared well through theglobal nancial crisis o 2007-09,

and is home to some o the worlds

leading energy, precious metals and

agricultural commodities companies.

Emerging markets include many com-

panies that are relatively insensitive to

policy changes in their home markets

and oer a strong strategic position

in global markets.

Overall, we believe that international

markets oer compelling valuations

and select areas or secular growth.

While there are countries and sec-

tors to avoid, we think there are also

world-class opportunities or long-

term investors willing to look beyond

the headlines.

GLOBAL EQUITIES

7/31/2019 Solving for 2012


Emerging Markets: Real Growth in a Weakening Global Economyc a. sh, cFa, pti m gb eit T

Ater sharp losses stemming rometreme risk aversion during 2011,

we believe emerging markets

(EM) equities may be poised or a

reboundrst or larger-capitalization

stocks and then smaller-cap issues. In

our view, undamentals remain strong

and, ater the sell-o, valuations

have become compelling. Perhaps

most importantly, compared with the

headwind that we epect developed

market companies to eperience, EMcompanies are currently beneting

rom real secular growth. While risks

remain, including domestic infation

and ongoing global economic pres-

sures, we believe that EM companies

ocused on meeting domestic demand

have attractive return potential in the

year ahead.

sell-oFF In 2011 WasIndIscrImInaTe

As 2011 began, loose monetary policy

in the developed markets helped push

commodities and energy prices higher.

This caused EM central bankers to

ocus on taming infation. The need

or vigilance was particularly pertinent

in high-growth economies such as

China, India and Brazil, and policymak-

ers embarked on monetary tightening

programs in an eort to limit the risko their economies overheating. While

this made sense economically, the

policy caused EM investors to worry

about slowing growth. In the second

hal o the year, the European sover-

eign debt crisis intensied. This, along

with signs o slowing growth across

the major developed economies, and

a potential hard landing or the Chi-

nese economy, led markets to a period

o massive risk aversion.

Given the risk-aversion sentiment,although undamentals generally

remained strong, investors sold o

EM equities. This risk-o trade began

in the third quarter, with the MSCI

Emerging Market Inde declining

22.5%, the worst perormance since

the ourth quarter o 2008. Now, with

valuations at attractive levels, and rela-

tively superior economic growth rates,

we view this as an attractive time or

investors with a longer-term view toreconsider emerging markets.

secular groWTH and THe

domesTIc advanTage

From our perspective, the secular

advantages emerging markets enjoy

over developed markets have only

increased, driving and sustaining their

longer-term growth trajectories. Gross

domestic product (GDP) growth is

highin act, some research suggests

EmERGInG mARkEtS: UnPARAllElEd GRowth At A low PRIcE

MSCI Emerging Markets MSCI World

Forward Price/Earnings* Forward EPS Growth Rates

0

5

10

15

20

25

30

35

11/119/113/119/103/109/093/099/083/089/073/079/063/060

5

10

15

20

25%

11/119/113/119/103/109/093/099/083/089/073/079/063/06

Sources: MSCI, FactSet, RIMES. Data as o November 30, 2011.* Based on one-year estimates. Based on 3-5 year earnings-per-share growth rates.

1. Source: Morgan StanleyGlobal Economics, August 2011.

7/31/2019 Solving for 2012

24/51Solving or 201

that up to 80% o global GDP growth

will be generated rom the emerging

markets in 2012.1 In addition, emerg-

ing markets countries tend to have

strong balance sheets versus the overlyindebted developed market countries.

Longer term, we believe one o the

most important secular drivers or EM

economies is their demographic pro-

le: Young and growing populations

are rapidly increasing their standards

o living and consumption habits,

driving growth or many domestically

ocused consumer staples, consumer

discretionary and health care com-

panies. These countries also have tospend on local inrastructure that will

benet local growth, improving e-

ciency and raising capacity.

A new positive shit weve seen is

taking place within emerging markets

eport sectors, which have tradition-

ally been aimed at developed markets.

In light o a slow global economy,

intra-emerging markets trade has been

the key growth driver or the eport

sector, and has resulted in more

eports remaining in EM. Clearly, com-

panies with the brand, distribution and

eposure to other growing economies

appear, at this point, better positioned

than those relying on developed mar-

kets or their growth.

In terms o market capitalization, we

see the most compelling valuations

in small- and mid-cap stocks, as they

underperormed or much o 2011

when investment und fows migrated

out o EM. With a longer-term view,

we think they oer an attractive risk/

reward prole as, in general, they are

well-positioned to benet rom thedomestic growth.

Issues remaIn BuT

are relaTIve

The types o issues we see in emerg-

ing markets can be categorized either

as eogenous (such as eects o

the global economic slowdown, EM

investor behavior and liquidity issues)

or internal (infation or sub-optimal

growth). While any o these couldimpact equity market perormance, we

take comort in the idea that strong

secular growth stories with solid

company and economic undamen-

tals should hold investment appeal,

particularly in light o the challenges

acing developed equity markets.

Regarding infation, while emerg-

ing markets companies continued to

see strong growth in 2011, higher

raw material and input costs as wellas higher wages created some mar-

gin pressure. We think these eects

will start to taper o; and, rom an

earnings growth standpoint, we

continue to eel more comortable

with the domestically oriented sec-

tors. To maintain growth in a slowing

global economy, many countries are

either already cutting rates or near-

ing the end o tightening cycles. In

cases where infation has remained

airly sticky, as in China and India,

policymakers appear to want to see

evidence that infation has abated

beore making denitive moves. On

the other hand, in Turkey, Indonesiaand Brazil, rate cuts are already under-

way. For Brazil, specically, high rates

had strengthened the real, which has

hurt eport sectors. A surprise rate cut

last summer was aimed at removing

some o the upward currency pres-

sure. The act remains, however, that

there is structural infation in emerg-

ing markets, with wages increasing

considerablywhich, in part, also

uels strong domestic demand. To help

increase productivity and oset wage

pressures, investments in capacity will

be needed. A general lack o capac-

ity is an ongoing problem hampering

overall growth, but it provides another

secular investment theme ocused on

industrial and materials companies.

cauTIous opTImIsm

As we look to the year ahead, we are

cautiously optimistic. When the market

returns to ocusing on the unda-

mentals, we think domestically driven

emerging markets companies could be

a real growth story or 2012.

GLOBAL EQUITIES

This material is provided or inormational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or holda security. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates.Investing entails risks, including possible loss o principal. Indexes are unmanaged and are not available or direct investment. Past perormance is no guarantee outure results.

Investing in oreign securities involves greater risks than investing in securities o U.S. issuers, including currency uctuations, interest rates, potential political instability,restrictions on oreign investors, less regulation and less market liquidity. Investing in emerging market countries involves risks in addition to those generally associated withinvesting in developed oreign countries. Securities o issuers in emerging market countries may be more volatile and less liquid than securities o issuers in oreign countrieswith more developed economies or markets.


7/31/2019 Solving for 2012


Greater China: Challenges, Select OpportunitiesF y, si pti m gt chi eit T

In recent years, China has achieved

generally stable and rapid economic

growth, averaging 10% gross domes-

tic product (GDP) growth in the last

31 years, and 9.4% in the rst three

quarters o 2011.1 As we look to 2012,

however, the sluggish world economy

and market volatility may pose sig-

nicant challenges or investors. Does

the Greater China region continue to

provide opportunities? In our view,

the answer is yes, especially in view

o 2011 market declines; althoughselectivity, as always, will be important

in this relatively volatile segment o the

worlds capital markets.

groWTH remaIns sTrong,

valuaTIons compellIng

Projected growth rates or China,

albeit lower than those seen recently,

remain strong. The Chinese govern-

ment has targeted GDP growth o

approimately 7% or the net ve

years,2 and we anticipate Chinese GDP

growth rates o 8.5% and 8% over the

net three and ve years, respectively. I

GDP growth rates or other economies

remain in line with consensus estimates,

these gures would be among the

highest in Asia and about two times

that o U.S. and Europe combined.

Chineseper capita GDP and private

consumption are much lower than

those o other major economies. Thisrefects the vast gap in living standards

between China and developed econo-

mies and, we believe, supports the case

or continued strong growth.

Also important, bargain-hunting

opportunities have emerged ollowing

the recent market corrections, with

valuations near 2008 lows despite

what we consider to be very strong

earnings potential. For eample, the

trailing 12-month price/earnings ratio

or the MSCI China Inde was 8.4 as

o September 30, 2011.3 This is despite

projected 2012 earnings-per-share

growth in the low teens or MSCIChina and mid-teens or the China

A-shares market.

underWeIgHTed In

gloBal IndIces

In our view, Greater Chinas weight-

ing in global indices does not prop-

erly refect its size, importance and

infuence in relation to global markets.

Mainland China is the worlds largest

emerging market and Greater China4(including Hong Kong and Taiwan) is

the second-largest equity market in

terms o market capitalization. How-

ever, the MSCI global indices only

include a subset o the Greater China

markets and do not refect the entire

opportunity set. The MSCI World Inde

contains only Hong Kong companies

listed in Hong Kong, which represents

just 1.3% o the inde total.5 Mean-

while, China is captured in the MSCIEmerging Markets (EM) Inde only as

mainland Chinese companies listed in

Hong Kong, and comprises 17.3% o

the inde (see display)6 versus 15.3%

or Brazil. In act, Greater China has

a market capitalization o over three

times that o Brazil, but the market is

under-represented by global indices

because only a portion o it is cap-

tured. In our view, this misalignment

underscores the magnitudeand,

thereore, the opportunity seto the

potential investment universe within

the Greater China equity markets (see

display on page 25).

sHIFT ToWard domesTIc

consumpTIon

Historically, GDP growth in China

has been driven by government

investment. Today, although still the

worlds largest eporter, the country

is becoming less dependent on ed

asset investment and oreign trade or

growth, refected by its standing as

the worlds second-largest importer.

In the rst three quarters o 2011,

growth o imports outpaced that o

eports, up 26.7% versus 22.7%,

respectively.7 Another key metric is

retail sales, which we consider an

important indicator o domestic con-

sumption. Retail sales rose 17.7% year-

over-year in September 2011 and 17%

in the rst three quarters o 2011.8 We

believe these shits in Chinas growth

model will contribute to the sustain-

ability o its long-term epansion.

1. National Bureau o Statistics o China.2. Outlines or the 12th Five-Year Plan on National Economic and Social Development, March 2011.3. Bloomberg, as o September 30, 2011.4. Greater China includes companies incorporated, organized under the laws o, or that have a principal ofce in, the Peoples Republic o China, Hong Kong SAR, Macau

SAR or Taiwan. It also includes companies that derive a majority o their revenue or profts or that have a majority o their assets in mainland China or Taiwan.5. Barclays Capital, as o August 31, 2011. Greater China represents Hong Kong companies listed in Hong Kong, which is in the MSCI World Index.6. Barclays Capital, as o August 31, 2011. China represents Mainland China companies listed in Hong Kong, which is in the MSCI Emerging Markets Index.7. Chinas Foreign Trade to Top $3 trillion This Year: Ofcia l, China Daily, October 29, 2011.8. Total Retail Sales o Consumer Goods in September 2011, National Bureau o Statistics, China.

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GLOBAL EQUITIES

InFlaTIon concerns aBaTe

Throughout 2011, the Chinese

government grappled with balanc-

ing slowing growth and the potentialor high infation. Since September

2010, the Peoples Bank o China

(the countrys central bank) has been

active in its tightening policyrais-

ing benchmark interest rates ve

times and increasing the reserve

requirement ratio or major banks to

a record 21.5% rom 17% last year.9

However, o late, policymakers have

eased these measures due to poten-

tial concerns over social unrest and

slowing growth.

Overall infation (as represented by

the Consumer Price Inde) peaked in

July 2011 at 6.5% and has gradually

decreased, easing to 6.2% in August

2011 and dipping slightly below 6.1%

in September 2011.10 We epect infa-

tion o approimately 5% or the last

quarter o 2011. Compared with the

countrys savings rate o approimately

3.5%, the real savings rate (ater infa-

tion) is still negative. While we believe

it remains too early to conrm that

infation has abated, we eel that the

easing to date is a positive indicator.

amId sloWIng, look To

IndusTry leaders

Looking ahead to 2012, Chinas eco-

nomic prospects will likely be aected

by slower projected growth in the

U.S. and Europe. However, we think a

healthy job market supported by ris-

ing wages reinorces the potential or

select opportunities in sectors driven

by economic growth and consump-

tion, such as consumer discretionary

and consumer staples. Within these

sectors, we are more optimistic about

companies that are leading players in

their respective industries, with high

top- and bottom-line visibility, stable

and recurring operating cash fows,

and robust distribution channels.

More broadly, although short-term

uncertainties persist, we believe the

Greater China equity markets are

at compelling valuations and seem

likely to rebound during the coming

year. In our view, taking a bottom-

up approach using on the groundresearch will be the best way to try to

limit the potential pitalls and capital-

ize on the opportunities in the region.

9. Corporate Yield Gap Shrinks as China Curbs Ease, Bloomberg, October 30, 2011.10. National Bureau o Statistics o China.



chInA IndEx wEIGhtInGS UndERwEIGht mAjoR mARkEt

Growth, Market Capitalization o LargestEmerging Equity Markets

12%

10

8

6

4

2

0

0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000

GDP Real Rate (% as of July 2011)

Market Capital ($ in billions as of September 30, 2011)

India

MainlandChina

Brazil

South Korea

Taiwan

Mexico

Turkey

Russia

Malaysia

Source: Bloomberg and CIA World Fact Book, as o September 30, 2011. Size o circlerepresents size o market capitalization. Mainland China includes A and B shares only.

Others2

17.25%

6.95%

6.74%

7.89%

10.99%

17.64%

14.38%

15.32%

2.83%

Taiwan

South Afr

Russia

Korea

Indonisia

India

China1

Brazil

MSCI Emerging Markets Index Constituents

Source: Barclays Capital, as o August 31, 2011.1. China represents Mainland China companies listed in Hong Kong, which is in the

MSCI Emerging Markets Index.2. Others include Chile, Colombia, Czech Republic, Egypt, Hungary. Malaysia, Mexico,

Morocco, Peru, the Philippines, Poland, Thailand, Turkey.

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GLOBAL FIxED INCOME

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Overview: Despite Uncertain Economy,A Generally Positive Outlook

B T, chi Itt of Fix I

level o pessimism. Overall, despite

a host o macro uncertainties, we

are generally positive about the

various sectors o the global ed

income market.

a look Back

The rst quarter o 2011 and much

o the remainder o the year were

a study in contrasts or the ed

income market. When the year

began, there were epectations or

a strengthening global economy

and infationary concerns. In the

rst quarter, despite many geopo-

litical issues, the ongoing European

sovereign debt crisis and the dev-

astating natural disasters in Japan,

most spread sectors outperormed

equal-duration Treasuries and U.S.

Treasury yields moved higher across

the curve. However, beginning in late

spring, global growth moderated and

investor risk appetite was replaced

with risk aversion. The risk o

trade gained momentum in the third

quarter o the year due in part to a

lack o U.S. scal discipline resulting

in Standard & Poors Treasury rating

downgrade, disappointing economic

data that triggered epectations or

a double-dip recession, and ears o

contagion rom the European sov-

ereign debt crisis. At one point in

September, the yield on the 10-year

Treasury ell to levels not seen since

the 1940s. At this point, it appears

that many spread sectors may gener-

ate positive returns in 2011, but lag

equal duration Treasuries.

gloBal economIc uncerTaInTy

Against such an uncertain backdrop,

the ollowing is our base case or

2012, albeit with several caveats given

the unolding situation in Europe,

evolving scal and monetary poli-

cies around the globe and questions

regarding Chinas ability to orchestrate

a sot landing or its economy.

What is crystal clear is the act that

the global recovery has lost some

momentum. Leading indicators across

the globe point to a slowdown that is

broad-based. Whats more, consumer

spendingthe true driver o an

economic epansionremains weak

as households deleverage and repair

their balance sheets. These head-

winds, coupled with a growing push

or scal consolidation and sovereign

debt reduction, lead us to believe

that global growth will remain below

trend in the short to medium term.

In the midst o elevated levels o risk

aversion and deteriorating macro-

economic undamentals, we eel that

eceptional stimulative measures are

likely to remain in place or longer than

previously anticipated. We also eel thatinterest rates around the globe should

remain relatively low. This is a potential

recipe or solid results rom many sec-

tors in the global ed income market.

Given spread widening that occurred

during recent fights to quality, we now

nd many spread sectors to be attrac-

tively valued.

The economic picture is clouded with an unusual number o macro issues that could potentiallyundermine global growth in 2012. However, should some o these issues be resolved or even become

less negative, the result could be an upside surprise or the global economy, given the current

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GLOBAL FIxED INCOME

We epect U.S. growth to remainmodest, but generally positive, as

the economy adjusts to tighter scal

conditions. Easy monetary conditions,

ample liquidity and stronger balance

sheets or both consumers and cor-

porations (higher savings rate or the

ormer and signicant amounts o cash

and etended debt maturities or the

latter) should, in our view, provide an

improved environment or consumer

spending and, thus, U.S. growth.

We think unemployment will remain

elevated but begin to drit lower.

Overall, in our opinion, GDP growth

will most likely be between 1.5% and

2.5% in 2012.

InTeresT raTes and InFlaTIon

We have a airly negative outlook or

Treasuries given recent valuation levels.

The outright level o rates, a multi-

decade low, refects a substantial

amount o risk/uncertainty premiumsassociated with the European situa-

tion, epectations or a U.S. recession

and potential or a defationary envi-

ronment. Given low Treasury yields,

any material change in sentiment and/

or positive surprises in economic data

will, in our view, result in negative

absolute returns or the asset class in

2012. We epect the trading range

or the 10-year U.S. Treasury to be

between 2% and 3% or 2012 and

or the ve-year Treasury to fuctu-

ate between 0.9% and 1.6%, given

the Feds commitment to keeping the

Federal Funds rate anchored in a his-

torically low range between zero and

0.25% until mid-2013. The longer end

o the curve (30-year maturities) has

the potential to be more volatile and

could trade between 3.0% and 4.4%

in 2012. We believe headline infation

will moderate rom 4%, while core

CPI should remain relatively steady

given the large positive gap betweenheadline and core CPI.

InvesTmenT grade credIT

While the near-term outlook or the

credit market is cloudy, we eel the

intermediate- to longer-term picture

remains bright. Near term, a number

o macro actors could overshadow

generally strong undamentals which

typically drive the perormance o the

credit market. These actors includeconcerns about contagion rom the

European sovereign debt crisis and

ears o a recession in the U.S. While

the situation in Europe remains fuid,

it is our belie that a resolution will

eventually occur. We also eel that the

U.S. will skirt a double-dip recession.

When some o the uncertainties

regarding the macro headwinds lit,

investor sentiment could improve,

providing a tailwind or the credit

PRIcInG In A REcESSIon, InVEStmEnt-GRAdE cREdIt APPEARS AttRActIVE

Source: Morgan Stanley, Moodys, the Yield Book, Federal Reserve. Data through October 31, 2011.

0

100

200

300

400

500

600

700

800

Spread to Treasury (bps)

BBBs (to Treasury)U.S. Recession AAA/AA (to Treasury)

200519951985197519651955194519351925

8081 Recession

S&L Crisis 9091 Recession

2001 Recession

Corporate Malfeasance

Credit Crisis

U.S. Economy, Rates and Sectorsaw a. Jh, chi Itt of Itt g Fix I

7/31/2019 Solving for 2012


market. Further supporting the credit

market is the undamental backdrop.

Overall, corporate balance sheets

are generally strong, with record

amounts o cash on their books. Inaddition, unlike the 2008 credit crisis,

U.S. banks have recapitalized, there

is ample liquidity, deault rates are

etremely low and we epect to see

more upgrades than downgrades.

Furthermore, corporations continue

to enjoy eceptionally low borrowing

costs and, given the low interest rate

environment, we believe demand or

the asset class will again be robust.

Given this outlook, we epect to

see investment-grade bond spreads

tighten in 2012.

resIdenTIal morTgage-Backed

securITIes

We are generally positive regarding

the agency mortgage-backed securi-

ties (MBS) market in 2012. Valuations

are airly attractive rom a historical

perspective and undamentals are

encouraging overall. In our view,

prepayment risks are muted, given

the high percentage o mortgages

that remain under water due to the

prolonged downturn in the housingmarket. Agency MBS are also a rela-

tively high-quality spread sector, which

could prove advantageous during

periods when there are heightened

concerns over credit risk. Also support-

ing the agency MBS market, in our

opinion, is the Federal Reserves initia-

tive to reinvest coupons and principal

payments rom its holdings o agency

debt and agency mortgage-backed

securities into agency MBS. The main

risk to our outlook comes in the orm

o unepected regulatory actions. In

particular, prepayment risks would

increase i the ederal government is

successul in introducing measures to

help homeowners who have negative

equity renance their mortgages.

In our view, the prospects or the non-

agency residential mortgage-backed

securities (RMBS) market are also

encouraging. A number o technical

actors, including the Federal Reserve

Bank o New Yorks attempts to sell

its stake in Maiden Lane II LLC in the

open market, caused non-agencyRMBS spreads to widen during the

spring o 2011. The downturn in this

sector resumed as the general shun-

ning o credit risk continued through

the summer and all. As a result, we

eel that non-agency RMBS loss-

adjusted yields havent been this

attractive since mid-2009. Fundamen-

tals in this market are also generally

benign, as we do not epect to see

signicant urther deterioration in

the housing market. In addition, we

could see urther progress between

regulators and mortgage originators/

servicing companies regarding the

servicing and oreclosure process. This

could positively impact the oreclosure

timeline, which, we believe, would be

benecial or the overall RMBS market.

REAl RAtES dRoP In PoSt-REcESSIon EnVIRonmEnt

10-Year Treasury and Fed Fund s Historical Real Rate

Source: Yield Book; data through October 31, 2011.

-2

-1

0

1

2

3

4

5

6%

2011200920072005200320011999199719951993199119891987

Fed Funds Real Rate 10-Year Treasury Real Rate

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Given the underlying undamentals

and current spread levels, we have a

positive outlook or the high yield/

bank loan market in 2012. From a

undamental perspective, despite

moderating economic growth, cor-

porate prots have generally been

solid and leverage levels are manage-

able. Furthermore, in our view, the

large amount o cash sitting idle on

corporate balance sheets providessomething o a cushion i economic

growth weakens urther. We also

eel that implied deault levels may

be overstated. In our view, deault

rates will not materially increase in

the net several years, even i the

U.S. slips back into a recession. The

usual catalysts or deaults have

signicantly dissipated, as bond and

loan maturities have been etended,

bank covenant packages have been

lightened and the average coupon is

not a signicant cash fow hurdle or

most issuers. More specically, we

anticipate a deault rate o roughly

2% in 2012, versus a historical aver-

age o approimately 4%.

asseT-Backed securITIes

We generally do not nd asset-backed

securities (ABS) to oer compelling

valuations, as their spreads have largely

moved back to their pre-credit crisis lev-els. Additionally, regulatory uncertainty,

especially in terms o how the Dodd-

Frank Act treats securitization going

orward, could negatively impact ABS.

In particular, the use o securitization

by nancial companies has become less

attractive and has resulted in less liquid-

ity in the secondary market.

commercIal morTgage-

Backed securITIesThe risk-o trade caused most spread

sectors to perorm poorly as 2011

progressed, and commercial mort-

gage-backed securities (CMBS) were

no eception. This has presented

what we consider some compel-

ling spreads at the top o the capi-

tal structure tranches in the CMBS

market. Loss severities on liquidated

loans have also not been as bad as

was eared a year ago, as commercialproperty pricesespecially in major

metropolitan marketshave oten

held up better than anticipated.

Potentially undermining our generally

positive outlook are regulatory uncer-

tainties related to the securitization

o commercial mortgages. We also

saw that the CMBS market was highly

susceptible to spread-widening dur-

ing recent periods o heightened risk

aversion. Given the unsettled macro

environment, we acknowledge that a

resumption o the risk-o trade could

negatively impact the CMBS market

in 2012, but we believe that this

would be temporary, as yield spreads

are very attractive or such relatively

high-quality assets.

Treasury InFlaTIon-

proTecTed securITIes

As we approach the conclusion o

2011, Treasury Infation-Protected

Securities (TIPS) seem likely to havegenerated a strong absolute return

or the year, but underperormed

Treasuries. For 2012, we epect TIPS

to deliver positive ecess returns as

break-even infation is epected to

rm. It is our belie that headline

infation data will remain volatile in

2012 and that the Federal Reserves

accommod

solving for 2012

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