The End of the Equity Cult?

Duncan GwytherChief Investment OfficerOctober 2010

2

The End of the Equity Cult

• Two significant bear markets and continuing high volatility

• Uncertainty over economic growth prospects

• Regulation designed to make ‘the world a safer place’ - Solvency 2 etc

Mean

• Global bond yields have fallen to multi-decade lows, and

• Insurance sector’s equity allocation just 4% (net of policyholder participation)

• Bond fund flows are now greater than equity flows were in 2000

But

• Sovereign debt crisis is real and ongoing

• Inflation isn’t dead, so is there a ‘real’ problem meeting future liabilities?Source: Investment Company Institute, Morgan Stanley European Strategy 27 September 2010

3Source: Association of British Insurers 31 August 2010

Equity exposure - UK insurance companies

Association of British InsurersLong-Term and General Insurance Holdings

UK Public Sector Securities, 12%

Overseas Ordinary Stocks and Shares, 15%

Property, 6%

Cash and Other Investments, 8%

Overseas Public Sector Securities, 6%

Unit Trusts, 13%

Other Overseas Company Securities, 14%

UK Ordinary Stocks and Shares, 15%

Other UK Company Stocks and Shares, 11%

4

Equity exposure - UK insurance companies

Source: Company data, Morgan Stanley European Strategy 27 September 2010

Morgan Stanley ResearchEstimate of Net Policyholder Participation

Govt Bonds, 30%

Corp Bonds, 27%

Loans, 8%

Other, 10%

Equities, 4%Cash, 5%

Cov Bonds, 5%

Str Credit, 11%

5

Fund flows - Solvency 2, equities not capital efficient

Standalone Capital Requirement 39.0% 49.0% 25.0% 16.5% 11.5% 8.2% 4.9%

Expected Excess Return 3.3% 4.3% 1.9% 1.3% 1.2% 1.1% 0.9%

Assumes that liabilities are cashflow-matched using swaps and other interest rate derivatives.Source: QIS5 technical specifications, Bloomberg, Morgan Stanley Research, Oliver Wyman 22 September 2010

Risk Adjusted Returnfrom different asset classes under Solvency 2

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

Equity PrivateEquity

Property Credit (10y) Credit (7y) Credit (5y) Credit (3y)

Exp

ecte

d R

etu

rn o

n S

CR

(%

)

6Source: WM Pension Funds 31 Dec 2009

Fund flows - pension funds structural sellers

0

10

20

30

40

50

60

70

80

90

100

1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

%

Property Alternatives UK Equities Overseas Equities Bonds Cash/Other

7Source: Investment Company Institute and Morgan Stanley Capital International 2010

Fund flows - US equity mutual fund flow v performance

Net Fund Flows to Equity Funds Relative to Global Equity Performance

-40

-30

-20

-10

0

10

20

30

40

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Bil

lio

ns

of

Do

lla

rs

-50

-40

-30

-20

-10

0

10

20

30

40

50

% T

ota

l R

etu

rn o

n E

qu

itie

s

Net new cash flow % Total return on equities

8Source: Investment Company Institute and Morgan Stanley Capital International 2010

Fund flows - US bond mutual fund flow v performance

Net Fund Flows to Bond Funds Relative to Bonds Returns

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

1995

1996

1996

1997

1997

1998

1999

1999

2000

2000

2001

2001

2002

2003

2003

2004

2004

2005

2006

2006

2007

2007

2008

2008

2009

Bil

lio

ns

of

Do

lla

rs

-5

0

5

10

15

20

% T

ota

l R

etu

rn o

n B

on

ds

Net new cash flow Total return on bonds

9

Government debt - debt swap now a public ‘problem’

Source: European Commission

European Commission Forecasts forBudget Deficit v General Government Debt in 2010

Sweden

Germany Italy

Euro AreaEU

FrancePortugal

GreeceSpain

Ireland

United Kingdom

0%

2%

4%

6%

8%

10%

12%

14%

20% 40% 60% 80% 100% 120% 140%

General Government Debt, % GDP

Bu

dg

et D

efic

it, %

GD

P

10

Government debt - initial debt is not the whole story

Source: EU commission, Eurostat, CBO, IMF, Morgan Stanley Research 25 Aug 2010

-1,800%

-1,600%

-1,400%

-1,200%

-1,000%

-800%

-600%

-400%

-200%

0%

200%

400%

Cost of ageing

NPV of structural deficits

Initial debt level

% of GDP

11

Government debt - revenue available to repay debt matters

Source: Eurostat, CBO, Morgan Stanley 25 Aug 2010

Sovereign Debt/Revenue

0%

50%

100%

150%

200%

250%

300%

350%

400%

De

bt/

Re

ve

nu

e %

12

Government debt - so how safe are sovereign bonds really?

• Sovereign debt crisis is global

• Private to public debt swap has to be ‘paid for’

• Increased taxes will raise sufficient revenue to cover the bill

• Default

– UK/English government has not defaulted on debt since 1594

– Other countries have

– Gilts rank senior to all other government debt

• ‘Financial oppression’

– Reneging on ‘unsustainable promises’ - pensions are an obvious target

– Repaying debt in devalued money e.g. through unexpected inflation

– Regulating institutions to purchase government debt at uneconomic prices

• No insurance against financial oppression at current yields

13

Inflation - money supply in ‘real’ economy contracting

14/10/10

O N D J F M A M J J A S O N D J F M A M J J A S O-2

0

2

4

6

8

10

12

14

16

18

UK MONEY SUPPLY M4 - 12 MONTH CHANGE SADJ

UK 12M GROWTH RATE OF MFI STERLING NET LENDING EXCL.SECURITISSource: DATASTREAM

14

Inflation - UK long-term expectations still well anchored14/10/10

2006 2007 2008 2009 20100.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

5.00

UK YOUGOV/CITIGROUP-INFLATION EXPECTATIONS FOR THE NEXT 12 MONTHS

UK YOUGOV/CITIGROUP-INFLATION EXPECTATIONS, NEXT 5-10 YEARS

Source: DATASTREAM

15

Rolling rates of real return - bonds and equities

Source: Quilter, DataStream

-10.0

0.0

10.0

20.019

3519

3719

3919

4119

4319

4519

4719

4919

5119

5319

5519

5719

5919

6119

6319

6519

6719

6919

7119

7319

7519

7719

7919

8119

8319

8519

8719

8919

9119

9319

9519

9719

9920

0120

0320

0520

0720

09

10 Y

ear

Rol

ling

Rea

l Ret

urn,

% p

.a.

-10.0

0.0

10.0

20.0

1935

1937

1939

1941

1943

1945

1947

1949

1951

1953

1955

1957

1959

1961

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

10 Y

ear

Rol

ling

Rea

l Ret

urn,

% p

.a.

16

Equities - excess equity return determined by dataflow14/10/10

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010-80

-60

-40

-20

0

20

40

60

80

-10

-8

-6

-4

-2

0

2

4

6

8

10

EXCESS UK EQUITY RETURN OVER 6M ROLLING PERIODS

OECD LEADING INDICATOR,6M CHANGE R/H SCALESource: DATASTREAM

17

Equities - unlike governments, companies have plenty of cash

Source: Morgan Stanley European Chartbook 7 October 2010

European companies have plenty of cash

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

900,000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Cas

h on

Bal

ance

She

et (

€m)

:

4

6

8

10

12

14

16

18

20

Cas

h as

% o

f M

arke

t C

ap/T

otal

Ass

ets

(%)

:

Cash on balance sheetCash as % market cap - rhsCash as % total assets - rhs

Source: MSCI, Worldscope

18

Equities - company cash flow is strong

Source: Morgan Stanley European Chartbook 7 October 2010

Cash flows are cheap to buy

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010e

FC

F Y

ield

for

MS

CI

Eur

ope

(%)

Source: FactSet, Datastream, MSCI, Worldscope, IBES, Morgan Stanley Research

19

Equities - company balance sheets are strong

Source: Morgan Stanley European Chartbook 7 October 2010

Corporate balance sheets are strong

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010e

Net

deb

t to

EB

ITD

A

30

35

40

45

50

55

60

65

70

75

Net

deb

t to

eq

uit

y

Net debt to EBITDA

Net debt to equity - rhs

Source: FactSet, Datastream, MSCI, Worldscope, IBES, Morgan Stanley

20

Equities - companies ready to ‘splash the cash’?

Source: Morgan Stanley European Chartbook 7 October 2010

M&A and the Profit Cycle

2

4

6

8

10

12

14

16

18

20

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

e

2011

e

2012

e

Europe M&A / Mkt Cap (%)

Europe ROE (%)

Note: 2010 number based on pro rata deal data up to 30 Sep 2010. ROE 10e, 11e &12e based on IBES estimates.

M&A activities should recover from record low levels as profitability improves

Source: FactSet, Datastream, MSCI, Worldscope, IBES, Morgan Stanley Research

21

Equities - UK dividend/corporate bond yield ratio

Source: Citi Research European Portfolio Strategist 19 August 2010

0.2

0.3

0.4

0.5

0.6

0.7

0.8

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Average

+1 St Dev

-1 St Dev

22

Equities - UK equity earnings/gilt yield ratio

0.0

0.5

1.0

1.5

2.0

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

+1 St Dev

Average

-1 St Dev

Source: Citi Research European Portfolio Strategist 19 August 2010

23

Equities - cheaper than corporate debt = M&A?14/10/10

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 102

3

4

5

6

7

8

9

10

11

12

13

GILT YIELDFTA 500 IND EARNINGS YLDCORP BOND BBB

CORP BOND AAASource: DATASTREAM

24

Equities - components of UK total return

Source: FTSE All Share, DataStream, to end 21 September 2010

-30%

-20%

-10%

0%

10%

20%

30%

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010YTD

20YRSANN

Income return Capital growth

25

The End of the Equity Cult - maybe not

• Governments will grow their way out of the unsustainable debt position

• Default unlikely, ‘Financial oppression’ almost a certainty

• Regulation mean institutions set up to be the ‘fall guys’

• Inflation may be tame short-term, but it is NOT dead longer term

• Structural investor selling will continue to dampen equity returns

• Equity valuations provide a large risk premium for future uncertainty

• Companies will take advantage of the valuation anomalies through M&A

• Dividends provide shorter-term ‘reward’ for ‘carrying’ the risk

26

DisclaimerThis communication has been prepared only for the recipient and date shown on the front page. It is not intended for any other persons and should not be relied upon by other persons.

This presentation has been prepared for information purposes only and is not a solicitation or an offer to buy or sell any security. It does not purport to be a complete description of our investment policy, markets or any securities referred to in the material. The information on which the presentation is based is deemed to be reliable, but we have not independently verified such information and we do not guarantee its accuracy or completeness. All expressions of opinion are subject to change without notice. Any reference to the Quilter model portfolio, which is used for internal purposes, is purely illustrative and should not be relied upon. All figures correct to 30 September 2010 unless otherwise noted.

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The End of the Equity Cult?

October 2010