Stands for the asset allocation shifting to a structure along the lines of strategiesand risk factorsPage 2

AASlide in the PMI below the key 50-pointthreshold in February raised doubts aboutthe European upswingPage 4

49.7Size of second bailout package, in euros, forGreece, which should cover its financingneeds up to 2014 – that’s the theoryPage 5

Rise on the STOXX Europe 600 and +21%for the S&P 500 since 23 September 2011Page 6

+23%Gain made by emerging-market shares, in US dollar terms, in the year to datePage 7

+18%Net increase in US consumer credit, in dollars, for December 2011Page 8

19.3bnExtent of swings in the euro/US dollarexchange rate during the course of 2011Page 13

20%Annual average return since 1989 from aportfolio of the 10 major international currencies using a carry-trade strategy Page 14

+4%Central banks’ coincident quantitative easing March 2012

130bn

perspectives|march 2012|2|

By shifting from an allocation structured on the basisof asset classes to one organised along the lines ofstrategies and risk factors, we are in effect choosing to focus on three very distinct categories of equities.First, at the strategic allocation level, we distinguishbetween defensives and growth stocks. Second, for theportion of a portfolio earmarked for tactical plays, wemake requisite adjustments to the portfolio’s totalexposure to equities by using passive vehicles, i.e.index-based instruments.

Drawing this distinction between defensive andgrowth shares seeks to achieve diversification in portfolios by capitalising on a market anomaly widely referred to as the ‘low-beta anomaly’. According tofinancial portfolio theory, highest-risk equities, those most sensitive to marketmovements (the high betas), should compensate investors for having toshoulder the increased risks by delivering superior returns over time, a premisethat, on the face of it, makes sound common sense. Analysis of historical returnsin reality shows otherwise, though. Defensive stocks have performed at least as well as or even better than high-beta shares. Not surprisingly, thisoutperformance is not visible for every short- and medium-term period as it alsohinges on the valuation of defensive stocks relative to the rest of the market atthe beginning of the period being observed.

Superior returns and lower volatility – what can this ostensible paradox be put down to? Plenty of explanations have been put forward, ranging frombehavioural finance causes to the option-like pay-off patterns for defensives as compared to more cyclical stocks. For those keen on mathematics, the thesis is that the risk/return profile for defensives might well be concave in shapewhereas the profile for cyclicals would be convex. We do not intend to wade intothese treacherous waters, but we are manifestly in favour of having a clearlydelineated exposure to these so-called defensive stocks. In this case, how can we factor this strategy into the portfolio’s structure? To start with, the merits ofhaving a specific allocation to this particular approach need to be highlighted. A portfolio of defensive shares will go through spells of quite noticeableunderperformance during market phases when investor enthusiasm verges on the euphoric, as during the techno bubble of the late 1990s or, more recently,the bull markets on commodities and emerging shares. At times like these, thetemptation to discount the fundamental premise of pursuing an investmentstrategy can be overpowering and giving in to it can lead to movements inportfolios that damage performance over the longer term. Moreover, it is vital

The anomalous case of defensive shares

EDITORIAL OUTLOOK

Yves BonzonChief Investment Officer

perspectives|march 2012 |3|

to pick defensive shares using very clear criteria relating to the creation ofshareholder value. This approach will help guard against overoptimisticforecasting or falling foul of the influence of fads and fashions prevalent inmarkets by focusing instead on historical sources of value creation, on thelikelihood that such sources will continue to generate value in future and on theabsolute price paid to capture the value to be created. Any fundamental analysisunderpinning the process of selecting and managing a portfolio of defensiveshares must clearly not cave in to short-term pressures; it must pinpoint and stayfocused on those perennial sources of wealth creation in the markets that havestood up resiliently to the tests of time.

Perspectives is also available to download.Sign up to subscribe and keep up-to-date online with our views on markets, the economy and key underlying trends on the Perspectives website:http://perspectives.pictet.com

perspectives|march 2012|4|

The second rescue package of aid for Greece forms part of an overall programme for a grand total of around 237 billion. This alsocovers the agreement for around 107 billion euros to cancel outGreek debt owned by private-sector creditors (primarily banks and investment funds). Furthermore, roughly a further 35 billionremaining from the plan agreed in May 2010 still have to be added.

Default by Greece staved offProvided Athens fulfils the remaining terms and conditionsfor the second bailout package for a total of 237 billion euroto be unlocked, the much dreaded risk of a default on its pay-ments will ostensibly have been averted. If this package hadnot gone through, the Greek government would have founditself unable to pay back debt of some 14.5 billion eurosfalling due on 20 March. Despite the audible signs of relief,plenty of unanswered questions still hang over the long-termoutlook. Considering the serious downward pressure ongrowth exerted by draconian austerity measures, there areserious doubts about the sustainability of Greek sovereigndebt beyond 2014. No one can reliably predict what will hap-pen, but it is reasonably safe to assume the risk of a systemiccrisis in the banking industry and the danger of the conta-gion spreading to other at-risk countries do appear to havebeen contained.

The proactive monetary-policy approach taken by the European Central Bank (ECB) since December 2011 has reinforced both the belief and the likelihood the crisis will besolved. At the time of writing, the ECB was on the verge ofembarking on its second long-term refinancing operation(LTRO), timetabled for 28/29 February. This latest LTRO willonce again give European banks the opportunity to secure financing at a very low cost of 1% over a three-year period.As we commented in our last issue of Perspectives, the ECBhas at long last crossed the Rubicon and advanced down theroute of quantitative easing, along the lines of strategies deployed by other central banks like the US Federal Reserve.Such a step was vital. We regard this as the only real way totake the sting out of the economic and financial pressures.

On top of the easing of tension about solving the eurozonedebt crisis, we have also seen a stream of less dishearteningeconomic numbers. Indicators have confirmed Germany inits role as the eurozone’s economic locomotive.

US: heading for self-sustaining growth?US economic news flow has continued to display a favourablepattern over the last few weeks, especially numbers for thejobs market and the manufacturing cycle. Consumer spend-ing data have been decidedly more mixed though. At thesame time, Congress’s decision to extend breaks on social

Haphazard default avoided in GreeceThe eurozone debt crisis took a fresh, but positive turn on 21 February: eurozone Finance Ministers andthe International Monetary Fund (IMF) agreed a second bailout deal totalling 130 billion euros to run tothe end of 2014.Christophe Donay*, Bernard Lambert, Jean-Pierre Durante and Reda Idrissi Kaitouni *with Wilhelm Sissener

MACROECONOMICS

payroll taxes (and other budgetary relief measures) and further gentle monetary easing by the Fed (swaps, extensionof projected period with zero interest rates) diminished theimpact of negative developments that had been fuelling fearsof another temporary cold snap for the economy in the firsthalf of 2012.

The US economy has been exhibiting signs of generatingmore self-sustaining growth over the past couple of months.The overall upswing in lending has been confirmed, the turn-around on the jobs front is looking more solidly established,business activity for small-/mid-sized firms at last appears tobe picking up and signs of the housing sector improving havealso been detected. But we are still some way short of beingable to declare a full-blown recovery is underway. Generallyspeaking, we believe the key underlying forces driving theUS economy are gradually gaining the upper hand. This isencouraging for the prospects of sustainable growth, but alsosurprising considering the process of household deleveraginghas not yet run its course and the property sector cycle is unlikely to stage much of a rebound before 2013.

On the debit side, the recent spike in the crude oil price hasstirred an extra ingredient of uncertainty into the mix. Higher oil prices would be likely to dent consumer spending, espe-cially if they climb further. We remain guarded about short-term prospects and stick with our belief that GDP growth inthe US will be weaker in the first six months of 2012 than ithad been in Q4 2011. Despite this, we expect the slowdownto be noticeably less pronounced at present than we hadthought only a few months ago.

Upswing in German economy confirmedRecent economic news has, on the whole, tended to confirmthe scenario envisaging a moderate recession for the euro-zone overall. Although the slide in the Purchasing Managers’Index (PMI) below the key 50-point threshold in Februaryraised doubts over the solidity of previous improving indi-cators, the fine detail of the survey findings was reassuring.The fall was primarily the fault of components that are generally lagging in the economic cycle, such as employment,whereas key leading indicators, such as orders or future

Considering the serious downward pressure on growth exerted by draconianausterity measures, there are serious doubtsabout the sustainability of Greek sovereign

debt beyond 2014

perspectives|march 2012 |5|

business expectations, remained pointing in the right direction.Furthermore, other barometers such as the Ifo business sentiment index or the National Bank of Belgium’s surveybacked up the guardedly optimistic view of the outlook. TheFebruary Ifo index offered a reassuring signal about the German economic cycle: not only did the ‘Expectations’ sub-index register its fourth monthly increase in a row, butperceptions of the current situation also posted their first rebound since June 2011. Any spluttering in the Germaneconomy should be confined to a single quarter of negativegrowth (Q4 2011).

Greece and yet more GreeceEven though a deal on a second bailout package has been putin place, Greece is likely to remain squarely in the glare of thespotlights. Investors’ attention will, however, focus on thepercentage of private-sector involvement (PSI) in the debtswap deal. If this PSI rate is not high enough, collective-action clauses (CACs), just approved retroactively byGreece’s parliament, will be triggered so the terms of theagreement are applied to all private-sector owners of Greekdebt. Greece’s parliamentarians will also be subject to closescrutiny to check that the tempo of reforms keeps pace withconditions imposed in the memorandum signed by the country’s main political parties.

The Greek government’s financing needs have, in theory,now been met up to 2014 thanks to the deal on the secondaid package worth EUR130bn. It is only in theory though.The underlying assumptions make such optimistic reading

that Greece is in serious danger of soon running into majordifficulties again if the economy fails to recover. If, in themeantime though, an agreement over increasing resourcesavailable from the IMF and the European Stability Mechanismcan be clinched, the markets might conceivably be reassuredabout the ability of the euro to survive irrespective ofGreece’s ultimate fate. This upbeat scenario is not entirelyfanciful, but a number of awkward and challenging phasesneed to be negotiated yet before that scenario materialises inreality.

China: progressively and selectively easing monetary policyAlthough inflation temporarily bounced back upwards in January, the People’s Bank of China decided to lower the reserve requirement ratio for banks by 50 basis points. Thepurpose behind this quantitative-easing measure is to compensate for the drying-up of interbank liquidity and tostimulate demand for lending. It reflects the Beijing authorities’determination to loosen its monetary grip over the economy toprevent it slowing down any further.

This resolve has not, however, deterred the authorities fromtaking a discriminating approach to monetary softening. Tightening measures applicable to the property sector remainin place even though the price of new housing throughout Chinese cities has fallen. Developments in this particular areapose the major risk to economic growth in China in 2012, especially if falling housing sales were to bring about a lastingslump in construction work. Nevertheless, the Beijing authorities have the power to step in and could relax theirpolicy at any time if they deemed it to be necessary.

SPAIN AND ITALY: YIELDS AND SPREADS ON 10-YEAR SOVEREIGN BONDS

Sources: Bloomberg, Pictet & Cie

Yields on Italian and Spanish sovereign debt fell quite steeply in January and February as they responded to diminishing fears that the European debt crisis would extend the contagion further. Spreads on Italian bonds even narrowed to levels close to those on Spanish debt.

-150

-100

-50

0

50

100

150

200

250

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5%

Italy

Spain

Q1 2010

Q2

bp (IT vs ES)

Q4Q3 Q1 Q2 Q3 Q4 Q1 2012

Q22011

perspectives|march 2012|6|

Economic numbers have continued toshow progress in both the US and Europe.This bodes promisingly for a moresustainable economic upswing thangenerally accepted. This turn of events,when coupled with the significant stepsmade towards solving the eurozone debtcrisis, has worked to the advantage ofthose asset classes sensitive to economiccycles. For instance, equities, carry-tradestrategies and high-yield corporate bondshave been generating handsome gains.Volatility on financial markets has beenlevelling out over the last few weeks: themost closely monitored benchmark, theVIX index measuring implied volatility ofoptions on the S&P 500 index, is nowhovering between readings of 15% and25%, a zone we have categorised as the‘average mode’. The VIX is currently wellbelow its peak of 48% over the last 12months and its score of almost 80% whenLehman Brothers collapsed in September2008. Diminishing volatility has beendriven primarily by declining levels of risksassociated with the eurozone debt crisis.

ECB’s injections of liquiditybuoying the marketsSince 2008, the crisis of debt mountainsin America and Europe, on the oneside, and action taken by governmentsand central banks to forestall

economies sinking into a trough ofdebt deflation, on the other, have ledto financial markets alternatingbetween hopes of reflation and fearsof deflation. Since September 2011,hopes of reflation ahead have had theupper hand over deflationaryworries. As a result, risk assets havebeen turning in the best performances.The STOXX Europe 600 is up 23%since 23 September 2011 and the S&P500 is up by 21% in local currencies.

Injections of liquidity by Europeangovernments via the EuropeanFinancial Stability Facility (EFSF) andthe European Stability Mechanism(ESM) provided the initial impetus formarkets. If we take the period fromend-September to mid-January, thetwo benchmark indices notched upgains of 17% and 15%, respectively.From mid-January onwards, the twolong-term refinancing operations (the3-year loans made available by theECB to European investment andcommercial banks) totalling someEUR1,100bn, coupled with hopes of athird round of quantitative easing bythe Fed, provided the boost tomarkets. Equities extended theirrallies: the STOXX Europe 600 indexhas advanced by 6% and the S&P 5005% since mid-January.

Looking longer term, thedeflationary process of deleveragingby US households and developed-world governments has not yet run itscourse. Bearing this in mind, we willbe persevering with a strategicallocation geared towards bolsteringportfolios against deflationary shocks.In contrast, if we take a shorter-termperspective, the US economy, plus theattempts to foster reflation, isbecoming one of the more influentialfactors driving the ongoing rally onmarkets. Emerging-market shareshave, without doubt, benefited fromthis good news, delivering the bestgains of all since the start of the year:+18% in US dollars.

If we switch to look at the otherextreme, a scenario of a 10% fall ormore by shares only looks to be likelyin the near term if an exogenous shock were to hit markets. We havepinpointed three possible sucheventualities: severe slump onChina’s property market; a steepclimb in oil prices in response tomounting geopolitical tensionbetween Iran and the US; a renewedupsurge in systemic risk stemmingfrom the eurozone crisis. If no suchshock materialises, stabilisation oreven continuation of the uptrend onmarkets still looks the most feasiblescenario.

Contrasting reporting seasons in theUS and Europe Even though the various risk factorshave not been fully dispelled, equitiesextended their advances intoFebruary as investors apparentlybecame more receptive to good newsand more immune to setbacks. Thiscan be seen from the fact that fourth-quarter results on the whole made lessgood reading than those released forQ3 2011. US companies’ net profitshave, on average, come in 2.9% ahead

Reflation hopes encouraging the marketsEquity markets were in high-volatility mode in the second half of 2011, reflecting intense pressures exerted bysystemic risk, but they have now shifted back into the average-volatility regime.Christophe Donay*, Jacques Henry, Yves Longchamp * with Wilhelm Sissener

STRATEGY

FINANCIAL MARKETS

Local-currency returns in % from financial markets. Data as of 29.02.2012

Index Since 30.12.2011 Previous month

US equities* USD S&P 500 9.0% 4.3%

European equities EUR STOXX Europe 600 8.1% 3.9%

Emerging-market equities* USD MSCI Emerging Markets 18.1% 6.0%

US government bonds* USD ML Treasury Master -0.3% -0.7%

US investment grade* USD ML Corp Master 3.1% 0.8%

US high yield* USD ML US High Yield Master II 5.2% 2.3%

Hedge funds USD Credit Suisse Tremont Index Global** 2.3% 2.3%

Commodities USD Reuters Commodities Index 5.6% 3.2%

Gold USD Gold Troy Ounce 10.2% 0.2%

* Dividends reinvested ** End-January

perspectives|march 2012 |7|

of expectations in Q4 2011, comparedto 4% in the previous quarter.Turnover figures have beenmarginally higher at 1.2%. Moving toEurope, around 40% of companieshave reported net profits, which arecurrently running some 8% short ofexpectations. The worst setbacks havecome from banks and insurancegroups, but disparities within sectorshave been quite striking.Disappointments in terms of turnoverhave been of a similar magnitude.Interestingly, analysts seem to havebeen overly conservative in theirforecasting for cyclical sectors(construction, chemicals, vehiclemanufacturing) as these havemanaged to deliver sales figuresslightly better than anticipated.Against this backdrop, revisions toearnings estimates for 2012 and 2013have produced divergent patternsbetween the US and Europe. Profitforecasts for US companies for 2012have been practically unchanged overthe past fortnight or so whereasrevisions have tended to be morevolatile in Europe with no real patterndiscernible. Earnings growthprospects for 2012 have evened out inFebruary at +8.5% for the USA and+7% for Europe.

Currencies: comeback by carrytrade confirmedLeading central banks’ monetary-easing cycle, the ongoing decline insystemic risk in Europe and thereassuring news about the state ofthe US economy are the three keyfactors working to the advantage ofthe carry-trade strategy in whichfunds are borrowed in a currencyoffering low interest rates andproceeds are reinvested in currenciesoffering high interest rates. The VIXindex continued to traveldownwards in February, settlingstably in average-volatility territory.This mode is generallyadvantageous for carry-tradestrategies. To illustrate this point,our model portfolio replicating anequal-weighted carry-trade strategyfor G10 currencies delivered a 1.8%gain for February this year.

More in-depth analysis of the tenmajor currencies reveals that carrytrade is a justifiable strategy onfundamental grounds. Among thosecurrencies offering low interest rates,we have the US dollar, the euro, thepound, the yen and the Swiss franc.The respective central bank for eachof this quintet of currencies ispursuing a strategy of quantitative

easing and holding interest ratesclose to zero – the expansion inliquidity is causing the currency’svalue to be diluted.

If we turn to those currencies to beinvested in, the main ones arecommodity-related currencies andones that tend to benefit from animproving global economic cycle:these include the Australian,Canadian and New Zealand dollars,plus the Norwegian krone. Swedenmay not export commodities or rawmaterials, but the Riksbank has beenimplementing an orthodoxmonetary policy. These currenciesoffer investors more attractiveyields.

The diminishing intensity of theeurozone sovereign-debt crisispushed the euro up against the USdollar in February. Nonetheless, weremain sceptical about the euro’scurrent valuation and would expectit to lose ground gradually towardsan exchange rate of USD1.25 to theeuro over the next three to sixmonths as the ECB presses aheadwith its quantitative easing.

Economic recovery confirmed in Germany At times, economic indicators can appear at odds with each other. Whensuch contradictions occur, investors need to focus not just on their trendsand patterns, but also look elsewhere to gauge what might really behappening.

HEADLINE NEWS FROM AROUND THE WORLD

+16%Of the ‘Big Four’ emerging economies, commonly referred to togetherunder the title of BRIC countries (Brazil, Russia, India and China), theBrazilian and Indian stock markets have performed best so far this year,up by 16%.

perspectives|march 2012|8|

USD 123.62 a barrelThe price of Brent crude oil, propelled upwards by Iran, closed trading on 23 February at its highest for 8 months. Iran, OPEC’s second biggest oil producer,halted sales of its crude oil to French and British oil companies. The country had beenproducing 3.5 million barrels of crude a day, exporting some 2.5 million.

19.3 billion dollars New consumer credit (net ofrepayments) in the US totalledUSD19.3bn in December 2011,much higher than had been expected. The rate of growth inconsumer credit rose fivefoldbetween Q3 and Q4 2011, a highlyencouraging development.

RRRChina moved to cut itsreserve requirement ratio(RRR) for banks by 50 basispoints, taking it to 20.5% forthe major banks and to 18.5%for the smaller institutions.

perspectives|march 2012 |9|

1%The Bank of Japan

stepped up its monetary easing to give support to the

economy, setting an

explicit 1% target for

inflation. It also announced it would berepurchasing an extra

10,000 billion yen’s worth of Japanese government

bonds (EUR100bn) between now and end-2012.

6.5%Indonesia’s economy grew by 6.5%in 2011, confirming this South-EastAsian country’s economicrobustness. Domestic consumerspending accounts for 60% ofIndonesia’s GDP.

109.6News that the composite PMIfor the eurozone had droppedto 49.7 points cast a shadowover just how solid theeurozone recovery might be,but the Ifo business sentimentindex in Germany providedwelcome reassurance as itadvanced for the fourth monthin a row to hit 109.6 in February.

4.25%The Reserve Bank of Australia

caught financial markets bysurprise when it decided to

leave its key interest rateunchanged at 4.2% whereas the

consensus view had beenlooking for it to be cut to 4%.

perspectives|march 2012|10|

Equities

Euphoria not subsiding

The rally by equities that started in lateNovember, further fuelled by the ECB’squantitative easing in December, has beensustained.

Volatility has come down in recentweeks, settling around 17%-18% onthe VIX, but it has not dipped into thelow-volatility zone. Share prices haveextended their advances: the S&P 500is up by 17.6% and the STOXX Europe600 by 20.4% since 24 November 2011.

Several factors would tend tosuggest that the gains are bigger andlonger-lasting than would havehappened in a bear-market bounce.The rally is no longer being drivensimply by low-quality sectors. Thespread of performance across sectorshas broadened out noticeably sincelate January, especially in the US. Thepattern of this rise looks more like therallies witnessed in March 2003 andMarch 2009. These marked thestarting-points for quite significantuptrends on the markets. If thisperception proves accurate, acorrection phase of 5% to 8% cannotbe ruled out as a possibility.

The S&P 500 is currently trading at12.7X projected current-year earnings,compared to the STOXX Europe 600’s10.8X ratio. Such multiples suggestpessimism stemming from the eurocrisis in summer 2011 has been fullyworked through.

Continuation of the uptrend byshares presupposes that the economicsituation goes on improving so that itfeeds through to boost corporateearnings growth prospects.

Bonds

Sovereign bonds resilient asoptimism returns

Although all asset classes responded to thefresh approach being pursued by the ECBwith its three-year LTROs, only safe-havensovereign bonds were unaffected at theoutset of 2012.

Yields on 10-year US Treasury bondscontinued to hover inside the 1.8%-2.05% range to which they havebeen confined since mid-December2011. Since the start of 2012, USTreasuries across the board ofmaturities have cushioned the damage,losing a mere 0.3% although those at thelonger-dated end of the spectrum didsuffer worse (-2.2% on 10-yearmaturities).

As for the eurozone, the Bund hascontinued to match US Treasuries,being similarly range-bound (1.75%-2.05%).

Over the period, we have seen anongoing narrowing of spreads oneurozone sovereign debt yields versusBunds. Only the most critical cases ofGreece and Portugal have been movingin the wrong direction. Yields on 10-year Italian bonds have droppedmost spectacularly, coming down byalmost 200 basis points since the start ofthis year (from 7.2% to under 5.5% at thetime of writing).

News about Greece will continue todominate sentiment over the next fewweeks as there is still considerable scopefor it to wreak havoc. However, if theencouraging signs seen so far this yearas regards both the economy and thehandling of the crisis are confirmed, we would expect safe-haven sovereigndebt to undergo quite a significantcorrection.

Corporate bonds

Appetite for risk dictating theleague table of returns

In the first couple of months of 2012,investors’ appetite for risk has continuedto dictate the pecking order among assetclasses. Corporate bonds still look to offerattractive features to help investors getthrough this tricky crisis-exit phase.

High-yield corporates delivered thebest returns in February (+2.3%),followed by investment-grade paper(+0.8%), but US Treasuries dipped intothe red zone (-0.7%). For comparison,the S&P 500 posted a 4.3% increase.The same order is reflected in year-to-date returns: S&P 500 (+9.0%),high-yield corporates (+5.2%),investment-grade paper (+3.1%) andUS T-bonds (-0.3%).

Corporate bonds have benefitedhandsomely from the better thanexpected economic situation anddiminishing systemic risk in Europe:spreads narrowed quite noticeably.

The ECB’s modified monetary-policy stance, the latest progress inresolving the eurozone crisis and someencouraging economic news helped tofuel this renewed optimism.

This clement climate may well last throughout the year so theperformance league table as it standsnow may well stay that way for 2012.Corporate bonds offer a greater degreeof safeguard than equities and remainan asset of choice during this ratherawkward phase when financialmarkets are still very vulnerable topotential shocks from the outside.

ASSET CLASSES AND CURRENCIES

Favourable volatility regimeEquities, high-yield and, to a lesser extent, investment-grade corporate bonds are among thoseassets benefiting most from the prevailing mode on markets of ‘average volatility’, according toour definition.

perspectives|march 2012 |11|

Hedge funds

Capturing short-termoptimism

Despite benefiting from a cyclicalstrengthening across global economies,hedge funds remain bearish over themedium term.

Hedge fund performances werepositive in January, with all the mainstrategies generating gains for themonth. The HFRI Fund WeightedComposite Index rose 2.6%, registeringits second highest monthlyperformance since December 2010. Asthe economy remains structurallyfragile, managers still have a bearishoutlook for the medium term.However, the cyclical improvementthat has occurred since the beginningof the year rewarded managers whotactically traded risk assets from thelong-side.

Estimated hedge fund returns inFebruary added to January’s gains.Event-driven strategies benefited froma tightening in deal spreads, bettercredit conditions and improvedmarket sentiment. Long/short equitymanagers captured the rally in stocks,in particular within the technologyand energy sectors. By the same token,long contracts in WTI and Brentcontributed to global macro managers’returns as oil markets reacted togeopolitical risks, notably in Iran.Curve trades, such as US steepeners,were again an important source ofgains for these managers in Februaryas 2-year US Treasury yields continuedto fall.

Precious metals

Prices extending their uptrend

The upturn in economic news from theUS and Europe, rising oil prices inFebruary and central banks’ quantitative-easing programmes caused inflationaryexpectations to harden, which tends to begood for prices of precious metals.

Some understanding of the shifts ininflationary expectations can begleaned implicitly from movementson bond markets. Judging by thespread between yields on US TIPS(Treasury Inflation-ProtectedSecurities) and fixed-rate straight UST-bonds, the markets are looking forinflation to run at 2.2% p.a. over thenext decade, up from a rate of 1.7%factored in last September. Hardlysurprisingly considering prices ofgold and other precious metals tend toclimb when inflationary expectationsare on the up, they have indeed risenquite steeply over the last few weeks.Moreover, the fall in the US dollar’svalue against the euro has alsocontributed mechanically to increasesin precious metal prices. We stick withour target for a gold price of USD3,000an ounce by 2015, our projectionpredicated on all the abundantsupplies of liquidity the world’scentral banks are set to pump out overthe next few months.

Exchange rates

Carry trade remains in vogue

The average-volatility mode on marketsworked to the advantage of carry-tradestrategies in February. Unless economicprospects worsen, the climate for thisstrategy looks likely to remainfavourable.

The key trends that began to surfacein January extended into February.Carry trade, which favours high-interest-rate currencies, once againdelivered solid gains. The US dollar,yen and pound, all offering interestrates at rock-bottom levels, tendedto weaken against the Australianand New Zealand dollars, theNorwegian krone and the Swedishkrona. The Norwegian currency roseby 5.1% against the dollar inFebruary, and the Swedish kronawas up by 2.7%. The yen alone lostground to the dollar (-6%).

Subsiding systemic risk in Europe,improving economic prospects inthe US and diminishing risks of arapid downturn in China sustainedthe wave of optimism ripplingthrough financial markets, creating aclimate conducive to carry trade.

The euro’s rise in value against theUS dollar did catch a good manyinvestors by surprise. We considerthe single currency to be overvaluedrelative to its fundamentals so itlooks likely to lose ground over thecoming months to reach a rate ofexchange of USD1.25 to USD1.30.

perspectives|march 2012|12|

Modern portfolio theory placesemphasis on the importance ofdiversification achieved by employingdifferent asset classes and retainingexposures to various regions of the world.As a result, an efficient portfolio willinevitably be exposed to shifts in the valuesof foreign currencies. These movementscan, at times, be big swings that can wipeout or significantly boost returns from theportfolio as a whole. Looking back at 2011,the euro/US dollar exchange ratefluctuated over as wide a range as 20%.That illustrates just how crucial it is totake currency exposure into considerationas a potential risk factor.Our portfolios include a high proportion

of investments in local currencies. Forinstance, the euro portfolio is primarilymade up of assets denominated in euros.This is likewise true for US dollar andpound sterling portfolios, but only to alesser extent for the Swiss franc as theinvestment universe available is morerestricted in scope.

Exchange rates: the divide betweentheory and practiceUnfortunately, economic theory is onlyof limited assistance when it comes toforecasting currency trends. Mostmodels provide an estimate of the

equilibrium levels that are supposed toapply for currencies over the long run.Such models cannot be directlydeployed for day-to-day managementof currency risk. Worse still, forexmarkets are hardly ever in a state ofequilibrium as the vast diversity ofmarket operators (financial institutions,multinational companies, tourists,central banks, etc.) is a root cause of theinefficiencies that persistently plaguecurrency markets. There are a numberof reasons for buying or sellingcurrencies, and not all of them have todo with trying to make a gain or not. Allin all, we have to approach exchangerates in practice quite differently fromwhat the theory might suggest.

Winning strategiesThree basic strategies are currentlyemployed on forex markets to take upa directional position on currencies:carry trade, value and momentum.Each has been tried and tested overtime, and a whole host of studiesvouch for their profitability. In thisarticle, we will be focusing on the firsttwo.

Carry trade involves exploiting thespread between interest rates ondifferent currencies by borrowing in alow-interest-rate currency andredeploying the proceeds in acurrency offering a high interest rate.The value strategy involves buyingcurrencies deemed to be undervaluedand selling those consideredovervalued. Generally speaking, amodel based on purchasing powerparity (PPP) will play a linchpin roleto estimate a currency’s equilibriumlevel. PPP gives the equilibrium rateof exchange that equalises the levelsof goods and services prices indifferent countries. The momentumstrategy is derived from statisticalanalysis of exchange-rate movements,

highlighting their cyclical patterns:any currency that has recentlyclimbed in value has a greaterprobability of firming even further infuture than losing value, and vice-versa.

Although all three strategies candeliver positive returns over the time-frame of several years, they are allalso prone to more or less protractedspells of negative returns. Thecorrelation in returns between the triois, fortunately, low, which suggeststhat each strategy addresses differentinefficiencies in the market. This leadsus to a couple of conclusions. Firstly,there is significant diversificationpotential among the strategies, socombining them should improve therisk/reward trade-off. Secondly, theevidence would seem to implyarbitrage opportunities are not allprofitable at one and the same time,which would suggest differentregimes exist depending on the time-periods chosen.

Volatility regimes and currencystrategiesIn the Topic of the month article in theDecember 2011 issue of Perspectives(Shifts in volatility regime: a power tool fortactical allocation), we put forward thevarious volatility regimes as a usefultool for deciding on the tacticalallocation for portfolios. This approachis just as useful when it comes tomanaging currency or exchange-raterisk.

In the above-mentioned article,Christophe Donay categorises impliedvolatility into three specific regimes –low, average and high – according tothe level of the VIX index whichmeasures implied volatility of S&P 500shares.• When the VIX is below 15%, markets

are operating in an economic climate

Volatility: tool for currency allocations Tactical currency allocation is of paramount importance in managing portfolios, affecting both sides of therisk/return equation. Fluctuations in exchange rates can have a significant impact – positive or negative – onthe return on an investment. On this score, asset price volatility is a useful and powerful tool when it comes tomaking decisions about tactical currency allocations in portfolios.

TOPIC OF THE MONTH: CURRENCY RISK

Yves LongchampEconomist

perspectives|march 2012 |13|

in which risks are low, economicgrowth is stable and inflation is undercontrol.

• With the VIX between 15% and 25%,i.e. in average-volatility mode, theeconomic climate is inclementbecause either growth is slowing orinflation is accelerating, or becausesystemic risks are building up.

• Lastly, when the VIX climbs above25%, the volatility regime is high,which usually occurs when systemicrisks or recession are confirmed.Analysing currency strategies

through the prism of volatility regimesthrows light on a number of regularpatterns that are helpful for decidingon tactical currency allocations. Inlow-volatility mode, carry trade is theleading strategy in terms of deliveringtotal return (exchange-ratefluctuations and interest-rate spreads).A currency portfolio comprising solely

the ten top global currencies wouldhave generated an annualised totalreturn of 4% p.a. since 1989 in this low-volatility mode.

When it comes to the high-volatilityregime, the value strategy comes outon top. Macroeconomic imbalances arepartly compensated by the values ofcurrencies being rebalanced moreclosely into line with their equilibriumlevels. The same currency portfoliowould deliver an annualised totalreturn in excess of 10% during suchspells of high volatility. When the sub-prime crisis flared up and the VIXrocketed skywards, the value strategyworked splendidly, which explainswhy our model portfolio performed sooutstandingly well.

When volatility is in average mode,the performance gap between thesetwo strategies is less obvious.Performance comparisons for the mid-

volatility regime points to fairlysimilar total returns of around 5% up to early 2000, at which pointperformances started to diverge. Fromthe turn of the new millennium to theonset of the sub-prime fiasco, carrytrade was noticeably superior as aneffective currency strategy in thisaverage-volatility mode, delivering anannualised total return of 3.2%compared to 0.4% for value. The gapbetween returns is even more strikingif we look at performances for theaverage- and low-volatility regimescombined: carry trade comes out evenfurther ahead, generating anannualised total return averaging5.4%, compared to 0.9% for value.

Carry trade favouredThe sub-prime crisis, followed by theserious recession and, lastly, by theeurozone crisis, obliged central banks in

Collage: Mischa Haller for Pictet & Cie

perspectives|march 2012|14|

developed economies to push interestrates down to historically rock-bottomlevels. As a result, spreads becamesingularly unattractive, whichundoubtedly curbed the appeal of carrytrade as a currency strategy. It would bea mistake, however, to presume it wascast into oblivion: carry trade justrelocated towards those emergingcountries where interest rates werehigh, such as Brazil.

At the outset of 2012, the VIX wasshowing that markets are currently inaverage-volatility mode. In theuniverse of the ten major currenciescovered for the purposes of this article,the most suitable strategy would seemto be carry trade. Currencies in whichfunds are raised at low interest rates areeither expensive by their equilibrium-value yardstick or under pressure as aresult of central banks pressing aheadwith quantitative-easing measures. Asfor currencies on which interest ratesare high, these are clearly more cyclicalowing chiefly to the fact that most ofthem are closely correlated withcommodities, but, on the whole,underlying economies are also in bettershape.

The currencies used for financingpurposes which we would advocatehedging are the US dollar, the euro, theSwiss franc and, to a lesser degree, thepound and the yen. High-yieldcurrencies offering potential in terms of

delivering a total return look to be theAustralian and Canadian dollars, theNorwegian krone as well as, to a lesserextent, the New Zealand dollar and theSwedish krona.

Since mid-December 2011 when theVIX dipped back below the 25%-threshold, marking the shift into theaverage-volatility regime, the carry-trade strategy has been outperformingthe value strategy, as the evidence of thechart showing the relative returns of thetwo strategies and the VIX indexgraphically illustrates. Nonetheless, wewill remain very watchful as oureconomic scenario for the year aheadsuggests markets are likely to oscillate

Contributors | Yves Bonzon, Christophe Donay, Jean-Pierre Durante, Reda IdrissiKaitouni, Bernard Lambert, Jacques Henry, Yves Longchamp, Kalina Moore, WilhelmSissener, | Content completed on 29 February 2012 Translation | Keith WatsonPrinter | Team Production Multimédia Pictet Geneva Paper | Printed on FSC-Certified paper

Disclaimer | This report is issued and distributed by Pictet & Cie based in Geneva,Switzerland. It is not aimed at or intended for distribution to or use by any person orentity who is a citizen or resident of, or located in, any locality, state, country or otherjurisdiction where such distribution, publication, availability or use would becontrary to law or regulation. The information and material presented in this reportare provided for information purposes only and are not to be used or considered as anoffer or invitation to buy, sell or subscribe to any securities or other financialinstruments. Furthermore, the information, opinions and estimates expressed hereinreflect a judgment as at the original date of publication and are subject to changewithout notice. The value and income of any of the securities or financial instrumentsmentioned in this document can go up as well as down. The market value may beaffected by changes in economic, financial or political factors, time to maturity, marketconditions and volatility, or the credit quality of any issuer or reference issuer.

Moreover, currency exchange rates may have a positive or adverse effect on the value,price or income of any security or related investment mentioned in this report.

Past performance should not be taken as an indication or guarantee of futureperformance, and no representation or warranty, expressed or implied, is made by Pictet & Cie regarding future performance. Instructions stipulated by the client asregards trading, transactions and investment constraints shall take precedence over,and may diverge from, the Bank’s overall investment strategy andrecommendations.Portfolio managers are granted a degree of flexibility so as toaccommodate the individual wishes and particular circumstances of clients. As such,the asset allocations specified in this report do not have to be strictly adhered to. Actual allocations to alternative, non-traditional investments (e.g. hedge funds) may exceed those mentioned in the grids herein provided that positions in traditionalequities are adjusted accordingly.

This publication and its contents may be quoted provided that the source is indicated.All rights reserved. Copyright © 2012 Pictet

TOPIC OF THE MONTH: CURRENCY RISK

between medium and high volatility,partly owing to risks associated withthe eurozone crisis. Currencyallocations might well have to undergotactical fine-tuning as shifts from onevolatility regime to the next occur, withcarry-trade and value strategies beingalternated.

CURRENCY STRATEGIES AND VOLATILITY REGIMES

Sources: Bloomberg, Pictet & Cie

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

50

60

70

80

90

100

110

2008 2009 2010 2011 2012

VIX index > 25%

Relativeperformance*

* Ratio of total returns from carry trade relative to value strategy (01.01.2008 = 100)

030201003- 02- 01-

030201003- 02- 01-

030201003- 02- 01-

030201003- 02- 01-

Light:Performanceprevious month

Dark:Performance since 30.12.2011

%

JPY —

HKD —

SEK —

NOK —

NZD —

CAD —

AUD —

CHF —

USD —

GBP —

%

HKD —

JPY —

EUR —

SEK —

GPB —

CAD —

CHF —

NOK —

AUD —

NZD —

%

USD —

HKD —

JPY —

EUR —

SEK —

GBP —

CAD —

NOK —

AUD —

NZD —

Emerging Debt (LC)

HY EUR

Emerging Debt $

HY USD

EUR

CHF

JPY

GBP

USD

%

-32.1

-3 -1 1 3 5 7 9 11 13

-10 -8 -6 -4 -2 0 2 4 6 -6 -4 -2 0 2 4 6 8 10 -10 -8 -6 -4 -2 0 2 4 6

Sugar

Cocoa

Corn

Agriculture

Baltic Freight

Natural gas

WTI

Brent

Energy

Lead

Tin

Zinc

Copper

Aluminium

Industrial metals

Palladium

Platinum

Silver

Gold

Precious metals*

%

%

%

% * Pictet Index

perspectives|march 2012 |15|

KEY FIGURES

MAIN ECONOMIC INDICATORS

GDP growth rates 2010 2011 2012E 2013E

US 3.0% 1.7% 2.4% (2.2%) 2.7% (2.5%)

Eurozone 1.8% 1.5% -0.1% (-0.3%) 1.0% (0.9%)

Switzerland 2.7% 1.9% 0.7% (0.2%) 1.5% (1.4%)

UK 2.1% 0.8% 0.4% (0.5%) 2.0% (1.8%)

Japan 4.5% -0.9% 1.5% (1.8%) 1.7% (1.4%)

China 10.3% 9.2% 8.8% (8.4%) 9.0% (8.6%)

Brazil 7.5% 2.8% 2.8% (3.2%) 5.4% (4.3%)

Russia 4.0% 4.3% 3.5% (3.5%) 3.8% (3.8%)

2010 2011 2012E 2013E

US 1.6% 3.2% 2.5% (2.0%) 2.3% (2.0%)

Eurozone 1.6% 2.7% 2.5% (2.0%) 1.5% (1.7%)

Switzerland 0.7% 0.2% -0.6% (-0.3%) 0.4% (0.7%)

UK 3.3% 4.5% 2.9% (2.6%) 2.4% (2.0%)

Japan -0.7% -0.3% -0.2% (-0.3%) -0.1% (0.0%)

China 3.3% 5.5% 4.3% (3.3%) 4.0% (3.7%)

Brazil 5.9% 6.5% 6.0% (5.3%) 5.1% (5.2%)

Russia 8.8% 6.1% 6.6% (6.6%) 6.1% (6.1%)

EXCHANGE-RATE MOVEMENTS (SINCE 30.12.2011)

Against EUR Against USD Against CHF

COMMODITIES

INTEREST RATES

Short (3-mth) Long (10-yr)

US 0.1% 1.9%

Eurozone 1.0% 3.3%

Switzerland 0.0% 0.6%

UK 0.5% 2.1%

Japan 0.1% 1.0%

China 6.6% (1 year) 3.5%

Brazil 10.5% 11.4% (9 years)

BOND MARKETS

Returns since 30.12.2011

STOCK MARKETS

Returns since 30.12.2011USD EUR CHF GBP

MSCI World* 10.2% 7.0% 7.2% 6.2%

S&P 500* 9.0% 5.8% 6.0% 5.0%

MSCI Europe* 11.4% 8.1% 8.4% 7.3%

Tokyo SE (Topix)* 9.1% 5.9% 6.2% 5.1%

MSCI Pacific ex. Japan* 17.4% 14.0% 14.3% 13.1%

SPI* 8.5% 5.3% 5.5% 4.5%

Nasdaq 13.9% 10.5% 10.8% 9.7%

MSCI Em. Markets* 18.1% 14.6% 14.8% 13.7%

Russell 2000 9.5% 6.2% 6.5% 5.4%

* Dividends reinvested

SECTORS

Returns since 30.12.2011 US Europe World

Industrials 9.6% 11.6% 11.3%

IT 15.3% 12.3% 14.5%

Materials 11.1% 13.9% 13.7%

Telecommunications 0.5% -2.4% 0.3%

Health care 4.5% -0.6% 3.8%

Energy 7.3% 4.2% 7.9%

Utilities -3.5% 1.8% 0.5%

Financials 13.1% 15.5% 15.1%

Consumer staples 2.2% 2.0% 3.3%

Consumer discretionary 11.6% 16.0% 13.9%

Pictet estimates – (consensus)

Inflation (CPI) Annual average, except year-end for Brazil

Economic indicators signalling green Economic indicators have continued to deliver positive surprises in both Europe and the US.Growth may well turn more sustained on both sides of the Atlantic over the next few months.

Data in charts and tables dated as of 29 February 2012

PER

SP A

NG

031

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