>Global Market Watch (AIG INVESTMENTS)

OVERVIEW

■ The nature of a business-cycle inflection point is that it is defined by elements that both bulls and bears favor – for very different reasons.

■ At the current inflection point, bears will likely point to the continued problems occurring in the U.S. and European banking sectors. Earnings at financial institutions appear to have rebounded during the first quarter of 2009. However, the U.S. government’s stress testing has revealed continued capital shortages at a number of large U.S. banks and the International Monetary Fund’s (IMF’s) most recent Financial Stability Report puts the global total losses from the financial markets crisis at a staggering $4 trillion. Add to that the new threat of a swine flu pandemic, and it is not hard to see why some investors remain extremely cautious.

■ However, we prefer to take the “glass-half-full-view.” We agree with those commentators highlighting the most recent improvements in the economic backdrop, not just here in the US and in Europe, but especially in Asia.

■ The financial markets also seem to have been on our side over the past few weeks. Global equity markets significantly outperformed government bonds in April. Additionally, Emerging Markets posted higher returns than the more developed regions for the fifth straight month, emphasizing the gradual decline in risk aversion. Within Developed Markets, Europe marginally outperformed the U.S. The worst performer, and the region where we have our largest underweight position, was Japan.

■ Among the three main regions in Emerging Markets, although we see the greatest potential for an economic rebound to be in Asia, surprisingly, Latin America and EMEA both outperformed

ASIA
■ What about signs of an inflection point in Japan? The collapse in activity in what is still the world’s second largest economy has been stunning and revealed a much greater export dependency than many economists expected. Quarterly GDP declined by a stunning 12.1% during the last quarter of 2008, and the IMF is looking for an overall 7.2% contraction this year.

■ There are, however, a few faint signs of hope that a pickup in regional trade is stirring an improvement in Japan’s industrial sector. In fact, Reuters’ monthly version of the widely watched Tankan business survey has stabilized in the past few months, March Industrial Production posted a small increase, and the decline in export volumes appears to have stopped.

■ A few weeks ago, the government announced its fourth fiscal stimulus package in six months,
but it will be the resumption of global trade that is most likely to provide the spark for a recovery in Japan.

■ In addition to the U.S., the other region that is showing the most convincing signs of improvement is Asia ex-Japan, where the aggressive policy response by the Chinese government is starting to arrest the decline in economic activity in the broader region. For example, bank-loan generation in China is hitting record highs, and the economy posted a stronger 5.8% increase in the first quarter. Korea’s economy eked out a small increase during the first quarter, and Taiwan’s exports to China have rebounded.

■ In contrast to SARS or the avian flu outbreak a few years ago, the epicenter of the current “swine flu” pandemic lies in the Western Hemisphere. However, Asia’s dependence on international trade could turn into a weakness again, if countries in North America or Europe decide to restrict air travel or close shipping ports. In the long run, Asia’s importance in the global economy will continue to grow, not just due to demographics, but also due to their healthier economies, improved fiscal balances and the lack of overleveraged private sectors.

INVESTMENT OUTLOOK
■ Our cautious approach to increasing risk in our equity and fixed income portfolios is starting to pay off. We had a small equity overweight in our balanced strategies as we started to tilt our portfolios towards the “Global Reflation” theme, and an eventual economic rebound. In addition, the gradual rotation away from the larger, more liquid developed markets towards areas with greater growth potential is proving to be the right strategy, as well.

■ We still do not have an outright overweight position in either Emerging Market equities or bonds, but we increased our exposure to both asset classes last month. The reflation theme suggests that, within both Developed and Emerging Markets, economies with more aggressive crisis response should continue to outperform; hence our overweight in the U.S. and Asia ex-Japan.

■ Finally, attractive valuation and signs of stabilization in financial market conditions continue to support our small overweight in High Yield credit in our fixed income strategies. Over the short-term, investor risk appetites may be curbed by the “swine flu” scare. However, we believe the improving economic backdrop and the continued aggressive policy response will support our current modestly constructive posture in both our equity and fixed income strategies

To see full report: Global Market Watch