COMPASS - Barclays Wealth

Barclays Wealth Global Research & Investments 

COMPASS 

March 2012 

Comfortable in the comfort zone 

Opportunities alongside the risks 

Covered bonds – flight to quality 

The dangers of over-familiarity 

Asia 2012: After the storm, another leveraged equity play?


Contents 

Comfortable in the comfort zone 2 

Opportunities alongside the risks 3 

The rally has some substance ........................................................................................ 3 

Valuations leave some headroom ................................................................................. 4 

Covered bonds – flight to quality 6 

History may not repeat itself but it rhymes… ............................................................. 6 

…but as safe as houses? ................................................................................................. 7 

And why covered bonds may help funding and hurt investors............................... 9 

Outlook and investment strategy.................................................................................. 9 

The dangers of over-familiarity 11 

There’s no place like home ........................................................................................... 11 

Familiarity and return..................................................................................................... 11 

Familiarity and risk.......................................................................................................... 12 

What’s the correct thing to do?................................................................................... 13 

Asia 2012: After the storm, another leveraged equity play? 14 

2011: A perfect storm.................................................................................................... 14 

Emergence of three moderating trends..................................................................... 14 

Eye of the storm.............................................................................................................. 15 

After the deluge .............................................................................................................. 15 

Why “CI 2 ”?........................................................................................................................ 16 

2012 challenges for Asia ............................................................................................... 17 

COMPASS March 2012 1


Aaron S. Gurwitz 

Chief Investment Officer 

Comfortable in the comfort zone 

Dear clients and colleagues: 

Between the beginning of August and the end of November last year, more than one out 

of four trading days saw global equity markets move up or down by 2% or more. Since 

then, there has been a single day, in December. Markets have moved into a comfort zone. 

I don’t take this as a sign of complacency. Everyone I speak to can recite a litany of risks: 

the euro area debt crisis, higher oil prices, slower corporate earnings growth in the US, 

and lower profit levels elsewhere in the world. But investors now seem able to formulate 

a market outlook that compounds negative and positive elements. The latter include 

much improvement in US indicators and a shift to stimulative policies in many of the 

large emerging economies. 

Through this period of subdued volatility markets have trended solidly upward, but it is 

not the case that markets are ignoring bad news. On a day when, say, we get some 

surprisingly weak earnings reports or street demonstrations in Athens turn violent, 

markets respond by trading off slightly. When home sales in the US tick up or the 

People’s Bank of China reduces reserve requirements, we get a small positive move. 

Markets are up over the past three months because, on balance, we’ve gotten more 

good news than bad. 

So, in my view, investors have been raising their allocations to relatively risky assets 

(stocks, commodities, leveraged real estate, etc.) because they’re comfortable, not 

because they’re complacent. If this assessment is correct, I see two broad implications 

for investment strategy. 

First, the balance of good and bad news has been appropriately reflected in low market 

volatility. At some point this will change. Some financial, economic, geopolitical, 

geological or biomedical event will upset markets and lead to a sharp drop, albeit, 

perhaps, from a substantially higher level than we are at today. Investors who are likely 

to be disturbed by some such inevitable future loss should consider taking advantage of 

current low volatility levels to position some downside protection in their portfolios either 

through the purchase of options or by implementing some of their investments via 

principle-protected structured notes. 

Second, investors may now be able to turn their attention away from day-to-day 

fluctuations and devote some time, study and money to neglected securities, sectors 

and investment strategies. Times when markets are in a directional ‘comfort zone’, may 

provide opportunities for investors to shift some money out of the ‘comfort’ asset 

classes of cash, high-grade bonds and blue chip stocks. 

This edition of Compass makes the case against ‘familiarity bias’ and in favour of 

venturing into several investment categories that are, in our view, attractively priced, in 

large part, because of their unfamiliarity. 

Sincerely yours, 

Aaron S. Gurwitz 

Chief Investment Officer 



Kevin Gardiner 

+44 (0)20 3555 8412 

kevin.gardiner@barclayswealth.com 

Figure 1: Interbank spreads subsiding? 

bps 

400 

300 

200 

100 

Opportunities alongside the risks 

The rally in stock markets is neither surprising nor without 

foundation. Economic data have been less fragile than feared, the 

ECB has partially back-stopped the euro area banks, and 

valuations are still subdued. We still favour a modestly pro-risk 

tactical stance in balanced portfolios, and would use setbacks to 

add to positions in developed equities and high-yield credit. 

The rally has some substance 

0 

Jun-07 Aug-08 Oct-09 Dec-10 Feb-12 

GBP 3m Libor - OIS Spread 3m Euribor - OIS Spread 

USD 3m Libor - OIS Spread 

Even now, it’s still not clear exactly who will pay for Greece’s debt write-down, nor how 

much they will pay. It’s also unclear when the peripheral euro area economies will 

stabilise, or when the more liquid euro area banks will feel able (or will be asked) to start 

lending again. Continental and UK consumers are facing record crude oil prices, driven 

partly by the ongoing geopolitical tension in and around the Gulf. Adding to this, 

postponed fiscal belt-tightening in the US still has the capacity to worry economists. 

As we noted in February, 2012 could well be “another year of living dangerously”. 

Moreover, there are plenty of profits on the table to be taken: developed stocks are 

now up roughly 20% from their October lows, and as we write the S&P500 is flirting 

again with its post-2008 high. But in the Chinese (and Welsh?) horoscope, 2012 is 

also the Year of the Dragon, and traditionally associated with good fortune. Focusing 

on the ongoing risks could mean missing many of the investment opportunities we 

think are out there. 

As far as the euro crisis is concerned, the fate of Greece may still hang in the balance, 

but the outlook for the wider euro area banking system feels a bit less worrying than it 

did in late 2011. The decisive actions of the ECB in December and now again in late 

February have partially ringfenced the system from the unfolding trauma in Greece. 

Easing tension is visible in both the key interbank spreads (Figure 1) and in the 

peripheral bond markets (Figure 2). In the latter, yields for the key Italian and Spanish 

markets have fallen, as have those in the smaller Irish market, even as those in Greece 

and Portugal have stayed high (with the former, of course, now pricing-in a loss). 

Figure 2: Selected 10-year European govt. bond yields 

0 

Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 

COMPASS March 2012 3 

% 

50 

40 

30 

20 

10 

Germany Greece Portugal Ireland 

Spain Italy UK 

Source: Bloomberg, Barclays Wealth Strategy Source: Datastream, Barclays Wealth Strategy


Figure 3: Developed world manufacturers' expectations 

Standard deviations from trend 

2 

1 

0 

-1 

-2 

-3 

-4 

Jan-91 Jan-96 Jan-01 Jan-06 Jan-11 

G3 industrial survey 

A definitive solution is of course still years away: it requires much greater fiscal 

integration, and a structurally more competitive southern euro area. But provided 

progress is being made in that direction, and the ECB continues to partially underwrite 

the banking system, we expect investor attention to shift elsewhere. 

In the meantime, business surveys in the euro area – and in the US, UK and Japan – have 

been markedly less fragile than feared a few months back. Taken at face value, our 

developed world cyclical indicator (Figure 3) is at a level that points not just to 

stabilisation, but to an above-trend pace of growth in the months immediately ahead. 

China’s purchasing managers’ indices have stabilised too, but are not yet that upbeat 

relative to their own (much higher, of course) trend. 

The latest data suggest that the US recovery is taking on a more sustainable tenor: the 

housing market seems to be at last showing signs of stabilisation, with inventories of 

unsold homes down to their lowest levels in around seven years, and housing starts 

showing more material signs of rebounding from their half-century lows (Figure 4). This 

is occurring against a backdrop in which the labour market is tightening more visibly, 

with weekly unemployment claims recently back down to early 2008 levels. 

The increase in crude oil prices does have the potential to unsettle consumers once 

more, particularly in the euro area and the UK, where they have hit new highs. However, 

there are few signs of this yet. Meanwhile, it is adding to corporate profits: there are 

more big corporate producers of oil than there are big buyers of it. 

This modest but visible improvement in the immediate economic outlook is not likely to 

have a material impact on near-term inflation. This is partly because earlier spikes in energy 

and commodity prices, and in indirect taxes in some countries (most notably the UK), are 

dropping out of year-on-year rates. Levels of unused industrial and labour capacity are of 

course still high, and while the euro area indicators have been firmer than feared we still 

see the area as being currently in a shallow recession. As a result, developed world interest 

rate expectations are likely to remain very subdued for a while longer – in fact, we think the 

ECB will likely cut rates a little further in the months ahead. 

Valuations leave some headroom 

The reduction in euro area banking nerves, and the modest improvement in the 

immediate economic outlook (without any deterioration in the interest rate outlook), we 

think leaves risk assets facing a more benign investment climate in early 2012 than has 

been priced in. The rally to date has closed some of this valuation gap, but in our view it 

remains historically wide. 

Figure 4: US private housing starts per capita, index 

20 

Q1 1960 Q1 1970 Q1 1980 Q1 1990 Q1 2000 Q1 2010 


160 

140 

120 

100 

80 

60 

40 

US private housing starts per capita (Q1 1960 = 100) 

Source: Datastream, Barclays Wealth Strategy Source: Datastream, Barclays Wealth Strategy


There is of course a very active ongoing debate about equity valuations. We track 

carefully, on a comparable basis, the valuations relative to trend of the nine asset classes 

that comprise Barclays Strategic Asset Allocation, and even after the rally, developed 

equities remain the cheapest (more than a standard deviation below trend). 

Figure 5: US stocks: trailing PE divided by an index of EVA 

Trailing PE / Corporate value-added 

35 

30 

25 

20 

15 

10 

5 

0 

Dec-74 Dec-80 Dec-86 Dec-92 Dec-98 Dec-04 Dec-10 

Source: MSCI, Datastream, Barclays Wealth Strategy 

MSCI USA 10y mav +/- one standard deviation 

High-yield credit, currently our other favoured risk asset, doesn’t look as inexpensive as 

equities because like bonds generally, spreads there are currently benefitting from the 

historically low levels of underlying interest rates. When rates and core yields eventually 

begin to normalise, high-yield spreads will narrow. Indeed, in a very severe interest rate 

reversal (which, as noted above, we do not currently think likely) mark to market losses 

are possible for high-yield bonds, as occurred in early 1994. 

We noted in January Compass how received wisdom on equity valuation has, in our view, 

been overly influenced by the apparently pessimistic picture painted by the ultra-long-term 

Cyclically Adjusted Price Earnings (CAPE) ratio for the US market. We are sceptical about 

the CAPE for several reasons – not the least of which is that the earnings data that predate 

the Great Depression are of questionable comparability. By way of balance, if we 

compare US equity PEs currently with a proxy for the underlying profitability or economic 

value added (EVA) of the quoted corporate sector, we find that the resultant ratio (Figure 

5) recently has been lower than even in the 1970s (which in most modern datasets usually 

contains the cheapest valuations). The long bull market of the 1980s and 1990s may now 

be a distant memory, but it was based partly on a real development – a sea change in the 

way most large companies were managed and added value for their shareholders. That 

change has not, in our view, been reversed. 

Our more cautious assessment of the outlook for core government bonds – US Treasuries, 

gilts and bunds – is based not on the worsened creditworthiness of the governments 

issuing them, but instead on the business cycle and their currently-elevated prices. We do 

not expect any large government to fail to meet its obligations, but we feel that the current 

general level of yields is being flattered by continuing risk aversion and, of course, by the 

activities of central banks. As it becomes clearer that the euro banking system is not about 

to collapse, and that the global economy is continuing to grow, we expect risk appetite to 

recover somewhat. We do not expect a sudden, dramatic rebound in yields – that feels 

unlikely in our central ‘muddle through’ scenario – but we do think that they are more likely 

to be drifting higher than lower through the rest of 2012. 



Fadi Zaher, PhD 

+44 (0)20 3134 8949 

fadi.zaher@barclayswealth.com 

Covered bonds – flight to quality 

Covered bonds are one of the fastest growing debt instruments, 

offering investors attractive defensive and yield-enhancing features. 

In our current ‘muddle through’ scenario for European economies, 

fiscal retrenchments and improved sentiment towards the financial 

system should benefit covered bonds. They continue to appeal to a 

wide range of investors, including short-term cash investors and 

asset managers as well as long-term investors such as pension 

funds and insurers. This year the market is expected to continue to 

grow, beyond its European hub, further supporting the market. 

History may not repeat itself but it rhymes… 

Covered bonds are a debt instrument with a secured priority claim on ring-fenced assets. 

They have become an increasingly attractive investment for both cash-oriented and longterm 

investors. During tense market episodes, covered bonds tend to remain resilient and 

outperform other corporate bonds. The majority of them have triple-A ratings and 

therefore tend to perform in-line with other safe haven assets. Last year was no exception: 

yields of covered bonds fell by about 80bps, not far behind the fall in developed 

government bond yields of around 100bps (Figure 1). In our view, this performance was 

largely driven by the ECB’s covered bond purchase programmes, by concerns about the 

global economy and the European banking system, and by weaker risk appetite. 

The investor base is well established in Europe and is gaining ground in other 

geographies such as Australia, New Zealand and the US. More recently, covered bonds 

have been considered by investors as a substitute for government bonds, as well as for 

senior unsecured bank debt, in peripheral Europe against the backdrop of tension in the 

European wholesale funding market and an economic slowdown in the euro area. 

Figure 1: Covered bonds spreads and yields over sovereign bonds 

Yield, % 

6 

5 

4 

3 

2 

1 

0 

-100 

Jan-07 Nov-07 Sep-08 Jul-09 May-10 Mar-11 Jan-12 

Global Covered Bond Yields (LHS) 

Spread Yield of Covered Bonds vs Developed Government Bonds 

Spread Yield of Senior Financial vs. Covered Bonds 

Source: Barclays Capital and Barclays Wealth Strategy 

Spread, bps 

400 


300 

200 

100 

0


In recent years, the euro area debt crisis and regulatory changes have driven banks to 

diversify their sources of funding in major currencies beyond euro-denominated issues. 

Covered bonds have been one of the main sources of funding for financial institutions 

globally. Bond issuance reached a record €240bn in 2011, with the total market size now 

standing at just over €2.5tr (Figure 2). The market is expected to expand by an additional 

€88bn in 2012 across the major currencies. Although the largest part of the market is likely 

to remain in euros (c. 80%) some of the expansion is expected to emerge from non-euro 

area peripheral countries, North America and Asia-pacific. 

Figure 2: Gross EUR, CAD, CHF, GBP and USD covered bond issuance 1998-2012 

(EUR bn equivalent) 

bn, EUR 

250 

200 

150 

100 

50 

0 

105 

127 

120 


95 

87 

131 

128 

155 

1998 2000 2002 2004 2006 2008 2010 2012e 

France Germany Netherlands Italy Other Spain Sweden UK 

Source: Barclays Capital 

Because of their liquidity, cash and short-maturity investors often consider covered 

bonds as effective diversification vehicles for their cash deposits and other instruments. 

With its established investor base, demand for covered bonds remained solid in the core 

developed world (Germany, France, Nordic countries, Canada and others), despite 

tensions in the euro area and uncertainties about the economy. 

…but as safe as houses? 

A covered bond is a debt instrument that is issued by a bank and is backed by a pool of 

collateral (mortgages account for 90% of the market, but some include public sector 

debt or a mix of both). Importantly, that collateral remains on the issuing bank’s balance 

sheet. Banks hold regulatory capital against the underlying loans, further reducing moral 

hazard since it’s in the banks’ interest to maintain the high quality of those loans. 

In the event of default, investors have claims on the ring-fenced asset, making the 

collateral pool a contingent security. Generally, the collateral sits in a separate Special 

Purpose Vehicle (SPV) or subsidiary, similar to securitized debt instruments where the 

SPV is acting as guarantors of underlying collateral, but different in that the SPV is on 

the bank balance sheet. 

Another difference with securitised mortgage-backed bonds – the source of much 

investment trauma in 2007-9 – is that the SPVs associated with securitised mortgages 

(ABS/RMBS) are completely isolated from the mortgage originator and tend to “slice and 

dice” or repackage into tranches different risks of the collateral pool when issuing bonds. 

This is not the case with covered bonds. A covered bond SPV/subsidiary does not itself 

issue the covered bonds, and is not isolated from the originator. The credit quality of the 

mortgages is actively managed and audited and has one pool rating (Figure 3). This 

provides transparency to the content of the cover pool and stricter governance around 

the content of the collateral. 

209 

184 

106 

134 

223 

245 

200


Moreover, ABS investors may not have recourse on residual claim to the originators’ 

balance sheet. In some countries (see comment below) covered bonds have recourse 

that is pari passu with senior unsecured bondholders if the cover pool is not sufficient to 

repay investors in the event of default. 

Figure 3: Simplified structure of a covered bond programme 

SPV of Bank A 

Loan Repayment Intercompany Loan 

Bank A (Issuer) 

Covered Bond Covered Bond Proceeds 

 

Covered Bond Investor 

Covered Bond 

Guarantee 

and Deed of 

Charge 

Note: The figure shows a bank entity that issues covered bonds. The mortgage assets covering those bonds are 

held in an on-balance-sheet SPV. The SPV purchases the assets from the issuing bank either through a loan from 

that bank or some other consideration. The SPV guarantees the covered bonds with the assets it holds. Source: 

Barclays Capital Investors AAA Handbook 

Often covered bond programmes require the issuer to allocate more collateral than 

the value of the outstanding pool (called overcollateralisation), which helps to protect 

the value of the underlying pool (Figure 4). There can be additional requirements on 

the credit quality of loans in the pool; maximum permitted loan-to-value levels; and/or 

limits on geographical concentration. These considerations all play a role in the rating 

of these bonds. When recourse to the originator balance sheet is not part of the 

covered bond, then the underlying bond often requires a higher level of 

overcollateralization to achieve AAA-rating. This could be the case for some French 

and Irish covered bonds. 

Figure 4: Some key criteria for covered bonds in European countries 

Minimum 

Overcollateralisation 

Maximum 

Substitution 

Residential property 

LTV barrier 

Commercial 

property LTV barrier 

External support 

if cover pool 

insufficient to 

satisfy claims 

Germany France Spain Italy UK 

102% Subject 

to Act 

125% 

(mortgages)/ 

143% public 

loans 

Varies Varies 

10% 20% 5% 15% 10% 

60% Usually 

80% 

80% 80% Varies


Euro area tensions have triggered a range of downgrades of financial institutions, but 

covered bond ratings have remained resilient. In general, covered bonds could have up 

to a seven notch difference from the issuer rating according to S&P. Highly rated issuers 

tend to have a smaller rating gap to the covered bond, providing additional comfort for 

rating sensitive investors since a downgrade of the issuer is less likely to result in a 

downgrade of the covered bond. S&P showed in a study that downgrades of issuers’ 

long-term ratings by three notches would not change the rating of 87% of all rated 

covered bonds. 1 Currently, around 75% of all outstanding covered bonds are AAA-rated 

and are better rated than the underlying issuer. 

And why covered bonds may help funding and hurt investors… 

The increase in covered bond supply has helped to improve banks’ balance sheets by 

supporting their asset and liability profile through the funding of long-dated assets such 

as: residential/commercial mortgages and public sector project finance loans with longdated 

maturities. This has to some extent reduced the liquidity risk profile of some of the 

larger financial institutions while benefiting the bondholders. 

From a bank capitalisation point of view, the regulatory environment is generally 

supportive for covered bonds, particularly compared to off-balance sheet debt 

instruments, but also with respect to the discussions about increasing senior unsecured 

bondholders’ loss participation in the event of a bank default. 

Of course, there is never a rose without thorns. The rapid expansion of the covered 

bond market has an impact on unsecured bond investors. As covered bonds occupy 

an increasing part of banks’ balance sheets, unsecured bondholders become more 

subordinated, which in turn could lead to lower recovery rates for unsecured 

bondholders in the event of bankruptcy. Deeper subordination of unsecured 

bondholders could trigger downgrades and suppress their values in the future, 

posing operational challenges for banks in the repo market as more collateral would 

be needed for lending against unsecured debt. 

Outlook and investment strategy 

In a ‘muddle through’ scenario for the euro area, revived risk appetite is likely to hurt 

developed government bonds more than covered bonds. On the other hand, future 

tensions in the euro area may lead to prolonged periods of high volatility and primary 

market closure of covered bonds, since funding costs could rise above the mortgage 

rates attached to a bond, as happened in the past. However, the ECB has stepped into 

the covered bond market on two occasions (2009 and 2011) to revive the primary and 

secondary market of long-dated covered bonds (around 10-years). The market closure 

of the primary market is more relevant for supply in Spain, Italy and Portugal as current 

spread levels are still too high to allow most banks to execute covered bond funding 

operations at economically reasonable levels. Non-euro area countries and non- 

European issuers might be less impacted. The majority of issuers here appear 

fundamentally more attractive as they are not directly impacted by the uncertainties 

surrounding the euro and they are generally more open to issuance in USD and other 

non-euro currencies. 

The housing market, a key driver of the covered pool value, is slowly stabilising after the 

price crash in Europe and the US due to the 2008/2009 crisis. Deterioration in the 

collateral pool in the event of default is a key risk to covered bond investors. Recent 

stimulus actions by major central banks, particularly the ECB’s Long Term Refinancing 

1 

S&P Research: “Scenario Analysis: How Sensitive Are Covered Bond Ratings To Changes In Issuer Ratings?” 

October 2011. 



Operations (LTRO), have averted systemic defaults of financial institutions. In our view 

the global economy is not dipping into a renewed recession, and worries about the 

housing market and bank defaults are likely to subside in the developed world. 

From an investment strategy point of view, we recommend covered bonds for three 

different purposes which are not necessarily mutually exclusive. (1) Investors who may 

want to diversify their overnight cash holdings, which will be mostly unsecured or backed 

by limited guarantee, could consider AAA-rated covered bonds that are highly liquid, 

backed by a high quality collateral pool and yield enhancement at certain maturities. (2) 

Medium/long-term investors could consider selected covered bond issuers to hold as a 

single-line or as a part of a portfolio for diversification purpose. This will help reduce market 

volatility compared to less senior bonds. (3) For peripheral European investors, switching 

from sovereigns into high quality covered bonds, again, should help mitigate volatility 

emerging from future uncertainty in Europe or on the global stage. 



Peter Brooks, Ph.D. 

+65 6308 2167 

peter.brooks@barclaysasia.com 

The dangers of over-familiarity 

It’s difficult to get a good handle on all the issues relevant to your 

investment decisions. So to protect ourselves from making 

mistakes, we often stick to those areas with which we’re more 

familiar. This can have both positive and negative investment 

consequences, depending on how you go about it. 

There’s no place like home 

For readers in the US or Europe, Benjamin Yeo’s essay on Asian economies may be 

compelling, but still give rise to feelings of apprehension. For readers in Asia, Benjamin’s 

piece likely confirms familiar investment themes you’re used to reading about. In both 

cases, when assessing investments familiarity is important. 

There are thousands of potential investments out there, so how do you choose where to 

invest? An intuitive ‘safe’ answer is to invest in things you know and with which you are 

more comfortable. This may be a business you know well, or an economy you 

understand. For many of us this has the positive effect of providing the emotional 

comfort necessary to invest in risky asset classes, and to start earning the associated 

long-term return premiums. However, familiarity can also lead to underestimating 

potential risk and overestimating potential return with assets we know well. The 

familiarity bias creates an illusion of safety and comfort by suppressing the perception of 

some portfolio risks. The most common symptoms are portfolios that are concentrated 

by geography or sector. 

Standard theories on portfolio construction suggest that optimal portfolios should be 

diversified across both asset types and geographies. To do anything else means limiting 

the most efficient risk and return characteristics of your portfolio. In this framework our 

inherent bias for familiarity is costly in a financial sense – either lowering return or 

increasing risk. Estimates often put the loss of risk-return efficiency in concentrated 

portfolios (as measured by the Sharpe ratio) to be greater than 10% and as high as 

35%. 2 However it is necessary for giving the peace of mind to invest. So the bias for 

familiarity is fine up to a point as it can promote positive actions, but too much 

familiarity bias is likely to be costly and risky. There is a balance to strike. While it’s not 

ideal to invest in assets you don’t understand, this doesn’t mean that in a diversified 

portfolio you need an intimate understanding of all assets. 

Familiarity and return 

One of the most common investment impulses is home bias. Investors often think their 

home region will provide relatively higher returns and therefore allocate more of their 

assets locally. Figure 1 shows estimates of the level of home bias displayed by investors. 

For investors in Asia-Pacific 57% of their asset allocation is invested in their home region, 

49% for Europeans, and 68% for North American investors. 

2 Bluethgen et al, The Cost of Home Bias - Empirical Evidence and Implications for Stock Market Participation 

(March 4, 2008). Available at SSRN: http://ssrn.com/abstract=1102131 - accessed Feb 2012 



Figure 1: Geographical split of investor asset allocations 

100% 

80% 

60% 

40% 

20% 

0% 

Asia-Pacific Europe North America 

North America Europe Asia-Pacific Latin America Middle East Africa 

Source: Capgemini/Merrill Lynch 2011 World Wealth Report 

In a study from the early 1990s, researchers took data on the home bias of US, UK and 

Japanese investors and computed the returns they would have to expect to justify the 

level of home bias in their asset allocations. Figure 2 shows these returns. The return 

estimates are not reflective of today’s markets, but the stark difference in ranking of the 

returns by individual investors is important. There is a huge positive expectation on the 

performance of the home country that would be difficult to justify as anything other 

than familiarity and optimism for local markets and institutions. 

Figure 2: Returns expectations needed to justify home bias 

Investor region 

Investable market US UK Japan 

US 5.5% 3.1% 4.4% 

UK 4.5% 9.6% 3.8% 

Japan 3.2% 3.8% 6.6% 

Source: French, K. R. and J.M. Poterba, 1991, “Investor Diversification and International Equity Markets,” 

American Economic Review, 81, 222-226. 

Familiarity and risk 

In addition to expecting higher returns it’s likely that our perceptions of risk are also 

skewed by familiarity. This can work in two ways. Firstly, our familiarity with the local 

economy can make us perceive it as being less risky than it actually may be. Added to the 

perception of higher investment returns this makes the case for investing locally even more 

compelling. Secondly, investors often add a risk penalty to foreign assets because they 

simply understand them less – whether it’s the company names, or their legal structures or 

corporate governance standards. Unfamiliarity with these creates more doubt and the 

perception of greater risk. This makes investing in foreign markets less appealing. 

With these expectations it is rational for investors to increase allocations to their home 

country. However, it’s the difference between these expectations and reality that can 

damage your portfolio. The 50% falls in emerging country equity markets during 2008 

are a painful reminder to investors that over-concentrating risk geographically can be 

damaging. The same can be said for the 30% fall in developed markets. 



What’s the correct thing to do? 

There are subtle steps you can take to use familiarity to your advantage. For example, if 

you are moving out of a cash portfolio, it may be easier for you to phase your 

investments into more familiar asset classes and geographies first. Greater personal 

comfort with familiar assets, markets, or companies will help reduce any mental barrier 

you have with investing, and help you build an investment portfolio that’s appropriate to 

your needs. However, if you use the familiarity bias to help you enter the market it’s 

important to prioritise your plan to diversify thereafter. 

Greater transaction costs and currency risks with foreign investing can be a barrier to 

diversifying your portfolio overseas (although some currency risk is not always 

detrimental to the equity portions of a portfolio). One way to counter this is to look for 

familiar names that derive a large portion of their revenues overseas. This will help you 

increase the international exposure of your portfolio returns, but in a way that’s more 

comfortable. For companies in the S&P500 that report the global sources of their sales, 

Standard and Poor’s reports that over 46% of 2010 sales were from outside the US. 3 

The biggest hurdle is your own expectations of risk and return for familiar markets. Be 

aware of these expectations and question whether familiarity is clouding your 

judgement and causing you to concentrate your investments in one location or 

market. Often the investment themes for regions are compelling and a lack of 

familiarity should not be a barrier. In many markets there are exchange traded funds 

(ETF) that will allow relatively cheap and efficient exposure to more diverse baskets of 

assets. This can be used as an easy way to increase geographical exposure without 

the higher fees for foreign transactions. 

Familiarity and unfamiliarity with the multitude of available investments can have both 

positive and negative effects on your investing. If you find yourself limiting your 

investments to one market, look to remedy this to avoid being caught out by an overconcentration 

of risk. In any case, once you start investing in new areas they will 

automatically become more familiar to you over time. 

3 

S&P 500: 2010 Global Sales, Standard and Poor’s, report available at www.standardandpoors.com. Accessed 

Feb 2012. 



Benjamin Yeo, CFA 

+65 6308 3599 

benjamin.yeo@barclaysasia.com 

Declining inflation in 

China is symptomatic 

of looser monetary 

conditions in Asia. 

Asia 2012: After the storm, 

another leveraged equity play? 

After last year’s perfect storm, Asian equity markets are steadily 

recovering on the back of depressed valuation, easier liquidity 

conditions and supportive economic growth. Is this momentum a 

reflection of renewed interest in Asia as a leveraged play on the 

global economy? 

2011: A perfect storm 

Asia suffered the perfect storm in 2011 as financial markets struggled against external 

headwinds like the European sovereign debt crisis and a slowing global economy. The 

wave of rising inflation in Asia brought about by higher food and commodity prices 

further rattled Asian capital markets (see Figure 1). Unsurprisingly, Asian central banks 

tried to calm the storm by repeatedly increasing short-term interest rates. It didn’t help 

that strong liquidity, primarily a result of the various quantitative easing undertaken in 

developed economies in 2010, was also slowing from a peak. Consequently, across Asia, 

purchasing managers’ indices dipped below the 50% mark, indicating a deceleration in 

economic activity. 

Figure 1: Inflation in China for the last five years 

CPI yoy (%) 

10 

8 

6 

4 

2 

0 

-2 

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 

Source: Bloomberg 

China CPI (yoy%) 

Emergence of three moderating trends 

Asian equity markets struggled to stay afloat last year, yielding to strong tides despite 

the emergence of three moderating trends. The first of these was inflation. At the start 

of the third quarter of 2011, inflation was already waning in countries such as China on 

the back of base effect changes and lower commodity and food prices. Secondly, 

confronted by moderating inflation (albeit from a high level) proactive central banks 

started pumping liquidity via open market operations. By the fourth quarter, the central 

banks of Indonesia, Thailand and Australia had all cut official short-term interest rates 

(see Figure 2). The third trend was portfolio outflows from Asian equity markets, 

affecting the more cyclically open economies and liquid equity markets in Asia. Even 



Bank Indonesia was 

one of the first central 

banks in Asia to cut 

interest rates last year. 

On P/BV ratios, 2011 

underperformers have 

clearly caught up year 

to date. 

India, despite its large domestic market, was hit by fund redemptions and withdrawals. 

This perfect storm in the Indian Ocean left Indian equities down by 25%, making it the 

worst performing Asian market in 2011. 

Figure 2: Bank Indonesia’s monetary policy moves since 2007 

Overnight short rates (%) 

10 

9 

8 

7 

6 

5 

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 

Source: Bloomberg 

Eye of the storm 

Indonesia Policy Rate 

At the height of last year’s storm, Asian equity markets were evidently attractive, with 

valuation trading below its respective historical (five-year or 10-year) averages on 

price/earnings ratio. In fact, some even came close to being one standard deviation from the 

mean. Taking a more stable ratio, which is less subjected to the vagaries of corporate 

earnings, the price/book (P/BV) parameter also painted a similar picture. Assuming that 

Asia trades up as a region to its recent five-year P/BV historical average of 1.9 times, the 

potential upside is around 27%; this compares favourably to US equities (where potential 

upside is limited to only 12% on the same basis) and the UK (which offers potential upside 

of 20%) but less attractive than indices such as the Euro Stoxx 50 (34%) and the Nikkei 

(31%). However, it has to be noted that the average Asian P/BV ratio masked the wide 

divergence between the potential upside of its two largest countries, namely China (84% 

Shanghai Composite/62% HSCEI/43% HSI) and India (38% Sensex) and the richly-valued 

south-east Asian countries; the latter had a slight downside when we compare its Dec 2011 

P/BV versus the five-year P/BV historical average, which ranges from -2% (Indonesia) to - 

14% (Thailand) – See Figure 3. 

After the deluge 

Since the start of 2012, we’ve seen a reversion to mean trend for Asian equity markets. 

The MSCI Asia Apex 50 has increased by approximately 15% on the back of an improving 

outlook for inflation, liquidity and economic growth. 2011’s major underperformers are 

now this year’s outperformers: India (28%); China (17%); and HK (17%). However, even 

with their year-to-date increases, valuation of these markets, relative to history is attractive 

(see Figure 3). 

To put Asia’s markets in a global perspective, since the late 1990s, there’s been a 

noticeable convergence in valuation for global equity markets, with most global equity 

markets currently trading at a low level of around 10 to 12 times price/earnings ratio. 

The valuation differential previously enjoyed by developing markets has nearly dissipated 

due to the uncertain outlook for future economic growth and corporate earnings. 

However, current equity market valuations have yet to discount the superior growth 

levels that Asian markets will enjoy if they continue along their historic growth trajectory, 



On the back of declining inflation and interest rates, economic growth in Asia may 

moderate somewhat in the short term. However, we remain constructive on the mediumterm 

outlook for the economies of China, India and Indonesia (labelled here as the “CI 2 ” 

countries). These three countries have (a) large populations with rapidly swelling middle 

classes, (b) continued and strong infrastructure cycles in place, and (c) in the short term, 

expected positive policy measures, especially on the monetary front. 

Why “CI 2 ”? 

Figure 3: Risk-reward ratios of Asian equity markets based on P/BV ratio 

Local Currency 

Total Return (%) 

The CI 2’ markets are fairly similar in nature. Each has a large domestic market; well 

designed, government-driven five-year economic plans and the growing need for 

infrastructure roll-out. For example, by 2020, most estimates suggest a burgeoning 

middle class society in China, with a growing demand for new products and services. 

India, on the other hand, offers a young and growing workforce: by 2015, 65% of the 

population will be part of the working class and aged between 18 and 35 years. 

As far as the execution of long-term economic plans in these countries is concerned, it 

all boils down to political grit and gumption. For instance, in India, last year’s rising 

inflation, budget deficit concerns and political scandals forced many of its proposed 

reforms to be put on hold. In 2012, we believe after various state elections, the 

government is likely to resume these projects, especially with easier monetary policy. 

Thus, at the start of the year, we upgraded our stance on Indian equities from negative 

to neutral, and have also revised our call on Indonesia, from neutral to positive. This 

comes on the back of an upgrade in its credit rating to investment grade by the ratings 

agencies Fitch and Moody’s, and the passing of a land reform bill late last year. We now 

Current GFC (2008-09) 5Y Average 

Index YTD12 2011 2010 2009 Price P/B P/B vs. Current vs Dec11 P/B vs. Current vs Dec11 

Hang Seng Index 15.9 -17.4 8.6 56.6 21361 1.5 1.0 -32% -23% 1.9 26% 43% 

Hang Seng China 

Ent Index 17.4 -19.6 1.7 66.0 11661 1.7 1.0 -39% -29% 2.4 41% 62% 

Shanghai SE 

Composite 9.6 -20.2 -12.8 82.6 2411 2.0 1.8 -10% -2% 3.3 68% 84% 

Taiwan TAIEX 

Index 12.1 -18.0 13.4 83.3 7930 1.8 1.0 -44% -37% 1.8 0% 12% 

KOSPI Index 10.0 -11.0 23.6 51.8 2009 1.2 0.8 -38% -34% 1.3 4% 12% 

FTSE Straits 

Times Index 12.1 -14.0 13.4 70.8 2963 1.4 0.8 -40% -34% 1.5 8% 19% 

Jakarta Composite 

Index 2.5 5.4 49.5 92.1 3919 2.9 1.2 -57% -56% 2.8 -4% -2% 

Stock Exchange 

of Thai Index 11.5 3.5 47.0 71.4 1140 2.1 0.8 -61% -57% 1.7 -21% -14% 

FTSE Bursa 

Malaysia KLCI 2.0 4.5 23.8 50.0 1556 2.3 1.2 -48% -47% 2.0 -12% -10% 

PSEi - 

Philippine SE Index 13.2 7.6 43.3 71.0 4947 2.7 1.2 -55% -50% 2.2 -21% -11% 

BSE Sensex 30 

Index 17.2 -23.6 19.1 83.3 18079 2.9 1.8 -37% -27% 3.5 18% 38% 

MSCI AC Asia 

ex Japan 15.2 -17.2 19.7 72.0 528 1.7 1.1 -37% -29% 1.9 13% 27% 

Source: Bloomberg as of 21 Feb 



expect to see Indonesia’s economic bottlenecks easing as its high levels of domestic 

demand help fuel a virtuous growth cycle with rising foreign direct investments and 

increasing infrastructure projects. 

2012 challenges for Asia 

The great challenge facing Asian policymakers this year is that of balancing the need for 

growth against rising inflation fears as oil prices continue to climb on the back of unrest 

in the Middle East. However, in the months ahead, Asian countries may attempt to avoid 

any sharp deterioration in economic growth, and support capital markets via an easier 

monetary stance. However, Asian central banks are unlikely to pump levels of liquidity to 

the same levels as they did at the end of 2008, due to concerns as to lurking inflation 

risks. In addition, should the current ‘risk-on’ market continue, the use of Asian equities 

as a leveraged play on the global economy may also gain momentum, despite the 

volatility that comes with it. This trade may not be suitable for the faint-hearted as 

equities currently remain out of favour with investors. Those patient investors may take 

the current opportunity to accumulate for the long term, especially businesses with 

sustainable growth business models. 

As far as the equity indices of CI 2 countries are concerned, they may have run up fairly 

quickly in the near term on the back of depressed valuations, especially India. However, 

on China, there are still sceptics, but we maintain that Chinese policymakers will manage 

to transition their economy for medium-term sustainable growth. Indonesia’s valuation 

based on market capitalisation as a percentage of GDP (a more relevant measure of 

structural outlook) remains attractive (GDP/market capitalisation < 1). Despite its 

constructive long-term outlook, the market is also still fairly under-owned. 

In general, as far as Asian equities are concerned, the recommended strategy is to stay 

invested via a diversified Asian equity portfolio. The global economy and the European 

debt issue will continue to rattle the markets, making it imprudent to pursue a 

momentum-based investment approach. Instead, we advise clients to focus on 

identifying the undervalued companies which may be challenged in terms of near-term 

revenue and earnings outlook, but which remain fundamentally sound in terms of their 

business models. 

No one knows when confidence regarding long-term economic growth and corporate 

earnings will return. Suffice to say, when it does, the positive growth differential of Asian 

markets will likely see a divergence in the valuation of Asian equities. While more nimble 

investors may be able to time the market, for most, determining your investment time 

horizon is key to accumulating attractive stocks at current market levels. 

. 



On assets & allocation: A snapshot 

We advocate that clients pursue portfolios that are diversified across nine global asset classes, in proportions tailored to each 

investor’s specific risk profile and Financial Personality. We have defined a long-term view of the mix of assets suited to five 

prototypical risk profiles, what we call our Strategic Asset Allocation (SAA). As well, senior members of our investment leadership 

are regularly assessing the markets to develop views on how those SAA weights would be adjusted to reflect more tactical views, 

which we call our Tactical Asset Allocation (TAA) views. Our current views are defined below in Figure 1. 

Figure 1: Current strategic (SAA) and tactical (TAA) asset allocation by risk profile 

Low Medium Low Moderate Medium High High 

Asset class SAA TAA SAA TAA SAA TAA SAA TAA SAA TAA 

Cash/Short-maturity Bonds 43% 45% 15% 16% 8% 8% 5% 5% 4% 2% 

Developed Government Bonds 10% 7% 13% 10% 9% 7% 6% 4% 4% 3% 

Investment Grade Bonds 3% 1% 4% 1% 4% 1% 3% 1% 2% 1% 

High Yield & Emerging Markets Bonds 4% 6% 7% 11% 8% 12% 8% 11% 6% 9% 

Developed Markets Equities 16% 17% 29% 30% 38% 39% 45% 46% 51% 52% 

Emerging Markets Equities 4% 4% 7% 7% 10% 10% 13% 13% 17% 17% 

Commodities 2% 2% 4% 4% 5% 5% 6% 6% 6% 6% 

Real Estate 7% 7% 5% 5% 4% 4% 3% 3% 2% 2% 

Alternative Trading Strategies 11% 11% 16% 16% 14% 14% 11% 11% 8% 8% 

Source: Barclays Wealth 

The major laggards of 2011, Developed and Emerging Market Equities – have begun 2012 with a strong rebound. Exposure to 

High Yield & Emerging Market Bonds has also been rewarding thus far in 2012. 

Figure 2: Total returns across key global asset classes 

Cash & Short-maturity Bonds 

Developed Government Bonds 

Investment Grade Bonds 

High Yield and Emerging Markets Bonds 

Developed Markets Equities 

Emerging Markets Equities 

-18.4% 

Commodities 

Real Estate* 

Alternative Trading Strategies** 

-13.3% 

-5.5% 

-4.1% 

0.4% 

1.6% 

3.4% 

2012 (through 29 Feb 2012) 2011 

1.4% 

4.8% 

2.8% 

7.1% 

Note: Past performance is not an indication of future performance. 

* As of year end 2011. 

** As of January 2012. 

Index Total Returns are represented by the following: Cash and Short maturity bonds by Barcap Global Governments 1-3 years; Developed Government Bonds by 

Barcap Global Governments 7-10 years; Investment Grade Bonds by Barcap Global Aggregate - Corporates; High Yield/Emerging Markets Bonds by Barcap Global 

High Yield, Barcap Global EM & Barcap EM Local Currency Governments; Developed Markets Equity by MSCI World Index; Emerging Markets Equity by MSCI EM; 

Commodities by DJ UBS Commodity TR Index; Real Estate by MIT TBI Index and IPD UK for January-March 2011 and NCREIF TBI Index and IPD UK Index for April 

2011-January 2012; Alternative Trading Strategies by Barclays Wealth ATS Equally Weighted Composite Index (25% Barclay Hedge Global Macro; 25% HFRI Relative 

Value TR; 25% Credit Suisse-Dow Jones Event Driven & 25% Credit Suisse-Dow Jones Managed Futures Index). 

Barclays Wealth recommends investors maintain a portfolio that is invested across the asset classes shown above, in a specific mix tailored to each investor. 


2.0% 

5.2% 

7.0% 

8.6% 

10.1% 

18.0%


Global Investment Strategy Team 

AARON GURWITZ, PhD Chief Investment Officer 

aaron.gurwitz@barclayswealth.com 1 212 526 9255 

US 

DANIEL EGAN Head of Behavioral Finance, Americas 

daniel.egan@barclayswealth.com 1 212 526 0549 

ELIZABETH FELL Fixed Income 

elizabeth.fell@barclayswealth.com 1 212 526 2589 

HANS OLSEN Head of Americas Investment Strategy 

hans.olsen@barclayswealth.com 1 212 526 4695 

DINAH WALKER Macro 

dinah.walker@barclayswealth.com 1 212 526 3426 

UK 

FRANCESCO CAPPONI Macro 

francesco.capponi@barclayswealth.com 44 (0)20 3555 8401 

GREG DAVIES, PhD Head of Behavioural and Quantitative Finance 

greg.davies2@barclayswealth.com 44 (0)20 3555 8395 

JIM DAVIES Equity 

jim.davies@barclayswealth.com 44 (0)20 3555 8397 

KEVIN GARDINER Head of EMEA Investment Strategy 

kevin.gardiner@barclayswealth.com 44 (0)20 3555 8412 

RYAN GREGORY Macro 

yan.gregory@barclayswealth.com 44 (0)20 3555 8403 

EMILY HAISLEY, PhD Behavioural Finance 

emily.haisley@barclayswealth.com 44 (0)20 3555 8057 

KYLIE HIGGINS Equity 

kylie.higgins@barclayswealth.com 44 (0)20 3555 8413 

WILLIAM HOBBS Equity 

william.hobbs@barclayswealth.com 44 (0)20 3555 8415 

TANYA JOYCE Commodities 

tanya.joyce@barclayswealth.com 44 (0)20 3555 8405 

PETR KRPATA FX 

petr.krpata@barclayswealth.com 44 (0)20 3555 8398 

AMIE STOW Fixed Income 

amie.stow@barclayswealth.com 44 (0)20 3134 2692 

CHRISTIAN THEIS Macro 

christian.theis@barclayswealth.com 44 (0)20 3555 8409 

FADI ZAHER, PhD Fixed Income 

fadi.zaher@barclayswealth.com 44 (0)20 3134 8949 

SINGAPORE 

PETER BROOKS, PhD Head of Behavioural Finance, Asia 

peter.brooks@barclaysasia.com 65 6308 2167 

KUNSHAN CAI Equity 

kunshan.cai@barclaysasia.com 65 6308 2985 

EDDY LOH Equity 

eddy.loh@barclaysasia.com 65 6308 3178 

XINYI LU Macro 

xinyi.lu@barclaysasia.com 65 6308 3114 

BENJAMIN YEO Head of Asia Investment Strategy 

benjamin.yeo@barclaysasia.com 65 6308 3599 

Risk 

tolerance 

Composure 

Market 

engagement 

Perceived 

financial 

expertise 

Delegation 


Belief 

in skill


Risk Tolerance 

This is an expression of the long-term trade-off between risk and return in your portfolio. Higher risk tolerance indicates a higher 

risk, higher return portfolio. 

Composure 

The composure scale measures how emotionally engaged you tend to be with the investment journey. 

Market Engagement 

This measures the degree to which you are inclined to avoid or engage in financial markets. It shows whether you have a mental 

hurdle to investing. 

Perceived Financial Expertise 

This dimension assesses how familiar and informed you feel you are with current financial circumstances, and how confident you 

feel in your financial knowledge and decision making. 

Delegation 

The delegation scale assesses how much you believe you can benefit from delegating day-to-day portfolio management decisions 

to someone. 

Belief in Skill 

This scale is used to determine how much you believe it is worth paying for an investment professional’s potential to achieve 

above-market returns. 


This document has been prepared by Barclays Wealth, the wealth management division of Barclays Bank plc (“Barclays”), for information purposes only. Barclays does not 

guarantee the accuracy or completeness of information which is contained in this document and which is stated to have been obtained from or is based upon trade and statistical 

services or other third party sources. Any data on past performance, modelling or back-testing contained herein is no indication as to future performance. No representation is 

made as to the reasonableness of the assumptions made within or the accuracy or completeness of any modelling or back-testing. All opinions and estimates are given as of the 

date hereof and are subject to change. The value of any investment may fluctuate as a result of market changes. The information in this document is not intended to predict actual 

results and no assurances are given with respect thereto. 

The information contained herein is intended for general circulation. It does not take into account the specific investment objectives, financial situation or particular needs of any 

particular person. The investments discussed in this publication may not be suitable for all investors. Advice should be sought from a financial adviser regarding the suitability of 

the investment products mentioned herein, taking into account your specific objectives, financial situation and particular needs before you make any commitment to purchase 

any such investment products. Barclays Wealth and its affiliates do not provide tax advice and nothing herein should be construed as such. Accordingly, you should seek advice 

based on your particular circumstances from an independent tax advisor. Neither Barclays Wealth, nor any affiliate, nor any of their respective officers, directors, partners, or 

employees accepts any liability whatsoever for any direct or consequential loss arising from any use of or reliance upon this publication or its contents, or for any omission. Past 

performance does not guarantee or predict future performance. The information herein is not intended to predict actual results, which may differ substantially from those reflected. 

The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors. This document shall not constitute an 

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Printed March 2012 

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