Draft No. 4 Date 7/20/06 Initials TM July 2006 Global Capital Markets Outlook How to Benefit from the Return of Volatility By Ranji Nagaswami, Chief Investment Officer AllianceBernstein Investments Display 1 Key Highlights: Volatility Has Spiked Upward from Unusual Lows Volatility* (1988–2006) Central banks continue to raise rates in response > to inflation fears, leading to global stock market declines. > After months at unusually low levels, volatility has spiked upward, causing widespread anxiety. > Higher interest rates will lead to a noticeable slowing of economic growth rates while inflation abates. > Although the U.S. slowdown will spread worldwide, it is not the precursor of a global recession. Investors can take advantage of volatility by > Global GLOBAL CAPITAL CAPITAL MARKETS MARKETS OUTLOOK OUTLOOK maintaining a globally diversified portfolio and rebalancing back to their target asset allocations. Turbulence in the Equity Markets For most of the past two years, stock market investors enjoyed a rare holiday from market volatility. The global developed markets delivered steady, consistent gains—and the emerging markets above-average gains—without any big bumps along the way. Prices rarely moved violently. With global inflation seemingly under control and U.S. inflation at 2.4%, the market assumed the U.S. Federal Reserve’s long series of interest rate increases were finally coming to an end. Then in May, inflation in the U.S. jumped to an annualized rate of 3.8% for the previous three months. On May 18, Federal Reserve Chairman Bernanke declared that inflation was “at an unwelcome level.” His remarks, and the actions of European Central Bank and the Bank of Japan, raised fears that interest (%) 70 U.S. (%) 70 Developed non-U.S. (%) 70 60 60 60 50 50 50 40 40 40 30 30 30 20 20 20 10 10 10 0 88 94 00 Average 06 0 88 94 00 06 0 88 Emerging Markets 94 00 06 Historical analysis does not guarantee future results. As of 31 May 2006 *Rolling four-quarter volatility. All returns in U.S. dollars. Volatility is the extent to which prices change. Higher volatility means greater price movements. Source: MSCI, Standard and Poor’s and AllianceBernstein rates would rise more than expected and that the global economy would slow more than expected. The reaction was swift. By June 12, the MSCI AllCountry World Index had declined 9.7%, with higherrisk companies and markets suffering the biggest hits. The sell-off was most extreme in emerging-market equities, which are more economically sensitive and dependent on the price of commodities. Nevertheless, the MSCI World and the MSCI Emerging Market Indices remained positive year-to- date. In short: It was a tough quarter but, thus far, hardly a disastrous year. policy will slow growth as well. Nonetheless, we forecast global economic growth for 2007 to be around 3%-below 2006 levels but still healthy (Display 3). We believe market fears of energy prices boosting inflation are exaggerated. Absolute inflation rates are actually quite low across the globe and also low relative to their longterm averages. We believe the central banks will win the battle against inflation and will continue using monetary policy to keep it under control. Display 3 Global Growth Will Moderate World Economic Growth Forecast PercentAverageAnnualRate 2006 At this stage, different countries are at different points on the interest rate cycle. (Display 2.) Although we believe the U.S. Federal Reserve will raise rates to 5.5%, it is coming to the end of its rate cycle. In Europe, we expect the ECB will continue to increase interest rates to 3.75% over the next two years. And the Bank of Japan will be raising rates this year and next—to 1.25%. 4.8% 5.0% EasternEurope LatinAmerica Global Japan Interest Rates Are Becoming More Restrictive U.S. Real Fed Funds Rate (%) 10 EuroArea 8 3.8% 3.0% 3.5% 3.0% 3.2% 2.5% 3.1% 2.4% 2.4% 2.1% Current estimates do not guarantee future results. As of 9 June 2006 Source: AllianceBernstein AllianceBernstein Forecast U.S. Back to Basics Our belief that the equity market’s performance will be reasonable going forward is based on our confidence in prudent monetary policy and solid corporate fundamentals. Around the world, the corporate sector remains in remarkably good shape (Display 4). European and emerging-market companies continue to post record numbers for return on equity even as commodity prices are at all-time peaks. Profits continue to surprise on the upside, which is most unusual this far into an economic expansion. Exceptionally high profits and cash generation are also leading companies to buy back their stock at record levels and to increase their M&A activity, both of which are remarkable signals of corporate confidence. 4 Europe 2 Japan 0 90 7.3% 6.7% AsiaEx-Japan Display 2 6 2007 92 94 96 98 00 02 04 06 Current analysis does not guarantee future results. As of 31 May 2006 *Since 1960. Source: Haver Analytics and AllianceBernstein We don’t think the current slowdown in the global markets is a precursor to the next recession. In the U.S., we see consumer spending growth slowing as a result of greater spending on energy and interest. In Europe, we anticipate mild growth in consumer spending during 2006, but a slowdown there as well when monetary policy becomes restrictive. In Japan, consumption is being revived, but eventually the Bank of Japan’s monetary Fair equity valuations also add fuel to our conviction (Display 5). Around the world, price/earnings ratios are very much in line with averages from the last 20 years or so. Equities are quite attractive, and the corporations buying back their stock understand this. 2 Display 4 Display 5 Corporate Profitability Is Well Above Average Globally Global Equity Valuations Remain Fair Return on Equity Trailing12-MonthROE:Jan1980–Mar2006 P/E Forward Earnings (x) 30 20 15 Highest 10 Current Average 5 0 (5) 20 Emerging Markets Europe (x) 30 20 Average 10 0 Lowest U.S. U.S. Europe Average 10 87 90 93 96 99 02 05 0 87 90 93 96 99 02 05 Japan (x) 80 Past performance does not guarantee future results. Source: FactSet Japan (x) 30 60 Although we believe global markets as a whole are fairly priced, we have been noting for some time that growth stocks seem attractive relative to value stocks. Although this opportunity is global, it’s particularly strong in the U.S. 20 40 Average Average 10 20 0 87 90 EmergingMarkets 93 96 99 02 05 0 87 90 93 96 99 02 05 Current valuations do not guarantee future results. 30 June 2006 Source: MSCI, Standard & Poor’s and AllianceBernstein Bonds now appear to be fairly valued at best and offer little opportunity. Credit spreads in the fixed income markets are at at or near their lowest historical levels. Although we believe that the U.S. Federal Reserve has stopped raising rates, we think global yields will be driven higher as other central banks hike official rates in response to accelerating growth. While we believe rates are going to rise a bit more, we are expecting them to peak at lower levels than previous cycles. Bonds smooth the ride for investors during equity market downturns, however, and we believe they are a necessary allocation for most investors, even through periods of lackluster returns. This advice is particularly important given our current view of the U.S. dollar, which has remained strong because it offers higher short-term rates than elsewhere in the developed world. But as interest rates rise around the world, and the interest rate differential decreases, the devaluation of the U.S. dollar is likely to continue. The unpredecented U.S. current account deficit will put additional pressure on the dollar. Since a weakening would hurt global investors holding unhedged USD investments, we advise them to diversify their exposure into other assets based in other currencies. Keeping Perspective While no one can predict the course or magnitude of market corrections, they can and do occur. We all know that equities don’t go up every quarter or every year. The economic slowdown we’re currently forecasting is by no means unprecedented in the global markets. The case for equity investing remains intact. Although economic growth should moderate, particularly in the U.S., the recent market volatility creates a number of attractive rebalancing opportunities (See box on page 4). Our overall advice is to stay the course. For long-term investors, the return opportunities in the global equity markets still outweigh the risks. We recommend that investors construct well-diversified global portfolios. The U.S. and Europe make up more than 75% of the world’s allocation in market cap. Emerging markets, by contrast, represent only 7%. A truly global strategy takes advantage of investment opportunities around the world and allows investors to avoid the type of volatility recently experienced by emerging-market investors. 3 Making Volatility Your Friend Volatility isn’t necessarily the investor’s enemy. In fact, it should be thought of as a lucrative rebalancing opportunity. When markets are volatile, asset classes fluctuate more than they do in stable markets, moving away from their long-term averages, and portfolios become unbalanced. blend that we recommend between growth and value stocks (Display 7). Investors who hold well-diversified portfolios will find volatile periods less threatening. In recent weeks, equities—especially the higher-risk emergingmarket stocks-have done poorly while bond returns have been flat. But well-diversified investors needn’t concern themselves with these short-term issues. They recognize that it is the overall results of a portfolio that matter, not the parts. Capital-market returns, however, are mean-reverting. That means that asset classes that are performing well will probably perform poorly in the future, and vice versa. Investors who understand this concept can take advantage of volatility by rebalancing their portfolios— selling assets that have appreciated in value relative to the market and replacing them with assets that are undervalued. Despite the recent investor overreaction, short-term equity volatility is not unduly high. Volatility was unusually low before it spiked in May and, by most measures, it is still below average. Investors can reduce the effects of volatility by incorporating multiple levels of diversification into their portfolios (Display 6). We believe global based portfolios should be invested in the most attractive opportunities, regardless of location. Adding bonds to a portfolio can smooth returns over the long term. And now is also the time to rebalance toward the 50/50 style Investors who react emotionally to volatility can end up making rash investment decisions they usually regret. But investors who respond in a disciplined manner can reap enormous benefits. By developing a target asset allocation and maintaining it by rebalancing, investors can turn periods of dramatic volatility into powerful drivers of performance. Display 6 Display 7 Diversification Remains the Key to Long-term Investing The Rebalancing Discipline: Buy Low and Sell High ByGeography ByAssetClass… Bonds Stocks 40% 60% Startwithaportfolio equallybalanced betweenassets. …AndByEquityStyle… Value 50% Ifoneoutperforms theotherbymore than5%,sellthe outperformingasset… Growth 50% Andbuythe underperforming asset… 4 …toreturnyour portfoliotoitsinitial assetallocation. Second-Quarter Market Returns based investors. We expect the U.S. dollar to continue to depreciate. Global stock markets experienced increased volatility > and downward pressure in the second quarter. Nevertheless, most markets are still positive for 2006 in local currency terms. Increases in global interest rates led to lackluster fixed > income returns. Currency had a major impact on returns. The > appreciating euro reduced global equity returns for euroDisplay 8 USD: 2006 Returns Positive Despite Latest Volatility 13.6% 2006:YTD 2006:2Q 7.2% 2.5% 2.4% (0.7)% (1.6)% (4.5)% S&P500 MSCI Europe 2.4% 2.3% 1.9% 0.7% (0.1)% (1.1)% (4.3)% MSCI Japan MSCI EM U.S.Bonds* World Bonds* EMBonds* Display 9 Euro: Strong Euro Dilutes Global Returns 2006:YTD 4.8% (0.7)% (1.2)% (2.4)% (3.0)% (4.9)% S&P500 (3.1)% (5.6)% (6.0)% (6.4)% MSCI Europe 2006:2Q (7.1)% (6.4)% (9.5)% (9.8)% MSCI Japan MSCI EM U.S.Bonds* World Bonds* EMBonds* Display 10 Yen: 2006 Returns Are Largely Flat 10.0% 2006:YTD 2006:2Q 3.8% (0.3)% (0.7)% (1.3)% (1.8)% (0.5% (0.9)% (0.8)% (2.5)% (4.0)% (4.2)% (7.3)% (7.5)% S&P500 MSCI Europe MSCI Japan MSCI EM U.S.Bonds* World Bonds* EMBonds* Past performance does not guarantee future results. See index descriptions at the end of the presentation. An investor cannot invest directly in an index or average, and they do not include sales charges or operating expenses associated with an investment in a mutual fund, which would reduce total returns. *Japan bonds: Lehman Japanese Aggregate; world bonds: Lehman Global Aggregate; emerging-market bonds: Lehman EM Aggregate Source: MSCI and AllianceBernstein 5 A Word About Risk Past performance is no guarantee of future results. There is no guarantee that any forecasts or opinions in this material will be realized. The information provided is for use by professional financial advisors and is not authorized for use by the general public. Please refer to the Funds’ offering circular for a discussion of the fees and expenses of the Funds and certain investment risks associated with investing in the Funds. Information provided should not be construed as investment advice These materials are prepared in the English language. AllianceBernstein L.P., its affiliates and third parties make no representation or warranty relating to the quality or accuracy of any foreign-language translation of these materials. The S&P 500 Index is an unmanaged index of 500 U.S. companies and is a common measure of the performance of the overall U.S. stock market. The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance. As of December 2003 the MSCI World Index consisted of the following 23 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States. The MSCI EMF Index (Emerging Markets Free) is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets and represents 26 of the world’s emerging equity markets. The Lehman Brothers Global Aggregate Bond Index Covers the most liquid portion of the global investment grade fixed-rate bond market, including government, credit and collateralized securities. The Lehman Brothers Euro-aggregate Bond Index covers the most liquid portion of the European investment grade fixed-rate bond market, including government, credit and collateralized securities. GEN–CEG–EN–GN–0706 www.alliancebernstein.com/investments