Market Commentary

September 30, 2007

PB Market Commentary

Global equity markets endured a volatile third quarter 2007, starting with the rapid deterioration of the subprime mortgage market in the United States, which led to rising delinquency rates and caused liquidity to dry up in the market for collateralized debt obligations (CDOs). With pricing in the mortgage derivative market effectively suspended, financial institutions tightened inter-bank lending to those counterparties that might be most exposed to it, with a concomitant impact on confidence that led to the collapse of some prominent hedge funds. This dealt a further blow to investor sentiment culminating in fears that Countrywide Financial, the biggest home loan company in the US, would file for bankruptcy. This led to a one-day bank run at their branches. Similarly, depositors made an unprecedented rush to withdraw money from Northern Rock, the fifth biggest mortgage lender in the United Kingdom. Despite the fact that the subprime mortgage market represents only a small part of the overall US economy, the wide distribution of risk and the uncertainly about which institutions had the largest exposures caused a severe blow to market sentiment.

The Federal Reserve and other central banks around the world were left with little choice but to invoke their duties as lenders of last resort and pump significant short-term funds into their respective banking systems. The Federal Reserve eventually cut its discount and federal fund rates by 100 and 50 basis points respectively. With confidence restored, the subsequent bargain hunting produced a strong rebound despite warning signs that the summer's credit market crisis could have a broader impact on economic growth ahead.

For the third quarter of 2007, the Dow Jones Industrial Average rose 3.6%. The MSCI AC Asia Pacific Index including Japan rose 7.6% while the MSCI AC Asia Pacific ex-Japan Index rose 16.4% in USD.

The relatively strong performance of the Asia Pacific ex-Japan equity markets owed much to the outstanding gains in the Hong Kong and China markets, which appeared to have decoupled from other world bourses. This was mainly due to a huge surge in liquidity, which resulted in both markets recording gains of more than 20% in the third quarter. China's prolonged period of rapid economic growth has translated into rising incomes, which coupled with the high saving rates in China, has resulted in a significant boost to local liquidity. Recently, some of this has found its way to the equity markets. Hitherto, this liquidity has been restricted to China's local stock market. However, the excessive valuations in China's domestic equity market prompted the government to introduce measures aimed at cooling these markets down. Hence, the government introduced a QDII quota allowing commercial banks to offer retail clients mutual funds that invest in overseas equity markets. The third quarter saw the actual implementation of this measure. The first mutual fund investing in overseas equity markets offered to retail clients by China Southern Fund Management saw a subscription of US$2 billion on its launch date alone, while the second overseas mutual fund offered to retail clients by China Asset Management saw a subscription of US$4 billion in just one day. As mentioned in previous reports, the bulk of this liquidity is expected to flow to Hong Kong given the price differences between the same stocks listed in Hong Kong and listed in China. At the same time, China's State Administration of Foreign Exchange (SAFE) also revealed plans to allow mainland residents to invest directly in stocks listed in Hong Kong.

Otherwise, most of the other equity markets in Asia followed the lead of the US and plunged through to mid August before rebounding strongly. However, the magnitude of the recoveries in individual equity markets differed. Among the stronger performing markets was India, as investors took advantage of any weakness to add to their exposure. With a good monsoon, India reported first quarter GDP growth at a strong 9.3%, while inflation stayed at a manageable level that relieved upward pressure on interest rates. Corporate earnings also beat expectations.

Among the weaker markets this quarter were Japan, the Philippines, and Malaysia. Japan's TOPIX Index ended the third quarter with a loss of more than 8% in local currency terms. On top of the overriding concerns about the state of the global credit markets, Tokyo stocks also faced political disruption with the sudden resignation of Prime Minister Shinzo Abe in September. Although Japan rebounded along with most other markets in response to the US interest rate cuts, the rally also had to contend with headwinds from a strengthening yen and signs of faltering economic growth.

In the case of the Philippines, the strong rally earlier in the year meant that investors did not rush back to bargain hunt. Moreover, given the volatility in global equity markets, investors have become more risk averse and the flight to quality mentality hurt the relative performance of this and other smaller markets. In Malaysia, the government had already announced various fiscal pump-priming measures. Going forward, what is likely to drive the market is how well the government implements these measures. Unfortunately, with a historically poor track record, investors have adopted a wait-and-see approach.

Past performance is not aguarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Investing in securities entails risks and there is no guarantee that any investment strategy discussed will work under all market conditions.

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