Commentary

Western Asset Management, the leading global fixed income manager wholly-owned by Legg Mason, Inc., said it is essential for long-term investors to look past the current panic and remain committed to spread-sensitive sectors. “Rather than fixate on near-term economic prospects, investors should focus on developments over the medium- and long-term,” said Mike Zelouf, Product Specialist at Western Asset. “Assuming that central bank and government policies succeed in sustaining some level of financial market and economic function, trust in the financial system will eventually recover. At that point, the deep liquidity discounts apparent across spread sectors should disappear, leaving prices that once again reflect the underlying probability of default.” “We continue to focus on mortgage-backed securities and the financial sector, two areas where we believe risk-adjusted returns look particularly promising over the next few years. Clearly, firms are susceptible to both a credit crunch and an economic downturn, but we believe investors are more than adequately compensated for bearing these risks,” said Zelouf. Zelouf noted that bank deleveraging has triggered a negative feedback loop in financial markets which has driven bond market pricing far from fundamental value. “This type of dynamic is restricted to fractional-reserve banking systems. The underlying global economy is not a fractional-reserve system. It will not experience such a negative feedback loop itself. It is vulnerable to the effects of such loops in the financial market, but only when monetary and fiscal policies fail to counter those effects. Policy-makers learned a lot from the mistakes made during the Great Depression and have been working hard to avoid repeating those mistakes during the current crisis,” continued Zelouf. Western Asset notes that while the magnitude of the current financial crisis is unprecedented, so too is the policy response. The U.S. Federal Reserve reduced policy rates by amounts unparalleled this early in the business cycle, and the real Fed funds rate has been negative for nearly a year. The Fed has also willingly expanded its balance sheet and provided short-term financing en masse to commercial banks, investment banks, and insurance companies alike. U.S. Treasury conservatorship has allowed Fannie Mae and Freddie Mac to continue their mortgage securitization operations, sustaining the flow of credit to the housing market at a time when the private-label mortgage securitization business has ceased to exist. This has helped reduce yields on conventional 30-year mortgages to pre-crisis levels, an important development that directly addresses problems in the U.S. housing market, the ultimate source of current ailments. The European Central Bank (ECB) and the Bank of England have implemented similar liquidity measures. While EU-wide fiscal initiatives have been slow, individual member states are aggressively taking independent counteractive action to the extent that they can, including deposit guarantees and coordinated government loans to troubled institutions. “We continue to believe that these and any forthcoming actions should be sufficient to prevent deep dislocations in the underlying economy, though we do expect a mild recession across much of Europe and the U.K.” “In seeking price stability, the ECB has intentionally been restrictive enough to induce a mild economic contraction. We now think the ECB has enough cover to begin its easing cycle and expect initial rate cuts before year-end. As such, we have increased duration in Europe to a slight long position to match our long position in sterling markets. We will also maintain short currency positions to the euro and pound sterling relative to the U.S. dollar as support erodes along with rate cuts,” Mike Zelouf concluded.

In the wake of recent market and firm failures, CFA Institute, the global association for investment professionals, today issued five facts investors should know when making investment decisions. Nearly 30 percent of CFA Institute members manage assets for individual investors.“Investors with properly diversified portfolios that match their risk tolerance are better able to focus on rebalancing their portfolios in response to turbulent markets,” said Stephen Horan, CFA, head of Private Wealth Management at CFA Institute. “Even in times of exceptional market stress such as we are experiencing now, the key fundamentals of investing can serve as sound guideposts. Focusing on these top five facts and seeking the advice of a trusted investment professional will help investors stick to their long-term investment plan and meet their financial goals.”1. Having an investment policy statement makes weathering financial storms easier. From the outset, every investor should form an investment policy statement that serves as a framework to guide future decisions. A well-planned strategy takes into account several important factors including goals, time horizon, tolerance for risk, amount of investable assets, and planned future contributions. “An investment policy statement conceived in normal market conditions provides critical guidance in severe market conditions that create a stressful decision-making environment,” said Horan. 2. Knowledge (of your risk tolerance) is power. “There is no such thing as risk-free investing, but knowing how much risk you are both willing and able to accept is a necessary step in building the portfolio that is right for you. It makes the difference between sensible investment decisions that providelong-term benefits and spur-of-the moment choices that can bring poor results,” said Horan. Determining your appetite for risk involves measuring the potential impact of a real dollar loss on both your financial condition and psyche. In general, individuals planning for long-term goals should be willing to assume more risk in exchange for the possibility of greater rewards. However, their psychological makeup maynot allow them to do so. You certainly don’t wait until a sudden or near-term drop in the value of your assets to conduct an evaluation of your level of tolerance for risk. Nonetheless, Horan added that determining risk tolerance “involves contemplating the impact on your wealth and psyche of severe fincial crises that might occur every decade or so.”3. Investing in a diversified portfolio of securities rather than individual stocks mitigates risk. Investing in only a few individual stocks increases risk for which an investor is not rewarded compared to investing in a diversified mutual fund or index fund. Investors should incorporate different asset classes and investment styles in their portfolio that do not tend to move together so that market swings in one part of their portfolio are offset in another part. Failing to diversify leaves individuals vulnerable to fluctuations in a particular security or sector, such as financial services. Also, investors should be mindful of not confusing mutual fund diversification with portfolio diversification. You may own multiple funds but find, on closer examination, that they are invested in similar industries and even the same individual securities. “Be careful to avoid investing in too many products, which can create unnecessarily high fees relative to the size of your portfolio,” said Horan. “It is relatively easy to create a diversified portfolio with only a few properly chosen investment products. Often, this can best be done with the advice of a professional advisor, such as one with the Chartered Financial Analyst designation.” 4. The fundamental principle of investing is buy low and sell high. So why do so many investors get that backwards? The main reason is “performance chasing.” People tend to invest in the asset class or investment style that has recently performed well. “For example, funds flowing into mutual funds peaked just before the technology bubble burst in 2000 and reached a low point just before the market turned around in 2003,” Horan said. “Someone who has a long-term investment strategy, but doesn’t have the tenacity to stick with it has a tendency to buy high and sell low. They throw their strategy out the window in response to short-term changes in the market, investing tactically instead of strategically. Actively reviewing one’s portfolio and doing nothing is a better strategy than acting on emotions.”When investing in individual stocks, many professional and novice investors alike have difficulty admitting they have made a mistake by selling a stock at loss. Many want to hang on until they break even. Smart investors realize when they may never recoup their losses. Not every investment will increase in value. Sometimes, it is far better to take the loss and redeploy the assets toward a more promising investment. 5. Frequent trading can be costly. Trading too often cuts into investment returns more than anything else. A study by two professors at the University of California at Davis examined the stock portfolios of 64,615 individual investors at a large discount brokerage firm. They found that transaction costs decreased investor returns by 2.4% per year and that these investors underperformed the market by 1.8% per year. Again, the solution is a long-term buy-and–hold strategy, rather than an active trading approach.

Japanese equity markets experienced sharp falls today in response to intensified strains in global financial markets in the wake of the failure or rescue of several US and European financial institutions. Downside risks to the world economy appear to be growing daily and we believe that the Japanese market is being driven by highly negative investor sentiment, rather than fundamental weakness in the underlying companies. The slowdown has spread from the US to the majority of economies around the world and undoubtedly Japan will be affected, especially as it is an open economy with a large export sector. In the short-term, we also see private sector domestic demand remaining weak, as real income growth is stagnant and capex is being hit by downward pressure on corporate earnings.However, although not immune from the global cycle, we believe the Japanese economy is now in better shape to withstand turmoil than in previous crises, making us optimistic for a more muted slowdown. In particular, the banking system is relatively unaffected by the credit crunch, having already been through painful deleveraging during the crisis of the 1990s.Uncertainties are likely to remain significant in the short term as the full extent of the fallout from the global financial crisis is still unclear. But we see many stocks with good fundamentals currently trading on extremely attractive valuations, presenting selective buying opportunities.

The combined wealth of Asia Pacific's millionaires expanded 12.5 percent to U.S. $9.5 trillion last year, according to the third annual Asia Pacific Wealth Report published by Merrill Lynch and Capgemini. The report covered nine key markets in Asia Pacific: Australia, China, Hong Kong, India, Indonesia, Japan, Singapore, South Korea and Taiwan.