Eating Carrots

Eating carrots : Investment radar through 2012

Summary
During WWII, British pilots were using radar technology but didn't want the Germans to know. So the
propaganda ministry put out the story that British pilots could see in the dark because they ate a lot
of carrots. Over the last few weeks we have been eating our carrots and have mapped out a scenario
for the shape of the investment markets through 2012 built on an analysis of the macro‐economic
picture and the challenges facing businesses and consumers.

 Economic performance in the major economies, with the exception of the US, is likely to be
sluggish at best over the next 2 years with weaker recovery prospects in Europe.
Constrained credit markets will subdue investment, consumer spending and capital
expenditures in the UK and Europe. Government spending will be reduced to combat the
budget deficits built up during the economic crisis as ‘austerity’ prevails.

 Interest rates will remain know as dis‐inflation or low levels of inflation will prevail as a
result of the above constraints on spending and investment. The desire to protect GBP by
raising rates is largely offset by the threat of exploding the debt time bomb within the banks
and at the household level.

 Equity and fixed income markets will largely move sideways with large swings on the back of
news flow and mixed economic data. Commodity and raw material prices will be driven up
by continued rapid development in Asia and stronger recovery in the US. Real estate offers
a safe haven for investors with low volatility, high yielding returns in an uncertain
environment. Property values are affected by rental levels (which will remain static) and
investment yields which is a function of demand and supply where supply will remain
constrained and demand will be rising.

 The great unknown is the actions that will be taken by governments, if any, to restructure
and reform the banking industry to allow greater flow of credit. This has the potential to
alter all of the scenarios above.

1

STRICTLY PRIVATE & CONFIDENTIAL

Zaggora LLP

Zaggora is a private investment partnership of outstanding individuals from the principal real estate
investment and banking universe (JP Morgan, Knight Frank, Union Bancaire Privee, The Ability Group) investing
in UK and European commercial real estate assets to provide highly visible, reliable and low volatility returns
that are high yielding for investors.

Macro‐Economic Performance

We believe that the economic recovery will be slower in Europe than in the US which itself will be largely
outpaced by China and Asia.  The shape of the recovery is more of an ‘L’ rather than an accentuated ‘V’. An L‐
shaped recovery represents the shape of the chart of certain economic measures, such as employment, GDP
and industrial output. An L‐shaped recovery involves a sharp decline in these metrics followed by a long period
of flat or stagnant growth. Many refer to the 1990s‐era in Japan as a classic example of an L‐shaped recession,
where there was an economy that essentially flat lined for a decade.  Whilst the experience of Europe over the
next 24 months may be less severe than that of Japan, there are more reasons for us to think this will be the
shape rather than a rapid ‘v’ recovery.

The UK Office for budget Responsibility (OBR) forecasts show growth in the UK economy for the coming five
years estimated to be 1.2% in 2010 and 2.3% in 2011. We believe these forecasts are optimistic.

Key limitations to rapid recovery;

 Weak provision of credit from a banking system still finding its feat after the financial crisis. Whilst
lending is increasing, it is largely subdued to households and businesses. This limitation will continue
to subdue consumer spending and business investment.

 Retail sales in the UK and Europe are stable but muted. House prices are seemingly more erratic.
Although reflecting markedly different rates on both a monthly and annual basis, both the Halifax and
Nationwide indices do at least agree that Q1 saw much slower growth than that achieved in Q4. Many
commentators still anticipate negative or, at best, no growth in 2010.

 Unemployment is still rising which will further dampen consumer spending, sentiment and is creating
more spare capacity in the UK and Europe. The OBR says unemployment will peak this year at 8.1%,
then fall each year to reach 6.1% in 2015.

 Government spending is falling as austerity measure and deficit attack plans kick‐in.  The UK coalition
believes the bulk of debt reduction must come from lower spending, rather than higher taxes ‐
roughly 80% through spending cuts and 20% through higher taxes. Measures today mean that 77% of
the total consolidation will be achieved through spending reductions and 23% through tax increases.
Total spending cuts amount to £180bn over the life of this Parliament.

Inflation & Interest Rates

CPI inflation dropped further than anticipated in February, to 3.0%, underpinning the BoE view that inflation is
not of great concern and should continue to fall throughout the year. The near‐term outlook is somewhat
higher than in February and suggests that inflation is likely to remain above target for the rest of this year.
Inflationary pressure is coming from commodity and input prices, the demand for which is being driven by the
emerging markets in Asia. As the temporary effects of rising inflation wane, downward pressure from the
persistent margin of spare capacity is likely to drag inflation below the target for much of 2011 and 2012.  As a
result of the domestic dis‐inflation and weak demand, we believe interest rates will remain at their current
levels through 2010 and much of 2011.  The spending cuts by the government will have to be balanced using
monetary policy and interest rates will do most of the heavy lifting. The threats posed to GBP during this
period could be defended by raising interest rates but because of the weaker demand, we believe that the
effect of raising rates on the debt load at the consumer, business and bank level would be damaging.

2


Investment Markets

Equity Markets

Fears of higher borrowing costs and the effects on growth of
fiscal austerity have seen a reversal of the equity market rally. 6000 FTSE‐100
The bull‐run that we have seen since March 2008, albeit from 5800
distressed levels, has been consistent across the worldwide 5600
exchanges as investors bought the recovery trade and the 5400
‘bargain prices’ of both blue‐chips and secondary market 5200
listings.   5000

4800
However, the market responded nervously to the debt woes
4600
of Dubai earlier in the year, the first cloud of the gathering
sovereign debt storm.   4400
4200
The continued rally in the equity markets came to an abrupt 4000
end with the announcement of civil investigations by the SEC

05, 2009

07, 2009

09, 2009

11, 2009

01, 2010

03, 2010

05, 2010
of the Goldman Sachs (GS) CDO trades, quickly followed by
news of a potential criminal investigation of GS and other
firms. This was followed by the request of Greece for an IMF
bailout and subsequent riots on the streets in protest at
austerity measures.

The increasing volatility was represented in a spike in the Vix Index and a ‘flash crash’ of the NYSE on May 6th
when the market fell 10%, before recovering 8%, all in the space of 8 minutes. It is no wonder investors have
taken profits and re‐positioned their portfolios in the face of such volatility.

Fundamentally, the market is more conscious than ever of the risk that the economic recovery story continues
to fall short of market expectations, causing equities to fall during 2010, correcting downwards by a further 5‐
10% from today’s levels.

In addition, the rate at which investors discount future profits has fallen significantly as a result of actions by
policymakers to boost liquidity in financial markets as well as signs that official interest rates are likely to be
very low for a prolonged period. We know that the rally in the FTSE 100 has coincided with the drop in real
yields on government bonds, consistent with our belief that equity markets would rally as long as interest rates
remain low.

While the prospects for economic growth are bad, the outlook for corporate profits looks worse. The large
amount of spare capacity in the economy, combined with the recent sharp rise in firms’ unit wage costs, is
likely to squeeze firms’ margins severely. We expect macroeconomic profits to fall by around 6.5% this year
and to be flat in 2011.

Forward‐looking indicators of corporate earnings, such as the CBI’s balance of manufacturers’ order books, are
consistent with further falls in corporate earnings over the next year.

Given the macro environment, we believe that the equity markets will largely trade sideways over the
remainder of 2010 and through 2011, reacting sharply to news flow with volatile swings.

3


Fixed Income

While bond yields have edged a little higher since Q4 2009, the prospect of a major fiscal squeeze, sluggish
growth and low inflation and interest rates should provide a more favourable backdrop for bonds later in the
year. The recent rise in yields has reflected three factors:

1. The rapid deterioration of the public finances and a hung parliament at the general election have
raised concerns about the risk of sovereign debt default. The CDS premium on UK government debt –
a measure of the cost of insuring against sovereign default – has risen alongside the rise in bond
yields.

2. Worries that the recent rise in headline consumer price inflation will prove longer‐lasting than the
Monetary Policy Committee expects have pushed inflation expectations higher.

3. The rise in yields has coincided with the easing in pace and (at least temporary) pause in the Bank of
England’s bond purchases under its quantitative easing scheme. The previous narrowing in the spread
between gilt yields and overnight index swaps – which had been attributed to the effect of QE – has
recently been reversed.

But we suspect that at least some of these pressures will ease later on in the year. For a start, the cross‐party
consensus on the need to tackle the fiscal position suggests that, even under a hung parliament, further plans
and action to reduce the budget deficit will emerge. These are due to be announced in the emergency budget
may keep the rating agencies happy. Second, inflation concerns should also fade in time as the full
disinflationary effects of the recession and the vast amount of spare capacity created become evident.

And finally, while gilt issuance will remain very high over the coming few years, a further extension of the
quantitative easing programme is yet possible. Meanwhile, new liquidity requirements requiring banks to hold
more government debt should also help soak up some of the supply.  Coupled with a fall in international bond
yields as the global economic recovery disappoints and inflation elsewhere remains subdued, we still expect
these developments to pull 10 year gilt yields back down to around 3% by the end of the year.  Meanwhile,
corporate bond spreads have continued to tighten over the quarter. But they may struggle to narrow further.
Spreads are not much wider than during the 2000s credit boom. And the relationship between the growth rate
of economic activity (as measured by the CIPS surveys) and corporate bond spreads hints that they may widen
a little again.

Commodities

The commodities market has largely responded
to the positive outlook for the recovery in line 260
CBOE Gold Index
with the risk seeking trend of the equities 240
market. The normally inverse correlation 220
between gold and equity prices was broken
200
some time ago as fears over currency levels have
pushed investors into Gold, Silver and Platinum. 180
As the equity markets have begun their 160
correction, commodities such as crude oil have 140
seen a correction.
120

We strongly believe that the gold market is due 100
for a significant correction. The demand/supply 80
factors behind the $1,250/oz gold price cannot 60
justify this level. The development of gold plated
09,2006
12,2006
03,2007
06,2007
09,2007
12,2007
03,2008
06,2008
09,2008
12,2008
03,2009
06,2009
09,2009
12,2009
03,2010

bullion ATMs as rolled out in Abu Dhabi are
surely indicative of a bubble. Broader demand
for raw materials and commodities from Asia is
driving inflation which we believe will persist
during 2010.

4


Real Estate Market

UK real estate can offer investors a safe haven from these volatile markets.

The opportunity exists to earn low volatility, annual equity returns of 8‐15% (received quarterly) by acquiring
UK commercial real estate assets let to excellent covenants (UK Government, Tesco leases etc) for 5‐10 years
with a 10‐15% annual IRR.

We believe in the current, limited visibility environment this represents an extremely interesting low risk, real
asset investment strategy. As a defensive play, the potential returns profile compares well with other
defensive alternatives such as cash/gold/treasuries. The strategy offers investors low volatility, transparent
returns with in‐built inflation protection at a time when GBP borrowing costs are low (2.5% for a 5 year fix and
4.04% for a 30 year fix) and exchange rates favourable relative to USD.

Real assets offering the following investment characteristics;

 8‐15% Fixed annual equity return (received quarterly)
 10‐15% Annual IRR
 Fixed income with annual increases (RPI/CPI/Fixed)
 FRI Income (All costs, management, insurance, maintenance, paid by tenants)
 Strong residual value driven by quality of asset and location

The UK market structure and framework provides the strongest opportunity because;

 Ultra‐Long leases 10‐20 years+ (without tenant break options)
 Upward‐only rents, if markets rents fall, tenants continue paying same rent
 FRI leases making tenants responsible for all management, maintenance and insurance costs
 Active lending market to secure leverage on modest basis (60%‐70% LTV)

Whilst asset price worries may dominate the thinking in the equity and fixed income markets, there are two
key reasons why we believe real estate values will hold up and increase over the next few years. Real estate
values are driven by rental income and investment yield.

We believe whilst rental values will remain static, the lack of development caused by a scarcity of financing
means that there are far fewer new assets for office and retail tenants to occupy. This lack of an increase in
‘normal supply’ will mean that there is support underneath the rental market.

The investment yield for assets is a function of demand and supply. We know that because of the lack of
development, new supply of assets is constrained. The large volume of supply threat from the banks has not
materialised and we believe will not materialise as long as interest rates remain low. Demand meanwhile will
continue to hold up as investors seek ‘bricks and mortar’ investments in a flight to quality.

Disclaimer (restructuring banks)

Our assumptions are based on a model where credit remains constrained. Bank reform and restructuring by
governments over the next 2‐3 years could dramatically alter these forecasts to allow a greater flow of credit.
Currently, the workout of assets and refinancing of debts by commercial banks with central banks is seen to
continue for the foreseeable future as de‐leveraging persists.

There is of course the permanent threat of an external shock of some sort and Nazim Taleb’s Black swan…but
we believe that despite the worries, most of the unknowns are known and the spread of outcomes is limited,
as defined above.

5

Eating Carrots

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