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I N V E S T M E N T S T R A T E G Y O U T L O O K Market Vantage for Investment Clients April 17, 2006 * * * WEEKLY COMMENTARY The New Economics Economics - long known as the dismal science due to famous pronouncements such as, "In the long-term, we are all dead." - has more recently become the confused science. To be sure, the established theories had often wobbled when confronted with the facts of individual behavior. Why pay a huge premium for an Ivy League education when most studies show that the added value is dubious at best? In fact, a CEO of an S&P 500 company is as likely to have an undergraduate degree from the University of Wisconsin as Harvard (15 each), according to Bloomberg Magazine. More importantly, there were 236 schools represented overall. The data seems almost heteroskedastic. Or why is it that surveys show venture capitalists have expected returns well in excess of what they have ever achieved historically? If economics represents how the world actually works, as claimed by Steven Levitt, then it struggles mightily to explain the activities of those seemingly irrational humans. But these various anomalies are of small import because, when taken in aggregate, the rational behavior the lauded practitioners are so fond of was still able to explain large scale effects. Their hope was to help economic managers avoid the periodic panics and crashes of the past. And in large part they have succeeded - even to the extent that in some of his parting speeches Alan Greenspan worried about the apparent success of economic managers in eliminating volatility. Why is that a worry? If expected volatility is low, then assumptions about appropriate risk premia will be wrong, and, consequently, asset pricing will be too high. There may now be evidence that globalization has the world drifting away from some of the economic fundamentals we all grew up with. Here are few macro examples: As savings increases, interest rates should drop because there are more funds to lend - at least until the investment (borrowing) activity increases sufficiently to offset the excess savings. Fiscal deficits are the opposite of savings. Yet, in the U.S., where neither the government nor the households seem able to save a penny, interest rates are quite reasonable. Neither does there seem to be a shortage of investment capital. Consider, also, the accumulation of foreign exchange reserves by emerging economies in Asia. Theory would imply that these balances could be more profitably deployed domestically to assist the rapid growth currently under way. Instead, they get invested in the fixed income securities of industrialized countries. Certainly, these central bankers are risk averse given the hard experience of the currency crises of the late 1990s, but the large insurance policy they have amassed is now a barrier to growth. Normally, large trade deficits were always a harbinger of weak currencies. The U.S. trade deficit grows worse every year, yet there has been no wholesale collapse in the dollar. Even Warren Buffet got this one wrong. Rising commodity prices should lead to higher inflation, but even with gold at $600 and oil at $70, global inflation is low and looks to stay there. What's going on here? One of the problems is that the measurement mechanisms are antiquated. Many are based on pre-Bretton Woods (fixed exchange rates) methodology. According to Michael Mandel of BusinessWeek, the $130,000 you spent on your child's college education is economically classified as consumption; no different than if you'd blown that amount on designer jeans, movies, video games, and bags of chips. Yet, your expectation for the impact of that spending is far different. In fact, many parents I know think of these sums as investments in their child's future. In effect, they are contributing to the increase in human capital. Economically, what you and your child accomplished does not register. When the value of your assets increases, you might consider that as an addition to your retirement nest egg, but, economically, you save only when you squirrel away part of your disposal income each year. This notion results in a U.S. savings rate that appears to be zero (or even negative) at a time when household net worth is increasing rapidly from real estate and other investment gains. Why are the theoretical elements that the discipline had well in hand now slipping away? One idea is that economists have not yet retooled their models to account for rapid global flows of economic inputs (labor and capital). Capital flows to high quality countries have been fluid for many decades, but now global investors are seeking out the best risk/return relationships even in relatively risky emerging countries. Other inputs also cross borders without friction. Intellectual labor can be shifted to the lowest cost location on the globe. Software (think open source) is now manufactured in a virtual environment that does not have a physical location. I expect it will be some time before the academic concepts catch up with the new reality. Until then, we are probably best off if the economic managers, especially the politicians, simply stand aside and watch. -------------------------------------------------------------------------------- High Five for the 10-Year U.S. Economic data continued to stream ahead as several surprises turned up. Retail sales advanced 0.6 percent; Michigander confidence notched higher, and industrial production came in above expectations. The market sense now is that there is an open field for Mr. Bernanke to run in, and he will likely be running rates higher than previously expected. The wonder is that equities continue to hold their position. Clearly, there is little fear of higher capital cost by investors where it would normally be felt - the ability of businesses to finance expansions. This may be because of the extreme liquidity evident among corporates. But, what of the over-leveraged consumer? Shouldn't these higher rates hinder their debt-driven consumption? Still the "creative" use of leverage on the home front continues. For the week, there was a six bps upward shift across the curve from six months to the long-bond. Ominously, the future's market now has a 5 percent Fed funds rate well entrenched and is marking a 50 percent chance of 5.25 percent in the June 29 FOMC session. -- Jim Anderson, Editor Investment Strategy Outlook is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates. * * * FX OUTLOOK Geopolitics and Currencies There seems to be plenty of instability in the world at the moment. Very often, the FX analyst needs to study a multitude of seemingly unrelated geopolitical, cultural, and political factors to assess what impact they may have on particular currencies. While a reaction may not always be currency-specific to the country generating the news, it can have a rollover effect and impact many other currencies. Thus, the FX analyst looks at a number of factors - how bilateral relations affect commodity prices; how civil unrest may impact currencies; how the news impacts interest rates because of the changing political and economic stances taken by governments. Here are some examples of how this works, set in the backdrop of current events. Iran: Nuclear proliferation; sell USD, buy CHF, and look for it to have a positive bias in favor of the euro. Energy-specific commodity prices will force oil higher, sell USD and JPY. Buy CAD, AUD. France: Student riots on labor laws. The inability of France to unwind the social programs that were put in place before the euro was formed with its Maastricht treaty debt to GDP levels that have been contravened by Germany, France, and Italy. The three biggest European economies have to cut expenditure to meet the targets, and France will now find it more difficult (if not impossible), potentially causing more friction in the EU as improbable fiscal targets become impossible. The cave-in by Chirac (now a leader with less credibility) to the demonstrators probably weakens the EUR overall, with spending not contracting. Germany needs him as a strong ally to push their agenda - the net outcome appears on balance to be negative. Employers receive subsidies when they take on 16- to 26-year-olds "in difficulty" on permanent contract. The cost: 150M euros in 2006, 300M euros in 2007 (yet to be approved by the Senate). The ineptitude of French politicians seems to have hit a new low as they even lost against the "children" of their population. Euro negative. Israel: Is Hamas really a more viable political animal? (PLO deja vu all over again.) Hamas is only doing the same thing the PLO did 20 years ago - trying to change its face into a political organization and a viable ruling, law-abiding entity (at least in perception). This perception was dented today with a suicide bombing killing six in Tel Aviv. The nervousness the election result brought about to the Israeli Shekel has now, to some extent, dissipated along with people's common sense. Just as when the PLO was the political faction and Hamas was the terrorist arm of Palestinians, now Hamas makes up the politicians and various jihadist groups are the terrorists. Is there any difference, or is my cynicism more narcissistic than usual? The strengthening of the ILS defies reason given the facts above and can only be put down to an in balance of more incoming flows supporting the currency. That said, a weaker currency from here would seem probable. Iceland: Government debt-funding crisis. After another failed government bond auction with no takers, Iceland is now on the verge of bankruptcy. The talk of possible contagion of other emerging market currencies that are trying to get to their young feet (like the EX Eastern block currencies) seems to have faded for the time being. The fears of a meltdown similar to that experienced in late 1990s now seems unlikely, but the ISK has fallen from 60 to nearly 75 to the USD this year. The central bank is set to continue raising interest rates, and contagion to higher interest rate currencies (like the NZD and AUD) is the concern. At least they have high commodity prices to support them. A meltdown looks unlikely; as time goes by, this will be viewed as a one currency risk. Italy: General election change from right wing to middle politics. Outgoing Premier Berlesconni was the anomaly of European politics as the only right-wing leader in the EU block. Now, deposed by Prodi (who has a fairly visible position slightly left of center), this could help resolve some of the pressure France and Germany have been directing at Italy (which has been as much a political play as anything to do with fiscal restraint). While Prodi's monetary philosophies might not lead in the direction Italy needs to go in (reducing its deficits), the overall politics, at least, won't be thumbing their nose at the rest of Europe from the other side of the fence. Euro positive. Mexico: The possibility of less Mexicans in the U.S. sending money home means less MXN buying - so the MXN would weaken as the current balance of cross-border fund flows changes. In the unlikely event of many people returning to Mexico, in the near-term the MXN would strengthen as the USD are converted for the return followed by a weakening of the currency as the level of repatriation flows declines (less funds would be sent south if legal workers view their residency in the U.S. as more permanent). Sell MXN. In the currency markets, many traders look for a "double win" for any of the reasons described above; they'll trade one currency against another. If they are correct about buying the currency that is expected to strengthen - and selling the one expected to weaken - the potential gains are more than betting a currency against the USD. If they are wrong, then the potential loss should be less than betting against the USD, as they will have a gain on one currency and the loss against the other (in USD terms) would be smaller! - Laurence Hayward, Senior FX Strategist, SVB Silicon Valley Bank's Global Financial Services * * * VC QUARTERLY UPDATE Silicon Valley Bank publishes a quarterly synopsis of VC investment trends. The Q4 2005 edition is now available. As a weekly reader of Investment Strategy Outlook, SVB Asset Management invites you to download this valuable report at http://www.svb.com/pdfs/vc_2005_q4.pdf. * * * MONEY MARKETS Treasuries Face Mixed Messages U.S. Treasuries held steady as a larger-than-expected drop in a gauge of manufacturing in New York state cast doubt as to whether the Federal Reserve will raise its interest-rate target two more times. The sign of slower growth comes with yields on 10-year notes above 5 percent for the first time since 2002. An April 14th article in the Wall Street Journal said some Fed officials aren't convinced they will need to raise rates as much as investors expect. (Bloomberg) Take on Bonds: Little to Like With the 10-year above 5 percent, the bond market finally has cracked, and financial advisers are scrambling to react and recalibrate. The average long-term government bond fund had lost 2.25 percent in the past four weeks and 4.23 percent in the past three months, according to Chicago-based Morningstar Inc. Between March 1 and April 13, rates on the 30-year bond jumped from 4.56 percent to 5.11 percent, with 10-year bond rates climbing from 4.59 percent to 5.03 percent during that same span, according to Barclays Global Investors in San Francisco. (InvestmentNews.com) Fed's Kohn: 'Sustainable' Growth Ahead The U.S. economic expansion should moderate this year to a "sustainable" pace of growth as weaker housing markets temper consumption and cause businesses to trim investment spending, said Federal Reserve Governor Donald Kohn. Fed officials are now basing interest rate decisions on what near-term data say about their internal forecast of slower growth in the second half of 2006. A more robust expansion may lead the central bank to raise the benchmark rate beyond the 5.25 percent that futures traders now predict. (Bloomberg) * * * TECH/LIFE SCIENCES/VC Sensible Computing Wireless, embedded sensors may be the next platform for connected computing, as the popularity of the tiny sensors accelerates. A number of venture-backed startups have developed embedded operating systems and Web services for wireless sensors. Companies such as Dust Networks, Foundation Capital, and others are helping to popularize mesh networking in sensors. The challenge is programming remote sensors with a standard protocol that allows data to be pulled from them into a variety of applications. (Red Herring) SAAS Takes Off SAAS or "software as a service" is touted as the answer to cumbersome traditional software implementations. Offering ease of use and streamlined implementation, SAAS uses a Web browser and the Internet to connect customers to the software, which is maintained by the provider on its computers at a cost of 10 to 20 percent of traditional software. However, a survey by AMR Research shows that of 100 SAAS users, 36 percent reported their experience fell below expectations due to higher prices or longer implementation than anticipated. Evidence suggests that this expectation gap occurs when SAAS is used in large organizations with complex needs. (Wall Street Journal) Diagnostics in a Test Tube Sophisticated and pricey genetic or protein tests are beginning to reshape the diagnostics landscape. The tests, often marketed directly to doctors rather than medical labs, can detect early-stage cancer, monitor heart transplants, and help with drug selection, thus accelerating the personalized medicine trend. Some experts are concerned, though, that the tests are not adequately regulated and that their hefty pricing contributes to runaway health care costs. (New York Times) Popular PIPEs Promote Profit Biotech firms are looking to PIPEs (private investment in a public company), instead of follow-on offerings to raise money, increasing the amount of money raised in the transactions by 100 percent over the $533 million in Q4 2005. About 50 U.S. life science companies raised $1 billion in PIPE deals in Q1 2006, according to Burrill & Co. The popularity of PIPE is due to poor response to biotechs in the public markets and the speed of completing a PIPE transaction. For the investor (often hedge funds, mutual funds, and VCs), PIPEs offer an 8 to 35 percent discount on a company's stock and a lower risk way to get a return on invested money. (Silicon Valley Business Journal) SPEs Provide Funding Alternative Special purpose entities are making a comeback in the biotech community as a way for public biotechs to accelerate drug development, reduce the associated risk, and advance drug development before licensing them to big pharma. In a recent example, Isis Pharmaceuticals inked a deal with private equity firm Symphony Capital to fund development of three drug candidates. A new entity, Symphony Genesis, will take ownership of the drug candidates for about four years but provide Isis an exclusive option to repurchase the drug rights for a preset price that gives Symphony a 32 percent average annual return. Isis is paying Symphony a fee, but if the drugs fail, Isis owes nothing. (Forbes) Biotech Boosts Regions A recent report released by Battelle and the Biotechnology Industry Organization (BIO) outlines the reasons why states are pouring billions of dollars into programs to support biotech development in their regions. Titled "Growing the Nation's Bioscience Sector: State Bioscience Initiatives 2006," the study found that each bioscience job in the U.S. generates almost six additional jobs in related industries. Although bioscience firms employ 1.2 million persons in the U.S., legislation encouraging biotech research is necessary for states to compete for biotech dollars. (PRNewswire, BIO) Investing in India Private equity and VC firms invested about $1.4 billion in 69 Indian companies during the first quarter 2006, 3.5 times the amount in the same period last year and 1.7 times that during Q4 2005, according to Venture Intelligence India. The average private equity deal size rose to about $20 million from $14 million during the same period last year, with increasing investments by private equity firms in the real estate industry as well as in mature IT, BPO, and manufacturing companies contributing to the increase in deal size. The number of early stage investments (16) approached the number of PIPE transactions (18) and companies at growth stage and late stage attracted 10 and 16 investments, respectively. (AltAssets) * * * GENERAL ECONOMY Retail Sales Surge U.S. retail sales increased 0.6 percent in March, the Commerce Department said Thursday, with unexpected strength in auto and building materials sales. "The big picture for the consumer still looks good," said Stephen Stanley, chief economist for RBS Greenwich Capital. Economists were looking for sales to rise a more modest 0.4 percent. Excluding the 1.6 percent rise in auto sales, retail sales increased 0.4 percent, as expected. Sales in February showed a 0.8 percent decline and sales rose 3 percent in January. The robust report kept yields on the 10-year Treasury above 5 percent for the first time in nearly four years. (MarketWatch) NY Manufacturing Slows Down Manufacturing in New York state expanded at a slower pace in April, as growth in sales and orders eased, a Federal Reserve report showed today. The Fed Bank of New York's General Economic Index fell to 15.8, the lowest since October, from 29 in March. A number greater than zero signals a higher percentage of the manufacturers in the survey reported an improvement in business than deterioration. The index outpaced last year's average of 15.6, and a measure of the outlook for the next six months improved. (Bloomberg) Capacity Utilization Surges The Federal Reserve reported Friday that capacity utilization in the industrial economy increased to 81.3 percent in March, the highest level since September 2000. The report also showed that output rose 0.6 percent in March, the best gain since December and capping another robust quarter for the factory sector. "Given that the Fed has been flagging inflation concerns related to further increases in resource utilization, this report underscores the likelihood of further rate increases in the months ahead," said John Ryding, chief U.S. economist for Bear Stearns. (MarketWatch) * * * FORWARD YIELD CURVE - ACTIVE U.S. GOVERNMENTS See this week's graph: http://www.svb.com/images/iso/curve041706.gif * * * ECONOMIC CALENDAR See this week's table: http://www.svb.com/images/iso/calendar041706.gif * * * For more information, call 415.512.4264 or visit http://www.svbassetmanagement.com. * * * SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group. 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