Video Transcript

< GAIN FROM OUR PERSPECTIVE ® >

March 2011
Dr. Michael Hasenstab Market Outlook
Is the global recovery at risk in 2011?
I think a little bit less so this year than last year, where it’s now a little
clearer where we are in terms of the recovery path. Just six months ago,
there was concern about a double dip in the U.S. I think that is clearly no
longer a major risk, but the degree of recovery is still going to vary quite
a bit. Those countries that didn’t have leverage are recovering faster and
those countries that don’t have a huge debt problem are recovering
faster. So that still leads us to areas such as the emerging markets or
countries like Australia or Sweden or Norway that we would expect to
both grow faster as well as normalize interest rates faster than you are
going to see in places like Europe, the U.S. or Japan.

Michael Hasenstab, Ph.D.
SVP, Portfolio Manager
Co-Director of International Bonds
®
Franklin Templeton Fixed Income Group
Now [the issue] it does raise is in 2011, looking at the relative policy
responses, what we want to pay close attention to is making sure
countries don’t get behind the curve. So that will be a big focus for
2011—analyzing which countries stay ahead of the curve, which
countries fall behind the curve. Those that fall behind could have issues
about asset price, inflation or real inflation. Those that stay ahead of the
curve, places like Australia that have been very responsible in fiscal
monetary as well as exchange-rate policy, we believe will have sustained
growth and be a healthy investment opportunity.

What is the outlook on inflation in 2011?

There are varying issues regarding inflation. Some of the inflation that countries are dealing with has to
do with more imported prices because of the rise in commodity prices as you mentioned. To deal with
this, one of the most effective tools is to allow currency appreciation because with a stronger currency,
you decrease the cost of those inputs. So if you are importing oil and your currency goes up 20% against
the [U.S.] dollar, the cost of oil just went down 20%. So a lot of countries which were fighting exchange
rate appreciation last year are now letting it go. Malaysia and Indonesia have been very explicit in saying
that exchange-rate appreciation is part of their policy mix to help fight imported inflation. For us, that can
actually be a very good development. Early stages of inflation, particularly imported inflation, can help
drive currencies to appreciate, which as an investor, can be a good thing for us.

Some countries are dealing with domestically-led inflation with growth, now exceeding potential growth
rates. You are seeing some wage price pressures particularly in some of the emerging markets, and in
that case it’s important for countries like China or India to stay ahead of the curve, to continue tightening
measures both through bank lending, through interest rates, through exchange-rates, through
contractionary fiscal policy. All of those are really important to stay ahead of the curve. So at this point,
we don’t see any countries falling critically behind the curve, but there are number of countries that need
to continue to remain vigilant and if they do, I think that is good news.

Where is your team finding currency opportunities?

There are always hidden risks, and that is why we tend to focus on diversification and a lot of
fundamental research in all the countries that we invest in. Some of our biggest opportunities are in non-
Japan Asia. We continue to think that the strong economic fundamentals, their lack of debt and the need
for currencies to appreciate to fight inflation will motivate good investment opportunities. Plus as they
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 Video Transcript

< GAIN FROM OUR PERSPECTIVE ® >

have been raising interest rates, we can buy very short-dated bonds without taking interest rate risk, but
earn a high yield and position for the currencies. So a lot of our investment thesis is around earning some
yield without taking a lot of interest rate risk, without taking a lot of credit risk, but at the same time,
positioning in currency markets.

In Europe, we are finding more opportunities in Northern Europe, places like Sweden, Norway and even
Central Europe, like Poland, which are benefiting from the robust growth and competitiveness in
Germany, and avoiding the problems of southern Europe which seem to be ongoing. There are
opportunities even in Europe despite the problems, but they are in a select subset of countries, and we
are still finding opportunities in Asia.

How is the team positioning to deal with rising interest rates?

Very simply, we think rates are going higher pretty much everywhere. It’s hard to find a country which will
actually be in a position to be lowering interest rates. The reasons will vary—in some countries rates are
going higher because of fiscal pressures. Greece is a primary example, some of the other problem
borrowers because of irresponsible fiscal policies, it’s pushing rates upward. The U.S. is at risk of that,
with a $1.5 trillion deficit year after year, ultimately that will probably push rates higher. So fiscal reasons
are one motivation for higher rates.

The other would be imported costs as commodities and food and fuel prices are elevated. That is putting
upward pressure on domestic inflation, the countries that import those goods. That is motivating central
banks to tighten policy. And then domestically-led growth is [also] motivating many central banks to
tighten policy. So whether it’s for inflation, growth or fiscal reasons, generally rates are going higher,
which is actually a good news because that is allowing us to earn high yields at the front-end of the curve,
roll over without taking interest rate risk, and as I mentioned earlier, position for those currencies.

What we are avoiding is a lot of long-duration assets. We’ve cut the average duration of our strategies
significantly. We have been increasingly defensive on our interest rate exposure, which is why, in the
fourth quarter of last year [2010], our strategies actually did well despite rising interest rates. So that was
a good stress test to see how we can position global fixed income in a rising interest rate environment,
and we feel pretty positive about how the early indications have come in.
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