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Three legs of potential growth in U.S. could move economy forward

Story Highlights

Uncertainty surrounding government policy is holding back the economy.
We see the U.S. economy moving forward on three legs of support: housing, energy and industry.
China, although still growing, has a similar situation to that faced in the U.S. in the 1970s, with the interplay between two forces: growth and inflation.

Investment Management

Hank Herrmann

CEO

As we move toward year-end, there are several important issues facing the global financial markets, including the euro zone’s sovereign debt crisis and the U.S. fiscal cliff. Let’s look at how these and other questions facing us over the next several months could impact the economy and financial markets.

The U.S. equity market is up significantly so far in 2012, despite sluggish economic growth. Why, and what is in store for the new year?

Uncertainty surrounding government policy is holding back the economy. Despite this, the market’s improvement is supported by companies with strong balance sheets and record high productivity. A better understanding of the outlook should come after the U.S. presidential election. Will taxes be raised and how much? Will there be big cuts in government spending? Will government intrusion into the economy expand further or contract? All are very important open questions. In the meantime, businesses and consumers will remain risk averse.

Despite the confusion surrounding government policy, as we look toward next year, we see the U.S. economy moving forward on three legs of support: housing, energy and industry. A quick look at why these three hold potential:

Housing:

We have under-built new homes relative to the increase in the working age population in this country since 2007. New home construction has fallen from more than a 2 million annual rate at the peak to less than 600,000 at the low. The U.S. requires a rate of about 1.2 million homes annually, just to stay even, given the growth in the working age population. As the unemployment rate comes down as the economy stabilizes, we’re likely to see an increase in new home demand. An improving housing sector benefits many areas, including construction materials, durable goods, furniture and so forth. To sustain improving housing demand, we need better job creation, and happily, the trend currently appears to be up.

Energy:

It’s become obvious to us that non-conventional energy resources, particularly shale oil and gas, are creating an upswing in exploration, development and production in the U.S. energy patch. Energy companies we’ve talked to report that, based on their production estimates, domestic oil and natural gas production will grow substantially over the next 10 to 15 years. This increase in supply of cheap energy allows the U.S. to become much more competitive globally, and reduces our dependence on foreign energy supply. Most important, getting the resources out of the ground and transporting them has and will continue to create many new jobs.

Industrials:

Boosted by lower energy costs, the industrial sector in the U.S. is becoming more competitive. The past few decades have seen meaningful declines in industrial activity here. That trend is now reversing. The new supply of energy has boosted the need to rejuvenate old refineries, build new ones, lay pipeline and build out infrastructure for transportation, etc. Add in new home construction, and you see industries in position for a phase of resurgence.

It’s evident that growth in China is slowing. Do you still see China as a growth story longer term, and what is its influence on global economic growth?

China remains the world’s main growth story, but a slower pace than we’ve seen in recent years is likely. Given the expanding middle class and continued desire for improving lifestyles, we think we’ll see growth in China at a rate of 5 percent to 7-plus percent in GDP for quite some time. This compares to a rate of approximately 2 percent or so in the developed world. For the past decade, China grew at a rate in excess of 10 percent per year, and even faster prior to that.

The reason that slower growth in China is important is that companies around the world have planned on higher Chinese growth rates. China now is going through a de-stocking phase, causing suppliers to begin to experience demand shortfalls relative to their expectations. The unwinding of inventory in China therefore can have a big impact on world growth, albeit perhaps only temporarily.A reduction in government policy flexibility in China is an added consideration impacting the growth level. Wage increases of approximately 10 to 20 percent over the past few years have created inflation risks. China has a similar situation to that faced in the U.S. in the 1970s, with the interplay between two forces: growth and inflation. The government wants to see more growth, but if it is not managed effectively, China will face inflationary consequences via labor and import costs. It is likely this quandary will retard growth rates somewhat, relative to the past.

Is the sovereign debt crisis in the European Union being effectively addressed?

The European Union has effectively addressed the bank liquidity and the sovereign financing crises. What remains is the fiscal crisis. That is, many of the 17 EU members are running unsustainably high deficits, with no apparent effective measures to reduce them. A common fiscal union among the member countries, or at least a common agenda in terms of taxing and spending, is needed. As Margaret Thatcher said when the EU was formed, you can’t have monetary union without fiscal union. The process of developing a workable fiscal union is likely to be prolonged and politically difficult. This would likely translate into very low, if any, growth in Europe, and a recession for southern euro zone countries.

What opportunities to do you see for investors in this environment?

There is a reasonable case to be made for U.S. equities, given the three legs of growth we’ve identified, along with ongoing easy monetary policy. We are broadly anticipating around 7 percent appreciation in the S&P 500 in 2013, driven by an expansion in the price-to-earnings (P/E) multiple, primarily. We expect that the government will, at worst, “kick the can down the road” in some fashion before the fiscal cliff is reached. Significant action regarding taxes and spending will need to be enacted before confidence can be fully restored. If none is forthcoming, markets will react, forcing something perhaps more painful to occur.

The yield on domestic stocks is higher in many cases than the yield on their outstanding bonds. Further, many companies are increasing dividends more aggressively, as balance sheets are strong. Domestic equities remain attractive to us relative to other alternatives.

The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered to represent the U.S. stock market. Investments cannot be made directly in an index.

Past performance is not a guarantee of future results. The opinions expressed in this article are those of Mr. Herrmann and are current through October 2012. Mr. Herrmann’s views are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. Waddell & Reed Financial, Inc. is the ultimate parent company of Waddell & Reed, Inc.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for any of the Waddell & Reed Advisors Funds or Ivy Funds, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.

For the U.S., it’s all about elections, fiscal issues and manufacturing

For the U.S., it's all about elections, fiscal issues and manufacturing

Story Highlights

Despite concerns for 2012, we think growth is likely to improve in 2013.
U.S. elections are just the start of key events that may affect the economy.
Manufacturing is one sector that could bring increasing economic strength.

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Investment Management

Derek Hamilton

Vice President

While there have been contrary indicators about the U.S. economy, most recent data indicate economic weakness. That raises the potential importance of events in the coming months, including the national elections, resolution of several fiscal issues and a decision about another increase in the debt ceiling. In analyzing the potential economic impact, we think it is important to keep an eye on another key factor: a stronger manufacturing sector.

Weak 2012, improving 2013

The U.S. economy continues to see sluggish growth. U.S. gross domestic product (GDP) grew at an average rate of 1.6 percent in the first half of 2012, when adjusted for inflation. That is down from an average of 2.7 percent in the second half of 2011. We don’t see much change in the immediate future, and expect growth in the second half of 2012 to be at or below the rate of the first half.

There have been some positive data releases in recent months, including September’s improvement in the unemployment rate. However, the overall evidence continues to point to economic weakness:

Orders for durable goods – a solid indicator of capital spending – have weakened in the last several months.
Despite the most recent employment report, private sector job growth continues to be subpar.
Export growth has been weakening and is likely to be a drag on growth through year end.
Business confidence is down because of uncertainty about the economies in Europe and China, as well as domestic concerns about the November elections and the fiscal cliff of expiring tax cuts and mandated budget cuts.

Despite the concerns about 2012, we think growth next year is likely to improve as the year progresses. Housing has been a bright spot in the economy this year, and we think improvement in household formations means housing demand should continue to recover in 2013. In addition, recent action by the Federal Reserve (Fed) to purchase mortgage-backed securities in an attempt to lower mortgage rates further should make homes even more affordable. The Fed’s action also should allow current homeowners to refinance their mortgages, thereby increasing household cash flow.

In our view, business confidence will be the key driver next year. Policymakers in Europe, especially the European Central Bank, continue working to eliminate the risks of a eurozone crisis for at least the near future. In China, the leadership transition and weakness in exports and housing continue to weigh on growth. But we expect to know the choice of new leaders soon and housing seems to be bottoming, which we think should cause GDP to bottom, too. More certainty about Europe and China could help business leaders become more confident. If that happens, we think the recent weakness in capital spending probably would reverse and companies would begin to spend again. We also think it is likely that the employment rate would improve in that environment.

Elections are just the beginning

There are several key events in the U.S. in the coming weeks that will be critical to economic growth. Many consider the U.S. elections in November to be among the most important in many years. Elected leaders will face decisions about the size of government, potential changes to entitlement programs and ways to revive economic growth.

No matter which candidate wins the presidency, we believe the payroll tax cut and extended unemployment benefits are likely to expire at year end. That would translate to about a 1-percent drag on GDP from fiscal policy. If President Barack Obama is re-elected, we think Democrats are likely to retain control of the Senate and Republicans are likely to maintain control of the House, although the latter party may lose some seats. This could bring about continued gridlock on the key economic issues. However, we think there would be a shift to an increase in government activity, with a focus on driving growth through government spending. The fiscal cliff negotiations also could be difficult in this scenario. Whether through agreement before Jan. 1 or retroactive agreement in the new year, we think income taxes are likely to go up for high earners. We also think taxes on dividends and capital gains could increase.

On the other hand, if Governor Mitt Romney wins the election, we think the Republicans are likely to control both the Senate and House. Under this scenario, we think government spending will be cut, which could cause a short-term drag on growth. We also think Romney will extend most elements of the fiscal cliff issues until there is agreement on a more comprehensive plan, including a reduction in tax rates and elimination of some exemptions.

It also is likely that the U.S. will hit the debt ceiling sometime before year end. As was the case in the summer of 2011, the Treasury Department can use some accounting methods to keep the government running for a couple of months. But Congress will need to raise the debt ceiling sometime in 2013. House Republican leaders have said an increase in the debt ceiling will require additional spending cuts. However, it is unclear whether they will stick to this demand, given the uproar that resulted from last year’s battle over the debt ceiling, for which Republicans largely were blamed.

Manufacturing may again hold the key

The manufacturing sector is one area that could bring increasing strength to the U.S. economy. There has been a lot of discussion in the past few years about a revival in U.S. manufacturing. A number of variables have made this more plausible, including a weak U.S. dollar; increasingly available cheap energy, such as natural gas; more competitive labor costs; and rising business costs in China. We believe the U.S. already is seeing this shift, with an increasing number of companies becoming hesitant to move more production to China.

Many companies now say they are considering bringing production back to the U.S. because labor costs have become more competitive with other countries. In fact, Boston Consulting Group estimates that within five years, the total cost of production in certain states will be only 10-15 percent more expensive than in Chinese coastal cities. This difference is minimal when other costs, such as shipping, also are considered.

If these trends were to continue, we think the U.S. could see a longterm, sustainable uptrend in capital spending and employment. The importance lies in the job multiplier for manufacturing jobs, which is estimated to be as high as three times. In other words, for every job that is created in the manufacturing sector, three more are created elsewhere. These jobs could be anything from suppliers of parts to service providers to construction. This potential impact leads us to watch manufacturing closely for any structural improvements.

Past performance is not a guarantee of future results. The opinions expressed in this article are those of Mr. Hamilton and are not meant to predict or project the future performance of any investment product. The opinions are current through Oct. 15, 2012. Mr. Hamilton’s views are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.

Investment return and principal value will fluctuate, and it’s possible to lose money by investing. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for the mutual funds offered by Waddell & Reed, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.

Global flexibility backed by in-depth research: Assessing volatility, policy risk and security selection around the world

Michael L. Avery
Co-Portfolio Manager

Ryan F. Caldwell
Co-Portfolio Manager

Story Highlights:

A viewpoint on volatility in the Fund
Flexibility and process: Formula One
China’s consumers remain in focus
Policy makers must lead the way

Waddell & Reed Advisors Asset Strategy Fund - August 2012

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True flexibility and global reac h – a phrase that has described the Waddell & Reed Asset Strategy Fund throughout its history. That mandate has the potential to offer particular value to investors now in a world of low interest rates and uncertain economic policies. Through the Waddell & Reed collaborative process, we pursue opportunities worldwide that support our goal of total return within a framework of capital preservation and risk management.

A viewpoint on volatility in the Fund

Many investors in today’s markets have begun to equate low volatility with low risk, and are willing to accept the returns that result. We do not think volatility is the same as risk, as we have said before, and we do not target a volatility level in the Fund. In short, we don’t think the pursuit of low volatility is a sustainable long-term strategy for investors.

The search for low volatility often ends at long-duration government securities, investment-grade credit instruments and stocks paying high dividend yields. While the volatility of such securities in general may be lower now than domestic or global equities, they often show what we call episodic volatility – both very high and very low.

In looking at low volatility with what might be seen as acceptable returns, the focus has become the U.S. Treasury market. But as we have said before, we think that approach will not provide a long-term solution for investors. We have anchored the Fund in equities, where we think valuations still are attractive. We also think we can price risk more effectively there. We believe we can generate returns with this strategy to help investors outpace future inflation.

In our view, the current historically low interest rates – which we think are likely to stay low into at least 2014 – still mean fixedincome securities carry risks that may become even more apparent when rates eventually begin to rise. And we think we’re in a period in which monetary and fiscal policy responses will provoke investor behavior in a way that will be favorable for global equity markets.

We’re also seeing investors pursuing lower volatility through investment-grade credit securities. But that strategy requires investors to take more duration risk when seeking returns. This is another example of what we consider episodic volatility, which we think could increase in the future.

Finally, we have begun to see investors pursue high dividend yields from stocks as a proxy for bonds. In our view, this approach still raises the potential for episodic volatility through the varying cash flows over time at dividend-paying companies. These companies, like most others, are subject to competitive forces that can erode cash flow.

Given the amount of capital that has flooded into dividend-paying stocks, we think many dividend payers are richly valued now. We think they may not hold their valuations as well as growth-oriented stocks in the long term. We therefore think investors may find it difficult to reach a goal that includes low volatility with acceptable returns using such an approach.

In looking at past investor behavior and comparing it with the current markets, we think many may be simply following a trend. As often happens, investors chase the asset class that had performance in the past. Now, we think many are adding the pursuit of low volatility. We do not believe such a strategy will provide the impetus to drive returns going forward.

When we have decided to be defensive in the Fund, we historically have increased the cash position as a method to protect assets. In the current markets, putting assets in cash means an automatic decline in real purchasing power because of the level of interest rates vs. inflation. For example, three-month Treasury bills were yielding only 0.09 percent in June while U.S. inflation was running at an annual rate of 1.4 percent in July.¹ The Fund can use cash as an asset class, but it’s tough for us to accept a built-in loss through a defensive asset class. We therefore are not using cash to a significant degree now. That could change, of course, if the environment changes. We could return to cash in the future if we wanted a defensive position and determined rates could provide positive return to investors.

The Fund continues to hold gold bullion as a hard asset and a currency hedge, as well as a hedge against the uncertainties of government monetary and fiscal policies around the globe. We believe there is a place for gold bullion in the Fund and expect that to continue as we watch for policy makers to provide clearer direction for the global economic future.

Flexibility and process: Formula One

The Fund’s pioneering investment approach provides the ability to move among all global asset classes with virtually no constraints. A recent investment in Formula One² (F1) clearly illustrates that flexibility. F1 is widely considered the world’s top motor racing series. Our investment in private equity and debt marked one of the most significant changes to the portfolio in the past two years. It became the largest overall holding at the end of the second quarter.

The Fund’s portfolio management team worked with analysts across our equities and fixed income teams to complete a lengthy, in-depth due diligence process. We think F1 is a unique business, which includes predictable cash flows from its long-term TV contracts and event promotion contracts. In that regard, we think it is similar to the Fund’s investment in CBS Corp.³ in 2010. That selection also was based in part on the increasing potential revenue from the broadcast rights for live sports, such as professional football and golf, and college football and basketball. We feel F1 could represent a similar opportunity.

F1 owns and sells the rights to host motor racing events around the world, along with their media rights. The schedule for 2012 has 20 races worldwide, with most in Europe and Asia. F1 also sells advertising and sponsorships, and licenses merchandise for the series and its related racing circuits.

This top-level motor racing series is one of the most popular sports worldwide. F1 estimates it drew more than one-half billion TV viewers worldwide in 2010. It tends to attract a wealthy, more global fan base. TV viewership is well established in Europe and is growing in Asia and the Middle East. And an F1 race scheduled for November near Austin, TX, may spur increased interest and viewership in the U.S.

F1 recently renegotiated TV contracts in key markets, including the U.K. and Italy, at significant increases from previous deals. As broadcasters look for content that consumers want to watch in real time, the value of live sports rights and the resulting price to broadcasters have increased.

We think F1 illustrates the Fund’s strategy in several ways. It’s an example of investment flexibility that draws on the expanding emerging-market consumer base and is based in solid cash flows from the live sports rights contracts.

China’s consumers remain in focus

China is the world’s second-largest economy by nominal gross domestic product (GDP) and the world’s fastest-growing major economy. It has grown its economy by an average of 10 percent per year over the past 30 years, as measured by its GDP. It also is a key driver of the global economy as the world’s largest exporter and second-largest importer.⁴

While that growth rate has slowed this year, we estimate China’s GDP can more than double from its current annual rate of 6 to 7 percent over the next 10 years. That’s the fundamental reason we remain bullish on China and other Asian markets.

We think it’s important to differentiate between what’s happening in the Chinese economy and how we invest in that economy. We see it as an example of the benefit of active management versus passive management in emerging markets.

China’s government has taken steps to slow economic growth from its previous levels. The central bank has eased interest rates and lowered bank reserve requirements, demonstrating that China wants to maintain steady – but not overly fast – growth. Individual stock selections related to China have become even more important. We think the situation argues against investing in China via the Hong Kong stock market index or other passive methods.

Instead, our active management style continues to lead us to a selective list of opportunities, using investments in companies located in the emerging markets as well as those in the developed world with solid positions in those markets.

Even with the slower growth in China’s economy overall, mass market consumption is growing across a wide range of products. And we see much more room to grow. China’s ratio of consumer consumption to GDP is about 38 percent, according to The World Bank, which is among the lowest of major global economies. By comparison, the ratio in the U.S. is 70 percent.

That difference is just one example of why we continue to focus on consumers. We’re working to capture their increased consumption in the Fund, both from China and across emerging markets generally. For example, the Fund holds positions in companies representing global automakers, global gaming, luxury goods, technology and financials – all with strong market positions in the region. These industries are leading the way in increased consumer consumption in the region.

Policy makers must lead the way

We think policy makers around the world must take action now to deal with the fiscal and monetary challenges that are restraining global economic growth. Uncertainty about policy responses to the ongoing sovereign debt crisis in the eurozone and the U.S. “fiscal cliff” of expiring tax cuts and social benefits are just two examples. Both have had significant effects on global markets.

In our view, the world still is in a balance sheet recession. Human behavior suggests that policy makers and central bankers are likely to respond with more aggressive monetary policy and more fiscal stimulus to push economic growth. We think these actions may tend to push equities prices higher in the short to medium term. But we do not think such stimulus will provide the long-term solution for rising debt levels around the globe.

Waddell & Reed Advisors Asset Strategy Fund

Global. Flexible. Authentic.

For more than 15 years, Waddell & Reed Asset Strategy Fund has applied a consistent investment management approach that provides the ability to move among all global asset classes, without constraints, in order to offer investors what the Fund feels is an appropriate risk/return profile.

The Fund seeks attractive returns within a framework that values capital preservation and risk management.

It is a pioneer in this investment approach and has not wavered from its original theme of tactical, global asset allocation.

Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s portfolio managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through August 15, 2012, and are subject to change due to market conditions or other factors.

Consider all factors. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. The Fund may allocate from 0 to 100 percent of its assets between stocks, bonds and short-term instruments of issuers around the globe, as well as investments in precious metals and investments with exposure to various foreign securities. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. The Fund may focus its investments in certain regions or industries, thereby increasing its potential vulnerability to market volatility. The Fund may seek to hedge market risk on various securities, increase exposure to various markets, manage exposure to various foreign currencies, precious metals and various markets, and seek to hedge certain event risks on positions held by the Fund. Such hedging involves additional risks, as the fluctuations in the values of the derivatives may not correlate perfectly with the overall securities markets or with the underlying asset from which the derivative’s value is derived. Investing in commodities is generally considered speculative because of the significant potential for investment loss due to cyclical economic conditions, sudden political events, and adverse international monetary policies. Markets for commodities are likely to be volatile and the Fund may pay more to store and accurately value its commodity holdings than it does with the Fund’s other holdings. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available a summary prospectus, containing this and other information for the mutual funds offered by Waddell & Reed, call your financial advisor or visit us online at www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.

Waddell & Reed Special Report: China at ground level

Waddell & Reed Advisors Funds Special Report - May 2012

Thomas W. Butch
CEO & President
Ivy Funds Distributor, Inc

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In the second quarter of 2012, Ivy Funds’ sales management team and many of its wholesalers accompanied Ivy Asset Strategy Fund Portfolio Manager Mike Avery, along with Ivy Pacific Opportunities Fund Portfolio Manager Frederick Jiang, on a nine-day trip to a number of cities in China. The trip reflected Ivy Funds’ commitment to provide its sales team an on-the-ground view of China, the observations gained from which would help them be more effective to the financial advisors with whom they work. The following encapsulates the observations of Tom Butch, CEO and president of Ivy Funds Distributor, Inc., who was making his third trip to China since 2007.

You cannot truly appreciate China (its scale, the magnitude and pace of change, the enormity of its diversity) until you see it. Then, once you do, the challenge becomes describing adequately the profound societal change you witness every day there, while avoiding the temptation to draw grand conclusions from the series of photographs you’ve been privileged to snap in your mind’s eye.

Our path took us to Beijing, where the hints of nationalism and national pride lay thick in the air and are manifest in the long lines waiting to visit Mao’s tomb and the reliably large masses that gather at dawn and dusk to see the flag raised and lowered in Ti An Men Square; to Xi’an, the ancient capital, which in 600 AD boasted 1 million residents and was thought to be the world’s most advanced city, now balancing its agricultural heritage with exploding growth and western-style redevelopment; to Dengfeng, a “Tier 6” city (meaning small, relatively, in population and economic clout) whose quality of life greatly exceeded our expectations; and, ultimately, Shanghai, the glittering showcase for the post-modern world.

The social, cultural, ideological underpinnings of each of these areas are no more alike than those of, say, Oklahoma City and Philadelphia. And yet, as within our own country, certain observations span and appear to ring true across the highly diverse environments in which we found ourselves. Following are key insights from our trip. Please review the full pdf document for more detail on each.

Inexorable urbanization

The breakneck urbanization of China continues unabated, across cities of all sizes. At the end of 2011, 51 percent of the Chinese population lived in urban areas, nearly double the urban population of 1990. By 2035, the urban population is projected at 70 percent of the population total.

A burgeoning middle class

Increasingly, this middle class will take on Western habits, including placing value on consumerism and individuality. With income per capita in China growing between 12 and 15 percent per year, the Chinese middle class (generally identified as a family with annual income of between $10,000 to $60,000 USD) is now about 300 million people, not far from the total population of the United States.

Push/pull amid state control, free commerce

The push/pull between an embedded philosophy of state control and an accelerating culture of free commerce and individuality creates challenges, but somehow continues to keep from fraying. The government model, imbalanced and imperfect though it may seem to Westerners, seems to work. We met with many government officials and many entrepreneurs. While they came at economic progress through different lenses, that was their common goal. In fact, the government officials with whom we met were far from the bureaucrats or technocrats one could easily conjure from afar; rather, they seem bound by their common determination (dare I say entrepreneurial spirit) to get things done.

Quality of life issues

As China moves through industrialization, quality of life issues, including environmental concerns, likely will come to the fore. Those visiting Beijing (and, to a lesser extent, the country’s other major cities) for the first time always are taken aback by the air pollution. The veneer of smog in Beijing, principally a result of coal-burning power plants there and in neighboring regions, goes with the turf of industrialization. Many with whom I have traveled adjudge it harshly. In doing so, I believe, they fail to recall the U.S. environment as it industrialized. Pittsburgh, for example, was in the late 19th century described by a visiting journalist as “hell with the lid off;” in the 1940s, when my mother worked downtown, professionals going out for lunch commonly covered their faces with handkerchiefs; and when I was growing up, a light sulfur haze obscured the skyline most every day. Today, of course, smog-free Pittsburgh is among the most picturesque major cities in North America.

China’s cities will no doubt get there as well, in time. A development official in Xi’an spoke unabashedly about accepting the environmental risks that come with attracting certain industries to his area, opining that, at a later time, they would focus on environmental impact.

The unfolding story

It is hard to imagine this story doing other than unfolding constructively over many years. On the ground, it appears to have a long tail. Economists and investment professionals vary in their perceptions of the sustainability of China’s growth miracle. Some worry of a hard landing, others of a less disruptive but still painful slowdown. Time will tell if they are correct; certainly, they could be. But the view from ground level (albeit more instinctual and less quantifiable) renders real the blur of high-growth statistics to which we have become accustomed.

We saw commercial construction everywhere, and yet vacancy rates for commercial space in major cities remains at low single-digit rates. We saw perhaps millions of new housing units built to accommodate ongoing migrations to larger cities, but little to suggest a lack of demand.

We saw, before our eyes, the breakneck unfolding of a new society, with progress and expectation everywhere. In that sense, seeing is believing.

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Brazil fears appear overblown; opportunities beckon

Jonas Krumplys, CFA
Portfolio Manager
Ivy Asset Strategy New Opportunities Fund

Ivy Asset Strategy New Opportunities Fund – September 2011

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Commodities stocks have been among the most negatively affected by the recent declining market sentiment, with many driven their lowest valuations of the year. Commodity-rich Brazil, the world’s eighth-largest economy and a major exporter of hard and soft commodities ranging from iron ore to soy, is shaping up to be one of 2011’s worst-performing equity markets. But Jonas Krumplys, portfolio manager of the Ivy Asset Strategy New Opportunities Fund, still sees pockets of potential opportunity in Brazil.

The concerns surrounding Brazil’s economy and markets are not without merit. After surging 85 percent in 2009 - 2010, the Bovespa stock index entered a bear market on July 27 after declining 20 percent from its November 2010 bull-market peak. The pullback caused some companies to postpone initial public offerings or discount them significantly.

The industrial sector represents a significant component of Brazil’s gross domestic product (GDP) at approximately 25 percent (proportionally the second-largest in the Americas), and agriculture is roughly 4 percent. Brazil’s No.1 export partner is China. We believe the greatest concern now is that China’s economy, which has grown too rapidly for too long, is overdue for a hard landing. While that appears to bode poorly for Brazil, it’s important to recognize how and what Brazil exports to accurately assess the potential impact of China’s slowdown.

Currently, Brazil’s total exports are only 12 percent of GDP; half of those exports are commodity based, and half of those commodity exports are agricultural. To break that down more specifically, Brazil is the world’s first or second largest exporter of coffee, sugar, soy products, orange juice, poultry and beef — commodities the world is not about to do without. This is a significant distinction, as we think prices for these commodities are not likely to collapse. We believe that the wealth of its natural resources and the stability of its export commodities mean Brazil is inherently more stable than the recent equity market decline would suggest.

Inflation fears overdone

There are economic issues in Brazil, including concerns that the loan growth rate is too high, consumers are carrying too much debt and the country has credit difficulties. But these issues are true of all underdeveloped emerging markets when it comes to mortgages, credit cards or small- and medium- enterprise (SME) loans. The fact that Brazil’s annual loan growth rate has been roughly more than 20 percent since 2004, and is not slowing, is not unusual or alarming, in our view.

Inflation, which has run above the Brazilian central bank’s annualized target range of 4.5 to 6.5 percent since April, also has investors’ attention. In an effort to slow the pace of inflation, policy makers have raised the benchmark interest rate five times this year. There was a fear among some investors that Brazil would have to raise rates above 14 percent. But in fact, on August 31, policymakers cut Brazil’s benchmark Selic rate by 50 basis points to 12 percent, bringing its tightening cycle to an end. The government also has cut spending this year by 50 billion reals ($31.46 billion) to help dampen demand and reduce inflation.

We think inflation will become less of a concern once the interest rate cycle turns around, which is likely to happen late this year, and if the government continues to watch spending. Brazil’s fiscal debts are coming down (with a current debt-to-GDP of 60.8 percent) and we believe its economic growth rates are sustainable: The economy is forecast to grow by approximately 4 percent this year after expanding 7.5 percent in 2010.

Such a backdrop has created what we see as a favorable buying environment in equities, despite recent ominous headlines. With respect to price-to-earnings (P/E) and price-to-book ratios, the Bovespa is in line with similarly developing economies. Its price-to-book ratio of 1.37 times, is 6 percent below the low of 1.47 seen in 2008-2009. Brazilian companies are trading now at 1.5 times book value with a P/E of around 10. Average debt-to-equity of Bovespa companies is near 90 percent, compared with 145 percent for the S&P 500.

Opportunities in real estate

While Brazil’s lending rate is high by U.S. standards, it’s important to recognize that real estate lending rates in Brazil are tied to a government program rather than to the central bank rates. Financed by the government-owned Caixa Bank, the Minha Casa Minha vida (My House My Life) program, launched in 2009 with a goal to build and sell 3 million homes by the end of 2014, is one of the world’s most ambitious social housing programs. The total market value of outstanding mortgages represents less than 5 percent of Brazil’s GDP vs. a range of 50 to 100 percent of GDP in the U.S. or Western European economies.

The Fund’s current exposure to Brazilian real estate is about 9 percent of total assets, with 4.5 percent in residential developers and 3.5 percent in commercial projects, including offices and shopping malls. Despite a population base of nearly 200 million people, Brazil has only about 400 shopping malls (compared with approximately 105,000 in the U.S.). But there is demand for a great many more. This is one of the most under-penetrated markets in the world — despite Brazil being the world’s eighth-largest economy. Inflation rates of over 1,000 percent less than two decades ago means that commercial mortgages are a relatively new phenomenon The existing malls primarily were built by wealthy individuals who had made their money in industry, agriculture or mining and were looking for an inflation hedge. The occupancy rate in Brazil’s malls is near 100 percent and sales per square meter are growing very rapidly.

Despite challenges, future appears promising

Recent events have not significantly changed our outlook for Brazil. Its economy has slowed on the industrial side because the Brazilian currency has appreciated so dramatically. That appreciation has hurt the profitability of companies making machinery, buses and cars, for example, which is an issue because Brazil is also a major auto exporter. Brazil is trying various tactics to temper its currency’s exchange rate, including charging taxes on foreign investors buying Brazilian stocks and bonds. It recently began taxing currency speculators at a rate of 1 to 25 percent in order to manage capital inflows into the country.

There is no doubt that the industrial side of Brazil’s economy has slowed, but we think it was growing too fast last year. The Brazilian economy should not grow faster than 4.5 percent per year because its infrastructure is so poor. This is a country the size of the continental U.S. but it has fewer paved highways than the U.K. — a far smaller country. Less than 10 percent of the roads in Brazil are paved, it has almost no passenger rail system and there are not enough freight railways. There are only three freight railway companies and two of them are controlled by iron ore companies. Brazil needs more airports and larger, more efficient ocean ports to accommodate the growth it is envisioning.

We see this need to build infrastructure as an investment opportunity. Petrobras, a Brazil-based leader in development of advanced technology for deep-water and ultra-deep-water oil production, plans to increase oil production from its current pace of 2 million barrels per day to 4 million by 2020. Petrobras will need 28 drill ships to accomplish its plans, and it must build three major refineries and an enormous amount of pipeline. The Fund is investing in this expansion by owning a couple of engineering and construction firms. One is a French firm, Technip-Coflexip1, which is one of three companies in the world that can operate a flexible riser that can reach the bottom of the ocean. It’s currently building a factory and research center in Brazil to supply floating production, storage and offloading systems to Petrobras. Another is Petrofac Limited2, a U.K.based company that provides facilities solutions to the oil and gas production and processing industry.

The Fund also owns Cosan³, with businesses in energy, food, logistics, infrastructure and agriculture property management. It’s also the largest private producer of ethanol, a commodity Brazil will need to fuel its infrastructure expansion. Cosan just completed a multibillion-dollar joint venture with Shell to produce low-carbon biofuel — ethanol made from sugarcane, an abundant crop in Brazil. Shell is combining its extensive retail experience, global network and research in advanced biofuels with Cosan’s technical knowledge of large-scale biofuel production. The joint venture aims to produce more than 520 million gallons of ethanol annually to support Brazil’s burgeoning demand.

An additional holding is Brasil Foods⁴, the world’s 10^th-largest food company and Brazil’s second-largest in revenue. The company is 60 percent domestic and sells a wide range of products, including poultry, pork, processed meats, frozen foods, and dairy products.

Tactical shifts, outlook

To manage short-term volatility, we have trimmed equity holdings in the Fund, including Brasil Foods (which nonetheless remains among the Fund’s top 10 holdings). Stocks tied to economies thought to be export-related have taken it on the chin in recent weeks, as have commodities. And we think that the markets will continue to be volatile in the near term on the negative sentiment surrounding the European banks and European sovereign debt.

Historically, Brazil is wary of inflation and tends to keep rates

high; however, as conditions change, it has room to again notch rates down to spur growth. It also has a sovereign wealth fund, hundreds of millions of dollars in foreign reserves, healthy banks with high tier-one capital and a government surplus. So we’re going to ride out the volatility and headline risk about Brazil, which we think is overdone.

1. Technip-Coflexip represented 1.27% of investments as of June 30, 2011.

2. Petrofac Limited represented 1.375 of investments as of June 30, 2011.

3. Cosan represented 1.13% of investments as of June 30, 2011.

4. Brasil Foods represented 2.40% of investments as of June 30, 2011. The Bovespa is a Sao Paulo-based stock and futures exchange. It tracks around 50 stocks traded on the São Paulo Stock, Mercantile & Futures Exchange. The Standard & Poor’s 500 Index is an unmanaged index of common stocks. Neither index is an investment product available for purchase.

Past performance is not a guarantee of future results. The opinions expressed are those of the Fund managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through July 28, 2011, and are subject to change due to market conditions or other factors. Unless specifically noted within the text, holdings mentioned within this perspective are as of August 30, 2011.

Risk Factors: As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund may allocate from 0-100% of its assets between stocks, bonds and short-term instruments, across domestic and foreign securities. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investing in small or mid-cap stocks may carry more risk than investing in stocks of larger, more well-established companies. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. The fund may focus its investments in certain regions or industries, thereby increasing its potential vulnerability to market volatility. The Fund may use short-selling or derivatives to hedge various instruments, for risk management purposes or to increase investment income or gain in the Fund. These techniques involve additional risk, as short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss for the fund, and the value of investments in derivatives may not correlate perfectly with the overall securities markets or with the underlying asset from which the derivative’s value is derived. Investing in physical commodities, such as gold, exposes the Fund to other risk considerations such as potentially severe price fluctuations over short periods of time and storage costs that exceed the custodial and/or brokerage costs associated with the Fund’s other holdings. These and other risks are more fully described in the fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

Holdings information is not intended to represent any past or future investment recommendations. Holdings and allocations can and do change frequently.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available a summary prospectus, containing this and other information for the Ivy Funds, call your financial advisor or visit us online at www.ivyfunds.com. Please read the prospectus or summary prospectus carefully before investing.

Government policy, debt concerns join slowing global growth to jolt markets

Michael L.Avery
Co-Portfolio Manager

Ryan Caldwell
Co-Portfolio Manager

Waddell & Reed Asset Strategy Fund – August 2011

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We have seen tremendous volatility in recent weeks. In our view, the world is debating the status and viability of economies and markets in two primary ways. There clearly is uncertainty surrounding macro risk and policy mistakes in a deflationary environment. We think the consensus argument surrounds whether there will be continued negative reaction to policy mistakes in the U.S. and in Europe, compounded by the fact that we are in a deflationary environment in which regulators have few tools to combat the problems of overleveraged developed economies. The counter argument focuses on the sustainability of corporate earnings growth, which has far exceeded nominal growth rates of gross domestic product (GDP) in the U.S., Europe and Japan. We are on the side of believing more sustainability to earnings growth exists — sustainability that will help fuel at least limited global growth — rather than siding with the policy mistake/deflationary argument.

Policy mistakes magnified in a deflationary environment

The risk of a deflation policy mistake seems to be front and center in the market’s mind, along with concern that we are heading into another global recession. We are surprised by the change in perception with respect to the U.S. economy. All along, we thought that nominal GDP in the U.S was going to be subpar for some time. So far, that has been the case, as nominal GDP in the first half of 2011 was roughly just 4 percent. The composition of GDP actually shouldn’t have been surprising, given the oil price shock and supply chain disruption from Japan. Inventory and exports both detracted from GDP in the first half of the year. Importantly, S&P 500 revenue growth in the first half of 2011 was 11 percent. Profitability was 18 percent. We expected and are getting a sluggish developed market recovery.

Working through the two big events in the first half of the year that restrained growth — the oil price shock due to unrest in the Middle East and the supply chain disruption out of Japan — we think we’ll recover some of that growth in the second half, although we think it will still be subdued at around 2 percent. That means in a good quarter, when inventory and exports can swing, we could see 3 to 4 percent growth; in a bad quarter, we could see zero growth. Perception of that growth, however, has changed markedly in the last few weeks as policy makers have stepped forth.

Staying the allocation course amid uncertainty

The Fund is allocated largely the way it was a month ago, with approximately 85 percent of investments in equities, 14 percent in gold bullion and 1 percent in cash. The Fund has not been hedged during the last month, despite the market’s volatility, and is not hedged now. Clearly, we are concerned about risk and managing downside risk remains our priority. However, we also take seriously our mandate to produce a positive, currency-adjusted return over a three-year period. To that end, we have used the market’s recent volatility to reposition the Fund in a way we think is more efficacious given our one- and three-year outlooks. We remain focused on global growth.

Policy questions and a lack of confidence

The crux of the broader problem is that we don’t see coherent fiscal policy. There is no fiscal policy “magic bullet” that will spur growth, which will remain subdued. Neither U.S. political party has done anything to create growth. The two tactics on the table — raising taxes and cutting spending — are both repressive to growth.

We have long believed that the U.S. economy is suffering a consumer balance sheet recession. Interestingly, the top 10 percent of income earners have continued to show accelerating growth sequentially. From the first quarter to the second quarter, the high end got better. From June to July, the high end got better. But we think the real risk to the economic recovery doesn’t have to do with the balance sheet recession — it has far more to do with confidence among the high-end spenders, corporate CEOs and CFOs that are retrenching due to the uncertainty that the politicians and policy makers have created. We think the reflexivity risk is far greater than the sluggish growth risk. The data through July show that the high end has held in well; we will be watching closely to see if that continues in the face of stock market volatility.

With respect to monetary policy, the Federal Reserve has made it clear it is going to fight deflation vehemently. By locking funding in through mid-2013, the Fed is trying to encourage investors to take duration and asset risk. By locking in low rates, they are forcing investors out on the risk curve. While this commitment may not be a massive change to the consensus expectation for Fed tightening, it did give leveraged players certainty to carry. The market’s response was immediate: mortgages, leveraged players and leveraged mortgage REITS all saw price explosions. The Fed wants to reinvigorate a credit cycle that will drive asset prices higher. This has been and, we believe, will continue to be the strategy going forward. The best price indicator we have seen is the price of gold going higher, which tells us inflation expectations are rising. We think we’ll see a bigger credit cycle than the one we just exited. The locking in of funding will drive stock buy backs, credit expansions from companies and will encourage the private sector — mainly corporations and investment players — to leverage capital.

The mid- to longer-term outlook is shadowed by fiscal and monetary issues. Nonetheless, there are places where we feel growth is prevalent and accelerating, and we have tried to steer the portfolio toward those places.

Recent developments in Europe

In July, due to market action in Italy, Europe was forced to come up with broad-scale changes to the European Financial Stability Fund (EFSF). Those changes expanded that bailout fund’s tool box, so now it can directly buy back bonds of the periphery nations, take preemptive measures where it deems fit, and provide capital to European banking systems. These were all very important changes that gave Europe the power to contain problems in the periphery. Unfortunately, the size of the EFSF was not increased, and currently stands at $440 billion (U.S.).

To put that into perspective, the Italian market currently has €1.6 trillion (euro) in debt outstanding, while Spain has €680 billion in debt outstanding. The bailout fund isn’t large enough to contain the issues. That’s forced the European Central Bank (ECB), which has the unlimited ability to expand its balance sheet, to step in and bridge the gap. The market put tremendous pressure on the curve in the periphery, and the ECB subsequently bought a large amount of debt in both Spain and Italy to try to bring back the interest rates in those curves. Spreads in Spain and Italy got as high as 400 basis points; right now, they’re hovering around 270 to 280 basis points. The ECB essentially brought Europe back from the brink.

The changes to the EFSF are now going to have to go through parliaments in Europe. That will begin in September and we hope by the beginning of October the EFSF will be fully operational with all of its new powers. In the interim, it is highly likely the ECB will have to continue to expand its balance sheets to provide stability to the marketplace.

We think the problem with Europe all along is that it has announced measures to deal with its crisis and then it hedged those measures. We’re seeing a game of chicken between the policy makers in Europe, the ECB and the marketplace. The market puts pressure on Europe and the ECB to act, Europe and the ECB act and spreads come down, and then they start hedging their actions and the market spreads right back out. To keep this situation stable, we feel the ECB is really going to have to be on the Spanish and Italian curves. The good news is it has the tools to do it. Ireland, Portugal and Greece are different situations; Greece is going to be restructured in a soft manner, while Portugal and Ireland are both on bailout facilities and are going to have to continue to implement austerity plans, which will likely be very painful.

Ultimately, we think there should be tighter fiscal integration in the euro zone, which points to the euro bond. That has many implications in Europe. The euro bond is problematic both for Germany and for poor countries, which will have to use their credit ratings to support it. It’s not popular among constituents, and it has dramatic ramifications in the periphery, where sovereignty is probably going to be extracted from those countries in exchange for using the common credit rating of the euro zone. Both of those are going to be very difficult to put through politically and will create a lot of noise in the marketplace going forward. It has to happen, however, to provide stability to the euro and get a common credit rating that will allow rates to come down. We think Italy stands to benefit tremendously. The debt load there is now 119 percent of GDP at the public level. Because of its labor market, Italy has a structurally low-growth economy with a potential GDP of 1 to 1.5 percent.

The changes at the EFSF will also likely allow it to provide capital into the Spanish banking system. Spain had a large real estate bubble that put a lot of pressure on its banking system. Many of the smaller banks in Spain need capital, but the market simply isn’t willing to provide that capital. The EFSF can now provide that capital to Spain’s banking system, which should help it go forward.

We are expecting Europe to get a handle on Italy and Spain, but it will be a drawn-out process with significant pressure on both countries by the market as well as political pressure and there will be a lot of volatility. We may see a bank or two go bankrupt, particularly in Spain, but wide-scale bankruptcies out of the core are highly unlikely. The type of write downs that may need to be taken in Greece are simply not severe enough to warrant that. They may have to engage in some restructuring, but Europe now has the policy tools to deal with the Italian and Spanish issues.

Pressure on emerging markets

Emerging markets have been under considerable pressure to raise rates to fight off inflation from currency carry as well as a vigorous rebound in economic growth. One of the benefits of the sell-off in commodities, specifically in energy prices, is that it will allow emerging market policy makers to slow their tightening measures. Inflation in China, for example, is 6.5 percent. We believe we’ve seen the peak in inflation there, so the question then becomes, “Will growth crash?”

We think China’s growth will moderate in the 8 to 9 percent range on a real basis, with 13 to 14 percent nominally, which is far more important for revenue growth. While China won’t be aggressively loosening monetary policy, the majority of the tightening is behind us, which should allow for better growth in the second half of the year than we saw in the last quarter. For India, another large economy with strong nominal growth, falling energy prices will be a huge benefit. It will take a lot of pressure off the government and India’s central bank.

Bullish on corporate earnings

We have been bullish on corporate earnings, partly because we believe management teams are skeptical of the recovery. They have not believed the recovery they’ve seen in revenue and are loathe to spend, which is partly why unemployment in the U.S. is more than 9 percent; companies are not hiring. Capital expenditures are still running under depreciation despite the fact they were up 30 percent in the second quarter of 2011. Margins are staying far higher than the bears are willing to admit. S&P 500 companies generated 11 percent revenue growth in the second quarter vs. nominal U.S. GDP of 4 percent. More than two times nominal GDP was produced in the top line with bottom line profitability at 18 percent.

The antithesis of sluggish growth is going to be better-than-expected profit growth, because companies are sourcing their revenue growth and costs from outside the U.S. and profitability is dropping within the

U.S. We see companies with cash flow yields, dividend yields and return on invested capital that are as strong as they have ever been. The market appears to us to be in one of the cheapest quintiles of free cash flow and earnings yield as far back as we can see. The market today, on a “cheapness” basis — based on cash flow generations, margins, incremental margins and return on capital — appears to us to be about as cheap as it was in the fourth quarter of 2008 and the first quarter of 2009.

When to hedge

We are often asked why we aren’t hedging the portfolio. For us to provide a real rate of return in a nominal interest rate environment that is as low as it is, we are going to have to embrace volatility at some point in the investment cycle. We look at and manage downside risk on a rolling three-year basis. We understand that our client base at times does not want to embrace volatility, but therein lies the opportunity set that we see in real returns. We think the real return in equities is far higher than in any other asset class. The cost/benefit question we have to ask ourselves is, “Should we embrace the volatility and will it reward the Fund with return over that three-year period in time?” Right now, we think the answer is yes.

Another factor to consider is the cost of hedging. There are several primary valuation measures we track when we’re looking for opportunities to hedge the portfolio. We look at the level of implied volatility on various indices versus realized volatility on those indices; we look at skew, being the cost of puts relative to the cost of calls; and we look at the term structure of the volatility surfaces of those indexes as well as the implied vs. realized correlation. What we see right now is that because investors seem to be leery of equities and will pay anything to strip volatility out of their portfolios, hedging has become extremely expensive — it’s currently three standard deviations above the average cost of buying puts on any global index. The cost of those puts is in the 99th percentile on every index that we’re looking at. It’s the most expensive we’ve seen. Right now, it wouldn’t be unusual to pay 5 to 6 percent for a put option that will go until the end of the year and that is 5 percent out of the money. To break even on that, the market would have to go down 11 percent from here. And because you’re paying 5 to 6 percent up front for that option, if the market goes up 5 to 6 percent, you’re not going to participate in any of the rebound from these low levels. That’s what you’re paying in terms of opportunity cost and how much downside you’re going to need from this point. We realize there is going to be some volatility, but when you systemically overpay for protection, you cut your legs off in terms of your potential return opportunity. Those are the things we continue to watch and when those valuation metrics come down, we will look for opportunities to layer in some hedges at a reasonable price.

We are often asked why we aren’t using index futures, given that they’re less expensive. Granted, the cost of futures is lower on a commission basis and debt spreads, and volumes are extremely high right now. In terms of liquidity, we have plenty to choose from. But what we have to look at is the opportunity cost of using futures. On a volatile day when everyone is getting whipsawed and the market is up 5 percent and you’re using futures, that isn’t going to be a true return to the Fund in terms of what you’re paying on those futures when the market goes up. Correlations are high right now, so we have the ability to use a lot of different tools in the derivatives universe to effectively hedge the portfolio. We aren’t doing that now because we think the risk is to the upside.

A flexible strategy

We do wish to underscore that we take risk management exceptionally seriously. That is our first mandate. We have the flexibility to orient the Fund in a way where we see, over a three-year period, what we think are the best opportunities for risk and reward. We are taking that opportunity to generate what we feel is optimal risk/return. And from that perspective, as well as an historical performance perspective, we believe we are succeeding in our mission.

Of the 35 Class A funds in the Morningstar World Allocation category that had at least a 3-year track record through July, only six had downside capture ratios1 vs. the S&P 500 Index that were lower than the Ivy Asset Strategy Fund.The Fund had a downside capture ratio of

53.7 — meaning that, over the 3-year period ended July 31, 2011, the Fund only incurred a little more than half the losses of the S&P 500 Index in periods when the index fell.

We also should note that the upside capture ratio of the Fund exceeded all seven of the peer funds that had lower downside capture ratios¹ during the 3-year period ended July 31, 2011 — a volatile period that included the market decline of late 2008/early 2009, the ensuing run-up in the second half of 2009 and early 2010, the mid-2010 correction and the post-crisis highs of April 2011.

In general, the Morningstar World Allocation funds that had better downside capture ratios were more devoted to holding cash and other assets that generally haven’t performed well when equity markets rose. In short, the Fund has offered a good balance of downside protection and upside potential.

¹Downside Capture Ratio measures a manager’s performance in down markets. A down market is defined as those periods (months or quarters) in which market return is less than zero. In essence, it tells you what percentage of the down-market was captured by the manager. For example, if the ratio is 110, the manager has captured 110% of the down-market and therefore underperformed the market on the downside. Upside Capture Ratio is a similar indicator, measuring a manager’s performance in up markets. In those markets, a higher ratio means the manager outperformed the market on the upside. (Source: Morningstar)

Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through August 9, 2011, and are subject to change due to market conditions or other factors.

Risk Factors: As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. These and other risks are more fully described in the fund’s prospectus. The Fund may allocate from 0-100% of its assets between stocks, bonds and short-term instruments, across domestic and foreign securities, therefore, the Fund may invest up to 100% of its assets in foreign securities. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. The fund may focus its investments in certain regions or industries, thereby increasing its potential vulnerability to market volatility. The Fund may use short-selling or derivatives to hedge various instruments, for risk management purposes or to increase investment income or gain in the Fund. These techniques involve additional risk, as short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss for the fund, and the value of investments in derivatives may not correlate perfectly with the overall securities markets or with the underlying asset from which the derivative’s value is derived. Investing in physical commodities, such as gold, exposes the Fund to other risk considerations such as potentially severe price fluctuations over short periods of time and storage costs that exceed the custodial and/or brokerage costs associated with the Fund’s other holdings. These and other risks are more fully described in the fund’s prospectus. Not all funds or fund classes may be offered at all broker/ dealers.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available a summary prospectus, containing this and other information for the Ivy funds, call your financial advisor or visit us at www.ivyfunds.com. Please read the prospectus or summary prospectus carefully before investing.

Maintain long-term view despite recent dramatic market moves

Fred Sturm
Portfolio Manager
Ivy Global Natural Resources

Ivy Global Natural Resources Fund - August 2011

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Despite the dramatic market moves of the past two weeks, we still expect global economic growth to return — tepid, for sure, but growth nonetheless. We expect margins and corporate earnings to prove more robust than the stock market apparently now believes, based on the recent market action. If we are correct, then markets have the potential to recover smartly after the shake-out.

Macroeconomic concerns remain

We believe the euro structure is poorly equipped to deal with the contrast of a solid core in Northern Europe – principally Germany, Europe’s largest economy – and a challenged group of periphery countries including Greece, Ireland, Portugal, Italy and Spain. We expect the European Central Bank (ECB) will step up its direct market intervention efforts of buying the sovereign debt of these countries, as it has recently. This intervention was a positive move, but the market is likely to test the ECB’s resolve. Its resolve must hold or some banks in Europe could be at risk, and we already have begun to see some pressure on selected European bank stocks.

The U.S. appears to be stuck in political wrangling rather than engaged in implementing solutions to its debt and budget issues. The lack of a long-term policy decision on these matters prompted Standard & Poor’s to downgrade U.S. Treasury debt on August 5 to AA+ from AAA with a further negative watch. The other major ratings agencies, Moody’s Investors Service and Fitch, have maintained their ratings at this time. Under normal circumstances, downgrades of a country’s debt lead to a higher cost of capital – for example, higher bond yields and a weaker currency. But we think a flight to safety, given current market and economic headlines, may well provide an offsetting prop to the U.S. dollar and help keep yields low. The U.S. Federal Reserve made it clear in its policy statement on August 9, that interest rates will stay low for an extended period of time.

Emerging-market countries have been tightening policy to combat inflation. Emerging markets stocks have been stuck between superior growth, relative to developed markets, and more hostile monetary policy. We expect these emerging markets to re-establish leadership once inflation has clearly peaked and investors begin to anticipate easier monetary policy. We expect inflation will peak in the third quarter and we may have easing measures by the fourth quarter. An announcement that we think really would generate excitement would be easier monetary policy intentions in China. However, we think China may hold off a little longer because it wants to wrestle commodity prices lower first.

A long-term view

We have made few changes to the portfolio of the Ivy Global Natural Resources Fund, but given the rapid price decrease of equities, we are looking to increase exposure at some point in the next several weeks. In the years prior to natural resources gaining widespread interest, higher quality companies with more visible prospects tended to fare better during stock market declines. However, now “swing traders” that also hold the stocks of these companies can apply additional pressure. This means we anticipate an opportunity to further concentrate in preferred sectors and companies, but we may need to wait for this selling to move through the system.

We maintain our bullish view on gold. While the stocks of companies in this sector have performed better than other sectors, they have not kept pace with the price rise of the metal itself. Coal stocks have been poor performers because they have had some delivery and cost pressure misses. However, we think electricity growth in emerging markets will be an enduring theme during the next three to three to five years. We still like this group despite the recent market pummelling. We also continue to favor energy service companies. Oil prices may be pushed lower by liquidation, but we do not expect low prices to last long enough to materially impact energy exploration and development expenditures.

Broader investment implications

Going forward, earnings estimates probably will need to be trimmed. Investor uncertainty can overshoot on the downside, compressing valuations further, but many stocks have fallen significantly to levels that we think offer stronger valuation support. Global forward price/ earnings ratios range from 9 to 14 times, with the average roughly 11 times. Even after allowing for a reduction in earnings expectations, we think this still leaves equities moderately undervalued relative to historic comparisons and very attractive relative to fixed income alternatives when using a multi-year view.

When we look at stocks, we favor financially strong market leaders – weaker companies are more exposed during challenging periods. We also prefer companies with what we consider attractive dividend yields. More than 150 U.S. companies have yields beyond government bonds, with at least a chance for dividend growth.

We think the macro issues around the globe should lead to sustained easing in monetary policy, and that easing should be supportive for limited-supply assets such as gold. Given additional social and budget stresses for oil-producing nations, we believe a higher oil price will be needed going forward, relative to past years. We would put that price at roughly $80 (U.S.) per barrel, and consider a price less than that to be unsustainable. Investors in oil may put pressure on prices as they liquidate, but Saudi Arabia is the only effective source of spare oil. The Saudi government may allow prices to drift temporarily, but it has the means to defend prices if it wishes.

Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through August 10, 2011, and are subject to change due to market conditions or other factors.

Risk Factors: Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investing in natural resources can be riskier than other types of investment activities because of a range of factors, including price fluctuation caused by real and perceived inflationary trends and political developments; and the cost assumed by natural resource companies in complying with environmental and safety regulations. Investing in physical commodities, such as gold, exposes the Fund to other risk considerations such as potentially severe price fluctuations over short periods of time. These and other risks are more fully described in the prospectus. Not all funds or fund classes may be offered at all broker/dealers.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. for a prospectus, or if available a summary prospectus, containing this and other information for the Ivy Funds, call your financial advisor or visit us online at www.ivyfunds.com. Please read the prospectus or summary prospectus carefully before investing.