2012 Outlook

2012: the year the bills come due?

In 2008, the world narrowly escaped a global depression thanks to quick action on an

unprecedented scale by governments and central banks around the world. Is this the year

that the global economy – and the markets – have to pay the bills for that rescue? We start

the coming year with more hope than confidence and believe that a cautious investment

stance is the most prudent.

The main points of our view are as follows:

� The first half of the year is likely to be difficult, as the struggle to preserve the

Eurozone continues and growth slows in China.

� The Eurozone will be the defining problem of 2012. We assume that Eurozone

leaders will successfully resolve the region’s problems, leading to a rise in investor

confidence and better markets in the second half. If not, things are likely to go from

bad to worse, with the likely outcome highly bipolar: either depression and

deflation, or much higher inflation.

� We expect China to have a "soft Landing" and overcome the global uncertainties.

Growth is likely to slow in 1H, but as inflation drops further, the government should

have the flexibility to act with appropriately accommodative measures.

� We expect modest, positive returns from equities this year. With earnings growth

expected to be lower than in 2011, it would take a significant re-rating of stocks to

push prices much higher. Any such re-rating is likely to come in 2H once we get more

clarity on the Eurozone situation. Chinese stocks should find support during 1H after

which we expect a solid uptrend.

� The biggest investment question is whether sovereign bonds will remain an effective

hedge for equity markets. It will be difficult for them to return as much as they did in

2011, however we still expect bonds to turn in a positive return, in our view.

� We favor non-financial investment-grade credit for investors seeking preservation of

capital with some income. Strong balance sheets and a recovering private sector

economy should also support high yield in the US.

� Given our outlook for slower growth and a general reduction in risk-taking, we are

not that optimistic about commodities as an asset class. Commodities with some

structural supply bottlenecks, such as copper and corn, should do best. Gold is likely

to remain an attractive hedge against potential problems in the fiat money system.

� In a world of increasing correlation, FX stands out as one market where some assets

are clearly outperforming others. This year we expect the dollar and the yen to be

the best performers initially, as risk aversion and the flight out of EUR continue. The

renminbi should continue with its appreciation trend, although in light of the difficult

global situation we look for only a 2%~3% rise vs. USD vs. the 4.4% gain in 2012.

2

2012: the year the bills come due?

Is this the year the bills come due? In 2008, the world narrowly escaped a global depression. Quick

action on an unprecedented scale by governments and central banks around the world managed to

avert a sudden collapse in economic activity that was actually more severe than what the world saw

in the beginning months of the Great Depression of the 1930s. Now however the ability of

governments to come to the rescue of the private sector has reached its limits. Monetary policy

cannot be loosened much further, while fiscal policy is everywhere being retrenched. Against this

background, the gradual disintegration of the Eurozone and the slowdown in China pose threats to

global growth. On top of which, the uneasy political balances that existed in the Middle East, Russia

and the Korean peninsula have been disturbed, with unknown results. We start the coming year with

more hope than confidence and believe that a cautious investment stance is the most prudent.

As we approach the new year, the major economic problems are well known:

� The inability of Eurozone leaders to solve their crisis after two years;

� Global deleveraging and the fallacy of thrift, which states that not everyone can save money

at the same time;

� The slowdown in Chinese growth and especially the property market

� The price of oil, which is approaching levels that previously have caused recession; and

� The health of the US economy.

Our central case is that the first half of the year will be difficult, as the struggle to preserve the

Eurozone continues and growth slows in China. We assume that leaders will successfully resolve

the Eurozone’s problems and that China will stabilize, leading to a more robust second half. Should

this not be the case however then things may well simply go from bad to worse.

Looked at from a longer-term perspective, we believe we are in an era of shorter, more frequent

economic cycles. We have come to the end of the era that began with the floating of the dollar in

1971 and the creation of pure fiat currencies, which has allowed governments to use countercyclical

fiscal and monetary policies to support growth and suppress inflation. With no policies left to prolong

the expansion artificially, the major economies are likely to see shorter economic cycles and slower

US economic expansions since 1854 (trough to peak, in months)

Source: Deutsche Bank Global Markets Research

0

20

40

60

80

100

120

140

Dec

185

4D

ec 1

858

Jun

1861

Dec

186

7D

ec 1

870

Mar

187

9M

ay 1

885

Apr 1

888

May

189

1Ju

n 18

94Ju

n 18

97D

ec 1

900

Aug

1904

Jun

1908

Jan

1912

Dec

191

4M

ar 1

919

Jul 1

921

Jul 1

924

Nov

192

7M

ar 1

933

Jun

1938

Oct

194

5O

ct 1

949

May

195

4Ap

r 195

8Fe

b 19

61N

ov 1

970

Mar

197

5Ju

l 198

0N

ov 1

982

Mar

199

1N

ov 2

001

Jun

2009

Average

Median

The last three expansions were

much longer than the historical

norm

3

growth. That does not mean permanent recession, but it does suggest that the era of long booms

and steadily rising asset prices may be a thing of the past. Investors who got used to double-digit

returns on their portfolios during this period of unprecedented debt build-up are likely to be

disappointed as they realize just how much of that return was due to leverage in the economy. With

the return of austerity, investors will have to get used to greater volatility and more modest returns

on their portfolios.

We shall deal with the major problems one by one, and then turn to our investment philosophy.

Leading indicators leading down

Our starting point is the OECD’s leading indicators.

They are not going in the right direction – the trend is

generally down for the developed world (data until

end-October). That does not necessarily mean

recession, but it does suggest further slowing in

growth from current levels. The question then is,

which way might events push the economy?

Unfortunately, it seems to us that the major risks are

on the downside. The Eurozone crisis remains the

dominant problem facing the world economy right

now. A recession in the region would be bad enough,

although it is possible for the rest of the world to

grow even if Europe does not. However the possible

break-up of the Euro would be an unprecedented shock to the global economy. We saw at the time

of the Lehman Bros. collapse how the global banking system can freeze up and send economies

everywhere into a tailspin. Questions over the fate of the Euro and the subsequent uncertainty over

debts in so many countries would dwarf even that cataclysmic event. This is the biggest problem that

we face, and one that is not likely to go away any time soon, in our view.

Eurozone: the defining problem of 2012

We think that 2012 will largely be driven by EU political decisions. The market’s tolerance for

muddling through is diminishing and so the tone of the year will probably be set by how the

authorities deal with the problem in Q1. They have shown their determination to keep the Eurozone

intact and their willingness to sacrifice growth for austerity. We therefore think this is likely to be a

poor year for growth, but one in which the prospects could brighten considerably by the end of the

year if a stronger EU is created and the US political impasse is resolved in the November elections.

Eurozone leaders have recently shown more willingness to compromise to get to the roots of the

region’s problem, which are a) a lack of economic convergence and b) the lack of fiscal union to

accompany monetary union. The economic reform packages being considered in the peripheral

regions should go some way to meet the first requirement, while the treaty revisions under

consideration in 26 of the 27 EU member states may move some way towards meeting the second.

Unfortunately neither can be reached quickly or easily and it remains to be seen whether the

markets will have the patience to wait while politicians compromise, make imperfect decisions and

stumble while trying to execute even those modest plans. There is an inherent contradiction

between the desire of EU officials to keep the pressure on the peripheral countries and their need to

simultaneously convince the markets that the Eurozone will remain intact. The real test this year

Leading indicators point towards further slowing

OECD Leading indicatorstrend-restored, 6m change annualized

-25%-20%-15%

-10%-5%

0%

5%

10%15%20%

25%30%

35%

2006 2007 2008 2009 2010 2011

OECD USA

Eurozone China

Source: Bloomberg Finance L.P.

4

then will be whether the debtor countries can maintain their austerity programs in the face of a

worsening recession and whether the relatively better-off core countries will be willing to help out

the periphery as falters. We believe that this struggle will be the deciding factor for markets in 2012

and it is a race against the clock.

Our working assumption is that policy

makers avoid a euro break-up or a disorderly

sovereign and bank default. We wonder

though whether they will reach a solution or

once again try to kick the can down the road.

That could be difficult this year because of the

huge boulder in the road, namely that Spain,

Italy and France need to find EUR954bn for

their debt and interest payments (EUR418bn

in the first four months alone). In this respect,

if the Eurozone is the key to markets this year,

Spain and Italy are the keys to the Eurozone. If

they can deliver on their structural reforms,

then the market are likely to give them the

benefit of the doubt and continue to buy their bonds. We give them a fighting chance; Spain’s new

government has a strong mandate to carry out structural reforms and seems determined to tackle

the banking sector’s problems, while in Italy, PM Mario Monti’s reform plans include both the fiscal

and growth-enhancing measures that EU officials (and the market) were looking for.

On the other hand, if resistance by politicians

or the public makes it look like the plans

won’t be implemented, then investors may

once again hesitate to buy these countries’

bonds and fears of a Eurozone break-up will

resume. Then all outcomes are likely to be

under discussion once again: debt

restructuring or default, full fiscal union, or

printing money on a vast scale. The European

crisis could therefore tip the world either into

deep recession and deflation, or aggressive

debt monetization and a rapid rise in inflation.

We hope that the leaders manage to navigate

their way between these two disasters, but so

far pessimism has proved correct every time,

as shown by the fall in CDS rates before the EU summits and the rise afterwards. The only way out

may have to be further ECB accommodation.

It’s unfortunate that governments are having such difficulty funding themselves just when the banks

have to roll over some EUR 750bn of debt during the year plus enough more to meet new, stricter

regulatory requirements. If the banks cannot raise the numerator (capital) of their capital adequacy

requirement, they will have to lower the denominator (assets). That deleveraging could cause a

downward spiral in economic activity.

The boulder in the road: bond issuance in 2012

Italian, Spanish and French monthly debt &

interest payments in 2012

0

20

40

60

80

100

120

140

Jan-12 Apr-12 Jul-12 Oct-12

Italy Spain France

EURb


Euro-pessimism has usually proved correct in the past

GIIPS CDS rate around

EU summits

300

400

500

600

700

800

900

Jun-11 Aug-11 Oct-11 Dec-11

Eurozone summits

GIIPS weighted average CDSrate

21-Jul 26-Oct

9-Dec

Source: Bloomberg Finance L.P., BOC (Suisse) SA

5

The Eurozone, the US and the “fallacy of thrift”

The problems of the Eurozone in a period of austerity and the banking system’s attempt to refinance

itself bring into focus the problem of global austerity and the “fallacy of thrift.” It makes sense for

each country to get their fiscal house in order by reducing their spending and lower their debt.

However, it is impossible for every country to save more money at the same time; someone has to

spend more. In this respect, the developed world runs the risk of falling into the same trap that

happened in 1937. With the economy finally emerging from the Depression the previous year, the US

Treasury cut spending and increased taxes, while the Fed raised bank reserve requirements twice to

rein in monetary policy. The result was another lurch down in activity in 1937~38. We fear that the

general move towards fiscal austerity in the developed world recently has echoes of that unfortunate

policy mistake, as do the criticisms leveled at the Fed for its quantitative easing. We hope officials

will decide that the risk of a little inflation is better than the risk of a deflationary depression and will

keep policy as loose as possible for the time being.

China: look to more loosening to support growth

The government has set the tone for 2012:

stabilizing growth ahead of mounting global

risks and rebalancing the economy’s reliance

on investment and export in favor of domestic

consumption. With inflation waning, the

government is gradually easing monetary

policy and fine tuning its actions with respect

to the economic slowdown. As mentioned in

December during the Central Economic Work

Conference, China’s politburo will combine its

monetary measures with proactive fiscal

policies in order to avert a slowdown in GDP

growth as economic activity slows during the

first half of this year.

The fact that inflation is decelerating and should be back within target gives the government room to

maneuver that some other governments don’t have. While we see Q1 and Q2 to be tough due to

difficult circumstances in the Eurozone, we expect the negative impact on China to be limited to the

first half of the year. Indeed, economic measures to be implemented in the coming months should

facilitate the rebound and could boost the economic activity as well as growth during 2H. Moreover

as the government emphasizes the role of consumption for growth, we expect retail sales to

continue expanding, helped by lower inflation, which historically has boosted sales.

The government is likely to keep tightening measures in place for the real-estate and property

sectors, in our view. The growth in real estate investment will probably slow but we do not expect

anything like the “China collapse” fears that one hears. The government has made clear its intention

to continue building more affordable housing, which should take up some of the slack and help to

support demand for commodities. Moreover, a drop in prices should be self-stabilizing after a point,

because more affordable housing should eventually attract buyers.

Falling input prices = lower inflation in China

Rate of change in core inflation vs input price PMI

-4

-3

-2

-1

0

1

2

3

2005 2006 2007 2008 2009 2010 2011 2012

25

30

35

40

45

50

55

60

65

70

75

Change in non-food CPI rate

from six months earl ier (L)

China Input prices PMI SA

lagged 3m (R )


6

US: Continued below-trend growth, but no recession expected

It’s a measure of how much the world has changed that the US economy only comes in for a mention

at this point in this essay. Usually, the US is the key determinant for the global economy. The market

expects US growth to be around trend, neither particularly exciting nor worrisome. Inflation seems

under control and monetary policy is frozen for now, unless the Eurozone problems worsen. Fiscal

policy too cannot move either way as long as the stalemate continues in Congress, so we expect it to

be on autopilot (which implies a modest fiscal drag due to the expiry of some tax cuts). That largely

rules out the pre-election spending spree that sometimes has caused a spurt in growth and a boost

to markets.

Recent data in the US, such as new residential construction, small business confidence and initial

jobless claims, an early indicator of the labor market, have exceeded expectations. But some of that

growth comes from one-off factors that might not continue. First off, many companies rebuilt their

inventories, but once they are restocked, that spurt in demand will slow. Secondly, consumers

reduced their savings somewhat and gasoline prices declined, but we do not expect those trends to

continue, either. Japan’s recovery after the tsunami caused a pick-up in demand, but Japan seems to

be slipping back into recession as well. Combined with the small fiscal drag, the result is likely to be

trend growth at best. The reduction in US household debt, a recovery in auto sales (the average age

of the US fleet has been rising steadily for four years) and the gradual improvement of the housing

market should help to keep the economy from weakening further, however.

What else might happen?

Finally, there are the geopolitical problems with will almost certainly arise but whose result cannot

possibly be predicted with any certainty. Foremost among them is the tension in the Middle East.

Egypt remains in turmoil, civil war has effectively broken out in Syria, the US departure from Iraq has

unleashed sectarian violence there, and the “cold war” against Iran’s nuclear weapons is heating up.

The Iranian threat to close the Strait of Hormuz and the US rejoinder that “any disruption will not be

tolerated” only raises the stakes. Higher oil prices remain a possibility that could tip fragile world

growth back down. Fortunately, the price of gasoline has declined substantially in the US recently,

US households have paid down a lot of their debt

New home sales recovering though prices still falling

US household debt, personal savingsas a % of disposable income

10

11

12

13

14

1980 1985 1990 1995 2000 2005 2010

0

2

4

6

8

10

12

Household debt payments (L)

Personal savings (R)

% %

US New home sales, house prices

-45

-35

-25

-15

-5

5

15

25

01 02 03 04 05 06 07 08 09 10 11-25

-20

-15

-10

-5

0

5

10

15

20

New home sales (3mmoving avg) (L)

Case/Shiller 20-city houseprice index (R)

% yoy % yoy% yoy

Source: Bloomberg Finance L.P. Source: Bloomberg Finance L.P.

7

and it would take a major shock to get that price back up towards the $4/gallon level that seems to

be where it begins to impact consumer behavior. We must also note the increase in shale oil and

natural gas production in the US as well, which could keep a lid on price rises. Nonetheless there is

considerable uncertainty; the US Energy Information Administration recently issued a not-very-

helpful forecast that the benchmark West Texas Intermediate crude oil could finish 2012 anywhere

between $49/bbl to $192/bbl (vs a recent price around $100/bbl). Note that barring any geopolitical

tensions, we would favor the lower end of that range as the development of shale gas and other new

energy supplies in the US may push prices downward.

We admit, this is a fairly pessimistic picture. We therefore must add some of the things we think

have a good chance of going right.

First off, the key point is that none of this is

secret. Policymakers are well aware of these

pitfalls. Thus we expect central banks to

remain accommodative and in particular for

the European Central Bank to become more

accommodative. They can afford to do so

because the much-feared burst of inflation

that some people thought might come with

quantitative easing has not yet occurred. If

anything, inflation is starting to slow in the

developed world. We could even see QE

extended to further asset classes if necessary

(in Japan, the Bank of Japan has already

started buying equity ETFs and REITs). Of

course, such policies could eventually backfire

and cause the demise of the fiat currency system that has prevailed since the link to gold was

abolished in 1971. After falling for six years, the US housing market appears to be stabilizing. Given

that it was the proximate cause of the 2008 collapse, this would be good news for the global

economy. It could bring some confidence back to the US consumer, the former driver of the world

economy. Finally, growth in emerging markets (particularly Asia) appears to be solid, although EM

has not decoupled from the developed world by any means.

Investment strategy: where to put your money in such times.

Against the background of this difficult economic

environment, we remain cautious on risky assets.

Too much debt around the world, continued

deleveraging of financial institutions and a high

level of risk aversion among investors, both

personal and professional, suggest that it will take

a major change in both the economic fundamentals

and investor sentiment to bring back the “animal

spirits” to the market. The downward trend in the

leading indicators mentioned above suggests this is

not likely to happen any time soon.

Global inflation remains quite subdued

CPI inflation rates

weighted by GDP at PPP

-2

0

2

4

6

8

10

12

2004 2005 2006 2007 2008 2009 2010 2011

G3 (inc UK) Asia ex Japan

Latam EMEA

%


Leading indicators suggest weaker markets

OECD Leading indicators

trend-restored, 6m change annualized

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

1996 1998 2000 2002 2004 2006 2008 2010 2012-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

OECD + 6 major EM (L)

MSCI World index % yoy (R)


8

We can see the change in investor sentiment by

comparing the forward earnings estimates on the

MSCI All Country World Index (ACWI) to the price

of that index. The sharp decline in the price in the

face of only a small drop in earnings estimates

shows how investors de-rated equities in the

second half of 2011. We believe this de-rating

applied not only to equities, but to all asset classes:

investors are reducing their expectations for the

future and becoming more risk averse. Given the

uncertainties that we have outlined above, we do

not see much on the horizon that would encourage

people to reconsider that view, at least in the first

half of the year.

Possible catalysts that could restore investors’ appetite for risk could include, first and foremost, a

satisfactory resolution to the Eurozone problems, either by political agreement or by the ECB

stepping up (watch the spread of Spanish and Italian bonds over Bunds). Other possibilities include a

recovery in US property prices or employment, which would boost US consumption; lower inflation

and interest rates in Asia, which rekindles the Asian consumer story; or a fall in oil and commodity

prices caused by an increase in supply.

Overall, we expect 2012 to remain a year of low conviction and high uncertainty among investors.

Much depends on politics and all the human error that that involves, and the possible outcomes are

quite binary. This combination is likely to give rise to continued volatility and high correlation. That

does not mean undifferentiated returns, however. As the chart below shows, there was significant

dispersion among asset classes last year, and the relative ranking of various asset classes changed as

usual. Within asset classes, there was also dispersion by region, meaning that asset allocation can

add value to a portfolio.

Investors are reconsidering risky assets

MSCI All World Index and

12m forward EPS

150

200

250

300

350

400

450

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

10

15

20

25

30

35

MSCI All World Index

price (L)12m forward EPS (R)


Major asset classes ranked by performance over the last 17 years

37.6 35.3 33.4 28.6 77.9 49.7 13.9 32.1 152.2 31.6 35.8 94.0 55.9 5.2 62.8 27.9 8.8

28.5 33.9 22.4 20.3 40.9 26.4 8.4 13.2 47.3 20.7 25.6 35.1 33.5 3.0 62.1 26.9 8.4

21.5 29.5 20.3 8.7 31.3 11.6 8.2 13.1 46.7 18.3 14.0 28.9 32.7 -10.9 58.2 15.1 7.7

20.3 23.0 16.8 5.5 27.3 6.3 7.9 10.3 39.2 17.3 12.4 26.9 11.6 -19.0 32.5 15.1 4.9

19.2 21.1 12.8 2.6 21.3 5.0 5.3 3.8 37.1 16.4 12.2 18.4 10.0 -26.2 28.2 14.4 2.5

18.5 16.5 9.7 1.9 21.0 -3.0 5.0 2.0 29.0 11.7 10.7 15.8 7.0 -33.8 28.0 12.0 0.2

15.3 13.5 5.6 -2.5 14.1 -5.9 4.6 -1.4 28.7 11.1 9.3 12.9 6.3 -37.0 27.2 10.2 -1.0

11.6 11.4 4.8 -17.5 4.8 -9.1 2.5 -1.5 25.7 10.9 4.9 11.8 5.5 -37.7 26.5 9.0 -3.7

6.5 6.4 2.1 -19.7 2.4 -14.0 1.4 -7.1 20.7 9.0 4.6 9.9 5.4 -43.1 20.0 8.2 -4.5

0.8 5.5 -14.1 -35.7 -0.8 -17.7 -11.9 -15.7 19.5 4.3 3.1 4.8 1.9 -45.7 13.5 6.5 -12.5

-29.2 3.6 -26.3 -44.9 -4.6 -25.4 -21.2 -20.5 4.1 1.3 2.7 4.3 -1.6 -46.5 5.9 0.2 -12.9

-31.9 -22.1 1.2 -5.6 2.4 -15.1 -15.7 -51.1 0.4 -0.8 -21.7


9

S&P 500 (Bloomberg: SPTR Index )

REIT (Bloomberg: FNERTR Index )

Chinese equities (Bloomberg: HSCEI Index )

European stocks (Bloomberg: RU20INTR Index )

Commodities (Bloomberg: SPGSCITR Index )

Non-US=EAFE (Bloomberg: GDDUEAFE Index )

Cash (Bloomberg: SPBDUB6T Index )

Bonds - Agg (Bloomberg: LBUSTRUU Index )

Hedge Funds (Bloomberg: HFRIFWI Index )

High Yield (Bloomberg: LF98TRUU Index )

EM Bonds (Bloomberg: JPEIGLBL Index )

Emerging Mkts (Bloomberg: GDLEEGF Index )

Color Asset Class

Equities: limited upside this year, possible buying opportunity long-term

We expect modest, positive returns from equities

this year. With earnings growth expected to be

lower than in 2011, it would take a significant re-

rating of stocks to push prices much higher. Any

such re-rating is likely to come in the second half of

the year, if at all, once we get more clarity on the

Eurozone situation (although that is probably what

many people thought at the beginning of 2011,

too!). Some analysts may argue that valuations are

cheap relative to history, but we are not sure that

the history of the last 20 years or so necessarily

represents fair value for risky assets going forward.

With the Shiller P/E ratio still above its post-war

average and earnings volatility off the charts, we

expect that investors will be hesitant to pay up for

stocks. The markets and companies that we expect

to do well are those that show high growth, high dividends and solid cash flow.

In the US, earnings were up about 15% yoy in 2011. We do not see this reoccurring and expect

earnings growth to fall back closer to trend of around 7% or even a bit lower. Thus while we think

stocks can advance overall, it will probably be difficult for them to break out of their two-year trading

range of 1,100~1,365 (except of course on the downside if the Eurozone starts to crumble). We look

for secular stories rather than cyclical ones, i.e. companies with good fundamentals and sound

earnings rather than simply a high correlation to growth. Companies that have less exposure to

Europe and more to emerging markets are likely to outperform. Growth should continue to

outperform value as well, as investors despair of waiting for the eventual rerating of value stocks.

Interest rates on hold indefinitely at zero means that dividend plays should continue to outperform

as well.

The Eurozone could offer some excellent buying opportunities later in 2012, but we would avoid it

almost entirely for now. Even those stocks that do manage to rise are likely to see much of their

gains offset by a falling euro, in our view. Nonetheless, we are keeping an eye on the timing for when

is right to go back into Europe. The market is already pricing in a lot of disappointment and may be

close to stabilizing. Earnings revisions seem to be bottoming out, valuations are well below long-term

averages, and investor positioning shows very little risk appetite. Moreover a weaker currency

should provide a boost to exporters at some point. But until these indicators are at levels consistent

with the distress shown in the CDS market, we would be hesitant to take even a market weight in

Europe.

Equities are still expensive relative to historical levels

Shiller P/E ratioinflation-adjusted price/10 years average earnings

0

5

10

15

20

25

30

35

40

45

1880 1900 1920 1940 1960 1980 2000 2020

19011966

2000

1929

Latest = 21.4

Postwar average =

18.2Long-term average =

16.4

Source: Robert Schiller

10

China: We expect the stock market to progress in two stages. At first, markets could move

aggressively lower due to heightened risks around developed countries debts, thus creating an

oversold environment with Hong Kong stocks being particularly hit. Then a bottom could be reached

around the end of Q1, when negative sentiment towards Chinese investments fade and fears on real

estate or the banking sector appear overdone. As market sentiment deteriorates and indices

weaken, we would expect investors to engage in bottom fishing among attractive names and

probably some sector leaders within the mid- and small-cap sectors. That should allow Mainland and

Hong Kong equities to start rebounding.

Flows of foreign liquidity are likely to keep HK stocks highly volatile. Mainland equities could benefit

from new schemes being launched such as RMB Qualified Foreign Institutional Investors (RQFII), a

scheme to facilitate access to mainland investments by foreign investors, which should help support

the base for an upward trend for local stock markets.

Other emerging market countries will almost

certainly outperform the industrialized world

in terms of growth, but will their stock

markets outperform as well? That wasn’t the

case in 2011, as developed markets

outperformed EM by some 27% in USD terms.

Higher growth does not always translate into

higher earnings; in fact, there is a small but

statistically significant negative correlation

between per capital GDP growth and earnings

over the long term. The growth surprise is

more important than the absolute level of

growth, and investors are already expecting

strong growth from EM. The risk is that they

may be disappointed so long as these markets

have not yet decoupled from developed markets.

Many EM markets appear cheap on earnings and asset-based valuations, both in absolute terms and

relative to developed markets. Nonetheless we remain cautious. In the first instance, slower global

growth suggests limited upside in commodity prices except for a possible rise in oil prices caused by

strife in the Middle East, which would be negative for most EM countries’ energy-intensive

economies. Secondly, there seems to have been a shift in the investment industry towards an

emphasis on absolute return and an avoidance of even short-term losses, which makes these

markets vulnerable to profit-taking and sudden changes in sentiment caused by market movements

elsewhere. The simultaneous fall in EM currencies when foreign investors exit only amplifies the

downward moves for DM investors. Finally, the asset class has become quite unpredictable. Neither

growth, nor value, nor momentum were successful investment strategies in EM in 2011.

Within EM, we prefer Asia. The region is likely to be least affected by the coming recession in Europe,

and any weakness in commodity prices should benefit Asian manufacturers and consumers. Plus

years of current account surpluses and sound fiscal policies have helped to underpin the region’s

resilience. India is a concern, though. Latin America is more exposed to a European downturn than

Asia is, particularly through a possible decline in commodity prices, the region’s comparative

advantage. Eastern Europe, which is closely linked to the Eurozone through trade and financial ties, is

likely to be the most deeply affected.

EM stocks beat DM stocks when EM-GDP gap is rising

BRICS vs G10 GDP and

EM vs DM equities

-2

0

2

4

6

8

10

1996 1998 2000 2002 2004 2006 2008 2010

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

BRICS GDP - G10 GDP (L)

EM stocks/G7 stocks (R )

Percentage

points


11

Sovereign Bonds: The biggest investment question of the year is probably whether sovereign bonds

will remain an effective hedge for equity markets. The normal approach to constructing a portfolio is

to include some government bonds as well as equity and other riskier assets for safety in case growth

falters and equity markets fall. Recently however bonds have stopped playing that role in some

countries; even in Germany, Bund yields rose when there were questions about economic growth

because of fears that the country’s rating would be downgraded. The increasing correlation between

stocks and bonds makes it unusually difficult to construct a balanced portfolio.

Government bonds in the seven major

industrialized countries returned a

respectable 5.9% in total during 2011 (see

graph). It will be difficult to match that

performance again this year, but bonds

should still turn in a positive return, in our

view. Obviously it is impossible for most

developed countries to lower interest rates

further, although with inflation subsiding and

activity still weak, we see little chance of a

tightening of monetary policy either. The US

and UK could announce another round of

quantitative easing, but we question how

much further yields can fall in any case. (Remember though that Japanese 10-year yields did get

down to 0.45% in June 2003, so it’s not impossible.) Sovereign bonds have a poor risk/reward ratio as

there is limited upside and unlimited downside, but the global economy also seems to have less

upside potential than downside too, thereby offsetting the risk/reward ratio somewhat. Among

developed countries, we would avoid most Eurozone debt except at the short end; less than three

years may be one way to pick up some additional return in Spain and Italy, assuming that the ECB’s

new three-year refinancing operation may support those markets. However, investors do not usually

buy sovereign bonds to speculate on default. This trade is therefore only for those able to take mark-

to-market risk, in which case we would prefer to buy quality equities with similar dividend yields that

have more potential upside in the price.

Credit: We favor non-financial investment-grade (IG) credit for investors seeking preservation of

capital with some income. Spreads are historically wide – they are at levels usually associated with

recessions in the US and much wider than at the start of any past downturn. Indeed, the low level of

sovereign yields means that spreads make up nearly 80% of overall yield on bonds, a record in both

EUR and GBP. On the other hand, corporate fundamentals remain well underpinned, even in Europe.

Non-financial companies continue to deleverage, thereby strengthening their balance sheets,

improving their coverage ratios, reducing default risk and holding down supply (although IG non-

financial supply was higher in 2011 than in 2010 for the US and UK). Non-financial issuers do not

have a redemption hump in 2012 so supply is not likely to be a problem unless they decide to

prefund the much higher redemptions due in 2013 and 2014.

G7 bonds have done well as rates fell

G10 Yields and total return on bonds

-10

-5

0

5

10

15

20

2005 2007 2009 2011

0

1

2

3

4

5

Bloomberg/EFFAS G7 global

bond index (USD) (L)G10 avg 10yr yields (R)

G10 avg 3m rates (R)

% yoy %


12

Meanwhile, the super-low level of yields at the short end means carry is attractive, and a slowdown

in the global economy and falling inflation rates mean the risk of a rising yield environment is that

much lower. Deleveraging and sluggish growth without recession (except in Europe) should be a

favorable environment for credit. As for Europe, it’s noticeable that in the peripheral countries,

investment-grade corporates are now trading at lower yields than their governments, meaning that

they are perceived as the less risky assets. It appears that corporate bonds are being priced not off of

their local government bonds but rather off the relevant maturity Bund. Nonetheless, we still expect

them to underperform the rest of the European credit universe until there is a systemic solution to

the Eurozone’s problems.

Given the opportunities, we recommend being overweight high yield relative to investment grade, at

least in the US and Asia.

Note that this discussion has concerned itself with non-financial bonds, not financials. This is a big

gap as financials represent the bulk of the private sector debt markets. There, we are still hesitant.

We believe particularly in Europe, banks may struggle to roll over the redemptions that are coming

due, despite near record yields and spreads. In fact, we would expect some of the money coming

into the market from maturing financial bonds to go into non-financial corporates, thereby

aggravating the situation. We do not recommend the sector except on a case-by-case basis

EM bonds: EM credits, rates and FX look

attractively valued to us, particularly if central

banks in the developed world keep interest

rates at rock-bottom levels, as we expect. Last

year, external debt (EM bonds denominated

in DM currencies) outperformed local

currency bonds as US Treasury yields declined

while EM FX depreciated. Starting from this

point however we think there is limited room

for UST yields to decline further, while the

current depressed levels of EM FX may

provide an additional return on unhedged

local currency bonds to long-term investors, in

our view. (This of course assumes a successful

resolution to the Eurozone crisis.) Most EM countries outside of Eastern Europe should be able to

weather the European downturn -- unlike the developed markets, they have room to expand their

EM bonds have given equity market returns over six years

EM sovereign & corporate bond total return

vs MSCI EM equities

75

100

125

150

175

200

225

250

275

2005 2006 2007 2008 2009 2010 2011

MSCI EM Total return USD

Latam bonds

EMEA bonds

Asia bonds

Jan 2005 = 100

xxx


13

fiscal spending through automatic stabilizers if the economy turns down. In any event, monetary

easing is likely to continue to be the first line of defense for much of the region, depending of course

on each central bank’s degree of tolerance for further FX weakness. Given the liquidity constraints in

EM bonds and the difficulty of doing research on individual credits, we recommend that investors

who are interested in local currency EM bonds do so through funds.

Commodities: Given our outlook for slower growth and a general reduction in risk-taking, we are

not that optimistic about commodities as an asset class. The fact that all asset classes are likely to be

affected by a limited number of overarching macro risks means higher correlation between

commodities and other risky assets, particularly during periods of risk aversion. The stronger dollar

too tends to be negative for commodities in general. Nonetheless, we can expect some commodities

to better than others. Commodities with constrained supply, such as copper and corn, are likely to

outperform within their sectors, in our view. Grains too tend to outperform more economically

sensitive commodities when growth is weak. By comparison, industrial metals and the softs (such as

coffee, cocoa, sugar, cotton, and orange juice) tend to be cyclical and to sell off during global

slowdowns. Energy, discussed above, tends to be the most cyclically sensitive.

The defensive nature of gold should underpin the precious metal as investors continue to worry

about quantitative easing and the future of the fiat money system. The safe haven bid should remain

in the market as the conditions that have driven gold higher over the past 11 years are likely to

persist, namely negative real interest rates, nervousness about stocks and central bank buying. The

main risk for gold is a continued appreciation of the dollar. The US currency’s recent strength has not

been accompanied by an inflow into physically backed gold ETFs, as it was in 2009 and 2010. By

comparison, silver tends to be more sensitive to the economic cycle because of its industrial uses and

we therefore do not expect it to outperform gold.

FX: In a world of increasing correlation, FX

stands out as one market where some assets

are clearly outperforming others. This year we

expect the dollar and the yen to be the best

performers initially, as risk aversion and the

flight out of EUR continue. Investors cutting

back on their EM positions are likely to join

European investors looking to diversify their

risk in buying the US currency. The EUR may

suffer not only from capital flight from the

possible break-up of the Eurozone, but even

investors who are confident of a solution may

worry that lower interest rates and

quantitative easing by the ECB are likely to be

part of that solution.

Yen remains a safe haven as well; despite the government’s incredible debt/GDP ratio, it has a solid

trade surplus and a capital account surplus that underpin the currency (and the government bond

market). The Swiss Franc historically has played that role as well, but following the Swiss National

Bank’s pledge to put a floor under EUR/CHF the currency is now seen as the euro or worse.

Is a new USD upcycle starting?

USD/Deutsche Mark Cycles

75

100

125

150

175

200

0 25 50 75 100 125 150 175 200 225Months from start

Oct '78 ~ Aug '97 (Oct '78 = 100)Jun '95 ~ now (Jun '95 = 100)

New USD uptrend begins in Aug '95

(= Nov '11?)


14

Renminbi: The problems in the Eurozone are

likely to cut into the growth of exports, which

are already slowing, and further dampen

growth. A lower trade surplus and

expectations of weaker growth could cause

the Renminbi to experience some volatility.

We do not however expect any change in the

general trend. Last year’s 4.4% appreciation vs

USD was in line with our target of 4%~5%. We

expect the uptrend to continue but at a

slower 2%~3% pace in light of the global

situation. We cannot exclude the possibility of

fluctuations and perhaps a brief depreciation

of 1% or so as the environment deteriorates.

It will be important though for the government to keep the strength of its currency during this US

election year to fend off trade friction, as well as supporting the goal of shifting the Chinese economy

towards increasing emphasis on domestic consumption. At the same time no risk will be taken by

appreciating the currency inappropriately and significantly hurting the export sector which is already

facing falling global demand.

Other EM currencies have moved along with global risk preferences and many currencies now stand

below fundamental value, in our view. Positioning is also very light. We therefore see room for EM

currencies to retrace their losses and more if the EU crisis is successfully resolved. However, if the EU

crisis escalates these currencies would rapidly be hit by non-residents’ hedging or repatriating their

local investments. We therefore favor currencies where the valuation and technicals are favorable

and the economies are not that exposed to Europe. As mentioned above, we expect that China

would not allow its currency to depreciate against USD in an election year. The Mexican peso may

benefit from the relative strength of the US economy, in contrast to the Brasilian real, where the

central bank is likely to cut interest rates further even in the face of high inflation in an effort to

weaken the currency.

CNY spot and possible 2012 trend

6.00

6.50

7.00

7.50

8.00

8.50

2006 2007 2008 2009 2010 2011 2012

CNY

May 06~Jul 08 trend

2011 trend

3% annual trend


15

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