20121213 Barclays Global Outlook

ResearchDecember 2012

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Global OutlookMoving away from risk on/risk off

Barclays | Global Outlook

13 December 2012 1

FOREWORD

The combination of weak economic and solid financial market performance remains intact. Central banks remain committed to supporting asset prices and keeping risk-free interest rates at record lows. This is forcing investors to move gradually out along the risk curve to achieve reasonable returns, and has resulted in a strong performance of stocks relative to bonds. We expect this economic/policy/market mix to persist into 2013: monetary support for financial assets is set to continue and probably expand, but it will not produce significantly stronger economic activity, which is likely to be stymied by fiscal tightening and associated business caution. As a result, we recommend that investors remain overweight equities relative to fixed income, at least in the developed markets.

One important development associated with increasingly aggressive central bank support is a reduction in the systemic risks – from euro area dissolution, to a China hard landing and a financial system collapse – that have been dominating markets since the end of the great recession. The approaching US fiscal cliff is another potential systemic risk, but we expect it to be resolved within the next couple of months. We think the most likely outcome will be another ‘kick the can down the road’ agreement that will avoid massive near-term spending cuts and tax increases, even though it will not produce a comprehensive deficit reduction plan that would put the US on a fiscally sustainable path and be constructive for markets and growth.

The ups and downs in investors’ perception of negative tail risks had produced highly correlated movements in asset prices both within and between asset classes, as markets oscillated between “risk on” and “risk off” modes. As these tail risks have faded, asset prices are being driven less by macro developments and more by asset-idiosyncratic considerations, as well as return-seeking flows into the next not-too-risky asset class. As a result, our investment recommendations are characterized less by weighting one asset class over another, and more by specific recommendations within each asset class. Even our call to overweight equities relative to fixed income is related to developed markets only. In emerging markets, we would overweight external and local debt. Within credit, we prefer high yield to investment grade corporate bonds, and within commodities, we favor oil, grains and gold over base metals.

We engage our economists and market strategists across every region and product area to put together the Global Outlook. We are dedicated to serving you – our clients – and sincerely hope that this integrated view of economies and markets helps you to make successful investment decisions.

Larry Kantor Head of Research


13 December 2012 2

SUMMARY OF ASSET ALLOCATION THEMES

KEY FORECASTS KEY RECOMMENDATIONS

Equities • Our 2013 S&P price target is 1525 (total return: ~9%) on the potential for earnings growth momentum. The near-term risk is lack of progress on the US fiscal cliff. A pullback could present a buying opportunity.

• Expect European equity markets to rally in 2013, due to ‘yieldfall’, a policy-induced contraction in cross-asset yields.

• We expect implied volatility to stay elevated, although significant upside is unlikely. Further declines are contingent on a credible US fiscal grand bargain.

• We expect US converts to post returns of ~6.5%, driven by modest equity returns, income and spread compression.

• Our sector positioning is cautious: overweight stocks with bond-like characteristics and underweight domestic cyclical sectors, nudging up exposure to capex and global growth.

• Italian and Spanish equities would benefit most from yieldfall.

• We recommend expressing a view on limited upside in volatility via VIX call spreads.

• Core positions in balanced intermediate duration high yield converts providing income and risk-controlled equity exposure, flanked by a basket of high income producing securities, including preferreds and select delta exposure.

Bonds • We expect 10y rates in the US to end the year at 1.6% after a mild Q1 sell-off caused by a fiscal cliff compromise. In the very near term, we remain long duration, as the risk of a fiscal accident is underpriced. We would turn neutral in the 1.4-1.5% area in 10s and look to short rates tactically below this range.

• The euro area crisis will likely remain a key driver of rates, spreads and overall volatility, both there and outside. But our base case is that backstops are or will be put in place to prevent it from deteriorating much further.

• We recommend buying Treasuries in the 3-4y sector, receiving 3y1y or 4y1y swaps for a Fed on hold. We like 7s-30s curve flatteners and long-end swap spread wideners in the near term given fiscal risks/Fed purchases. We also like selling intermediate-expiry mid-tail options such as 1y*10y and 2y*10y to monetize the range in rates.

• We expect the ECB to ease aggressively and for a long time: the short end will rally and then be pegged, while the longer end will likely stay in a range. Favour steepening 2s/10s in Germany and swaps. Hold swap spread tighteners.

Commodities • After taking a back seat to broader financial market concerns, commodity risk looks set for a more active role in early 2013.

• Oil is highly vulnerable to a further ratcheting up of geopolitical risks in early 2013 and grains markets to bad weather in key southern hemisphere exporters.

• Once markets come to believe a US fiscal cliff solution is near, a broad-based rally across commodities is possible, as investors are under-exposed. But we think that this provides opportunities to short some markets.

• Position for commodity price upside in Brent crude, where the put skew allows for favourable options pay-offs.

• Be ready to short markets where higher prices are not yet justified – aluminium and copper fundamentals look weak in early 2013.

• Prepare for a resumption of reflation risk in the gold market and be ready to buy on price dips toward the 200-day MA.

• Avoid obvious China trades like copper. Being long palladium is a better way to position for stronger China growth.

Inflation • The front end of the US breakeven curve looks attractive post-fiscal cliff uncertainty. A dovish Fed and gradually improving economic data argue for wider fwd breakevens.

• 5-10y breakevens appears relatively attractive in €is but poor value in the UK.

• Long US front-end breakevens post-fiscal cliff uncertainty. Look to be long 5y5y breakevens on any declines.

• Long forward 2018 €i breakevens.

Credit • Most parts of credit will struggle to return much more than their coupon: excess returns of 300bp and 200-225bp for US and Europe investment grade; total returns of 4-6% and 5.5-7.5% for US and European high yield.

• Unprecedented levels of central bank support should translate into muted macro-led volatility; as a result, we expect fundamentals to be the key driver of performance, more than in any other period since the financial crisis.

• The premium for liquidity is unlikely to shrink in 2013, and cash volumes are likely to remain concentrated.

• In investment grade, we recommend select financials as a key source of alpha. In the US, we are Overweight life insurers, and in Europe, we find value in the subordinated parts of the capital structure for core European banks.

• In US high yield, we expect CCCs to perform in line with the rest of the market but continue to underperform their beta. In European high yield, we favor single Bs to BBs and CCCs.

• Remain up in liquidity. In HG cash, large-cap banks remain the most liquid, so they are an ideal means to adjust beta. In derivatives, focus on trading 5y CDS on index names.

Emerging Markets

• The reduction of tail risks in EM and persistent diversification flows to EM fixed income provides a positive backdrop for the markets.

• We expect 2013 to deliver modest (5.5%) returns on EM sovereign credit and 6.5% on EM local government bonds at the index level.

• In credit, we favour high yielding sovereigns (Venezuela), LatAm sub bank bonds, select Russian banks and shorter-dated quasi sovereigns.

• We recommend Brazil local bonds (2014 real and nominal) and favour 10y nominals in Russia, India and Malaysia FX unhedged.

Foreign Exchange

• A more dovish BoJ should have profound implications for the yen.

• We look at the fiscal cliff as an entry opportunity into long cyclical currency positions.

• Relative value ideas likely to emerge in a more stable global environment, as extreme conditions may begin to revert.

• Buy USD/JPY and GBP/JPY via 3m options.

• We look to enter into long MXN, ZAR, RUB, and MYR basket, after cliff risks begin to dissipate.

• We like CNY over TWD, RUB over TRY, PLN over HUF, ZAR over AUD, and EUR over CZK on relative value grounds.


13 December 2012 3

CONTENTS

Overview ............................................................................................................................. 4 Moving away from risk on/risk off Aggressive monetary policy measures are reducing the systemic risks and ensuing swings in investor positioning that have dominated markets since the start of the great recession. This low risk and return environment is forcing investors to move out the risk curve.

Asset Allocation ........................................................................................ 9 It’s a grind The 30-year boom in fixed income is approaching plausible limits. This should reinforce the continued migration out of safe-haven and into riskier assets, although it is likely to involve an extended grind appreciation in risky assets, rather than a headlong rush into risk.

Economic Outlook ..................................................................................................... 25 Overcoming austerity The main headwind confronting the global economy in 2013 is ongoing fiscal austerity. However, we think that by 2014 this will abate, permitting activity to pick up in response to ongoing monetary accommodation.

Commodity Markets Outlook ............................................................................. 47 The return of commodity risk Stretched supply lines and limited shock-absorbing capability mean that oil markets are highly vulnerable to a further ratcheting up of geopolitical risks in early 2013 and grains markets to bad weather in key southern hemisphere exporters.

Foreign Exchange Outlook .................................................................. 55 Stay with the policy tides We expect the newly elected Japanese government to give the BoJ a stronger mandate for targeting higher, much-needed inflation. As a result, we think the yen is likely to experience a large, one-off depreciation, mostly in Q1.

Interest Rates Outlook .......................................................................... 64 Running in place Rates in most developed markets should stay low in Q1 2013, owing to mediocre growth, fiscal austerity, and central bank support. Investors will have to eke out returns by opportunistically trading the range and through relative value trades.

Credit Market Outlook .......................................................................... 72 A good bond is hard to find We think that most parts of the credit market are limited in terms of capital appreciation and, as a result, that credit has become more of an income asset class with a few notable high beta exceptions.

Equity Market Outlook ......................................................................... 83 Yieldfall Our S&P 500 end-2013 price target is 1525 (total return: 9%) given the potential for earnings growth to build momentum through 2013. Even against a backdrop of anaemic growth, falling profit margins and fair valuations, we expect European equities to rally in 2013.

Emerging Markets Outlook ............................................................... 104 Searching for yield, hoping for growth We see the global liquidity backdrop continuing to drive a search for yield, while we find the growth performance still uninspiring, at least in H1.


13 December 2012 4

OVERVIEW

Moving away from risk on/risk off • Aggressive monetary policy measures are reducing the systemic risks and ensuing

swings in investor positioning that have dominated markets since the start of the great recession.

• In a lower risk and return environment, investors need to focus more on asset-idiosyncratic considerations and continue to shift from overvalued “safe” assets into somewhat riskier investments.

• Although current and prospective central bank purchases should continue to support asset prices, economic growth continues to be held back by significant fiscal tightening, associated business uncertainty and structural changes in Europe.

• Whilst we do not advise a major step up in exposures, our strongest recommendation is to underweight fixed income and overweight equities in developed markets, which offer expected returns only modestly below historical norms.

• A significant market correction resulting from lack of progress on the US fiscal cliff would likely provide a buying opportunity.

The economic and financial market landscape is little changed since the last issue of the Global Outlook went to press three months ago. Global economic performance, while varied, continues to be generally mediocre and somewhat disappointing, while financial market performance remains quite good: global stock markets are on pace to deliver double-digit gains this year. This divergence reflects the unprecedented commitment from the major central banks to support asset prices and push risk-free interest rates to record lows, in the process creating highly liquid market conditions. This process has progressed to the point where a broad range of assets on the “safe” end of the spectrum now offers expected returns that are unattractive by any historical benchmark, forcing investors to move gradually out along the risk curve to achieve a reasonable return.

We believe this economic/policy/market mix is likely to persist at least through the first half of 2013, with monetary stimulus probably continuing to fail to ignite a more robust global expansion. While financial system recovery is now well underway and emerging economies are in generally good shape, the key roadblock to better global economic performance is increasingly focused on the other side of the policy equation. Significant fiscal tightening (Figure 1) and an associated high degree of business uncertainty across the major developed economies, as well as structural changes in Europe (growth supportive only in the medium term), will continue to hold back growth in early 2013.

Meanwhile, central bank support will continue and even expand, which should successfully contain large negative tail risks. Reduced tail risks in turn suggest that the recent trends toward lower market volatility and declining correlations between and within asset classes will persist. Asset performance is likely to be driven less by macro developments and the resulting risk-on/risk-off swings in investor positioning that have been so prominent since the recession, and more by asset-idiosyncratic considerations and return-seeking flows into the next not-too-risky asset class.

Larry Kantor

+1 212 412 1458 [email protected]

Global economic performance continues to be generally mediocre, while financial market performance remains quite good

Reduced tail risks suggest that the recent trends toward lower market volatility and declining correlations between and within asset classes will persist


13 December 2012 5

FIGURE 1 Fiscal tightening will continue to dampen growth in 2013

-5

-4

-3

-2

-1

0

1

2

2008 2009 2010 2011 2012 E 2013 F 2014 F

US Euro area Japan OECD

Change in structural budget balance % GDP

Barclays forecast

Source: Barclays Research, Haver

In such a relatively low risk and return environment, we do not recommend a major step up in exposures, but rather a continued shift in positioning from increasingly over-valued "low risk assets" into somewhat riskier areas. Our strongest recommendation is to underweight fixed income and overweight equities in the developed markets. It is not that we expect interest rates to rise significantly next year; little change in rates across 2013 is the most likely outcome given continued aggressive monetary policy support. But prospects for reasonable returns on fixed income are rather dismal, as there is little room left for further price appreciation (i.e., still lower yields) that could offset already historically low coupon rates. Equities, however, offer a reasonably balanced distribution around an expected return only modestly below historical norms. With aggressive monetary expansion and significant systemic risks successfully contained by the central banks, the major market risk that investors should be concerned with is the possibility of a reversal in the 30-year trend toward lower yields, which has driven them to unsustainable levels. While we do not see this as imminent, investors should consider protecting against this possibility as 2013 progresses.

The other risk we believe worth noting is the possibility that the current economic weakness in the US and Europe reverses more sharply than expected next spring or summer. While this is beyond a 3-month asset allocation horizon, it is possible that investors could begin to anticipate the turn after a resolution of the US fiscal cliff negotiations and another round of broad-based ECB easing in Q1. These risk considerations reinforce our preference for equities over bonds, at least in the developed countries.

Within fixed income, we favor high yield vs. investment grade credit, and expect US financials to outperform industrials. In emerging markets, we would overweight external and local debt, where supply should be light. Within equities, we would balance our allocation to the relatively low risk US with positions in Europe – which is notably cheaper – and Japan, where we expect the Bank of Japan (BoJ) to step up its support of growth. We do not recommend an overweight of EM equities generally, given limited prospects for growth acceleration and FX appreciation, but do see opportunity in Brazil, where growth should recover somewhat in 2013 and where valuations are attractive. Russia also looks attractive on valuation grounds, for the exposure it offers to oil markets, and because the liberalization of the domestic bond market could help lower private and public sector funding costs.

Prospects for returns in fixed income seem rather dismal


13 December 2012 6

We do not believe that 2013 will be a very exciting year for growth-sensitive commodities, but do see potential strength in oil and grain prices early in the year due to low spare capacity as well as geopolitical and weather risks. Gold is one commodity that may receive some support from central bank actions and we would recommend buying it against the yen, which we expect to depreciate by as much as 10% in response to easier monetary policy from the BoJ.

The US fiscal cliff Since the great recession, investors have generally been cautious, partly in recognition of a range of risks of extreme events, including euro area dissolution, a China hard landing and financial system collapse. Perception about the likelihood of realizing such risks appears to have faded considerably during the past year in the face of concerted and increasingly effective central bank efforts. We believe this decline is justified and will continue into 2013.

The possibility of the US falling off the fiscal cliff is another case in point. Even with year-end rapidly approaching and the noise level in Washington rising in a discouraging tone, markets have shown little concern. We think this is the correct read. It is unlikely that over the next month or two Congress and the President will reach a comprehensive agreement to put the US on a fiscally sustainable path – something that would be potentially very constructive for markets. And it is entirely possible that no agreement is reached by year-end and tax rates jump. It is highly unlikely, however, that Congress and the President would allow this fiscal shock to persist for very long given the high cost to both sides if the tax increases are allowed to persist and the available opportunities for a compromise that kicks the hard issues down the road. We do not think it is worth lightening positions significantly in front of crunch time due to the unpredictability of the timing and nature of any agreement. But if lack of progress triggers a sharp market selloff – which is certainly possible – we would see this as a buying opportunity.

China adjusts to a lower trajectory One major risk that seems to have come and gone is a Chinese hard landing. Recent Chinese data confirm that growth has stabilized and is improving somewhat and that the authorities have been successful in establishing a lower trend growth rate. At the same time, policymakers are driving a significant shift in income distribution towards households and away from businesses, which are facing surging wage and other production costs. While this means that China will not play the same locomotive role globally, it will make the Chinese expansion more politically as well as economically sustainable and the global economy less exciting but more stable. Along with the lower growth rate, the shift from investment to consumption will moderate China's appetite for many non-agricultural commodities, which is a key reason why we take a relatively cautious view of commodity markets generally in 2013.

Europe not out of the woods, but safer than before The future of the euro area is probably the risk that has been most responsible for market swings over the past two years, and it certainly has not been put to rest. But European governments and institutions across the board have recently reconfirmed their commitment

We recommend buying gold against the yen, which we expect to depreciate in response to easier BoJ policy

Policymakers in China are driving a shift in income distribution towards households and away from businesses

It is highly unlikely that Congress and the President would allow a fiscal shock to persist for very long


13 December 2012 7

to the euro project: they have begun work on a framework for euro area-wide banking reform; an agreement has been reached with Greece that should prevent default in 2013; the ECB stands ready to buy Spanish sovereign debt if Spain needs and requests a formal program; and more traditional monetary easing is on the horizon if the euro area economy continues to contract. European policymakers have managed to get at least one step ahead of the ongoing crisis for the first time since it began. They now have the ammunition on hand to use if and when the next challenge appears. Euro dissolution risks may well resurface down the road, but they are not likely to be significant over the next several months.

All that said, the road toward euro area integration will almost certainly continue to be bumpy, and a solution to the US fiscal cliff will likely shift investor attention back to Europe. Upcoming elections in Italy – likely to take place in Q1 – have re-introduced political uncertainty there for the first time in over a year. And continuing missed fiscal targets in Spain due to the ongoing severe recession will likely revive concerns about the country’s debt sustainability and require Spain to request outside assistance, something that is unlikely to occur without considerable noise during the process.

Upside growth surprise could emerge, but probably not in Q1 With downside risks having faded (at least beyond the US fiscal cliff), it is worth considering prospects for an improvement in global growth. The emerging market world is generally healthy, although any significant growth acceleration would likely be contained by policymakers due to the risk of rising inflation. In the developed world, considerable progress has been made in repairing the damage done by the financial crisis and cumulative policy mistakes. This is particularly the case in the US, where the financial system is back on a sound footing and the housing sector – the epicenter of the downturn – has begun a strong rebound in both activity and prices. Meanwhile, business competitiveness has been boosted by costs for energy that are well below world norms, and state and local government budgets are in much better shape. The main remaining constraint on US performance is the large and structurally rising federal budget deficit and uncertainty about how it will (or will not) be dealt with. Whatever the outcome of the current negotiations, it is likely that the first half of 2013 will see a continuation of significant fiscal restraint. The last of the temporary stimulus measures – the payroll tax holiday and extended unemployment benefits – will very likely end and the 3% surtax on investment income (which is part of the health care law) will take effect. Even if no other deficit-reducing measures are forthcoming, these will amount to well over a percentage point of GDP, which will produce a setback to growth in early 2013.

If a comprehensive and credible agreement to reduce the budget deficit significantly over the medium term is eventually reached, growth would still be constrained in the first half of 2013 and the fiscal tightening could be even greater. But such an agreement could potentially be a very positive outcome for markets. If the agreement included growth-oriented tax reform and adjustments to entitlement programs that put them on a sustainable trend, it would remove much of the policy uncertainty and might permit investors to look through the next few quarters and price in significantly improved growth prospects in 2014 and 2015. The other recent constraint to US growth has been business

It is likely that the first half of 2013 will see a continuation of significant fiscal restraint in the US, constraining growth

The likely near-term scenario on the fiscal cliff is another ‘kick the can down the road’ agreement without the intermediate term clarity or growth orientation

European policymakers have managed to get one step ahead of the ongoing crisis for the first time since it began


13 December 2012 8

investment, which has been soft over the past year. This partly reflects the end of tax incentives at the beginning of the year, but is also probably accounted for by business concerns about fiscal prospects and, thus, could have the potential to bounce if these concerns are alleviated. We do not, however, think that there is either the time or inclination to reach such a comprehensive agreement over the next couple of months, and the more likely near-term scenario is another ‘kick the can down the road’ agreement with short-term fiscal tightening and without the intermediate term clarity or growth orientation.

The euro area is making slow but steady progress, but remains in recession While Europe certainly has more to do than the US, it has made considerable progress as well. The work on a framework for a much more tightly integrated euro area has begun, and although it will be a multi-year undertaking, the political will in the core and the periphery seems relatively solid. This intermediate term road map could provide a foundation for the return of confidence in the future of the euro area. Importantly as well, the peripheral countries have made considerable progress in improving competitiveness and trade balances against the core (Figure 2), even within the constraints of a common currency. Of course, this progress also comes with the political risk associated with painful downward wage and public spending adjustments.

The immediate problem for Europe, however, is continued recession. It is worrisome that activity in the core has weakened significantly. This is particularly the case in France – which appears to be facing a significant downturn in both household and business spending – but Germany as well appears to be skirting into negative territory, at least in the current quarter. The spreading of weakness to the core means that even in the best of circumstances, significant improvement in euro area growth is still a ways down the road. With better performance in both Europe and the US still not imminent, it is probably too early to position for a significant, sustainable developed economy growth upturn, although this is a possibility that investors would do well to pay attention to further into 2013.

The European peripheral countries have made considerable progress in improving competitiveness and trade balances against the core

But significant improvement in euro area growth is still a ways down the road

FIGURE 2 Competitiveness in the peripheral euro area countries is improving

Compensation per employee as % of German level

40%

50%

60%

70%

80%

90%

100%

110%

120%

130%

99 00 01 02 03 04 05 06 07 08 09 10 11 12

Italy Spain FrancePortugal Greece

Exports of goods and services, % GDP

20

25

30

35

40

45

05 06 07 08 09 10 11 12

PortugalSpainItalyFranceGreece

Source: Haver, Barclays Research Source: Haver, Barclays Research


13 December 2012 9

ASSET ALLOCATION

It’s a grind • For much of the post-crisis period, financial market performance has been dominated

by a ‘risk-on/risk-off’ market dynamic, resulting in highly correlated asset prices and sharp distinctions between safe-haven and risky assets. This market tendency is not likely to vanish entirely in 2013. However, as tail risks of a global economic or financial event have been mitigated by time, fundamental policy action and extraordinarily activist monetary policy, asset-price correlations should become less extreme, as they have recently shown signs of doing.

• The 30-year boom in fixed income is approaching plausible limits. So far, investors have been insulated from low yields on fixed income by capital gains created by yet further reductions in already-low market yields. In our view, 2012 is likely to mark the peak of this historical boom in global fixed income, and 2013 the year when investors are finally forced to confront the high price of continuing to lurk in safe assets. This should reinforce the continued migration out of safe-haven and into riskier assets that lies at the center of our asset-allocation call. This is likely to involve an extended grind appreciation in risky assets, rather than a headlong rush into risk.

• With the economic and financial outlook marked more by continuity than rupture, we have made only modest changes in our recommended investment stance. We continue to prefer equities to fixed income. We think that safe-haven bond markets will continue to offer valuable portfolio risk-mitigation, and remain underweight high-grade corporate credit.

Another good quarter for risk… and for safe-haven assets. Now what? Although the Q4 rally in global risk assets was somewhat overshadowed by the selloff in US equity markets that followed the November elections and subsequent preoccupation with US fiscal politics, Q4 has (as of this writing) been another good one for risk assets. In Q4 (through December 10), advanced equity markets other than the US returned more than 3.2% (in USD), emerging market equities returned roughly 2%, and global high yield corporate bonds returned more than 3%. US equities, which so often seem to set the tone of global asset markets, look uncharacteristically out of sync with the positive tone in world financial markets. That’s an interesting development.

Another interesting development is that the generally positive tone in asset markets was not accompanied by the selloff in safe-haven bond markets that market participants have come to associate with a ‘risk-on’ episode. Safe-haven government bonds generally rallied and investors earned at least a little more than their coupon, although not as much as they would have earned owning bonds of sovereigns with higher perceived credit risk, such as Italy or Spain.

These broad market developments have been accompanied by some reduction in conventional measures of market correlation, within and across asset classes. Over the past six months (Figure 2), correlations remain elevated, but have recently declined materially.

Michael Gavin


Guillermo Felices +44 (0)20 3555 2533 [email protected]

Michael Gapen +1 212 526 8536

[email protected] Sreekala Kochugovindan

+44 (0)20 7773 2234 sreekala.kochugovindan@ barclays.com

US equities look uncharacteristically out of sync with the positive tone in world financial markets


13 December 2012 10

FIGURE 3 Q4 was another good quarter for risky, and also for safe-haven, assets

QTD YTD

Equity market returns (MSCI) Advanced markets 0.5% 15.3%

US -1.8% 16.6% Other advanced markets 3.2% 14.0% Euro zone 7.6% 24.3% UK 2.3% 11.7% Japan 1.3% 3.8% Emerging markets 2.1% 14.7% Asia 3.4% 18.4% EMEA 2.1% 14.7% Latin America -0.5% 3.8%

Government bond returns (10-year) Safe haven US 1.6% 4.1%

UK 1.2% 3.7% Japan 1.3% 3.3% Germany 2.3% 6.0% 'Peripheral' Eurozone

Italy 8.0% 26.9% Spain 8.3% 1.7%

Global credit returns (Barclays indexes) Global investment grade - corporate 1.4% 10.6%

Global high yield - corporate 3.2% 17.4% Emerging markets (USD) 2.6% 17.2% Source: Barclays Research

FIGURE 4 Cross-asset correlations remain high, but have recently declined materially

30

35

40

45

50

55

60

65

70

00 01 02 03 04 05 06 07 08 09 10 11 12

First principal component

% Percent of variance explained by:

Note: Rolling six-month correlation of daily returns of equity returns in advanced economies, emerging market equities, commodity prices, FX, US corporate bonds, US Treasuries, and global government bonds. Source: Barclays Research

This market ‘decoupling’ has happened before, and been reversed, which highlights the danger of extrapolating a few months of market behaviour into the future. But in this case, we think reduced correlations reflect a reduction in the perceived ‘tail risks’ of a global economic or financial event that is likely to carry over into 2013. If, as we consider likely, US political actors find a compromise before the economy is destabilized, we suspect that 2013 will, like


13 December 2012 11

Q4 2012, be a period in which tail risks no longer wag the market dog, which is likely to be driven to a much greater extent by medium-term valuations and expected return differentials, and by idiosyncratic market developments.

FIGURE 5 Barclays’ forecasts are little changed from Q3, and broadly in line with consensus

Real GDP (% y/y)

Barclays vs Q3 GO* vs Consensus

2013 2014 2013 2013 2014

Global 3.3 4.0 -0.2 -0.1 -0.1

Developed

1.2 1.9 -0.2 -0.1 -0.2

Emerging

5.4 6.0 -0.1 -0.2 -0.1

BRIC 6.6 6.9 -0.1 -0.3 -0.2

Americas 2.4 2.8 -0.2 0.0 -0.4

United States 2.1 2.5 0.0 0.2 -0.5

Canada

1.9 2.2 -0.3 -0.1 -0.2

Latin America 3.3 3.9 -0.7 -0.4 -0.1

Brazil 3.0 3.6 -1.1 -0.8 -0.6

Mexico 3.0 4.0 0.1 -0.5 0.5

Asia/Pacific 5.6 6.0 0.0 -0.2 -0.1

Japan

0.3 0.7 -0.6 -0.5 -0.4

Australia

2.7 2.1 -0.2 -0.1 -1.2

Emerging Asia 6.7 7.1 0.1 -0.2 0.0

China 7.9 8.1 0.3 -0.2 -0.4

Hong Kong 3.0 3.5 0.0 -0.5 -0.8

India** 6.5 7.2 -0.2 -0.1 0.8

Indonesia 6.3 6.4 0.3 0.3 -0.2

South Korea 3.3 4.0 -0.3 0.0 0.1

Taiwan 3.4 4.5 0.0 -0.1 0.1

Europe and Africa 1.1 2.1 -0.2 -0.2 0.1

Euro area

0.1 1.4 -0.3 -0.1 0.2

France 0.4 1.6 -0.2 0.2 0.5

Germany 1.2 1.8 -0.2 0.4 0.4

Italy -0.8 1.0 -0.4 -0.1 0.5

Spain -1.5 0.8 0.3 0.1 -0.2

United Kingdom 1.3 2.2 -0.1 0.0 0.0

EM Europe & Africa 2.8 3.4 -0.2 -0.3 -0.2

Poland 1.0 2.8 -0.6 -1.0 0.1

Russia 3.3 3.5 -0.3 -0.2 -0.4

Turkey 4.2 4.7 0.5 0.2 0.7

South Africa 2.8 3.5 -0.2 -0.1 -0.3 Source: Barclays Research * Forecasts on 25 September 2012 ** Consensus forecasts for India are for FY. Consensus forecasts are of Nov 12

The economic outlook – What you see is what you get The economic backdrop, as we see it, is largely marked by continuity. Barclays research analysts are forecasting a very modest acceleration of growth in 2013, from 3.1% in 2012 to 3.3% in 2013, mainly driven by a modest acceleration in emerging market economies. This is very slightly below our previous (September) forecast for 2013 and very slightly below consensus forecasts. The largest revision is in Brazil, and the most market-sensitive is arguably China, where the small upward revision in 2013 GDP growth (to 7.9%) is probably more significant for what it says about the declining risks of a ‘hard landing’ than for the numerical forecast revision itself.


13 December 2012 12

Key economic tail risks fading in market salience If economics have been driving markets, it is not mainly because of big reassessments of the base case, but rather because of the fading significance of perceived tail risks to the baseline forecast of a lacklustre but reasonably steady rate of economic and financial recuperation. Although markets remain preoccupied with fiscal politics in the US, perceived risks from Europe and China have faded significantly over the course of 2012. It is not inconceivable that market concerns about either story could emerge again in 2013. But for the first half of 2013, at least, this does not seem likely.

Europe – A more convincing game plan Economic, financial, and political adjustments in Europe are not complete. But the risks that posed an imminent threat to the integrity of the eurozone in 2012 (and thereby to global financial stability) were addressed by forceful action by the ECB. The Spanish economic and financial crisis could still go poorly, and Italian politics could result in enough backsliding in the policy framework to reawaken market doubts about sustainability. Resolution of the Greek debt overhang remains a work in progress, and the program may become a focus of market attention later in 2013. But, in our view, the strategy to strengthen the eurozone and overcome the crisis is broadly sound and, more to the point, the ECB has made clear its intention to support stressed sovereigns with its potentially unlimited balance sheet, in order to prevent an unravelling of the eurozone. As long as commitment of the major political actors in ‘core’ and ‘peripheral’ Europe to the monetary status quo remains strong, the implied threat of a firm ECB response is likely to prevent market downdrafts of the magnitude experienced in 2012, and the best response to such ‘attacks’ is likely to be to fade them.

China – Fears of a ‘hard landing’ fade In China, reasonably widespread anxiety about the threat of a globally disruptive ‘hard landing’ has been replaced with a comparatively firm expectation that the next phase of Chinese expansion is under way, but likely to be far less explosive than the post-recovery rebound. Looking far enough into the future, it seems probable that concern about Chinese economic activity will re-emerge. China is a manufacturing economy, with large structural imbalances that will need eventually to be addressed if the country is to move on to the next phase of the development process. The importance of the very cyclical property and construction sectors is unlikely to fade quickly, and the economy is likely to remain exposed to fluctuations in global trade flows. Policymakers have at their disposal powerful but in some ways blunt policy tools that will need to be refined as part of the long-term reform agenda. In light of all this, it would be surprising indeed if China did not face the occasional threat of a cyclical downturn. But with recent signs of stabilization of the property sector in China, of relatively resilient labor markets and household spending, and some support from public infrastructure spending, we suspect that concerns about such a ‘hard landing’ are likely to remain limited in the first half of 2013.

US fiscal politics – Still unresolved but unlikely to result in disaster As 2013 approaches, political negotiations to resolve the ‘fiscal cliff’ are still ongoing. Involving as they do an important element of brinksmanship, there is some possibility that the eventual resolution will be preceded by an outbreak of market anxiety that has so far been almost entirely absent, confined to a period of fairly modest underperformance of US equities. Given the equanimity with which investors have so far been approaching the event (only 15% of respondents to Barclays December Global Macro Survey felt that the fiscal cliff ‘is likely to result in a significantly heavier drag on US domestic demand than is generally expected’), it is somewhat tempting to fade the market’s sense of confidence and seek hedges against an outbreak of anxiety about a destabilizing fiscal event in 2013.

The eventual resolution of the fiscal cliff could be preceded by an outbreak of market anxiety that has so far been almost entirely absent

https://live.barcap.com/go/publications/content?contentPubID=FC1886500�


13 December 2012 13

On balance, though, we think that the market’s relaxed approach to the political risks is about right. Although brinksmanship may delay resolution of the problem, it is in the interest of no relevant political force to blow up the US economy, and we do not think it will happen. We would be inclined to fade an outbreak of anxiety, and feel that our ‘barbell’ approach to asset allocation gives us enough firepower power to do so.

FIGURE 6 Limited anxiety so far about the ‘fiscal cliff’

0%

10%

20%

30%

40%

50%

60%

70%

80%

Likely to be resolvedin a way that avoidsadverse market oreconomic impact

Likely to create somemarket anxieties as

the deadline approaches,but in the end will probablybe resolved to avoid adverse

economic impact

Likely to result ina significantly heavierdrag on US domestic

demand than is generallyexpected

Source: Barclays Global Macro Survey

Reduced tail risks unlikely to trigger pronounced relief rally, but do create a more positive context for risk asset performance in 2013 The easing of perceived ‘tail risks’ from Europe and China is arguably priced into markets already, since most market participants have also ratcheted down their assessment of the risks. In December, fewer than 10% of the respondents to Barclays’ Global Macro Survey thought China was in the midst of a ‘hard landing’ that would require a more forceful policy response. Only a tiny minority believe that any country other than Greece will depart the eurozone in the next 12 months, and fewer than 20% of respondents now believe that Greece will leave the euro area.

FIGURE 7 Fears of a Chinese ‘hard landing’ have faded…

FIGURE 8 … along with concerns of an imminent breakup of the euro

0%

10%

20%

30%

40%

50%

60%

Is close to the bottom of the

cycle…

Will not show convincing signs of a cyclical rebound for at least several

more months

Is in the midst of a 'hard landing' …

0%10%20%30%40%50%60%70%80%

No Yes: just Greece

Yes: Greece

+ Portugal

Yes: including Greece

+ Portugal + Spain

Yes: including Greece,

Portugal, Spain and

Italy

Yes: One or more northern euro area countries will break

away Source: Barclays Global Macro Survey Source: Barclays Global Macro Survey




13 December 2012 14

Japan: Not a “head fake”, but not the “big one” either If there is a major economy in which there exists the potential for a substantial break from the status quo, it is Japan, where upcoming elections hold the potential for a meaningful shift in the economic policy framework. Conventional wisdom ranks Japan as having lost the post-crisis ‘currency war’, condemned by cautious monetary policy and the acceptance of deflation and stagnation. According to this view, a marked easing of monetary policy would seem to be in order given the stability of the equilibrium in which policymakers find themselves. As St. Louis Fed President James Bullard outlined in Seven Faces of “The Peril”, traditional interest rate policy at the zero lower bound needs to be complemented by credible quantitative easing, and the failure of the BoJ to fully reverse the deflationary process is due to the premature withdrawal of stimulus. Figure 7 plots the monthly outcome of inflation and interest rates in the US and Japan since 2002. The US came close to sliding into a Japan-style outcome, but committed to doing “whatever it takes” to avoid further disinflation. Creating the regime shift in Japan – and the “big bang” that many investors believe Japan needs – would require a level of commitment to alter policy that has so far been elusive.

Arguing against the view are optical illusions associated with two kinds of shrinkage in Japan. First is deflation, which distorts international competitiveness and contributes to a stronger yen (Figure 8). However, domestic costs have been falling, offsetting the effect of a stronger yen on competitiveness and contributing to a real exchange rate that is far from stretched by historical standards. The second illusion relates to the shrinkage of the Japanese workforce. Failure to account for this can distort broad economic comparisons with countries where the workforce is not shrinking. For example, Japan has outperformed the US in terms of real GDP per working age-person since 2000, a marked shift from the underperformance during the 1990s.1 This is not to say that monetary policy should not be more accommodative, but it can speak to the magnitude of any needed policy change.

So where does this leave us? It leaves us thinking that policy in Japan is moving in the right direction, but we have yet to see enough to change our view. Our research team in Tokyo argues that a radical shift in policy is not to be expected, although steps to reinforce the longstanding 2% ‘eventual’ target for inflation may be forthcoming.2 In light of this, we believe investors should expect an evolutionary, rather than a revolutionary, change in

1 For more on this, see What’s the difference between Japan and the US, 31 August 2011 2 BOJ and political pressure: Seven Proposals, necessity of legal changes, feasibility, 20 November 2012 and Japan outlook: Policy mix in the political mix, Global Economics Weekly, 23 November 2012.

Upcoming elections in Japan hold the potential for a meaningful shift in the economic policy framework

FIGURE 9 Interest rates and inflation in Japan and the US

FIGURE 10 JPY has not appreciated much in real terms

0

1

2

3

4

5

6

-2.0 -1.0 0.0 1.0 2.0 3.0

Japan

US

Core inflation (y/y% chg)

Nominal policy rate (%)

60

70

80

90

100

110

120

130

140

150

160

60

70

80

90

100

110

120

94 96 98 00 02 04 06 08 10 12

JPY: NEER JPY: REER

month avg., 2010=100

Source: OECD, Barclays Research

Source: BIS, Barclays Research

http://research.stlouisfed.org/econ/bullard/pdf/SevenFacesFinalJul28.pdf�






13 December 2012 15

monetary policy, which is likely to have a more subtle effect on economic performance than proponents of a more inflationary policy stance might expect. Our FX strategists look for a one-off impact on the JPY of about 10%, taking the currency to 88 in six months. This, combined with the potential for entrenched deflationary expectations and QE to keep JGB bond rates low, and our economic team’s forecast for a return to modest growth in Q1 of next year, suggests Japanese equities could also see continued momentum. Altogether, developments on the policy front in Japan coincide with our recommendations to remain constructively engaged in risk assets and to overweight developed market equities.

Financial backdrop – Elements of continuity On balance, then, the economic backdrop now seems unlikely to catalyze a major shift in market tone in the months to come. Our baseline forecast for 2013 is similar in its essentials to 2012, to our previous forecasts, and to published consensus forecasts. We see a substantial reduction in ‘tail risks’ around the baseline, but this too is consistent with widespread and seemingly firmly-held consensus views, and is therefore unlikely to trigger a relief rally in the months to come.

We see important elements of continuity in the financial landscape as well. These include:

• Rock-bottom policy rates, with a strong commitment by the US Federal Reserve to maintain policy at its extraordinarily easy setting for years to come. Globally, investors have come to anticipate a powerful monetary ‘policy put’ that provides at least limited insulation from adverse economic news. And extraordinarily lax monetary policy in key reserve currencies has become global, as central banks in other countries ease defensively, to counteract pressures for currency appreciations.

• A chronic shortage of safe assets that is unlikely to ease materially for the foreseeable future.

• Resulting sky-high prices of safe (and nearly safe) assets, which sets the stage for very low returns on fixed income going forward, including a very high probability of strongly negative inflation-adjusted returns on the safest bonds for years to come. In contrast, equity valuations are far from distressed, but generally remain within historically normal ranges, supporting the case for something like historically normal equity returns over the medium term, and strong outperformance by equities of extremely expensive ‘safe’ bonds.

We see a substantial reduction in ‘tail risks’ around the baseline, but this is unlikely to trigger a relief rally in the months to come

FIGURE 11 safe-haven real bond yields have become even more negative

FIGURE 12 Equity PE ratios remain at historically normal levels

-1.5-1.0-0.50.00.51.01.52.02.53.03.54.0

Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11

10-year US TIPs 10x10y forward

0

5

10

15

20

25

30

35

40

45

Jan-00 Mar-02 May-04 Jun-06 Aug-08 Oct-10 Nov-12

Advanced markets Emerging markets Source: Bloomberg, Barclays Research Source: MSCI


13 December 2012 16

• Although perceived risks have declined, and investors perceive equities as fairly valued, positioning remains cautious. According to the most recent Barclays Global Macro Survey, only 10% of survey respondents characterized their positions as ‘large’ or ‘at limit’, a smaller fraction than in the September survey.

FIGURE 13 How would you characterize the size of positions you are currently running?

0%

10%

20%

30%

40%

50%

60%

Very light Light Average Large At limit

Nov 11 Mar 12 Jun 12 Sep 12 Dec 12

Source: Barclays Global Macro Survey

These are very familiar elements of the financial backdrop, and we feel no need to elaborate on what we have already written. But it is important to bear these market drivers in mind as we contemplate a historical inflection point in global asset markets that has not received the attention that we think it deserves: the approaching end of a 30-year bull market in bonds.

End of the road for bonds? Equity booms and busts make the headlines, but it seems to us that the 30-year old boom in fixed income has in many ways been as consequential as the sharper, more visible, and occasionally more disruptive swings in equity markets that investors have endured during the same period. The boom began as a positive response to the great inflation stabilizations undertaken in the US and the UK in the early 1980s. But in recent years it has gathered momentum, in response to investors’ revulsion against equity-market volatility, unprecedentedly easy monetary policy, an acute shortage of safe-haven assets and, perhaps, an element of complacency about the outlook for returns that would be natural after such a long history of positive returns. As it has matured, the bond-market boom has become a truly global event, spreading to countries whose initial economic conditions were not as disorderly as in the US and UK in the late 1970s.

An investor who maintained an exposure to US or UK 10-year government bonds since the early 1980s would have earned equity-like real returns of about 5% per year, and during the 30 years would have multiplied the portfolio’s value by a factor of 6-7 times, again after adjustment for inflation. Who needs equity markets, when ‘safe’ assets are providing returns like these?

An investor who maintained an exposure to US or UK 10-year government bonds since the early 1980s would have earned equity-like real returns of about 5% per year




13 December 2012 17

FIGURE 14 The great boom in US bonds: Inflation-adjusted total return on 10-year US Treasury bonds, and illustrative scenarios

FIGURE 15 The great boom in UK bonds: Inflation-adjusted total return on 10-year UK gilts, and illustrative scenarios

0

100

200

300

400

500

600

Jan-62 Jan-71 Jan-80 Jan-89 Jan-98 Jan-07 Jan-16

History Optimistic Less optimistic

0

100

200

300

400

500

600

700

800

Jan-57 Mar-67 May-77 Jul-87 Aug-97 Oct-07 Dec-17

History Optimistic Less optimistic

Source: Barclays Research Source: Barclays Research

It does not require advanced market math to understand that returns like this are no longer remotely plausible. But they say that fish don’t know that they live in the water (until they are removed from it), and we wonder if some of the many market participants whose entire professional experience has been conditioned by the financial backdrop created by the bond-market rally might underestimate some consequences of its termination.

FIGURE 16 Annualized inflation-adjusted returns on 10-year government bonds

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

5-year 10-year 30-year

US UK Source: Barclays research

We are, in all likelihood, about to find out. Even under the optimistic assumption that bond yields remain constant for the next five years (and that investors earn the current coupon in each of the coming five years), bonds will be transformed into wealth destroyers. (This is the ‘optimistic’ assumption in Figures 12 and 13, above, which also assumes that US inflation averages 2.25% in the US and 2.5% in the UK.) In the more likely case that yields drift higher in the coming half decade, they will destroy wealth even more effectively. (Figures 12 and 13 also illustrate the effects of a rise of about 85bp in 10y yields over the next 5 years.) Unless the economic environment looks meaningfully more deflationary than now seems likely, 30 years of boom will give way to a bear market.

30 years of boom markets for government bonds will give way to a bear market


13 December 2012 18

Does it matter? Low interest rates are old news, but so far investors have been rescued from the consequences of low interest rates by further declines to even lower levels, and some investors may alter habits and mind sets created by the long boom only after the bear market becomes a fact. At the very least, the eventual end of the boom creates additional support for our view that equities remain a better option than bonds in the years to come.

Asset allocation and top trades

Overview – Maintain the ‘barbell’ approach to managing portfolio risk, continue to move out the risk curve With the economic and financial backdrop largely in line with that of September, we have made modest changes in our asset allocation recommendations. The dominant theme remains to move out the risk curve, and in particular to continue to position for equity-market outperformance. We continue recommend a ‘barbell’ approach to portfolio risk management, holding a neutral position in safe-haven fixed income for risk mitigation, while maintaining an underweight allocation to high-grade credit.

A final theme is to position for somewhat less correlated asset markets, as the reduction in economic and financial tail risks reduces the intensity of the ‘risk-on/risk-off’ market dynamic. This should restore the importance of asset-selection within asset classes, and some value to diversification in an asset-allocation context.

FIGURE 17 Overview of asset allocation recommendations

Asset class Current Previous (Sept. 25)

Comments

Developed market equities Overweight Overweight Valuation gap between risky and safe assets

US Overweight Overweight Resolution of fiscal cliff likely, recovery weak but not fragile

UK Overweight Overweight

Europe Overweight Neutral Reduced tail risk, valuation gap relative to US

Spain Overweight Overweight Deep value, further policy progress, ECB backstop via OMT

Japan Neutral Neutral Upside risk from potentially more aggressive policy easing

Emerging market equities Neutral Neutral Some expensive, cyclical vulnerability in Asia

Brazil Overweight Overweight Valuation remains compelling, some comfort on FX

South Africa Neutral Overweight Returned 6.2% since September 25

Global government bonds Neutral Overweight

Safe-havens Neutral Overweight Negative beta with global equities

Peripheral Europe Neutral Underweight Further policy progress

EM sovereign credit Overweight Underweight Prefer EM credit exposure over EM equity

Brazil Overweight N/A More policy easing. Favor nominals and inflation-linked

Russia Overweight N/A Bond market reform, high yields, strong currency

Global credit Underweight Underweight

Investment grade Underweight Underweight Rich valuation, favor financials over industrials

High yield Overweight Neutral More upside than in investment grade

US MBS Neutral Overweight US housing recovery, but valuations becoming full

Commodities Neutral Neutral Continued weak growth

Gold Overweight N/A Long gold/yen from global central bank easing.

Source: Barclays Research


13 December 2012 19

Equities The underperformance of US equities during Q4 has diminished the valuation gap between US and European equities, but it remains substantial, and we do not expect investors’ attention to US fiscal politics to disappear entirely, even in the likely event that a deal is reached to avoid a destabilizing fiscal event early in 2013. The case for US equity outperformance seems less compelling to us than it would be in a more defensive financial context. We therefore balance our overweight position in US equities with a move from neutral to overweight European equities, while retaining our previous overweight positions in UK and Spanish markets.

A decidedly looser monetary policy in Japan would likely be equity-supportive. But equities in Japan are not particularly cheap in an international context, and the outlook for growth is not outstanding. We prefer to position for a potential shift in monetary policy in the currency, leaving our neutral allocation to Japanese equities unchanged.

Our stance toward emerging market equities is largely unchanged from last quarter, although valuations have continued to become more compelling. We do not expect EM equities to become a market theme, not because the asset class is fundamentally challenged, but because it is so diverse in its valuations, and economic circumstances. Although it has been a tough trade and the news flow has recently been poor, Brazil continues to look inexpensive to us. With a dividend rate now solidly higher than real interest rates in the country, investors are paid to wait for other investors to shed their pessimism about what is an unspectacular, but nevertheless solid growth story.

Government bonds We believe that the secular boom in safe-haven bonds is reaching an end of the road, but we do not think the road terminates in a cliff or a brick wall. Investors will likely earn negative real returns on safe-haven bonds, but we do not expect a collapse in bond values, and investors will receive mark-to-market portfolio insurance as compensation for the negative real returns. Our increased allocation to equities comes at the expense of the allocation to safe-haven bonds, which we move from overweight to neutral, and is motivated by the same perception that 2013 is likely to be a year in which investors continue to move out the risk curve.

Although we think that the upside in southern European equity markets is considerably higher than in bond markets, the reduction in tail risks to the immediate integrity of the eurozone justifies, in our view, an increase in our recommended allocation to Italian and Spanish government bonds from underweight to neutral. The Q4 rally reduced the scope for additional outperformance, and the upcoming elections in Italy pose event risk to the market, even if they are unlikely to result in a market downdraft comparable to mid-2012. Investors may, therefore, want to scale into these positions somewhat opportunistically, and with a sharp eye on the evolution of the underlying economic and political risks.

EM local bonds delivered solid returns, with the Barclays benchmark index up 13.8% on an FX-unhedged basis and 6.8% hedged. Despite last year’s high returns, 2013 we still find EM yields attractive. Nominal EM bonds are likely to benefit from declining inflation, a benign supply outlook and some further monetary easing. We expect Brazil, India, and Poland to deliver more cuts than what are priced into local curves, which should naturally pull down nominal yields. One of the consequences of QE3 and the ECB’s actions in 2012 was a sharp drop in global real yields to low levels, by historical standards (with EM real yields falling to about 1%). This naturally means that a further fall in nominal will necessitate a fall in inflation expectations, taking some of the shine from EM linkers. However, we are not bearish EM linkers across the board. Brazilian real yields stand out as the highest in EM and we expect them to compress in the next few quarters, given the country’s likely interest rate cuts and long-term growth challenges. In cash space, we favour Russian (OFZ) bonds given the attractive FX outlook and the prospect for bond-market liberalisation.

The case for US equity outperformance seems less compelling to us than it would be in a more defensive financial context

Our increased allocation to equities comes at the expense of the allocation to safe-haven bonds


13 December 2012 20

Credit As was the case in the September outlook, we think the additional spread offered by global credit is insufficient to fully compensate for the lack of liquidity, particularly in the investment grade category. Consequently, we maintain our underweight position to accommodate our overweight position in equities. The safest parts of the global credit market have rallied the most in recent quarters and those investors wishing to move out the risk spectrum have to believe in the dicier parts of the asset class. For those looking for value within the investment grade category, we suggest either moving down the credit spectrum to BBB-rated credits or looking to US financials as offering more room for spread compression relative to the remainder of the investment grade class. The improvement in bank balance sheets and higher capital ratios, along with the fact that debt of the large financials is shrinking as a percent of the total asset class, are factors that support our view that financials have a more solid investment thesis at this stage.

In our previous recommendations, we steered investors to the US mortgage market, where housing has been in a solid recovery phase for much of 2012, rather than move down into riskier parts of the corporate credit market. The view of our economics team is that the recovery in housing is expected to continue through 2013 and the sector should prove more resilient to any adverse outcome on the fiscal cliff given that the level of single-family housing activity as a share of GDP is still well below that seen at any point in the past 50 years. However, a recovery in US housing is now a widely held view and most parts of the asset class are fully priced, in our opinion. Therefore, we reduce our position to market neutral from overweight. This is not to say that the asset class cannot deliver reasonable performance, but that further outperformance of the sector relative to heightened expectations would be needed to justify maintaining our overweight. If the US economy takes a significant step back in the early part of next year and housing-related assets move lower in sympathy, we may have a different view, but not at current levels.

This leaves us with the high yield segment of the global credit market, where the illiquidity of the market continues to tell us that investors need to be fully comfortable holding positions they acquire. A constructive view on the high yield segment of the market requires the conviction that the current policy backdrop can keep financial market conditions – and therefore default rates – from worsening significantly in a weaker growth environment. Actions by the Federal Reserve in recent months and the extent of pre-financing by many individual names in the asset class, as far out to 2016 in some cases, suggest to us that a constructive view of the sector is justified. We therefore move high yield credit to overweight from neutral. Like equities, we see this segment of the credit market as offering a more compelling risk-return thesis.

FX Despite a weak growth environment in G10, central bank actions are likely to lead to meaningful currency moves in developed FX markets. In Japan, we expect an LDP led government to give the BoJ a stronger mandate for targeting higher inflation. As a result, we think the yen is likely to experience a large depreciation vs. the USD. Major European currencies, such as the EUR and GBP, should also outperform the JPY. However, we expect these currencies to face the headwinds of a weaker euro area growth outlook than in the US. In particular, we see further downside to EUR/USD in 2013 as we think the ECB will be forced to ease policy while the Fed may start tapering off its asset purchases.

As the fiscal cliff concerns alleviate, we expect the outlook for risky currencies to improve and we look forward to funding such positions with JPY and EUR. As in other asset classes, we expect relative performance to be driven more by idiosyncratic factors, such as the authorities’ tolerance of appreciation, valuation and carry. The likes of MXN, ZAR, RUB and MYR will benefit from one or more of these factors setting them to outperform other cyclical currencies in the supportive risk environment that we anticipate for 2013. In addition, stretched valuations from abnormal conditions should begin reverting in 2013, highlighting vulnerabilities in currencies such as the AUD for the medium term.

US financials offer more room for spread compression relative to the remainder of the investment grade class

A recovery in US housing is now a widely held view and most parts of the asset class are fully priced

We see this high yield segment of the credit market as offering a more compelling risk-return

We see further downside to EUR/USD in 2013 as we think the ECB will be forced to ease policy while the Fed may start tapering off its asset purchases


13 December 2012 21

Commodities In light of the continued tepid outlook for global growth, we also expect various commodity complexes to be driven more by idiosyncratic factors than by swings in global risk appetite. Our commodities strategists are cautious on the overall direction across the asset class. But they highlight upside risks in oil and grains prices given the backdrop of exceptionally low inventory/spare capacity and the high level of geopolitical/weather risk that these markets are facing early next year. The outlook for base metals, however, is more challenging given the rebalancing of Chinese growth toward consumption and relatively weak fundamentals in major markets, such as copper (where Chinese inventories remain very high) and aluminium. Our highest conviction view in commodities remains gold. The yellow metal has fallen off the radar recently, but we believe the prospect of easier monetary policy in the G10 should lead to potentially large moves in 2013.

Top trades In our last quarter’s Global Outlook top trades section, we recommended that investors increase their long equity exposure in the US, while keeping an overweight exposure to safe havens for insurance purposes. We also advocated an extension of risk in other asset classes, such as EM corporate credit and EM FX (MXN, ZAR, RUB and INR), where we saw appreciation tolerance, and attractive valuations and carry. We also suggested inflation protection in the face of global monetary stimulus via inflation linkers in Poland, Turkey and Brazil, where real rates were relatively high, and via US 2y2y inflation breakevens.

Most of these positions still offer value, in our view. Given that our views on risk extension are broadly unchanged, we retain most of these recommendations and are only making minor adjustments to them. EM linkers in Poland and Turkey have returned more than 10% since last quarter, so we elect to take profits and to keep the Brazilian linkers. US 2y2y breakevens have been relatively stable over the past quarter. We keep this trade in order to position for medium-term inflationary risks. We remain constructive on the EM carry currencies that we picked last quarter, but we replace INR for MYR, where we see compelling reasons for appreciation as a result of likely portfolio inflows into the local bond market, and privatization-related flows after the election.

FIGURE 18 Top trade performance Q4 2012

Entry date Open Current P&L Rationale

Equity Long iShares S&P 500 ETF (total return)

25 Sep 144.76 143.13 -1.13% The combination of political event risks and extraordinary support from G10 central banks supports a barbell strategy in risk. Long UST and long US equities

Fixed income

Long UST 1.625% 15 August 2022 (total return)

25 Sep 99.00 100.31 1.32%

2y2y US Breakeven inflation 25 Sep 217bp 224bp 0.14% We recommend that investors position for medium-term inflationary risks given the extent of global monetary stimulus. US 2y2y breakevens appear complacent to inflation risks over the 2- to 4-year horizon. EM inflation-linked bonds provide positive real yields, face longer term inflationary pressures and we expect continued yield compression as investor flows remain strong.

Long Polish Aug 2023 linker (total return)

25 Sep 119.72 131.89 10.16%

Long Turkish Feb 2022 linker (total return)

25 Sep 112.13 127.28 13.51%

Long Brazil Aug 2014 NTN -B (total return)

25 Sep 162.65 168.59 3.65%

FX Long MXN/USD (spot) 25 Sep 12.84 12.82 0.18% MXN should benefit from a hands-off central bank and any support US growth receives from loose monetary policy.

Long EM Basket (Long ZAR, INR, RUB short USD, JPY, CHF) (3m forward ending 27 Dec 12)

25 Sep 1.03% We select cyclical EM currencies that offer a combination of carry and attractive valuations.


We expect various commodity complexes to be driven more by idiosyncratic factors than by swings in global risk appetite



13 December 2012 22

Stay long risk with some exposure to safe havens… We continue to recommend buying a ‘barbell’ in US risk comprising the S&P500 and the UST 10-year in equal weights to provide mark-to-market insurance. This trade is up only marginally since inception in our previous Global Outlook. It was hit by the negative performance of US equities, but the strategy served its purpose with the fixed income leg making money. Given the lower volatility of USTs and their smaller (than one) beta to world equity risk, an equally weighted notional position is effectively long equity risk. We maintain this position as it is consistent with our risk extension theme.

Stay long Spanish equities. We believe Spain is still a secular buying opportunity. Despite a rally of more than 30% since the mid-2012 lows, the IBEX remains 35% below its post-financial crisis peak in early 2010. Valuation indicators still look cheap, with a cyclically-adjusted dividend yield greater than 5%. These high dividend yields discount such an extreme risk premium that future trends in dividend payments become a less relevant driver of positive returns. The key catalyst for this call is a reduction in euro area uncertainty driven by a combination of the ECB OMT programme; progress toward European integration; and ongoing domestic structural reforms. Italian equities also have a very high dividend yield (Figure 17). However, we prefer to avoid the large swings that are likely ahead of the general elections in early 2013.

FIGURE 19 Spanish equity valuations remain attractive

0

1

2

3

4

5

6

7

8

9

10

1976 1981 1986 1991 1996 2001 2006 2011

UK: Cyclically Adjusted Dividend YieldGermany: Cyclically Adjusted Dividend YieldFrance: Cyclically Adjusted Dividend YieldItaly: Cyclically Adjusted Dividend YieldSpain: Cyclically Adjusted Dividend YieldSecular buying opportunities (CADY>5%)Long-term median CADY since 1909

Source: Datastream, Barclays Research

Buy EM local bonds selectively. We also recommend extending risk by buying EM local bonds selectively. We think the Russian bond market offers an attractive pocket of value. In particular, we favour OFZ Apr’21, which offers close to 7%. The curve is upward-sloping and the hiking cycle in Russia is nearly over. Furthermore, in January, the government is seeking to liberalise the local bond market where foreign ownership is currently very low (10%). Steady progress has been made in terms of allowing bonds to be cleared through Euroclear. Our bullish view on the currency is backed largely by our constructive outlook for oil prices, which also makes this trade attractive.


13 December 2012 23

FIGURE 20 Foreign holdings of OFZ are still low

FIGURE 21 OFZ yields are very attractive

0%

10%

20%

30%

40%

50%H

unga

ry

Mal

aysi

a

Pola

nd

Mex

ico

Indo

nesi

a

Turk

ey

Kore

a

Thai

land

Russ

ia

Sep-12

3

4

5

6

7

8

9

10

Nov-09 May-10 Nov-10 May-11 Oct-11 Apr-12 Oct-12

Russia EM LC bonds (Barclays Index)

% yield


…with some inflation protection

We continue to favour inflation linkers in Brazil (NTN-Bs Aug 14). Real yields remain high (3.4%) and we see further scope for them to compress in the next quarters. The challenging growth outlook for Brazil means we expect another 100bp cut in the Selic rate in Q1 2013. This should be supportive of both real and nominal (eg, NTN-F Jan’14) bonds.

We continue to recommend buying gold/JPY. Gold is one of the few assets with currency-like characteristics that will not suffer from central bank debasement. Such a real asset should perform well in an environment where there is the potential for further monetary policy easing in large economies such as the euro area, Japan and the US. We elect to fund the gold position in JPY, our highest conviction short among the low-yielding currencies, given the prospect of significant monetary easing that would likely follow an LDP victory on 16 December.

FIGURE 22 Current real yields versus 12 month range, Brazilian rates still elevated

FIGURE 23 Gold/JPY: A decisive break above recent trend line resistance adds a bullish signal

0

1

2

3

4

5

6

7

Braz

il

Pola

nd

Isra

el

Mex

ico

Turk

ey SoF

Thai

land

Kore

a

Current

100,000

105,000

110,000

115,000

120,000

125,000

130,000

135,000

140,000

145,000

150,000

Nov-10 Mar-11 Jul-11 Nov-11 Mar-12 Jul-12 Nov-12

Gold/JPY Source: Barclays Research Source: Barclays Research


13 December 2012 24

Position for lower correlations across some asset classes European equities and EUR/USD to diverge as ECB easing supports risk taking. One of our main calls in Europe is that the actions by the ECB will help reduce tail risks and support risk appetite in the euro area. We expect the ECB to ease monetary policy further by cutting the refi rate in Q1 2013 and potentially embarking on further unconventional easing. In addition, we expect the OMT programme to be activated by Spain requesting aid. Further ECB easing should also imply a weaker EUR/USD provided we see no significant shifts in the Fed’s stance, as we expect, next year. ECB easing has recently led to a weaker EUR versus the USD and higher European equities (Figure 22). We believe this pattern should become more evident in 2013. Currently, however, the options market is pricing in a positive correlation between EUR/USD and Euro stoxx 50 (SX5E), presenting opportunities to express the view that those correlations should drop. For example, an options structure such as a 6m dual digital with Euro stoxx 50 rising above 2700 and EUR/USD falling below 1.25, costs around 12%. This cheapens significantly the vanilla digitals, which cost close to 40% for SX5E and 25% for EUR/USD.

FIGURE 24 Recent ECB easing has led to temporary divergence between and Eurostoxx 50 and EURUSD, we expect more to come.

1.18

1.23

1.28

1.33

1.38

1.43

1,800

1,900

2,000

2,100

2,200

2,300

2,400

2,500

2,600

2,700

2,800

Oct-11 Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12

"Euro stoxx 50" "EURUSD"

ECB rate cut



13 December 2012 25

ECONOMIC OUTLOOK

Overcoming austerity • The advanced economies have been beset by private and then public sector austerity,

but we think that by 2014 these headwinds will abate, permitting activity to pick up in response to ongoing monetary accommodation.

• The US is relatively advanced in private sector balance sheet adjustment; housing and labour markets are gaining traction, which should overcome the fiscal headwind. Confidence in the euro area should recover in response to a raft of policy measures.

• Emerging economies have much better growth prospects than those for advanced economies. They are likely to continue contributing positively to global demand expansion, via incremental fiscal stimulus and monetary easing.

Global economics summary: Monetary policy gains traction Compared with a quarter ago, the Barclays projection for global GDP growth in 2013 has been trimmed further, down to 3.3% from 3.5%, while our 2012 estimate is unchanged at 3.1%. We still expect a sharp divide to persist between the advanced and emerging economies: we look for the former to grow about 1¼% in 2012 and 2013, and the latter to grow 5.4% next year, compared with 5.0% this year.

In 2014, we look for a firmer pace of expansion, as the headwinds resulting from private sector de-leveraging and fiscal consolidation begin to fade at the OECD level and as central banks’ highly expansive monetary policies begin to gain traction. This process should be assisted by solid progress to restore high capital ratios on banks’ balance sheets, and a further appreciable reduction in the euro area headwinds to global and European confidence in response to economic adjustments in the problem countries and governance changes, including further moves towards a collectivisation of euro area government liabilities from 2014.

Julian Callow

+44 (0)20 7773 1369 [email protected]

Yiping Huang +852 2903 3291 [email protected]

Dean Maki +1 212 526 1731 [email protected]

Global growth for 2013 projected at 3.3%, after about 3% in 2012

By 2014, it is likely that highly expansive monetary policies gain more traction, as headwinds related to fiscal, de-leveraging and confidence effects begin to fade

FIGURE 1 Global business confidence shows signs of turning around

FIGURE 2 Our global GDP indicator stabilizes, albeit at a weak level

-5

-4

-3

-2

-1

0

1

2

98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Global business confidenceManufacturing confidenceServices confidence

normalized diffusion index, 3mma

signs of stabilisation

-7

-5

-3

-1

1

3

5

7

98 00 02 04 06 08 10 12 14

Global GDP*

Global GDP indicator*

Barclays global GDP forecasts (to Q4 2014)

% q/q saar

* Barclays aggregate

Q4 estimate based on Nov. GDP indicator

Source: Barclays Research, using data from Markit (PMIs), ISM, NBS (China) Source: Barclays Research, using data from Markit (PMIs), ISM, NBS (China)


13 December 2012 26

Global business confidence has begun to turn the corner (Figure 1), and this has fed through into our global GDP indicator (Figure 2). Nonetheless, the weak level of our global GDP indicator still points to some risk of downside surprises emerging in global GDP during Q4 and Q1. Such risks would, in our view, be more likely to materialise in Europe. The very strong degree of global monetary stimulus is apparent in terms of ultra-low real forward interest rates in the US, Japan, Britain and Germany, as well as in record rates of corporate debt issuance in recent months at the global level (led by firms in North America and in EM markets). Additionally, there is tentative evidence of some stabilisation in global money aggregates, which in turn could be an early indication of a turning point in global nominal GDP (Figure 3).

The main headwind confronting the global economy in 2013 is ongoing fiscal austerity, as is apparent in Figure 4. The US general government deficit/GDP ratio in 2012 is likely to be about 8.5% of GDP; while down from 10.2% in 2011, this is still wide. For the euro area, the fiscal deficit this year, in contrast, is likely to be about 3% of GDP, down from 4.2% in 2011, helped by a balanced German budget and further progress in deficit reduction across the remaining countries. Whereas fiscal consolidation – defined in terms of the change in the structural budget balance – has been particularly intensive during 2012 in the euro area, reaching 1.2% after 0.9% in 2011, in 2013 the pace may diminish slightly, given a small degree of German loosening. That said, many other EU countries still face substantial fiscal consolidation in 2013, including France, Greece, Ireland, Italy, Portugal and Spain, which will likely act as a further substantial drag on demand.

At the same time, we look for the pace of US fiscal consolidation to pick up in 2013 to an amount greater than for the euro area – about 1.5% of GDP, from 1.0% in 2011 and 2012 – as many forms of temporary stimulus are due to expire or be only partially extended. There is considerable uncertainty, however, concerning the US fiscal situation (see the US section). In Japan, even though the general government deficit is likely to be close to 10% of GDP in 2012, we think that 2013 will still have some degree of modest fiscal stimulus, pushing the deficit ratio above 10%, before the consumption tax bites strongly in 2014, thereby depressing activity. In aggregate, at the OECD level, the fiscal headwind is likely to be over 1% of GDP in 2013.

FIGURE 3 Global monetary aggregates have shown stable growth

FIGURE 4 … but fiscal headwind is set to intensify in 2013

-3

0

3

6

9

12

15

94 96 98 00 02 04 06 08 10 12 14

Global nominal GDP

Global M1

Global M2

% y/y

nom

inal

GD

P fo

reca

st

pp 2010 2011 2012 E 2013 F 2014 FAustria 0.4 0.6 0.4 0.7 0.3Belgium 0.6 -0.3 1.0 0.5 0.2Finland -1.4 1.9 -0.5 0.4 0.6France 0.8 1.7 1.3 2.0 0.4Germany -0.9 1.2 0.5 -0.2 0.0Greece 6.0 3.3 3.9 2.2 2.1Ireland 1.7 1.6 2.3 2.1 1.8Italy 1.1 0.2 2.3 1.1 0.4NL 1.1 -0.2 0.8 1.1 0.3Portugal 0.8 2.2 2.1 1.6 1.6Spain 1.1 0.1 1.2 2.3 2.0Others ... ... ... ... ...Euro area 0.5 0.9 1.2 1.1 0.6Japan -0.5 -0.7 -0.5 -0.2 0.6Sweden 0.2 -0.7 -0.2 -0.8 0.1UK (FY) 0.6 2.1 1.6 1.2 1.3US 0.6 1.0 1.0 1.5 0.5OECD 0.4 0.8 0.9 1.1 0.6

Change in structural budget balance/GDP ratio

Source: Haver Analytics, Barclays Research Source: Barclays Research

Evidence of very accommodative global monetary conditions

Fiscal headwind in 2013 likely to intensify at the global level; it should ease in 2014

Intensified pace of fiscal consolidation in the US in 2013, then in Japan in 2014 as the consumption tax hike takes effect


13 December 2012 27

FIGURE 5 US financial conditions have loosened

FIGURE 6 Euro area financial conditions also easier

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-4

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-2

-1

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1

2

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-10

-8

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4

6

8

10

Mar-95 Mar-98 Mar-01 Mar-04 Mar-07 Mar-10 Mar-13

% q/q saar US GDP (LHS)GDP equation (LHS)US FCI (RHS)

Index

Barc

lays

GD

P fo

reca

st

-5

-4

-3

-2

-1

0

1

2

3

4

5

-12

-10

-8

-6

-4

-2

0

2

4

6

Mar-00 Mar-03 Mar-06 Mar-09 Mar-12

% q/q saar

Euro area GDP (LHS)

GDP equation (LHS)

EA FCI (RHS)

Index

Barc

lays

GD

P fo

reca

st

Source: OECD (for Financial Conditions Index (FCI)), Barclays Research. The GDP equation is a regression using the FCI and the structural fiscal balance.

Source: OECD (for Financial Conditions Index (FCI)), Barclays Research. The GDP equation is a regression using the FCI and the structural fiscal balance.

The contrast between financial and fiscal conditions is apparent in Figure 5 and Figure 6. These show a measure of financial conditions (sourced from the OECD), which has become significantly easier up to Q3, particularly for the US. The ‘GDP equation’ is a simple regression that includes financial conditions and the change in the structural fiscal balance (from Figure 4). As can be observed, the combination of loose financial conditions with a worsening fiscal headwind in the US produces a projection that growth will continue near a trend-like 2%, in line with our forecast. In contrast, the euro area GDP equation signals quicker growth than has materialised in recent quarters, which, in our view, is attributable to the negative effects on confidence arising from elevated uncertainty within the euro area. Such uncertainty has also had an appreciable effect in driving down global trade volumes, particularly imports in the euro area (Figure 7 and Figure 8): Chinese November exports to Europe fell 17% y/y; Japanese exports were down 25% y/y in October.

The combination of financial and fiscal conditions signals trend-like growth for the US and some potential for improvement in the euro area

FIGURE 7 Export volumes stagnate

FIGURE 8 Import volumes dragged down by euro area crisis

60

70

80

90

100

110

120

130

140

07 08 09 10 11 12

averageUSChinaEuro areaJapan

SA, Jan 07 = 100

Export volumes

60

70

80

90

100

110

120

130

140

07 08 09 10 11 12

Import volumes

Source: Haver Analytics, Barclays Research; Euro area Oct. reading estimated Source: Haver Analytics, Barclays Research; Euro area Oct. reading estimated


13 December 2012 28

FIGURE 9 Gross interest rate liabilities, non-financial domestic sectors

FIGURE 10 Gross interest rate liabilities, non-financial domestic sectors

100

200

300

400

93 95 97 99 01 03 05 07 09 11

IrelandPortugalGreeceSpainItalyFranceGermany

% GDP (SA)

100

200

300

400

93 95 97 99 01 03 05 07 09 11

JapanUKUSEuro area

% GDP (SA)

Source: Haver Analytics, Barclays Research; Data consolidated when available Source: Haver Analytics, Barclays Research; Data consolidated when available

On this point, and as is discussed further in the euro section, we conclude that while a gradual process of adjustment is continuing, it is still too early to declare an all-clear. In particular, even the private sector in southern Europe is deleveraging, gross economy-wide leverage has still been rising, on account of the transfer of leverage from the private to the public sector (Figure 9). Additionally, the euro area is suffering from a record degree of labour market disequilibrium, with the consequence that the jobless rate was at a record high of 11.7% in October. This is fuelled by a rapid rise in unemployment in southern Europe and, increasingly, France (where the jobless rate hit 10.7% in October). In contrast, unemployment has been declining in the United States (Figure 11) and remains low in Japan and China.

FIGURE 11 Jobless rates continue to surge in most of the euro area, but rate has fallen sharply in the US; holds steady in China (% sa)

2

3

4

5

6

7

8

9

10

11

12

13

95 97 99 01 03 05 07 09 11 13

Euro areaUSUKJapanChina (urban)

2

3

4

5

6

7

8

9

10

11

12

13

95 97 99 01 03 05 07 09 11 13

France BelgiumGermany AustriaNL

2

5

8

11

14

17

20

23

26

95 97 99 01 03 05 07 09 11 13

SpainIrelandGreecePortugalItaly

Source: Haver Analytics, Barclays Research


13 December 2012 29

FIGURE 12 Domestic demand: Diverse perspectives in mature countries

FIGURE 13 Domestic demand strengthens in most EM countries

90

100

110

120

130

140

02 03 04 05 06 07 08 09 10 11 12 13 14

USUKFranceGermanyEuro areaJapanSpainItaly

Domestic demand - Advanced economiesIndex Q1 02=100

80

120

160

200

240

280

320

02 03 04 05 06 07 08 09 10 11 12 13 14

ChinaIndiaMalaysiaRussiaTurkeyIndonesiaSouth AfricaBrazilKoreaMexico

Domestic demand - Emerging economiesIndex Q1 02=100

Source: Haver Analytics, Barclays Research Source: Haver Analytics, Barclays Research

Across advanced economies, there is a wide dispersion of growth in domestic demand. US domestic demand had already surpassed its previous peak (in Q3 07) by Q1 12, and has since advanced further; we expect this trend to be maintained. But euro area domestic demand is still 5% below its peak (Q1 08): on our projections, it is not expected to come close to that during the next three years (Figure 12). Japanese domestic demand is expected to surpass its previous peak (Q1 08) by Q2 13, but domestic demand in Italy is 10% below its peak and in Spain it is 15% below. Domestic demand in nearly all major emerging countries is already above the pre-crisis peak and on our projections is set to grow sharply further (Figure 13), supported in particular by a shift towards consumption (particularly in China) as well as infrastructure spending (such as in Brazil, India and ASEAN). Whereas large output gaps persist in advanced economies (and indeed have deepened further in southern Europe), in EM economies they are closed or positive (Figure 14).

FIGURE 14 Estimates for 2013 output gap: Emerging economies generally close to balance; negative in advanced economies

-5.4

-4.3

-3.4-2.7 -2.4 -2.2 -1.9 -1.9

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0.0 0.2 0.3 0.5

2.6

Spai

n

Italy NL

Euro

are

a

Fran

ce

US*

UK*

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Japa

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Aus

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Ger

man

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bal

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Mex

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Braz

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Russ

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i Ar.

Output gap (2013 estimates, % potential GDP)

Note: This approach applies a Hodrick Prescott filter to the GDP projections through till 2017 (except * - US and UK use Barclays estimates). Source: Barclays Research


13 December 2012 30

Even though caution must be applied concerning precise output gap estimates, nonetheless, a combination of still-sizeable output gaps (Figure 14) and weak import price inflation has helped push core inflation down below the 2% threshold in the US and euro area (particularly the latter if we exclude the effect of government measures on inflation, estimated to be adding about 0.75pp to headline inflation, Figure 15). This enables central banks to maintain a combination of near-zero interest rates and expansive balance sheet posture (Figure 17; see below for further discussion). In contrast, inflation has been stickier in emerging economies (Figure 16) but has been moderating in general. The combination of generally small deficits and positive real interest rates implies that policymakers in most emerging economies would have scope for further incremental easing during 2013 should demand be sluggish (Figure 18). Following evidence of slower growth, we expect further monetary easing in EMEA, India and Brazil, while in China the political changes are likely to be accompanied by a faster pace of infrastructure spending.

FIGURE 15 ‘Core’ inflation subdued in most advanced countries

FIGURE 16 ‘Core’ inflation stable or moderating in most EM countries

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-1

0

1

2

3

4

Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

UK (ex FATE)US core PCE (mkt.-based)Euro area 'core' (ex FATE)Euro area core HICP ex. gov't measures*Japan ex food & energy

% y/y

-10-8-6-4-202468

10121416

Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

India (ex food & energy)Turkey (ex unproc. food, alc., tob, en.)Russia (ex food & energy)Brazil (IPCA ext. core)S Africa (core, broad exclusion inc VAT)China (ex food & energy)

% y/y% y/y

Note: FATE = food, alcohol, tobacco, energy; * = Barclays estimate, using HICP ex. seas. food & energy as ‘core’. Source: Haver Analytics, Barclays Research


FIGURE 17 Central bank balance sheets (% GDP)

FIGURE 18 Room remains for easing in many EM countries

0

5

10

15

20

25

30

35

40

45

04 05 06 07 08 09 10 11 12

Bank of JapanEurosystem (% of euro area GDP)memo: Bundesbank (% German GDP)Bank of EnglandFederal Reserve System

China

India

Indon.

S Korea

HN Poland

Russia

S Africa

Turkey

Brazil

ChileColom.Mexico

Aus.

Canada

€ area

JapanUK US

-10

-8

-6

-4

-2

0

2

4

-3 -2 -1 0 1 2 3 4

Official policy rate minus core inflation*

Fisc

al b

alan

ce %

GD

P (2

012,

IMF

estim

ate)

mor

e po

tent

ial f

or fi

scal

eas

ing

more potential for lowering interest rates

Source: Haver Analytics, Barclays Research Note: * Ex food and energy (conventional measure).


Low inflation implies that central banks in advanced economies have further scope to ease policy; in most EM countries, there is scope for orthodox loosening, and discretionary fiscal stimulus should demand fall short of expectations


13 December 2012 31

United States: Moderate growth with one big risk US real GDP growth has been in line with our expectations, and our 2012 forecast (2.3%) remains the same as in September. Growth was revised down in Q2 12 (1.3% saar from 1.7%), but was stronger than we expected in Q3 12 (2.7% vs. 2.0%). A split in the economy continues to develop between the manufacturing sector, which has been weighed down by a weakening in export orders and a slowdown in domestic capital spending, and the service sector, which has begun to rebound of late. For example, the ISM manufacturing index has deteriorated from earlier in the year and been fluctuating around the breakeven 50 level, while the ISM nonmanufacturing index has moved higher over the past few months and is now consistent with solid growth in the sector (Figure 19). This is a significant development, as the service sector is responsible for 86% of the jobs in the US economy. The return to moderate service sector activity growth has propelled increasing hours worked in the sector; on a 3m/3m annualized basis, they rose at a 1.5% annualized pace in November, compared with -0.5% growth in the manufacturing sector (Figure 20). Because of the large service sector share, this meant that overall hours worked were growing at a solid pace as well.

The moderate growth in activity in recent months has also meant that payroll growth has been unspectacular but relatively steady, with gains averaging 157k per month over the 12 months ending in November. While this was not as strong an increase as in the past two expansions, it has been enough to push the unemployment rate down at a pace faster than at any point in the previous expansion and about in line with the fastest one in the expansions of the 1990s (Figure 21). We believe this is in large part because of the retirements of the baby boomers, which our analysis indicates is the largest single force that has pushed the labor force participation rate down in recent quarters (see Dispelling an urban legend: US labor force participation will not stop the unemployment rate decline, March 1, 2012). This downward force on the participation rate means that fewer jobs are now needed to keep the unemployment rate steady; we estimate employment growth of 75-100k per month would do so and job growth significantly above that tends to push the unemployment rate down. This also implies that potential GDP growth has slowed as well, because labor supply growth is a key element of potential GDP growth, and a falling participation rate implies that labor supply growth is now weaker than in the past. We estimate potential GDP growth in the US is 2.0%, and, indeed, the unemployment rate has been falling at a rapid rate despite real GDP growth that has been weaker than in the past two cycles (Figure 22). We view this as evidence of a fall in the potential growth rate.

The service sector has firmed, helping real GDP and employment growth

FIGURE 19 ISM points to a pickup in service sector activity…

FIGURE 20 …that is reflected in hours worked

30

35

40

45

50

55

60

05 06 07 08 09 10 11 12Nonmanufacturing Manufacturing

Index, 3mma US ISM

-30

-25

-20

-15

-10

-5

0

5

10

05 06 07 08 09 10 11 12Service sector Manufacturing

3m/3m % chg, saar Aggregate hours worked

Source: ISM, Haver Analytics Source: BLS, Haver Analytics

Less GDP and job growth is now needed to push the unemployment rate down




13 December 2012 32

FIGURE 21 Less job growth now needed to push unemployment lower

FIGURE 22 Weaker GDP growth now needed to lower unemployment

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-1

0

1

2

3

4

-700-600-500-400-300-200-100

0100200300400

90 95 00 05 10

Nonfarm payrolls (lhs) Unemployment rate (rhs)

12m avg chg, thous 12m chg, pp

-2

-1

0

1

2

3

4

-6

-4

-2

0

2

4

6

90 95 00 05 10GDP (lhs) Unemployment rate (rhs)

y/y % chg 4q chg, pp

Source: BLS, Haver Analytics Source: BLS, BEA, Haver Analytics

US growth continues to be supported by the recovery in the cyclical sectors of autos and housing. Auto sales continue to trend higher (Figure 23), due to a combination of moderate job and income growth, some easing in lending standards, and pent-up demand. The NAHB homebuilders’ survey suggests that housing starts will keep moving up in the coming months (Figure 24). We see increased housing starts as driven in part by similar factors to those contributing to rising auto sector activity, as well as record low mortgage interest rates and shrinking new home supply, which is now at its lowest level ever.

The above discussion suggests that moderate US growth is set to continue, but that is subject to the assumption that the full $650bn tightening embodied in the fiscal cliff does not occur. Instead, we assume that about $200bn in fiscal tightening occurs, owing to a combination of a lack of extension of the payroll tax cut; tax increases from the Affordable Care Act; some increase in taxes on upper-income households; and some, but not all, of the sequestration budget cuts that are scheduled to occur. We assume that an agreement is reached either in late 2012 or early 2013. If such an agreement is not reached, then we would expect much weaker H1 13 growth.

A cyclical rebound in autos and housing continues to support growth

FIGURE 23 US light vehicles remain on an upward trend

FIGURE 24 Homebuilders survey points to stronger housing starts

8

10

12

14

16

18

20

05 06 07 08 09 10 11 12

mil, saar, 3mma

US light vehicle sales

400

800

1200

1600

2000

2400

0

10

20

30

40

50

60

70

80

00 01 02 03 04 05 06 07 08 09 10 11 12 13

NAHB housing market index (6m lag, lhs)Housing starts (rhs)

Index Thous, saar

Source: BEA, Haver Analytics Source: NAHB, Census Bureau, Haver Analytics

A lack of timely legislation to avert the fiscal cliff would pose significant downside risks to our growth forecast


13 December 2012 33

We believe the Fed will continue to ease by expanding its balance sheet throughout 2013. We expect the FOMC to continue to buy agency MBS and long-term Treasury securities at an $85bn per month pace at least through the end of H1 13, at which point we project some tapering off. We expect it to keep buying at a lesser pace at least through the end of 2013.

Euro area: Rebuilding confidence As observed above, the euro area economy continues to be negatively affected by exceptionally weak levels of confidence and a very substantial fiscal headwind. Our forecast for 2013 GDP growth has been downgraded marginally, compared with three months earlier, to 0.1%, while our 2012 projection is slightly better at -0.4% (vs. -0.5%). That said, our quarterly profile envisages stability in GDP in Q1 13 (after a renewed contraction in Q4) and a gradual recovery thereafter. The consequence is that by 2014, we look for GDP in the euro area to rise 1.4%. The reasons for our projection of a recovery (albeit weak) during 2013 are that we expect a gradual improvement in real sector confidence from southern Europe, borne out of the consequences of structural, financial sector, and fiscal reforms, and led by further improvement in financial sector confidence. Additionally, the fiscal headwind in 2013 is likely to be slightly less than experienced this year, given that we look for Germany to engage in some modest discretionary loosening, as discussed above. Also, we consider that the euro area is in a phase of substantial de-stocking; hence, the inventory cycle should prove a modest fillip to activity during H1 13. That said, we caution that there is still elevated uncertainty, in the context of potentially difficult discussions over future governance reforms, and with general elections due in Italy (in Q1) and Germany (Q4).

Elevated financial risk premia have tended to depress confidence in the ‘real’ economy. These have arisen from a set of associated concerns, related to fiscal and financial uncertainty, that at times have fed into uncertainty about the euro’s status. However, it is clear that financial risk premia have been substantially reduced since the summer. This has resulted especially from the ECB’s announcement that it had developed the new Outright Monetary Transactions (OMT) instrument that could result in unlimited purchases of shorter maturity government debt for countries within an ESM programme. While the OMT has not yet been deployed, our baseline continues to be that Spain will ask for a programme in the months ahead, thereby triggering OMT purchases by the ECB.

We expect the Fed to keep easing throughout 2013

Euro area continues to be negatively affected by low levels of confidence, but we expect some improvement during 2013

FIGURE 25 German new orders (excluding large transport items)

FIGURE 26 Real effective exchange rates adjust to varying degrees

60

70

80

90

100

110

120

130

140

05 06 07 08 09 10 11 12

Vol ume SA 2005 = 100

Rest of world

Domestic

Euro area

60

80

100

120

140

160

99 00 01 02 03 04 05 06 07 08 09 10 11 12

Jan 99 = 100

Spain Italy FranceGreece Portugal GermanyIreland

Source: Haver Analytics, Barclays Research Source: Barclays Research, using IMF series for REERs deflated by manuf. ULCs

Analysing factors that have enabled confidence to return so far . . . we still look for Spain to apply for a programme that would trigger OMTs


13 December 2012 34

Additionally, risk premia have been reduced by other factors, including evidence of stronger commitments and often progress towards reducing fiscal deficits; an adjustment of the competitiveness and current account balances in the ‘periphery’; awareness of the level of political commitment to drive deeper euro area integration (including the ‘road map’ presented by the “Four Presidents’ Report”); structural economic reforms in southern Europe, related to labour and product markets; bank sector restructuring and recapitalisation in southern Europe, including the Spanish stress tests and utilisation of ESM finance; and the progress made by the new Greek cabinet, which has helped pave the way for a new financing package (substantially allaying market concerns of euro fragmentation).

As identified by our GDP equation (Figure 6), euro area financial conditions, despite the fiscal headwind, imply that GDP ought already to be slightly positive. The fact that GDP outturns have been so weak suggests that the main source of downward pressure is confidence. A key bellwether for the EU is Germany, particularly its industrial orders. Figure 25 shows that German orders from outside the euro area have been gradually rising, but that there has been exceptional weakness in orders from its euro area trading partners. This reflects the rapid contraction in domestic demand in southern Europe and Ireland. It has also evidently affected domestic orders negatively, on account of the reduction in domestic capacity utilisation and confidence. Nonetheless, the improvement in financial confidence should be accompanied by stronger domestic financing capacity. We look for the current account position of the entire periphery to show surpluses in 2013 (see data appendix). About two-thirds of this correction should come from import contraction, but one-third should arise from export growth. The recovery in exports is in some proportion to the relative change in competitiveness: whereas the Italian real effective exchange rate series has not adjusted down so much, the REERs for most other peripheral economies have (particularly for Ireland, and more recently for Greece, Figure 26).

While there are some grounds for cautious optimism, the euro area is characterised by an intensification of labour market disequilibrium (Figure 11), plus a requirement for heavy fiscal consolidation in many countries in 2013 (including France) at a time of economic stress. Despite the narrowing in bond spreads, financing conditions remain very diverse, being heavily restrictive in southern Europe (as is apparent from surveys of smaller firms) and very accommodative in the north and France (Figure 28). Much relies, therefore, on the ultra-low rates prevailing in northern Europe driving stronger domestic demand, as well as a recovery of financial market confidence in the south.

Various other factors can help explain an improvement in financial market confidence

Southern Europe likely to see further progress towards current account balance

FIGURE 27 10y government bond yields: declining in aggregate

FIGURE 28 Diverse financing conditions across major euro economies

0

2

4

6

8

10

12

14

16

06 07 08 09 10 11 12

PortugalIrelandSpainItalyGermanyEA GDP-weighted (ex Greece)Banking senior (Euro aggregate)

%

-3

0

3

6

9

92 94 96 98 00 02 04 06 08 10 12

ItalySpainFranceGermany 11 Dec. 2012

----------Monetary union----------

10y sovereign yields minus nominal trend growth(real potential growth + 5Y inflation expectations)

Source: Bloomberg, Barclays Research Source: Bloomberg, Barclays Research

An intensification of labour market disequilibrium and still-uneven financing conditions implies that the ECB needs to undertake more easing, particularly measures that can assist financing conditions in southern Europe


13 December 2012 35

In this context, the ECB clearly has a vital role to play. We look for it to lower the main policy rate in Q1, quite possibly as early as January 10. We do not expect it to lower the deposit rate, however, given potential issues concerning communication and technical operation. For the ECB, the main focus needs to be to improve further the highly asymmetric nature of the monetary transmission across countries. In this context, an OMT programme for Spain and then potentially some other countries (such as Ireland and Portugal) would be, in our view, the most effective way of providing additional monetary assistance.

UK: MPC focus now on FLS The UK economic recovery continues to be held back by a combination of fiscal austerity, the effects of the euro crisis, persistent inflation and tight credit conditions. GDP rose strongly in Q3, but was artificially boosted by a shift in holiday patterns and the Olympics: the indicators for Q4 point to a contraction. Household spending remains subdued, despite renewed growth in real disposable incomes, while business investment intentions have stayed weak in the face of ongoing uncertainty about both domestic and external demand. A worsening fiscal position means there is little prospect of extra stimulus from the government. The (independent) Office for Budget Responsibility (OBR) has cut its forecast for nominal GDP sharply, and the government has responded by saying it will not introduce the additional austerity that would be needed to meet its fiscal rule to have public debt declining as a share of GDP in 2015-16. The OBR expects it to be four years before government borrowing falls appreciably below this year’s level. A loss of the UK’s triple-A credit rating in early 2013 seems increasingly likely, an event that would cause some embarrassment for the government, which has previously vowed to retain the top rating.

The BoE halted its programme of QE in November, as inflation rose to 2.7%, further away from the 2% target (Figure 15). It does not now expect inflation to return to target until H2 14. While QE remains the first line of defence against demand weakness, MPC members have begun to question its effectiveness within the prevailing low-confidence environment and seem to place increasing importance on the Funding for Lending Scheme (FLS) to improve credit flows, though it remains too early to gauge its likely success. Our baseline is that the economy will improve slowly during 2013, growing 1.3% following a 0.1% contraction in 2012, and that no more QE will be forthcoming. However, we do not see the MPC as being strongly opposed to further easing, and if the stagnation in demand persists into the new year, another tranche of QE would be likely.

EEMEA: More monetary easing amid soft growth The growth outlook is still weak, with some notable exceptions. In much of Central and Southeastern Europe, weaker-than-expected Q3 GDP and disappointing euro area performance led us to lower our 2012-13 growth forecasts; Poland, in particular, continues to slow. Away from the core of Europe, the picture remains mixed. Turkey’s growth has slowed, but the significant easing of financial conditions since mid-year could turn around domestic demand. South Africa’s economy has visibly suffered from the severe strikes in the mining sector, and an end to these could add to growth. Russian growth slowed more than expected in H2 12 and is expected to slow further in 2013, but should remain supported by oil prices. GCC economies also are supported by high oil prices; however, with oil extraction volumes close to maximum capacity in 2012 in many oil exporting countries, the contributions to growth from oil production are forecast to be weaker in 2013.

Q3 GDP boosted by temporary factors; likely to contract in Q4

BoE ends QE; focus increasingly on FLS


13 December 2012 36

Overall, we expect more monetary easing and a new focus on exchange rates. Central bank actions in core markets since the summer provided the backdrop for those in EEMEA to start easing (Turkey, Hungary and Poland) or continue to ease (Czech Republic, Israel). Diminished fears of euro area breakup and additional global liquidity allowed those who had previously maintained high rates to stabilise their currencies (Turkey, Poland and Hungary) to loosen policy. While inflation is still above target in most cases, core inflation is trending down and headline inflation has also dropped recently on food and energy price developments.

We therefore expect further monetary loosening from many EEMEA countries. Others may stay on hold (South Africa and Russia), but we expect no rate hikes in 2013. Notably, some monetary policymakers have also started to refer explicitly to the exchange rate as part of the mix: the Czech CNB made it clear recently that with interest rates now at zero, additional easing would occur through weakening the currency via QE. Turkey recently communicated specific REER thresholds that would trigger rate cuts.

Japan: Set for aggressive expansion in BoJ APP We have again cut our real GDP forecast for Japan. While the 2012 forecast remains at 2.1%, we lowered the 2013 forecast to 0.3% from 0.9% in our September forecast. Important sources of weakness include faltering exports and declining equipment investment (Figure 29). We look for growth to stabilize in Q4 12 and to begin to recover in H1 13. However, we see downside risks to that forecast, including the size of the fiscal tightening in the US, the length and intensity of anti-Japan demonstrations and boycotts in China, and the amount of JPY appreciation pressure in the coming months.

We expect the BoJ to respond to disappointing growth by easing further in either December or January. This may involve a JPY5-10trn expansion of the Asset Purchase Program (APP) and a stronger commitment to maintaining the balance of the APP after the target is reached at end-2013. The BoJ may also increase its Rinban operations, which are currently conducted at a monthly pace of JPY1.8trn. There has been a striking expansion in the APP: at end 2011, it was JPY42trn (9% of GDP), whereas by end-2012 it is likely to be JPY65trn (14%), and we forecast it to rise to JPY100trn (21% of GDP) by end-2013. We also expect further fiscal easing, such as increased infrastructure spending.

EEMEA central banks have loosened policies significantly, but further rate cuts are likely in Q1 13

We have again lowered our real GDP forecast for Japan

FIGURE 29 Japanese exports and equipment investment contracting

FIGURE 30 Japanese industrial production falling sharply

-25

-20

-15

-10

-5

0

5

10

15

20

25

-60

-40

-20

0

20

40

60

05 06 07 08 09 10 11 12

Exports (lhs) Equipment investment (rhs)

2q % chg, saar 2q % chg, saarJapan

-75

-50

-25

0

25

50

05 06 07 08 09 10 11 12

3m/3m % chg, saar Japan manufacturing production

Source: Cabinet Office of Japan, Haver Analytics Source: METI, Haver Analytics

We look for further easing from the BoJ


13 December 2012 37

Emerging Asia and Australia: Rebalancing We believe that China is in the middle of a transition toward a “new normal” of slower growth and higher inflation. We do not expect aggressive policy stimulus or dramatic growth acceleration in 2013, but the new government may unveil several well-prepared policy reforms in the coming months. We project that GDP growth will improve slightly, from 7.7% in 2012 to 7.9% in 2013 (with growth potential about 8%), and growth performance may fluctuate around this rate in the coming years. We look for a small rise in inflation from 2.7% in 2012 to 3.2% in 2013. Fiscal policy should remain modestly expansionary and the monetary policy stance should return to neutral. Meanwhile, the currency may gain 2-3% against the US dollar during the next year, and re-balancing towards consumption seems likely to continue.

We expect the Chinese government to retain its 7.5% growth target for 2013 and its 4.0% inflation target. M2 growth may stay at 14%, while the fiscal deficit might come to 1.7% of GDP. Continuing with its proactive fiscal policy, the new government may introduce some new investment projects, especially in areas of urban infrastructure, but the overall magnitude should be modest. Economic activity finally started to turn the corner from September, with improvement in export performance and strengthening of infrastructure investment. As well, the pace of retail sales growth has been picking up in nominal and real terms for the past months, and the official and market PMIs returned to above-50 levels.

In our China: Beyond the Miracle series, we discuss how the asymmetric liberalization approach – ie, completely liberalized product markets and widely distorted factor markets – contributed to strong growth performance and serious structural problems. That approach, however, is rapidly coming to an end, with three important conditions that had supported Chinese growth during the past decade now waning: the unlimited supply of labor, the low cost of production, and the rapid expansion of exports. The economy now needs to overcome the “middle-income trap” by focusing more on innovation and upgrading.

Factor market distortions, which in the past served as implicit subsidies of corporates and of taxes on households, are being reversed. The rapid rise in wages hurts corporate profits but adds to household incomes, so the downturn in profitability is structural as well as cyclical. As well, the share of national income accounted for by household income is increasing, and income inequality among households has declined; for example, during 2005-10, income of

Signs that economy turned the corner in Q3

FIGURE 31 Chinese domestic activities pick up gradually, in line with PMI

FIGURE 32 Chinese income distribution has improved recently

35

40

45

50

55

60

65

70

-10

0

10

20

30

40

Nov -07 Nov -08 Nov -09 Nov -10 Nov -11 Nov -12

IP (% 3m/3m, saar) NBS PMI production (RHS)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

0

1

2

3

4

5

6

7

8

9

10

1987 1990 1993 1996 1999 2002 2005 2008 2011

Highest income group to lowest income group ratioUrban income to rural income ratio (RHS)

% %

Source: CEIC, Barclays Research Source: CEIC, Barclays Research

Economic transition, and overcoming the middle income gap

Narrowing income equality supports consumption-led growth


13 December 2012 38

the bottom fifth of households increased 89%, while that of the richest quintile grew 80%. Improved income distribution, plus the rising household/national income ratio, has begun to reverse the weak consumption trend. Official statistics reveal that consumption’s contribution to GDP growth rose from 36.5% in 2010 to 51% in 2011 and 55% in Q1-Q3 12. This gain so far is mainly reflected in the mass, rather than luxury goods, market.

A bigger challenge lies in the capability of industries to upgrade in the face of rapidly eroding low-cost advantages. This requires a significant shift in policy priorities, from directly supporting fixed asset investment to strongly facilitating research and innovation.

China’s new Politburo has outlined the guidelines for economic policy in the coming year: “stabilizing growth, adjusting structure, promoting reform and benefiting people’s livelihood”. It also underscored the importance of maintaining stability and continuity in macroeconomic policies. Incoming Premier Li Keqiang highlighted that reform is the biggest “dividend” to be exploited. However, while the policy style is changing, we caution against excessive expectations for stimulus policy and structural reform. Unless the economy suffers from major job losses, the government is unlikely to engage in aggressive easing, and building a consensus on more dramatic reforms takes time. Near term, we expect the government to focus on well-deliberated policy measures and those where experiments have already been carried out. Among the new economic reforms that could be expected in the coming months are a possible relaxation of restrictions on the one-child policy for urban residents, and further reform of the household registration system (by granting official urban residency status to migrant workers and their families on certain conditions). The government may also extend its policy experiments involving property and resource taxes and conversion of business taxes to value-added taxes for the service industry.

The monetary policy stance may return to neutral, although the official language will likely still be “prudential”. We no longer expect the PBoC to take further easing steps, although we cannot rule out the possibility of its lowering the reserve requirement ratio (for liquidity management). PBoC policy regulation should continue to lean more heavily on open market operations, eventually shifting toward interest rate targeting. It may also allow market forces to play a greater role in determining the RMB rate. This should eventually require a further widening of the RMB band, but we do not think any moves are imminent.

From a global perspective, there are likely to be several consequences of these changes:

• The contribution of China to global economic growth may decline, and China could turn from a source of global disinflation to a source of inflation;

• An acceleration in industrial upgrading could provide opportunities for low-cost countries but add to competitive pressures on more advanced economies;

• Rebalancing could turn China into a global consumer market: the growth of Chinese demand for base metals may decline, but demand for consumption-related commodities such as coffee, gold and aluminium may well accelerate;

• The redistribution of income from the corporate sector to households means the squeeze on corporate profitability may not be temporary, posing serious challenges to equity and direct investors in Chinese companies;

• As the PBoC reduces FX intervention, its accumulation of foreign reserves may slow, which could eventually affect the funding costs of US Treasury bonds.

In contrast, Indian policymakers face a complicated mix of very weak growth and inflation that has remained stubbornly high throughout the course of this year. Q3 GDP data, in particular, showed few signs of improvement and the details highlighted a worrying trend in

Aims of the new Politburo

PBoC measures may be confined to lowering RRR

India: a complicated mix of very weak growth and inflation


13 December 2012 39

private consumption (which has historically provided a resilient base for overall demand), showing a marked slowdown (to 3.7% y/y). Near term, the government has few policy options that it could employ to turn the situation around. High public debt and deficits mean there is little scope to provide countercyclical fiscal support to the weak economy.

Despite being under significant political pressure, the central bank has resisted easing while inflation remains uncomfortably high. September saw a flurry of reform announcements – including opening up the economy to FDI flows, reducing fuel subsidies, and the proposal to establish a National Investment Board to fast-track key investment projects – but these gave only a brief boost to investor confidence; the outlook for new initiatives remains uncertain. In early 2013, we expect inflation to start softening, which should provide scope for the RBI to lower policy rates: we forecast a 100bp loosening of monetary policy in H1 13. Lower interest rates, an expansion in credit availability, and some of the recent policy initiatives targeted at unlocking stalled investment should provide some modest momentum to the economy. However, we expect the recovery to be listless and Indian growth to remain below par, reaching only 6.4% in CY 13.

The outlook for Asian NIEs appears to be improving, with a recent turnaround in exports, particularly electronics in Korea and Taiwan. Going into 2013, we expect better export performance and a looser monetary policy to support a pickup in corporate investment in Korea. In Taiwan, the deepening of cross-Strait ties should increase the flow of tourists from China which should help boost domestic service sectors.

ASEAN economies are likely to demonstrate strong and resilient growth into 2013. For Indonesia, Malaysia, Philippines, and Thailand, the drag this year from weaker exports was offset by strong domestic demand (particularly investment). In 2013, we expect external demand to improve, helped by a better outlook for China; consumption should remain supported by strong labour markets and rising real wages. That said, we expect investment to slow from unsustainably high levels, particularly in Malaysia and Indonesia.

Possible fading of new reform initiatives in India . . . we look for 100bp of rate cuts in H1 13

FIGURE 33 Consumption to contribute more to Chinese GDP growth

FIGURE 34 RBI the only Asian central bank set to lower rates in 2013

4.0 3.6 4.0 4.4 5.1 5.6 4.2 4.6 4.5 5.2 4.0 4.2 4.4

4.4 6.3 5.5 4.35.5 6.0

4.58.1

5.5 4.53.8 3.9 3.8

-4

0

4

8

12

16

-4

0

4

8

12

16

2002 2004 2006 2008 2010 2012(F) 2014(F)

contribution to China's annual GDP growth, pp

Consumption Gross Capital FormationNet Export Real GDP (RHS)

%y/y

5

6

7

8

9

10

11

Apr-11 Oct-11 Apr-12 Oct-12 Apr-13 Oct-13

Reverse repo rate (%)Repo rate (%)WPI inflation (%, y/y) Forecasts

Source: Barclays Research, Haver Analytics Source: Barclays Research

Asian NIEs see better outlook

ASEAN demonstrates strong and resilient domestic demand driven growth


13 December 2012 40

Australia is approaching a major turning point, as the record boom in mining investment should peak next year, with growth slowing very sharply in 2014 as the resources sector returns to earth. The RBA’s cash rate is now at a multi-decade low of 3% and the housing market is responding to earlier rate cuts. We expect rates to be on hold, although the risks are skewed to easier policy, given that non-mining companies are reluctant to lift their investment and the high currency is causing problems for some industries. The government should soon abandon its goal of returning the budget to surplus this financial year, as there is no political appetite for austerity measures ahead of an election in late 2013.

Latin America: More divergence, but convergence ahead In our previous two Global Outlooks, we noted a widening divergence between growth in economies such as Brazil and Argentina and faster-growing ones such as Mexico and Chile. In general, this separation has continued. Growth remains quite weak in Brazil and Argentina (Figure 35). Brazilian investment spending continues to contract, and exports remain weak. In contrast, growth has been more resilient in Chile and Mexico (Figure 36). However, while Chilean growth remains robust, Mexican investment spending and export growth have begun to weaken. We look for Mexico and Brazil to grow at the same rate (3.0%) in 2013, so we believe the divergence is set to give way to convergence, at least for these two large economies in the region.

Despite this expectation for convergence, we believe the negative growth surprise this year in Brazil opens the door to further easing, where we look for two 50bp rate cuts in Q1 13. In contrast, we see the Mexican central bank keeping rates on hold throughout 2013. We look for rate hikes in Chile, but not until late 2013. More generally, we see policymakers throughout the region being biased toward keeping rates low, as inflation is not expected to be high enough to cause near-term tightening.

Australia: approaching a major turning point as mining investment peaks

A separation has developed between faster- and slower-growing economies in Latin America

FIGURE 35 Growth remains sluggish in Brazil and Argentina

FIGURE 36 Mexican and Chilean growth remain more resilient

-15

-10

-5

0

5

10

15

05 06 07 08 09 10 11 12Argentina Brazil

2q % chg, saar Real GDP

-20

-15

-10

-5

0

5

10

15

05 06 07 08 09 10 11 12Chile Mexico

2q % chg, saar Real GDP

Source: MEyOSP, IBGE, Haver Analytics Source: BCC, INEGI, Haver Analytics

We expect Latin American policymakers generally to err on the side of accommodation in the coming months


13 December 2012 41

FIGURE 37 Global Forecasts (1): GDP and inflation

Weight* 2Q12 3Q12 4Q12 1Q13 2Q13 2011 2012 2013 2014 3Q12 4Q12 1Q13 2011 2012 2013 2014Global 100.0 2.3 2.8 3.3 3.2 3.4 3.8 3.1 3.3 4.0 2.7 2.8 2.9 3.9 2.9 3.0 3.2

Advanced 50.5 0.4 1.0 0.8 1.0 1.5 1.4 1.3 1.2 1.9 1.6 1.8 1.6 2.5 1.9 1.7 2.1

Emerging 49.5 4.4 4.7 6.0 5.5 5.3 6.5 5.0 5.4 6.0 4.4 4.6 5.1 6.4 4.8 5.1 4.9

BRIC 31.2 5.1 6.2 7.7 6.7 6.1 7.6 6.0 6.6 6.9 3.6 4.2 5.0 6.7 4.2 4.7 4.4

Americas 32.1 1.6 2.6 2.4 1.9 2.6 2.6 2.4 2.4 2.8 3.0 3.3 3.1 4.3 3.3 3.5 3.9

United States 21.3 1.3 2.7 2.5 1.5 2.0 1.8 2.3 2.1 2.5 1.7 2.0 1.7 3.2 2.1 2.0 2.5

Canada 2.0 1.8 0.6 2.0 2.0 2.0 2.4 1.8 1.9 2.2 1.2 1.5 1.4 2.9 1.6 1.8 2.4

Latin America 8.8 2.3 2.9 2.5 3.0 4.2 4.5 2.9 3.3 3.9 7.5 7.6 7.9 8.2 7.6 8.3 8.5

Argentina 1.0 -3.4 4.5 4.5 3.0 4.0 8.9 2.1 3.2 3.2 26.8 28.0 28.7 23.5 26.1 28.0 29.5

Brazil 3.3 1.0 2.4 1.7 3.3 4.1 2.7 0.9 3.0 3.6 5.2 5.5 5.9 6.6 5.4 5.7 5.7

Chile 0.4 8.3 5.7 3.2 4.6 5.0 6.0 5.6 5.1 5.5 2.6 2.4 2.1 3.3 3.1 3.0 3.0

Colombia 0.7 6.7 1.5 5.5 4.5 4.8 5.9 4.2 4.6 4.5 3.0 2.8 2.4 3.4 3.2 2.8 2.9

Mexico 2.4 3.3 1.8 1.0 2.5 5.0 3.9 3.8 3.0 4.0 4.6 4.2 3.8 3.4 4.1 3.9 3.8

Peru 0.5 6.4 8.7 7.4 6.3 7.6 6.9 6.3 6.6 6.5 3.5 2.9 3.2 3.4 3.7 2.8 2.5

Venezuela 0.5 3.6 2.5 1.4 -1.5 -2.2 4.2 5.3 0.3 2.6 18.5 18.8 21.7 26.1 21.1 29.6 31.8

Asia/Pacific 40.3 4.5 4.3 6.2 5.9 5.3 6.0 5.4 5.6 6.0 2.1 2.3 2.7 3.7 2.4 2.7 3.1

Japan 6.2 -0.1 -3.5 0.2 0.9 0.9 -0.6 2.1 0.3 0.7 -0.2 0.0 -0.1 -0.3 -0.1 0.1 1.6

Australia 1.3 2.3 1.9 2.3 3.3 2.6 2.4 3.6 2.7 2.1 2.0 3.0 3.6 3.3 2.0 3.3 2.4

Emerging Asia 32.8 5.5 6.0 7.5 7.0 6.3 7.6 6.2 6.7 7.1 3.0 3.1 3.8 5.6 3.5 3.7 3.8

China 17.8 6.4 8.4 10.2 6.8 7.2 9.3 7.7 7.9 8.1 1.9 2.1 3.2 5.4 2.7 3.2 3.5

Hong Kong 0.5 -0.3 2.6 2.8 3.2 3.2 4.9 1.2 3.0 3.5 3.1 3.4 3.7 5.3 4.0 3.5 3.8

India 6.6 5.8 3.8 5.6 10.3 5.5 7.4 5.3 6.5 7.2 7.9 8.0 7.7 9.5 7.7 7.1 5.8

Indonesia 1.7 6.7 5.4 7.1 5.4 7.3 6.5 6.3 6.3 6.4 4.5 4.5 4.6 5.4 4.3 5.0 5.0

South Korea 2.2 1.1 0.2 3.6 3.2 5.3 3.6 2.2 3.3 4.0 1.6 1.8 1.6 4.0 2.2 2.1 3.0

Malaysia 0.7 5.3 2.9 4.0 6.5 4.0 5.1 5.2 5.1 5.7 1.4 1.3 1.5 3.2 1.7 2.2 3.4

Philippines 0.6 3.0 4.9 1.0 16.5 0.1 3.9 6.2 5.6 5.7 3.5 3.0 3.7 4.7 3.1 4.1 4.0

Singapore 0.4 0.5 -5.9 1.5 2.0 5.0 4.9 1.4 2.1 3.6 4.2 4.2 4.2 5.2 4.6 3.9 3.2

Taiwan 1.3 -0.4 3.9 4.5 3.2 2.8 4.1 1.2 3.4 4.5 2.9 1.8 1.9 1.4 1.9 1.5 2.2

Thailand 0.9 11.7 5.0 -1.5 3.5 7.2 0.1 5.5 4.0 5.5 2.9 3.4 3.4 3.8 3.1 3.6 2.0

Europe and Africa 27.6 0.2 0.9 0.3 0.9 1.5 2.4 0.6 1.1 2.1 2.9 2.9 2.8 3.6 3.0 2.7 2.5

Euro area 14.9 -0.7 -0.2 -1.2 0.1 0.7 1.5 -0.4 0.1 1.4 2.5 2.3 2.0 2.7 2.5 1.8 1.7

Belgium 0.6 -2.1 0.1 -1.0 0.5 1.3 1.8 -0.2 0.4 1.7 2.4 2.3 2.1 3.5 2.6 1.9 1.3

France 3.0 -0.2 0.9 -0.5 0.2 0.5 1.7 0.1 0.4 1.6 2.3 1.9 1.5 2.3 2.3 1.4 1.5

Germany 4.3 1.1 0.9 -0.7 1.4 2.3 3.1 1.0 1.2 1.8 2.1 2.0 1.8 2.5 2.1 1.8 2.3

Greece 0.4 -3.4 -3.2 -5.3 -5.0 -4.3 -7.2 -5.9 -4.1 -0.5 0.8 0.8 0.4 3.1 1.1 0.1 -0.5

Ireland 0.3 0.0 2.4 0.6 1.1 1.5 1.4 0.4 1.3 2.4 2.3 2.1 1.5 1.2 2.0 1.0 1.3

Italy 2.4 -2.9 -0.7 -2.0 -0.8 -0.2 0.6 -2.1 -0.8 1.0 3.4 2.6 2.0 2.9 3.3 2.0 2.0

Netherlands 1.0 0.5 -4.1 -1.8 -0.3 0.4 1.1 -1.0 -0.6 1.2 2.6 3.3 3.1 2.5 2.8 2.6 1.3

Portugal 0.3 -4.6 -3.3 -3.1 -1.9 -0.3 -1.7 -3.0 -1.7 0.8 3.0 2.0 1.2 3.6 2.8 0.9 0.4

Spain 1.9 -1.7 -1.1 -2.5 -1.9 -1.1 0.4 -1.4 -1.5 0.8 2.8 3.2 2.6 3.1 2.5 1.9 1.1

United Kingdom 3.1 -1.5 3.9 -0.7 1.3 1.7 0.9 -0.1 1.3 2.2 2.4 2.6 2.5 4.5 2.8 2.8 2.4

Switzerland 0.5 -0.5 2.3 0.8 1.2 1.2 1.9 1.0 1.2 1.5 -0.5 -0.2 0.5 0.2 -0.7 0.9 1.5

Sweden 0.5 3.0 2.0 -3.2 0.0 2.2 3.9 1.1 0.7 2.4 0.6 0.0 0.0 3.0 0.9 0.7 2.2

Norway (mainland) 0.4 2.8 2.1 2.6 2.8 2.8 2.4 3.3 2.7 3.0 0.4 1.2 1.3 1.2 0.6 1.5 1.7

Denmark 0.3 -2.7 0.3 0.8 1.2 1.6 0.8 -0.4 1.0 1.8 2.5 2.3 1.7 2.8 2.4 1.9 1.8

EM Europe & Africa 7.9 2.4 1.7 3.8 2.3 2.7 4.8 2.7 2.8 3.4 5.3 6.0 6.3 6.6 5.6 5.8 4.8

Czech Repub. 0.4 -1.0 -1.4 -1.0 -0.5 0.4 1.6 -1.0 -0.3 0.9 3.5 3.0 2.2 1.9 3.3 2.2 2.0

Hungary 0.3 -1.7 -0.8 0.5 0.2 0.4 1.7 -1.4 0.1 1.2 6.1 5.9 4.5 3.7 5.6 4.0 3.2

Poland 1.1 0.0 0.0 0.0 -0.7 0.7 4.3 2.0 1.0 2.8 3.8 2.8 2.5 3.9 4.0 2.2 2.5

Russia 3.5 1.6 3.3 4.8 2.7 3.2 4.3 3.7 3.3 3.5 4.5 7.3 8.4 8.9 5.4 7.3 5.3

Turkey 1.6 6.9 0.7 7.4 4.1 3.6 8.5 2.9 4.2 4.7 9.1 6.7 6.1 6.5 8.9 6.3 6.3

Israel 0.3 3.4 2.9 2.6 2.7 2.8 4.8 3.2 3.0 3.4 1.8 2.0 2.1 3.4 1.8 2.0 2.1

South Africa 0.8 3.4 1.2 1.5 2.9 3.6 3.5 2.5 2.8 3.5 5.1 5.7 6.2 5.0 5.7 6.0 5.5

Consumer prices% over a year ago

Real GDP% over previous period, saar

Real GDP% annual change

Consumer prices% annual change

Note: Weights used for real GDP are based on IMF PPP based GDP, and weights used for consumer prices are based on IMF nominal GDP (5yr centered moving average). * IMF PPP-based GDP weights for 2013. Source: Barclays Research


13 December 2012 42

FIGURE 38 Global Forecasts (2): External and government balances

2009 2010 2011 2012F 2013F 2014F 2009 2010 2011 2012F 2013F 2014FGlobal 0.3 0.3 -0.1 -0.1 0.0 -0.1 -7.1 -6.5 -5.3 -4.8 -4.2 -3.8

Advanced -0.6 -0.5 -0.7 -0.7 -0.5 -0.5 -8.5 -8.2 -7.0 -6.0 -5.3 -4.8

Emerging 2.5 1.9 1.1 0.9 0.7 0.6 -4.0 -3.0 -2.1 -2.5 -2.4 -2.1

BRIC 2.5 2.1 1.3 1.4 1.0 0.9 -4.0 -3.1 -2.1 -2.4 -2.4 -2.4

Americas -2.2 -2.6 -2.6 -2.7 -2.6 -2.6 -9.6 -9.1 -8.1 -6.9 -5.8 -5.4

United States -2.7 -3.0 -3.1 -3.1 -2.9 -2.9 -11.9 -11.4 -10.2 -8.6 -7.2 -6.8

Canada -3.0 -3.1 -2.8 -3.2 -3.0 -2.8 -4.9 -5.6 -4.5 -3.5 -3.2 -3.0

Latin America -0.2 -0.8 -0.8 -1.4 -1.5 -1.7 -3.3 -2.9 -2.8 -3.0 -2.6 -2.1

Argentina 3.6 0.8 -0.1 0.3 -0.5 -1.8 -2.5 -1.8 -2.7 -2.9 -4.0 -3.9

Brazil -1.5 -2.2 -2.1 -2.3 -2.7 -2.7 -3.3 -2.5 -2.6 -2.5 -2.5 -2.5

Chile 2.0 1.5 -1.3 -3.8 -4.3 -4.4 -4.2 -0.4 1.3 -0.2 -0.4 -0.2

Colombia -2.1 -3.1 -3.0 -3.3 -3.1 -3.1 -2.7 -3.3 -1.9 -0.9 -0.6 -0.6

Mexico -0.6 -0.2 -0.9 -0.7 -1.1 -0.9 -2.3 -2.8 -2.5 -2.3 -2.0 -1.9

Peru 0.2 -1.7 -1.3 -2.5 -2.9 -2.0 -1.6 -0.5 1.8 1.6 0.9 0.5

Venezuela 4.5 5.9 10.6 5.0 8.9 8.2 -8.2 -10.3 -11.6 -16.7 -9.1 -2.0

Asia/Pacific 3.4 3.2 2.0 1.4 1.2 1.2 -5.2 -4.5 -4.4 -4.5 -4.4 -3.9

Japan 2.9 3.7 2.1 1.0 0.8 0.7 -8.8 -8.4 -9.5 -9.8 -10.2 -9.3

Australia -4.2 -3.0 -2.3 -3.7 -4.5 -3.8 -2.2 -4.2 -3.4 -2.9 -1.5 -0.5

Emerging Asia 4.5 3.6 2.4 2.2 2.0 1.9 -3.7 -2.6 -2.2 -2.5 -2.4 -2.3

China 4.9 4.0 2.8 2.9 2.6 2.3 -2.3 -1.7 -1.1 -1.5 -1.7 -1.7

Hong Kong 9.5 6.5 6.5 7.0 7.5 9.0 1.6 4.2 3.8 1.1 2.0 2.9

India -2.8 -2.7 -4.2 -3.5 -3.5 -2.5 -9.4 -8.1 -8.1 -8.0 -7.5 -7.5

Indonesia 2.0 0.7 0.2 -2.5 -2.1 -1.8 -1.6 -0.7 -1.1 -2.1 -1.5 -1.5

South Korea 3.9 2.9 2.4 3.5 2.2 1.8 -4.8 -1.6 -1.5 -1.1 -0.5 0.1

Malaysia 15.5 11.0 11.0 5.4 5.3 5.5 -7.0 -5.6 -4.8 -4.5 -4.3 -3.7

Philippines 5.5 4.5 3.1 3.5 3.2 2.8 -3.7 -3.5 -2.0 -1.9 -2.1 -2.2

Singapore 16.2 24.4 21.9 16.5 17.8 17.9 -1.1 0.3 1.2 0.4 -0.2 -0.1

Taiwan 11.4 9.3 9.0 7.6 6.9 6.1 -4.5 -3.3 -2.2 -2.4 -2.2 -1.0

Thailand 8.3 4.1 1.5 -0.6 1.7 1.5 -4.4 -2.0 -1.8 -4.0 -3.0 -2.0

Europe and Africa 0.5 0.6 0.6 1.2 1.6 1.4 -6.2 -5.6 -3.3 -2.6 -2.3 -1.7

Euro area -0.2 0.0 0.1 1.3 1.9 2.1 -6.4 -6.2 -4.1 -3.1 -2.4 -1.8

Belgium -1.6 1.4 -1.0 -1.4 -0.6 -0.2 -5.6 -3.8 -3.7 -2.8 -2.1 -1.1

France -1.3 -1.6 -2.0 -2.3 -2.1 -1.8 -7.5 -7.1 -5.2 -4.6 -3.1 -2.2

Germany 5.9 5.9 5.7 6.3 6.4 6.2 -3.1 -4.1 -0.8 0.0 -0.2 0.1

Greece -11.0 -9.8 -9.4 -3.3 0.8 1.9 -15.6 -10.7 -9.4 -7.0 -5.7 -4.7

Ireland -2.4 1.1 1.1 3.5 2.7 2.7 -14.0 -31.2 -13.1 -8.3 -7.4 -5.8

Italy -2.2 -3.6 -3.1 -0.8 0.0 0.3 -5.4 -4.6 -3.9 -3.0 -2.3 -1.7

Netherlands 5.2 7.6 9.7 8.2 8.1 9.2 -5.6 -5.1 -4.7 -4.2 -3.0 -2.5

Portugal -10.9 -10.0 -6.5 -1.1 2.6 2.8 -10.2 -9.8 -4.2 -5.1 -4.7 -3.0

Spain -4.8 -4.5 -3.5 -1.7 1.5 3.3 -11.2 -9.7 -9.4 -8.0 -5.9 -4.8

United Kingdom -1.3 -2.5 -1.9 -3.9 -2.8 -3.1 -11.4 -10.2 -7.8 -5.5 -6.1 -5.5

Switzerland 10.5 14.3 10.5 11.5 10.0 9.0 1.1 0.7 0.8 0.9 0.9 1.2

Sweden 6.8 6.8 7.0 6.7 6.3 5.9 -1.0 -0.1 0.1 -0.4 -1.0 -0.2

Norway 10.8 12.4 14.5 15.4 15.8 13.9 10.6 11.2 13.7 13.6 12.8 11.9

Denmark 3.3 5.9 5.6 5.7 4.8 4.1 -2.5 -2.5 -1.8 -3.9 -2.0 -0.7

EM Europe & Africa 0.4 0.0 -0.5 -0.3 -0.6 -1.1 -5.8 -4.5 -1.3 -2.1 -1.9 -1.6

Czech Republic -2.5 -3.8 -2.9 -1.0 -1.1 -1.1 -5.8 -4.8 -3.3 -5.0 -2.9 -2.9

Hungary -0.1 1.2 1.4 2.1 2.6 2.8 -4.8 -4.3 4.2 -2.9 -2.9 -2.9

Poland -4.1 -4.2 -3.9 -3.2 -2.1 -2.7 -7.3 -7.8 -5.6 -3.5 -3.5 -3.0

Russia 3.9 4.7 5.3 4.6 3.4 2.2 -5.9 -4.0 0.7 -0.3 -0.4 0.0

Turkey -2.2 -6.4 -9.9 -7.3 -7.4 -6.9 -7.0 -2.6 -1.3 -2.5 -2.4 -2.5

Israel 3.8 3.8 0.8 -1.1 -0.4 0.5 -5.2 -3.7 -3.3 -4.1 -3.3 -3.0

South Africa -4.0 -2.8 -3.3 -5.9 -6.1 -6.5 -1.2 -6.9 -4.9 -4.9 -5.3 -4.9

Current account (% GDP) Government balance (% GDP)

Note: Weights used are based on IMF nominal GDP (5yr centered moving average). Source: Barclays Research


13 December 2012 43

FIGURE 39 Official interest rate projections

Last Next move

Current Date Level move expected Q4 12 Q1 13 Q2 13 Q3 13

AdvancedFed funds rate 0-0.25 Easing: 17 Sep 07 5.25 Dec 08 (-75-100) Beyond 2013 0-0.25 0-0.25 0-0.25 0-0.25

BoJ overnight rate 0.10 Easing: 30 Oct 08 0.50 Oct 10 (0-10) Q1 16 (+20) 0-0.10 0-0.10 0-0.10 0-0.10

ECB main refinancing rate 0.75 Easing: 3 Nov 11 1.50 Jul 12 (-25) Q1 13 (-25) 0.75 0.50 0.50 0.50

BOE bank rate 0.50 Easing: 6 Dec 07 5.75 Mar 09 (-50) May 14 (+25) 0.50 0.50 0.50 0.50

RBA cash rate 3.00 Easing: 1 Nov 11 4.75 Dec 12 (-25) Beyond 2014 3.00 3.00 3.00 3.00

RBNZ cash rate 2.50 Easing: 10 Mar 11 3.00 Mar 11 (-50) H2 14 (+50) 2.50 2.50 2.50 2.50

Swiss National Bank 0-0.25 Easing: 8 Oct 08 2.75 Aug 11 (-25) Beyond 2013 0.25 0.25 0.25 0.25

Norges Bank 1.50 Easing: 14 Dec 11 2.25 Mar 12 (-25) Q3 13 (+25) 1.50 1.50 1.50 1.75

Riksbank 1.25 Easing: 20 Dec 11 2.00 Sep 12 (-25) Dec 12 (-25) 1.00 1.00 1.00 1.00

Bank of Canada 1.00 Tightening: 1 Jun 10 0.25 Sep 10 (+25) Q2 13 (+25) 1.00 1.00 1.25 1.25

Emerging AsiaChina: 1y bench. lending rate 6.00 Easing: 7 Jun 12 6.56 Jul 12 (-31) Beyond Q3 13 6.00 6.00 6.00 6.00

Hong Kong: Base rate 0.50 Easing: 19 Sep 07 6.75 Dec 08 (-100) Beyond 2013 0.50 0.50 0.50 0.50

India: Repo rate 8.00 Easing: 17 Apr 12 8.50 Apr 12 (-50) Q1 13 (-50) 8.00 7.50 7.00 7.00

Indonesia: O/N policy rate 5.75 Easing: 11 Oct 11 6.75 Feb 12 (-25) Beyond Q3 13 5.75 5.75 5.75 5.75

Korea: Base rate 2.75 Easing: 12 Jul 12 3.25 Oct 12 (-25) Beyond Q3 13 2.75 2.75 2.75 2.75

Sri Lanka: Reverse repo 9.75 Tightening: 3 Feb 12 8.50 Apr 12 (+75) Beyond Q3 13 9.75 9.75 9.75 9.75

Malaysia: O/N policy rate 3.00 Tightening: 4 Mar 10 2.00 May 11 (+25) Q4 13 (+25) 3.00 3.00 3.00 3.00

Philippines: O/N lending 3.50 Easing: 19 Jan 12 4.50 Oct 12 (-25) Q4 13 (+25) 3.50 3.50 3.50 3.50

Taiwan: Rediscount rate 1.875 Tightening: 24 Jun 10 1.38 Jun 11 (+12.5) Beyond Q3 13 1.875 1.875 1.875 1.875Thailand: O/N repo rate 2.75 Easing: 30 Nov 11 3.50 Oct 12 (-25) Beyond Q3 13 2.75 2.75 2.75 2.75Vietnam: Reverse repo rate 8.00 Easing: Jul 11 15.00 Jul 12 (-150) Q3 13 (+100) 8.00 8.00 8.00 9.00Emerging Europe, Middle East & Czech Republic: 2w repo rate 0.05 Easing: 8 Aug 08 3.75 Nov 12 (-20) Beyond Q3 13 0.05 0.05 0.05 0.05

Hungary: 2w deposit rate 6.00 Easing: 28 Aug 12 7.00 Nov 12 (-25) Dec 12 (-25) 5.75 5.00 5.00 5.00

Poland: 2w repo rate 4.25 Easing: 7 Nov 12 4.75 Dec 12 (-25) Jan 13 (-50) 4.25 3.25 3.00 2.75

Romania: Key policy rate 5.25 Easing: 4 Feb 08 10.25 Mar 12 (-25) Beyond Q3 13 5.25 5.25 5.25 5.25

Russia: Overnight repo rate 5.50 Tightening: 13 Sep 12 5.25 Sep 12 (+25) Beyond Q3 13 5.50 5.50 5.50 5.50

South Africa: Repo rate 5.00 Easing: 11 Dec 08 12.00 Jul 12 (-50) Sep 14 (+50) 5.00 5.00 5.00 5.00

Turkey: 1w repo rate 5.75 Easing: 20 Nov 08 16.75 Aug 11 (-50) Q1 13 (-25) 5.75 5.50 5.50 5.50

Egypt: Deposit rate 9.25 Tightening: 24 Nov 11 8.25 Nov 11 (+100) Beyond Q3 13 9.25 9.25 9.25 9.25

Israel: Discount rate 2.00 Easing: 26 Sep 11 3.25 Oct 12 (-25) Q1 13 (-25) 2.00 1.75 1.75 1.75

Latin AmericaBrazil: SELIC rate 7.25 Easing: 31 Aug 11 12.50 Oct 12 (-25) Jan 13 (-50) 7.25 6.25 6.25 6.25

Chile: Monetary policy rate 5.00 Easing: 12 January 12 5.25 Jan 12 (-25) Q4 13 (+25) 5.00 5.00 5.00 5.00

Colombia: Repo rate 4.50 Easing: 27 Jul 12 5.25 Nov 12 (-25) Beyond 2013 4.50 4.50 4.50 4.50

Mexico: Overnight rate 4.50 Easing: 16 Jan 09 8.25 Jul 09 (-25) Beyond 2013 4.50 4.50 4.50 4.50

Peru: Reference rate 4.25 Tightening: 6 May 10 1.25 May 11 (+25) Oct 13 (+25) 4.25 4.25 4.25 4.25

Uruguay: Monetary Policy Rate 9.00 Tightening: 22 Sep 10 6.25 Sep 12 (+25) Dec 12 (+25) 9.25 9.50 9.50 9.50

ForecastsStart of cycle

Note: Rates are COB of 10 December 2012. Source: Barclays Research


13 December 2012 44

FIGURE 40 General government/GDP debt longer term projections

2010 2011 2012 F 2013 F 2014 F 2015 F 2010 2011 2012 F 2013 F 2014 F 2015 FAustria 71.9 72.2 73.0 73.0 72.3 70.9 Spain* 61.5 69.3 85.2 91.3 94.1 95.4Belgium 96.0 98.0 99.4 99.5 97.7 94.4 Euro area 85.3 87.2 92.2 93.4 92.8 91.1Finland 48.6 49.0 52.4 53.7 53.8 53.5 US 98.4 102.8 107.0 110.0 112.0 113.0France 82.3 85.8 89.1 90.6 90.7 89.6 UK 79.4 85.0 88.2 93.7 96.1 97.2Germany 82.5 80.5 81.5 80.5 78.3 76.1 Japan 192.7 205.5 212.7 222.9 230.2 236.0Greece 148.3 170.6 178.6 190.6 195.3 189.8 Australia 24.3 30.2 32.6 33.2 32.7 31.6Ireland 92.5 108.2 117.3 121.6 119.8 117.7 Canada 85.1 85.4 87.5 87.0 85.0 83.0Italy 118.6 120.1 126.3 128.3 127.1 124.6 Sweden 39.4 38.4 38.5 39.6 39.7 39.3NL 62.9 65.2 69.6 72.2 72.8 72.3 Norway 11.3 13.8 13.7 14.0 13.5 13.0Portugal 93.3 107.8 119.5 125.4 125.1 123.4 Denmark 42.9 46.5 45.5 45.0 44.5 43.0

Gross government debt ratio (% GDP) - projections to 2015

Note: (*) The 2012 deficit includes some of the (one-off) bank recapitalization costs. Source: Barclays Research

FIGURE 41 US economic projections

2011 2012 2013 Calendar year average

% Change q/q saar Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2011 2012 2013 2014

Real GDP 0.1 2.5 1.3 4.1 2.0 1.3 2.7 2.5 1.5 2.0 2.5 2.5 1.8 2.3 2.1 2.5

Private consumption 3.1 1.0 1.7 2.0 2.4 1.5 1.4 2.5 1.5 2.0 2.5 2.5 2.5 1.9 2.0 2.5

Public consumption and invest. -7.0 -0.8 -2.9 -2.2 -3.0 -0.7 3.5 -2.0 -2.0 -2.0 -1.5 -1.5 -3.1 -1.4 -1.2 -1.1

Residential investment -1.4 4.1 1.4 12.1 20.5 8.5 14.2 15.0 10.0 10.0 12.0 12.0 -1.4 12.0 11.7 10.2

Equip. & software investment 11.1 7.8 18.3 8.8 5.4 4.8 -2.7 3.0 5.0 8.0 10.0 10.0 11.0 6.3 5.1 8.2

Structures investment -28.2 35.2 20.7 11.5 12.9 0.6 -1.1 3.0 5.0 8.0 8.0 8.0 2.8 9.7 4.7 6.7

Net exports ($bn, real) -417 -400 -398 -418 -416 -407 -403 -396 -394 -392 -393 -394 -408 -405 -394 -394

Net exports (contr to GDP, pp) 0.0 0.5 0.0 -0.6 0.1 0.2 0.1 0.2 0.1 0.1 0.0 0.0 0.1 0.0 0.1 0.0

Final sales 0.6 2.4 2.3 1.5 2.4 1.7 1.9 2.3 1.4 2.1 2.7 2.7 2.0 2.1 2.0 2.4

Ch. inventories ($bn, real) 30.3 27.5 -4.3 70.5 56.9 41.4 61.3 67.0 71.0 71.0 72.0 73.0 31.0 56.7 71.8 75.5

Ch. inventories (contr to GDP, pp) -0.5 0.0 -1.1 2.5 -0.4 -0.5 0.8 0.2 0.1 0.0 0.0 0.0 -0.1 0.2 0.1 0.0

GDP price index 2.0 2.6 3.0 0.4 2.0 1.6 2.7 1.7 1.7 2.0 3.2 2.8 2.1 1.8 2.1 2.5

Nominal GDP 2.2 5.2 4.3 4.2 4.2 2.8 5.5 4.2 3.2 4.0 5.8 5.4 4.0 4.2 4.2 5.0

Industrial output 4.4 1.2 5.6 5.1 5.9 2.3 0.0 5.0 4.0 4.5 4.5 5.0 4.1 3.9 3.8 4.9

Employment (avg mthly chg, K) 192 130 128 164 226 67 168 145 150 180 200 200 153 151 183 200

Unemployment rate (%) 9.0 9.1 9.1 8.7 8.2 8.2 8.1 7.8 7.7 7.5 7.3 7.1 8.9 8.1 7.4 6.8

CPI inflation (%y/y) 2.1 3.4 3.8 3.3 2.8 1.9 1.7 2.0 1.7 1.9 2.2 2.3 3.2 2.1 2.0 2.8

Core CPI (%y/y) 1.1 1.5 1.9 2.2 2.2 2.3 2.0 2.0 2.2 2.2 2.4 2.7 1.7 2.1 2.4 2.9

Core PCE price index (%y/y) 1.1 1.3 1.6 1.7 1.9 1.8 1.6 1.7 1.7 1.8 2.1 2.4 1.4 1.7 2.0 2.6

Current account (%GDP) -3.2 -3.2 -2.9 -3.1 -3.5 -3.0 -3.1 -2.9 -2.9 -2.9 -2.9 -2.9 -3.1 -3.1 -2.9 -2.9

Federal budget bal. (%GDP) -8.7 -7.0 -6.2 -5.6

Federal funds rate (%) 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25

Note: All numbers expressed in q/q saar % unless otherwise specified. The budget balance is fiscal year. Source: BEA, BLS, Federal Reserve, US Treasury, Barclays Research


13 December 2012 45

FIGURE 42 Euro area economic projections


% change q/q♣ Q1 Q2 Q3 Q4 Q1 Q2 Q3E Q4E Q1E Q2E Q3E Q4E 2011 2012E 2013E 2014E

Real GDP 0.6 0.2 0.1 -0.4 0.0 -0.2 -0.1 -0.3 0.0 0.2 0.3 0.3 ... ... ... ...

Real GDP (saar) 2.6 0.9 0.4 -1.4 -0.1 -0.7 -0.1 -1.2 0.1 0.7 1.0 1.3 ... ... ... ...

Real GDP (y/y) 2.4 1.6 1.3 0.6 -0.1 -0.5 -0.6 -0.6 -0.5 -0.2 0.1 0.8 1.5 -0.4 0.1 1.4

Private consumption 0.0 -0.4 0.2 -0.5 -0.3 -0.4 0.0 -0.3 -0.2 -0.1 0.1 0.1 0.1 -1.1 -0.6 0.6

Public consumption -0.1 0.1 -0.3 0.0 0.1 -0.1 -0.2 -0.4 -0.3 -0.2 -0.1 0.0 -0.1 -0.2 -0.9 0.0

Investment 1.9 -0.3 -0.3 -0.6 -1.2 -1.8 -0.7 -0.5 -0.1 0.3 0.5 0.5 1.6 -3.6 -0.7 2.2

- Residential construction 3.0 -0.6 -0.6 -0.2 0.2 -1.5 0.1 -0.2 -0.2 -0.1 0.1 0.3 0.9 -1.5 -0.7 1.2

- Non-residential construction 2.0 -1.1 -1.0 -0.3 -2.1 -1.4 -0.8 -0.5 0.0 0.1 0.5 0.5 -1.4 -4.5 -0.7 1.5

- Non-construction investment 1.3 0.4 0.2 -0.9 -1.6 -2.2 -0.9 -0.9 -0.1 0.7 0.8 0.8 3.8 -4.3 -0.6 3.7

Inventories contribution (pp) 0.0 0.3 -0.3 -0.5 0.0 0.0 -0.2 0.0 0.0 0.0 0.0 0.1 0.2 -0.6 -0.1 0.1

Final dom. demand cont. (pp) 0.3 -0.3 0.0 -0.4 -0.3 -0.6 -0.2 -0.3 -0.2 0.0 0.1 0.2 0.3 -1.3 0.7 0.8

Net exports contribution (pp) 0.2 0.2 0.4 0.6 0.3 0.4 0.3 0.1 0.2 0.2 0.1 0.1 1.0 1.5 0.7 0.2

Industrial output (ex construct.) 1.0 0.2 0.5 -1.8 -0.5 -0.5 -0.5 -1.5 -0.9 -0.4 -0.3 -0.1 3.4 -2.5 -2.8 0.0

Employment (q/q) 0.1 0.2 -0.1 -0.3 -0.3 0.0 -0.1 -0.1 -0.1 -0.2 -0.1 -0.1 0.3 -0.4 -0.5 0.0

Unemployment rate % 9.9 9.9 10.2 10.6 10.9 11.3 11.5 11.7 11.9 12.0 12.1 12.3 10.2 11.4 12.1 12.1

CPI inflation (y/y) 2.5 2.8 2.7 2.9 2.7 2.5 2.5 2.3 2.0 1.9 1.8 1.7 2.7 2.5 1.8 1.7

Core CPI (ex food/energy) y/y 1.1 1.6 1.3 1.6 1.5 1.6 1.6 1.4 1.4 1.4 1.4 1.3 1.4 1.5 1.4 1.2

Current account % GDP 0.0 -0.3 0.0 0.5 0.9 1.2 1.5 1.5 1.7 1.9 2.0 2.1 0.1 1.3 1.9 2.1

Government balance % GDP ... ... ... ... ... ... ... ... ... ... ... ... -4.1 -3.1 -2.4 -1.8

Refi rate (period end %) 1.00 1.25 1.50 1.00 1.00 1.00 0.75 0.75 0.50 0.50 0.50 0.50 1.00 0.75 0.50 0.50

Note: All numbers expressed in % q/q unless otherwise specified. Source: Barclays Research

FIGURE 43 UK economic projections


% Change q/q Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2011 2012 2013 2014

Real GDP 0.5 0.1 0.5 -0.4 -0.3 -0.4 1.0 -0.2 0.3 0.4 0.5 0.5 ... ... ... ...

Real GDP (saar) 2.0 0.3 2.1 -1.4 -1.2 -1.5 3.9 -0.7 1.3 1.7 1.9 2.0 ... ... ... ...

Real GDP (y/y) 1.4 0.7 0.6 0.7 -0.1 -0.5 -0.1 0.1 0.7 1.5 1.0 1.7 0.9 -0.1 1.3 2.2

Private consumption -1.1 -0.2 -0.1 0.2 0.3 -0.2 0.6 -0.3 0.1 0.2 0.3 0.3 -0.9 0.5 0.5 1.6

Public consumption 0.2 0.3 0.1 0.3 3.1 -1.6 0.6 -0.7 0.0 0.1 -0.1 -0.2 0.2 2.4 -0.7 -1.4

Investment -1.9 0.0 0.5 -0.7 3.2 -2.7 0.5 -1.4 0.1 0.2 1.0 1.1 -2.4 0.8 -0.5 6.5

Inventories (q/q cont.) 0.0 0.6 0.5 -0.8 -1.2 1.3 -0.3 0.0 0.2 0.1 0.1 0.1 0.3 -0.6 0.6 0.0

Net exports (q/q cont.) 1.3 -0.5 -0.1 0.4 -0.5 -0.8 0.7 0.4 0.1 0.1 0.1 0.1

-0.5 0.6 0.4

Nominal GDP 1.6 0.4 0.5 0.6 0.0 1.0 1.2 1.0 1.0 1.2 1.3 1.1 3.6 2.5 4.5 4.7 Industrial output -0.1 -1.1 -0.2 -1.4 -0.2 -0.7 0.8 -2.1 0.7 0.3 0.3 0.3 -0.7 -2.3 -0.2 2.0

Employment 0.4 0.0 -0.6 0.3 0.4 0.7 0.3 -0.1 0.0 0.0 0.1 0.1 0.5 1.0 0.3 0.3

Unemployment rate % 7.8 7.9 8.3 8.4 8.2 8.0 7.8 7.9 8.0 8.1 8.1 8.2 8.1 8.0 8.1 8.2

CPI inflation y/y 4.1 4.4 4.7 4.7 3.5 2.7 2.4 2.6 2.5 2.9 3.0 2.7 4.5 2.8 2.8 2.4

Core CPI y/y 3.2 3.3 3.2 3.2 2.5 2.1 2.1 2.6 2.3 ... ... ... 3.2 2.3 ... ...

Current account % GDP -1.7 -0.8 -2.9 -2.2 -4.0 -5.4 -3.7 -2.7 -2.8 -2.8 -2.8 -3.0 -1.9 -3.9 -2.8 -3.1

Govt. balance % GDP* ... ... ... ... ... ... ... ... ... ... ... ... -8.0 -5.1 -6.1 -5.1

Bank Rate (EOP, %) 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 1.25

Note: *Fiscal year forecasts, 2012 = FY 12-13; excludes the impact of financial sector interventions. Source: ONS, Barclays Research


13 December 2012 46

FIGURE 44 Japan economic projections


% change Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2011 2012 2013E 2014E

Real GDP (q/q, saar) -7.3 -2.8 10.4 0.3 5.7 -0.1 -3.5 0.2 0.9 0.9 1.3 2.1 -0.6 2.1 0.3 0.7

Real GDP (q/q) -1.9 -0.7 2.5 0.1 1.4 0.0 -0.9 0.1 0.2 0.2 0.3 0.5 - - - -

Private consumption (q/q) -1.4 0.9 1.4 0.5 1.1 0.1 -0.4 0.3 0.2 0.2 0.2 0.4 0.5 2.4 0.6 0.2

Public consumption (q/q) 0.1 0.4 0.1 0.5 1.4 0.5 0.6 0.3 0.2 0.1 -0.3 -0.5 1.5 2.7 0.6 -0.8

Residential investment (q/q) 2.1 -2.8 4.2 -0.1 -1.1 1.5 0.9 2.1 1.1 0.3 2.7 3.6 5.5 2.3 6.2 3.1

Public investment (q/q) -4.0 0.6 -1.7 -1.3 7.8 5.4 1.5 -1.0 -3.2 -2.6 -0.6 0.7 -7.5 11.0 -3.6 1.4

Capital Investment (q/q) 0.2 -0.2 2.2 7.3 -2.4 0.1 -3.0 -1.7 0.3 0.4 0.5 0.5 3.3 2.2 -1.9 1.9

Net exports (q/q)* -0.3 -1.0 0.8 -0.7 0.1 -0.2 -0.7 0.0 -0.0 0.0 0.0 0.1 -0.9 -0.8 -0.3 0.1

Ch. Inventories (q/q)* -0.7 -0.3 0.5 -0.5 0.3 -0.3 0.3 0.1 0.1 0.1 0.1 0.1 -0.4 0.1 0.3 0.1

Nominal GDP (q/q) -2.2 -1.4 2.3 -0.3 1.5 -0.5 -0.9 0.1 0.2 0.3 0.0 0.4 -2.4 1.3 -0.0 0.9

Industrial output (q/q) -1.5 -4.2 5.4 0.4 1.2 -2.0 -4.2 -0.3 2.2 0.9 1.1 1.6 -2.4 0.1 0.6 2.1

Employment (q/q) 0.2 -0.4 -0.2 0.4 0.4 -0.2 0.2 0.1 0.1 0.1 0.2 0.1 -0.1 0.5 0.4 0.5


CPI inflation (y/y) -0.8 -0.3 0.2 -0.2 0.1 0.0 -0.2 0.0 -0.1 0.0 0.1 0.1 -0.3 -0.1 0.1 1.6

Core CPI ex food/energy (y/y) -1.4 -0.9 -0.5 -1.1 -0.6 -0.5 -0.6 -0.4 -0.3 -0.2 0.0 0.1 -1.0 -0.5 -0.1 0.6

Current account (% GDP) 3.0 1.6 2.2 1.4 1.2 1.3 0.8 0.6 0.6 0.6 0.9 1.0 2.0 1.0 0.8 0.7

Government balance (% GDP) … … … … … … … … … … … … -9.5 -9.8 -10.2 -9.3

Overnight call rate 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10

Note: *Contribution. Central bank rates are for end of period %. Source: BoJ, Cabinet Office, METI, MIC, MoF, Barclays Research

FIGURE 45 China economic projections


% change y/y Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2011 2012 2013 2014

Real GDP 9.8 9.5 9.2 8.9 8.1 7.6 7.4 7.8 7.9 8.1 7.9 7.6 9.3 7.7 7.9 8.1

Real GDP (q/q, saar) 9.6 8.7 8.4 9.2 6.3 6.4 8.4 10.2 6.8 7.2 7.4 9.1 … … … …

Consumption* (pp) 6.1 5.0 5.0 5.2 6.4 4.7 4.2 4.0 4.5 4.0 4.0 4.0 5.2 4.0 4.2 4.4

Investment* (pp) 3.8 4.5 4.4 4.5 2.4 4.0 3.9 4.0 3.2 3.8 3.8 3.8 4.5 3.8 3.9 3.8

Net exports contribution* (pp) -0.1 0.1 0.1 -0.4 -0.7 -0.9 -0.4 -0.4 -0.4 -0.3 -0.2 -0.2 -0.4 -0.1 -0.2 -0.1

Industrial output 14.3 13.9 13.8 12.8 11.6 9.5 9.1 9.1 9.8 10.6 11.4 11.8 13.7 9.8 11.0 12.0

CPI inflation 5.1 5.7 6.3 4.6 3.8 2.9 1.9 2.1 3.2 3.1 3.0 3.5 5.4 2.7 3.2 3.5


Current account (% GDP) 1.9 3.5 3.0 2.5 1.4 2.9 3.5 3.0 2.6 2.6 2.6 2.6 2.8 2.9 2.6 2.3

Government balance (% GDP) … … … … … … … … … … … … -1.1 -1.5 -1.7 -1.7

Key CB rate (period end, %) 6.06 6.31 6.56 6.56 6.56 6.31 6.00 6.00 6.00 6.00 6.00 6.00 6.56 6.00 6.00 6.00

Note: All numbers are expressed in y/y % change unless otherwise specified. *Contributions by GDP expenditure components are all reported as “year to date” numbers officially. Source: Barclays Research


13 December 2012 47

COMMODITY MARKETS OUTLOOK

The return of commodity risk • After taking a back seat to broader financial market and macroeconomic concerns

recently, commodity risk looks set to play a more active role in early 2013.

• Stretched supply lines and limited shock-absorbing capability mean that oil markets are highly vulnerable to a further ratcheting up of geopolitical risks in early 2013 and grains markets to bad weather in key southern hemisphere exporters.

• If US fiscal cliff issues can be resolved soon, a strong and broad-based rally across commodities is possible, as investors are under-exposed. However, we think that this will provide selective opportunities for shorting in some markets.

Things can only get better If not quite an annus horribilis, 2012 has certainly proved difficult for commodities. Financial market instability has, with few exceptions, dominated over fundamentals, with “risk-on, risk-off” the main driver of price trend and direction. Global growth has disappointed and China’s slowdown has weighed heavily on consumption. In most markets, growth in physical demand has fallen a long way below projections made at the start of the year.

Even after QE3, prices in many markets are still flat to down on year-ago levels. Commodity investment performance has been desolate, sector benchmarks have underperformed their counterparts in almost all other risky assets and previously successful commodity alpha strategies have disappointed. Investment flows into commodities should grow a little this year, but if gold is excluded from the picture, the net allocation of new funds to commodity assets is close to zero, the weakest in a decade.

With the US fiscal cliff poised to deliver another macro shock to growth-sensitive assets, commodity markets appear to have collectively thrown in the towel, and risk-taking appetite is at a nadir. Volumes traded on most commodity exchanges are feeble even for the time of year; in many markets, implied volatility is at its lowest in recent memory, whilst futures price curves for several important commodities are at their flattest for a long time.

Kevin Norrish

+44 (0)20 7773 0369 [email protected]

Helima Croft +1 212 526 0764 [email protected]

Risk appetite in commodities is at extremely low levels

FIGURE 1 Flat lining: Crude oil volatility at a 5-year low...

FIGURE 2 ….copper forward curve straightens out

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5-year trading range

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months forward

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months forward

LME forward copper price curve ($/t)



13 December 2012 48

Position for another early-year rally After the past 12 months, it is not surprising that markets are suffering “event fatigue”, but it is partly the extreme limits to which commodity risk aversion has been pushed that provide at least one good reason to expect a change of direction before long, though there are others. Each of the past two years has had a strong early-year rally in commodities prices and that looks a probable outcome again in 2013.

Our call this time last year for a strong early-year rally in commodities (see Global Outlook December 2011: A cautious step forward) was a relatively straight-forward one to make. The speed with which prices had fallen in early Q4 could be justified only if the global economy was heading for recession, so even the modest growth we expected required a rapid recalibration of price levels across almost all markets. Sure enough, the main benchmarks of commodity spot prices rallied 10-15% in the first two months of the year, supported by an easing in European sovereign debt concerns and a big move up in oil prices sparked by fears the Iranian nuclear enrichment dispute could result in the disruption of oil shipments through the Straits of Hormuz.

The similarities in current market conditions are striking and suggest that the likelihood of another strong start to the year for commodities is quite high. Once again, commodities prices have fallen for most of Q4 and risk appetite is being constrained by fears that politicians will be unable to solve a pressing financial threat. If anything, the geopolitics of oil are even more worrying heading into 2013 than they were a year ago and the potential for shocks in markets such as grains has also risen.

On current positioning, hedge funds and institutional investors look light in their commodity exposure to the long side. Since the announcement of QE3 in early September, CFTC data confirm that long positions across all major commodity sectors except silver have been cut back sharply. Aggregate net long positions across all US commodity futures, excluding precious metals, have fallen more than 30% since early September.

The picture is similar for retail and institutional investors. We estimate that in October, $1.2bn was withdrawn from commodity indices, after five months of modest inflows.

Of the net total of $3.3bn invested in commodities in October via indices, ETPs and structured products, precious metals accounted for more than 90%.

Current market conditions look similar to those prior to the strong early rallies of past two years

Hedge funds have cut long positions in most markets since QE3

FIGURE 3 A strong rally for commodities in early 2013 would repeat the pattern of the past two years

FIGURE 4 Hedge fund long positions in most commodities have been cut back since QE3

400

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Nov Dec Jan Feb

2011/122012

DJUBS commodity spot price index from November

2010/11

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Silver Grains Oil Gold Copper Softs Fibre

Current Wk prior QE3

Managed money positions in selected US commodity futures relative to 5-year peak

Source: Ecowin, Barclays Research Source: CFTC, Barclays Research




13 December 2012 49

Fundamentals: Glimmers of hope There are three key trends underway that, if sustained, may soon require markets to revise their levels of pessimism.

First, China growth risks are subsiding. Key drivers of its commodity demand, including construction activity, industrial production and fixed asset investment, have all picked up recently, business confidence is stronger and in October there were the early signs of a concerted recovery in demand growth across a range of different commodities. Although a rapid rebound from the 2012 slowdown is unlikely, at least the debate is now about the strength of the recovery, rather than the prospects for a hard landing, which dominated China discussions for most of the past year.

Second, market concerns over tail risk events are easing. Of course, one major threat looms, but if the US can overcome its fiscal cliff problems (and our base case is that whilst the December 31 deadline may be missed, the situation will be resolved by the end of January), the financial market environment, whilst still facing obstacles in Europe, could start to look brighter than for some time. Crucially for commodities, the evidence suggests that as perceptions of the tail risk from European sovereign debt issues have receded, commodities have become less shackled to financial market events, driven more by their own fundamentals, and are displaying a wider range of price outcomes (Figure 6).

Third, risks that are idiosyncratic to commodities themselves are on the rise. On the one hand, many of the supply threats that have been present for some time now in one form or another, including bad weather affecting agricultural markets, geopolitical threats in oil and the labour problems that have hit mining, look likely to persist or get even worse in 2013. On the other, many markets are already struggling to cope with tightly stretched supply lines, depleted inventory levels and high rates of capacity utilisation. There are several markets, including oil and grains, where the mere threat of supply problems is likely to be enough to prompt a substantial price response.

The China debate is now about recovery…

….tail risk fears have subsided…

FIGURE 5 Growth in China’s electricity, oil and copper demand all turned up in October

FIGURE 6 Correlation between different commodities has fallen as the threat of financial shock from Europe has eased

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Spanish & Italian sovereign bond CDS (RHS)

Commodity correlations & European sovereign debt

Source: Barclays Research Source: Ecowin, Barclays Research

….and risks idiosyncratic to commodities are on the rise


13 December 2012 50

Tension points The backdrop of better financial market sentiment and a gradual improvement in growth suggests that commodity fundamentals should be freed up to exert much greater influence on price patterns in early 2013 than was the case this year and that the potential for supply risk is likely to be a key differentiator of price performance.

Geopolitical threats to oil 2013 will be a critical year in international efforts to curb Iran’s nuclear ambitions. If no deal is reached in the first half of the year, the risks of a crisis that could exert upward pressure on oil prices will rise, in our view. With the election campaign behind President Obama, we expect him to redouble efforts to secure a diplomatic settlement with Iran. Obama has displayed little enthusiasm for a military confrontation and continually stressed the need to continue with a diplomatic course, while at the same time ratcheting up the economic pressure on Tehran. Iran, facing deteriorating domestic economic conditions, has recently signalled a desire to return to the bargaining table. Talks between the permanent members of the UN Security Council plus Germany (P5+1) are expected to resume in January. Senior US officials have also reportedly indicated a willingness to hold direct bilateral negotiations with Iran to break the diplomatic impasse.

Despite the new momentum behind talks, it remains far from certain that the two sides will be able to overcome the serious obstacles that have stymied the negotiations thus far. The P5+1 are demanding that Iran first undertake confidence building measures, such as halting uranium enrichment at 20% levels, shipping the highly enriched stockpiles out of the country, and closing the heavily fortified Fordow enrichment site, before discussing the removal of sanctions. Iran, on the other hand, has insisted on international recognition of its right to enrich uranium and immediate relief from sanctions before considering concessions such as freezing 20% enrichment. Ultimately, a deal may hinge on whether Iran is permitted a face-saving measure, such as being allowed to enrich at 3.5-5.0% levels, which would be consistent with a civilian nuclear power programme.

The Iranian government consistently denies that it is building a weapons program and insists that its nuclear activities are solely for peaceful purposes. The Obama administration has been reluctant thus far to allow any enrichment, but it may prove more flexible on this point in 2013. Such a shift, however, could upset the Israeli government, as Prime Minister Netanyahu has repeatedly insisted on no Iranian enrichment. Speedy sanctions relief could also prove challenging, as some of the most stringent measures, such as the central bank sanctions, originated in the US Congress. US legislators do not seem in any mood to lessen the economic pressure on Iran. The Senate just passed by a 94-0 vote a new round of sanctions targeting Iran’s energy, shipping and shipbuilding sectors.

The stakes are very high, in our view. Next year may produce an important inflection point for President Obama and his counterparts in Western capitals. They may face the difficult choice of either allowing Iran to reach the point of nuclear breakout capability or taking military action to forestall that possibility. The Obama administration and the Netanyahu government have divergent nuclear redlines. The Obama administration has repeatedly declared that it will never allow Iran to build a nuclear weapon and has publicly ruled out a containment strategy. Netanyahu, by contrast, maintains that Iran should never be permitted to approach the point at which it can produce a nuclear device in a relatively short time because of the size of its enriched uranium stockpiles. During his September UN General Assembly speech, Netanyahu indicated that Iran will cross this redline sometime during spring or summer 2013. While Obama will probably continue to push back on efforts to get him to alter his redline, we believe that there will be, at a minimum, heightened discussion of potential Israeli military action next spring if Iran does not significantly slow its nuclear activities.

New momentum for talks with Iran

But there exist serious obstacles to an agreement

Israel’s line in the sand

Iran could reach nuclear break-out capability early in 2013


13 December 2012 51

Weather risk in agricultural commodity markets The effect of this year’s bad weather and poor harvests and the huge volatility it caused in agricultural commodity markets has faded for now, but it lives on in the extremely low inventory levels projected for the marketing years ending in 2013 and the constrained ability of key exporters such as the US to make their usual contribution to global markets. The net effect is that supplies in several key agricultural staples, including corn, soybeans and wheat, look even more vulnerable to bad weather than they were 12 months ago.

Over the past few months, several factors have contributed to some easing of supply concerns in agricultural commodity markets, but this relative calm may not last much longer. Demand for corn from the US ethanol sector has softened recently, but that has more to do with economics than policy. Higher oil prices would quickly improve ethanol margins and boost corn ethanol demand again. China’s corn and soybean imports have also fallen, but this is likely to prove no more than a temporary adjustment in what is still a strong long-term upward trend. Moreover, the US winter wheat harvest is proceeding poorly, with a quarter of the crop graded at “poor” or worse due to continued dry weather in the plains.

The fate of upcoming harvests in the world’s major southern hemisphere exporters Brazil, Argentina and Australia are likely to be key price drivers in early 2013. So far, there have been some minor downgrades to South American grains and soybean harvest expectations as the result of difficult planting conditions, whilst heavy rains have led to downgrades to Australian wheat output forecasts.

So far, losses have been relatively minor, and healthy export projections for grains and soybeans have remained intact. However, early next year South American crops will enter the growing season, when they are at their most vulnerable. Bad weather at this time, especially a repeat of the dry conditions that hit US corn and soybeans crops earlier this year, would have very serious consequences indeed.

Whilst it is impossible to predict extreme weather events with any accuracy, the anecdotal evidence certainly suggests that they are becoming more common and a growing number of climate scientists are attributing these events, especially the increased incidence of drought, to global warming (see, for example, “Explaining extreme events of 2011 from a climate perspective” at http://www1.ncdc.noaa.gov/pub/data/cmb/bams-sotc/2011-peterson-et-al.pdf or “A decade of weather extremes” at http://www.nature.com/nclimate/journal/v2/n7/full/nclimate1452.html).

Calmer tone in agricultural commodity markets may not last

FIGURE 7 Global stocks of grains and soybeans in 2013 will be below average for the second year running

FIGURE 8 Availability of corn for export is forecast to fall next year, LatAm is the key short-term risk for further downgrades

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South American harvests in focus in early 2013

http://www1.ncdc.noaa.gov/pub/data/cmb/bams-sotc/2011-peterson-et-al.pdf�

http://www.nature.com/nclimate/journal/v2/n7/full/nclimate1452.html�


13 December 2012 52

The key is that whilst extreme weather events with the potential to wreak serious disruption to agricultural output are becoming more common, markets are more poorly equipped to deal with the consequences than for a very long time. Indeed, given the depletion in global inventories, especially of grains in recent years, it would not take a very extreme weather event early in 2013 to make markets very concerned about supplies over the rest of the year.

Labour problems in mining Recent times have seen many mining companies suffering from a deterioration in labour relations, resulting in more strikes, disruption and lost output. The past few years have seen major disputes in Australia, many parts of Latin America and Indonesia, with the focus in 2012 on South Africa and its precious metals mines.

This worsening of labour disruptions in the mining sector has its roots in several factors. In countries such as Australia and Chile, a big expansion in mining activity has bumped up against limited labour resources, giving workers a great deal more leverage than in previous cycles. Unions have also become emboldened by consistently high prices on global markets and a desire to make sure their members get a fair share of profits. In some countries, such as South Africa, this is leading to growth in membership of unions seen as likely to take a more aggressive approach to negotiations on pay and conditions. Mining companies themselves are also taking a harder line than previously. This is due to rapid cost escalation in recent years, made worse by big increases in the value of many mining country exchange rates and the knock-on effect in swelling their local currency costs, the biggest component of which is usually labour.

The dynamics that have underpinned the greater incidence of labour disruptions seem unlikely to dissipate any time soon, and in some markets, lost output in recent years has been of sufficient magnitude to substantially alter global market balances and put upward pressure on prices. The best recent example of this is in platinum, where lost output in 2012 exceeded 400k oz, about 7% of global supply.

In early 2013, the focus is likely to remain on South Africa, where the framework of labour relations in the mining sector is already stretched to the breaking point and is likely to be put under even more strain in the run-up to the mid-year biennial wage negotiations. Elsewhere, labour contract renewals are due at Escondida in Chile and Grasberg in Indonesia, the world’s two largest copper mines. Both have suffered from poor labour

Grains markets poorly placed to deal with any more lost supply

FIGURE 9 Labour costs in key mining countries such as Australia have soared in recent years

FIGURE 10 Labour disruption in SA was the key factor pushing platinum into deficit this year

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Labour disruption is becoming more common in the mining sector


13 December 2012 53

relations and production losses in recent years, though a recent vote by Escondida’s workers to start negotiations early is viewed as a sign that negotiations may progress more smoothly this time round. This suggests that in the short term, it is likely to be the PGMs that are more vulnerable to labour issues than base metals, though markets will be keeping a wary eye on copper once again, given its tendency for supply to underperform expectations on a regular basis.

Trade recommendations: Positioning for upside Given our fundamental view that conditions are improving for commodities, that the Chinese economy will continue to pick up momentum gradually and that the fiscal cliff problem will be solved before it delivers a major negative growth shock to the US, we believe that the key risk investors should be positioning for in commodities is a sharp move to the upside in early 2013.

However, any further easing of financial market tensions is also likely to support the process by which commodities are becoming less correlated with each other and driven more by their own market dynamics. If this process continues to gather pace, as we expect, it will also pay for investors to adopt a much more differentiated set of positions in commodities than has been the case for some time.

Our key recommendations are as follows:

• Position for broad upside price risk. We think a general upside move across commodities of the magnitude seen in the past two years is likely in early 2013, with the exact timing depending on US fiscal cliff progress. An obvious way to try to participate in this is via options on a commodity index. However, a relatively short tenor for the trade, plus flat forward curves for the liquid options markets in the S&PGSCI or DJUBS indices, means that the pay-offs for such a strategy are not attractive. A much better approach is to take advantage of the backwardation in Brent crude and small put skew that allow for an options position with some limited downside protection and a greater degree of upside participation at almost zero cost. This kind of positioning should also benefit if geopolitics moves back onto oil traders’ radars and boosts prices, as we expect it to in early 2013.

• Be ready to short markets where higher prices are not yet justified. Short covering has prompted a recovery in base metals that is likely to gather pace in early 2013. However, fundamentals are still weak, especially in major markets such as aluminium and copper and we recommend shorting the rally should it continue. Aluminium fundamentals are the weakest for any base metal at present, but price volatility tends to be quite low. Instead, we recommend shorting copper if cash prices rise much above $8,500/t. A large stock overhang in China means its import demand will likely be sharply down on year-ago levels, and following the recent abolition of export taxes on tolled copper, there could be a steady stream of exports early next year, which could turn market sentiment very negative.

• Prepare for a resumption of reflation risk. Gold prices have fallen back recently, as investors have little desire to use it to hedge US fiscal cliff risks, given the strong correlation with other risky assets displayed through 2012. Disappointing price action, a slowing of ETP buying, and an overhang of hedge fund positions in futures are negatives for gold in the weeks ahead. But with real interest rates at their lowest for many years and central banks still in an aggressively reflationary mode, little has changed in the longer-term supportive environment for gold and we recommend buying on dips toward the 200-day moving average, currently at $1660/oz.


13 December 2012 54

• Avoid the “obvious” China trades. With China likely to continue its gradual improvement, investors might be tempted to go long base metals, with copper the most obvious pick. However China’s copper market looks oversupplied in the short term and with the intensity of copper usage now in a long-term decline, there are better ways to position for a China recovery. China has become increasingly important in the palladium market as its auto sector grows (currently about 10% of global consumption). A dip in its imports last year is indicative, in our view, of some mild de-stocking, and with China’s auto production forecast to pick up in 2013, this should boost imports in a market that is already in structural deficit as a result of a big decline in Russia’s export potential. One caveat is that tactical long positioning in palladium is already quite high, but we would view it as a buy on price dips that may materialise heading into the end of 2012 or in early 2013.


13 December 2012 55

FOREIGN EXCHANGE OUTLOOK

Stay with the policy tides • We think central bank action is likely to create interesting opportunities in FX markets

in spite of the slow growth environment that we see for 2013.

• We expect the newly elected Japanese government to give the BoJ a stronger mandate for targeting higher, much-needed inflation. As a result, we think the yen is likely to experience a large, one-off depreciation, mostly in Q1.

• Thus, we recommend holding USD/JPY and GBP/JPY 3m calls as of now. Furthermore, we look to fund long cyclical currency positions with the yen once the US fiscal cliff risks begin to dissipate.

• We think the MXN, ZAR, RUB and MYR are set to outperform all other currencies in the supportive risk environment that we expect for 2013.

• Stretched valuations from abnormal conditions should begin reverting in 2013, highlighting vulnerabilities in currencies such as the AUD for the medium term.

Top themes for 2013 We look at the year ahead with excitement about the interesting opportunities (and challenges) FX markets may offer to express a wide variety of themes. These include: Japan’s intention to inflate the economy and establish a new monetary policy target; the consequences this may mean for other Asian crosses; the risks markets may face before the US fiscal cliff is resolved and the opportunities that these risks may create thereafter; and the chances that the ECB embarks on a more aggressive easing to support activity. There are also the geopolitical risks from Iran’s nuclear program that may play out in H1 13, the valuation themes that we expect to reverse years of dislocations produced by abnormal fundamental and policy circumstances, and the transition from deflation to inflation pressures that may affect currencies in countries with vulnerabilities and weak central bank hands.

We provide our views on each of these themes and offer ideas about how to approach them from the FX market perspective, even if we expect some of them to come later in the year. As a roadmap, let us start from the themes and trades that we think our clients should be involved with as of now.

Sell JPY – this time is different We expect the new government, to be elected on December 16, to overhaul its monetary authority mandate by moving from an inflation goal of 1% to a firmer, explicit inflation target of 2%. We think these changes will have a profound, depreciatory one-off impact on the JPY of over 10% from 78 to 88 over six months.

After the initial bearish move that we expect in the coming months, the shock to inflation expectations should erase the downward slope of the USD/JPY of the past few decades (Figure 1) and even steeper trend versus other trading partners (Figure 2), with chances of a small upward trajectory on the cross, eventually translating into a structural upward shift in domestic interest rates. We think this move is likely to be the main driver of FX returns in EM and G10 crosses in 2013, making the JPY our preferred funding currency, initially against the USD and later against more cyclical currencies once fiscal cliff risks begin to dissipate.

Jose Wynne


Guillermo Felices +44 (0)20 3555 2533 [email protected]

Koon Chow +44 (0)20 7773 7572

[email protected] Aroop Chatterjee


Nick Verdi +65 6308 3093 [email protected]

FX markets likely to see more price action than the current state of the global cycle w ould suggest

Buy USD/JPY calls: new government to target higher inflation, breaking from the past

Policy action is highly likely


13 December 2012 56

Our high conviction on this move is based on three main reasons. First, we think the likelihood of action is high. The more stable global environment that we expect in 2013 provides a window of opportunity for action, as volatility in domestic rates and the JPY may be more bearable in a more stable environment for the EUR and China growth. Importantly, for the first time, a new government will have the chance to replace three of the nine voting board members, including the governor and two deputy governors. Also, the economy is in a technical recession and a one-off monetary stimulus would be politically and cyclically palatable.

Second, if there is determination to pursue a higher inflation target, we expect the impact on the yen to be large. Structural fiscal imbalances impede the government from relying on fiscal spending to jump-start inflation, which means the bulk of the work to change sticky inflation expectations built over the years will have to fall on the BoJ. From the monetary policy perspective, then, two main channels can be expected to be used to engineer inflation against a likely initial public reluctance to believe in higher inflation: lower real rates, via quantitative easing, and a weaker yen. While we would expect the first to be pursued via long maturity bond purchases, further out than the 2-3 year current practice, we expect the chances of boosting lending and therefore growth and inflation via this channel to be limited.

This means foreign exchange will have to carry the heavy burden of this process, and the question is, how low could the yen go? Our model estimates the FX pass-through to inflation at 15%, which means a 10% multilateral nominal depreciation provides a one-off boost to inflation of 1.5%. In other words, a bigger move is needed in USDJPY to push NEER lower by 10% given that other sensitive crosses will tend to follow the JPY – and all this results merely in a small boost to inflation in the hope of jump-starting inflation expectations.

Our forecasts assume there is determination to target 2% inflation; hence, we pencil in a near 13% USD/JPY upward move from the 78 before the market took a higher target seriously. While the direct inflation impact of such a move is not enough by itself to achieve the new target, we expect activity and inflation to pick up due to the stimulus provided by lower rates and a cheaper currency.

Third, we think the USD/JPY move will be frontloaded. Our forecasts anticipate the bulk of the adjustment to happen during the first quarter of 2013. The JPY has already weakened 4% and we expect the completion of the move to come with new information, early in the year. We see

FIGURE 1 JPY bull trend is likely over

FIGURE 2 Sensitive Asian partners should take note

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Policy action to have a large, one-off depreciatory effect on the yen

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13 December 2012 57

the market trading on three pieces of information. The first is the election, confirming Mr. Abe’s appointment. A majority would likely bring more confidence to markets that changes to the BoJ are in the works. The second is the list of board member candidates, providing indication that the government has decided to break from the more hawkish past. The third is statements by the new board that it is discussing unconventional tools (long maturity bond purchases and even foreign assets). The new board is to be in place on April 8.

Positioning is the number one risk (Figures 3 and 4). Positioning is rather stretched from an historical perspective and if the elections or the political process upset market expectations, offshore investors are poised to unwind. We would expect a disorderly move lower in USD/JPY in that case, likely tamed by some central bank intervention. But we also believe the positioning fears should not be overplayed. Offshore investors are mostly moving ahead of the likely changes that should affect domestic corporates and households after they begin believing in a higher inflation outlook. Offshore JPY short positions are not front-running the more sophisticated local investors like banks, pension funds and insurance companies, as they are naturally hedged given domestic liabilities.

JPY spillovers on other crosses A 13% move in the JPY is unlikely to pass unnoticed by other sensitive Asian crosses, such as the KRW. Our models suggest the KRW is cheap from a multilateral perspective and we expect a partial correction of this misalignment to occur in 2013. But we do not expect this multilateral correction to hinge entirely on a big appreciation against the USD, as suggested by our year-end forecast of 1050. Rather, we think a weaker JPY and other crosses should help the KRW rebalance towards stronger levels against all partners.

Because of this, and due to our front-loaded JPY forecast, we recommend selling downside inside 1070 in USD/KRW in the next three months. Also because of the fiscal cliff risk, we recommend adopting a more defensive position by looking for a timid move up in USDKRW ahead of some stress that may confront markets in the next month.

A weaker yen is likely to affect the KRW more than other Asian crosses, but others will also be affected. Countries such as Korea, China and Taiwan will mostly face headwinds from Japan’s monetary experiment. We base this assumption on two main reasons. First, because Japan is a major trading partner of China, Taiwan and Korea, a cheaper JPY should have a

Positioning is a risk factor, but should not be a deterrent at this stage

FIGURE 3 Short JPY positioning looks crowded…

FIGURE 4 Posing downside risks to short JPY

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13 December 2012 58

direct effect on import and exports flows. But this feature is also shared by other Asian countries that are unlikely to be as affected. Second, and more importantly, these countries compete with each other in other markets. Japan and Korea compete in the US automobile market, for example, and a cheaper JPY may slow Korea’s exports growth to the US and, thus, the KRW appreciation against the USD (Figure 5). Furthermore, competitiveness issues in third markets are more general and not confined to idiosyncratic cases such as the US automobile example, as export patterns are remarkably similar among them, in spite of the natural differences extant in the quality and complexity of goods produced (Figure 6).

Among the CNY, TWD and KRW, we expect the last to be most affected. While a cheaper JPY will slow CNY appreciation, domestic growth engines in China, a closely managed exchange rate regime, and significant product value-added differences between China and Japan should keep downside risks contained. We see the TWD as a bit more vulnerable, given its export dependence, which is why we recommend a short 3m TWD/CNY fwd. With USD/CNY spot currently trading at the strong end of the band, CNY forwards (marked off the fix) provide greater upside than CNH (which more closely follows CNY spot) versus the TWD.

A weaker yen should not pose headwinds to all currencies in Asia, though. We think the MYR is likely to benefit from a looser BoJ stance. The net income flows of exports in Malaysia are positively correlated with those of Japan. This suggests there is complementarity in production and trade flows and that a one-off stimulus to Japan exports should motorize Malaysian exports as well. In addition, domestic economic conditions remain robust. With national elections out of the way by April next year, we expect ongoing bond inflows and increased FDI to provide solid fundamental support. These reasons make us constructive about the ringgit outlook and therefore we stand ready to include it in our long risk basket, as soon as we put the US fiscal cliff stress behind us.

We also think that IDR and INR should escape the pressures of a much weaker yen. For the IDR, this is because its commodity outlook is complementary with Japan’s needs. Still, domestic factors make our economists cautious and us bearish on the currency outlook relative to the region. But the INR resilience to a weaker JPY makes the rupee an attractive candidate for our long risk basket, when the US cliff risks dissipate. Indeed, positive sentiment from increased political momentum and a more favourable growth/inflation dynamic that allows the Reserve Bank of India to deliver long-overdue rate cuts, encouraging net foreign equity inflows, would likely boost the INR.

China and Taiwan will likely also be affected, but with relatively limited effect on the CNY and TWD

FIGURE 5 Share of US automotive market (%, 12-month average)

FIGURE 6 Export by sector (% of total exports)

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Others, such as the MYR, should benefit

IDR and INR face no major headwinds from a weaker yen


13 December 2012 59

Opportunities from the US fiscal cliff

The US fiscal cliff discussions have the potential to create interesting opportunities both before and after its final resolution, which we expect during the first days of 2013.

We are not outright short risk across the board ahead of these risks but recommend holding a defensive position on high-beta currencies until these risks begin to dissipate. We have chosen to express this view by putting our long carry ideas on hold (neutral) and by holding long USD/MXN positions via 3m call options. We do not believe carry is enough to compensate for the downside risks that markets may face if a resolution is delayed beyond the first days of 2013.

Our reasons to stay defensive ahead of these discussions are two-fold. First, while we count on a resolution of the fiscal cliff in early 2013, we disagree with some market participants that a deal can be cut before year-end, and we consider it likely that the US economy will be temporarily sent over the cliff. We think resetting taxes higher and letting tax breaks expire would provide the ground for agreement that is absent under the current circumstances. Second, and more important, we see a steep market downside to going and staying over the cliff, given that the resilient US consumer would be affected by lower pay checks. Recent data on US consumer confidence reinforce this concern. Furthermore, we think a weaker US consumer may bring renewed concerns about the growth outlook in China and the funding risks of peripheral Europe (Figures 7 and 8).

Against these concerns, market sentiment has improved as the cliff approaches. Leaving aside those who expect a resolution before year-end, others count on an early resolution of discussions before US consumers (and global markets) are even affected. While we also consider this likely, we believe the cliff is too steep for markets to ignore and the political process messy enough to take risks seriously.

Buy risk, beyond the cliff Regardless of whether market stress offers better entry levels into risky currencies in the coming days, we look with enthusiasm at the opportunities that a more constructive risk environment may bring in the first quarter of 2013. With the US fiscal cliff behind us, European peripheral risks contained, and China on a firm path away from its 2012 slowdown, the global environment would likely have the building blocks needed for a slow recovery.

FIGURE 7 China exports hinge on US consumers

FIGURE 8 US cliff may bring financial instability back to peripheral Europe

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We see the US cliff market stress as an entry opportunity into risky currency longs


13 December 2012 60

We expect two phases in the cyclical currency appreciation path that we envision for Q1 13. The first is a brief “risk-on” environment early in the year, in which risk-defensive positions are squared and a more aggressive stance is adopted in the most cyclical currencies vulnerable to the US cliff. We expect the MXN, INR and ZAR to be the best expressions of the better environment that we see beyond the cliff. Coincidentally, these currencies display cheap valuations (Figure 9) and high betas to global risks (Figure 10).

These currencies have been cheap and volatile for good reasons, but this is about to change. These crosses are linked to the global manufacturing cycle and discretionary world spending. Global manufacturing slowed at a rate five times greater than the contraction in GDP back in 2008, revealing the vulnerabilities of these currencies to severe global slowdowns. With fears of a severe global slowdown behind us, we expect a relief rally in response. We look to close our long 3m USD/MXN call option when the rally begins and start an outright long basket on the MXN, INR, and ZAR, as well as the MYR and RUB (funded with JPY). We do not expect the last two to have the same responsiveness to the relief rally but would include them in the long basket for the quarter ahead.

The second phase of cyclical currency outperformance is based on a more structural view. With the relief rally behind us, ample global liquidity provided by major central banks, a stable growth outlook in EM and an appetite for risk among global portfolios with a full year ahead to meet returns, we think carry and valuation are likely to become key drivers of excess returns – a theme we advocate more broadly across other asset classes.

Keep valuation on your radar Timing correction in currency misalignments is more art than science, but there are times when stretched valuations are more likely to catch market eyes. We think 2013 may offer opportunities for valuation themes to turn into market drivers, after years of market stresses and dislocations that, while persistent, could start being resolved.

One interesting feature of our fair value model (BEER) is that while several manufacturing currencies are cheap, commodity currencies look expensive. It is not surprising to see strong commodity currencies in a context of global easing and relatively elevated commodity prices, but our model, while imperfect, does incorporate terms of trade as a driver of currency fair value; therefore, this feature should, in principle, be factored in.

Once risks begin to dissipate, we expect the MXN, INR and ZAR to outperform all other currencies

But we would also add the MYR and RUB as part of the currency long basket

FIGURE 9 Manufacturing currencies are cheap

FIGURE 10 FX return betas to global factors

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13 December 2012 61

But commodity producers have also benefited from a long cycle of high export prices, which allowed them to enter the 2008 crisis with very strong public and private balance sheet positions. That feature has given some currencies, such as the AUD, a safe-haven status of sorts. This is reflected in the share of foreigners’ holdings of Australian government bonds, which rose from 62% in Q2 09 to 81% in Q2 12. Moreover, there is room for these holdings to grow, with non-residents holding only 39% of the semi-government market in the corresponding quarter.

Cross-border capital flows have been an important additional factor in supporting currencies with stretched valuations, while increasing appreciation pressure on countries with undervalued exchange rates. In the case of international bond and stock flows, destinations have been limited. This scarcity has had to do with the lack of safe havens for bond flows and lack of growth for equity ones. Currencies of countries with safe haven-like properties, such as the AUD, CAD and SEK in G10 and SGD in EM, have benefited despite their overvalued exchange rates. On the other hand, these flows have pushed up currencies of high-growth countries with cheap equity market valuations, such the KRW, INR, BRL, MXN and PLN.

But AUD valuation levels now look overly stretched relative to both the AUD’s own history and other key cyclical currencies such as the ZAR and KRW (Figure 11). While global monetary easing and the Chinese infrastructure-led recovery will likely make it difficult to trigger a sharp reversal of the value of the AUD in the first months of 2013, we do believe that valuation poses limits to appreciation in the near term. Further out, long-term investor concerns are likely to centre on imbalances in domestic economic growth and the peak in the commodities investment cycle. A slower economy and potential further rate cuts could accelerate this process, as we are seeing in the BRL (Figure 12).

Bearish euro times to come While we think the euro is likely to trade sideways in the near future, we continue to be euro bearish for 2013. We forecast conflicting cross-flows in the next three months, with a small upward bias in EUR/USD. This call is driven mostly by a weak USD view after the cliff, rather than by a stronger outlook for the EUR in the near term.

The relative monetary policy views are the main drivers of our near-term view. Against our call, we expect better US growth performance relative to the eurozone in the coming

AUD upside looks limited near term on valuation concerns; further out, AUD value may be vulnerable to a correction

FIGURE 11 AUD, expensive; KRW and ZAR, cheap

FIGURE 12 BRL/MXN misalignment, already underway

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13 December 2012 62

quarters, with the US growing 2-2.5% and the eurozone in contraction mode q/q, seasonally adjusted until Q3 13, when we expect stabilization before recovery starts. But monetary policy is likely to remain more aggressive in the US than in Europe, at least in the first quarter of 2013, putting upward pressure on EUR/USD three months out. The relative monetary stance is partly, but not exclusively, justified by the Fed’s dual mandate. Despite differences among board members, the FOMC seems more cohesive than the ECB board.

We expect the Fed to roll Operation Twist into an USD85bn-per-month bond purchase programme, which should last for at least the first half of 2013. Later in the year, we expect it to reduce the purchase program to USD45bn per month through year-end 2013, driving our weak USD views for H1 (Figure 13). Furthermore, we expect the ECB to stay on hold until early March 2013, when we expect a repo rate cut of 25bp. But we believe more will be needed to support activity and with the ECB inflation forecasts below the target for 2013, we expect further action even after the OMT program is up and running before Q1 ends. Further action may include corporate bond buying, an unsterilized OMT program, negative interest rates in deposits, and/or easier financial conditions for small and medium-sized firms across Europe.

Regardless of the tools found appropriate, we think the ECB will look for ways to ease financial conditions in line with its inflation target, driving the euro lower (Figure 14). We think the timing is hard to predict but expect this to begin about three months hence.

We see the euro’s move lower as relatively steep and, hence, recommend trading our bearish euro view, with a target of 1.22 by year-end 2013, from a peak of 1.32 in three months. In Q1, we would replace the JPY as our preferred funding currency with the EUR when the ECB starts easing, keeping it as the main funding currency throughout the rest of 2013. But we do not see this happening just yet.

This backdrop is likely to drive the GBP. As in the case of the euro, easy money from the Fed should support the GBP versus the USD in the three-month horizon, but further out, we expect the UK recovery to face headwinds from a weaker eurozone. A combination of easy monetary and tight fiscal policy is likely to challenge the GBP’s outlook against the USD, but cheap valuations should provide the grounds for outperformance relative to the EUR, supporting our EUR/GBP forecasts of 0.78 in 12 months.

FIGURE 13 Fed easing likely to stay ahead of the curve

FIGURE 14 ECB easing likely to be stepped up to support growth

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But in three months, we expect the EUR downside to gain traction; we target 1.22 by year-end

The GBP to trade in between the USD and the EUR


13 December 2012 63

Oil risks Supply risks are likely to remain latent in 2013, motivated by tensions stemming from Iran’s nuclear development program. Major G10 and EM currency vulnerabilities to oil prices vary, depending on the effect on economic growth, the external balance, and monetary policy. Figure 15 shows the results of our aggregate score of an oil price increase by currency, showing that oil importing countries in EM Asia and EMEA are the most vulnerable from economic growth and external perspectives.

Vulnerabilities in a number of these currencies, such as TRY, SGD, TWD and INR, are exacerbated by central banks that tend to accommodate inflation shocks from oil supply disruptions. Among the G10, the CHF and the JPY appear more vulnerable than others. In contrast, an oil supply shock favours currencies such as the RUB, MXN and NOK, given the positive effect such a shock would have on their current accounts, limited growth implications, and more proactive monetary policy to prevent second-round inflation effects. Our long RUB/TRY relative trade recommendation offers insurance against these risks at a positive carry of 170bp in 3m forward, fairly favoured by valuation considerations.

FIGURE 15 Oil supply vulnerability index combining effect on economic growth, external balance and monetary policy (higher implies higher risk to the currency value)

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Take geopolitical risks seriously

Long RUB/TRY offers insurance against oil at positive carry, limited downside and supportive valuations


13 December 2012 64

INTEREST RATES OUTLOOK

Running in place • While the near-term focus in the US is on the fiscal cliff, the full 600bn+ of fiscal

tightening is unlikely even if no agreement is reached before year-end. Conversely, even if the cliff is avoided, the US faces sizeable medium-term fiscal tightening. US housing should continue to help the economy, but is unlikely to be a game changer.

• We expect 10y US Treasury rates to rise to 1.8% in Q1, but a sustained further sell-off is unlikely. This forecast reflects an economy growing at 2% next year. Factors driving our low-for-long rates view include headwinds posed by bank regulation and structural demand for ‘safe’ assets.

• In Europe, the ECB has lowered tail risk in financial markets, and peripheral economies have made progress in improving competitiveness. But debt dynamics remain poor, weighed down by poor growth. Europe needs continued fiscal and structural reforms, which would weigh on the economy. We expect virtually no growth in 2013.

• The key question is whether continued reforms will be politically tolerable, given social fatigue. Europe is unlikely to provide upside surprises next year, while downside risks exist, mainly from political upheavals. Rates in core European countries should stay low and range-bound.

• In the UK, disappointing fiscal numbers and ‘sticky’ inflation data could push up term premia in the gilt curve. But with the MPC not closing the door to future gilt buying, the market will be wary of getting too short gilts. We are biased higher in gilt yields but expect any sell-off to be contained.

• The BOJ is likely to continue to support the JGB market through debt purchases next year, just as it did in 2012. We expect 10y JGB yields to trade between 0.6% and 1.0%, with the lower bound likely to be tested in H1 2013.

• In sum, rates in most developed markets should stay low in Q1 2013, owing to mediocre growth, fiscal austerity, and central bank support. Investors will have to eke out returns by opportunistically trading the range and through relative value trades.

For our full 2013 outlook, please refer to Global Rates Outlook 2013: Running in place, 7 December 2012.

As 2013 approaches, financial markets are in better shape than they were a year ago. Most equity indices are up for the year, sovereign yields in Southern Europe are down sharply from the levels of 12 months ago, and equity and interest rate volatility is near pre-crisis lows. But this benign outcome is not due to strong data or because of a resolution of the European debt crisis. Growth has disappointed in most economies, and forecasts have been repeatedly revised down over 2012. Instead, asset prices have been supported by unprecedented easing by central banks across the world.

But most regions still face very significant challenges, not least on the growth front. In this environment, interest rates should stay low and range-bound in 2013, and fixed income investors will likely feel like they spent the year running in place.

Ajay Rajadhyaksha


Laurent Fransolet +44 (0)20 7773 8385 [email protected]

Rajiv Setia +1 212 412 5507

[email protected] Michael Pond


Chotaro Morita +81 3 4530 1717 [email protected]



13 December 2012 65

US: Beyond the fiscal cliff In the US, the most immediate challenge is the fiscal cliff, which is unlikely to be resolved by the time we go to press. But regardless of how the next few weeks play out, there are two points to be made. First, even if the ‘cliff’ is hit, the US will almost certainly not see the full $600+bn of fiscal tightening in 2013; retroactive legislation should offset much of the spending cuts and tax increases. Our economists estimate that the US will see $200bn in cliff-related fiscal tightening in 2013.

More importantly, the US faces a longer-term fiscal challenge. In early 2011, we estimated that the US would need to cut deficits by $6trn over the next decade to get to a sustainable fiscal path by the end of 2021 (see Beyond the Supercommittee, November 18, 2011 for details). Even if this entire amount is not achieved, the US should see sizeable fiscal tightening over the medium term. For example, the president’s budget plan and the House plan (passed in 2012) call for significant deficit reduction (see Figure 1); the disagreement is on how to get there. Fiscal tightening should not be thought of as a 2013 event, but rather as a persistent headwind for several years. There is, of course, a chance that policymakers just ignore the US fiscal profile. But the main reason to keep ignoring fiscal pressures would be if growth underwhelms, which is not a scenario where rates would rise.

Housing is a bright spot One bright spot next year should be US housing. We expect aggregate home prices to rise 5.5% in 2012 and 4% in 2013.3 There are three main reasons for US home prices to keep rising. First, housing looks fairly cheap on a fundamental basis, on metrics such as rent-buy ratios, median home price-median income, land share in home prices, etc. (with wide regional variations; please see A sustainable recovery, 19 November 2012, for details). Second, the negative pressures from distressed sales have faded. Real estate owned (REO) properties are at the lowest levels in many years, while 90+ loans (those delinquent for over 90 days) peaked more than two years ago. Finally, home prices in virtually every index that we follow are now up significantly for the past four quarters. The last time this occurred was in 2006. Home prices have momentum; buyers stay on the sidelines if prices are falling, and vice versa.

3 This might seem impressive, but aggregate home prices are now 28% below their 2006 peak. Adjusted for inflation, that number jumps to 38%.

Even if the fiscal cliff is hit, retroactive legislation should undo some of the tightening

Regardless of the result of the fiscal cliff negotiations, the US should see sizeable medium-term fiscal tightening

FIGURE 1 Both parties are looking to tighten fiscal policy aggressively

FIGURE 2 US banks need to raise more regulatory capital

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

2012 2013 2014 2015 2016 2017 2018Neutral Policy President House

Primary Balance, % GDP

7.0%

7.5%

8.0%

8.5%

9.0%

9.5%

JPM BAC C WFC US Bancorp

BNY Mellon

Q3 12 Q2 12 Source: CBO’s analysis of the President Budget, March 2012 Baseline and House budget plan, Barclays Research

Source: Bank regulatory filings, Barclays Research

Home prices should keep rising in 2013, and housing continues to help the economy…




13 December 2012 66

Despite this bullish stance on home prices, housing is not a silver bullet for the US economy. Residential investment spending has already added significantly to US GDP in recent quarters. Even as home prices rise, homeowners will have limited ability to tap into home equity, unlike in the previous cycle. ‘Cash-out’ loans, where borrowers take out a bigger mortgage while paying off their existing mortgage and then spend the difference, are virtually non-existent now. Finally, mortgage credit availability remains constrained, with lending standards from the GSEs still tight and non-agency issuance virtually zero. Housing should help the US economy in 2013, but is not a game-changer.

Other factors also point to low rates Away from fiscal issues and housing, a few other factors drive our medium-term rates outlook. Despite the move lower in the jobless rate, wage inflation and real income growth have stayed weak, as we discuss in US Rates Strategy: Cloudy with a chance of thunderstorms. A sharp uptick in wage inflation or much faster payroll growth would be needed to justify a large rate sell-off. Investors will also have to factor in the monetary policy framework. Vice Chair Janet Yellen is widely tipped to replace Chairman Bernanke in 2014. She recently noted that the Fed should be on hold until the jobless rate approaches 6%. With the market pricing in a fed funds rate of 50bp in Q4 15 and 100bp in Q4 16, and with consensus unemployment rate forecasts for end-2015 at 6.7%, the fed funds curve has room to flatten.

Bond bears are unlikely to be helped by inflation fears, either. 5y5y cash inflation breakevens are at 2.77% in early December, above the levels prior to QE2 and at the higher end of the range of the last few years. We have a long breakeven bias in the US (see Inflation-linked Markets Overview: Providing diversification). Regardless, medium-term premia due to an expected policy error are unlikely to rise, unless the Fed alters its inflation target.4 Finally, there are the headwinds posed by bank regulation, specifically from higher capital ratios (see Figure 2). A relaxation of bank capital rules would be a risk to our low for long view. But this seems unlikely5; capital and liquidity rules should remain a drag on growth in 2013.

It is important to note that our low for long rate call is not based on a collapsing US economy. While the US faces fiscal and regulatory headwinds, housing has likely bottomed, monetary policy is very accommodative and the wealth effect (equities are up sharply in the past two years) should help the consumer. Our economists expect the US to grow at 2.1% in 2013. Our year-end 2013 forecast of 1.6% on 10s reflects an economy growing at trend. For a significant rate sell-off, sustained growth of 2.5-3.0% for several quarters and inflation expectations well above the Fed target for an extended period are needed.

Europe: Lower tail risk but poor base case From a systemic standpoint, the sovereign crisis in Europe has waned in intensity. Investors have the ECB to thank, for reducing tail risk twice in the past 12 months. A year ago, the ECB removed the risk that a big European bank would face a funding crisis via the 3y LTRO programs. And a few months ago, it removed the risk that a Southern European country would run out of funding, with its offer of conditional debt purchases. But from an economic standpoint, Europe looks to be in poor shape in 2013. Our forecasts call for eurozone growth to be virtually flat next year, much worse than either the US or the UK. Consequently, while near-term funding pressures have receded, Europe continues to face two longer-term issues. One is the difference in competitiveness between various economies that share a common currency. The other is high levels of sovereign indebtedness, coupled with a lack of growth.6

4 Note that since the Fed announced open-ended QE, term premia have not risen. 5 The July 2012 NPR (notice of proposed rulemaking) from the Fed was more stringent than Basel III in some areas. 6 From a fiscal perspective, the growth that matters most is nominal growth. If real growth picks up but inflation moderates, that is not as useful to manage debt dynamics.

…but it is not a game-changer

A dovish Fed and headwinds from bank regulation should continue to support yields

Our low for long US rates call reflects an economy growing near trend

The ECB has reduced tail risks over the past few quarters, but the economic outlook remains weak





13 December 2012 67

Consider the competitiveness issue first. If countries have varying levels of competitiveness, exchange rates help restore the balance. Less-competitive countries see their currency weaken, making them more competitive. This adjustment mechanism is missing in a currency union. Fiscal transfers are often used instead. For example, the US (a currency union where states have differences in competitiveness) conducts permanent fiscal transfers from some coastal states to some states in the Midwest and South.7 But fiscal transfers are very difficult between countries. Instead, the eurozone is trying to reduce the competitiveness gap through reform.

On that front, there has been significant progress. Current account deficits in the periphery have almost closed, peripheral exports have picked up, and there has been significant convergence in wage labor costs (though there is still a gap with Germany). For example, Spanish compensation per employee has been marginally negative in Q2 and Q3, notable in a country with wage indexation and strong labor laws. But further competitiveness convergence is needed. The key question is whether the price (through high unemployment rates and falling wages in some areas) will remain politically tolerable in Southern Europe, amidst considerable social fatigue.

Debt dynamics stable in some, worse in others Now consider the debt challenges. There are a few ways for a government to reduce a debt burden, such as running a primary surplus and ensuring that the country’s cost of funding is lower than nominal GDP. For example, Italy has a healthy primary surplus. But its average cost of funding (assuming it is the 10-year point) is 4-5%. With real growth contracting over 2% in 2012 (and expected to contract 0.8% in 2013), nominal growth will be well below Italy’s nominal funding. Ideally, Italy’s nominal growth needs to move above its cost of funding, at which point its debt-GDP ratio can start to decline meaningfully. Meanwhile, the recent package for Greece has bought the country some time; while Greece might well require further debt relief, risk aversion on this issue should stay contained for the next few quarters.

The Spanish situation is different. Spain missed the 2011 deficit target and is likely to miss the 2012 target as well ( -6.3pct of GDP ex bank recapitalization costs; Barclays -6.9pct of GDP). But this does not mean a crisis is imminent, as the markets expect some ( limited) fiscal slippage. In Euro Area Rates Strategy: Moving on from high volatility to stability, we note that selling pressures in peripheral sovereigns have now abated, and foreign ownership of Spanish and Italian debt troughed in Q1 12 (see Figure 3). Our call is that Spain remains solvent, though its fiscal profile is worse than we forecast at the start of 2012 and will likely

7 Delaware, New Jersey and New York send more in federal taxes than they receive in federal spending. Kansas and Alabama get more from the federal government than they send.

The eurozone has made significant progress in reducing the competitiveness gap

Selling pressure in peripheral sovereigns has now abated

FIGURE 3 Evolution of foreign peripheral debt ownership

FIGURE 4BoE balance sheet (% GDP)

20%

25%

30%

35%

40%

45%

50%

55%

Jun-09 Feb-10 Oct-10 May-11 Jan-12 Aug-12

Italy debt securities held by foreigners (ex ECB)

0%

5%

10%

15%

20%

25%

1973 1977 1981 1985 1989 1993 1997 2001 2005 2009

BOE Balance sheet (% GDP)

Source: Bank of Italy, Spanish Treasury, Barclays Research Source: Bank of England

Spain’s fiscal profile has deteriorated more than was expected a few quarters ago



13 December 2012 68

keep worsening for some more years. Consequently, it is not certain that Spain will enter the ESM program even in Q1 13. But there is no denying the tightrope it will have to walk. For example, if Spain accelerates fiscal consolidation to get to a primary surplus sooner, it risks much weaker growth, further spikes in the jobless rate, and higher NPLs and losses in the banking sector. On the other hand, slow the pace of consolidation and the market might turn more skeptical of the country’s ability to reach a primary surplus.

These examples illustrate that countries in Southern Europe with high debt burdens need low costs of funding for an extended period, high nominal GDP, and significant fiscal tightening to create a primary surplus. All this requires continued and painful fiscal and structural reforms. This should weigh on economic performance for the foreseeable future, so we expect virtually no growth in the eurozone in 2013, with most countries exiting recession only by mid-year.

Political will is the key With the economics likely to remain poor, political will is the key variable. Over the past two years, Europe’s policymakers have repeatedly shown the will to keep the eurozone intact, even if it involves steps once considered unlikely8. On the other hand, national politics have caused risk flares in markets, as electorates tired of austerity and high unemployment have elevated fringe participants to the mainstream. For example, the Greek political party Syriza was a small presence until the 2011 elections. But by mid-2011, markets were worried that Syriza would win and disavow the Greek austerity plan, leading to a possible exit from the eurozone. The risk is that electoral unhappiness with reforms could show up in election results, as well as in policy decisions made by individual countries.

Admittedly, there is now a better understanding that there is no silver bullet to this crisis and that the institutional setup of the euro area will need a long time to evolve. Progress, as per the ‘four presidents’ report’, is likely to be slow, but expectations seem to be lower as well. One area to watch is how the banking union takes shape. Details of the common supervisory role for the ECB, as well as of a common euro area-wide deposit, resolution and recapitalization framework, will provide clues on how quickly Europe will make progress.

It seems safe to say that Europe is unlikely to provide upside surprises next year, while the potential for downside surprises exists, mainly on the political side (for example, Italian elections in April). Hence, we expect rates to stay low and range-bound next year. Given the recent rally, they are at the lower end of the range in core countries such as Germany, but a significant sell-off remains unlikely. Meanwhile, a further rally would require a sudden spike in uncertainty on the political front that then bleeds into markets, but this is not our base case, either.

UK: Caught in two minds Over the past several quarters, gilts have surprised markets by the strength of their performance. For example, 10y spot yields are now much lower than what forwards (as well as most outlooks) were calling for a year ago. The BOE9 has made the case that the gilt rally has been due to expectations that policy rates would stay low for a considerable period, coupled with stable inflation expectations, and we agree (see UK Rates Strategy (20)13: unlucky for some?). For rates to rally further, a significant fall in core inflation that pushes out a hike in the policy rate further is needed.

Inflation is becoming a bigger factor in the BOE decision-making process. For example, the November Inflation report is the first time that Governor King did not state that the Committee’s inflation expectations would come back to target over the medium term. This seems an admission that persistent inflation is a medium-term problem. This ‘stickiness’ in

8 For example, the ECB debt purchase program, Northern Europe agreeing to recapitalize banking systems independent of the sovereigns, etc. 9 Quarterly Bulletin Q3 2012 – What accounts for the fall in UK ten-year government bond yields?

The eurozone should have virtually no growth in 2013

Despite being at the lower end of the range, yields in core countries are unlikely to sell off significantly

For gilts to rally further, a decline in core inflation that pushes out a hike in the BOE policy rate is required

The government’s forecast of a stabilization of the fiscal profile has been repeatedly pushed back…



http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb120302.pdf�


13 December 2012 69

inflation seems to be a factor in the MPC’s decisions on future gilt purchases, as seen in statements by MPC officials Martin Weale and Spencer Dale. Meanwhile, the UK has continued to disappoint on the fiscal side. Government forecasts of when the UK’s fiscal profile will stabilize have been repeatedly pushed back. For example, this week, the Office for Budget Responsibility (OBR) said that the UK’s debt-GDP ratio will peak at 79.9% in 2015-16, higher and later compared with their March forecast of a 76.3% peak in 2014-15. The report also stated that the structural deficit will not be eliminated until 2016-1710. We expect the UK’s AAA rating to come under pressure in 2013, which should push up term premia in the gilt curve.

On the other hand, with the MPC not closing the door to future purchases (see Figure 4), the market will be wary of getting short gilts. For example, Governor King has stated that the MPC has not ‘lost faith’ in QE. In addition, growth is expected to remain weak in 2013 (though better than in 2012) and with continued fiscal austerity, there is scope for downward revisions (for example, the OBR just reduced its GDP forecast for 2013 to 1.2%, from 2.0% previously). Gilts have attracted, and could continue to attract, support if the European sovereign crisis flares up again. Hence, even as we expect higher gilt yields in 2013, our forecast does not call for an aggressive rate sell-off.

Japan: BoJ policy options and the JGB curve The BoJ’s expansion of JGB purchases since April has resulted in an extremely strong impact on yield-curve shape over time, as seen in the JGB market during Oct-Dec 2012. Yields in the deliverable bond sector (7-10y) have dropped excessively because of demand from banks suffering from low returns in the short- and medium-term sectors, but 20-40y yields, which rely on life insurer demand, have not declined much. As apparent in the unprecedented 5s10s20s butterfly spread, “market segmentation hypothesis” has been completely realized between the sector influenced by BoJ monetary easing and the sector not being affected. Additionally, investors have been pricing in enhancement of easing actions, assuming post-election restoration of an LDP government since mid November.

The LDP is advocating enhanced monetary easing and expanded public spending as economic measures if it returns as the ruling party after the election. We expect JGB investors to focus heavily on the concrete content of these initiatives and their market impacts from early in the Jan-Mar 2013 quarter. Whether the Bank adopts a 2% inflation target represents more of an ideological point for enhanced monetary easing, and we think the main focus will be specific policy options. The BoJ cannot directly buy foreign bonds and will face volume limits for increased ETF and REIT purchases. Realistic policy tools hence are 1) extending the maturity of JGB purchasing by the APP (from 3y to 4-5y), 2) increasing rinban operation, and 3) lowering the interest rate paid on excess reserves.

The 5y yield might not immediately decline to the same level as the policy rate, even if the Bank extends the maturity in the APP, because 5y JGBs are a new issuance zone. However, the yields up to the 5y will fall to a level fairly flat with the policy rate eventually as purchase volume steadily expands. We think the longer-term 10y-zone yield could decline to about 0.6% in this case and thereby will make 5s10s20s even wider. If the BoJ decides to expand rinban operations, meanwhile, higher purchase over a broad range up to 30y JGBs is likely to alleviate steepening pressure beyond 10y, which has significantly steepened thus far. With flattening pressure on the 3-5y curve at a limit, the change in the 5s10s20s balance should differ from the case of maturity extension in the APP. We expect less yield impact in the 10y zone. We think lowering the interest rate paid on excess reserves would have the worst side effects on the overall financial markets among the three policy options because this option

10 Economic and Fiscal Outlook: December 2012, Office for Budget Responsibility.

…and we expect the UK to lose its AAA rating in 2013

Given the potential for slower growth and risk aversion episodes, we do not expect an aggressive sell-off in gilts

http://cdn.budgetresponsibility.independent.gov.uk/December-2012-Economic-and-fiscal-outlook23423423.pdf�


13 December 2012 70

should worsen the profit of the banks. If this option is adopted, it would obviously serve as a bull-steepening factor, but its probability is low.

We foresee a positive effect on JGB direction regardless of which policy option the Bank selects. Fiscal policy, however, has the potential to weaken market conditions. We doubt that the government would adopt extremely expansionistic fiscal actions, considering Japan’s current fiscal position and downgrade risk. Yet the over 10y sector might be vulnerable to steepening due to speculation about higher issuance if the supplemental budget, expected to be compiled in January, appears on track to exceeding JPY5trn in actual spending basis. Increasing rinban operation can offset some of the impact. On the other hand, a choice by the BoJ to extend maturity in the APP might lead to further steepening of the yield curve. The swap curve might also steepen at the long end if large-scale expansion of public spending fuels speculation about a JGB downgrade and weakens the yen. We expect a start in March if higher issuance is needed and project a sizable effect on supply/ demand of the JGB market around this timing.

Bottom line: Running in place Add up the macro views across regions, and a few commonalities emerge. Fiscal tightening should continue to be a drag on growth across most developed economies. Growth is unlikely to collapse in the US, while Europe should continue to underperform the US. Monetary policy should stay accommodative for an extended period across the developed world, as an offset to fiscal austerity. Central banks will continue to look to asset price increases as a transmission mechanism for monetary policy. And interest rates are likely to remain low in this environment in most core markets.

Given these views, we recommend being long the front end of the US Treasury curve, in cash and swaps (receive 3y1y). We also like 7s-30s and 10s-30s curve flatteners at current levels; we feel that the market is under-pricing the risk of a near-term fiscal accident and the effect of Fed purchases of Treasuries past 2012. In swaps, we recommend selling 1y1y FRA-OIS, given our view that European banks will continue to reduce their dollar funding needs. In Europe, many of the more interesting trades are in sovereign spreads (for details, see Europe: Sovereign Spreads: ECB to the rescue?). We like holding 3s/10s Spain steepeners versus 3s/10s Italian flatteners. The logic is that Spain will need market pressure to enter an OMT program, in which case bearish steepening will be more pronounced in Spain than in Italy.

Longer term, we like French, German and UK linker ASWs for USD investors to take advantage of the cross-currency basis (for details, please see Inflation-linked markets – providing diversification). In Europe, we recommend using the 1.5-2% range in 10y €i breakevens and 2-2.25% in 5y5y euro HICPx swaps. We also see value in the Bund€i16/18 forward breakeven and in long RPI swaps amidst formula uncertainty in the UK. Finally, we have very different views of rate volatility in the US and Europe, given valuations. We like selling 1y*10y and 2y*10y systematically in the US. On the other hand, given how much rate vol in Europe has collapsed, we recommend buying EUR rate vol against USD rate vol (such as in the 1y*30y contract). For details, please see European Volatility: Relatively long.

Every outlook has risks, and our rates forecasts are no exception. An extension of the payroll tax cut in the US or some other unexpected fiscal stimulus, as well as a relaxation of Basel III capital standards, could pose risks to our low-for-long view. A sharp uptick in payrolls or wage inflation could likewise push up term premia in the belly of the US curve. In the UK, a combination of weak fiscal numbers and stubbornly high inflation poses a similar risk. On the other hand, a fiscal accident in the US or a political upset in Southern Europe could be the catalyst for a rate rally. But none of these scenarios is part of our base case. We expect rates markets across the developed world to stay close to current levels for much of 2013.

Overall, safe-haven yields are likely to remain low in 2013







13 December 2012 71

Global bond yield forecasts

US Treasuries US swap spreads

Fed funds 3m Libor 2y 5y 10y 30y 10y RY 2y 5y 10y 30y

Q1 13 0.00-0.25 0.25 0.20 0.75 1.80 2.90 -0.95 Q1 13 15 10 5 -20

Q2 13 0.00-0.25 0.25 0.20 0.65 1.60 2.70 -1.00 Q2 13 15 10 5 -20

Q3 13 0.00-0.25 0.20 0.20 0.65 1.60 2.75 -1.00 Q3 13 15 10 5 -20

Q4 13 0.00-0.25 0.20 0.20 0.65 1.60 2.75 -1.00 Q4 13 15 10 5 -20

Euro government (Germany)

Euro area swap spreads

Refi rate 3m 2y 5y 10y 30y 10y RY 2y 5y 10y 30y

Q1 13 0.5 0.20 0.10 0.50 1.60 2.30 -0.15 Q1 13 40 40 30 5

Q2 13 0.5 0.20 0.10 0.60 1.70 2.40 -0.10 Q2 13 40 40 30 5

Q3 13 0.5 0.25 0.15 0.65 1.75 2.45 -0.10 Q3 13 40 40 30 5

Q4 13 0.5 0.25 0.20 0.70 1.80 2.50 -0.10 Q4 13 40 40 30 5

UK government

UK swap spreads

Bank rate 3m 2y 5y 10y 30y 10y RY 2y 5y 10y 30y

Q1 13 0.50 0.55 0.40 1.05 1.90 3.10 -0.50 Q1 13 40 20 10 -15

Q2 13 0.50 0.55 0.45 1.20 2.05 3.15 -0.45 Q2 13 35 15 5 -10

Q3 13 0.50 0.57 0.55 1.35 2.25 3.20 -0.35 Q3 13 35 15 0 -10

Q4 13 0.50 0.60 0.65 1.50 2.40 3.30 -0.30 Q4 13 30 10 0 -10

Japan government

Japan swap spreads

Official rate 3m 2y 5y 10y 30y 10y RY 2y 5y 10y 30y

Q1 13 0.10 0. 20 0.10 0.15 0.70 1.90 0.30 Q1 13 15 11 0 -4

Q2 13 0.10 0. 20 0.10 0.15 0.70 1.90 0.40 Q2 13 15 12 1 -4

Q3 13 0.10 0. 20 0.10 0.15 0.75 1.95 0.50 Q3 13 15 13 2 -10

Q4 13 0.10 0.20 0.10 0.15 0.80 2.00 0.50 Q4 13 15 13 3 -10

Australia government

Official Rate 3y 5y 10y AU-US 10y

Q1 13 3.00 2.85 3.10 3.35 1.55

Q2 13 3.00 2.85 3.05 3.20 1.60

Q3 13 3.00 2.90 3.10 3.30 1.70

Q4 13 3.00 2.95 3.15 3.35 1.75



13 December 2012 72

CREDIT MARKET OUTLOOK

A good bond is hard to find • The actions of global central banks created a unique opportunity to take risk in

2H12. We believe these policies will continue in 2013 and therefore expect credit to remain the beneficiary of a global reach for yield. However, we think that most parts of the credit market are limited in terms of capital appreciation and, as a result, that credit has become more of an income asset class with a few notable high beta exceptions.

• Given limited opportunity for upside; modest global growth forecasts; macro concerns in the US, Europe, China, and the Middle East; and the potential for an increase in leverage from industrials, we believe most parts of the credit market will struggle to return much more than their coupon, but remain in favor relative to other even lower yielding fixed income assets.

• We expect fundamentals to be the key driver of performance in what looks to be an increasingly idiosyncratic credit market in 2013.

What’s left to rally in 2013? 2012 was a year of broken records in credit. Supply reached new heights in several markets, such as US IG and HY, Asia IG, and LatAm/EEMEA. Despite this influx of supply, technicals remained extremely robust. Yields declined to new all-time lows in much of the market, driven by both tighter spreads and the effect of central bank actions on risk-free rates. Many of these thresholds were broken in the fall as systemic concerns abated following the announcement of Outright Monetary Transactions (OMT) by the ECB in an effort to stem the European sovereign credit crisis. While performance was strong across the credit markets, the lowest credit quality parts underperformed, particularly on a beta-adjusted basis. This is not surprising, given the technical nature of the rally and ongoing concerns about global growth. We believe correctly assessing the parts of the market that have not fully participated in the rally will determine performance in 2013, and credit fundamentals will be the key driver, more than in any other period since the credit crisis.

The past two earnings seasons have provided a preview of how credit markets will trade in a low growth environment that is not overwhelmed by macro concerns. Correlation between regions and issuers has broken down, and companies that missed estimates were punished. With our economics team forecasting growth in 2013 of 0.1% in the euro area and 2.0% in the US, the environment is ripe for credit differentiation. While we believe the developments in the European periphery, the fiscal cliff in the US, and slowing growth in China will all have an effect on markets, we do not expect the swings to be as extreme as in the past few summers, thanks largely to the liquidity infusion provided by global central banks. Instead, we believe that investors will differentiate themselves by looking for the parts of the market that have lagged and taking a view on whether there are catalysts for change in 2013. In Figure 1, we summarize the key themes across markets.

One common theme that has developed over the past few years that we believe will remain and perhaps become more extreme is the premium for liquidity. This is in many ways driven by the changing regulatory environment. While many of the questions that we hoped to have answered by regulators have been delayed (especially concerning CDS), the dealer community has already shifted to smaller balance sheets that will be necessary regardless of the final rules. We do not expect dealer balance sheets to increase in the near future, and, as a result, the premium for liquidity is likely to remain in 2013.

Jeffrey Meli


Bradley Rogoff, CFA +1 212 412 7921 [email protected]


13 December 2012 73

FIGURE 1 Key market themes and forecasts for 2013

Market Key question Barclays answer Excess return forecast (bp)

Total return forecast (bp)

Developed Markets

US IG Can financials tighten the gap vs. industrials?

Redemptions of subordinate financial bonds and improving bank balance sheets should allow financials to trade on top of industrials, where leverage metrics are now deteriorating.

300 425

EUR IG Where are the opportunities in BBBs?

We are comfortable going down in ratings for industrials that should show stable credit metrics and find subordinated core financials a good source for yield.

200-225 125-150

GBP IG Can GBP credit outperform EUR/USD indices for a second year?

The pickup in carry and spread duration of sterling credit over euro markets suggests that GBP markets will outperform again in 2013.

300-400 50-150

US Municipals (tax-exempt)

Can low-IG rated states improve their finances and get a ratings boost?

We believe that the November elections put California on the path for an upgrade and that it should outperform Illinois. Puerto Rico has upside potential if it is not downgraded to HY.

- 240

US HY Will CCC returns finally catch up with their beta?

A substantial coupon pickup should offset growth concerns and the premium associated with less liquid CCCs, to produce returns in line with higher quality HY.

300-500 400-600

EUR HY ex-fin Can peripherals hold onto recent gains?

The story should shift somewhat in 2013 as stronger peripherals become less volatile and concerns about cyclicals increase because of the poor growth environment.

600-800 550-750

US Lev Loan Will the new issue CLO bid compensate for the deleveraging of older deals?

Loans are attractive from a relative value standpoint, but the recent rally has made CLO equity returns less appealing. AAA CLOs are cheap and should tighten to support issuance.

350-550 350-550

Emerging Markets

Asia IG Can China/Hong Kong bonds catch up with the rest of Asia beta-adjusted?

Strong institutional demand in the high BBB/single A segment and lower concerns about China growth should help these bonds catch up with the rest of Asia.

225-250 325-350

CIS IG* Will issuance cause Russia to underperform?

The oil and gas sector is set for heavy supply, and we expect the 10y portion of the curve to underperform as a result.

350 450

LatAm IG Will the senior/sub spread compress in LatAm banks?

We forecast Brazil growth rising from 1% in 2012 to 3% in 2013. NPLs have stabilized, and debt affordability metrics are sound. We like the sub debt of national champion banks like BANBRA.

425 550

GCC IG** Will the geopolitical risk premium widen?

We expect periodic sell-offs, but as long as key infrastructure (eg, the Strait of Hormuz) is not disrupted, these should be contained and short lived.

300 400

Asia HY Can Chinese property continue its stellar performance from 2012?

Spread compression for BBs is likely to be limited, but medium-sized B developers yielding 8-12% are likely to deliver returns well above the benchmarks.

400-500 500-600

LatAm HY Will the global reach for yield finally extend to LatAm HY?

While returns should benefit from the substantial coupon, we think that fundamental weakness will cause the asset class to underperform its beta.

725 850

Note: *CIS is the Commonwealth of Independent States. **GCC is the Gulf Cooperation Council. Source: Barclays Research

Of the macro concerns we mentioned above, the fiscal cliff will likely dominate early in the year as a grand bargain does not appear imminent. This may diminish the typical positive January effect, but we expect a solution that will avoid recessionary concerns in the US early in the year. Potential downgrades to Spain and Italy are not our base case and represent some of the biggest risks to our returns forecasts in Europe. These concerns will likely persist throughout the year regardless of whether they come to fruition. Chinese economic data appear to have bottomed out and our macro outlook is consistent with our economics team view that Chinese GDP growth in 2013 should be similar to 2012. Finally, the biggest long-term risk is obviously a change in central bank policies. At record low yields, total returns would be significantly exposed to any tightening policy. However, we do not think this will be a theme that credit investors need to be concerned with in 2013.


13 December 2012 74

FIGURE 2 2013 excess return forecasts versus current OAS

US IG

EUR IG

GBP IG

Asia IG

CIS IG

LatAm IG US HY

EUR HY ex-fin

Asia HY

LatAm HY

GCC IG

100

200

300

400

500

600

700

800

100 200 300 400 500 600 700 800

2013 Exc Ret (bp)

OAS (bp) Note: OAS levels as of November 30, 2012. Source: Barclays Research

Supply sets records, but demand rules

Supply not likely to eclipse 2012 records Credit investors have always been focused on supply as a source of alpha and were generously rewarded in 2012. As we have shown in the past (see High Yield New Issue: Where the Yankees Slump, August 3, 2012), new issue is an effective means of outperforming, but in a hot market, new issue discounts disappear, the use of proceeds gets more aggressive, and supply eventually overwhelms the market. This occurred during the rally this fall, when new issue discounts turned to premiums in investment grade and dividend deals were a common occurrence in high yield.

In the US, investment grade and high yield set issuance records in 2012. As a result, the need for corporates to issue in 2013 has diminished. Investment grade companies have termed out their debt profiles, and the average number of years to maturity for issuers in our index has extended one year since the credit crisis (Figure 3). For high yield, the once-feared loan maturity wall of 2014 has diminished to less than $50bn, a decline of almost

FIGURE 3 US investment grade company debt profile

FIGURE 4 US leveraged loan maturities, $bn

10%

11%

12%

13%

14%

15%

16%

17%

18%

10.7

10.9

11.1

11.3

11.5

11.7

11.9

12.1

12.3

Jan-05 Apr-06 Jul-07 Oct-08 Jan-10 Apr-11 Jul-12

Avg Yrs to Mat 0-2y Debt as % of Total (RHS)

0

20

40

60

80

100

120

140

160

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2011 2012 2013 2014 2015 2016 2017 2018 2019

end-2010 end-2011 Nov-2012 Source: Capital IQ, Barclays Research Source: S&P LCD, Barclays Research




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$100bn over the course of 2012 (Figure 4). The loan market grew for the first time since 2008, and the continuation of the bond-for-loan takeout trade was supportive enough to extend maturities for all but the most stressed issuers. Less need to issue does not mean that we will witness a substantial pullback in 2013 issuance from US credit markets. Rates remain historically low, industrials are increasing leverage, M&A looks set to increase, and private equity will be seeking a return on its investments through debt-financed dividends. With markets growing as well, we forecast modest declines in gross issuance for investment grade and high yield bonds of 8% and 14%, respectively.

Emerging markets USD issuance has been climbing steadily from all regions and easily eclipsed previous records (Figure 5). Some of the issuance is supporting bond-for-loan takeouts, as the USD EM market is an avenue that was not accessible to many companies in the past. Growth also should lead to increased M&A issuance, and with a prevalence of property-related corporates in Asian high grade and high yield, opportunities for property development in Hong Kong/China will help dictate the pace of issuance in 2013. For LatAm and EEMEA, we believe that higher rated corporates are in a place similar to the US investment grade market and will issue opportunistically based on market conditions. For high yield in these regions, if the market closes for any prolonged period, there could be stress on certain issuers that have a much greater need to come to market in 2013.

For Europe, 2012 was not as much of a banner year for issuance as a result of the volatility throughout the summer. Net issuance for investment grade was negative as a result of deleveraging by financials and peripheral industrials (Figure 6). High yield issuance is similar to the previous record from 2010, but the size of the market has doubled since the beginning of 2010. To compensate for greater volatility in Europe, many issuers focused on the more stable US market, and Yankee issuance set a new record as a result of a huge increase from industrials. The more modest issuance from Europe in 2012 and the need to come to the US market highlight that supply has been less opportunistic and at times more of a necessity for certain European companies. The bond-to-loan trade is not nearly as complete in European leveraged finance as it is in the US, and BBB peripherals should be aggressive issuers if volatility remains subdued.

With less deleveraging from financials and the hope that a more stable macro environment will allow industrials to issue more in their native currency, we expect a modest increase in European supply in 2013. Financials should also be less of a drag on net issuance compared

FIGURE 5 LatAm/EEMEA YTD gross supply, $bn

FIGURE 6 Euro-denominated net investment grade supply, EURbn

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Source: Dealogic, Barclays Research


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with 2012 as a result of potential LTRO repayments and a new wave of contingent convertible debt instruments (CoCos) issued to meet new capital rules. We believe the CoCo market could grow from EUR19bn today to EUR400bn over time as Basel 3 gets fully implemented and think that there will be opportunities for those willing to sift through the documentation.

FIGURE 7 Gross supply forecasts

Market 2012* supply Record 2013E supply Y/Y growth

US IG $1,080bn Yes $1,000bn -8%

EUR IG €445bn No €480bn +8%

GBP IG £48bn No £55bn +16%

Asia IG $94bn Yes $70-80bn -20%

US Municipals $371bn No $390bn +5%

US HY $335bn Yes $275-300bn -14%

EUR HY €37bn No €40bn +8%

Asia HY $24bn No $20-30bn +5%

LatAm/EEMEA $159bn Yes $128bn -19%

US Lev Loan $225bn No $225-250bn +6%

US CLO $50bn No $60-75bn +35%

Note: *2012 supply is annualized based on supply through late-November 2012. Source: Barclays Research

Demand drives return forecasts The primary market will remain an important source of performance in 2013, but we think forecasting general demand will have a much greater effect on overall credit returns. The post-credit crisis period has been defined by a shift in allocations toward fixed income spread product. The rush into credit has been supported by a preference away from the riskiest assets, such as equities (Figure 8), and a lack of available product in lower risk spread products, such as agency debt and mortgages (Figure 9). We do not expect any change in the stance of central banks, and as a result, we think credit will continue to benefit from a lack of supply in higher quality assets. While it is possible that bullish investors will shift to equities, where high dollar prices and call constraints do not limit upside, we do not believe the exodus from credit would be enough to affect valuations

FIGURE 8 US equities and IG credit fund flows since 2007, $bn

FIGURE 9 US credit market net borrowing by instrument, $bn

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2007 Jun11-Jun12 Note: Excludes ETFs. Source: Lipper, Barclays Research Source: Federal Reserve Flow of Funds, Haver Analytics, Barclays Research


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significantly. The exception would be if the move to equities is accompanied by a substantial rise in Treasury yields that could produce negative total returns for higher quality credit. However, our interest rate strategists expect a benign year for rates, and the current accommodative central bank policy makes us believe this downside risk is remote.

The shift into credit has occurred across most major constituents of the developed market investor base. Insurance has remained the steadiest owner of investment grade credit globally, pensions are allocating away from equity into credit, and the growth of corporate bond mutual funds has been the key catalyst for the growth of the market. In Asia and other emerging markets, corporate bonds are still in the developmental stage, and we are witnessing a change in mandates from participants to include corporates in their portfolios. Local institutions that traditionally owned only developed market corporates are now, ironically, diversifying into EM issuers. In addition, we are seeing growth in EM benchmarked funds that have launched somewhat recently. With many of these strategies fairly nascent, we expect especially strong demand for high grade EM corporates in 2013 and, as a result, above market returns should follow.

Turning back to developed markets, we expect the key sources of demand mentioned above to remain positive in 2013, but to a lesser extent than in 2012. The key areas of focus will be pension funds and retail. As yields continue to set new all-time lows, we believe it is becoming harder for pension funds to shift out of equities and into credit. Public pensions face liability targets that now exceed the yield on every ratings category except CCC, and private pensions struggle with an increased burden from low discount rates. We do not expect these flows to reverse, but the pace of inflows should diminish. The bigger concern is retail, as significant flows into mutual funds and ETFs have been the biggest driver of supply and subsequent spread tightening, in our view. Investment grade mutual funds have experienced incredibly steady flows (only one week of outflows all year in the US and minimal outflows even at the height of European volatility this summer), and we expect inflows to continue as long as rates remain low.

Along with IG corporates, municipals have rallied recently as they represent another substitute for scarce low risk assets. For corporate investors, we believe that the taxable municipal market has room to compress versus the US Corporate Index as underlying fundamentals improve and returns receive a boost from the market’s longer duration. In the larger tax-exempt market we remain positive as the uncertainty on tax rates related to the fiscal cliff has buoyed demand. Our forecast for solid returns is predicated on municipals retaining their tax exempt status in the 2013 budget process. Any significant changes or a lack of grandfathering existing securities could represent substantial downside.

In high yield, dedicated mutual funds are the largest portion of the market in the US and Europe. With core plus and income funds also looking for yield, retail represents close to half of the US market and one-third of the European market. However, the weakness in high yield flows amid only modest volatility this fall demonstrates that retail demand will likely be tempered if the market trades inside of 7% for extended periods. With the US market more call constrained than Europe, we believe it will produce slightly lower returns.

Some of the flows out of high yield in the US have gone to leveraged loans. After huge outflows following the Fed’s announcement regarding an extended period of low interest rates in the summer of 2011, loans have made a comeback with the retail investor base in 2H12. We believe the record low yields for high yield were also a factor in these flows. With similar yields and capped upside in both asset classes, it is attractive to move up in the capital structure and shorten duration even if rising interest rates are a secondary concern. While the support of the retail base is helpful for leveraged loans, mutual funds own less than 15% of the market. Half of the institutional loan market is owned by CLOs, and we


13 December 2012 78

expect enough issuance next year to offset ~$40bn of amortization from the pre-credit crisis CLO base. This bid should make loans less volatile than high yield and produce returns in line with the current coupon.

Finally, for Europe, we note that the actions of the rating agencies could have a large effect on demand as well. While it is not our base case, if Spain and Italy were to be downgraded to high yield and all of the corporates eventually became sub-investment grade as well, the European high yield market would increase by ~75% ex-financials and almost double when including financials. Even though not all of the owners of these bonds would be forced to sell, we believe it would be hard for the current sources of demand immediately to absorb this paper. A downgrade is not our base case, but we factor in some probability in our projections and if this scenario does not materialize, then there should be some upside to our European forecasts as global investors that are underweight Europe reallocate back toward market weight.

It’s not just the flows; results will matter The high correlation across asset classes and within credit has forced portfolio managers to focus more on macro than micro over the past four years. Markets were generally either in risk-on or risk-off mode, and subsectors moved in that direction according to their beta. However, as tail risks decreased and corporate earnings disappointed in 2H12, we began to see greater differentiation (Figures 10 and 11). We believe this is a trend that will continue into 2013.

Relative performance should come increasingly from single-name credit calls, and sector positioning should also be more important than it has been in recent years. This year, the metals & mining sector produced the most volatility throughout the year, and we expect this to continue in 2013. We do not like the fundamentals for coal or steel, but recognizing the strong liquidity and already-elevated yields for most companies, it is difficult to have an Underweight rating on the sector.

While consumers have been fairly resilient considering the recession in Europe and slower growth in the US, we expect challenges for certain parts of the retail sector to subsist. We have an Underweight rating on retail in the US across investment grade and high yield, with mid-tier retailers and consumer electronics a particular concern. In Europe, we have concerns about cyclicals in general, with automotives a key Underweight. This contrasts with the US, where

FIGURE 10 Rolling 60-day correlation of CDX IG and iTraxx Main spread changes

FIGURE 11 US high yield/US investment grade corporate OAS ratio

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our positive view on Ford makes us comfortable with automotives. Performance in the technology sector has been disparate, as companies must react quickly to secular change. We have concerns about certain hardware producers that are facing these challenges, but are positive enough on other parts of the sector to rate it Market Weight.

We believe that financials will be a key source of alpha in 2013. In the US, we expect financials to trade on top of industrials by the end of 2013 and have an Overweight rating on life insurers. European core financial unsecured bonds are already trading in line with industrials and we are underweight many of the peripheral banks. However, we find value in the subordinated parts of the capital structure for core European banks and would look to add risk there. Senior/sub compression in banks is also a trade we like in Emerging Markets.

While financials may be deleveraging, the record low cost of debt could fuel releveraging for industrials. These concerns are more concentrated in the US, as the lower growth environment in Europe will probably keep aggressive issuance to a minimum. As shown in Figure 12, leverage for US investment grade corporates is back to early-2010 levels; and share buybacks and dividends, after falling sharply during the financial crisis, have since recovered to pre-crisis levels (Figure 13). In high yield, issuance for aggressive uses of proceeds such as LBOs, share repurchases, and dividends topped $30bn for the first time since 2008.

While we expect these trends to continue in 2013, we do not think they will approach the pace of the mid-2000s and believe that the trading implications are different regardless. In investment grade, we think it is important to consider rotating out of companies that are trading at tight levels and could increase their leverage target. AT&T is a recent example of a company that underperformed for this reason. However, the traditional trade of shorting low-spread names that could be subject to a bid from private equity is likely to be less effective. The leveraged finance market appears capable of supporting significant issuance, but private equity is less likely to form consortiums that will lead to numerous large LBOs. In fact, with margins at all time highs, the names that have been reported in the press as possible LBO candidates have been stressed high yield issuers such as Best Buy and Supervalu, which would likely tighten if a deal were announced. If M&A in general increases, we believe that high yield companies will likely benefit and do not expect a substantial effect on the spreads of larger acquirers.

FIGURE 12 US non-financial investment grade gross leverage

FIGURE 13 Shareholder-friendly activities of US non-financial investment grade companies, $bn

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Source: Capital IQ, Barclays Research Note: Share repurchases and dividends are LTM median values for US non-financial companies in the Corporate Index. Source: Capital IQ, Barclays Research


13 December 2012 80

Liquidity and regulation limit opportunities Over the past year, many of the themes for our outlook have changed. One that has not is the more difficult trading liquidity in credit markets. The catalyst for diminished liquidity has been the well-publicized decrease in the size of dealer balance sheets following the credit crisis. In 2012, inventory levels bottomed out in July at a level not seen in the previous decade. A large portion of this decline has been due to changes in regulation that will persist for the foreseeable future. Basel 3 is a prime example, as capital charges on lower rated securities have become especially onerous for banks. In fact, this is part of our thesis on why illiquid CCC bonds will not catch up with the rest of the high yield market unless growth surprises materially to the upside. Regulatory changes have served as a catalyst for a renewed focus on ROE by bank equity investors. This has helped capital-inefficient securities lag the market as banks focus on the returns of risk-weighted assets and not solely on P&L.

Perhaps as important as the rules to be implemented globally due to Basel 3 is uncertainty related to incomplete regulation at the local level. A year ago, we expected to have the final text of Dodd Frank in the US and CDS to be cleared and traded through swap execution facilities (SEFs). Neither of those occurred, and we believe uncertainty about the final language of the Volcker Rule has been another factor holding down dealer inventories.

CDS liquidity will get better, but probably not in 2013 We are more optimistic that we will get clarity on many of these items in 2013, but expect delays to occur once again. We laid out the most recent projected timelines in Regulation Update, July 13, 2012, and would highlight that completing the Dodd-Frank ISDA protocol by year-end is needed to trade CDX in 2013. Realistically, we believe that most investors will not be trading cleared single-name CDS on SEFs until very late in 2013. Unfortunately, this will likely cause current trends in CDS liquidity to persist. The number of credits trading $100mn+ per week has dropped precipitously, and trades are concentrated at the 5y point except in stressed credits (Figures 14 and 15). Once counterparty risk is eliminated and prices are widely disseminated, we believe that liquidity will begin to improve, especially at the 5y point. However, we think this will take time and is probably a 2014 event as the basis adjusts to entice marginal buyers and sellers of protection. Therefore, in 2013, we would focus on

FIGURE 14 Number of single-name corporate CDS tickers with weekly volume > $100mn

FIGURE 15 Maturity profile of single-name CDS, $trn notional

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trading 5y CDS on index names and look for opportunities in which the basis is skewed in either direction. Recently, the basis has turned more positive, and we would look to set longs in derivatives that do not face the same dollar price constraints as the cash market.

Europe is even further behind with respect to clearing, although a historical tendency to trade electronically should allow it to transition to a multi-dealer execution facility eventually. Where we have seen major changes in Europe in 2012 is the sovereign CDS market. Beginning November 1, sovereign CDS could only be bought to hedge government bonds or other exposures to a country or liabilities to a private entity in that country that is highly correlated with the value of government debt. Volumes in sovereign CDS remained strong going into November 1, but relative to corporate CDS volumes, there has been a decrease in sovereign CDS activity recently. This is partly confounded by the general risk-on sentiment since November 1 (sovereign CDS tends to be most active in a sell-off), but we do expect a decrease in activity of approximately 20% as a result of these changes. This is important because sovereigns represent 17 of the top 25 CDS names by volume.

Cash volumes remain concentrated The record year of issuance has provided a boost to trading that should produce overall volumes that marginally exceed 2011. Market turnover (calculated as TRACE volumes divided by par outstanding) is similar to the depressed level in 2011, at approximately 0.75x for investment grade and 1x for high yield (Figures 16 and 17). While this trend did not regress, the dominant issue remains concentration of those volumes. We focus most of our liquidity commentary on the US because of the better availability of TRACE data. The work we have done across regions indicates that the same concentration and bid ask issues are occurring in other areas as well. However, as emerging markets mature, there are greater prospects for improvement in volumes, although concentration is likely to persist.

With markets much less volatile than in 2H11, bid offer has declined slightly from late last year, although only to levels similar to early in 2011. The trend that concerns us most is not the level of liquidity, but the concentration. In investment grade, 34 tickers represent 50% of volumes, and in high yield, that universe is only slightly larger, at 48 tickers.

FIGURE 16 US investment grade size, volume, and turnover, $bn

FIGURE 17 US high yield size, volume, and turnover, $bn

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Note: *2012 data are annualized based on volume through 3Q 2012. Source: TRACE, MarketAxess, Barclays Research

Note: *2012 data are annualized based on volume through 3Q 2012. Source: TRACE, MarketAxess, Barclays Research


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One reason for the concentration in liquidity has been the rise of corporate credit ETFs with narrow benchmarks. In the US, the trend has been most pronounced in high yield, where AUM has increased from $20bn to more than $30bn in 2012. While this still represents only 3% of the market, the holdings are concentrated in the largest bonds, and as a result, these ETFs often own a mid- to high single-digits percentage of a given issue. With the promise of daily liquidity to investors and active trading in the underlying securities by arbitrageurs of the create/redeem process, the technical can be substantial. The two largest ETF benchmarks announced rule changes in 2H12 that leave us more optimistic that some of these concentration issues could abate in 2013.

Other markets have seen an increase in ETF AUM as well, although not enough to cause concentration issues. US IG corporate ETFs now own $53bn of bonds, and loan ETFs remain in their infancy with less than $1.5bn. In Europe, adoption of the ETF product has been slower, with only $13bn total AUM. Surprisingly, EM corporate investors have been more accepting of the product, as it was virtually non-existent a year ago and represents $8bn of demand today.

While ETFs are a new phenomenon that is worth monitoring, the key question for corporate bond liquidity remains unchanged. Will smaller dealer balance sheets be sufficient for the increased portion of the investor base that needs daily liquidity, including, most prominently, mutual funds and ETFs? Unfortunately, in the near future, we do not expect an increase in dealer balance sheets, which means that dealers are likely to use their limited inventories for the most liquid securities. Investors that wish to implement short-term market views will need to do so through the most liquid parts of the market. For example, the seven most liquid investment grade tickers are all financials, which makes that sector an ideal means of adjusting beta. This does not mean there is not a use for less liquid instruments, as we have observed a decrease in measures such as the premium for 144a bonds when the market is strong. We caution that the portion of a portfolio dedicated to these less liquid strategies must be sized according to the volatility of each investor’s flows.


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EQUITY MARKET OUTLOOK

Yieldfall • Our S&P 500 end-2013 price target is 1525 (total return: ~9%), given the potential for

earnings growth to build momentum through 2013. On balance, our sector positioning is cautious: we overweight stocks with bond-like characteristics and underweight domestic cyclical sectors, nudging up exposure to capex and global growth.

• We believe near-term risks for US earnings and stocks lie to the downside, given the low probability of a grand bargain in the budget negotiations. With earnings estimates looking overly optimistic, share prices having overshot core fundamentals and policy uncertainty high relative to market risk measures, the first significant move of 2013 could be downward. Still, such a pullback could present a buying opportunity.

• Even against a backdrop of lacklustre global growth, falling profit margins and already fair valuations, we expect European equity markets to rally in 2013. The key driver is what we call ‘yieldfall’, a policy-induced contraction in cross-asset yields. Drivers include: 1) easy monetary policy, which has already suppressed investors’ reaction function to economic data; and 2) diminished European policy uncertainty. We think Italian and Spanish equities would benefit most from yieldfall.

• With the marked reduction in tail risks, key volatility metrics are trading at the bottom end of their post-2007 “new normal” levels, suggesting rising market fear of the “right-tail” risk of a return to the “old normal”. For the US, this would require a credible fiscal resolution, which seems unlikely in the short term. Similarly, for Europe, the road to recovery is likely to remain bumpy. Thus, although significant volatility spikes are unlikely, further declines should be limited, at least in the first half of 2013.

• We expect convertibles to post competitive returns in 2013 amid macro uncertainty and a more modest returns environment than in 2012 across most asset classes. Our base case return expectations are c.6.5% in the US, c.5% in EMEA, and c.4% in Asia Pacific, driven by modest underlying equity returns, income, and some spread compression. Global convertible valuations remain fair and we expect strong market technicals to provide valuation support in 2013. We also expect supply to be robust in EMEA and Asia Pacific. In the US, though we expect higher supply, we believe it is unlikely to match the market’s appetite and capacity to absorb new paper.

US: Policy-driven correction presents buying opportunity

We remain cautious, looking to capex and potential global growth upside We are not yet prepared to increase beta or assign a significant overweight to cyclical sectors; we continue to believe the first significant move for equities in 1H13 is likely to be lower. Still, we believe that if the fiscal negotiations lead to an economic contraction, economic and corporate imbalances are not large enough to cause a sharp drop in corporate profits. In the event of this downside scenario, we would expect a snapback in 2H13.

In our base case, we assume a fair amount of fiscal drag from the federal budgetary negotiations. Public policy uncertainty should remain elevated during 1H13 if a deal is reached that fails to address long-term debt sustainability or is phased in over four to six

US Equity Strategy Barry Knapp


European Equity Strategy Dennis Jose +44 (0)20 3134 3777 [email protected] Joao Toniato +44 (0)20 7773 4813

[email protected]

Equity Derivatives Strategy Maneesh S. Deshpande +1 212 526 2953 [email protected]

Convertibles Venu Krishna


Luke Olsen

+44 (0) 20 7773 8310 [email protected]

mailto:[email protected]�


13 December 2012 84

months. We think a correction could come as soon as January, during the 4Q12 earnings season, if not sooner, if there is a delay or negative outcome on the fiscal cliff negotiations.

However, we expect fiscal drag and policy uncertainty to dissipate in 2H13. Earnings growth deceleration, attributable to slowing global growth and the US political environment, should trough before mid-year. Earnings growth should then begin to reaccelerate, potentially gaining additional momentum in 2014 as a recovery in capital spending develops, the housing recovery broadens and aggressive monetary policy leads to stronger nominal GDP growth.

Capital spending has been the weakest part of the economy in 2012. A reasonable deal out of Washington should lead to a decline in policy uncertainty and at least some rebound in capex. In addition, the potential benefits of US energy positioning and manufacturing competitiveness, in the face of depressed levels of capital investment, could spark something of a revival in corporate capex in mid-2013, building into 2014.

Thus, the outlook for corporate earnings in 2014 should improve, offsetting some of the downward pressure on multiples from financial repression. We are not raging bulls, but we do think the most likely outcome is some marginal multiple expansion in 2013 with another year of 4% earnings growth. Our base case is for the S&P 500 to end 2013 at 1525 (~9% total return). Our positioning is cautious: overweight stocks with bond-like characteristics and underweight domestic cyclical sectors, nudging up exposure to capex and global growth.

Macro factors in our 2013 outlook

Capital spending

The marked slowdown in capital spending in 2012 presents an opportunity, in our view. Public policy uncertainty is the main factor behind weak business confidence, but throughout this cycle there have been periods when that uncertainty has ebbed, confidence recovered and labor and capital investment improved. A reasonable deal on the cliff, even if just a downpayment, could set the stage for improved business confidence, with corporate investment potentially starting to improve by mid-year. In that scenario, capital-spending-sensitive industry groups would likely rebound sharply.

FIGURE 1 Policy uncertainty has impaired business confidence and disrupted the investment cycle

FIGURE 2 The financing gap remains below zero, illustrating firms’ reluctance to deploy available cash

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Source: FRB, Haver, Barclays Research. Note: Financing gap equals nonfinancial corporation capital expenditures less the sum of internal funds and inventory valuation adjustment. “GVA” is Gross Value Added


13 December 2012 85

Housing

We believe the first positive external effect of the housing recovery, improved consumer confidence, has already accrued to the economy in the form of a lower savings rate. The next effect is likely to be an improvement in construction jobs, but with the credit channel impaired and builder capacity low, it is unclear whether enough progress will be made by spring to significantly improve the labor market in early 2013. Still, this is the best part of the US economic picture. A policy mistake in the form of an attempt by the federal government to tax its way out of debt, could derail the nascent housing recovery.

Consumption

Weak labor trends, softening real disposable income and the drop in the savings rate have left consumers vulnerable to cash flow impairments. The clear risk is going off the tax cliff and staying there for a good portion of 1Q13. The not so obvious risk is a spike in energy prices, which the Fed could exacerbate via balance sheet expansion. This is not a forecast, only a plausible scenario that underscores the fragility of the consumer in the near term, even if a bounce in business confidence leads to increased labor investment. The risks to the consumer in 1H13 are considerable; elevated consumer confidence, inasmuch as it has played a role in the drop in the savings rate, is as much a negative as a positive.

Public sector deleveraging

With the tax cliff still unresolved, it remains an open question whether public sector deleveraging, the final stage of the process, has really begun. Growth in public sector debt has in fact slowed; state and local governments have made considerable progress on deleveraging, while the federal budget deficit, as a percentage of GDP, has fallen (from a peak of 10.4% in December 2009 to 6.9% at the end of fiscal 2012). Essentially, the growth rate of nominal GDP is above the Treasury’s financing rate, but if the negotiations fail to address mandatory spending, we do not believe this situation can lasst much longer, not with trillion dollar budget deficits and growth in entitlements (the long-term driver of public debt).

We expected the market to give the Treasury a ‘free pass’ through the 2012 elections; however, in 2013, the prospect of a repeat of the August 2011 risk flare-up looms Finally, without action from Congress, any further improvement under current law will come from tax hikes rather than spending cuts. Yet the recent experience of European austerity (Spain, Italy, France and Portugal) suggests that taxing one’s way out of debt may ultimately be ineffective.

Beyond the fiscal cliff: Long-term catalysts and risks There is a bullish scenario for US growth and the equity market in the back half of the decade, but stable monetary and public policy are necessary conditions. Looking beyond the tax cliff, we see a few potential catalysts for improvement in the outlook (US energy and manufacturing advantages well as demographics) as well as at least one large risk (entitlements). As a result of capital investment in the prior business cycle, the US could become the world’s largest energy producer. Benefits have begun accruing to the US economy but, starting in 2014, we believe the infrastructure to exploit the vast supply of cheap shale gas will start coming online. Another positive is domestic manufacturing competiveness and the potential for capacity sent overseas to return to the US. Finally, US demographics are better than in much of the developed (and parts of the developing) world.

This brings us to the major risk: entitlement spending could offset the benefits accruing to the private sector from energy, manufacturing and a rebounding population. In late 2013, many of the most significant and costly portions of the Affordable Care Act start to go into effect – which, given the apparent incentives written into the law, may lead large corporations to shift the costs of employee health care onto the taxpayer and small businesses.


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The capital required to build energy infrastructure or additional manufacturing capacity may not be available, particularly if the Fed reaches its limit on debt monetization. In addition, deleveraging must progress far enough so capital is available to invest in the private sector. We suspect it will become apparent in mid-2013 whether private capital investment is picking up; if it does, it will set the stage for an improved earnings outlook in 2014.

Earnings: Risks to our forecast in 1H13; more optimistic about 2H13 and ‘14 Our macro-based earnings forecast is $105 (4% y/y) for 2013 and $111 (6% y/y) for 2014. Earnings growth decelerated sharply in 2012 and trends in revenues and earnings are close to recession levels. We expect earnings growth to bottom in 1H13, though our base case forecast of 4% faces downside risks. However, an improved capital spending environment should develop later in 2013, thus setting the stage for earnings growth to accelerate to 6% in 2014, providing the catalyst for multiple expansion in the back half of the year. The risks to our 2013 and 2014 earnings forecasts, while mainly to the downside, are limited by a lack of imbalances in the corporate sector and in the most economically cyclical components of growth (autos, housing or the financial sector).

Consistent with the read from global PMIs, corporate fundamentals show a slowdown in growth, with revenue and earnings growth trends at levels typically plumbed when headed into recession. However, the weak growth outlook does not seem to have been integrated into bottom-up consensus forecasts. To put this in perspective, the relationship between the ISM and earnings growth shows that 10% consensus growth is consistent with an ISM of 55 (annual average), suggesting a robust US recovery. Still, at least in our forecasts, global growth is set to expand rather than contract in 2013 assuming the US avoids a greater-than-expected fiscal drag. This should set the stage for an improved capital investment environment in 2014.

Valuations: Initiate 2013 at 1525 (10% total return) We see three possible equity outcomes in 2013 (Figure 5). We do not expect a significant expansion of equity valuations, given continued slow growth and financial repression. Reducing public and monetary policy uncertainty will in our view be key to creating the environment necessary for sustained multiple expansion (as in the 1950s, 1980s, 1990s).

FIGURE 3 Corporate fundamentals confirm growth slowdown; revenue and earnings trends are at typical pre-recession levels

FIGURE 4 10% consensus growth is consistent with an ISM of 55 (annual average), which suggests a robust US recovery

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Still, overall, we do not envisage a particularly poor end to 2013, though policy missteps could lead to messy first half, particularly if they weakened Europe and Asian export channels.

FIGURE 5 Our 2013 S&P 500 price target is 1525, a ~9% estimated total return

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Bull Improved investment. Fed & inflation cap upside 15.0x 1600 ~14%

Base Struggle in 1H13, but avoid recession 14.5x 1525 ~9%

Bear 1H13 correction to June 2012 lows, rebound in 2H13 15.8x 1450 ~4%

Source: Barclays Research. Note: Trailing multiple is on our estimates of year-end 2013 earnings. Total return is based on return as of 12/11/13 close.

Base Case

Our base case assumes at least some slowdown in the first half, with the downside risk of a fiscal-cliff-induced recession, which should spark a correction. Still, we think the probability of the market staying depressed is low and we would view a market downturn as a buying opportunity, particularly for capital spending-exposed cyclical stocks.

Bull Case

In our bull case, an improved outlook for capital spending and future earnings growth gives multiples a modest multiple uplift. However, upbeat economic optimism lead the Fed to taper purchases in 2H13, which, combined with an inflation backdrop and rising energy prices, cap the upside. It might seem counterintuitive to view the beginning of the Fed’s exit strategy as a favorable factor for equities when it is likely the first reaction would be negative; however, the best period for equity returns typically follows the first step in monetary policy normalization (i.e., 1983, 1994, and 2004).

Bear Case

Our bear case calls for a shallow fiscal-cliff-induced recession in 1H13. The consumer has made significant headway on deleveraging. Corporate balance sheets are healthy and no single sector of the economy is particularly bloated. Based on a simulation of such a recession,

FIGURE 6 A drop in economic and policy uncertainty paves the way for confidence improvements and multiple expansion

FIGURE 7 Any fiscal cliff-induced recession in 2013 would likely be shallow; the 1949 recession provides a good example

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a 5-10% y/y drop in 2013 earnings seems reasonable. Earnings in prior shallow downturns – 1949, 1974 and 1980 (see USPS Focus: The ‘E’ in P/E is safer than you think, 8/11/11) – did not drop nearly as much as in the past two downturns, when contributions from technology (2001) and financials (2009) caused approximately 65% of the index earnings drop. In addition, we think a market-related correction would be short lived, with a rebound in 2H13.

To illustrate, we look back to the 1949 recession in President Truman’s second term, during the last period of financial repression. The market rallied into 1949, but lost momentum in 1Q49, followed by a rapid drop of ~10% in 2Q as the country fell into recession. However, the S&P bounced back and climbed steadily higher, ending the year up 12%. To put this example in today’s context, an equivalent ~10% correction would put the S&P near 1275. Coincidentally, the June low forward PE was 11.9x, a ~10% drop from today’s levels. A drop to these levels would be attractive entry points, particularly for cyclical stocks, as we would expect a snap back into year-end. We would not expect as strong a reacceleration as in 1949. On an earnings base reset, the market would likely price in higher earnings growth and lift the multiple marginally. We think 1450 sounds reasonable.

FIGURE 8 Cycle multiples provide bounds for the markets path in 2013; upside likely capped by the Mar ‘12 and Sep ‘12 highs, with cliff-induced recession downside to the June ‘12 lows

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Sectors and themes: Bond-like characteristics and capex recovery The two key themes that drove sector performance in 2012 remain: financial repression and a reversal in the five-year downtrend in home prices. However, we believe housing recovery beneficiaries have overshot core fundamentals, while stocks with bond-like characteristics should continue to offer decent risk-adjusted returns, particularly in 1H13, when we expect the equity market to struggle. The weakest part of the US economy and the equity market in 2012 was capital investment and related equities (enterprise technology and machinery being notable examples), due largely to public policy uncertainty. In addition, with the decline in global growth likely to reverse in 2013, but without a ‘V’ shaped recovery, we think that, on the margin, ‘going global’ should outperform domestically leveraged sectors.

A full-fledged rotation to cyclicals is not warranted, in our view, but we are incrementally more constructive on the full-year outlook. Certain defensive sectors remain attractive on a relative basis, which should favor large caps, but there are also pockets of cyclicals, particularly those exposed to the slowdown in capex. We expect some rebound in capital investment, despite the low probability of fiscal policy that increases investment incentives.



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Should there be a correction early in the year, we will look to increase exposure to capital spending-sensitive equities. On balance, our sector positioning is cautious. We are overweight stocks with bond-like characteristics, but if capital investment rebounds sharply in 2H13, it is possible that the Fed could begin tapering purchases, which could mark the beginning of the end of the chase for yield. We are underweight domestic cyclical sectors, with a small increase in exposure to capital investment and global growth.

European equities to benefit from ‘Yieldfall’ • Even with a backdrop of lacklustre global growth, falling profit margins and already

fair valuations, we see European equity markets rallying. The key driver is Yieldfall, a policy-induced contraction in cross-asset yields.

• Two catalysts we need to drive this Yieldfall scenario are: 1) further easing monetary policy, which has already suppressed investors’ reaction function to economic data; and 2) a gradual reduction in European policy uncertainty, although elections in Italy may create some short-term volatility.

• We believe the markets that offer the best value have the greatest potential for yield contraction. Of the 10 cheapest markets globally, 8 are from developed Europe. Of these we prefer Italian and Spanish equities. We would use any short-term uncertainty on the political landscape in Italy to position for further upside.

Yieldfall, a policy-induced contraction in cross-asset yields Post-2008, governments in cohorts with central banks have, rather successfully, kept at bay the fires of deleveraging-induced deflation through financial repression. That is, ensuring that rates of return on safe haven assets are so low that investors eventually have to move up the risk curve and therefore, help create asset price inflation.

Meanwhile the structural supply of safe haven assets has reduced dramatically given central bank buying, the phasing out of Government Sponsored Enterprises (GSEs), Asset Backed Securities (ABS) as well as the ratings downgrades of sovereigns such as Italy, Spain etc. However, the demand for these assets has remained strong given the volatile macro-economic environment as well as regulatory reform such as Solvency II, Basel 3, etc.

FIGURE 9 After collapsing over the summer, relative defensive sector momentum is trending higher

FIGURE 10 Heading into 2013 we prefer large caps for yield and global exposure

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This supply-demand imbalance has led to significant yield compression in safe-haven government bonds in 2010 and 2011. In 2012, with real yields on these safe-haven bonds near zero percent, investors were forced up the risk curve into credit and emerging market bonds. Consequently, we have witnessed significant yield compression within these assets as well. We can see this from Figure 11 where we plot the contraction in yields across the different European asset classes within these years.

FIGURE 11 Yield contraction in govt. bonds in 2010/11; EM Bonds, Credit in 12; Equities in 2013?

2010, 2011 saw yieldfall in govt. bond yields

2012 saw yieldfall in credit and

emerging market bonds

Will 2013 see yieldfall European equities?

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Given this significant yield compression, heading into 2013, prospective returns on safe-haven government bonds and credit markets are at very low levels relative to history.

In Figure 12, we highlight the number of standard deviations current yields are below the long-term average. From this we can see that safe haven assets as well as risk assets such as credit and emerging market bonds are trading at very low yields versus history.

Central banks have, to an extent, been successful in creating asset price inflation within several asset classes. However, yields are now near all-time lows and further compression looks difficult. Our rates strategists expect safe-haven government bonds to hover around current levels through 2013. Our credit strategists again note that we have to go up the beta scale to find names that could witness significant yield compression.

FIGURE 12 Financial repression has led to risky assets trading very tight versus history

Risky assets are being priced at yields that are extremely low

relative to history.

This policy induced yield contraction is yieldfall!

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We believe that the lack alternative assets with reasonable yields will be the key driver for the equity market in 2013 as investors are yet again forced up the risk curve. This is what we see as ‘Yieldfall’.

Catalyst 1: Easy monetary policy We believe the real impact of both central bank easing has been to suppress the reaction function of equity markets to policy uncertainty. In Figure 13 we plot the VSTOXX index and European economic policy uncertainty. Between 1999 and 2007, economic policy uncertainty was the key driver of equity volatility. However, this has changed in the liquidity enhanced post-2008 environment. While economic uncertainty remains high, volatility is very low. Fundamental economic data do not appear to matter as much!

Thus QE has worked by subduing volatility in the stock markets to levels well below where they traditionally would be. Our economic base case scenario is that the peripheral European crisis resolves itself slowly but steadily in 2013, and growth remains sub-par but not recessionary. In this scenario, central bank policy upside (with the Fed potentially converting Operation Twist into outright treasury purchases) should help maintain calm within markets, keeping investors’ reaction function to economic shocks subdued.

FIGURE 13 QE has suppressed the reaction function of equity markets to policy uncertainty

While economic uncertainty is still near all-time highs,

VSTOXX volatility is subdued

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Catalyst 2: A slow, but steady easing of EU tail risk We would characterise the bull market since 2009 as having been hounded by fear. Investors have favoured bonds to equities, US equities to European equities and growth to value. Levels of implied volatility have been high and inter-stock correlations have been elevated – all of this has primarily been driven by the fear of a fracture within the eurozone.

However, more recently European policy tail risk has been steadily declining and our economists expect the trend to continue in 2013. If that proves to be the case, we could see a structural change in the equity market. We could be entering a new normal with lower levels of implied volatility, aided by further central bank easing. Investors correspondingly could have a higher tolerance towards equity market risk.

The risk-on/risk-off theme that worked so well 2010-2012 is likely to translate into one whereby idiosyncratic risk matters more, as was the case in the previous cycle. Stock picking would consequently start to regain importance. Such an environment is likely to benefit value investing in particular, as the willingness of investors to embrace risk increases

http://www.policyuncertainty.com/�


13 December 2012 92

(Figure 14). This is the key catalyst that should aid Yieldfall, as investors become more willing to move up the risk curve. (see European Strategy Elements: A brave new world, 10 Dec 2012.)

FIGURE 14 Value should maintain recent outperformance versus growth

New normal should encourage investors to embrace risk.

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Remain positive through Q1 2013, prefer Italy, Spain within Europe Our positive call on European equities is not based on earnings growth. In fact, we forecast earnings growth for the STOXX 600 in 2013 to be 0% (European Strategy Elements: 2013 - Equities to benefit from Yieldfall, 21 November 2012). Our positive call is a policy-induced re-rating story, which we call Yieldfall. We saw this re-rating within government bonds in 2010-2011, and in credit and emerging market bonds in 2012. Going forward, we expect to see this re-rating within equity markets, aided by further central bank easing, as investors are pushed up the risk curve into higher yielding assets.

FIGURE 15 8 of 10 cheapest regions globally are from Dev Europe, they have the greatest potential for Yieldfall

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A gradual reduction in European tail risk should aid Yieldfall. As we highlighted previously, 2012 could have marked an inflection point in European tail risk, particularly driven by the proactive stance from the ECB through the LTRO and the OMT programs (see European Strategy Elements: A brave new world, 10 December, 2012). We had signs of renewed political conviction within European leadership to erase doubts regarding the irreversibility of the euro, and our economists think that we should continue to see this in 2013.

This reduction in European tail risk could mark a structural change for European equity markets, with investors consequently viewing European equities as investable yield products. This value attraction is well showcased in Figure 15. Of the 10 cheapest regional indices based on the Cyclically Adjusted PE (Shiller PE), 8 are from developed Europe. We think the value attraction we witness within European equities, along with the general underweight positioning, should continue to drive European equities higher in 2013.

Within European equities, we prefer Italy and Spain in particular. We believe Italy and Spain are still secular buying opportunities with a cyclically-adjusted dividend yield greater than 5% (Figure 16). Such opportunities have historically yielded 16% total returns over the last 100+ years. For further detail, please refer to European Strategy Elements: 2013 - Equities to benefit from Yieldfall, 21 November 2012.

However this is not to say that we are not cognizant of the risks. Italian elections could temporarily halt the reduction in European policy uncertainty. As our economists highlight in Italy: Early elections likely to be called after Budget approval…, at this stage it is difficult assess whether Mario Monti will enter the political arena or not; but we can not rule it out completely. Should the risks of political impasse post the election materialise, the political parties may try to compromise and in so doing form a grand coalition, which potentially could be led once again by Mario Monti – this is similar to what happened in November last year. In such a scenario, a grand coalition formed by the Democratic Party (PD), Union of the Centre (UDC; centre) and some MPs elected with PDL, could decide to support a second mandate for Mario Monti. Therefore, if Italian election-related uncertainty leads to a significant selloff, we would in fact see this as a greater buying opportunity, particularly to position within the Italian and Spanish equity indices.

With high CADY and low CAPE, we believe Italy and Spain are secular buying opportunities.

FIGURE 16 We see Italy and Spain as secular buying opportunities, with the greatest potential for yield compression

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In the US, as our US equity strategy team highlights, there are a wide range of possible outcomes for the federal budgetary negotiations. In our base case, we assume there will be a decent amount of fiscal drag. If the deal that emerges fails to address long-term debt sustainability, or is a phased-in deal where key issues are left to be resolved over a four- to six-month period, public policy uncertainty is likely to remain elevated during 1H13. While this would perhaps be detrimental to the performance of US equities, we think European equities are likely to continue to perform well on a relative basis, assuming that there is a concurrent decline in European tail risk.

Volatility Outlook: A year of reckoning Several of the key left-tail risks highlighted in our 2012 outlook appear to have waned. Thus, the ECB seems to have done its part in building, in Chairman Mario Draghi’s words, “a bridge towards a stable future.” Now the onus is on governments to tackle the more fundamental problems. China, for now, appears to have avoided a hard landing and the global economy growth looks tepid but steady. As a result, several key volatility metrics are now trading at the bottom end of or even below their post-2007 “new normal” levels, suggesting that markets are increasingly worried about a right-tail risk of a return to the “old normal”.

However, in our view, it is too early to call the all-clear. For the US, a return to the old normal would require a credible and comprehensive grand bargain, which looks unlikely in the near future. Similarly, for Europe, the road to recovery is likely to remain bumpy. As a result, while significant spikes in volatility are unlikely, further declines should be limited during the first half of 2013. Further declines in risk premia will depend on a fiscal grand bargain.

US fiscal cliff: Shall we jump? Our baseline scenario remains that the “fiscal can will be kicked down the road” for 3-6 months after some sort of temporary “down payment”. Thus, while short-term volatility might decline, mid-term volatility is likely to remain elevated. The negotiations for the upcoming debt-ceiling breach in early February and the comprehensive “grand bargain” required later in the year are likely to be quite contentious.

In our view, several metrics suggest markets are assigning a rather high probability to the “kick the can” scenario. Most risky assets have now recovered to their pre-election levels, with the VIX now a few points lower (Figure 17). Figure 18 shows the forward volatility

FIGURE 17 Equity markets have retraced their post-election selloff…

FIGURE 18 …and not much price action is priced over the year-end

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priced by SPX options through the first quarter of 2013. Forward volatility is elevated for the few days prior to year-end, but this excess volatility is not that significant. Indeed, if all that excess volatility were assumed to occur on one day, it would translate into a 2.6% move.

However, current rhetoric also suggests that the probability of a “fiscal bungee jump” has risen. In this scenario, the US goes over the fiscal cliff with only the hope that time pressure and the markets will force some sort of deal. Given current expectations, the markets could sell off substantially and volatility would spike in such a scenario. But just how bad might the market reaction be?

In our view, the reaction is unlikely to be as extreme as the summer of 2011, though the situations are similar. That turbulent period was almost a perfect financial storm, with a confluence of the US debt ceiling crises, fears of a double-dip in global growth and the escalating European debt crises. Although the European debt situation is by no means resolved, the tail risk of EMU breakup is significantly lower. Outside Europe, it appears that China will avoid a hard landing and some of the overhang due to the leadership change should be alleviated. In the US, our economists continue to expect a tepid but steady recovery. The recent earnings season has underscored the fact that growth in US corporate earnings is unlikely to continue to be as robust as it has over the past few years. However, while this could cap equity upside, any sell-off is unlikely to be a violent affair. Finally, the “Bernanke put” is firmly in place and should continue to support risky assets via the portfolio channel effect. Hence, while VIX would likely spike in a “fiscal bungee jump” scenario, we would not expect it to rise beyond the mid-30s.

European debt crisis: Despite bandages, wounds still festering In 2012, the ECB finally rode to the rescue. The LTRO program for the banks earlier in the year and the announcement of the OMT program this summer have significantly reduced the tail risk of an EMU breakup, in our view. A positive development to come out of the otherwise contentious negotiations around the latest Greek loan disbursement was that Germany has opened the door to future outright haircuts for official-sector holdings of Greek debt. However, the region is certainly not out of the woods.

Our economists believe that Greek debt dynamics remain unsustainable in the long term (even after a successful bond buyback) and that the troika’s baseline scenario of 124% debt to GDP ratio for 2020 is overly optimistic. The final resolution will ultimately require further debt relief from official-sector holdings, but any resolution seems likely to be postponed at least until after German elections in 2013.

Growth in the peripheral countries has continued to surprise to the downside, largely as a result of austerity programs; in our opinion, the key risk remains political backlash against these programs. In our view, Spain’s bleak growth outlook for 2013, rising NPLs, and a sizeable fiscal deficit makes it likely that the country will have to request the activation of ECB’s OMT program. Indeed, sharply lower Spanish bond yields suggest this is already to large extent priced in and any delay or deterioration in macro fundamentals could boost volatility.

European growth outlook still has downside risks and expectations for 2013 GDP and equity earnings for 2013 continue to come down. And while our economists’ baseline scenario is that Europe will avoid an outright recession, risks remain to the downside. Our European equity strategists expect earnings growth of a below-consensus 0% in 2013 but feel that the sluggish earnings growth is likely to be overshadowed by an increase in PE ratios as a continuing decline in European policy uncertainty should reduce the risk premium demanded by investors and boost demand for higher-yielding assets.


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Are we approaching the end of the “new normal”? In our 2010 outlook (Volatility Outlook 2010: A New Normal), we anticipated that the volatility in the markets would likely remain elevated for some time as the wounds of the 2008 crises would take some time to heal. Remarkably, as we discuss next, several of these metrics are testing the bottom end of their post-2007 levels.

While many market participants tend to focus on short term volatility measures, such as the VIX, these are necessarily tied to the level of realized volatilities. Thus, although the current level of VIX (~15) appears low, it is trading at a premium to trailing realized one month volatility (~13.5%). Thus, long-term volatilities (> six months) are more reflective of risk perception. Their current levels across equity indices and other asset classes are quite striking in that they are now approaching or even below the bottom end of their range post- 2007 (“new normal”) range (Figure 19).

We see that SPX and SX5E volatilities are indeed trading at the bottom end of the post-2007 range and are only 30% above the 2006 (“old normal”) levels. The levels of UKX and DAX are even lower. The very low level of Asian volatilities is driven by the recent range-bound nature of these indices and, more important, the impact of structured products flow where retail investors sell volatility.

The key question is whether the various tail-risks that have plagued the market over the past five years have been completely mitigated. That is, are we back to the “old normal”?

FIGURE 19 Mid-term volatilities decreased dramatically during 2012 & are trading at the bottom end of their post 2007 “new normal” range

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Focusing on SPX, it is interesting to note that the average single stock volatility has in fact already reached the levels of 2005. Thus, what is keeping up index volatility is the level of implied correlation being priced by the market. The question of whether index volatilities have further downside can thus be translated into whether implied correlation will continue trending down. As we have discussed before, trends in correlation have both cyclical and secular elements. The decade-long secular trend appears to be driven by increasing use of index and ETF products and this appears to be continuing to grow. In fact, even as equity mutual funds have continued to see outflows, flows into ETFs have continued to be positive over the past year. As a result, in our view, while some decrease in correlation is possible, the decrease is likely to be limited, thus also putting a floor below SPX implied volatilities.



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FIGURE 20 Single stock volatilities already at pre-2007 lows

FIGURE 21 Secular increase in correlation

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Source: Barclays Research, OptionMetrics Source: Barclays Research, OptionMetrics

However, the very long-term volatilities (>2Y) are something of a different story given the changing demand-supply dynamics as the Variable Annuity (VA) insurance industry undergoes a secular shift. Briefly, variable annuities are insurance products with equity underlyings with minimum guarantees in which the insurer is short long-dated puts to the retail investors. Because of losses during 2008, insurance companies are retrenching from these products. In addition, instead of regular equity funds, the new policies are being written on funds that maintain a target level of volatility by dynamically allocating between equities and fixed income assets. In essence, the volatility risk is being transferred from the insurers to the end-investors. If the AUM in these target volatility funds continues to increase, their hedging dynamics are likely to increase the actual equity volatility but, more important, decrease the demand for long-dated volatility.

While implied volatilities have flirted with current levels before over the past five years, the decrease in skew, which is perhaps a more direct measure of tail risk, is much more striking (Figure 22). Thus, we see that the SPX and UKX skew appear to have begun to decline since June 2012, after trending up over the past several years. Skew for European indices, which

FIGURE 22 Lower skew indicates substantially lower tail risk

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13 December 2012 98

were already trading at a discount relative to SPX since the beginning of the year, has continued to decline and is now in fact trading at 2006 levels. Finally, the behaviour of Asian skew has been even more dramatic. Clearly, these have historically traded at significant discounts to other indices. With the onset of the crises, the differential had narrowed quite significantly and now the Asian skew is also trading below 2006 levels. Remarkably, the skew is almost zero, indicating that call and put implied volatilities are equal.

We identify several factors driving these trends. The first is the significant decrease in tail risk highlighted above. Second, investors are perhaps still not fully positioned into risky assets and hence have less of a need to hedge. This is especially relevant for Europe. In Asia, the historical discount has been driven by structured product issuance (where retail investors sell puts) and a resurgence of that flow has probably also contributed to the decline. In the US, another contributing factor has been a fundamental shift in variable annuity (VA) insurance hedging. Essentially, while these investors have preferred to use variance swaps, now they appear to be shifting towards using fixed strike options, leading to a decrease in demand for convexity and, hence, skew.

Finally, a more direct reason is that implied skew has not “performed”. In other words, one reason to be long puts and short calls is the expectation that implied volatility for the put strikes should increase as the market falls while implied volatility for calls should fall as the market rallies. Figure 22 shows the rolling 3-month beta of the changes in fixed strike implied volatilities with spot changes for SPX, SX5E and NKY. Changes in strike volatilities were mildly positively correlated with index moves prior to the crisis but became negatively correlated during the “new normal” era and have been reverting back to traditional behaviour over the past few months. The beta has become less negative recently for both SPX and SX5E, which might explain the recent decline in their skew. This is another manifestation of the fact that the volatility of moves is now heightened during rallies. Again, this is probably linked to the fact that investors are under-invested and hence not panicking to buy protection during market falls.

FIGURE 23 Skew is no longer “performing”

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13 December 2012 99

US convertibles: Ready to bat After strong relative performance by US convertibles (+13.4%) in 2012 (vs HY +14.9% and SPX +14.8%), we expect the asset class to continue to post competitive risk-adjusted returns in 2013. In our base case, we expect US convertibles to return ~6.5%, driven by the combination of 10% underlying equity appreciation, an attractive 4% yield11, and support from modest spread compression in a benign rate environment. In our upside case, we expect US convertibles to return ~9% while in our downside scenario, we expect the asset class to return -2.6%, highlighting the compelling risk-reward attributes of the asset class.

Against a backdrop of uncertainty emanating from the fiscal cliff, the continuation of European sovereign debt issues, the path of US economic growth and global growth concerns, the return prospects of the convertible asset class driven by income and risk-controlled equity exposure are attractive vis-à-vis expectations for equity and credit. In aggregate, US converts sport a healthy yield of 4% (with a current yield of 3.4%), relatively short duration of ~ 3.4 years, and an effective equity exposure of 47%. High yield and non-rated converts remain modestly cheap on a valuation basis.

Solid outperformance in 2012 Following a weak showing in 2011 when they lost 5.25%, US converts bounced back nicely, posting a competitive 13.4% return YTD through December 6, 2012. Over the same period the S&P500 returned 14.8%, the Russell 1000 15.2%, Convertible Underlying Equities 12.8%, BarCap HY 14.9%, BarCap IG Index + 10.2% and 7-10 Year Treasuries +5.3%.

The outperformance in the asset class was driven by tightening credit spreads, ~3.7% income, improvement in valuations and a modest Treasury rally. The highlight of the year was outperformance relative to the underlying equities12 in a rising equity returns environment. Capital Goods, Communications, Financials, Consumer Cyclical and Consumer Non Cyclical converts significantly outperformed the market driving returns. From a returns perspective, preferred structures (+21%), small & mid capitalization converts (+15.8% and +14.3%, respectively), and Non-investment grade converts (+15.9%) also outperformed.

Convertible arbitrage funds had a positive year as well outperforming many other hedged strategies (HFRX Convertible Arbitrage Index +6.1%). Anecdotally convertible arbitrage return estimates range from mid to high single digits.

Income, Risk-Controlled Equity Exposure and Technicals Look Attractive

We think convertibles remain appealing heading into 2013. The multi-pronged return sources in the asset class (namely income, risk-controlled equity exposure and potential for valuation improvement) are especially attractive. Moreover, the continued benign rate environment and positive market technicals should benefit the asset class.

From a valuation standpoint, the high yield and non-rated segments (73% of the market) are ~0.4% cheap and the 618bp spread on non-IG converts remains attractively wider (116bp) than the HY B index (502bp).

Investment grade convertible bond implied volatility stands at 29.7%, in line with listed options volatility, and we expect the technical bid on IG converts to remain strong.

11 Greater of Yield to Put/Maturity and Current Yield 12 Convert market value weighted underlying equity basket rebalanced on a weekly basis.


13 December 2012 100

FIGURE 24 Aggregate valuations reasonable

FIGURE 25 Non-IG converts trading cheap relative to HY ‘B’ index

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FIGURE 26 IG volatility in line with listed volatility

FIGURE 27 Defensive equity exposure with yield

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Positive market technicals remain strongly in place as we head into 2013. While the market is now marginally more equity-sensitive, the overall profile mix is still attractive, with 45% ‘equity sensitive’, 32% ‘typical’, and 22% ‘busted’. The asset class buyer base remains healthy, with a balanced mix of arbitrage (48%) and fundamental investors (52%). By our estimate, leverage deployed by arbitrage funds also remains modest at 1.5-2.0x and while liquidity has declined over the year it is meaningfully better than in the high yield market. While the primary calendar continues to underwhelm, the demand-supply picture remains robust, providing additional support for valuations.



FIGURE 28 Ownership remains balanced

FIGURE 29 Market profile

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Typical Equity Sensitive Busted Distressed Source: Barclays Research, SEC Filings Source: Barclays Research

We recommend multi-pronged positioning to reap returns from various sources

Against a mildly optimistic equity backdrop (albeit in a challenging macro environment) we expect our ~6.5% base case return estimate to be generated via multiple sources: coupon income, equity-driven appreciation, primary market cheapness and some spread-driven valuation improvement.

At a portfolio level, we recommend a large core of balanced intermediate duration high yield/non-rated bonds with decent income and equity exposure flanked by a basket of higher income producing securities including preferreds and select stronger conviction high delta exposures. We broadly favour high yield and non-rated securities given their cheaper valuations and higher yields. We also prefer intermediate duration bonds for their favourable balance of yield and risk and have avoided shorter duration bonds that carry much lower yields and/or premiums that will decay rapidly. Lower equity market correlations and the incrementally higher convert market delta would make security selection a more important factor of performance differentiation in 2013.

Risks: The primary risks to our thesis are macro driven. Our expectations hinge on the performance of the broader economy, the path of fiscal cliff resolution, an improvement in the European debt situation and the allied performance of the equity, credit and treasury markets. Treasury yields are already very low and afford little room for appreciation if economic conditions deteriorate, and absolute credit spread levels are fairly tight leading to the possibility of a potentially sharp selloff in the event of a downturn. While equity valuations increased in 2012 on an improvement in the economy and modest earnings growth, any reversal poses a risk. Last, the continued weakness in the supply of new paper in the convertible market poses a challenge. We expect higher issuance in 2013, but we believe it is unlikely to match the market’s appetite and capacity to absorb new paper.

EMEA and Asia Pacific convertibles: Surprising strength Our core thesis going into 2013 is one of surprising strength in the convertible market – surprising because the market has already performed very strongly (the EMEA convertible index total return was 15.2% YTD to 10 December, while for Asia ex-Japan it was 11.2%), issuance has rebounded from the mid-year doldrums, particularly in EMEA (€17.7bn YTD, the fourth highest since 2003), and relative valuations have improved substantially (EMEA



index cheapness has compressed by 3.1% YTD, Asia ex-Japan by 2.0%). The ‘mean reversion’ argument suggests caution. However, we take a contrarian view, for now.

We expect the convertible market to continue to perform strongly going into 2013, on the back of robust technicals and historically low yields in other asset classes. We see similarities with two years ago, when a strong H2 2010 led to a stretching of valuations in H1 2011. As such, we may turn more cautious as 2013 progresses, should valuations reach excessive levels.

Performance projections We project a c.5% total return for EMEA convertibles in 2013 and c.4% for Asia Pacific convertibles, based on our forecasts for high single-digit potential equity index upside, modest credit spread gains, and carry/yield.

The convexity of convertibles remains key in a still uncertain environment. For average equity scenarios of +25%, 0% and -25%, we project convertible returns of 8.5%, 1.0% and -5.2% in EMEA; and 6.9%, 0.8% and -2.9% in APAC ex-Japan.

Positioning We believe convertibles are well positioned for our central recommendation of a gradual shift into equities from credit, given their upside participation and the universe’s majority composition of high-yielding bonds. This is augmented by their embedded options, for example dividend protection to capture the upside in dividend-supported stocks, and change of control protection.

Key themes Convertible-implied volatilities are slightly above option-implied and realised volatilities, as the latter declined sharply. However, they are quite low in absolute terms versus their historical levels.

Credit-sensitive convertibles offer compelling yields compared to straight bonds, and with lower duration, as straight bond yields have declined towards historical lows.

Net supply outlook In our view, issuance will continue to be driven by the coupon saving, equity performance and a generally benign macro backdrop. Regional refinancings may also benefit from the loan-to-bond shift (Europe) and the upcoming redemption schedule (Asia Pacific).

We forecast €9.7bn of EMEA redemptions for 2013 and $20.7bn in Asia Pacific, two-thirds of which are in Japan. IG redemptions due are €4.8bn in EMEA and $6.1bn in Asia Pacific.

Review of 2012 In EMEA, convertibles returned 15.2% YTD to 10 December versus 18.1% for equities, but with substantially reduced volatility, c.5%. Convertibles in Asia ex-Japan returned 11.2% YTD, with c.4% volatility, versus 20.2% for equities. Japan convertibles returned -1.7%.

New issuance stands at €17.7bn YTD in EMEA and $8.6bn in Asia Pacific, after a strong pick-up since September. The convertible universe market values are currently €82bn in EMEA and $67bn in Asia Pacific.



FIGURE 30 Valuations improved substantially in 2012; moving up through the 3y average rich/cheapness

FIGURE 31 Issuance was strong in EMEA with positive 2012 net supply, but relatively anemic in APAC; we expect more in 2013

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FIGURE 32 EMEA relative valuations richened versus option-implied and realised volatility, as the latter measures fell sharply…

FIGURE 33 … and in Asia Pacific; yet convertible-implied volatilities remain low in both regions compared to recent years’ levels

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FIGURE 34 Busted (credit-sensitive) EMEA convertible index yields are comparable to HY bond yields, with lower duration…

FIGURE 35 … and similarly for Asia; suggesting that convertible relative value opportunities remain

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Note: Market value weighted average yield in %. Source: Barclays indices Note: Market value weighted average yield in %. Source: Barclays indices



EMERGING MARKETS OUTLOOK

Searching for yield, hoping for growth Going into 2013, we essentially extend the strategy we initiated in September. We see the global liquidity backdrop continuing to drive a search for yield, while we find the growth performance still uninspiring, at least in H1. Reduced anxiety about extreme events helped end the markets’ risk-off/on pattern. This not only supports risky assets and flows, but should also allow assets to benefit from idiosyncratic drivers.

• Credit: We prefer corporate bonds and higher yielding sovereigns: overweight Venezuela, long LatAm sub bank bonds and shorter-dated Russian quasi-sovereigns.

• Rates: We expect real and nominal yield compression in Brazil (buy 2014 NTN-F and NTN-B). We prefer longs in 10y government bonds in Russia, India and Malaysia, FX-unhedged. In swap space, we recommend a 2y-10y IRS steepener in Poland.

• FX: Expecting a weaker yen, we fund longs in the MXN and ZAR with the JPY. We recommend a long RUB against the EUR-USD basket and see relative value in long MYR against the SGD, long PLN against the HUF, and long RUB against the TRY.

Evolution, not revolution, in 2013 investment themes In Emerging Markets Quarterly: Ride the tide, 25 September 2012, we pointed to decisive policy actions that had finally broken the stress-intervention cycle. This implied a better outlook for risky assets, increased flows into EM, and called for extending further out on the risk curve. We recommended higher yielding credit and corporate bonds. We liked local currency bonds with high nominal yields and inflation-linkers, and in FX we opted for currencies where central banks were less likely to oppose appreciation.

For 2013, we see an evolution of this strategy, rather than any radical new theme: large-scale monetary stimulus continues to drive the hunt for yield, while the global growth outlook is varied and not one of broad-based expansion. The anxiety trades and the risk-on/risk-off mode that dominated much of 2012 are unlikely to reappear. The euro area will likely continue to struggle, but it now has architecture in place that seems sufficient to

Christian Keller

+44 (0)20 7773 2031 [email protected]

Koon Chow +44 (0)20 7773 7572 [email protected]

Piotr Chwiejczak +44 (0)20 3134 4606

[email protected] Alanna Gregory


Andreas Kolbe +44 (0)20 3134 3134 [email protected]

Strategy initiated in September broadly worked…

FIGURE 1 Globally, linkers and equity outperformed this year

FIGURE 2 Among EM assets, credit and inflation linkers stand out

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Source: Barclays Research Source: Bloomberg, Barclays Research

…we evolve the theme rather than making radical shifts




prevent serious crisis scenarios. The fiscal cliff in the US is a non-negligible risk, but does not have the threat potential of a euro area break-up.

By the same token, it has become unlikely that ground-breaking policy announcements will trigger the kind of rallies that occurred as a result of long-term refinancing operations (LTRO), the Outright Monetary Transactions (OMT) announcement and additional QE: eg, a potential activation of the ECB’s OMT by Spain in Q1 13 is not likely to have the effect the LTRO had in Q1 12. Other important European policy initiatives (eg, banking union) are likely to take the form of a difficult piecemeal process, rather than of a breakthrough event. Certainly, a sudden and comprehensive agreement on solving the US fiscal cliff could boost market sentiment, but we think a compromise to kick the can further down the road seems more likely.

FIGURE 3 Barclays growth and inflation forecasts (%)

Real GDP (Barclays) vs. consensus Inflation (Barclays) vs. consensus

2012 2013 2012 2013 2012 2013 2012 2013

Global 3.1 3.3 0.0 -0.1 2.9 3.0 0.1 0.2

US 2.3 2.1 0.1 0.1 2.1 2.0↓ 0.0 0.0

Japan 1.6↓ 0.1↓ -0.2 -0.2 -0.1 0.1 -0.1 0.3

Euro area -0.4 0.1↓ 0.1 0.1 2.5 1.8 0.1 0.0

Developed 1.2 1.2 0.0 0.0 1.9 1.7 0.0 0.1

Emerging 5.0 5.5 0.0 0.0 4.8 5.1↓ 0.2 0.4

Brazil 0.9↓ 3.0↓ -0.6 -0.6 5.4 5.5 0.0 0.2

Mexico 3.8 3.0 -0.1 -0.1 4.2 4.0 0.1 0.3

China 7.7 7.9↑ 0.0 0.0 2.7↓ 3.2↓ 0.0 -0.1

India 5.3 6.5 -0.3 -0.3 7.7 7.1 0.0 0.6

South Korea 2.2↓ 3.3↓ -0.1 -0.1 2.2 2.1 -0.1 -0.6

Indonesia 6.3↑ 6.3↑ 0.1 0.1 4.3 5.0 -0.2 -0.2

Poland 2.3 1.5 0.0 0.0 3.7 2.7 -0.1 0.0

Russia 3.7 3.6↓ 0.0 0.0 5.4↑ 7.3↑ -1.3 1.4

Turkey 2.9 4.2↑ 0.0 0.0 8.9 6.3↓ -0.1 -0.8

South Africa 2.5 2.8 0.0 0.0 5.7 5.7 0.2 0.2

Note: Arrows indicate revisions of more than 0.3pp compared with September EMQ. *Annual average. Source: Barclays Research

As the ‘anxiety-followed-by-large-policy-response’ themes have run their course, developments in economic data could, in principle, become the catalyst for larger market moves. However, the global growth outlook remains mixed: China has stabilized and US data (in particular housing) look more robust, but European weakness is likely to extend into 2013 and the performance of key EM economies other than China remains lackluster as well. This makes for a rather modest and uneven recovery, we think. It does not yet lend itself to more aggressive calls, such as a broad-based EM equity rally and/or a general back-up in rates.

Calling for more of the same at least for the first half of 2013 may appear uninspiring, but we believe it creates its own opportunities for EM trades. In particular, we think that the environment of lower tail risks and less global, macro-driven trends will not only continue to drive flows further down the risk curve (eg, into high yielders such as Venezuela and EM corporate credit), but also allow for the taking advantage of idiosyncratic developments in EM (eg, easier bond market access in Russia, structural reforms in Mexico, rate cuts in India, Brazil and Poland).

Euro area break-up risk diminished

Fiscal cliff seems a more manageable risk

Less room for policy-induced market rallies

Growth outlook still too feeble for more aggressive strategies

End of risk-on/risk-off gives room for idiosyncratic factors



Growth recovery prospects remain modest… Confirmation of China’s turnaround in growth was the main positive economic news since our September EMQ. Most recent export data remain mixed, but other indicators signal that the economy as a whole is expanding again and we revised up our China growth forecast for 2012 and 2013 to 7.7% and 7.9%, respectively (still slightly below the 8.1% consensus forecast for 2013). This is good news for global growth, in particular for Asian trading partners and those linked to China through commodity demand. Second, confidence in the US recovery has grown, in particular helped by robust housing market indicators. We see US growth at 2.1% in 2013, somewhat above consensus.

Elsewhere, however, the growth data have been more mixed. In the euro area, the continuing contraction in activity in the periphery has started to affect the core economies more visibly, including Germany. Indeed, German IP data point to a GDP contraction in Q4. Even if this is reversed in Q1, as we forecast, the overall outlook for the euro area remains one of a very slow recovery. We forecast a timid 0.1% GDP expansion in 2013, following this year’s negative growth (-0.4%). We also see growth in Japan next year reaching just 0.3%.

Importantly, outside China, growth in EM did not excel. All other BRIC economies showed weak Q3 GDP, led by a massive downside surprise in Brazil, which now could grow less than 1% this year. Importantly, we now forecast Brazilian growth to reach only 3% in 2013, down from 4.1% forecasted previously. Russia and India have also continued to show weakness, leading to further downward revisions in their growth outlook for 2013. There are some brighter spots: the larger ASEAN economies have not slowed and we revised up our growth forecast for Indonesia. In LatAm, the Andean economies continue to perform well and Mexico’s positive outlook is unchanged. In EEMEA, Poland’s 2013 growth was revised down markedly, while Turkey could grow faster than earlier projected as a consequence of monetary easing.

Overall, however, the negative news prevailed, leaving us with a weaker EM forecast of 5.0% in 2012 and 5.4% for 2013, down from the forecast of 5.1% and 5.6%, respectively, in September. Together with weaker growth in advanced economies, this brings down our forecast for global growth to 3.1% and 3.3% in 2012 and 2013, respectively.

US growth in 2013 above consensus

China growth revised up

Euro area growth now also weaker in the core

Brazil growth disappoints

India and Russia also weaker

ASEAN economies not slowing

FIGURE 4 Global business confidence: stabilizing but still weak

FIGURE 5 Many EM central banks are still in easing mode

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Overall EM growth forecast lower than in September



… leading to still more easing and increased currency focus Weaker demand and softer commodity prices seem to make for a relatively benign inflation outlook. Indeed, in parallel to lowering growth forecasts, we have also generally reduced our inflation forecasts in EM and in advanced economies. With inflation risks contained and core market central banks easing monetary conditions further, EM central banks have responded by (further) easing as well.

In our September EMQ, we saw ‘many doves, rare hawks, a warrior and an inventor’. Three months later, there are as many doves as ever and the ‘rare hawks’ seem to have become extinct; we no longer expect further hikes in the main policy rate in Russia or in Indonesia. Anywhere we see a potential for hikes (Malaysia, Philippines, Chile, Peru), we do not expect them before Q4 13.

In the meantime, some of the doves have become even more dovish: we expected Brazil’s rate cutting cycle to end at 7.25% in October, but now forecast another 100bp of cuts in Q1 13 as a consequence of the weak Q3 12 growth. Similarly, after Poland finally started cutting rates in October, we now forecast a deeper cycle than before: another 150bp until a final rate of 2.75% in Q3 13. Hungary had started cuts earlier, and we still see another 100bp. India is approaching its cutting cycle, we think, and we still expect 100bp of cuts in H1. Given recent announcements, Turkey also seems to be considering cuts in its repo and borrowing rate. In our baseline, Korea remains on hold, but the risk is for a cut. We expect South Africa and Mexico to remain on hold throughout 2013, although South Africa seems in a tougher spot, as it faces disappointing growth, combined with potentially rising inflation and a much depreciated rand.

In our September EMQ, we called Turkey’s CBT the ‘innovator’ among EM central banks, and it did not disappoint. In addition to its multi-interest rate framework and its ‘reserve option mechanism’ (which allows it to replace required local currency reserves with FX), the CBT also recently announced REER threshold levels that would trigger rate cuts. Hence, Turkey has quietly joined Brazil as a ‘currency warrior’ of sorts.

Inflation forecasts also revised down

Central banks have become even more dovish

Additional cuts in Brazil …

… in Poland and Hungary…

… and in Turkey

Mexico and South Africa on hold

FIGURE 6 Turkey joins Brazil in ‘currency war’ by setting REER limits

FIGURE 7 Softer BRICs: GDP growth disappoints

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Turkey joins Brazil in fighting a currency war



Relief about China … Following a prolonged period of continuous weakening, China’s activity data finally turned in September/October, due to better export performance, sustained infrastructure investment and rising consumption. GDP likely bottomed during Q3 12, and the economy is now in the middle of the transition toward the ‘new normal’ of lower potential growth and higher inflation. The party congress in November brought no surprises in terms of leadership or policy orientation, and we expect growth to gravitate towards its new potential rate of about 8% in 2013, supported by a modest fiscal expansion and a broadly neutral monetary stance (including a 2-3% currency appreciation against USD).

China’s lower growth trajectory implies that it can no longer play the same role as global growth engine. Moreover, the transition towards more domestic demand-driven growth shifts income from corporations to households. It will have implications for China’s commodity demand (eg, less steel, more food) and could affect global inflation (as wages rise and China no longer ‘exports’ disinflation). However, these effects will play out only over time. In the meantime, the risk of a hard landing in China, which preoccupied markets for some time in 2012, has clearly abated.

… but without reforms, past EM ‘stars’ could lose their shine… Elsewhere on the BRICS landscape, however, developments were more mixed: most notably, Brazil’s disappointing Q3 GDP highlighted that its slowdown this year may be more than cyclical in nature. Increased government intervention in many areas of the economy has depressed investment and risks lowering the economy’s potential growth. The immediate reaction seems to be additional short-term cyclical stimulus, in particular on the monetary front. This should help growth rebound in 2013. But if not buttressed by structural reforms that promote investment and rising productivity, Brazil could more permanently shift to lower trend growth.

In India, we also expect additional monetary accommodation and some favorable base effects for industrial growth to drive a modest recovery in 2013. But growth remains below historical averages and with inflation elevated and public debt high, the potential for policy stimulus is limited. The economic reform plans announced shortly before our September EMQ were a step in the right direction (invite FDI, reduce subsidies, etc) but the follow-up will be crucial. We expect some new initiatives in Q1, but the reform drive will likely remain hostage to the ruling party’s performance in the various elections throughout 2013.

FIGURE 8 Portfolio inflows to EM continue…

FIGURE 9 …from an increasingly diverse investor base

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China finally stabilized Transition to ‘new normal’ Potential growth around 8%

China no longer global locomotive Changes in commodity demand pattern

Brazil’s growth weakness has structural reasons… … not addressed by short-term intervention

India faces large structural challenges… … and recent reform initiatives require follow through



In Russia, a lot of commodity-related earnings leave the country as private capital outflows rather than being invested domestically. This keeps investment low and growth weaker than it could be. Thus far, the pace of economic reforms, including privatization, has been modest and after the final accession to WTO this summer, there are signs of back-pedaling on some related obligations. Progress is being made in some areas, however, notably in the opening of the local government bond market. This should support the development of local financial markets, and we think it creates good opportunities for fixed income investors. However, more is needed to encourage broad-based optimism on the economy.

While our outlook for Sub-Saharan Africa is generally very constructive, its key market, South Africa – the ‘S’ in BRICS – has lost some of its allure this year as well. Dramatic strikes in the mining sector not only weighed on growth, but also turned the focus on some of the country’s structural challenges regarding unemployment, education, infrastructure, etc. Investors are likely to pay attention to the discussion of new growth and development plans during the ANC congress in mid-December for clues about structural reforms and investment initiatives.

We could easily extend the list beyond the BRICS, but the examples above seem to illustrate our point well enough: while the mixed EM growth performance in 2012 can clearly be linked to the deterioration in EM’s core export markets, in particular the euro area, the role of domestic structural factors cannot be denied. Certainly, capital flows into EM continue from an increasingly diverse investor base (Figure 8 and 9). However, avoiding making the effort to undertake structural reforms because foreign financing is easily available is risky and could hurt over the longer run. Despite their many advantages, most EMs still have much room to improve on the structural front.

Indeed, there are examples of such reform efforts. In addition to those in India, we highlight Mexico’s. Since the passing of labor market reform, Mexico’s new government has announced further plans for reforms in the fiscal and energy areas. We believe these can translate into sustained higher growth rates and will become reflected in asset valuations.

Russia’s oil income moved abroad, not invested at home WTO membership is positive Progress on opening local bond market

Strikes put focus on structural issues in South Africa ANC’s reaction in spotlight

Capital inflows are not a substitute for reform

FIGURE 10 Capital flows are not a substitute for reform: Most EM economies still have much room for improvement

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Mexico is positive example



The known unknowns: Fiscal cliff, euro area and geopolitics As a China hard landing or euro area breakup seems no longer on the list of potential ‘extreme events’ (at least in the near future), the focus has shifted to the US fiscal cliff. While time is obviously running out for finding compromise before year-end, our base case remains: no comprehensive solution but a compromise that postpones some of the decisions. This implies a fiscal tightening of about 1.3% of GDP and growth 0.8-0.9pp lower than in a case of no fiscal tightening. This is incorporated in our US growth forecast for 2013. Even if this were not achieved by year-end, we find it hard to imagine that politicians would allow the resulting fiscal shock to extend for long.

Investors are still concerned about Europe’s debt issue, but developments since the summer, including the willingness to find a way to deal with Greece’s additional financing needs, seem to confirm an underlying commitment to keep the euro area together. As mentioned above, we expect the institution-building process, including the project of a banking union, to take time, but indications are that there is sufficient commitment to make progress. We think Spain could finally request a program in Q1 13, which would trigger the ECB’s OMT. However, at current yields, it does not seem that a further delay would necessarily spook markets. Italy’s upcoming election was always prone to make headlines and we do not downplay the risks. However, we believe the recent developments towards early elections could reduce the risks created by a protracted electoral campaign. Similarly, there is some potential upside that the German elections in the fall could lead to some limited fiscal stimulus in Europe’s largest economy.

On the geopolitical front, China’s assertiveness regarding territorial matters could continue occasionally to create tensions with neighbors. And the confrontation with Japan has shown that these can at least temporarily affect markets. The more obvious threat in H1 13, however, could be a potential confrontation of the US and or Israel with Iran over its nuclear programme. With US elections out of the way, the risk seems now higher that potential news about Iran’s progress on its nuclear capabilities could make those countries consider military options. A surge in oil prices could be the consequence. However, such scenarios seem impossible to predict (and to time), and one cannot even fully dismiss a potentially positive scenario in which a diplomatic solution has the opposite effect.

After China, market fears shifted to US fiscal cliff

Our baseline remains the same, but time is running out

Early elections in Italy could be a good thing

OMT trigger by Spain may no longer matter that much

Euro area bought itself time

More China-related tensions in Asia possible

Iran risk seems higher after US election

FIGURE 11 Barclays client survey – Less concern about China*

FIGURE 12 Barclays client survey – Positioning still ‘light-to-average’

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Strategy overview The macro outlook for the major EM economies, while not necessarily very bullish, has lower tail risks than a year ago. The developed markets’ tail risks are lower, and there is a greater understanding of the deleveraging flows, the challenges and the policy backstop for the global financial sector. This is an environment of risk extension, where EM FX plays some catch-up and safer EM havens do not enjoy most of the inflows.

The flows to EM are very likely to remain robust: 2012 was a very strong year for dedicated EM credit fund flows and cross-investor flows to EM local bonds. 2013 will probably be a good year for both asset classes. The sovereign credit net supply fundamentals are bullish. Local government net supply is also easily manageable measured against the diversification flows. We see about USD180bn of net local sovereign supply, against a likely USD110bn+ of inflows from abroad. Foreign investors hold about USD566bn of EM local government bonds, the equivalent of 1% of OECD institutional investor AUM. Meanwhile, official sector and intra-EM demand for EM local government bonds is still rising.

Last year had another large wave of G3 monetary stimulus, leading to a sharp move down in DM and EM real interest rates. We see this as unlikely to reverse, with (positive) implications for risk taking and powerful implications for asset selection, particularly in EM local rates and FX. The low level of real rates in EM, not necessarily low inflation in EM, argues for greater differentiation in bullish rates trades in terms of country and product (linkers versus nominal). The climate in EM FX is probably where policymakers are very focused on growth. The ideal location for EM longs will be where the main policy is not real currency competitiveness or where there is a decent real interest rate differential.

Highest conviction trades: • Credit: Long Venezuela (PDSVA ‘22s, VE26s, 31s), Zambia (‘22s) and LatAm sub-banks.

Long Bonar ‘13s for carry, SOAF 3s5s CDS flattener as a risk hedge.

• FX: Long RUB (versus EUR-USD), MXN (versus JPY) and MYR (versus SGD).

• Rates: Long Brazil (NTNF Jan’14, NTN-B Aug’14), Russia (OFZ Apr’21), Malaysia (10y).

FIGURE 13 Barclays client survey – ‘Go local’

FIGURE 14 Barclays client survey – More flows on the way

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Risk extension…

…with inflows supporting EM credit and local currency bonds

More differentiation in local bonds EM FX increasingly attractive but intervention risks persist



EM external credit – Don’t fight the technicals EM external credit has had a stellar year in 2012: the Barclays EM Sovereign credit index is up 17.3% on a total returns and 13.4% on an excess returns basis YTD. EM corporates marginally underperformed sovereigns, with YTD total returns of 16.4% and excess returns of 13.0%. EM dedicated hard currency funds received 33% of flows by AUM YTD, which helped the market to absorb a record volume of new corporate and sovereign supply.

It is increasingly hard to argue that valuations in EM credit are still generous. The breakeven default rate of the EM USD credit index (ie, the rate of default an index investor could sustain before the spread carry is wiped out) is c.3.5%, based on a 25% recovery rate assumption. Default rates of a (theoretical) basket of global issuers with a similar rating as the current EM USD credit index have exceeded this on several occasions in the past.

However, such a long-term measure is not an indication of near-term returns in an environment of record-low core yields and ample global liquidity conditions, and we do not forecast a surge in default rates in EM credit either (please also refer to the EM corporate credit outlook). The ongoing legal dispute on Argentina is likely to remain in the spotlight, but repercussions for broader EM markets have remained limited so far. Moreover, while overall yields are at record lows, spreads are not (Figure 16) and powerful technical factors are still in place, in our view, that should keep demand for the asset class anchored: preference for local-currency issuance among many EM benchmark names, shrinking fiscal deficits and pre-financing of 2013 requirements in 2012 are likely to result in very supportive supply/redemption dynamics for EM sovereign credits in particular. For EM sovereigns, we forecast very manageable net supply of c.USD15bn (net of amortizations and interest payments) for 2013. Front-loaded redemptions (Figure 17) are likely to provide a boost particularly in the early weeks of the coming year.

On balance, we forecast c.20bp of tightening for EM sovereigns at the index level for 2013, resulting in total returns of about 5.5%. Rising US Treasury yields are a risk, but according to Barclays’ forecasts, this is something to worry about only after 2013. We expect the spread tightening to come primarily from higher-yielding credits, whereas many of the high-grade credits already trade at too tight levels to offer room for

A massive rally in 2012…

…leaves risk premia in EM credit much compressed

The global environment and powerful technical supply/ redemption factors leave us constructive for 2013

FIGURE 15 Index breakeven default rates: Risk premia much compressed after the 2012 rally…

FIGURE 16 …but spreads are not at record lows and have room to compress further, in our view

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We forecast 5.5% total returns for EM sovereign credit next year, with pockets of EM corporate credit to outperform



outperformance. We expect some pockets of EM corporate credits to outperform sovereigns (Figure 18). On a risk-adjusted basis, LatAm and CIS IG corporates and EM sovereign high yielders seem to offer the “sweet spots”.

The following themes and trades offer a promising strategy for 2013 in EM credit:

• Overweight/long select sovereign HY names, move into corporates in IG LatAm/Russia: We recommend overweights in Venezuela (PDVSA 22s, VE 26s, 31s) and some smaller higher-yielding sovereigns: Zambia 22s is one of our highest conviction longs. In the LatAm corporate IG space, we highlight LatAm subordinated bank bonds (Bancolombia sub 6.125% 2020s, 5.125% 2022s and BANBRA subs are among our top picks). In Russia, we think that senior bank bonds (VTB, Sberbank and Gazprombank) and shorter-dated quasi sovereigns (Gazprom ‘16s, ‘18s and Rurail ‘17s) offer value. China HY property names such as KWG, Guangzhou R&F ‘16s and Kaisa have room to outperform in Asia, in our view.

• Underweight tight HG benchmark sovereigns: We recommend underweighting tight sovereigns, especially HG LatAm sovereigns such as Brazil, Mexico, Colombia, Panama, and Peru, whose absolute spread levels simply do not leave much room for outperformance in a benign market. We also recommend an underweight in Philippines and tactically balance these with overweights in the slightly higher-yielding benchmark sovereigns Indonesia, Russia and Turkey.

• Tactical trades and risk hedges: Local law bonds in Argentina for carry, SOAF CDS flattener. We suggest holding local law Bonar 13s for carry. The bond is not subject to the legal dispute, yields over 10% and matures in September next year. We recommend a neutral stance on Argentina overall, but among the external bonds, we would prefer the ones that have been oversold, in our view: USD/EUR Discount and G17s versus the Pars. As a global risk hedge, we recommend a 3s5s CDS flattener in South Africa. HG CDS curves have steepened massively lately, so select DV01-neutral flatteners can be set up at close to flat carry/roll, creating an opportunity for a cheap hedge. South Africa, given its deteriorating credit fundamentals, is a prime candidate for such a hedge, in our view.

EM credit trades

FIGURE 17 Front-loaded redemptions likely to give a technical boost to EM sovereign credit in early 2013

FIGURE 18 HY sovereigns and LatAm/CIS IG corporates among our favourite sectors in the EM credit universe

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Local rates/bonds: Real premium EM local bonds delivered solid returns, with the Barclays benchmark index up 13.8% on a FX unhedged basis and 6.8% hedged. The hedged returns benefited hugely from offshore inflows and the last round of monetary loosening.

Despite last year’s high returns, 2013 still seems to be a receiver climate and we find EM yields attractive from a relative and an absolute perspective. In relative terms, the FX premia in EM local yields are high: although nominal yields have fallen, it has been by the same amount as the fall in credit spreads plus the fall in US Treasury yields. The implied long-term FX premium (which we think can be measured by local yields - EM credit spread - UST) has hardly adjusted. It remains as high as +200bp for most EM countries (Figure 21). From an absolute perspective as well, EM rates should still look attractive to foreign investors where the alternatives (in fixed income markets) are the low nominal and negative real yields in developed markets. Flows to EM local bonds should persist.

In terms of bottom up drivers, nominal EM bonds are likely in 2013 to benefit from declining inflation, a benign supply outlook and some further monetary easing. We expect Brazil, India, and Poland to deliver more cuts than what are priced into local curves, which should naturally pull down nominal yields.

One of the consequences of QE3 and the ECB’s actions in 2012 was a sharp drop in global real yields to low levels, by historical standards (with EM real yields falling to about 1%). This naturally means that a further fall in nominal will necessitate a fall in inflation expectations, taking some of the shine from EM linkers. We are not, however, bearish EM linkers: there are pockets of value and valuations are not, generally, a problem.

Brazilian real yields stand out as the highest in EM and we expect them to compress in the next few quarters, given the country’s likely interest rate cuts and long-term growth challenges. An interesting way to think about linker valuations is the real FX premium embedded into the real yields (measured by local linker yield - EM credit spread - US TIPS). This real FX premium is high in Mexico, which supports our recommendation of a flattening trade in real and nominal space (Long Mbono’42 and UDI’35). The real FX premium in Poland is also very high (175bp). This supports our recommendation to own 10y PLN linkers at 1.65%, targeting real yields to compress 50bp in 3m. In Asia, the real FX premium

Strong rally but lagging EM credit…

But it also means still good levels of (FX) premium left in the market

Selective receiving in nominals

In real space there are also still pockets of value

FIGURE 19 Sharp drop in real yields (10y linkers)…

FIGURE 20 …yet BE stable, suggesting room for fall in nominal yield

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is higher than it was a year ago, as the credit spread and US TIPS rates have tightened much more than rates there. Still, we do not expect Korean or Thai long-term real rates to decline but the gains should be expected in nominal bond appreciation.

For 2013, we recommend:

• Cash-based investors to favour the higher-yielding bonds with an attractive FX outlook: In our model portfolio, we accordingly overweight India, Russia and South Africa. Rate cuts in India, bond-market liberalization in Russia and a favourable risk reward on the ZAR supports our overweights. We finance our positions with underweights in Central Europe and Indonesia (mainly on an FX view versus the USD). Malaysia is also an overweight (due to our bullish FX view there).

• Nominal receivers where rates can be cut aggressively or where there is room for inflation to fall, pulling down yields. These are not the same as the overweight recommendations for cash investors, as the aggressive cuts could negatively affect FX and therefore total (USD terms) returns. Brazil (NTN-F Jan’17), India (10y) and Poland (via a steepener of 10y versus 2y swaps) are our favoured pure directional rates trades.

• Linker hot spots where valuations look particularly attractive. This includes Brazil (NTN-B Aug’14s) and Poland (POLGB Aug’23), where even though inflation may not be an issue for the coming 12 months, the risk premium embedded into real yield levels is too high, by our calculations.

• RV trades: Supply and policy focused. We look for ASW tightening/bond richening, as the amount of new local bond supply looks manageable for 2013 against local demand and foreign inflows. Asia probably benefits the most from a likely richening of bonds to swaps, where there may be catch-up demand by foreign investors for bonds and IRS paying interest, as monetary policy is perceived to have bottomed. We recommend positioning for ASW tightening in India, Malaysia, Singapore and Thailand. We favour flatteners in markets where the rate easing cycle is advanced (TRY 2s10s) against steepeners where it still has much further to go (PLN 2s10s).

EM rates trades

FIGURE 21 Nominal rates – The imbedded FX premia*

FIGURE 22 Real rates – The imbedded FX premia**

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FX: Winners from flows EM currencies also had strong returns, particularly in EEMEA and LatAm, with the Barclays GEMS total returns index up 7.9% year-to-date: 10.6% in EEMEA, 8.2% in LatAm and only 4.9% in Asia. This differentiation in return patterns has been due to the different beta characteristics of the three regions, FX intervention and downward reassessment on the EEMEA risk outlook after the ECB’s actions in the past twelve months.

We take a constructive view on EM FX in 2013, as the easing of growth risks in EM probably encourages more portfolio inflows and less FX hedging of them. In 2012, fixed income flows dominated, but this may not be the case again in 2013, given the improvement, albeit a modest one, of the growth outlook. In addition, the stability of policy rates in the majority of EM economies next year (as well as the flattening in local bond curves) probably means less FX hedging demand by foreign bond and equity investors.

The outlook for EM FX, while improved, will still need to take into account FX intervention, which is unlikely to fade. Policymakers may use the backdrop of stable inflation to support the cyclical economic recovery by leaning on appreciation. The favoured EM FX longs, as result, should be where the FX intervention risks are lowest or where the real interest rate levels/and the spread of these levels over trading partners are high. The first point is uncontroversial and one of the reasons we favour the RUB and MYR as longs. Real rate differentials are important, given that policymakers are probably focusing on real measures of competitiveness (such as the real effective exchange rate) and if they keep the real measure stable, investors are left with only the real rate differentials.

In 2013, there should be much focus and fine-tuning of the funding currencies against EM FX longs. Next year, we look for the USD to appreciate both against the EUR (5%) and the JPY (8%), driven by very sluggish growth in the euro area and Japan (relative to the US), a catch-up in monetary easing in both cases and prospects for looser fiscal policy under the next government in Japan (which could put pressure on the sovereign ratings, leading to increasing selling of Japanese government bonds and capital outflows). If our view on the EUR/USD and USD/JPY pan out, then investors should have their EM FX longs in the EUR and JPY, instead of just the natural cross (which in many cases is against the USD). This is particularly important given that when intervening or considering additional rate cuts, EM

Flows likely to be at least as robust as 2012, with less FX hedging

FIGURE 23 Equity flows needed to encourage FX

FIGURE 24 Cheap to hedge (FX) in rising flows

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Risks of FX intervention and real interest rate differentials will help guide decision on longs

Choosing the right funding currencies is always important, particularly in 2013, given our view of a weak EUR and JPY



policymakers focus on the trade-weighted basket of their currencies, rather than just against the USD. Accordingly, we express some of our longs against some mix of the EUR, USD and JPY.

More granularly, we think that the following trades offer a promising strategy for 2013 in EM FX, leveraging off these issues:

• Directional trades where there is policymaker tolerance of real and nominal appreciation and strong bottom-up flow drivers (long RUB, MYR and MXN): In Russia, bond market liberalization is likely to bring additional capital flows, which should support the RUB. The MYR is likely to enjoy strong bond portfolio flows and a post-election pick-up in privatisation flows. The reform picture in Mexico seems very supportive of long-term capital inflows and Banxico has one of the most flexible FX policy stances in the region. The MXN should be a big beneficiary of easing fiscal cliff anxieties. At the other end of the spectrum, we see the Czech central bank acting to weaken its currencies, which makes the CZK an attractive funding currency in EM, and we also recommending being long EUR/CZK.

• Trading the competitiveness implications of JPY weakness (long CNY/TWD and long MYR/SGD): China and Taiwan’s export competitiveness with Japan would be negatively affected by JPY weakness. However, China’s managed currency float is likely to cause the TWD to underperform. We recommend funding MYR longs with the SGD, as the trade weighted level of the latter is high, which probably means that if USD/JPY rises, the MYR can outperform the SGD. We recommend funding ZAR (an appreciation catch-up story), MXN and CLP longs with the JPY.

• RV trades that take advantage of real interest rate differentials (short TRY/RUB and long PLN/HUF): Turkey has lower real rates than Russia and is more focused on keeping its currency stable in real terms. We also like the PLN over the HUF, particularly given Poland’s capacity (higher weight in benchmark bond indices) to absorb a larger portion of portfolio flows to EM. Real rates in Poland are higher than in Hungary, and YTD, the REER levels in Poland have moved less, as well. The RV trades work from the perspective of relative risk fundamentals and real interest rate differentials.

Themes and trades for which to position in EM FX

FIGURE 25 Strong REER gains so far…

FIGURE 26 …and could be aggravated by EUR-JPY weakness *

-15%

-10%

-5%

0%

5%

10%

15%

HU

F

MX

N

CLP

CO

P

PHP

RUB

PLN

TRY

KRW

THB

INR

ARS

ZAR

IDR

BRL

REER change, 12m

0%

20%

40%

60%

80%

100%

MX

N

CO

P

BRL

CLP

PHP

INR

MYR

ARS

KRW

ZAR

THB

IDR

TRY

RUB

HU

F

PLN

USD EUR JPY

Currency share in each countries REER

Source: Barclays Research Source: Barclays Research, * weights are derived from export destination/import

source. Hence USD weight likely higher for commodity exporters such as Russia

13 December 2012 LAST PAGE

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20121213 Barclays Global Outlook

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