Cs ges 101208_2011_outlook


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Cs ges 101208_2011_outlook

  1. 1. 08 December 2010 Global Equity Research Investment Strategy (Strategy) Global Equity Strategy Research Analysts STRATEGY Andrew Garthwaite 44 20 7883 6477 andrew.garthwaite@credit-suisse.com 2011 Outlook: Asset allocation and regions Luca Paolini 44 20 7883 6480 ■ Equities: stay overweight luca.paolini@credit-suisse.com Marina Pronina We forecast a 13% rise in the global markets in 2011. We expect 4.4% 44 20 7883 6476 global GDP growth in 2011E (with momentum troughing now); equities look marina.pronina@credit-suisse.com cheap relative to other asset classes; they provide a hedge against inflation Mark Richards until inflation expectations rise above 4%; and are clearly under-owned by 44 20 7883 6484 long term investors. mark.richards@credit-suisse.com Sebastian Raedler We forecast global 2011 EPS growth of 10–15%. We think the risks posed 44 20 7888 7554 by peripheral Europe, Chinese inflation and the end of inventory rebuild are sebastian.raedler@credit-suisse.com manageable. Tactical indicators look slightly extended in the near term but risk appetite is not extreme. ■ Bonds: We stay a small underweight. We prefer equities to corporate bonds. ■ Cash: We are a large underweight. ■ Regional allocation Our major overweight remains Global Emerging Markets (25% overweight); we raise Japan (to a small overweight from benchmark), reduce the UK to benchmark and stay underweight both Continental Europe and the US (albeit less underweight than we have been). Figure 1: Regional weightings and index target Index End-2011 Target Upside Asia ex Japan GEM MSCI EMF GEM 1,400 24% Japan Nikkei 225 12,000 18% UK FTSE 100 6,500 13% Hedged portfolio Europe ex UK DJ Euro Stoxx 300 10% (local currencies) US S&P 500 1,350 10% -15% -5% 5% 15% 25% 35% MSCI AC World 385 13% Source: Thomson Reuters, Credit Suisse estimatesDISCLOSURE APPENDIX CONTAINS ANALYST CERTIFICATIONS AND THE STATUS OF NON-US ANALYSTS. FOROTHER IMPORTANT DISCLOSURES, visit www.credit-suisse.com/ researchdisclosures or call +1 (877) 291-2683.U.S. Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result,investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investorsshould consider this report as only a single factor in making their investment decision.
  2. 2. 08 December 2010Table of contentsExecutive Overview 32011 Outlook: Asset allocation and regions 8 (1) Global momentum is improving 9 (2) QE2 will likely be more effective than investors assume 30 (3) Valuation still supportive 34 (4) Equities are one of the cheapest inflation hedges 39 (5) When credit spreads were last at current levels, the S&P was at close to 1,500 39 (6) Earnings growth still above trend in 2011E 40 (7) There is scope for leverage and asset turns to increase 42 (8) Investor positioning still not bullish 43 (9) M&A and buybacks activity looks set to increase 46 (10) Tactical indicators—a slight caution 47 (11) Seasonality is supportive 52 We think there could be a bear market as early as 2012 53What is the bear case for equities? 54Bonds: small underweight 61Regional allocation 65Emerging markets: in our view the best beta play—focus on NJA 66Japan: raise from benchmark to a small overweight 88UK: downgrading to benchmark 94Continental Europe: underweight 103US: stay underweight 116Appendix 1: US weekly lead indicator 122Appendix 2: US housing—excess inventory 123Appendix 3: Companies that look ‘safer’ and ‘cheaper’ than their respectivegovernments’ bonds 124Appendix 4: Bull/bear ratio—backtest results 125Appendix 5: GEM risk appetite and relative performance 126Appendix 6: PE model for GEM countries—detail 127Appendix 7: GEM plays 128Appendix 8: Country risk scorecard 129Global Equity Strategy 2
  3. 3. 08 December 2010Executive OverviewWe stay 5% overweight equities, we have a small underweight in bonds and are veryunderweight of cash.We think economic momentum is re-accelerating, and that global GDP growth will be4% to 4.5% in 2011. Global growth is supported by:■ Global PMIs are consistent with 4.4% global GDP;■ Corporates appear to be under-invested (FCF is at a record high, while the investment share of GDP is at a record low with investment intentions still generally strong);■ We estimate US employment should rise by 1% a year and we believe that US corporates have overshed labour;■ Half of global GDP (on a PPP basis) now comes from emerging markets. We forecast Chinese inflation to accelerate steadily (to 6% by mid-2011E), but critically core inflation is still 1.3% yoy, while export prices in both dollar and RmB terms are not rising. Despite the much vaunted housing bubble, the Chinese house price to post-tax income ratio is very similar to the UK;■ The power of abnormally low real bond yields helps government funding arithmetic considerably and pushes down the savings ratio.QE2: We believe that QE2 is more effective than investors realise—by reducing real bondyields, by de facto exporting QE and creating an NJA liquidity bubble, and by allowingpoliticians to postpone fiscal tightening.■ We think it is significant that QE2 will be much more focused on buying non-bank assets than QE1, in that less of the Fed’s money should end up in excess reserves and more in financial markets.■ Ultimately, we would expect QE2 to continue until US core inflation rises to 1.5–2% and the unemployment rate falls below 7%. That requires 4% real GDP growth over the next 3-3 ½ years, on our estimates.■ QE only becomes counterproductive if inflation expectations rise above 4%, if the dollar trade-weighted falls 25%, or if real bond yields rose sharply. The threat would be politics (i.e., stopping QE early) but we judge this to be a low risk.■ We continue to believe that by the end of 2011, the UK, the US and Japan will all be engaged in some form of QE and the quality of the ECB’s balance sheet will be deteriorating.■ The result in our view is an environment of abnormally low real bond yields in the developed world to transfer wealth from creditors to debtors.The risks to monitor■ Chinese inflation (as above), which we think is manageable until we see a sharp rise in export prices;■ Peripheral Europe. Critically, we think even under a severe private sector de- leveraging scenario, Spanish government debt to GDP would only rise to 100% by 2014E which would make its funding arithmetic sustainable, provided fiscal policy is tightened by another 2% of GDP (which should be politically possible). We think core Europe will continue to support peripheral Europe (the cost of it not doing so would be at least $500bn on our estimates); the European Financial Stability Facility (EFSF) is likely to be extended and the ECB is unlikely to withdraw from the policy of providing unlimited liquidity to the banks. Peripheral Europe needs Germany’s economy to grow well above trend (after all it is 50% larger than the periphery) – and that, we think, will continue to happen.Global Equity Strategy 3
  4. 4. 08 December 2010■ The inventory rebuild has been extreme: normally, a reversal of an inventory rebuild of this magnitude is associated with a slowdown in growth. Yet, the level of inventories (to sales) is not extreme and there should also be a positive surprise to domestic demand, which again limits de-stocking;■ Fiscal overkill. Yet, we estimate fiscal tightening now accounts for just 1% of GDP globally in 2011 and is being watered down; especially now that the Bush tax cuts have been renewed.■ Contraction in lending. Yet, US bank leverage is already close to a 30-year low and US and European bank lending conditions are consistent with a pick-up in loan growth.Equities: stay overweight (as we were through 2010). We forecast a 13% return overthe course of 2011. The following factors keep us overweight:■ Economic momentum has stabilised and earnings revisions are still positive;■ Equities offer better value than all other major assets classes. The equity risk premium is 7.3% on IBES numbers (and 6% on our preferred measure, which assumes IBES growth figures for two years, then reverts growth back to trend). This compares to a long run average ERP of 3.6% and our target ERP of 4.3% (based on credit spreads and ISM index).■ Equities are among the cheapest inflation hedges at a time when the Fed is aiming to push up inflation. Equities only de-rate once inflation expectations rise above 4%;■ We forecast 11% EPS growth in the US (our US strategist Doug Cliggott is more cautious at 4%) and 15% in Europe. Although margins are very high, our models suggest that margins do not fall until labour gets pricing power;■ Both asset turns and leverage are abnormally low. If leverage were to return to 2x net debt to EBITDA, we calculate US EPS would rise by 12%;■ Last time credit spreads were here (December 2007), the S&P500 was at around 1,500;■ Long term investors (retail, pension funds and insurance companies) are fundamentally cautiously positioned in equities. Yet, very recently investors have started to switch out of bond funds and into equity funds. We believe that cash financed buyback activity and M&A will pick up;■ The third year of the US Presidential cycle has been an up year on each occasion since 1952 with an average return of 18%:■ Some tactical indicators are slightly extended near-term (equity sentiment is a 4-year high) but critically neither the risk appetite nor the equity sector risk appetite are extended relative to their norm.Fundamentally we think that a new bear market starts when QE ends, the Fed raises ratesor labour gets pricing power. None of this is likely in the near term though possible in 2012in our view.We consider the bear case for equities on pages 54-60:■ $6.3trn excess leverage in the developed world. We agree but highlight that this will not become relevant until there is a sharp rise in real bond yields (which forces governments to de-lever and drives up savings ratios) which is only likely once the Fed stops QE2.■ A government bond funding crisis. Unlikely until the Fed raises rates, the Fed stops QE (owing to the dollar being 25% weaker) or until banks are overweight bonds (which they are not).Global Equity Strategy 4
  5. 5. 08 December 2010■ QE ends up with a sharp rise in inflation… unlikely in 2011 given the amount of spare capacity.■ A hard landing in China—not until there are clear signs of accelerating export prices■ Equities are not cheap in absolute terms (we agree) but they are in relative terms (and investors are not positioned that way).■ Margins are abnormally high. We agree but they are unlikely to fall until labour gets pricing power (which requires sub 7% unemployment rate in the US).■ A European debt crisis. Unlikely given our view that the situation in Spain is manageable.■ An ageing population forces de-equitisation. Surely this is not the case if some equities look relatively ‘safer’ than governments.■ China as a competitive threat. This is one of the most underappreciated risks longer term, in our view.Bonds: small underweightThe ISM has troughed and bond yields tend to rise consistently after a trough in the ISM;there is a record gap between lead indicators, cyclical performance and bond yields, bondyields are still well below long-term fair value levels and net inflows into bond funds havebeen abnormally high in this recovery and are now reversing.We do not envisage a big rise in bond yields. We expect the Fed to be on hold for the nextfew couple of years, pushing investors out along the yield curve; core inflation is set to fallin the near term (owing to the size of the output gap); banks are still much moreunderweight bonds than they were in 1994; and the Fed QE de-facto caps yields.GEM: we stay 25% overweight of emerging markets, particularly focusing on NJA.We have been overweight emerging markets for most of the last ten years. We stayoptimistic on the region, given that:■ Fundamental re-rating. Fundamentals suggest that GEM and NJA should trade on a 20% to 30% P/E premium to global markets (they traded on much higher premiums in the 1970s), compared to a 5% premium for NJA and a 4% discount for GEM. NJA is discounting a 19% growth premium to global equities, but has delivered more than double the EPS and economic growth than the global norm over the past 10 years. The region benefits from superior productivity growth (nearly 8% in NJA, 3.5% in GEM) driven by labour migration from rural to manufacturing and growing school enrolment; superior balance sheets (government debt, private sector debt, bank leverage are all in much better shape than the developed world); and undervalued currencies (20% for GEM and 30% for NJA currencies). On top of this, the gap between the RoE and the cost of debt has never been this high (in absolute and relative terms) and the DuPont model shows that RoE attribution has been more sustainable than that of the US (relying on de-leveraging, lower rates and asset turns, rather than higher margins);■ Tactically, we can see a bubble potentially being caused by unsterilised interventions of QE2-driven money inflows and rates being up to 10% below nominal GDP, especially in Asia (indeed most Asian countries have negative real rates which is likely to force dis-saving, with savings ratios still very high). In our view the only way to prevent a bubble would be a very sharp rise in rates or a 30%+ rise in the RmB/$ (which would allow other currencies to revalue)—neither seems likely;■ Other tactical positives are: historically this region outperforms 80% of the time the dollar weakens (which we think under QE2 it will); it is generally the best performing region into a global soft landing; and neither GEM sector risk appetite or funds flows look extreme;Global Equity Strategy 5
  6. 6. 08 December 2010■ The issue is when does the market start worrying about the unsustainability of rising inflation. The experience with other assets bubbles suggests that it is only when a country starts running a very large current account deficit and becomes a net international debtors that markets typically start to worry. Yet, in China’s case this looks a long way off. Only in the case of Brazil and India, both of which have overvalued currencies, do our models flag potential inflationary problems;■ Our P/E model (based on saving ratios, leverage, twin deficits, trend GDP growth and inflation) indicates that the most attractive emerging markets are Russia, Korea and China, while India looks the least attractive.Japan: a tactical upgrade to overweight■ This is the right stage of cycle for Japan. Japan historically outperforms 4 to 7 months after a trough in lead indicators (the reason being that it is the most operationally leveraged country globally, as well as being the major region most in deflation and thus most in need of global growth) – and we think lead indicators are in the process of rebounding;■ With around 60% of its exports to Non-Japan Asia, Japan has now underperformed its downtrend line versus NJA by 9%;■ Policy is getting marginally better, including attempts to cap Yen/$ at 80, QE2 (with purchases of equity ETFs, J-REITs and corporate bonds), which is likely to be extended, and additional fiscal stimulus;■ Valuations are looking cheap with P/B relative to global markets now at an all-time low;■ Our model of Japan’s relative price performance (based on Y/$ and US 10 year bond yields) suggests 9% relative upside, while positioning is still very bearish.■ Foreign investors remain abnormally underweight.UK: take to benchmark from overweight, given that:■ The UK tends to be a defensive market, underperforming when equities or lead indicators rise as the market is overweight defensives and underweight cyclicals;■ Near term, sterling strength could limit FTSE performance (75% of the time sterling appreciates, the UK underperforms in local currency terms, as approximately 70% of earnings are from overseas). Sterling trades 2% cheap against the dollar on PPP but could trade up to a slight premium given: no near term QE by the MPC; a stronger recovery in PMIs and employment growth than in the US; the RICS survey suggesting some stability in housing; and little sovereign credit risk attracting foreign inflows to gilts (given a credible deficit reduction plan, only 30% of gilts are held by foreign investors, and average maturity of debt of nearly 14 years);■ Valuation is no longer attractive: the UK ranks in the middle of our valuation scorecard and the dividend yield relative is close to a 28-year low;■ UK equity risk appetite is much more stretched than other regions.Continental Europe: stay underweight. While we do not believe peripheral Europeposes a risk of a global systemic crisis, we are worried about the implications for therelative performance of the Continental European stock market, especially given that itshould have underperformed by another 4% given the rise in sovereign CDS spreads.Global Equity Strategy 6
  7. 7. 08 December 2010There are three aspects of peripheral Europe that make us worried about ContinentalEurope:■ We see another 5% to 10% deflation to come in peripheral Europe (these countries, we think, either have to have undervalued currencies or current account surpluses), taking 0.8% to 1.6% off headline Euro-area growth;■ Current bond spreads are in our opinion unsustainable in Portugal, Greece and Ireland;■ Political risk is rising. Recall peripheral Europe is 17% of pan-European GDP and core European banks have $900bn in peripheral Europe and the ECB owns or repos around €350bn of peripheral European bonds;■ Other concerns are: economic momentum is deteriorating, the US and Japan are easing fiscal policy (relative to previous intentions, while this is not happening in Europe); relative earnings momentum is the worst of any region; we do not expect the euro to weaken much from here; valuations are only marginally attractive (0.7std cheap on sector adjusted p/e relatives) and, unlike in last May, neither relative regional risk appetite nor funds flow show capitulation;■ We continue to believe that the macro fundamentals of Germany, Norway, Switzerland and Sweden look very good, with Germany and Sweden having undervalued currencies—thus we would be buying domestic plays in these economies.US: stay underweight■ Nearly 65% of sales are domestic and we believe that domestic problems are worse than in Europe (long term unemployment is higher, the unemployment rate is higher and growth in employment has been weaker than in core Europe or the UK);■ The US is the most expensive region on our scorecard;■ The US tends to outperform when lead indicators decelerate (as Congress eases fiscal policy quicker, the Fed renews QE quicker and cost cutting is more rapid) – but we believe that this phase has now passed;■ The US has the worst cyclically adjusted budget deficit of any G20 country and no clear plan to tackle the deficit;■ The US tends to underperform (in single currency terms) when the dollar weakens.Global Equity Strategy 7
  8. 8. 08 December 20102011 Outlook: Asset allocation and regionsOverweight equities; small underweight in bonds, underweight cashWe continue to be overweight equities and underweight bonds and cash.Figure 2: Asset Allocation table: 5% overweight in equities; small underweight in bonds Benchmark Recommended weight OW (+) UW (-)Equities 60 65 5Government bonds 25 24 -1Corporate bonds 5 3 -2Cash 10 8 -2Total 100 100 0Source: Credit Suisse Global equity strategyWe think investors should be overweight equities and we now forecast a 13% return onMSCI World by the middle of 2011 and the end of 2011. But we think that most of thiscould be reversed in 2012E when either QE ends or inflation expectations rise above 4%.Doug Cliggott has an 1100–1300 range on the S&P 500.Figure 3: Index targets Credit Suisse Global Strategy - Index targets Price return, mid- Price return, end- Market Current mid-2011E end-2011E 2011E 2011ES&P 500 1,223 1,350 10% 1,350 10%DJ Euro Stoxx 272 300 10% 300 10%FTSE 100 5,770 6,500 13% 6,500 13%Nikkei 225 10,167 12,000 18% 12,000 18%MSCI EMF GEM 1,126 1,400 24% 1,400 24%MSCI AC World 340 385 13% 385 13%Source: Credit Suisse Global equity strategyWe see eleven reasons to be overweight equities:(1) Global economic momentum is improving;(2) We believe there will likely be unlimited QE2 until US GDP is above 3%;(3) Valuations look attractive relative to other assets;(4) Equities are a cheap inflation hedge;(5) When credit spreads were last at current levels, the S&P was at close to 1,500;(6) We project earnings growth will remain above trend in 2011;(7) There is scope for leverage and asset turns to increase;(8) Long-term investors still appear to be cautiously positioned – and equities are likely to benefit from the outflow out of bond funds;(9) There is scope for more corporate buying via M&A and buybacks in our view;(10) Our tactical indicators are not yet extended;(11) Seasonality is positive, with the third year of a Presidential Cycle in the US typically bringing strong equity returns.Global Equity Strategy 8
  9. 9. 08 December 2010We discuss each of these points in detail below: (1) Global momentum is improvingOur proprietary weekly lead indicator of US growth is now consistent with around 3 ½ -4%GDP growth (for details, see Appendix 1). Credit Suisse’s global fixed income strategyteam estimates that global IP momentum troughed at 4.5% in October 2010 and that will itre-accelerate to 9% by the end of Q1 2011.Figure 4: Our US weekly lead indicator is picking up and Figure 5: Global IP momentum looks set to reboundis consistent with real growth of around 4% 20% 8% 15% 6% 10% 4% 5% 2% 0% 0% -5% -2% -10% Global IP Momentum (3m/3m% ann.) with Forecast -4% US lead indicator: Implied GDP growth (1q lead) -15% -6% -20% US GDP qoq %, saar -8% -25% 92 94 96 99 01 03 05 07 10 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse Fixed Income estimatesGlobal PMIs are consistent with global GDP growth of 4.4% at PPP (3.5% at marketexchange rates), compared with a 2011 IMF estimate of 4.2% (3.3% on market exchangerates).Figure 6: Global PMIs are consistent with 4.4% real growth at PPP (3.5% on marketexchange rates) 58 5.5% 4.5% 53 3.5% 48 2.5% 1.5% 43 0.5% -0.5% 38 Global manufacturing PMI Global GDP at PPP, 6m lag -1.5% 33 -2.5% Jan-98 Mar-00 May-02 Jul-04 Sep-06 Nov-08 Jan-11Source: Markit, Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 9
  10. 10. 08 December 2010This matters for equities, given that they tend to move sideways or decline marginallywhen lead indicators roll over and earnings revisions turn negative, as has been the casefrom June to September this year.Figure 7: The difficult phase for markets is when ISM and earnings revisions roll over …this phase is now nearly complete Periods when earnings revision were negative and ISM rolled over Performance of S&P after Date 1m 2m 3m 6m 12m Sep-91 2% 0% 0% 6% 11% Mar-92 2% 3% 1% 3% 12% Jun-97 8% 2% 8% 8% 28% Mar-02 -2% -5% -11% -25% -24% Jun-07 1% -6% -4% -6% -12% Average 2% -1% -1% -3% 3% Median 2% 0% 0% 3% 11% % outperform 80% 40% 60% 60% 60%Source: Thomson Reuters, Credit Suisse researchNow, however, not only is economic momentum improving, but also earnings momentumhas turned positive again.Figure 8: Earnings revisions have bounced back into positive territory (% of totalrevisions) 60 Earnings breadth 40 20 0 -20 -40 -60 -80 US -100 Dec-90 Dec-94 Dec-98 Dec-02 Dec-06 Dec-10Source: Thomson Reuters, Credit Suisse researchThere are five aspects of the global cycle that we find encouraging: a) Corporates still look clearly under-investedFree cash flow as a proportion of GDP is particularly high, while the investment share ofGDP in the G4 relative to trend is very low.Global Equity Strategy 10
  11. 11. 08 December 2010Figure 9: FCF as a % of GDP is at a record high … Figure 10: … as the investment share of GDP is still abnormally low 23% 4.5% 4.3% G4: Non financial corporate FCF/GDP 22% 4.0% Average 3.5% 21% 3.0% 20% 2.5% 19% 2.0% 18% G4 investment share of GDP 1.5% Trend 17% 1.0% 0.5% 16% 0.0% 15% Q4 1995 Q4 1997 Q4 1999 Q4 2001 Q4 2003 Q4 2005 Q4 2007 Q4 2009 1980 1985 1990 1995 2000 2005 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchInvestment intentions, as proxied by the Philly Fed spending intentions index and the CBIspending survey in the UK, are still consistent with positive investment growth. Weacknowledge that the US CEO confidence index fell in Q3, but this has historically alwaysbeen the case before mid-term election since the 1980s, partly reflecting worries abouttaxation.Figure 11: US Philly Fed suggests capex growth of about Figure 12: … as does the UK CBI survey10% yoy 30 20 25 Capex, y/y% 40 CBI invest plant & equip, deviation from 5-yr avg, rhs 25 15 20 30 20 10 15 20 15 5 10 10 10 0 5 5 0 -5 0 0 -10 -10 -5 -5 -15 -20 -10 -10 Philly Fed Capex Intentions -15 -20 US Private Non-residential Investment y/y (rhs) -15 -30 -20 -25 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 -20 -40 Q1 1983 Q1 1987 Q1 1991 Q1 1995 Q1 1999 Q1 2003 Q1 2007Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchIndeed our recent proprietary Credit Suisse survey of corporate spend (Corporatespending recovery accelerates, 24 November 2010) shows that more respondents areintending to increase spending over the next six months than when the survey was lasttaken, in July. The increase in spending intentions is seen across all areas of capex.Global Equity Strategy 11
  12. 12. 08 December 2010Figure 13: More respondents are planning to increase Figure 14: All areas of corporate capex saw an increase incorporate spending in the next six months spending expectations 40% 50% Employment & Latest Survey 35% Wages New Survey Old Survey 40% Advertising July Survey 30% budget Percentage of Respondents 30% 25% 20% Building & Plant 20% Cars & expenditure 10% Commercial 15% Dow n Up Vehicles 0% 10% Corporate Spending, % ch 5% -10% IT budget Machinery expenditure 0% -20% % respondents expecting spending to Travel budget <40% 26- 11- 1-10% Flat 1-10% 11- 26- > 40% increase minus % expecting it to decrease 40% 25% 25% 40% -30%Source: Credit Suisse proprietary survey Source: Credit Suisse proprietary surveyWe would note that capex is already increasing significantly, with spending on equipmentand software in the US rising 17% yoy, the strongest pace in 20 years and accounting for55% of total GDP growth year-to-date.Figure 15: Investment spending on equipment and Figure 16: … and contributing 55% to real GDP growthsoftware is rising sharply … up an annualised 17% year- year-to-dateto-date... 20% US GDP- Share of GDP vola, % Contribution to GDP growth Expenditure GDP explained* Last 4Q Last Quarter 15% PCE 70% 54% 61% 79% 10% Inventories 1% 28% 57% 52% Equipment/Software 7% 60% 55% 44% 5% Fixed Investment 12% 61% 36% 8% 0% Government 20% 0% 15% 32% Residential 2% 31% -7% -30% -5% Net exports -4% 11% -68% -70% -10% *over last 10 years, quarterly change -15% US Equipment/Software capex, yoy change -20% -25% Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 1985 1988 1990 1993 1995 1998 2000 2003 2005 2008 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchWe wonder whether some capital spending may have been postponed until after the mid-term election, in the expectation prior to the mid-term election of a possible investment taxcredit in 2011.We continue to see investment as the high beta component of GDP: it normally has a betaof 2x to GDP – yet, in the last recession it fell five times as much as GDP. Moreover, evenafter their strong rebound, capital goods orders in the US and Germany are still 28% and19% below their respective previous peaks.Global Equity Strategy 12
  13. 13. 08 December 2010Figure 17: Beta of investment to GDP is very high Figure 18: Capital goods orders still well below previous peaks 65 1.4 0% 60 1.3 -2% Q3 1990 Q4 1969 -4% Q1 1980 55 1.2 -6% 1.1 Q2 1960 50 -8% 1 Investment Q3 1981 Q1 2001 45 -10% Q4 1973 0.9 40 -12% Decline in GDP and private 0.8 -14% Q3 1957 non-residential investment 35 during US recessions 0.7 -16% (NBER dates used) 30 US core capital goods orders 0.6 -18% Q4 2007 25 German capital goods orders (rhs) 0.5 -20% -4.0% -3.0% -2.0% -1.0% 0.0% 20 0.4 GDP 1993 1996 1999 2002 2005 2008 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research b) Our employment model in the US is still consistent with about 1% employment growthIf we assume real wage growth of 1%, a 0.5 percentage point fall in the savings ratio (anoutcome suggested by our model) and an extension of all Bush tax cuts, this wouldsuggest that US real consumption growth could be about 2% in 2011E.Figure 19: Our model of US employment suggests 1% Figure 20: Our model tracks employment growth in the USgrowth – 3m annualised very closely Model of monthly change in US non-farm payrolls Input variables (3m lead) Coefficient Last Standardized 400Temporary employment, 3m change 0.47 103.7 1.4Consumer employment exp. 5.9 -6.4 -0.2 200Jobless claims (4-w average) -0.2 437 -0.9Job-cuts announcements 0.1 38.0 1.0 0ISM employment, composite (no lead) 26.5 52.9 0.6Intercept -1203 Model estimate % rise in empl. -200R2 0.79 111 1.0% -400 US non-farm payrolls, monthly change -600 Model -800 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Source: Thomson Reuters, Credit Suisse estimates Source: Thomson Reuters, Credit Suisse estimatesInterestingly, a proxy of real payroll income growth (total hours worked times wage growthminus core inflation) is growing at an annualised rate of 4.6%, suggesting upside risk forUS consumption (the proxy hit 7% in October).Global Equity Strategy 13
  14. 14. 08 December 2010Figure 21: Our model of US employment and savings ratio Figure 22: … and a proxy of real payroll income suggestssuggests a 2.4% growth in US consumption a much higher consumption growth, close to 5% on a 3m/3m basis US private consumption drivers 12m Comments 8% 8%Employment growth 1.0% Estimate from our modelHourly wage growth 2.1% Latest 6% 6%Core CPI 0.6% Latest 4%Real Income 2.5% 4%Income tax paid (% income) 0.9% Assuming extension of Bush tax cuts 2%Real Disposable Income 1.6% 0% 2%Savings ratio (latest) 5.7% LatestSavings ratio (fair value) 4.9% Estimate from our model -2% 0%Change in savings ratio -0.8% -4%Private consumption growth 2.4% -2% -6% US payroll income proxy, 3m saar, real -4% -8% US private consumption, 3m saar, real (rhs) -10% -6% Nov-00 Nov-02 Nov-04 Nov-06 Nov-08 Nov-10Source: Thomson Reuters, Credit Suisse estimates Source: Thomson Reuters, Credit Suisse researchDespite expectations about an abnormally large jobless recovery we would note that thegrowth in non-farm payrolls relative to the rebound in GDP is roughly in line with its normat this stage of the cycle. Furthermore, in absolute terms the increase in employment isslightly above the average for the previous four recessions (although we admit that the USjob recovery is abnormally muted relative to the degree of labour shedding).Figure 23: This is not an unusually large jobless recovery in the US 12% 10.1% 9.4% 8.8% 10% 7.5% 8% 5.8% 4.8% 4.7% 6% 4.5% 3.8% 3.6% 3.5% 3.1% 2.6% 4% 1.2% 2% 0.5% 0.3% 0.2% 0% % increase 17m after trough -2% -1.7% GDP Employment -4% -6% -8% 1957-58 1960-61 1969-70 1973-1975 1980 1981-1982 1990-91 2001 2007-09Source: Thomson Reuters, Credit Suisse researchWe still think that US corporates have overshed labour. Employment in the US hasdeclined by 6% from the peak, compared with a 4.1% decline in GDP. This is the largestgap on record, reflecting the record increase in productivity during the recession.Global Equity Strategy 14
  15. 15. 08 December 2010Figure 24: US companies have overshed labour in the downturn 3% 1.9% 1.9% 2% 1% 0.3% 0.1% 0.1% 0.0% 0% -0.2% -1% Peak to trough decline Employment minus GDP fall in % -1.7% -2% -1.8% -3% 1957-58 1960-61 1969-70 1973-1975 1980 1981-1982 1990-91 2001 2007-09Source: Thomson Reuters, Credit Suisse researchWe note that in the UK, where labour shedding relative to the decline in GDP was lessmarked (hours worked and employment fell 5.0% and 2.5% from peak to troughrespectively, compared with a fall in GDP of 6.5%), employment has already rebounded by1.2%. c) Emerging market growth is set to remain strongGlobal emerging markets (GEM) currently account for half of global GDP growth on a PPPbasis and nearly a third on current exchange rates, with China alone accounting for 44%of the increase in global GDP growth over the past four years. Critically, the Chinese PMIis now consistent with 10%+ GDP growth, having risen four months in a row.Figure 25: GEM share of GDP is already close to 50% on Figure 26: China PMI consistent with 10%+ real GDPPPP growth 13 60 60 Emerging economies, share of global GDP (PPP basis, IMF) 12 50 Developing Asia 11 55 10 40 9 50 8 30 7 45 GDP, y /y % 20 6 China PMI, 3m lead, rhs 5 40 10 4 3 35 0 2005 2006 2007 2008 2009 2010 2011 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013Source: IMF Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 15
  16. 16. 08 December 2010The question is how sustainable Chinese growth will turn out to be, with Chinese GDPaccounting for half of Non-Japan Asian (NJA) GDP and a quarter of total GEM GDP thisyear. The biggest worries in our view are inflation, a housing bubble or leverage:■ If we look at inflation, we find ourselves a bit more sanguine than many. The litmus test for inflation in China is whether export prices are rising in both dollar terms and RmB terms. They are not and this, in our opinion, means that productivity growth and margins should be able to absorb the acceleration in wage growth. We think this can continue until profitability falls to very low levels (currently, on Credit Suisse HOLT®, this is roughly in line with its long run average) or there is a sharp decline in Chinese productivity. The latter is hard to measure but we believe that the bulk of the rise in Chinese productivity is accounted for by the steady rural to urban migration and we are unlikely to see that stopping, when 40% of the population are employed in the agricultural sector, where productivity per worker is only at around 16% that of the industrial sector, according to our global demographics research team.Figure 27: China export prices to the US are not rising .... Figure 28: ... and China’s corporate profitability is roughly in line with average on HOLT 9% 8.0 US Import prices from China y/y% China ex-financials: CFROI® 8% US Import prices from China in RMB y/y% 6.0 7% 4.0 6% 2.0 5% 4% 0.0 3% -2.0 2% -4.0 1% -6.0 0% Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010ESource: Thomson Reuters, Credit Suisse research Source: Credit Suisse HOLTAdditionally, there is no obvious sign of run-away wage growth, which is in line with itslong-run average (minimum wages are up 22% on the year – but this is in part due to awish to redistribute income, given that the top income decile earns 28x more than thebottom income decile, according to a Credit Suisse Expert Insights report AnalysingChinese Grey Income, August 6th 2010 consisting of a study by Professor Wang Xialou ofthe China Reform Foundation). Other indicators of core inflation show no sharpacceleration: the Chinese PMI price index is still consistent with ex-food inflation at 2%,compared to the current rate of 1.6%. Core inflation ex food and energy is currently 1.3%.Global Equity Strategy 16
  17. 17. 08 December 2010Figure 29: Wage growth is accelerating but is still in line Figure 30: ... and the China PMI price index suggests corewith its long run average inflation should not rise above 2% over the next 4 months 24 China: Average Wage (% yoy) 2.5 80 CH minimum wage growth (%yoy) 2 22 70 1.5 20 1 60 0.5 18 Sep-10, 15.7 0 50 16 -0.5 China CPI inflation ex food 40 -1 14 (yoy, %) -1.5 China PMI - input prices, 30 12 -2 lead 4 months -2.5 20 10 2005 2006 2007 2008 2009 2010 2011 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Source: Credit Suisse China Economics research Source: Credit Suisse China Economics researchThe problem is food inflation, which accounts for 4 percentage points of the 6 percentagepoints of inflation, at which level our Chinese economists expect inflation to peak next year.It is unclear to us how tightening monetary policy alleviates food inflation to any greatdegree, especially as Chinese food inflation is actually growing at a slower rate than globalfood prices (10% yoy compared with 19% globally).■ Housing: the house price to wage and house price to nominal GDP ratios are in line with their norms (on official data). According to Credit Suisse’s China property analyst, Du Jinsong, the average national house price to post-tax income ratio is at 6x, roughly the same level as in the UK, while the affordability index is at very high levels compared to history (housing is very expensive only in some cities such as Beijing and Shanghai, where price to income ratios are c18x).Figure 31: Chinese house prices are not extended relative Figure 32: Affordability metrics of Chinese housingto GDP (2004=100) 120 1 Price to Income multiple (RHS) 10 110 0.9 Affordability index (LHS) 9 0.8 100 0.7 Getting more expensive 8 90 0.6 0.5 7 80 0.4 70 6 0.3 Beijing house price to GDP 0.2 60 Shanghai house price to GDP 5 0.1 Getting less expensive 50 0 4 2004 2005 2006 2007 2008 2009 2010 May 09 Nov 09 1995 1997 1999 2001 2003 Jan-07 Mar-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 July 08 Nov-08 Mar-09 July 09 Sept 09 Jan 10 Mar 10 May-10 Sep-10 Nov-10 Sep-08 Jul-10 2005 May-07Source: Credit Suisse Asia Strategy Source: Credit Suisse China property teamGlobal Equity Strategy 17
  18. 18. 08 December 2010Even if house prices were to fall 20% to 30%, we think that the impact would bemanageable as:(1) banks only have loan-to-value ratios of 50% to 60%;(2) it would only take prices back to levels of 18 months ago; and(3) only 20% of local government funding comes from the property market.In our view the authorities clearly want to dampen the housing market. This could beachieved via increasing supply (with some 10 million subsidised homes about to hit themarket) and imposing stricter lending criteria for second homes. Indeed with housingsupply up 70% a year, a soft landing is possible.■ Leverage: as yet both government debt (19% of GDP – or, including all the off balance sheet debt of the local governments, 52% of GDP) and household debt are very low (at 18% of GDP) compared to the global average.Figure 33: The government debt to GDP in China is very Figure 34: ... and the Chinese households arelow ... underleveraged Gross government debt to GDP, % 100% 120 90% United States Norw ay Total OECD Portugal IsraelSweden Ireland Spain China 80% Canada 100 South Korea China including local govt debt Household debt, % of GDP 70% Netherlands 80 60% Japan Finland Greece Germany 50% Malay sia France South Africa Hong Kong Austria 60 40% Singapore G Poland Belgium Chile Czech Italy 30% Hungary 40 Republic 20% China Brazil 20 10% India Russia 0% 0 0 20,000 40,000 60,000 80,000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010e GDP per capitaSource: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchThe overall problem in emerging markets and particularly NJA is that monetary conditions(a combination of real rates, currency valuation and money supply growth relative tonominal GDP growth) are too loose in our view, at a time when a good number of GEMcountries are operating at or above potential (i.e. positive output gaps), on our estimates.The good news is that inflation starts becoming a problem (>5% yoy) only when the outputgap is above 4%—and only Brazil and India are in this situation currently.Global Equity Strategy 18
  19. 19. 08 December 2010Figure 35: GEM monetary conditions look too loose ... Figure 36: ... given that most GEM countries have positive output gaps 2.0 Argentina BRICs MCI, st. dev. from average G4 MCI, st. dev. from average 8% Russia Turkey 2011E CPI yoy 1.5 7% India 6% Indonesia 1.0 South Africa 5% 0.5 Brazil Colombia 4% UK Korea Philippines 0.0 Hungary Malaysia China 3% Denmark Israel Belgium -2% Norway Australia Sweden Poland Hong Kong -0.5 2% US Thailand Austria Czech Republic Canada France Germany Greece -1.0 1% Netherlands Taiwan 2011E Output Gap Spain Italy Japan 0% -1.5 -18% -15% -12% -9% -6% -3% 0% 3% 6% 9% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, EIU estimates, Credit Suisse research. Output gap calculated as % deviation of 2011E estimated real GDP level relative to 15Y trend line.The question then becomes: how can these countries tighten policy significantly and whendo markets start to anticipate this? In simple terms, with interest rates below inflation ineconomies that have savings ratios of between 20% and 40% and some 10% belownominal GDP, interests rates need to rise significantly. This cannot happen, however,unless China is willing to revalue the RMB by a considerable amount (as no country islikely to want to lose competitiveness with China). China appears unwilling to revalue theRMB for fear of political unrest (Premier Wen was recently quoted by Reuters as sayingthat, in case of a rapid rise in the Renminbi, “many of our exporting companies would haveto close down, migrant workers would have to return to their villages”) – and thus we thinkrates are set to remain too low.When do markets anticipate the end of the emerging markets growth story? In our opinionthis will be once countries run large current account deficits, resulting in them becomingnet debtors. We believe this is a long way off, however (for details, see the emergingmarket section on page 66). We retain our belief that the China story will not end untilthere is excess leverage (there is not), lack of labour (yet, 40% of people still work on theland), lack of capital (yet there is $2.5trn of FX reserves which are rising at an annualisedrate of 36% in the last quarter) or a clear over-investment (as proxied by profit marginsfalling to very low levels, which the HOLT data shows they are not). d) The power of abnormally low real ratesThere has been a significant decline in real rates, with the five-year TIPS in the US havingfallen from 4.2% at the end of 2008 to around zero now. Low real rates typically have fourvery critical impacts:■ They greatly improve the fiscal funding arithmetic. Given current real rates, the fiscal tightening required to stabilise the government debt-to-GDP ratio in the US is only around 4.5% of GDP (compared to 7% if real rates were at equilibrium levels). If we assume a multiplier of 0.5 (in line with IMF estimates) and an adjustment over a five- year period, we estimate this would take about 0.3 percentage points off GDP growth per year, a manageable amount in our view;Global Equity Strategy 19
  20. 20. 08 December 2010Figure 37: Sharp decline in real bond yields, with the TIPS Figure 38: This reduces the fiscal tightening required tocurve negative up to 6 years - keep the government debt-to-GDP ratio stable 4% 4.0 US 10Y real rates US 10Y real bond yield required to keep US government debt to 3% GDP stable (at 3% trend growth rate) 3.5 US 5Y real rates 2% 3.0 2.5 1% Real bond yield 2.0 0% 1.5 -1% 1.0 -2% Government to GDP ti t bl if Primary balance % GDP = Debt/GDP *(bond 0.5 -3% i ld t d th t ) 0.0 -4% -0.5 -5% -1.0 -1% 0% 1% 2% 3% 4% 5% 6% 7% Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Fiscal tightening % GDPSource: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research■ Low real rates improve both housing affordability (which is now at a record high) and asset valuations (each 1 percentage point off real rates adds 20% to our equity DCF valuations);■ Low real rates drive down the savings ratio: Each 1 percentage point off real rates takes 0.4 percentage points off the savings ratio (as the top income quintile has a savings ratio of 33% and accounts for nearly 40% of consumption).. Our model of the savings ratio suggests it should be nearly 0.8pp lower than the current level of 5.7%.Figure 39: Our model of the US savings ratio has a very Figure 40: … suggesting the current savings ratio is 0.8ppgood fit … too high Input Variables: Coeff. T-value Current 12 US Net household wealth/DPI -2.8 -12.5 4.7 US personal savings ratio Model US 10Y bond yield 0.4 10.3 2.6 10 Intercept 16.8 12.6 16.8 R2 0.91 8 Standard error 0.83 US savings ratio (model) 4.9 6 US savings ratio (latest) 5.7 Note: 4 a 10% increase in house prices reduces the savings ratio by 0.5% a 10% increase in stock prices reduces the savings ratio by 0.3% 2 a 1% rise in BY raises the savings ratio by 0.4% 0 Q3 1980 Q3 1985 Q3 1990 Q3 1995 Q3 2000 Q3 2005 Q3 2010Source: Thomson Reuters, Credit Suisse estimates Source: Thomson Reuters, Credit Suisse estimatesGlobal Equity Strategy 20