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  • 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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
  • 21. 08 December 2010■ Low real rates keep insolvencies low.Partly for the reasons mentioned above and partly because the low cost of servicing debt,low real rates also keep NPLs and insolvencies at artificially low levels. The UK companyinsolvency rate peaked at just 0.88% in Q3 2009, far below the peak in the wake of theearly 1990s recession of 2.65%. Our model of US business insolvencies suggests a 43%decline over the next 12 months, taking insolvencies very close to an all-time low.Figure 41: The increase in corporate liquidations has Figure 42: ... while insolvencies in the US are far lowerbeen far more muted than in previous recessions in the than in the 1990s recession and our model suggests theyUK... will fall to historical lows 3.00 80000 US bankruptcy filings, last 12m Model 2.50 Liquidation rate, 4Q sum, % 70000 of registered cos 60000 2.00 50000 1.50 40000 1.00 30000 0.50 20000 Recessions 10000 0.00 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q1 1976 Q1 1981 Q1 1986 Q1 1991 Q1 1996 Q1 2001 Q1 2006 1990 1993 1995 1998 2000 2003 2005 2008 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research. Regression model based on real GDP growth, corporate bond yield and net debt to Ebitda for non-financial corporationsThe key to dealing with the situation of global over-leverage (on our calculations, there isUS$6.3trn of excess leverage in the G4, see page 54) is to engineer a large transfer ofwealth from creditors to debtors – and negative real rates is one way of achieving this. Wenote that this is also what happened the last time the US government debt-to-GDP ratiowas at its current levels: in 1942, the Fed fixed long-term interest rates at 2.5%, and, withinflation averaging 6% over the next decade – and thus real rates becoming stronglynegative – the government debt-to-GDP fell from around 121% to 66% in 1955.We believe the risks to the macro environment are overstated: a) US housingUS housing activity has decelerated sharply since the expiry of the first-time buyer taxcredit in spring 2010, with residential investment contracting by an annualised 28% in 3Q,home sales down 24% from April and existing home prices down 7% since February (on athree-month moving average basis).However, the key is that the house price-to-income ratio at 2.8x is close to a 30-year low,house prices relative to rents are only 4% above the all-time low, and housing affordabilityis at an all-time high. Housing at just 2% of GDP is unlikely to get any lower. Weacknowledge that house prices might fall 5–10% (they are already down 7% since 1Q2010), but we struggle to see significant knock-on effects, especially given that around65% of mortgages are now owned or guaranteed by the government. Currently, housinginventory (unsold homes on the market) are 2.6% of the total housing stock (compared toa long-run average of 2.2%) and we estimate that the excess inventory (taking intoGlobal Equity Strategy 21
  • 22. 08 December 2010account the impact of foreclosures) is equal to 2.3x current housing starts (see Appendix 2for details; incidentally, we think that investors have under-estimated the impact ofobsolescence and have over-estimated the impact of foreclosure, with only 40% offoreclosed homes becoming vacant).Figure 43: Housing inventories still too high relative to Figure 44: … but housing valuation looks very attractivesales … 3.5% 4.3 US existing house price/median income US unsold homes, % total 4.1 (seasonally adj.) housing stock 3.0% Pre-bubble average 3.9 Average 3.7 3.5 2.5% 3.3 3.1 2.0% 2.9 2.7 1.5% 2.5 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 1982 1986 1990 1994 1998 2002 2006 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchThe good news here is that US pending home sales, which lead existing home sales by amonth or two according to our US economics team, rose 10.4% in October – the biggestmonthly increase on record, which potentially signals that the worst of the correction inhousing is over. b) Fiscal tighteningIMF forecasts fiscal tightening for 2011 at about 1% of GDP, which would take about 0.5%off GDP globally. The US have greatly eased fiscal policy relative to initial expectations:fiscal tightening in the US is now expected by the IMF to be 1.1%, compared to 2.3% ofGDP expected in May (we look at the change in the cyclically-adjusted primary budgetbalance).We note that the US House of Representatives passed a bill on 3 December to extend the2001 and 2003 Bush tax cuts (on labour income, dividends and capital gain) for thoseearning less than $200-250k and President Obama has said he would agree to renew theBush tax cuts for high-income taxpayers in exchange for extending the unemploymentbenefits. c) Peripheral Europe sovereign risk – no systemic riskWe believe that at current bond yields, the fiscal situation in peripheral Europe isunsustainable, given that at current bond yields, interest payments as a proportion of GDPare clearly above the most optimistic assessment of long term trend nominal GDP growthin Portugal, Greece and Ireland. Furthermore, it is hard to see how Ireland and Greececan avoid restructuring, with government to GDP ratio of c140% in 2014, on our estimates.Yet, we do not expect a widespread sovereign default.Global Equity Strategy 22
  • 23. 08 December 2010Figure 45: At current bond yields, Greece, Ireland and Portugal have net interest payment as a percentage of GDP thatis well above trend nominal GDP Estimated Required fiscal Current 10Y Government debt, Net interest Trend nominal Government cyclically- fiscal Country Gap tightening to keep bond yield % GDP (2010E) payments, % GDP growth adj primary balance tightening debt/GDP stable 2010-14Greece 11.6% 130.2% 15.1% 4.5% 10.6% -1.5% 10.7% 8.3%Ireland 8.0% 99.4% 8.0% 4.5% 3.5% -6.1% 9.6% 10.7%Spain 5.1% 63.5% 3.2% 4.5% -1.3% -5.7% 6.0% 4.1%Portugal 5.9% 83.1% 4.9% 4.5% 0.4% -3.0% 4.2% 4.8%Italy 4.3% 118.4% 5.1% 4.5% 0.6% 0.7% -0.9% 1.7%Source: Thomson Reuters, IMF estimates, Eurostat, Credit Suisse estimates. We assume long-term nominal GDP growth of 4.5%. Requiredfiscal tightening is equal to Govt. debt/GDP ratio*(Bond yield-growth) - current primary balanceWe do not see this becoming a systemic issue for the following reasons: a) Looking at the Euro-area as a whole, leverage levels are in line with those in the US, UK and Japan – and as a whole the Euro-area has a current account deficit of only 1.3% of GDP. The problem is merely the distribution of debt.Figure 46: Aggregate leverage in the Euro-area is not Figure 47: ... and the aggregate current account isparticularly high... balanced 400% 2 Non-financial corporates 350% Housholds 1 Government 0 300% -1 250% Current account -2 b l 200% Euro area % -3 United States 150% -4 100% -5 50% -6 0% -7 US Euro-area UK Japan 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Source: IMF, OECD, ECB, Federal Reserve, National Statistics Office, Source: IMF, Credit Suisse researchThomson Reuters b) There is enough money available in the various bail-out funds to fund a worst- case scenario in Portugal, Greece, Ireland, and Spain.We believe that the problem in peripheral Europe (with the exception of Greece) is notgovernment debt but private sector debt, which is well above the global best fit line.Global Equity Strategy 23
  • 24. 08 December 2010Figure 48: Private sector leverage and GDP per capita 300% Ireland 250% Denmark Spain Private sector leverage, % GDP Australia United Kingdom 200% Hong Kong Portugal France Japan United States 150% Hungary China Malay sia Germany Canada Greece Italy 100% Norw ay (86090,188%) India South Africa Chile Singapore Brazil 50% Indonesia Poland Turkey Czech Republic Egy pt Mex ico Russia 0% 0 10,000 20,000 30,000 40,000 50, 000 60,000 GDP per capita, USDSource: IMF, OECD, Eurostat, Credit Suisse researchTo estimate the likely impact of the deleveraging of the private sector on governmentfinances, we assume that a third of private sector debt has to be taken on board by thegovernments, in which case government debt to GDP ratio would rise to 144% in Ireland,101% in Spain and 110% in Portugal, requiring a fiscal tightening of 11%, 6% and 4.5%,respectively at current bond yields.Figure 49: Required fiscal tightening under our assumptions of total fiscal costs of private sector deleveraging Required fiscal tightening under different scenarios Fiscal tightening required to stabilize government Fiscal cost of Government debt to GDP Estimated debt to GDP using: Bond yield private de- Interest costs, % fiscalCountry (10Y) leveraging, % of GDP (2014E) tightening 2014E (incl. de- EFSF rate (5.8% for Ireland, GDP 2010E 2014E Current bond yield 2010-14 leveraging) Portugal; 5% Greece)Ireland 8.0% 30% 99.4% 113.9% 143.9% 11.6% 11.2% 8.0% 10.7%Spain 5.1% 20% 63.5% 80.6% 100.6% 5.1% 6.3% 6.3% 4.1%Portugal 5.9% 15% 83.1% 94.8% 109.8% 6.5% 4.5% 4.4% 4.8%Greece 11.6% 0% 130.2% 139.4% 139.4% 16.2% 11.4% 2.2% 8.3%We assume long-term nominal GDP growth of 4.5%. Required fiscal tightening is equal to Govt. debt/GDP ratio*(Bond yield-growth) - current primary balanceSource: Thomson Reuters, IMF estimates, Eurostat, Credit Suisse estimates. We assume long-term nominal GDP growth of 4.5%. Requiredfiscal tightening is equal to Govt. debt/GDP ratio*(Bond yield-growth) - current primary balanceIf we rather pessimistically assume that government debt to GDP is not sustainable above100%, this would suggest about €182bn of write-offs for Spain, Portugal, Ireland andGreece (or €470bn once we adjust for our anticipated rise in government debt as a resultof private sector de-leveraging). This compares to about €670bn from the EFSF and otherfunds (de facto, €480bn of actually disbursable money—of which €410bn remains after theIreland bail-out). We note that some senior policy makers, such Axel Weber of theBundesbank, have suggested the bail-out fund size could be increased if necessary.Global Equity Strategy 24
  • 25. 08 December 2010Figure 50: Estimated fiscal cost of public and private sector deleveraging for Ireland, Spain, Portugal and Greece ismanageable and less than bailout funds available Fiscal costs of Fiscal costs of public sector Government debt to Government debt Government debt to GDP private sector deleveraging (including 1/3 GDP (2014E), % of Country GDP to GDP (2010E), (2014E), % of GDP, including deleveraging private sector deleveraging) GDP - IMF % of GDP 1/3 private sector deleveraging estimates €bn €bn Ireland 157 99% 114% 144% 47 69 Spain 1066 64% 81% 101% 213 6 Portugal 171 83% 95% 110% 26 17 Greece 228 130% 139% 139% 90 Total (€bn) 1622 286 182 Total bailout funds still available (€bn) - excluding Greek and Irish bailouts 410Source: IMF, Credit Suisse estimates. Funds available are the EFSF, EFSM, IMF pledged funds minus Greek and Irish bailoutsAn alternative way of calculating the likely magnitude of write-downs is to look at theaverage cost of past severe emerging market banking crises. This has been around 30%of GDP (in Thailand, Malaysia and Argentina) compared to write-downs of 8% of GDP inthe European periphery so far. This would suggest the additional cost would be around€120bn for Portugal, Greece and Ireland (€350bn if we include Spain). But critically in thecase of Spain, we think the government can afford to recapitalise the banks (asgovernment debt to GDP will still be 81% of GDP by 2014 on IMF estimates—hence thebill would be much lower (indeed on this method of calculation, Spanish government debtto GDP would again rise to around 100% if the government had to shoulder the entire costof the banking crisis). c) We think the situation in Spain is manageable until the 10 year bond yields rises above 6.5%.This is because the government debt to GDP ratio was very low at the start of the crisis(42%, according to the OECD) – and even assuming that the private sector deleveragesuntil the private-sector credit to GDP ratio falls to the global best-fit line (as above) and thegovernment has to pay for a third of this process, government debt to GDP is likely to riseto around 100% of GDP. This keeps the net interest rate payments close to trend nominalGDP growth and hence the required amount of fiscal tightening (on a cyclically adjustedbasis) is 6.3% of GDP, compared to 4.1% of GDP already announced. We think thatpolitically and economically, this is feasible. d) We still believe that core Europe has to stand behind peripheral Europe as it would stand to lose $500bn directly and, indirectly, 2–3x this.Directly, it would lose money because core European banks have $900bn of assets inperipheral European countries on BIS data (and with net foreign liabilities close to annualeconomic output, if any of these countries left the euro we think it would default) – thus,assuming a 40% hair-cut, default would cost around $360bn. Additionally under the ECBcharter, the regional central banks would have to recapitalise the ECB (i.e. two thirds ofany loss that the ECB makes would have to be funded by core Europe). The ECB owns€67bn of peripheral European bonds directly – and most of the ECB repo financing toEuropean peripheral banks (€330bn) is secured against domestic government bonds.Thus, in the case of a peripheral European default, the cost to recapitalise the ECB couldeasily be $200bn. Indirectly, the cost is considerably more, for if a newly created Germancurrency revalued by, say, 20%, trade tension could easily escalate.Global Equity Strategy 25
  • 26. 08 December 2010 e) On EFSF rates and assuming that the already announced fiscal deficit reduction plans will be implemented, the debt arithmetic becomes much less problematic (as shown in Figure 49).We also find that the implied default probabilities for peripheral countries look a bitextreme now. Assuming a 40% recovery rate (the historical average has been 39% forsovereign defaults since 1998, according to our head of European Credit research WilliamPorter), the five-year default probability implied in the CDS market is 56% for Greece and41% for Ireland.Figure 51: Implied sovereign default probabilities in the CDS market looks a bit extreme 5Y Implied default at recovery rate of: Country 5Y CDS 40% 60%Greece 993 56% 72%Ireland 605 41% 54%Portugal 547 33% 44%Spain 351 26% 36%Italy 246 19% 27%Germany 51 3% 6%Source: the BLOOMBERG PROFESSIONAL™ service, Credit Suisse estimatesWe would highlight that the week before the Lehman Brothers default in September 2008,its 5Y CDS spread was hovering around 600bp, compared to 993bp for Greece and 605bpIreland now. f) Peripheral Europe needs to be bailed out by core European growth and IFO in Germany is now consistent with nearly 5% GDP growthRecall, Germany is 50% larger than the peripheral European economies added together.The weaker euro has added around 1% to nominal GDP in the Euro-area growth on ourestimates.Figure 52: IFO consistent with German GDP growth of 5% 5% 105 100 3% 95 1% 90 -1% 85 -3% Ifo business expecations, lhs, 6m lead 80 -5% German real GDP (y/y) 75 -7% 1995 1997 2000 2003 2005 2008 2011Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 26
  • 27. 08 December 2010Critically, the deflationary pressures in peripheral Europe are forcing the ECB to keepinterest rates at levels that we think are inappropriately low for core Europe – we estimateGerman short-term rates should be 4½ -5% (see page 113 for details) compared to minus5.4% for peripheral Europe. g) The most important factor is timeGiven enough time, banks can rebuild their reserves via their pre-provisioning profits(which each year equate to 2.5% of assets), while the ECB benefits on the carry trade(recall the ECB funds at zero and is buying Irish debt at 8% and thus makes a goodspread on this business).d) Inventory cycle is turning downThis recovery, especially in the US, has been driven by investment growth and stockrebuilding. Inventories contributed 1.9pp of GDP growth, or 62% to growth, over the lastyear, the highest contribution since 3Q 1984, while the ISM inventories index is at a 25-year high. Our US economists believe that inventories will subtract 0.2pp from US growthnext year, after adding 1.5pp this year.Figure 53: Inventory contribution to real GDP growth has Figure 54: US ISM Inventory index is close to a 26-yearbeen 1.9pp over the last 4 quarters high, suggesting strong inventory rebuilding 4.00 60 US inventories, % contr. To growth (last 4q) 3.00 55 2.00 50 1.00 45 0.00 40 -1.00 35 US ISM Manufacturing Inventory Index -2.00 30 -3.00 25 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchWe note that a peak in the inventory cycle has historically been associated with a declinein the ISM (92% of the time) and weakish or falling equity markets – even more so if welook at the episodes when the inventory contribution to GDP was as high as it is currently.Global Equity Strategy 27
  • 28. 08 December 2010Figure 55: Equities tend to fall or rise well below average in the 6 months after the peakin inventory Inventory Peak Equities after peak in inventory cycle Date Level* Dow Ind. 1q 2q 3q 4q 30/06/53 1.40 278 -2.2% -0.8% 4.6% 17.2% 30/06/55 1.87 423 7.0% 14.0% 12.8% 14.5% 30/06/59 2.37 635 3.3% 1.7% -1.0% -1.5% 31/03/62 2.15 713 -10.8% -13.7% -10.6% -4.4% 31/12/66 1.14 795 6.2% 9.6% 14.2% 9.9% 31/12/73 1.38 855 0.1% -6.1% -17.6% -28.0% 30/06/76 2.32 991 -1.7% -3.5% -5.1% -6.1% 30/09/81 2.63 921 -7.3% -11.9% -9.2% -5.6% 31/12/87 1.54 1914 6.6% 2.0% 4.0% 8.6% 31/12/94 0.89 3678 8.0% 19.5% 25.6% 37.1% 30/06/97 0.89 7258 8.7% 8.6% 15.9% 25.6% 31/12/02 1.09 8805 -8.9% -2.4% 6.2% 9.4% 30/09/10 1.93 10214Average after peak in inventory cycle 0.7% 1.4% 3.3% 6.4%Average after peak in Inventories as high as today -4.1% -6.8% -6.5% -4.4%Average all quarters 1.8% 3.7% 5.5% 7.4%% time ISM falls 92% 92% 92% 75%* contribution to GDP growth in pp, last 4 quartersSource: Thomson Reuters, Credit Suisse researchWe can also see this if we look at the relationship between ISM and ISM new orders toinventories ratio – with the latter being consistent with the ISM falling to 45.Figure 56: The ISM New orders to inventory ratio suggests the ISM could fall 30 ISM: new orders minus inventories 70 ISM (rhs) 25 65 20 60 15 55 10 50 5 45 0 40 -5 -10 35 -15 30 1990. 1995. 2000. 2005. 2010.Source: Thomson Reuters, Credit Suisse researchHowever, the reasons it could be different this time around are:■ there is likely to be a greater bounce back in demand – which has been lagging previous cycles so far;■ a large proportion of the inventory rebuild has been accounted for by rising imports (+16% yoy, at a 26-year high) , thus destocking may have a small impact on GDP growth. Indeed, the ending of Chinese export rebates may have led to an export surge (and thus inventory build), distorting the data;Global Equity Strategy 28
  • 29. 08 December 2010■ The level of excess inventories is not particularly high –it is just back to its downward- slopping trend line. Furthermore, the inventory cycle is now less relevant for the economy, given the increased focus on just-in-time inventory management.Figure 57: US final demand growth has been weak relative Figure 58: The level of inventories is only back to itsto previous recoveries downtrend (relative to sales) 1.6 Contribution to US GDP growth in the first 5 quarters of a recovery US Business Inventories/Sales GDP Real GDP Final demand Inventory 1.5 Trough cumulative Change % GDP Change % GDP 31/03/1975 7.0% 5.6% 81% 1.3% 19% 1.5 30/09/1980 3.1% 2.6% 84% 0.5% 16% 31/03/1982 3.8% 3.9% 103% -0.1% -3% 1.4 31/03/1991 3.7% 3.4% 92% 0.3% 8% 30/09/2001 2.3% 2.0% 87% 0.3% 13% 1.4 30/06/2009 3.6% 2.8% 76% 0.9% 24% Average 3.9% 3.4% 87.2% 0.5% 13% 1.3 1.3 1.2 1995 1997 1999 2001 2003 2005 2007 2009 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchWe would also note that Jonathan Wilmots models suggest that inventory levels havefallen globally, not risen, in the past few months. Overall, he believes that inventoriesremain at neutral levels, with the level of global IP broadly in line with final demand.Figure 59: Global inventory levels 210 Global Industrial Production Global Demand Proxy (70% retail sales, 30% fixed asset investment) 190 170 150 130 110 90 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10Source: Credit Suisse Fixed Income research■ we found that historically once the index of ISM new orders to inventory turns, as it did in September 2010, 60% of the time ISM rises over the next 6-12 months (and it rose in all of the last five episodes).Global Equity Strategy 29
  • 30. 08 December 2010Figure 60: The ISM index tends to rise after a trough in the New orders to Inventory ratio Trough in new orders minus Change in ISM after inventories 3m 6m 12m Apr-1951 -11.4 -3.9 -16.8 Jun-1956 7.8 5.0 -1.8 Feb-1960 -9.7 -4.7 -8.7 Nov-1966 -6.1 -9.2 0.5 Mar-1970 4.2 -2.8 4.3 Jul-1973 8.4 4.3 -3.0 Apr-1980 -2.4 18.1 14.2 Oct-1981 -1.8 -2.2 -0.6 Jul-1984 -5.3 -5.8 -8.2 Jun-1989 -1.3 0.1 1.9 Mar-1991 9.6 14.2 13.9 Jan-1996 3.8 4.2 8.3 Feb-2001 -0.8 4.2 8.6 Dec-2008 3.9 12.8 22.4 Average -0.1 2.5 2.5 Median -1.1 2.2 1.2 % times fall 57% 43% 43%Source: Thomson Reuters, Credit Suisse research (2) QE2 will likely be more effective than investors assumeThe Fed’s decision on 3 November 2010 to renew its asset purchase programme, withannounced purchases of US$600bn until the end of Q2 2011 ($850bn-900bn including thereinvestment of MBS proceeds on Fed estimates) will result in the Fed’s balance sheetexpanding to US$3trn by the end of next year, according to Credit Suisse’s US interestrate team (equal to 21% of GDP).The critical change in our opinion is that the Fed is now acknowledging that the currentrate of inflation is not consistent with its mandate and it is thus committed to pushinginflation up from current levels. If it is targeting higher inflation, it clearly has to targethigher wage growth (about 70% of final costs are accounted for by wage costs over thelast 10 years, on national account data), which in turn means it has to target lowerunemployment, given that this is the main driver of wage growth. With trend productivitygrowth of nearly 1.5% and the rate of growth of the labour force at around 1% the Fed hasto target GDP growth of above 2.5% in order to push down the unemployment rate. UsingOkun’s Law, we estimate that if the Fed wants to reduce the unemployment rate to 6–7%(a level consistent with positive real wage growth, as shown on page 41) over the nextthree years, it should target 4.2% growth over three years, one percentage point above theIMF’s growth estimate for the US economy. In consequence, we believe that the Fed hasa de facto open-ended commitment to QE until US GDP growth is well above 3% on asustainable basis.Recent comments from Fed governors (Tom Hoenig on October 25th said more QE is a“bargain with the devil” as reported in the Wall Street Journal) and some members of theHouse of Representatives (Tea-party congressman Ron Paul, the incoming chairman ofthe House subcommittee on monetary policy, said it wants to abolish the Fed and go backto the gold standard , according to The Economist, November 25th) have raised concernsthat the Fed will be unable to renew QE if it thought it necessary to do so – but we thinkthis risk is minimal.Global Equity Strategy 30
  • 31. 08 December 2010Figure 61: The Fed should target c4% real growth for three years to achieve a 7%unemployment target on our estimates Years to achieve unemployment* of: Nairu = 5.3% 6% 7% 8% 9% 2.75% 28.4 24.0 17.3 10.7 4.0 Average real growth p.a. 3.00% 15.5 13.1 9.5 5.8 2.2 3.25% 10.6 9.0 6.5 4.0 1.5 3.50% 8.1 6.9 5.0 3.0 1.1 3.75% 6.5 5.5 4.0 2.5 0.9 4.00% 5.5 4.6 3.4 2.1 0.8 4.25% 4.7 4.0 2.9 1.8 0.7 4.50% 4.2 3.5 2.5 1.6 0.6 * based on Okuns law - 1% real GDP above trend = 0.5p decline in unemployment rateSource: Thomson Reuters Credit Suisse estimatesIs QE2 likely to work?We believe QE2 should work through the following mechanisms – and will likely be moreeffective than investors think (for more details, see our report of 3 November 2010—QE2:more effective than investors think): (a) QE drives down real rates and therefore improves fiscal funding arithmetic (see page 20 above); (b) QE forces up asset prices and encourages dis-saving (as detailed above). A rise in asset prices stimulates spending through the wealth effect (consumers and companies spend more when they feel richer), while higher asset prices, at the margin, also make it more attractive for corporates to build capacity rather than to buy it in the equity market (leading to increased capital spending). An increase in asset prices also raises the collateral value for existing and new loans. Spending is further helped by lower interest rates, which push down the opportunity cost of consumption (effectively forcing savers into spending through lower returns on savings), as well as stimulating demand for credit-sensitive goods (such as cars and housing) and lowering households’ and companies’ cost of debt servicing (making them less likely to cut back on spending as a response to perceived over-leverage); (c) Weaker dollar: an increase in the money supply should push down the value of the dollar relative to other currencies. Each 10% off the dollar trade weighted boosts US growth by 0.7%, according to our US economist Jay Feldman. But the critical transmission mechanism is that it leads other developed markets to print money. If developed countries do not participate in QE, their currencies appreciate. We think below Yen/$ 80, the BoJ would likely expand QE2. The ECB is already seeing the quality of its balance sheet deteriorate (i.e., it is buying lower credit rated peripheral Europe) and is postponing a tightening of liquidity requirements. If confidence in peripheral Europe were to return, we think the euro could appreciate to €/$1.50, at which point Europe would be close to deflation, forcing the ECB to take some form of unsterilised intervention. Additionally, the excess liquidity goes into emerging markets and in the case of China, only half of this can be sterilised. Thus either emerging markets accept a bubble or a revaluation of their currencies; (d) Funds flow: Put simply, if the Fed buys assets, the previous holders of those assets tend to get forced into riskier financial instruments (the so-called portfolio effect). Critically, unlike QE1, in QE2 the Fed is likely to buy the majority of its assets off the non-banking system (as it anticipates that the assets purchased willGlobal Equity Strategy 31
  • 32. 08 December 2010 have an average duration of 5–6 years, while the average duration of the US banks’ bond holdings is only 3-4 years). We think this money would feed through to asset markets more quickly than it did during the first round of QE, when the Fed bought securities from banks, which then left the money as excess reserves with the Fed; (e) Psychology: Low bond yields typically allow politicians to postpone fiscal tightening—and reduce the risk of over-tightening. Since the summer, we have already seen a US$34bn extension to unemployment benefits in the US, as well as additional aid to states worth US$26bn and the announcement that the R&D credit, worth around US$100bn, would be made permanent. Furthermore, the Republican success in the mid-term elections makes it more likely that the Bush tax cuts will be extended, even for the richest taxpayers, until at least the end of next year.A common criticism of QE2 is that the economy could be in a liquidity trap and, hence, allmoney injected into it would be saved rather than spent. Yet, we have already argued thatQE is likely to have an impact on consumers’ and corporates’ willingness to spend. In thiscontext, we note that during QE1 the stock market nearly doubled – and each 10% on theUS stock market takes about 0.3 percentage points off the savings ratio, on our models.Figure 62: The S&P index rose when the Fed started and expanded QE 1600 S&P 500 1500 1400 1300 End-Mar 10: QE end 1200 1100 1000 27 Aug 10: Bernankes 900 speech at JH 800 25 Nov 08: QE announced 700 18 Mar 09: QE extended 600 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10Source: Thomson Reuters, Credit Suisse researchLastly, we note that lending conditions – which lead loan growth by one year – are easingand loan demand is improving.Global Equity Strategy 32
  • 33. 08 December 2010Figure 63: US loan demand is picking up ... Figure 64: ... and lending conditions are improving, suggesting c5-1-% loan growth next year 50 15 -30 -20 30 -10 10 0 10 10 5 20 -10 30 0 40 -30 Banks reporting stronger Bank l oan growth, y/y%, 1 yr lag 50 demand (% bal) -5 -50 Banks tighteni ng credit conditions - average of fi rms, 60 Large & medium firms mortgages, cr edit card, r hs, inverted 70 -70 -10 80 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchWhen does QE stop being effective? a) If inflation expectations start to rise to levels that threaten asset prices. We believe at a minimum this is a 4% inflation rate; b) If the dollar rose sharply (as it is through a weaker dollar that the Fed is ‘exporting’ QE). Our FX team points out that the dollar TWI does not look cheap relative to other major currencies and, on our estimates, it is only 6% below its downward sloping trend line since 1967. Our FX analysts now forecast €/US$ at 1.50 in 12 months’ time.Figure 65: US$ TWI is close fair value versus the G10 Figure 66: The US$ is not significantly below its downtrend (1% p.a.) since 1967 170 140 USD TWI "Majors" FV +/-2 StDev 140 USD Trade-weighted 160 130 130 150 120 120 140 110 110 130 100 100 120 90 90 110 80 80 70 70 100 60 60 90 1984 1988 1992 1996 2000 2004 2008 80 70 1967 1974 1981 1988 1995 2002 2010Source: Credit Suisse FX team Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 33
  • 34. 08 December 2010 We do not think the Fed would be concerned about the inflationary impact of the weaker dollar until the dollar weakened by some 25–30% (imports are now only 15% of GDP and we calculate each 10% trade-weighted decline in the dollar at most adds 0.2% to inflation). c) If real bond yields were to rise. From here we would not expect a major rise on bond yields (owing to the Fed keeping rates close to zero until 2012, the Fed’s buying of Treasuries and banks having 14% of their assets in government securities, compared to 20% in 1994). d) If oil prices increased to above US$110/bbl (each 10% on the oil price takes 0.3% off GDP growth in the US, on IMF estimates), something we think is unlikely given that OPEC now has around 5.6mbd of spare capacity according to Bloomberg. (3) Valuation still supportiveWe acknowledge that in absolute terms valuations of the equity market are not cheap.Indeed, our long-term valuation metrics (market cap to GDP, Tobin’s Q, Price to trend EPSand real equity returns) suggest fair value on the S&P is close to 1,050.Figure 67: Market cap-to-GDP ratio Figure 68: Tobin’s Q 1.6 1.5 US Tobins Q ( EV at market/replacement 1.4 v alue, nonfinancial business) 1.4 Non-farm, non-financial US corporates Av erage 1.3 1.2 1.2 Market cap / GDP Av erage 1.0 1.1 1.0 0.8 0.9 0.6 0.8 0.7 0.4 0.6 0.2 0.5 1952 1957 1962 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 1954 1958 1963 1968 1973 1977 1982 1987 1992 1996 2001 2006 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 34
  • 35. 08 December 2010Figure 69: Price-to-trend earnings Figure 70: Real equity return slightly below trend 40 3.0 S&P 500: price to trend reported earnings Av erage 2.0 35 30 1.0 0.0 25 18.0 -1.0 20 15.6 -2.0 15 -3.0 10 -4.0 5 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011 1920 1927 1935 1942 1950 1957 1965 1973 1980 1988 1995 2003 2011 Real equity returns - dev iation from trendSource: Thomson Reuters, Credit Suisse research Source: Credit Suisse Global equity strategyFigure 71: On long-term traditional valuation metrics, the fair value for the S&P index isc1050 Current level S&P value if indicators wereValuation indicator Value St.dev. from avg/trend at long term levelsTobins Q (EV/replacement value) 1.0 0.7 1054Market Cap to GDP 0.9 1.0 894Price to trend EPS 18.0 0.4 1044Wilmot LR returns 10.5 -0.1 1212Average 0.5 1051Source: Thomson Reuters, Robert Shiller, Credit Suisse Fixed Income research, Credit Suisse researchThese measures essentially tell us that very long-term returns in equities are likely to beslightly below their long-term average (in the long run, equities would generate a 6% realrate of return p.a.), compared to the 10-year real return from bonds (TIPS) at just 0.7%and likely negative real returns on cash.Moreover, these measures only provide a guide over a 30–50-year period and tend tohave limited usefulness for most fund mangers (given that extreme readings only occuronce every 30–40 years). Lastly, we would question the usefulness of some of the long-term measures, in spite of the prominence they are often given in financial commentary:■ market cap to GDP, for instance, suffers from the fact that a much greater proportion of US earnings is now coming from overseas than was the case historically;■ replacement value has less meaning in a service-based economy;■ real EPS growth has been just 2.2% p.a. since 1920, compared to real GDP growth of 3.2%, suggesting that there has been structural dilution, which perhaps is likely to diminish as a result of better corporate governance such as shareholder options or the threat of aggressive M&A to underperforming managements.In our view the key is relative valuationThere are three forms of relative valuation support for equities: a) The ratio of equity to bond returns is still hovering around 30-year lows The only period during which relative equity performance was meaningfully worse was that surrounding the American Civil War.Global Equity Strategy 35
  • 36. 08 December 2010Figure 72: Equity to bond returns is abnormally low … - Figure 73: … with equities underperforming for around 30 years … 8.0 Performance of Bonds relative to equities Longest period of US equities under- 7.0 US Long term Equity to Bond Ratio 30.5years after bonds started performance relative to US bonds outperforming equities 6.0 Start End Years 1y 5y 10y Nov-1980 Dec-2010 30.1 5.0 Slope = 3.2% Aug-1929 Feb-1951 21.5 4.0 Apr-1901 Jun-1932 31.2 20% -15% 0.3% Nov-1852 May-1897 44.5 13% 13% -18% 3.0 2.0 1 SD = 24% Slope = 2.5% 1.0 0 1850 1870 1890 1910 1930 1950 1970 1990 2010Source: Credit Suisse Fixed Income research Source: Credit Suisse Fixed Income research, Global Equity strategy team b) The 12-month US consensus earnings yield (at 8%) relative to the 10-year real bond yields (0.7%) is the most attractive it has been in 50 years (if we exclude the high-inflation period in the 1970s, which pushed down real rates to abnormally low levels. Although this leads some to argue that low real rates were hardly a positive for equities in the 1970s, this was simply because as we show below, once inflation expectations rise above 4%, equities tend to de-rate).Figure 74: The US earnings yield is more than 7.3pp higher than the real BY 30% WW1 EY minus real BY 25% 20% WW2 Inflation shocks 15% 10% 5% 0% -5% 1880-1985-: 12m trailing EY - 10Y BY + 10y trend CPI growth rate -10% 1985-2003: 12m consensus EY - BY + Consumer inflation expectations 2003-: 12m consensus EY - 10Y TIPS -15% 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010Source: Robert Shiller, Thomson Reuters, Credit Suisse research c) The FCF yield is at an all-time high versus the corporate bond yield, at a time when high-yield issuance is above its previous peak, at an annualised €248bn (showing that the arbitrage can be put on).Global Equity Strategy 36
  • 37. 08 December 2010Figure 75: FCF yield at all-time high relative to the Figure 76: US high-yield issuance at all-time high thiscorporate bond yield year, up 78% from 2009 18% FCF y ield US S&P FCF y ield IBES forecast 16% 250 industrials BAA corporate bond y ield +78% US high yield, $bn issued 14% *YTD (Jan-Oct) 12% 200 li d 10% 150 8% 6% 100 4% 2% 50 0% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 0 1996 1998 2000 2002 2004 2006 2008 2010*Source: Thomson Reuters, Credit Suisse research Source: SIFMA, Credit Suisse researchThe FCF yield in Europe is 7.6% and in the US it is 6.8%, against a BAA corporate bondyield (which is the same credit rating as the median corporate in the equity market) of5.2% and 4.8%, respectively. d) The equity risk premiumThe equity risk premium is 7.3% if we just take I/B/E/S numbers over the next five years. Ifwe take I/B/E/S numbers over the next two years and then revert earnings to trend growth(6.4%), the ERP is 6%.Figure 77: US equity risk premium still c3pp above long-term average 12m th fw d 12-24m th fw d 3-5yr fw d EPS Equity risk US ERP EPS EPS grow th grow th prem ium Consensus EPS estimates $94.1 13.6% 11.4% 7.3% Consensus 12mth fw d EPS and 12-24 mth fw d EPS grow th $94.1 13.6% 6.4% 6.0% Trend reported EPS of $64 $64.5 6.4% 6.4% 4.5% Historical average equity risk premium 3.6%Source: Thomson Reuters, Credit Suisse researchThis compares with our target ERP of 4.3% (we calculate the target ERP on the basis ofBAA credit spreads and the ISM). This would rise to 4.7% if we assume ISM falls to 53and credit spreads rise by 30bps. Earnings are slightly above their long-run trend, buteven putting earnings back to trend would leave the market ERP marginally cheap at 4.5%,on our estimates.Global Equity Strategy 37
  • 38. 08 December 2010Figure 78: Our warranted ERP on operating earnings is Figure 79: The appropriate equity risk premium dependswell below the ERP implied in stock prices on the ISM and corporate bond spreads and suggests a value of 4.3% (4.7% with a small decline in the ISM and a 30bp rise in spreads) ISM Index US ERP on cons EPS (growth going back to trend) 9 US Warranted ERP 49 51 53 55 57 59 US BAA Corp. spread 8 US ERP on consensus EPS 207 4.6 4.5 4.4 4.2 4.1 4.0 232 4.7 4.6 4.4 4.3 4.2 4.0 7 257 4.8 4.6 4.5 4.4 4.2 4.1 6 282 4.8 4.7 4.5 4.4 4.3 4.1 307 4.9 4.7 4.6 4.5 4.3 4.2 5 % 332 4.9 4.8 4.7 4.5 4.4 4.3 357 5.0 4.9 4.7 4.6 4.5 4.3 4 3 Assuming ISM and credit spreads stable at current levels 2 1 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchThe more important issue, in our view, is whether equities should be cheap or expensiveon a structural (as opposed to a cyclical) basis. The bears would say worseningdemographics (which make investors more risk averse) and high volatility require below-average multiples. The bulls (including us) would reply that the following factors shouldsupport a lower than average ‘structural’ equity risk premium:■ in the very long run, the biggest risk to an equity investor is an infringement of minority shareholders’ rights, which are now structurally much better protected, owing to the alignment of minority and management interests through executive share option schemes, the threat of aggressive M&A and equity as a form of capital raising.■ corporate balance sheets look uncharacteristically strong relative to sovereign balance sheets – and this should be reflected in a lower required return for holding equities relative to bonds (i.e., a lower equity risk premium);■ the ability of the government to tax corporates is limited for international companies as they can relocate. As a response, the UK corporate tax rate, for instance, will be cut by 3 percentage points over the current parliament;■ corporates have rarely been in a better position to reduce labour costs to support margins (to a degree that would, in many countries, have been unrealistic 30 years ago).Global Equity Strategy 38
  • 39. 08 December 2010 (4) Equities are one of the cheapest inflation hedgesEquities are a real asset—and tend to re-rate until inflation rises above 4%, on our data.We note that inflation expectations (5y-5y forward) have risen to 2.7% since Bernanke’sspeech at Jackson Hole at the end of August, in which he mentioned the possibility of anew programme of asset purchases.Figure 80: Trade-off between P/E multiples and inflation Figure 81: Inflation expectations picking up since the end of August 19 S&P 500 average P/E, 1871 to present 3.00 18 12m fwd P/E 2.50 17 12m trailing P/E 12.8 16 14.9 2.00 15 14 1.50 13 US 5Y 5Y breakeven 1.00 inflation rate 12 Bernankes speech at Jackson Hole 11 0.50 10 -3% or -3 to - -2 to - -1 to 0 to +1 to +2 to +3 to +4 to +5 to 6% or below 2% 1% 0% +1% +2% +3% +4% +5% +6% above 0.00 Nov- May- Nov- May- Nov- May- Nov- May- Nov- May- Nov- Inflation range shown 05 06 06 07 07 08 08 09 09 10 10Source: Thomson Reuters, Robert Shiller, Credit Suisse research Source: Thomson Reuters, Credit Suisse research (5) When credit spreads were last at current levels, the S&P was at close to 1,500Equities have lagged credit in this recovery: US high-yield CDS spreads are now back totheir levels of three years ago, while equities are still 20% lower. If equities had performedin line with credit, the S&P would now be standing at around 1,500.Figure 82: Credit is back to pre-crisis levels, equities are Figure 83: Credit spreads have behaved well recentlynot S&P 500, lhs 1,600 300 6.5 CDX high yield spread, rhs, inverted 1,500 6.0 500 1,400 700 5.5 1,300 5.0 1,200 900 US BAA corporate spread 4.5 1,100 1,100 US high yield spread 1,000 4.0 1,300 900 3.5 800 1,500 3.0 700 1,700 2.5 600 3- 17- 1- 15- 29- 12- 26- 9- 23- 7- 21- 4- 18- 2- Nov-07 May-08 Nov-08 May-09 Nov-09 May-10 Nov-10 Jun Jun Jul Jul Jul Aug Aug Sep Sep Oct Oct Nov Nov DecSource: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 39
  • 40. 08 December 2010 (6) Earnings growth still above trend in 2011EWe expect earnings growth to be around 10% in 2011E. Historically, GDP has had to beabove 2% for profit growth to be positive. Yet, we think that owing to the extent of costcutting and global exposure (37% of US earnings came from overseas in 2Q2010), thisbreak-even point, if anything, should be lower.Figure 84: Positive profit growth if real GDP is above 1.5–2.0% 40 US EPS y/y (2q lag, lhs) US real GDP y/y (rhs) 12 30 10 8 20 6 10 4 0 2 -10 0 -20 -2 -30 -4 -40 -6 Q4 1980 Q4 1983 Q4 1986 Q4 1989 Q4 1992 Q4 1995 Q4 1998 Q4 2001 Q4 2004 Q4 2007 Q4 2010Source: Thomson Reuters, Credit Suisse researchOur EPS forecast for the S&P 500 index is slightly below the bottom-up consensus(US$91, compared with US$94 for 2011E), but well above the Blue Chip consensusforecast of 6.3% on NIPA profits. Our US strategist Doug Cliggott forecasts a moremoderate 4 % EPS growth. In Europe, we forecast 15% EPS growth (recall that typically,European earnings lag US earnings by roughly a year).Figure 85: On our models, US profit growth should be Figure 86: In Europe, we expect EPS growth to be 15% in11% in 2011E 2011EModel inputs, % chg Coefficient t-value 2010E 2011E MSCI EMU Operating earnings forecastUS Real GDP (adj. for foreign exp.) 5.6 3.4 3.5% 2.7% 2008A 2009E 2010E 2011ENon-fin. corporate GDP deflator 6.2 3.0 1.0% 0.8% Credit Suisse model 18.2 9.8 13.4 15.4Total costs (ULC+NULC)* -6.4 -5.3 -3.0% 0.0%USD trade-weighted -0.4 -1.8 -7.0% 0.0% growth -46% 37% 15%*ULC= Unit labour costs, NULC (nonlabor unit costs = 50% depr./10% interest/ 40% taxes) IBES bottom up 18.2 9.8 13.3 15.3Model output growth -46% 36% 15%S&P 500 - operating EPS, yoy 39% 11%S&P 500 - operating EPS (level) $82 $91 Cons. $84 $94Source: Thomson Reuters, I/B/E/S, Credit Suisse research Source: Thomson Reuters, I/B/E/S, Credit Suisse researchCritically, our margin proxy suggests that margins are unlikely to fall until labour haspricing power, which, on our estimates, will only happen once the unemployment rate fallsbelow 6 1/2% (recall, the NAIRU is close to 5%). We expect margins to rise 7% in the USin 2011E—broadly in line with consensus (in Europe, consensus margin growth is 10%).Global Equity Strategy 40
  • 41. 08 December 2010Figure 87: Our profit margin proxy suggests margins Figure 88: Unit labour costs are unlikely to rise untilshould be even higher unemployment falls below 6 ½ % 3 3 9% 5% US Profit margin proxy (PPI-ULC, yoy%) US, pct change in profit margin (rhs) 4% 4 7% 2 3% 5% 5 2% 1 3% 1% 6 1% 0% 0 7 -1% -1% -1 -2% 8 -3% US Hourly wage growth - deflated by core CPI -3% (%) -2 -5% 9 -4% Unemployment rate - inv (rhs) -7% -5% -3 10 Q1 1976 Q4 1981 Q3 1987 Q2 1993 Q1 1999 Q4 2004 Q3 2010 1988 1991 1995 1999 2002 2006 2010Source: Thomson Reuters, I/B/E/S, Credit Suisse research Source: Thomson Reuters, I/B/E/S, Credit Suisse researchGlobal Equity Strategy 41
  • 42. 08 December 2010 (7) There is scope for leverage and asset turns to increaseMargins are high but crucially, the RoE is not.Figure 89: US net margins well above average Figure 90:US non-financial ROE in line with average 8% 2 0% 1 8% 7% 1 6% 6% 1 4% 5% 1 2% 1 0% 4% 8% 3% 6% 2% 4% U S n on -fin an c ia ls: R o E U S non-financ ials : net m argin 1% 2% 0% 0% 1 98 0 19 8 3 1 9 86 1 98 9 19 9 2 1 9 95 1 99 8 20 0 1 2 0 04 2 0 07 2 01 0 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010Source: Thomson Reuters, IBES, Credit Suisse HOLT Credit Suisse Source: Thomson Reuters, IBES, Credit Suisse HOLT, Credit Suisseresearch researchThis is because two important drivers of the RoE on a Du Pont analysis – asset turns andleverage – are still low.Figure 91: US asset turnover well below average Figure 92:US non-financial leverage at 20-year low 1.2 4.0 US non-financials: lev erage 1.2 3.8 1.1 U S non-financ ials : as s et turns 3.6 1.1 3.4 1.0 3.2 1.0 3.0 0.9 2.8 0.9 2.6 0.8 2.4 0.8 2.2 0.7 2.0 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010Source: Thomson Reuters, IBES, Credit Suisse HOLT Credit Suisse Source: Thomson Reuters, IBES, Credit Suisse HOLT, Credit Suisseresearch researchWe calculate that if all US corporates were to return leverage to 2x net debt to EBITDA,EPS would rise by around 12% (and if only those corporates with net debt-to-EBITDAbelow 2x were to re-leverage to that level, EPS would rise by 19% in the US and 21% inEurope).Global Equity Strategy 42
  • 43. 08 December 2010Figure 93: If US and European companies were to re-leverage to2x net debt-to-EBITDA,EPS level would rise by c20% on average Market cap that needs to be bought to relever to 2X net debt to EBITDA US Europe US Europe Non-financial corporate sector If companies with net debt/ebitda <2X If market aggregate net debt/ebitda relever to that level rises to 2X % companies with net debt/Ebitda 83% 63% <2X Underleverage ($bn) 1,685 1,412 1,399 260 % market cap 19% 22% 13% 3% % impact on EPS 19.1% 21.2% 11.6% 2.9%Source: Thomson Reuters, I/B/E/S, Credit Suisse estimates (8) Investor positioning still not bullishSince the beginning of 2009, 95% of new money has flowed into bond funds.Figure 94: Since the beginning of 2009, inflows into global Figure 95: 4-week annualised inflows into bond fundsbond funds have been far stronger than inflows into have just turned negative...equity funds 800 30% 4-week annualized inflows, % of net assets, all regions Flow s into global funds, USD bn 690 700 20% Equities Bonds 10% 600 0% 500 387 -10% 400 -20% 300 -30% 200 -40% 65 81 100 49 30 -50% Global bond funds 0 -60% Since Jan 2009 Year-to-date Last three months 2004 2005 2006 2007 2008 2009 2010 2011Source: EPFR, Credit Suisse research Source: EPFR, Credit Suisse researchYet, we think flow momentum is now turning, with investors realising that a combination ofthe Fed being set on pushing up inflation, a rebounding macro cycle and strong corporateearnings is bond-negative and equity-positive. In fact, 4-week flows into global bond fundshave just turned negative, while inflows into global equity funds have spiked up – and arenow stronger than they have been at any point over the past four years. We also note thatNovember was the first month since May 2009 in which inflows into equity funds haveexceeded those into bond funds. Interestingly, inflows into money market funds have beenhigh in the recent weeks, signalling to some extent that investors are implicitly cautious.This also implies to some extent that equities, not bonds, are being seen as a relative‘safe-haven’, especially after the US municipal bond market sell-off.Global Equity Strategy 43
  • 44. 08 December 2010Figure 96: ... while inflows into equity funds are stronger Figure 97: In November, inflows into global equity fundsthan they have been at any point over the past four years have been stronger than inflows into bond funds for the first time since May 2009 12% Monthly flow s into global funds, USD bn 3-month annualized inflows, % of net assets, all regions Equities 70 9% Equities Bonds 6% 50 3% 30 0% 10 -3% -10 -6% -30 -9% -12% -50 -15% Jan- Mar- May - Jul- Sep- Nov - Jan- Mar- May - Jul- Sep- Nov - 2004 2005 2006 2007 2008 2009 2010 2011 09 09 09 09 09 09 10 10 10 10 10 10Source: EPFR Global, Thomson Reuters Source: EPFR Global, Thomson ReutersWe think these inflows into equity funds have further to run, given that the exposure ofboth US mutual funds and US households to equities are still below average levels: 46%of US mutual fund assets are now invested in equities compared with an average of 51%since the mid-1990s, while equities directly or indirectly account for 47% of UShouseholds’ total financial assets, compared with an average of 50%.Figure 98: Equities account for 46% of total US mutual Figure 99: … and 47% of US households’ total financialfund assets … assets 70% 70% US households - Asset mix (Flow of funds) Money markets Equities Bonds Equities Bonds Cash 60% 60% 50% 50% 40% 40% 30% 30% 20% 20% 10% Q3 1960 Q3 1966 Q3 1972 Q3 1978 Q3 1984 Q3 1990 Q3 1996 Q3 2002 Q3 2008 10% 1996 1999 2002 2005 2008 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchUS insurance companies, US pension funds and UK pension funds also have anabnormally low weighting in equities. In particular, the US pension funds have an averageequity weighting of only 32% compared to a long-run average of 45%.Global Equity Strategy 44
  • 45. 08 December 2010Figure 100: Equity weightings of US Pension funds at all- Figure 101: Equity weightings are close to historical lowstime lows. for US P&C insurance companies 65% 35% US P&C insurance, equities as % of invested assets US private pension funds, 60% equities as % of invested assets 30% 55% 50% 25% 45% 20% 40% 35% 15% 30% 10% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchFigure 102: … and for UK pension funds Figure 103: High inflows into money market funds indicate investor caution 80% Total shares & other equity / total financial assets - 70% UK insurance companies & pension funds 75% 4-week annualized inflows, % of net assets 50% 70% 30% 65% 10% 60% 55% -10% 50% -30% 45% -50% 40% Money markets -70% 35% 1987 1991 1995 1999 2003 2007 2011 Jan-07 Aug-07 Mar-08 Oct-08 May -09 Dec-09 Jul-10 Feb-11Source: Thomson Reuters, Credit Suisse research Source: EPFR Global, Thomson ReutersFundamentally, we believe that investors are mis-positioned for the two most acute risksthe markets are facing currently:■ sovereign default, which is bad for government bonds■ inflation…equities are a better hedge against inflation than bondsIn Appendix 3, we show a screen with equities that have a CDS spread below theirgovernments and a dividend yield above the government bond yield. These are the sort ofcompanies that could be considered relatively more attractive than governments, offer ahedge against inflation – and still yield more than government bonds.Global Equity Strategy 45
  • 46. 08 December 2010 (9) M&A and buybacks activity looks set to increaseWe believe that M&A and buyback activity will increase significantly over the next 12months, supporting both ROE and market sentiment, given that: a) M&A is profitable, with a record gap existing between the FCF yield and the corporate bond yield; b) High yield issuance, i.e., the ability to finance a bid, is close to all time highs. (We note that in late November, Wind issued the largest high yield bond issue since 2007); c) Corporate leverage is low: net debt-to-EBITDA for the S&P 500 index is currently 1.1x, compared to an average of 1.6x ; d) Business confidence indicators are still strong and tend to lead M&A activity by about a year; e) M&A and buybacks tend to lag the stock market and the economic cycle by about 12 to 18 months.Figure 104: M&A activity lags the business cycle … Figure 105: … and the market by one year S&P 500, y/y%, lead 12 month, lhs Global M&A 12m sum as % of Mkt cap ISM new orders, rhs, lead 12m 80% Global M&A 12m sum as % of Mkt cap 12% 12% 60% 10% 70 10% 40% 8% 60 8% 20% 6% 50 6% 0% 4% 40 -20% 4% 2% -40% 2% 30 -60% 0% 0% 20 1981 1986 1991 1996 2001 2006 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchWe think that the corporate sector could end up being the major buyer of equities. Yet sofar this year, corporate net buying has been quite muted (owing to the impact of banksrights issues), as we show on page 50.Global Equity Strategy 46
  • 47. 08 December 2010 (10) Tactical indicators—a slight cautionFigure 106: Summary of our tactical indicators for equities Score Com m entEarnings revisions Earnings revisions are strong globally and in the USEquity sentiment indicator slightly above average (+0.44std)Risk appetite slightly above average (+0.6std)Insider buying Insider (i.e. directors) buying is slightly below the 03-07 bull mkt averageEconomic macro surprises rolled over in the US and globallyCorporate net buying negative on the back of rising equity issuanceMarket breadth (i.e. Advance/ decline line) has decoupled from the overall market momentumS&P net speculative positions remain highOverbought/ oversold indicator (% of stocks 76%above 10-w eek MA)Overall tactical message for equities = Strong positive, = Positive, = Neutral = Negative, = Strong NegativeSource: Thomson Reuters, Credit Suisse researchSome of our tactical indicators give us reason for concern:(i) Overall equity sentiment has recovered to a 4-year highOur equity sentiment indicator is a combination of put/ call, slope of implied volatility skew,inflows into equity funds, and bullish sentiment. Our equity sentiment is above average(+0.4 standard deviations) but is not extreme in a historical context.Figure 107: Equity sentiment indicator: slightly above the average level (but hasrecovered quite sharply from being minus one std in late August) 1.8 1.3 Equity sentiment excl Risk appetite 0.8 0.3 -0.2 -0.7 -1.2 -1.7 -2.2 Jan-97 Mar-98 May-99 Jul-00 Sep-01 Nov-02 Jan-04 Mar-05 May-06 Jul-07 Sep-08 Nov-09 Jan-11Source: Thomson Reuters, Credit Suisse researchWe highlight the elements of investor sentiment that are high:The bull/bear ratio for Financial Advisors has risen close to the top end of its range (butremains 31% below the all-time high level reached in June 2003).Global Equity Strategy 47
  • 48. 08 December 2010Figure 108: The bull/bear ratio for Financials Advisors (the black line) has risen close tothe top end of its range (but remains 31% below the all-time high level reached in June2003). Encouragingly, Individual Investors Bull/ Bear ratio no longer looks that extended 60 Bulls minus Bears Individual investors 40 Financial advisors 20 0 -20 -40 -60 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11Source: Thomson Reuters, Credit Suisse researchWe back-tested this indicator: on previous occasions when it rose to current levels, themarket was flat over the following three months (-2% on a 1-month view) – but up slightlyon a 6-month basis.Figure 109: We back-tested Financial Advisors Bull/ Bear radio: on previous occasionswhen it rose to current levels, the market was flat on a 3-mth view, (-2% on a 1-monthview) but up slightly on a 6-month basis Performance of S&P after Date 1wk 2wk 1m 2m 3m 6m 12m Jun-03 2.7% -0.1% 0.4% -0.7% 3.9% 7.5% 14.9% Jun-04 0.2% 0.4% -2.2% -5.9% -0.3% 6.5% 6.6% Dec-04 2.2% 2.4% 0.9% 2.2% 3.6% 1.5% 6.8% Aug-05 -1.0% -1.1% 0.0% -2.9% -1.0% 2.8% 2.8% Nov-06 -1.1% 0.9% 1.1% 2.0% 4.1% 8.5% 1.0% Oct-07 -1.7% -2.9% -5.8% -3.9% -11.2% -13.5% -37.1% Jan-10 1.2% -3.9% -5.1% 1.2% 5.4% -3.6% 3.7% May-10 -1.5% -4.5% -6.0% -12.9% -4.5% 2.1% 0.4% Average 0.1% -1.1% -2.1% -2.6% 0.0% 1.5% -0.1% Median -0.4% -0.6% -1.1% -1.8% 1.6% 2.4% 3.3% % outperform 50.0% 37.5% 50.0% 37.5% 50.0% 75.0% 87.5%Source: Thomson Reuters, Credit Suisse researchRather encouragingly, the bull/ bear ratio for individual investors has come off its recenthighs (but even when it was as extended as it was three weeks ago, the market was up ona 1-6 month basis). We show this back-test in Appendix 4).(ii) S&P 500 speculative positions (as a proportion of open interest) are still very high,though they have rolled over slightly.Global Equity Strategy 48
  • 49. 08 December 2010Figure 110: S&P 500 net speculative positions remain very high, though rolled overslightly 80% S&P 500, net speculative positions, % open interest 60% 40% 20% 0% -20% -40% -60% -80% -100% Jan-94 Nov-96 Sep-99 Jul-02 May-05 Mar-08 Jan-11Source: the BLOOMBERG PROFESSIONAL™ service, Credit Suisse researchOn previous occasions when the S&P 500 net speculative positions rose to current levels,the S&P 500 was slightly down over the next two months (but this includes 2000 and2008).Figure 111: On previous occasions when the S&P 500 net speculative positions rose tocurrent levels, S&P 500 was slightly down (but then it was 2000 and 2008) Performance of S&P after Date 1wk 2wk 1m 2m 19-Sep-00 -2% -2% -5% -6% 07-Nov-06 1% 1% 2% 2% 14-Oct-08 -4% -6% -9% -12% Average -2% -2% -4% -5%Source: Thomson Reuters, Credit Suisse research(iii) US corporate net buying (that is share buybacks plus cash financed acquisitions minusIPOs and secondary equity issuance) has turned negative.Though share buybacks remain in line with their historical average and announced cashtakeovers are some 20% above the norm, corporate net buying has been depressed bystrong equity issuance (which is three times its average levels).Global Equity Strategy 49
  • 50. 08 December 2010Figure 112: Corporate net buying: turned negative.... Figure 113: ... primarily driven by strong equity issuance 2.4 2.6 1.9 2.4 2.2 1.4 Equity issuance, as % of mk cap 2.0 0.9 Average 1.8 0.4 1.6 1.4 -0.1 1.2 -0.6 1.0 Average -1.1 0.8 Corporate net buying, as % of mkt cap 0.6 -1.6 0.4 -2.1 0.2 -2.6 0.0 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11Source: Trim Tabs, Credit Suisse research Source: Trim Tabs, Credit Suisse research(iv) Market breadth (i.e. advance/ decline line) has decoupled from the overall marketmomentum.Figure 114: Market breadth (i.e. advance/ decline line) has decoupled from the overallmarket momentum 10% 21 11 5% 1 0% -9 -19 -5% -29 -10% -39 6m rolling advance/decline line, % S&P500 deviation from 130 day average, % (rhs) -15% -49 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11Source: Thomson Reuters, Credit Suisse research(v) Credit Suisse’s macro surprises indicator has rolled over and turned slightly negative inthe US, while Global macro surprises remain positive.Global Equity Strategy 50
  • 51. 08 December 2010Figure 115: US macro surprises: just turned a mild Figure 116: Global macro surprises remain positivenegative 0.4 0.6 0.2 0.3 0.0 0.0 -0.3 -0.2 -0.6 -0.4 -0.9 Global macro surprises indicator -0.6 US macro surprise index -1.2 -0.8 -1.5 Jan-01 Sep-02 May-04 Jan-06 Sep-07 May-09 Jan-11 Jan-01 Sep-02 May-04 Jan-06 Sep-07 May-09 Jan-11Source: Credit Suisse European economics team, Thomson Reuters, Source: Credit Suisse European economics team, Thomson Reuters,Credit Suisse research Credit Suisse research(vi) The market does look somewhat extended, with 76% of NYSE stocks trading abovetheir 10-week moving average.Yet, on previous occasions when this indicator reached even more extended levels, theequity market saw positive returns over the next 1–3 months.Figure 117: Currently 76% NYSE stocks trading above Figure 118: Back testing: S&P 500 price performancetheir 10-week moving average when this indicator has risen above 86%100 100 90 90 Date --S&P 500 pe rform ance after this indicator rose above 86%-- 80 80 1-w e ek 2-w ee k 1-m onth 2-m onth 3-m onth 70 70 07-May-03 1.0% -0.7% 8.7% 6.5% 9.6% 02-Jan-04 1.2% 2.8% 3.4% 1.3% -1.2% 60 60 05-Dec-06 -0.2% 0.8% 1.2% -0.6% 2.3% 50 50 05-May-09 0.5% 0.5% 0.9% 7.9% 15.5% 03-Jun-09 0.8% -2.3% 0.1% 10.6% 15.0% 40 40 27-Jul-09 2.1% 2.5% 3.5% 11.1% 12.9% 30 30 10-Sep-09 2.0% 0.6% 4.7% 5.9% 8.8% 14-Oct-09 -1.0% -4.5% 1.7% 4.5% 1.6% 20 20 15-Apr-10 -0.2% -0.4% -9.0% -11.0% -11.9% Me an 0.7% -0.1% 1.7% 4.0% 5.9% 10 10 Median 0.8% 0.5% 1.7% 5.9% 8.8% 0 0 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11Source: NYSE, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchWe note that Jonathan Wilmot’s global risk appetite has recovered quite sharply and isnow 0.6 standard deviations above its norm. Yet, it remains well below euphoria levels.Our equity sector risk appetite is still not extended (around 0.2 std above norm). We waitfor this indicator to get to extended territory before tactically downgrading equities.Global Equity Strategy 51
  • 52. 08 December 2010Figure 119: Wilmot’s global risk appetite has recovered Figure 120: Equity sector risk appetite: just aroundquite a lot but is still well below euphoria levels neutral10 3.0 3.0 8 Equity sector risk appetite indicator 2.0 2.0 Euphoria 6 No. of standard deviaitons 1.0 1.0 No. of standard deviations 4 2 0.0 0.0 0 -1.0 -1.0 -2 -2.0 -2.0 -4 Wilmots Global Risk Appetite Panic -6 -3.0 -3.0 Jan-81 Jan-86 Jan-91 Jan-96 Jan-01 Jan-06 Jan-11 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11Source: Credit Suisse fixed income research Source: Thomson Reuters, Credit Suisse research (11) Seasonality is supportiveSeasonality should be supportive from three points of view: a) Time of the year: Historically, November and December account for 38% of the average annual return (8.5% since 1964), but there is clearly an October-to-March effect.Figure 121: November and December account for 38% of Figure 122: The 3rd year of the US Presidential electionthe average annual return of the S&P500 cycle has been very good for equities since 1952—with an average return of 18% 110 120% DJ index return -Calendar 108 S&P 500 - average weekly cumulative price ft l ti 100% performance since 1964 (ex-2008) 100% Average return % positive ret. (rhs) 106 80% 73% 104 57% 60% 102 47% 40% 100 18% 20% 98 5% 4% 6% 28-May 1-Oct 20-Aug 10-Sep 5-Mar 16-Apr 30-Jul 12-Nov 3-Dec 24-Dec 22-Oct 18-Jun 1-Jan 22-Jan 12-Feb 26-Mar 9-Jul 7-May 0% 0 1 2 3Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research b) The third year of a US Presidential cycle: Each third year of the US presidential election cycle since 1952, equity prices have risen on average by 18%, compared with an 8% average for the entire sample since 1952 (bond returns have been on average 7.3% in the third year, again the best-performing year in the Presidential election cycle). Indeed, in the period we look at, equities have never fallen during the third year in the cycle; c) Volumes: Transaction volumes are very low but so far have roughly followed the path of the last bull market, which would suggest a pick-up in the coming months.Global Equity Strategy 52
  • 53. 08 December 2010Figure 123: Volumes cannot fall much further from here 0.55% SPX - daily traded value, % of mkt cap, 4-wk avg Post March 2009 Post March 2003 0.50% 0.45% 0.40% 0.35% 0.30% 0.25% No. of trading days post market trough 0.20% 1 61 121 181 241 301 361 421 481 541 601Source: the BLOOMBERG PROFESSIONAL™ service, Credit Suisse researchWe think there could be a bear market as early as 2012We do not think this is a normal bull market, with the major potential catalysts for the nextbear market being the following, in our view: 1) The end of QE and/or a rise in ratesOur main concern is that global excess leverage could prove problematic once rates startrising or QE ends. The fundamental problem is that, on our calculations, there is stillaround US$6.3trn of excess leverage in the G4 economies (and for that matter aroundUS$1.5trn of excess leverage for the US consumer). The problem is that when the marketstarts anticipating central banks’ exits from QE and real bond yields rise, this debt willbecome costly to service and de-leveraging will have to accelerate.As we have pointed out above, the degree of insolvencies has been very low relative tothe decline in GDP, largely due to the benefit of abnormally low real rates. We wouldexpect this to reverse once rates start rising.The same problem that faces the private sector in this scenario could also hurtgovernments with high debt levels (especially if the rise in rates coincides with a sharppick-up in bank loan growth, leading banks to substitute holdings of government debt withprivate sector loans). If real bond yields were to rise to 3%, then we calculate the degreeof fiscal tightening needed to stabilise the US and UK government debt rises to 7% and6.5% of GDP respectively. 2) By 2012E–13E overheating in China may have moved one step too farWe fear that by 2012E/13E, inflation in China may have risen to levels that force anaggressive policy response (via interest rates and the RMB) at a time when profitabilitywould have fallen to a very low level.Global Equity Strategy 53
  • 54. 08 December 2010What is the bear case for equities?In this section we examine the bear arguments on both the economy and equity markets –and highlight why we do not find them convincing: 1. Excess leverage. Required de-leveraging reduces trend growthWe agree with this. As we said above, we believe that there is $6.3trn of excess leveragein the four major regions and $1.5trn in the US households sector alone. (We take theaverage of the household debt deviation from trend relative to household assets andrelative to GDP.)Figure 124: Total leverage in the G4 is about US$6.3trn Figure 125: The US household sector is stillabove trend (assuming a trend growth rate relative to overleveragedGDP of 2.5%) ... 314% 32% 28% US Household debt / GDP, dev. from trend US, UK, Japan & Germany: total debt (% of GDP) 24% US Household debt / assets, dev. from trend 277% Trend, assuming leverage grows by 2.5pp per year 20% 16% 240% 12% 8% 4% 203% 0% -4% 167% -8% -12% -16% 130% Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchHowever, it is not the excess leverage that counts but the level of savings ratio (i.e. thespeed of the de-leveraging). Our model implies that the savings ratio should be 5%,slightly below 5.3% currently (as shown on page 20). The two critical inputs of the modelare wealth and the level of bond yields (the lower the bond yield, the lower the savingsratio, as on our calculation the top income quintile has a savings ratio of 33% andaccounts for 40% of consumption). We estimate that assuming no change in asset prices,a 6% savings ratio for 3 years or a 5% savings ratio for c4 years would take householddebt levels back to normal levels (this calculation is based on the most conservativehousehold debt to asset ratio).Global Equity Strategy 54
  • 55. 08 December 2010Figure 126: A savings ratio of 6% for three years would take US household debt to assetsratio normal levels US Household BS 3Q, $trn Scenario Liabilities 13.9 12.0 Savings ratio 6% for 3y Equity holdings* 10.8 10.8 Flat equity prices Housing wealth 17.1 17.1 Flat house prices Other assets 39.5 39.5 Total assets 67.4 67.4 HH liabilities/ assets 21% 18% Trend 18% 18% Excess leverage 2.2 0.1 memo: GDP $trn 14.7 *direct + indirectSource: Thomson Reuters, Credit Suisse researchThe level of government debt is also unsustainably high (the IMF estimates the USgovernment debt to GDP ratio will reach 108% in 2014). As we highlighted earlier, givencurrent real rates, the fiscal tightening required to stabilise the government debt-to-GDPratio in the US is only around 3.5% of GDP. If we assume a multiplier of 0.5 and anadjustment over a five-year period, this would take about 0.3 percentage points off GDPgrowth per year, a manageable amount in our view.As we highlighted above, we think the solution for excess leverage is a substantial transferof wealth from creditors to debtors via negative real rates—the same solution, incidentally,that was used after the Second World War, when the Fed capped bond yields at 2.5% andinflation averaged 6%, resulting in the government debt to GDP halving from 121% in1945 to 66% a decade later.Figure 127: Post the Second World War, negative bonds yields resulted in the halving ofthe government debt to GDP in a decade 20% US real Bond yield 140% 15% US Government debt to GDP, rhs 120% 10% 100% 5% 80% 0% 60% -5% 40% -10% -15% 20% -20% 0% 1925 1935 1945 1955 1965 1975 1985 1995 2005Source: BEA, Thomson Reuters, Credit Suisse researchIn short, we believe that it is very likely that bond investors will not be able to preservetheir capital in real terms.Global Equity Strategy 55
  • 56. 08 December 2010 2. The excess government leverage can lead to a funding crisisIf real bond yields rose significantly to level which might be deemed reasonable, we wouldexpect to face a major de-leveraging crisis. Indeed a reasonable level of real bond yieldsshould, in our opinion, be something in excess of the 20-y average (2.7%) to reflect theabove-average risk of sovereign default and the above average return on capital. Yet, thekey point is that over the next three years or so real bond yields are likely to remain atartificially low, if not negative, levels because:■ The Fed will remain a buyer of most of net Treasury issuance■ The Fed is likely to stay on hold (if we look at our model of the Taylor Rule) until 2014, pushing investors up the yield curve (a 1pp yield pick up compensates for a 20bps rise in bond yields). Indeed, our fair value model (based on the current level of rates and ISM and core inflation) suggests that US bond yields are now slightly above fair value, as shown on page 63.■ US Banks still have 14% of assets of government securities compared to a peak of 20% in 1994.Figure 128: US banks’ holdings of government securities Figure 129: European banks’ holdings of bonds still loware 14% of total assets 24% US Commercial banks, US government/Agency 3.5 9.0% Euro-area banks, Government securities % total assets 2.5 securities % total assets 3.0 Euro-area 10Y-2Y (rhs) 22% US 10Y-2Y (rhs) 8.0% 2 2.5 20% 2.0 7.0% 1.5 18% 1.5 6.0% 1 16% 1.0 0.5 5.0% 0.5 14% 0.0 12% 4.0% 0 -0.5 10% -1.0 3.0% -0.5 1996 1998 2000 2002 2004 2006 2008 2010 8% -1.5 1975 1980 1985 1990 1995 2000 2005 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research 3. QE ends up in an inflation surge, driving up risk premiaIn the long term, inflation is a monetary phenomenon, so a sharp rise in the availability ofmoney relative to the level of trend GDP should result in much higher inflation rates. Wedo not believe, however, that QE will result in very high structural inflation – that is aninflation rate well above a level at which the Fed would likely feel comfortable, for thefollowing reasons:■ We think that the Fed would likely respond quickly once inflation and inflation expectations clearly breached 2% (i.e. 4% plus).■ QE – the expansion of the Fed’s balance sheet – can be easily reversed once inflation risks emerge, via reverse repos, higher reserve requirement ratios etc.■ the increase in the monetary base since 2008 (c$1.7trn or 17% of GDP) is surely unprecedented but has to be seen in the light of the unprecedented shrinkage of liquidity in the ‘shadow’ banking system.Global Equity Strategy 56
  • 57. 08 December 2010The Fed has estimated (Shadow banking, July 2010, Federal Reserve Bank of New York)that since the start of the crisis, the US ‘shadow’ banking system in the US—financecompanies, asset-backed commercial paper (ABCP) conduits, limited-purpose financecompanies, structured investment vehicles, credit hedge funds, money market mutualfunds, securities lenders, government-sponsored enterprises—has shed about $5trn ofliabilities, de-facto reducing the credit available in the market by 15%. Thus, the increasein QE in part offsets the contraction in the shadow banking system.Figure 130: The Fed is printing money but still not enough to compensate for the declinein liquidity provided by the banking system 25 Liabilities of the US banking system ($trn) 20 Central bank Commercial Banks 15 Shadow banking 10 5 0 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009Source: Federal reserve, Credit Suisse research■ an ageing and wealthy society with a contribution-based pension system has a long- term bias against inflation, in our view.Ultimately, we believe that QE is just another way of conducting monetary policy, asBernanke recently said. The only difference is that the Fed is now targeting the long-end ofthe yield curve, rather than the short-end where rates are already close to zero.We would also note that, to get very high inflation at some point in the future, we wouldfirst have to get moderate inflation. Yet, as we mentioned earlier, equities do not tend tode-rate until inflation expectations rise above 4%.Global Equity Strategy 57
  • 58. 08 December 2010Figure 131: Trade-off between P/E multiples and inflation Figure 132: Inflation expectations picking up since the end of August 19 S&P 500 average P/E, 1871 to pre sent 3.00 18 12 m fw d P/E 2.50 17 12m trai lin g P/E 12.8 16 14.9 2.00 15 14 1.50 13 US 5Y 5Y breakeven 1.00 inflation rate 12 Bernankes speech at Jackson Hole 11 0.50 10 - 3% or -3 to - -2 to - -1 to 0 to +1 to +2 to +3 to +4 to +5 to 6% or below 2% 1% 0% +1% +2 % +3% +4% +5% +6% above 0.00 Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Inflation range sho wn 05 06 06 07 07 08 08 09 09 10 10Source: Thomson Reuters, Robert Shiller, Credit Suisse research Source: Thomson Reuters, Credit Suisse research 4. A hard landing in ChinaWe have discussed this issue on pages 16 to 18. Our conclusion is that: a) Inflation pressures are not extreme (export prices are not yet rising in either dollar or RmB terms), while wage growth is in line with its 10 year average; b) On official data, the house price to wage ratio is not significantly above its norm; c) Without allowing the RMB to revalue significantly, the authorities are unable to tighten monetary policy by much, leaving monetary conditions too loose, in our view; d) Markets tend not to worry about policy becoming unsustainable until there is a sustained and large current account deficit, which, in turn, leads to countries becoming net international debtors. In our view none of this is likely to happen any time soon in the case of China.Critically, with the Chinese government’s primary goal of achieving a rate of growth highenough to minimise the risk of social unrest (GDP growth of 7%+) and the substantialresources at its disposal (€2.7trn of FX reserves and very low government debt), webelieve that any significant weakness in economic momentum would result in additionalfiscal and monetary stimulus. 5. The reversal of the inventory cycleAs we have explained in detail on page 27 to 30, the inventory cycle is turning down andde-stocking will take 1.7pp off growth in the US in 2011 relative to 2010, on our estimates.The question is whether an acceleration of final demand can compensate for this.With the fundamentals for capex still strong (business confidence high, the investmentshare of GDP abnormally low, large cash balances and easy access to credit markets), anemerging market consumer bubble likely to develop and consumption supported by theextension of the Bush tax cuts as well as the recovery in employment growth, we believethat de-stocking will not derail the recovery. Moreover, as we have pointed out above, thelevel of excess inventories is not high.Global Equity Strategy 58
  • 59. 08 December 2010 6. The rise in long-term unemployed, the low participation rates become a big secular headwindThis is a potential issue for the US and we address this point in the regional allocationsection on page116 below. 7. Equities are not cheap in absolute termsEquities are not cheap when we look at very long-term valuation metrics, but this does notgive a useful short-term trading signal and near term the key is that equities are cheaprelative to other asset classes (which are also over-owned – see page 37 above). 8. Margins are very high for this stage of the cycleOn national accounts data, margins have recovered very well in this cycle and are now at13% (2.4pp above average). A consequence of this is that earnings are 2% above trendand sales are 12% below trend.Figure 133: US profit margins are already well above average 16% US non-financial corporate profits/non-financial corporate GDP 15% 14% 13% 12% 11% 10% 9% 8% 7% 6% Q2 1971 Q3 1974 Q4 1977 Q1 1981 Q2 1984 Q3 1987 Q4 1990 Q1 1994 Q2 1997 Q3 2000 Q4 2003 Q1 2007 Q2 2010Source: Thomson Reuters, Credit Suisse researchHowever, our margin proxy still suggests that margins are unlikely to fall until labour haspricing power and on our estimates, this is only likely to happen once the unemploymentrate falls below 6-7% (recall, the NAIRU is close to 5%). This is unlikely before 2013E, inour opinion (see page 41 for details). We also think, as we highlighted on page 42, thatthere is plenty of scope for asset turns and leverage to rise to offset the impact of thedecline in margin on RoE. 9. An ageing population will mean equity weightings fallPut simply, the older the investor the shorter the investment horizon, and the higher thedemand for yield and safety. According to one rule of thumb of investment strategy, theallocation to equities in a balanced portfolio should be equal to 100 minus the investor’sage. With the share of population aged 65 and above rising by 2.3% in developed marketsand 4.5% in emerging economies (compared to 0.2% and 1.3% total population growth)over the next 10 years according to UN estimates, a structural shift from equities intofixed-income products is possible.As our US strategist Doug Cliggott points out, there is a good correlation between theshare of the population accounted for by people aged between 35 and 54 and theGlobal Equity Strategy 59
  • 60. 08 December 2010allocation to equities. On US census estimates, this share should fall by 3 percentagepoints over the next 10 years, consistent with a decline in the share of equity holdings ofc7 percentage points.Figure 134: In the longer term, the higher the share of the population in their 30s-50s ,the higher the allocation to equities 32% % US Population Age 35-54 36% Forecast (Census) Equity Holdings as a % of Household Net Worth (rhs) 30% 30% 28% 24% 26% 18% 24% 12% 22% 20% 6% 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014 2018Source: Federal Reserve, US Census, Credit Suisse researchHowever, we would highlight that some equities now look relatively more attractive thanbonds (better balance sheets, hedge against inflation in an environment of significant QEand currency debasement) and are yielding 7pp above real bond yields on a 12mconsensus basis, as we highlighted above (see page 36), so the impact of ageing is likelyto be marginal, in our view. 10. China as a competitive threatWe think China presents a significant competitive threat in the medium term.The risk here is that as China has pushed down the global price of labour over the pastdecade by creating 80 million urban jobs (equal to 3% of the global workforce, on theestimates of Credit Suisse’s demographics research team), at wage levels equivalent to10% of the US average, it could now push down global corporate margins by supporting‘national champions’ with artificially low cost of capital and low profitability.Currently, there are only a few industries globally affected by margin pressure fromChinese competition (areas of capital goods, power generation, chemicals, telecomequipment, aerospace – see Credit Suisse’s report China as a competitive threat, 18November 2009, for details), but we expect the industries mentioned in the 12th Five-YearPlan to experience margin pressure in the future (new energy, environmental protection,new materials, biotech, IT networks, high-end equipment manufacturing, new energyvehicles).Global Equity Strategy 60
  • 61. 08 December 2010Bonds: small underweightWe maintain a small underweight in bonds – we believe that nominal bonds yields willtrade in range over the next three to six months (our US fixed income team has a mid-2011 forecast of 2.8% for the 10Y yield).The negatives for bonds are the following: 1) The ISM has troughed, in our opinion — and bond yields tend to rise consistently after a trough in the ISM;Figure 135: Bond yields consistently trough when the ISM Figure 136: … with a lag of 1–2 months over the past 25troughs … years 65 8 Trough in: Lag US bond yields ISM (months) 60 7 Jan-63 3.83 Aug-62 49.5 5 Mar-67 4.54 Apr-67 42.8 -1 55 Dec-74 7.43 Jan-75 30.7 -1 6 Dec-76 6.87 Nov-76 51.7 1 50 Jun-80 9.78 May-80 29.4 1 5 May-83 10.38 May-82 35.5 12 45 Jun-85 10.16 May-85 47.1 1 Feb-91 7.85 Jan-91 39.2 1 4 40 Jan-96 5.65 Jan-96 45.5 0 ISM Manufacturing(lhs) Oct-01 4.57 Oct-01 40.8 0 35 US 10y bond yield (rhs) 3 Jun-05 4.00 May-05 51.0 1 Dec-08 2.42 Dec-08 32.5 0 Average 6.82 42.1 1.5 30 2 1992 1995 1998 2001 2004 2007 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research 2) There is a record gap between lead indicators, cyclical performance and bond yields, suggesting bond yields should rise from current levels;Figure 137: The gap between IFO and German bond yields Figure 138: German bond yields should be around 150bpsis extreme higher, given the outperformance of cyclicals 110 5.0 5.0 80 105 4.5 4.5 75 100 4.0 4.0 95 70 90 3.5 3.5 65 85 3.0 60 3.0 80 Germany IFO ex pectations index (3m 2.5 55 European cy clicals relativ e to defensiv es 2.5 75 lead) 10Y German bond y ield (rhs) German 10-y ear bond y ield, %, rhs 70 2.0 50 2.0 2003 2004 2005 2006 2007 2008 2009 2010 2011 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 61
  • 62. 08 December 2010 3) Bond yields seem too low if we look at long-term valuations and/or we assume that we do not fall into structural deflation – i.e. we assume the average inflation rate will be in line with the Fed target and the breakeven rates (2.1% over the next 10 years);Figure 139: In the long-run, bond yields are set to rise Figure 140: ... on our bond model- if we plug in the 10Y breakeven rate, bonds would be overvaluedFair value of long-term bond yields over the US Euro-area UK Japan 3 10-year US Treasury bonds, std. deviation fromcycle 2.3 fair valueLabour force growth 1.0% 0.3% 0.8% -0.5%Productivity growth 1.5% 1.0% 1.0% 1.0% assuming 10y implied CPI and stable ISM 2GDP growth 2.5% 1.3% 1.8% 0.5%Inflation target 2.0% 1.8% 2.0% 0.5%Nominal GDP growth 4.5% 3.1% 3.8% 1.0% 1Historical spread of BY over GDP growth 0.2% 0.5% 0.4% 1.4%Impact of rise in Govt debt/GDP* 0.9% 0.7% 0.4% 1.2%Fair level of bond yields 5.6% 4.2% 4.5% 3.5% 0Current level 2.9% 2.6% 3.3% 1.2%Deviation from fair level (pp) -2.7% -1.6% -1.2% -2.3%*50bps for each 10pc rise in Debt/GDP ratio (IMF estimates, 2010) -1 -2 US bonds "cheap" -3 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010Source: Thomson Reuters, IMF , Credit Suisse estimates Source: Thomson Reuters, Credit Suisse research 4) Relative to equities, valuation is even more problematic—with bonds having outperformed for 31 years, as shown on page 36 above; 5) Inflows into bonds have been unsustainably strong until very recently (as highlighted on page 43); 6) QE2 is about lower real bond yields, not nominal bond yields.We note that during QE1 (November 2008 to March 2010), nominal bond yields rose from2.1% to 3.9%.Figure 141: QE1 was negative for bonds 4.5 US 10Y bond yield, rhs End-Mar 10: QE1 end 4 3.5 3 2.5 25 Nov 08: QE1 announced End-Aug Bernankes speech ah JH 2 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 62
  • 63. 08 December 2010However, we also see some positives for bonds:(1) Bond yields are roughly in line with our estimated fair valueOur model of the US 10Y government bond yield – based on ISM, core inflation and short-term rates – suggests a fair value of 2.7%, slightly below the current level.Figure 142: US bond yields are slightly below our Figure 143: US bond yields are now slightly below fairestimate of the fair value – in the short-term value 3Model inputs Coeff. t-value Current Scenario 10-year US Treasury bonds, std. deviation fromISM Index 0.1 9.7 57 57 fair valueUS core CPI, yoy % 1.0 17.8 0.6 2.0 2US 3-month T-bill rate 0.3 12.3 0.2 0.2 1Model output10Y Treasury yield (fair value) 2.7 4.1 0RSQ 0.82St. error of estimate 0.58Intercept -2.1 -110Y Treasury Yield (current) 2.9 2.9ISM priced in: 59 40 -2GDP growth (qoq saar) : 4.7% -1.4% US bonds "cheap" -3 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010Source: Thomson Reuters, Credit Suisse estimates Source: Thomson Reuters, Credit Suisse estimatesWe would highlight that bond yields have risen by roughly 60bps since their recent troughin both Europe and the US – with a rise in inflation expectations accounting for the biggestpart of it.(2) The Fed, with its commitment to QE, has de-facto set a cap on bond yieldsWe do not expect the Fed to announce any change in strategy in the near term, for thereasons highlighted on page 31.(3) Core inflation is likely to continue to fall for at least another 6-12 monthsWith unemployment at 9.6%, compared with a NAIRU of 5–6% and the lowest estimate(by the OECD) of the output gap being above 3%, it is difficult to see inflation going up anytime soon. Our US economists do not expect the core CPI to trough before end-2011 atthe earliest (with a point estimate of 0.4%, compared with 0.6% currently).Global Equity Strategy 63
  • 64. 08 December 2010Figure 144: Core inflation typically troughs when the Figure 145: Rent inflation lags house prices by 2 years,output gap turns positive suggesting further downside … and rents account for almost 40% of core CPI 6 25 8 US Output Gap, % of pot. GDP (lhs) 4 5 20 6 US Core CPI yoy (current - 12M ago, rhs) 3 15 4 4 2 10 2 1 3 5 0 0 2 0 1 -5 -2 -1 -10 -4 -2 0 US CPI Rent, y/y % (LHS) -15 -6 -3 -1 US existing home prices, y/y % , 2yr lead (RHS) -20 -8 -4 -2 -25 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010E 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research(4) Banks are still buying bonds to reduce their risk-weighted assetsBanks currently hold only 14% of their assets in government bonds, well below the peak of20% in mid-1994 when the yield curve was as steep as it is now. In our view, a major sell-off in bonds is possible only when banks resume lending to the private sector, thuscrowding out public debt (and this is unlikely to happen before the end of 2011, at theearliest, in our view).Figure 146: US banks’ holdings of government securities Figure 147: European banks’ holdings of bonds still loware 14% of total assets 24% US Commercial banks, US government/Agency 3.5 9.0% Euro-area banks, Government securities % total assets 2.5 securities % total assets 22% 3.0 Euro-area 10Y-2Y (rhs) US 10Y-2Y (rhs) 8.0% 2 2.5 20% 2.0 7.0% 1.5 18% 1.5 6.0% 1 16% 1.0 14% 0.5 5.0% 0.5 0.0 12% 4.0% 0 -0.5 10% -1.0 3.0% -0.5 1996 1998 2000 2002 2004 2006 2008 2010 8% -1.5 1975 1980 1985 1990 1995 2000 2005 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 64
  • 65. 08 December 2010Regional allocationOn regions, our biggest overweight remains the emerging markets – and NJA in particular.Our biggest underweights are the US and Continental Europe (which we downgraded frombenchmark to a 5% underweight in November—see Asset Allocation, emerging markets,Europe, 10 November 2010). We raise Japan to a 5% overweight and take the UK tobenchmark from a 5% overweight.Figure 148: Regional allocation recommended weights Hedged portfolio Benchmark Region Overweight / Recommended Change in weight (%) Previous weighting Previous weights (Underweight) weight (%) weighting US 46.7 -7% 43.5 -7% 43.5 0% Europe ex UK 19.1 -5% 18.1 -5.0% 18.1 0% UK 9.6 0% 9.6 5% 10.1 -5% Japan 9.5 5% 9.9 0% 9.5 5% GEM 15.1 25% 18.9 25% 18.9 0% Asia ex Japan 10.8 33% 14.4 33% 14.4 0%Source: MSCI, Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 65
  • 66. 08 December 2010Emerging markets: in our view thebest beta play—focus on NJAWe have been overweight both emerging markets and NJA for the past decade, apartfrom a six-month period in 2008. In 2010, we have added to our overweights in both NJAand GEM on three occasions (April, May and September), having reduced weightings to asmall overweight in the middle of 2009 (when risk appetite rose to extreme levels).We think that emerging markets are likely to enter a bubble – but that this is not yet trulyunder way. Fundamentals suggest to us that NJA should be on a P/E premium to theglobal average of around 30%, with a similar premium for GEM—yet currently NJA tradeson a 5% premium and GEM on a 4% discount. In the 1970s, the NJA countries traded onsubstantial premia (100%+) at a time when as now, developed markets had much worsefundamentals than emerging markets.Figure 149: NJA relative 12m P/E at the top of a 20-year Figure 150: … and the same is true for GEM in aggregaterange, but there is scope for re-rating 250% NJA rel World: 12m fw d P/E 240% GEM rel World: 12m fw d P/E Av erage 220% 220% Av erage 200% 190% 180% 160% 160% 140% 130% 120% 100% 100% 80% 70% 60% 40% 40% 1975 1981 1987 1993 1999 2005 2011 1988 1991 1995 1999 2003 2007 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchPE relatives are at the top end of their 20-year range but, as in the 1970s, thefundamentals suggest much more of a re-rating.Global Equity Strategy 66
  • 67. 08 December 2010Figure 151: NJA relative price/book Figure 152: GEM relative price/book 200% 140% P/B - Emerging Markets relativ e to World Av erage 180% 120% NJA rel World: P/B Av erage 160% 100% 140% 120% 80% 100% 60% 80% 40% 60% 40% 20% 1981 1986 1991 1996 2001 2006 2011 1996 1999 2002 2005 2008 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchWe calculate that the implied EPS growth in GEM stocks is only 40% higher than in theUS, even though the expected and actual long-term growth rates in GEM and NJA arealmost double. On our calculations, based on EIU estimates for trend growth and adjustingfor the overlapping geographical sales split (some GEM companies have exposure toforeign growth, as US companies have some exposure to GEM growth), GEM shouldtrade at a c40% premium to the US, as opposed to a 9% discount currently (and a 8%premium on a sector adjusted basis).Figure 153:GEM should trade at about 40% premium to the USVariables GEM US GEM premium RemarksGovt. bond yield 5.6% 3.0%ERP 6.1% 6.1% CS estimateCOE 11.7% 9.1% 28% CS estimate12m PE 11.6 12.7 -9% On IBES cons.Real growth 6.6% 2.6% 154% 2015E IMF est.Inflation 3.8% 1.9% 100% 2015E IMF est.Fair PE 17.5 12.4 42% 45% payoutImplied Growth 7.8% 5.6% 40% COE- payout/PE20Y hist. EPS growth 11.8% 6.1% 92%IBES LT EPS growth 19.9% 11.4% 74%Source: Thomson Reuters, EIU estimates, Credit Suisse estimatesIf we look at Non-Japan Asia, on our estimates the implied growth premium is only 19%relative to the global average, compared to a long-term GDP growth premium of 111% onEIU estimates (136% premium on historical GDP growth).Global Equity Strategy 67
  • 68. 08 December 2010Figure 154: Implied growth rate premiums for NJA and GEM are smaller than theirearnings and GDP track record suggests Premium of NJA over Premium of GEM overGrowth rate NJA GEM World global growth global growthHistoric 10-year GDP 6.4 7.3 2.7 136% 168%Historic 10-year EPS 16.7 22.0 8.3 101% 166%Expected long-term GDP 6.7 7.5 3.2 111% 136%Implied EPS growth 7.5 7.8 6.3 19% 24%Source: Thomson Reuters, IBES estimates, EIU estimates, Credit Suisse estimatesThe structural argumentWe also believe that this time around, GEM is structurally much better positioned than thedeveloped market and thus should re-rate—to a potentially 30% premium—for fourreasons:(1) Superior productivity growth, fuelled by the switch from rural to manufacturing employment and increasing school enrolment. These trends are still very much in place.Figure 155: Employment in agriculture (% of total Figure 156: School enrolment, tertiary education (%employment) gross) 60 90 80 US 50 Russia Indonesia 70 OECD high income 40 Ch ina 60 30 50 Turkey 40 20 Braz il Turkey Mexico 30 Brazil Mexico 10 Ru ss ia 20 China OECD h igh inc ome Indonesia 10 0 India US 0 04 08 84 88 92 96 80 00 20 19 19 19 19 19 20 20 91 93 97 99 03 95 01 05 07 20 19 19 20 20 19 19 19 20Source: World bank, Credit Suisse EMEA Equity strategy Source: World bank, Credit Suisse EMEA Equity strategyWe would highlight that about half of the Chinese population still work on the land – andthe reform of the Hukou system (by which rural migrants are not registered as urbandwellers and so have no or very limited access to social security and services) could leadto an increase in urban migration.(2) Superior balance sheets in the public and private sector, banks and central banks (FX reserves).Global Equity Strategy 68
  • 69. 08 December 2010Figure 157: 2010E NJA and GEM government debt to GDP Figure 158: 2010E NJA and GEM budget deficit is only 3%is only 33% and 36%, respectively, compared with 93% in and 3.2% of GDP, compared with 9% of GDP in the USthe US 110% Govt debt to GDP 4% Budget Balance, % of GDP 100% NJA 2% GEM United States 90% 0% 80% -2% 70% -4% 60% -6% GEM 50% -8% NJA US 40% -10% 30% -12% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010Source: IMF, Credit Suisse research Source: IMF, Credit Suisse researchFigure 159: NJA and GEM private sector is Figure 160: NJA bank leverage is very lowunderleveraged, with credit to GDP of 99% and 77% ofGDP, compared to 173% of GDP in the US 190% Priv ate Sec tor credit, % of GDP 35 GEM Tangible assets to tangible equity 170% 30 NJA US 150% 25 130% 20 110% 15 90% 10 70% 5 50% 0 1991 1994 1997 2000 2003 2006 2010 EMEA Latam US NJA UK Japan Europe ex UKSource: IMF, Credit Suisse research Source: Credit Suisse HOLT, Credit Suisse research(3) GEM currencies, in aggregate, are around 20% undervalued against the dollar on our FX team’s models (30% for NJA currencies) – and are still around 25% below the level of 1997 (15% for NJA).Global Equity Strategy 69
  • 70. 08 December 2010Figure 161: NJA currencies still undervalued against the Figure 162: … and 15% below the level of 1997dollar, by about 30% … - 80% Deviations from FV +/- One St. Dev. Band expensive 110 60% GEM NJA EMEA Latam 100 40% 90 20% 80 0% 70 -20% 60 -40% cheap 50 -60% USD TWI CNY SEK JPY KRW PLN SGD MXN EUR CAD ZAR NZD AUD CHF THB GBP NOK CZK TWD HUF 40 Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- 96 98 99 01 02 04 05 07 08 10Source: Credit Suisse FX team Source: Thomson Reuters, Credit Suisse researchWe also highlight that on our emerging markets economics team’s REER fair valuemodels—based on productivity, terms of trade and short-term rates—the only emergingmarkets countries with overvalued exchange rates (and current account deficits) arecurrently Brazil and Turkey.(4) More sustainable RoE drivers, with a large part of the improvement in RoE coming from asset turns and lower interest costs (as a result of de-leveraging), rather than margins, as in the US. Historically, we find that improvements in asset turns are more sustainable than improvement in net margins.Figure 163: Over the last cycle, an improvement in asset Figure 164: … while in the US improvements were largelyturns and interest burden was one the key drivers of driven by higher marginsprofitability in NJA … M SC I NJ A 6% 4% S&P Industrials 1998 - 200 9 5% 3% 1993 - 2009 3% 4% 2% 3% 2% 2% 1% 1% 1% 0% 0% -1 % -1% -1 % -2% -2 % -2 % -3% Ta x In teres t EBIT As set T urn Le verage RoE Tax Interest EBIT Asset Turn Lev erage RoE Burde n Burd en marg in Burden Burden m arginSource: Credit Suisse HOLT, Credit Suisse research Source: Credit Suisse HOLT, Credit Suisse researchGlobal Equity Strategy 70
  • 71. 08 December 2010We note that the RoE in emerging markets relative to the cost of government debt is atrecord levels, while this measure for the US is only at average levels.Figure 165: GEM ROE vs bond yields at a record high … Figure 166: … but not in the US 12% 16% GEM return on equity minus cost of government debt US return on equity minus cost of gov ernment debt 10% 14% 8% 12% 6% 10% 4% 8% 2% 6% 0% 4% -2% 2% -4% 0% -6% -2% 1998 2000 2002 2004 2006 2008 2010 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchAdditionally, as a sanity check, we find that GEM market cap to GDP and market cap percapita are not extreme.Figure 167: GEM market cap to GDP is in line with other Figure 168: GEM market cap per capita is also belowregions other regions 140% 50,000 45,294 124% 45,000 120% Market cap to GDP 38,160 40,000 Market cap per capita, USD, 000s 100% 35,000 81% 80% 30,000 25,940 63% 63% 61% 22,496 59% 25,000 54% 60% 20,000 40% 15,000 10,000 4,959 20% 2,700 5,000 2,075 0% 0 UK US GEM NJA Japan Cont. LATAM UK US Japan Cont. LATAM GEM NJA Europe EuropeSource: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchThis is important because we believe that in the long term global productivity per capitawill converge, owing to improvements in technology that allow greater trade in globalservices and also minimise the differences in human capital in the production process.Moreover, the increasingly global nature of business education enables improvements inmanagement processes to be spread more easily. Finally, human capital is improvingmuch more quickly in emerging markets and this again increases the relevance of marketcap per unit of population.Global Equity Strategy 71
  • 72. 08 December 2010The tactical argumentTactically, the following factors also support emerging markets: a) The weaker dollar and QE2About 80% of the time the dollar weakens, NJA and GEM outperform, on our calculations.This is because NJA de facto adopts US monetary policy, with Hong Kong being the mostobvious example, due to its currency board. As we have argued above, the dollar couldweaken a lot further (25% on a tradeweighted basis before weakness poses a problem forthe Fed).Figure 169: NJA tends to outperform when the dollar Figure 170: … and the same is true for GEM overallweakens (local currency terms) … NJA price rel. (local currency , lhs) GEM price rel. (USD, lhs) 1.0 70 1.0 70 0.9 USD TWI (rhs, inv erted) 0.9 USD TWI (rhs, inv erted) 80 80 0.8 0.8 0.7 90 0.7 90 0.6 0.6 100 100 0.5 0.5 0.4 110 0.4 110 0.3 0.3 120 120 0.2 0.2 0.1 130 0.1 130 1990 1993 1996 1999 2002 2005 2008 2011 1990 1993 1996 1999 2002 2005 2008 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research b) The asset bubbleWe think GEM—in particular, NJA—is likely to experience an asset bubble, for thefollowing reasons:■ QE results in excess liquidity looking for both higher rates and higher currency appreciation. Not surprisingly, part of this ends up going into emerging markets. In the case of China not all of the increase in reserves can be sterilised (as if it was, rates would rise and that would put pressure on the RmB to revalue; moreover the capital markets are not deep enough to absorb the new issuance). Money inflows then lead to an increase in money supply and that has tended historically to help equity multiples.Global Equity Strategy 72
  • 73. 08 December 2010Figure 171: An increase in FX reserves leads to a rise in Figure 172: … which, in turn, should drive up assetmoney supply … valuations 200 45 1000 China: 450 DS China equity index PE, y/y% (lhs) 900 400 China M1 growth, y/y% (rhs) 40 Change in M1, last 12m ($bn) 150 800 350 35 Money inflow, last 12m ($bn) 700 300 100 30 250 600 200 25 500 50 150 20 400 100 300 0 15 50 200 0 10 100 -50 -50 5 0 -100 Oct- Apr- Oct- Apr- Oct- Apr- Oct- Apr- Oct- Apr- Oct- -100 0 05 06 06 07 07 08 08 09 09 10 10 1997 1998 2000 2002 2003 2005 2007 2008 2010Source: Thomson Reuters, Credit Suisse research. Money inflows are Source: Thomson Reuters, Credit Suisse researchcalculated as change in FX reserves minus current accountClearly capital inflows are manifesting in rising FX reserves, with the exception of Russia,which has experienced capital outflows over the last 10 years. In China, FX reserves haverisen by almost $200bn in the third quarter alone.Figure 173: NJA and GEM FX reserves are rising Figure 174: The BRIC countries have seen significant capital inflows, with the exception of Russia, over the last 10 years 8,000 FX reserv es, $ bn External account since 2001 (annual average, %GDP) 7,000 Current Net Change in FX NJA GEM Country Capital Flows 6,000 account Borrowing res. 5,000 China 5.9% 1.2% 2.6% 8.6% India -0.5% 1.0% 2.9% 3.1% 4,000 Brazil -0.4% 0.3% 1.8% 1.9% 3,000 Russia 8.3% 1.8% -4.3% 5.8% 2,000 1,000 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Source: IMF Source: Thomson Reuters, EIU, Credit Suisse researchMonetary conditions are set to stay too loose: we can see below that monetaryconditions in emerging markets are still too loose in spite of most of the major marketsbeing close to full capacity when we look at output gap.Global Equity Strategy 73
  • 74. 08 December 2010Figure 175: NJA monetary conditions are still very loose Figure 176: … but GDP is already above potential… 1.0 10% 5% 0.5 0% 0.0 -5% -0.5 -10% 2010E Output Gap, % potential GDP -15% -1.0 NJA MCI, st. dev. from average -20% -1.5 -25% Philippines Turkey US Argentina China Thailand Indonesia Hong Russia Poland South Malaysia Czech Japan France Netherlan Sweden Colombia Brazil Israel Belgium Germany Norway Italy Denmark UK India Taiwan Korea Austria Australia Canada Spain Greece -2.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, EIU, Credit Suisse estimatesIn India, China, Korea, Thailand and Hong Kong, real rates are negative. This tends todrive consumers into real assets as a form of inflation hedge. This rise in asset pricescould be particularly large because GEM countries tend to have abnormally high savingsratios (China: 39% of disposable income, India: 30%, Russia: 17% on our regionaleconomists’ estimates).Figure 177: Interest rates are below the nominal GDP growth rate in all major EMeconomies with the exception of Brazil Real GDP growth Interest rate minus Current Nominal GDP Interest rate Real rate (2011 EIU nominal GDP Long term rate Output Gap inflation growth estimate) growthIndia 6.3 9.8 -3.6 8.6 18.4 -12.2 8.0 4.5%Hong Kong 0.5 2.5 -2.0 4.3 6.8 -6.3 2.5 1.1%China 2.8 4.4 -1.6 8.9 13.3 -10.5 4.0 3.0%Thailand 1.8 2.8 -1.0 4.0 6.8 -5.0 3.6 1.7%Korea 2.5 3.3 -0.8 3.9 7.2 -4.7 4.4 -2.9%Indonesia 6.5 6.3 0.2 6.0 12.3 -5.8 7.6 1.7%Russia 7.8 7.5 0.3 4.0 11.5 -3.8 5.8 -0.1%Singapore 4.3 3.5 0.8 4.2 7.7 -3.5 2.3 -1.6%Brazil 10.8 5.4 5.4 4.5 9.9 0.9 4.1 5.0%Source: Thomson Reuters, EIU, Credit Suisse research. For China we use the 1-year deposit rate.In the long run we think the appropriate monetary policy is to have interest rates close tonominal GDP, especially in economies where there is limited spare capacity (as proxied bythe output gap). Yet seven out of the eight main emerging market economies shownabove are operating close to full capacity, with rates being at least 3pp below nominalGDP, excluding Brazil (in the case of India and China, rates are more than 10pp belownominal GDP growth).We acknowledge that a few countries have recently started to hike rates (China raised by25bps to 2.5% on 19 October and Korea by 25bps to 2.5% on 16 November, Thailand by25bp on 1 December), but critically the rise in rates has been less than the rise in inflation,leaving real rates lower than they were at the start of the year.Global Equity Strategy 74
  • 75. 08 December 2010In our view, the only way to have an appropriately tight monetary policy would be to allowthe domestic currency to revalue at the same time as raising rates significantly. For this tohappen, the RMB would have to appreciate significantly; however, Premier Wen believesthat with profit margins of the non-quoted export sector are already very low, such a RMBappreciation would potentially be problematic (he is quoted by Reuters as saying onOctober 7th in Brussels that a faster rise in the renminbi could cause social unrest inChina as “many of our exporting companies would have to close down, migrant workerswould have to return to their villages”). We believe that other emerging markets areunlikely to allow their currencies to appreciate significantly against the RMB, as this wouldreduce their market share in commoditised manufactured goods.Dong Tao, head of Credit Suisse’s China Economics team, expects a150bp hike in ratesby the end of 2011 and a new lending quota of RmB 6trn—this would be below the quotaof RmB 7.5trn for 2010 but would still imply loan growth of 13% for 2011.We believe the only way to stop a bubble forming would be to raise rates aggressively. Yet,this would lead to an undesirable appreciation in exchange rates.Capital controls may partially help to alleviate the extent of a liquidity bubble, butfundamentally capital controls have two problems:■ they can be relatively ineffective: for example, Brazil and Thailand would need to impose a tax on capital inflows of 97% and 85%, respectively to make their domestic rates equal to that of the US on a post-tax basis); and■ in the case of China there is a need to create capital outflows (to offset a current account surplus of 5% of GDP and no amount of control on capital inflows can create the outflows. c) NJA is the best performing region into a global soft landingHistorically, NJA has been the best performing region in a soft landing—defined as phaseswhen the ISM falls but troughs above 50—as opposed to a hard landing.Figure 178: Regional relative performance when ISM rolls Figure 179: Regional relative performance when ISM rollsover but stays above 50 (since 1980) over and falls below 45 (since 1980) 7% Median relative performance during "soft-landings" (i.e. ISM 6% 4.8% rolls over and troughs above 50) 4% 6% 1.7% 2% 5% 0% -0.1% -2% -0.8% -0.9% 4% -4% 3% -6% 2% -8% Median relative performance during "hard-landings" -10% (i.e. ISM rolls over and troughs below 45) 1% -12% 0% -14% -13.2% -16% -1% UK US Eur exUK NJA GEM Japan NJA Japan UK GEM Eur exUK USSource: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchEven as lead indicators roll over and the Fed is not raising rates, GEM, and within thatNJA, can be the best performing region.Global Equity Strategy 75
  • 76. 08 December 2010Figure 180: NJA and GEM outperformed after peak in ISM New orders in 1993 and 2002 (‘soft-landings’ with the Fed notraising rates) Periods following a peak in ISM New orders and before Fed hike. Relative performance vs. MSCI World. Duration Start End ISM Peak ISM at end US Eur exUK UK Japan GEM NJA (mm) Dec-83 Feb-84 2 74.8 64.9 -3.7% 4.5% 6.9% 5.6% - 9.2% Sep-86 Dec-86 3 61.1 55.4 0.7% -0.9% 3.6% -1.7% - 16.5% Jan-93 Jun-93 5 63.0 51.6 -6.3% 2.7% -4.5% 9.3% 22.2% 6.8% Jun-96 Oct-96 4 59.4 52.9 3.1% 0.3% 5.2% -9.3% -6.0% -6.5% Mar-02 Nov-02 8 59.4 52.9 2.0% -9.1% -2.0% 5.0% 7.9% 4.8% Jan-04 Jun-04 5 70.6 60.9 -1.3% -1.0% 0.2% 9.5% -7.8% -10.3% Average 5 64.7 56.4 -0.9% -0.6% 1.6% 3.1% 4.1% 3.4% % of times positive return 50% 50% 67% 67% 50% 67%Source: Thomson Reuters, Credit Suisse research. Soft landings defined as economic slowdowns in which the ISM New orders does not fallbelow 50.More importantly, we can see that there is a 4:1 ratio between NJA exports and US retailsales—thus a potential pick up in US retail sales particularly helps NJA.Figure 181: There is a 4:1 ratio between NJA exports and Figure 182: Chinese retail sales appear to have decoupledUS retail sales from US retail sales 40% 24% US nominal retail sales, y /y , % 9% Chinese nominal retail sales, y /y , % 30% 19% 20% 14% 4% 10% 9% 0% -1% 4% -10% -1% -6% -20% US nominal retail sales, y /y , 3m lead -30% -6% NJA ex ports, y /y , % -11% -40% -11% 1994 1996 1999 2002 2005 2008 2011 1997 1999 2001 2004 2006 2008 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research d) GEM is essentially a growth ‘stock’ that benefits from low discount ratesWe believe that the discount rate (i.e. cost of debt) will remain abnormally low and thus willre-rate long duration earnings (i.e. growth).Global Equity Strategy 76
  • 77. 08 December 2010Figure 183: Growth stocks tend to have more upside if the discount rate falls 180% 160% % change in the fair value of: 140% High growth (=5%) stock 120% Low growth (=2%) stock 100% 80% 60% 40% Discount rate falls 20% 0% 5% 4% 3% 2% 1% 0% Bond yieldSource: Credit Suisse estimates e) Benefits from higher commodity pricesFor the commodity exporters, the rise in commodity prices (on account of QE) leads to apotentially very large terms-of-trade—and even volume—boost.The major GEM commodity net exporters (as a percentage of GDP) are Saudi Arabia,Russia, Argentina and Malaysia, as shown below.Figure 184: Net Commodity exports, as a percentage of GDP 60% N et comm odity ex ports , as % of GDP 50% 40% 30% 20% 10% 0% -10% -20% South Africa United States Portugal Argentina Austria Indonesia Ireland N etherlands Denmark Italy United Kingdom Saudi Arabia R ussia Australia France Switzerland Finland C hina Japan Singapore H ungary Czech R epublic Brazil M alaysia Canada Sweden Spain Mexic o Thailand Korea Germany Norw aySource: WTO, World Bank, Credit Suisse researchFurthermore, we would note that in aggregate, GEM markets are overweight commodities,suggesting they should outperform if commodity prices were to rise further.Global Equity Strategy 77
  • 78. 08 December 2010Figure 185: GEM has a 25% weight in commodity-related Figure 186: GEM tends to outperform when commoditiessectors, 9pp above the global average rise 1100 CRB metals MSCI GEM relativ e, rhs 3.5 35% 33% 1000 3.3 Energy + Mining, % market cap 30% 900 3.1 25% 800 2.9 25% 700 2.7 20% 16% 600 2.5 15% 500 2.3 13% 400 2.1 10% 8% 300 1.9 5% 5% 200 1.7 100 1.5 0% UK GEM Global US Eur ex UK Japan 2003 2004 2005 2006 2007 2008 2009 2010 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research f) Neither NJA nor GEM yet have excessive risk appetite or excessive inflowsWe acknowledge that risk appetite in GEM is among the most extended of any region, butwe note that in relative terms it is well below previous peaks. When the GEM relative riskappetite has historically been at current levels, GEM has tended to outperform over thesubsequent 3–6 months (see Appendix 5).Figure 187: GEM risk appetite is high … Figure 188: … but well below previous peak relative to global 0.5 2.5 Equity sector Risk appetite (number of GEM rel Global risk appetite 0.4 2.0 standard dev iations) 0.3 1.5 0.2 1.0 0.1 0.0 0.5 -0.1 0.0 -0.2 (1.15) -0.5 -0.3 -1.0 -0.4 -1.5 UK US Japan GEM Europe ex UK -2.0 1996 1999 2002 2005 2008 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchFurthermore, inflows into GEM funds have picked up recently, but are still far fromprevious highs.Global Equity Strategy 78
  • 79. 08 December 2010Figure 189: Inflows into NJA funds have picked up Figure 190: Inflows into BRIC funds are flatrecently, but are still relatively low 60% 3m annualised net flow s into NJA 160% 3m annualised net flow s into BRIC equity funds, as a % of assets equity funds, as a % of assets 50% 120% 40% 30% 80% 20% 40% 10% 0% 0% -10% -40% -20% -80% -30% -40% -120% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Jan-06 Sep-06 May -07 Jan-08 Sep-08 May -09 Jan-10 Sep-10Source: EPFR, Credit Suisse research Source: EPFR, Credit Suisse researchGlobal Equity Strategy 79
  • 80. 08 December 2010Two potential threats for GEM 1) A potential inflation problemA combination of a loose monetary policy and negative output gaps (i.e., real GDP abovetrend) would, we believe, lead to accelerating inflation. Yet on our estimates, onlyArgentina, India and Brazil have output gaps above 4% of GDP, a level associated withinflation rates above 5%, as shown on page 19.When does the market worry about the inflation problem?The critical question is: at what stage do investors worry about the sharp rise in inflationand perceive that overheating is becoming unmanageable? For this, we look at fiveinstances of historical overheating (Mexico and Turkey in 1994, Thailand in 1997,Malaysia in 1997 and Spain during the present crisis) and find that the problems do nottend to manifest until the country has run a current account deficit for years (at least fouryears, in our sample) and has net foreign liabilities.Figure 191: Instances of overheating in the past were Figure 192: ... resulting in net foreign liabilities at the peakoften triggered after countries had been running current of the overheating phase ...account deficits for years ... 0 40% Net International inv positions during year of overheating -2 20% -4 0% -6 % -20% -8 -40% -10 CA balance in previous overheatin g episodes -60% -12 Thailand 1995 Spain 2007 Malaysia 1995 Turkey 1993 M exico 1994 -80% -100% Turkey Mex ico Thailand Malaysia Spain 2008 China 1994 1994 1997 1997Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchHowever, GEM on aggregate is still running a current account surplus and has significantlyimproved its net external investment position, with NJA having net foreign assets of 16%.Global Equity Strategy 80
  • 81. 08 December 2010Figure 193: GEM now has a significant current account Figure 194: ... and is net foreign creditors (netsurplus ... international investment position, % GDP 4.5 20% International inv estment position, Net assets as % of GDP 4.0 3.5 10% GEM NJA 3.0 2.5 0% 2.0 1.5 -10% 1.0 0.5 -20% 0.0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 -30% GEM: Current account balance, as % of GDP 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchFigure 195: Historically, countries that suffered from a Figure 196: … yet, FX reserve levels relative to GDP arecrisis after a period of overheating have found considerably higher now than they used to bethemselves constrained by a lack of FX reserves … 60% FX Reserves during year of crisis 60% FX Reserves, % GDP 50% 50% 40% 40% 30% 30% 20% 20% 10% 10% 0% Thailand 1997 China 2010 Malaysia 1997 Turkey 1994 Mexico 1994 0% India Thailand Indonesia Brazil GEM Malaysia China Russia Korea Mexico TurkeySource: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research 2) Rising food pricesFood is a very high proportion of the CPI basket in emerging markets, and food prices areup sharply.Global Equity Strategy 81
  • 82. 08 December 2010Figure 197: Emerging markets are more exposed to food Figure 198: Chinese food inflation is 10%—much lowerprice inflation than the 19% rise in CRB food stuffs 60.0 50 CRB food stuffs, y /y % Emerging markets much more exposed to a bout of 40 China food price inflation 50.0 food price inflation 30 40.0 20 10 30.0 0 20.0 -10 10.0 -20 -30 0.0 -40 Taiwan Japan Hong Kong India China Philippines Brazil Europe US UK Australia Mexico Poland Chile Argentina Malaysia Thailand Russia Turkey Korea Singapore S. Africa Indonesia Colom bia 2001 2003 2005 2007 2009 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchHowever, we would note that Asia relies mainly on wheat and rice, and the prices for bothare up a lot less that other commodities.Figure 199: Rice and wheat are still some way off previous peaks Cotton 41% Silver 37% Rubber 26% Palladium % difference vs 07-09 peak 21% Coffee 21% Gold 14% Pulp 6% Nylon 3% Tin -2% Copper -3% Rapeseed -5% Lum ber -7% Raw sugar -10% Aluminum -20% Cocoa -21% Soyabean -22% C orn -24% Barley -31% Oil -40% Lead -44% Steel -47% Wheat -47% Rice -49% Zinc -53% N ickel -68% -57% NatGas -70% -50% -30% -10% 10% 30%Source: Thomson Reuters, Credit Suisse researchHowever, our thematic research analyst Mary Curtis points out that in the past threeoccasions when food prices have been up this much (i.e. more than 30% year on year),they have subsequently corrected by an average of 8%.Global Equity Strategy 82
  • 83. 08 December 2010What to buy in GEM?Our GEM P/E model highlights Russia, Korea and China as the most attractively valuedamong the emerging markets.Figure 200: Our GEM P/E model highlights Russia, Korea and China 60% Ex pensiv e Cheap 50% 40% Gap betw een 12m fw d P/E and model estimate 30% 20% 10% 0% -10% -20% -30% -40% Sout h Africa I ndonesia India Hong Kong China Korea Brazil Egypt Colombia Chile Singapore Malaysia Thailand Poland Russia Philippines Hungary US Mexico TurkeySource: Thomson Reuters, IMF, OECD estimates, National data, Credit Suisse estimatesWe show the details of our model, which is based on total debt, the budget balance, thecurrent account balance, gross savings ratios, potential GDP growth and inflation, inAppendix 6.The cheapest plays in our preferred and cheapest (on Credit Suisse HOLT®) GEMmarkets (Russia, Korea and China) are listed below: we highlight Sberbank and Lukoil inRussia, Samsung and Posco in Korea, and Guangxi in China.Global Equity Strategy 83
  • 84. 08 December 2010Figure 201: Stocks in Russia, Korea, China that look cheap on Credit Suisse HOLT®, have FCF yields above 5% and arerated Outperform by Credit Suisse) -----P/E (12m fwd) ------ ------ P/B ------- Yield (2010e) HOLT Momentum rel to mkt % rel to mkt % Price, % Consensus 3m Sales 3m EPS Credit SuisseName Abs rel to Industry above/below Abs above/below FCY DY change to (buy less holds rating average average best & sells)Weichai Power Co 11.8 76% 29% 5.9 134% 6.7% 0.9% 62.5 17.8 12.9 25.0 OutperformBaoshan Iron & Ste 7.9 70% n/a 1.1 n/a 6.4% 4.8% 118.2 24.8 2.7 83.3 OutperformAngang Steel Co Lt 12.4 110% 102% 1.5 8% 5.0% 2.7% 18.0 -13.2 -2.4 -16.7 OutperformYangzijiang Shipbu 11.6 74% n/a 0.9 n/a 7.3% 2.3% 44.9 13.3 2.4 14.3 OutperformGuangxi Liugong Ma 14.2 91% n/a 5.0 n/a 5.6% 1.2% 118.0 28.7 14.1 75.0 OutperformLonking Holdings 11.7 75% n/a 4.5 n/a 6.1% 2.1% 21.3 25.5 16.2 25.0 OutperformShantui Constructi 12.5 80% n/a 3.4 n/a 5.5% 1.3% 143.4 12.0 10.2 81.8 OutperformSamsung Ele ctronic 9.3 76% 9% 1.7 8% 10.8% 1.3% 99.7 -5.9 -8.7 91.1 OutperformSberbank Rossii 8.7 90% 13% 2.7 11% n/m 0.4% 4.4 -6.2 7.2 100.0 OutperformLukoil Oil Company n/a n/a n/a 24.7 n/a n/a n/a n/a n/a @NA n/a OutperformPosco 7.7 69% 8% 1.0 32% 7.2% 2.1% 65.8 -8.0 -0.4 100.0 OutperformHyundai Mobis 9.5 77% 32% 2.9 76% 10.2% 0.6% 176.5 11.2 2.6 90.7 OutperformLg Chemical n/a n/a n/a 4.3 301% 7.1% 1.1% 34.3 n/a @NA 80.0 OutperformSk Energy Co Ltd 9.2 85% n/a 1.5 n/a 7.7% 1.5% 16.9 7.9 2.0 79.5 OutperformLg Display Co Ltd 9.4 n/a 42% 1.3 -13% 8.5% 1.2% 84.4 -28.5 -0.9 50.0 OutperformKt Corporation 7.4 67% -15% 1.0 -2% 17.8% 5.6% 92.8 -3.1 2.3 82.9 OutperformKt&G Corporation 10.4 83% 17% 2.0 14% 10.4% 4.6% 21.4 6.8 -1.0 67.6 OutperformHyundai Mipo Dock 7.1 45% 7% 1.1 -32% 14.3% 2.0% 32.9 3.9 0.7 57.1 OutperformNeowiz Games Co Lt 10.5 81% n/a 3.9 n/a 8.0% 0.0% 31.3 NM NM 92.9 OutperformDaum Communication 11.2 61% -51% 3.9 -21% 9.9% 0.0% 61.3 32.6 0.6 68.8 OutperformSource: MSCI, I/B/E/S, Thomson Reuters, Factset, Credit Suisse HOLT, Credit Suisse researchOur NJA strategist Sakthi Sivas preferred countries are Korea, China and Thailand. Withinthese countries her top stock picks are Hyundai Heavy, Samsung Electronics, HyundaiMobis, ABC and SCB. We show valuations of these stocks on our scorecard in the tablebelow.Figure 202: Our NJA strategist’s top picks in preferred countries -----P/E (12m fwd) ------ ------ P/B ------- Yield (2010e) HOLT Momentum rel to mkt % rel to mkt % Price, % Consensus 3m Sales 3m EPS Credit SuisseName Abs rel to Industry above/below Abs above/below FCY DY change to (buy less holds rating average average best & sells)Hyundai Heavy Inds 9.6 61% 30% 2.1 109% 12.1% 1.0% 37.3 11.4 0.5 78.4 NeutralHyundai Mobis 10.1 82% 34% 3.0 75% 10.2% 0.5% 176.5 11.5 2.9 91.1 OutperformAgricultural Bk Ch 10.4 99% n/a 4.1 n/a n/m 3.2% n/a -0.3 -3.3 -23.1 OutperformSiam Commercial Bk 14.2 135% 56% 2.7 79% n/m 2.6% -4.2 0.2 0.0 79.0 OutperformSamsung Ele ctronic 9.3 76% 9% 1.7 8% 10.8% 1.3% 99.7 -5.9 -8.7 91.1 OutperformSource: MSCI, I/B/E/S, Thomson Reuters, Factset, Credit Suisse HOLT®, Credit Suisse researchOur EMEA strategist Alex Redmans preferred countries are Russia, Poland, Egypt,Hungary, while he is underweight South Africa.We are underweight India, where we see the following negatives:a) India is the most expensive GEM market in our scorecard;b) Monetary policy is very loose, with interest rates of 6.25%, real GDP growth of 10%,and nominal GDP growth of 21%%. As we highlight above, based on history short ratesshould be close to nominal GDP. Even the IMF is now warning that India is overheating;Global Equity Strategy 84
  • 85. 08 December 2010c) India is heading for a current account of 3.3% and a budget deficit of 8.5% in 2011E,according to our economists;d) India is a net commodity importer – in particular its net oil imports are 4% of GDP atcurrent oil prices;e) The Rupee is overvalued by 4% on our fixed income research team’s model—seeFigure 203; andf) Portfolio flows into India have been extreme this year.So far this year, net FII flows into Indian equities have been $26bn compared to a previouspeak of $18bn in 2007, with India accounting for more than half the NJA ex-China flowscompared to its market cap weight of 20%, according to our NJA strategist Sakhti Siva.According to the Financial Times (November 29th), which quotes the Indian regulator’sdata, foreign investors have turned net sellers of Indian stocks after the issues surroundingIndia’s 2G telecoms licence auctions, with net outflows of $158m since 12 November.We also highlight that India is the top underweight country of Sakhti’s NJA regionalportfolio (Asia Equity Strategy: 2011 Outlook, November 23rd).We would be neutral Brazil despite it looking cheap on our scorecard. There are threefeatures that worry us: an output gap of 5% (which poses an inflation risk); a currentaccount deficit of 3.5% estimated by our economists for 2011 (implying a loss ofcompetitiveness) and a Real that is now 35% overvalued. The reason we avoid anunderweight is that on our model it is cheap and Brazil is also the only GEM country withshort rates above nominal GDP—i.e., at appropriate levels.Figure 203: The Brazilian real is the most overvalued currency in the GEM universe onour model 40% Overvaluation REER, % deviation from fair value 30% 20% 10% 0% -10% Model based on: productivity, terms of trade, short-term real rates -20% -30% Brazil Israel Czech Republic Egypt Chile Thailand Russia Saudi Arabia Poland Peru Korea Colombia Indonesia India Venezuela Singapore South Africa Nigeria Mexico Malaysia Kazakhstan China Ukraine Argentina Hungary Turkey Philippines Taiwan Romania Hong KongSource: Credit Suisse Fixed Income research, Global Equity strategy teamThe decision of the Central Bank of Brazil on 3 December to raise the additional reserverequirement rate from 8% to 12% on cash and time deposits and to raise capitalrequirements on household loans with maturities above two years, highlights the risk ofmonetary policy tightening in an environment of rising inflationary pressures (headline CPIrose to 5.4% in October).Global Equity Strategy 85
  • 86. 08 December 2010Direct versus indirect NJA playsInvestors often ask us about the relative merit of playing the GEM story through direct orthrough indirect plays. We note that direct NJA plays are now one standard deviationexpensive against indirect plays (although, in absolute terms, they are still trading at aslight discount). Furthermore, we note that indirect NJA plays now look attractively valuedrelative to the global market.Figure 204: Direct NJA plays have recently appreciated Figure 205: Indirect NJA plays now look attractivelyagainst indirect NJA plays valued relative to global markets 310% 12m fw d P/E NJA indirect rel NJA direct Av erage NJA indirect play s 12m fw d P/E rel World 240% Av erage 260% 190% 210% 140% 160% 90% 110% 60% 40% 1990 1993 1996 1999 2002 2005 2008 2011 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchWe show the corresponding charts for GEM in Appendix 7.Focusing on GEM—and particularly NJA—consumer playsWe have continued to focus on the consumer plays, partly because the consumer share ofGDP in the BRIC countries is abnormally low and partly because an appreciation of theexchange rate greatly benefits consumers (as they benefit from the greater purchasingpower that a stronger exchange rate brings). The table below shows our preferred directNJA consumer plays.Global Equity Strategy 86
  • 87. 08 December 2010Figure 206: The direct plays on the NJA consumer -----P/E (12m fwd) ------ ------ P/B ------- Yield (2010e) HOLT Momentum rel to mkt % rel to mkt % Price, % Consensus 3m Sales 3m EPS Credit SuisseName Abs rel to Industry above/below Abs above/below FCY DY change to (buy less holds rating average average best & sells)Agricultural Bk Ch 9.7 97% n/a 2.6 n/a n/m 3.4% n/a 1.3 1.1 -25.9 OutperformChina Mobile Ltd 10.9 76% -12% 2.9 5% 6.2% 3.9% 100.8 -0.1 0.1 3.2 OutperformHero Honda 14.6 123% 34% 10.2 58% 5.8% 2.1% 67.1 -5.5 0.2 -54.3 OutperformKt&G Corporation 10.7 85% 16% 2.1 14% 11.1% 4.5% 24.4 7.4 -0.9 68.4 OutperformHtc Corporation 14.2 105% 43% 12.7 83% 5.2% 4.0% 2.7 13.1 8.3 53.3 OutperformSiam Commercial Bk 13.3 132% 48% 2.5 74% n/m 2.7% -5.1 1.5 0.6 80.0 OutperformWilmar Interl Ltd 15.7 108% n/a 3.7 n/a 2.8% 1.2% -1.6 -20.4 1.0 23.8 OutperformAsian Paints Ltd 24.7 169% 66% 23.5 276% 2.7% 1.4% -10.2 -1.1 -0.6 72.7 OutperformCdl Hospitality Tr 16.7 n/a n/a 1.4 n/a n/m 5.2% -12.3 3.2 -1.0 33.3 OutperformChina Mengniu Dair 19.3 133% -8% 4.3 -8% 1.1% 0.9% -27.0 -0.5 0.0 70.4 OutperformGome Electrical Ap 18.2 119% 19% 3.8 -32% 3.9% 0.9% -36.5 2.5 1.4 50.0 OutperformIndosat Tbk 22.5 157% 123% 1.8 -5% -0.9% 1.7% -39.5 -22.3 -0.9 -26.3 OutperformTaiwan Fertilizer 27.6 189% 45% 2.2 184% -24.7% 1.9% -56.3 3.5 NM 50.0 OutperformSource: MSCI, I/B/E/S, Thomson Reuters, Factset, Credit Suisse HOLT, Credit Suisse researchGlobal Equity Strategy 87
  • 88. 08 December 2010Japan: raise from benchmark to asmall overweightWe believe that tactically Japan should outperform for the following reasons: (1) This is the right stage of the cycle for JapanWe find that historically Japan starts outperforming 4 months after the trough in global leadindicators and we think global momentum troughed in October.The rationale for this is that Japan is the most operationally leveraged market as itseconomy has the highest fixed cost base and, of the major economies, is the most indeflation. On our calculations, Japan’s EPS rises 5.2% for each 1% increase in globalindustrial production, compared to 2.9% in the US, as shown below.Figure 207: Japan typically outperforms 4 months after Figure 208: Operational leverage is high….and thus a playpeak in lead indicators on cycle OECD Lead indicator Msci Japan vs. World Lag(+) Peak Trough Price rel. Trough Country/region Beta of EPS to Global IP Lead(-) Feb-89 May-89 -3.3% Sep-89 4 Feb-90 Jan-91 -19.8% Sep-91 8 Japan 5.2 Sep-91 Dec-91 -6.0% Aug-92 8 Emerging markets 4.1 Apr-92 Sep-92 3.8% Mar-93 6 Nov-94 Apr-95 -13.6% Jun-95 2 Continental Europe 3.6 Mar-98 Sep-98 -5.7% Jan-99 4 World 3.3 Apr-00 Oct-01 -8.6% Dec-01 2 May-02 Mar-03 -7.5% May-03 2 US 2.9 Jan-05 Apr-05 -0.4% Jun-05 2 UK 2.5 Jun-07 Feb-09 -26.0% Feb-09 0 Average -9% 4 Monthly data over last 20 years, yoy % changeSource: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchWe believe that global PMIs and industrial production troughed in October.Figure 209: Our US weekly lead indicator is picking up Figure 210: Global IP momentum looks set to reboundand is consistent with real growth of c4% 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: Implie d GDP growth (1q lead) -15% -6% -20% US GD P 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: Credit Suisse Global Strategy TeamGlobal Equity Strategy 88
  • 89. 08 December 2010(2) Japan now has nearly 60% of exports going to NJA and has underperformedNJA by 9%, relative to its downtrendFigure 211: Japan exports by destination: increasing Figure 212: Japan is trading around 9% below itsshare of NJA downward sloping trend line against NJA equities 60% JP Ex ports to US % tot. ex p 56% 35% MSCI Japan rel. to MSCI NJA , tot. return in local currency, deviation from trend JP ex ports to Asia % tot ex p. 50% JP ex ports to China % tot ex p. 25% 40% 15% 30% 5% 19% 20% -5% 16% 10% -15% 0% -25% 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2001 2003 2005 2007 2009 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research(3) Policy at the margin appears to be getting no worseIn our view the issue is that Japan’s policy response has been so far inadequate; howeverwe have now seen two encouraging, albeit relatively mild, developments:(a) An additional fiscal stimulus in the form of a supplementary budget worth Y4.9trn (1%of GDP) and Y1-2trn of additional public-works-related spending. This is due to beimplemented in Q1 and Q2 next year, according to our Japan economics team.Fiscal stimulus does appear to be working in Japan, with durable goods sales accountingfor almost 40% of 3Q GDP growth (3.9% qoq saar), thanks to the eco-points incentivescheme for home appliances.b) QE2 in JapanThe BOJ intervened to weaken the Yen in September and effectively re-started QE on 5October by announcing a programme of asset purchases worth Y5trn (1% of GDP). TheBOJ has announced it will buy Y0.5trn of risky assets (equity ETFs and J-Reits) andCP/Corporate bonds of lower credit rating (BBB).Critically, Governor Shirakawa has indicated that the BOJ will increase the size of theasset purchase fund if necessary.(4) Valuation looks cheap on traditional metricsJapan’s relative 12m forward PE and price to book multiples are very close to its all-timelows, reached in March 2005 and January 1999.Global Equity Strategy 89
  • 90. 08 December 2010Figure 213: Japan 12-month forward P/E relative to global Figure 214: Japan P/B relative to global marketmarket 4.0 1.8 Japan Price to Book rel. to global Japan 12m Price/Earnings rel. to global 3.5 1.6 1.4 3.0 1.2 2.5 1 2.0 0.8 1.5 0.6 1.0 0.4 1990 1993 1996 1999 2002 2005 2008 2011 1981 1986 1991 1996 2001 2006 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchOn our model of Japanese relative performance, there is still 9% upside potential forJapan.The model is based on four variables (OECD lead indicator, US 10Y bond yields,Yen/USD and net foreign purchases of Japanese equities), all of which are suggesting thatJapan should outperform going forward.Figure 215: Our model suggests Japan has 9% upside Figure 216: Japan relative performance model detailspotential from here Input variables Coeff. st.dev T-value 2.8 OECD leading indicator 1.62 0.58 2.8 2.6 US 10Y bond yield 3.72 4.91 0.8 Yen/USD -1.62 0.37 -4.4 2.4 Net foreign purch.JP stocks, 6m% 0.00 0.00 1.1 Intercept 2.00 0.55 3.6 2.2 R2 0.65 2 1.8 Japan rel. performance vs. global in local currency 1.6 Model 1.4 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Source: Thomson Reuters, Credit Suisse estimates Source: Thomson Reuters, Credit Suisse estimatesOn HOLT (see page 118) , as well as on our regional valuation scorecard (see page 117),Japan is the cheapest region.Global Equity Strategy 90
  • 91. 08 December 2010(5) We expect the Yen to weakenWe acknowledge that the Yen is broadly neutrally valued on both PPP and REER.Figure 217: The Yen is neutrally valued on PPP ... Figure 218: ... and on real effective exchange rate 120% Yen/USD deviation from PPP exchange rate 160 Yen- real effective exchange rate 100% Average 150 80% 140 60% 130 120 40% 110 20% 100 0% 90 -20% 80 -40% Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 80 83 86 89 92 95 98 01 04 07 10Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchHowever, we believe that the main driver of the Yen/$ is the short-term interest ratedifferential and we cannot see the US short-term rates falling from here. A wider gapbetween the US and Japan rates should support the dollar against the Yen, we believe.Additionally, the monetary conditions in Japan can hardly get any worse, being 1.9standard deviations above average—the highest since 1994.Figure 219: The Yen/$ is driven by interest rate Figure 220: ... and the monetary conditions index cannotdifferentials ... get any higher in Japan 3 JP MCI, st. dev. from average 100 USD/Yen US 2Y minus JP 2Y rate (rhs) 1.2 2 98 weaker Yen 1.0 96 1 94 0.8 92 0 90 0.6 -1 88 0.4 86 -2 84 0.2 82 -3 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 80 0.0 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchThe first FX intervention since 2004 by the BOJ last September, when the BOJ soldY2.1trn to buy dollars, suggests that the pain threshold for the Ministry of Finance (whichinstructs the BOJ to intervene) is $/Yen 80-82.Global Equity Strategy 91
  • 92. 08 December 2010(6) Positioning still looks very bearishMutual funds are underweight Japan and net outflows have been significant recently.Figure 221: Mutual funds are underweight Japan Figure 222: Significant outflows from Japanese equities 90% 3m annualised net flow s into Japan equity 2.0% funds, as a % of assets 70% 1.0% 50% 0.0% 30% -1.0% -2.0% 10% -3.0% -10% -4.0% -30% -5.0% -50% -6.0% -70% Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Fund managers weighting on Japan relative to benchmark AverageSource: EPFR Source: EPFRWe also highlight that the risk appetite in Japan is the lowest of any region, as shown onpage 78.The following Japanese companies look cheap on HOLT and have a high FCF yield(above 5%) with positive earnings revisions: Sony, Fijitsu, Eisai, Yamada Denki.Figure 223: Japanese companies that look cheap on HOLT and have a FCF yield above 5% with positive earningsrevisions -----P/E (12m fwd) ------ ------ P/B ------- Yield (2010e) HOLT Momentum rel to mkt % rel to mkt % Price, % Consensus 3m Sales 3m EPS rel to Credit SuisseName Abs above/below Abs above/below FCY DY change to (buy less holds Industry rating average average best & sells)Nippon Tel&Tel Cp 9.6 87% -55% 0.6 -61% 13.3% 3.2% 117.4 1.8 0.2 45.5 OutperformSony Corp 21.8 129% -1% 1.0 -21% 5.8% 0.9% 37.1 8.1 -1.1 45.5 OutperformFujitsu 10.9 84% 1% 1.5 14% 14.4% 1.8% 29.2 1.6 -2.2 20.0 OutperformSumitomo Electric 11.6 81% -45% 1.0 -33% 6.1% 1.7% 40.2 3.0 0.9 12.5 OutperformEisai Co 15.1 150% -3% 2.1 11% 11.8% 5.2% 158.9 4.9 -0.9 0.0 OutperformMitsubishi Chem Hl 9.6 69% 167% 1.0 -38% 12.4% 2.0% 68.7 36.8 -1.4 17.7 OutperformYamada Denki Co 8.4 58% -40% 1.2 -40% 11.5% 0.8% 44.1 11.8 2.6 17.7 OutperformKuraray Co 12.9 92% -32% 1.2 -13% 10.8% 2.3% 0.3 9.1 0.0 41.2 OutperformSega Sammy Hldgs I 9.3 65% -44% 1.5 -38% 12.4% 2.9% 33.6 35.0 2.8 63.6 OutperformDainippon Sumitomo 28.3 280% 23% 0.8 -46% 14.5% 2.4% 113.5 118.3 1.3 -37.5 OutperformSeiko Epson Corp 15.6 119% 32% 1.0 -3% 5.0% 1.4% 84.6 2,083.1 0.1 0.0 OutperformSanten Pharm Co 12.7 126% -13% 1.8 30% 8.0% 2.8% 8.0 0.2 -0.9 27.3 OutperformKonami Corp 13.8 106% -27% 1.2 -46% 10.5% 2.1% 28.0 2.9 -0.4 -6.7 OutperformFp Corp 10.2 84% n/a 1.5 n/a 5.7% 2.6% 3.6 1.4 1.4 66.7 OutperformSource: MSCI, IBES, Factset, Thomson Reuters, Credit Suisse research, Credit Suisse researchGlobal Equity Strategy 92
  • 93. 08 December 2010Our top picks in Japan, included in the Japan Focus List, are shown below.Figure 224: Japan top picks -----P/E (12m fwd) ------ ------ P/B ------- Yield (2010e) HOLT Momentum rel to mkt % rel to mkt % Price, % Consensus 3m Sales 3m EPS Credit SuisseName Abs rel to Industry above/below Abs above/below FCY DY change to (buy less holds rating average average best & sells)Inpex Corporation 13.7 127% -8% 0.8 -62% -3.2% 1.3% -6.2 -24.9 -4.8 36.8 OutperformMitsubishi Chem Hl 9.6 69% 167% 1.0 -38% 12.4% 2.0% 68.7 36.8 -1.4 17.7 OutperformAstellas Pharma 15.0 148% 11% 1.4 -17% 9.7% 4.1% 95.3 -6.9 0.1 -12.5 OutperformTerumo Corp 19.4 142% -14% 2.7 30% 4.4% 0.7% -33.0 -6.8 -1.1 17.7 OutperformHitachi Metals 15.8 141% -29% 1.8 29% 8.3% 1.2% -24.1 -6.2 0.0 20.0 NeutralMitsubishi Elec Cp 13.6 95% -17% 1.9 32% 4.1% 1.2% -9.3 25.6 0.1 37.5 OutperformFanuc Ltd 18.5 118% -27% 2.9 54% 5.2% 1.5% -33.1 13.2 8.2 36.8 OutperformOlympus Corp 26.0 190% 6% 3.6 114% 6.7% 1.3% -38.1 -26.5 -2.9 -63.6 OutperformKonami Corp 13.8 106% -27% 1.2 -46% 10.5% 2.1% 28.0 2.9 -0.4 -6.7 OutperformNgk Insulators 14.6 94% -43% 1.3 -21% 2.8% 1.6% -22.3 -4.4 -2.8 -33.3 OutperformSource: MSCI, IBES, Factset, Thomson Reuters, Credit Suisse research, Credit Suisse researchOur Japan equity strategist Shun Maruyama has a 2011-end target for the Topix index of1200, and sees Japanese equities entering a structural bull market from the end of 2011E.Global Equity Strategy 93
  • 94. 08 December 2010UK: downgrading to benchmarkThe UK has performed in line with global equities in local currency terms andoutperformance by 1.6% in dollar terms since July 2010. Incidentally, the trough in relativeperformance roughly coincided with the General Election in May. Since then the UKmarket has outperformed by 2.3% in local currency terms and by 7.3% in dollar terms.Figure 225: UK relative performance in 2010 104 102 100 98 96 94 MSCI UK rel to World (local 92 currency ) 90 MSCI UK rel ($) 88 Jan-10 Mar-10 May -10 Jul-10 Sep-10 Nov -10Source: Thomson Reuters, Credit Suisse researchWe revise our overweight stance in this report. We have five main reasons for taking theUK down to benchmark:(1) The UK tends to be a defensive marketThe UK tends to underperform when the global equity market is rising and when economiclead indicators are rising. One simple reason is that the UK market is underweightcyclicals and overweight defensives. We can see on page 118 that the UK has the lowestoperational leverage of any market.Global Equity Strategy 94
  • 95. 08 December 2010Figure 226: UK tends to underperform when equities rise Figure 227: The UK is underweight cyclicals and overweight defensives 40% World equities, 6m %ch -20% 60 UK rel to world equities, 6m %ch, rhs, inverted 30% -15% Cyclical Defensive Financial Energy 50 20% -10% 10% 40 -5% 0% 0% 30 -10% 5% -20% 20 10% -30% UK outperforms as 10 -40% global equities fall 15% -50% 20% 0 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Japan US GEM Europe ex UK UKSource: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchWe believe that a combination of QE2, a trough in global IP momentum (on Wilmot’sindicators) and the potential for a 10% return in equities in the first half of 2011, meansthat investors should, in aggregate, be less defensive than they were six months ago.(2) Sterling strength could limit UK outperformanceThe relative performance of the UK equity market tends to be inversely correlated tocurrency strength.Figure 228: UK tends to underperform in local currency Figure 229: UK tends to outperform in US dollar whenwhen sterling strengthens sterling strengthens 2.3 MSCI UK rel to World (local currency) 1.0 1.20 MSCI UK rel ($) 2.2 USD / GBP, rhs, inv USD GBP, rhs 2.2 1.15 UK outperforms when 1.2 2.0 2.1 sterling weakens 1.10 2.0 1.4 1.05 1.8 1.00 1.9 1.6 0.95 1.6 1.8 0.90 1.7 1.8 1.4 0.85 1.6 0.80 UK underperforms in USD 2.0 1.2 1.5 when sterling weakens 0.75 1.4 2.2 0.70 1.0 1985 1989 1993 1997 2001 2005 2009 1985 1989 1993 1997 2001 2005 2009Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchWe believe that near term sterling could strengthen to slightly above $1.65, although in thelong term we maintain our view that sterling should trade 10% below fair value on PPPagainst the dollar (PPP is $1.62, which would imply around $1.46).Global Equity Strategy 95
  • 96. 08 December 2010Currently, sterling is trading marginally below the US dollar on PPP ($1.62) and 10%below PPP against the euro (€1.30). Historically, sterling has traded on a 5% discount onPPP.Figure 230: Sterling trades in line with the dollar and 10% below the euro on PPP 40% GBP USD - Deviation from PPP GBP overvalued 40% GBP EUR - Deviation from PPP, rhs 30% 30% 20% 20% 10% 10% 0% 0% -10% -10% -20% -20% -30% -30% GBP undervalued -40% -40% 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09Source: Thomson Reuters, Credit Suisse researchNear term we can see sterling being supported by:a) Renewed QE by the Fed, but not by the MPCThe Fed’s decision to renew its programme of asset purchases is in contrast to the MPC’sdecision not to add to the £200bn of asset purchases. This relative easing in US policyshould be supportive of sterling. The earliest QE2 could occur in the UK is February butthe MPC might well wait for the May Inflation report.b) Reasonable economic strengthThe rebound in the UK labour market suggests that the economic recovery is strongerthan we had previously anticipated. Employment indicators, particularly from themanufacturing PMI, are at multi-year highs and consistent with close to 1% employmentgrowth.Global Equity Strategy 96
  • 97. 08 December 2010Figure 231: PMI indicators of employment are holding up Figure 232: Bank of England’s monthly survey ofwell employment intentions is consistent with close to 1.0% growth 2 2 55 1.5 1 1 50 0.5 0 45 0 -0.5 -1 40 -1 -2 Employment growth, lhs Services Employment -1.5 35 BoE agent survey - employment intentions, rhs, lead -3 M anufactu ring Employment -2 6m 30 -2.5 -4 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 97 98 99 00 01 02 03 04 05 06 07 08 09 10Source: Markit, Credit Suisse research Source: Thomson Reuters, Bank of England, Credit Suisse researchThe rise in employment has also been earlier than after previous recessions despite thedegree of labour shedding being less than historically (relative to the decline in GDP).Figure 233: The recovery in UK employment has been Figure 234: The decline in employment during theearlier than after previous recessions recession was low relative to the decline in GDP Workforce Jobs: current 0% 104 LFS employment: current 103 -1% LFS employment: 1980s 102 LFS employment: 1990s -2% 101 -3% -2.5% -2.5% 100 -4% 99 Employment in previous -5% 98 recoveries 97 -6% -5.7% Quarters from trough in output -6.3% 96 -7% -6.5% -6.5% 1979-81 1990-92 2008-09 95 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 GDP peak to trough Employment Peak to troughSource: Bank of England Source: Thomson Reuters, Credit Suisse researchc) Reduced sovereign credit risk…potentially adding to capital inflowsThe UK has taken measures to secure its AAA credit rating. The net cash requirement hasfallen by 1.1% of GDP and the credit rating agencies have endorsed the government’splans to reduce the cyclically adjusted budget deficit by 2015/16 to just 0.3% of GDP. Webelieve a 5-year fixed term parliament as stipulated in the Coalition government’sagreement, which states no election is due until May 2015, helps to remove politicalbarriers to such aggressive fiscal tightening.Global Equity Strategy 97
  • 98. 08 December 2010Figure 235: The public sector net cash requirement is Figure 236: Sovereign debt weighted average time tobeginning to improve maturity 150 12% Public Sector Net Cash Requirement (£bn) 14 130 % of GDP 10% 110 12 8% 90 10 6% 70 4% 8 50 2% 6 30 0% 4 10 -10 -2% 2 -30 -4% 0 France Japan Belgium Portugal Italy Germany UK US Canada Greece Spain Ireland China -50 -6% 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010Source: Thomson Reuters, Credit Suisse research Source: the BLOOMBERG PROFESSIONAL™ service, Credit Suisse researchWe also note that the UK has a very long maturity of debt (if need be, the cost of servicingthe debt can be reduced by issuing below-average maturity bonds) and a relatively lowportion of debt (30%) is held by the foreign investor. Appetite for UK debt amongst foreigninvestors should therefore remain strong. In the first ten months of 2010 foreign investorsbought 55% of net gilt issuance, potentially adding further support to sterling.Figure 237: The UK has one of the lowest foreign Figure 238: Foreign investors have bought 55% of net giltownership rates of government debt issuance in 2010 90% Banks and building socs 35 Foreign 80% % of General govt debt held abroad 30 Non-bank private sector 70% Central bank 25 60% Net gilt issuance (DMO) 20 50% 15 40% 10 30% 5 20% 0 10% -5 0% -10 Czech Republic Korea Netherlands Denmark Norway Slovak Republic Germany Austria Greece Australia Japan Slovenia France Ireland Spain New Zealand Portugal Belgium Italy US UK Finland Sweden Canada -15 Monthly changes in gilts holdings (£bn) -20 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10Source: IMF Source: Debt Management Office, Thomson Reuters, Credit Suisse research a) Housing market likely to be flat in 2011EHousing, from a sentiment point of view, tends to be disproportionately important (after allit is the banking sector’s and households’ major asset). One positive is that the number ofnew buyer enquiries has risen relative to the number of new instructions, suggesting thatthe recent slack in the market should be short-lived. On balance, we expect the housingmarket to remain roughly flat through 2011E.Global Equity Strategy 98
  • 99. 08 December 2010Figure 239: The number of new buyer enquiries has risen Figure 240: The ratio of sales to stocks leads house pricerelative to the number of new instructions inflation by 4 months RIC S - new buyer enquiries / new instructions 40% Halifax house price inflation 0.8 80 RIC S - sales to stocks, rhs, la g 6m 0.6 RICS sales to stocks, rhs, lead 4m 0.7 60 30% 0.5 0.6 40 20% 0.5 20 0.4 10% 0.4 0 0.3 0.3 -20 0% -40 0.2 0.2 -10% -60 0.1 -80 0.1 -20% 0.0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 84 86 88 90 92 94 96 98 00 02 04 06 08 10Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research b) Inflation: core inflation unlikely to breach 2.5%We think sterling should get some support from better controlled inflation. In our viewmarket concern over high UK inflation is misplaced. CPI inflation on a constant tax rate is1.4% (albeit assuming no pass-through of higher taxes), which is much lower than theheadline rate of 3.2%. The Bank of England concluded that 2% points of the rise ininflation over the last year was due to sterling and ½% point was from the VAT rises,leaving core inflation below 1%. Credit Suisse economists highlight the risk of headlineinflation rising above 4% temporarily (see their report The land deflation forgot, 3December 2010), but believe the underlying inflation rate is close to 2.5%.Figure 241: Inflation is much lower once adjusted for the Figure 242: Core goods inflation lags sterling by 12increase in VAT months - thus the inflationary impulse should pass 6 8 -30 Core goods inflation -25 5 6 Trade-weighted sterling, 12m % ch, rhs, CPI CPI constant tax rates inverted, 12m lead -20 4 4 -15 -10 3 2 -5 2 0 0 5 1 -2 10 0 -4 15 1995 1997 1999 2001 2003 2005 2007 2009 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 99
  • 100. 08 December 2010Long term, we are not bullish on sterling against the dollar as we see three issues inthe UK being worse that the US: consumer leverage, bank leverage and overvaluation ofhousing. But on a 3- to 6-month view, we would not be surprised to see sterlingappreciating to $1.65 (our FX team’s forecast is $1.60 and $1.67 on a 3-month and 12-month horizon).Figure 243: The UK consumer is more indebted than the Figure 244: UK housing is still more overvalued than theUS US 50% UK house price to wage ratio rel to average UK household liabilities to disposable income 170% US house price to wage ratio rel to average US household liabilities to disposable income 40% 30% 150% 20% 130% 10% 110% 0% -10% 90% -20% 70% -30% Q1 1987 Q1 1990 Q1 1993 Q1 1996 Q1 1999 Q1 2002 Q1 2005 Q1 2008 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research(3) Valuation no longer attractiveOn an absolute basis the UK is the cheapest market, but ranks in the middle of ourvaluation scorecard.Figure 245: The US is the most expensive market on traditional valuation metrics Regional valuation scorecard 12m Fwd PE Price to Book PEG ratio Dividend Yield Implied LT EPS growth Composite Rank Rel. to trend Region Abs Rel Z-score Abs Rel Z-score Abs Rel Z-score Abs Rel Z-score Abs Z-score Z-score Z-score GDP growthJapan 13.3 1.10 -1.0 1.08 0.59 -1.3 0.58 0.65 -0.5 1.97 0.84 2.8 8.7% 4.00 1.8 -1.3 1Eur exUK 10.8 0.90 -0.1 1.52 0.83 0.1 0.94 1.07 0.1 2.91 1.24 0.0 7.5% 2.13 0.1 -0.5 2UK 10.3 0.86 -0.3 1.72 0.94 -0.3 0.63 0.73 -1.2 2.86 1.21 -2.1 10.3% 2.98 0.8 -0.5 3GEM 11.5 0.95 0.8 2.28 1.24 2.2 0.58 0.65 -0.5 2.19 0.93 -0.8 7.8% 1.08 -0.9 -0.1 4NJA 13.0 1.08 1.3 2.23 1.22 2.2 0.63 0.70 1.0 2.09 0.89 -1.0 7.3% 0.85 -1.1 1.0 5US 12.6 1.05 0.6 2.30 1.25 -0.9 1.09 1.28 3.0 1.87 0.79 -0.6 7.4% 1.78 -0.3 1.3 6Source: Thomson Reuters, Credit Suisse researchIn graphical form, we show that the UK’s P/E relative is now above its average and thedividend yield relative is close to a 30-year low.Global Equity Strategy 100
  • 101. 08 December 2010Figure 246: The UK is now trading above its average P/E Figure 247: The UK’s dividend yield relative is close to anrelative to MSCI World all-time low relative to global equities 1.00 2.5 0.95 UK dividend yield relative to world, 2.3 total market 0.90 2.1 0.85 0.80 1.9 0.75 1.7 0.70 UK MSCI PE relative 0.86 1.5 0.65 average 0.81 1.3 0.60 0.55 1.1 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010Source: Thomson Reuters, MSCI, Credit Suisse research Source: Thomson Reuters, Credit Suisse research(4) Risk appetite looks more stretched than other regionsEquity sector risk appetite looks more stretched in the UK than in other regions, suggestedlimited upside for the high beta sectors.Figure 248: UK equity sector risk appetite is the most Figure 249: ... while global equity sector risk appetite isextended of all regions... only slightly below average 3 Equity sector risk appetite 3 0.6 Global Equity sector risk appetite UK 2 2 0.4 (number of standard deviations) 1 1 0.2 0.0 0 0 (1.16) -0.2 -1 -1 -0.4 -2 -2 US Japan GEM Global UK Europe ex UK -3 -3 02 03 04 05 06 07 08 09 10Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 101
  • 102. 08 December 2010(5) Relative economic and earnings momentum is mixedRelative EPS momentum has already rebounded from its lows, while relative economicmomentum is weak on the composite PMI new order indices.Figure 250: Relative earnings momentum has rebounded Figure 251: Relative economic momentum remains weak 40% 1.15 Earnings breadth, UK relative to World, 4- UK relative to Global PMI wk average 30% New Orders 1.10 20% 1.05 10% 0% 1.00 -10% 0.95 -20% 0.90 -30% -40% 0.85 2004 2005 2006 2007 2008 2009 2010 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchExpensive Underperform-rated UK stocksBelow we show those UK stocks that are have more than 10% downside on HOLT and areUnderperform-rated by Credit Suisse analysts.Figure 252: UK Underperform-rated stocks that are have more than 10% downside on HOLT -----P/E (12m fwd) ------ ------ P/B ------- Yield (2010e) HOLT Momentum rel to mkt % rel to mkt % Price, % Consensus 3m Sales 3m EPS Credit SuisseName Abs rel to Industry above/below Abs above/below FCY DY change to (buy less holds rating average average best & sells)Sainsbury(J) 13.6 103% 10% 1.3 -15% -1.4% 4.0% -18.7 1.4 0.6 -67.7 UnderperformStandard Life 13.3 139% n/a 1.3 n/a n/m 5.9% -29.4 -5.5 -1.1 -81.8 UnderperformSchroders 14.9 148% 16% 2.3 33% n/m 2.0% -26.2 4.7 2.1 -20.0 UnderperformImi 12.1 77% 30% 7.7 276% 7.8% 2.7% -12.0 6.2 1.6 52.9 UnderperformNorthumbrian Wtr G 12.0 79% n/a 5.6 n/a 1.1% 4.2% -61.0 2.9 0.4 -84.6 UnderperformMitchells &Butlers 11.9 68% 4% 1.4 54% 8.8% 1.3% -85.7 2.8 -0.6 13.0 UnderperformLadbrokes 8.7 50% -16% 4.7 794% 10.8% 5.5% -25.8 -0.3 -0.8 -63.6 UnderperformKesa Electricals 12.0 83% 19% 4.3 40% 5.6% 3.9% -45.9 7.8 2.5 -33.3 UnderperformMorgan Crucible Co 11.1 71% 21% 3.9 95% 11.7% 3.1% -10.8 4.0 2.2 33.3 UnderperformDairy Crest Group 7.7 53% n/a 1.7 n/a 11.9% 5.3% -30.0 -2.1 -1.5 -60.0 UnderperformSource: MSCI, IBES, Factset, Thomson Reuters, Credit Suisse research, Credit Suisse researchGlobal Equity Strategy 102
  • 103. 08 December 2010Continental Europe: underweightWe took Continental Europe down to benchmark from overweight on 6 October 2010 (seeContinental Europe: a downgrade); and then down to a small underweight in mid-November (see Asset Allocation, emerging markets, Europe, 10 November 2010).We have the following concerns about Continental Europe: a) Continental Europe should have underperformed more given the impact of rising CDS spreadsWe can see that recently the relative performance of Europe has decoupled from CDSspreads, suggesting a 4% underperformance from here.Figure 253: Continental Europe’s price relative has done better than what is implied bythe CDS spread 30 100 50 99 70 98 90 97 110 96 130 95 Europe ex UK, relativ e to w orld, local currency Eur x UK CDS Spread, rhs, inv 150 94 170 93 Sep-09 Nov -09 Jan-10 Mar-10 May -10 Jul-10 Sep-10 Nov -10 Jan-11Source: Thomson Reuters, Credit Suisse researchWe worry about three aspects of peripheral Europe for core Europe and thus Europeaninvestors: b) Peripheral Europe is likely to require a lot more deflation than investors realise. Put simply, we believe the peripheral European countries we believe have to end up with either current account surpluses (to generate excess savings) or a clearly undervalued currency. We see neither as being the case.Global Equity Strategy 103
  • 104. 08 December 2010Figure 254: Peripheral European countries still show Figure 255: ... and overvalued real exchange ratescurrent account deficits... 140 Real Effective exchange rates (2000 = 100): 0 135 Spain -2 Ireland 130 Greece -4 Italy 125 Portugal -6 120 Germany -8 115 110 -10 Greece 105 -12 Ireland Current account, % 100 of GDP Portugal -14 95 Spain -16 90 2000 2002 2004 2006 2008 2010E 2012E 2014E 1998 2000 2002 2004 2006 2008 2010Source: IMF estimates Source: Thomson Reuters, Credit Suisse researchThis clearly indicates to us that domestic prices levels (and wages) need to fall another 5–10% in peripheral Europe. Such a fall in prices would not only make their real effectiveexchange rates competitive but also lead to current account surpluses (as de facto importswould probably fall another 10–15%). Clearly, a sharp increase in trend productivity wouldhelp, but we still do not see a clear acceleration in terms of structural reforms, which are apre-condition of rising productivity.Figure 256: Wages in Spain, Greece and Ireland would need to fall by 8–10% for thesecountries to regain competitiveness Relative % increase rel. to Germany since 2000 Required fall in wages to restore Country competitiveness in 5 years* Unit labour costs Core CPISpain 28% 10% -7.7%Ireland 34% 11% -9.1%Greece 22% 19% -8.0%Italy 30% 8% 0.8%Portugal 30% 11% 0.8%Euro-area 18% 4% -*required change in wage level over the next 5 years for the country to be 5% more competitive (rel. to Germany) than it was in 2000Source: Thomson Reuters, Eurostat, Credit Suisse estimates Indeed, the way such deflation could come about would be a significant cut in public sector wages (for example, in Ireland these have already fallen 15%, with the recently announced five-year austerity plan reducing the statutory minimum hourly wage by €1, or 13%). Thus the result could be government finances, current accounts and competitiveness all improving to sustainable levels. The price of this is much more deflation in the medium term, however. The mechanism for deflation could be deposit flight, as described below.We think such a base case scenario would then cause weakening pan European growth.Each 5% off nominal GDP growth in peripheral Europe would take nearly 0.7% off totalEuropean GDP. c) Peripheral European spreads look unsustainable in Greece, Ireland and Portugal, as shown on page 24.This is because at current bond yields, net interest payments as a percentage of GDP are16%, 12% and 6.5% of GDP for Greece, Ireland and Portugal on our 2014 governmentdebt to GDP estimate (we added to it one third of the required private sector deleveraging)Global Equity Strategy 104
  • 105. 08 December 2010– well above the estimated trend nominal growth and requiring a fiscal tightening that ismuch bigger than that announced already in order to stabilise the government debt toGDP ratio.In particular, we think we need to see the following in peripheral Europe in order to makethe debt arithmetic sustainable:■ some form of haircut /debt restructuring in Ireland and Greece, given that government debt to GDP at 140% is unsustainable. This could be a very complicated process;■ the ECB agreeing to act along the lines of the IMF, providing unlimited liquidity and above all buying bonds in peripheral Europe if the spreads are judged to be too wide. But this starts to become political and every time the situation in peripheral Europe eases the ECB considers withdrawing liquidity (as it is still planning to do in March). In our view, in order to stabilise peripheral Europe, the ECB would have to provide liquidity, with the EFSF being used to sort out solvency problems;■ Spain and Portugal should be bought into an extended EFSF, removing the likelihood of speculation on a Spanish default (which we judge to be a low probability). Indeed our credit team believes that Spanish banks need to raise €80bn–100bn of capital—a round of capital raising by Spanish banks would, we believe, underpin confidence; and■ the euro weakening to a level that causes inflation to rise in Germany and core Europe to alleviate the deflationary pressures of peripheral Europe. But it is hard to see parity when the Fed is printing money. Additionally, the Euro-area monetary policy has tended to be biased towards that of core Europe and particularly the Bundesbank, which is unlikely to tolerate a large rise in German inflation.We see the following further complications:■ there appears to be a wish among European policy makers to change foreclosure laws (which would potentially unsettle both senior and junior government bank bond holders) to allow junior debtors, in particular, to be loss absorbing (and in particular to change the current situation were seniors debtors have de facto ranked pari passu with depositors); this could be problematic given that senior debt accounts for €5trn or 15% of banks funding.■ -the threat of a flight of corporate deposits, which have been noticeably more volatile in the case of Ireland and Spain than retail deposits. d) We see increasing political risk in the Euro-area■ weak governments—for example Spain, Portugal and the Netherlands have minority governments; there is still no government in Belgium; Ireland and Italy are likely to have elections early next year; and public support for the German government is below 40% in the latest polls—suggest the degree of possible macroeconomic reform is limited;■ there is also a risk that that the newly created ESM, intended to replace the EFSF after mid-2013, could face a legal challenge in the German Constitutional Court.■ public support for austerity measures may fade, limiting fiscal consolidation and forcing the EU/IMF to stop disbursing the agreed bailout funds (Greece is due for a review of its fiscal deficit reduction plan in early February).■ we have consistently been concerned that about half of Spanish spending is carried out by the 17 largely autonomous regional authorities.Global Equity Strategy 105
  • 106. 08 December 2010 e) Europe’s relative economic momentum is deterioratingEuropean economic momentum has now slipped to close to the bottom on our economicmomentum scorecard—and Continental Europe’s relative manufacturing PMI is well belowits peak.Figure 257: Europe now ranks second last on our Figure 258: Continental Europe’s relative manufacturingeconomic macro scorecard, down from first in May PMI is picking up 1.10 PMI w hole economy output: Continental Europe rel to global Composite PMI Rank Region Score Index, now Index, 3m ch 1.05 1 US 56.8 1.5 1.5 2 UK 54.2 1.9 1.0 3 GEM 55.4 1.3 0.9 1.00 4 Europe ex UK 55.5 -0.7 -0.6 5 Japan 48.7 -0.8 -2.8 0.95 0.90 0.85 1999 2001 2003 2005 2007 2009 2011Source: Markit, Credit Suisse research Source: Markit, Credit Suisse research f) Europe’s relative earnings momentum is the worst of any region on our scorecardOn our combined scorecard or relative earnings momentum, Continental Europe scores atthe bottom – it has been the only major region globally with net earnings downgrades overthe last month.Figure 259: Regional earnings momentum scorecard – Continental Europe scores at the bottom Net Upgrades (% tot. revisions) 12m EPS change 2010 EPS change Total score (50% upgrades, 50% 1m 3m z-score 1m 3m z-score 1m 3m z-score EPS change)US 39% 27% 1.5 0.2% -0.3% 1.0 -1.5% 0.2% -0.3 0.9Japan 11% -9% -0.8 0.3% -0.5% 0.6 1.4% 2.0% 1.2 0.0UK 17% 7% 0.0 0.1% -0.5% 0.2 -0.1% -2.6% -0.7 -0.1GEM 16% 13% 0.2 -0.1% -0.5% -0.4 -2.2% -0.5% -0.7 -0.2Europe ex UK -5% 6% -0.8 -0.2% -0.8% -1.4 0.7% 0.8% 0.6 -0.6Global 22% 14% 0.1% -0.6% -1.5% 1.5%Source: Thomson Reuters, MSCI, IBES, Credit Suisse researchThe weakness in economic and earnings momentum, we think, is due in part to the strongcurrency, with each 10% on the euro TWI taking nearly 1.5% off nominal GDP.In addition, we are worried that private-sector leverage in the Euro area has continued togo up, while the US private sector has gone through (forced) private-sector deleveraging,shedding debt equivalent to around 10% of GDP. As a consequence, Continental Europe’saggregate leverage is now very similar to that in the US. Lastly, at the margin themomentum of fiscal tightening in Europe is increasing while in the US fiscal tightening isbeing postponed (with Obama now apparently willing to extend all the Bush tax cuts).Global Equity Strategy 106
  • 107. 08 December 2010Figure 260: Private sector leverage is falling in the US, but Figure 261: The US is tightening less than expected innot in Europe May, Europe a bit more 190% 0.6% Private sector leverage, % of GDP 0.4% 180% Euro-area US 0.2% 170% 0.0% -0.2% 160% -0.4% Change in net fiscal tightening 2011e, -0.6% May to Nov, % GDP 150% -0.8% 140% -1.0% -1.2% 130% -1.4% GEM UK US Euro-area Japan Peripheral Global Europe 120% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Source: Thomson Reuters, Credit Suisse research Source: IMF, Credit Suisse research g) We expect the euro to strengthen from hereOur concern is that the euro temporarily overshoots to euro/$ 1/40 , given that:■ The Fed is essentially participating in open-ended QE while the ECB, even in the middle of a sovereign crisis, has discussed the possibility of going back to variable tender procedure. Indeed our European economics team highlights that a recovery in euro-area lending growth is likely to induce the ECB to reduce its balance sheet even further. At the last press conference after the ECB meeting on 2 December, Jean- Claude Trichet confirmed that bond purchases will continue and the fixed-rate tender with full allotment will be extended—but the purchases will be sterilised as before—in our view this is well short of aggressive QE.Additionally, even though eight national representatives and four staff members in the 22members of the ECB governing council can be considered as coming from the periphery,a few of them represent countries with strong fiscal positions (Malta, Slovenia andCyprus), and thus are most likely to side with Germany on policy.■ On a trade-weighted basis, the euro is just in line with the long-run average (on PPP, it is 4% expensive).Global Equity Strategy 107
  • 108. 08 December 2010Figure 262: The Euro is at fair value on a trade-weighted Figure 263: The ECB’s balance sheet is shrinking at abasis time when the Fed has announced more QE 115 2500 Fed, balance sheet ($bn) 110 Euro Trade-weighted 2300 ECB, balance sheet (€bn) 105 2100 100 1900 95 1700 90 1500 85 1300 80 1100 75 900 70 1980 1985 1990 1995 2000 2005 2010 700 Nov-06 Aug-07 May-08 Feb-09 Nov-09 Aug-10Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchOur model suggests that a strong euro does not in itself cause deflation in ContinentalEurope until the euro rises to €/US$1.60. Thus, we would expect the ECB to only startworrying about euro strength around the €/US$1.50–1.55 level.However, we think that in the very short term the euro may decline a little bit more if thetensions in the periphery do not abate. In particular, the sovereign CDS spreads suggestthe euro should be at around $1.23 while the basis swap rate suggests it should be at$1.32.Figure 264: CDS spreads suggest Euro may fall a bit Figure 265: The Euro basis swap rate is consistent withfurther from here $/€ of 1.25 180 1.15 58 Euro basis swap 1-y ear 1.2 European sovereign CDS spread 53 Eur/USD, rhs, inv 160 EUR/USD, rhs 1.20 1.25 48 140 1.25 43 1.3 120 1.30 38 1.35 100 1.35 33 28 1.4 80 1.40 23 1.45 60 1.45 18 40 1.50 1.5 13 20 1.55 8 1.55 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research h) Valuations are only marginally attractiveBoth Continental Europe’s P/E and P/B relatives are only slightly below averageGlobal Equity Strategy 108
  • 109. 08 December 2010Figure 266: Continental Europe’s P/E relative to the US is Figure 267: … as is the P/B relativeback to historical average levels … 140% 12m fw d P/E - Europe Ex UK relativ e to USA 100% P/B - Europe Ex UK relativ e to USA Av erage Average 95% 130% 90% 120% 85% 110% 80% 75% 100% 70% 90% 65% 60% 80% 55% 70% 50% 1991 1995 1999 2003 2007 2011 1991 1995 1999 2003 2007 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchOn sector-adjusted basis, Europe trades at a 10% discount relative to the US compared toan average discount of 3%. On our regional valuation scorecard, Europe is only 0.4standard deviations cheap.Figure 268: Continental Europe’s sector adjusted P/E Figure 269: Regional aggregate valuation scorecardrelative 145% 1.5 Expensive Europe ex UK sector adjusted Composite relative v aluation (Z-score) based on 12m fw d P/E relativ e to US 1.0 12M PE, PB, PEG ratio, DY and implied EPS 130% Average grow th vs. trend nominal GDP grow th 0.5 115% 0.0 100% -0.5 85% -1.0 70% -1.5 1995 1999 2003 2007 2011 Japan Eur ex UK UK GEM NJA USSource: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 109
  • 110. 08 December 2010 i) Risk appetite in Continental Europe still does not look that depressed versus other regionsFigure 270: Continental Europe’s equity sector risk Figure 271: Continental Europe’s equity sector riskappetite relative to global appetite versus other major regions 1.5 0.5 Equity sector Risk appetite (number of 0.4 1.0 standard dev iations) 0.3 0.5 0.2 0.1 0.0 0.0 -0.5 -0.1 -0.2 (1.15) -1.0 -0.3 -0.4 -1.5 UK US Japan GEM Europe ex UK Europe ex UK rel Global risk appetite -2.0 1997 1999 2001 2004 2006 2008 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchFurthermore, outflows from European equity funds are not nearly as extreme as they werewhen we upgraded our overweight on continental Europe in May (Better than you think 17May 2010).Figure 272: Outflows out of European equity funds are not as extreme as they were inMay 3m annualised net flow s into Cont Europe 30% equity funds, as a % of assets 20% 10% 0% -10% -20% -30% 2004 2005 2006 2007 2008 2009 2010 2011Source: Thomson Reuters, EPFR GlobalWe view positively the fact that Continental Europe has outperformed the US by 4% sinceMay in dollar terms.Global Equity Strategy 110
  • 111. 08 December 2010Figure 273: Continental Europe has outperformed by 4% since May in dollar terms 5.7 Europe ex UK relativ e, dollar terms 5.5 5.3 5.1 4.9 4.7 4.5 Jan-10 Feb-10 Mar-10 Apr-10 May -10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 111
  • 112. 08 December 2010Not all of Europe is the same—stay overweight‘safer’ Europe: Germany and SwedenWhen we look at our fundamental scorecard we find that four European countries rank inthe top 10 globally on the key economic variables (current account, fiscal position, netexternal debt, gross leverage of both private and public sector, long term growth and creditrating – see Appendix 8 for details).Indeed two of them—Sweden and Germany—have an undervalued currency.We continue to be bullish of domestic Germany—the big beneficiary of a weaker euro (asthe German economy is abnormally open), German asset reflation (interest rates are verylow), strong pent-up demand, an undervalued housing market (the third cheapest in theworld on IMF data), the lowest unemployment rate since 1992) solid public finances (nofiscal consolidation required) and low leverage.Figure 274: Germany has very low leverage ... Figure 275: ... solid public finances 700% C yc lica l y- a djus te d p rim a ry b al a nc e , % of 2 pote ntial GD P (2 01 0 E IU e stim a tes ) 600% Total debt, % of GDP 0 500% -2 400% 300% -4 200% -6 100% -8 P or tug al S w it ze rla nd C z e ch R e p. D enm a rk Aus tr a lia N ew Z ea la nd N eth er lan ds Be l gi u m C a na da I rel an d H unga r y Fi nl an d Au s tri a F r a nc e It aly Ge rm an y Spa i n Ja p an Gree ce UK US 0% N orway D enmark Sw itz erlan d Franc e Au str ali a Italy G erm any Gr eece Canada Iceland Portug al Unit ed State s N ew Zealand Spain Japan United Kingdom Ir elandSource: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchFigure 276: Housing still undervalued in Germany ... Figure 277: ... and labour costs are not rising 3 30 % R E ER , incr e a se s in ce 2 0 00 (% ) Aver age o f h ouse p rice /ren t and house pr ice/wage, st and ard deviat ion from aver a (IM F, A pr . 2010) ge 2 25 % 1 20 % 0 15 % -1 10 % -2 5% -3 0% M alaysia Chin a Belgium Colom bia Sp ain Australia Sw eden S out h Africa Unit ed States Italy Canada Thailand Japan Indonesia Argentina Korea Israel Philippines Czech R epublic Netherlands Hong Kong SAR Austria Russia iwan Pola nd In dia F rance Unit ed King dom Germany enmark N et he r la n ds Ireland Greece Norway G er m an y Sp a in Po rtu g a l Bel giu m Gre ece Fra n ce Fi nl and A u str ia I tal y Ire la nd Ta -5 % DSource: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 112
  • 113. 08 December 2010With the German unemployment rate back to 1992 levels, we estimate that using theTaylor rule (based on data going back to 1998), the appropriate level of short-term ratesshould be 4.8% in Germany, 3.8pp above current levels. On OECD estimates, 100bplower rates raises GDP growth by 0.4pp, meaning that effectively the ECB policy isboosting German GDP by 1.5pp above trend growth, with the result that the actual growthrate of 3% can be sustained – our economists forecast 3.5% GDP growth next year.Figure 278: Interest rates in Germany are almost 4pp Figure 279: ... with the unemployment rate back to 1992below the level suggested by a simple Taylor rule levels Unemployment 14 Unemployment rate, % Country CPI core* CPI-target Taylor Rule Gap US Germany UK JapanGermany 0.7% -1.1% -1.5% 4.8%Italy 1.6% -0.2% 1.5% 1.4% 12France 1.0% -0.9% 1.4% 1.3%Greece 1.9% 0.1% 3.4% -0.9% 10Portugal 0.7% -1.1% 3.5% -1.4%Ireland 0.1% -1.7% 6.9% -5.8% 8Spain 1.1% -0.7% 8.2% -7.0%Euro-area 1.1% -0.7% 1.4% 1.4% 6Euro-Periphery 1.1% -0.7% 6.9% -5.4%* CPI core adjusted for tax increases. Target is assumed to be 1.8%. 4 2 1993 1995 1997 1999 2001 2003 2005 2007 2009Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchAdditionally, the German economy looks to be re-accelerating, with the IFO index nowconsistent with 5% real GDP growth—compared with a 2011 consensus growth estimateof 2.1% (our European economists forecast 3.2% GDP growth next year)—and retailconfidence close at all-time high (consistent with 3% consumption growth).Figure 280: The IFO index is consistent with German GDP Figure 281: ... likely driven by very strong consumptiongrowth of 5% ... growth 110 10% Ifo retail confidence, lhs 20 German retail sales (ex cars, y/y %, 6mma) 3 105 6% 10 2 100 0 2% 1 95 -10 0 -2% -20 90 -1 -6% -30 85 Ifo business expecations, lhs, 3m lead -2 -40 German real GDP (q/q annualized) -10% 80 -3 -50 75 -14% -60 -4 1995 1997 2000 2003 2005 2008 1997 1999 2001 2003 2005 2007 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 113
  • 114. 08 December 2010We also highlight that Germany looks cheap on both relative P/E and price to book,trading at 10% and 17% respective discounts relative to global, compared with averagediscounts of 4% and 6%, respectively.Figure 282: Germany looks cheap on relative forward PE... Figure 283: ... and price to book 160% 140% 145% 130% 130% 120% 115% 110% 100% 100% 85% 90% 70% 80% 55% 70% 40% 60% 1990 1993 1997 2000 2004 2007 2011 1990 1993 1997 2000 2004 2007 2011 Germany rel World:12m fwd P/E Average ex bubble Germany rel World:P/B Average ex bubbleSource: Thomson Reuters, IBES, Credit Suisse research Source: Thomson Reuters, IBES, Credit Suisse researchBelow we show the German domestic stocks (i.e., with >35% of sales from the domesticmarket) - these include Commerzbank, Deutsche Wohnen, Deutsche Euroshop.Figure 284: German stocks with domestic exposure above 35% of total sales -----P/E (12m fwd) ------ ------ P/B ------- Yield (2010e) HOLT Momentum rel to mkt % rel to mkt % Price, % Consensus 3m Sale s Domestic Sales 3m EPS Credit SuisseName Abs rel to In dustry above/below Abs above/below FCY DY change to (buy less holds Exposure (in %) rating average average best & sells)Deutsche Wohnen Ag 100% 22.2 129% n/a 0.9 n/a n/m 1.7% -43.5 -5.0 -8.3 -9.1 OutperformCommerzbank Ag 93% 9.9 102% 13% 0.3 -70% n/m 0.0% 4.4 56.1 0.0 -63.6 OutperformDeutsche Euroshop 83% 16.5 95% n/a 1.1 n/a n/m 4.2% -21.8 1.5 0.1 -27.3 OutperformFielmann Ag 81% 21.0 145% 44% 5.2 84% 4.0% 3.2% -37.0 0.1 -0.1 -50.0 NRAxel Springer Ag 79% 11.5 87% -25% 3.0 -8% 9.5% 4.1% -5.3 3.1 1.5 25.0 NRDouglas Hldg Ag 66% 16.5 113% 28% 2.2 7% 6.1% 2.6% -11.8 1.0 0.9 22.2 NRMetro Ag 39% 15.5 118% 31% 3.4 51% 3.1% 2.2% -25.1 4.4 0.1 -14.3 NeutralSource: MSCI, I/B/E/S, Thomson Reuters, Factset, Credit Suisse HOLT, Credit Suisse researchWhich stocks would we avoid?Below we show those European stocks that look expensive on HOLT, with a FCF below5% and with negative earnings momentum. Underperform-rated stocks are Galp Energia,Vestas, Eiffage, Ypsomed.Global Equity Strategy 114
  • 115. 08 December 2010Figure 285: Continental European stocks that look expensive on HOLT, have FCF yields below 5% and earningsmomentum below the market -----P/E (12m fwd) ------ ------ P/B ------- Yield (2010e) HOLT Momentum rel to mkt % rel to mkt % Price, % Consensus 3m Sales 3m EPS Credit SuisseName Abs rel to Industry above/below Abs above/below FCY DY change to (buy less holds rating average average best & sells)Galp Energia 20.6 191% n/a 4.2 n/a -3.2% 1.6% -53.1 -2.7 0.6 26.3 UnderperformVeolia Environneme 16.3 138% 26% 1.3 -42% 1.1% 5.8% -8.1 -3.7 0.7 20.0 NeutralSgs Sa 20.0 n/a 62% 6.5 93% 4.7% 2.4% -5.4 -1.1 -0.6 -36.8 NeutralColruyt Sa 15.9 121% 28% 5.1 30% 3.4% 2.4% -5.9 -0.4 -0.2 -44.0 NeutralVestas Wind System 12.7 88% -28% 10.6 214% -6.7% 0.0% -3.5 -17.3 0.7 -28.2 UnderperformSsab Ab 13.6 121% 90% 0.9 -12% 3.9% 1.6% -11.3 -29.0 -1.1 -56.5 NeutralEiffage 10.9 82% 46% 1.3 -6% 3.2% 3.7% -39.6 -0.4 1.2 -84.6 UnderperformNeste Oil Oyj 9.9 91% 5% 1.3 -40% -16.0% 2.3% -14.0 -3.7 0.1 -30.4 NeutralEdf Energies Nouv 16.0 n/a n/a 1.7 n/a -31.7% 1.4% -89.6 0.0 1.4 -4.4 NeutralRhoen-Klinikum Ag 14.3 123% 5% 1.6 -26% -1.9% 1.9% -14.6 -3.9 -0.7 30.8 NeutralBulgari Spa 27.0 148% 72% 2.8 -19% 3.0% 1.0% -43.6 -5.8 1.3 -68.8 NeutralNobel Biocare Ag 17.8 130% -17% 6.4 -34% 4.8% 1.5% -37.7 -16.3 -0.3 -58.3 NeutralYpsomed Hold ing Ag 46.2 n/a n/a 1.3 n/a 2.9% 0.2% -65.1 -23.9 -2.8 -100.0 UnderperformSource: MSCI, I/B/E/S, Factset, Thomson Reuters, Credit Suisse HOLT, Credit Suisse researchWe also worry that the dollar exporters are looking quite expensive.Figure 286: The price relative is high for dollar earners … Figure 287: … although their 12-month forward P/E relative has corrected a bit 230 Europe USD transactional ex posure 12m fw d P/E rel market Europe USD transactional ex posure price rel market 190% Av erage 210 170% 190 150% 170 130% 150 110% 130 90% 110 70% 90 50% 1999 2001 2003 2005 2007 2009 2011 1992 1995 1998 2001 2004 2007 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchExhibit 288: Continental European dollar exporters Proportion of Price rel perf Proportion of FCF yield, HOLT % change Company revenues in Difference since 17th Mar CS Rating costs in US$ 2010e to best: 2010 US$ 10 EADS 75% 28% 47% 3.3% -29.5 22% Underperform LVMH 50% 33% 17% 4.2% -23.0 43% Neutral Richemont 50% 33% 17% 4.3% -25.9 40% Neutral Atlas Copco 20% 12% 8% 5.6% -10.6 48% Neutral SKF 20% 13% 7% 7.0% -17.7 58% NeutralSource: MSCI, I/B/E/S, Factset, Thomson Reuters, Credit Suisse HOLT, Credit Suisse researchGlobal Equity Strategy 115
  • 116. 08 December 2010US: stay underweightIn local currency terms we keep the US underweight for the following reasons:(1) c65% of sales still come from the US (a bit more if we look at earnings) and westill think that prospects for domestic demand are worse than those in the UK,Europe or emerging marketsWe believe that a problem in the US is that there appears to be much more of a rise in thesecular or trend unemployment than elsewhere. The Bureau of Labor’s preferred measureof underemployment (unemployment plus discouraged workers plus part-timers thatcannot find a permanent job) is at all-time high of 17% and the long-term unemployed (>27weeks) account for a record 41% of total unemployment (in 1982, the US unemploymentrate was 1pp higher than it is now, but the proportion of long-term unemployed was halfthe current level).Figure 289: Unemployment may be trending up in the US Figure 290: ... but is trending down in Europe... 50% US, long-term unemployed (>27weeks), % tot. 12% 12.0 US unemployment rate (rhs) 45% 11% 10.0 40% 10% 35% 9% 8.0 30% 8% 25% 6.0 7% 20% 6% 4.0 15% US unemployment rate, 5y mav 10% 5% 2.0 Germany unemployment rate, 5y mav 5% 4% 0% 3% 0.0 1971 1976 1981 1986 1991 1996 2001 2006 2011 1975 1980 1985 1990 1995 2000 2005 2010Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchWe would highlight that employment is up 0.5% yoy in the US over the past 12 months,compared to 0.9% in Germany and 1% in the UK, even if GDP growth has been roughlysimilar.Figure 291: Employment growth in the US has been very weak compared to otherdeveloped countries % change over last 12 months Country Employment GDP Employment/GDP Australia 3.0% 2.9% 1.04 Canada 1.8% 3.2% 0.57 UK 1.0% 2.8% 0.36 Germany 0.9% 3.9% 0.23 Japan 0.7% 4.1% 0.17 US 0.5% 3.2% 0.15Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 116
  • 117. 08 December 2010Indeed one of the problems in the US is not only the 2.1m of job losses in the constructionrelated sector over the last 4 years (accounting for 26% of total job losses) but asimportantly, after 99 months of unemployment, benefits cease and job retraining schemesare less generous than in other countries (0.2% of GDP compared to 1.2% in Germany, onOECD data), suggesting more of a skills mismatch.(2) The US is the most expensive region in our scorecardOn our scorecard, based on relative 12m forward PE, price to book, PEG ratio, dividendyield and implied EPS growth relative to trend GDP growth, the US looks the mostexpensive of any region, as shown below.Figure 292: The US looks the most expensive market globally on traditional valuation metrics Regional valuation scorecard 12m Fwd PE Price to Book PEG ratio Dividend Yield Implied LT EPS growth Composite Rank Rel. to trend Region Abs Rel Z-score Abs Rel Z-score Abs Rel Z-score Abs Rel Z-score Abs Z-score Z-score Z-score GDP growthJapan 13.3 1.10 -1.0 1.08 0.59 -1.3 0.58 0.65 -0.5 1.97 0.84 2.8 8.7% 4.00 1.8 -1.3 1Eur exUK 10.8 0.90 -0.1 1.52 0.83 0.1 0.94 1.07 0.1 2.91 1.24 0.0 7.5% 2.13 0.1 -0.5 2UK 10.3 0.86 -0.3 1.72 0.94 -0.3 0.63 0.73 -1.2 2.86 1.21 -2.1 10.3% 2.98 0.8 -0.5 3GEM 11.5 0.95 0.8 2.28 1.24 2.2 0.58 0.65 -0.5 2.19 0.93 -0.8 7.8% 1.08 -0.9 -0.1 4NJA 13.0 1.08 1.3 2.23 1.22 2.2 0.63 0.70 1.0 2.09 0.89 -1.0 7.3% 0.85 -1.1 1.0 5US 12.6 1.05 0.6 2.30 1.25 -0.9 1.09 1.28 3.0 1.87 0.79 -0.6 7.4% 1.78 -0.3 1.3 6Source: Thomson Reuters, IBES estimates, Credit Suisse estimatesIn particular, we highlight that the US trades above the long-term average on both relativeprice earnings ratio and price to book.Figure 293: US 12-month forward P/E relative Figure 294: US price-to-book relative 120% 12m fw d P/E - USA relativ e to World 150% P/B - USA relativ e to World Av erage Av erage 115% 140% 110% 130% 105% 120% 100% 95% 110% 90% 100% 85% 90% 80% 75% 80% 70% 70% 1991 1995 1999 2003 2007 2011 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchWe would also note that the US market looks expensive on HOLT.Global Equity Strategy 117
  • 118. 08 December 2010Figure 295: The US market looks expensive on HOLT 1. 9 US NJA 1. 7 UK GEM LatAm 1. 5 Value-t o-cost 1. 3 EMEA Europe (ex UK) 1. 1 0. 9 Japan 0. 7 3% 4% 5% 6% 7% 8% 9% 10% CFROI®, 2010ESource: Credit Suisse HOLT(3) The US tends to be a defensive market, outperforming when global leadindicators roll over and fall below 2% year-on-yearWe think that the bulk of deceleration in global growth has occurred—which is negative forUS relative performance.Figure 296: US price relative and OECD lead indicators ... Figure 297: ...as the US has low operational leveragenegative correlation ... 25 US rel. pf. Yoy% (lhs) -14 Country/region Beta of EPS to Global IP OECD lead indicator y/y% (rhs, inv.) -12 20 Forecast -10 Japan 5.2 15 -8 Emerging markets 4.1 -6 Continental Europe 3.6 10 -4 World 3.3 -2 5 US 2.9 0 UK 2.5 0 2 Monthly data over last 20 years, yoy % change 4 -5 6 8 -10 10 -15 12 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010Source: Thomson Reuters, Credit Suisse estimates Source: Thomson Reuters, Credit Suisse researchThis is because historically, the response of Congress and the Fed to slower growth hasbeen quicker than elsewhere into a slowdown (as we have again seen this time round withthe Fed renewing QE and Congress renewing the Bush tax cuts). In addition, into aslowdown corporates have been more able than elsewhere to cut costs. Policy andbusiness flexibility typically results in lower operational leverage – on our calculation theUS market has an operational leverage (defined as beta of EPS to global industrialproduction over the last 20 years) which is almost half that of Japan and 20% belowGlobal Equity Strategy 118
  • 119. 08 December 2010Europe (the UK has very low operational leverage but that is largely irrelevant as only 10%of UK earnings come from the UK cyclical sectors).Additionally, we do not think this is the stage of the cycle where cost cutting is thepremium issue. Top line is the premium issue.(4) No clear plan (or apparent will) to tackle the fiscal deficitThe US has the worst cyclically adjusted primary budget deficit of any OECD country thisyear (7% of GDP)—we calculate it would need fiscal tightening equivalent to 4.5% of GDPto stabilise the government to GDP ratio. Only Japan has more fiscal tightening to do.Figure 298: The US has one of the worst cyclically- Figure 299: ... leading to a required fiscal tighteningadjusted budget deficit and no plans to reduce it beyond 2012 of 4.5% of GDP just to stabilise the debt tosignificantly in the next few years... GDP ratio 8% 10% Underlying primary deficit 2010E Required fiscal tightening required to stabilize 8% 6% (% of GDP) debt over the long term (% of GDP) 6% 4% 4% 2% 2% 0% -2% 0% -4% -2% -6% -8% -4% Czech Republic Luxembourg Switzerland Netherlands Italy United States Norway Denmark Hungary Slovak Republic Sweden Japan Spain Ireland Canada New Zealand Greece Australia Korea United Kingdom Belgium Portugal Germany Iceland Poland France Austria Finland Italy United Iceland Austria Czech Finland United States Slovak Norway Germany Netherlands Denmark Hungary Japan Ireland Poland Spain New Zealand France Australia Greece Switzerland Luxembourg Korea Portugal Belgium Canada SwedenSource: Thomson Reuters, Credit Suisse research Source: OECD, Economic Outlook November 2010We would also highlight that according to OECD estimates (OECD Outlook, November2010), the fiscal tightening required to stabilise the government to GDP ratio beyond 2012,i.e., taking into account the measures that have been announced already, would be 5.2%of GDP in the US, by far the second biggest adjustment after Japan (8.4% of GDP).The UK and other countries (peripheral Europe) have very clear plans to reduce theirdeficits. In the case of the UK, we think the plan is credible because the currentgovernment has another maximum of 53 months in office. In peripheral Europe, the planshave to be credible (not least because otherwise the ECB would stop re-poing the bondsof the banks and the EU/IMF bailout disbursements are conditional on achieving strictdeficit targets).We worry that there is now fiscal confusion in the US.(5) A weaker dollar is historically not good for US market relative performanceWe acknowledge that a weaker dollar is a boost to export growth, but exports account foronly 12% of GDP and the exposure to foreign sales for the S&P is about 35% according toour US strategist Doug Cliggott.Historically, a weaker dollar has been associated with the US market underperformingglobal markets in common currency terms, as shown below.In particular, we would highlight that the current level of the US dollar trade-weighted isconsistent with a 5% underperformance of US equities relative to global equities.Global Equity Strategy 119
  • 120. 08 December 2010Figure 300: The US market tends to underperform when the dollar weakens 4.10 105 US rel. to global equities (in USD) USD trade-weighted (rhs) 4.00 100 3.90 95 3.80 3.70 90 3.60 85 3.50 80 3.40 3.30 75 2005 2006 2007 2008 2009 2010Source: Thomson Reuters, Credit Suisse researchWe think that the Fed’s policy is likely to lead to a further debasement of the dollar. Thiscould make investors cautious about investing in US assets altogether, we believe.We would highlight that the dollar has not yet fallen to levels far below its downtrend (7%versus 17% below in 1995) and it is actually tracking quite closely the performance of theYen during the BOJ quantitative easing in 2001-2006, which would suggest furtherdownside is likely from here.Figure 301: The dollar has further to fall relative to its Figure 302: The dollar is tracking the Yen during BOJdowntrend (1% p.a.) quantitative easing in 2001-2006 40% Yen Trade-weighted ( Mar 01 - Mar 06) US$ trade-weighted, % deviation 145 Dollar trade weighted ( Sep. 08 - present, rhs) from long-term trend 95 30% 140 90 20% 135 85 10% 130 80 0% 125 75 -10% 120 70 -20% 1 25 49 73 97 121 145 169 193 217 241 265 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 Weeks ( 0 = quantitative easing introduced)Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research(6) The tactical indicators look a bit worryingNet inflows into US equity funds have been quite significant over the last three months andthe relative price momentum look extended, as shown below.Global Equity Strategy 120
  • 121. 08 December 2010Figure 303: Net inflows into US equity funds is quite high Figure 304: US price momentum: % deviation from 6- month moving average 15% 15% 10% 10% 5% 5% 0% 0% -5% -5% -10% -10% -15% -15% 3m annualised net flow s into US equity funds, -20% as a % of assets -20% -25% 1990 1993 1997 2000 2004 2007 2011 2004 2005 2006 2007 2008 2009 2010 2011 USA:Price mom Average ex bubbleSource: EPFR Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 121
  • 122. 08 December 2010Appendix 1: US weekly lead indicatorOur weekly lead indicator is a composite index of 10 lead indicators with a strong trackrecord in predicting quarterly real GDP growth in the US. For each component, wecalculate the standardised 3-month rate of change, and the average standardised valueacross all components is the value of the index, which is in turn translates into an impliedquarterly annualised growth of US real GDP using a simple regression analysis (data startin January 1980).The components of our lead indicators are listed below:■ ISM New Orders■ Jobless Claims■ Steel production capacity■ Redbook weekly Retail Sales■ Money/ABC Consumer Comfort Index■ NAHB Housing Index■ CRB Raw Industrial Index■ Yield Curve (10y-3m)■ Corporate BAA - Treasury 10y spread■ Earnings Revisions ratio (S&P 500 Index)Global Equity Strategy 122
  • 123. 08 December 2010Appendix 2: US housing—excess inventoryFigure 305: Estimate of the US housing excess inventory ... 2.3 years at current startslevel Estimate of US housing demand (million units) Household formation 1.31 Trend growth of vacant units 0.05 Net Removal of housing units 0.24 Underlying demand of housing units 1.60 Placements of mobile homes 0.14 Underlying numbers of completions 1.46 Units startetd but not completed 0.06 Underlying numbers of housing starts 1.52 Current level of housing starts 0.52 Net demand 1.00 Net supply from unsold homes 1.35 Net supply from foreclosed properties* 0.97 Excess housing inventory 2.3 Years required to absorb excess inventory 2.3 *50% of housing units in foreclosure processSource: CBO, Thomson Reuters, Credit Suisse estimatesGlobal Equity Strategy 123
  • 124. 08 December 2010Appendix 3: Companies that look‘safer’ and ‘cheaper’ than theirrespective governments’ bondsFigure 306: European companies with CDS below their governments’ and dividend yield above the bond yield -----P/E (12m fwd) ------ ------ P/B ------- Yield (2010e) HOLT Momentum rel to mkt % rel to mkt % Price, % Consensus 3m Sales 3m EPS Credit SuisseName CDS Spreads Abs rel to Industry above/below Abs above/below FCY DY change to (buy less holds rating average average best & sells)Novartis Ag 35 10.2 101% -25% 2.3 -21% 8.7% 4.2% 74.2 2.2 2.2 51.4 NeutralRoche Hldgs Ag 42 9.7 96% -31% 21.9 660% 9.1% 4.7% 83.8 -2.2 -1.3 33.3 OutperformAstrazeneca 53 7.4 73% -43% 2.0 -56% 14.5% 5.2% 94.7 2.0 0.4 -20.0 NeutralGlaxosmithkline 56 10.5 104% -14% 7.3 -6% 7.9% 4.8% 29.4 -16.2 -1.0 -2.4 UnderperformBrit Amer Tobacco 58 12.5 100% 44% 5.7 72% 7.2% 4.7% -8.6 -0.1 -0.1 20.0 NeutralTotal 59 7.7 71% -17% 1.4 -21% 5.4% 6.1% 52.1 -1.2 2.2 43.8 NeutralRoyal Dutch Shell 60 8.3 77% -19% 0.9 -47% 8.1% 5.6% -3.2 0.9 5.1 48.2 NRSanofi-Aventis 62 7.2 72% -43% 1.2 -34% 18.4% 5.4% 126.9 2.1 1.0 39.4 RestrictedPearson 66 13.0 98% 2% 1.7 -12% 12.4% 4.0% -1.2 0.3 -0.4 -20.0 OutperformFrance Telecom 70 9.1 82% -8% 1.4 -32% 13.0% 8.7% 37.7 4.3 0.5 -2.6 UnderperformMobistar 70 11.6 82% 2% 9.1 30% 8.8% 8.8% 3.7 1.6 1.5 -52.4 NeutralGdf Suez 76 11.8 99% n/a 1.0 n/a 0.9% 5.8% 12.3 2.6 0.4 30.8 NREdf 80 14.9 126% -15% 1.9 -44% -0.7% 3.6% -16.0 0.1 0.6 36.0 NREni 80 7.6 71% -7% 1.2 -34% 2.7% 6.5% 61.6 -0.4 1.7 -21.2 NeutralSnam Rete Gas 80 12.3 89% 0% 2.2 66% 2.6% 5.7% -29.6 2.8 0.6 -4.4 OutperformUnibail-Rodamco Se 85 15.3 n/a 8% 1.3 8% n/m 5.8% -23.9 -2.0 -1.4 -39.1 OutperformBouygues 87 8.9 66% -27% 1.3 -21% 10.1% 4.8% 14.6 -5.1 0.5 23.8 NRAtlantia Spa 153 12.3 65% n/a 3.2 n/a -1.1% 4.8% -29.6 -5.5 -1.1 100.0 OutperformEdison Spa 156 19.1 n/a n/a 0.5 n/a 6.2% 5.3% -27.4 -1.5 -2.7 -40.0 NRUnipol Gruppo Fin 170 8.9 93% n/a 0.5 n/a n/m 5.1% 24.6 -9.5 -7.4 -53.9 NRFinmeccanica Spa 192 7.3 60% -42% 0.8 -18% 12.4% 4.7% 56.1 -0.2 -0.2 -13.0 NeutralEnel 199 8.0 67% -31% 1.0 -35% 7.4% 7.3% 41.5 1.1 0.9 25.7 NeutralEndesa Sa 199 8.9 n/a 6% 1.3 -26% 9.1% 6.3% 67.0 8.2 5.7 -38.5 NRTelefonica Sa 200 8.9 81% -15% 3.9 102% 11.0% 8.0% 29.8 0.0 2.5 28.9 NeutralIberdrola Sa 211 10.2 86% 10% 1.0 -6% 4.1% 6.1% 47.6 2.3 2.3 -9.1 NeutralBanco Santander 242 6.5 67% -19% 0.9 -42% n/m 7.5% 23.8 -3.9 0.7 0.0 NRBbva(Bilb-Viz-Arg) 257 6.3 65% -21% 0.9 -43% n/m 5.5% 13.8 -2.3 0.0 8.6 NRGas Natural Sdg 280 8.8 63% -28% 0.8 -60% 10.9% 7.5% 41.8 -13.7 2.3 -15.4 OutperformSource: MSCI, IBES, Factset, Thomson Reuters, Credit Suisse research, Credit Suisse researchGlobal Equity Strategy 124
  • 125. 08 December 2010Appendix 4: Bull/bear ratio—backtest resultsFigure 307: We back-tested Individual Investors Bull/ Bear ratio: on previous occasionsit rose to the highs reached 3 weeks ago, the market was up on a 1-6 month view Performance of S&P after Date 1wk 2wk 1m 2m 3m 6m 12m Mar-88 -3.3% -3.8% -4.6% -5.9% 1.1% 0.5% 8.1% Feb-91 3.8% 2.0% 3.4% 4.5% 5.3% 9.3% 14.5% Apr-92 1.9% 1.8% 1.9% -1.4% 2.1% 2.7% 7.1% Nov-92 0.7% 2.2% 2.8% 2.0% 1.7% 6.0% 8.1% Mar-95 2.2% 2.7% 5.0% 7.9% 11.1% 18.3% 35.2% Nov-95 1.9% 2.9% 4.7% 2.1% 12.1% 12.9% 24.1% Dec-96 -0.1% -3.0% -1.5% 5.1% 5.7% 12.3% 30.5% Jun-97 3.4% 3.6% 5.6% 7.9% 7.9% 12.1% 28.5% Dec-98 0.5% -1.1% 4.6% 8.9% 4.3% 10.2% 18.9% May-99 -1.6% -5.3% -3.9% 3.5% -5.5% 1.3% 2.0% Nov-99 1.5% 1.0% 5.4% -2.1% -1.6% 2.3% -3.4% May-01 -0.9% 3.8% 1.2% -5.6% -4.5% -11.5% -13.7% Oct-01 -2.3% 3.1% 4.8% 5.5% 3.2% 0.8% -17.4% Mar-02 0.4% -2.3% -5.3% -9.5% -13.0% -22.0% -31.0% Nov-02 0.8% -1.0% -2.6% -5.7% -8.2% 4.4% 15.9% May-03 3.5% 5.6% 8.2% 8.0% 9.0% 13.3% 18.4% Oct-04 -1.7% -1.0% 4.6% 5.9% 5.5% 4.6% 5.0% Jun-05 -1.0% -0.7% 1.1% 0.5% 0.6% 4.1% 3.2% Nov-05 0.5% 0.8% -0.2% 2.1% 1.8% 1.0% 11.3% Jan-07 0.1% 1.4% 2.0% 0.6% 3.7% 6.3% -6.3% Average 0.5% 0.6% 1.9% 1.7% 2.1% 4.4% 8.0% Median 0.5% 1.2% 2.4% 2.1% 2.6% 4.5% 8.1% % outperform 65% 60% 70% 70% 75% 90% 75%Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 125
  • 126. 08 December 2010Appendix 5: GEM risk appetite andrelative performanceFigure 308: When the GEM relative risk appetite has historically been at current levels, GEM has tended to outperformover the subsequent 3–6 months Rel. performance of GEM(lc) when RA reached current level after Date 1 wk 2 wk 1m 2m 3m 6m 12m Jul-96 0.4% -2.4% -2.9% -4.0% -6.1% -5.0% -7.3% Jun-98 -4.8% -5.8% -8.6% -7.3% -22.3% -17.8% 0.8% Oct-98 -0.9% -0.2% 1.9% -2.7% -4.1% 5.9% 24.7% Dec-99 0.8% 1.7% 8.5% 12.1% 4.3% -3.9% -14.2% Feb-01 0.3% 2.1% 1.1% -2.0% -4.4% -2.5% 19.8% May-01 -0.1% 1.6% 3.4% 3.6% 2.5% 4.4% 36.2% Feb-02 -0.6% -0.3% 2.4% 8.5% 6.6% 7.2% 15.3% Nov-02 2.0% 1.9% 2.5% 5.0% 4.5% 0.9% 13.4% Nov-04 0.2% 1.7% 0.5% 1.5% 4.2% 2.1% 13.1% Mar-05 -1.0% -1.3% -2.7% -2.9% -2.7% 3.6% 12.0% Sep-05 0.6% 2.1% 4.6% 1.5% 3.6% 8.6% 11.1% Nov-05 0.0% 0.3% 2.0% 6.4% 7.8% 11.4% 10.0% Feb-07 -0.6% 0.2% -1.2% 1.8% 2.2% 13.7% 27.0% Jun-07 2.0% 3.7% 6.2% 6.4% 12.3% 18.7% 20.5% Apr-08 1.9% 2.1% 1.6% 2.0% -2.6% -13.7% 2.9% Sep-08 2.0% 2.7% 4.7% -2.3% 3.5% 14.3% 25.5% Feb-10 -0.6% -0.4% -0.3% -2.1% -0.8% 8.0% Average 0.1% 0.6% 1.4% 1.5% 0.5% 3.3% 13.2% Median 0.2% 1.6% 1.9% 1.5% 2.5% 4.4% 13.3% % outperform 59% 65% 71% 59% 59% 71% 88%Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 126
  • 127. 08 December 2010Appendix 6: PE model for GEM countries—detailFigure 309: PE model for GEM countries Budget & CA Gross Warranted Total debt Potential Inflation Country balance (2010,% savings 12m fwd P/E 12m fwd Gap (2010,% of GDP) GDP growth (2010E) of GDP) ratio P/EIndia 140% -11% 31% 8% 13% 16.5 11.9 -28%Colombia 72% -6% 21% 5% 2% 19.5 14.5 -25%Hong Kong 193% 7% 33% 4% 3% 16.6 12.9 -23%Philippines 78% 0% 19% 4% 4% 15.6 13.4 -14%Chile 73% -3% 25% 5% 2% 16.8 14.6 -13%Mexico 61% -4% 19% 5% 4% 15.6 14.0 -11%Singapore 201% 13% 49% 5% 3% 14.1 12.7 -10%US 259% -11% 10% 2% 2% 12.8 11.9 -7%Malaysia 177% 7% 34% 5% 2% 14.7 13.8 -7%Indonesia 56% -1% 32% 7% 5% 14.7 14.8 1%Egypt 111% -11% 19% 6% 12% 10.7 11.7 9%South Africa 123% -9% 14% 4% 6% 11.8 12.9 9%Thailand 135% -1% 29% 5% 3% 12.5 13.9 11%Turkey 90% -9% 13% 4% 9% 10.5 11.7 12%Brazil 126% -6% 15% 4% 5% 10.8 12.9 19%Poland 112% -10% 21% 4% 2% 11.4 13.6 19%Hungary 235% -2% 18% 4% 5% 9.6 11.8 23%China 146% 3% 53% 10% 4% 12.2 15.9 31%Korea 153% 0% 32% 4% 3% 9.7 12.9 33%Russia 53% 1% 22% 4% 7% 8.6 13.0 51%Source: Thomson Reuters, IMF, OECD estimates, National data, Credit Suisse estimatesGlobal Equity Strategy 127
  • 128. 08 December 2010Appendix 7: GEM playsFigure 310: 12m fwd P/E GEM indirect rel GEM direct Figure 311: 12m fwd P/E GEM indirect 270% 12m fw d P/E GEM indirect rel GEM direct 130% GEM Indirect play s 12m fw d P/E rel World Av erage Av erage 250% 120% 230% 110% 210% 190% 100% 170% 90% 150% 80% 130% 70% 110% 90% 60% 70% 50% 1991 1995 1999 2003 2007 2011 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse researchGlobal Equity Strategy 128
  • 129. 08 December 2010Appendix 8: Country risk scorecardFigure 312: Country risk scorecard Economic indicators Ratings & CDS 2011 2011 Current Private Net Government Government Potential Country account sector external CDS Credit Overall budget debt GDP balance credit assets spreads Ratings score balance growth as % of GDP Weighting 11% 11% 11% 11% 21% 5% 11% 21% 1 Greece -0.4% -7.0% 139% 122% -87% 0.7% 988 BB+ 49.1 2 Portugal -5.3% -5.5% 99% 171% -113% 1.4% 419 A- 48.8 3 Iceland -0.3% -5.7% 128% 489% -390% 3.3% 295 BBB 48.3 4 Ireland -0.8% -11.8% 92% 314% -102% 2.6% 556 A 46.6 5 Spain -4.1% -7.1% 78% 226% -96% 1.7% 273 AA 44.4 6 Hungary 1.1% -3.1% 83% 153% -129% 3.8% 357 BBB- 43.0 7 Latvia 2.3% -6.0% 37% 101% -86% 3.9% 258 BB 39.6 8 Romania -6.6% -4.6% 39% 40% -65% 4.7% 320 BBB- 38.9 9 Italy -3.6% -4.2% 135% 121% -21% 1.4% 164 A+ 37.2 10 Turkey -5.8% -2.9% 43% 47% -45% 3.9% 142 BB+ 36.9 11 Poland -3.1% -6.5% 60% 52% -65% 4.0% 146 A 36.8 12 Ukraine -1.9% -4.3% 40% 77% -34% 5.1% na BB- 36.3 13 Lithuania 2.1% -6.3% 30% 68% -62% 2.8% 262 BBB 35.9 14 Bulgaria -4.0% -2.8% 15% 50% -115% 4.5% 246 BBB 35.9 15 Egypt -2.3% -8.3% 75% 36% -16% 6.1% 213 BBB- 35.8 16 India -3.3% -8.0% 72% 67% -9% 8.1% na BBB- 35.6 17 Brazil -3.4% -2.9% 61% 66% -38% 4.1% 116 BBB+ 33.0 18 New Zealand -4.5% -4.5% 44% 157% -105% 2.8% 64 AAA 32.3 19 United Kingdom -0.9% -9.0% 91% 215% -22% 2.8% 67 AAA 31.3 20 Belgium -1.6% -4.7% 105% 217% 45% 1.8% 137 AA+ 30.9 21 Czech Republic -3.8% -4.5% 40% 46% -47% 3.5% 91 A+ 30.8 22 United States -3.9% -7.0% 95% 165% -19% 2.4% 27 AAA 30.5 23 Colombia -2.3% -3.8% 46% 25% -26% 4.8% 118 BBB+ 30.2 24 South Africa -4.6% -4.3% 40% 83% -14% 4.5% 132 A+ 29.2 25 France -2.1% -6.4% 99% 154% -12% 2.1% 79 AAA 29.1 26 Estonia 0.6% -2.1% 7% 103% -84% 3.3% 82 A 28.9 27 Argentina 0.8% -0.8% 45% 12% 18% 3.0% 655 B 28.7 28 Philippines 3.1% -3.4% 54% 24% -10% 4.0% 132 BB+ 28.5 29 Japan 3.2% -6.9% 205% 163% 57% 1.8% 38 AA 27.0 30 Mexico -1.2% -2.3% 39% 23% -40% 4.7% 121 A 26.1 31 Indonesia 0.5% -1.8% 28% 28% -40% 6.9% 0 BB+ 25.7 32 Australia -3.3% -1.0% 26% 231% -48% 3.3% 46 AAA 25.3 33 Israel 2.2% -3.4% 78% 85% -3% 3.7% 113 AA- 25.2 34 Kazakhstan 3.8% 0.5% 18% 52% -42% 6.2% na BBB 25.0 35 Canada -2.1% -3.0% 81% 131% -9% 2.5% na AAA 24.9 36 Thailand 2.9% -3.4% 44% 91% -2% 5.3% 101 A- 24.5 37 Korea 0.6% -0.7% 37% 116% -18% 4.1% 98 A+ 23.6 38 Austria 1.9% -4.1% 77% 102% -14% 2.0% 60 AAA 22.6 39 The Netherlands 4.6% -4.5% 79% 222% 17% 1.8% 53 AAA 22.1 40 Russia 4.3% -3.2% 10% 42% 10% 4.3% 161 BBB+ 21.8 41 Denmark 3.9% -4.8% 57% 249% 4% 2.5% 27 AAA 21.6 42 Malaysia 11.0% -4.5% 55% 121% 18% 5.2% 76 A+ 21.2 43 Chile -2.0% -0.6% 8% 65% -12% 4.6% 88 AA 19.4 44 Germany 4.8% -2.5% 84% 134% 38% 1.7% 37 AAA 17.4 45 Sweden 5.5% -1.0% 57% 226% 1% 3.4% 26 AAA 16.9 46 China 5.0% -2.1% 19% 127% 37% 9.6% 61 A+ 16.1 47 Switzerland 7.8% -0.8% 41% 193% 138% 2.0% 44 AAA 13.3 48 Hong Kong 7.5% -0.7% 2% 190% 353% 4.2% 44 AA+ 12.6 49 Singapore 13.3% -0.1% 107% 94% 240% 4.7% 48 AAA 11.9 50 Norway 13.9% 9.4% 53% 137% 86% 1.9% 23 AAA 11.5 0.6% -3.8% 62% 124% -20% 4% 165Source: IMF, OECD, Thomson Reuters, National source, Credit Suisse researchGlobal Equity Strategy 129
  • 130. 08 December 2010Companies Mentioned (Price as of 03 Dec 10)Agricultural Bank of China (1288.HK, HK$4.09, OUTPERFORM [V], TP HK$4.66)Angang Steel Company Ltd (0347.HK, HK$11.18, OUTPERFORM [V], TP HK$13.50)Asian Paints (ASPN.BO, Rs 2590.00, OUTPERFORM, TP Rs 3045.25)Astellas Pharma (4503, ¥3,075, OUTPERFORM, TP ¥3,700, MARKET WEIGHT)Astra International (ASII.JK, Rp 54350.00, NEUTRAL, TP Rp 64000.00)AstraZeneca (AZN.L, 3023.00 p , NEUTRAL, TP 3100.00 p , OVERWEIGHT)Atlantia (ATL.MI, Eu 15.39, OUTPERFORM, TP Eu 25.00, OVERWEIGHT)Atlas Copco (ATCOa.ST, SKr 154.50, NEUTRAL, TP SKr 146.00, UNDERWEIGHT)Baoshan Iron & Steel (600019.SS, Rmb 6.37, OUTPERFORM [V], TP Rmb 8.50)British American Tobacco (BATS.L, 2333.50 p , NEUTRAL, TP 2430.00 p , OVERWEIGHT)Bulgari (BULG.MI, Eu 7.49, NEUTRAL, TP Eu 6.50, MARKET WEIGHT)CDL Hospitality Trusts (CDLT.SI, S$2.06, OUTPERFORM, TP S$2.52)China Construction Bank (0939.HK, HK$7.08, RESTRICTED)China Mengniu Dairy (2319.HK, HK$22.90, OUTPERFORM, TP HK$28.00)China Mobile Limited (0941.HK, HK$78.25, OUTPERFORM, TP HK$116.00)Colruyt (COLR.BR, Eu 38.34, NEUTRAL, TP Eu 38.00, OVERWEIGHT)Commerzbank (CBKG.F, Eu 5.73, OUTPERFORM [V], TP Eu 7.66, OVERWEIGHT)Compagnie Financiere Richemont SA (CFR.VX, SFr 54.75, NEUTRAL, TP SFr 55.00, MARKET WEIGHT)Dainippon Sumitomo Pharma (4506, ¥735, OUTPERFORM, TP ¥870, MARKET WEIGHT)Dairy Crest (DCG.L, 365.00 p , UNDERPERFORM, TP 375.00 p , OVERWEIGHT)Daum Communications Corp (035720.KQ, W 74,800, OUTPERFORM, TP W 99,000)Deutsche Euroshop (DEQGn.DE, Eu 26.05, OUTPERFORM, TP Eu 27.00, MARKET WEIGHT)Deutsche Wohnen (DWNG.DE, Eu 9.25, OUTPERFORM [V], TP Eu 9.00, MARKET WEIGHT)EADS (EAD.PA, Eu 17.22, UNDERPERFORM, TP Eu 15.50, MARKET WEIGHT)EDF Energies Nouvelles (EEN.PA, Eu 29.27, NEUTRAL, TP Eu 33.00, MARKET WEIGHT)Eiffage (FOUG.PA, Eu 32.65, UNDERPERFORM, TP Eu 48.00, OVERWEIGHT)Eisai (4523, ¥2,881, OUTPERFORM, TP ¥3,800, MARKET WEIGHT)Enel (ENEI.MI, Eu 3.67, NEUTRAL, TP Eu 4.15, MARKET WEIGHT)ENI (ENI.MI, Eu 15.35, NEUTRAL, TP Eu 17.70, MARKET WEIGHT)Fanuc (6954, ¥12,220, OUTPERFORM, TP ¥15,400, OVERWEIGHT)Finmeccanica (SIFI.MI, Eu 8.88, NEUTRAL, TP Eu 9.00, MARKET WEIGHT)FP (7947, ¥4,375, OUTPERFORM, TP ¥5,400)France Telecom (FTE.PA, Eu 15.76, UNDERPERFORM, TP Eu 16.50, MARKET WEIGHT)Fujitsu (6702, ¥552, OUTPERFORM, TP ¥710, MARKET WEIGHT)Galp Energia SGPS (GALP.LS, Eu 12.88, UNDERPERFORM, TP Eu 12.90, MARKET WEIGHT)Gas Natural (GAS.MC, Eu 10.36, OUTPERFORM, TP Eu 15.20, MARKET WEIGHT)GlaxoSmithKline (GSK.L, 1224.50 p , UNDERPERFORM, TP 1225.00 p , OVERWEIGHT)GOME Electrical Appliances Holding Limited (0493.HK, HK$3.07, OUTPERFORM [V], TP HK$3.20)Guangxi Liugong Machinery (000528.SZ, Rmb 38.19, OUTPERFORM [V], TP Rmb 42.75)Hero Honda Motors Ltd (HROH.BO, Rs 1951.00, OUTPERFORM, TP Rs 2364.73)Hitachi Metals (5486, ¥990, NEUTRAL [V], TP ¥880, MARKET WEIGHT)HTC Corp (2498.TW, NT$845.00, OUTPERFORM, TP NT$850.00)Hyundai Heavy Industries (009540.KS, W 365,500, NEUTRAL [V], TP W 327,000)Hyundai Mipo Dockyard (010620.KS, W 173,500, OUTPERFORM [V], TP W 229,000)Hyundai Mobis (012330.KS, W 275,000, OUTPERFORM, TP W 327,000)Iberdrola (IBE.MC, Eu 5.38, NEUTRAL, TP Eu 6.70, MARKET WEIGHT)IMI Plc (IMI.L, 862.00 p , UNDERPERFORM [V], TP 740.00 p , UNDERWEIGHT)Industrial & Commercial Bank of China (1398.HK, HK$5.96, RESTRICTED)INPEX Corporation (1605, ¥439,000, OUTPERFORM, TP ¥465,000, MARKET WEIGHT)Kesa Electricals (KESA.L, 167.50 p , UNDERPERFORM [V], TP 115.00 p , MARKET WEIGHT)Konami (9766, ¥1,579, OUTPERFORM, TP ¥2,100, MARKET WEIGHT)KT Corp (030200.KS, W 46,000, OUTPERFORM, TP W 60,000)KT&G Corp (033780.KS, W 63,200, OUTPERFORM, TP W 86,000)Kuraray (3405, ¥1,184, OUTPERFORM, TP ¥1,420, MARKET WEIGHT)Ladbrokes (LAD.L, 126.10 p , UNDERPERFORM, TP 119.00 p , MARKET WEIGHT)LG Chem Ltd. (051910.KS, W 381,500, OUTPERFORM, TP W 450,000)LG Display Co Ltd. (034220.KS, W 40,900, OUTPERFORM, TP W 50,000)Lonking Holdings Ltd. (3339.HK, HK$4.84, OUTPERFORM [V], TP HK$4.54)LUKOIL (LKOH.RTS, $58.10, OUTPERFORM [V], TP $81.40)LVMH (LVMH.PA, Eu 117.05, NEUTRAL, TP Eu 125.00, MARKET WEIGHT)Metro (MEOG.F, Eu 55.69, NEUTRAL, TP Eu 50.00, OVERWEIGHT)Mitchells & Butlers (MAB.L, 345.60 p , UNDERPERFORM, TP 280.00 p , MARKET WEIGHT)Mitsubishi Chemical Holdings (4188, ¥486, OUTPERFORM, TP ¥690, MARKET WEIGHT)Mitsubishi Electric (6503, ¥840, OUTPERFORM, TP ¥1,100, MARKET WEIGHT)Global Equity Strategy 130
  • 131. 08 December 2010Mobistar (MSTAR.BR, Eu 44.90, NEUTRAL, TP Eu 49.00, MARKET WEIGHT)Morgan Crucible (MGCR.L, 237.40 p , UNDERPERFORM [V], TP 210.00 p , MARKET WEIGHT)Neowiz Games Corp (095660.KQ, W 48,800, OUTPERFORM [V], TP W 75,000)Neste (NES1V.HE, Eu 10.84, NEUTRAL, TP Eu 11.80, MARKET WEIGHT)NGK Insulators (5333, ¥1,255, OUTPERFORM, TP ¥1,500, OVERWEIGHT)Nippon Telegraph and Telephone (9432, ¥3,850, OUTPERFORM, TP ¥6,000, OVERWEIGHT)Nobel Biocare (NOBN.VX, SFr 16.64, NEUTRAL [V], TP SFr 18.00, OVERWEIGHT)Northumbrian Water (NWG.L, 331.90 p , UNDERPERFORM, TP 335.00 p , MARKET WEIGHT)Novartis (NOVN.VX, SFr 54.05, NEUTRAL, TP SFr 59.00, OVERWEIGHT)NTT Data (9613, ¥276,800, SUSPENDED)Olympus (7733, ¥2,406, OUTPERFORM [V], TP ¥2,900, MARKET WEIGHT)Pearson (PSON.L, 931.50 p , OUTPERFORM, TP 1080.00 p , OVERWEIGHT)POSCO (005490.KS, W 452,500, OUTPERFORM, TP W 675,000)PT Indosat Tbk (ISAT.JK, Rp 5600.00, OUTPERFORM, TP Rp 8200.00)Rhoen Klinikum (RHKG.DE, Eu 15.97, NEUTRAL, TP Eu 17.00, MARKET WEIGHT)Roche (ROG.VX, SFr 138.60, OUTPERFORM, TP SFr 170.00, OVERWEIGHT)Sainsbury (SBRY.L, 360.00 p , UNDERPERFORM, TP 330.00 p , OVERWEIGHT)Samsung Electronics (005930.KS, W 836,000, OUTPERFORM, TP W 940,000)Sanofi-Aventis (SASY.PA, Eu 46.97, RESTRICTED)Santen Pharmaceutical (4536, ¥2,886, OUTPERFORM, TP ¥3,800, MARKET WEIGHT)Sberbank (SBER.RTS, $3.30, OUTPERFORM [V], TP $3.60)Schroders (SDR.L, 1630.00 p , UNDERPERFORM, TP 1650.00 p , MARKET WEIGHT)Sega Sammy Holdings (6460, ¥1,430, OUTPERFORM, TP ¥1,650, MARKET WEIGHT)Seiko Epson (6724, ¥1,390, OUTPERFORM, TP ¥1,700, MARKET WEIGHT)SGS Surveillance (SGSN.VX, SFr 1644.00, NEUTRAL, TP SFr 1610.00, MARKET WEIGHT)Shantui Construction Machinery (000680.SZ, Rmb 16.52, OUTPERFORM [V], TP Rmb 19.31)Siam Commercial Bank (SCB.BK, Bt 107.00, OUTPERFORM, TP Bt 132.00)SK Energy (096770.KS, W 160,000, OUTPERFORM, TP W 175,000)SKF (SKFb.ST, SKr 186.70, NEUTRAL, TP SKr 180.00, UNDERWEIGHT)Snam Rete Gas (SRG.MI, Eu 3.69, OUTPERFORM, TP Eu 3.82, MARKET WEIGHT)Sony (6758, ¥2,970, OUTPERFORM, TP ¥3,600, MARKET WEIGHT)SSAB (SSABa.ST, SKr 94.35, NEUTRAL [V], TP SKr 105.00, OVERWEIGHT)Standard Life (SL.L, 209.00 p , UNDERPERFORM, TP 226.00 p , MARKET WEIGHT)Sumitomo Electric Industries (5802, ¥1,117, OUTPERFORM, TP ¥1,530, OVERWEIGHT)Taiwan Fertilizer Co Ltd (1722.TW, NT$112.50, OUTPERFORM, TP NT$139.20)Telefonica (TEF.MC, Eu 16.59, NEUTRAL, TP Eu 17.00, MARKET WEIGHT)Terumo (4543, ¥4,570, OUTPERFORM, TP ¥5,500, MARKET WEIGHT)Total (TOTF.PA, Eu 37.10, NEUTRAL, TP Eu 43.50, MARKET WEIGHT)Unibail Rodamco (UNBP.PA, Eu 134.85, OUTPERFORM, TP Eu 171.00, MARKET WEIGHT)Veolia Environnement (VIE.PA, Eu 20.52, NEUTRAL, TP Eu 24.30, MARKET WEIGHT)Vestas (VWS.CO, DKr 156.50, UNDERPERFORM, TP DKr 150.00, MARKET WEIGHT)Weichai Power Co. Ltd (2338.HK, HK$54.15, OUTPERFORM [V], TP HK$58.50)Wilmar International Ltd (WLIL.SI, S$6.09, OUTPERFORM, TP S$7.35)Yamada Denki (9831, ¥5,310, OUTPERFORM, TP ¥7,500, MARKET WEIGHT)Yangzijiang Shipbuilding (Holdings) Ltd (YAZG.SI, S$1.81, OUTPERFORM, TP S$2.20)Ypsomed (YPSN.S, SFr 55.25, UNDERPERFORM, TP SFr 53.00, OVERWEIGHT)Companies mentioned in the report but not coveredAxel Springer Ag, Banco Santander, Bbva(Bilb-Viz-Arg), Bouygues, Douglas Hldg Ag, Edf, Edison Spa, Endesa Sa,Fielmann Ag, Gdf Suez, Golden Eagle Retail, Lukoil Oil Company, Royal Dutch Shell, Sberbank Rossii, Unipol Gruppo Fi Disclosure AppendixImportant Global DisclosuresThe analysts identified in this report each certify, with respect to the companies or securities that the individual analyzes, that (1) the viewsexpressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or hercompensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.The analyst(s) responsible for preparing this research report received compensation that is based upon various factors including Credit Suisses totalrevenues, a portion of which are generated by Credit Suisses investment banking activities.Analysts’ stock ratings are defined as follows:Outperform (O): The stock’s total return is expected to outperform the relevant benchmark* by at least 10-15% (or more, depending on perceivedrisk) over the next 12 months.Neutral (N): The stock’s total return is expected to be in line with the relevant benchmark* (range of ±10-15%) over the next 12 months.Global Equity Strategy 131
  • 132. 08 December 2010Underperform (U): The stock’s total return is expected to underperform the relevant benchmark* by 10-15% or more over the next 12 months.*Relevant benchmark by region: As of 29th May 2009, Australia, New Zealand, U.S. and Canadian ratings are based on (1) a stock’s absolute totalreturn potential to its current share price and (2) the relative attractiveness of a stock’s total return potential within an analyst’s coverage universe**,with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities.Some U.S. and Canadian ratings may fall outside the absolute total return ranges defined above, depending on market conditions and industryfactors. For Latin American, Japanese, and non-Japan Asia stocks, ratings are based on a stock’s total return relative to the average total return ofthe relevant country or regional benchmark; for European stocks, ratings are based on a stock’s total return relative to the analysts coverageuniverse**. For Australian and New Zealand stocks a 22% and a 12% threshold replace the 10-15% level in the Outperform and Underperform stockrating definitions, respectively, subject to analysts’ perceived risk. 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  • 133. 08 December 2010To the extent this is a report authored in whole or in part by a non-U.S. analyst and is made available in the U.S., the following are importantdisclosures regarding any non-U.S. analyst contributors:The non-U.S. research analysts listed below (if any) are not registered/qualified as research analysts with FINRA. 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