2012: the year the bills come due?In 2008, the world narrowly escaped a global depression thanks to quick action on anunpr...
2012: the year the bills come due?Is this the year the bills come due? In 2008, the world narrowly escaped a global depres...
growth. That does not mean permanent recession, but it does suggest that the era of long boomsand steadily rising asset pr...
then will be whether the debtor countries can maintain their austerity programs in the face of aworsening recession and wh...
The Eurozone, the US and the “fallacy of thrift”The problems of the Eurozone in a period of austerity and the banking syst...
US: Continued below-trend growth, but no recession expectedIt’s a measure of how much the world has changed that the US ec...
and it would take a major shock to get that price back up towards the $4/gallon level that seems tobe where it begins to i...
We can see the change in investor sentiment by                          Investors are reconsidering risky assetscomparing ...
Color                                  Asset Class                          S&P 500 (Bloomberg: SPTR Index )              ...
China: We expect the stock market to progress in two stages. At first, markets could moveaggressively lower due to heighte...
Sovereign Bonds: The biggest investment question of the year is probably whether sovereign bondswill remain an effective h...
Meanwhile, the super-low level of yields at the short end means carry is attractive, and a slowdownin the global economy a...
fiscal spending through automatic stabilizers if the economy turns down. In any event, monetaryeasing is likely to continu...
Renminbi: The problems in the Eurozone are CNY spot and possible 2012 trendlikely to cut into the growth of exports, which...
DisclaimerThe content of this document has been approved and issued by BOC (Suisse) SA (“BOCS”) for informationpurposes on...
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2012 Outlook


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My outlook for the year, written in December last year. Overly pessimistic unfortunately but with Spanish yields now over 6%, we\'re not out of the woods yet! (Pls note I did not write the China stocks or currency section.)

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2012 Outlook

  1. 1. 2012: the year the bills come due?In 2008, the world narrowly escaped a global depression thanks to quick action on anunprecedented scale by governments and central banks around the world. Is this the yearthat the global economy – and the markets – have to pay the bills for that rescue? We startthe coming year with more hope than confidence and believe that a cautious investmentstance is the most prudent.The main points of our view are as follows: The first half of the year is likely to be difficult, as the struggle to preserve the Eurozone continues and growth slows in China. The Eurozone will be the defining problem of 2012. We assume that Eurozone leaders will successfully resolve the region’s problems, leading to a rise in investor confidence and better markets in the second half. If not, things are likely to go from bad to worse, with the likely outcome highly bipolar: either depression and deflation, or much higher inflation. We expect China to have a "soft Landing" and overcome the global uncertainties. Growth is likely to slow in 1H, but as inflation drops further, the government should have the flexibility to act with appropriately accommodative measures. We expect modest, positive returns from equities this year. With earnings growth expected to be lower than in 2011, it would take a significant re-rating of stocks to push prices much higher. Any such re-rating is likely to come in 2H once we get more clarity on the Eurozone situation. Chinese stocks should find support during 1H after which we expect a solid uptrend. The biggest investment question is whether sovereign bonds will remain an effective hedge for equity markets. It will be difficult for them to return as much as they did in 2011, however we still expect bonds to turn in a positive return, in our view. We favor non-financial investment-grade credit for investors seeking preservation of capital with some income. Strong balance sheets and a recovering private sector economy should also support high yield in the US. Given our outlook for slower growth and a general reduction in risk-taking, we are not that optimistic about commodities as an asset class. Commodities with some structural supply bottlenecks, such as copper and corn, should do best. Gold is likely to remain an attractive hedge against potential problems in the fiat money system. In a world of increasing correlation, FX stands out as one market where some assets are clearly outperforming others. This year we expect the dollar and the yen to be the best performers initially, as risk aversion and the flight out of EUR continue. The renminbi should continue with its appreciation trend, although in light of the difficult global situation we look for only a 2%~3% rise vs. USD vs. the 4.4% gain in 2012.
  2. 2. 2012: the year the bills come due?Is this the year the bills come due? In 2008, the world narrowly escaped a global depression. Quickaction on an unprecedented scale by governments and central banks around the world managed toavert a sudden collapse in economic activity that was actually more severe than what the world sawin the beginning months of the Great Depression of the 1930s. Now however the ability ofgovernments to come to the rescue of the private sector has reached its limits. Monetary policycannot be loosened much further, while fiscal policy is everywhere being retrenched. Against thisbackground, the gradual disintegration of the Eurozone and the slowdown in China pose threats toglobal growth. On top of which, the uneasy political balances that existed in the Middle East, Russiaand the Korean peninsula have been disturbed, with unknown results. We start the coming year withmore hope than confidence and believe that a cautious investment stance is the most prudent.As we approach the new year, the major economic problems are well known: The inability of Eurozone leaders to solve their crisis after two years; Global deleveraging and the fallacy of thrift, which states that not everyone can save money at the same time; The slowdown in Chinese growth and especially the property market The price of oil, which is approaching levels that previously have caused recession; and The health of the US economy.Our central case is that the first half of the year will be difficult, as the struggle to preserve theEurozone continues and growth slows in China. We assume that leaders will successfully resolvethe Eurozone’s problems and that China will stabilize, leading to a more robust second half. Shouldthis not be the case however then things may well simply go from bad to worse.Looked at from a longer-term perspective, we believe we are in an era of shorter, more frequenteconomic cycles. We have come to the end of the era that began with the floating of the dollar in1971 and the creation of pure fiat currencies, which has allowed governments to use countercyclicalfiscal and monetary policies to support growth and suppress inflation. With no policies left to prolongthe expansion artificially, the major economies are likely to see shorter economic cycles and slower US economic expansions since 1854 (trough to peak, in months)140 The last three expansions were120 M edian much longer than the historical100 Average norm 80 60 40 20 0 Jun 1861 Mar 1879 Jun 1894 Jun 1897 Jun 1908 Mar 1919 Mar 1933 Jun 1938 Oct 1945 Oct 1949 Mar 1975 Mar 1991 Jun 2009 Dec 1854 Dec 1858 Dec 1867 Dec 1870 May 1885 Apr 1888 May 1891 Dec 1900 Aug 1904 Jan 1912 Dec 1914 Jul 1921 Jul 1924 Nov 1927 May 1954 Apr 1958 Feb 1961 Nov 1970 Jul 1980 Nov 1982 Nov 2001 Source: Deutsche Bank Global Markets Research 2
  3. 3. growth. That does not mean permanent recession, but it does suggest that the era of long boomsand steadily rising asset prices may be a thing of the past. Investors who got used to double-digitreturns on their portfolios during this period of unprecedented debt build-up are likely to bedisappointed as they realize just how much of that return was due to leverage in the economy. Withthe return of austerity, investors will have to get used to greater volatility and more modest returnson their portfolios.We shall deal with the major problems one by one, and then turn to our investment philosophy.Leading indicators leading downOur starting point is the OECD’s leading indicators. Leading indicators point towards further slowingThey are not going in the right direction – the trend is OECD Leading indicatorsgenerally down for the developed world (data until 35% trend-restored, 6m change annualized 30%end-October). That does not necessarily mean 25%recession, but it does suggest further slowing in 20% 15%growth from current levels. The question then is, 10%which way might events push the economy? 5% 0% -5%Unfortunately, it seems to us that the major risks are -10% OECD USA -15%on the downside. The Eurozone crisis remains the -20% Eurozone Chinadominant problem facing the world economy right -25% 2006 2007 2008 2009 2010 2011now. A recession in the region would be bad enough,although it is possible for the rest of the world to Source: Bloomberg Finance L.P.grow even if Europe does not. However the possiblebreak-up of the Euro would be an unprecedented shock to the global economy. We saw at the timeof the Lehman Bros. collapse how the global banking system can freeze up and send economieseverywhere into a tailspin. Questions over the fate of the Euro and the subsequent uncertainty overdebts in so many countries would dwarf even that cataclysmic event. This is the biggest problem thatwe face, and one that is not likely to go away any time soon, in our view.Eurozone: the defining problem of 2012We think that 2012 will largely be driven by EU political decisions. The market’s tolerance formuddling through is diminishing and so the tone of the year will probably be set by how theauthorities deal with the problem in Q1. They have shown their determination to keep the Eurozoneintact and their willingness to sacrifice growth for austerity. We therefore think this is likely to be apoor year for growth, but one in which the prospects could brighten considerably by the end of theyear if a stronger EU is created and the US political impasse is resolved in the November elections.Eurozone leaders have recently shown more willingness to compromise to get to the roots of theregion’s problem, which are a) a lack of economic convergence and b) the lack of fiscal union toaccompany monetary union. The economic reform packages being considered in the peripheralregions should go some way to meet the first requirement, while the treaty revisions underconsideration in 26 of the 27 EU member states may move some way towards meeting the second.Unfortunately neither can be reached quickly or easily and it remains to be seen whether themarkets will have the patience to wait while politicians compromise, make imperfect decisions andstumble while trying to execute even those modest plans. There is an inherent contradictionbetween the desire of EU officials to keep the pressure on the peripheral countries and their need tosimultaneously convince the markets that the Eurozone will remain intact. The real test this year 3
  4. 4. then will be whether the debtor countries can maintain their austerity programs in the face of aworsening recession and whether the relatively better-off core countries will be willing to help outthe periphery as falters. We believe that this struggle will be the deciding factor for markets in 2012and it is a race against the clock.Our working assumption is that policy The boulder in the road: bond issuance in 2012makers avoid a euro break-up or a disorderlysovereign and bank default. We wonder EURb Italian, Spanish and French monthly debt & interest payments in 2012though whether they will reach a solution or 140once again try to kick the can down the road. 120 Italy Spain FranceThat could be difficult this year because of the 100huge boulder in the road, namely that Spain, 80Italy and France need to find EUR954bn for 60their debt and interest payments (EUR418bnin the first four months alone). In this respect, 40if the Eurozone is the key to markets this year, 20Spain and Italy are the keys to the Eurozone. If 0they can deliver on their structural reforms, Jan-12 Apr-12 Jul-12 Oct-12then the market are likely to give them the Source: Bloomberg Finance L.P.benefit of the doubt and continue to buy their bonds. We give them a fighting chance; Spain’s newgovernment has a strong mandate to carry out structural reforms and seems determined to tacklethe banking sector’s problems, while in Italy, PM Mario Monti’s reform plans include both the fiscaland growth-enhancing measures that EU officials (and the market) were looking for.On the other hand, if resistance by politiciansor the public makes it look like the plans Euro-pessimism has usually proved correct in the pastwon’t be implemented, then investors may GIIPS CDS rate aroundonce again hesitate to buy these countries’ 900 EU summits 9-Dec 21-Jul 26-Octbonds and fears of a Eurozone break-up will 800resume. Then all outcomes are likely to beunder discussion once again: debt 700restructuring or default, full fiscal union, or 600printing money on a vast scale. The European 500crisis could therefore tip the world either into Eurozone summitsdeep recession and deflation, or aggressive 400 GIIPS weighted average CDSdebt monetization and a rapid rise in inflation. 300 rateWe hope that the leaders manage to navigate Jun-11 Aug-11 Oct-11 Dec-11their way between these two disasters, but so Source: Bloomberg Finance L.P., BOC (Suisse) SAfar pessimism has proved correct every time,as shown by the fall in CDS rates before the EU summits and the rise afterwards. The only way outmay have to be further ECB accommodation.It’s unfortunate that governments are having such difficulty funding themselves just when the bankshave to roll over some EUR 750bn of debt during the year plus enough more to meet new, stricterregulatory requirements. If the banks cannot raise the numerator (capital) of their capital adequacyrequirement, they will have to lower the denominator (assets). That deleveraging could cause adownward spiral in economic activity. 4
  5. 5. The Eurozone, the US and the “fallacy of thrift”The problems of the Eurozone in a period of austerity and the banking system’s attempt to refinanceitself bring into focus the problem of global austerity and the “fallacy of thrift.” It makes sense foreach country to get their fiscal house in order by reducing their spending and lower their debt.However, it is impossible for every country to save more money at the same time; someone has tospend more. In this respect, the developed world runs the risk of falling into the same trap thathappened in 1937. With the economy finally emerging from the Depression the previous year, the USTreasury cut spending and increased taxes, while the Fed raised bank reserve requirements twice torein in monetary policy. The result was another lurch down in activity in 1937~38. We fear that thegeneral move towards fiscal austerity in the developed world recently has echoes of that unfortunatepolicy mistake, as do the criticisms leveled at the Fed for its quantitative easing. We hope officialswill decide that the risk of a little inflation is better than the risk of a deflationary depression and willkeep policy as loose as possible for the time being.China: look to more loosening to support growthThe government has set the tone for 2012: Falling input prices = lower inflation in Chinastabilizing growth ahead of mounting globalrisks and rebalancing the economy’s reliance Rate of change in core inflation vs input price PMI 3 75on investment and export in favor of domestic 70 2consumption. With inflation waning, the 65government is gradually easing monetary 1 60 55policy and fine tuning its actions with respect 0 50to the economic slowdown. As mentioned in -1 45December during the Central Economic Work -2 Change in non-food CPI rate 40Conference, China’s politburo will combine its -3 from six months earlier (L) China Input prices PMI SA 35 30monetary measures with proactive fiscal -4 lagged 3m (R ) 25policies in order to avert a slowdown in GDP 2005 2006 2007 2008 2009 2010 2011 2012growth as economic activity slows during the Source: Bloomberg Finance L.P., BOC (Suisse) SAfirst half of this year.The fact that inflation is decelerating and should be back within target gives the government room tomaneuver that some other governments don’t have. While we see Q1 and Q2 to be tough due todifficult circumstances in the Eurozone, we expect the negative impact on China to be limited to thefirst half of the year. Indeed, economic measures to be implemented in the coming months shouldfacilitate the rebound and could boost the economic activity as well as growth during 2H. Moreoveras the government emphasizes the role of consumption for growth, we expect retail sales tocontinue expanding, helped by lower inflation, which historically has boosted sales.The government is likely to keep tightening measures in place for the real-estate and propertysectors, in our view. The growth in real estate investment will probably slow but we do not expectanything like the “China collapse” fears that one hears. The government has made clear its intentionto continue building more affordable housing, which should take up some of the slack and help tosupport demand for commodities. Moreover, a drop in prices should be self-stabilizing after a point,because more affordable housing should eventually attract buyers. 5
  6. 6. US: Continued below-trend growth, but no recession expectedIt’s a measure of how much the world has changed that the US economy only comes in for a mentionat this point in this essay. Usually, the US is the key determinant for the global economy. The marketexpects US growth to be around trend, neither particularly exciting nor worrisome. Inflation seemsunder control and monetary policy is frozen for now, unless the Eurozone problems worsen. Fiscalpolicy too cannot move either way as long as the stalemate continues in Congress, so we expect it tobe on autopilot (which implies a modest fiscal drag due to the expiry of some tax cuts). That largelyrules out the pre-election spending spree that sometimes has caused a spurt in growth and a boostto markets.Recent data in the US, such as new residential construction, small business confidence and initialjobless claims, an early indicator of the labor market, have exceeded expectations. But some of thatgrowth comes from one-off factors that might not continue. First off, many companies rebuilt theirinventories, but once they are restocked, that spurt in demand will slow. Secondly, consumersreduced their savings somewhat and gasoline prices declined, but we do not expect those trends tocontinue, either. Japan’s recovery after the tsunami caused a pick-up in demand, but Japan seems tobe slipping back into recession as well. Combined with the small fiscal drag, the result is likely to betrend growth at best. The reduction in US household debt, a recovery in auto sales (the average ageof the US fleet has been rising steadily for four years) and the gradual improvement of the housingmarket should help to keep the economy from weakening further, however. US households have paid down a lot of their New home sales recovering though prices still debt falling 14 % US household debt, personal savings % 12 US New home sales, house prices as a % of disposable income 25 % yoy % yoy 20 % yoy 10 15 Household debt payments (L) 15 13 Personal savings (R) 10 8 5 5 12 6 -5 0 -15 -5 New home sales (3m 4 moving avg) (L) -10 11 -25 2 Case/Shiller 20-city house -15 -35 price index (R) -20 10 0 -45 -25 1980 1985 1990 1995 2000 2005 2010 01 02 03 04 05 06 07 08 09 10 11 Source: Bloomberg Finance L.P. Source: Bloomberg Finance L.P.What else might happen?Finally, there are the geopolitical problems with will almost certainly arise but whose result cannotpossibly be predicted with any certainty. Foremost among them is the tension in the Middle East.Egypt remains in turmoil, civil war has effectively broken out in Syria, the US departure from Iraq hasunleashed sectarian violence there, and the “cold war” against Iran’s nuclear weapons is heating up.The Iranian threat to close the Strait of Hormuz and the US rejoinder that “any disruption will not betolerated” only raises the stakes. Higher oil prices remain a possibility that could tip fragile worldgrowth back down. Fortunately, the price of gasoline has declined substantially in the US recently, 6
  7. 7. and it would take a major shock to get that price back up towards the $4/gallon level that seems tobe where it begins to impact consumer behavior. We must also note the increase in shale oil andnatural gas production in the US as well, which could keep a lid on price rises. Nonetheless there isconsiderable uncertainty; the US Energy Information Administration recently issued a not-very-helpful forecast that the benchmark West Texas Intermediate crude oil could finish 2012 anywherebetween $49/bbl to $192/bbl (vs a recent price around $100/bbl). Note that barring any geopoliticaltensions, we would favor the lower end of that range as the development of shale gas and other newenergy supplies in the US may push prices downward.We admit, this is a fairly pessimistic picture. We therefore must add some of the things we thinkhave a good chance of going right.First off, the key point is that none of this issecret. Policymakers are well aware of these Global inflation remains quite subduedpitfalls. Thus we expect central banks to 12 % CPI inflation ratesremain accommodative and in particular for weighted by GDP at PPPthe European Central Bank to become more 10accommodative. They can afford to do so 8because the much-feared burst of inflation 6that some people thought might come withquantitative easing has not yet occurred. If 4anything, inflation is starting to slow in the 2developed world. We could even see QE 0 G3 (inc UK) Asia ex Japanextended to further asset classes if necessary -2 Latam EMEA(in Japan, the Bank of Japan has already 2004 2005 2006 2007 2008 2009 2010 2011started buying equity ETFs and REITs). Of Source: Bloomberg Finance L.P., BOC (Suisse) SAcourse, such policies could eventually backfireand cause the demise of the fiat currency system that has prevailed since the link to gold wasabolished in 1971. After falling for six years, the US housing market appears to be stabilizing. Giventhat it was the proximate cause of the 2008 collapse, this would be good news for the globaleconomy. It could bring some confidence back to the US consumer, the former driver of the worldeconomy. Finally, growth in emerging markets (particularly Asia) appears to be solid, although EMhas not decoupled from the developed world by any means.Investment strategy: where to put your money in such times.Against the background of this difficult economic Leading indicators suggest weaker marketsenvironment, we remain cautious on risky assets. 20% 120%Too much debt around the world, continued OECD Leading indicators 15% 100%deleveraging of financial institutions and a high trend-restored, 6m change annualized 80% 10%level of risk aversion among investors, both 60% 5% 40%personal and professional, suggest that it will take 0% 20%a major change in both the economic fundamentals -5% 0%and investor sentiment to bring back the “animal -10% -20% OECD + 6 major EM (L) -40%spirits” to the market. The downward trend in the -15% -60% MSCI World index % yoy (R)leading indicators mentioned above suggests this is -20% -80% 1996 1998 2000 2002 2004 2006 2008 2010 2012not likely to happen any time soon. Source: Bloomberg Finance L.P. 7
  8. 8. We can see the change in investor sentiment by Investors are reconsidering risky assetscomparing the forward earnings estimates on theMSCI All Country World Index (ACWI) to the price MSCI All World Index and 450 12m forward EPS 35of that index. The sharp decline in the price in the 400face of only a small drop in earnings estimates 30shows how investors de-rated equities in the 350 25second half of 2011. We believe this de-rating 300applied not only to equities, but to all asset classes: 20 250investors are reducing their expectations for the MSCI All World Index 15 200future and becoming more risk averse. Given the price (L) 12m forward EPS (R)uncertainties that we have outlined above, we do 150 10 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012not see much on the horizon that would encouragepeople to reconsider that view, at least in the first Source: Bloomberg Finance L.P.half of the year.Possible catalysts that could restore investors’ appetite for risk could include, first and foremost, asatisfactory resolution to the Eurozone problems, either by political agreement or by the ECBstepping up (watch the spread of Spanish and Italian bonds over Bunds). Other possibilities include arecovery in US property prices or employment, which would boost US consumption; lower inflationand interest rates in Asia, which rekindles the Asian consumer story; or a fall in oil and commodityprices caused by an increase in supply.Overall, we expect 2012 to remain a year of low conviction and high uncertainty among investors.Much depends on politics and all the human error that that involves, and the possible outcomes arequite binary. This combination is likely to give rise to continued volatility and high correlation. Thatdoes not mean undifferentiated returns, however. As the chart below shows, there was significantdispersion among asset classes last year, and the relative ranking of various asset classes changed asusual. Within asset classes, there was also dispersion by region, meaning that asset allocation canadd value to a portfolio. Major asset classes ranked by performance over the last 17 years 37.6 35.3 33.4 28.6 77.9 49.7 13.9 32.1 152.2 31.6 35.8 94.0 55.9 5.2 62.8 27.9 8.8 28.5 33.9 22.4 20.3 40.9 26.4 8.4 13.2 47.3 20.7 25.6 35.1 33.5 3.0 62.1 26.9 8.4 21.5 29.5 20.3 8.7 31.3 11.6 8.2 13.1 46.7 18.3 14.0 28.9 32.7 -10.9 58.2 15.1 7.7 20.3 23.0 16.8 5.5 27.3 6.3 7.9 10.3 39.2 17.3 12.4 26.9 11.6 -19.0 32.5 15.1 4.9 19.2 21.1 12.8 2.6 21.3 5.0 5.3 3.8 37.1 16.4 12.2 18.4 10.0 -26.2 28.2 14.4 2.5 18.5 16.5 9.7 1.9 21.0 -3.0 5.0 2.0 29.0 11.7 10.7 15.8 7.0 -33.8 28.0 12.0 0.2 15.3 13.5 5.6 -2.5 14.1 -5.9 4.6 -1.4 28.7 11.1 9.3 12.9 6.3 -37.0 27.2 10.2 -1.0 11.6 11.4 4.8 -17.5 4.8 -9.1 2.5 -1.5 25.7 10.9 4.9 11.8 5.5 -37.7 26.5 9.0 -3.7 6.5 6.4 2.1 -19.7 2.4 -14.0 1.4 -7.1 20.7 9.0 4.6 9.9 5.4 -43.1 20.0 8.2 -4.5 0.8 5.5 -14.1 -35.7 -0.8 -17.7 -11.9 -15.7 19.5 4.3 3.1 4.8 1.9 -45.7 13.5 6.5 -12.5 -29.2 3.6 -26.3 -44.9 -4.6 -25.4 -21.2 -20.5 4.1 1.3 2.7 4.3 -1.6 -46.5 5.9 0.2 -12.9 -31.9 -22.1 1.2 -5.6 2.4 -15.1 -15.7 -51.1 0.4 -0.8 -21.7 Source: Bloomberg Finance L.P. 8
  9. 9. Color Asset Class S&P 500 (Bloomberg: SPTR Index ) REIT (Bloomberg: FNERTR Index ) Chinese equities (Bloomberg: HSCEI Index ) European stocks (Bloomberg: RU20INTR Index ) Commodities (Bloomberg: SPGSCITR Index ) Non-US=EAFE (Bloomberg: GDDUEAFE Index ) Cash (Bloomberg: SPBDUB6T Index ) Bonds - Agg (Bloomberg: LBUSTRUU Index ) Hedge Funds (Bloomberg: HFRIFWI Index ) High Yield (Bloomberg: LF98TRUU Index ) EM Bonds (Bloomberg: JPEIGLBL Index ) Emerging Mkts (Bloomberg: GDLEEGF Index )Equities: limited upside this year, possible buying opportunity long-termWe expect modest, positive returns from equitiesthis year. With earnings growth expected to be Equities are still expensive relative to historical levelslower than in 2011, it would take a significant re- 45 Shiller P/E ratiorating of stocks to push prices much higher. Any 2000 inflation-adjusted price/10 years average earningssuch re-rating is likely to come in the second half of 40the year, if at all, once we get more clarity on the 35 1929Eurozone situation (although that is probably what 30many people thought at the beginning of 2011, 25 1901 1966 Postwar Long-term average = Latesttoo!). Some analysts may argue that valuations are 20 average = 18.2 = 21.4 16.4cheap relative to history, but we are not sure that 15the history of the last 20 years or so necessarily 10represents fair value for risky assets going forward. 5With the Shiller P/E ratio still above its post-war 0average and earnings volatility off the charts, we 1880 1900 1920 1940 1960 1980 2000 2020expect that investors will be hesitant to pay up for Source: Robert Schillerstocks. The markets and companies that we expectto do well are those that show high growth, high dividends and solid cash flow.In the US, earnings were up about 15% yoy in 2011. We do not see this reoccurring and expectearnings growth to fall back closer to trend of around 7% or even a bit lower. Thus while we thinkstocks can advance overall, it will probably be difficult for them to break out of their two-year tradingrange of 1,100~1,365 (except of course on the downside if the Eurozone starts to crumble). We lookfor secular stories rather than cyclical ones, i.e. companies with good fundamentals and soundearnings rather than simply a high correlation to growth. Companies that have less exposure toEurope and more to emerging markets are likely to outperform. Growth should continue tooutperform value as well, as investors despair of waiting for the eventual rerating of value stocks.Interest rates on hold indefinitely at zero means that dividend plays should continue to outperformas well.The Eurozone could offer some excellent buying opportunities later in 2012, but we would avoid italmost entirely for now. Even those stocks that do manage to rise are likely to see much of theirgains offset by a falling euro, in our view. Nonetheless, we are keeping an eye on the timing for whenis right to go back into Europe. The market is already pricing in a lot of disappointment and may beclose to stabilizing. Earnings revisions seem to be bottoming out, valuations are well below long-termaverages, and investor positioning shows very little risk appetite. Moreover a weaker currencyshould provide a boost to exporters at some point. But until these indicators are at levels consistentwith the distress shown in the CDS market, we would be hesitant to take even a market weight inEurope. 9
  10. 10. China: We expect the stock market to progress in two stages. At first, markets could moveaggressively lower due to heightened risks around developed countries debts, thus creating anoversold environment with Hong Kong stocks being particularly hit. Then a bottom could be reachedaround the end of Q1, when negative sentiment towards Chinese investments fade and fears on realestate or the banking sector appear overdone. As market sentiment deteriorates and indicesweaken, we would expect investors to engage in bottom fishing among attractive names andprobably some sector leaders within the mid- and small-cap sectors. That should allow Mainland andHong Kong equities to start rebounding.Flows of foreign liquidity are likely to keep HK stocks highly volatile. Mainland equities could benefitfrom new schemes being launched such as RMB Qualified Foreign Institutional Investors (RQFII), ascheme to facilitate access to mainland investments by foreign investors, which should help supportthe base for an upward trend for local stock markets.Other emerging market countries will almost EM stocks beat DM stocks when EM-GDP gap iscertainly outperform the industrialized world risingin terms of growth, but will their stockmarkets outperform as well? That wasn’t the 10 Percentage points BRICS vs G10 GDP and 1.1case in 2011, as developed markets EM vs DM equities 1.0 8outperformed EM by some 27% in USD terms. 0.9Higher growth does not always translate into 6 0.8higher earnings; in fact, there is a small but 4 0.7statistically significant negative correlation 0.6 2 0.5between per capital GDP growth and earnings 0.4over the long term. The growth surprise is 0 BRICS GDP - G10 GDP (L) 0.3more important than the absolute level of -2 EM stocks/G7 stocks (R ) 0.2growth, and investors are already expecting 1996 1998 2000 2002 2004 2006 2008 2010strong growth from EM. The risk is that they Source: Bloomberg Finance L.P., BOC (Suisse) SAmay be disappointed so long as these marketshave not yet decoupled from developed markets.Many EM markets appear cheap on earnings and asset-based valuations, both in absolute terms andrelative to developed markets. Nonetheless we remain cautious. In the first instance, slower globalgrowth suggests limited upside in commodity prices except for a possible rise in oil prices caused bystrife in the Middle East, which would be negative for most EM countries’ energy-intensiveeconomies. Secondly, there seems to have been a shift in the investment industry towards anemphasis on absolute return and an avoidance of even short-term losses, which makes thesemarkets vulnerable to profit-taking and sudden changes in sentiment caused by market movementselsewhere. The simultaneous fall in EM currencies when foreign investors exit only amplifies thedownward moves for DM investors. Finally, the asset class has become quite unpredictable. Neithergrowth, nor value, nor momentum were successful investment strategies in EM in 2011.Within EM, we prefer Asia. The region is likely to be least affected by the coming recession in Europe,and any weakness in commodity prices should benefit Asian manufacturers and consumers. Plusyears of current account surpluses and sound fiscal policies have helped to underpin the region’sresilience. India is a concern, though. Latin America is more exposed to a European downturn thanAsia is, particularly through a possible decline in commodity prices, the region’s comparativeadvantage. Eastern Europe, which is closely linked to the Eurozone through trade and financial ties, islikely to be the most deeply affected. 10
  11. 11. Sovereign Bonds: The biggest investment question of the year is probably whether sovereign bondswill remain an effective hedge for equity markets. The normal approach to constructing a portfolio isto include some government bonds as well as equity and other riskier assets for safety in case growthfalters and equity markets fall. Recently however bonds have stopped playing that role in somecountries; even in Germany, Bund yields rose when there were questions about economic growthbecause of fears that the country’s rating would be downgraded. The increasing correlation betweenstocks and bonds makes it unusually difficult to construct a balanced portfolio.Government bonds in the seven major G7 bonds have done well as rates fellindustrialized countries returned a G10 Yields and total return on bondsrespectable 5.9% in total during 2011 (see 20 % yoy % 5graph). It will be difficult to match that 15 4performance again this year, but bonds 10should still turn in a positive return, in our 3view. Obviously it is impossible for most 5 2developed countries to lower interest rates 0 Bloomberg/EFFAS G7 globalfurther, although with inflation subsiding and -5 bond index (USD) (L) 1 G10 avg 10yr yields (R)activity still weak, we see little chance of a -10 0 G10 avg 3m rates (R)tightening of monetary policy either. The US 2005 2007 2009 2011and UK could announce another round ofquantitative easing, but we question how Source: Bloomberg Finance L.P., BOC (Suisse) SAmuch further yields can fall in any case. (Remember though that Japanese 10-year yields did getdown to 0.45% in June 2003, so it’s not impossible.) Sovereign bonds have a poor risk/reward ratio asthere is limited upside and unlimited downside, but the global economy also seems to have lessupside potential than downside too, thereby offsetting the risk/reward ratio somewhat. Amongdeveloped countries, we would avoid most Eurozone debt except at the short end; less than threeyears may be one way to pick up some additional return in Spain and Italy, assuming that the ECB’snew three-year refinancing operation may support those markets. However, investors do not usuallybuy sovereign bonds to speculate on default. This trade is therefore only for those able to take mark-to-market risk, in which case we would prefer to buy quality equities with similar dividend yields thathave more potential upside in the price.Credit: We favor non-financial investment-grade (IG) credit for investors seeking preservation ofcapital with some income. Spreads are historically wide – they are at levels usually associated withrecessions in the US and much wider than at the start of any past downturn. Indeed, the low level ofsovereign yields means that spreads make up nearly 80% of overall yield on bonds, a record in bothEUR and GBP. On the other hand, corporate fundamentals remain well underpinned, even in Europe.Non-financial companies continue to deleverage, thereby strengthening their balance sheets,improving their coverage ratios, reducing default risk and holding down supply (although IG non-financial supply was higher in 2011 than in 2010 for the US and UK). Non-financial issuers do nothave a redemption hump in 2012 so supply is not likely to be a problem unless they decide toprefund the much higher redemptions due in 2013 and 2014. 11
  12. 12. Meanwhile, the super-low level of yields at the short end means carry is attractive, and a slowdownin the global economy and falling inflation rates mean the risk of a rising yield environment is thatmuch lower. Deleveraging and sluggish growth without recession (except in Europe) should be afavorable environment for credit. As for Europe, it’s noticeable that in the peripheral countries,investment-grade corporates are now trading at lower yields than their governments, meaning thatthey are perceived as the less risky assets. It appears that corporate bonds are being priced not off oftheir local government bonds but rather off the relevant maturity Bund. Nonetheless, we still expectthem to underperform the rest of the European credit universe until there is a systemic solution tothe Eurozone’s problems.Given the opportunities, we recommend being overweight high yield relative to investment grade, atleast in the US and Asia.Note that this discussion has concerned itself with non-financial bonds, not financials. This is a biggap as financials represent the bulk of the private sector debt markets. There, we are still hesitant.We believe particularly in Europe, banks may struggle to roll over the redemptions that are comingdue, despite near record yields and spreads. In fact, we would expect some of the money cominginto the market from maturing financial bonds to go into non-financial corporates, therebyaggravating the situation. We do not recommend the sector except on a case-by-case basisEM bonds: EM credits, rates and FX look EM bonds have given equity market returns overattractively valued to us, particularly if central six yearsbanks in the developed world keep interest EM sovereign & corporate bond total returnrates at rock-bottom levels, as we expect. Last 275 Jan 2005 = 100 vs MSCI EM equities 250year, external debt (EM bonds denominated MSCI EM Total return USD Latam bondsin DM currencies) outperformed local 225 EMEA bondscurrency bonds as US Treasury yields declined 200 xxx bondsAsiawhile EM FX depreciated. Starting from this 175point however we think there is limited room 150for UST yields to decline further, while the 125current depressed levels of EM FX may 100provide an additional return on unhedged 75 2005 2006 2007 2008 2009 2010 2011local currency bonds to long-term investors, inour view. (This of course assumes a successful Source: Bloomberg Finance L.P., BOC (Suisse) SAresolution to the Eurozone crisis.) Most EM countries outside of Eastern Europe should be able toweather the European downturn -- unlike the developed markets, they have room to expand their 12
  13. 13. fiscal spending through automatic stabilizers if the economy turns down. In any event, monetaryeasing is likely to continue to be the first line of defense for much of the region, depending of courseon each central bank’s degree of tolerance for further FX weakness. Given the liquidity constraints inEM bonds and the difficulty of doing research on individual credits, we recommend that investorswho are interested in local currency EM bonds do so through funds.Commodities: Given our outlook for slower growth and a general reduction in risk-taking, we arenot that optimistic about commodities as an asset class. The fact that all asset classes are likely to beaffected by a limited number of overarching macro risks means higher correlation betweencommodities and other risky assets, particularly during periods of risk aversion. The stronger dollartoo tends to be negative for commodities in general. Nonetheless, we can expect some commoditiesto better than others. Commodities with constrained supply, such as copper and corn, are likely tooutperform within their sectors, in our view. Grains too tend to outperform more economicallysensitive commodities when growth is weak. By comparison, industrial metals and the softs (such ascoffee, cocoa, sugar, cotton, and orange juice) tend to be cyclical and to sell off during globalslowdowns. Energy, discussed above, tends to be the most cyclically sensitive.The defensive nature of gold should underpin the precious metal as investors continue to worryabout quantitative easing and the future of the fiat money system. The safe haven bid should remainin the market as the conditions that have driven gold higher over the past 11 years are likely topersist, namely negative real interest rates, nervousness about stocks and central bank buying. Themain risk for gold is a continued appreciation of the dollar. The US currency’s recent strength has notbeen accompanied by an inflow into physically backed gold ETFs, as it was in 2009 and 2010. Bycomparison, silver tends to be more sensitive to the economic cycle because of its industrial uses andwe therefore do not expect it to outperform gold.FX: In a world of increasing correlation, FXstands out as one market where some assets Is a new USD upcycle starting?are clearly outperforming others. This year we 200 USD/Deutsche Mark Cyclesexpect the dollar and the yen to be the bestperformers initially, as risk aversion and the 175 Oct 78 ~ Aug 97 (Oct 78 = 100) Jun 95 ~ now (Jun 95 = 100)flight out of EUR continue. Investors cuttingback on their EM positions are likely to join 150European investors looking to diversify their New USD uptrend begins in Aug 95risk in buying the US currency. The EUR may 125 (= Nov 11?)suffer not only from capital flight from the 100possible break-up of the Eurozone, but eveninvestors who are confident of a solution may 75worry that lower interest rates and 0 25 50 75 100 125 150 175 200 225quantitative easing by the ECB are likely to be Months from startpart of that solution. Source: Bloomberg Finance L.P., BOC (Suisse) SAYen remains a safe haven as well; despite the government’s incredible debt/GDP ratio, it has a solidtrade surplus and a capital account surplus that underpin the currency (and the government bondmarket). The Swiss Franc historically has played that role as well, but following the Swiss NationalBank’s pledge to put a floor under EUR/CHF the currency is now seen as the euro or worse. 13
  14. 14. Renminbi: The problems in the Eurozone are CNY spot and possible 2012 trendlikely to cut into the growth of exports, which 8.50are already slowing, and further dampengrowth. A lower trade surplus and 8.00expectations of weaker growth could cause CNY May 06~Jul 08 trendthe Renminbi to experience some volatility. 7.50 2011 trendWe do not however expect any change in the 3% annual trendgeneral trend. Last year’s 4.4% appreciation vs 7.00USD was in line with our target of 4%~5%. Weexpect the uptrend to continue but at a 6.50slower 2%~3% pace in light of the globalsituation. We cannot exclude the possibility of 6.00 2006 2007 2008 2009 2010 2011 2012fluctuations and perhaps a brief depreciationof 1% or so as the environment deteriorates. Source: Bloomberg Finance L.P., BOC (Suisse) SAIt will be important though for the government to keep the strength of its currency during this USelection year to fend off trade friction, as well as supporting the goal of shifting the Chinese economytowards increasing emphasis on domestic consumption. At the same time no risk will be taken byappreciating the currency inappropriately and significantly hurting the export sector which is alreadyfacing falling global demand.Other EM currencies have moved along with global risk preferences and many currencies now standbelow fundamental value, in our view. Positioning is also very light. We therefore see room for EMcurrencies to retrace their losses and more if the EU crisis is successfully resolved. However, if the EUcrisis escalates these currencies would rapidly be hit by non-residents’ hedging or repatriating theirlocal investments. We therefore favor currencies where the valuation and technicals are favorableand the economies are not that exposed to Europe. As mentioned above, we expect that Chinawould not allow its currency to depreciate against USD in an election year. The Mexican peso maybenefit from the relative strength of the US economy, in contrast to the Brasilian real, where thecentral bank is likely to cut interest rates further even in the face of high inflation in an effort toweaken the currency. 14
  15. 15. DisclaimerThe content of this document has been approved and issued by BOC (Suisse) SA (“BOCS”) for informationpurposes only and should not be construed as an offer or recommendation or solicitation for sale, purchase orengagement in any other transaction and shall be distributed to financial professionals and/or institutionalinvestors only, e.g. in the United Kingdom and in the United States of America.Other countries: Laws and regulations of other countries may also restrict the distribution of this report.Persons in possession of this document should inform themselves about possible legal restrictions and observethem accordingly.The information and opinions contained in this document are for background information and discussionpurposes only and do not purport to be full or complete. No information in this document should be construedas providing financial, investment or other professional advice. This information contained herein is for the soleuse of its intended recipient and may not be copied or otherwise distributed or published without BOCS’sexpress consent. No reliance may be placed for any purpose on the information contained in this document ortheir accuracy or completeness.Investment Risks: The value of all investments and the income derived there from can fluctuate due to marketmovements and you may not get back the amount originally invested. In the case of overseas investments,values may vary as a result of changes in currency exchange rates. This may be due, in part, to exchange ratefluctuations in investments that have an exposure to currencies other than the base currency of the portfolio.Past performance is no guide to or guarantee of future performance.Limitation of Liability and Indemnity: BOCS expressly disclaims liability for errors or omissions in theinformation and data contained in this document. No representation or warranty of any kind, implied,expressed or statutory, is given in conjunction with the information and data. BOCS accepts no liability for anyloss or damage arising out of the use or misuse of or reliance on the information provided including, withoutlimitation, any loss of profits or any other damage, direct or consequential.You agree to indemnify and hold harmless BOCS and its affiliates, and the directors and employees of BOCS andits affiliates from and against any and all liabilities, claims, damages, losses or expenses, including legal fees andexpenses arising out of your access to or use of the information in this presentation, save to the extent thatsuch losses may not be excluded pursuant to applicable law or regulation. Any opinions contained in thispresentation may be changed after issue at any time without notice.Copyright and Other Rights: The copyright, trademarks and all similar rights of this presentation and thecontents, including all information, graphics, code, text and design, are owned by BOCS.Further information is available on request. Subject to copyright with all rights reserved. 15