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Global Strategic Outlook...... Read all 64 pages and remain thoroughly confused.... 64 pages of data without conclusions isn't knowledge. A great read for us given our collective wisdom. Reach us info@pamria.com for solutions to life's investment challenges.

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GSO

  1. 1. This document is not suitable for private clientsGlobal Strategic Outlook1st Quarter 2012 Q1 2012
  2. 2. ContentsSection oneExecutive summary 7Section two Sector allocation summary 11Section threeThematic piece 13Section fourStrategy summary and global economic outlook 15Section fiveEquities outlook 20Section sixFixed income outlook 31Section sevenMulti asset outlook 36Section eightSustainability Research – long term trends 38Section nineEconomic forecast and valuation review 39Section tenMarket valuations 42Section elevenRCM overview 58Section twelveGlobal Policy Council biographies 59RCM is a global investment advisory organization, consisting of separate affiliated firms, which operates under the brand name RCM. The affiliated firms include RCM Capital Management LLC,an investment adviser registered with the US Securities and Exchange Commission; RCM (UK) Ltd., which is authorized and regulated by the Financial Services Authority in the UK; RCM AsiaPacific Ltd., licensed by the Hong Kong Securities and Futures Commission; RCM Capital Management Pty Limited, licensed by the Australian Securities and Investments Commission; and RCMJapan Co., Ltd., registered in Japan as a Financial Instruments Dealer. This presentation constitutes advertising as defined in section 31(2) of the German Securities Trading Act.
  3. 3. Global Strategic Outlook - 1st Quarter 2012Dear reader As we head into 2012, I will focus on the themes likely to shape the direction of capital markets and provide a brief outlook for each major asset class. As has now become customary, I shall highlight our predictions from one year ago and contrast those with actual events. Finally, I will formulate the outlook for the main variables for 2012. Economic outlook Our predictions for 2011: trend economic growth will remain lower than before the crisis; however, given the low level of central bank rates, high cash positions of the corporate sector Andreas Utermann and solid demand from emerging markets, economic growth should be reasonable. Global Chief Investment Officer, RCM While 2011 growth was indeed solid, we clearly are facing a significant slowdown in economic activity in 2012. The rise in the oil price in 1H 2011, tighter monetary policy in emerging markets and, of course, fiscal tightening in the US and Europe are all taking their toll on growth. Since the summer, tensions in the financial markets have added further pressure: with financing conditions for banks becoming more difficult, we expect this to have a negative impact on credit growth in future. Already, lending surveys are pointing to a headwind for the credit cycle. Still, we do not expect most developed economies to fall into recession, as real interest rates remain ultra-low and, also, because the private sector RCM is in a position to spend out of cash flow. We are also expecting emerging RCM is an investment division of Allianz market growth to remain solid, supported by increasing domestic demand. Global Investors, a global asset management company committed to helping clients achieve However, growth risks clearly are increasing. This is particularly true sustainable success. As a global asset manager, for Europe, where fiscal tightening is most pronounced. This could be RCM’s investment platform operates across exacerbated if the stressed financial system, notably the banks, continues four continents, six time zones and from six to see balance-sheet contraction in response to the crisis, which would international offices – Frankfurt, Hong Kong, further reduce credit availability to the private sector at a time when it is London, San Francisco, Sydney and Tokyo. Within needed most. A recession in the core eurozone economies is now almost RCM we have over 450 investment, business and certain. research professionals all dedicated to delivering an information advantage to our clients. Our medium-term outlook remains unchanged: in times of high public- sector debts, and private- and public-sector de-leveraging, trend growth will be lower than before the bubble burst. This period is likely to last for several years. Budget deficits Our predictions for 2011: while major sovereign defaults have been averted, the spectre of debt restructuring or even default for some of the eurozone’s peripheral countries will continue to haunt the markets. While our expectations for ongoing debt problems in the eurozone have turned out to be correct, we did not and could not have anticipated the kind of escalation of the debt crisis we have witnessed since the summer. 3
  4. 4. Global Strategic Outlook - 1st Quarter 2012 Given the complexity of the problems, a quick fix is unlikely. Political actions that can realistically be implemented – i.e., fiscal tightening as well as tighter harmonisation of economic and fiscal policy in Europe – take a long time to be implemented and even longer to be effective, in our view most likely too long for financial markets. The longer the debt crisis looms, the bigger the political risk. As the recent developments in Greece show, there is a real threat of a break-up of the eurozone if political processes get out of control. While debt monetisation is already on the agenda in the US and the UK, this process is not yet on the agenda in the European Monetary Union (EMU), even though the European Central Bank (ECB) has become more ‘Fed-like’ recently. Medium-term, though, we think that a more active and aggressive role for the ECB is a likely outcome. This necessitates decisions by policymakers to build a much more fiscally and politically integrated eurozone, including sanctions for countries with unsound fiscal policies. Inflation Our predictions for 2011: we will see diverging inflation trends, with continued moderate inflation within the central banks’ comfort zone in the more highly indebted countries, and higher inflation in the countries with trend or above-trend growth. Indeed, inflation has risen in emerging markets, in some cases to double-digit rates. Central banks have reacted accordingly and embarked on a tightening cycle. In 2H 2011, rates peaked but even now remain at comparatively high levels. In the developed world, inflation rates clearly are below the levels witnessed in emerging markets. However, they have also risen to new cyclical highs and are now above the levels central banks are aiming for in the medium term. The rise in the oil price at the beginning of the year is not the only explanation for a pick-up in commodity prices. Core inflation has started to increase as well in developed markets; in emerging markets, wage pressure has added to price increases. We think that the cyclical moderation will trigger a moderation in inflation rates again. Given the low level of real interest rates, ongoing central bank balance sheet expansion and our expectations of continued solid growth in Asia, we don’t expect a return of deflationary fears, despite weakening growth. On the other hand, with demand for money strong in the current period of de-leveraging, neither is inflation likely to be a threat in the foreseeable future. Interest rates and bonds Our predictions for 2011: we anticipate little movement in short rates for the major OECD economies but gradual tightening in the emerging markets. We would be very cautious toward medium- to long-term maturities globally, which we feel are significantly overvalued owing to quantitative easing activity and undue risk aversion. The ECB hiked interest rates twice in 2011 but has now started to back-pedal and cut rates again. US and UK interest rates have remained extremely low, whilst in emerging markets, the ongoing cycle of rate hikes has come to an end and, in fact, several emerging economies have recently started to cut rates.4
  5. 5. Global Strategic Outlook - 1st Quarter 2012 Looking ahead, we expect rates to start to come down further in the eurozone, whilst emerging markets are likely to continue to reduce rates. In the US, the UK and Japan, we expect the policy of extremely low interest rates to continue into the foreseeable future. While our expectations for the short end of the yield curve turned out to be reasonably correct, the long end of the yield curve has behaved differently. In the US and the UK, ongoing sovereign bond purchases by the central banks, in addition to weaker economic data since the spring, have brought bond yields down. As we do not anticipate a major reversal in the economic newsflow, and as the Fed and the Bank of England (BoE) may continue to buy bonds again on a large scale, the downside to bond prices in both markets clearly is limited. Bond returns in both markets likely will be around the current redemption yield. In Europe, bond markets are very much driven by political developments. Admittedly, bonds in the EMU periphery very much discount potential losses. However, as long as political uncertainty persists and economic data remain weak, we expect risk aversion to prevail. Bunds are likely to remain safe- haven assets for the time being. A ‘risk-on’ trade within the European bond markets is only likely to start once economic data starts to improve or the ECB takes a more active role in solving the debt crisis. Longer-term, we remain cautious on sovereign bonds at current yields. Even if nominal returns may turn out to be positive, we expect real – i.e., inflation-adjusted – returns to be disappointing. Equities Our predictions for 2011: political tensions or sovereign debt fears would be another buying opportunity for those who want to establish longer-term positions. Note that these preferences could reverse following a bout of risk aversion, during which emerging market equities would probably underperform. After strong performance in 1H 2011, equity prices have fallen significantly from their calendar-year highs and now are slightly below the levels seen at the beginning of the year in the US, down around 20% in Europe and down 17% in Japan. Emerging markets, too, have fallen in absolute terms. Some of the headwinds, which explain the reversal in stock prices in 2011, likely will stay with us in the coming months and could continue to weigh on equities next year. In particular, the EMU debt crisis remains unsolved even though the most recent decisions are a step in the right direction. Still, markets likely will continue to price in the continuation of the debt crisis for longer. This, per se, also increases the risk of policy failures, which may cause electorates to start to question the concept of a European currency union altogether. The most recent developments in Greece and Italy show that this risk is not abstract but very real. Against this backdrop, and with economic activity slowing down globally and moderate equity returns, we prefer stocks with relatively high dividends and pay-out ratios. Dividend payments should offer investors some protection in the current environment. A lasting rebound in equity markets is expected to take place only if markets can start to price in a credible solution to the EMU debt crisis and/or when economic data point toward a stabilisation in economic activity. 5
  6. 6. Global Strategic Outlook - 1st Quarter 2012 Currencies Our predictions for 2011: the US dollar currently could rally somewhat against the euro. Longer-term, we continue to expect emerging market currencies to appreciate against the US dollar and somewhat less against the euro. The US dollar has range-traded against the euro this year. In future, we expect some appreciation of the US dollar due to the still unsolved eurozone debt crisis. In addition, the US dollar looks somewhat undervalued relative to the euro. Emerging markets turned out to be weaker this year than we originally expected. With the exception of the renminbi, which has continued to show solid and steady appreciation against developed market currencies, the picture for other emerging markets is rather mixed. The Brazilian real and Indian rupee, in particular, depreciated against the US dollar, due to both risk aversion and relatively high valuations. Strategically, we will hold on to our expectation of appreciating emerging market currencies due to superior growth (and productivity gains). We are waiting for an attractive entry point to re-enter this asset class. Emerging markets Our predictions for 2011: the strategic importance of emerging markets has been confirmed and 2011 will see a continuation of this theme. Goodbye G7; hello G20. Emerging markets remain strategically important and the slowdown in economic activity will end, in our opinion, in a soft rather than hard landing. The reasons for our relative optimism are the negative real interest rates, the rather low level of total indebtedness and strong underlying demand. Our positive view on emerging markets leads us to a strategically positive view on emerging market assets, be they equities, bonds or currencies, valuations notwithstanding. In conclusion, we expect 2012 to be similar to 2011: bouts of risk aversion followed by increases in risk appetite, all against a background of relatively low growth and great political uncertainties in all regions (US elections; eurozone fiscal-consolidation ratification concerns; Iran, North Korea, North Africa). Countercyclical and long-term–oriented investment behaviour will be imperative for market participants. I wish all readers a healthy and prosperous 2012. Andreas Utermann Global Chief Investment Officer, RCM6
  7. 7. Global Strategic Outlook - 1st Quarter 2012 1 Executive summary Sector allocation The biggest influence on our future sector positioning will probably be the handling of the European debt crisis and its repercussions on the global cycle. Our general macroeconomic scenario still justifies a slightly defensive positioning – our economic base scenario now includes a eurozone recession but not a globally spread recession. We are underweight financials, driven by the intensified stress in the global financial system, but will be prepared to adjust this if conditions improve and/or bond spreads in the EMU periphery decrease sustainably. We continue to have a balanced view on commodity-related sectors and remain positively orientated on commodities. On defensive sectors, we are moderately overweight, with a clear preference for healthcare stocks. Within cyclical sectors, we have retained a preference for technology stocks, as they appear attractive on some valuation measures. We remain cautious on consumer discretionary stocks, as in many economies consumers increasingly feel severe austerity measures and/or their real purchasing power has decreased as inflation has absorbed wage increases in 2011. Thematic piece: Crystal maze perspectives from RCM’s European equity investors In this quarter’s thematic view Neil Dwane, CIO Europe, considers the prospects for investing in European equities over 2012. Equity market volatility – especially elevated in 2011 – has dissuaded a lot of investors from leaving money and bond markets behind to invest in equities again, especially as many now fear austerity will bring recessions back. However, we find not only quality companies to be attractive, being valued at the same levels as weaker companies, but also companies that offer strong and sustainable dividends. Furthermore, over the medium term, we expect a higher proportion of the equity return to be generated through the return of cash to shareholders and thus offer investors some measure of protection against de-leveraging, deflationary pressures and fears of inflation if central bankers resort to more quantitative easing. We see further challenges ahead, however, as financial regulation standards tighten and political pressures return through the EU electoral cycle. Global and economic outlook We think that global markets currently are facing three challenges that are interrelated and show different dynamics: firstly, we identify a structural headwind of lower growth in developed economies due to the necessary de-leveraging both of private and public sectors. The cyclical weakness, the second headwind for capital markets, is partially a consequence of the policy reaction by central banks. Tight fiscal policy is directly dragging down economic activity in developed economies. The big risk, though, to our growth outlook is related to the third headwind capital markets faced in 2011: the EMU crisis. If the current stress in the EMU financial system accelerates, we cannot exclude negative spillovers to the rest of world, which could even lead to a global recession. The EMU debt crisis has morphed during the past two years from being a Greek debt problem into a wider EMU-periphery crisis until it ultimately turned into a fundamental lack of trust in the financial architecture of the EMU. In 2012, we think the developed world will face a hard landing . The oil price increase has worked as a tax on consumers in developed economies. Still, we are of the opinion that we can avoid a global recession. While we are reiterating our view that the final outcome of this crisis is a tighter fiscal and political European union, the risk of a break-up of the monetary union is not negligible. Ultimately, voters in each member country will have to decide if they accept fiscal austerity (in the economically weak countries), financial guarantees (in the economically strong countries) and the partial ceding of sovereignty rights (for example to an EU supervisory body or the EU Court of Justice). 7
  8. 8. Global Strategic Outlook - 1st Quarter 2012 Bond and equity markets Based on our analysis, our equity market outlook for 2012 overall is moderate. Economic weakness clearly will be a headwind for stock prices. The recent rise in economic surprise indicators may be coming to an end soon – surprise indicators have in the past usually started to turn down at current levels. Bonds could continue to benefit from a cyclical tailwind. This is particularly true for US treasuries, Bunds and gilts. However, from a long-term perspective, valuations are too high. Most EMU sovereign bond markets except Bunds are, on our numbers, attractively priced. In particular, Italian and Spanish bonds, which are priced for a 30% haircut (10-year maturity) look attractive. On valuation grounds, we are also constructive on corporate bonds relative to government bonds. With EU policymakers addressing the underlying problems of the EMU financial architecture, the downside from here is limited. Greek debt levels, however, are not sustainable on our numbers. We doubt that the currently envisaged 50% haircut on Greek government bonds is sufficient. On valuation grounds, we are also constructive on corporate bonds relative to government bonds. Temporarily, the cyclical weakness in Europe could still be a drag on this asset class. Asset allocation For long-term investors, global equity valuations offer attractive entry points. Regionally, we prefer US equities in the current economic downturn: growth data are showing signs of bottoming out and share buy-backs are an additional reason to be long US stocks in a global equity portfolio. We remain cautious on European equities. We will be keen to add to Europe once spreads in the government bond as well as money and swap markets tighten. We are underweight Japanese equities because of the high cyclicality of the equity market. While remaining structurally constructive on emerging markets, we think it is currently time to trim back the exposure. Our only long position at this juncture is China, which is moderately priced, and has one of the highest growth potentials as well as still strong corporate profitability. US equities outlook We remain impressed by the ability of the US economy to eke out some sort of 2H 2011 reacceleration, albeit a relatively mild one, despite the global slowdown. However, we still remain sceptical of the staying power of this wave going into 2012. Certainly, employment growth has improved, but with headline inflation having temporarily reached almost 4% in Q3 2011, real disposable income growth has slowed down to around 1%. We also hold reservations about capital spending. With the labour market moderately picking up and commodity prices not really falling but stabilising, companies’ cost bases are rising. All this takes place in times of lower growth rates in the rest of the world. The most recently published leading indicators for the US housing market, however, show a moderate improvement after one year of stagnation post a major collapse and net exports also have recently contributed slightly positively to growth. The big question remains: how much fiscal policy tightening will we see this year? The Bush payroll tax cuts have just been extended by another two months until February. The odds are that we will see a further extension until the end of 2012. European equities outlook Going into 2012, consensus expectations are for flat GDP growth in Europe, which we see as perhaps too optimistic; however, the bigger question for investors is the resultant effect on earnings growth. Q1 is likely to see a continuation of high levels of volatility in markets. Recently, we have seen some improvement in some peripheral credit spreads, yet there are still many risks, such as a lack of proper implementation of reforms. We also need a large and credible buyer of last resort for sovereign debt. A key event for the quarter will be8
  9. 9. Global Strategic Outlook - 1st Quarter 2012 the EU summit in January that will deal with measures to encourage economic growth as well as increasing employment. Given that the expectation is for flat growth in Europe, any encouraging moves at the summit could be very positive for markets. Asia-Pacific equities outlook Asia is likely to continue facing volatility due to uncertainty from slowing developed markets and regional political events, while slowing in China is likely to have reached a nadir. We maintain our view, however, that the long-term fundamental macroeconomic outlook for Asia remains quite robust and does not include a hard landing or the persistence of a stagflationary environment of rising inflation and slowing growth. The potential for de-leveraging from European banks in the current environment could weigh on Asia as liquidity flees. With a substantial amount of eurozone debt maturing in the coming months, the pressures on the banking systems could begin to take a visible hold on the European economies if there is not sufficient support from the ECB. Disregarding external macro factors, within Asia inflation will be the key metric to watch into and through the early part of next year. Particularly for inflation-sensitive markets like India, signs of falling inflation will be welcome as fiscal and current account balances take a heavy toll in environments of high inflation. The political environment in Asia should add some excitement to the investment environment this year. Upcoming presidential and legislative elections in South Korea, Taiwan and India, as well as the establishment of new leaders in China and Hong Kong, should make way for more constructive growth policies. Currencies in the region still look quite attractive as higher interest rates and still robust growth opportunities make the market attractive. Equities outlook – style As investment style favourites, like positive earnings revisions, strong growth and high price momentum were ahead of the benchmark, 2011 was a solid year for style investors. Among the long-term investment style winners, only value lagged. In future, as we expect the global economy to continue to cope with its problems, investors should look for growth stocks with reasonable valuation and some support from earnings revisions and price momentum as their preferred investment styles. Dividends as an investment theme can help to position the portfolio for the increased risk of a renewed recession. Global fixed income outlook While conditions are rather mixed around the globe and although growth is likely to remain below potential – in particular in developed nations – the world economy is not on the brink of recession at this stage. Overall, we expect different growth paths in the US and the eurozone going into next year. The sovereign debt crisis in Europe likely will remain the dominant theme for global bond markets in 2012. European fixed income outlook European fixed income markets will continue to be driven this year by developments in the sovereign debt crisis. After hopes of a resolution were regularly dashed in 2011, 2012 is shaping up as a watershed year that comes down to a simple choice – either European leaders manage to, finally, set up an integrated and credible European project or the eurozone runs the risk of disintegration. However, the ECB has begun a generous policy to allocate liquidity. While its firm attitude regarding requests regarding debt monetisation may disappoint some, it has expanded its firepower of unconventional tools in impressive fashion. While government bond investments are subject to political factors and therefore offer little visibility, we are 9
  10. 10. Global Strategic Outlook - 1st Quarter 2012 taking a much more constructive approach to corporate issuers, including High Yield issuers. Seldom have companies faced an economic slowdown with so much going for them, including cash hoards on their balance sheets, solid free cash flow, moderate debt and historically high EBITDA-to-interest coverage. Asia-Pacific fixed income outlook Even though Asia boasts strong economic and fiscal fundamentals, it is not immune from global market turbulence and external shocks. However, Asia has several buffers to contain such negative spillovers. High currency reserves are a major one. While Asian economies, not to mention the even more susceptible capital markets, will not be able to fully decouple from a global slowdown, they are supported by higher indigenous growth and much greater room for fiscal policy stimulus, should that be required by a further deterioration of global growth. Asia is also not burdened by high refinancing needs or concerns about sovereign debt. Given secular economic growth prospects and sound fiscal fundamentals, Asian bond markets remain an attractive investment target, even if currency appreciation will most likely remain subdued or postponed until the global big picture has improved. For longer-term investors, short-term currency weakness driven by global turbulence should offer an attractive entry point. Global multi asset outlook As we begin 2012, many investors have a relatively high cash allocation and in combination with new risk budgets this paves the way for reinvestment across a plethora of different asset classes. However, 2012 is likely to be marked by uncertainty driven by political events and risks caused by the global growth trajectory, eroding the conviction of any allocation decision. Right now, it is unclear whether we are more likely to experience range-bound markets or strong trends. If a credible and rapid solution to the EMU crisis is not forthcoming, and is combined with a low growth environment, investors will persist in trading on policy and politics, and a continuation of the prevailing risk-on/risk-off pattern is likely. Our market cycle model, in combination with our market selection indicators, recommends precisely this portfolio allocation; overall it suggests a moderately defensive position to address the absolute risks stemming from uncertainty. Asset allocation decisions should be taken within a clearly defined risk-budget approach as at any point the underlying factors could change. In addition to proposing to overweight high yielding assets, and underweight low yielding assets and those with a low carry to profit from a volatile range-bound market, we also recommend investing in concepts that are short in volatility. Sustainability research outlook We believe that companies will be under growing pressure to demonstrate value creation in addition to the products and services they provide. Companies will be expected to behave ethically, with integrity and transparency, and to take the lead in helping to solve social and environmental problems. Expectations will continue to rise with evidence of concrete action being taken by companies rather than a corporate responsibility agenda that is driven by a public relations exercise or ‘green washing’. The UK government–led Kay Review will further scrutinise how the equity market functions and examine whether there is a problem with short-termism debasing the performance of companies and investors.10
  11. 11. Global Strategic Outlook - 1st Quarter 2012 2 Sector allocation summary Looking back on 2011, our moderately defensive sector positioning paid off. Within global MSCI sectors, healthcare and consumer staples were the best-performing sectors, while basic resources and financials – banks worse than insurance – were on the other side of the spectrum. Within Q4 2011 and going into 2012, we have made the first small step toward reducing the defensive tilt in our sector positioning while not completely abandoning it. The main argument behind this is the considerable shift in relative valuations: cyclically exposed sectors became cheaper, while sectors like consumer staples entered expensive territories in relative terms. Nevertheless, our general macroeconomic scenario still justifies a slightly defensive positioning, reflecting, firstly, the clear deceleration in economic growth momentum we witnessed in 2H 2012, most notably demonstrated by the rolling over of purchasing manager indices (PMI) in Europe and parts of Asia and, second, the adverse developments in global financial conditions. Our economic base scenario now includes a eurozone recession but not a globally spread recession. That is why we have balancing overweight positions in sectors like IT and energy. The biggest influence on our future sector positioning will probably be the handling of the European debt crisis and its repercussions on the global cycle. As a general theme, we have identified dividends: companies with a proven willingness and ability to pay dividends (often characterised by high payout ratios) have the opportunity to outperform the market over the coming cycle. We decided to underweight financials, driven by the intensified stress in the global financial system spreading from the eurozone. This stress is characterised by rising swap spreads, a dysfunctional interbank lending market in the eurozone and, connected to this, more expensive funding for banks in the eurozone and elsewhere. The sector continues to suffer from its correlation to sovereign risks and up to now we have not seen a sustainable relaxation of sovereign bond spreads in peripheral eurozone bond markets. The sluggish relative performance of financials is still highly correlated with developments of EMU peripheral government bond spreads (versus German bonds). The long-term challenges, including stricter regulations and, connected to this, a higher cost of capital, remain. Taking into account all these strong arguments, there are two reasons a underweight in the financial sector demands a lot of attention: firstly, valuations are now lower than at the March 2009 trough on price-to-book ratios, and second, the sector remains a consensus underweight position in global equity portfolios, according to surveys. Therefore, we may have to adjust the position promptly if financial conditions improve and/or bond spreads in the EMU periphery decrease sustainably. The generous liquidity provision over a three-year period of the ECB and the addressing of financial sustainability on the 9th December 2011 EU summit could be first steps in the right direction. Currently, we continue to have a balanced view on commodity-related sectors. We continue to overweight the energy sector and underweight the materials sector. This reflects the global growth slowdown and its dampening effect on commodity prices, which has been more pronounced in industrial metals than for oil, also driven by tighter monetary policy in several emerging markets earlier in 2011. However, we envisage that the tightening cycle has peaked. Indeed, there have been initial rate cuts in several emerging markets and reserve rate requirements have eased in China, almost coinciding with the peak of the inflation rate in China in October. This would improve the outlook for commodities. Additionally, the relative valuation of mining stocks has come down markedly and implies lower commodity prices in the future. Hence, we will consider a more constructive view on this sector going forward but we are waiting for signals that confirm growth resilience in China, as well as other developing markets, and a less risk-averse global market environment. Longer-term, we remain positively orientated on commodities, given significant pent-up demand in developing nations, supply constraints and the negative real interest environment created by many central banks globally. 11
  12. 12. Global Strategic Outlook - 1st Quarter 2012 On defensive sectors, we are moderately overweight, with a clear preference for healthcare stocks. The rolling over of various leading indicators, witnessed since spring 2011, is typically an environment in which non-cyclical stocks perform reasonably well. Relative valuation, in the meantime, is a much less compelling argument. For that reason, we have cut the overweight in the consumer staples sector, as it shows relative valuation almost at record highs on our blended valuation measure. We prefer telecoms versus utilities for valuation reasons, which are most pronounced on relative P/E and dividend yield measures. In both sectors, regional considerations are important, as in southern European countries higher taxation of regulated telecom and utility industries has been discussed. Looking ahead, as we see tentative signs of a stabilisation in global PMI data, further weight reductions in defensive sectors may soon be on the agenda. Within cyclical sectors, we have retained a preference for technology stocks, as they appear attractive on some valuation measures, especially Price/Earnings (P/E). They continue to benefit from the, so far, relatively resilient capital expenditure from the corporate sector, of which some is structural growth in areas like automation and efficiency through the use of modern software. Select companies could also benefit from well-received innovations in the consumer electronics space (such as tablet computers). We reduced the underweight in industrial stocks, which became more attractive valuation-wise but continued to suffer from sharp deterioration in earnings revisions. This might turn in the coming months, as various global industry sentiment data at least stabilise going into 2012. We remain cautious on consumer discretionary stocks, as in many economies consumers increasingly feel severe austerity measures and/or their real purchasing power has decreased as inflation has absorbed wage increases in 2011. Sector Allocation - Virtual GPC Portfolio Global Consumer Consumer Health Telecom Sectors Discr. Staples Energy Financials Care Industrials IT Materials Services Utilities Active Weight U O O U O U O U N U BMK Weight 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% Legend: N = Neutral OW = Overweight UW = Underweight12
  13. 13. Global Strategic Outlook - 1st Quarter 2012 Thematic piece: Crystal maze perspectives 3 from RCM’s European equity investors As RCM’s investors survey the investment opportunities of 2012, many may conclude that markets are wrongly attributing the difficulties caused by excessive debts and de-leveraging to the equity markets, where – excluding financials – there remain many very strong and well-positioned companies. Clearly, equity market volatility – especially elevated in 2011 – has dissuaded a lot of investors from leaving money and bond markets behind to invest in equities again, especially as many now fear austerity will bring recessions back. However, RCM finds not only quality companies to be attractive, being valued at the same levels as weaker companies, but also companies that offer strong and sustainable dividends. Furthermore, over the medium term, we expect a higher proportion of the equity return to be generated through Neil Dwane the return of cash to shareholders and thus offer investors some measure of protection against de-leveraging, deflationary pressures and fears of inflation if central bankers resort to more quantitative easing. As ever, an alternative way to describe the attractions of equity can be described as ‘a living economic organism with proven powers of monetary adaption.’ Within the talismanic banking sector, so conjoined with the EU sovereign debt crisis, under such pressure in 2011, RCM sees further challenges ahead as financial regulation standards tighten and political pressures return through the EU electoral cycle. The ECB has offered much assistance to the EU banking system with the three-year long-term refinancing operation (LTRO) as well as the Federal Reserve unlimited US dollar swaps, such that banks should be able to achieve an orderly de-leveraging to meet Basel III restrictions. Unfortunately, shareholders will receive little dividend relief over this period. Gold is also seen as an effective hedge against the threat of monetisation of government debt as well as an attractive investment for emerging country central banks, which own substantially less gold than OECD banks do. Within this theme, we find many global gold stocks to be attractive investments, having seen their share prices underperform gold itself. Within Europe, we see many German companies as very attractive to domestic and international investors, as they offer not only good and growing exposures to emerging markets but also a strong domestic franchise relative to other EU countries. Nevertheless, we expect a period of austerity in the eurozone and the UK as credit and banking de-leveraging lessen and inhibit corporate investment in 2012. The scale of the recession will be decided in 2012 by the eventual scope and timing of any ECB intervention as a lender of last resort after the completion of the new EU ‘enhanced fiscal compact,’ if achieved. We expect to see some exciting elections in both the US at the end of the year as well as in Russia, and this volatility will unnerve and shape investor perceptions during this year as well as hinder the management of economic policy if trouble occurs. Possibly one of the most powerful transitions will occur in Beijing in the autumn, where the regime shift will be one of the most profound for global growth prospects into 2013. We expect, however, that the rise of the BRIC consumer will continue to accelerate, which will promote both higher living and food standards and also generate demand for many Western consumer goods. 13
  14. 14. Global Strategic Outlook - 1st Quarter 2012 Thematically, we still expect to see gas and coal as beneficiaries from medium-term global energy needs, boosted by the Japanese energy shift – much of its nuclear power industry has closed following the tsunami. Whilst many of the energy miners are seen as a play on China’s growth, we believe they will benefit from a need to keep the Chinese economy going through the transition in 2012. Excitingly, we are beginning to expect a rising production profile of new drugs from pharma as well as further gripping technology transitions as smart mobility and cloud services emerge through the year. We also expect to see, post-Kyoto negotiations, dramatic changes in the price of carbon and the consequent investment incentives for utility companies, which may in fact store up energy constraints for many economies in the future.14
  15. 15. Global Strategic Outlook - 1st Quarter 2012 Global | US | Europe | Asia-Pacific 4 Strategy summary and global economic outlook In 2011, global equities lost around 8% (as of the day of writing), while global bonds are up approximately 6%. In Q4 2011, both asset classes showed a marginally positive performance. Regionally, US equities were almost unchanged over the year, while the more cyclical market in Japan is down almost 20%, similar to Europe. Global emerging markets ‘only’ lost 13%. In the bond markets, we find a similar regional ranking: US government bonds up around 10%, followed by emerging market bonds (up 7%), while Japan (up 3%) and the EMU (up 1.5%) are clearly lagging. In both asset classes (bonds and equities), Europe slightly outperformed in Q4, while emerging markets and Japan both underperformed. What are the underlying forces characterising last year’s capital market developments? How will they Stefan Hofrichter develop going forward? We think that global markets currently are facing three challenges that are interrelated and show different dynamics: firstly, we identify a structural headwind of lower growth in developed economies due to the necessary de-leveraging both of private and public sectors. As history shows, countries undergoing the process of debt reduction face a prolonged period of trend growth significantly below the growth rate observed while leverage in the economy is increased. This is quite understandable, as the private sector no longer runs at extremely low or even negative savings rates; the public sector, too, needs to cut expenses and increase taxes in order to trim its debt ratios. We estimate that trend growth in developed economies will be around 0.5% lower compared to the years prior to 2007. While economic growth strategies in general may have a positive impact on economic activity in future, any growth-enhancing structural reforms will only show their effect over a medium-term, multi-year horizon. As a consequence of the ongoing de-leveraging and tighter fiscal policy, central banks have reduced rates massively and provided additional liquidity to the system. We expect real rates to be extremely low or even negative in years to come. The cyclical weakness, which has been the second headwind for capital markets, is partially a consequence of the policy reaction described here. Tight fiscal policy is directly dragging down economic activity in developed economies. This could, at least to some extent, be compensated by strong demand from emerging markets. However, due to substantial capital inflows until mid 2011, emerging markets had to react by tightening monetary policy. Low interest rates have additionally added to speculative demand for commodities, thereby adding to inflationary pressure, in particular in emerging markets. As a consequence of monetary policy tightening, demand in emerging markets has slowed down. The oil price increase, fuelled by initially strong demand from emerging markets, financial investments in commodities and political uncertainty in the Middle East, has worked as a tax on consumers in developed economies. In five out of six previous oil price spikes similar to the one we had in early 2011, the Western world fell into recession. In 2012, we think the developed world will face a hard landing as well. Still, we are of the opinion that we can avoid a global recession. The private sector is cash-flow positive and, hence, is able to compensate for lower government spending. Admittedly, there are limits to driving down the savings rate, as the private sector is no longer able or willing to increase its leverage, as was the case in the mid 2000s. Still, private-sector demand can dampen the slowdown. 15
  16. 16. Global Strategic Outlook - 1st Quarter 2012 Global | US | Europe | Asia-Pacific Monetary policy, too, remains highly accommodative. Real short rates are negative in most economies; central bank balance sheets are expanding via non-conventional measures. For instance, the ECB has just provided EUR489 billion over a period of three years to the EMU banking sector – more than enough to secure banks’ refinancing needs. This should certainly lead to an improvement in lending conditions, which have started to tighten again since summer. Finally, we see the first signs that the slowdown in emerging markets is coming to an end. Central banks in many emerging markets globally have started to ease again. Consequently, the yield curves in many emerging economies, especially in Asia, have started to steepen. The big risk, though, to our growth outlook is related to the third headwind capital markets faced in 2011: the EMU crisis. If the current stress in the EMU financial system accelerates, we cannot exclude negative spillovers to the rest of world, which could even lead to a global recession. For the EMU itself, a recession has already become our base-case scenario for next year. The EMU debt crisis has morphed during the past two years from being a Greek debt problem into a wider EMU-periphery crisis until it ultimately turned into a fundamental lack of trust in the financial architecture of the EMU. How else can we explain that markets are pricing in a haircut on 10-year Spanish sovereign bonds of around 25%, of 30% for Italian, of close to 50% on Irish and almost 67% on Portuguese bonds, not to speak of the 90% for Greek bonds. How could this happen and how can policymakers restore confidence? Let us take a step back. When setting up the euro area in the 1990s, the decision was taken to use a common, independent central bank and a common currency as an instrument to promote tighter political union. However, this architecture implied that the set-up of the eurozone was incomplete from its start. According to economic theory and practice, a functioning monetary union requires several ingredients and preconditions to make sure that growth within the monetary union does not diverge too much and that imbalances within the region can be financed: a high degree of labour mobility so that labour moves within the monetary union to jobs and regions where labour is scarce; high capital mobility, i.e. surplus regions financing deficit regions; fiscal transfers, i.e. a partial redistribution of income from rich to poor regions; low public debt, so that deficit regions are able to conduct anti-cyclical fiscal policy; and, finally, a harmonised economic policy to avoid economic imbalances in the first place. In particular, the last three aspects have not been in place in the past. While there are transfers in place to enhance structural growth, the EMU does not have a permanent fiscal transfer system in place. One could argue that the European Financial Stability Facility (EFSF) and, in future, the European Stability Mechanism (ESM) will take over this role in times of crisis. Because of excessive private-sector debt in some countries such as Spain and Ireland, however, growth rates as well as international competitiveness within the EMU diverged strongly. Ireland and Spain have started to implement structural reforms since the burst of the real estate bubble but must continue work to reduce unit labour costs. The same holds true for Portugal. The rise in public-sector debt during the financial crisis in these countries is collateral damage, as tax revenues collapsed and banks had to be bailed out once the debt-driven bubble burst three years ago. On the other side, in Greece as well as in Italy, high public-sector debt has its roots in an inefficient tax system. One could also argue that even the two biggest economies in the region, Germany and France, have to accept part of the blame for the current public debt crisis, as neither countries complied with Maastricht criteria in 2003, but they did not pay a fine for breaking the Stability and Growth Pact.16
  17. 17. Global Strategic Outlook - 1st Quarter 2012 Global | US | Europe | Asia-Pacific The current structural and cyclical headwinds have clearly amplified the fears about the sustainability of the EMU financial architecture. What can policymakers do to soothe markets at this juncture? Simply speaking, they need to address the fundamental weakness of the EMU structure. We think that policymakers have actually started doing this. The decisions taken on 9th December in Brussels are definitely going in the right direction to improve fiscal prudence: countries with excessive deficits will face a semi-automatic sanctioning mechanism and debt ceilings will be introduced in each member country’s constitution. Decisions taken in previous months target a better harmonisation of fiscal and economic policy, and the introduction of measures and processes to better identify and tackle economic imbalances within the region. The next EU summit, in January 2012, will have the labour market and economic growth on the agenda. On a national level, too, governments are trying to implement fiscal austerity measures as well as structural reform plans. Are all those reforms sufficient to restore confidence and regain trust in the EMU architecture? Time and market participants will tell, but the possibility of a positive outcome has clearly increased during the past few weeks. Nevertheless, there are still implementation and execution risks. Markets may stay cautious until the majority of all reform plans have been implemented. That may be the reason why investors are calling for two more rescue packages: a major ECB purchase programme of sovereign bonds as well as the introduction of eurobonds. An intervention by the ECB in the bond markets could clearly help in the short term, as it could buy time until the structural reforms are at work. The costs related to that are that the ECB could lose its credibility to fight inflation. We, therefore, think that the ECB will postpone any bond purchase programme for as long as possible. However, in case of a further significant spread widening of sovereign bonds in the EMU, the ECB may be forced to rethink its current position. A trigger for this could be a deeper recession in the EMU than currently forecast and more stress in the financial system, to name a couple. We think the ECB could also justify an increase of its security market programme (SMP) in case further spread widening leads to a sharp economic slowdown and raises the risk of deflation. The introduction of a eurobond – or ‘stability bond’ as it was called recently by Mr. Barroso, President of the European Commission – only makes sense, in our opinion, if the moral hazard problem is solved. This requires severe sanctions and the ceding of sovereignty rights for governments with excessive debts and deficits. The institutional set-up in Europe is not yet prepared for eurobonds. While we are reiterating our view that the final outcome of this crisis is a tighter fiscal and political European union, the risk of a break-up of the monetary union is not negligible. Ultimately, voters in each member country will have to decide if they accept fiscal austerity (in the economically weak countries), financial guarantees (in the economically strong countries) and the partial ceding of sovereignty rights (for example to an EU supervisory body or the EU Court of Justice). Based on our analysis, our equity market outlook for 2012 overall is moderate. Economic weakness clearly will be a headwind for stock prices. The recent rise in economic surprise indicators may be coming to an end soon – surprise indicators have in the past usually started to turn down at current levels. Nevertheless, the steepening of the Asian yield curves could provide a better market backdrop in the course of next year. The second driving factor for markets will be signs of a credible step toward a solution of the EMU debt crisis, which could not only be supportive for EMU stocks but also for all risky assets. Still, 17
  18. 18. Global Strategic Outlook - 1st Quarter 2012 Global | US | Europe | Asia-Pacific sovereign spreads remain wide in absolute terms, indicating that markets are still quite sceptical. However, the yield curve in some markets, notably the Italian yield curve, has steepened again – probably a first indication for a change in the market’s perception of the EMU debt crisis. In summary, we expect the volatile market environment to continue but envisage a slight rise in stock prices in the coming years. For long-term investors, though, global equity valuations offer attractive entry points. Regionally, we prefer US equities in the current economic downturn. In addition, US growth data are showing signs of bottoming out. While valuations are not overly attractive, share buy-backs are an additional reason to be long US stocks in a global equity portfolio. For the time being, we remain cautious on European equities. We are keen to add to Europe once spreads in the government bond as well as money and swap markets tighten. From a valuation point of view, European equities are attractive. The Graham-Dodd P/E of around 12 is at one of the lowest levels on record. This particularly is true for the EMU-periphery equity markets. Japan, too, is a market we do not favour at this juncture. Even though the strong yen is currently no driving factor for equities – the correlation between yen and the Tokyo Price Index (TOPIX) is close to zero – we are underweight Japanese equities because of the high cyclicality of the equity market. While remaining structurally constructive on emerging markets, we think it is currently time to trim back the exposure. In times of high uncertainty, high beta markets usually suffer. As long as capital is leaving emerging markets, we prefer a more neutral portfolio exposure. Our only long position at this juncture is China, which is moderately priced, and has one of the highest growth potentials as well as still strong corporate profitability. Bonds could continue to benefit from a cyclical tailwind. This is particularly true for US treasuries, Bunds and gilts. However, from a long-term perspective, valuations are too high. The downside in nominal terms is limited, though, as central banks will have to keep interest rates at extremely low levels for longer to not break the economic cycle. In real terms, however, returns for sovereign bonds are likely to be very low, probably even negative. Most EMU sovereign bond markets except Bunds are, on our numbers, attractively priced. The implied haircuts and default rates are higher than what we think is realistic. In particular, Italian and Spanish bonds, which are priced for a 30% haircut (10-year maturity) look attractive. Based on our estimates, both government debts are on a sustainable debt path. With EU policymakers addressing the underlying problems of the EMU financial architecture, the downside from here is limited. We are becoming more favourable on sovereign bonds issued by these two countries. The situation is different for Greece, for which the market is currently pricing in a 90% haircut for 10- year maturity bonds. However, Greek debt levels are not sustainable on our numbers. We doubt that the currently envisaged 50% haircut on Greek government bonds is sufficient. On valuation grounds, we are also constructive on corporate bonds relative to government bonds. Temporarily, the cyclical weakness in Europe could still be a drag on this asset class. We have trimmed our commodity exposure in the last couple of months. Commodities are a leveraged play on the global and emerging markets cycle. As long as cyclical data are weak, commodities are likely to continue underperforming.18
  19. 19. Global Strategic Outlook - 1st Quarter 2012 Global | US | Europe | Asia-Pacific Our currency preference also reflects our views on the global cycle as well as the discussion on EMU: we prefer the US dollar over the euro due to the ongoing discussions about the EMU debt crisis and our expectations of additional ECB rate cuts. The downside for the euro is unlikely to be dramatic, though, as many market participants have already implemented a short position, as can be seen in Commodity Futures Trading Commission (CFTC) data. In line with our regional equity and commodity allocation, we are short the overvalued yen as well as currencies of commodity-exporting economies, like the Australian dollar. Among emerging market currencies, our preferred currency is the renminbi. We are waiting for better entry points for other emerging market currencies. Asset Allocation - Virtual GPC Portfolio* Global MSCI Citi Global DJ UBS Euribor TAA World BIG TR 1M Active Weight N N U O BMK Weight 60% 30% 5% 5% Equity MSCI MSCI MSCI MSCI MSCI China A Regions USA EMU UK Japan EM Shares Active Weight O U N U N O BMK Weight 35% 25% 10% 15% 15% 0% USA EMU UK Japan Cash FI JP ML US JP ML EMU JPM JPM Euribor Regions USA Corp EMU Corporate UK Japan 1M Active Weight N O N O N U U BMK Weight 20% 15% 20% 15% 10% 10% 10% Global Legend: FX EUR GBP JPY CHF AUD Emerging RMB N = Neutral Active Weight UW N UW N UW N OW OW = Overweight BMK1 0% 0% 0% 0% 0% 0% 0% UW = Underweight 1 BMK (long/short PF). *The hypothetical or virtual portfolio has some inherent limitations. The asset allocation for a portfolio actually managed by RCM or its affiliates will differ from those presented here, due in part to a portfolio’s investment objective and guidelines and market and economic conditions that would impact RCM’s decision-making when managing actual portfolios. There is no guarantee that these investment strategies will work under all market conditions. Each sector of the bond market entails risk. The guarantee of Treasury and Government Bonds is the timely repayment of interest, and does not eliminate market risk. Mortgage-backed securities & Corporate Bonds may be sensitive to interest rates. When interest rates rise the value of fixed-income securities generally declines. There is no assurance that private guarantors or insurers will meet their obligations. An investment in high-yield securities generally involves greater risk to principal than an investment in higher-rated bonds. Equity investing is subject to the basic stock market risk that a particular security or securities, in general, may decrease in value. Investing in foreign securities may entail risk due to foreign economic and political developments and may be increased when investing in emerging markets. The securities of emerging markets may be less liquid and subject to the risks of currency fluctuations and political developments. 19
  20. 20. Global Strategic Outlook - 1st Quarter 2012 Global | US | Europe | Asia-Pacific 5 Equities outlook - US 2012 surprising on the upside – but still below trend With profit growth becoming increasingly scarce around the world, equity investors despondent, and pressures building in the streets around the world on policy makers to do something – anything – to reduce or diffuse the pain, we want to be especially vigilant about a possible shift in the tides in 2012. We remain impressed by the ability of the US economy to eke out some sort of 2H 2011 reacceleration, albeit a relatively mild one, despite the global slowdown. However, we still remain sceptical of the staying power of this wave going into 2012. Certainly, Rob Parenteau employment growth has improved: non-farm payrolls have been increasing by close to $140 thousand per month since the end of 2010 and private sector labour income growth has been around 4% annualised. However, with headline inflation having temporarily reached almost 4% in Q3 2011, real disposable income growth has slowed down to around 1%. The revival in consumer spending in 2H 2011 has been fuelled in no small part by reducing the savings rate, which is now running at around 3.5%, down from 5.2% at the end of 2010. Can the savings rate decline further? Not by much or for too long, as the private household sector is still sitting on a high stock of debt and will not be able nor willing to add new net debt to finance consumption. Admittedly, inflation rates will likely come down in the course of 2012, unless energy prices reaccelerate and, consequently, have a positive impact on real disposable income in future. Nevertheless, we expect consumer spending to slightly moderate next year. We also hold reservations about capital spending. True, the Institute for Supply Management (ISM) new orders have bounced back much more strongly than we ever anticipated, but there is simply no follow through in the Commerce Department new orders results. More importantly, capital goods and industrial equipment analysts report that US companies have gone quiet on guidance after being very constructive in the prior quarter; the Oracle shortfall has also put technology sector investors on alert. This should not come as a big surprise: earnings, the major driver for investments at this juncture, and margins are cyclically high. With the labour market moderately picking up and commodity prices not really falling but stabilising, companies’ cost bases are rising. All this takes place in times of lower growth rates in the rest of the world, in particular in EMU. Consequently, business investment in structures as well as in business equipment and software is expected to moderate from current high single digit figures. Residential housing, though, may edge upwards and be a marginally positive contributor to economic growth. The most recently published leading indicators for the US housing market show a moderate improvement after one year of stagnation post a major collapse. Net exports also have recently contributed slightly positively to growth. This may continue. We are seeing the first signs for a stabilisation in Asian growth – monetary leading indicators are pointing at a trough in activity – and we also expect European growth to trough in 1H 2012. All this should prove positive in terms of demand from outside the US. Indeed, the ISM export order component has stabilised as well and remains solidly above 50 – indicating ongoing expansion. The big question remains: how much fiscal policy tightening will we see this year? The Bush payroll tax cuts have just been extended by another two months until February. The odds are that we will see a further extension until the end of 2012.20
  21. 21. Global Strategic Outlook - 1st Quarter 2012 Global | US | Europe | Asia-Pacific If our expectations on fiscal policy turn out to be correct, we feel comfortable with our GDP growth estimate of around 1.75% for 2012. Still, this figure is slightly below trend growth and below our growth expectation for Q4 2011 of 2.5%, but is much better than expected by many market participants during summer and autumn of last year. Economic surprise indicators, measuring to what extent economic data releases have been better (or worse) than anticipated by consensus, have increased substantially since September. If history is a guide for the future also this time, however, the next direction in the surprise indicator for the US is down, as a lot of the improvements have already been reflected in consensus estimates. Clearly, this could temporarily put pressure on US assets. Nevertheless, the US economy may be able to show the strongest growth dynamics in the developed world in 2012 against a backdrop of global slowdown. This is the reason why we are holding on to our overweight in US equities. We believe 2013, however, will be challenging, as fiscal policy tightening will be hard to avoid. For investors, we think this will become a major theme only in 2H 2012. Citi economic surprise indicator for US 100 80 60 40 20 0 -20 -40 -60 -80 -100 -120 -140 -160 May 03 May 04 May 05 May 06 May 07 May 08 May 09 May 10 May 11 May 12 Sep 03 Sep 04 Sep 05 Sep 06 Sep 07 Sep 08 Sep 09 Sep 10 Sep 11 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Source: Bloomberg 21
  22. 22. Global Strategic Outlook - 1st Quarter 2012 Global | US | Europe | Asia-PacificEquities outlook - Europe With the turbulent backdrop of 2011 in mind, one can be excused for feeling somewhat anxious going into 2012. We have seen economic, social and political unrest in Europe in recent times that has left us hard to shock. The result was a year that experienced record volatility in equity markets on an intraday basis as well as very high intra-sector correlation, making the environment challenging for stock pickers. Going into 2012, consensus expectations are for flat GDP growth in Europe, which we see as perhaps too optimistic; however, the bigger question for investors is the resultant effect on earnings growth. The one beacon of financial strength remains the corporate balance sheet. Neil Dwane Statistically, market performance in Q1 has set the tone for the rest of the year and this will largely be determined by the release of 2011 results and 2012 outlook statements. However, the macro picture will remain a very big driver of markets. There is a large amount of eurozone government debt due to be refinanced in the quarter (see chart). Market participants have short attention spans as evidenced by the fast-changing subject of focus; in recent weeks, the EU crisis has also been less prominent. These issues could quickly bring attention back to the solvency and liquidity problems facing sovereign borrowers in the region. A key event for the quarter will be the EU summit on 30th January that will deal with measures to encourage economic growth as well as increasing employment. Given that the expectation is for flat growth in Europe, any encouraging moves at the summit could be very positive for markets. The previous summit saw politicians disappoint expectations, and Greece surprise investors the world over by calling a referendum on its bailout. Recently, we have seen some improvement in some peripheral credit spreads (see chart), yet there are still many risks, such as a lack of proper implementation of reforms. We also lack a large and credible buyer of last resort for sovereign debt. The ECB’s Securities Market Programme remains limited, while the larger borrowing countries such as France and Italy have recently attracted negative speculation. This is worrying but seems to be contagion rather than well-founded fears concerning solvency and liquidity. Germany will continue to be instrumental in proceedings, given its strength and ultimate role as the ‘backstop’ for the euro. To date, Chancellor Merkel has been resolute in refusing to support quantitative easing or eurobonds, but a break-up of the European Monetary Union (EMU) would lead to a stronger currency for Germany – not desirable, as a big exporter. Once again, politics is likely to be key, as Merkel tries to placate her voters by being tough with the fiscal renegades, but she must acknowledge the need to bail out the eurozone to some extent. The recent decision by the UK to veto changes to the Lisbon Treaty has led to talk of its being isolated, which is arguably true, but whether that is such a bad thing is debatable. Suggested reforms would have seen the large UK financial sector negatively affected, yet this split within the EU is a worrying occurrence at a time when solidarity is required. The UK’s Credit Default Swap (CDS) continues to trade below that of Germany. In April, we have the French elections – likely to heighten the political posturing by Sarkozy in Q2 2012 and, more importantly for the crisis, at the January summit. During the quarter, there will also be IMF reviews of Greece and Ireland; while most have written off the former, negative news on the latter would refocus negative attention on the weak periphery. It was good, though, to see a realisation in 2011 that these peripheral countries for the most part are not that material to the eurozone, with the exception of Spain. Spain is the fourth largest economy in Europe and, given its high level of exposure22
  23. 23. Global Strategic Outlook - 1st Quarter 2012 Global | US | Europe | Asia-Pacific to property and construction and increasing unemployment, it is much more vulnerable than Italy and France going into 2012. Q1 is likely to see a continuation of high levels of volatility in markets. With expectations for flat to negative GDP growth in the region, it looks like Earnings Per Share estimates may be optimistic, but the rating of the market, and particularly the more cyclical stocks, seems to account for this. The consensual negativity concerning the problems we face with talk of reinstatement of pre-euro currencies is somewhat comforting, as it feels we are getting close to a nadir in sentiment. The table shows the extent to which sovereign bond yields are pricing in default and hint to a break-up of the EMU. To gain confidence, we will need to see strict implementation of budgetary reforms and a more unified approach within Europe to solving the current problems. Realistic and innovative growth initiatives at the January summit would be very supportive for markets and help to show that the politicians are finally tackling the need to act quickly and effectively. Figure 1: Q1 Debt Maturity 70 60 52.9 53.1 50 44.2 Euro Billions 40 35.9 30 20 15.6 17.4 14.5 9.2 8.8 10 0 January February March France Italy Spain Source: Bloomberg Figure 2: Q1 5 Year CDS spread 1200 1000 800 600 400 200 0 25 Nov 11 27 Nov 11 29 Nov 11 01 Dec 11 03 Dec 11 05 Dec 11 07 Dec 11 09 Dec 11 11 Dec 11 13 Dec 11 15 Dec 11 17 Dec 11 19 Dec 11 21 Dec 11 23 Dec 11 25 Dec 11 27 Dec 11 29 Dec 11 31 Dec 11 Spain Portugal Ireland Italy France Source: Bloomberg 23

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