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.)

1. 2012: the year the bills come due?
In 2008, the world narrowly escaped a global depression thanks to quick action on an
unprecedented scale by governments and central banks around the world. Is this the year
that the global economy – and the markets – have to pay the bills for that rescue? We start
the coming year with more hope than confidence and believe that a cautious investment
stance 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. 2012: the year the bills come due?
Is this the year the bills come due? In 2008, the world narrowly escaped a global depression. Quick
action on an unprecedented scale by governments and central banks around the world managed to
avert a sudden collapse in economic activity that was actually more severe than what the world saw
in the beginning months of the Great Depression of the 1930s. Now however the ability of
governments to come to the rescue of the private sector has reached its limits. Monetary policy
cannot be loosened much further, while fiscal policy is everywhere being retrenched. Against this
background, the gradual disintegration of the Eurozone and the slowdown in China pose threats to
global growth. On top of which, the uneasy political balances that existed in the Middle East, Russia
and the Korean peninsula have been disturbed, with unknown results. We start the coming year with
more 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 the
Eurozone continues and growth slows in China. We assume that leaders will successfully resolve
the Eurozone’s problems and that China will stabilize, leading to a more robust second half. Should
this 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 frequent
economic cycles. We have come to the end of the era that began with the floating of the dollar in
1971 and the creation of pure fiat currencies, which has allowed governments to use countercyclical
fiscal and monetary policies to support growth and suppress inflation. With no policies left to prolong
the 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 were
120 M edian much longer than the historical
100 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. growth. That does not mean permanent recession, but it does suggest that the era of long booms
and steadily rising asset prices may be a thing of the past. Investors who got used to double-digit
returns on their portfolios during this period of unprecedented debt build-up are likely to be
disappointed as they realize just how much of that return was due to leverage in the economy. With
the return of austerity, investors will have to get used to greater volatility and more modest returns
on their portfolios.
We shall deal with the major problems one by one, and then turn to our investment philosophy.
Leading indicators leading down
Our starting point is the OECD’s leading indicators. Leading indicators point towards further slowing
They are not going in the right direction – the trend is
OECD Leading indicators
generally 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 China
dominant problem facing the world economy right -25%
2006 2007 2008 2009 2010 2011
now. 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 possible
break-up of the Euro would be an unprecedented shock to the global economy. We saw at the time
of the Lehman Bros. collapse how the global banking system can freeze up and send economies
everywhere into a tailspin. Questions over the fate of the Euro and the subsequent uncertainty over
debts in so many countries would dwarf even that cataclysmic event. This is the biggest problem that
we face, and one that is not likely to go away any time soon, in our view.
Eurozone: the defining problem of 2012
We think that 2012 will largely be driven by EU political decisions. The market’s tolerance for
muddling through is diminishing and so the tone of the year will probably be set by how the
authorities deal with the problem in Q1. They have shown their determination to keep the Eurozone
intact and their willingness to sacrifice growth for austerity. We therefore think this is likely to be a
poor year for growth, but one in which the prospects could brighten considerably by the end of the
year 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 the
region’s problem, which are a) a lack of economic convergence and b) the lack of fiscal union to
accompany monetary union. The economic reform packages being considered in the peripheral
regions should go some way to meet the first requirement, while the treaty revisions under
consideration 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 the
markets will have the patience to wait while politicians compromise, make imperfect decisions and
stumble while trying to execute even those modest plans. There is an inherent contradiction
between the desire of EU officials to keep the pressure on the peripheral countries and their need to
simultaneously convince the markets that the Eurozone will remain intact. The real test this year
3

4. then will be whether the debtor countries can maintain their austerity programs in the face of a
worsening recession and whether the relatively better-off core countries will be willing to help out
the periphery as falters. We believe that this struggle will be the deciding factor for markets in 2012
and it is a race against the clock.
Our working assumption is that policy
The boulder in the road: bond issuance in 2012
makers avoid a euro break-up or a disorderly
sovereign and bank default. We wonder EURb
Italian, Spanish and French monthly debt &
interest payments in 2012
though whether they will reach a solution or 140
once again try to kick the can down the road. 120 Italy Spain France
That could be difficult this year because of the 100
huge boulder in the road, namely that Spain, 80
Italy and France need to find EUR954bn for
60
their debt and interest payments (EUR418bn
in the first four months alone). In this respect, 40
if the Eurozone is the key to markets this year, 20
Spain and Italy are the keys to the Eurozone. If 0
they can deliver on their structural reforms, Jan-12 Apr-12 Jul-12 Oct-12
then 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 new
government has a strong mandate to carry out structural reforms and seems determined to tackle
the banking sector’s problems, while in Italy, PM Mario Monti’s reform plans include both the fiscal
and growth-enhancing measures that EU officials (and the market) were looking for.
On the other hand, if resistance by politicians
or the public makes it look like the plans Euro-pessimism has usually proved correct in the past
won’t be implemented, then investors may GIIPS CDS rate around
once again hesitate to buy these countries’ 900 EU summits 9-Dec
21-Jul 26-Oct
bonds and fears of a Eurozone break-up will 800
resume. Then all outcomes are likely to be
under discussion once again: debt 700
restructuring or default, full fiscal union, or 600
printing money on a vast scale. The European
500
crisis could therefore tip the world either into
Eurozone summits
deep recession and deflation, or aggressive 400
GIIPS weighted average CDS
debt monetization and a rapid rise in inflation. 300 rate
We hope that the leaders manage to navigate Jun-11 Aug-11 Oct-11 Dec-11
their way between these two disasters, but so Source: Bloomberg Finance L.P., BOC (Suisse) SA
far 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 out
may have to be further ECB accommodation.
It’s unfortunate that governments are having such difficulty funding themselves just when the banks
have to roll over some EUR 750bn of debt during the year plus enough more to meet new, stricter
regulatory requirements. If the banks cannot raise the numerator (capital) of their capital adequacy
requirement, they will have to lower the denominator (assets). That deleveraging could cause a
downward spiral in economic activity.
4

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 refinance
itself bring into focus the problem of global austerity and the “fallacy of thrift.” It makes sense for
each 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 to
spend more. In this respect, the developed world runs the risk of falling into the same trap that
happened in 1937. With the economy finally emerging from the Depression the previous year, the US
Treasury cut spending and increased taxes, while the Fed raised bank reserve requirements twice to
rein in monetary policy. The result was another lurch down in activity in 1937~38. We fear that the
general move towards fiscal austerity in the developed world recently has echoes of that unfortunate
policy mistake, as do the criticisms leveled at the Fed for its quantitative easing. We hope officials
will decide that the risk of a little inflation is better than the risk of a deflationary depression and will
keep policy as loose as possible for the time being.
China: look to more loosening to support growth
The government has set the tone for 2012:
Falling input prices = lower inflation in China
stabilizing growth ahead of mounting global
risks and rebalancing the economy’s reliance Rate of change in core inflation vs input price PMI
3 75
on investment and export in favor of domestic
70
2
consumption. With inflation waning, the 65
government is gradually easing monetary 1 60
55
policy and fine tuning its actions with respect 0
50
to the economic slowdown. As mentioned in -1 45
December during the Central Economic Work -2 Change in non-food CPI rate 40
Conference, China’s politburo will combine its -3
from six months earlier (L)
China Input prices PMI SA
35
30
monetary measures with proactive fiscal -4
lagged 3m (R )
25
policies in order to avert a slowdown in GDP 2005 2006 2007 2008 2009 2010 2011 2012
growth as economic activity slows during the Source: Bloomberg Finance L.P., BOC (Suisse) SA
first half of this year.
The fact that inflation is decelerating and should be back within target gives the government room to
maneuver that some other governments don’t have. While we see Q1 and Q2 to be tough due to
difficult circumstances in the Eurozone, we expect the negative impact on China to be limited to the
first half of the year. Indeed, economic measures to be implemented in the coming months should
facilitate the rebound and could boost the economic activity as well as growth during 2H. Moreover
as the government emphasizes the role of consumption for growth, we expect retail sales to
continue 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 property
sectors, in our view. The growth in real estate investment will probably slow but we do not expect
anything like the “China collapse” fears that one hears. The government has made clear its intention
to continue building more affordable housing, which should take up some of the slack and help to
support 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. US: Continued below-trend growth, but no recession expected
It’s a measure of how much the world has changed that the US economy only comes in for a mention
at this point in this essay. Usually, the US is the key determinant for the global economy. The market
expects US growth to be around trend, neither particularly exciting nor worrisome. Inflation seems
under control and monetary policy is frozen for now, unless the Eurozone problems worsen. Fiscal
policy too cannot move either way as long as the stalemate continues in Congress, so we expect it to
be on autopilot (which implies a modest fiscal drag due to the expiry of some tax cuts). That largely
rules out the pre-election spending spree that sometimes has caused a spurt in growth and a boost
to markets.
Recent data in the US, such as new residential construction, small business confidence and initial
jobless claims, an early indicator of the labor market, have exceeded expectations. But some of that
growth comes from one-off factors that might not continue. First off, many companies rebuilt their
inventories, but once they are restocked, that spurt in demand will slow. Secondly, consumers
reduced their savings somewhat and gasoline prices declined, but we do not expect those trends to
continue, either. Japan’s recovery after the tsunami caused a pick-up in demand, but Japan seems to
be slipping back into recession as well. Combined with the small fiscal drag, the result is likely to be
trend growth at best. The reduction in US household debt, a recovery in auto sales (the average age
of the US fleet has been rising steadily for four years) and the gradual improvement of the housing
market 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 cannot
possibly 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 has
unleashed 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 be
tolerated” only raises the stakes. Higher oil prices remain a possibility that could tip fragile world
growth back down. Fortunately, the price of gasoline has declined substantially in the US recently,
6

7. and it would take a major shock to get that price back up towards the $4/gallon level that seems to
be where it begins to impact consumer behavior. We must also note the increase in shale oil and
natural gas production in the US as well, which could keep a lid on price rises. Nonetheless there is
considerable uncertainty; the US Energy Information Administration recently issued a not-very-
helpful forecast that the benchmark West Texas Intermediate crude oil could finish 2012 anywhere
between $49/bbl to $192/bbl (vs a recent price around $100/bbl). Note that barring any geopolitical
tensions, we would favor the lower end of that range as the development of shale gas and other new
energy 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 think
have a good chance of going right.
First off, the key point is that none of this is
secret. Policymakers are well aware of these Global inflation remains quite subdued
pitfalls. Thus we expect central banks to
12 % CPI inflation rates
remain accommodative and in particular for weighted by GDP at PPP
the European Central Bank to become more 10
accommodative. They can afford to do so 8
because the much-feared burst of inflation 6
that some people thought might come with
quantitative easing has not yet occurred. If 4
anything, inflation is starting to slow in the 2
developed world. We could even see QE 0
G3 (inc UK) Asia ex Japan
extended to further asset classes if necessary -2 Latam EMEA
(in Japan, the Bank of Japan has already 2004 2005 2006 2007 2008 2009 2010 2011
started buying equity ETFs and REITs). Of Source: Bloomberg Finance L.P., BOC (Suisse) SA
course, such policies could eventually backfire
and cause the demise of the fiat currency system that has prevailed since the link to gold was
abolished in 1971. After falling for six years, the US housing market appears to be stabilizing. Given
that it was the proximate cause of the 2008 collapse, this would be good news for the global
economy. It could bring some confidence back to the US consumer, the former driver of the world
economy. Finally, growth in emerging markets (particularly Asia) appears to be solid, although EM
has 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 markets
environment, 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 2012
not likely to happen any time soon.
Source: Bloomberg Finance L.P.
7

8. We can see the change in investor sentiment by Investors are reconsidering risky assets
comparing the forward earnings estimates on the
MSCI All Country World Index (ACWI) to the price MSCI All World Index and
450 12m forward EPS 35
of that index. The sharp decline in the price in the
400
face of only a small drop in earnings estimates 30
shows how investors de-rated equities in the 350
25
second half of 2011. We believe this de-rating 300
applied not only to equities, but to all asset classes: 20
250
investors are reducing their expectations for the MSCI All World Index 15
200
future 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 2012
not see much on the horizon that would encourage
people 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, a
satisfactory resolution to the Eurozone problems, either by political agreement or by the ECB
stepping up (watch the spread of Spanish and Italian bonds over Bunds). Other possibilities include a
recovery in US property prices or employment, which would boost US consumption; lower inflation
and interest rates in Asia, which rekindles the Asian consumer story; or a fall in oil and commodity
prices 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 are
quite binary. This combination is likely to give rise to continued volatility and high correlation. That
does not mean undifferentiated returns, however. As the chart below shows, there was significant
dispersion among asset classes last year, and the relative ranking of various asset classes changed as
usual. Within asset classes, there was also dispersion by region, meaning that asset allocation can
add 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. 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-term
We expect modest, positive returns from equities
this year. With earnings growth expected to be Equities are still expensive relative to historical
levels
lower than in 2011, it would take a significant re-
45 Shiller P/E ratio
rating of stocks to push prices much higher. Any 2000
inflation-adjusted price/10 years average earnings
such re-rating is likely to come in the second half of 40
the year, if at all, once we get more clarity on the 35 1929
Eurozone situation (although that is probably what 30
many people thought at the beginning of 2011, 25 1901
1966
Postwar
Long-term average = Latest
too!). Some analysts may argue that valuations are 20 average = 18.2 = 21.4
16.4
cheap relative to history, but we are not sure that 15
the history of the last 20 years or so necessarily 10
represents fair value for risky assets going forward. 5
With the Shiller P/E ratio still above its post-war
0
average and earnings volatility off the charts, we 1880 1900 1920 1940 1960 1980 2000 2020
expect that investors will be hesitant to pay up for Source: Robert Schiller
stocks. The markets and companies that we expect
to 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 expect
earnings growth to fall back closer to trend of around 7% or even a bit lower. Thus while we think
stocks can advance overall, it will probably be difficult for them to break out of their two-year trading
range of 1,100~1,365 (except of course on the downside if the Eurozone starts to crumble). We look
for secular stories rather than cyclical ones, i.e. companies with good fundamentals and sound
earnings rather than simply a high correlation to growth. Companies that have less exposure to
Europe and more to emerging markets are likely to outperform. Growth should continue to
outperform 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 outperform
as well.
The Eurozone could offer some excellent buying opportunities later in 2012, but we would avoid it
almost entirely for now. Even those stocks that do manage to rise are likely to see much of their
gains offset by a falling euro, in our view. Nonetheless, we are keeping an eye on the timing for when
is right to go back into Europe. The market is already pricing in a lot of disappointment and may be
close to stabilizing. Earnings revisions seem to be bottoming out, valuations are well below long-term
averages, and investor positioning shows very little risk appetite. Moreover a weaker currency
should provide a boost to exporters at some point. But until these indicators are at levels consistent
with the distress shown in the CDS market, we would be hesitant to take even a market weight in
Europe.
9

10. China: We expect the stock market to progress in two stages. At first, markets could move
aggressively lower due to heightened risks around developed countries debts, thus creating an
oversold environment with Hong Kong stocks being particularly hit. Then a bottom could be reached
around the end of Q1, when negative sentiment towards Chinese investments fade and fears on real
estate or the banking sector appear overdone. As market sentiment deteriorates and indices
weaken, we would expect investors to engage in bottom fishing among attractive names and
probably some sector leaders within the mid- and small-cap sectors. That should allow Mainland and
Hong Kong equities to start rebounding.
Flows of foreign liquidity are likely to keep HK stocks highly volatile. Mainland equities could benefit
from new schemes being launched such as RMB Qualified Foreign Institutional Investors (RQFII), a
scheme to facilitate access to mainland investments by foreign investors, which should help support
the base for an upward trend for local stock markets.
Other emerging market countries will almost
EM stocks beat DM stocks when EM-GDP gap is
certainly outperform the industrialized world
rising
in terms of growth, but will their stock
markets outperform as well? That wasn’t the 10 Percentage
points
BRICS vs G10 GDP and 1.1
case in 2011, as developed markets EM vs DM equities 1.0
8
outperformed EM by some 27% in USD terms. 0.9
Higher growth does not always translate into 6 0.8
higher earnings; in fact, there is a small but 4 0.7
statistically significant negative correlation 0.6
2 0.5
between per capital GDP growth and earnings
0.4
over the long term. The growth surprise is 0
BRICS GDP - G10 GDP (L) 0.3
more important than the absolute level of
-2 EM stocks/G7 stocks (R ) 0.2
growth, and investors are already expecting 1996 1998 2000 2002 2004 2006 2008 2010
strong growth from EM. The risk is that they Source: Bloomberg Finance L.P., BOC (Suisse) SA
may be disappointed so long as these markets
have not yet decoupled from developed markets.
Many EM markets appear cheap on earnings and asset-based valuations, both in absolute terms and
relative to developed markets. Nonetheless we remain cautious. In the first instance, slower global
growth suggests limited upside in commodity prices except for a possible rise in oil prices caused by
strife in the Middle East, which would be negative for most EM countries’ energy-intensive
economies. Secondly, there seems to have been a shift in the investment industry towards an
emphasis on absolute return and an avoidance of even short-term losses, which makes these
markets vulnerable to profit-taking and sudden changes in sentiment caused by market movements
elsewhere. The simultaneous fall in EM currencies when foreign investors exit only amplifies the
downward moves for DM investors. Finally, the asset class has become quite unpredictable. Neither
growth, 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. Plus
years of current account surpluses and sound fiscal policies have helped to underpin the region’s
resilience. India is a concern, though. Latin America is more exposed to a European downturn than
Asia is, particularly through a possible decline in commodity prices, the region’s comparative
advantage. Eastern Europe, which is closely linked to the Eurozone through trade and financial ties, is
likely to be the most deeply affected.
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11. Sovereign Bonds: The biggest investment question of the year is probably whether sovereign bonds
will remain an effective hedge for equity markets. The normal approach to constructing a portfolio is
to include some government bonds as well as equity and other riskier assets for safety in case growth
falters and equity markets fall. Recently however bonds have stopped playing that role in some
countries; even in Germany, Bund yields rose when there were questions about economic growth
because of fears that the country’s rating would be downgraded. The increasing correlation between
stocks and bonds makes it unusually difficult to construct a balanced portfolio.
Government bonds in the seven major G7 bonds have done well as rates fell
industrialized countries returned a
G10 Yields and total return on bonds
respectable 5.9% in total during 2011 (see 20 % yoy % 5
graph). It will be difficult to match that 15
4
performance again this year, but bonds
10
should still turn in a positive return, in our 3
view. Obviously it is impossible for most 5
2
developed countries to lower interest rates 0
Bloomberg/EFFAS G7 global
further, 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 2011
and UK could announce another round of
quantitative easing, but we question how Source: Bloomberg Finance L.P., BOC (Suisse) SA
much further yields can fall in any case. (Remember though that Japanese 10-year yields did get
down to 0.45% in June 2003, so it’s not impossible.) Sovereign bonds have a poor risk/reward ratio as
there is limited upside and unlimited downside, but the global economy also seems to have less
upside potential than downside too, thereby offsetting the risk/reward ratio somewhat. Among
developed countries, we would avoid most Eurozone debt except at the short end; less than three
years may be one way to pick up some additional return in Spain and Italy, assuming that the ECB’s
new three-year refinancing operation may support those markets. However, investors do not usually
buy 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 that
have more potential upside in the price.
Credit: We favor non-financial investment-grade (IG) credit for investors seeking preservation of
capital with some income. Spreads are historically wide – they are at levels usually associated with
recessions in the US and much wider than at the start of any past downturn. Indeed, the low level of
sovereign yields means that spreads make up nearly 80% of overall yield on bonds, a record in both
EUR 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 not
have a redemption hump in 2012 so supply is not likely to be a problem unless they decide to
prefund the much higher redemptions due in 2013 and 2014.
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12. Meanwhile, the super-low level of yields at the short end means carry is attractive, and a slowdown
in the global economy and falling inflation rates mean the risk of a rising yield environment is that
much lower. Deleveraging and sluggish growth without recession (except in Europe) should be a
favorable 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 that
they are perceived as the less risky assets. It appears that corporate bonds are being priced not off of
their local government bonds but rather off the relevant maturity Bund. Nonetheless, we still expect
them to underperform the rest of the European credit universe until there is a systemic solution to
the Eurozone’s problems.
Given the opportunities, we recommend being overweight high yield relative to investment grade, at
least in the US and Asia.
Note that this discussion has concerned itself with non-financial bonds, not financials. This is a big
gap 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 coming
due, despite near record yields and spreads. In fact, we would expect some of the money coming
into the market from maturing financial bonds to go into non-financial corporates, thereby
aggravating the situation. We do not recommend the sector except on a case-by-case basis
EM bonds: EM credits, rates and FX look EM bonds have given equity market returns over
attractively valued to us, particularly if central six years
banks in the developed world keep interest EM sovereign & corporate bond total return
rates at rock-bottom levels, as we expect. Last 275 Jan 2005 = 100 vs MSCI EM equities
250
year, external debt (EM bonds denominated MSCI EM Total return USD
Latam bonds
in DM currencies) outperformed local 225 EMEA bonds
currency bonds as US Treasury yields declined 200 xxx bondsAsia
while EM FX depreciated. Starting from this 175
point however we think there is limited room 150
for UST yields to decline further, while the 125
current depressed levels of EM FX may 100
provide an additional return on unhedged 75
2005 2006 2007 2008 2009 2010 2011
local currency bonds to long-term investors, in
our view. (This of course assumes a successful Source: Bloomberg Finance L.P., BOC (Suisse) SA
resolution to the Eurozone crisis.) Most EM countries outside of Eastern Europe should be able to
weather the European downturn -- unlike the developed markets, they have room to expand their
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13. fiscal spending through automatic stabilizers if the economy turns down. In any event, monetary
easing is likely to continue to be the first line of defense for much of the region, depending of course
on each central bank’s degree of tolerance for further FX weakness. Given the liquidity constraints in
EM bonds and the difficulty of doing research on individual credits, we recommend that investors
who 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 are
not that optimistic about commodities as an asset class. The fact that all asset classes are likely to be
affected by a limited number of overarching macro risks means higher correlation between
commodities and other risky assets, particularly during periods of risk aversion. The stronger dollar
too tends to be negative for commodities in general. Nonetheless, we can expect some commodities
to better than others. Commodities with constrained supply, such as copper and corn, are likely to
outperform within their sectors, in our view. Grains too tend to outperform more economically
sensitive commodities when growth is weak. By comparison, industrial metals and the softs (such as
coffee, cocoa, sugar, cotton, and orange juice) tend to be cyclical and to sell off during global
slowdowns. Energy, discussed above, tends to be the most cyclically sensitive.
The defensive nature of gold should underpin the precious metal as investors continue to worry
about quantitative easing and the future of the fiat money system. The safe haven bid should remain
in the market as the conditions that have driven gold higher over the past 11 years are likely to
persist, namely negative real interest rates, nervousness about stocks and central bank buying. The
main risk for gold is a continued appreciation of the dollar. The US currency’s recent strength has not
been accompanied by an inflow into physically backed gold ETFs, as it was in 2009 and 2010. By
comparison, silver tends to be more sensitive to the economic cycle because of its industrial uses and
we therefore do not expect it to outperform gold.
FX: In a world of increasing correlation, FX
stands out as one market where some assets Is a new USD upcycle starting?
are clearly outperforming others. This year we 200
USD/Deutsche Mark Cycles
expect the dollar and the yen to be the best
performers 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 cutting
back on their EM positions are likely to join 150
European investors looking to diversify their New USD uptrend
begins in Aug '95
risk in buying the US currency. The EUR may 125
(= Nov '11?)
suffer not only from capital flight from the
100
possible break-up of the Eurozone, but even
investors who are confident of a solution may
75
worry that lower interest rates and 0 25 50 75 100 125 150 175 200 225
quantitative easing by the ECB are likely to be Months from start
part of that solution. Source: Bloomberg Finance L.P., BOC (Suisse) SA
Yen remains a safe haven as well; despite the government’s incredible debt/GDP ratio, it has a solid
trade surplus and a capital account surplus that underpin the currency (and the government bond
market). The Swiss Franc historically has played that role as well, but following the Swiss National
Bank’s pledge to put a floor under EUR/CHF the currency is now seen as the euro or worse.
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14. Renminbi: The problems in the Eurozone are CNY spot and possible 2012 trend
likely to cut into the growth of exports, which 8.50
are already slowing, and further dampen
growth. A lower trade surplus and 8.00
expectations of weaker growth could cause CNY
May 06~Jul 08 trend
the Renminbi to experience some volatility. 7.50 2011 trend
We do not however expect any change in the 3% annual trend
general trend. Last year’s 4.4% appreciation vs 7.00
USD was in line with our target of 4%~5%. We
expect the uptrend to continue but at a 6.50
slower 2%~3% pace in light of the global
situation. We cannot exclude the possibility of 6.00
2006 2007 2008 2009 2010 2011 2012
fluctuations and perhaps a brief depreciation
of 1% or so as the environment deteriorates. Source: Bloomberg Finance L.P., BOC (Suisse) SA
It will be important though for the government to keep the strength of its currency during this US
election year to fend off trade friction, as well as supporting the goal of shifting the Chinese economy
towards increasing emphasis on domestic consumption. At the same time no risk will be taken by
appreciating the currency inappropriately and significantly hurting the export sector which is already
facing falling global demand.
Other EM currencies have moved along with global risk preferences and many currencies now stand
below fundamental value, in our view. Positioning is also very light. We therefore see room for EM
currencies to retrace their losses and more if the EU crisis is successfully resolved. However, if the EU
crisis escalates these currencies would rapidly be hit by non-residents’ hedging or repatriating their
local investments. We therefore favor currencies where the valuation and technicals are favorable
and the economies are not that exposed to Europe. As mentioned above, we expect that China
would not allow its currency to depreciate against USD in an election year. The Mexican peso may
benefit from the relative strength of the US economy, in contrast to the Brasilian real, where the
central bank is likely to cut interest rates further even in the face of high inflation in an effort to
weaken the currency.
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