Deutsche Bank - The Markets in 2012-Foresight With Insight

Deutsche Bank Corporate & Investment Bank
The Markets in 2012 Foresight with Insight
Markets in 2012Foresight with Insight Deutsche Bank
Foreword A broader view
The year 2012 looks set to be as challenging as 2011 with many open questions about the outlook for the markets and the future of the global economy.
It will be harder than ever for investors to make decisions that strike a strategic balance between opportunity and risk, both in the shorter and longer term. More than ever, understanding the issues impacting the market as a whole will be critical to investors' success in the year ahead. Strategies based purely on expertise in a particular industry or asset class will be insufficient; developing a broader view is essential to navigate the increasingly correlated environment. With this publication, we aim to deliver exactly that comprehensive overview to help you refine your perspective across a host of markets, economies and industries. We hope you find it useful. On behalf of all of my colleagues, we thank you for choosing to work with Deutsche Bank and look forward to further partnership in the year ahead.
Anshu Jain Head of the Corporate & Investment Bank Member of the Management Board
The Markets in 2012 Foresight with Insight
Contents
1 1.1 1.2 1.3 1.4
Leaders Global Economy The outlook for 2012 The Renminbi The worlds next reserve currency? The Case for Equities Is fundamental valuation dead? US Elections Presidential prospects and implications Investing in a Crisis Tough times ahead but there will be opportunities Executive Viewpoints
3 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8
Markets US Equities Its all about the multiple European Equities Time to be bold Asian Equities Focus on large caps Emerging Market Equities Difficult year ahead Credit Outlook for 2012 Commodities Can they push higher? FX Prospects for key exchange rates Rates Two scenarios ABS Challenges and opportunities
Financing, Investment & Risk Management: Bond Market Outlook Outlook for 2012 Equity Market Outlook Prospects for issuers Commercial Mortgage Backed Securities False boom, real dawn Art The waiting room Financing, Investment & Risk Management: Research Viewpoints
5.1 5.2 5.3
5.4
1.5
1.6 1.7 1.8
1.9
Brazil Economic prospects Risk Monitor Ten key risks to watch out for Inflation Central banks looking the other way? Trade Finance Back in fashion
5.5 5.6
3.9
The Ideal Portfolio What to own European Financial Risk How to hedge systemic risk
4 4.1
Sectors & Corporate Strategy 6 Regulation & Trading Technology Regulatory Change Whats ahead Electronic Trading Trends to watch Centralised Clearing Adopt early or wait and see?
2 2.1 2.2 2.3
Economics & Geo-Politics The Eurozone Crisis Fast track Europes road map China Soft or hard landing? The US Dollar Are we entering a post-dollar world? US Green shoots or parched roots? Growth Solutions What Greece and Italy could learn from Ireland Emerging Markets Can they decouple? Africa The next frontier: who to watch Asia Slowing but how much?
2.4 2.5
2.6 2.7 2.8
Outlook for Corporates Test of nerve 4.2 M&A Outlook for 2012 4.3 Natural Resources Valuation disconnect 4.4 Telecoms & Media The digital revolution 4.5 Consumer Goods Deals on the way 4.6 Industrials Prospects for earnings 4.7 Financial Institutions Deleveraging 4.8 Financial Sponsors Shifting focus 4.9 Technology Cloud computer land 4.10 Healthcare Whats ahead for 2012?
6.1 6.2 6.3
Articles marked with the
icon are based on Deutsche Bank Research.
Leaders
Global Economy The Renminbi The Case for Equities US Elections Investing in a Crisis
1.1 Leaders
David Folkerts-Landau Global Head of Research
1.1 Leaders
Global Economy The outlook for 2012
The year just ending was challenging for the world economy the US economy suffered a significant slowdown, Japan was hit by a devastating earthquake and Europes sovereign debt crisis deepened. Despite these shocks, a strong growth performance in emerging markets enabled the global economy to expand by 3.5% in 2011, a pace we expect to continue in 2012, as a rebound in Chinas growth and a continued recovery in the US economy offset a likely recession in Europe.
In our view 2012 will see the turning point in the European sovereign crisis. Recent events have seen dramatic political shifts in the peripheral euro zone nations, especially Greece and Italy, which should boost reform and, ultimately, ensure that the region emerges stronger and more stable. The situation in Greece is stabilising, and the changes now being made should remove the country from the spotlight. Italy is where the key risks and challenges lie, in our opinion. We believe the country is solvent: Italy has significant economic potential, low private sector debt, the highest household wealth among the G7 and a record of delivering primary surpluses during the past decade. The key challenge going forward will likely be the ability of politicians to push though growth-enhancing reforms in order to unlock Italys potential. We note recent changes in the government point in the right direction. We are particularly encouraged by progress thus far in Spain, which has demonstrated a strong commitment to adjustment, as well as by Irelands advances in competitiveness which have turned around market sentiment. Ireland has doubled its trade surplus since 2008 and robust export performance has more than made up for the weakness in the domestic economy. We expect France to remain in the spotlight in 2012, as elections approach and doubts are raised about its ability to hold on to its AAA status. In our view, despite the governments recent announcement of additional spending cuts, we believe more fiscal measures will be required to avoid a downgrade, as growth will likely be weak in 2012. Indeed, we believe the eurozone economy is sliding into recession which at best will be mild and last only for a couple of quarters, although there are considerable downside risks. While the fiscal austerity measures and reforms being put in place are necessary for the peripheral economies to regain market confidence and restore competitiveness,
they will likely have a negative impact on growth. Growth will also suffer from the acceleration in bank deleveraging that Basel 3 regulations will require in 2012. We expect eurozone growth to decline to 0.4% in 2012 from 1.5% in 2011. Even the data out of Germany has turned down recently. We expect the European Central Bank (ECB) to continue reversing the interest rate hikes of 2011 and see another 25bp cut early in the New Year. We also expect the ECB to continue buying peripheral country bonds, albeit at a measured pace, and to keep its various liquidity taps open. Fortunately, the United States appears to be recovering, albeit slowly, after a surprisingly weak first half of 2011. There has been a clear improvement in the economic data in the past couple of months, with consumers showing surprising resilience and firms maintaining a decent level of investment. We expect the economy to strengthen further in 2012, as some of the headwinds from Europe abate, credit growth picks up and the housing market stabilises. The Fed has also signalled that it will leave its official interest rates close to zero through to mid 2013 at least, providing further support to the economy. We have revised up our forecast for US growth to 1.8% for 2011 and 2.3% in 2012. Key risks we see facing the US economy are that Congress fails to agree to stem some of the near-term fiscal drag (2% of GDP in 2012) and, more importantly, that it fails to agree on longer-term deficit reduction measures in the longer term to avoid a more serious downgrade by ratings agencies. We remain confident that some agreement will be reached. There has been much conjecture recently about the other motor of the world economy China. Although we believe the risks from the property, banking and small business sectors are overstated, we do see growth slowing to an annualised 7% around the turn of the year. We expect that the economy will avoid a hard landing, however, and that growth will accelerate to almost 9% by H2 2012. Inflation is now falling sharply
but we do not expect a major policy stimulus to follow as a result. The government is likely to launch targeted measures in some parts of the economy instead. For the rest of emerging Asia we see a slowdown in growth but, again, no hard landing, as real interest rates are low and domestic demand is still robust. The landing could be a little harder in a few economies as rapid property price increases and high credit growth potentially reverse in 2012. But while authorities have already shifted policy away from combating inflation, as with China, we dont expect major policy relaxation unless the growth or inflation outcomes are significantly lower than we forecast. Japan, nine months after its devastating earthquake and tsunami which damaged global supply chains is likely to have seen its economy contract by around 0.5% in 2011, not helped by a strong yen. We see growth of just over 1% in 2012, helped by further postquake reconstruction spending by the government. But the strength of the yen and the crisis in Europe could turn out to be a bigger drag on the economy if policymakers do not implement the right measures. Overall, we expect growth in 2012 to hold up reasonably well. If the threat of a systemic event in Europe fades in the early part of next year, as we expect, 2012 could offer significant upside potential for risk assets.
1.2 Leaders
Alan Cloete Head of Global Finance & Foreign Exchange
1.2 Leaders
The Renminbi The worlds next reserve currency?
To understand why the renminbi (RMB) will become a major reserve currency in the next decade, you only have to follow the money. In September, for instance, Chiles central bank reported that 0.3% of its international reserves are now held in RMB, while Nigeria said it would add RMB to its mix of US dollars, euros and sterling. Within 10 years, the RMB could account for 15% of global currency reserve holdings, according to US economist Barry Eichengreen.
The rise of the RMB may happen even faster, if the past year is any guide. Since July 2010, the monthly volume of RMB-denominated trade settlements has soared almost twenty-fold to RMB185 billion in August 2011, almost 9% of Chinas total monthly trade volume. Hong Kong once Chinas financial window on the world is now the worlds back door for access to RMB. Daily transactions on Hong Kongs offshore RMB spot market, opened in August 2010, now amount to about USD2 billion. Demand for RMB is bound to accelerate, given Chinas commitment to liberalise its capital and current account by the end of 2015. Hardly a month goes by without the Peoples Bank of China further loosening the restrictions on onshore RMB trade settlements for foreign investors and customers. For instance, since August 2011 foreign businesses have been able to settle contracts in RMB in any province in China, a relaxation of the rules that would have been unimaginable even two years ago. What all these developments signify from Nigerias central bank vaults to Hong Kongs trading floors is the imminent arrival of the RMB as a reserve currency that reflects Chinas economic weight. That, in turn, will reduce worldwide demand from central banks for US dollars and euros, with forecasts suggesting the dollars share of global reserve currencies could fall from about 60% to 50% over the next decade. The RMBs international rise will bring with it an end to the present restrictive system of parallel foreign exchange markets for Chinas currency. The socalled non-deliverable offshore RMB forward market has no long-term future of its own, since companies can increasingly find deliverable liquidity on Hong Kongs burgeoning RMB spot market. Hong Kongs near-monopoly of offshore spot trading is also under threat: Singapore is in negotiations with Beijing to open a competing market. So where does this leave the Hong Kong dollar? My view is that it will merge with the RMB to become one currency. The rationale for a separate Hong Kong currency is becoming increasingly weak, as its economy merges with the mainland. One sign of the times is the growing number of Hong Kong-based companies with operations in China that have begun to pay their employees in RMB. Expect more to follow. But I do not expect the switch to take place for the next two years at least which opens up perhaps the biggest question of all: what will happen to the Hong Kong dollar between now and its eventual merger with the RMB? The Hong Kong dollar is already under immense pressure: pegged to the US dollar yet operating in an economic environment with high inflation, strong growth and signs of an asset price bubble, it is clearly undervalued. But the Hong Kong Monetary Authority faces a difficult challenge in resolving this problem. If it aligns the Hong Kong dollar to the RMB, it opens up Chinas capital account too quickly. If it moves the peg from 7.8 to 7, speculation about further changes will increase. But if it moves the peg decisively from 7.8 to, say, 6, this could destabilise the economy. The saviour may turn out to be the global economy. If growth slows significantly, easing pressure on asset prices, then Hong Kong may be able to keep the peg in place for a few more years until it is ready to adopt the RMB. If it doesnt, we can expect continued pressure on the Hong Kong dollar. Interesting times ahead, either way.
Trades on market dislocation between onshore and offshore spot market

Date 19 Oct10 USD CNY 6.6446 USD CNH 6.4745 CNH Premium 2.6% Trades for Corporates A corporate sold CNH at 6.4745 with 2.6% premium to onshore CNY spot rate. This premium was realised by offshore exporters receiving payment in RMB when exporting goods to China. A corporate bought CNH at 6.5500 with 2.5% discount to onshore CNY spot rate. This discount was realised by offshore importers making payment in RMB when importing goods from China. In reality, given the expectation of RMB appreciation, onshore exporters always charge a premium for USD invoicing relative to RMB invoicing to hedge their risk. It is much cheaper for offshore importers to use RMB invoicing. The discount of using RMB invoicing and buying CNH offshore instead of using USD invoicing would be close to 10%.
23Sep11
6.3883
6.5500
2.5%
Trades on market dislocation between onshore and offshore forward market

CNH DF 12M 23Sep11 6.4890 CNY FWD 12M 6.3320 CNH DF 12M Premium 2.5% Trades for Corporates Since the establishment of the offshore CNH DF market, CNH DF has always been trading at a discount to onshore forward market, providing a cheaper RMB source in the forward space. Corporates bought offshore CNH DF at 6.4890 with 2.5% discount to onshore CNY forward. This discount was realised by offshore importers making payment in RMB in 12 months time when importing goods from China.
Trades on market dislocation between CNH DF market and NDF market

USD CNH DF 12M 23Sep11 6.5810 NDF 12M 6.4603 USD CNH DF Premium (in %) 1.8% Trades for Financial Institutions (FI) FI took the opportunity to migrate from the NDF market to the USD CNH DF market. Instead of selling at 6.4603 in the NDF market, FI sold at 6.5810 in USD CNH DF market, benefiting from a 1.8% premium. Since the offshore market is deliverable, FI also benefited from the positive carry of using the deliverable CNH to invest in bonds. In this case, FI would be subjected to the spot basis risk between the CNH spot and CNY fixing. However, this basis would be meanreverting.
Trades when CNH forward is in premium

Date 26Oct11 USD CNH Spot 6.4015 USD CNH 12M FWD 6.4085 USD CNH 12M FWD Premium 0.1% Trades for Corporates With USD CNH forward trading at a premium, corporates raised CNH funding through money market, certificates of deposits and bond issuance at very low yield given the strong demand for CNH asset in Hong Kong. They then swapped this CNH funding into USD funding via an FX swap. This cheap USD funding offered in the CNH market would provide a cheaper source of USD funding for corporates situated in countries with wide CCS basis.
Market dislocation on bond market and trades for corporates

Onshore Offshore bond basis MarOct11 around 300 bps Trades for Corporates A corporate secured cheap CNH funding in Hong Kong by issuing offshore CNH bonds at yields that are on average 300 basis points lower than onshore levels and using FDI to bring the proceeds back into the onshore market.
Asset Swap trades

Bond Yield 1Mar11 Around 1% USD CNH 12M Implied 1.4% Asset Swap Yield 2.4% Trades for Corporates Corporates raised USD offshore and swapped it into CNH to invest in the CNH bond market. Since the implied yield was as much as 1.4%, if the CNH bond yields around 1%, corporates enjoyed a return of approximately 2.4%.
Garth Ritchie Global Head of Equities
1.3 Leaders
The Case for Equities Is fundamental valuation dead?
Equities selected on the basis of fundamental value analysis will deliver significant upside in 2012 but investors will need to adopt the right trading strategies to get the best returns.
Equities are, in my opinion, significantly undervalued. At the time of writing, European equities are trading on a P/E ratio of 11.2 and the S&P 500 at 12.8. This is the lowest since the nadir of March 2009. The main reason for this undervaluation is the low levels of allocations by real money investors. After the crisis of 2008 many institutions slashed equity allocations from 10% to 2% and moved USD1 trillion into the credit markets. But the investment tide is turning as investors recognise that bonds are no longer risk-free in the wake of the Greek default and unfolding European debt crisis. Investor appetite for equities should intensify as developed world interest rates start to increase, and as investors seek to address the capital erosion in their fixed-income portfolios. The fundamental case for equities is very strong. First, the dividend yield on the S&P 500 is 2.1% compared to 2.2% for US government bonds. But dividends are growing by 15% a year, while bond coupons are static. On a cashflow basis, the S&P 500 ex-financials is yielding 12%, 6% more than Baa-rated bonds.
Second, many large corporates are sitting on cash and many are also benefiting from continued economic growth in Asia and other emerging markets. Profits at S&P 500 companies are growing at 9% year-on-year. But to take full advantage of the opportunities, investors need to select the right stocks and trade them in the right way. Over the past three years, many investors have adopted a Mark To Market (MTM) approach to equity investment. With the markets in a risk on, risk off mode and a high degree of correlation between geographic regions, this has been sensible. But the recovery is likely to be much more uneven, with different countries recuperating at different speeds and some failing to leave the sick bay. Bank sector solvency and liquidity also varies widely between countries. In such a patchwork-quilt environment, active management (i.e. alpha over beta) will be the better option. Emerging market growth is perhaps the most compelling story. But it may be best accessed via multinational companies listed on exchanges in
Europe and North America rather than via locally-listed local players which are coming under increased margin pressure, largely due to wage and resource inflation. But even emerging market growth may slow from 2012, presenting some risks. In an environment in which access to liquidity is critical, the use of advanced electronic execution tools including Broker Crossing Systems and advanced algorithms enable investors to trade more efficiently at the same time as managing their costs. If investors are to successfully navigate the challenges of multiple trading platforms, fragmented markets, increased volatility, and an increasingly complex regulatory environment, they also need to look to maximise their use of the consultative services of their broker. By supplementing electronic execution with traditional OTC trading, investors will find it easier to amass sizeable equity stakes and cope with other executional challenges, including wider spreads. Striking the right balance between the traditional and the cutting-edge should ensure that the alpha derived from effective stock selection is not eroded by clumsy trading.
1.4 Leaders
Frank Kelly Head of Communications and Public Affairs, Americas
US Elections Presidential prospects and implications
If we dont see a significant improvement in economic conditions by the summer, President Obama will struggle to get re-elected. The possibility of a Republican President, Congress and Senate would bring significant changes to US economic policy and financial regulation.
The United States is now less than a year away from presidential and congressional elections which could have a very significant impact on the future direction of the US economy and financial markets. Clearly, markets are most focused on the presidential elections. President Barack Obama has informally launched his re-election campaign and begun significant fundraising efforts. His goal is to raise USD1 billion, the highest ever for a presidential election. Overall, observers believe President Obamas re-election will be a tough road. The economic situation is one of the worst in recent US history; unemployment rates are hovering at 9%; and the Iraq and Afghanistan military campaigns remain unresolved. Recent polls show President Obamas job approval ratings in the mid-40% range. Only one president in modern times has had ratings this low and gone on to be re-elected: Ronald Reagan in 1984. But the economic outlook was
stronger then than it is now: having decisively made the turn out of recession and with recovery firmly on the horizon. A better comparison may be 1980 when President Carter came up for re-election just as the economy moved into recession (and with the Iran hostage debacle fresh in voters minds), and duly lost to Reagan. The parallel is not precise. In Q2 1980, the US economy declined by 7.9%, its biggest fall since the great depression. Barring a string of severe tail-risk events such as a collapse of the euro, it is hard to see the US economy contracting by this amount in 2012. Nevertheless, it seems likely that if the economic situation does not improve before mid 2012, Obama will face a significant challenge. The biggest factor in President Obamas favour is the lack of sustained excitement around the Republican candidates lining up to run against him.
Former Massachusetts Governor Mitt Romney has steadily kept in the forefront of most polls but has failed to fully engage voters. Other candidates such as Texas Governor Rick Perry and former pizza executive Herman Cain have temporarily grabbed polls leads only to recede back into the pack. Republican primaries start on 3 January. We will know the final candidate by May. While President Obamas approval ratings are low, Congress ratings are lower far lower. In fact, they have never been worse. In a recent Gallup poll, just 13% of voters approve of Congress performance while 81% disapprove. If this is a true indication of voter sentiment and (once again) the economy does not improve, we may see many voters vote out the incumbent no matter what their political affiliation. This would hit the Democrats harder than the Republicans since 25 of the 33 state elections due next year are currently held by Democrats. If they get voted out, the Republicans would gain a majority in the Senate.
It is important to remember though that there is still the better part of a year to go until the elections and several significant events could change the dynamics considerably. First among these is the so-called congressional Super Committee. The Super Committee, composed of 12 hand-picked senators and congressmen, is charged with finding at least USD1.2 trillion in deficit cuts by 23 November 2011. If they reach an agreement, both chambers of Congress (the House of Representatives and the Senate) must approve by 23 December 2011. At the time of writing, the outcome of both remained unknown. But failure to reach an agreement will trigger immediate cuts to national healthcare programmes such as Medicare as well as deep cuts to the defence budget, and may lead to further rating downgrades. It is difficult to predict which party would be damaged more by this turn of events but it would definitely increase the likelihood of incumbents being voted out.
Washington is also beginning to watch the direction of the various federal legal challenges to President Obamas hallmark healthcare legislation. There is growing likelihood that the US Supreme Court will hear arguments from various states over the constitutionality of the proposed legislation as early as January 2012. If this happens, there is a strong likelihood the Court will hand down its decision next summer perhaps in late June. And if the initial decisions by several junior federal courts are any indication, there is significant risk the Supreme Court will strike down the law dealing a setback to President Obama only months before the election. Finally, and perhaps most importantly for financial services, there is Dodd-Frank. If a Republican wins presidential office, and the party retains their majority in Congress and gains it in the Senate, there is a strong possibility that DoddFrank could get rolled back or perhaps repealed altogether. If Obama is reelected, change seems unlikely.
1.5 Leaders
Rich Herman Global Head of the Institutional Client Group
Investing in a Crisis Tough times ahead but there will be opportunities
2012 will not be an easy year for investors but it will not be a re-run of 2011: fundamentals will play a more important part in asset valuation, and there will be more opportunities to outperform.
In 2011, the markets were driven by macro themes and events with very high levels of correlation between asset classes. In 2012 barring a major shock such as an EMU country exiting the euro, which we do not expect systemic risk should ease and we should see greater dispersion in returns. We could also see fairly strong market rallies. The equity and credit markets are currently pricing in a severely negative market environment for 2012. But calling the bottom will, as ever, remain challenging. Beta investors face some formidable challenges. Fixed income yields are likely to remain at their current low levels in 2012 as markets seem more concerned about the spectre of deflation than any inflationary pressures that quantitative easing may stoke. The Federal Reserve has committed to keeping official rates low for as long as it takes, the European Central Bank (ECB) is cutting rates soon and the Bank of England has just launched more quantitative easing. And for US Treasuries, the traditional safe haven, yields could actually be negative. A recent study by Deutsche Bank Research showed that if yields revert to the mean, investors in 30-year Treasuries will suffer an annualised loss
of 3.3% over the next five years and 1.3% over the next 10. Those who buy the 10year benchmark bond will suffer losses of 4.3% and 2% respectively. There is historic precedence for these kinds of losses. After 1946, when gilt yields were last this low, the bonds lost 75% of their value over the next three decades in real terms, as inflation took its toll. And, as we know, the lower the yield on an asset when bought, the lower the long-term returns are likely to be. If the world goes back into recession, the past indicates that bonds will fare much better than equities, although that, in turn, was dependent on low inflation, something that is by no means certain this time round. The outlook for equities could be promising for investors seeking capital gains with several of our equity strategists predicting significant rises for next year if the major tail risks do not materialise. US dividend yields are now higher than 10 year US Treasury yields, something that has only been seen once (briefly in 2008 and 2009) since the mid1950s. But if 2011 is any guide, we can expect sustained volatility and market swings which could result in significant MTM moves.
So if the prospects for beta or index based investment strategies are challenging, where should investors focus in 2012? In fixed income, one potentially attractive option is relative value trading buying one security and selling another to profit from differences in their performance (or doing so synthetically via a swap). During 2011, we saw some outstanding trading opportunities in this area, typically created by dislocations in the market which led to some assets selling off more than others. A quick example: in June 2011, we saw a major sentiment gap open up between the equity and bond markets with equity investors being relatively optimistic about the short-term outlook and fixed income investors extremely nervous. By going short the equity indices but long the credit indices, investors were able to make a positive return of 7% in less than three months with carry of 1.77% a year. One of the best things about this trade was that in addition to offering a very respectable return, it also provided a very useful hedge against an increase in eurozone sovereign credit risk, a dualpurpose advantage that is often available on many relative value strategies.
I am confident we will continue to see opportunities like this in 2012 given the probability of further market volatility. In equities, some of the most exciting openings could come in the field of thematic investment where you take a view on a specific trend by buying stocks that will be most affected. Lets say you believe that merger and acquisition activity will increase in 2012. You can buy a note or a swap linked to a basket of stocks that have been specially selected as likely takeover targets. The range of thematic investment products available has grown significantly in recent years and there are now hundreds to choose from, including large numbers that do not require bull market conditions to perform well. Some are based around specific events such as political elections or the launch of a new product (such as our own Apple supplier basket). Others are around longer-term economic trends such as an increase in European exports to the US. The advantage of these products (particularly when done on a synthetic basis) is that they capture macro trends but can often be less volatile and more
liquid than straight long positions on equity indices or individual stocks during periods of high market volatility. Both thematic investment and relative value trading require fair amounts of analysis on the part of investors and the banks that they partner with, but hard work will I suspect be the key to success in 2012.
Executive Viewpoints
Brazil Risk Monitor Inflation Trade Finance
1.6 Executive Viewpoints
Bernardo Parnes CEO Deutsche Bank Latin America, Chief Country Officer Deutsche Bank Brazil
Brazil Economic prospects
After growing 7.5% in 2010, the Brazilian economy decelerated in 2011 due to the tighter fiscal and monetary policies introduced by the government to bring down inflation and the global slowdown. GDP growth for 2011 is likely to be around 3%.
I expect growth to stay below potential in 2012 with Brazil being particularly sensitive to developments in China where a slowdown could reduce demand for Brazilian exports and cut commodity prices which account for around 70% of the countrys exports. But despite the challenging global economic environment, Brazil still offers some great opportunities especially for investors who can take a long-term view. The economys potential is attested by the sheer volume of foreign direct investment (FDI): USD76 billion in the last 12 months. Foreign companies are actively pursuing M&A opportunities in Brazil. Asian buyers have been particularly aggressive, focusing on oil, metals, mining and agribusiness. The construction and infrastructure sectors could benefit from two important developments. First, the mortgage market remains very small in Brazil (a mere 4% of GDP), but is growing very fast due to the economys financial stabilisation and lower interest rates. Given the pent-up demand for housing,
we expect further credit penetration in the long term. Second, the government is committed to boost investment on infrastructure to eliminate bottlenecks and to prepare for the 2014 FIFA World Cup and the 2016 Olympic Games. The retail sector offers interesting opportunities too as it has benefited enormously from the drop in unemployment and strong expansion in consumer credit observed over the past six years. Even when the economy contracted by 0.6% in 2009, private consumption still grew a hefty 4.1%. We expect consumption to remain buoyant in 2012 due to fiscal and monetary easing and a sizeable minimum wage increase. Banks may provide an interesting investment opportunity as well, as concerns about rapid credit expansion are overblown. Although bank loans have grown very fast over the past few years, credit penetration (48% of GDP) remains small by international standards. The debt burden on consumers is very high, but mainly reflects the short loan maturities and high interest rates.
Credit penetration is bound to increase further as interest rates decline and maturities increase. Moreover, Brazilian banks are very well capitalised (their capitalisation ratio is 17%), and the Central Bank has plenty of room to provide liquidity by cutting towering reserve requirements on bank deposits and interest rates, if necessary. While interest rates are falling, real rates remain relatively high and offer interesting opportunities. Dollardenominated interest rates (cupom cambial) are particularly attractive for foreign investors, as they have not accompanied the decline in Brazils risk premium (as measured by its CDS spreads), mainly due to government intervention in the FX market. Offshore structured notes obtaining a dollar yield of approximately 2% to 3% for a three-year maturity offer an excellent return, considering that interest rates in developed economies are close to zero. Inflation is an important risk. Although consumer prices rose 5.9% in 2010 and could increase approximately 6.5%
this year, the Central Bank has initiated an easing cycle and is poised to cut rates further, as the authorities seem to be more sensitive to fluctuations in output than in prices. While the global slowdown and resulting drop in commodity prices will help the Central Bank tame inflation, prices could rebound should the global economy recover faster than expected. Investors can buy inflation protection through inflation-linked bonds issued by the Treasury. All in all, 2012 looks set to be an interesting year.
Tom Joyce CMTS Strategist Ram Nayak Global Head of Structuring
Risk Monitor Ten key risks to watch out for
1. Greece euro exit We dont believe this will happen but the inconceivable is no longer unthinkable after Merkel and Sarkozy crossed the Rubicon at the G-20 Summit in November. Return to the drachma would involve a sharp redenomination lower of all private sector assets, a larger debt restructuring, the imposition of capital controls, and a probable collapse of the Greek banking system (at a cost >30% of Greek GDP). For Europe, a run on peripheral banking systems could follow. Hedges: switch out of European assets into safe havens such as gold or US Treasuries; long volatility indices such as VIX, CVIX or DB Tail Risk index; buy protection on the Sovereign X credit default swap index; go long the yen or sterling which could benefit from an accompanying fall in the euro. 2. Italian and Spanish funding crises Together, Italy and Spain are too big to fail, too large to bail. The eurozones third and fourth largest economies have a combined EUR 2.7 trillion debt outstanding (>30% of eurozones total). Both are liquidity problems, not solvency problems. A crisis of confidence and deep recession are the catalysts for this risk. For Spain, watch the private sector and banking system. For Italy, the concern is politics and underperforming growth. The European Central Bank, and possibly global central banks, would need to respond aggressively. At stake would be the global financial system and the fate of the euro itself. Hedges: as above plus short subordinated bonds of French and British banks; go short Eastern European currencies that tend to track the euro but have yet to price in euro break up risk as extensively as the euro itself; long options on CDX.IG index.
3. US downgrade and/or double dip recession The first quarter 2011 showed how quickly large unexpected shocks can translate to the real economy: GDP growth slowed to 0.8% after political change in the Middle East and the earthquake in Japan. If Risk 1 or Risk 2 materialise, then a double dip is a very real possibility. If the highly anticipated fiscal cuts due 23 December 2011 disappoint, or growth underperforms, there is a real risk that the US could be downgraded once again. Though treasuries could rally again, dont expect a simple repeat of the historic August downgrade as a ripple effect to US banks sector downgrades could follow this time. To measure the impact, timing could be everything. Hedges: Issuers can protect themselves by pre-funding; investors by going overweight non-financials and higherrated non-cyclicals or by entering into payer swaptions that knock in when equities drop below a certain level. The premiums on these can be reduced by as much as 70% by linking them to rising rates. 4. China hard landing For China, 5% to 6% growth would seem like a recession. China growth could be stimulated quickly but the global capital markets would be left exposed to sudden sharp declines in commodity prices and global equities. But the declines may be short lived. With USD3.2 trillion of FX reserves, China has the power to stop the slide quickly. Hedges: a six month put option on a basket of WTI crude oil and copper or a six month worst-of option on WTI crude oil, copper and gold. Upfront premium costs are 10.5% and 1.95% of notional respectively.
5. France loses AAA rating Quite possible, in our view, given badly delayed fiscal austerity in advance of the Presidential election. With France trading at a 20 year wide to Germany, the downgrade risk may already be priced in. More concerning would be the economic impact of bank funding market pressures and the more aggressive fiscal austerity to follow. Implications for the European Financial Stability Facility would also be negative, and come at a very bad time. Hedges: buy protection on French sovereign CDS; buy best-of-put options that provide a put over the equity index that experienced the best performance over the period: the rationale being that when there is major macro event, equity markets tend to go down simultaneously; it provides a cheaper, yet effective hedge for a global correlated sell-off. 6. Aggressive, sustained European bank deleveraging The question is not if European banks will deleverage aggressively in 2012, but by how much. Current estimates suggest as much as USD2 trillion within 18 months. Strong headwinds include a sovereign crisis, a recession, closed funding markets and Basel 3. If the negative feedback loop to the real economy is not broken, look for funding and capital markets to be the channels for global contagion. Hedges: look for protection on cyclical industries, lower-rated credits and financials, particularly those with high funding needs; go long volatility both in equity and credit markets.
Figure 1: Composition of Debt/GDP Across Selected Economies

Source: Central Banks Financial Non-Financial Business 500% 496% 400% 393% 300% Greece Govt Debt/GDP=160% 382% Households Government
353%
347%
333%
332% 264%
200%
100%
0% Japan Spain Portugal US UK Greece Ireland Italy
7. Liquidity crunch in commodity trade finance Commodity trade finance is highly concentrated across five European banks, three of them French. In aggregate, they provide an estimated 75% of the financing for the big Swissbased commodity trading houses. History suggests that the shorter duration maturity of this market is at high risk when banks deleverage (see Risk 6). Just as in 2008, commodity prices could fall sharply. Hedges: reinforces case for downside protection on commodities (see Risk 4). European borrowers should diversify their sources of funding into the US; investors could look into one-year USD100 puts on Brent or a one-year USD100 put on Brent with a 1.2000 Knock-in on EUR/USD. 8. Declining universe of safe haven assets The old adage find safety in numbers did not find consistently reliable friends in Gold, the Swiss franc and yen in 2011. In the peak volatility of August-September, US Treasuries and Bunds proved more reliable safe haven assets. However, the rising debt obligations of both economies (albeit for different reasons) may warrant more prudent diversification strategies, as well as protection against inflation and higher rates. Hedges: diversify into a wider range of AAA-rated assets such as supranational bonds and gilts.
9. Ballooning US pension fund deficits When it comes to US pension fund deficits, rounding errors can be measured in trillions. For US corporates, funding gaps range from USD400 500 billion, while comparable US public sector deficits are estimated at USD3 4 trillion depending on discount rate assumptions. Declining corporate profitability, public sector rating agency downgrades, and unexpected funding crises could follow. Continued low rates only exacerbate the challenge. Fund outflows from equities to bonds could increase. Hedges: for the companies involved, ALM strategies such as receiver/payer swaptions; for investors, puts on major equity indices where premium is only payable if rates rise. The rationale here is that equity puts are somewhat expensive, and the premium is only due if rates rise, which is less likely than implied by the forward market. 10. Better than expected economic growth A large degree of downside risk is being priced into markets; investors are primarily focusing on further de-risking of debt exposures. However, such an environment introduces another risk from the potential for upside surprises: if Europe stabilises, both global growth and risk asset prices could exceed expectations. Hedges: 10y/20y euro rates payer spreads; long non-conforming mezzanine debt; Short AUD v Long MXP.
Figure 2: 2012 2014 European Bank Debt Redemptions

Source: Deutsche Bank Research 900 800 700 600 500 400 300 200 100 0 2012 2013 2014 673 583 EUR billion 845
Figure 3: Gold During the Perfect Storm (August 5 October 10, 2011)
Source: Bloomberg 1950 $ 1900 1850 1800 1750 1700 1650 1600 1550 2-Sep 9-Sep 16-Sep 23Sep 30-Sep 5Aug 12Aug 19-Aug 26Aug 7-Oct Oct. 10: Europe announces Grand Plan Aug. 5: Historic US downgrade
Michele Faissola Head of Global Rates and Commodities
Inflation Central banks looking the other way?
For most of the past two decades, inflation has not had a major impact on the investment decisions of market players. With the rise of independent central banks endowed with strict inflation fighting mandates, inflation expectations successfully converged towards central bank targets. This low and stable inflation environment was a key contributor to the great moderation period enjoyed during the past two decades, a period of an unusually stable macroeconomic environment for advanced economies.
The 2008 financial crisis and its aftershocks which continue to reverberate across the world have forced investors to question the stability of both inflation and growth in coming years. First, established forecasting models failed to predict accurately the rise in inflation in 2011. Second, high debt levels, weak growth prospects and difficult market conditions are making it challenging for central banks to focus solely on inflation targets, with financial stability and employment increasingly taking precedence in their objective functions. Indeed, only one year ago, economists and policy makers were preoccupied by the spectre of deflation. US core inflation fell to 0.6% in October 2010 and speakers at the Feds Jackson Hole conference in August 2011 expressed concerns about the risk of additional price declines in the following year. Instead, US core inflation rose to 2% while headline inflation soared to almost 4% in September 2011. Similarly, inflation rates in the UK, China and in the euro area have been rising more quickly than anticipated and are currently running at levels well above central banks targets. Against this backdrop, central banks appear stuck in a low real rate trap. Financial markets are more fragile than ever, while public debt levels remain perilously high. This makes it difficult for monetary authorities to focus solely on their inflation mandates, as low real policy rates may be required to keep markets and economies afloat. The European Central Bank (ECB) has been alone among the major central banks in fighting inflation risks raising interest rates twice earlier this year, although it was forced to reverse course recently. All other major central banks have maintained extremely low interest rates and have engaged in aggressive quantitative easing, despite inflation rates above their targets. The current environment and policy actions are not without risks for the inflation outlook. The most visible
effect of record low policy rates is the upward pressure on real asset prices which via commodities has been a major driver of this years acceleration in global consumer price inflation. Central bank policies may also have impacted domestic inflation. Unconventional policy measures are likely to have supported inflation expectations, which in turn may have added some stickiness to inflation in the face of subdued demand. With commodity prices unlikely to rise at the frantic pace of 2011 and global economic activity softening, inflation rates should come down in 2012. However, the post 2008 experience suggests that central banks will continue to intervene aggressively in support of economic growth and markets tolerating risks on the inflationary side in particular in the US and the UK where policy makers have made it clear they stand ready to add additional support if required. For most central bankers, except perhaps the ECB, the risk of an above-target inflation rate is viewed as a relatively low price to pay for financial or economic stability. In this environment, inflation markets offer attractive opportunities for investors. Breakeven inflation rates the inflation compensation priced in by inflation-linked and conventional government bonds have been negatively affected by several factors: flight-to-quality into more liquid nominal bonds; concerns about downside risks to growth; and official intervention, such as central bank purchases of UK gilts or Italian BTP. In most markets valuations anticipate inflation rates to run below policy targets for the coming years. As such, investors can switch from nominal to inflation-linked bonds, generate a profit if inflation turns out to be on average at the central bank target and get an inflation insurance for free.
Werner Steinmller Head of Global Transaction Banking
Trade Finance Back in fashion
Over the past three years, transaction banking has been recognised as a key strategic pillar of global wholesale banking. Indeed, since the financial crisis broke in 2008, the worlds leading international banks have increased their focus on this business as a stable form of revenues in a very uncertain business environment.
Within transaction banking, trade finance products (invariably traditional, well developed products) have become particularly fashionable as clients have sought to diversify their funding sources. Regulatory discussions, most notably around Basel 2 and Basel 3, have cast something of a cloud on these products. Trade financing products are userfriendly and in the aftermath of the first stage of the crisis, so vital to oil the wheels of trade but over-regulation has threatened to stifle their use and, ultimately, make them more expensive for clients. Deutsche Bank and other major players in the trade finance market led discussions with regulators over the need to ensure trade products do not become too expensive for clients. G20 leaders also expressed concern about the
impact of an over-aggressive regulatory regime on trade-related products, especially given its importance to fastgrowing developing countries. The International Chamber of Commerce (ICC) provided firm evidence of the relatively low-risk nature of this business. The ICCs recently released data revealed that in over USD2 trillion trades, over a five year period, there were only 3,000 defaults. These statistics covered 65% of the worlds trade finance transactions. The Basel Committee eventually relaxed the Basel 3 regulatory capital adequacy framework for trade finance by issuing two waivers relating to letters of credit. Firstly, the committee is waiving the one-year maturity floor for certain trade finance instruments under the advanced internal ratings-based approach for credit
risk. This applies to issued and confirmed letters of credit and reduces the riskadjusted capital charge on those assets. Secondly, the committee is waiving the so-called sovereign floor for certain trade-finance related claims on banks using the standardised approach for credit risk in other words, on trade loans to businesses in countries where the sovereign debt is unrated. This applies to standardised and Foreign Investment Review Board (FIRB) riskbased approaches. These decisions are important for the market and demonstrate that the Basel Committee recognises the crucial role played by trade finance in low income countries particularly in the current climate. It is important to realise that if the cost of capital of a relatively low-risk, lowmargin activity like trade finance is the
same as a higher-risk, higher-margin activity, banks will naturally gravitate towards the higher-margin business. This is exactly what the Basel Committee is trying to avoid in its far-reaching directives. Therefore, an unintended consequence of Basel 3 may have been a negative effect on business models and clients access to the trade finance solutions offered by banks. These waivers represent only two of the concerns that the trade finance industry has over Basel. There will be further discussions. But trade finance will play a key role in the eventual recovery of the global economy, however slow that now may be. All relevant parties should be aware that overbearing regulation could choke its progress.
Economics & Geo-Politics

The Eurozone Crisis China The US Dollar US Growth Solutions Emerging Markets Africa Asia
The articles marked with this icon are based on Deutsche Bank Research.
2.1 Economics & Geo-Politics
Gilles Moec & Mark Wall Co-Heads of European Economics Research
The Eurozone Crisis Fast track Europes road map
Europe remains deeply mired in its sovereign debt crisis, something that is likely to dominate markets in the year ahead, and not just in Europe. The whole world has an interest in the resolution of a crisis that deepened dramatically through the fourth quarter, and enveloped more and more major economies putting European leaders on the back foot as events threatened to overwhelm them.
While we continue to believe that the eurozones authorities will do whatever it takes to hold the euro together, the urgency of the need to act has risen sharply. The G20 summit in Cannes in October failed to meet the great expectations it had stirred and was almost entirely overshadowed by the market chaos sparked by the suggestion of a referendum in Greece and the subsequent departure of George Papandreou, the Greek Prime Minister. The eurozone economy now appears to be sliding into recession which we hope will only last for a couple of quarters, although we admit something worse could happen, especially if politicians and central bankers fail to respond rapidly to the deteriorating situation. Given the market's entrenched scepticism, what is needed now is a big Grand Bargain, way beyond anything we've had so far. Indeed, this is the price Europe is having to pay for lacking enough will to date. Unfortunately, the actions required are complex and politically contentious and so will likely be prone to scepticism from markets. The bigger the intended action, the bigger the risk that things go wrong when rigorous implementation is needed. In our opinion, three radical steps are now required. First and foremost of these is a large final buyer of government debt. We believe the European Central Bank (ECB) is the only credible source. The ECB is not allowed to buy primary issuance from governments but can buy bonds on the secondary market, as it has been doing in recent months, while noting it may not be entirely content with that course of action. True, significant purchases could be seen as a contradiction of the ECBs statute. But the German Constitutional Court recently dismissed lawsuits taking this line. We think the inflation risk of such purchases is negligible, given the looming credit crunch and recession in the eurozone. Inflation is not Europe's number one problem right now. We believe deflationary pressure should
be more of a concern. The ECB could pledge to purchase a set volume of bonds, say EUR200 billion worth over the next 12 months. That on its own appears enough to finance Italy through 2012. It would be difficult for the ECB to say it is only buying Italian debt but there is no technical reason why it cannot commit to purchasing a set volume of bonds in the secondary market, exactly as it is doing right now with covered bonds. We believe the second step needed is a big, deliverable and rapid structural reform package from Italy to convince markets it can pull through the crisis. The package needs to be proven immune from the vagaries of the economic or political cycles. Third, we need to see rapid and clear signs from the EU that fiscal integration, involving changes to treaties, is coming. We believe there has to be some sacrifice by member states of sovereignty. An example would be giving the European Council the right to veto national budgets. This is the sort of quantum leap in governance reform that the ECB is asking for. The ECB will likely demand that if it is to launch significant bond purchasing, it has to see the second and third actions outlined above. If it launches this action without demanding any conditions, the eurozone may look weak because it would be seen to be printing money without credible political change or fiscal control. We note that would likely be poorly received by markets. But time is short. So the ECB, in our view, will have to make a leap of faith and step up its intervention on the basis of a statement of intent from the eurozone's governments. Even a treaty revision under enhanced cooperation limited to the 17 EMU members would take several months since it would need to follow national ratification procedures. A replication of the EFSF drama is likely, with heated discussions in at least Finland, the Netherlands and Slovakia. ECB intervention will likely have to be particularly large around the key dates for
national debates. Even if governments strive to get the new treaty sorted as fast as possible, we think the summer of 2012 is probably the earliest date. In the meantime, we believe we need to move from implicit to explicit conditionality. Indeed, in its current form, the ECBs bond purchasing follows an implicit conditionality with contacts between the ECB and the governments which never are as comprehensive and publicly debatable as memoranda of understanding (MoUs) signed with the IMF. This likely creates two symmetric risks. First, that public opinion in the core countries consider that the commitments of the peripheral countries are insufficient to warrant an indefinite increase in the ECB's balance sheet. And second, that peripheral countries resent the transformation of the ECB into a benevolent economic dictator triggering ultimately a rejection of its support. From a practical point of view, we think that an emergency European Council should be organised as soon as possible to deliver the letter of intent which could allow the ECB to step up its interventions and act as lender of last resort.
Jun Ma Chief Economist, Greater China
China Soft or hard landing?
The Chinese economy is likely to visibly decelerate in early 2012, amid a significant drop in export growth and weakening real estate activities. We expect annualised quarter-on-quarter GDP growth to fall to 7% (or slightly below) in Q1 2012, before recovering in the remainder of the year towards 9%.
For the year as a whole, we expect Chinas GDP growth to be 8.3% in 2012, down from 9.1% in 2011. CPI inflation is also likely to decline sharply to 3% in the first half of 2012, from 5% in Q4 2011, as a result of falling agriculture and commodity prices. The three main factors driving the deceleration of Chinese economic growth will be the eurozone sovereign debt crisis, falling volumes in the local real estate market and ongoing credit tightening. The contraction of the eurozone economy as a result of the sovereign debt crisis and the deleveraging of the global banking sector will have a significant impact. Given the decline in external demand from the EU and the US, we expect Chinas nominal export growth to slow from 20% in 2011 to 10% in 2012. The first half of 2012 may see even weaker single-digit rate export growth. The fall in Chinese property transaction volumes and the resulting deceleration in investments by developers will also be important. Developers investment, which accounts for 16% of the total investment in China, is likely to slow from 30% year-on-year to sub-10% in Q1 2012. This will lead to weakness in demand for materials. The ongoing credit tightening, which has resulted in the suspension of 70% of the railway construction projects and constrained the production of many small enterprises, will only be relaxed gradually in the coming months. We expect the government to ease macro policy in the final months of 2011 and early 2012 in reaction to inflation and GDP data. November 2011s CPI inflation (due to be reported in mid-December) is likely to show a fall to less than 5%. Q4 GDP growth (due to be reported in midJanuary 2012) is likely to be around 9%, with export growth falling to 10% or less in Q1 2012. Together with persistent weakness in property sales and investments, this data should convince the government that the priority should be shifted towards supporting growth rather than restraining inflation. The response from the People's Bank of China (PBOC) and the government is likely to be to permit an increase in monthly net lending to around RMB700 billion per month (from the current RMB500 billion per month), consider a cut in the reserve requirement ratio, introduce some more tax cuts to support SMEs and the service sectors, and expand the local government bond issuance programme to support infrastructure financing. Changes in official interest rates are not necessary in our view and the RMB is likely to continue its appreciation at 4 5% against the US dollar in 2012. Thanks to this policy easing, we expect Chinas GDP growth to recover on a quarter-on-quarter basis from Q2 2012, begin to rise on a year-on-year basis from Q3, and reach 9% on an annualised qoq basis in H2 2012. We are also relatively optimistic about Chinese equities. While in the short-term, the European uncertainty and the fear of Chinas economic slowdown are likely to generate significant market volatility, on a 12-month basis we believe Chinas equity index is likely to deliver one of the best performances in emerging markets.
Sanjeev Sanyal Global Strategist
The US Dollar Are we entering a post-dollar world?
The ongoing economic crisis has called into question many of the fundamentals of the world economic system, with growing talk of how the US dollar will be or should be replaced as the worlds anchor currency.
Governor Zhou Xiaochuan of the Peoples Bank of China has called for creative reform of the existing international monetary system. Many prominent economists agree with a UN panel, headed by Joseph Stiglitz, recommending a Global Reserve System (essentially an expanded SDR) to replace the dollars hegemony.1 While there are good reasons, in my view, to suggest that we may in future see a broader range of reserve currencies including the CNY, as Alan Cloete argues in his article, the long history of global currencies suggests that the US dollar will remain the anchor for many years to come. During Roman times, India ran a large trade surplus with the empire with Pliny the Elder (2379 AD) writing that "not a year passed in which India did not take fifty million sesterces away from Rome". The trade deficit meant that there was a continuous drain in gold and silver coins that in turn created shortages of these metals in Rome. In modern terms, the Romans faced a monetary squeeze. Rome responded by reducing the gold/ silver content (the ancient equivalent of monetisation) which led to a decline in the real value of the coins and inflation. Yet, frequent findings of Roman coins in India suggest that Roman coinage continued to be accepted for a long time after it must have been obvious that the gold/silver content had fallen.
Fast forward 1,000 years or so to the 16th century when Spain emerged as a super-power following its conquest of large parts of Latin America and with it abundant silver mines. Between 1501 and 1600, 17 million kg of silver and 181,000 kg of gold flowed to Spain which it spent on wars in the Netherlands and elsewhere. This increase in the supply of precious metals caused a sustained bout of inflation. Prices rose at least four-fold in Spain over the course of the 16th century. Despite its wealth, Spain became increasingly unable to service its war debts, eventually defaulting four times and went into geo-political decline. Yet Spanish silver coins (known as pieces of eight or Spanish dollars) continued to be the key currency used in world trade right up to the American Revolutionary War. In fact, they remained legal tender in the US untill 1857 long after Spain itself had ceased to be a major power. By the middle of the 19th century, the world was functioning on a bi-metallic system based on gold and silver. However, following Britains lead, most major countries shifted to a gold-standard by the 1870s. The Bank of England would convert a pound sterling into an ounce of (11/122 fine) gold on demand. The US Treasury was similarly committed to convert an ounce of gold at USD4.86.2
The system was finally disrupted by World War One. Then in the Great Depression, the Bank of England was forced to choose between providing liquidity to the banks and honouring the gold peg. It opted for the former on 20 September 1931. Yet pound sterling continued to be a major world currency till well after World War Two. Even in 1950, 55% of foreign exchange reserves were held in sterling and many countries continued to peg themselves to it. Note that this was more than half a century after the US had replaced Britain as the worlds largest industrial power. Three things should be clear to the reader by now. First, a global monetary system based on precious metals does not resolve the fundamental imbalances of a global economic system. Second, precious metals do not even resolve the problem of inflation. Third, the anchor currency and the underlying eco-system of world trade will often outlive the geopolitical decline of the anchor country. A new economic order was established after World War Two with the United States as the anchor country. Dubbed the Bretton Woods system, it involved the US dollar being linked to gold at USD35/ounce and with other currencies being linked to the dollar (although allowed occasionally to make adjustments). A flaw in the system
was that while it underpinned global economic expansion as long as the US was willing to provide dollars by running up deficits, these same deficits would eventually undermine the ability of the US to maintain the USD35/ounce gold price. In the 1960s, the US responded by creating a Gold Pool that obliged other countries to reimburse the US for half of its gold losses. This soon began to breed discontent with France leaving the Gold Pool in 1967, and the Bretton Woods system collapsing in 1971. Or did it collapse? Despite the problems of the 1970s, the US dollar remained the worlds dominant currency, with a new generation of Asian countries most notably China pegging their currencies to it. Deutsche Banks David FolkertsLandau, Peter Garber and Michael Dooley dubbed the resulting relationship as Bretton Woods Two. In common with its older version, the system allowed the peripheral economy (China) to grow rapidly even as the anchor economy (US) enjoyed cheap financing. Note how the relative rise of China did not diminish the role of the US dollar and may even have enhanced it. Indeed, like the Japanese during their period of high growth, the Chinese until recently resisted the internationalisation of the renminbi. So, are we entering a post-dollar world? Despite the pain caused by the great
recession, there is no sign that the world will forsake the dollar. The world is still willing to finance the US at a low interest rate and the nominal trade-weighted index of the dollar has not collapsed. It declined significantly before the crisis but has since stabilised. History shows that once an anchor currency has established itself, it can be very resilient and often outlasts the economic and geo-political dominance of its country of origin. It is possible (albeit not certain) that China will replace the US as the worlds largest economy within a decade but we feel that US dollar will remain the dominant global currency for a long time afterwards.
1. http://www.un.org/apps/news/story.asp?NewsID=32020&Cr= financial+crisis&Cr1= 2. The Gold Standard in Theory & History, Barry Eichengreen and Marc Flandreau, Routledge 1985.
Peter Hooper Co-Head of Global Economics
US Green shoots or parched roots?
2012 is likely to mark the fourth year of a painfully sluggish recovery of the US economy from the recession of 2008. However, the range of uncertainty around the central expectation of slow to moderate growth is unusually wide thanks to the crucial role that politics will be playing in determining the course of economic events.
The broad consensus expectation, and our own, is that real GDP growth will struggle to rise much above its trend rate of about 2.5%. This means that unemployment is likely to remain uncomfortably high near 9%. The high unemployment, in turn, should help to quell inflation pressures and hold the underlying rate of inflation a bit below the Feds informal target of just under 2%. This projection reflects the effects of two sets of countervailing forces. On the positive side are several key drivers of growth, including pent-up demand for durables and structures, strong corporate sector balance sheets, and household deleveraging. Spending on consumer durables and business equipment, as well as investment in business structures and housing, in the aggregate, is still running near historic lows as a share of GDP. This spending will add an extra 5%
to the level of GDP in the years ahead as it returns to levels needed to keep the stock of homes and durables expanding in line with a growing population. Corporate profits are at all-time highs relative to output, and corporate net worth is robust; this financial strength is underpinning the recovery of business spending on equipment and new structures. Consumer spending will be supported by the significant progress US households have made in deleveraging, reducing their debt service burdens to below normal levels. On the negative side are several drags on growth, including fiscal drag and ongoing uncertainties about economic policies in the US and Europe, continued weakness in the US housing sector, and the negative effects of depressed home and stock prices on household wealth and consumer spending.
The wind-down of various stimulus programmes is slated, in our view, to subtract as much as two percentage points from GDP growth over the year ahead. At the same time, the US Congress will likely have to implement a much more far-reaching deficit and debt reduction programme to put the US fiscal outlook on a sustainable path and avoid a more serious downgrade of US Treasury debt. Uncertainties on this front, as well as on the euro front have been weighing on sentiment, holding both consumer confidence and stock market valuations to levels normally associated with recessions. In the housing market, an excess stock of vacant homes and large number of foreclosures continues to weigh on home prices. These asset price developments will be a depressant offsetting the positive developments on the debt side of household balance sheets.
Absent the drags, the economy would be expanding at a robust pace; absent the drivers, it would be headed into recession. Either extreme is possible depending on how political forces shape the resolution of US fiscal challenges over the year ahead and the resolution of fiscal and financial challenges facing the eurozone. Given the relatively subdued central projection and the wide range of risks, we expect the Fed to continue with its extraordinarily stimulating monetary stance over the year ahead and not to adopt further quantitative easing unless the economy edges toward recession.
Torsten Slok Chief International Economist
Growth Solutions What Greece and Italy could learn from Ireland
The solution to Italy and Greeces current dilemmas may not just lie in debt reduction. Improving business regulation is also key currently, it is seriously dampening economic growth at a time when growth is urgently required.
Studies by organisations such as the World Bank have shown that business regulation (such as red tape, taxes, labour laws and how long it takes to start a business) is a key factor behind GDP growth. For this reason, progress on this front (or the lack of it) will be a useful yardstick for institutions seeking to understand the eurozone sovereign debt crisis in 2012. The World Bank in early 2011 collected data for 183 countries for the time to start a business, dealing with construction permits, getting electricity, registering property, getting credit, protecting investors, paying taxes, trading across borders, enforcing contracts, and enforcing insolvency. This study (see Figure 1) came up with some interesting findings. Ireland, for example, ranks significantly higher than other peripheral European economies and many core European ones too; while Italy and Greece come well below many developing nations. Figure 2: It takes a long time to start a business in Brazil, a short time in Italy, US, Canada and Portugal
Source: World Bank 140 days Time to start a business (days) 140 120 100
On the key issue of the length of time it takes to establish a business, Portugal ranks well ahead of Italy and Greece (see Figure 2). This would suggest, by this yardstick at least, that Portugal could find it easier to secure the growth it needs to meet its debt obligations than some of its peripheral neighbours. But on the issue of the cost of starting a business, Ireland scores best with Greece and Italy both lagging a long way behind. Together with its strong showing in the time spent paying tax and strength of legal rights categories (see Figure 3), this helps to explain why Ireland has managed to recover from the 2008 financial crisis better than other peripheral European nations. We are expecting the Irish economy to grow by 0.8% in 2012 compared to a 2.2% contraction in Greece and a 0.2% contraction in Italy. Any improvements in the business environment in Greece and Italy should help support growth in those countries
Figure 1: Rankings on ease of doing business for selected countries

Source: World Bank
Rank Economy 1 2 3 4 5 6 7 8 9 10 11 12 13 14 ... 18 19 20 Singapore Hong Kong New Zealand United States Denmark Norway United Kingdom Korea, Rep Iceland Ireland Finland Saudi Arabia Canada Sweden ... Malaysia Germany Japan
Rank Economy 21 ... 28 29 30 31 ... 43 44 45 ... 86 87 88 ... 90 91 92 Latvia ... Belgium France Portugal Netherlands ... Puerto Rico (US) Spain Rwanda ... Mongolia Italy Jamaica ... Uruguay China Serbia
Rank Economy ... 99 100 101 ... 119 120 121 ... 125 126 127 ... 131 132 133 ... ... ... Yemen, Rep. Greece Papua and New Guinea ... Cape Verde Russian Federation Costa Rica ...
120
Figure 3: A lot of time spent paying taxes in Brazil; less time spent in Ireland
Source: World Bank 450 400 350 hrs/year Paying taxes, time spent for businesses (hours per year) hrs/year 2600
Bosnia and Herzegovina

100
Brazil Tanzania ... West Bank and Gaza India Nigeria ... ...
80 60 40 20 119 38 30 29 28 23 15 13 13 10 5 0 5 80 60 40
300 250 2590 200 150 100 20 0 50 2600 398 330 290 285 275 254 224 221 187 187 132 131 110 United Kingdom 0 76 Ireland 2580
Russian Federation
United States
Germany
France
Spain
Russian Federation
Germany
United Kingdom
United States
Canada
Portugal
Portugal
Canada
Brazil
China
India
Spain
Japan
Ireland
Greece
France
Italy
Brazil
China
Italy
Greece
Japan
India
but the slow speed with which politicians in those countries appear to be reforming is worrying to us. The analysis also offers useful insights into the long-term prospects for BRIC economies with Brazil, Russia, India and China having significant room for improvement. The high growth rates of these countries in recent years (with the exception of Russia) might indicate that this improvement is not necessary. But in reality, the growth has been driven by their low production costs (see Figure 4). Italian wages are about 20 times higher than in India to make just one comparison. BRIC countries still have a significant amount of catch-up to do before their costs of production are even remotely near the costs of production in the G7 countries. But, what the World Bank data does suggest is that if the regulatory environment in these countries is not improved, growth rates will slow in the
medium term and they will find it hard to make the leap from low-cost to valueadded economic activity. Second and perhaps counter-intuitively the data also indicates that growth rates in these countries could be significantly higher if efforts were made to remove red tape. Many other insights can be drawn from these statistics but the general conclusion is very clear: with the global economy still struggling with lack of demand, it is vital that countries improve their business regulation, in particular in Greece, Italy, Spain, and Portugal, which all have significant room for improvement. Implementing more business-friendly regulation in Southern Europe would not only raise GDP growth and hence living standards but would also make economies more resilient in the face of future shocks. For investors, the implications are also clear; countries that in 2012 make it easier to do business are likely to outperform those that do not.
Figure 4 : Minimum wages high in Canada, UK, and Italy; low in China, Russia, and India
Source: World Bank
Country
Minimum wages for a 19-yearold worker or an apprentice (USD/month) 1,904 1,655 1,614 1,548 1,536 1,243 1,146 1,044 987 790 782 300 183 139 30
Ratio of minimum wage to value added per worker
Canada UK Italy Japan Ireland USA Germany Spain Greece Portugal France Brazil China Russian Federation India
0.34 0.34 0.37 0.29 0.31 0.21 0.21 0.27 0.29 0.29 0.14 0.26 0.37 0.12 0.17
Gustavo Canonero Head of Latin America and EEMEA Economics Research
Emerging Markets Can they decouple?
Although emerging market economies are bound to be adversely affected by the subdued outlook for growth in the US and Europe, we remain relatively constructive towards the asset class.
EM cyclical coupling and trend decoupling (% YoY)

EM Trend EM Cycle 8 6 4 2 0 -2 -4 -6 1980 1985 1990 1995 2000 2005 2010 G7 Trend G7 Cycle Source: Deutsche Bank
Fundamentals are supportive for growth across emerging markets (EM) and, for the most part, these economies are much less constrained by sovereign and private sector debt than those of OECD counties. In addition, emerging economies have more room to implement counter cyclical policies, particularly monetary policy. This more benign backdrop is evidenced, for example, in the stable consumption growth of recent quarters, even in the smaller open economies, where historically the decline in exports would have been expected to lead to at least a modest softening of consumption growth. Consequently, the two-speed nature of the global economy we highlighted last year is actually reinforced in our new 2012 outlook, with the growth differential in favour of EM remaining comparatively high. We caution, however, that a further worsening outlook in the advanced world might be increasingly challenging for EM, at least within the next year. Even a shallow recession in the US and/ or Europe would likely elicit a strong response in EM especially in the smaller, more open economies due to reversals of capital flows as well as a temporary contraction in exports to the region in recession that would render the relationship between US/EU growth and EM growth non-linear.
Nonetheless, based on a muddling through scenario for the main economies, with growth staying at around 1.5%, we project EM economic growth to advance 5.7% in 2012 from an estimated 6.2% this year. To some extent this is due to the greater resilience of the largest countries in Asia China, India, and Indonesia, and the associated strength of Latin American economies. Emerging market resilience Emerging economies have so far weathered the slowdown in the US/EU better than might have been expected, and we are inclined to expect this resilience to continue. A key element of this outperformance is the robust growth process in the major countries in Asia, the increasing intra-EM integration, and the fact that commodity prices especially oil and soft commodities have been higher than expected during most of this year. Indeed, the fact that our commodities team has maintained stable price forecasts for 2012 lends support to our expectation that Latin America could weather the extended period of weaker US growth reasonably well. In addition to high and relatively stable commodity prices, it is also the case that outside Latin America, central banks had been slow to normalise monetary policy, with the result that in Asia and
most of EMEA real interest rates have been declining over the past year and in many cases are again in negative territory. We think this declining interest rate environment has helped to support consumption growth beyond what would have historically been the case given the slowdown in exports. In emerging Asia, the most recent forecast revisions have been less than what a simple application of historical growth betas would have suggested, although changes have been much larger in some of the smaller economies. Hong Kong, Singapore and Thailand, had already reported a GDP decline, and Taiwan barely grew, during 2Q11. For the region as a whole, it certainly helps that three of the largest economies China, India and Indonesia have historically been quite immune to fluctuations in US and European growth. Since July, we have lowered our China and India growth forecasts but at 8.3% and 8.0%, respectively, growth in these two economies remains robust and helps to underpin a positive view on the whole region. EMEA is the emerging region most vulnerable to weaker growth in the core economies. Most of the regions economies are relatively small and open, and most have strong trade and financial
linkages within the eurozone. Public and private sector balance sheets are also generally weaker than in Latin America and Asia, providing less room for policy adjustment to support growth. As in Latin America, the commodity price outlook supports the Russian, Kazakhstan and Middle East forecasts. Most of the other economies, however, are very exposed to the slowdown in Europe, suggesting an almost unit elasticity between growth in the two regions. Vulnerability and risks The previous arguments notwithstanding, there are a number of valid concerns about this somewhat optimistic picture. For example, a potential new global equilibrium where the big savers of emerging Asia would have to consume more and export less could pose a risk for growth in EM. Some economists believe that the fast growth of emerging Asia in the past few years (an impulse that is more necessary than ever before in the new global conjuncture to prevent a global downturn) has been facilitated by large production of tradable goods. Shifting a large country like China away from this specialisation in manufacturing could slow its mediumterm growth by more than 200bp a year, reflecting the inherent instability of the current global balance.
Another concern about the current conjuncture is related to the political economy equilibrium that demands a slow process of rebalancing. The rise of protectionist rhetoric in the US and Europe is the most evident expression of such concern. Disillusion with the prevailing international order was probably the main cause of the end of the previous large wave of globalisation, largely precipitated by the Great Depression. Furthermore, even after a few years of political stability in EM, future political shocks cannot be entirely ruled out. All this notwithstanding, at the present juncture, the major risk for EM seems to be a dislocation in European markets that could trigger a global recession. Although that is not our most likely scenario, it is not a negligible risk.
Robert Burgess EEMEA Chief Economist Marion Mhlberger Economist
Africa The next frontier: who to watch
Africas economic revival has been rightly hailed in many quarters and looks set to continue in 2012.
Figure 1: Local capital markets are small
Source: Bloomberg Finance LP, National Stock Exchanges, Deutsche Bank 7 6 5 4 3 2 1 0 Cote dIvoire Mauritius Ghana Kenya Botswana Uganda Tanzania Zambia Nigeria Market capitalisation (% of South African market) *all SSA equity markets with a capitalisation > USD 2bn
The small size and illiquid local capital markets, however, continue to deter many mainstream debt and equity investors. For example, while the Johannesburg Stock Exchange is among the largest in the world with market capitalisation of about USD665 billion, this is eight times larger than the other bourses in sub-Saharan Africa combined. This should change with time. Capital market development and economic growth tend to go hand in hand, and the prospects for the latter look relatively bright (see Figure 1). We identify eight strongly-performing economies in sub-Saharan Africa that seem to offer the strongest potential for foreign investors. Our list comprises Angola, Ghana, Kenya, Nigeria, Senegal, Tanzania, Uganda, and Zambia, which make up 45% of the regions population, 61% of its economic activity, and have a combined output roughly equivalent to the size of the Polish economy. Over the past decade, growth in our eight frontier sub-Saharan markets has accelerated to 6.6% from 3.0% over the previous two decades and is set to be sustained at close to these levels over the next five years. This matches the 6.6% expansion in the BRICs, tops the 4.9% growth seen in the rest of emerging Asia, and is well in excess of growth of around 3.5% in South Africa (see Figure 2). While we think frontier markets in North Africa also offer potentially attractive returns over the longer term, bumpy political transformations are likely to weigh on confidence and economic
activity for many months to come. For the year ahead, therefore, we think the growth prospects south of the Sahara are better. As in other emerging regions, their economies have been buffeted by headwinds from the global financial crisis over the past three years. But in contrast to past global slowdowns, Africa has not been left behind as the current global recovery has unfolded. In part this reflects improved policies. Most countries have done a better job in recent years of banking the dividends from stronger economic growth. Foreign reserves have increased and debt levels have been reduced, helped in some cases by debt relief from official creditors. These buffers enabled many countries to ease policies during the recent downturn (see Figures 3 & 4). Stronger linkages with China and other rapidly growing markets have also added impetus to growth. Almost half of sub-Saharan African exports now go to emerging and developing markets compared with less than one-quarter in 1990 with China alone accounting for about 17% of the regions trade. In some respects, this is just another manifestation of the secular boom in commodities resulting from the rise of emerging markets over the last decade. Africas abundance of natural resources makes it an obvious beneficiary of this super cycle. But growth has also been strong in countries that do not depend so heavily on commodity exports, such as Tanzania and Uganda (see Figures 5 & 6).
Figure 3: African growth has not been left behind in this recovery
Current cycle (t=2009) Average last three cycles (1982, 1991, 2001) 7.5 6.5 5.5 4.5 3.5 2.5 1.5 0.5 t-4 t-3 t-2 t-1 t t+1 t+2 t+3 t+4 Real GDP growth (%) Source: Deutsche Bank
Figure 4: Rebuilding policy buffers

Reserves (excl. Nigeria) (lhs) Public debt (rhs) 18 17 16 15 14 13 12 11 10 9 8 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 30 20 50 40 70 60 GDP (%) Source: Deutsche Bank GDP (%) 90 80
Next year is likely to be a difficult one for global markets and African economies will also need to overcome their share of challenges. Low incomes, rapidly growing urban populations, ethnic divisions, pervasive corruption, and long histories of armed conflict, continue to leave some countries susceptible to bouts of social unrest and political tension, as reflected in our political risk indicators. Encouragingly, elections in 2011 in Nigeria, Uganda and Zambia, passed off smoothly. And polls in Ghana in 2012 are expected to further underscore the countrys already strong reputation for political stability. Kenyas elections, however, will be a significant test of its democratic credentials and ability, under a new constitution, to avoid a repeat of the protracted stand-off following the disputed 2007 elections, with all but the bravest of investors likely to remain sidelined until transition to the next administration is complete (see Figure 7 on next page).
Figure 2: African growth is catching up

Africa frontier BRICs Source: IMF, World Bank, Deutsche Bank 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 81-85 86-90 91-95 96-00 01-05 06-10 11-15 Real GDP (%)
Figure 5: Trade diversification towards emerging markets

EU US Emerging Markets 70 60 50 40 30 20 10 0 1993 1996 1999 2002 2005 2008 2011 Source: Source: IMF DOTS, Deutsche Bank % of total SSA trade (exports + imports)
Figure 6: High commodity dependence

Main commodity exports in % of total exports (2011 estimate) Source: Deutsche Bank
Angola Ghana Kenya Nigeria Senegal Tanzania Uganda Zambia
97% oil 39% gold, 26% oil, 17% cocoa 19% tea, 12% horticulture 90% oil 11% fish, 11% phosphate 37% gold 18% coffee 84% copper
Taimur Baig Chief Economist India, Indonesia and Philippines
Inflation has accelerated to about 11% over the past four to five months from a low of 7% a year ago, reflecting rising international food and fuel prices and a reticence in some countries to roll back accommodative policies put in place after the last crisis. In East Africa, these pressures have been exacerbated by a severe drought and weaker exchange rates, which have pushed inflation to 19% in Kenya, 17% in Tanzania, and 31% in Uganda. Central banks have responded with aggressive rate hikes in the last few months. This should help to restore macroeconomic stability and prop up their currencies, but is likely to hold back economic growth in the short term. Africas exposure to commodity markets, which has driven its terms of trade to record highs, could also prove to be a double-edged sword. Global growth of much below 3% would likely be associated with weaker oil and
industrial metals prices, which would be negative news for the regions major oil producers, Angola and Nigeria, as well as Zambia given its reliance on copper exports. On the other hand, continued negative real interest rates in core markets may continue to provide support for gold, which could help to mitigate some of the negative effects of a global slowdown on Ghana and Tanzania. Further ahead, the durability of the economic revival in Africa will also depend on how countries manage their commodity revenues. Nigerias recent experience has underscored that, if not appropriately managed, oil revenues can lead to wildly pro-cyclical spending patterns and macroeconomic volatility. Going forward, we are more optimistic that the government will be able to rein in public spending, which, should in turn, bring some stability back to the foreign exchange market and pave the way for continued strong growth.
The newest kid on the block is Ghana, where new oil production is set to push economic growth up to about 14%, making it easily one of the fastest growing economies in the world this year. Ghanas framework for managing oil wealth has only recently been approved but includes several useful elements, including a strong emphasis on transparency and the creation of oil savings funds designed to insulate the economy against volatile movements in oil prices and to preserve some oil wealth for future generations. Consistent implementation of this framework through both good and bad times should help to further lock in Ghanas growing reputation as of one of the continents brightest long term prospects.
Asia Slowing but how much?
A lacklustre 2011 is likely to be followed by an equally, if not more, challenging 2012 for Asian economies. The debt crisis in peripheral Europe, a renewed sluggish recovery in the US, and anaemic growth in Japan will likely continue to drag down demand for Asias exports.
Financial market uncertainty, stemming primarily from Europe, could also adversely impact fundraising and system of payments, adding an extra layer of downside risk. Given this cloudy outlook, it is logical to expect a slowing of growth in Asia. Our Asia (ex Japan) growth forecast for 2012 is about half a percentage point lower than in 2011 (7.2% vs. 7.6%). There are considerable downside risks to this forecast, and they stem not just from weak external demand (and its subsequent impact on local investment and consumption), but also from the outlook for food and energy prices. Recent floods in Thailand could have adverse implications for rice prices in the region going into 2012. With respect to energy, global supply bottlenecks, poor inventory levels, and sustained emerging market demand suggest a continuation of high prices. These two factors could keep inflation at elevated levels in many countries, thus reducing the room available for interest rate cuts. Unlike 2009, when a sharp slowdown in the global economy was accompanied by a collapse in commodity prices, allowing central banks around the world to cut rates aggressively, the situation appears to be less clear cut for 2012. We expect inflation to average about 4% in the region next year, lower than 2010 and 2009, but not low enough to allow for sizeable policy easing. Moreover, other than China and India, money and credit conditions are already rather loose in most countries, so rate cuts or liquidity measures may not have much traction in any case. With the exception of India, Asian economies tend to be characterised by sizeable balance of payments surpluses, which has in recent years led to sustained exchange rate appreciation pressure. Currencies may not appreciate substantially in the coming year though, as trade surpluses are on track to shrink and capital flow volatility is likely to continue. We therefore expect regional exchange rates to either remain steady or to show only mild appreciation tendencies in the coming year. The outlook could be even worse had it not been for the fact that household, corporate, and public sector balance sheets in Asia economies are by and large stronger than their Western counterparts. There is clearly some room available for fiscal and monetary stimulus if economic weaknesses exacerbate. The chart below shows that public sector indebtedness in the region is strikingly lower than in the Western economies. At a time when sovereign debt crises are dominating the headlines, this is indeed a key differentiating element. Perhaps because of their fiscal and balance of payments strengths, consumer and business confidence in Asian economies have remained robust this year, despite a sharp drop in trade and a surfeit of negative external developments. Short of a major exacerbation of the global economy and financial markets, Asia could continue to generate growth rates that would be several hundred basis points higher than their Western counterparts. Decoupling remains unachievable for now, but Asias intrinsic balance sheet strength should still allow for 2012 to be a year of no more than only a modest slowdown in a world fraught with economic risks.
Figure 7: Differing degrees of political risk

Fragility Resilience Score: 24=worst, 0=best 0 Kenya Uganda Tanzania Angola Nigeria Zambia Ghana Senegal Source: Deutsche Bank 5 10 15 20 25
Ivory Coast South Africa Botswana
General government debt

115 100 85 70 55 40 25 10 17 China 68.1 India 26.1 Indonesia 53.1 Malaysia 61.9 Philippines 31.9 South Korea 41.6 Thailand 102.9 G20 Advanced 91.2 EU 77.1 UK 96.8 US % of GDP
Pakistan Bangladesh Lebanon Egypt Sri Lanka Serbia Note: The political instability index is composed of two subindices. The fragility sub-index gauges a country's vulnerability according to socio economic factors, while the resilience subindex measures the capacity of a country to mitigate political risk and withstand economic shocks.
Markets
US Equities European Equities Asian Equities Emerging Market Equities Credit Commodities FX Rates ABS
3.1 Markets
Binky Chadha Chief US Equity Strategist
3.1 Markets
Figure 2: Equity Returns in Presidential Election Years

30 % 20 10 0 -10 -20 -30 -40 2008 1940 2000 1960 1948 1984 1956 1992 Avg 1968 2004 1952 1988 1964 1944 1972 1976 1996 1980 1936 Lehman Collapse WW II Tech Bubble Brust Mean 6.2% Mean 9.0%
US Equities Its all about the multiple
With earnings set to grow by 7%, but the market trading near March 2009 low multiples of 12.5x, 30% below fair value, equity returns depend critically on what happens to the multiple.
Figure 3: Share Buy Backs over past Decade

S&P 500 Net Buybacks (USDbn, ar) 600 400 200 0 -200 -400 -600 -800 -1000 Sep 95 Feb 98 Feb 03 Nov 96 May 99 Aug 00 Nov 01 May 04 Aug 05 Nov 06 Feb 08 May 09 Aug 10 Nov 11
Despite ongoing scepticism, the outlook for earnings looks good and we expect them to grow by 7% in 2012. S&P 500 earnings per share (EPS) recovered to near trend levels in Q2 2011, and then grew robustly in Q3, making them the one clear element that has exhibited a classic V-shape in this economic recovery. In our baseline of slow GDP growth (consensus and Deutsche Bank), sales will continue to grow significantly faster in 2012, as is typical in recoveries, with margins remaining well supported. Indeed our 2012 S&P 500 EPS estimate of USD106 could be on the conservative side.
The equity multiple is more open to interpretation. During 2009/2010, multiples rebounded strongly from a low of 12.5x LTM earnings in March 2009 and traded around fair value of 16.4x LTM earnings through April 2010. But since May 2010 the multiple has persistently been below fair value and, at the time of writing, was 12.5x 2011 earnings, the same as at the March 2009 low. True, the multiple remains within its historical one standard deviation band of 10 to 20 but it is 30% below fair value in our estimation. So will the multiple continue to de-rate in 2012 and fall to the
bottom or below these bands? Or will it rise toward fair value? It is worth noting that episodes of the multiple falling to the bottom of these bands were historically all associated with large negative shocks, deep recessions, high inflation and/or high bond yields, or high tax rates. Many observers point to a host of reasons why the multiple will remain low. These include the lack of investor demand for equities when 10-year returns are near zero; an ageing population which is raising the relative demand for fixed
income; the unsustainability of earnings made by cost cutting and cyclically high margins; a higher uncertainty premium with potentially more frequent business cycles; macro policy uncertainty and sovereign debt risks. Many have drawn parallels with the 1930s and with the lost decade in Japan. But we are constructive on prospects for the multiple in 2012 for several reasons: 1. US recession is unlikely. Recessions typically happen late in economic cycles when companies are over-extended and cost pressures rampant. With recovery from the last recession far from complete and companies still running lean, we see the initial conditions for widespread cutbacks a central part of previous recessions as absent. 2. The US is not Japan. While Japanese equities de-rated significantly in the 1990s they did so from bubble levels. It is striking that they traded persistently at a significant premium (10 15%) to US equities as they priced in an extended period of low bond yields. 3. Lesson from the 1930s. In the 1930s the trailing multiple averaged 16.2x. This is close to what we consider to be fair value (16.4x). The multiple averaged 19.6 (typical recovery multiple) between the two recessions in the 1930s.
4. Labour cost inflation will remain benign. We believe elevated unemployment will continue to restrain labour costs which represent 70% of firm costs. Just released Q3 2011 data reinforce this read: real GDP growth of 2.5% on a seasonally adjusted basis, nominal of 5%, while unit labour costs fell by 2.4%. 5. Fed policy. The Fed is committed to keeping bond yields low. The consensus tends to attribute the low multiples of the 1970s to inflation. It is true that runaway labour and commodity costs did erode margins but in our view high bond yields played the bigger role by providing high alternative rates of return. 6. Presidential election year. Presidential election years have, historically, not been bad for equities. In the last 19 presidential election years, the S&P 500 they rose by average of 6.2%; if you exclude the outliers of 1940 (WWII Germany invaded France), 2000 (Tech bubble burst) and 2008 (Lehman) they rose by an average of 11%. The congressional super committee on spending cuts (due to report after this publication goes to print) remains a clear and present risk but our baseline view is that the committee reaches agreement.
7. M&A and share buy backs. Corporates are the largest buyers of US equities. With equities very cheap to credit, buybacks and take outs through cash M&A will run over a net USD600 billion 2011 and we expect the pace to pick up in 2012. 8. Rising dividends. A notable development of late has been the large number of firms instituting or raising dividends. As long as equities remain cheap and corporate cash flows strong, dividends will continue to be raised. Investors have been paying a premium for high dividend stocks and an overall increase will support the market multiple. All in all, therefore, we are constructive on prospects for US equities in 2012. We recommend being overweight the domestic cyclical sectors (financials, industrial, tech, discretionary) versus defensives (staples, healthcare, telecoms, utilities). The domestic cyclicals massively underperformed the defensives in 2011 from February through the early October bottom in equities, but have been recovering strongly with the market. We see this unwind as having much further to run.
Figure 1: PE Multiples over the Past Century

Recession S&P 500 Trailing PE 30 Average Upper-Lower bands Source: Bloomberg 30
25
Avg P/E, 1930s: 16.2x Avg P/E, 1933-37: 19.6x
25
20
20
15 Fair Value (16.4x)
15
10
10
5 Oct28 Oct32
WW-II, very high ination Oct36 Oct40 Oct44 Oct48
Very high ination, 1949 recession Oct52 Oct56 Oct60 Oct64 Oct68 Oct72 Oct76 Oct80 Oct84
Oil shocks, very high ination & bond yields Oct84 Oct88 Oct92 Oct96 Oct00 Oct04 Oct08 Oct12
3.2 Markets
Gareth Evans Co-Head of European Equity Strategy
European Equities Time to be bold
The key question for investors in European equities, in our opinion, is whether to switch from the defensive stocks that have served them well in the crisis to cyclical stocks.
Classic defensives such as Nestl are, at the time of writing, on PE multiples of 17 times or so while some cyclicals such as Rio Tinto are trading at just eight times. The difference between the PE multiples of defensives and cyclicals is now more than 6.5 times, the same margin as the final quarter of 2008 when the crisis was at its height. Our view is that the time is now right to make the switch to cyclicals. First, the threat of a global recession is easing with the US economy looking healthier and Chinese risks looking less negative than before. If global GDP growth in 2012 reaches 3.5% (as we expect it to do), and we avoid the worst case scenario in Euroland, it is not unreasonable to expect earnings to grow by 6% or more. True, we have seen flat to modestly softer margins but we note this does not pose a significant threat since the bulk of the increase in margin expectations since 2010 have not been priced into the market because of concern over their sustainability. Second, debt levels at many European companies are low and cash levels are high so there is scope for dividend
increases and/or buybacks and special dividends. Buybacks in the UK for example should finish 2011 at more normal levels (1% of market cap). Our preference for cyclicals does not extend to financials, however. While banks look cheap and may recover in the short term, they face a headwind of weaker Euroland growth, dividend cuts and question marks about their long-term returns. The downside risks are especially pronounced in France and Italy where an avoidance of consumer related stocks in general also seems sensible. Stocks with a high exposure to government spending are another subset of domestic stocks that continues to look vulnerable. The best opportunities, we believe, will be found in globally exposed cyclicals which sold off dramatically in the summer and now look undervalued. It is important to remember that European stocks are not plays on whether or not we get a solution to the sovereign debt crisis. Underweighting or overweighting Europe relative to other regions is really about global growth and whether European stocks are a cheaper route in to that growth.
We think they are. In July, a company with a higher than normal sales exposure to China was trading on a 20% premium to its sector on forward PE basis. Now, or at least at the time of writing, they are trading at a discount. This strikes us an over-reaction particularly given that domestic economic conditions are hardly better than in China. We recommend an overweight position in autos (which have performed as though we are facing another credit crunch), basic resources and chemicals and believe the DAX looks relatively attractive.
3.3 Markets
Ajay Kapur Head of Asia Equity Strategy
3.3 Markets
Asian Equities Focus on large caps

Figure 1: Asia free cash flow yield* (3%) well below the US (6%), Europe (9%) & Japan (6%)
US 10.0% 8.0% EU AXU JP 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% 1/90 1/92 1/94 1/96 1/98 1/00 1/02 1/04 1/06 1/08 1/10 1/12 Free cashow yield
Asian equities are likely to underperform developed market equities in 2012 just as they did in 2011. While bouts of reflationary expectations in the US, Europe and especially China are likely to lead to periodic rallies, the underlying dynamics in Asia are challenging.
6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0%
Source: Deutsche Bank, Factset, MSCI. Note: *Free cash flow yield (12m trailing)=(net income after preferred dividends + Depreciation and amortisation expense Capital expenditure)/ Market cap. Numbers based on non-financial companies in the MSCI regional indices.
We think a focus on large-cap stocks with inexpensive valuations (especially dividends), solid balance sheets and analyst support is the way to generate relative returns. Countries that have underinvested Korea, Thailand, and the Philippines have pockets of value, in our opinion. Growth investors should focus on the projected growth in middle-aged and older folks in Asia financial services (not banks), luxury goods, travel and entertainment, and upper-end healthcare look promising. The expected contraction in youth cohorts (except in India and the Philippines) is likely to pose a challenge to technology and internet stocks. A more disorderly slowdown in China, a consequence of a policy error, is likely to pose a threat to the decadelong bull market in base materials and industrial cyclicals.
There are three key reasons why we think Asian equities are likely to underperform developed market equities. First, Asian equities have little or no valuation advantage over developed equities. As an example, Figure 1 shows the free cash flow yield for the four key regions. Asia ex-Japan has paltry FCF yields of around 3%, compared with 6% each for the US and Japan, and 9% for Europe. On conventional models comparing Price-Book ratios with the gap between Return on Equity (ROE) and Cost of Equity (COE), again, Asia exJapan is only half as undervalued as the US, Europe or Japan. The price of entry into any investment story is important.
3.3 Markets
3.3 Markets
Second, the relationship between nominal GDP growth and EBIT margins has broken down around the world. Spain and Italy have higher EBIT margins than most of the growthy emerging markets (see Figure 2). The reason is past over-investment in many Asian countries particularly China, Indonesia, India, Taiwan and Hong Kong. Conversely, the US, Europe and Japan have all seen their corporate sectors cut back on capital investment since 2007. A crisis can be cathartic, and capex cuts normally lead EBIT margin expansion by about four years. On a cyclical basis, the gap between Asias pricing power and unit labour costs is at peak levels and rolling over (see Figures 3 and 4). So, both on a cyclical and structural basis, we note Asias margin power is likely to suffer. This problem is likely to turn acute in China, where the productivity of incremental credit expansion is falling, and poor investment is already leading to an erosion in profit margins. We believe only a world-record beating rise in sales growth (compared to the asset base of firms) or a rise in financial leverage can mitigate the decline in profit margins.
The third key reason is the fact that the US dollar is at its lowest levels since the breakdown of Bretton Woods. Any rise in the USD versus a basket of currencies is normally bad for Asian/emerging market equities (see Figure 5). While it is not our house view, the risk case of a global recession only amplifies these issues for Asian equities. What could go right? What are the risks to this conservative view? A global reflationary package, monetary or fiscal, would likely lead to a rally in Asian equities. A reflation in China would be especially powerful for regional equities. A shift from bonds into equities by institutional investors, attracted by relative valuations would also be beneficial to Asian equities. Domestic pension funds in the region are severely under-invested in the equity asset class, and a policy or regulatory shift here would have a substantial positive impact. A drop in regional inflation, would lead to lower interest rates and be helpful to Asian equities.
Figure 2: Correlation between nominal GDP growth and EBIT margins breaking down? Spain and Italy have better EBIT margins than most of Asia
25.0% 23.0% 21.0% 19.0% 17.0% 15.0% 13.0% 11.0% 9.0% 7.0% 5.0% 0.0% Japan 5.0% 10.0% 15.0% 20.0% 25.0% Spain Belgium Switzerland Italy US UK Portugal France Austria Germany Finland Korea Taiwan Denmark Canada Norway EBIT margin % 20101 HK Philppines
Russia Brazil Indonesia
Mexico S Africa
Malaysia Singapore India
Sweden Thailand
China Turkey
Source: Deutsche Bank, IMF, Factset Note: EBIT margin is calculated based on non-financial company annual reported data; there are around 5,000 companies as of 2010
Figure 3: EBIT margin drivers in Asia price less unit labour costs is peaking
EBIT Margin, 12mth (RS) OPI YoY% less ULC YoY% 12mma, pushed forward by 6m (LS) 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% -4.0% -5.0% 1/92 1/95 1/98 1/01 1/04 1/07 10% 9% 8% 1/10 14% 13% 12% 17% 16% 15%
Figure 4: EBIT margin drivers in Asia prior capex boom predicts weaker margins
EBIT Margin, 2y MA (RS) Capex/GDP, 2y MA, pushed fwd by 4 yrs 24% 20% 18% 27% 16% 14% 12% 33% 10% 8% 36% 11% 39%
30%
6% 4% 2%
42% 1/87 1/90 1/93 1/96 1/99 1/02 1/05 1/08 1/11 1/14 1/17
0%
Source: Deutsche Bank, CEIC, FactSet. Note: EBIT margin is calculated based on non-financial companies in MSCI Asia ex Japan. CPI yoy% less ULC yoy% are the average number of China, Hong Kong, Korea, Singapore, Taiwan and Thailand.
Source: Deutsche Bank, CEIC, FactSet. Note: EBIT margin is calculated based on non-financial Asian (excluding Japan) companies; there were 2,400 companies as of 2010. Capex/GDP is the gross fixed capital formation as percentage of GDP. Numbers for Asia (excluding Japan) are USD nominal GDP weighted.
Figure 5: USD was strong in 2002; GEMS had underperformed US for eight years. Today, the US dollar is at new lows.
Source: Deutsche Bank, Datastream US Trade Weighted Real Broad Dollar Index (LS) Emerging Market Equity Index (USD)/World Equity Index (USD), axis reversed (RS) 40 60 Dollar Strengthening Dollar Strengthening 80 100 120 Dollar Weakening Dollar Weakening 140 160 180 200 1/73 1/78 1/83 1/88 1/93 1/00 1/98 1/03 1/08
120 115 110 105 100 95 90 85 80 75 70 Dollar Weakening
3.4 Markets
John-Paul Smith Global Emerging Markets Strategist
3.4 Markets
Emerging Market Equities Difficult year ahead
2012 looks to be another difficult year for emerging market (EM) equities which entered into bear territory against the developed markets, and the US in particular, around a year ago, and look set to remain there.
Ive long been sceptical about the ability of leading EM economies to decouple from the sub-par growth rates in Europe and the US: the key argument put forward by EM equity bulls. The falls experienced by EM markets in August/September and their partial recovery in October supports this view and it seems likely that EM will continue to follow the lead set by the US and Europe and by the EUR/US dollar exchange rate next year. A key driver will be China. It is possible that the Chinese authorities will be able to engineer a soft landing through easier fiscal and monetary policy but a deterioration in the countrys news flow seems more likely in 2012 given the difficulty of resolving the two key problems of falling productivity rates and bad debts in the banking sector. How should investors position for this new environment? In absolute terms, its hard to take a strong view as the deterioration in the medium-term growth outlook is to some extent discounted in the current low level of valuations across the asset class. We would not put much store on earnings-based ratios given the prevailing level of uncertainty, but emerging equity markets are cheap relative to their history on both book value-based measures and on the CROCI1 equivalent of Tobin's Q ratio, namely EV/NCI. The cashflow measures looks less reassuring however, especially for the BRIC markets and indicate that emerging equities are much more dependent on top line growth than their developed market counterparts. We are
also concerned that further US dollar appreciation against EM currencies will leave many EM corporates exposed by their short US dollar, long commodity positions and that retail allocations to EM equity funds will be reduced. Relative return investing within EM over the past 18 months or so has been difficult, given that no one style has tended to pay off, in the absence of any real sustainable momentum we think that this is unlikely to change over coming months. We would accordingly advise investors to adopt either a long-term approach based on a combination of valuation and structural political economy factors, or else a more active but highly contrarian trading-based approach, which seeks to exploit the rapid swings in sentiment which regularly sweep the EM investor base. Our current recommendations are mostly based upon the expectation that commodity prices will resume their decline before too long and eventually decouple on the downside from risk appetite towards financial markets in general. We therefore remain underweight in Russia and Brazil despite what we view as superficially attractive valuations and are particularly concerned about the extent to which the policies of their respective governments are likely to drive medium term returns for investors. We believe the economies of Turkey and Central Europe should be major beneficiaries of lower commodity prices so we are overweight here. We acknowledge that the risks are relatively high but think they are at least partially discounted. India should also gain from
cheaper commodities, but we would like to see lower valuations and a clearer road map for reform before we upgrade. We are also overweight in Mexico and Taiwan, which we view as relatively safe havens on reasonable valuations, even if both appear a little uninspiring from an absolute return perspective. We are underweight Indonesia, where the high level of valuations indicates to us that investors overestimate its relative resilience. Finally we are underweight Korea, where we are concerned about the impact of declining external demand on a potentially fragile domestic economy. It is worth noting that these are the views of the EM strategy team not the house view which is more optimistic on China, commodities and EM FX.
1. Cash Return On Capital Investment.
3.5 Markets
Jim Reid Global Head of Fundamental Credit Strategy
Credit Outlook for 2012
What does 2012 have in store for the credit markets? The short answer is that it could depend on whether the European Central Bank (ECB) is a vastly different organisation in 12 months time to what it is today.
Figure 1: Business Expansion Cycles: A comparison of their lengths

Source Deutsche Bank Fundamental Credit Research 140 120 100 80 60 40 20 0 Median Average Golden Age
present or whether we will revert back to more normal length ones. Given the significant lack of policy flexibility in the Western World (fiscal contraction/austerity in full swing and monetary policy compromised by the zero bound) and risks of continued bank deleveraging, we think a return to normal length cycles is likely. Indeed we are arguably seeing policy contraction too soon after the once in a lifetime financial crisis seen in 2008. A repeat of the 1937 (deep) recession is possible as this too was preceded by fiscal and monetary contraction too soon after the Depression. Also, as mentioned in the introduction, the risk of an extreme outcome in Europe is building. In the 18 months since the initial Greek bailout weve now seen five countries require outside assistance (EU/IMF or the ECB) in funding their Government debt. With Spain and, more worryingly, Italy now reliant on the ECB we are getting to a critical point in this crisis. Fiscal measures now seem inadequate to arrest this crisis. For us the ECB is the only institution that can prevent an extreme scenario in Europe. The crisis may not stop at Italy. If the ECB is not prepared/allowed to dramatically expand its balance sheet
in 2012 then the worst case scenario in Europe looks feasible. Think the unthinkable continues to be our mantra. For credit specifically, banks continue to be under pressure despite recent supportive measures from the authorities. Significant build up of leverage during the boom years means that banks continue to face a three pronged problem term funding, liquidity and capital. The primary market shutdown has meant that banks are not able to fund long term and given the refinancing needs of EUR1.4 trillion until 2013 we expect term funding to remain stressed in 2012. This is likely to encourage further deleveraging which is a negative for economic growth. The lack of long term funding has also put the focus on short term liquidity and the stress in the European interbank markets is now inching towards levels last seen at the start of the credit crisis and this is despite banks actively using the ECB window to fund themselves. Despite recent capitalisation efforts, we strongly believe that the current round doesnt budget for the scenario where Europe goes into a deep recession which is possible with the crisis playing out in the region. In such a scenario, we believe European banks would need more than EUR300 billion in
capital rather than the EUR100 billion announced leaving banks vulnerable if events dont turn out as planned. However, current depressed sub debt prices also offer banks alternate ways of capitalisation. We estimate that Tier One securities offer around EUR30 billion of potential benefit through buybacks via tenders or exchanges. Although we note these buybacks are easier said than done in this environment, they nevertheless highlight a unique opportunity for banks to take out legacy securities ineligible for Basel 3 regulations and replace them appropriately. Although we strongly believe that any recapitalisation from tax payers would lead to increased pressure for burden sharing on subordinated debt, current T1 pricing shows that there could be idiosyncratic opportunities in case of buybacks for both the bank and investors. Overall within bank capital structure, we like bank senior paper given the capitalisation wave and conviction shown by authorities to protect the par amounts. In non-financials, Q3 2011 saw a significant re-pricing that took credit spreads from late cycle levels to early recessionary levels. The good news is that we are now pricing in levels of default higher than anything we have actually seen since the Great Depression.
In addition we believe it would be fair to say that, in isolation, non-financial credit fundamentals and technicals remain extremely supportive. Indeed default rates are close to historic lows and will have initial protection from the macro environment as high yield/ levered corporates have been very successful (unlike banks) in managing their redemption profiles with the peak refinancing years not until 2014-2015. That said its difficult to ignore the fact that credit markets still remain at the mercy of the macro environment, whether it be concerns around European sovereigns/financials or more general economic growth concerns. Therefore we could easily see spreads eventually trade wider than the peaks in Q3 2011 at some point in 2012. Overall, the credit markets in 2012 are likely to be driven by how the ECB responds to the eurozone crisis and how its role and its relationship with eurozone members evolves. Our belief is that it needs to significantly expand its bond buying operations and adjust its mandate to do so. Without such a conversion the European sovereign crisis could destabilise all global financial markets.
Jul 1921
Jul 1924
Jun 1861
Jun 1894
Jun 1897
Aug 1904
Jun 1908
Nov 1927
Jun 1938
Nov 1970
Jul 1980
Nov 1982
Nov 2001
Mar 1879
May 1885
May 1891
Mar 1919
Mar 1933
May 1954
Mar 1975
(months)
The whole European issue has driven credit spreads throughout 2011 with high levels of correlation between eurozone events and market moves and is certain to continue to do so in 2012. If the ECB does not feel comfortable monetising large amounts of European Government debt then 2012 could be a year of extreme stress in credit markets. Even if the ECB does become more aggressive, it will likely reduce the risk of a systemic shock but it won't necessary help prevent a recession in Europe and perhaps elsewhere. Credit spreads are highly cyclical and therefore an understanding of the business cycle
is essential in any predictions for credit. Our big macro call over the last 18 months has been for shorter business cycles and 2012 was always going to be the year where our theory was tested. Figure 1 above shows the length of each business cycle expansion since the 1850s (the higher the bar, the longer the length of the expansionary cycle). As you can see, over the past 30 years we have had long cycles by historical standards. This cycle is fast approaching average length and the big question is whether the forces that enabled the long cycles of the last 30 years are still
Mar 1991
Dec 1854
Dec 1858
Dec 1867
Dec 1870
Dec 1900
Dec 1914
Jun 2009
Apr 1888
Jan 1912
Apr 1958
Feb 1961
Oct 1945
Oct 1949
Michael Lewis Global Head of Commodities Research
3.6 Markets
Commodities Can they push higher?
Ten years ago, commodity prices began their long march in response to strong demand growth across the emerging markets and years of underinvestment in new productive capacity.
Since super-cycles in commodity markets typically last up to 20 years, one could argue that we are only half way through the current one. However, the ability of commodity prices to push higher in 2012 is not certain, and will depend on whether the Feds efforts to stimulate growth are successful, whether China can engineer a soft landing and whether European policy-makers can find a market friendly solution to the regions sovereign debt crisis. If unsuccessful, then the implications for global growth and hence world commodity demand would be bleak. Of these, we view Europes financial crisis as the greatest risk. It is also worth noting that even if it is not contained, we will see bank de-leveraging that will curb access to trade finance, which is involved in as much as 90% of world trade. For this reason, trading strategies in commodities should remain defensive. Bullish strategies should only occur when there is evidence that markets have overpriced bad news or where commodity prices have fallen below marginal cost of production and long term supply-demand trends are tightening. Since the onset of the financial crisis over four years ago, commodity markets have had to contend with increasingly frequent, longer lasting episodes of heightened asset market volatility. We believe we will continue to see episodes of risk aversion through 2012.
These episodes have typically punished energy and industrial metal prices. Consequently, our strongest conviction trade remains long precious metals and specifically gold. In an environment where real interest rates are negative and the US equity risk premium is high we expect this will sustain strong private and public sector demand for gold. Indeed given investor appetite to protect against tail events such as the break-up of the eurozone, we view an overshooting in the gold price as a high probability event. According to the measures we employ, gold would need to move above USD2,170/oz for prices to be considered extreme and for the market to start displaying bubble characteristics. We believe the fortunes of the energy and industrial metal sectors remain closely tied to the prospects for world growth. If, as we expect, global GDP can grow by over 3% in 2012 then this should ensure that any corrections in energy and industrial metal prices will prove short-lived. Indeed physical fundamentals in the oil market are tightening and we would continue to view low OPEC spare capacity as sustaining geopolitical risk in the oil market particularly given our assumption that Libyan crude oil exports will be slow to return to the market. If world growth slows more sharply than we expect next year, then the dilemma for OPEC will be balancing the need for lower oil prices to support world growth against the ability of high oil prices to finance domestic social programmes.
Break-even oil prices for both external and fiscal accounts across the Middle East and North Africa have risen substantially over the last few years. For the GCC nations as a whole, we estimate break-even oil prices stand at around USD86.5/barrel (Brent equivalent) and indicate a level at which OPEC might start to consider production cuts to defend the oil price. We find that OPEC has a successful track record in defending oil prices via production cuts although not when world growth is below 3% as the cartel is unable to cut production as fast as world oil demand growth is slowing. We believe the prospects of the industrial metals and bulk commodity markets will start to improve as the authorities in China loosen monetary policy. We believe this will be helped by a moderation in food inflation. However, the low level of inventories across many agricultural markets will mean that any unforeseen production setbacks, perhaps linked to a developing La Nia phenomenon, can still have the power to cause significant policy headaches for central banks and government.
3.7 Markets
Alan Ruskin Global Head of G10 FX Strategy
FX Prospects for key exchange rates
The single biggest factor driving exchange rates in 2012 should again be the eurozone sovereign debt crisis.
Under the assumption that the crisis fails to abate but EUR constituent currencies remain unchanged, we expect further declines in the euro, with the yen followed by the US dollar the primary beneficiaries. We expect the US dollar to appreciate by between 5% and 10% against the euro in 2012 and the yen to rise by more than 10% versus the euro. This is not a EUR hardlanding, although some investors may wish to protect against such a scenario. Trading strategies None of the usual trading methodologies carry, momentum or valuation worked especially well in 2011. This is likely in part because the difference in performance between the strongest G10 currency (CHF) and weakest currency (CAD) is just 8% the lowest differential for at least 30 years. This is indicative of the same macro issues driving all currencies, as well as a tendency for Central Banks to try to avert large CHF and JPY strength, while supporting weak, systemically important currencies like the USD and EUR.
Unfortunately the global backdrop that produced modest returns is not likely to change materially in 2012. But the uncertain macro-economic outlook has created some interesting dislocations, particularly in the area of implied versus realised volatility. At the time of writing, many FX derivative contracts were pricing in high levels of implied volatility in their underlying exchange rates. But realised volatility will likely be lower, because G4 interest rate spread volatility is likely to remain low, and central banks will again try smooth excessive volatility in systemically important currencies like the EUR and USD. Euro versus US dollar Directionally, the EUR is expected to remain a favourite short. EUR/USD levels near 1.40, or 20% above PPP, will remain an active sell zone, while the downside limit is less easily demarcated but will likely stall before 1.20. A collapse in the EUR is not expected without more evidence that capital flows
are exiting core asset markets. So far, most flows from the periphery have simply found their way to the core, in an attempt to circumvent credit risk, without taking on additional currency risk. Stress in Frances bond market would be one signal that larger EUR losses are likely to be forthcoming. On the other side, a US narrow basic balance (current account + foreign direct investment) deficit approaching 5% of GDP has been holding back the USD from taking full advantage of the EURs travails. A US election year marked by substantial fiscal drag on the real economy, and continued pressure from the rating agencies, will also not help the USDs cause. We believe an even better flight to quality vehicle than the USD is the yen. While periodic large scale BOJ/MOF intervention will produce infrequent spikes in yen pairs, the tendency of
Japanese investors to hedge the FX risk on their US dollar investments, by selling US dollars forward, should keep the yen well bid, and grinding to Y70 on USD/ JPY and Y95 on EUR/JPY. Although the 2012 risk environment is likely to be volatile, only a crisis will lead to a change in Chinese FX policy that has allowed the CNY to appreciate by approximately 5% in nominal terms, and over 8% in real terms in the past year. A basket of quasi-China longs (CNY, MYR, SGD, TWD) with some of the strongest external balance fundamentals, should continue to outperform a G3 funding basket of the EUR, USD and GBP. Much of the rest of the developing world will similarly be defined by the global risk environment. If market attention remains centered on Euro Sovereign debt, we note being short Eastern European currencies like the PLN and HUF would make sense since they have historically fallen even faster than the euro in periods of market concern about Europe not least because of less liquid markets.
Going short the PLN and HUF versus the ILS and ZAR could also be an option since the two latter currencies have historically been much less vulnerable to downturns in confidence about Europe, but are driven by many of the same factors as the PLN and HUF. A similar intra regional trade this time in Asia is short THB/PHP. Unlike in G10, the developing world has much more divergence in monetary policy to capitalise on, and Thailand may ease while the Philippines holds steady. Lastly, many developing currencies have the reserves to smooth out a further risk blow-out, which supports buying zero cost BRL risk reversals versus the US dollar to take advantage of their skew.
3.8 Markets
Dominic Konstam Global Head of Rates Research Francis Yared Head of European Rates Research
Conor OToole European Securitisation Research Steven Abrahams Head of US MBS and US Securitisation Research
3.9 Markets
Rates Two scenarios
ABS Challenges and opportunities
In the US, rates look set to oscillate between two distinct economic and policy situations in 2012: the first disinflationary, the second inflationary.
At the time of writing (November 2011), market pricing implied a disinflationary environment for 2012 with lower rates, flatter yield curves, wider spreads and the out-performance of Treasuries versus riskier assets. We expect this disinflationary theme to continue in the first quarter of 2012 as the cuts proposed by the congressional budget Super Committee intensify the existing fiscal headwind blowing against growth. But as the year progresses, we expect these disinflationary dynamics to dissipate. A more inflationary pricing structure could result either from robust economic growth, or from further large scale asset purchases, or QE3, from the Fed as a reaction to falling inflation or recession. In this environment, we would expect to see rates rise, yield curves flatten, spreads tighten and risky assts outperform non-risky assets. Three issues that cloud the outlook are the cuts due to be proposed by the super-committee, the presidential election, and possible changes in the Feds communication policy. The super-committee is between the devil and the deep blue sea. If it makes front loaded cuts, this will intensify the existing fiscal headwind. If it backloads them, this could undermine market confidence in the ability of the US to cut fiscal deficits and potentially cause further downward pressure on the USs credit rating. The presidential election complicates matters further, as the entitlement reform which could provide a time-consistent means of addressing future deficits is politically difficult. The third issue consists of potential changes in the Feds communication strategy regarding the trade-off between unemployment and inflation. Increased efforts by the Fed to decrease unemployment potentially at the expense of higher short term inflation could result in a longer period of ultralow rates, QE3, or both. In Europe, while we believe that the tail risks of a systemic crisis are unlikely to materialise over the near term, we are more bearish than consensus on the medium term macro outlook. Since the beginning of the crisis, European policymakers have followed what can be characterised as a muddle through approach: responding to each round of market pressure with positive but insufficient incremental steps. In 2012, this approach wont generate much relief, in our opinion. The market is already questioning the credibility of the policy response in such a fundamental way that large core countries (from Italy to France) are now under significant pressure, with the (GDP weighted) average government bond yield in Europe now diverging from the expected policy rate. More aggressive policies will be required in 2012 and we expect the European Central bank to cut rates from 1.25% to 1% during 1H 2012 and to keep them low for a prolonged period of time. However, rate cuts alone will not be sufficient owing to the breakdown in monetary transmission in the eurozone, which means that a European Central Bank (ECB) rate cut does not de facto lead to a fall in borrowing costs for individuals or companies. Thus, we expect the ECB, which is the only institution with sufficient flexibility and firepower to stem the current negative sentiment, to expand their fiscal efforts via increased purchase of government bonds. Until a stronger policy response materialises, a general flight to quality should continue to benefit German bunds and prevent a significant normalisation, only to be at risk of a violent unwind when the policy reaction function shifts. Within Europe, following the repricing of the Italian bond market in November, the focus will probably shift to other weaker sovereigns. Structurally, we expect greater pressure on Spain and France relative to Belgium and Austria. Finally, we cant help but noting that the European bond market appears to be pricing a significant probability of an extreme outcome, which is not truly reflected in many assets outside of Europe. For this reason, we believe nonEuropean assets could provide a better hedge against systemic risk in Europe than European assets.
Investors and traders in asset backed securities will have some interesting challenges and opportunities to navigate in 2012.
In Europe, the market can be divided into two parts: vanilla core markets which are broadly functioning well and should continue to do so in 2012, and peripheral and non-vanilla core markets where there will likely be trading opportunities but very little new issuance. The core markets are UK and Dutch prime residential mortgage backed securities (RMBS), and credit card and auto loan securitisations. During 2012, we expect new issuance volumes in these areas to increase. The issuance will continue to be senior only though so it will continue to be a funding tool for banks rather than a capital relief strategy, as it was before 2008. There will be no return to subordinated issuance. The peripheral markets are RMBS from peripheral European nations such as Portugal, Ireland, Italy, Spain and Greece, non-vanilla core include commercial mortgage backed securities (CMBS) and collateralised loan obligations. New RMBS issuance by peripheral banks looks extremely unlikely in 2012 but if and when the eurozone crisis eases we believe secured funding will be one of the channels that banks will look to tap first. The prospects for CMBS and CLO issuance look better but still limited because of (in the former case) their relatively high funding costs compared to the unsecured market, and (in the latter) as the arbitrage continues to be unconvincing. But although the primary outlook is not particularly exciting, there will likely be interesting opportunities in the secondary market. During 3Q 2011, we saw a major sell off in these markets in response to the worsening eurozone news but the fundamentals (with the exception of Ireland and Greece) improved. They now look undervalued. Another factor to bear in mind in 2012 is regulation. Asset backed securities got hit hard by Basel 3 and Solvency 2 proposals as well as the imminent arrival of CRD3 which are all expected to impinge on the amount of capital financial institutions need to hold to own ABS. However, we are beginning to see some push back on these capital and liquidity requirements, and may see some changes. In the US, the outlook for the USD5.4 trillion agency MBS market is that it should grow slightly as securitisations issued by Fannie Mae, Freddie Mac and Ginnie Mae continue to fund more than 90% of all US mortgage lending. Efforts by US regulators to raise the cost of agency loan guarantees, ease mortgage refinancing, relieve debt pressure on borrowers and stabilise home prices should shape MBS market pricing. Investors will also have to watch the Federal Reserves appetite for agency MBS. Low and stable US rates should favor MBS with the best carry. The USD1.1 trillion non-agency MBS market should contract by another USD200 billion next year as amortisation, prepayments and defaults overwhelm almost nonexistent new issuance. A soft US economy and unpredictable liquidity in the sector pose challenges. If new federal efforts to stabilise home prices work, however, non-agency MBS would be a major beneficiary. The USD693 billion CMBS market should continue its steady rebound. New issuance should rise from roughly USD30 billion this year to USD45 billion next. The sectors steady shift toward higher levels of credit enhancement and public transactions should also help widen the investor audience. Highly rated CMBS should continue looking like good value relative to highly rated corporate debt. Finally, the USD600 billion non-mortgage ABS market should continue catering to the financing needs of a growing auto market and to a range of corporate issuers looking to use securitisation to lower the cost of funds. Auto lenders including lenders to subprime auto buyers used securitisation to raise USD67 billion in funds so far this year, and that volume looks likely to grow. Credit card lenders continue to stand back from securitisation in light of the low cost of funding with bank deposits, but lenders in the fast food, telecommunications and other markets issued a steady flow of niche securitisations. Wide spreads on corporate debt should continue to make securitisation an attractive source of funds for niche issuers.
Sectors & Corporate Strategy

Outlook for Corporates M&A Natural Resources Telecoms & Media Consumer Goods Industrials Financial Institutions Financial Sponsors Technology Healthcare
4.1 Sectors & Corporate Strategy
Stephan Leithner Co-Head of Investment Banking Coverage & Advisory
Outlook for Corporates Test of nerve
2012 will be an interesting test of nerve for corporates, both the executives that run them and the institutions that invest in them.
The financial markets and Western economy are clearly in a fragile state with numerous situations, particularly the eurozone crisis, capable of delivering sharp shocks to market confidence. If the eurozone situation deteriorates, we can expect severe disruptions to all areas of the market with capital becoming harder to raise, counterparty credit risk increasing, commodity prices falling, and large parts of the developed world slipping into recession. But if the situation stabilises or improves, and this is our baseline view, we could see very favourable conditions indeed for corporates with growth returning to the US, Europe shrugging off recession, share prices rising, falling credit spreads and the return of liquidity to the capital markets. The vast gulf between these two scenarios makes the strategic choices taken by corporates in 2012 especially important. The two key questions for corporates, as always, are how to employ capital (if you have it) and how to raise it (if you dont). The choice in the former is between growth (expanding capacity and/or making an acquisition) and consolidation
or defensive strategies (buying back shares, and initiating or increasing dividends). Buying back shares certainly appears attractive whatever the economic conditions. US equities are currently trading at their lowest multiples since March 2009 and are now, in the opinion of our equity strategists, 30% below fair value. Dividend increases seem more suited to negative economic scenarios. In a rising market, they will not significantly enhance share prices. In a weak or falling market, with investors focusing on income rather than capital growth, it could have significant benefits. The choice between organic capacity expansion and mergers & acquisitions is, perhaps, the most intriguing. In some sectors, growing earnings significantly through organic growth alone may be challenging. The pharmaceuticals industry, for example, appears to have hit a ceiling in the area of new drug development with slow progress on new drug approvals making it hard to maintain returns on research and development above the cost of capital. Here, the focus is likely to be on mergers & acquisitions.
Prospects for M&A activity generally look strong. According to Deutsche Banks 'M&A affordability index' which looks at debt financing costs, growth expectations and other variables, the conditions for M&A are now the strongest in recent history. In others, the case for capacity expansion is compelling. Investment in cloud computing technologies and services, for example, looks set to increase by 19% in 2012 with large technology vendors like IBM expected to spend over USD50 billion on new infrastructure in the next three years. Emerging markets continue to offer significant opportunities with Africa emerging as a region with particular potential. We expect to see large cap companies continuing to spin off non-core assets and using the proceeds to increase their operations in Asia. On the second question of financing, the outlook for 2012 is broadly positive. Demand for non-financial investment grade corporate bonds is strong (partly because of investor concern about the banking sector), and interest in high yield paper has picked up significantly in recent months.
This suggests that many companies will be able to raise large amounts of debt in the public bond markets in 2012 at extremely competitive rates of interest. The outlook for equity issuance is also positive, providing we see some stabilisation in the macro-economic and market climate. However, it seems likely that we will see some periods of instability in both equities and bonds when (because of macro events) the markets close to certain issuers, just as they did in 2011. Given this, it would seem prudent for corporates to raise as much as they can, as early as they can in the year to protect themselves against prolonged market closures. An interesting alternative to public equity issuance are private funds such as sovereign wealth funds and private equity funds many of which are actively looking to take strategic stakes in selected corporates. The third key area that corporates will need to focus on is risk management. During 2011, we saw some very severe, sudden swings in both commodity prices and exchange rates. This increased the cost of hedging using plain vanilla
products and made multi-asset hedges more attractive. I would expect this to continue in 2012. Another issue that many corporates will need to address is pension liabilities. Estimates for the funding gap for US corporates range from USD400 to USD500 billion depending on discount rate assumptions. Studies indicate that for each 1% decline in rates, these liabilities will increase by between 10% to 15%. Corporates that are able to understand and monitor these risks and have the systems, staff and infrastructure to identify appropriate hedges will outperform. The uncertain regulatory outlook for hedging products such as interest rate swaps and FX options is a further complication but we may see greater clarity next year. All in all, a challenging but potentially very exciting year ahead.
Henrik Aslaksen Global Head of Mergers & Aquisitions
M&A Outlook for 2012
Despite the volatility and capital market stresses that began over the summer, global M&A activity has continued, albeit at a slightly lower pace.
Through November 9, global M&A volumes in 2011 are about 13% higher than the comparable period in 2010. From a regional perspective, Americas has experienced the highest growth and is up 22%, while EMEA and Asia are up 11% each. From a sector perspective, the activity has been broad based as shown in the chart below.
While overall cross border volume is modestly up, one segment that has seen a substantial increase is outbound M&A activity from Japan. Backed by a stronger yen and faced with low domestic growth environment, Japanese outbound M&A activity has posted a 72% increase through the first nine months of 2011, compared to the same period last year. Current M&A environment: Given the proximity in time to the M&A downturn that followed the bankruptcy of Lehman Brothers in 2008, the question of whether we are entering a repeat of the 2008/2009 scenario is a natural one. It is our view that this is not the case and that there are some fundamental differences in the underpinnings of the current environment that facilitate continued deal making activity even with the backdrop of elevated volatility: Credit markets have not shut in the way they did in 2008/2009 for subinvestment grade borrowers and for a while for investment grade borrowers. Furthermore, we are in a low interest rate environment, with the cost of financing for well capitalised acquirers near historic lows. However, deleveraging among banks is ongoing and that could continue to make the availability of financing more volatile.
Bolstered by record levels of cash, earnings growth and value creation continue to be the main themes at Boards and C-Suites, whereas liquidity and risk management were the main themes in 2008/2009. M&A activity is ultimately correlated with equity market performance, and while we have had a modest fall off in equity values post the onset of the volatility, we have not experienced the type of significant contraction that followed the Lehman bankruptcy. Importantly, equity valuation multiples were higher leading up to the 2008/2009 crisis (i.e., there was more room to fall), whereas current equity multiples are relatively low by historical standards. Reviews of a large sample of earnings calls and transcripts from various Q3 earnings announcements indicate that M&A is a priority for many corporates. M&A currently represents, we believe, the best opportunity for growth in a slow organic growth macroeconomic environment in the industrialized economies. Under this backdrop, we expect to see well capitalised companies engaging in all cash or mostly cash strategic acquisitions driven by an alltime high in the M&A affordability index.
M&A in 2011: Sector Breakdown

M&M TECH Utilites Chemicals FIG Energy 8% 7% 5% 3% 14% 13%
Industrials Consumer REGLL M&T Healthcare Source: Thomson Reuters, as of November 9, 2011. Excludes AIG preferred to common conversion.
13% 11% 10% 8% 8%
The index, which we introduced last year, tracks the gap between the implied P/E multiple of single A rated debt and the P/E multiples of broad market indices such as the S&P 500 and Euro Stoxx 50. The index is currently near its all-time highest level and would indicate an attractive opportunity for M&A activity by well capitalised companies using cash consideration. How the index works is that the greater the index value, the more affordable it is for a company that can raise single A rated debt to fund the acquisition of a target trading at levels comparable to that of the broader market. To illustrate, the composite yield on 10-year single-A rated corporate debt in the US is currently approximately 3.37%. For an acquirer whose marginal tax rate is 40%, the implied P/E of new debt is therefore 49.4x (the inverse of the after tax cost of debt). The latest 12-month P/E of the S&P 500 is about 13.4, which gives the index a value of 36, about the highest it has ever been. By comparison, during the peak of the up cycle in 2007, the index stood at circa 13. Underpinning this is an arbitrage opportunity: low interest rates have significantly reduced the costs of funding a transaction and we have seen a significant number of strategic transactions using cash as currency to drive growth. With the overhang of continued anemic GDP growth, we expect this trend continue to be a big driver of deal making in 2012. Multi-line corporations looking to unlock value through spinoffs Many multi-line corporations, either as a result of their own strategic reviews, or as a result of pressure from activist shareholders, are taking a hard look at corporate spinoff transactions as a means of unlocking value. One of the drivers of this trend is historically low
valuation multiples, and valuations that are in many cases at discounts to the sum-of-the-parts valuation. Investors appear to be placing greater value on pure play focus, and spinoff transactions have generally been well received by the market. Several large corporations including Pfizer, Kraft, ConocoPhillips, Tyco, Abbott, Carrefour and ThyssenKrupp have all recently announced such transactions. In addition to positive investor reaction, one of the key drivers of increased use of these types of transactions is that corporate boards are able to implement them unilaterally with minimal execution risk. We expect this trend to continue into 2012. Regional flows We believe there will be a continuation of the secular trend of M&A activity focused on targets in higher growth emerging markets, and the pace of such activity will largely depend on the extent to which the regulatory framework and capital markets in these economies facilitate deal making. We think the Japan outbound theme is likely to continue in the near term. We also believe the China outbound theme is likely to continue, especially in the natural resources sector. Financial sponsor activity We expect the bulk of the activity in the near term to be driven by corporations. We also believe financial sponsors, with significant amounts of un-invested capital, will continue to participate in the M&A market. This will likely take the form of both through traditional buyouts of targets that have the ability to tap the leveraged debt markets, as well as through other forms of investment less dependent on the availability of leveraged debt markets.
Conclusion Over the last three decades, we have seen three M&A up-cycles, lasting between five and nine years each, and three down cycles, lasting between two and three years each. The most recent trough was in 2009, and 2011 marks the second year of the current M&A up-cycle. While there have been some bumps in the road as a result of the European sovereign debt crisis, under the assumption that the volatility subsides and stability returns, we expect the M&A up-cycle to continue in 2012.
Alan Brown & Dan Ward Co-Heads, Global Natural Resources Group
Natural Resources Valuation disconnect
We currently see a fundamental disconnect between the discounted future prices of commodities and the underlying market valuation of the majority of resource-based corporates that could provide scope for corporate activity in the short term. Longer term, the nature of corporate activity will change significantly.
In the short term, macro-economic and geo-political issues will likely continue to dominate the market performance of resource companies, particularly those which are under-capitalised, own interests in uncompetitive assets, or possess significant emerging market exposure. These issues will likely exceed in influence those of a sector or companyspecific nature, despite the best efforts of management teams. In time, as market volatility abates, and in part due to the alignment of long-term corporate planning horizons and long-life assets, we expect companies fundamental value to be recognised increasingly. Longer term we see seven fundamental trends driving the sector. 1. Strengthening demographics and increased industrialisation which will drive greater consumption. Combined with the increased competitiveness of emerging markets, will lead to increased demand for all commodities.
2. This demand will drive increased investment into 'resource economies'. Discontinuities in the global supply/ demand dynamic will mean that market structures will take time to settle we expect to see market balkanisation persist before an evolution towards global homogeneity. A good example of this is the global gas market where prices differ significantly from location to location but will increasingly converge as the boom in US shale gas production leads to exports. 3. An increasingly 'south-to-south' dimension to capital flows with countries such as China bypassing major financial locations to go straight to producer countries like Brazil. In this context we see Africa as a positive but longer term play, given political and infrastructure constraints. 4. The combination of accelerating demand and resultant investment will lead to continued upward pressure on commodity prices, increased commodity and currency volatility, a sustaining of the mining super-cycle, and an extension
of the energy and in particular the agriculture cycles for multiple decades. 5. Governments will adopt more coherent (and increasingly expansive) policies, which will, for example, drive substantial capital expenditure in the utilities sector, combined with protectionism and intervention, including resource nationalism. The indirect impact of austerity measures will partially moderate industrial growth and resource demand. 6. Concern about climate change will lead to a re-balancing of the fuel mix, with gas acting as the transition fuel in many markets. We expect a reduction in subsidies for renewable technologies as they become more efficient and governments cut spending, and, in time, a nuclear renaissance. 7. The underlying cost of commodities to companies and end consumers will rise dramatically which will have social implications, and lead to regulation of certain competitive market segments.
We believe that market participants will respond to these trends in six key ways. 1. Companies will become increasingly focused on acquiring access to physical resources, predominantly Tier 1 and of scale, which in turn will accelerate cross-border investment, both organic and by way of acquisition. In so doing, managing complex risk across commodities, currencies and inflation will be more important than ever, and risk tolerance generally will reduce. 2. Corporates will increasingly seek to secure finance from alternative providers, such as sovereign wealth funds and pension funds in addition to bank and capital market finance. The size of their capital expenditure programmes will force such behaviour. Access to capital will become a source of competitive advantage for companies. We expect a boom in infrastructure financing, which is illustrative of one of many areas where we believe that corporates will increasingly seek to re-cycle capital, via asset sales and domestic listings, and exiting non-core assets and businesses.
3. Non-traditional owners of discretionary assets such as banks and governments will continue to look to dispose these assets, the latter via privatisations, particularly in Europe but also, in time, across North America. 4. Consolidation through mergers and acquisitions will continue in selected, mature markets that are characterised by over-supply, fragmentation, low growth and inefficiencies. Consolidation will also occur where the scale and concentration of capital expenditure is only sustainable by significant balance sheet strengthening that is not available by other means. 5. Financial investors will show continued strong demand for regulated utility infrastructure companies that provide long-term, asset-backed, cash flows and earnings, that have the additional benefit (for some) of being directly linked to inflation, and that are able to sustain reasonable levels of leverage on debt financing terms that currently remains competitive.
6. Acquisitions will take place in sectors where there is a fundamental mismatch between public and private market valuations. We believe this will be particularly the case where the disconnect between public market valuations and underlying commodity price outlook persists. An example is the regulated utility infrastructure sector where listed companies typically trade at a modest premium to their relevant regulatory asset values but recent publicto-private transactions indicate that acquirers are willing to pay a substantial premium to the underlying asset value and prevailing share price. Finally, despite our confidence in identifying the outlook, drivers and factors influencing investment, corporate success will come in part from possessing sufficient humility to accept that we will continue to experience 'Black Swan' events whether of a political, economic, technological or managerial nature. The upside of these events is that they will likely give the larger, better capitalised investors the opportunity to acquire relatively distressed businesses on compelling terms.
David Pearson Head of Global Media & Telecom Group
Telecoms & Media The digital revolution
The growth of digital distributors of entertainment content, such as music and videos, has led some commentators to predict a revolution that will significantly impact the business models of established media companies. We believe that this digital revolution will take a lot longer to play out than many people think, that it will complement rather than replace traditional methods of consuming media, and that we may see significant changes to the structure of the industry in the years ahead. Access to quality content and the cost of that content will be a critical factor.
The emergence and rapid growth of digital distributors (companies that offer music, television and films via computers, tablets and mobile phones) over the past decade has dramatically changed the way media is consumed. Music was the first form of content to be offered digitally, with Apple being the first major player to offer it digitally on a legal basis via iTunes. The success of iTunes encouraged other companies such as Hulu and Netflix to offer video digitally as broadband capacity increased and speeds accelerated. These companies have experienced tremendous growth in revenues and subscriber bases in recent years with growing numbers of users switching from renting videos or watching them via cable to purchasing them online. However, a recent influx of new market entrants such as Blockbuster, Amazon, Google, Facebook and others has increased content procurement costs for these companies and depressed margins. Moves by incumbent multiple system operators (MSOs) and premium cable players into the business have further intensified competition. Although MSOs have taken a timid approach to digital distribution to date, with their TV Everywhere service they are now offering content to their users on a digital basis. The increase in competition has led to a debate about the business models and profitability of the sector with the ability to secure quality content emerging as a critical issue. Over the past year, the cost of buying content has increased for many players.
Netflixs content acquisition costs were 13.9% in 2010. In 2011, they are estimated to be around 22.9%, with many analysts expecting a further increase in 2012. Currently, content players hold the negotiating power since consumers generally value quality over quantity of content. As a result, several digital distributors have begun experimenting with original content production. For example, Google recently announced plans to spend USD150 million to create original shows with partners such as Warner Bros, BermanBraun, FremantleMedia and Shine Group. In addition, Netflix secured rights to license House of Cards, an original TV series set to be directed by David Fincher, and most recently, YouTube announced its entrance into original content by signing talent to its newly developed channels offered through its website. Although the effectiveness of original web content as a means of increasing subscriber bases is unclear, digital distributors may still need to come up with innovative cost structures to compete effectively with traditional content players such as Disney and Time Warner. Given the current pricing model for digital subscriptions, players in this space should also seek revenue-sharing agreements to secure quality talent. Perhaps an equally important issue is content delivery infrastructure. Since video content requires a high amount of bandwidth, industry players that have the infrastructure to deliver this bandwidth (and the capability to offer a streaming service) will be in an advantageous position.
This would seem to indicate that MSOs and telecom companies which possess both capabilities may ultimately be the frontrunners in the next generation of content distribution. Ultimately, digital distribution remains a fragmented market with low barriers to entry. The recent influx of players is making it harder for companies to differentiate themselves through quality, depth and uniqueness of content. So we expect to see consolidation to a handful of major players.
Scott Bell & Keith Wargo Global Co-Heads of Consumer Group
Consumer Goods Deals on the way
The US Congress plans to reform corporate taxation is going to fuel increased M&A in the consumer packaged goods sector during 2012. Other major trends in the sector include the rise of the emerging market multinational and the ironing out of the current PE mismatch between large caps and small and medium cap stocks in the sector.
The corporate taxation reforms expected in 2012 should have the effect of reducing the overall corporate tax rate, at the same time as closing down a great many tax loopholes. This will have the unexpected side-effect of boosting M&A activity. Most medium to large companies in the sector own large numbers of distinct brands and assets, and many of these are several decades, even centuries, old. Thanks to their longevity many of these brands and assets have a very low tax basis, which make disposals unattractive under the current fiscal regime since they would cause tax leakage. Under the new tax regime, holding on to under-performing or non-core assets will become less attractive, and we believe this will trigger a marked increase in M&A activity. A new wave of consolidation in the consumer packaged goods sector, particularly in the developed markets, is widely expected among investors and analysts. However, we doubt mega deals will materialise in 2012, largely as a result of anti-trust policies in the US and Europe and the surprising lack of valuation discrepancies in the sector. Instead we predict a multitude of acquisitions of smaller growth brands and assets. With strong balance sheets, low funding costs and challenging targets for organic growth, corporates are still going to want to make acquisitions in 2012. Finding organic growth increasingly hard to achieve, managements will seek out smaller deals that bring clear growth opportunities. These will include emerging market assets and developed market targets in higher-growth channels or categories. Meanwhile, many emerging market players have quietly been transforming themselves into global challengers in recent years. Given the market backdrop of sluggish growth in the developed world and continued emerging market outperformance, 2012 may well be the tipping point for such firms, as they seek to roll out their presence by buying up western brands and technologies. Where price-earnings ratios are concerned, there has traditionally been a clear pecking order in the sector, with the largest firms having the strongest multiples. However this pattern changed from 2006 onwards, as investors were drawn to a number of preferred mid and small-cap stocks. This drove up the PEs of small and mid-cap stocks to above or to parity with those of the large caps. The phenomenon was reinforced by the behaviour of index trackers and ETFs. The result has been a mismatch between pricing and fundamentals. Companies with many market-leading brands and strong emerging market exposure factors that should lead to a valuation premium now trade at discount to midcaps with lower market share brands and lower exposure to the emerging markets. As we enter 2012, two catalysts will realign this valuation mismatch to the benefit of large-caps. 1. The uncertain and volatile macro outlook will drive investors back to well-known multinational names which benefit from geographical spread, stronger balance sheets, and a larger sales mix of number one brands which have the pricing power to withstand a higher inflationary environment. 2. Investors will increasingly prioritise yield over capital growth which will also favour the large cap stocks in the consumer packaged goods industry. These generally have higher pay-out ratios and higher dividend yields.
Paul Stefanick Head of Global Industrial Banking
Industrials Prospects for earnings
While macro uncertainty looms, leading secular indicators point to a gradual recovery in the industrials sector led by emerging market economies.
For industrial players globally, we are positive on the outlook for earnings, observing tailwinds from the demand for infrastructure build-out, cost management efforts (labour, raw material, restructuring), and flexible manufacturing initiatives. Emerging markets are at the epicentre of the focus on growth due to their attractive demographic trends, consumer consumption, and industrialisation. Chinas 12th five-year plan illustrates the scale and magnitude of the industrial opportunity. In contrast, the 'established' economies are showing tepid growth. While the US has successfully demonstrated 26 consecutive months of industrial growth since the June 2009 bottom, the October PMI indicator of 50.8% is just a fraction above the 50% zero growth break-point. Faced with the post-Lehman downcycle, industrial players across the board focused on operational performance and cash preservation. Earnings fell precipitously back down to 2004-levels and the impact on the sector was compounded by the destocking of inventories which reverberated up the supply chain. More positively, industrial players took the opportunity to build in significant cost management capabilities and flexibility into their systems.
Today, conditions do not support another 2009-type fall given low inventory levels, solid and growing backlogs, and the impact of over three years of restructuring. One Deutsche Bank client made the case against a return of the 2009 crisis on industrial players in 2012 by saying 'you cant fall six feet off a three foot ladder' indicating that further severe manufacturing declines were unlikely given already weak industrial demand. We are now in an environment where industrials are carefully managing earnings expectations which will likely facilitate easier near-term outperformance as they benefit from a rebound in demand for their equipment or services. In reporting Q3 earnings, 87% of US industrials that have demonstrated growth and 63% have exceeded street expectations. The sector now trades at 13.9x next 12 months (NTM) EPS, an 11% discount to the 10year average NTM valuation of 15.6x. Clarity around 2012 earnings forecasts combined with a view on the magnitude of any 'leg up' in 2013 would be the likely catalysts for investor interest in the sector over the near-to-medium-term. Within the various sub-verticals that comprise the broad industrial sector are specific macro trends characterised by their unique demand cycle, competitive
dynamics, and industry fragmentation. We observe the following: 1. Aerospace & Defence Defence spending remains uncertain until after the next presidential election; on the other hand, commercial aviation appears to be rebounding with a resurgence in commercial aviation passenger miles and revenue. 2. Automotive We expect the consumer-supported North American recovery to continue, yet face demand and pricing risks in Europe, China and Brazil. In addition, the trend towards global consolidation and collaboration among original equipment manufacturers (OEM) and suppliers is expected to rise with the sector recovery. 3. Capital Goods Secular demand for food and commodities as well as construction spending is driving the outlook which is benefiting from continued strong growth in emerging markets as well as a recovery from cyclical troughs in developed markets. Consolidation driven by players in emerging markets seeking to expand their international presence as well as selected strategic expansion by the global majors.
4. Diversifieds Companies are seeking growth in a) new technologies with high value add and barriers to entry, b) strong market positions in developed economies to leverage scale, and c) greater access to emerging markets. The spate of recent corporate split-ups underscores the need to justify diversified portfolios on their strategic and financial merits. 5. Home Building/Building Products After nearly six years of headwinds, home builders continue to remain cautious on the housing recovery which will be driven by jobs and consumer confidence improvement. Access to capital has enabled public home builders to take market share from private builders through the downcycle. Building products companies with repair and maintenance exposure as opposed to new home construction have outperformed but remain cautious near term. 6. Paper & Packaging Paper grades are facing secular pressures from digital media which is expected to accelerate consolidation to better match supply to demand. Deals in 2011 focused on repositioning portfolios into growth markets with more favourable dynamics. We expect this to continue in 2012. Packaging remains resilient due to stable demand
characteristics and consistent cash flows. Recent commodity declines are helping to offset volume weaknesses. Corporates are well capitalised and looking to drive growth through accretive acquisitions. 7. Transportation 2012 earnings will be driven by the trends in economic growth as transportation is the hub of movement of goods and services critical to the global economy. We will continue to see targeted consolidation amongst leading players. With regards to industrial M&A activity, after a hiatus in significant transactions in 2008/H1 2009, we began to see a return to consolidation focused on operational cost opportunities at relatively modest TEV/EBITDA transaction multiples in the 810x range at the end of 2009. Representative of this trend was the late 2009 merger of StanleyWorks and Black & Decker resulting in USD450 million of synergies equivalent to around 10% of target sales. In late 2010/early 2011, we saw M&A increasingly focused on longer-term strategic growth and higher valuations more commonly in the range of 912x. Transactions such as GEs energy-related acquisitions or Caterpillars acquisition of Bucyrus underscore this focus on global
mega trends, infrastructure investment, and emerging market presence. Today, M&A, in our opinion, is being driven by the convergence of high cash balances and underutilised balance sheets, low cost financing and availability of funds for the 'right' deals, and relatively low asset valuations. We see underperforming industrial assets or sub-optimal corporate structures being penalised and driving transaction activity witness Tyco and ITTs announced split ups. Further portfolio activity is coming from investors taking a dim view of assets within portfolios that are not measuring up to the corporate level expectations. This was the key factor behind the sale of Tycos TEMP and Ingersoll Rands Hussmann businesses to a private equity firm in 2011. Meanwhile, companies with solid M&A track-records are seeking future growth engines by focusing on global build-out opportunities and new adjacencies. Recent market volatility has made balancing seller price expectations with buyers return requirements challenging. Clarity around 2012 forecasts should help unleash deals.
Tadhg Flood Co-Head Financial Institutions Group, EMEA Stephen Westgate Director, Financial Institutions Group
Financial Institutions Deleveraging
Bank deleveraging in 2012 managed balance sheet reduction or fire sales?
Since 2007, the reduction in European bank leverage has been largely achieved through retained earnings and capital raisings. The fall in equity valuations and consequential negative impact on equity raising has shifted focus to the asset side of bank balance sheets. Pressure on banks to deleverage is increasing as they seek to address capital and funding requirements imposed by regulators, meet the requirements of the market and, in certain cases, achieve ECimposed restructuring deadlines. It is widely believed that asset deleveraging across the European banking sector will increase substantially in 2012 and that European banks have identified over EUR1 trillion in asset deleveraging. Amongst investors, there is a widespread expectation that significant asset portfolio sales may take place in 2012 at fire sale prices. However, in our view, rapid and price insensitive deleveraging on a widespread basis is unlikely. There are several reasons why deleveraging through asset sales by European banks will occur in a much more staggered and orderly manner over an extended timeframe than many expect. These include:
1. Continuation of well established deleveraging process Deleveraging through asset sales is not new with many banks undertaking significant deleveraging since 2007. The deleveraging trend will continue with new asset classes becoming relevant but increased volumes of assets identified for deleveraging will likely be incremental to a well-established process, not a step-change. 2. Asset sales are a less attractive form of deleveraging Asset deleveraging can occur via several means: write-off, disposal, redemption or refinancing. Given the capital benefit of run-down over divestment, we would expect the majority of assets to be reduced by refinancing or redemption. 3. Funding pressures Whilst a reduction in US dollar funded assets remains a priority for those European banks finding access to US dollar funding markets difficult, immediate term funding pressure has reduced as the European Central Bank (ECB) has expanded provision of term liquidity to banks. ECB funding reliance is not sustainable and will need to be addressed through deleveraging but only over time. In addition, innovations in secured funding give banks increased
flexibility to hold funded assets to maturity rather than incur losses immediately. 4. Regulatory pressures Regulatory pressure to meet capital ratios will only be aided by certain forms of deleveraging. With the exception of certain high RWA and other marked-tomarket trading book assets, large scale deleveraging through asset sales is unlikely to be capital accretive, making it a less attractive strategy for banks required to meet substantial new capital requirements under the Basel 3 or EBA frameworks. 5. Interaction of deleveraging with alternative capital relief measures Deleveraging is only one tool to achieve capital objectives. The relative attractions of alternatives such as cancelling dividends, equity raising or liability management will have a significant bearing on the volumes and pricing levels of asset sales. 6. Substitutability of portfolios identified for deleveraging Non-core assets identified for deleveraging that prove difficult to sell could be supplemented by other assets identified for their saleability rather than their profitability.
7. Separating platforms from portfolios A substantial business element of certain loan portfolios may reduce buyer appetite but may be difficult to divorce from a portfolio sale due to, for example, goodwill destruction or stranded costs. Bank deleveraging through asset sales are likely to continue in 2012, at an increased but managed pace, as banks continue to use deleveraging as a tool to address capital and funding pressures and restructure business models to ensure adequate shareholder returns. In an environment where many banks are simultaneously seeking to reduce balance sheets, asset deleveraging processes will need to be carefully constructed. Two key elements to improving execution are 1. definition of the sale portfolio perimeter and sale structure; and 2. the sale process. The sale portfolio perimeter definition and sale structure, in our opinion, will have a material impact on buyer appetite. Sale portfolio sizes will need to be kept small, despite significant deleveraging requirements, due to buyer funding availability and the reduced attractiveness of portfolios that are too diversified to buyers. Portfolio tailoring is essential to minimise cherry picking. Structured sales (e.g. tranching) may be required
to attract a wider investor base. Sale strategies should evolve in response to buyer interest, competing processes and changing market conditions. A series of narrow auctions or bilateral discussions may be better than a failed process polluting further deleveraging initiatives. For acquirers of assets, the key challenges faced in 2012 will be 1. identifying and accessing available opportunities; 2. differentiating interest with sellers likely to be inundated by often opportunistic interest; and 3. acquiring assets that meet pricing and return expectations. Buyers must identify opportunities early and demonstrate credibility. For banks with substantial deleveraging objectives, it may not be necessary for buyers to wait for a formal sale process. Given the substantial deleveraging task for certain banks, reverse enquiries may be well received. Importantly, a detailed understanding of seller objectives, time pressures, pricing constraints and alternative strategies may assist buyer positioning, through highlighting such attributes as transaction track record, due diligence efficiency and access to financing. As the focus of asset sales moves from bank trading books to whole loans and loan portfolios, banks face a greater
disparity between carrying value and realisable value. As pressure on banks to delever increases, pricing expectations may fall but buyers may find that they also need to adjust return expectations. Increasing innovation and detailed understanding and insight are required in an environment where funded buyers are few and resource constrained. Further innovation is expected, and needed, in areas such as financing, facilitating buyers into new asset classes and the way portfolios or businesses are presented to the market. In an increasingly volatile and complex banking environment a mutual understanding of objectives and drivers between buyers and sellers becomes less straightforward but even more necessary to ensure an efficient transfer of assets.
John Eydenberg Global Head of Financial Sponsors Group
Financial Sponsors Shifting focus
2012 will see a growing number of private equity (PE) firms shift their attention to non-traditional markets such as high yield and structured credit, distressed debt, public equity, commodities, real estate and infrastructure as they look for ways to deploy their USD500 billion of un-invested capital.
services while some of the most successful investments in recent years have been in more cyclical sectors such as chemicals, energy, and retail. Sponsors are today spending significant time looking at industry verticals, especially in the real estate and finance sectors, where banks are looking to shed assets and raise capital ratios to meet ever-changing regulatory restrictions. Another theme we saw in 2011 which we expect to accelerate in 2012 is sponsors pursuing more venture-like growth investments, particularly in new media and tech services. Additionally, sponsors have cast their eyes east where record amounts are being raised, deployed and some already exited in Asia. While many PE firms are sticking to their knitting, others are stepping out into new asset classes. In fact, the 10 largest PE fund managers now have more capital deployed in credit and other assets than they do in private equity. What started as an opportunistic business expansion leveraging in-house expertise in leveraged corporate credit is now a dedicated business for PE. PE credit investment takes various forms, from portfolio managers overseeing separate loan and high-yield bond funds to PE principals buying debt as a 'distress for control' strategy. While distressed investing took a bit of a holiday when asset prices re-inflated sharply in mid2011, opportunities should proliferate as continued market turmoil and intermittent capital scarcity sorts winners and losers, and selected companies with overstretched balance sheets in tougher sectors struggle to refinance.
PE firms are delving into other assets as well including structured credit, public equity, commodities, real estate and infrastructure. Real estate probably stands out as the area where sponsors are staffing up the most to be ready to buy everything from credit/MBS to individual assets to corporate platforms in both dedicated funds as well as within their core private equity funds. Disposals: Promising opportunities ahead PE firms are very focused on returning capital to their limited partners as they begin to map out the next wave of fundraising. Contrary to some popular belief, there is no gun to the head of sponsors to return capital and by and large the companies which have gone public have been the portfolio winners (with a few exceptions where equity capital was necessary to de-lever capital structures). 2011 saw the continued drumbeat of filings as sponsors readied their candidates but deals ground to a halt in early August following the US debt downgrade and the markets seemingly unanimous and simultaneous conclusion that global growth would come to a grinding halt, sweeping away the general optimism that prevailed only weeks before. As we move into the end of 2011 and look forward, many of the deferred IPOs are being revisited. They represent around 42% of the filed backlog. So, if 2012 is reasonably stable, there will be record IPO activity. This offers a unique and very attractive opportunity for public equity investors.
If the markets remain stable, we can expect record numbers of IPO exits, as funds seek to return capital to their limited partners as they begin to map out the next wave of fundraising. Large numbers of sponsor IPOs were put on hold in Q3 because of market volatility but are now back in play. They include some very high quality assets bought during the leveraged buy-out (LBO) boom of 2006/7 that should be well worth looking at if they are correctly priced. While new LBOs have been scarce and the credit markets volatile, the strong fundamentals and general resilience of the high yield market will continue to offer attractive financing. LBO volumes will never return to 2006/7 levels but we easily could see USD100 billion in volume in 2012 or 2013. I also predict that we will see more private equity firms going public via listings, giving us the opportunity to observe the inner workings of these firms some of which are among the most innovative, creative institutions in operation today.
Investing: Hunting for deals, moving into new asset classes The key challenge for private equity firms in 2012 lies on the investing side. Private equity funds have around USD500 billion of capital that has yet to be invested but many have found it hard to find suitable assets. At their core, most private equity firms practice the narrow discipline of controloriented, leveraged buyout investing. They seek 20% IRRs and at least a two times multiple of invested equity. While there is substantial unspent capital in PE hands, few public companies have been willing to entertain bidders and corporates flush with cash have been reticent to sell even non-core businesses. In fact, only USD72.7 billion of public to private transactions have occurred, cumulatively in the three years, since January 2009, down from USD275.8 billion at the peak in 2007. One catalyst for increased deal activity could be a sustained rally in high yield combined with flat equity markets: which could cause corporates to ramp up divestitures of non-core assets and use proceeds to buyback undervalued stock.
The dearth of deal activity has driven sponsors to comb through each others portfolios in search of gems they believe may yield incremental return under new ownership. Since 2010 there has been USD45 billion of sponsor-to-sponsor deals such as the sales of Total Safety, Associated Materials, BakerCorp and American Tire Distributors To address the issue of 'sellers remorse', 2011 saw numerous creatively-structured deals where sellers disposed of 49-51% stakes, thereby retaining substantial upside while realising liquidity and creating a path to an exit. Examples are Tycos sponsored spin of EMP and CVCs sale of a stake in Univar. We expect to see more of these in 2012. Sponsors have also looked exhaustively at portfolio company tuck-in acquisitions where they can boost growth through smart synergised deals: this focus on investing and growing successful portfolio companies will continue and is likely here to stay. Sponsor investments have been spread very broadly across industries, with significant activity in the more traditional defensive sectors such as healthcare, consumer products and business
First, the quality of sponsor-owned companies is better than ever: in the LBO boom of 2006 and 2007, many sponsors bought 'category killer' best in class operators across industries, in addition to the traditional value plays. The companies now going public have been tested and proven through the global financial crisis and in most cases are re-emerging in fighting trim. Second, the selling sponsors invariably will continue to own the lions share of the equity postIPO, aligning their interests in maximizing value for all shareholders. The only mistake they can really make is to overprice the IPO which would put their ultimate exit in jeopardy. Accordingly, sponsor IPOs in recent years have outperformed non-sponsor IPOs. More Public PE Firms Finally, 'private' equity has become much more public as some of the industry leaders have themselves become public companies in recent years. 2012 will see continuation of this theme and some new entrants in the public markets. This gives public investors more opportunity to observe the inner workings of these firms and the contrasting investment theses and business models. As the buyside seeks to better understand how to value PE firms, we will watch as the public PE firms continue to grow and diversify their businesses while maintaining a focus on their core competencies. Whether public or private, private equity firms will continue to be some of the most interesting players in the market and will find creative ways to invest in volatile times.
Chris Colpitts, Richard Hart and Leslie Pfrang Technology Coverage Team
Technology Cloud computer land
In 2012 we expect to see an acceleration of several trends firmly established in 2011. We will see continued growth in companies such as Facebook, Twitter, and Zynga as social networking becomes embedded in more and more applications for consumers and enterprises.
Mergers will continue among large enterprise software and hardware vendors as cloud computing forces the kind of vertical consolidation heralded by Oracles acquisition of Sun and Dells acquisition of Force10. Growth in software delivered as a service (SaaS) will accelerate as enterprises seek operational and technological flexibility. Meanwhile, use of tablets and smartphones in the enterprise has proliferated and is requiring rapid changes in IT infrastructure. All this requires greater investment. Bears believe that the events in Europe and a tired US consumer will reduce growth in IT spend, which Gartner says was 7% in 2011. However, during 2009, when US GDP growth was negative, revenue growth among public SaaS companies was still positive on an average basis. Similarly, in 2012, while enterprise IT spending is expected to grow only 3.9%, investments in cloud computing technologies and services are expected to increase by 19%. The rapid adoption of new mobile technologies and the need to manage and analyse ever greater amounts of data are among the other trends that will drive technology investments in 2012 and beyond. 1. Social networking Facebook hit 800 million active users in 2011. These users installed an average of 20 million apps every day, keeping over 180,000 developers employed. Faced with a generation of knowledge workers that want to bring the value of collaboration and networking to the workplace, enterprises are gearing up investments in similar platforms to get closer to the consumer and better market their products. 2. Mobility The emergence of the Apple iPhones, iPads and Google Android devices has ushered in the era of BYOD (Bring Your Own Device) to the enterprise, unseating a carefully controlled laptop and Blackberry-only landscape. In a survey of CIOs by Computerworld, 87% of respondents revealed that their employees used personal devices for work-related purposes. The growth in these devices the iPad grew 166% in the last year has in turn driven the need for cloud computing as users demand access to the same data and applications regardless where they are and what device they are using. Many of the Google and Apple smartphone apps are being adopted by enterprises, creating a new category of high-growth software and internet companies. 3. Cloud computing Deployments of cloud computing technologies and applications are expected to triple in the next two years. In preparation for what may amount to over USD50 billion of spend over the next three years, large technology vendors such as IBM, Oracle, SAP, Microsoft, Google and Amazon are already building the infrastructure to accommodate the influx. This will lead to larger and more consolidated data centers as companies seek economies of scale. In 2012 growth companies will debut in the public equity markets and mature companies will finance growth in the equity and debt markets. How can we not be bullish?
Darren Campili Head of EMEA Healthcare Group
Healthcare Whats ahead for 2012?
Amid declining returns on R&D, global healthcare companies will be forced to find new ways to deliver shareholder value through accelerated investment in emerging markets and M&A.
Innovation is the key to growth in developed markets, yet it is becoming harder and harder to achieve. To add insult to injury, institutional investors ascribe little or no value to healthcare pipelines and are lobbying for the return of cash through dividends and share buybacks. As a result, global healthcare companies are turning to emerging markets and to acquisitions, divestitures and joint ventures to better position their businesses for future growth. Why is innovation-led growth challenging? The pharmaceutical industry is absorbing significant shortfalls in revenues from expected patent expirations. The top 12 global pharmaceutical companies face a cumulative USD72 billion1 potential loss in revenues from upcoming US patent expiries over the five years through 2016, or 14% of 2010 revenues. A similar decline is expected in Europe. At the same time, the industrys ability to replace lost sales through pipeline development alone is being called into question. Escalating R&D costs, longer development times, high failure rates, stagnant progress on US Food and Drug Administration ('FDA') approvals of new drugs, and an increasingly risk-averse regulatory environment are making it hard for the pharmaceutical sector to maintain returns on R&D above the cost of capital.
Since 2004 new FDA approvals have remained relatively steady at between 18 and 36 per year2, while R&D expenditure has continued to increase in absolute terms. The top 12 global pharmaceutical companies are spending an average of 15%3 of sales on R&D, or an average USD4.5 billion each per year. Why is large-cap pharma so enamoured with emerging markets? Healthcare spending is set to grow more than two times faster in emerging markets than in developed markets from 2010 to 2015, with spending in India, China, Russia and Latin America forecast to rise 9.7%4, compared with 3.9%5 in the developed markets of the US, Japan and Europes five largest economies. Whilst this growth is from a relatively low base compared with developed markets, it accounts for a substantive portion of the nominal increase over the period. The growing middle class is not the only key driver for emerging markets. The attractive payer mix, which is significantly out-of-pocket spend (about 80% of overall pharma spending in India, Brazil and Mexico and 60% in China and Russia), means that companies are less reliant on governments and other payers, that have come under pressure in developed markets, for revenues.
Evolving corporate strategies In our view, global healthcare providers have not yet done enough to reposition their business models to respond to the pressure from governments, payers and patients to share the burden of rising healthcare costs. Once, drug companies focused on developing blockbuster products that would generate more than USD1 billion of annual revenues. Now they are struggling to discover and bring these cash cows to market. Many of the biggest incumbents can no longer justify their size and infrastructure without making acquisitions or restructuring their business. Several themes have emerged, each of which is largely dependent on a companys current asset composition and future ambition, including: 1. Reduced R&D investment: the decrease in R&D productivity is leading to a reduction of in-house R&D, with R&D and M&A viewed as interchangeable. Outsourced innovation provides the purest incentive for entrepreneurial management teams to deliver the innovative products that will become the future portfolio of pharma. The challenge is financing. 2. Consolidation: mega-mergers have long been a strategic feature of the
pharmaceutical industry and have shaped todays leading companies. Tack-on acquisitions in areas impacted by generic competition should also continue. 3. Reducing corporate complexity: a number of corporate restructurings and divisional sales have emerged, focusing on core profitable operations and aligning incentives for mid-level management. Examples include Pfizers review of its Animal Health and Nutritional businesses; Abbotts proposed separation into two companies, Diversified Medical Products and Research-Based Pharmaceuticals; and AstraZenecas sale of its Astra Tech business. 4. Diversification: industry players have responded to the fear of the patent cliff by diluting their reliance on the 'small white pill' to embrace a hybrid model that combines pharmaceuticals with diagnostics, consumer healthcare, animal health and generics, which all tend to benefit from longer product lifecycles. Emerging markets M&A The robust growth in healthcare projected in emerging markets will continue to attract the attention of multinational pharmaceutical companies, despite the significant organic growth and M&A activity that have already taken place in recent years. Where
local incumbents historically outpaced their multinational peers, bolstered by the resistance of shareholders and governments to foreign buyers, a tougher economic and competitive environment and lofty valuations have made sales more attractive. Examples include Abbotts acquisition of Piramals India based Healthcare Solutions business and Hypermarcas acquisition of Brazilian rival Mantecorp. Meanwhile, for global players, emerging market acquisitions offer a way to deploy rather than repatriate their swelling offshore cash reserves. Multiple strategies will emerge We are likely to see a myriad of strategies in the years to come as companies manoeuvre through the minefield of modern healthcare. Although we do not expect emerging market expansion, M&A and corporate restructuring to be the cure for all developed market ailments, they do provide a near term response to investors demand for long-term growth while also buying time to address the more fundamental issue of how to restructure developed market businesses.
1. Evaluate Pharma, US product sales from products expiring within 1 year (20112016) 2. Food and Drug Administration, NMEs approved (filed under NDAs and BLAs) 3. CapitalIQ 4. Business Monitor International, healthcare expenditure at constant exchange rates 5. Business Monitor International, healthcare expenditure at constant exchange rates
Financing, Investment & Risk Management

Bond Market Outlook Equity Market Outlook Commercial Mortgage Backed Securities Art
5.1 Financing, Investment & Risk Management
Zia Huque Global Head of Global Risk Syndicate
Bond Market Outlook Outlook for 2012
The deleveraging cycle that started with homeowners in 2007, should ultimately come to a culmination with sovereigns in 2012. The negative feedback loop from stressed sovereigns to banks remains very prevalent for financial issuance, while corporate fundamentals will be tested as global growth slows. However, as we saw in 2011, there will be regional divergence across debt markets. US credit markets will likely continue to show a remarkable resilience to exogenous pressures, with investment-grade borrowers having the ability to access capital continuously at price. In contrast, our opinion is the EU market will be more sensitive to sovereign event-risk, due to proximity. From an issuer perspective, the decision to access one market over another for debt funding needs is not always as straightforward as lowest cost of capital. Many European corporates, for instance, have been reluctant to access the US capital markets given the documentation process, additional reporting disclosure and legal opinions required, while large US corporates have traditionally accessed the Eurobond markets to diversify funding needs away from the home market. If the Eurobond market volatility continues in 2012, we believe US issuers will be less likely to continue to fund abroad while European corporates may be more willing to spend the added time and overhead costs required to access the US markets. However, like regional differences, debt markets will likely also see sector by sector rebalancing in 2012. Investment grade corporate debt markets will remain robust in 2012 helped particularly by exceptionally strong cash reserves and consequently squeezed supply. For example, the strength of balance sheets currently puts UK corporate cash reserves at 180% of UK GDP, or put another way 44% of the FTSE100 market-capitalisation. (Source: ONS)
If 2011 was a year of thinking the unthinkable, 2012 will be a case of living through the unthinkable. The fate and path of European sovereigns is likely to continue to be the driving force for global debt markets in 2012.
Globally, we expect three key drivers to corporate issuance in 2012: M&A driven sector consolidation, financial disintermediation, and debt-funded share buybacks. The M&A driven sector consolidation trend is already building momentum. With corporate funding levels at near historic lows on a yield basis, and equity valuations once again driven off fundamentals, its not surprising the current backdrop is ripe for consolidation. The bond markets would certainly welcome this supply. The market has already evolved to allow corporates to term out funding before the acquisition is consummated with the use of deal contingent language. This has allowed corporates to avoid drawing down costly acquisition facilities, an added incentive in an environment that has seen the cost associated with bridge facilities rising aggressively. Corporate treasurers no longer have the luxury of relying on a deep and at times subsidised loan market, as an economical alternative to capital markets funding. Bank wholesale funding costs have risen exponentially since 2007, while the full effects of balance sheet deleveraging and RWA scrutiny has put added pressure on an already challenging environment for corporate/ bank loan refinancing conversations. In the financial debt sector we expect funding costs to continue their highbeta relationship with sovereign funding costs. Jurisdictional discrimination will continue to drive market access for term funding and market capital. Significantly in 2011 we saw investors seek refuge in the more stable and benign covered bond space in times of market volatility. This growth of record covered bond supply has been triggered by the lack of access of many peripheral European banks to the senior unsecured space. Our opinion is this redistribution of funding mix will be at the fore in 2012. However, given the constraints of encumbering balance sheets further,
covered bond supply is unlikely to be sufficient to plug funding gaps. With this, market attention has turned to 2012 funding needs, and we estimate this to be in the region of EUR762 billion across government-guaranteed, covered, senior and subordinated bonds for European banks. Significantly 78% of this funding is from banks from France, Italy, Spain and Germany. Importantly less than 7% of the financing needs in 2012 are for banks from Portugal, Ireland or Greece, which all have access to the European Central Bank -12mth/13-mth LTRO for liquidity lines. [Source: Dealogic] Volatility across the financial institution group (FIG) capital markets will likely continue. However, if institutions can raise capital via balance sheet reduction, asset disposals and liability management the greater the chances that banks can reduce the bilateral negative sovereign feedback loop. Market access for banks will remain regionally driven, with Northern European banks at the fore. Another key component of 2012 financial debt markets will be capital. Finalisation of Basel 3 and Europes CRD4 implementation should occur in 2012, giving those that have access to markets the ability to raise hybrid capital. Significantly, the EUR106 billion of capital that the European Banking Authority has deemed requisite for European banks to withstand European sovereign liabilities, can be met by hybrid and contingent capital debt securities issued in 1H 2012. Contingent capital securities issued by Rabobank and Credit Suisse will provide a likely blueprint for strong issuers, while government injected hybrids will form a significant proportion of the capital shortfall of more challenged banks. What will remain consistent in 2012 for the debt capital markets is the brevity and depth of issuance. Composition will differ from historical norms, however we believe volumes will remain elevated.
Edward Sankey Global Co-Head of Equity Syndicate
Equity Market Outlook Prospects for issuers
2012 could be a busy year for the Equity Capital Market (ECM) if market conditions stabilise. There is a large backlog of deals from 2H 2011 as well as recapitalisation and privatisation deals that could come to market.
ECM 2010 Full Year

Pos. 1 2 3 4 5 6 Sector Finance Oil & Gas Real Estate/Property Computers & Electronics Insurance Utility & Energy Auto/Truck Mining Transportation Healthcare Subtotal Total
Source: Dealogic. Full Year 2010
Deal Value (USDm) No of Issues 252,781.27 137,220.83 77,206.98 68,959.24 67,950.10 57,644.79 55,535.45 50,730.22 36,921.47 33,565.14 838,515.49 1,061,810.55 849 620 464 857 71 226 117 1,233 196 655 5,288 7,599
Pos. 1 2 3 4 5 6 7 8 9 10
Issuer Nationality United States China Brazil Japan Canada United Kingdom Hong Kong Australia Germany India Subtotal Total
Deal Value (USDm) No of Issues 244,561.32 220,362.03 95,332.95 64,593.94 42,870.24 39,417.39 36,700.08 34,361.56 32,665.58 30,711.03 841,576.11 1,061,810.55 1,528 897 46 270 1,078 455 325 936 135 200 5,870 7,599
Despite volatile market conditions, the primary equity markets remained active during 2011 with issuance down just 4% year-on-year at USD545 billion for the first nine months. The biggest issuers were financials which raised USD142 billion, over 20% of the global total, with real estate, oil and gas, tech and resources being the other dominant sectors. The biggest growth in volumes compared to 2010 was in the chemical and metal sectors which raised nearly USD50 billion between them. As in 2010, US and Chinese companies accounted for the lions share of new issuance (29% and 16% respectively) with 45% of IPOs globally coming from emerging market issuers. But it is interesting to note that Chinese issuance fell much more sharply than US issuance: down nearly 50% versus a 20% decline in the US. Indian issuance declined significantly too while German issuance actually increased. Another trend worth picking up on is the increase in issuance by private equity funds which accounted for 13% of total deals in the first nine months of 2011, nearly double their share in 2010.
So what does 2012 hold? The pipeline is certainly robust with over 550 deals with a combined value of USD93 billion waiting to come to market. Some of these were launched or due to launch in 2011 but were put on hold because of poor market conditions that saw quarterly volumes fall to their lowest since 2009 in 3Q 2011. I would expect many of these deals to move forward as soon as we see some stabilisation in the macro economic and market environment. This is particularly likely on assets owned by private equity funds which will look to tap issuance windows as they appear. Another source of deals are the expected bank recapitalisations in Europe and European Union privatisations, both of which are likely to lead to significant volumes, market conditions permitting. European governments have over EUR300 billion of assets that could be part of a privatisation programme whether secondary sell downs or listings. A pick up in M&A could also boost volumes should there be financing requirements and, as we have seen though the last two years, corporate spinouts are also likely to be popular.
With secondary volumes still lighter on a relative basis and an increased proportion of that volume dominated by high frequency trading, if there is a marked change in sentiment we could see the institutional investor base using the calendar to reweight their exposure, as they did in 2009 and 2010 and the earlier part of 2011. But the key to the activity levels and indeed development of the calendar is the macro picture and how it plays out for the corporate universe.
7 8 9 10
ECM 2011 Full Year

Pos. 1 2 3 4 5 6 7 8 9 10 Sector Finance Real Estate/Property Oil & Gas Computers & Electronics Mining Utility & Energy Healthcare Insurance Chemicals Metal & Steel Subtotal Total
Source: Dealogic. 1 January to 14 November 2011
Deal Value (USDm) No of Issues 142,016.70 68,164.05 52,762.76 47,129.01 39,163.49 31,792.55 30,907.75 30,302.25 25,729.03 23,129.39 491,096.98 655,935.83 640 353 501 583 905 167 514 39 145 117 3,964 5,580
Pos. 1 2 3 4 5 6 7 8 9 10
Issuer Nationality United States China Canada Germany Australia Italy Japan United Kingdom South Korea Spain Subtotal Total
Deal Value (USDm) No. 192,159.52 106,943.18 39,648.99 38,755.59 23,536.64 21,603.45 20,068.37 15,081.18 13,852.19 13,682.61 485,331.72 655,935.83 1,171 566 868 100 742 29 183 384 116 26 4,185 5,580
Jonathan Pollack Head of Commercial Real Estate, Americas
Commercial Mortgage Backed Securities False boom, real dawn
Many have quipped that 2011 was a false dawn for commercial mortgage backed securities (CMBS). But while total US 2011 volume will be a middling USD30 billion around USD10 billion short of expectations a healthy process of product development and innovation has been taking place. CMBS volumes are consistent with the broader fixed income market, which has seen a near cessation of normal activity since early August, when the events in Europe raised volatility. The CMBS industry did not experience a false dawn in 2011 it had a false boom.
Bond market The first twelve months of CMBS 2.0 issuance was exclusively via 144A private placements, a response to investors call for more transparency. As illiquidity increased it became apparent that there werent nearly enough AAA investors to support consistent CMBS issuance, so Deutsche Bank, along with its partners, brought its August deal to market with public super-senior AAA securities. This was designed to be a new market benchmark, with simple structure and high credit enhancement, to attract a broader base of investors. We believe it has achieved this goal and all CMBS fixed rate deals since have employed this structure. We would expect more parts of the capital structure to be offered as public securities as the CMBS industry attempts to satisfy its core investors desires while appealing to a broader audience to generate more liquidity. The market also produced the first floating rate CMBS deals since the crisis, and launched a Markit index called TRX 2.0 to track performance of the rebuilding market. TRX potentially gives aggregators their first correlated hedging instrument. Competitive environment As we struggled throughout 2010 to build a consistent loan pipeline, we were just happy to put enough collateral together to finally get to market with the first deals of the post-crisis world. Then 2011 began, and suddenly competition was everywhere. Where it felt like we were competing with two or three investment banks on a regular basis in 2010, now there were
at least seven making a go at it, and several REITs and funds had established lending platforms. From June to August, the newly resurgent CMBS lending market got squeezed hard. The combination of a very full pipeline, the limited AAA investor universe, and shrinking fixed income demand due to the macro volatility picture, conspired to destroy the profitability of the industrys new pipeline. As the summer progressed and AAA spreads moved from 105 to 250bp over swaps, many of the new lending shops folded, including one investment bank platform so far. The false boom is over, and the competitive environment looks much like it did in 4Q 2010. We believe this is a good thing for the market. This market has the opportunity to establish a positive brand for post-crisis CMBS, and that was becoming increasingly difficult as competitors cut credit standards and increased leverage to win business to support their new enterprises. We need to maintain respect for risk and our investors, and continue to evolve the product to reach a broader community. With more CRE loans maturing in the coming years than have matured since 2007, CMBS is an important source of liquidity for the economy. Distressed market activity The bid-ask gap between investors and holders of distressed mortgages in the US collapsed in 2011. This has been driven by a number of factors, including increasing pressure from regulators on banks to use their earnings to cut legacy assets; greater competition in the investor community; and recently the availability of financing for portfolios of distressed mortgages. There is also
a sense, now that the shape of the recovery is clear, that sellers are not bottom-ticking the market. The highlight of the market this year was the competitive auction by Anglo Irish Bank of its USD10 billion US loan book. Most notable to us among the many revelations of that process was the fact that bids increased consistently throughout the month of August up to the final bid date. Clearly the depth of demand in this market was not impacted by the vanishing liquidity in the broader capital markets in the same time period. We are watching two themes closely for 2012. The first is the emergence of warehouse financing, whether it will remain consistent and how it will evolve (will NPL securitisation nirvana be achieved, for example). The second is how (not whether) the impending flood of CRE asset sales by European banks will impact demand and pricing in the space.
Alistair Hicks Curator, Deutsche Bank Art Collection
Art The waiting room
Most artists are action men and women. They dont like waiting around, but of course like the rest of us they have to.
Even the single-minded legends such as Lucian Freud or Frank Auerbach have waited at times for a response. Not that this was ever enough. Obviously nothing will replace the excitement of the first sale, the first exhibition or good review, but there is another awkward period in the waiting room, when artists are beginning to get the recognition they deserve but not yet registering on the international market. For art collectors, this time in an artists career can be a great time to buy: you can help remove an artist from purgatory. Though it is well to remember that you are betting against the market. The most interesting opportunities are often found among artists who produce deliberately difficult art as a way of challenging the market establishment. Yane Calovski, Mathilde ter Heijne, the Raqs Media Collective and the Yangjiang Group are all in this category for a variety of reasons. None of them as yet has a serious auction record, all of them have made works that change the way I see the world. The Raqs Media Collective from Delhi are one of the best known artist collectives in the world: they are represented by several good galleries and are an integral part of intellectual debate. Their most famous work Escapement uses a series of clocks to question the systems that rule our lives. They have suffered from the prejudice against collectives. The art market still subscribes to the old-fashioned precept of the solitary genius in his bohemian attic. There is also a volatility issue. Like pop bands, collectives have a tendency to break up. The Yangjiang Group come from the city of the same name in China, but its
leading member Zheng Guogu is also marketed as an international artist in his own right. Guogu experiments with photography, sculpture and installations, but retires at every opportunity to his lifes work of creating a real town of his own. Though made of solid materials it has the look of a playing card construction. This building work parodies the lack of planning in the surrounding cities, while revealing a deep regenerative spirit in the act of building. The theme of Yangjiangs main series equally demonstrates that regeneration cannot be produced by solely relying on traditional methods. They produce calligraphy on canvas and paper, but as they draw they drink, and slowly the figures dissolve into a passing resemblance of a Jackson Pollock. 99% of Deutsche Banks collection is made on paper, so we have Zheng Guogu in the collection, but not sadly yet the Yangjiang Group or Raqs. We have, however, named floors in Deutsche Bank Towers after Mathilde ter Heijne and Yane Calovski. Calovski perhaps suffered to a lesser degree than the bigger groups from the collective bias as his strongest early work was done in partnership with Hristina Ivanoska, who he then went and married. His work, like Zheng Guogu and the Yiangjiang Groups is about rebuilding society. There is a problem of scale as though his work is usually comprised of small fragmentary drawings, crumbs as he describes them, they are built into a large network. Mathilde ter Heijne is one of the most powerful feminist artists working in Europe. She claims to be the first women artist to turn her body into a sex doll: she replicated herself in blowup form for video performances. She
explores the statistics about why more women than men are prepared to be suicide bombers. She mainly makes videos and installations, but has also made several series of photographs that could be bought for home, such as Domestication, which with their doll-like Vermeer interiors, play on our desire to set up house. She inserts Alice in Wonderland type images of herself into her work. Alice was the creation of Lewis Carroll, a bachelor Victorian don. In Domestication, a prostrate Alice and upturned furniture indicate trouble in this idealised paradise. The blame for this violence is laid firmly at the door of outdated male thinking. Londons big galleries are celebrating the London Olympics with the largest names. The National Portrait Gallery and Blain Southern are giving Lucian Freud shows, while the Tate and Gagosian are devoting their largest spaces to Damien Hirst. Yet at the same time we should be remembering that the contemporary art market needs to constantly change. It feeds off change. I would be surprised if the work of most of these artists did not become part of the regular international auction circuit, but it is not their financial worth that is of primary importance. All of them are playing crucial parts in changing our culture for the better.
Zheng Guogu: Consume is ideal, to consume dispels despair
Financing, Investment & Risk Management: Research Viewpoints

The Ideal Portfolio European Financial Sector Risk
5.5 Financing, Investment & Risk Management: Research Viewpoints
Vinay Pande Chief Investment Advisor, Research
Figure 2: Euro Stoxx 50 OAS/ERP

Euro Stoxx 50 ERP Euro Stoxx 50 OAS/ERP Source: Datastream, Bloomberg Finance LP, PricewaterhouseCoopers, Standard & Poor's, MSCI, DB GMR.
Figure 3: S&P 500 OAS/ ERP

S&P 500 ERP S&P 500 OAS/ERP Source: Datastream, Bloomberg Finance LP, PricewaterhouseCoopers, Standard & Poor's, MSCI, DB GMR.
The Ideal Portfolio What to own
10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
In a world of unprecedented uncertainty, it is no longer possible to optimise investment portfolios on an asset class by asset class basis, nor are nave asset allocation strategies acceptable.
Figure 1: The ideal portfolio for 2012

Unlevered Portfolio (90%) plus Relative Value (10%) Long Equity Volatility Relative Value Trades Global Equities Long AUD 10-yr Swap 22.9 10.0 18.5 17.2
Credit EM Equities EM Linkers Gold Commodities
2.9 8.6 11.4 2.9 5.7
We should never assume that the future will resemble the past, unless there is strong reason to believe so. The experience of the stable 1980s and 1990s has caused many lazy habits to get institutionalised as conventional and acceptable practice as market participants are learning to their cost. More focused investment strategies are required. Our recommended multi-asset portfolio (see Figure 1) is designed to deliver profits in as many of the scenarios that we can anticipate over the next year from outright market crisis to sustained recovery. The portfolio is liquid and, for all intents and purposes, unlevered (with the exception of some relative value positions and some substantial long volatility or option positions). The portfolio is divided into five main parts: 1. Strategic assets: emerging markets equities and bonds, EMFX overlays, gold and commodities. These are assets we consider to have the biggest positively-biased asymmetric pay-off profile, on an option-adjusted valuation basis, across multiple scenarios. This involves an assessment of the nature and intensity of each scenario against the volatility adjusted valuation of the asset in question. 2. Defensive assets: principally long regulated utility positions in Europe. These are assets that have historically outperformed during periods of high volatility.
3. Defensive hedges: including equity variance swaps and a number of shortdated currency and rate option positions. These are positions that statistical analysis reveals to perform well in dislocated markets and market crises. 4. A relative value book, in which one of the largest trades is a short position in non-financial European equities versus selling protection on the iTraxx Crossover index. 5. A currency overlay of long emerging market foreign exchange versus EUR and GBP. There is currently no excess cash recommended but there are large cash positions available against the face amount of derivative positions. The rationale behind our mix of asset selections is as follows: we recognise that the unstable world we live in will not last forever. Indeed, we suspect that by the end of the decade, we will enter a world of lower real growth, of emerging market currency appreciation and of possible higher inflation. In such a world, owning the longestduration, highest real-yielding, assets available is a good strategy. Ideally these should be denominated in emerging market currencies (e.g. Brazilian inflation-linked bonds); or should be assets capable of being hedged back to emerging market currencies (e.g. Western European regulated utilities); or assets that mirror the behaviour of emerging market currencies (e.g. agricultural commodities, gold).
Figure 4: MSCI Europe non-financials ERP vs iTraxx Crossover 5-year CDS yield vol adjusted
MSCI Europe Non-Financials ERP iTraxx EUR Crossover 5-yr CDS (yield vol adj. rel. to MX Eur. Non-Fin) MSCI Europe Non-Financials ERP minus iTraxx EUR Xover 5-yr CDS (yield vol adjusted) 10% 8% 6% 4% 2% 0% -2% Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Source: Datastream, Bloomberg Finance LP, PricewaterhouseCoopers, Standard & Poor's, Markit, DBIQ, DB GMR
We think each of these asset classes should be bought whenever they are attractively priced, using capital accumulated by astutely navigating the current treacherous markets. We are overweight equities versus rates because our analysis indicates that the equity risk premium for equities is now at unprecedented levels versus rates, even on an option adjusted basis (see Figures 2 and 3). In credit, we focus on crossover paper because they have cheapened as much as equities (when you compare equity risk premia against volatility adjusted credit spreads) and seem to us to offer value (see Figure 4). The rationale behind our defensive hedge selections is as follows: we recognise that in the short-term, there is a very considerable risk of systemic market failures with about a 40% chance of negative shocks ranging from a prolonged bear market in sovereign bonds to a market crisis. Powerful policy medicine needs to be applied (and is being applied) to correct the imbalances of the past but there is no guarantee that these policy measures (some of which are just addressing the symptoms) will work.
Our defensive positions are selected using option-based analytical tools that identify asymmetric pay-offs: trades that should perform well overall in highly volatile markets and also when our strategic assets under-perform. The large out-of-the-money receiver position in Australian interest rates is intended to address a deflation scenario, in which Australias strong domestic economic fundamentals are overwhelmed by global fundamentals. Large short dated EUR put options are designed to protect a multi-currency portfolio from USD appreciation, especially in a euro crisis scenario. We are looking for cheap options on assets or derivatives with large asymmetric pay-offs.
Levered Portfolio (Long Options) Note: option positions face amounts as a percentage of the unlevered portfolio are adjusted by the current deltas delta of the option 0.0 0.1 20 15 10 % unlevered portfolio exposure 5 0 Long Equity calls Long Payer Swaptions (USD, GBP) Long Receiver Swaptions (AUD) Long Currency Options
Currency composition (Original Unlevered Portfolio) LatAm Asian ex JPY Other USD 12.4 7.7 9.8 54.8
Gold and Commodities EUR GBP JPY Currency Composition after FX overlays
8.7 6.2 0.2 0.3
Short EUR, USD and 5.0 GBP bskt vs. Long EM FX bskt Short $ long 4-mo RMB NDF 5.0 Long CAD & NOK TWI 5.0 Short EUR long USD 5.0 Short GBP long JPY 5.0
Short AUD long JPY Un-hedged Source: Deutsche Bank
5.0 70.0
Jean-Paul Calamaro Global Head of Quantitative Credit Strategy
European Financial Sector Risk Hedging systemic risk in the European financial sector
How are European financials reacting to the systemic risk build-up and to the policies and measures European officials have taken to date?
1. In the latest sovereign crisis episode we find that the market has placed more importance on the banks potential sovereign losses than on the institutions capital levels. This is a strong statement on the part of the market because bonds of a banks own sovereign typically carry zero risk weight in risk-based capital calculations. Measures European authorities can undertake to improve the financing profile of sovereigns under pressure, combined with the banks own efforts to reduce sovereign holdings, are likely to provide greater benefits than an across-the-board recapitalisation intended to absorb potential sovereign exposure-related losses.
2. The most salient driver of credit spreads in the European financial system is a systemic risk factor that alone explains over three-quarters of overall financials spread variance. The amount of widening bank spreads experienced as a result of an increase in systemic risk varies across banks and points in the capital structure. The less widening they experience per unit of carry, the more attractive they are. To date, the market apportions greater value on average to banks in the Netherlands, Switzerland and the UK than to banks in Belgium, France, Italy, Portugal and Spain (see Figure 1).
Figure 1: Systemic risk sensitivity per unit of carry The market apportions greater value on average to banks in the Netherlands, Switzerland and the UK
Source: Deutsche Bank Quantitative Credit Strategy 28% 26% 24% 22% 20% 18% Most Attactive 16% 14% 12% 10% BE FR IT PT SP CH NE UK
Least Attractive
3. The senior/subordinated bank spread relationship appears to be significantly influenced by systemic risk. Sovereigns under pressure tend to impart systemic risk onto their banks. Systemic risk absorption is particularly high at the senior (default remote) part of the capital structure. For a selected number of relatively 'high quality' banks in Spain and Italy, senior spreads are wide relative to sub. Senior spreads are pressured wider due to a widening in Spanish and Italian sovereign spreads while the fundamentals of these banks dont currently justify subordinated spreads as wide. The opposite holds true in Germany (Figure 2). Normalisation would occur if sovereign spreads move tighter or if continued widening in these leads investors to question the fundamental strength of these banks, pushing subordinated spreads wider. 4. European bank requirements to increase core Tier 1 capital levels to 9% in order to provide a buffer from the sovereign crisis as well as recent amendments to Basel 3 regulation have triggered a re-pricing of Tier 1 hybrid securities. Until recently, these securities were priced to redemption at first call. Faced with potential equitisation, cash tenders below par or phase-out beyond first step-up date, these securities have experienced a significant downward
re-pricing. Even Tier 1 securities of the most robust European banks that do not face any of these scenarios are under pressure because of system wide funding concerns. What hedges can investors use to hedge systemic risk in the European financial system? Hedges come in various forms and are a function of focus, liquidity and attractiveness. Macro hedges tend to offer better liquidity but tend to be more diffuse. Micro hedges tend to be more attractive than macro hedges when the latter are crowded. Cross-asset class hedges may be the only option available when liquidity dries up or insurance is expensive in the target asset class. In all cases there is a trade-off between markto-market and tail risk hedges. No vanilla credit hedges against a further rise in systemic risk in the European financial system are cheap at present. The only ones that offer some value relative to standard credit index shorts (eg iTraxx.Fin, SovX) are micro hedges. These involve buying protection on selected senior/sub CDS on French and Italian bank and insurance credits. These hedges fall directly from the framework discussed in Point 2 on the previous page.
Looking beyond credit into equity space, Mar-12 put spreads on E-Stoxx 50 (SX5E) or EURO STOXX Banks (SX7E) look attractive relative to credit hedges. We recommend Mar-12 8595% put spreads i.e. investors buy a Mar-12 put at 95% strike and sell a Mar-12 put at 85% strike so that the trade has a maximum upside of 10%. The maximum upside to cost ratios of the two put spreads are about 3.4x and 2.9x respectively. Broader equity market hedges take advantage of the highly inverted volatility term structure. This is to be expected in a stressed environment as the market anticipates volatility to be high in the short term and then to revert back to more normal levels in the medium term. Longer-dated options are currently attractive given liquidity and pricing level (SX5E Mar-12 ATM implied vol is 3 vol points lower than Dec-11). Buying longer dated volatility would benefit from sustained pressure in the financial system through March expiry. FX hedges, in particular EUR/USD puts can serve as potential tail risk hedges. These are subject to more basis risk than the strategies mentioned thus far and require views on the future sensitivity of EUR/USD levels vs credit. However, tail risk hedges are scenario-driven and a wealth of historical scenarios can help establish potential costs and maximum draw downs. Hedging with EUR/USD puts can lead to cheaper hedges in periods typically associated with heightened concerns about European risk.
A material and sustained reduction in systemic risk requires action on two broad fronts: first, greater fiscal and political integration among eurozone countries; and second, breaking the inter-dependency between sovereigns and banks. Among several measures that would help break the negative inter-dependency between banks and sovereigns is a well designed bail-in mechanism. Such a mechanism would clarify and reduce European sovereign contingent liabilities, making explicit sovereign guarantees more valuable. It would also end the implicit subsidy of the banking sector forcing European banks to limit the scope of their business to justifiably profitable activities thus re-establishing the value in senior debt. The harmonisation of European deposit guarantee schemes based on a prefunding strategy would also help. Such schemes would reduce the pressure on the strained finances of European sovereigns and improve depositor confidence that these schemes have the needed funds in critical times. Until European officials embark on a credible path of reforms, systemic risk will continue to pose a threat to the financial system. And we will continue to recommend efficient hedges against a rise in systemic risk as opportunities arise.
Figure 2: Sovereigns under pressure impart systemic risk onto their banks
80
Probability of restructuring given a credit event %
CMZB
60
40
DexiaCL MONTE
20
Lloyds, RBS SANTAN, Intesa BESPL
10
20
30
40
50
60
5-year subordinated protection value (pts)

Source: Deutsche Bank Quantitative Credit Strategy
Regulation & Trading Technology

Regulatory Change Electronic Trading Centralised Clearing
6.1 Regulation & Trading Technology
Daniel Trinder Global Head of Regulatory Policy
Regulatory Change Whats ahead
In 2011 financial markets have seen a greater volume of regulatory proposals than at any time since the 1930s from updated capital and liquidity requirements for banks, to regulation of alternative investment funds and the creation of new macro-prudential regulatory bodies almost no aspect of financial market regulation has been left untouched.
of 5% above or below prices from the preceding five minutes. Circuit breakers will also be under debate in Europe as part of MiFID proposals whilst the revised Market Abuse Directive (MAD) seeks to define HFT strategies that constitute abuse such as quote stuffing, layering and spoofing and harmonise sanctions across Europe. Commodity derivatives will continue to be another area of focus in 2012, with regulators in both the US and the EU proposing position limits in reaction to political concern about volatility in food and fuel prices. Regulators have focused on the rapid growth and complexity of structured products, particularly ETFs, as a source of systemic risk. ESMA is introducing new transparency and disclosure requirements while MiFID proposes banning inducements and limiting the sale of certain products to retail investors. There is a risk of a wider range of products being brought into scope and additional restrictions being introduced through the UCITS review. OTC reforms The story of OTC reform for 2011 was one of delay, missed deadlines and divergence between the EU and US. It is a narrative that looks set to continue, making the end-2012 G20 deadline for OTC derivatives to be centrally cleared, reported and traded on exchanges look extremely ambitious. In the US, progress on Dodd-Frank implementation has been slowed by political wrangling and regulatory capacity constraints, whilst in Europe no political agreement yet exists on the final shape of the European Market Infrastructure Regulation (EMIR). There
is also significant uncertainty as detailed rules are not finalised on key aspects of the proposals, such as what margin requirements for non-cleared swaps might look like and what classes of derivatives must be cleared. It is also unclear how these two regimes will interact with each other, let alone the rest of the world. For example, while Dodd-Franks clearing requirements apply to all swaps, EMIR covers OTC only; US authorities favour lowering eligibility criteria for membership of CCPs, while EMIR will set higher standards for CCP to ensure clearing members are able to withstand a default. The US and EU are both intending to adopt margin requirements for noncleared swaps and momentum is starting to build for global minimum standards for margin requirements. Regulatory capital Although a new international agreement on capital and liquidity requirements has been reached with Basel 3, 2012 will see critical debates around implementation in the EU and US. With Europe moving ahead quickly to propose legislation, the US continues to debate whether Basel 3 is the right approach and is consistent with the Dodd-Frank Act. In the current environment, international regulators are starting to admit that changes may be required to other elements of the Basel accords in order to adjust to realities in financial markets. For example, revisiting the list of eligible assets to cover liquidity needs in a period of stress or questioning the risk-free status of sovereign debt. Concerns remain that there is an inherent contradiction between the significantly reduced Return on Equity for the financial sector that will result from Basel 3 and the pressure to increase regulatory
capital in a short period of time. This will be exacerbated by the recent agreement to require many EU banks to reach a 9% Core Tier 1 capital ratio after accounting for exposures to sovereign debt. These broader macroeconomic concerns are combined with the risk of unintended effects on lending to the broader economy which will be squeezed by more liquid assets on balance sheets, general bank deleveraging and undrawn facilities being heavily penalised in a number of areas of the framework. These trends will accelerate as the January 2013 deadline for implementation of Basel 3 approaches. Taxes, levies and structural changes The increased political focus on the financial sector stemming from continued economic uncertainty and consequent fiscal pressures on governments could play out in unpredictable ways during the course of 2012. In Europe proposals for a broadbased Financial Transaction Tax are already on the table which, if adopted in their current form, could significantly alter the economics of cash and derivatives markets. Meanwhile the retail ring fencing proposals coming out the UK will create templates for structural interventions to tackle too-big-to-fail concerns which will generate debate and interest from other jurisdictions during the course of the year.
In spite of the fact that many existing regulatory initiatives on both sides of the Atlantic are still not finalised, the flow of new proposals will continue through the course of 2012 with significant implications for all market participants. The increased politicisation of regulatory debates will be a key theme in 2012. In the US, the political focus has shifted to economic growth and the competitiveness of US banks which has led to a slowing in the pace of DoddFrank Act implementation. In contrast, in light of the eurozone crisis, the political dynamics in Europe are likely to see demands for regulatory intervention increase. New initiatives market regulation Whereas 2011 saw international regulatory debates focused largely on prudential issues, 2012 will see increased attention on regulating markets and products. Alongside familiar proposals such as changes to rules on capital and liquidity and reform of OTC derivatives, regulators will also be under political pressure to address risks around High
Frequency Trading (HFT) and specific products such as Exchange Traded Funds (ETFs). The most significant regulatory initiative of 2012 will be the revised Markets in Financial Instruments Directive (MiFID). This will dominate the regulatory debate in Europe and could fundamentally alter market structures through a significant extension of pre- and post-trade transparency across all asset classes. It will also impose new requirements for HFT, commodity derivatives and enhance investor protection. These far-reaching proposals with additional requirements for third country firms will, if implemented in their current form, be felt well beyond the EU. The focus on HFT which started in the US with the 2010 flash crash has already reached the EU and looks set to be a key theme through 2012. In the US, the SEC, having already implemented a single stock circuit breaker programme, is now proposing a limit up limit down mechanism, which would require trades to be executed within a range
Global Regulatory Proposals OTC Derivatives
Summary Central clearing and reporting to be required, with standardised products traded on-exchange or electronically, with additional capital requirements for noncleared trades
Impact Could reduce liquidity and the ability to fully hedge exposures Risk of divergence of rules to make it harder to deploy capital across borders
Timing G20 agreed to implement by end 2012, but implementation in EU and US likely to stretch into 2013 and possibly beyond CPSS-IOSCO to issue final principles in early 2012
European Market Infrastructure Regulation (EMIR)
Mandates central clearing for eligible OTC derivatives and requires all derivatives to be reported Open access rules for CCPs and trading venues Pan-EU rules requiring notification and public disclosure of significant net short positions Ban on naked credit default swaps Creation of European passport for alternative funds Requirements on governance and remuneration Strict rules governing depositories and outsourcing
ESMA to recommend Potential to reduce ability to fully hedge detailed requirements by end exposures June 2012 Need for clients to reassess clearing solutions Regime to take effect end 2012 Possible reduced liquidity in equity markets Naked CDS ban potential significant negative impact but depends on detailed ESMA requirements Hedge funds are for the first time bound to prudential and conduct rules Stricter depository liability will have farreaching effects on custodian businesses In principle agreement reached To take effect November 2013, along with detailed rules ESMA submitted its initial advice on level 2 rules to the European Commission in November 2011 Takes effect July 2013 Draft Legislation published July 2011, with agreement taking up to a year Implementation of main components phased in from January 2013 Legislation expected December/January 2012 Unlikely to be agreed by all EU Member States, but potentially starting in 2014
Short Selling & CDS
Financial Market Infrastructure
These infrastructures will become New global standards for systemically preconditions for executing transactions; important: payment systems; central their safety and soundness will be critical securities depositories; securities settlement for market efficiency and stability systems; central counterparties; and trade repositories New principles for regulation and oversight of commodity derivatives market Includes recommendation that regulators use position limits and position management tools Greater transparency will benefit price formation and gives regulators more oversight to spot abuse However, position limits potentially hinder client activity and liquidity
Alternative Investment Fund Managers Directive IOSCO principles endorsed by G20 November 2011; IOSCO to report on implementation by end 2012 IOSCO initial recommendations endorsed by G20 in November 2011; further work requested by mid-2012 FSB initial recommendations approved by G20 November 2011 FSB to oversee five work streams in 2012 Phased in between January 2013 and January 2019 US Regulatory Proposals Volcker Rule Implementation from January 2016 Insurance work to be complete by November 2012 OTC Derivatives G20 endorsed framework November 2011 FSB timetable is for resolution plans to be submitted to regulators by end 2012
Commodities
High Frequency Trading
Initial recommendations on market integrity High level principles only to date further proposals expected in 2012 and efficiency. Includes measures to address risks posed by high frequency trading
Capital Requirements Directive IV Implements Basel 3 in EU, raising level and quality of capital and introducing liquidity and leverage ratios Includes capitalisation of bank exposures to CCPs and CVA charge for derivatives Crisis Management Recovery and resolution planning, powers for regulators to resolve failing banks and bail-in debt 0.1% tax on share and bond transactions and 0.01% on derivatives with EU financial institutions
Harmonisation across all 8,000 EU banks an important step towards single rule book Same impacts as Basel 3 with potential for divergence from international framework
Shadow Banking
Greater oversight and regulation of shadow banking, focusing on bank exposures to sector, money market funds, securities lending and repos
Potential for exposure limits or capital requirements for certain counterparties
Questions about feasibility/investor appetite for bail-in debt Relocation of securities markets and derivatives
Financial Transaction Tax
Basel 3
Pressure on cost of capital and return on Enhances quality and quantity of bank equity, leading to balance sheet reduction capital and introduces liquidity requirements across industry and leverage ratio Conservative approach to counterparty Strengthens counterparty risk framework, risk could impede banks ability to provide through capitalisation of bank exposures to clearing services CCPs and CVA charge for derivatives Additional 1-2.5% common equity requirement for banks that are global systemically important financial institutions (SIFIs) Global regulators assessing insurance SIFIs Systemically important firms to submit recovery and resolution plans to regulators. Firms resolvability to be assessed by regulators Potential for global regulators to consider bail-in debt at later stage Bank surcharge adds to the impact of Basel 3 and introduces competitive distortions between firms Insurance companies may also be subject to additional requirements Significant process to implement but key to managing another crisis Resolvability assessments may have implications for institutions business models and structure Questions about investor appetite for bail-in
Summary Ban on proprietary trading in deposit-taking banks, with exemptions for hedging and market making Limits banks investment in private funds Central clearing required for all derivatives deemed clearable by CFTC and SEC Exchange trading required for all swaps that are cleared; all swaps to be reported to repositories SEC proposal for single stock limit up limit down mechanism to limit variation in price SEC proposal for recalibration of thresholds in market-wide circuit breakers CFTC proposed position limits in 28 commodities, with exemptions for hedging Potential introduction of floating net asset value Potential capital requirements Dodd-Frank Act mandates capital requirements for banks and systemically important non-bank financials US rules expected to be broadly in line with Basel 3 and SIFI surcharge but unpredictability on timetable and detailed implementation Systemically important non bank financial companies to be identified by Financial Stability Oversight Council (FSOC) New Say on Pay votes implemented in 2011 Agencies proposed rule to implement clawback and deferral for large banks SEC to decide whether to adopt International Financial Reporting Standards in line with G20
Impact Heavy burden of proof on firms to demonstrate compliance with ban Elimination of P and L from proprietary trading Cleared derivatives being exchange traded will lead to bid/ask compression Non-cleared trades subject to greater capital requirements Limit impact of extreme price movements and mitigate market confusion by pausing trading during periods of extraordinary price volatility Potential to reduce liquidity and ability to fully hedge exposures Could negatively impact wholesale funding markets Basel 3 expected to only apply to largest banks with more than USD50 billion assets Potential additional requirements for foreign bank holding companies Potential for divergence from international framework Firms identified as systemically important will be regulated and have detailed reporting requirements to FSOC US rules implement global standards
Timing Effective 21 July 2012 under Dodd-Frank Act, but allows two year transition period Final rules on entity, product definitions and end user exemptions expected by end 2011, with other rule-making in H1 2012 Final rules expected end 2011/early 2012
SIFI Surcharge
Bank Resolution
High Frequency Trading
Commodities EU Regulatory Proposals Markets in Financial Instruments Directive (MiFID2) Summary Extends pre- and post-trade transparency requirements for equities to all financial instruments Requires sufficiently liquid OTC derivatives to trade on venues Harmonisation of rules for exchanges, electronic trading platforms and other trading venues Additional requirements for high frequency trading firms and commodities Strengthens and clarifies investor protection rules Impact Decreased liquidity/trading volumes and wider spreads, with restrictions on trading platforms all limiting trading choice for investors Harmonised risk controls in HFT protect against shocks, but requiring algorithms to market make will have severely negative impact Bringing all commodity traders into scope increases market transparency, but position limits for commodity derivatives hamper liquidity May change EU product distribution landscape The intent to manipulate/abuse leads to legal uncertainty for individuals and firms and is difficult for firms to plan for Timing Money Market Funds Draft legislation published October 2011 agreement could take a year or more Detailed technical rules from ESMA in 2013 Effective in 2014 at the earliest, more likely 2015
Final rule proposed October 2011 SEC expected to propose rules early 2012 Federal Reserve expected to propose rule on some elements of Basel 3 in Q1 2012
Capital Requirements
Shadow Banking
FSOC expected to begin designating firms as systemically important in 2012 Final rule expected Q1 2012
Market Abuse Directive
Extension of market abuse rules to all financial instruments including commodities Introduces new offence of intent to manipulate Defines specific abuses in high frequency trading Harmonised sanctioning regime
Draft legislation published October 2011 agreement could take a year or more Effective in 2014
Governance and Remuneration
Accounting and Valuation
Make balance sheets internationally more comparable
First half of 2012
Serge Marston Global Head of eCommerce Sales
Chris Hansen Global Head of OTC Clearing Sales
Electronic Trading Trends to watch
Centralised Clearing Adopt early or wait and see?
The electronic trading revolution that has transformed the equity markets in recent years looks set to sweep through other asset classes in 2012 and 2013 bringing with it new trading strategies, tools and challenges.
Large parts of the derivatives industry are going to move to centralised clearing regardless of what happens to Dodd Frank. Other regulatory changes notably Basel 3, CRD4 and Solvency 2, which will impose higher capital charges on providers and users of derivatives, make it economically inevitable.
and order slicing tools that calculate how to split up big orders to prevent moving the market. Smart communication systems have evolved that allow investors to listen in to trader commentary in real time as if they were sitting on the trading floor, and to analyse complicated financial variables like the difference between the volatility of different markets extremely quickly. Were starting to see banks develop systems that process information on client activity to pro-actively identify bespoke trades and hedges for individual accounts and work out what research and analysis they will be interested in at given points in time. Not every investor will want this service but some will appreciate the benefits it could bring. Another exciting development is the emergence of basis risk trading tools, which allow investors to trade the difference between two assets without becoming exposed to price movements between the execution of the first leg of the trade and the second. Further innovations in trading technology can be expected in 2012, opening up new opportunities for investors and traders across multiple markets. So the big question corporates and financial institutions need to ask is not is centralised clearing coming? but should I adopt centralised clearing now and get first mover advantage or wait until the details are clear and the process settles down? Every business will need to look at this issue from its own perspective but there are some fundamental issues that everyone should bear in mind. 1. There is an economic cost involved in shifting to centralised clearing. You have to post variation margins in cash, and only certain types of asset can be used as collateral for initial margin. 2. Protecting that collateral will be critical, as will the rules on how default waterfalls will progress through bankruptcy. We learnt this with Lehman in 2008. We are learning it now with MF Global. 3. Moving to centralised clearing will reduce counterparty risk (unless you are only executing trades with a AAA rated bank) but that risk will be harder to hedge because of the difficult of pricing CDS protection on a central counterparty clearing house (CCP) than is backed by dozens of different organisations. 4. If you cant hedge or get transparency on your hedges, this may lead to significant liability management complications. For many companies, these issues will outweigh the benefits of early adoption, and its interesting that while some institutions have made the move (mostly US organisations concerned about eurozone exposures) most have not. Nevertheless, given the inevitability of the move, it would seem sensible to make at least some preparations. One strategy that could prove useful is to novate (transfer) derivative positions from a diverse range of derivative providers to a single intermediary. This would give you one counterparty on all your derivative positions, one single standardised CSA agreement and the infrastructure needed to channel trades through to a single organisation: everything you will need, in fact, to shift to centralised clearing when the rules come into force. You would get used to daily margin calls requirements another requirement of centralised clearing and gain the ability to view your risk in a holistic way across your relationship rather than on a bilateral basis. Assuming the intermediary has a CDS spread of less than 300 basis points, it could also result in an immediate reduction in counterparty risk given the fact that derivative providers are trading at 350 basis points or more. A second, and additional strategy that could be worth considering is to set up a segregated account for collateral in a bankruptcy remote vehicle that ensured your collateral is protected in the event of a broker failure not least if you have chosen a single counterparty to provide Intermediation services. This would come at a cost not just in fees but in reductions in capital efficiency and the resulting drain in liquidity from the market. But given CCPs and regulators will require segregated collateral, companies may see it as a price worth paying for the experience alone. Looking forward to how the changes could impact the structure of the industry the shift to centralised clearing is likely to benefit brokers with the highest credit ratings and strongest balance sheets, providers of tri-party segregated services and providers of cash management services.
Equity trading has changed a lot since Instinet established the first electronic trading venue in 1969. Gone are the days when shares were only traded on one exchange by brokers that offered clients guaranteed prices on a fixed amount of shares, and the biggest traders were established financial institutions. Today, shares are traded on dozens of different venues, investors can trade directly with other investors and algorithmic computer programmes identify minute market dislocations and react to opportunities in micro-seconds. The benefits of these changes have been considerable. Trading volumes have soared, increasing liquidity and bringing down the cost of buying and selling shares. Prices have become much more transparent making it easier for investors to identify if they are getting a competitive price. But the changes have also made equity trading much more complicated. Instead of simply ringing up a broker and executing a deal in its full amount at a guaranteed price, investors now have to decide themselves what market to trade on, what price to offer or bid, and how to split up the order to get the best price. Over the past few years, similar trends have taken place in the foreign exchange
market with the rise of algorithmic FX trading tools, and we are now starting to see it happen in the rates market with the development of US Treasury algo strategies. The credit market remains some way behind but we expect it to follow in 2013. These changes are likely to have a significant impact on these markets just as they did on the equity markets: liquidity will fragment with volumes being spread across multiple markets, large trades will become harder to execute without moving the market, and we will see significant shifts in the liquidity and volatility of different assets and markets as high frequency traders focus on specific areas. The changes are likely to happen faster than they did in equities. The equity market took 30 years to reach its current state. The FX market looks set to reach the same level in 10 years. Rates could get there in five and credit in three. Numerous techniques that have been developed to help equity investors operate in this challenging environment are starting to become available for FX, rates and credit investors too. They include liquidity seeking tools that compare different markets to identify where investors will get the best price,
Disclaimers
MARKETING MATERIAL This document is intended for information purposes only. It does not create any legally binding obligations on the part of Deutsche Bank AG and/or its affiliates ('DB'). Without limitation, this document does not constitute an offer, an invitation to offer or a recommendation to enter into any transaction. We are not acting and do not purport to act in any way as an adviser or in a fiduciary capacity. We therefore strongly suggest that recipients seek their own independent advice in relation to any investment, financial, legal, tax, accounting or regulatory issues discussed herein. Analyses and opinions contained herein may be based on assumptions that if altered can change the analyses or opinions expressed. Nothing contained herein shall constitute any representation or warranty as to future performance of any financial instrument, credit, currency rate or other market or economic measure. Furthermore, past performance is not necessarily indicative of future results. This document does not constitute the provision of investment advice and is not intended to do so, but is intended to be general information. Any product(s) or proposed transaction(s) mentioned herein may not be appropriate for all investors and before entering into any transaction you should take steps to ensure that you fully understand the transaction and have made an independent assessment of the appropriateness of the transaction in the light of your own objectives, needs and circumstances, including the possible risks and benefits of entering into such transaction. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but we make no representation or warranty, expressed or implied, with respect to the fairness, correctness, accuracy, reasonableness or completeness of such information. In addition we have no obligation to update, modify or amend this communication or to otherwise notify a recipient in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. Opinions, estimates, projections and forecasts herein constitute the current judgement of the authors as of the date of this communication. They do not necessarily reflect the opinions of Deutsche Bank. Assumptions, estimates and opinions contained in this document constitute our judgement as of the date of the document and are subject to change without notice. Any projections are based on a number of assumptions as to market conditions and there can be no guarantee that any projected results will be achieved. Past performance is not a guarantee of future results. This material was prepared by a Sales or Trading function within DB, and was not produced, reviewed or edited by the Research Department. Any opinions expressed herein may differ from the opinions expressed by other DB departments including the Research Department. Sales and Trading functions are subject to additional potential conflicts of interest which the Research Department does not face. DB may engage in transactions in a manner inconsistent with the views discussed herein. DB trades or may trade as principal in the instruments (or related derivatives), and may have proprietary positions in the instruments (or related derivatives) discussed herein. DB may make a market in the instruments (or related derivatives) discussed herein. Sales and Trading personnel are compensated in part based on the volume of transactions effected by them. The distribution of this document and availability of these products and services in certain jurisdictions may be restricted by law. Any offering or potential transaction that may be related to the subject matter of this communication will be made pursuant to separate and distinct documentation and in such case the information contained herein will be superseded in its entirety by such documentation in final form. You may not distribute this document, in whole or in part, without our express written permission. DB SPECIFICALLY DISCLAIMS ALL LIABILITY FOR ANY DIRECT, INDIRECT, CONSEQUENTIAL OR OTHER LOSSES OR DAMAGES INCLUDING LOSS OF PROFITS INCURRED BY YOU OR ANY THIRD PARTY THAT MAY ARISE FROM ANY RELIANCE ON THIS DOCUMENT OR FOR THE RELIABILITY, ACCURACY, COMPLETENESS OR TIMELINESS THEREOF. DB is authorised under German Banking Law (competent authority: BaFin Federal Financial Supervising Authority) and regulated by the Financial Services Authority for the conduct of UK business. Securities and investment banking activities in the United States are performed by Deutsche Bank Securities Inc., member NYSE, FINRA and SIPC, and its broker-dealer affiliates. This document is prepared by [Deutsche Bank AG London Branch] and is distributed in Japan by Deutsche Securities Inc. ('DSI'). Please contact the responsible employee of DSI in case you have any question on this document because DSI serves as contact for the product or service described in this document. FUTURES Futures: The risk of loss in futures trading, foreign or domestic can be substantial. As a result of the high degree of leverage obtainable in futures trading, losses may be incurred that are greater than the amount of funds initially deposited. Unless governing law provides other, all transactions should be executed through the Deutsche Bank entity in the investors home jurisdiction. DERIVATIVES Options disclaimer: Derivatives and options are complex instruments that are not suitable for all investors, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Supporting documentation or any claims, comparisons, recommendations, statistics or other technical data will be supplied upon request. Any trade information is preliminary and not intended as an official transaction confirmation. In the US, read the http://onn.theocc. com/publications/risks/riskstoc.pdf or contact the sales desk at +1-212250-4960. Because of the importance of tax considerations to many option transactions, the investor considering options should consult with his/her tax adviser as to how taxes affect the outcome of contemplated option transactions. Please note that multi-leg option strategies will incur multiple commission charges. OTC DERIVATIVES This communication was prepared solely in connection with the promotion or marketing, to the extent permitted by applicable law, of the transaction or matter addressed herein, and was not intended or written to be used, and cannot be used or relied upon, by any taxpayer for purposes of avoiding any US federal income tax penalties or any other applicable tax regulation or law. The recipient of this communication should seek advice from an independent tax adviser regarding any tax matters addressed herein based on its particular circumstances. Principal protection: If applicable, the principal protection feature applies only if the securities or instruments are held to maturity. Please note: market values may be affected by a number of factors including index values, interest rates, volatility, time to maturity, dividend yields and issuer credit ratings. These factors are interrelated in complex ways, and as a result, the effect of any one factor may be offset or magnified by the effect of another factor. Calculations of returns: Calculations of returns on instruments referred to herein may be linked to a referenced index or interest rate. In such cases, the investments may not be suitable for persons unfamiliar with such index or interest rate, or unwilling or unable to bear the risks associated with the transaction. Products denominated in a currency, other than the investor's home currency, will be subject to changes in exchange rates, which may have an adverse effect on the value, price or income return of the products. These products may not be readily realisable investments and are not traded on any regulated market. The securities referred to herein involve risk, which may include interest rate, index, currency, credit, political, liquidity, time value, commodity and market risk and are not suitable for all investors. Not insured: These OTC derivative instruments are not insured by the Federal Deposit Insurance Corporation (FDIC) or any other US governmental agency. These instruments are not insured by any statutory scheme or governmental agency of the United Kingdom. These securities have not been registered under the United States Securities Act of 1933 and trading in the securities has not been approved by the United States Commodity Exchange Act, as amended.
Those organisations without a full suite of these services may inevitably look to partner and innovate to become more service provision orientated, driven toward higher P/E annuity based revenue streams and 'brokers' will start to morph more clearly into 'asset servicers', which may introduce healthy competition to the incumbent custodial and tri-party service providers. The economic cost of centralised clearing to end users cannot be finalised until rule making is completed in the US and Europe but conservative estimates indicate around USD2 trillion of additional collateral will be needed to margin the new world of bilateral and centrally cleared OTC trades. This will likely have a major impact on basis with some forms of assets (eligible as collateral) becoming much more in demand and less available, and others the reverse.
We can also expect a similar trend in the derivatives market with securities that can be centrally cleared becoming increasingly liquid, and those that cannot becoming less liquid. How will this play out? It all depends on the choices made by end users such as corporates which use OTC derivatives for hedge accounting purposes. These organisations will have weighed up the increased cost of using unlisted securities versus the precision they offer in hedging a particular risk. The decisions they make may have a significant impact on the structure of the derivatives industry going forward.
Disclaimers
Sections of this publication have been produced by the Research Department of Deutsche Bank and have been previously published. For relevant research disclosures please use this link https://gm.db.com/equities. The information and opinions in the research sections of this document were prepared by Deutsche Bank AG or one of its affiliates (collectively 'Deutsche Bank'). The information herein is believed to be reliable and has been obtained from public sources believed to be reliable. Deutsche Bank makes no representation as to the accuracy or completeness of such information. Deutsche Bank may engage in securities transactions, on a proprietary basis or otherwise, in a manner inconsistent with the view taken in this research report. In addition, others within Deutsche Bank, including strategists and sales staff, may take a view that is inconsistent with that taken in other research report. Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a recipient thereof in the event that any opinion, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. Prices and availability of financial instruments are subject to change without notice. This report is provided for informational purposes only. It is not an offer or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy. Target prices are inherently imprecise and a product of the analyst judgement. As a result of Deutsche Banks recent acquisition of BHF-Bank AG, a security may be covered by more than one analyst within the Deutsche Bank group. Each of these analysts may use differing methodologies to value the security; as a result, the recommendations may differ and the price targets and estimates of each may vary widely. Deutsche Bank has instituted a new policy whereby analysts may choose not to set or maintain a target price of certain issuers under coverage with a Hold rating. In particular, this will typically occur for 'Hold' rated stocks having a market cap smaller than most other companies in its sector or region. We believe that such policy will allow us to make best use of our resources. Please visit our website at http://gm.db.com to determine the target price of any stock. The financial instruments discussed in this report may not be suitable for all investors and investors must make their own informed investment decisions. Stock transactions can lead to losses as a result of price fluctuations and other factors. If a financial instrument is denominated in a currency other than an investor's currency, a change in exchange rates may adversely affect the investment. Past performance is not necessarily indicative of future results. Deutsche Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis. Foreign exchange transactions carry risk and may not be appropriate for all clients. Participants in foreign exchange transactions may incur risks arising from several factors, including the following: 1. foreign exchange rates can be volatile and are subject to large fluctuations, 2. the value of currencies may be affected by numerous market factors, including world and national economic, political and regulatory events, events in equity and bond markets and changes in interest rates and 3. currencies may be subject to devaluation or government imposed exchange controls which could negatively affect the value of the currency. Clients are encouraged to make their own informed investment and/or trading decisions. Past performance is not necessarily indicative of future results. Deutsche Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis Deutsche Banks Cash Return On Capital Invested (CROCI) valuation metric attempts to transform an accounting return to an economic return. Cash flows are calculated on an operating (pre-exceptional) basis and compared to the 'real' (economic) invested capital in a business. The latter may include items such as R&D or brands that cannot appear on a balance sheet under current accounting standards. A judgement on current share price valuation can be made by comparing the current and expected Cash Return On Capital Invested with the true asset multiple of the company, sector or region. CROCI charts show the results of our calculation and include annual returns, the real invested capital base on an annualised basis, and the valuation of the company, again on an annualised basis. If you require any further information on our methodology, please contact croci.valuations@ db.com. CROCI is a registered trade mark of Deutsche Bank AG in certain jurisdictions. Deutsche Bank AG reserves all of its registered and unregistered trade mark rights. Derivative transactions involve numerous risks including, among others, market, counterparty default and illiquidity risk. The appropriateness or otherwise of these products for use by investors is dependent on the investors' own circumstances including their tax position, their regulatory environment and the nature of their other assets and liabilities and as such investors should take expert legal and financial advice before entering into any transaction similar to or inspired by the contents of this publication. Trading in options involves risk and is not suitable for all investors. Prior to buying or selling an option investors must review the 'Characteristics and Risks of Standardised Options' at http:// www.theocc.com/components/docs/ riskstoc.pdf. If you are unable to access the website please contact Deutsche Bank AG at +1 (212) 2507994, for a copy of this important document. The risk of loss in futures trading, foreign or domestic, can be substantial. As a result of the high degree of leverage obtainable in futures trading, losses may be incurred that are greater than the amount of funds initially deposited. Unless governing law provides otherwise, all transactions should be executed through the Deutsche Bank entity in the investor's home jurisdiction. In the US this report is approved and/or distributed by Deutsche Bank Securities Inc., a member of the NYSE, the NASD, NFA and SIPC. In Germany this report is approved and/or communicated by Deutsche Bank AG Frankfurt authorised by the BaFin. In the United Kingdom this report is approved and/ or communicated by Deutsche Bank AG London, a member of the London Stock Exchange and regulated by the Financial Services Authority for the conduct of investment business in the UK and authorised by the BaFin. This report is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. This report is distributed in Singapore by Deutsche Bank AG, Singapore Branch, and recipients in Singapore of this report are to contact Deutsche Bank AG, Singapore Branch in respect of any matters arising from, or in connection with, this report. Where this report is issued or promulgated in Singapore to a person who is not an accredited investor, expert investor or institutional investor (as defined in the applicable Singapore laws and regulations), Deutsche Bank AG, Singapore Branch accepts legal responsibility to such person for the contents of this report. In Japan this report is approved and/ or distributed by Deutsche Securities Inc. The information contained in this report does not constitute the provision of investment advice. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch Register Number in South Africa: 1998/003298/10). Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. This report may not be reproduced, distributed or published by any person for any purpose without Deutsche Bank's prior written consent. Please cite source when quoting.
London Deutsche Bank AG Winchester House 1 Great Winchester Street London EC2N 2DB UK Tel: +44 (20) 7 545 8000
New York Deutsche Bank 60 Wall Street New York, NY 10005-2836 USA Tel: +1 (212) 250 2500
Hong Kong Deutsche Bank AG Level 52 International Commerce Centre 1 Austin Road West Kowloon Hong Kong Tel: +852 2203 8888
Frankfurt Deutsche Bank AG Taunusanlage 12 60325 Frankfurt am Main Germany
Tel: +49 (69) 910 00

Deutsche Bank - The Markets in 2012-Foresight With Insight

Загружено:

Сведения о документе

Исходное описание:

Оригинальное название

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

Deutsche Bank - The Markets in 2012-Foresight With Insight

Загружено:

Авторское право:

Доступные форматы

Deutsche Bank Corporate & Investment Bank

The Markets in 2012 Foresight with Insight

Markets in 2012Foresight with Insight Deutsche Bank

Foreword A broader view

Markets in 2012Foresight with Insight Deutsche Bank

The Markets in 2012 Foresight with Insight

1 1.1 1.2 1.3 1.4

3 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8

5.1 5.2 5.3

1.6 1.7 1.8

2 2.1 2.2 2.3

2.6 2.7 2.8

6.1 6.2 6.3

Articles marked with the

icon are based on Deutsche Bank Research.

David Folkerts-Landau Global Head of Research

Global Economy The outlook for 2012

Markets in 2012Foresight with Insight Deutsche Bank

Markets in 2012Foresight with Insight Deutsche Bank

Alan Cloete Head of Global Finance & Foreign Exchange

The Renminbi The worlds next reserve currency?

Trades on market dislocation between onshore and offshore spot market

Trades on market dislocation between onshore and offshore forward market

Trades on market dislocation between CNH DF market and NDF market

Trades when CNH forward is in premium

Market dislocation on bond market and trades for corporates

Asset Swap trades

Markets in 2012Foresight with Insight Deutsche Bank

Markets in 2012Foresight with Insight Deutsche Bank

Garth Ritchie Global Head of Equities

The Case for Equities Is fundamental valuation dead?

Markets in 2012Foresight with Insight Deutsche Bank

Markets in 2012Foresight with Insight Deutsche Bank

Frank Kelly Head of Communications and Public Affairs, Americas

US Elections Presidential prospects and implications

Markets in 2012Foresight with Insight Deutsche Bank

Markets in 2012Foresight with Insight Deutsche Bank

Rich Herman Global Head of the Institutional Client Group

Investing in a Crisis Tough times ahead but there will be opportunities

Markets in 2012Foresight with Insight Deutsche Bank

Markets in 2012Foresight with Insight Deutsche Bank

1.6 Executive Viewpoints

Brazil Economic prospects

Markets in 2012Foresight with Insight Deutsche Bank

Markets in 2012Foresight with Insight Deutsche Bank

1.7 Executive Viewpoints

Tom Joyce CMTS Strategist Ram Nayak Global Head of Structuring

1.7 Executive Viewpoints

Risk Monitor Ten key risks to watch out for

Figure 1: Composition of Debt/GDP Across Selected Economies

0% Japan Spain Portugal US UK Greece Ireland Italy

Figure 2: 2012 2014 European Bank Debt Redemptions

Markets in 2012Foresight with Insight Deutsche Bank

Markets in 2012Foresight with Insight Deutsche Bank

1.8 Executive Viewpoints

Michele Faissola Head of Global Rates and Commodities

1.8 Executive Viewpoints

Inflation Central banks looking the other way?

Markets in 2012Foresight with Insight Deutsche Bank

Markets in 2012Foresight with Insight Deutsche Bank

1.9 Executive Viewpoints

Werner Steinmller Head of Global Transaction Banking