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The Markets in 2012 Foresight with Insight

Markets in 2012—Foresight 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

Markets in 2012—Foresight with Insight Deutsche Bank

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 world’s 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 It’s 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

5

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 What’s 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 Europe’s 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 What’s ahead for 2012?

6.1 6.2 6.3

Articles marked with the ‘

’ icon are based on Deutsche Bank Research.

1 Leaders Global Economy The Renminbi The Case for Equities US Elections Investing in a Crisis .

5% in 2011. Even the data out of Germany has turned down recently. We expect the economy to strengthen further in 2012. There has been a clear improvement in the economic data in the past couple of months. We also expect the ECB to continue buying peripheral country bonds. and to keep its various liquidity taps open. We see growth of just over 1% in 2012. While the fiscal austerity measures and reforms being put in place are necessary for the peripheral economies to regain market confidence and restore competitiveness. Growth will also suffer from the acceleration in bank deleveraging that Basel 3 regulations will require in 2012. There has been much conjecture recently about the other motor of the world economy – China. 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. Despite these shocks. although there are considerable downside risks. more importantly. Fortunately. which has demonstrated a strong commitment to adjustment. with consumers showing surprising resilience and firms maintaining a decent level of investment. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . Ireland has doubled its trade surplus since 2008 and robust export performance has more than made up for the weakness in the domestic economy. as growth will likely be weak in 2012. The Fed has also signalled that it will leave its official interest rates close to zero through to mid 2013 at least. we believe more fiscal measures will be required to avoid a downgrade. We expect that the economy will avoid a hard landing. In our view 2012 will see the turning point in the European sovereign crisis. Overall. Japan was hit by a devastating earthquake and Europe’s sovereign debt crisis deepened. no hard landing. We expect France to remain in the spotlight in 2012. If the threat of a systemic event in Europe fades in the early part of next year. helped by further postquake reconstruction spending by the government. Indeed. We expect eurozone growth to decline to 0. In our view. a strong growth performance in emerging markets enabled the global economy to expand by 3. ensure that the region emerges stronger and more stable. Italy is where the key risks and challenges lie. not helped by a strong yen. a pace we expect to continue in 2012. as with China. and that growth will accelerate to almost 9% by H2 2012. ultimately. The landing could be a little harder in a few economies as rapid property price increases and high credit growth potentially reverse in 2012. and the changes now being made should remove the country from the spotlight. they will likely have a negative impact on growth. despite the government’s recent announcement of additional spending cuts. the United States appears to be recovering. again. we believe the eurozone economy is sliding into recession which at best will be mild and last only for a couple of quarters. We remain confident that some agreement will be reached. after a surprisingly weak first half of 2011. we expect growth in 2012 to hold up reasonably well. albeit at a measured pace. 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. the highest household wealth among the G7 and a record of delivering primary surpluses during the past decade. we don’t expect major policy relaxation unless the growth or inflation outcomes are significantly lower than we forecast. banking and small business sectors are overstated. as well as by Ireland’s advances in competitiveness which have turned around market sentiment. 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.1. as a rebound in China’s growth and a continued recovery in the US economy offset a likely recession in Europe. providing further support to the economy. We have revised up our forecast for US growth to 1. nine months after its devastating earthquake and tsunami – which damaged global supply chains – is likely to have seen its economy contract by around 0.1 Leaders David Folkerts-Landau Global Head of Research 1. We note recent changes in the government point in the right direction. Recent events have seen dramatic political shifts in the peripheral euro zone nations. as real interest rates are low and domestic demand is still robust. albeit slowly. especially Greece and Italy. as elections approach and doubts are raised about its ability to hold on to its AAA status.8% for 2011 and 2.5% in 2011. that it fails to agree on longer-term deficit reduction measures in the longer term to avoid a more serious downgrade by ratings agencies. low private sector debt. in our opinion. For the rest of emerging Asia we see a slowdown in growth but. which should boost reform and.5% in 2011. credit growth picks up and the housing market stabilises.4% in 2012 from 1. Although we believe the risks from the property. The government is likely to launch targeted measures in some parts of the economy instead. Inflation is now falling sharply but we do not expect a major policy stimulus to follow as a result. as we expect.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. however. The key challenge going forward will likely be the ability of politicians to push though growth-enhancing reforms in order to unlock Italy’s potential. But while authorities have already shifted policy away from combating inflation.3% in 2012. we do see growth slowing to an annualised 7% around the turn of the year. The situation in Greece is stabilising. We are particularly encouraged by progress thus far in Spain. 2012 could offer significant upside potential for risk assets. as some of the headwinds from Europe abate. We believe the country is solvent: Italy has significant economic potential. Japan.

if the past year is any guide. almost 9% of China’s total monthly trade volume.5500 with 2.4%. In reality.6% premium to onshore CNY spot rate. In September. strong growth and signs of an asset price bubble. if the CNH bond yields around 1%. corporates raised CNH funding through money market. Trades on market dislocation between onshore and offshore spot market Date 19 –Oct–10 USD CNY 6.4890 with 2. Trades when CNH forward is in premium Date 26–Oct–11 USD CNH Spot 6. They then swapped this CNH funding into USD funding via an FX swap.3883 6. This premium was realised by offshore exporters receiving payment in RMB when exporting goods to China. a relaxation of the rules that would have been unimaginable even two years ago. Expect more to follow.2 Leaders Alan Cloete Head of Global Finance & Foreign Exchange 1. This discount was realised by offshore importers making payment in RMB when importing goods from China.8 to 7. the RMB could account for 15% of global currency reserve holdings. CNH DF has always been trading at a discount to onshore forward market. euros and sterling.4890 CNY FWD 12M 6. Market dislocation on bond market and trades for corporates Onshore – Offshore bond basis Mar—Oct–11 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. it opens up China’s capital account too quickly. The discount of using RMB invoicing and buying CNH offshore instead of using USD invoicing would be close to 10%.4%. For instance.3% of its international reserves are now held in RMB.6% Trades for Corporates A corporate sold CNH at 6.3320 CNH DF 12M Premium –2. with forecasts suggesting the dollar’s share of global reserve currencies could fall from about 60% to 50% over the next decade.1% Trades for Corporates With USD CNH forward trading at a premium. say. in turn. If it doesn’t. The rationale for a separate Hong Kong currency is becoming increasingly weak.5% discount to onshore CNY spot rate. That. this basis would be mean–reverting. now amount to about USD2 billion. Trades on market dislocation between CNH DF market and NDF market USD CNH DF 12M 23–Sep–11 6. It is much cheaper for offshore importers to use RMB invoicing. What all these developments signify – from Nigeria’s central bank vaults to Hong Kong’s trading floors – is the imminent arrival of the RMB as a reserve currency that reflects China’s economic weight. it is clearly undervalued. Hong Kong – once China’s financial window on the world – is now the world’s back door for access to RMB. But the Hong Kong Monetary Authority faces a difficult challenge in resolving this problem. The socalled ‘non-deliverable’ offshore RMB forward market has no long-term future of its own. certificates of deposits and bond issuance at very low yield given the strong demand for CNH asset in Hong Kong. So where does this leave the Hong Kong dollar? My view is that it will merge with the RMB to become one currency. Interesting times ahead. But if it moves the peg decisively from 7.5810 in USD CNH DF market. the monthly volume of RMB-denominated trade settlements has soared almost twenty-fold to RMB185 billion in August 2011.4085 USD CNH 12M FWD Premium 0. onshore exporters always charge a premium for USD invoicing relative to RMB invoicing to hedge their risk.8% Trades for Financial Institutions (FI) FI took the opportunity to migrate from the NDF market to the USD CNH DF market.5% Trades on market dislocation between onshore and offshore forward market CNH DF 12M 23–Sep–11 6. you only have to follow the money. Since July 2010. given China’s commitment to liberalise its capital and current account by the end of 2015. since August 2011 foreign businesses have been able to settle contracts in RMB in any province in China. 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. The saviour may turn out to be the global economy.4745 CNH Premium 2. Asset Swap trades Bond Yield 1–Mar–11 Around 1% USD CNH 12M Implied 1. 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. opened in August 2010. Since the implied yield was as much as 1. as its economy merges with the mainland.4% Asset Swap Yield 2. while Nigeria said it would add RMB to its mix of US dollars. Corporates bought offshore CNH DF at 6.4015 USD CNH 12M FWD 6. benefiting from a 1. for instance. Demand for RMB is bound to accelerate. This discount was realised by offshore importers making payment in RMB in 12 months time when importing goods from China. The rise of the RMB may happen even faster.5500 –2.6446 USD CNH 6. given the expectation of RMB appreciation. FI would be subjected to the spot basis risk between the CNH spot and CNY fixing. The RMB’s international rise will bring with it an end to the present restrictive system of parallel foreign exchange markets for China’s currency. 23–Sep–11 6. If it moves the peg from 7. If growth slows significantly. However. Since the offshore market is deliverable. speculation about further changes will increase.4603 in the NDF market.5% Trades for Corporates Since the establishment of the offshore CNH DF market.8% premium. FI sold at 6. corporates enjoyed a return of approximately 2. we can expect continued pressure on the Hong Kong dollar. 6.4745 with 2. either way. In this case.1. providing a cheaper RMB source in the forward space. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . Instead of selling at 6.4603 USD CNH DF Premium (in %) 1. 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.8 to.4% Trades for Corporates Corporates raised USD offshore and swapped it into CNH to invest in the CNH bond market. since companies can increasingly find ‘deliverable’ liquidity on Hong Kong’s burgeoning RMB spot market.5% discount to onshore CNY forward. Hardly a month goes by without the People’s Bank of China further loosening the restrictions on onshore RMB trade settlements for foreign investors and customers. according to US economist Barry Eichengreen. will reduce worldwide demand from central banks for US dollars and euros. 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. easing pressure on asset prices. this could destabilise the economy. A corporate bought CNH at 6. Chile’s central bank reported that 0.5810 NDF 12M 6. If it aligns the Hong Kong dollar to the RMB. Hong Kong’s near-monopoly of offshore spot trading is also under threat: Singapore is in negotiations with Beijing to open a competing market. FI also benefited from the positive carry of using the deliverable CNH to invest in bonds.2 Leaders The Renminbi The world’s next reserve currency? To understand why the renminbi (RMB) will become a major reserve currency in the next decade. Within 10 years. Daily transactions on Hong Kong’s offshore RMB spot market.

If investors are to successfully navigate the challenges of multiple trading platforms. The fundamental case for equities is very strong. increased volatility. Second. 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. This is the lowest since the nadir of March 2009. in my opinion.Garth Ritchie Global Head of Equities 1. and an increasingly complex regulatory environment. the S&P 500 ex-financials is yielding 12%.8. 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 dividend yield on the S&P 500 is 2.e. But to take full advantage of the opportunities. Emerging market growth is perhaps the most compelling story. this has been sensible. Over the past three years. including wider spreads. investors will find it easier to amass sizeable equity stakes and cope with other executional challenges. many large corporates are sitting on cash and many are also benefiting from continued economic growth in Asia and other emerging markets. risk off mode’ and a high degree of correlation between geographic regions. while bond coupons are static. Equities are. The main reason for this undervaluation is the low levels of allocations by real money investors. investors need to select the right stocks and trade them in the right way. In an environment in which access to liquidity is critical.2 and the S&P 500 at 12. presenting some risks. active management (i. But dividends are growing by 15% a year. 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.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. With the markets in a ‘risk on. alpha over beta) will be the better option. In such a patchwork-quilt environment. But even emerging market growth may slow from 2012. significantly undervalued. First. 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. largely due to wage and resource inflation. 6% more than Baa-rated bonds. At the time of writing. 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. On a cashflow basis. 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. many investors have adopted a Mark To Market (MTM) approach to equity investment.1% compared to 2. After the crisis of 2008 many institutions slashed equity allocations from 10% to 2% and moved USD1 trillion into the credit markets.2% for US government bonds. Profits at S&P 500 companies are growing at 9% year-on-year. Bank sector solvency and liquidity also varies widely between countries. they also need to look to maximise their use of the consultative services of their broker. fragmented markets. European equities are trading on a P/E ratio of 11. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . By supplementing electronic execution with traditional OTC trading.

we may see many voters vote out the incumbent no matter what their political affiliation. If they get voted out. Republican primaries start on 3 January. Former Massachusetts Governor Mitt Romney has steadily kept in the forefront of most polls but has failed to fully engage voters. they have never been worse. composed of 12 hand-picked senators and congressmen. there is a strong likelihood the Court will hand down its decision next summer – perhaps in late June. and duly lost to Reagan. If this happens. His goal is to raise USD1 billion. observers believe President Obama’s re-election will be a tough road. the US economy declined by 7. The Super Committee. and may lead to further rating downgrades. just 13% of voters approve of Congress’ performance while 81% disapprove. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . 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. both chambers of Congress (the House of Representatives and the Senate) must approve by 23 December 2011. 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. While President Obama’s approval ratings are low. 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. and perhaps most importantly for financial services. 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. it seems likely that if the economic situation does not improve before mid 2012.9%. Only one president in modern times has had ratings this low and gone on to be re-elected: Ronald Reagan in 1984. The possibility of a Republican President. Congress’ ratings are lower – far lower. and the Iraq and Afghanistan military campaigns remain unresolved. there is Dodd-Frank. If a Republican wins presidential office. If Obama is reelected. The economic situation is one of the worst in recent US history. Americas US Elections Presidential prospects and implications If we don’t see a significant improvement in economic conditions by the summer. In a recent Gallup poll. and the party retains their majority in Congress and gains it in the Senate.4 Leaders Frank Kelly Head of Communications and Public Affairs. In Q2 1980. This would hit the Democrats harder than the Republicans since 25 of the 33 state elections due next year are currently held by Democrats. At the time of writing. Recent polls show President Obama’s job approval ratings in the mid-40% range.2 trillion in deficit cuts by 23 November 2011. If they reach an agreement. Overall. Congress and Senate would bring significant changes to US economic policy and financial regulation. Finally. Clearly. And if the initial decisions by several junior federal courts are any indication. it is hard to see the US economy contracting by this amount in 2012. is charged with finding at least USD1. the Republicans would gain a majority in the Senate. 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. 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). Barring a string of severe tail-risk events such as a collapse of the euro. First among these is the so-called congressional ‘Super Committee’. its biggest fall since the great depression. 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. there is significant risk the Supreme Court will strike down the law dealing a setback to President Obama only months before the election. change seems unlikely. President Barack Obama has informally launched his re-election campaign and begun significant fundraising efforts. The biggest factor in President Obama’s favour is the lack of sustained excitement around the Republican candidates lining up to run against him. In fact. President Obama will struggle to get re-elected. 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. We will know the final candidate by May. The parallel is not precise. Washington is also beginning to watch the direction of the various federal legal challenges to President Obama’s hallmark healthcare legislation. the outcome of both remained unknown. the highest ever for a presidential election. If this is a true indication of voter sentiment and (once again) the economy does not improve. Obama will face a significant challenge.1. markets are most focused on the presidential elections. there is a strong possibility that DoddFrank could get rolled back or perhaps repealed altogether. unemployment rates are hovering at 9%. Nevertheless.

Some are based around specific events such as political elections or the launch of a new product (such as our own Apple supplier basket). the markets were driven by macro themes and events with very high levels of correlation between asset classes. 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. In equities. as inflation took its toll. the bonds lost 75% of their value over the next three decades in real terms. Both thematic investment and relative value trading require fair amounts of analysis on the part of investors and the banks that they partner with. By going short the equity indices but long the credit indices. A quick example: in June 2011. Others are around longer-term economic trends such as an increase in European exports to the US. The Federal Reserve has committed to keeping official rates low for as long as it takes. But if 2011 is any guide. 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. I am confident we will continue to see opportunities like this in 2012 given the probability of further market volatility. In 2011. as we know. as ever. the traditional safe haven. 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). typically created by dislocations in the market which led to some assets selling off more than others. the lower the long-term returns are likely to be. The equity and credit markets are currently pricing in a severely negative market environment for 2012. when gilt yields were last this low. yields could actually be negative. And. but hard work will I suspect be the key to success in 2012. 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. although that. After 1946. was dependent on low inflation. something that has only been seen once (briefly in 2008 and 2009) since the mid1950s. in turn. 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. But calling the bottom will.77% a year. we can expect sustained volatility and market swings which could result in significant MTM moves. Let’s say you believe that merger and acquisition activity will increase in 2012. something that is by no means certain this time round. We could also see fairly strong market rallies.3% and 2% respectively. 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. it also provided a very useful hedge against an increase in eurozone sovereign credit risk. Beta investors face some formidable challenges. There is historic precedence for these kinds of losses. where should investors focus in 2012? In fixed income. remain challenging. 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. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . If the world goes back into recession.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. the European Central Bank (ECB) is cutting rates soon and the Bank of England has just launched more quantitative easing. And for US Treasuries. 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. So if the prospects for beta or index based investment strategies are challenging. One of the best things about this trade was that in addition to offering a very respectable return. During 2011. investors in 30-year Treasuries will suffer an annualised loss of 3. and there will be more opportunities to outperform. we saw some outstanding trading opportunities in this area. A recent study by Deutsche Bank Research showed that if yields revert to the mean. including large numbers that do not require bull market conditions to perform well. the past indicates that bonds will fare much better than equities.3% over the next five years and 1.3% over the next 10. a dualpurpose advantage that is often available on many relative value strategies. investors were able to make a positive return of 7% in less than three months with carry of 1. US dividend yields are now higher than 10 year US Treasury yields. Those who buy the 10year benchmark bond will suffer losses of 4. the lower the yield on an asset when bought.

1 Executive Viewpoints Brazil Risk Monitor Inflation Trade Finance .

private consumption still grew a hefty 4. the mortgage market remains very small in Brazil (a mere 4% of GDP). metals. and the Central Bank has plenty of room to provide liquidity by cutting towering reserve requirements on bank deposits and interest rates. Given the pent-up demand for housing. Banks may provide an interesting investment opportunity as well. 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 country’s exports.9% in 2010 and could increase approximately 6. focusing on oil.5% this year. Moreover.1. Asian buyers have been particularly aggressive. Even when the economy contracted by 0. but is growing very fast due to the economy’s financial stabilisation and lower interest rates.6 Executive Viewpoints Bernardo Parnes CEO Deutsche Bank Latin America. mainly due to government intervention in the FX market. Investors can buy inflation protection through inflation-linked bonds issued by the Treasury. real rates remain relatively high and offer interesting opportunities. Chief Country Officer Deutsche Bank Brazil Brazil Economic prospects After growing 7. First. The construction and infrastructure sectors could benefit from two important developments.5% in 2010. Although consumer prices rose 5. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . Second. The economy’s potential is attested by the sheer volume of foreign direct investment (FDI): USD76 billion in the last 12 months. 2012 looks set to be an interesting year. Brazil still offers some great opportunities especially for investors who can take a long-term view. mining and agribusiness. prices could rebound should the global economy recover faster than expected. 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. considering that interest rates in developed economies are close to zero. credit penetration (48% of GDP) remains small by international standards. the Central Bank has initiated an easing cycle and is poised to cut rates further. Although bank loans have grown very fast over the past few years. Brazilian banks are very well capitalised (their capitalisation ratio is 17%). We expect consumption to remain buoyant in 2012 due to fiscal and monetary easing and a sizeable minimum wage increase. Inflation is an important risk. if necessary. While interest rates are falling. Offshore structured notes – obtaining a dollar yield of approximately 2% to 3% for a three-year maturity – offer an excellent return. 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. Dollardenominated interest rates (‘cupom cambial’) are particularly attractive for foreign investors. as the authorities seem to be more sensitive to fluctuations in output than in prices.6% in 2009. as they have not accompanied the decline in Brazil’s risk premium (as measured by its CDS spreads). But despite the challenging global economic environment. Foreign companies are actively pursuing M&A opportunities in Brazil. we expect further credit penetration in the long term. The debt burden on consumers is very high. Credit penetration is bound to increase further as interest rates decline and maturities increase.1%. GDP growth for 2011 is likely to be around 3%. as concerns about rapid credit expansion are overblown. All in all. 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. While the global slowdown and resulting drop in commodity prices will help the Central Bank tame inflation. but mainly reflects the short loan maturities and high interest rates.

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. a run on peripheral banking systems could follow. the Swiss franc and yen in 2011. Continued low rates only exacerbate the challenge. 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. Italian and Spanish funding crises Together. long non-conforming mezzanine debt. Though treasuries could rally again. Hedges: as above plus short subordinated bonds of French and British banks. Figure 1: Composition of Debt/GDP Across Selected Economies Source: Central Banks Financial Non-Financial Business 500% 496% 400% 393% 300% Greece Gov’t Debt/GDP=160% 382% Households Government 353% 347% 333% 332% 264% 200% 100% 0% Japan Spain Portugal US UK Greece Ireland Italy 7. commodity prices could fall sharply. Hedges: switch out of European assets into safe havens such as gold or US Treasuries. go long the yen or sterling which could benefit from an accompanying fall in the euro. timing could be everything. and come at a very bad time. look for funding and capital markets to be the channels for global contagion. The premiums on these can be reduced by as much as 70% by linking them to rising rates. The rationale here is that equity puts are somewhat expensive. given badly delayed fiscal austerity in advance of the Presidential election. Short AUD v Long MXP. CVIX or DB Tail Risk index. Hedges: reinforces case for downside protection on commodities (see Risk 4).7 Executive Viewpoints Risk Monitor Ten key risks to watch out for 1. it provides a cheaper. 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. equity markets tend to go down simultaneously.2000 Knock-in on EUR/USD. Hedges: diversify into a wider range of AAA-rated assets such as supranational bonds and gilts. long options on CDX.1. which is less likely than implied by the forward market. such an environment introduces another risk from the potential for upside surprises: if Europe stabilises. and the premium is only due if rates rise. a recession. Current estimates suggest as much as USD2 trillion within 18 months. and possibly global central banks. Declining universe of safe haven assets The old adage – ‘find safety in numbers’ – did not find consistently reliable friends in Gold. 6. investors are primarily focusing on further de-risking of debt exposures. the rising debt obligations of both economies (albeit for different reasons) may warrant more prudent diversification strategies. 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. A crisis of confidence and deep recession are the catalysts for this risk. Italy and Spain are too big to fail. a larger debt restructuring. yet effective hedge for a global correlated sell-off. too large to bail. US Treasuries and Bunds proved more reliable safe haven assets. If the negative feedback loop to the real economy is not broken. they provide an estimated 75% of the financing for the big Swissbased commodity trading houses. For Spain. Upfront premium costs are 10. However. while comparable US public sector deficits are estimated at USD3 – 4 trillion depending on discount rate assumptions. copper and gold. 2. At stake would be the global financial system and the fate of the euro itself. Aggressive. Hedges: buy protection on French sovereign CDS. 4.8% after political change in the Middle East and the earthquake in Japan. investors could look into one-year USD100 puts on Brent or a one-year USD100 put on Brent with a 1.IG index. there is a real risk that the US could be downgraded once again. then a double dip is a very real possibility. 8. the imposition of capital controls. However. Return to the drachma would involve a sharp redenomination lower of all private sector assets.5% and 1. 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 downgrade risk may already be priced in. Hedges: Issuers can protect themselves by pre-funding. Ballooning US pension fund deficits When it comes to US pension fund deficits. Hedges: look for protection on cyclical industries. Just as in 2008. To measure the impact. watch the private sector and banking system.7 trillion debt outstanding (>30% of eurozone’s total). China has the power to stop the slide quickly. History suggests that the shorter duration maturity of this market is at high risk when banks deleverage (see Risk 6). 2011) Source: Bloomberg 1950 $ 1900 1850 1800 1750 1700 1650 1600 1550 2-Sep 9-Sep 16-Sep 23‐Sep 30-Sep 5‐Aug 12‐Aug 19-Aug 26‐Aug 7-Oct Oct. buy protection on the Sovereign X credit default swap index. not solvency problems. If the highly anticipated fiscal cuts due 23 December 2011 disappoint. Implications for the European Financial Stability Facility would also be negative. Fund outflows from equities to bonds could increase. Greece euro exit We don’t 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. But the declines may be short lived. More concerning would be the economic impact of bank funding market pressures and the more aggressive fiscal austerity to follow. would need to respond aggressively. go long volatility both in equity and credit markets. Liquidity crunch in commodity trade finance Commodity trade finance is highly concentrated across five European banks. European borrowers should diversify their sources of funding into the US. in our view. sustained European bank deleveraging The question is not if European banks will deleverage aggressively in 2012.2 trillion of FX reserves. 9. With USD3. three of them French. 3. for investors. lower-rated credits and financials. 10: Europe announces “Grand Plan” Aug. Better than expected economic growth A large degree of downside risk is being priced into markets. particularly those with high funding needs. The European Central Bank. as well as protection against inflation and higher rates. The eurozone’s third and fourth largest economies have a combined EUR 2. Declining corporate profitability. and a probable collapse of the Greek banking system (at a cost >30% of Greek GDP). and unexpected funding crises could follow. For Italy. funding gaps range from USD400 – 500 billion. long volatility indices such as VIX. or growth underperforms. 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. Both are liquidity problems. 5. For US corporates. France loses AAA rating Quite possible.95% of notional respectively. don’t expect a simple repeat of the historic August downgrade as a ripple effect to US banks sector downgrades could follow this time. Strong headwinds include a sovereign crisis. Hedges: for the companies involved. public sector rating agency downgrades. 5% to 6% growth would seem like a recession. With France trading at a 20 year wide to Germany.7 Executive Viewpoints Tom Joyce CMTS Strategist Ram Nayak Global Head of Structuring 1. 5: Historic US downgrade Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . If Risk 1 or Risk 2 materialise. 10. In aggregate. puts on major equity indices where premium is only payable if rates rise. China hard landing For China. ALM strategies such as receiver/payer swaptions. For Europe. both global growth and risk asset prices could exceed expectations. the concern is politics and underperforming growth. In the peak volatility of August-September. closed funding markets and Basel 3. Hedges: 10y/20y euro rates payer spreads. rounding errors can be measured in trillions. but by how much. 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.

weak growth prospects and difficult market conditions are making it challenging for central banks to focus solely on inflation targets. although it was forced to reverse course recently. while public debt levels remain perilously high. with financial stability and employment increasingly taking precedence in their objective functions. economists and policy makers were preoccupied by the spectre of deflation. as low real policy rates may be required to keep markets and economies afloat.8 Executive Viewpoints Inflation Central banks looking the other way? For most of the past two decades. central banks appear stuck in a low real rate trap. a period of an unusually stable macroeconomic environment for advanced economies. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . In this environment. concerns about downside risks to growth.8 Executive Viewpoints Michele Faissola Head of Global Rates and Commodities 1. 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. only one year ago. For most central bankers. inflation rates should come down in 2012. As such. such as central bank purchases of UK gilts or Italian BTP. Indeed. Unconventional policy measures are likely to have supported inflation expectations. except perhaps the ECB. high debt levels. despite inflation rates above their targets.1. which in turn may have added some stickiness to inflation in the face of subdued demand. First. inflation rates in the UK. Central bank policies may also have impacted domestic inflation. With commodity prices unlikely to rise at the frantic pace of 2011 and global economic activity softening. This makes it difficult for monetary authorities to focus solely on their inflation mandates. Instead. All other major central banks have maintained extremely low interest rates and have engaged in aggressive quantitative easing. 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. inflation expectations successfully converged towards central bank targets. US core inflation rose to 2% while headline inflation soared to almost 4% in September 2011. established forecasting models failed to predict accurately the rise in inflation in 2011. 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. China and in the euro area have been rising more quickly than anticipated and are currently running at levels well above central banks’ targets. inflation markets offer attractive opportunities for investors. This low and stable inflation environment was a key contributor to the ‘great moderation’ period enjoyed during the past two decades. investors can switch from nominal to inflation-linked bonds. In most markets valuations anticipate inflation rates to run below policy targets for the coming years. Second. the risk of an above-target inflation rate is viewed as a relatively low price to pay for financial or economic stability. inflation has not had a major impact on the investment decisions of market players. The current environment and policy actions are not without risks for the inflation outlook. The European Central Bank (ECB) has been alone among the major central banks in fighting inflation risks raising interest rates twice earlier this year.6% in October 2010 and speakers at the Fed’s Jackson Hole conference in August 2011 expressed concerns about the risk of additional price declines in the following year. and official intervention. US core inflation fell to 0. 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 year’s acceleration in global consumer price inflation. Against this backdrop. Similarly. With the rise of independent central banks endowed with strict inflation fighting mandates. generate a profit if inflation turns out to be on average at the central bank target and get an inflation insurance for free. Financial markets are more fragile than ever.

banks will naturally gravitate towards the higher-margin business. G20 leaders also expressed concern about the impact of an over-aggressive regulatory regime on trade-related products. 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. since the financial crisis broke in 2008. trade finance products (invariably traditional. ultimately. transaction banking has been recognised as a key strategic pillar of global wholesale banking. especially given its importance to fastgrowing developing countries. well developed products) have become particularly fashionable as clients have sought to diversify their funding sources. over a five year period. There will be further discussions. most notably around Basel 2 and Basel 3. Within transaction banking. This is exactly what the Basel Committee is trying to avoid in its far-reaching directives. make them more expensive for clients. the world’s leading international banks have increased their focus on this business as a stable form of revenues in a very uncertain business environment. lowmargin activity like trade finance is the same as a higher-risk. however slow that now may be. This applies to issued and confirmed letters of credit and reduces the riskadjusted capital charge on those assets. Indeed. Firstly. The International Chamber of Commerce (ICC) provided firm evidence of the relatively low-risk nature of this business. This applies to standardised and Foreign Investment Review Board (FIRB) riskbased approaches.000 defaults. But trade finance will play a key role in the eventual recovery of the global economy. the committee is waiving the one-year maturity floor for certain trade finance instruments under the advanced internal ratings-based approach for credit risk. so vital to oil the wheels of trade – but over-regulation has threatened to stifle their use and. 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. These statistics covered 65% of the world’s trade finance transactions. there were only 3. These waivers represent only two of the concerns that the trade finance industry has over Basel. It is important to realise that if the cost of capital of a relatively low-risk.1. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . higher-margin activity. Therefore. have cast something of a cloud on these products. Secondly. All relevant parties should be aware that overbearing regulation could choke its progress. 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. 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. Regulatory discussions. The Basel Committee eventually relaxed the Basel 3 regulatory capital adequacy framework for trade finance by issuing two waivers relating to letters of credit. The ICC’s recently released data revealed that in over USD2 trillion trades. Trade financing products are userfriendly – and in the aftermath of the first stage of the crisis.9 Executive Viewpoints Werner Steinmüller Head of Global Transaction Banking Trade Finance Back in fashion Over the past three years.

2 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. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank .

exactly as it is doing right now with covered bonds. We believe the second step needed is a big. Indeed. We believe the European Central Bank (ECB) is the only credible source. ECB intervention will likely have to be particularly large around the key dates for national debates. the actions required are complex and politically contentious and so will likely be prone to scepticism from markets. So the ECB. way beyond anything we've had so far. 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. A replication of the EFSF drama is likely. And second. significant purchases could be seen as a contradiction of the ECB’s statute. and enveloped more and more major economies putting European leaders on the back foot as events threatened to overwhelm them. in our view. the ECB’s 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. in its current form. deliverable and rapid structural reform package from Italy to convince markets it can pull through the crisis. First. involving changes to treaties. The ECB will likely demand that if it is to launch significant bond purchasing. the Netherlands and Slovakia. as it has been doing in recent months. something that is likely to dominate markets in the year ahead. with heated discussions in at least Finland. the eurozone may look weak because it would be seen to be printing money without credible political change or fiscal control. True. Indeed. it has to see the second and third actions outlined above. We believe there has to be some sacrifice by member states of sovereignty. First and foremost of these is a large final buyer of government debt. If it launches this action without demanding any conditions. While we continue to believe that the eurozone’s authorities will do whatever it takes to hold the euro together. 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.2. But time is short. An example would be giving the European Council the right to veto national budgets. and not just in Europe. the bigger the risk that things go wrong when rigorous implementation is needed. that peripheral countries resent the transformation of the ECB into a benevolent economic dictator triggering ultimately a rejection of its support. Unfortunately.1 Economics & Geo-Politics The Eurozone Crisis Fast track Europe’s road map Europe remains deeply mired in its sovereign debt crisis. But the German Constitutional Court recently dismissed lawsuits taking this line. especially if politicians and central bankers fail to respond rapidly to the deteriorating situation. although we admit something worse could happen. This likely creates two symmetric risks. this is the price Europe is having to pay for lacking enough will to date. The bigger the intended action. We believe deflationary pressure should be more of a concern. we believe we need to move from implicit to explicit conditionality. Even if governments strive to get the new treaty sorted as fast as possible. Third. In the meantime. In our opinion. Given the market's entrenched scepticism. 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. That on its own appears enough to finance Italy through 2012. 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. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . we need to see rapid and clear signs from the EU that fiscal integration. The ECB could pledge to purchase a set volume of bonds. We think the inflation risk of such purchases is negligible. Inflation is not Europe's number one problem right now. is coming. We note that would likely be poorly received by markets. three radical steps are now required. given the looming credit crunch and recession in the eurozone. 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 urgency of the need to act has risen sharply. The eurozone economy now appears to be sliding into recession which we hope will only last for a couple of quarters. what is needed now is a big ‘Grand Bargain’. the Greek Prime Minister. 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. we think the summer of 2012 is probably the earliest date. say EUR200 billion worth over the next 12 months. The whole world has an interest in the resolution of a crisis that deepened dramatically through the fourth quarter. while noting it may not be entirely content with that course of action. The ECB is not allowed to buy primary issuance from governments but can buy bonds on the secondary market.1 Economics & Geo-Politics Gilles Moec & Mark Wall Co-Heads of European Economics Research 2. From a practical point of view. This is the sort of quantum leap in governance reform that the ECB is asking for. The package needs to be proven immune from the vagaries of the economic or political cycles.

2.2 Economics & Geo-Politics

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 China’s 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 China’s 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 2011’s 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 China’s 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 China’s economic slowdown are likely to generate significant market volatility, on a 12-month basis we believe China’s equity index is likely to deliver one of the best performances in emerging markets.

Markets in 2012—Foresight with Insight Deutsche Bank

Markets in 2012—Foresight with Insight Deutsche Bank

2.3 Economics & Geo-Politics

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 world’s anchor currency.

Governor Zhou Xiaochuan of the People’s 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 dollar’s 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 (23–79 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 Britain’s 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 world’s 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 world’s dominant currency, with a new generation of Asian countries – most notably China – pegging their currencies to it. Deutsche Bank’s 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 world’s 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.

Markets in 2012—Foresight with Insight Deutsche Bank

Markets in 2012—Foresight with Insight Deutsche Bank

2.4 Economics & Geo-Politics

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 Fed’s 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.

Markets in 2012—Foresight with Insight Deutsche Bank

Markets in 2012—Foresight with Insight Deutsche Bank

2. West Bank and Gaza India Nigeria .5 Economics & Geo-Politics Torsten Slok Chief International Economist 2...... 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.. .. 18 19 20 Singapore Hong Kong New Zealand United States Denmark Norway United Kingdom Korea. Malaysia Germany Japan Rank Economy 21 .. 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 . ranks significantly higher than other peripheral European economies and many core European ones too.. by this yardstick at least.. 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.. Rep Iceland Ireland Finland Saudi Arabia Canada Sweden .. time spent for businesses (hours per year) hrs/year 2600 Bosnia and Herzegovina 100 Brazil Tanzania .. Uruguay China Serbia Rank Economy .. This study (see Figure 1) came up with some interesting findings. Portugal ranks well ahead of Italy and Greece (see Figure 2). Belgium France Portugal Netherlands . Cape Verde Russian Federation Costa Rica .. trading across borders. Together with its strong showing in the ‘time spent paying tax’ and ‘strength of legal rights’ categories (see Figure 3)..5 Economics & Geo-Politics Growth Solutions What Greece and Italy could learn from Ireland The solution to Italy and Greece’s current dilemmas may not just lie in debt reduction.. But on the issue of the cost of starting a business. this helps to explain why Ireland has managed to recover from the 2008 financial crisis better than other peripheral European nations.... 28 29 30 31 .. 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 7 6 6 Russian Federation United States Germany France Spain Russian Federation Germany United Kingdom United States Canada Portugal Portugal Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank Canada Brazil China India Spain Japan Ireland Greece France Italy Brazil China Italy Greece Japan India . Puerto Rico (US) Spain Rwanda .. Figure 2: It takes a long time to start a business in Brazil. getting electricity. Rep. Studies by organisations such as the World Bank have shown that business regulation (such as red tape. protecting investors...2% contraction in Italy. US. that Portugal could find it easier to secure the growth it needs to meet its debt obligations than some of its peripheral neighbours. Greece Papua and New Guinea .8% in 2012 compared to a 2.2% contraction in Greece and a 0.. getting credit..... 99 100 101 ... 119 120 121 ... Yemen. paying taxes.. This would suggest. a short time in Italy. . .. it is seriously dampening economic growth at a time when growth is urgently required.... Ireland scores best with Greece and Italy both lagging a long way behind.. 90 91 92 Latvia . We are expecting the Irish economy to grow by 0. 86 87 88 . labour laws and how long it takes to start a business) is a key factor behind GDP growth. while Italy and Greece come well below many developing nations. and enforcing insolvency. Ireland. registering property. enforcing contracts. The World Bank in early 2011 collected data for 183 countries for the time to start a business.. For this reason. 125 126 127 .. taxes. Improving business regulation is also key – currently.. for example. dealing with construction permits. 131 132 133 .. 43 44 45 . Mongolia Italy Jamaica .. less time spent in Ireland Source: World Bank 450 400 350 hrs/year Paying taxes. 120 Figure 3: A lot of time spent paying taxes in Brazil.

904 1. UK. 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. Russia.26 0.243 1.14 0.29 0. 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.29 0.5 Economics & Geo-Politics but the slow speed with which politicians in those countries appear to be reforming is worrying to us. Russia. which all have significant room for improvement. the implications are also clear. the growth has been driven by their low production costs (see Figure 4).37 0.31 0.536 1. For investors.29 0. what the World Bank data does suggest is that if the regulatory environment in these countries is not improved.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 0.21 0. 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.21 0. Italian wages are about 20 times higher than in India – to make just one comparison. The high growth rates of these countries in recent years (with the exception of Russia) might indicate that this improvement is not necessary. 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.2. low in China.17 Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank .655 1. India and China having significant room for improvement.12 0. and Portugal.146 1. But. 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.34 0. and Italy.37 0. and India Source: World Bank Country Minimum wages for a 19-yearold worker or an apprentice (USD/month) 1.34 0. in particular in Greece.27 0.614 1. countries that in 2012 make it easier to do business are likely to outperform those that do not. But in reality. The analysis also offers useful insights into the long-term prospects for BRIC economies with Brazil. Spain. Italy. Figure 4 : Minimum wages high in Canada.548 1.

largely precipitated by the Great Depression. it certainly helps that three of the largest economies – China. in the stable consumption growth of recent quarters. for example. the major risk for EM seems to be a dislocation in European markets that could trigger a global recession. we have lowered our China and India growth forecasts but at 8. and Taiwan barely grew. there are a number of valid concerns about this somewhat optimistic picture. the most recent forecast revisions have been less than what a simple application of historical ‘growth betas’ would have suggested. Shifting a large country like China away from this specialisation in manufacturing could slow its mediumterm growth by more than 200bp a year. Singapore and Thailand. Kazakhstan and Middle East forecasts. Vulnerability and risks The previous arguments notwithstanding.7% in 2012 from an estimated 6. and the associated strength of Latin American economies. and we are inclined to expect this resilience to continue. with growth staying at around 1. however. and the fact that commodity prices – especially oil and soft commodities – have been higher than expected during most of this year. In emerging Asia. Furthermore. This more benign backdrop is evidenced. All this notwithstanding.6 Economics & Geo-Politics 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. with the growth differential in favour of EM remaining comparatively high. the increasing intra-EM integration. for the most part. reflecting the inherent instability of the current global balance. 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. respectively. even in the smaller open economies. 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.2% this year. where historically the decline in exports would have been expected to lead to at least a modest softening of consumption growth. We caution. and Indonesia. emerging economies have more room to implement counter cyclical policies. central banks had been slow to ‘normalise’ monetary policy. had already reported a GDP decline. In addition to high and relatively stable commodity prices.3% and 8. are very exposed to the slowdown in Europe. To some extent this is due to the greater resilience of the largest countries in Asia – China. Public and private sector balance sheets are also generally weaker than in Latin America and Asia. Nonetheless. and most have strong trade and financial linkages within the eurozone. In addition. India and Indonesia – have historically been quite immune to fluctuations in US and European growth. Although that is not our most likely scenario. Disillusion with the prevailing international order was probably the main cause of the end of the previous large wave of globalisation. 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. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . A key element of this outperformance is the robust growth process in the major countries in Asia. particularly monetary policy. providing less room for policy adjustment to support growth. the commodity price outlook supports the Russian. however. we project EM economic growth to advance 5. For the region as a whole.5%. Hong Kong. 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. Emerging market resilience Emerging economies have so far weathered the slowdown in the US/EU better than might have been expected.0%. India. EMEA is the emerging region most vulnerable to weaker growth in the core economies. 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. The rise of protectionist rhetoric in the US and Europe is the most evident expression of such concern. 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.2. Even a shallow recession in the US and/ or Europe would likely elicit a strong response in EM – especially in the smaller. at the present juncture. Since July. Consequently. Indeed. during 2Q11. Another concern about the current conjuncture is related to the political economy equilibrium that demands a slow process of rebalancing. future political shocks cannot be entirely ruled out. it is also the case that outside Latin America.6 Economics & Geo-Politics Gustavo Canonero Head of Latin America and EEMEA Economics Research 2. we remain relatively constructive towards the asset class. the ‘two-speed’ nature of the global economy we highlighted last year is actually reinforced in our new 2012 outlook. As in Latin America. For example. Most of the region’s economies are relatively small and open. Most of the other economies. suggesting an almost unit elasticity between growth in the two regions. it is not a negligible risk. 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. even after a few years of political stability in EM. based on a muddling through scenario for the main economies. growth in these two economies remains robust and helps to underpin a positive view on the whole region. these economies are much less constrained by sovereign and private sector debt than those of OECD counties. although changes have been much larger in some of the smaller economies. that a further worsening outlook in the advanced world might be increasingly challenging for EM. at least within the next year.

0% over the previous two decades and is set to be sustained at close to these levels over the next five years. Capital market development and economic growth tend to go hand in hand. For the year ahead.2. Uganda. as reflected in our political risk indicators. In some respects.5 0. 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 region’s trade.7 Economics & Geo-Politics Africa The next frontier: who to watch Africa’s economic revival has been rightly hailed in many quarters and looks set to continue in 2012. Tanzania. and have a combined output roughly equivalent to the size of the Polish economy. such as Tanzania and Uganda (see Figures 5 & 6). this is just another manifestation of the secular boom in commodities resulting from the rise of emerging markets over the last decade. In part this reflects improved policies.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. will be a significant test of its democratic credentials and ability. and long histories of armed conflict. These buffers enabled many countries to ease policies during the recent downturn (see Figures 3 & 4).5 5.0 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. and is well in excess of growth of around 3. 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.5 2. Foreign reserves have increased and debt levels have been reduced.5 3. Deutsche Bank 7 6 5 4 3 2 1 0 Cote d’Ivoire 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. Senegal. pervasive corruption.0 3. to avoid a repeat of the protracted stand-off following the disputed 2007 elections. 26% oil. bumpy political transformations are likely to weigh on confidence and economic activity for many months to come.6% expansion in the BRICs. tops the 4. 11% phosphate 37% gold 18% coffee 84% copper Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . therefore. Ghana. elections in 2011 in Nigeria. we think the growth prospects south of the Sahara are better. 12% horticulture 90% oil 11% fish. and Zambia.0 6.0 2.0 7. While we think frontier markets in North Africa also offer potentially attractive returns over the longer term.7 Economics & Geo-Politics Robert Burgess EEMEA Chief Economist Marion Mühlberger Economist 2. and the prospects for the latter look relatively bright (see Figure 1). Figure 1: Local capital markets are small Source: Bloomberg Finance LP. We identify eight strongly-performing economies in sub-Saharan Africa that seem to offer the strongest potential for foreign investors. which make up 45% of the region’s population. Kenya. however. ethnic divisions. 17% cocoa 19% tea.0 1. Africa has not been left behind as the current global recovery has unfolded.5 6. however. rapidly growing urban populations. 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. 2001) 7. while the Johannesburg Stock Exchange is among the largest in the world with market capitalisation of about USD665 billion. 1991.0 4. Low incomes.5 1. passed off smoothly. But in contrast to past global slowdowns. their economies have been buffeted by headwinds from the global financial crisis over the past three years.9% growth seen in the rest of emerging Asia. National Stock Exchanges. this is eight times larger than the other bourses in sub-Saharan Africa combined. Stronger linkages with China and other rapidly growing markets have also added impetus to growth. Nigeria. For example. continue to leave some countries susceptible to bouts of social unrest and political tension. continue to deter many mainstream debt and equity investors. Figure 3: African growth has not been left behind in this recovery Current cycle (t=2009) Average last three cycles (1982. This matches the 6. 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). As in other emerging regions. Figure 2: African growth is catching up Africa frontier BRICs Source: IMF.6% from 3. 61% of its economic activity. Our list comprises Angola. And polls in Ghana in 2012 are expected to further underscore the country’s already strong reputation for political stability. World Bank. Over the past decade. helped in some cases by debt relief from official creditors. Deutsche Bank 8. Africa’s 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. This should change with time. Kenya’s elections. Uganda and Zambia.5 4.5% in South Africa (see Figure 2). under a new constitution. Most countries have done a better job in recent years of banking the dividends from stronger economic growth.0 5. Encouragingly. growth in our eight frontier sub-Saharan markets has accelerated to 6.

allowing central banks around the world to cut rates aggressively. a renewed sluggish recovery in the US. With the exception of India. but is likely to hold back economic growth in the short term. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . On the other hand. With respect to energy.2. if not more. if not appropriately managed. could also prove to be a double-edged sword. These two factors could keep inflation at elevated levels in many countries. The outlook could be even worse had it not been for the fact that household. This should help to restore macroeconomic stability and prop up their currencies.1 Malaysia 61. but not low enough to allow for sizeable policy easing. Global growth of much below 3% would likely be associated with weaker oil and industrial metals prices. At a time when sovereign debt crises are dominating the headlines. adding an extra layer of downside risk. Currencies may not appreciate substantially in the coming year though. global supply bottlenecks. as trade surpluses are on track to shrink and capital flow volatility is likely to continue. There are considerable downside risks to this forecast. We expect inflation to average about 4% in the region next year. Financial market uncertainty. as well as Zambia given its reliance on copper exports. Indonesia and Philippines 2. The chart below shows that public sector indebtedness in the region is strikingly lower than in the Western economies. this is indeed a key differentiating element.2 EU 77. Recent floods in Thailand could have adverse implications for rice prices in the region going into 2012. The debt crisis in peripheral Europe. There is clearly some room available for fiscal and monetary stimulus if economic weaknesses exacerbate.9 Philippines 31. We therefore expect regional exchange rates to either remain steady or to show only mild appreciation tendencies in the coming year. which has in recent years led to sustained exchange rate appreciation pressure. 7. these pressures have been exacerbated by a severe drought and weaker exchange rates. and public sector balance sheets in Asia economies are by and large stronger than their Western counterparts. could also adversely impact fundraising and system of payments. 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. and 31% in Uganda. Central banks have responded with aggressive rate hikes in the last few months.9 South Korea 41. Given this cloudy outlook. should in turn. which. and they stem not just from weak external demand (and its subsequent impact on local investment and consumption). which would be negative news for the region’s major oil producers. Unlike 2009. Asian economies tend to be characterised by sizeable balance of payments surpluses. Ghana’s framework for managing oil wealth has only recently been approved but includes several useful elements. but Asia’s 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. which have pushed inflation to 19% in Kenya. lower than 2010 and 2009. consumer and business confidence in Asian economies have remained robust this year. Going forward. 17% in Tanzania. In East Africa. money and credit conditions are already rather loose in most countries. The fragility sub-index gauges a country's vulnerability according to socio‐ economic factors.7 Economics & Geo-Politics Taimur Baig Chief Economist India. corporate. Decoupling remains unachievable for now.1 India 26. Figure 7: Differing degrees of political risk Fragility Resilience Score: 24=worst. Further ahead. Perhaps because of their fiscal and balance of payments strengths. 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. challenging 2012 for Asian economies. where new oil production is set to push economic growth up to about 14%. Angola and Nigeria.1 UK 96. Africa’s exposure to commodity markets. The newest kid on the block is Ghana. Asia Slowing but how much? A lacklustre 2011 is likely to be followed by an equally. continued negative real interest rates in core markets may continue to provide support for gold.9 G20 Advanced 91. and anaemic growth in Japan will likely continue to drag down demand for Asia’s exports. thus reducing the room available for interest rate cuts.2% vs.6%). stemming primarily from Europe.8 US % of GDP Pakistan Bangladesh Lebanon Egypt Sri Lanka Serbia Note: The political instability index is composed of two sub‐indices. we are more optimistic that the government will be able to rein in public spending. Nigeria’s recent experience has underscored that. Consistent implementation of this framework through both good and bad times should help to further lock in Ghana’s growing reputation as of one of the continent’s brightest long term prospects. Short of a major exacerbation of the global economy and financial markets. but also from the outlook for food and energy prices. while the resilience sub‐index measures the capacity of a country to mitigate political risk and withstand economic shocks. and sustained emerging market demand suggest a continuation of high prices. 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. the durability of the economic revival in Africa will also depend on how countries manage their commodity revenues.8 Economics & Geo-Politics Inflation has accelerated to about 11% over the past four to five months from a low of 7% a year ago. Our Asia (ex Japan) growth forecast for 2012 is about half a percentage point lower than in 2011 (7. which could help to mitigate some of the negative effects of a global slowdown on Ghana and Tanzania. which has driven its terms of trade to record highs. oil revenues can lead to wildly pro-cyclical spending patterns and macroeconomic volatility. so rate cuts or liquidity measures may not have much traction in any case. when a sharp slowdown in the global economy was accompanied by a collapse in commodity prices.6 Thailand 102. Asia could continue to generate growth rates that would be several hundred basis points higher than their Western counterparts. despite a sharp drop in trade and a surfeit of negative external developments. making it easily one of the fastest growing economies in the world this year. the situation appears to be less clear cut for 2012. bring some stability back to the foreign exchange market and pave the way for continued strong growth. it is logical to expect a slowing of growth in Asia.1 Indonesia 53. Moreover. poor inventory levels. other than China and India.

Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank .3 Markets US Equities European Equities Asian Equities Emerging Market Equities Credit Commodities FX Rates ABS The articles marked with this icon are based on Deutsche Bank Research.

dividends will continue to be raised. an ageing population which is raising the relative demand for fixed income.4x) 15 10 10 5 Oct–28 Oct–32 WW-II. A notable development of late has been the large number of firms instituting or raising dividends. Investors have been paying a premium for high dividend stocks and an overall increase will support the market multiple. The consensus tends to attribute the low multiples of the 1970s to inflation. healthcare. We recommend being overweight the domestic cyclical sectors (financials. sales will continue to grow significantly faster in 2012.5% on a seasonally adjusted basis. While Japanese equities de-rated significantly in the 1990s they did so from bubble levels. M&A and share buy backs. with margins remaining well supported. S&P 500 earnings per share (EPS) recovered to near trend levels in Q2 2011. Figure 3: Share Buy Backs over past Decade S&P 500 Net Buybacks (USDbn. therefore. The Fed is committed to keeping bond yields low. equity returns depend critically on what happens to the multiple. These include the lack of investor demand for equities when 10-year returns are near zero. 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. not been bad for equities. 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.6x 25 20 20 15 Fair Value (16. Indeed our 2012 S&P 500 EPS estimate of USD106 could be on the conservative side. or high tax rates. the multiple remains within its historical one standard deviation band of 10 to 20 but it is 30% below fair value in our estimation. The US is not Japan. we see the initial conditions for widespread cutbacks – a central part of previous recessions – as absent. 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. We see this unwind as having much further to run. very high inflation & bond yields Oct–84 Oct–88 Oct–92 Oct–96 Oct–00 Oct–04 Oct–08 Oct–12 5 Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . 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. macro policy uncertainty and sovereign debt risks.2x. 1949 recession Oct–52 Oct–56 Oct–60 Oct–64 Oct–68 Oct–72 Oct–76 Oct–80 Oct–84 Oil shocks. Just released Q3 2011 data reinforce this read: real GDP growth of 2. In our baseline of slow GDP growth (consensus and Deutsche Bank). telecoms. All in all. but have been recovering strongly with the market.4x LTM earnings through April 2010. and then grew robustly in Q3.4x).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. 2000 (Tech bubble burst) and 2008 (Lehman) they rose by an average of 11%. In the last 19 presidential election years. Fed policy. In the 1930s the trailing multiple averaged 16. 2. 1933-37: 19. but the market trading near March 2009 low multiples of 12.5x. if you exclude the outliers of 1940 (WWII Germany invaded France). Recessions typically happen late in economic cycles when companies are over-extended and cost pressures rampant.2%.2% Mean 9. historically. Rising dividends. Many observers point to a host of reasons why the multiple will remain low. high inflation and/or high bond yields. During 2009/2010. Many have drawn parallels with the 1930s and with the ‘lost decade’ in Japan. But since May 2010 the multiple has persistently been below fair value and. the outlook for earnings looks good and we expect them to grow by 7% in 2012. 6. True. the S&P 500 they rose by average of 6. Presidential election years have. deep recessions. Labour cost inflation will remain benign.5x 2011 earnings. was 12. The equity multiple is more open to interpretation. Corporates are the largest buyers of US equities.0% US Equities It’s all about the multiple With earnings set to grow by 7%. making them the one clear element that has exhibited a classic V-shape in this economic recovery. Lesson from the 1930s. This is close to what we consider to be fair value (16. The domestic cyclicals massively underperformed the defensives in 2011 from February through the early October bottom in equities. tech.2x Avg P/E. The multiple averaged 19. 7. we are constructive on prospects for US equities in 2012. 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. As long as equities remain cheap and corporate cash flows strong. But we are constructive on prospects for the multiple in 2012 for several reasons: 1. 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. multiples rebounded strongly from a low of 12. very high inflation Oct–36 Oct–40 Oct–44 Oct–48 Very high inflation.5x LTM earnings in March 2009 and traded around fair value of 16.4%. the unsustainability of earnings made by cost cutting and cyclically high margins. 8. a higher uncertainty premium with potentially more frequent business cycles. With recovery from the last recession far from complete and companies still running lean.3. US recession is unlikely. industrial.1 Markets Binky Chadha Chief US Equity Strategist 3. 1930s: 16. the same as at the March 2009 low.6 (typical recovery multiple) between the two recessions in the 1930s. 4. as is typical in recoveries. while unit labour costs fell by 2. 3. at the time of writing. With equities very cheap to credit. discretionary) versus defensives (staples. utilities). nominal of 5%. Presidential election year. We believe elevated unemployment will continue to restrain labour costs which represent 70% of firm costs. 30% below fair value. 5. 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.

on PE multiples of 17 times or so while some cyclicals such as Rio Tinto are trading at just eight times. however.3. dividend cuts and question marks about their long-term returns. will be found in globally exposed cyclicals which sold off dramatically in the summer and now look undervalued. Second. Classic defensives such as Nestlé are.5 times. Now. It is important to remember that European stocks are not plays on whether or not we get a solution to the sovereign debt crisis. basic resources and chemicals and believe the DAX looks relatively attractive. Buybacks in the UK for example should finish 2011 at more normal levels (1% of market cap). 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. 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. Our preference for cyclicals does not extend to financials. the same margin as the final quarter of 2008 when the crisis was at its height. it is not unreasonable to expect earnings to grow by 6% or more. We recommend an overweight position in autos (which have performed as though we are facing another credit crunch). in our opinion. and we avoid the worst case scenario in Euroland. is whether to switch from the defensive stocks that have served them well in the crisis to cyclical stocks. In July. they face a headwind of weaker Euroland growth. at the time of writing. Stocks with a high exposure to government spending are another subset of domestic stocks that continues to look vulnerable. a company with a higher than normal sales exposure to China was trading on a 20% premium to its sector on forward PE basis. True. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank .5% (as we expect it to do). 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. The difference between the PE multiples of defensives and cyclicals is now more than 6. Our view is that the time is now right to make the switch to cyclicals. While banks look cheap and may recover in the short term. This strikes us an over-reaction particularly given that domestic economic conditions are hardly better than in China. The downside risks are especially pronounced in France and Italy where an avoidance of consumer related stocks in general also seems sensible. The best opportunities. We think they are.2 Markets Gareth Evans Co-Head of European Equity Strategy European Equities Time to be bold The key question for investors in European equities. 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. we believe. or at least at the time of writing. First. they are trading at a discount.

3. travel and entertainment. Growth investors should focus on the projected growth in middle-aged and older folks in Asia – financial services (not banks). While bouts of reflationary expectations in the US. The price of entry into any investment story is important. is likely to pose a threat to the decadelong bull market in base materials and industrial cyclicals.0% 8.0% -6. Asia ex-Japan has paltry FCF yields of around 3%. Asia exJapan is only half as undervalued as the US. Numbers based on non-financial companies in the MSCI regional indices. On conventional models comparing Price-Book ratios with the gap between Return on Equity (ROE) and Cost of Equity (COE). As an example. There are three key reasons why we think Asian equities are likely to underperform developed market equities.0% Source: Deutsche Bank.0% 8. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . Thailand. in our opinion. luxury goods. and upper-end healthcare look promising. compared with 6% each for the US and Japan. a consequence of a policy error. Factset. solid balance sheets and analyst support is the way to generate relative returns.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 cashflow yield Asian equities are likely to underperform developed market equities in 2012 just as they did in 2011. A more disorderly slowdown in China. again. Asian equities have little or no valuation advantage over developed equities. the underlying dynamics in Asia are challenging.0% -4. 6. Europe and especially China are likely to lead to periodic rallies. Europe (9%) & Japan (6%) US 10. MSCI. Countries that have underinvested – Korea. Figure 1 shows the free cash flow yield for the four key regions.0% 4.0% 4. and 9% for Europe. First. Europe or Japan. Note: *Free cash flow yield (12m trailing)=(net income after preferred dividends + Depreciation and amortisation expense – Capital expenditure)/ Market cap.0% 6. The expected contraction in youth cohorts (except in India and the Philippines) is likely to pose a challenge to technology and internet stocks.0% -2.0% -4.0% -2.0% 0. and the Philippines – have pockets of value.0% EU AXU JP 10.0% 2.0% 2.0% 0.3 Markets Ajay Kapur Head of Asia Equity Strategy 3.0% -6.3 Markets Asian Equities Focus on large caps Figure 1: Asia free cash flow yield* (3%) – well below the US (6%). We think a focus on large-cap stocks with inexpensive valuations (especially dividends).

0% 5. Numbers for Asia (excluding Japan) are USD nominal GDP weighted. A drop in regional inflation.0% 11.0% -1. Capex/GDP is the gross fixed capital formation as percentage of GDP. FactSet. would likely lead to a rally in Asian equities.0% 23.3 Markets 3. Taiwan and Hong Kong.0% 5. pushed forward by 6m (LS) 6. Factset Note: EBIT margin is calculated based on non-financial company annual reported data.0% 13. A shift from bonds into equities by institutional investors. the relationship between nominal GDP growth and EBIT margins has broken down around the world. attracted by relative valuations would also be beneficial to Asian equities. Note: EBIT margin is calculated based on non-financial companies in MSCI Asia ex Japan. Europe and Japan have all seen their corporate sectors cut back on capital investment since 2007. GEMS had underperformed US for eight years.3. India. This problem is likely to turn acute in China. The reason is past over-investment in many Asian countries – particularly China.0% -3. the risk case of a global recession only amplifies these issues for Asian equities. CEIC. A crisis can be cathartic.0% 3. would lead to lower interest rates and be helpful to Asian equities. 12mth (RS) OPI YoY% less ULC YoY% 12mma. both on a cyclical and structural basis. where the productivity of incremental credit expansion is falling. Figure 5: USD was strong in 2002.0% 25. Singapore. and poor investment is already leading to an erosion in profit margins. monetary or fiscal. Source: Deutsche Bank.0% 4. the US. FactSet.3 Markets Second.0% 0. IMF. 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.0% 2.0% -5.0% 15. and a policy or regulatory shift here would have a substantial positive impact. Taiwan and Thailand. Note: EBIT margin is calculated based on non-financial Asian (excluding Japan) companies. there were 2. Spain and Italy have higher EBIT margins than most of the ‘growthy’ emerging markets (see Figure 2).0% 20. What could go right? What are the risks to this conservative view? A global reflationary package.0% 1. CPI yoy% less ULC yoy% are the average number of China. the US dollar is at new lows. Today. So.0% 15. Conversely.0% 21.0% 19.0% 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. 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 Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . CEIC. Any rise in the USD versus a basket of currencies is normally bad for Asian/emerging market equities (see Figure 5). 2y MA. Korea. and capex cuts normally lead EBIT margin expansion by about four years.0% -2. the gap between Asia’s pricing power and unit labour costs is at peak levels and rolling over (see Figures 3 and 4).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. On a cyclical basis. Source: Deutsche Bank.0% -4. A reflation in China would be especially powerful for regional equities.0% 9.0% Japan 5.0% 7. Hong Kong. Domestic pension funds in the region are severely under-invested in the equity asset class. we note Asia’s margin power is likely to suffer.0% 10.000 companies as of 2010 Figure 3: EBIT margin drivers in Asia – price less unit labour costs is peaking EBIT Margin.0% 0.0% 17. While it is not our house view. The third key reason is the fact that the US dollar is at its lowest levels since the breakdown of Bretton Woods. Indonesia. 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. Datastream US Trade Weighted Real Broad Dollar Index (LS) Emerging Market Equity Index (USD)/World Equity Index (USD). Figure 2: Correlation between nominal GDP growth and EBIT margins breaking down? Spain and Italy have better EBIT margins than most of Asia 25.400 companies as of 2010. 2y MA (RS) Capex/GDP. there are around 5.

but we would like to see lower valuations and a clearer road map for reform before we upgrade. and look set to remain there. where the high level of valuations indicates to us that investors overestimate its relative resilience. We acknowledge that the risks are relatively high but think they are at least partially discounted. I’ve 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.4 Markets John-Paul Smith Global Emerging Markets Strategist 3. 1. Cash Return On Capital Investment. We believe the economies of Turkey and Central Europe should be major beneficiaries of lower commodity prices so we are overweight here. in the absence of any real sustainable momentum – we think that this is unlikely to change over coming months. 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. India should also gain from cheaper commodities. which seeks to exploit the rapid swings in sentiment which regularly sweep the EM investor base.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. 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 country’s 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. given that no one style has tended to pay off. 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. it’s 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. How should investors position for this new environment? In absolute terms. especially for the BRIC markets and indicate that emerging equities are much more dependent on top line growth than their developed market counterparts. We would not put much store on earnings-based ratios given the prevailing level of uncertainty. We are also concerned that further US dollar appreciation against EM currencies will leave many EM corporates exposed by their short US dollar. or else a more active but highly contrarian trading-based approach. We would accordingly advise investors to adopt either a long-term approach based on a combination of valuation and structural political economy factors. Relative return investing within EM over the past 18 months or so has been difficult. It is worth noting that these are the views of the EM strategy team not the house view which is more optimistic on China. long commodity positions and that retail allocations to EM equity funds will be reduced. A key driver will be China. commodities and EM FX. 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. where we are concerned about the impact of declining external demand on a potentially fragile domestic economy. around a year ago. namely EV/NCI. We are also overweight in Mexico and Taiwan. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . and the US in particular. even if both appear a little uninspiring from an absolute return perspective. 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. which we view as relatively safe havens on reasonable valuations. Finally we are underweight Korea. The cashflow measures looks less reassuring however.3. We are underweight Indonesia.

more worryingly. Despite recent capitalisation efforts. over the past 30 years we have had long cycles by historical standards. Credit spreads are highly cyclical and therefore an understanding of the business cycle is essential in any predictions for credit. In such a scenario. The crisis may not stop at Italy. Overall within bank capital structure. banks continue to be under pressure despite recent supportive measures from the authorities. Q3 2011 saw a significant re-pricing that took credit spreads from late cycle levels to early recessionary levels. As you can see. However. Although we note these buybacks are easier said than done in this environment.3. That said it’s difficult to ignore the fact that credit markets still remain at the mercy of the macro environment. Indeed we are arguably seeing policy contraction too soon after the once in a lifetime financial crisis seen in 2008. the risk of an extreme outcome in Europe is building. current T1 pricing shows that there could be idiosyncratic opportunities in case of buybacks for both the bank and investors. 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. 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. With Spain and. we believe European banks would need more than EUR300 billion in capital rather than the EUR100 billion announced leaving banks vulnerable if events don’t turn out as planned. Fiscal measures now seem inadequate to arrest this crisis. Therefore we could easily see spreads eventually trade wider than the peaks in Q3 2011 at some point in 2012. current depressed sub debt prices also offer banks alternate ways of capitalisation. In addition we believe it would be fair to say that. we think a return to normal length cycles is likely. non-financial credit fundamentals and technicals remain extremely supportive. For us the ECB is the only institution that can prevent an extreme scenario in Europe. 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.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. For credit specifically. The good news is that we are now pricing in levels of default higher than anything we have actually seen since the Great Depression. Although we strongly believe that any recapitalisation from tax payers would lead to increased pressure for burden sharing on subordinated debt. whether it be concerns around European sovereigns/financials or more general economic growth concerns. Figure 1 above shows the length of each business cycle expansion since the 1850s (the higher the bar. liquidity and capital. A repeat of the 1937 (deep) recession is possible as this too was preceded by fiscal and monetary contraction too soon after the Depression. This is likely to encourage further deleveraging which is a negative for economic growth. 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. Overall. it will likely reduce the risk of a systemic shock but it won't necessary help prevent a recession in Europe and perhaps elsewhere. We estimate that Tier One securities offer around EUR30 billion of potential benefit through buybacks via tenders or exchanges. Our belief is that it needs to significantly expand its bond buying operations and adjust its mandate to do so.4 trillion until 2013 we expect term funding to remain stressed in 2012. 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. ‘Think the unthinkable’ continues to be our mantra. 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 Markets in 2012—Foresight with Insight Deutsche Bank 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 Markets in 2012—Foresight with Insight Deutsche Bank . Italy now reliant on the ECB we are getting to a critical point in this crisis. they nevertheless highlight a unique opportunity for banks to take out legacy securities ineligible for Basel 3 regulations and replace them appropriately. the longer the length of the expansionary cycle). 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. Significant build up of leverage during the boom years means that banks continue to face a three pronged problem – term funding. we strongly believe that the current round doesn’t budget for the scenario where Europe goes into a deep recession which is possible with the crisis playing out in the region. Even if the ECB does become more aggressive. as mentioned in the introduction. Also. If the ECB is not prepared/allowed to dramatically expand its balance sheet in 2012 then the worst case scenario in Europe looks feasible. 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. Without such a conversion the European sovereign crisis could destabilise all global financial markets. we like bank senior paper given the capitalisation wave and conviction shown by authorities to protect the par amounts. In non-financials. 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. In the 18 months since the initial Greek bailout we’ve now seen five countries require outside assistance (EU/IMF or the ECB) in funding their Government debt. in isolation. The primary market shutdown has meant that banks are not able to fund long term and given the refinancing needs of EUR1.

perhaps linked to a developing La Niña phenomenon. we will see bank de-leveraging that will curb access to trade finance. the ability of commodity prices to push higher in 2012 is not certain. We believe we will continue to see episodes of risk aversion through 2012. However. If unsuccessful. whether China can engineer a soft landing and whether European policy-makers can find a market friendly solution to the region’s sovereign debt crisis. These episodes have typically punished energy and industrial metal prices. 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. and will depend on whether the Fed’s efforts to stimulate growth are successful. commodity markets have had to contend with increasingly frequent. We believe the prospects of the industrial metals and bulk commodity markets will start to improve as the authorities in China loosen monetary policy. 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. 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. can still have the power to cause significant policy headaches for central banks and government. we view an overshooting in the gold price as a high probability event.6 Markets Commodities Can they push higher? Ten years ago.5/barrel (Brent equivalent) and indicate a level at which OPEC might start to consider production cuts to defend the oil price. 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. as we expect. It is also worth noting that even if it is not contained. our strongest conviction trade remains long precious metals and specifically gold. For this reason. 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. For the GCC nations as a whole. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . Since super-cycles in commodity markets typically last up to 20 years. then the implications for global growth and hence world commodity demand would be bleak. longer lasting episodes of heightened asset market volatility. trading strategies in commodities should remain defensive. we estimate break-even oil prices stand at around USD86. 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. However.Michael Lewis Global Head of Commodities Research 3. We believe this will be helped by a moderation in food inflation. If world growth slows more sharply than we expect next year. According to the measures we employ. Of these. which is involved in as much as 90% of world trade.170/oz for prices to be considered extreme and for the market to start displaying bubble characteristics. Indeed given investor appetite to protect against tail events such as the break-up of the eurozone. 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. We believe the fortunes of the energy and industrial metal sectors remain closely tied to the prospects for world growth. we view Europe’s financial crisis as the greatest risk. Consequently. If. gold would need to move above USD2. one could argue that we are only half way through the current one. Since the onset of the financial crisis over four years ago. the low level of inventories across many agricultural markets will mean that any unforeseen production setbacks. commodity prices began their long march in response to strong demand growth across the emerging markets and years of underinvestment in new productive capacity.

the EUR is expected to remain a favourite short. many FX derivative contracts were pricing in high levels of implied volatility in their underlying exchange rates. momentum or valuation – worked especially well in 2011. while supporting weak. the developing world has much more divergence in monetary policy to capitalise on. 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 EUR’s travails. will also not help the USD’s cause. 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. Although the 2012 risk environment is likely to be volatile. by selling US dollars forward. because G4 interest rate spread volatility is likely to remain low. Trading strategies None of the usual trading methodologies – carry. as well as a tendency for Central Banks to try to avert large CHF and JPY strength. A basket of quasi-China longs (CNY. although some investors may wish to protect against such a scenario. and continued pressure from the rating agencies.40. which supports buying zero cost BRL risk reversals versus the US dollar to take advantage of their skew. At the time of writing. A similar intra regional trade this time in Asia is short THB/PHP. should keep the yen well bid. with the yen followed by the US dollar the primary beneficiaries. A US election year marked by substantial fiscal drag on the real economy. Lastly. EUR/USD levels near 1. systemically important currencies like the USD and EUR. 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. A collapse in the EUR is not expected without more evidence that capital flows are exiting core asset markets.3. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . particularly in the area of implied versus realised volatility. and central banks will again try smooth excessive volatility in systemically important currencies like the EUR and USD. and over 8% in real terms in the past year. This is not a EUR hardlanding. While periodic large scale BOJ/MOF intervention will produce infrequent spikes in yen pairs. USD and GBP. TWD) with some of the strongest external balance fundamentals. But realised volatility will likely be lower. MYR. Euro versus US dollar Directionally. Much of the rest of the developing world will similarly be defined by the global risk environment. in an attempt to circumvent credit risk. or 20% above PPP. So far. 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. 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. Unlike in G10. We believe an even better flight to quality vehicle than the USD is the yen. most flows from the periphery have simply found their way to the core.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. we expect further declines in the euro. the tendency of Japanese investors to hedge the FX risk on their US dollar investments. while the downside limit is less easily demarcated but will likely stall before 1. SGD. and grinding to Y70 on USD/ JPY and Y95 on EUR/JPY. Under the assumption that the crisis fails to abate but EUR constituent currencies remain unchanged. many developing currencies have the reserves to smooth out a further risk blow-out. will remain an active sell zone. If market attention remains centered on Euro Sovereign debt. without taking on additional currency risk. Stress in France’s bond market would be one signal that larger EUR losses are likely to be forthcoming.20. On the other side. But the uncertain macro-economic outlook has created some interesting dislocations. and Thailand may ease while the Philippines holds steady. Unfortunately the global backdrop that produced modest returns is not likely to change materially in 2012. but are driven by many of the same factors as the PLN and HUF. should continue to outperform a G3 funding basket of the EUR. This is indicative of the same macro issues driving all currencies. 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.

we expect these disinflationary dynamics to dissipate. or from further large scale asset purchases. Highly rated CMBS should continue looking like good value relative to highly rated corporate debt. and credit card and auto loan securitisations. only to be at risk of a violent unwind when the policy reaction function shifts. Finally. which is the only institution with sufficient flexibility and firepower to stem the current negative sentiment. More aggressive policies will be required in 2012 and we expect the European Central bank to cut rates from 1. 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. in our opinion. In Europe. we expect the ECB. non-agency MBS would be a major beneficiary. In the US. Structurally. The USD1. relieve debt pressure on borrowers and stabilise home prices should shape MBS market pricing. prepayments and defaults overwhelm almost nonexistent new issuance. QE3. 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. Wide spreads on corporate debt should continue to make securitisation an attractive source of funds for niche issuers. or ‘QE3’. this could undermine market confidence in the ability of the US to cut fiscal deficits and potentially cause further downward pressure on the US’s credit rating. and possible changes in the Fed’s communication policy. The ‘peripheral’ markets are RMBS from peripheral European nations such as Portugal. A more inflationary pricing structure could result either from robust economic growth. Ireland.4 trillion agency MBS market is that it should grow slightly as securitisations issued by Fannie Mae. we can’t help but noting that the European bond market appears to be pricing a significant probability of an extreme outcome. telecommunications and other markets issued a steady flow of niche securitisations. There will be no return to subordinated issuance. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . 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. During 3Q 2011. rates look set to oscillate between two distinct economic and policy situations in 2012: the first disinflationary. Italy. we expect new issuance volumes in these areas to increase. Auto lenders – including lenders to subprime auto buyers – used securitisation to raise USD67 billion in funds so far this year. ease mortgage refinancing. The ‘core’ markets are UK and Dutch prime residential mortgage backed securities (RMBS). with the (GDP weighted) average government bond yield in Europe now diverging from the expected policy rate. we would expect to see rates rise. At the time of writing (November 2011). the second inflationary. Freddie Mac and Ginnie Mae continue to fund more than 90% of all US mortgage lending. spreads tighten and risky assts outperform non-risky assets.8 Markets Dominic Konstam Global Head of Rates Research Francis Yared Head of European Rates Research Conor O’Toole European Securitisation Research Steven Abrahams Head of US MBS and US Securitisation Research 3. 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. Investors and traders in asset backed securities will have some interesting challenges and opportunities to navigate in 2012. For this reason. as it was before 2008. 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. The super-committee is between the devil and the deep blue sea. we expect greater pressure on Spain and France relative to Belgium and Austria. rate cuts alone will not be sufficient owing to the breakdown in monetary transmission in the eurozone. But although the primary outlook is not particularly exciting. market pricing implied a disinflationary environment for 2012 with lower rates. In Europe. Low and stable US rates should favor MBS with the best carry. Another factor to bear in mind in 2012 is regulation. we believe nonEuropean assets could provide a better hedge against systemic risk in Europe than European assets. Within Europe. In this environment. Credit card lenders continue to stand back from securitisation in light of the low cost of funding with bank deposits. The third issue consists of potential changes in the Fed’s communication strategy regarding the trade-off between unemployment and inflation. however. 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. this will intensify the existing fiscal headwind. However. During 2012. or both. Three issues that cloud the outlook are the cuts due to be proposed by the super-committee.3. If it makes front loaded cuts. a general flight to quality should continue to benefit German bunds and prevent a significant normalisation. If it backloads them. to expand their fiscal efforts via increased purchase of government bonds. from the Fed as a reaction to falling inflation or recession. yield curves flatten. The sector’s steady shift toward higher levels of credit enhancement and public transactions should also help widen the investor audience. the market can be divided into two parts: ‘vanilla core’ markets which are broadly functioning well and should continue to do so in 2012.9 Markets Rates Two scenarios ABS Challenges and opportunities In the US. and (in the latter) as the arbitrage continues to be unconvincing. and that volume looks likely to grow. But as the year progresses. 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. 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. A soft US economy and unpredictable liquidity in the sector pose challenges. but lenders in the fast food. flatter yield curves. Efforts by US regulators to raise the cost of agency loan guarantees. Thus. The USD693 billion CMBS market should continue its steady rebound. and ‘peripheral’ and ‘non-vanilla core’ markets where there will likely be trading opportunities but very little new issuance.25% to 1% during 1H 2012 and to keep them low for a prolonged period of time. following the repricing of the Italian bond market in November. ‘non-vanilla core’ include commercial mortgage backed securities (CMBS) and collateralised loan obligations. the presidential election. we are more bearish than consensus on the medium term macro outlook. and may see some changes. 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. the focus will probably shift to other weaker sovereigns. Since the beginning of the crisis. New issuance should rise from roughly USD30 billion this year to USD45 billion next. Investors will also have to watch the Federal Reserve’s appetite for agency MBS. we are beginning to see some push back on these capital and liquidity requirements. while we believe that the tail risks of a systemic crisis are unlikely to materialise over the near term. there will likely be interesting opportunities in the secondary market. In 2012. the outlook for the USD5. However. The presidential election complicates matters further. Spain and Greece. 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. Finally.1 trillion non-agency MBS market should contract by another USD200 billion next year as amortisation. this approach won’t generate much relief. They now look undervalued. as the entitlement reform which could provide a time-consistent means of addressing future deficits is politically difficult. which is not truly reflected in many assets outside of Europe. 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. If new federal efforts to stabilise home prices work. wider spreads and the out-performance of Treasuries versus riskier assets. Until a stronger policy response materialises.

4 Sectors & Corporate Strategy Outlook for Corporates M&A Natural Resources Telecoms & Media Consumer Goods Industrials Financial Institutions Financial Sponsors Technology Healthcare Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank .

Buying back shares certainly appears attractive whatever the economic conditions. 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 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. growth expectations and other variables. On the second question of financing. in the opinion of our equity strategists. Dividend increases seem more suited to negative economic scenarios. providing we see some stabilisation in the macro-economic and market climate. the conditions for M&A are now the strongest in recent history. both the executives that run them and the institutions that invest in them. Corporates that are able to understand and monitor these risks and have the systems.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. However. the outlook for 2012 is broadly positive. share prices rising. the focus is likely to be on mergers & acquisitions. The two key questions for corporates. it would seem prudent for corporates to raise as much as they can. The financial markets and Western economy are clearly in a fragile state with numerous situations. Demand for non-financial investment grade corporate bonds is strong (partly because of investor concern about the banking sector). In a rising market. In others. Estimates for the funding gap for US corporates range from USD400 to USD500 billion depending on discount rate assumptions. with investors focusing on income rather than capital growth. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . In a weak or falling market. 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. 30% below fair value. commodity prices falling. The choice between organic capacity expansion and mergers & acquisitions is. the case for capacity expansion is compelling. According to Deutsche Bank’s 'M&A affordability index' which looks at debt financing costs. Investment in cloud computing technologies and services. a challenging but potentially very exciting year ahead. This increased the cost of hedging using plain vanilla products and made multi-asset hedges more attractive. particularly the eurozone crisis. US equities are currently trading at their lowest multiples since March 2009 and are now. Emerging markets continue to offer significant opportunities with Africa emerging as a region with particular potential. During 2011. Here. for example. But if the situation stabilises or improves. The third key area that corporates will need to focus on is risk management. as always. Europe shrugging off recession. for example. perhaps. Studies indicate that for each 1% decline in rates. we could see very favourable conditions indeed for corporates with growth returning to the US. The choice in the former is between growth (expanding capacity and/or making an acquisition) and consolidation or defensive strategies (buying back shares. If the eurozone situation deteriorates. capable of delivering sharp shocks to market confidence. the most intriguing. All in all. as early as they can in the year to protect themselves against prolonged market closures. and this is our baseline view. In some sectors. The outlook for equity issuance is also positive. just as they did in 2011. Prospects for M&A activity generally look strong. The vast gulf between these two scenarios makes the strategic choices taken by corporates in 2012 especially important. I would expect this to continue in 2012. sudden swings in both commodity prices and exchange rates. it could have significant benefits. 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. growing earnings significantly through organic growth alone may be challenging. staff and infrastructure to identify appropriate hedges will outperform. Given this. these liabilities will increase by between 10% to 15%. and large parts of the developed world slipping into recession. and initiating or increasing dividends). and interest in high yield paper has picked up significantly in recent months. 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. counterparty credit risk increasing. they will not significantly enhance share prices. We expect to see large cap companies continuing to spin off non-core assets and using the proceeds to increase their operations in Asia. The pharmaceuticals industry. are how to employ capital (if you have it) and how to raise it (if you don’t). falling credit spreads and the return of liquidity to the capital markets. we can expect severe disruptions to all areas of the market with capital becoming harder to raise. we saw some very severe. Another issue that many corporates will need to address is pension liabilities. 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.4.

we have not experienced the type of significant contraction that followed the Lehman bankruptcy. To illustrate.37%. the question of whether we are entering a repeat of the 2008/2009 scenario is a natural one. we have seen three M&A up-cycles. Carrefour and ThyssenKrupp have all recently announced such transactions. Excludes AIG preferred to common conversion.4x (the inverse of the after tax cost of debt). The most recent trough was in 2009. We expect this trend to continue into 2012. Tyco. about the highest it has ever been. and three down cycles. Backed by a stronger yen and faced with low domestic growth environment. equity valuation multiples were higher leading up to the 2008/2009 crisis (i. In addition to positive investor reaction. Several large corporations including Pfizer. We also believe the China outbound theme is likely to continue. 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. we are in a low interest rate environment. ConocoPhillips. We think the Japan outbound theme is likely to continue in the near term. 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. Through November 9. 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. with significant amounts of un-invested capital. 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. Under this backdrop. We also believe financial sponsors.4. Financial sponsor activity We expect the bulk of the activity in the near term to be driven by corporations. Furthermore. However. 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. While overall cross border volume is modestly up. 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. While there have been some bumps in the road as a result of the European sovereign debt crisis. How the index works is that the greater the index value. Conclusion Over the last three decades. and spinoff transactions have generally been well received by the market. Abbott. 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. Importantly. lasting between five and nine years each. which gives the index a value of 36. there was more room to fall). as of November 9. we expect the M&A up-cycle to continue in 2012. lasting between two and three years each. Multi-line corporations looking to unlock value through spinoffs Many multi-line corporations. we believe. The latest 12-month P/E of the S&P 500 is about 13. global M&A activity has continued. From a regional perspective. and while we have had a modest fall off in equity values post the onset of the volatility. as well as through other forms of investment less dependent on the availability of leveraged debt markets. 2011. during the peak of the up cycle in 2007. whereas current equity multiples are relatively low by historical standards. the index stood at circa 13. 13% 11% 10% 8% 8% The index. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . which we introduced last year.. and valuations that are in many cases at discounts to the sum-of-the-parts valuation. the best opportunity for growth in a slow organic growth macroeconomic environment in the industrialized economies. This will likely take the form of both through traditional buyouts of targets that have the ability to tap the leveraged debt markets. either as a result of their own strategic reviews. compared to the same period last year. M&A currently represents. Bolstered by record levels of cash. 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. Americas has experienced the highest growth and is up 22%. For an acquirer whose marginal tax rate is 40%. From a sector perspective. 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. With the overhang of continued anemic GDP growth. 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’. with the cost of financing for well capitalised acquirers near historic lows.2 Sectors & Corporate Strategy M&A Outlook for 2012 Despite the volatility and capital market stresses that began over the summer. and 2011 marks the second year of the current M&A up-cycle. are taking a hard look at corporate spinoff transactions as a means of unlocking value.e. One of the drivers of this trend is historically low valuation multiples. or as a result of pressure from activist shareholders. Kraft. especially in the natural resources sector. while EMEA and Asia are up 11% each. M&A activity is ultimately correlated with equity market performance.2 Sectors & Corporate Strategy Henrik Aslaksen Global Head of Mergers & Aquisitions 4. whereas liquidity and risk management were the main themes in 2008/2009. Current M&A environment: Given the proximity in time to the M&A downturn that followed the bankruptcy of Lehman Brothers in 2008. By comparison. global M&A volumes in 2011 are about 13% higher than the comparable period in 2010. earnings growth and value creation continue to be the main themes at Boards and C-Suites. Japanese outbound M&A activity has posted a 72% increase through the first nine months of 2011. Investors appear to be placing greater value on pure play focus. we expect this trend continue to be a big driver of deal making in 2012. deleveraging among banks is ongoing and that could continue to make the availability of financing more volatile.4. the composite yield on 10-year single-A rated corporate debt in the US is currently approximately 3. 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. albeit at a slightly lower pace. will continue to participate in the M&A market. the activity has been broad based as shown in the chart below. the implied P/E of new debt is therefore 49. one segment that has seen a substantial increase is outbound M&A activity from Japan. under the assumption that the volatility subsides and stability returns.

In the short term. 6. 1. drive substantial capital expenditure in the utilities sector. both organic and by way of acquisition. 4. Governments will adopt more coherent (and increasingly expansive) policies. In this context we see Africa as a positive but longer term play. combined with protectionism and intervention. 6. drivers and factors influencing investment. which is illustrative of one of many areas where we believe that corporates will increasingly seek to re-cycle capital. increased commodity and currency volatility. which will. given political and infrastructure constraints. or possess significant emerging market exposure. macro-economic and geo-political issues will likely continue to dominate the market performance of resource companies. technological or managerial nature. The underlying cost of commodities to companies and end consumers will rise dramatically which will have social implications. 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. as market volatility abates. which in turn will accelerate cross-border investment. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . Financial investors will show continued strong demand for regulated utility infrastructure companies that provide long-term. asset-backed. across North America. 2.4. the nature of corporate activity will change significantly. we expect companies’ fundamental value to be recognised increasingly. in time. Corporates will increasingly seek to secure finance from alternative providers. Longer term we see seven fundamental trends driving the sector. low growth and inefficiencies. In time. cash flows and earnings. In so doing. Combined with the increased competitiveness of emerging markets. 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. 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. better capitalised investors the opportunity to acquire relatively distressed businesses on compelling terms. 5. a sustaining of the mining super-cycle. Finally. We expect a reduction in subsidies for renewable technologies as they become more efficient and governments cut spending. and lead to regulation of certain competitive market segments. The indirect impact of austerity measures will partially moderate industrial growth and resource demand. a nuclear renaissance. Concern about climate change will lead to a re-balancing of the fuel mix. and. 7. despite the best efforts of management teams. Longer term. 4. including resource nationalism. predominantly Tier 1 and of scale. despite our confidence in identifying the outlook. and in part due to the alignment of long-term corporate planning horizons and long-life assets. for example. particularly in Europe but also. 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. 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. fragmentation. 1. 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. We believe this will be particularly the case where the disconnect between public market valuations and underlying commodity price outlook persists. We believe that market participants will respond to these trends in six key ways. that have the additional benefit (for some) of being directly linked to inflation. 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. Non-traditional owners of discretionary assets such as banks and governments will continue to look to dispose these assets. The upside of these events is that they will likely give the larger. Consolidation through mergers and acquisitions will continue in selected. the latter via privatisations. via asset sales and domestic listings. and that are able to sustain reasonable levels of leverage on debt financing terms that currently remains competitive. These issues will likely exceed in influence those of a sector or companyspecific nature.3 Sectors & Corporate Strategy Alan Brown & Dan Ward Co-Heads. Acquisitions will take place in sectors where there is a fundamental mismatch between public and private market valuations. 3. in time. mature markets that are characterised by over-supply. economic. particularly those which are under-capitalised. and risk tolerance generally will reduce. This demand will drive increased investment into 'resource economies'. such as sovereign wealth funds and pension funds in addition to bank and capital market finance. The combination of accelerating demand and resultant investment will lead to continued upward pressure on commodity prices. 3. managing complex risk – across commodities. We expect a boom in infrastructure financing. The size of their capital expenditure programmes will force such behaviour. own interests in uncompetitive assets. 5. 2. will lead to increased demand for all commodities. with gas acting as the transition fuel in many markets. and an extension of the energy and in particular the agriculture cycles for multiple decades. and exiting non-core assets and businesses. Companies will become increasingly focused on acquiring access to physical resources. currencies and inflation – will be more important than ever. Access to capital will become a source of competitive advantage for companies. Strengthening demographics and increased industrialisation which will drive greater consumption.

Google. depth and uniqueness of content.9% in 2010. Although MSOs have taken a timid approach to digital distribution to date. The recent influx of players is making it harder for companies to differentiate themselves through quality. and most recently. they are estimated to be around 22. Netflix’s content acquisition costs were 13. content players hold the negotiating power since consumers generally value quality over quantity of content. Access to quality content and the cost of that content will be a critical factor. In addition. YouTube announced its entrance into original content by signing talent to its newly developed channels offered through its website. such as music and videos. For example. players in this space should also seek revenue-sharing agreements to secure quality talent.9%. digital distribution remains a fragmented market with low barriers to entry. that it will complement rather than replace traditional methods of consuming media. The success of iTunes encouraged other companies such as Hulu and Netflix to offer video digitally as broadband capacity increased and speeds accelerated. 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. a recent influx of new market entrants such as Blockbuster. Ultimately. tablets and mobile phones) over the past decade has dramatically changed the way media is consumed. We believe that this digital revolution will take a lot longer to play out than many people think.4 Sectors & Corporate Strategy David Pearson Head of Global Media & Telecom Group 4. FremantleMedia and Shine Group. Given the current pricing model for digital subscriptions. several digital distributors have begun experimenting with original content production. Currently. with Apple being the first major player to offer it digitally on a legal basis via iTunes. 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. Since video content requires a high amount of bandwidth. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . 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. Netflix secured rights to license House of Cards. with many analysts expecting a further increase in 2012. Facebook and others has increased content procurement costs for these companies and depressed margins. 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. So we expect to see consolidation to a handful of major players. an original TV series set to be directed by David Fincher. with their ‘TV Everywhere’ service they are now offering content to their users on a digital basis. Amazon. television and films via computers. BermanBraun. has led some commentators to predict a ‘revolution’ that will significantly impact the business models of established media companies. the cost of buying content has increased for many players. industry players that have the infrastructure to deliver this bandwidth (and the capability to offer a streaming service) will be in an advantageous position.4 Sectors & Corporate Strategy Telecoms & Media The digital revolution The growth of digital distributors of entertainment content. Although the effectiveness of original web content as a means of increasing subscriber bases is unclear. and that we may see significant changes to the structure of the industry in the years ahead. As a result. Perhaps an equally important issue is content delivery infrastructure. The emergence and rapid growth of digital distributors (companies that offer music. Google recently announced plans to spend USD150 million to create original shows with partners such as Warner Bros. Music was the first form of content to be offered digitally. Moves by incumbent multiple system operators (MSOs) and premium cable players into the business have further intensified competition. However. In 2011.4.

at the same time as closing down a great many tax loopholes. is widely expected among investors and analysts.5 Sectors & Corporate Strategy 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. and many of these are several decades. These generally have higher pay-out ratios and higher dividend yields. 2012 may well be the tipping point for such firms. The corporate taxation reforms expected in 2012 should have the effect of reducing the overall corporate tax rate. old. as they seek to roll out their presence by buying up western brands and technologies. Given the market backdrop of sluggish growth in the developed world and continued emerging market outperformance. With strong balance sheets. Thanks to their longevity many of these brands and assets have a very low tax basis. A new wave of consolidation in the consumer packaged goods sector. The phenomenon was reinforced by the behaviour of index trackers and ETFs. This drove up the PEs of small and mid-cap stocks to above or to parity with those of the large caps. This will have the unexpected side-effect of boosting M&A activity. Instead we predict a multitude of acquisitions of smaller ‘growth’ brands and assets. However. 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 investors were drawn to a number of preferred mid and small-cap stocks. we doubt mega deals will materialise in 2012.4. particularly in the developed markets. The uncertain and volatile macro outlook will drive investors back to well-known multinational names which benefit from geographical spread. 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. As we enter 2012. 2. Investors will increasingly prioritise yield over capital growth which will also favour the large cap stocks in the consumer packaged goods industry. and we believe this will trigger a marked increase in M&A activity. Finding organic growth increasingly hard to achieve. Where price-earnings ratios are concerned. largely as a result of anti-trust policies in the US and Europe and the surprising lack of valuation discrepancies in the sector. However this pattern changed from 2006 onwards. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . with the largest firms having the strongest multiples. there has traditionally been a clear pecking order in the sector. even centuries. managements will seek out smaller deals that bring clear growth opportunities. Meanwhile. Under the new tax regime. These will include emerging market assets and developed market targets in higher-growth channels or categories. The result has been a mismatch between pricing and fundamentals. many emerging market players have quietly been transforming themselves into global challengers in recent years. two catalysts will realign this valuation mismatch to the benefit of large-caps. corporates are still going to want to make acquisitions in 2012.  1. which make disposals unattractive under the current fiscal regime since they would cause tax leakage. low funding costs and challenging targets for organic growth. stronger balance sheets. and a larger sales mix of number one brands which have the pricing power to withstand a higher inflationary environment. Most medium to large companies in the sector own large numbers of distinct brands and assets. holding on to under-performing or non-core assets will become less attractive.

commercial aviation appears to be rebounding with a resurgence in commercial aviation passenger miles and revenue.4. The sector now trades at 13. Deals in 2011 focused on repositioning portfolios into growth markets with more favourable dynamics. raw material. we began to see a return to consolidation – focused on operational cost opportunities at relatively modest TEV/EBITDA transaction multiples in the 8–10x range at the end of 2009. Home Building/Building Products After nearly six years of headwinds. cost management efforts (labour. With regards to industrial M&A activity. solid and growing backlogs. 7. 4. the 'established' economies are showing tepid growth. China’s 12th five-year plan illustrates the scale and magnitude of the industrial opportunity. This was the key factor behind the sale of Tyco’s TEMP and Ingersoll Rand’s Hussmann businesses to a private equity firm in 2011. Today. the October PMI indicator of 50. and the impact of over three years of restructuring. 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. yet face demand and pricing risks in Europe. In contrast. Emerging markets are at the epicentre of the focus on growth due to their attractive demographic trends. the trend towards global consolidation and collaboration among original equipment manufacturers (OEM) and suppliers is expected to rise with the sector recovery. in our opinion. Aerospace & Defence Defence spending remains uncertain until after the next presidential election. industrial players took the opportunity to build in significant cost management capabilities and flexibility into their systems. Recent commodity declines are helping to offset volume weaknesses.9x next 12 months (NTM) EPS. Today. Faced with the post-Lehman downcycle. conditions do not support another 2009-type fall given low inventory levels. an 11% discount to the 10year average NTM valuation of 15. We will continue to see targeted consolidation amongst leading players. we saw M&A increasingly focused on longer-term strategic growth and higher valuations more commonly in the range of 9–12x. Clarity around 2012 forecasts should help unleash deals. 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. leading secular indicators point to a gradual recovery in the industrials sector led by emerging market economies.6x. low cost financing and availability of funds for the 'right' deals. 3. and industry fragmentation. Automotive We expect the consumer-supported North American recovery to continue. Access to capital has enabled public home builders to take market share from private builders through the downcycle.6 Sectors & Corporate Strategy Industrials Prospects for earnings While macro uncertainty looms. and flexible manufacturing initiatives. We expect this to continue in 2012. infrastructure investment. and emerging market presence. home builders continue to remain cautious on the housing recovery which will be driven by jobs and consumer confidence improvement. One Deutsche Bank client made the case against a return of the 2009 crisis on industrial players in 2012 by saying 'you can’t fall six feet off a three foot ladder' indicating that further severe manufacturing declines were unlikely given already weak industrial demand. restructuring). In late 2010/early 2011. Paper & Packaging Paper grades are facing secular pressures from digital media which is expected to accelerate consolidation to better match supply to demand. Meanwhile. Corporates are well capitalised and looking to drive growth through accretive acquisitions.6 Sectors & Corporate Strategy Paul Stefanick Head of Global Industrial Banking 4. and c) greater access to emerging markets. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . industrial players across the board focused on operational performance and cash preservation. We see underperforming industrial assets or sub-optimal corporate structures being penalised and driving transaction activity – witness Tyco and ITT’s announced split ups.8% is just a fraction above the 50% zero growth break-point. Recent market volatility has made balancing seller price expectations with buyers return requirements challenging. and relatively low asset valuations. M&A. 87% of US industrials that have demonstrated growth and 63% have exceeded street expectations. observing tailwinds from the demand for infrastructure build-out. In reporting Q3 earnings. companies with solid M&A track-records are seeking future growth engines by focusing on global build-out opportunities and new adjacencies. Diversifieds Companies are seeking growth in a) new technologies with high value add and barriers to entry. China and Brazil. on the other hand. competitive dynamics. Transactions such as GE’s energy-related acquisitions or Caterpillar’s acquisition of Bucyrus underscore this focus on global mega trends. 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. While the US has successfully demonstrated 26 consecutive months of industrial growth since the June 2009 bottom. The spate of recent corporate split-ups underscores the need to justify diversified portfolios on their strategic and financial merits. 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. is being driven by the convergence of high cash balances and underutilised balance sheets. Consolidation driven by players in emerging markets seeking to expand their international presence as well as selected strategic expansion by the global majors. Packaging remains resilient due to stable demand characteristics and consistent cash flows. 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. 6. 2. Building products companies with repair and maintenance exposure as opposed to new home construction have outperformed but remain cautious near term. In addition. b) strong market positions in developed economies to leverage scale. we are positive on the outlook for earnings. More positively. Within the various sub-verticals that comprise the broad industrial sector are specific macro trends characterised by their unique demand cycle. and industrialisation. 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. 5. We observe the following: 1. consumer consumption. 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. For industrial players globally. after a hiatus in significant transactions in 2008/H1 2009.

despite significant deleveraging requirements. 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. 5. As pressure on banks to delever increases. meet the requirements of the market and. large scale deleveraging through asset sales is unlikely to be capital accretive. asset deleveraging processes will need to be carefully constructed.g. Two key elements to improving execution are 1. and 3. facilitating buyers into new asset classes and the way portfolios or businesses are presented to the market. banks face a greater disparity between carrying value and realisable value. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . Portfolio tailoring is essential to minimise cherry picking. ECB funding reliance is not sustainable and will need to be addressed through deleveraging but only over time. equity raising or liability management will have a significant bearing on the volumes and pricing levels of asset sales.7 Sectors & Corporate Strategy Tadhg Flood Co-Head Financial Institutions Group. Given the capital benefit of run-down over divestment. reverse enquiries may be well received. Further innovation is expected. definition of the sale portfolio perimeter and sale structure. Given the substantial deleveraging task for certain banks. Buyers must identify opportunities early and demonstrate credibility. achieve ECimposed restructuring deadlines. 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. will have a material impact on buyer appetite. Structured sales (e. Asset sales are a less attractive form of deleveraging Asset deleveraging can occur via several means: write-off. in certain cases. For acquirers of assets. time pressures. for example. Sale strategies should evolve in response to buyer interest. Financial Institutions Group Financial Institutions Deleveraging Bank deleveraging in 2012 – managed balance sheet reduction or fire sales? Since 2007. at an increased but managed pace. The sale portfolio perimeter definition and sale structure. the reduction in European bank leverage has been largely achieved through retained earnings and capital raisings. 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. competing processes and changing market conditions. 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. through highlighting such attributes as transaction track record. Importantly. rapid and price insensitive deleveraging on a widespread basis is unlikely. as banks continue to use deleveraging as a tool to address capital and funding pressures and restructure business models to ensure adequate shareholder returns. Sale portfolio sizes will need to be kept small. 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. pricing expectations may fall but buyers may find that they also need to adjust return expectations. 6. and 2. 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. Continuation of well established deleveraging process Deleveraging through asset sales is not new with many banks undertaking significant deleveraging since 2007. in areas such as financing. 2. With the exception of certain high RWA and other marked-tomarket trading book assets. EMEA Stephen Westgate Director. Increasing innovation and detailed understanding and insight are required in an environment where funded buyers are few and resource constrained. innovations in secured funding give banks increased flexibility to hold funded assets to maturity rather than incur losses immediately. goodwill destruction or stranded costs. Amongst investors. Bank deleveraging through asset sales are likely to continue in 2012. disposal. in our view. redemption or refinancing. differentiating interest with sellers likely to be inundated by often opportunistic interest. The fall in equity valuations and consequential negative impact on equity raising has shifted focus to the asset side of bank balance sheets. not a step-change. For banks with substantial deleveraging objectives. 3. there is a widespread expectation that significant asset portfolio sales may take place in 2012 at fire sale prices. 4. due to buyer funding availability and the reduced attractiveness of portfolios that are too diversified to buyers.4. In addition. In an environment where many banks are simultaneously seeking to reduce balance sheets. These include: 1. identifying and accessing available opportunities. pricing constraints and alternative strategies may assist buyer positioning. 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. 7. it may not be necessary for buyers to wait for a formal sale process. a detailed understanding of seller objectives. The relative attractions of alternatives such as cancelling dividends. the key challenges faced in 2012 will be 1. we would expect the majority of assets to be reduced by refinancing or redemption. making it a less attractive strategy for banks required to meet substantial new capital requirements under the Basel 3 or EBA frameworks. Pressure on banks to deleverage is increasing as they seek to address capital and funding requirements imposed by regulators. Interaction of deleveraging with alternative capital relief measures Deleveraging is only one tool to achieve capital objectives. As the focus of asset sales moves from bank trading books to whole loans and loan portfolios. However. Regulatory pressures Regulatory pressure to meet capital ratios will only be aided by certain forms of deleveraging. 2. in our opinion. acquiring assets that meet pricing and return expectations. tranching) may be required to attract a wider investor base. and needed. the sale process. immediate term funding pressure has reduced as the European Central Bank (ECB) has expanded provision of term liquidity to banks. A series of narrow auctions or bilateral discussions may be better than a failed process polluting further deleveraging initiatives. due diligence efficiency and access to financing.

few public companies have been willing to entertain bidders and corporates flush with cash have been reticent to sell even non-core businesses. While there is substantial unspent capital in PE hands. consumer products and business First. While new LBOs have been scarce and the credit markets volatile. Another theme we saw in 2011 which we expect to accelerate in 2012 is sponsors pursuing more venture-like growth investments. 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 January 2009. many sponsors bought 'category killer' best in class operators across industries. real estate and infrastructure as they look for ways to deploy their USD500 billion of un-invested capital. from portfolio managers overseeing separate loan and high-yield bond funds to PE principals buying debt as a 'distress for control' strategy. 'private' equity has become much more public as some of the industry leaders have themselves become public companies in recent years. most private equity firms practice the narrow discipline of controloriented. 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. there will be record IPO activity. Associated Materials. What started as an opportunistic business expansion leveraging in-house expertise in leveraged corporate credit is now a dedicated business for PE. LBO volumes will never return to 2006/7 levels but we easily could see USD100 billion in volume in 2012 or 2013. 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.8 billion at the peak in 2007. creative institutions in operation today. Additionally. 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. BakerCorp and American Tire Distributors To address the issue of 'seller’s remorse'. I also predict that we will see more private equity firms going public via listings. public equity. commodities. and retail. Accordingly.7 billion of public to private transactions have occurred. Whether public or private. commodities. 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. This gives public investors more opportunity to observe the inner workings of these firms and the contrasting investment theses and business models. We expect to see more of these in 2012. down from USD275. services while some of the most successful investments in recent years have been in more cyclical sectors such as chemicals. real estate and infrastructure. As we move into the end of 2011 and look forward. the quality of sponsor-owned companies is better than ever: in the LBO boom of 2006 and 2007. While many PE firms are sticking to their knitting. 2012 will see continuation of this theme and some new entrants in the public markets. in addition to the traditional value plays. others are stepping out into new asset classes. So. Large numbers of sponsor IPOs were put on hold in Q3 because of market volatility but are now back in play. leveraged buyout investing. many of the deferred IPOs are being revisited. Second. They seek 20% IRRs and at least a two times multiple of invested equity. This offers a unique and very attractive opportunity for public equity investors. Since 2010 there has been USD45 billion of sponsor-to-sponsor deals such as the sales of Total Safety. particularly in new media and tech services. The only mistake they can really make is to overprice the IPO which would put their ultimate exit in jeopardy. They represent around 42% of the filed backlog. sponsors have cast their eyes east where record amounts are being raised.8 Sectors & Corporate Strategy John Eydenberg Global Head of Financial Sponsors Group 4. distressed debt. the selling sponsors invariably will continue to own the lion’s share of the equity postIPO. 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.4. Sponsors are today spending significant time looking at industry verticals. deployed and some already exited in Asia. If the markets remain stable. 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. While distressed investing took a bit of a holiday when asset prices re-inflated sharply in mid2011. as funds seek to return capital to their limited partners as they begin to map out the next wave of fundraising. if 2012 is reasonably stable. At their core. 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. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . we can expect record numbers of IPO exits. thereby retaining substantial upside while realising liquidity and creating a path to an exit. with significant activity in the more traditional defensive sectors such as healthcare. giving us the opportunity to observe the inner workings of these firms some of which are among the most innovative. Contrary to some popular belief. As the buyside seeks to better understand how to value PE firms. In fact. aligning their interests in maximizing value for all shareholders. 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. we will watch as the public PE firms continue to grow and diversify their businesses while maintaining a focus on their core competencies. and selected companies with overstretched balance sheets in tougher sectors struggle to refinance. public equity. 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. 2011 saw numerous creatively-structured deals where sellers disposed of 49-51% stakes. sweeping away the general optimism that prevailed only weeks before.8 Sectors & Corporate Strategy 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. only USD72. PE credit investment takes various forms. PE firms are delving into other assets as well including structured credit. energy. Investing: Hunting for deals. More Public PE Firms Finally. the strong fundamentals and general resilience of the high yield market will continue to offer attractive financing. Examples are Tyco’s sponsored spin of EMP and CVC’s sale of a stake in Univar. Sponsor investments have been spread very broadly across industries. where banks are looking to shed assets and raise capital ratios to meet ever-changing regulatory restrictions. 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). sponsor IPOs in recent years have outperformed non-sponsor IPOs. moving into new asset classes The key challenge for private equity firms in 2012 lies on the investing side. the 10 largest PE fund managers now have more capital deployed in credit and other assets than they do in private equity. opportunities should proliferate as continued market turmoil and intermittent capital scarcity sorts winners and losers. In fact. cumulatively in the three years. especially in the real estate and finance sectors.

Meanwhile. Faced with a generation of knowledge workers that want to bring the value of collaboration and networking to the workplace. Twitter. Growth in software delivered as a service (SaaS) will accelerate as enterprises seek operational and technological flexibility. 3. Microsoft. 1. Google and Amazon are already building the infrastructure to accommodate the influx. and Zynga as social networking becomes embedded in more and more applications for consumers and enterprises. However. large technology vendors such as IBM. 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. while enterprise IT spending is expected to grow only 3. use of tablets and smartphones in the enterprise has proliferated and is requiring rapid changes in IT infrastructure. unseating a carefully controlled laptop and Blackberry-only landscape. which Gartner says was 7% in 2011. in 2012. Many of the Google and Apple smartphone apps are being adopted by enterprises.9%. Bears believe that the events in Europe and a tired US consumer will reduce growth in IT spend. How can we not be bullish? Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank .Chris Colpitts. creating a new category of high-growth software and internet companies. when US GDP growth was negative.000 developers employed. enterprises are gearing up investments in similar platforms to get closer to the consumer and better market their products. revenue growth among public SaaS companies was still positive on an average basis. keeping over 180. In a survey of CIOs by Computerworld. Mobility The emergence of the Apple iPhones. These users installed an average of 20 million apps every day. Similarly. Cloud computing Deployments of cloud computing technologies and applications are expected to triple in the next two years. Mergers will continue among large enterprise software and hardware vendors as cloud computing forces the kind of vertical consolidation heralded by Oracle’s acquisition of Sun and Dell’s acquisition of Force10. Social networking Facebook hit 800 million active users in 2011. 2. Richard Hart and Leslie Pfrang Technology Coverage Team 4. 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. 87% of respondents revealed that their employees used personal devices for work-related purposes. In 2012 growth companies will debut in the public equity markets and mature companies will finance growth in the equity and debt markets. SAP. We will see continued growth in companies such as Facebook. All this requires greater investment. investments in cloud computing technologies and services are expected to increase by 19%. This will lead to larger and more consolidated data centers as companies seek economies of scale. iPads and Google Android devices has ushered in the era of BYOD (Bring Your Own Device) to the enterprise.9 Sectors & Corporate Strategy Technology Cloud computer land In 2012 we expect to see an acceleration of several trends firmly established in 2011. Oracle. In preparation for what may amount to over USD50 billion of spend over the next three years. during 2009.

Evolving corporate strategies In our view. for global players. The attractive payer mix. Examples include Pfizer’s review of its Animal Health and Nutritional businesses.7%4. Reduced R&D investment: the decrease in R&D productivity is leading to a reduction of in-house R&D. 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. 3. Examples include Abbott’s acquisition of Piramal’s India based Healthcare Solutions business and Hypermarcas’ acquisition of Brazilian rival Mantecorp. divestitures and joint ventures to better position their businesses for future growth. Many of the biggest incumbents can no longer justify their size and infrastructure without making acquisitions or restructuring their business. Business Monitor International. Since 2004 new FDA approvals have remained relatively steady at between 18 and 36 per year2. Brazil and Mexico and 60% in China and Russia). Emerging markets M&A The robust growth in healthcare projected in emerging markets will continue to attract the attention of multinational pharmaceutical companies. yet it is becoming harder and harder to achieve. Now they are struggling to discover and bring these cash cows to market.10 Sectors & Corporate Strategy Healthcare What’s ahead for 2012? Amid declining returns on R&D. it accounts for a substantive portion of the nominal increase over the period. which is significantly out-of-pocket spend (about 80% of overall pharma spending in India. which all tend to benefit from longer product lifecycles. Where local incumbents historically outpaced their multinational peers. China. Abbott’s proposed separation into two companies. high failure rates. CapitalIQ 4. Tack-on acquisitions in areas impacted by generic competition should also continue. Business Monitor International. Why is innovation-led growth challenging? The pharmaceutical industry is absorbing significant shortfalls in revenues from expected patent expirations. healthcare expenditure at constant exchange rates Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . Reducing corporate complexity: a number of corporate restructurings and divisional sales have emerged. Food and Drug Administration. Russia and Latin America forecast to rise 9. 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. emerging market acquisitions offer a way to deploy rather than repatriate their swelling offshore cash reserves. global healthcare providers have not yet done enough to reposition their business models to respond to the pressure from governments. animal health and generics. and AstraZeneca’s sale of its Astra Tech business. drug companies focused on developing blockbuster products that would generate more than USD1 billion of annual revenues. Consolidation: mega-mergers have long been a strategic feature of the pharmaceutical industry and have shaped today’s leading companies. 1. 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. Whilst this growth is from a relatively low base compared with developed markets. Several themes have emerged. stagnant progress on US Food and Drug Administration ('FDA') approvals of new drugs. with R&D and M&A viewed as interchangeable. Innovation is the key to growth in developed markets. NMEs approved (filed under NDAs and BLAs) 3. the industry’s ability to replace lost sales through pipeline development alone is being called into question. The top 12 global pharmaceutical companies are spending an average of 15%3 of sales on R&D. 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. Once. healthcare expenditure at constant exchange rates 5. 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. while R&D expenditure has continued to increase in absolute terms. To add insult to injury. including: 1.10 Sectors & Corporate Strategy Darren Campili Head of EMEA Healthcare Group 4. or an average USD4. global healthcare companies will be forced to find new ways to deliver shareholder value through accelerated investment in emerging markets and M&A. payers and patients to share the burden of rising healthcare costs. bolstered by the resistance of shareholders and governments to foreign buyers. Outsourced innovation provides the purest incentive for entrepreneurial management teams to deliver the innovative products that will become the future portfolio of pharma. longer development times. At the same time. for revenues. The growing middle class is not the only key driver for emerging markets. Japan and Europe’s five largest economies. institutional investors ascribe little or no value to healthcare pipelines and are lobbying for the return of cash through dividends and share buybacks. with spending in India. 4. The challenge is financing. each of which is largely dependent on a company’s current asset composition and future ambition. A similar decline is expected in Europe. focusing on core profitable operations and aligning incentives for mid-level management.5 billion each per year. global healthcare companies are turning to emerging markets and to acquisitions. 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. Escalating R&D costs. despite the significant organic growth and M&A activity that have already taken place in recent years. Although we do not expect emerging market expansion. 2. or 14% of 2010 revenues. As a result. Meanwhile. that have come under pressure in developed markets. consumer healthcare.9%5 in the developed markets of the US. US product sales from products expiring within 1 year (2011–2016) 2. compared with 3. means that companies are less reliant on governments and other payers.4. M&A and corporate restructuring to be the cure for all developed market ailments. Diversified Medical Products and Research-Based Pharmaceuticals. Evaluate Pharma. a tougher economic and competitive environment and lofty valuations have made sales more attractive.

5 Financing. Investment & Risk Management Bond Market Outlook Equity Market Outlook Commercial Mortgage Backed Securities Art Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank .

covered bond supply is unlikely to be sufficient to plug funding gaps. an added incentive in an environment that has seen the cost associated with bridge facilities rising aggressively. and we estimate this to be in the region of EUR762 billion across government-guaranteed. should ultimately come to a culmination with sovereigns in 2012. additional reporting disclosure and legal opinions required. senior and subordinated bonds for European banks. for instance. With this. Investment grade corporate debt markets will remain robust in 2012 helped particularly by exceptionally strong cash reserves and consequently squeezed supply. The bond markets would certainly welcome this supply. Spain and Germany. What will remain consistent in 2012 for the debt capital markets is the brevity and depth of issuance. with investment-grade borrowers having the ability to access capital continuously at price. The negative feedback loop from stressed sovereigns to banks remains very prevalent for financial issuance. due to proximity. Ireland or Greece. (Source: ONS) If 2011 was a year of ‘thinking the unthinkable’. Investment & Risk Management Bond Market Outlook Outlook for 2012 The deleveraging cycle that started with homeowners in 2007. however we believe volumes will remain elevated. Jurisdictional discrimination will continue to drive market access for term funding and market capital.1 Financing. financial disintermediation. if institutions can raise capital – via balance sheet reduction. while corporate fundamentals will be tested as global growth slows. giving those that have access to markets the ability to raise hybrid capital. while government injected hybrids will form a significant proportion of the capital shortfall of more challenged banks. 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. we expect three key drivers to corporate issuance in 2012: M&A driven sector consolidation. 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. In contrast. Corporate treasurers no longer have the luxury of relying on a deep and at times subsidised loan market. debt markets will likely also see sector by sector rebalancing in 2012.5. Composition will differ from historical norms. covered. Importantly less than 7% of the financing needs in 2012 are for banks from Portugal. This has allowed corporates to avoid drawing down costly acquisition facilities. Contingent capital securities issued by Rabobank and Credit Suisse will provide a likely blueprint for strong issuers. the strength of balance sheets currently puts UK corporate cash reserves at 180% of UK GDP. 2012 will be a case of ‘living through the unthinkable’. it’s not surprising the current backdrop is ripe for consolidation. given the constraints of encumbering balance sheets further. as an economical alternative to capital markets funding. Market access for banks will remain regionally driven. Globally. Italy. and debt-funded share buybacks. Our opinion is this redistribution of funding mix will be at the fore in 2012. and equity valuations once again driven off fundamentals. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . In the financial debt sector we expect funding costs to continue their highbeta relationship with sovereign funding costs. The fate and path of European sovereigns is likely to continue to be the driving force for global debt markets in 2012. like regional differences. With corporate funding levels at near historic lows on a yield basis. However. or put another way 44% of the FTSE100 market-capitalisation. as we saw in 2011. the EUR106 billion of capital that the European Banking Authority has deemed requisite for European banks to withstand European sovereign liabilities. If the Eurobond market volatility continues in 2012. Another key component of 2012 financial debt markets will be capital. From an issuer perspective. However. 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. However. while large US corporates have traditionally accessed the Eurobond markets to diversify funding needs away from the home market. our opinion is the EU market will be more sensitive to sovereign event-risk. However. Significantly 78% of this funding is from banks from France. The market has already evolved to allow corporates to term out funding before the acquisition is consummated with the use of ‘deal contingent language’. [Source: Dealogic] Volatility across the financial institution group (FIG) capital markets will likely continue. with Northern European banks at the fore. Bank wholesale funding costs have risen exponentially since 2007. have been reluctant to access the US capital markets given the documentation process. there will be regional divergence across debt markets. asset disposals and liability management – the greater the chances that banks can reduce the bilateral negative sovereign feedback loop.1 Financing. Investment & Risk Management Zia Huque Global Head of Global Risk Syndicate 5. can be met by hybrid and contingent capital debt securities issued in 1H 2012. market attention has turned to 2012 funding needs. which all have access to the European Central Bank -12mth/13-mth LTRO for liquidity lines. Finalisation of Basel 3 and Europe’s CRD4 implementation should occur in 2012. For example. Significantly in 2011 we saw investors seek refuge in the more stable and benign covered bond space in times of market volatility. Many European corporates. The M&A driven sector consolidation trend is already building momentum. US credit markets will likely continue to show a remarkable resilience to exogenous pressures. Significantly. the decision to access one market over another for debt funding needs is not always as straightforward as lowest cost of capital.

US and Chinese companies accounted for the lion’s share of new issuance (29% and 16% respectively) with 45% of IPOs globally coming from emerging market issuers.164. 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. Investment & Risk Management Equity Market Outlook Prospects for issuers 2012 could be a busy year for the Equity Capital Market (ECM) if market conditions stabilise. 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 244.943.56 32.39 491. oil and gas.49 1. nearly double their share in 2010.700.921.580 Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . Full Year 2010 Deal Value (USDm) No of Issues 252. 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.171 566 868 100 742 29 183 384 116 26 4.332.24 39.2 Financing.206. corporate spinouts are also likely to be popular. as we have seen though the last two years.18 39.288 7.58 30.11 1.45 20.016.61 485. This is particularly likely on assets owned by private equity funds which will look to tap issuance windows as they appear.98 68. The biggest issuers were financials which raised USD142 billion.810.55 1.964 5. Another source of deals are the expected bank recapitalisations in Europe and European Union privatisations. 1 January to 14 November 2011 Deal Value (USDm) No of Issues 142. with real estate.129. 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.55 30.18 13.19 13.593.576.70 68.565. over 20% of the global total.730.233 196 655 5.03 841. market conditions permitting.95 64.907. European governments have over EUR300 billion of assets that could be part of a privatisation programme whether secondary sell downs or listings.950. 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.078 455 325 936 135 200 5.5.24 67. 7 8 9 10 ECM 2011 Full Year Pos.185 5.79 55.361.83 640 353 501 583 905 167 514 39 145 117 3. The biggest growth in volumes compared to 2010 was in the chemical and metal sectors which raised nearly USD50 billion between them.603.081.76 47. 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 2011.729.83 1. 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.2 Financing. Indian issuance declined significantly too while German issuance actually increased.535.47 33.14 838. 192.98 655.159.163.362. I would expect many of these deals to move forward as soon as we see some stabilisation in the macro economic and market environment.72 655.870 7.75 30.37 15.32 220.27 137.561. Investment & Risk Management Edward Sankey Global Co-Head of Equity Syndicate 5.52 106.331.08 34.417.05 52. tech and resources being the other dominant sectors.94 42. as they did in 2009 and 2010 and the earlier part of 2011.536.55 849 620 464 857 71 226 117 1.599 Pos.220.01 39.03 95. As in 2010.39 36.792. 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.03 23. if there is a marked change in sentiment we could see the institutional investor base using the calendar to reweight their exposure.762.665.64 21.302.580 Pos.061.25 25.59 23.682.959.528 897 46 270 1.870. both of which are likely to lead to significant volumes. There is a large backlog of deals from 2H 2011 as well as recapitalisation and privatisation deals that could come to market.711. 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.852.648.45 50.644.810.49 31.599 Despite volatile market conditions.99 38.068.935. A pick up in M&A could also boost volumes should there be financing requirements and.515. With secondary volumes still lighter on a relative basis and an increased proportion of that volume dominated by high frequency trading.83 77.061.781.096.22 36.935. ECM 2010 Full Year Pos.129.755. the primary equity markets remained active during 2011 with issuance down just 4% year-on-year at USD545 billion for the first nine months.10 57.

brought its August deal to market with public super-senior AAA securities. along with its partners. now that the shape of the recovery is clear. real dawn Many have quipped that 2011 was a false dawn for commercial mortgage backed securities (CMBS). The second is how (not whether) the impending flood of CRE asset sales by European banks will impact demand and pricing in the space. with simple structure and high credit enhancement. many of the new lending shops folded. Distressed market activity The bid-ask gap between investors and holders of distressed mortgages in the US collapsed in 2011. We believe it has achieved this goal and all CMBS fixed rate deals since have employed this structure. As illiquidity increased it became apparent that there weren’t nearly enough AAA investors to support consistent CMBS issuance. This was designed to be a new market benchmark. Bond market The first twelve months of CMBS 2. 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. We are watching two themes closely for 2012. The market also produced the first floating rate CMBS deals since the crisis. conspired to destroy the profitability of the industry’s new pipeline. and several REITs and funds had established lending platforms. As the summer progressed and AAA spreads moved from 105 to 250bp over swaps. The highlight of the market this year was the competitive auction by Anglo Irish Bank of its USD10 billion US loan book. We believe this is a good thing for the market. The first is the emergence of warehouse financing. The combination of a very full pipeline. and suddenly competition was everywhere. for example).0 to track performance of the rebuilding market. including one investment bank platform so far. 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. TRX potentially gives aggregators their first correlated hedging instrument. so Deutsche Bank. the newly resurgent CMBS lending market got squeezed hard. Competitive environment As we struggled throughout 2010 to build a consistent loan pipeline. The CMBS industry did not experience a false dawn in 2011 – it had a false boom. and launched a Markit index called TRX 2. 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. This market has the opportunity to establish a positive brand for post-crisis CMBS. to attract a broader base of investors. which has seen a near cessation of normal activity since early August. greater competition in the investor community. 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. and recently the availability of financing for portfolios of distressed mortgages. when the events in Europe raised volatility. Then 2011 began. including increasing pressure from regulators on banks to use their earnings to cut legacy assets. a response to investors’ call for more transparency.3 Financing.5. With more CRE loans maturing in the coming years than have matured since 2007. Investment & Risk Management Commercial Mortgage Backed Securities False boom. CMBS volumes are consistent with the broader fixed income market. that sellers are not bottom-ticking the market. We need to maintain respect for risk and our investors. The false boom is over. Where it felt like we were competing with two or three investment banks on a regular basis in 2010. CMBS is an important source of liquidity for the economy. This has been driven by a number of factors.0 issuance was exclusively via 144A private placements. and that was becoming increasingly difficult as competitors cut credit standards and increased leverage to win business to support their new enterprises. Americas 5. now there were at least seven making a go at it. There is also a sense. and shrinking fixed income demand due to the macro volatility picture. we were just happy to put enough collateral together to finally get to market with the first deals of the post-crisis world.3 Financing. the limited AAA investor universe. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . and continue to evolve the product to reach a broader community. From June to August. Investment & Risk Management Jonathan Pollack Head of Commercial Real Estate. and the competitive environment looks much like it did in 4Q 2010. whether it will remain consistent and how it will evolve (will NPL securitisation nirvana be achieved.

Zheng Guogu: Consume is ideal. It feeds off change.4 Financing. The theme of Yangjiang’s main series equally demonstrates that regeneration cannot be produced by solely relying on traditional methods. Obviously nothing will replace the excitement of the first sale. Yane Calovski. There is also a volatility issue. collectives have a tendency to break up. This building work parodies the lack of planning in the surrounding cities. We have. who he then went and married. Investment & Risk Management Alistair Hicks Curator. the Raqs Media Collective and the Yangjiang Group are all in this category for a variety of reasons. so we have Zheng Guogu in the collection. play on our desire to set up house. For art collectors. London’s big galleries are celebrating the London Olympics with the largest names. but not sadly yet the Yangjiang Group or Raqs. 99% of Deutsche Bank’s collection is made on paper. They produce calligraphy on canvas and paper. All of them are playing crucial parts in changing our culture for the better. None of them as yet has a serious auction record. They have suffered from the prejudice against collectives. sculpture and installations. to consume dispels despair Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . and slowly the figures dissolve into a passing resemblance of a Jackson Pollock. Mathilde ter Heijne. 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. 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. a bachelor Victorian don. Like pop bands. but as they draw they drink. She inserts Alice in Wonderland type images of herself into her work. The blame for this violence is laid firmly at the door of outdated male thinking. however.5. I would be surprised if the work of most of these artists did not become part of the regular international auction circuit. They don’t like waiting around. The most interesting opportunities are often found among artists who produce deliberately difficult art as a way of challenging the market establishment. this time in an artist’s career can be a great time to buy: you can help remove an artist from purgatory. but it is not their financial worth that is of primary importance. Deutsche Bank Art Collection 5. but retires at every opportunity to his life’s work of creating a real town of his own. Guogu experiments with photography. She mainly makes videos and installations. The National Portrait Gallery and Blain Southern are giving Lucian Freud shows. named floors in Deutsche Bank Towers after Mathilde ter Heijne and Yane Calovski. all of them have made works that change the way I see the world. Investment & Risk Management Art The waiting room Most artists are action men and women. when artists are beginning to get the recognition they deserve but not yet registering on the international market. Yet at the same time we should be remembering that the contemporary art market needs to constantly change. such as ‘Domestication’. they are built into a large network. while revealing a deep regenerative spirit in the act of building. His work. 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. while the Tate and Gagosian are devoting their largest spaces to Damien Hirst. Though it is well to remember that you are betting against the market. like Zheng Guogu and the Yiangjiang Group’s is about rebuilding society. but has also made several series of photographs that could be bought for home. a prostrate Alice and upturned furniture indicate trouble in this idealised paradise. The Yangjiang Group come from the city of the same name in China. The art market still subscribes to the old-fashioned precept of the solitary genius in his bohemian attic. but of course – like the rest of us – they have to. Their most famous work ‘Escapement’ uses a series of clocks to question the systems that rule our lives. There is a problem of scale as though his work is usually comprised of small fragmentary drawings. In ‘Domestication’. which with their doll-like Vermeer interiors. but its leading member Zheng Guogu is also marketed as an international artist in his own right. Mathilde ter Heijne is one of the most powerful feminist artists working in Europe. but there is another awkward period – in ‘the waiting room’. ‘crumbs’ as he describes them. Though made of solid materials it has the look of a playing card construction. ‘Alice’ was the creation of Lewis Carroll.4 Financing. 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. the first exhibition or good review.

Investment & Risk Management: Research Viewpoints The Ideal Portfolio European Financial Sector Risk The articles marked with this icon are based on Deutsche Bank Research.5 Financing. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank .

Long EM FX bskt Short $ long 4-mo RMB NDF 5. Strategic assets: emerging markets equities and bonds. A currency overlay of long emerging market foreign exchange versus EUR and GBP.5 17. 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. Investment & Risk Management: Research Viewpoints Vinay Pande Chief Investment Advisor. Indeed.0 18. The large out-of-the-money receiver position in Australian interest rates is intended to address a deflation scenario. unless there is strong reason to believe so. even on an option adjusted basis (see Figures 2 and 3). 5. Standard & Poor's.0 70.9 8.9 5. Defensive assets: principally long regulated utility positions in Europe. DB GMR. Bloomberg Finance LP. We are overweight equities versus rates because our analysis indicates that the equity risk premium for equities is now at unprecedented levels versus rates.5 Financing. to MX Eur.6 11. 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. The portfolio is liquid and.8 % Gold and Commodities EUR GBP JPY Currency Composition after FX overlays 8.0 Short EUR long USD 5. Large short dated EUR put options are designed to protect a multi-currency portfolio from USD appreciation.g. MSCI.7 6. 4.5. of emerging market currency appreciation and of possible higher inflation.7 9. we suspect that by the end of the decade. Standard & Poor's.g. In credit.3 Short EUR. A relative value book. PricewaterhouseCoopers. Bloomberg Finance LP.5 Financing.7 We should never assume that the future will resemble the past.0 % Short AUD long JPY Un-hedged Source: Deutsche Bank 5.2 0. Standard & Poor's. PricewaterhouseCoopers.8 54. 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. 2. gold and commodities. it is no longer possible to optimise investment portfolios on an asset class by asset class basis. assets available is a good strategy. DBIQ. USD and 5. Research 5.0 GBP bskt vs.0 0. GBP) Long Receiver Swaptions (AUD) Long Currency Options Currency composition (Original Unlevered Portfolio) LatAm Asian ex JPY Other USD 12. in which Australia’s strong domestic economic fundamentals are overwhelmed by global fundamentals.4 7.1 20 15 10 % unlevered portfolio exposure 5 0 Long Equity calls Long Payer Swaptions (USD. Markit.g. We are looking for cheap options on assets or derivatives with large asymmetric pay-offs. especially in a euro crisis scenario. 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. DB GMR We think each of these asset classes should be bought whenever they are attractively priced. DB GMR. for all intents and purposes. PricewaterhouseCoopers. MSCI. Bloomberg Finance LP. EMFX overlays. These are assets we consider to have the biggest positively-biased asymmetric pay-off profile. These are positions that statistical analysis reveals to perform well in dislocated markets and market crises. using capital accumulated by astutely navigating the current treacherous markets. agricultural commodities. More focused investment strategies are required. There is currently no excess cash recommended but there are large cash positions available against the face amount of derivative positions. or assets that mirror the behaviour of emerging market currencies (e. nor are naïve asset allocation strategies acceptable.0 Short GBP long JPY 5.0 Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . owning the longestduration. Defensive hedges: including equity variance swaps and a number of shortdated currency and rate option positions. highest real-yielding. These are assets that have historically outperformed during periods of high volatility. 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. The rationale behind our defensive hedge selections is as follows: we recognise that in the short-term. 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. unlevered (with the exception of some relative value positions and some substantial long volatility or option positions).2 % Credit EM Equities EM Linkers Gold Commodities 2. 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 22.4 2.2 0. 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). In such a world. Investment & Risk Management: Research Viewpoints Figure 2: Euro Stoxx 50 OAS/ERP Euro Stoxx 50 ERP Euro Stoxx 50 OAS/ERP Source: Datastream. The portfolio is divided into five main parts: 1. rel. Figure 3: S&P 500 OAS/ ERP S&P 500 ERP S&P 500 OAS/ERP Source: Datastream. across multiple scenarios. or should be assets capable of being hedged back to emerging market currencies (e. gold). Brazilian inflation-linked bonds). 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. we will enter a world of lower real growth. Ideally these should be denominated in emerging market currencies (e.9 10. on an option-adjusted valuation basis. 3.0 Long CAD & NOK TWI 5. Western European regulated utilities). in which one of the largest trades is a short position in non-financial European equities versus selling protection on the iTraxx Crossover index. The rationale behind our mix of asset selections is as follows: we recognise that the unstable world we live in will not last forever. This involves an assessment of the nature and intensity of each scenario against the volatility adjusted valuation of the asset in question. 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 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.

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 Markets in 2012—Foresight with Insight Deutsche Bank Least Attractive Markets in 2012—Foresight with Insight Deutsche Bank . The less widening they experience per unit of carry. Measures European authorities can undertake to improve the financing profile of sovereigns under pressure. Portugal and Spain (see Figure 1). the more attractive they are. Italy. 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. are likely to provide greater benefits than an across-the-board recapitalisation intended to absorb potential sovereign exposure-related losses. the market apportions greater value on average to banks in the Netherlands. 2.6 Financing. 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. Investment & Risk Management: Research Viewpoints 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. 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 than to banks in Belgium. To date. This is a strong statement on the part of the market because bonds of a bank’s own sovereign typically carry zero risk weight in risk-based capital calculations. France. 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.Jean-Paul Calamaro Global Head of Quantitative Credit Strategy 5. combined with the banks’ own efforts to reduce sovereign holdings.

these securities have experienced a significant downward re-pricing. cash tenders below par or phase-out beyond first step-up date. 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. Hedging with EUR/USD puts can lead to cheaper hedges in periods typically associated with heightened concerns about European risk. The only ones that offer some value relative to standard credit index shorts (eg iTraxx. No vanilla credit hedges against a further rise in systemic risk in the European financial system are cheap at present. The senior/subordinated bank spread relationship appears to be significantly influenced by systemic risk. Such a mechanism would clarify and reduce European sovereign contingent liabilities. And we will continue to recommend efficient hedges against a rise in systemic risk as opportunities arise. Systemic risk absorption is particularly high at the senior (default remote) part of the capital structure. In all cases there is a trade-off between markto-market and tail risk hedges. systemic risk will continue to pose a threat to the financial system. Looking beyond credit into equity space. senior spreads are wide relative to sub. breaking the inter-dependency between sovereigns and banks. in particular EUR/USD puts can serve as potential tail risk hedges. However. making explicit sovereign guarantees more valuable. 4. 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. These involve buying protection on selected senior/sub CDS on French and Italian bank and insurance credits. The maximum upside to cost ratios of the two put spreads are about 3. Investment & Risk Management: Research Viewpoints 3. The opposite holds true in Germany (Figure 2). 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. tail risk hedges are scenario-driven and a wealth of historical scenarios can help establish potential costs and maximum draw downs. A material and sustained reduction in systemic risk requires action on two broad fronts: first.5. greater fiscal and political integration among eurozone countries. and second. Normalisation would occur if sovereign spreads move tighter or if continued widening in these leads investors to question the fundamental strength of these banks. We recommend Mar-12 85–95% put spreads – i. these securities were priced to redemption at first call. Macro hedges tend to offer better liquidity but tend to be more diffuse. 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%.e.Fin. FX hedges. Intesa BESPL 0 0 10 20 30 40 50 60 5-year subordinated protection value (pts) Source: Deutsche Bank Quantitative Credit Strategy Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . pushing subordinated spreads wider. Until European officials embark on a credible path of reforms. Among several measures that would help break the negative inter-dependency between banks and sovereigns is a well designed bail-in mechanism. liquidity and attractiveness. 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. Until recently. Cross-asset class hedges may be the only option available when liquidity dries up or insurance is expensive in the target asset class. Investment & Risk Management: Research Viewpoints 5. 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. Broader equity market hedges take advantage of the highly inverted volatility term structure. 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. Mar-12 put spreads on E-Stoxx 50 (SX5E) or EURO STOXX Banks (SX7E) look attractive relative to credit hedges. Micro hedges tend to be more attractive than macro hedges when the latter are crowded.4x and 2. For a selected number of relatively 'high quality' banks in Spain and Italy. Sovereigns under pressure tend to impart systemic risk onto their banks. SovX) are micro hedges. RBS SANTAN. Buying longer dated volatility would benefit from sustained pressure in the financial system through March expiry. These hedges fall directly from the framework discussed in Point 2 on the previous page.9x respectively. Faced with potential equitisation. 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. 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).6 Financing. Senior spreads are pressured wider due to a widening in Spanish and Italian sovereign spreads while the fundamentals of these banks don’t currently justify subordinated spreads as wide. The harmonisation of European deposit guarantee schemes based on a prefunding strategy would also help.6 Financing. 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.

6 Regulation & Trading Technology Regulatory Change Electronic Trading Centralised Clearing Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank .

For example. US authorities favour lowering eligibility criteria for membership of CCPs. 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. regulators will also be under political pressure to address risks around High Frequency Trading (HFT) and specific products such as Exchange Traded Funds (ETFs). with regulators in both the US and the EU proposing position limits in reaction to political concern about volatility in food and fuel prices. With Europe moving ahead quickly to propose legislation. while EMIR will set higher standards for CCP to ensure clearing members are able to withstand a default.and post-trade transparency across all asset classes. be felt well beyond the EU. New initiatives market regulation Whereas 2011 saw international regulatory debates focused largely on prudential issues. OTC reforms The story of OTC reform for 2011 was one of delay. In the US. The most significant regulatory initiative of 2012 will be the revised Markets in Financial Instruments Directive (MiFID). progress on Dodd-Frank implementation has been slowed by political wrangling and regulatory capacity constraints. 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. in light of the eurozone crisis. The increased politicisation of regulatory debates will be a key theme in 2012. the US continues to debate whether Basel 3 is the right approach and is consistent with the Dodd-Frank Act. 2012 will see increased attention on regulating markets and products. of 5% above or below prices from the preceding five minutes. Alongside familiar proposals such as changes to rules on capital and liquidity and reform of OTC derivatives. There is a risk of a wider range of products being brought into scope and additional restrictions being introduced through the UCITS review. commodity derivatives and enhance investor protection. In contrast. 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. 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. 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. 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. Regulators have focused on the rapid growth and complexity of structured products. In the current environment.1 Regulation & Trading Technology Daniel Trinder Global Head of Regulatory Policy 6. These far-reaching proposals with additional requirements for third country firms will. making the end-2012 G20 deadline for OTC derivatives to be centrally cleared. These trends will accelerate as the January 2013 deadline for implementation of Basel 3 approaches. Commodity derivatives will continue to be another area of focus in 2012. the SEC. 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. ‘layering’ and ‘spoofing’ and harmonise sanctions across Europe. 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. Taxes. Regulatory capital Although a new international agreement on capital and liquidity requirements has been reached with Basel 3. reported and traded on exchanges look extremely ambitious. In spite of the fact that many existing regulatory initiatives on both sides of the Atlantic are still not finalised. if implemented in their current form. 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. For example. It will also impose new requirements for HFT. In the US. particularly ETFs. the political dynamics in Europe are likely to see demands for regulatory intervention increase. if adopted in their current form.1 Regulation & Trading Technology Regulatory Change What’s 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. 2012 will see critical debates around implementation in the EU and US. It is also unclear how these two regimes will interact with each other. There is also significant uncertainty as detailed rules are not finalised on key aspects of the proposals. EMIR covers OTC only. In Europe proposals for a broadbased Financial Transaction Tax are already on the table which. ESMA is introducing new transparency and disclosure requirements while MiFID proposes banning inducements and limiting the sale of certain products to retail investors. In the US. whilst in Europe no political agreement yet exists on the final shape of the European Market Infrastructure Regulation (EMIR). 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’. as a source of systemic risk. while Dodd-Frank’s clearing requirements apply to all swaps. which would require trades to be executed within a range Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . let alone the rest of the world. general bank deleveraging and undrawn facilities being heavily penalised in a number of areas of the framework. It is a narrative that looks set to continue. could significantly alter the economics of cash and derivatives markets. 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. such as what margin requirements for non-cleared swaps might look like and what classes of derivatives must be cleared. revisiting the list of eligible assets to cover liquidity needs in a period of stress or questioning the risk-free status of sovereign debt. is now proposing a ‘limit up limit down’ mechanism.6. the flow of new proposals will continue through the course of 2012 with significant implications for all market participants. having already implemented a single stock circuit breaker programme. This will dominate the regulatory debate in Europe and could fundamentally alter market structures through a significant extension of pre. missed deadlines and divergence between the EU and US.

but requiring algorithms to market make will have severely negative impact ― Bringing all commodity traders into scope increases market transparency. position limits potentially hinder client activity and liquidity Alternative Investment Fund Managers’ Directive ― IOSCO principles endorsed by G20 November 2011. 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. product definitions and end user exemptions expected by end 2011. 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. central counterparties. 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 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. powers for regulators to resolve failing banks and ‘bail-in’ debt ― 0. 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.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.6.1 Regulation & Trading Technology Global Regulatory Proposals OTC Derivatives Summary ― Central clearing and reporting to be required. risk could impede banks’ ability to provide through capitalisation of bank exposures to clearing services CCPs and CVA charge for derivatives ― Additional 1-2. ― 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. leading to balance sheet reduction capital and introduces liquidity requirements across industry and leverage ratio ― Conservative approach to counterparty ― Strengthens counterparty risk framework. 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.1% tax on share and bond transactions and 0. 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. important: payment systems.1 Regulation & Trading Technology 6. Includes measures to address risks posed by high frequency trading Capital Requirements Directive IV ― Implements Basel 3 in EU. IOSCO to report on implementation by end 2012 ― IOSCO initial recommendations endorsed by G20 in November 2011. 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. 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. 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. but allows two year transition period ― Final rules on entity. with standardised products traded on-exchange or electronically. securities settlement for market efficiency and stability systems. central their safety and soundness will be critical securities depositories. money market funds. 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.01% on derivatives with EU financial institutions ― Harmonisation across all 8. 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.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. but potentially starting in 2014 Short Selling & CDS Financial Market Infrastructure ― These infrastructures will become ― New global standards for systemically preconditions for executing transactions. 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 Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . 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. with restrictions on trading platforms all limiting trading choice for investors ― Harmonised risk controls in HFT protect against shocks. 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.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.

and the biggest traders were established financial institutions. 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. Further innovations in trading technology can be expected in 2012. The changes are likely to happen faster than they did in equities. 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. in fact. CRD4 and Solvency 2. We learnt this with Lehman in 2008. Another exciting development is the emergence of basis risk trading tools. Protecting that collateral will be critical. and we will see significant shifts in the liquidity and volatility of different assets and markets as high frequency traders focus on specific areas. One strategy that could prove useful is to novate (transfer) derivative positions from a diverse range of derivative providers to a single intermediary. it would seem sensible to make at least some preparations. They include liquidity seeking tools that compare different markets to identify where investors will get the best price. Instead of simply ringing up a broker and executing a deal in its full amount at a guaranteed price. investors can trade directly with other investors and algorithmic computer programmes identify minute market dislocations and react to opportunities in micro-seconds. rates and credit investors too. and we are now starting to see it happen in the rates market with the development of US Treasury algo strategies. Equity trading has changed a lot since Instinet established the first electronic trading venue in 1969. This would give you one counterparty on all your derivative positions. Over the past few years. 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. 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. Nevertheless. one single standardised CSA agreement and the infrastructure needed to channel trades through to a single organisation: everything you will need.3 Regulation & Trading Technology 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. what price to offer or bid. The FX market looks set to reach the same level in 10 years. 4. 2. 3. Prices have become much more transparent making it easier for investors to identify if they are getting a competitive price. There is an economic cost involved in shifting to centralised clearing. as will the rules on how default waterfalls will progress through bankruptcy. The benefits of these changes have been considerable. companies may see it as a price worth paying for the experience alone. tools and challenges. We’re 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. But the changes have also made equity trading much more complicated. opening up new opportunities for investors and traders across multiple markets. Assuming the intermediary has a CDS spread of less than 300 basis points. 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. The equity market took 30 years to reach its current state. and order slicing tools that calculate how to split up big orders to prevent moving the market. Not every investor will want this service but some will appreciate the benefits it could bring. to shift to centralised clearing when the rules come into force.6. A second. 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. Large parts of the derivatives industry are going to move to centralised clearing regardless of what happens to Dodd Frank. 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. investors now have to decide themselves what market to trade on.2 Regulation & Trading Technology Serge Marston Global Head of eCommerce Sales Chris Hansen Global Head of OTC Clearing Sales 6. If you can’t hedge or get transparency on your hedges. 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. Rates could get there in five and credit in three. The credit market remains some way behind but we expect it to follow in 2013. and to analyse complicated financial variables like the difference between the volatility of different markets extremely quickly. and only certain types of asset can be used as collateral for initial margin. Trading volumes have soared. 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. which will impose higher capital charges on providers and users of derivatives. Numerous techniques that have been developed to help equity investors operate in this challenging environment are starting to become available for FX. similar trends have taken place in the foreign exchange market with the rise of algorithmic FX trading tools. ‘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 it’s interesting that while some institutions have made the move (mostly US organisations concerned about eurozone exposures) most have not. increasing liquidity and bringing down the cost of buying and selling shares. these issues will outweigh the benefits of early adoption. Today. You have to post variation margins in cash. large trades will become harder to execute without moving the market. make it economically inevitable. 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. Other regulatory changes notably Basel 3. For many companies. 1. providers of tri-party segregated services and providers of cash management services. shares are traded on dozens of different venues. But given CCPs and regulators will require segregated collateral. and how to split up the order to get the best price. Markets in 2012—Foresight with Insight Deutsche Bank Markets in 2012—Foresight with Insight Deutsche Bank . given the inevitability of the move. We are learning it now with MF Global. this may lead to significant liability management complications.

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