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United States
US Economic and Interest Rate Forecast: Recovery Arrives - but Not a ‘V'
September 10, 2009

By Richard Berner & David Greenlaw | New York

We continue to believe that a sustainable recovery is underway in the US economy, but it likely will be a bit quicker
and even bumpier than we expected a month ago (see It's Bumpy and Slow...but it Will Be a Sustainable
Recovery, August 10, 2009). While we have boosted our 2H09 GDP outlook this month by 0.25% to 3%
annualized, we now believe that a 3Q surge (+4.5%) will give way to a more tepid gain in 4Q (+1.5%). We
expected +3.5% and +2%, respectively, last month. The sharper deceleration in the current forecast reflects
somewhat larger ‘paybacks' in vehicle and housing sales. That slowing may stir ‘double dip' recession fears,
especially as the jobless rate heads higher, consumer income remains under pressure and companies continue to focus
on cost control. Yet in our view, the near-term slowing will simply represent a bumpy path to sustainable growth, as
is also reflected in our first cut at the outlook for 2011.

US Forecasts at a Glance

(Year-over-year 2009E 2010E 2011E


percent change)
Real GDP -2.5% 2.7% 2.8%
Inflation (CPI) -0.4 2.1 2.5
Core Inflation (CPI) 1.6 1.4 2.0
Unit Labor Costs -1.4 -0.5 1.1
After-Tax "Economic" -10.5 12.6 8.7
Profits
After-Tax "Book" -9.8 12.8 8.1
Profits

Source: Morgan Stanley Research E= Morgan Stanley Research Estimates

Two Key Elements in the Case for Sustainable Growth

The case for sustainable growth isn't open and shut. But it rests on two key, near-term developments: First, credit is
becoming cheaper and somewhat more available as markets heal and lenders return to profitability. While spreads on
risky assets remain wider than two years ago, they are significantly narrower than they were at the height of the
crunch. 30-year mortgage rates are hovering just over 5%, or more than 100bp lower than last fall, and spreads to
Treasuries have returned to historical norms of 160-170bp. The Fed's credit and liquidity programs and those of
other central banks have significantly improved the functioning of and liquidity in funding markets, so that the absolute
levels of interbank lending rates stand at record lows and spreads over overnight index swaps (OIS) are nearly back
to pre-crisis levels. Correspondingly, although lenders are still cautious, the terms on which they are extending credit
and making it available are both easing. Captive finance companies at vehicle OEMs have reduced required down-
payments, and borrowing rates on new car loans have slipped below 4%. And while credit spreads have been
locked in a range over the past month, the lagged impact of the narrowing that occurred previously is only now
starting to help refinancing and economic activity.

Second, and in contrast to worries that the effects of fiscal stimulus will soon peter out, we believe that there are
significant lags between fiscal thrust and fiscal impact, with the latter providing ongoing support for growth. Some

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background on this point might be helpful. The term fiscal stimulus generally refers to a budgetary change that is
measured relative to a standard baseline. In other words, the dollar amount of tax cuts or spending increases
compared to what would otherwise have occurred in the absence of any policy change. In the US, policymakers
have arbitrarily decided to use a 10-year window to measure the amount of stimulus associated with any policy
proposal. So, the US$787 billion of stimulus associated with the American Recovery and Reinvestment Act of 2009
(ARRA) that was adopted back in February reflects the cumulative budgetary impact, through FY 2019, relative to
the CBO baseline. Such a measure of ‘stimulus' can be misleading for several reasons. First, the current law baseline
is not necessarily the appropriate starting point from which to measure the amount of policy stimulus. For example,
the US$787 billion estimate includes US$83 billion in FY 2010 for an alternative minimum tax fix. But this clearly
does not represent any net new stimulus because the exact same AMT relief has been adopted every year for quite
some time. The US$83 billion is merely an adjustment to account for a distorted baseline. Moreover, ARRA did not
address the scheduled expiration of the 2001 and 2003 tax cuts at the end of next year. This will lead to a significant
tightening of US fiscal policy in 2011.

A more meaningful measure of fiscal policy involves the cyclically adjusted or standardized budget concepts. These
measures filter out the impact of cyclical and other special temporary factors on the budget (see "The Cyclically
Adjusted and Standardized Budget Measures", CBO, October 2008, for more details on how these series are
derived). Changes in these measures of the budget are generally considered to be a good gauge of ‘fiscal thrust' - the
influence of the budget on overall aggregate demand. But there can be lags between the budgetary impact of a policy
change and the associated influence on aggregate demand. In this particular instance, we believe that such lags are
significant.

Measured by the change in the cyclically adjusted federal deficit in relation to potential GDP, fiscal thrust should fall
to about zero by the middle of 2010, and if the Bush tax cuts sunset as scheduled on December 31, thrust could turn
into significant fiscal drag. But because we suspect that there are lags of anywhere from 3-9 months between thrust
and impact - especially for infrastructure outlays which seem only now to be improving - we believe that the fiscal
impact will remain positive well into 2011. Indeed, we have long argued that the credit crunch and consumer wealth
losses would reduce the so-called multiplier effects of fiscal stimulus, at least through much of 2009 (see Policy
Traction: The Key to Recovery, February 17, 2009). The jury is still out, but it appears that such multipliers may
well improve later this year and into early 2010. And of course, there is a third element: Both forms of stimulus buy
time for the healing in financial markets to continue, for companies to liquidate inventories until they are lean, and for
the building of some pent-up demand for durables that typically boosts spending following a long period of
retrenchment.

One additional part of the stimulus story deserves mention. As many analysts have observed, at least a portion of the
stimulus coming from the federal government is being offset by spending cuts and tax increases at the state and local
level. This is no doubt true today, but keep in mind that such offsets always occur at this stage of the economic
cycle. This reflects the fact that almost all state governments and local jurisdictions are prohibited from running a
budget deficit. When the economy slows, their finances always come under pressure and they respond with standard
pro-cyclical measures. The more severe the economic slowdown, the more severe the budgetary pressures. What
differs from cycle to cycle is the magnitude of the federal response. In fact, federal grants to state and local
governments to help fund Medicaid outlays have been a major cushion for the state and local budget crunch. So, we
should not get too hung up on any state and local offset - it is hardly a unique feature of this cycle.

Ending Incentive Programs May Trigger Paybacks

Two (and perhaps three) elements of fiscal stimulus do appear to have gotten traction with significant bang for the
buck: The ‘cash-for-clunkers' program and the first-time homebuyer tax credit incentives have boosted demand for
vehicles and homes. In addition, bonus depreciation investment incentives may be boosting business investment. But
because of their ‘use-it-or-lose-it' nature, these programs all boosted purchases while in effect, but ending them may
trigger near-term ‘paybacks' for demand that was brought forward. Just how big those paybacks are is uncertain, but
past experience suggests that they may be significant and last for a few months.

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The ‘cash-for-clunkers' (C4C) program is probably the clearest example of an incentive that temporarily boosted
today's demand at the expense of tomorrow's. The auto scrappage program provided either a US$3,500 or
US$4,500 credit towards the purchase of a new, more fuel-efficient car or truck when old, gas-guzzling clunkers
were traded in. Congress initially funded the program at US$1 billion, but quickly expanded it to US$3 billion, and
funding ran out exactly a month after being put into effect. The Department of Transportation estimates that 690,114
vehicles, primarily cars, were sold under the program at a cost to the taxpayer of US$2.877 billion, so it clearly was a
huge success in attracting buyers.

Industry anecdotes suggest that roughly a third to a half of the purchases were simply brought forward into July and
August at the expense of September and October. Past experience with sizeable incentives for vehicle purchases -
for example, the post 9/11, zero interest rate ‘Keep America Rolling' financing program on all GM models that lasted
for five weeks - also suggests that the surge in demand may be short-lived when the incentives expire. Sales jumped
35% in September 2001 to a record 21.7 million, but were already fading fast by late October. When Hurricane
Katrina ‘scrapped' thousands of vehicles in 2005, insurance payments fueled a 15% sales surge, which gave way to a
payback in subsequent months. However, even though a portion of the recent sales surge is borrowed from future
months, signs of healing in the broader economy mean that demand should still hold above the 9.5 million annualized
pace seen during the first half of the year. We assume that sales will slip from August's 14.1 million rate to roughly 10
million in September/October and then gradually improve.

Answering the same questions about the first-time homebuyer tax credit is more difficult because the program lasted
longer, the incentive represents only about 5% of the price of homes typically purchased by first-time homebuyers
(versus 16% for C4C), and because there is scant basis for comparison - there is only one example of a similar credit
(in 1975, and that one was for new homes only). This time round, lawmakers enacted two credits for first-time
homebuyers. A US$7,500 credit launched in July 2008 was really an interest-free loan. Then, in February 2009,
Congress replaced it with a true credit running up to US$8,000 for low-income buyers who had not owned a
residence in the last three years, expiring on December 1, for both new and existing properties.

The new credit probably stimulated demand, but it is unclear by how much. According to the National Association of
Realtors (NAR), about 350,000 of the 1.8-2.0 million buyers who will claim the credit this year would not have
purchased a home without it. But it is uncertain how much of that is genuine additional demand and how much was
simply brought forward. Traditional measures of affordability have soared, courtesy of the plunge in home prices and
in mortgage rates. But with lenders demanding bigger down-payments and with the credit not available until the deal
is closed, down-payments and credit availability remain hurdles for many buyers, especially first-time ones.

The 1975 homebuyer credit represents the sole historical parallel and may shed light on the potential payback this
time. That earlier incentive, which was aimed only at new homes, initially boosted sales and triggered a second surge
as the expiration date neared. Fueled by lower mortgage rates, pent-up demand and the credit, new home sales
jumped by 63% over 1975, but declined by 16% over several months in 1976 after the credit expired. That
moderate ‘payback' may foreshadow today's experience, as home-ownership rates today for those up to 35 years of
age are back down to 1999 levels, indicating a modest improvement in pent-up demand. Also, earlier this year, the
state of California adopted a US$10,000 tax credit (to be applied over the course of three years) for purchase of
newly constructed residences. The program got up and running in March, and the US$100 million of authorized
funding was exhausted as of August 31. About 10,000 buyers took advantage of the program over this six-month
interval, and we think the program was probably too small to generate any payback effects. Total home sales in
California during 2009 should be somewhere in the neighborhood of 550,000 - so the program was used for only
about 2% of this year's sales. The bottom line is that we assume both home sales and single-family housing starts will
soften a bit early next year and rise moderately thereafter. One caveat - the industry is pushing hard for an extension
of the homebuyer credit, and numerous pieces of such legislation have been introduced in Congress. If passed, an
extension would certainly boost our near-term outlook, but our Washington contacts believe that the prospects are
relatively low at this point.

The third temporary incentive - ‘bonus depreciation', or temporary partial expensing of capital investment of 50% for
corporate investment in assets with tax service lives of 20 years or less - will expire at the end of this year. We do not
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believe that this incentive significantly boosted capex, especially for those companies that had no tax liability this year
or in the immediate future. So, any payback from the sunset of this incentive probably will also be minimal.

Aggressive Payroll Cuts Make a Jobless Recovery Less Likely

Fears of a ‘jobless recovery' are rising, following relentless declines in payrolls and increased unemployment. In turn,
limited or no job gains would stifle recovery in spendable income and consumer outlays, further suppressing what we
see as a moderate recovery. Businesses aren't likely to hire until they are confident in recovery, and with the
workweek low, businesses likely will expand hours for existing workers before hiring new ones. However, we
believe that a jobless recovery is less likely than in the past two recoveries, partly because past job cuts have virtually
eliminated what were minimal hiring excesses.

One way to measure the extent of hiring excess or shortfall involves cumulating the errors made by a relatively
standard relationship used to forecast labor hours worked (and, with a projection for the average workweek,
employment). The explanatory variables include the outlook for output, factors that affect productivity such as the
services from capital, and a dynamic adjustment process that captures the typical pro-cyclical surge in productivity
early in recovery. If positive, the cumulative differences between actual hours and those predicted by the relationship
suggest that there is an overhang of labor to work off. As it turns out, the errors over the course of the expansion that
ended in December 2007 were small, reflecting business caution about hiring. And through 2Q09, the errors
cumulate to zero, suggesting that the aggressive job cuts seen in this recession have eliminated any excess. Although
we expect employment to begin growing by the end of this year, declines over the July-December period will push
those cumulative errors sharply negative, implying some underlying pent-up demand for labor that should materialize at
some point down the road.

Slow Exit from Policy Support Means Sustainable Growth Through 2011

Policymakers will slowly exit from monetary and fiscal stimulus as inflation remains low, markets heal and the cyclical
dynamics of recovery take hold. Officials have signaled those intentions with regularity since meeting at Jackson Hole
in late August, in speeches, Op-Ed pieces in the financial press, and at the G20 meetings of central bank chiefs and
finance ministers in London this past weekend. We continue to think that the Fed will taper off its asset purchase
programs, wind down its credit and liquidity programs as market conditions permit, and keep rates unchanged until
mid-2010. Such a stance should enhance prospects for sustained growth beyond 2010. And we believe that the lags
in fiscal policy mean that stimulus from the fiscal side will persist through 2011.

However, as we look ahead to 2011 for the first time, we do see a slower expansion. On a 4Q/4Q basis, we expect
GDP growth will moderate from 3.25% in 2010 to around 2.5% (which is in line with our estimate of potential
growth), while inflation will move slightly higher in tandem with the trajectory of oil prices. (Note that on a year-on-
year basis, we expect 2011 real GDP to accelerate to 2.8% from 2.7% in 2010; mostly that reflects a hearty end to
2010.) In our view, several factors will promote a slowing in growth. Unless policies change, fiscal drag will begin in
2011, with the sunset of the Bush tax cuts (a tax hike of about US$300 billion, or 3% of disposable income) and the
waning effects of ARRA. In addition, a less stimulative monetary policy, higher rates out the curve as private credit
demands begin to normalize and (to a modest extent) higher oil prices will promote a deceleration.

Nonetheless, in 2011 several forces of recovery will still be at work. Home prices should stabilize or even rise, and
financial conditions and credit availability will likely ease a bit further. Inventory liquidation may shift to accumulation.
Rising operating rates and cash flow may help capital spending. Those factors probably contribute to the Fed's
buoyant forecast for 4.2% (4Q/4Q) growth in 2011. Despite the expected deceleration and a still-high
unemployment rate, we look for the Fed to continue moving policy back towards neutral during 2011. We currently
expect the Fed to raise rates by 150bp in 2H10; a further increase of 100-150bp would get policy a lot closer to
neutral by the end of 2011.

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Germany
More Muddling Through?
September 10, 2009

By Elga Bartsch | London

Despite the Bounce-Back, Beware of the Headwinds

Rising hopes of a V-shaped recovery and a consensus view that the general election will bring about a change in
government towards a more market-friendly centre-right coalition have pushed survey-based business expectations
up. Investor expectations canvassed by the ZEW are now considerably above their long-term average and company-
based expectations for the next six months polled by the Ifo Institute are climbing rapidly towards the long-term
average too. The cyclical DAX is up more than 50% from its March trough and many forecasters, including us, are
bringing up near-term estimates. In the light of these positive factors, it is vital not to lose sight of the challenges that
still lie ahead.

Recent regional elections have revealed an unexpectedly weak outcome for the Christian Democrats, who lost their
absolute majority in two states, and a surge in voter support for the smaller parties, including the Left Party. Hence,
hopes for a change in government could still be thwarted by a re-run of the Grand Coalition. In addition, the
recession has likely done considerable damage to the economy, much of which still has to show - among other things
in the labour market, fiscal balances and bank lending. Notwithstanding the vigorous initial bounce-back, the
recovery eventually will likely be a tepid one, we think.

Four Years into the Grand Coalition...

In politics, four years can be a long time, especially in these turbulent times. Four years ago, Angela Merkel was
hailed by some media as a new Margaret Thatcher in European politics. Campaigning on a strong pro-market
election platform, she and her Christian Democratic Party (CDU/CSU) were seen as bringing political change to
Germany. However, the bold reform platform nearly lost Mrs. Merkel the 2005 election. Despite having had a
comfortable lead in the polls over the then incumbent Gerhard Schroeder (SPD), the election night turned into a cliff-
hanger and a razor-thin election outcome eventually resulted in a Grand Coalition between the two largest parties,
Merkel's CDU/CSU and the Social Democrats (SPD) - an alliance that worked surprisingly well given that neither of
the two parties were too keen on the concept (and still aren't).

...Our Call of a Reform Standstill Now Seems Too Optimistic

In September 2005, we argued that the electorate had opted for a clear ‘neither nor' as far as reforms were
concerned and that political standstill was the most likely outcome (see German Economics - A Clear ‘Neither
Nor', September 19, 2005). With the benefit of hindsight, standstill was probably too optimistic a call because the
Grand Coalition reversed some of the hard-fought-for labour market reforms (e.g., by introducing minimum wages
in several sectors, extending unemployment benefits for older workers, and bulking up short-shift subsidies sharply).
A hike in the VAT by three percentage points - a move the Social Democrats had initially opposed in their election
campaign - slowed the economy down in early 2007. In exchange, top income taxes were hiked (instead of lowered
as the CDU/CSU election platform had envisaged) with the introduction of a so-called ‘Reichensteuer', which
introduced a new top income tax bracket at 45% from 42% before. Corporate tax reform lowered the statutory
corporate tax rate from 25 to 15%, limiting the overall tax rate including local trade taxes and the solidarity surcharge
to less than 30% of profits in exchange for a widening in the tax base (see German Economics: Cutting Corporate
Taxes, July 14, 2006).

A Notable Shift to the Left in the Whole Political Spectrum

In response to the ambitious labour market reforms pushed through by the Red-Green government under Chancellor
Schroeder, the SPD lost a part of its left wing, as disgruntled members joined forces with the former East German
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communists, PDS, to form a new Left Party. It is partially in response to the formation of this new party at the left
end of the political spectrum that the big mainstream parties - the Christian Democrats and the Social Democrats -
started gravitating towards the left in an attempt to limit the fallout from a further fragmentation of the political
spectrum. The financial turmoil has likely reinforced the shift in the political platforms.

Fragmented Political Spectrum Makes it Difficult to Govern

Despite the concessions of the mainstream parties, the political spectrum in Germany remains more fragmented than
ever. While under the German constitution a 5% hurdle for parliamentary representation keeps out smaller political
groupings and parties, the share of votes that pollsters are predicting for the Left Party, the Greens and the Free
Democrats (FDP) have never been higher. As a result, it will be more difficult for one of the larger parties - be it the
CDU/CSU or the SPD - to form a government with just one junior partner. Instead, the unpalatable choice becomes
one between another Grand Coalition and a tripartite coalition with two of the smaller parties. Neither of the two
constructs is stable and a second term of the Grand Coalition might not even last a whole parliament, as both parties
will want out as another Grand Coalition would weaken their base, boosting smaller parties.

Power Struggles and Crisis Could Change the Perspective

Four years into the forced marriage between CDU/CSU and SPD, the key question is to what extent Chancellor
Merkel's policy initiatives were driven by the necessity of keeping the coalition together and to what extent they reveal
a change in her own party's political agenda. An election outcome, which allows Merkel to form a government with
the pro-market Free Democrats (FDP), would allow her to revive her radical reform ideas - if she still deems them
appropriate. The experience of handling the deepest recession in post-war history and trying to limit the fallout of the
biggest financial turmoil since the Great Depression might have changed her perspective. In addition, some
CDU/CSU state premiers have openly embraced more leftist policies over the last few years. With some of these
state premiers potential rivals for political leadership, Chancellor Merkel probably will want to ensure she does not
corner herself with too bold a reform agenda.

A Quick Glimpse at the Election Platforms

In what follows, we provide a brief overview of where the parties stand with respect to the key policy areas and
contrast these election platforms against what we deem necessary in terms of reforms and against the restrictions
posed by the need to comply with the German constitution, notably on the newly introduced debt-brake, and
European legislation in areas such as the competition policy and state subsidies.

Taxation

Regarding corporate taxes, only two parties have clear proposals in their respective election platforms. The Free
Democrats aim to remove some of the restrictions introduced as part of the 2008 corporate tax reform, notably the
new limits introduced to the tax-deductibility of interest payments, carrying losses forward after a takeover and off-
shoring, thus reducing the effective corporate tax burden. The Left Party, by contrast, aims to raise the corporate tax
rate from 15% to 25% while also broadening the tax base. When it comes to income taxes, all parties aim to raise
the tax-free income (Left, Greens) or alternatively the tax credit for families (CDU/CSU, SPD, FDP). In addition,
CDU/CSU, SPD and FDP all aim to lower the lowest tax band from the current 14% to 12%, 10% and 10%,
respectively.

Meanwhile, the Social Democrats, the Left Party and the Greens seek to raise the top income tax rate from 42% to
47%, 53% and 45%, respectively. In addition, both the Left Party and the Greens are aiming to raise wealth and
inheritance taxes. Like the Social Democrats, both also support a (re)introduction of the stamp duty on financial
transactions, ideally as a Europe-wide tax.

Our assessment: While the centre-left parties favour tax hikes rather than spending cuts to reduce the budget deficit,
a centre-right coalition would need to reduce government spending and rein in the budget deficit before being able to
cut taxes.
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Social Security (Health, Pension)

Faced with deteriorating demographics, shrinking payrolls and rising outlays for healthcare, pensions and
unemployment benefits, all parties seek to restore the financial balance of the social security system somehow. With
respect to healthcare, the Social Democrats, the Left Party and the Greens are in favour of extending the current
system covering private sector wage-earners to civil servants and the self-employed (who tend to be privately
insured). In addition to wage income, property and investment income should be subjected to social security
contributions. The FDP, by contrast, is heading down a completely different route, proposing a basic private
insurance for all, with subsidies for those who cannot meet the costs and with pre-funding age-related outlays. The
CDU/CSU is essentially aiming to maintain the status quo, having abandoned its more radical reform ideas.

With respect to pensions, both the CDU/CSU and the FDP are in favour of maintaining the status quo in terms of its
funding, while the remaining three parties (SPD, Left and Greens) would favour extending the current system for wage
earners to civil servants and the self-employed or even to all adults. Only the CDU/CSU seems committed to see
through the planned gradual increase in the pension age to 67. The Left Party explicitly wants to reverse the steps
already taken to raise the pension age. In addition, the Left Party proposes to phase out financial incentives for
private pension plans. The FDP has exactly the opposite in mind, proposing to strengthen private pensions (both
personal and corporate plans). In addition, the FDP essentially proposes to do away with the fixed pension age and
instead allow individuals to decide when they want to retire based on actuarially fair factors once they have passed
their 60th birthday. The FDP is also in favour of allowing pensioners to earn more additional income without cutting
their pension benefits.

Our assessment: None of the parties presently addresses the fiscal time bomb caused by the combination of a
rapidly aging society and generous entitlements to pension benefits, healthcare and long-term care.

Labour Market

Given that bilateral agreements between trade unions and employers associations regarding pay, working conditions
and employment protection are a cornerstone of the German economic model, labour market policy does not feature
prominently in election platforms. With two exceptions: minimum wages and potential deviations from the
sector-wide agreements. While SPD, the Left Party and the Greens in general favour a uniform minimum wage
across sectors and regions, they differ with respect to the level at which the minimum wage should be set. The Left
Party wants to go furthest by setting a uniform minimum wage at €10 per hour while the Greens and the Social
Democrats are somewhat lower at €7.50 per hour. The CDU/CSU proposes, and indeed in the current parliament
has already supported, sector-specific minimum wages. The FDP, by contrast, is firmly pitched against minimum
wages.

Next to the minimum wage question, another key feature of the labour market programmes is whether parties are in
favour of allowing individual companies and their workers to deviate from the sector-wide agreements or whether
they even will make them binding for all companies. Typically, companies that aren't members of an employer
association are not bound by the sector-wide agreement. Here the Left Party wants to force everyone into the
straight-jacket of the sector-wide agreement, while the FDP is in favour of allowing companies to negotiate tailor-
made deals. In addition, the Left Party is proposing to reduce working time to 35 hours per week at full pay. The
Greens have some sympathy for the idea of limiting deviations from the sector deals and so does the SPD.

In addition, the Social Democrats plan to create four million new jobs by 2020 as part of their so-called ‘Deutschland
Plan'.

Our assessment: In our view, the ability of individual companies and their workers (represented by trade unions) to
hammer out tailor-made agreements on work and pay was instrumental in the highly successful corporate restructuring
(see German Economics: Macro Reforms Meet Micro Restructuring, August 25, 2005). It would therefore be
important not to turn back the clock on minimum wages, which more than anything are a barrier to new competition,
and to allow for more, not less, flexibility in company-specific negotiations.
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Environment and Energy

One area that has already attracted investor attention ahead of the election is that of energy policy - notably the
phasing-out of nuclear power and the issue of solar-tariffs. All major parties are committed to promote renewable
energy; they differ in their degree of ambition ranging from 20% for all energy and 30% for electricity by 2020 in the
case of the CDU/CSU, to 50% for electricity by 2020 in the case of the Left Party or even 100% for electricity by
2030 and for all energy by 2040 in case of the Greens.

Parties also differ in their commitment to building new power stations (notably modern coal plants) and to capturing
and storing carbon dioxide (CO2), which the CDU, SPD and FPD are in favour of and the Left and the Greens are
against. Major difference also exists with respect to running existing nuclear power stations longer (which is
acceptable to the CDU/CSU and the FDP). While no party in Germany is proposing to build new nuclear power
stations, the Left Party would like to close down existing power stations immediately while the SPD and the Greens
would stick to the agreed exit strategy.

All parties are in favour of radical CO2 emission cuts. The CDU/CSU, the SPD and the Greens aim for at least a
40% reduction by 2020, while the FPD is a bit less ambitious at a 30% cut, and the Left party wants to go further and
halve emissions. CDU/CSU, FDP and the Greens are explicitly supporting carbon trading. While the CDU/CSU is
keen to compensate companies for the costs of carbon trading, the Greens would like to see a phase-out of
exceptions for energy-intensive sectors. When it comes to international carbon offsets, the FDP would like to see
more of these being used, while the Greens want to disallow them.

Most parties have not made clear commitments regarding carbon or energy taxes in their manifestos. Only the
FDP states that it would like to see a cut in the VAT on energy or a cut in explicit energy taxes, while the Greens are
clear that they want the exceptions from the energy tax to be abolished and cut back subsidies for activities harming
the environment.

Our assessment: While the nuclear question is important for securing long-term energy supply, many of the other
issues, notably the commitment to cut emissions or to boost renewable energy sources, are eventually taken at the
European or even the global level.

Fiscal Consolidation

All parties are rather ‘stumm' when it comes to explaining to voters how the ballooning budget deficit is meant to be
reduced in the years to come, certainly one of the key challenges facing the incoming government. Based on the
election platforms, it seems that the Left Party would probably be the least committed to fiscal consolidation because
it fundamentally favours a bigger government sector and, if anything, would engineer it via higher taxes, notably for
companies and higher-income earners. Meanwhile, the FDP and to a lesser extent the CDU/CSU, which both aim to
lower taxes in the next parliament, would probably favour a reduction in government spending in order to create the
room for tax cuts. While SPD's Finance Minister Steinbrueck spoke out in favour of an early start of the fiscal
consolidation, it is not clear whether this statement reflects the views of the whole party.

Our assessment: All parties would be under pressure to comply not just with the rules of the Stability and Growth
Pact (SGP) but also with newly introduced debt brake laid down in the German Constitution. The debt brake
essentially limits borrowing of the federal government to 0.35% of GDP from 2016 onwards while not allowing
regional states to run deficits from 2020. An only tepid recovery will limit the cyclical improvement in budget
balances, we think, and, like many other governments, the next German government is likely to look at various
options, including privatisation (see European Economics & Strategy: Poor State of Government Finances &
Implications for Equities, September 1, 2009).

At the Moment, the Polls Show a CDU/CSU Lead over the SPD

As a result, it looks likely that the election could indeed bring a change in government towards a centre-right coalition

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of the CDU/CSU and the FDP. Based on the colours representing the two parties, such a combination has also been
coined a Black-Yellow coalition. But the relatively narrow lead of the two parties, the surprises in the recent regional
elections and the uncertainties created by the German election system suggest that there is a chance of the change in
government being thwarted. While arithmetically, in addition to the Grand Coalition, a number of other
combinations would be possible, largely incompatible election platforms make these unlikely at the national level - at
least for now. Only one pollster currently deems a Red-Red-Green coalition between the SPD, the Left Party and
the Greens possible.

The So-Called ‘Chancellor Model'...

As an alternative to the polls, a statistical model can be used to predict the election outcome. One such model is the
so-called Chancellor Model, whose claim to fame is to have predicted the last election outcome correctly with a
margin of error of only 0.3 percentage points (see H. Norpoth, T. Geschwend - "The Chancellor Model: Forecasting
German Elections", International Journal of Forecasting, forthcoming). In 2002, the model also did very well
when it correctly predicted a return of the Red-Green coalition with its three-month-ahead forecast beating even the
exit polls on the night, according to the authors. For the upcoming election, the model forecasts a coalition between
the CDU/CSU and the FDP with a clear majority of 52.9%.

...Suggests an Even Clearer Outcome than the Polls

The model is based on three factors: 1) the popularity of the incumbent, which in Angela Merkel's case at 71% is very
high; 2) the long-term partisanship of the population, which is estimated at 44.1% for CDU/CSU and FDP combined;
and 3) voter fatigue with the governing coalition, which tends to rise over time. But given that Angela Merkel has only
been in office for four years, voter-fatigue should still be limited. Two factors introduce potential uncertainties: first,
the fact that the parties of the Grand Coalition ideally want to part company after the election poses a predicament
for the model, which is set up to predict the likely return of government coalitions. Second, for the new Left Party,
long-term partisanship is still difficult to estimate. Hence, despite the model's impressive track record, we could still
be in for a surprise on the election night.

Additional So-Called Overhang Mandates that Individual Candidates Can Win...

The potential for surprises on the election night is partially due to some procedural rules of the election system, notably
the existence of so-called overhang mandates. These overhang mandates imply that it is not clear a priori how many
seats the new parliament will have. This is because in any general election, German citizens cast two votes. With the
first vote, they choose a candidate in their election district; with the second, they vote simply for a party. It is the
second vote that determines the parties' relative strength in the lower house of parliament, the German Bundestag.
However, if a party manages to win more direct seats than the share in the second vote would suggest, it retains the
additional seats as so-called ‘overhang mandates'. The overhang mandates make it possible that a party can have
more seats in parliament than the share in the second vote would suggest.

...and the 5% Hurdle Can Make Election Outcome Hard to Predict

The second element causing potential surprises is the hurdle for parliamentary representation: only parties that receive
at least 5% of the (second) votes or gain at least three direct mandates on the first votes can be represented in
parliament. Hence, votes for small parties that don't make the cut get lost in terms of parliamentary representation.
This is why often less than 50% of votes in the polls are sometimes sufficient to form a coalition. At the current
juncture, none of the three smaller parties that are represented in parliament is estimated to come in anywhere near the
5% hurdle though. But this has been different in past elections. With some votes falling out of parliamentary
representation due to the 5% hurdle and some extra seats being added due to overhang mandates, sometimes as little
as 47% of the national vote has been sufficient to capture the majority of parliamentary seats.

Election Timeline Could Be Upset by Twitter Too

Usually the timeline of events on an election night is very clear. The polling stations in Germany close at 18.00 local
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time. First estimates of the outcome based on exit polls are typically available soon afterwards from all major TV
stations. Within the first 90 minutes, they tend to have a pretty good handle on the election outcome. The preliminary
official result typically is known before midnight. Ahead of these official results, a big TV debate with the leaders of
all major parties takes place starting around 21:00 local time, which gives first insights about potential coalitions to be
formed. However, new means of communication could upset this well-rehearsed routine. In the recent regional state
elections, exit polls were leaked to the public via Twitter, and there are concerns that this might happen again in the
general election. As in many other countries, publishing exit polls while the polling stations are still open is illegal and
could potentially trigger a discussion about whether the vote could be void. Even though legal experts believe that
such a leak is unlikely to cause the vote to be void, the discussion would add to the uncertainty.

Latin America
Latin America: V-Shaped Recovery?
September 10, 2009

By Daniel Volberg | New York

With Latin America's growth passing the trough of the recession and markets sustaining a bumpy rebound,
the pace of economic recovery in the months ahead has come into sharper focus. One of the many
implications of the shape of the eventual recovery may be the monetary policy stance in the region. While all the
inflation-targeting central banks in Latin America are now firmly on hold, questions on the timing of monetary policy
tightening are gaining ground. Yield curves in Latin America - from Brazil to Chile to Mexico - are pricing in hikes
already next year. In contrast, a modest recovery may be associated with limited inflationary pressure and lower
policy rates for longer. In addition, anemic growth may prove to be a formidable headwind for rebuilding fiscal
responsibility in the region. We suspect that markets may have run ahead of themselves in extrapolating a sharp
recovery, and expect a modest recovery for three reasons.

Weak Global Demand

First, the developed world remains the demand-side engine of world growth, but this engine is sputtering.
There is no question that the developed economies, particularly the US and the Euro-zone, are in the midst of one of
the deepest downturns in recent history, as consumers in both economies retrench. While we acknowledge that there
is a debate on whether Emerging Market consumers can take up the leadership role in driving global consumer
demand - the idea of world growth rebalancing - we suspect that the size differentials between developed and
emerging economies are a headwind for such an extreme change in demand-side leadership. We suspect that the
structure of the world economy remains largely unchanged - with developed economies on the demand side and
emerging economies making up the supply side. After all, when we use market exchange rates to aggregate private
consumption - the ultimate driver of demand - across the developed and the 27 largest emerging economies, we find
that just the US and the Euro-zone account for close to half (49.9%) of world demand. With US and European
consumers suffering a downturn of unusual severity, the repercussions for global demand should not be taken lightly.

Both in Europe and the US there are several headwinds facing the consumer. In the US, the consumer is
buffeted by a negative wealth shock (from a collapse in housing wealth and asset-based savings) and a negative
income shock (as unemployment soars); the result has been a structural adjustment in consumer behavior. In addition,
the financial system is only beginning to heal and credit conditions remain tight. The result is that the US consumer is
now saving more and consuming less - the personal saving rate has already nearly tripled from an average of 1.8% of
disposable income in 2007 to 5.2% in 2Q09. And our US economics team expects the personal saving rate to remain
elevated for the foreseeable future, forecasting the saving rate to eventually climb to 5.6% of disposable income by the
end of 2010. In the Euro-zone, private consumption has only begun to stabilize in 2Q09 after four consecutive
quarters of negative sequential growth. Looking ahead, our European economics team expects further pain on the
consumer front as short-term employment subsidies run out and labor markets continue to soften (see "Euroland
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Economics: Euroland Recovery Arrives Early", Investment Perspectives - Europe, August 19, 2009). With at least
half of the world's demand side in the midst of a painful adjustment, we remain skeptical of calls for a sustained robust
recovery in the production side and thus continue to expect a modest recovery in Latin America.

Inventory Cycle

Second, much of the recent rebound in developed world activity appears to be driven by the inventory
cycle, while final demand remains weak. There has been much focus on the recent tentative signs of growth
recovery in the developed world. In 2Q, there was a significant moderation in the pace of GDP growth decline in both
the US and the Euro-zone. In fact, already in 2Q, two of the Euro-zone's less dynamic economies - France and
Germany - posted positive sequential growth. But we urge caution in reading recent improvements as signals of a
robust economic recovery. After all, in both the US and Euro-zone an important factor that appears to be driving
growth of late is the sharp drawdown of inventories and the beginning of an inventory rebuilding cycle. This is a far cry
from robust final demand. Take the US, for example, where inventories peaked at 1.5 months of sales at the turn of
the year and have now come down to 1.4 months in June. This is still above the 1.3 months of sales that was
prevalent in 2007, just prior to the start of the downturn, but is heading in the right direction. However, the drawdown
of inventories comes in sharp contrast to the continued rise in the personal saving rate and soaring unemployment - a
signal that final demand may remain subdued. And in Europe, the central banks' survey data suggest that while
inventories have nearly normalized, final demand remains weak. Weakness in final demand raises the risk that the
recent improvement in growth data may prove unsustainable and that the pace of the growth recovery may moderate.
Over time, weak final demand in the developed world may act as a brake on growth in emerging economies.

Exporting Out of Recession?

Finally, we are concerned that, despite weak global demand, emerging economies are trying to export their
way out of recession. We have aggregated data on goods trade for the developed and the 27 largest emerging
economies and find that while trade has fallen globally, emerging economies may be most vulnerable. After all, the
biggest drop was in goods imports in the developed world, while the biggest rebound appears to be in emerging
world exports. Given our assessment that final demand in the developed world remains weak, exporting out of the
recession may be a risky strategy for emerging economies.

Within Latin America, external demand has been a key driver of the recently improved growth performance. For
example, in Brazil the net contribution from external demand was 0.7% in 1Q while overall GDP fell 1.8%. Domestic
demand contracted 1.4% in annual terms in 1Q. In Mexico, while overall GDP fell 8.4%Y in 1Q, domestic demand
fell by more, contracting 9.2%Y. That means external demand played an outsized role in pulling up the final growth
results. And this is by no means limited to the region's largest economies - we observe a similar pattern in Argentina,
Chile, Colombia and Peru. With final demand in advanced economies still weak, relying on export-driven growth may
be a risky bet for Latin America and, indeed, emerging markets more broadly.

Bottom Line

The global economy may be showing signs of recovery, but we see underlying demand-side weakness as a
headwind for a sharp snapback. With the developed world in the midst of a deep structural adjustment and final
consumption expected to remain anemic over the forecast horizon, emerging market economies may be embarking on
a risky strategy by trying to export their way out of the recession. We suspect that weak final demand may constrain
the pace of recovery in Latin America and the modest growth outlook may, in turn, keep inflationary pressures at bay.
This combination of modest growth and subdued inflation should allow the inflation-targeting central banks in the
region to remain on hold for longer. Moreover, we are concerned that the markets may have been too quick to price
in a robust recovery.

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