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RESEARCH

December 2009

GLOBAL OUTLOOK
BEYOND THE RECOVERY TRADE

PLEASE REFER TO THE LAST PAGE FOR ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES

Barclays Capital | Global Outlook

FOREWORD
Given the massive swings in economies and markets over the past couple of years, it seems unusual that not much has changed since the September issue of the Global Outlook (“Still in the sweet spot”). The global economy remains in recovery mode, which, after such a severe recession, translates into above-trend growth. The expansion in Asia – where the recovery began – is now downshifting to a more sustainable pace, but this is being offset by activity in the laggards such as the US, which is just now gaining a head of steam. Meanwhile, much of the extreme policy stimulus – including direct purchases of financial assets – remains in place. The combination of economic recovery and unusually low policy rates continues to provide strong support to asset prices of nearly all stripes in most regions of the world. Until signs emerge of a change in that environment, we recommend that investors maintain their allocations to risky assets. All good things come to an end, and this unusually friendly environment for financial assets will too, probably in the first half of 2010. Ironically, the signal could well be a confirmation of above-trend economic growth in the US – the last shoe to drop in the global recovery story. We believe – contrary to the consensus – that the US economy has shifted to a 4-5% GDP range for this quarter and next, and that the labor market will generate job growth and establish a peak in the unemployment rate by the end of the first quarter. Such a development would likely generate concerns that the Fed will soon begin to remove its extraordinarily accommodative stance. History suggests that this would interrupt the steady rise in asset prices and produce a market correction. We look for the biggest impacts to be on money market rates (up), the dollar (up) and gold prices (down). That said, any sign of change in the enormously supportive environment is likely to trigger a broad-based correction (just as the lift to asset prices has been broad based), and the equity and credit markets will not be immune. But we do not see the onset of Fed tightening as triggering a bear market in either sector. Valuations are not extreme, and it will be a long time before Fed policy is even remotely restrictive. This publication strives to serve you – our clients – by providing objective in-depth analysis across all asset classes and regions. We sincerely hope that it helps you make informed investment decisions.

Larry Kantor Head of Research Barclays Capital

10 December 2009

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Barclays Capital | Global Outlook

SUMMARY OF ASSET ALLOCATION THEMES
KEY FORECASTS Equities

KEY RECOMMENDATIONS

Our general expected path for equities next year is a sharp rally in Q1, followed by some sideways corrective behaviour in Q2 and Q3 as investors grapple with potential policy shifts. US economic growth is likely to prove sustainable, to the benefit of S&P 500 earnings. However, the equity market has already enjoyed considerable multiple expansion in 2009; as inflation rises, we believe that multiples are likely to compress in 2010. In 2010, rate markets will have to live with the prospects of rate hikes, a decline in the current abundant liquidity, and the lack of support from QE buying. A large sell-off is looming, and is likely to take place around the end of Q1 10. Until then, rates might continue to range trade, with an upwards bias. We see little value in bonds and swaps, especially in the US and UK. Only Japanese rates have potential for a meaningful rally from here. The broad price recovery in commodities is closer to maturity, but there is still upside in several markets including oil and some base metals. A slowdown in China’s import demand is still the main threat to a continuation of the recovery, while an end to the dollar weakening trend would be especially negative for gold. Slower global growth and the existence of some spare capacity in markets like oil suggest much slower price appreciation further ahead in 2010. Real yields biased higher in 2010 from ongoing economic recovery, although breakevens then likely to be supported by normalization in inflation. We expect credit returns in 2010 to be strong by historical standards but lower than in 2009, increasing the importance of relative value to generating outperformance. Performance between now and early next year will likely be robust, with risk later in the year from the withdrawal of central bank liquidity. Demand for corporate credit is likely to benefit from a lack of spread alternatives, amid slow US and European growth, historically low yields, and a heavy supply of government bonds. All regions of the emerging world are now in recovery, though the recovery is weaker and more varied in EMEA and the smaller countries of LatAm. Monetary easing is largely behind us, and tightening should begin in Q4 (India), gather pace in Q1 (Mexico and Korea) and become generalized in Q2. Tightening will be cautious, gradual and will include FX as a tool. Although we are not sure the USD has bottomed, in H1 10, the greenback should stage a limited rally. USD/JPY enjoys significant upside potential at the end of the Fed asset purchase program. GBP volatility should rise in 2010. Commodity currencies may have one more leg up.

In the immediate term, we are biased to staying long in equities. Our suggested mix of sectors remains industrials, technology, basic materials and energy, but we would recommend shifting into more defensive areas as the quarter progresses. In the US, we have reduced exposure to cyclical sectors facing secular headwinds, namely financials and consumer discretionary, and maintain exposure to cyclical sectors poised to benefit from secular tailwinds, such as technology and industrials. Short-end rates look too low (especially post 1y), and should start selling off around the end of Q1, with the biggest move expected in Q2 10. Strategically, we like being short and in money market steepeners. At the long end, rates are equally expensive in most major markets, and will invariably sell off, keeping the curves steep until at least the end of Q1 10, and probably longer in the US. Cross market, we still prefer euro rates, but entry levels are not currently attractive. Long crude oil, given that improving global diesel demand should provide a further leg-up to prices, but short US natural gas, which still looks oversupplied. Long copper and nickel, which should be among the main beneficiaries of a cyclical OECD recovery in Q1. Long corn and sugar on strong demand for ethanol and recent supply problems. Short silver as it is the precious metals market most exposed to a more stable dollar outlook. 5y sector offers greatest potential to benefit from a recovery-led repricing of breakevens. Financials, especially banks, are likely to outperform owing to better technicals, including negative net issuance and build-up of liquidity. Improving fundamentals, better liquidity and normalization in funding costs should lead lower BBB-rated issuers to outperform. A barbelled HY portfolio takes advantage of historically wide double-B spreads and potential outperformance of selected CCC paper. Taxable munis appear attractive versus corporates of similar maturity and quality. We think high-quality external debt will outperform US Treasuries, but earn quite low total returns. Achieving better than mediocre returns will hinge upon country allocations and asset selection. EM FX strength is more than dollar weakness. Asia FX should outperform on the basis of strong external positions, policy tightening, and CNY appreciation. Buy USD/JPY. Buy commodity currency basket against the CHF. Sell AUD/CAD. Sell EUR/SEK.

Bonds

Commodities

Inflation

Credit

Emerging Markets

Foreign Exchange

10 December 2009

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Barclays Capital | Global Outlook

CONTENTS
OVERVIEW 4 Beyond the recovery trade The recovery trade is still on for now, but the powerful cyclical forces that have driven the rally are set to give way to structural issues, resulting in lower correlations among asset classes and regions and the need for portfolio managers to become more selective. ASSET ALLOCATION 8

Cross currents The market outlook for 2010 is characterised by higher-than-normal levels of uncertainty. Conditions at the start of the year seem appropriate for the continuation of recent trends, with a decent probability of some asset classes moving into overvalued territory. ECONOMIC OUTLOOK 18

Hard to derail We expect strong global growth in the next two quarters: Asia is likely to slow significantly from its recent rapid pace, while the laggards of this global recovery – the US and Europe – are likely to remain robust. COMMODITIES OUTLOOK 31

Cruise control Although most of the broad uptrend in commodity prices is now over, a period of strong growth ahead for the US and Europe should enable further gains to be made in base metals and oil markets during Q1 10. FOREIGN EXCHANGE OUTLOOK 39

The return of two-way risks The phase of the strong trending market is coming to an end. Although we cannot be sure that the USD has bottomed, 2010 should see the greenback doing better as elevated USD risk premium diminishes. INTEREST RATES OUTLOOK 44

Asymmetrically biased higher Rates are biased asymmetrically higher going into 2010, as abundant liquidity conditions and the support of QE buying for bond markets are fading away. CREDIT OUTLOOK 54

The hunt for yield We expect credit returns in 2010 to be strong by historical standards but lower than in 2009, increasing the importance of relative value to generating outperformance. US EQUITY OUTLOOK 65

The Fed giveth and the Fed taketh away Growth is likely to prove sustainable, to the benefit of earnings. However, the equity market has already enjoyed considerable multiple expansion; as inflation rises, multiples are likely to compress. EMERGING MARKETS OUTLOOK 72

Sharpen your pencil While there appears to be some life left in the ‘stronger for longer’ market call, its shelf life is limited, and we think the time has come for investors to sharpen their pencils and focus on differentiation across asset classes, countries, and investment instruments.

10 December 2009

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Following two years of high drama and unexpected twists and turns. our forecasts for 2010 are little changed from those in the September Global Outlook. The global economic expansion broadened as the recovery took hold. and the growth laggards such as the US are set to post stronger-than-expected economic growth. Money market rates. we see relatively little risk of a serious growth disappointment given the relative youth of the global expansion. But the powerful cyclical forces that have driven the recovery rally are set to give way to structural and intermediate-term issues. With both economies and markets closely tracking Barclays Capital expectations. When it does. the past three months have been remarkably stable by comparison.kantor@barcap. which should continue through the first half of next year and keep global growth near its peak. That said. financial system healing continued. most likely in the first half of the year. as policy remains enormously stimulative. A maturing cycle 2010 may not provide the excitement of 2009. but it should still be favorable for growth and inflation fundamentals The countries in Asia that have led the global economic recovery have completed the initial period of rapid growth and are now slowing. At the other extreme. the laggards – most notably Europe and the US – are just now entering the period of maximum growth. and policy settings have moved very little from those that were put in place at the height of the crisis. resulting in lower correlations among asset classes and regions and the need for portfolio managers to be more selective. The recovery trade is still on for now. as the pace of advance in the laggards settles back. We are on the alert for signs of change in the current liquiditydriven environment As far as positioning is concerned.com Following the drama of the past two years. we find it difficult to tear ourselves away from the recovery trade. Global growth is expected to slow later in 2010. But the uniformly favorable environment for asset prices – post-recession above-trend growth and extraordinarily easy monetary policy (including specific measures to support asset prices) – is likely to change in 2010. and asset valuations moved higher – all largely as expected. The powerful cyclical forces that have dominated markets for the past couple of years will give way to structural factors that are more difficult to assess and time. it is just gaining its footing in most of the developed world. portfolio selection will become much trickier and asset managers will have to become more selective.Barclays Capital | Global Outlook OVERVIEW Beyond the recovery trade Larry Kantor +1 212 412 1458 larry. and recommend reducing risk and diversifying positions when these signs emerge. asset valuations have returned to more normal levels. An upturn in the US labour market could lead the Fed to signal before mid-2010 that a withdrawal of policy stimulus is imminent. at least for now. the dollar and gold are more vulnerable than equities and credit to potential monetary tightening. We are on the alert for signs of change in the current liquidity-driven environment. While the economic recovery is approaching its first anniversary in Asia. the still-depressed levels of cyclically sensitive sectors such as 10 December 2009 4 .

Consensus growth estimates have risen considerably and are no longer significantly below Barclays Capital forecasts for the first time in more than a year. While there remains some resistance among investors to a full embrace of the economic recovery story. An upturn in the US labor market could signal the end of the recovery market rally Ironically. Continued deterioration in the labor market has held investors back from fully embracing the recovery story. it has become generally accepted. both because of the extreme and unprecedented nature of the policy ease and the fact that the Fed's approach to policy setting for more than a decade – since Chairman Greenspan initiated an "experiment" with easier monetary policy in 1997 – is now facing serious scrutiny.Barclays Capital | Global Outlook autos and business investment. Equities. it could also signal that the end of the recovery market rally is in sight. It first produced instability in asset prices. When unemployment starts falling. we expect much lower correlations among various assets and regions. credit spreads and commodity prices for the most part seem reasonably valued. While 2010 may not provide the excitement of 2009. But now that continued asset price swings have led to 10 December 2009 5 . it should be another very favorable year for growth and inflation fundamentals. This is the top intermediate-term issue we would focus on for early 2010. The November labor market report went some way toward dispelling that concern. Investors positioned either for recovery or defensively and were rewarded accordingly. there are no screaming buys left. regulatory responses to the financial turmoil. but employment is still not increasing and the strength of the US recovery thus remains in doubt. we see inflation risks as muted at least for the next year or so as excess capacity remains pervasive and inflation tends to lag the growth cycle. which the Fed thought it could contain without serious damage to the real economy. as markets should be driven by a broader range of structural and intermediate-term issues rather than being dominated by the twists and turns of an all powerful global financial crisis and the resulting economic cycle. Expect lower correlations among asset classes and geographies The recovery trade's final act Before leaving the recovery trade behind entirely. while an upturn in the labor market would be important in confirming that a sustainable recovery is underway. Moreover. For 2010. Correlations between assets and across geographies have been very high and exactly how risk exposure was taken mattered relatively little. Market drivers to become more multidimensional There are no screaming buys left Successful positioning in financial markets over the past couple of years has been a one-act play. the intermediate-term consequences – particularly for inflation – of the extreme liquidity measures employed by central banks. We believe that 2010 will be different. and the extreme ease of policy settings everywhere. Among the issues that investors will need to consider are the exit strategies to be taken by central banks. Labor market improvement is a necessary (although not sufficient) condition for the Fed to begin tightening policy. there is one piece of unfinished business – the most lagging sector in the most lagging economy – the US labor market. asset valuations have returned to more normal levels. Similarly. the debt dynamics resulting from severe budget deficits. While the market rallies of the past year do not appear excessive relative to underlying fundamentals (except possibly for gold and government bonds). Low for how long? It is particularly difficult to judge the pace and timing of policy adjustment in the current cycle. and the adequacy of raw material supply for another emerging market-led expansion. the course of Fed policy will be back on the table.

followed by comments by a range of Fed officials to the effect that rates will stay low for long. the dollar and gold most sensitive to monetary tightening One surprise over the past three months has been the decline in US Treasury yields – particularly in the short end – despite generally favorable economic data. but particularly in the short end. and rising asset prices. upward revisions to consensus economic forecasts. Higher short-term interest rates accompanied by confirmation of a stronger-than-expected US economic recovery could also boost the dollar. and certainly under almost any scenario US monetary policy will remain easy for a long time. making the outcome even more uncertain. y/y % chg (rhs) It is not too early for investors to focus on what the world will look like when the Fed starts withdrawing support We believe that with asset prices already back to at least "neutral" (consistent with Chairman Bernanke's judgment). The end of Fed purchases of MBS is set to boost net bond supply. Federal Reserve asset purchases are likely to cease as scheduled by the end of Q1 and if. Asian and other emerging market central banks have resisted the consequent upward pressure on their currencies by buying dollars and putting the proceeds into short-end Treasuries. and policy settings as extreme as they are. the US labor market shows clear signs of improvement over the next few months and asset prices continue to appreciate. which would add to the upward pressure on short-term yields that would naturally occur as investors price in Fed tightening. as we believe. we 6 10 December 2009 . But there has been much more to Fed policy than a near-zero Fed funds rate and much of it has been aimed directly at supporting asset prices. We recommend that investors underweight exposure to US (and European) risk free assets across the entire government yield curve. it is not too early for investors to focus on what the world will look like when the Fed starts withdrawing support. the Fed may well have to adjust its approach to policy once again. and interrupt the steady uptrend in commodity prices The approach of a turn in Fed policy could begin to unwind these patterns. Money market rates.Barclays Capital | Global Outlook real economy instability (Figure 1). the Fed could signal before midyear that a withdrawal of policy stimulus is imminent. Figure 1: Volatility in asset prices has led to volatility in the economy 60 40 20 0 -20 -40 -60 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 S&P 500. which would be met by reduced central bank buying of Treasuries. encouraged investors to bid down rates. The jump in the unemployment rate in October. The problem for investors is that the debate over what adjustments are called for and when they should be implemented is in its infancy and is taking place amidst a heated political environment. The prospect of Fed tightening would likely reverse the trends of lower government bond yields and a falling US dollar. This is not to say that a rate increase is around the corner. y/y % chg (lhs) Source: BEA. Although we believe that the dollar could remain soft for a few more months. This has tended to weaken the dollar and strengthen gold and other commodity prices. further lowering their yields. S&P and Haver Analytics 6 4 2 0 -2 -4 -6 US real GDP. the financial system very substantially healed.

however. That said. that has been the historical record after large equity rallies that have anticipated economic recoveries and benefited from low interest rates. As a result. It is true that things really are different this time (see “Advanced emerging markets – A reassessment of an asset class”. emerging market investors should pay particular attention to signs that policy tightening is approaching. Prospects for higher interest rates. Equities and credit less vulnerable We do not expect the onset of Fed tightening to trigger a bear market As noted earlier. but the combination of unusually low risk-free rates and better-than-expected US economic activity and corporate profits suggests that the asset class will continue to deliver positive excess returns in 2010. with the timing of the turn dependent on perceptions of Fed policy. 10 December 2009 7 . That said. We feel similarly about corporate credit. which we expect to do not much better than tread water over much of 2010. the equity market may well start to rise again. once markets price in a modicum of Fed tightening. particularly if the Fed keeps rates at an accommodative level for an extended period in deference to a still-high unemployment rate. and interest rates are coming from such extraordinarily low levels that it will be some time before Fed policy is even remotely restrictive. since Japan is again experiencing deflation and is thus likely to be among the last countries to raise interest rates. A move up in the dollar and the prospect of higher interest rates are likely to interrupt the steady uptrend in commodity prices. We particularly like prospects for the dollar versus the yen. Valuations are no longer compelling. risk premiums associated with emerging market assets have declined significantly and their sensitivity to perceptions of a reduction in market liquidity remains higher than that for developed market assets. equities no longer offer overwhelmingly attractive valuations. While the fundamentals for emerging markets have improved significantly.Barclays Capital | Global Outlook see an upturn in the dollar setting in before long. Indeed. Higher inflation readings in developing economies (especially in Asia) owing to rising food prices (which have a bigger weight in those countries) as well as strong recoveries are likely to trigger policy tightening locally. Global Economics Special Report. Profit margins are quite high. Indeed. and emerging markets have been particularly vulnerable to Fed tightening in the past (especially in Latin America). we do not expect the onset of Fed tightening to trigger a bear market. and any sign of a shift in Fed policy toward tightening is likely to trigger selling pressure. they are still likely to correct more than developed markets in response to prospects for tighter liquidity conditions Investors in emerging markets need to weigh the very favorable secular growth story against the vulnerability to policy tightening both locally and in the US. mean that absolute returns will not be nearly as strong. 12 November) and we recommend that investors hold a larger proportion of their assets on average in emerging markets.

Our market outlook is bullish for the next quarter. A large rise in longer-term interest rates is improbable while economic slack remains sizeable and private sectors continue to repay debt. private sector deleveraging and a resumption of global official FX reserve growth are the three main factors that will conspire to keep medium. The combination of ultra-low short-term interest rates. During the first half of 2010. We expect liquidity conditions to remain bullish for at least the earlier part of next year We expect liquidity conditions to remain bullish for at least the earlier part of next year. A move up in bond yields in the wake of the end of QE programs is likely to be modest. Going into 2011. the length of time that current liquidity conditions persist is open to question. Both economic and market fundamentals are certainly supportive of most asset classes in the short term. Domestic US nonfinancial borrowing has declined from a peak of $2.bond@barcap. with risks of a shift toward tighter monetary policies starting to cloud the outlook in Q2 and Q3. We recommend owning hedges against an unexpected tightening in liquidity. a possible resurgence of inflation and an earlier than usual termination of the business cycle. In the short run. even as government borrowing has increased. However. We also like the idea of owning Treasury-TIPS breakeven spreads. in our view. A similar point applies to monetary policy. Broadly. with disinflationary output gaps of indeterminate scale visible in the larger industrialised nations.and long-term real interest rates at low levels.5trn in H1 09. we have rising concerns about potential policy mistakes. but more circumspect thereafter.1trn pace of government borrowing over the past four quarters. as total savings increase and total borrowing falls. Our favoured current strategy is to barbell the risk spectrum. we expect markets to do well in the first quarter.com The market outlook for 2010 is characterised by higher-than-normal levels of uncertainty. and we expect a $1. viewing yen FX shorts and out-of-the-money puts on gold as the most efficient hedges. with positions in high beta equity markets and sectors. The underlying picture shows the private nonfinancial sector actively paying off debt. a globally synchronised policy tightening poses little imminent threat to either economic growth or buoyant asset prices.8-2. positions in high yield credit and the remainder of the portfolio in cash. We would advise taking risk off the table as the next quarter progresses. The implication is that. even as the various quantitative easing programs draw to a close.5% during the latter part of 2010. The latter factor has provoked a profound alteration in the balance of supply and demand in the capital markets. The federal deficit has already started to narrow. as yet. US nonfinancial businesses and households repaid their debts at a $435bn pace in Q2 09. inflation remains below trend in most economies. Conditions at the start of the year seem appropriate for the continuation of recent trends.Barclays Capital | Global Outlook ASSET ALLOCATION Cross currents Tim Bond +44 (0) 20 7773 2242 tim.6trn at the end of 2007 to $1. down from the $1. it is possible that total nonfinancial borrowing will fall further.5trn total for 2010. 10 December 2009 8 . a broad consensus has emerged that significant fiscal tightening should be delayed until the recovery is more firmly established. with US 10y yields unlikely to move far from current levels in Q1 or above 4. with a decent probability of some asset classes moving into overvalued territory. With governments sensitive to the perceived fragility of the initial stages of the expansion.

In short. Indeed. Both the y/y and quarterly annualised flows are running at a little more than $400bn at the moment.0 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 US seasonally adjusted budget deficit. government borrowing and QE have been of a similar scale in the US and UK. the growing dichotomy between developing world interest rate trajectories and US policy settings should also accelerate global foreign exchange reserve growth. as the rise in corporate profits outpaces spending on capex. Clearly.0 -1. Net financial investment by US domestic businesses and households averaged $611bn in H1 09. while private sector savings flows remain high. while private sector borrowing has yet to increase. it is plausible that households will continue to reduce debt. while private sector borrowing has yet to increase Over the first half of next year. In the short run. $ trill Source: Thomson Datastream 10 December 2009 9 . inflows from foreign official reserve managers seem destined to increase. net non-financial borrowing might be running at an annualised pace as low as $1trn or less in the first half of 2010. This outlook tends to mitigate the upward pressure on yields from the ending of the QE programs.5 -2. The scale of foreign official reserve manager purchases of USD bonds is displayed in Figure 1. business net borrowing is likely to decline further. This is mostly due to the recoveries in global trade and commodity prices swelling foreign exchange reserve growth in the large developing and oil-producing economies. During the same period.5 0. Figure 1: 3-month seasonally adjusted moving sum. Meanwhile. Thus. and so long as the practice of fixed or pegged exchange rates continues. this process is likely to continue to help finance US deficits. an existential funding crisis is very improbable. albeit at a more modest pace than was visible this year. These flows tend to be recycled into western bond markets.0 0. Equally clearly. the US financial cycle has probably entered the sweet spot during which government borrowing has started to decline. as countries such as China are forced to intervene more aggressively against hot money flows. M&A and dividends. resulting in a relative upward move in government bond yields. QE has provided a significant portion of total financing this year. US budget deficit 1.5 -1. 3 month annualised. However. the end of QE will change the supply/demand balance in the capital markets.0 -0. during which government borrowing has started to decline.Barclays Capital | Global Outlook The US financial cycle has entered the sweet spot.

Nov 2007 . we can have a high degree of confidence that this flow out along the yield curve will persist.Nov 2003 . This increase in the demand for longer-duration bonds should counterbalance the US government’s objective of lengthening the average maturity of the national debt.Mar 2007 .Jan 1977 .Nov 7 6 5 4 3 2 1 0 1999 . As Figure 2 should illustrate.3trn remaining in US money market funds.May 2001 . With more than $3.Sep 1989 .Barclays Capital | Global Outlook Low short-term interest rates encourage savers to move out of cash and invest further along the yield curve The impact on bond yields of the asset reallocations encouraged by the low rate policy also needs to be considered. US money market mutual funds 50 40 30 20 10 0 -10 -20 1997 . $ bn 700 600 500 400 300 200 100 0 -100 -200 1972 .Nov 2009 . Low short-term interest rates encourage savers to move out of cash and invest further along the yield curve.Nov 2001 . ICI Fed Funds rate 10 December 2009 10 .Jan yy change in custody holdings foreign official inst 3 month annualised change in custody holdings foreign official inst Source: Haver Analytics Figure 3: y/y % change in assets under management. Figure 2: US custody holdings of Treasuries and agencies for foreign official institutions.Nov 2005 .Nov 1983 . This process is visible in the flow out of US money market funds. 3-month annualised change. so long as the fed funds rate stays near zero.Nov % change yy money market mutual fund assets Source: Haver Analytics. net flows to money market mutual funds display great sensitivity to the level of short-term interest rates. currently running at a quarterly annualised pace of $1trn.Jul 1995 .

In light of the impending near-term rise in corporate profits.Barclays Capital | Global Outlook We expect the decrease in loan books to accelerate. a permanent elevation in the funding of government deficits by the banking system will become visible. Although the banking system may have initially welcomed the decrease in their assets.0 1.and long-term real yields. Fed expectations. Figure 4: Actual and modelled real yields. it is improbable that banks will be happy with a persistent shrinkage equivalent to an annual 25% reduction in their business loan books or 11% reduction in total bank credit. Over the course of 1993. in spite of apparently onerous government borrowing requirements. business borrowing y/y 5. To summarise.5 4. the quarterly annualised shrinkage has been running at a $1trn pace. nearby Fed expectations and the growth rate of business borrowing are very effective explanatory variables for modelling medium. having shrunk over $500bn from their 2008 peak. we also note the effect of the new liquidity regulations for banks. These require banks to massively increase – by tenfold or more – the size of their liquidity portfolios. a depression in real interest rates tends to displace capital out along the risk curve. resulting in the elevation of most asset prices. The effect can be powerful. history suggests that the combination of low short-term interest rates and private sector deleveraging tends to keep longer-term real interest rates low. the theoretical bank buying appetite would be between $700bn and $1trn. The equation is illustrated in Figure 3.0 3. As these rules are phased in over the next couple of years. Mexico ended that year in crisis.5 0. In this context. When the liquidity conditions changed in 1994.0 4. Since bank loans are currently the most expensive form of debt. from fed funds rate. as long-term real yields fell 2%. As was the case during comparable episodes in the past (1992-93). If we exclude the data from November. clear bubbles developed in many emerging markets.0 2.5 1. at least in the early part of next year We would reiterate a similar point regarding the composition of bank balance sheets. an interlude marked by a low fed funds rate and US business sector deleveraging. we can show that the fed funds rate. The net effect should be to strengthen the trend for banks to replace maturing loans with high grade securities. longterm real yields soared 3%. most emerging markets collapsed and global equity P/E ratios fell 6 points. Were US bank holdings of bonds to return to the share of assets seen in the last major deleveraging cycle (1992-93).5 2. which are comprised of short-dated government paper. In 1992-93. which were distorted by the banking sector’s assuming the assets of a failed nonbank intermediary. To formalise this point. loan books are bearing the brunt of deleveraging. with businesses becoming net borrowers once again and the Fed hiking rates.5 3.0 Mar-97 The combination of low short-term interest rates and private sector deleveraging tends to keep longer-term real interest rates low Sep-98 Mar-00 Sep-01 Mar-03 Sep-04 Mar-06 model Sep-07 Mar-09 Sep-10 TIPS 10y real yield Source: Barclays Capital 10 December 2009 11 . global equity 12m forward P/E ratios (exUS) expanded from 16 to 21. at least in the early part of next year. it is likely that this decrease in loan books will accelerate.0 0.

there is an unusually high level of uncertainty surrounding the prevailing degree of economic slack and the speed at which this will be absorbed. later. the trend is more global. we would stress that at the current juncture. with both households and firms paying off debt. To date. This uncertainty is compounded by possible shifts in central bank reaction functions. selling off sizeable amounts of gilts or MBS should be considered a last resort and a development that would only take place after a bubble was clearly visible. due to the immense fluctuations in GDP over the past few years. sheer undervaluation at the beginning of the year and. In mitigation. However. private sector deleveraging and developing world exchange rate targeting. The policy outlook is fraught with uncertainty First. However. commercial property is cheap to other asset classes and commodity prices broadly reflect the balance of supply relative to industrial demand. following two successive episodes in which monetary policy has almost certainly played a role in inflating asset bubbles. recoveries often tend to be symmetrical to recessions. global equities are slightly cheap to fair value on our modelling. There is a considerable repertoire of economic and policy uncertainties that render the outlook a good deal more opaque and harder to read than usual. It is worth examining these potential risks. short-term real interest rates are considerably lower than they were in 1993. In this respect. Additionally. with the exception of government bonds and gold. prevent the formation of bubbles. today’s de-leveraging is much more extensive. we should expect these symptoms to proliferate across more asset classes. In the absence of any change to the underlying causal triumvirate of very low policy rates. We would now caution that this view does not translate to an explicit recommendation to ratchet portfolio risk up to extreme levels. Central banks are likely to be much more sensitive to potential asset bubbles than used to be the case The counterbalancing factor is that central banks are likely to be much more sensitive to potential asset bubbles than used to be the case. Although investors may know that the phase of abundant liquidity is temporary. it is extremely hard to gauge how long disinflationary output gaps will persist. first. with the funds rate 12 10 December 2009 . the rally in most asset classes has been driven by. they cannot foresee the termination point with any certainty. The broad consensus is for a relatively slow recovery. Under such circumstances. the private survey data and the official numbers for UK GDP point to very different levels of activity. If our knowledge of the current level of GDP is more limited than usual. For the sake of practical example. by improving economic fundamentals. It is also true that the Fed and the BoE have tools – in the shape of their vast securities portfolios – that enable them to dampen any liquidity bubble that threatens to get out of hand. However. The combination of a need for current return and the business or career risk of persistent underperformance of peers then tends to enforce participation in bubbles. Indeed. with comparable developments visible across much of the OECD. Whether the likely duration of bullish liquidity conditions is measured in months. although it is strongest in the UK and US. our Fed forecast assumes a two-step normalisation of policy. Strong liquidity flows in either direction tend to desensitise markets to fundamental factors.Barclays Capital | Global Outlook Strong liquidity flows in either direction tend to desensitise markets to fundamental factors In comparison with the 1992-93 interlude. of itself. Furthermore. and we would stress the upside risks to our own growth forecasts. few asset classes display obvious symptoms of a bubble. The existence of these tools will not. quarters – or even years – is very much an open question. The hypothetical asset bubbles are likely to prove much more unstable and fragile than is typically the case. credit spreads are at fair value. the acute depression of longterm real yields on government bonds and the meteoric ascent of gold prices are both symptomatic of a potent tide of liquidity that has begun to flood asset markets. so is our ability to predict the imminent rate of growth. which are somewhat stronger than the consensus. it is therefore very plausible to argue that conditions are compatible with the formation of asset bubbles. disrupting their ability to effectively incorporate future risks into prevailing pricing. In the short run.

The broad point is that the policy outlook – and hence the financial market liquidity outlook – is fraught with uncertainty. a related point can be made specifically regarding the US labour market and the timing of Fed tightening. The former scenario is typical of the aftermath of financial crises.0 1. This possibility raises the risk of a much sharper-than-expected snap-back in employment at some stage. but then left at that level for some time. volatility of nominal GDP growth 7 6 5 4 3 2 1 3. output gap error. Uncertainty surrounding the pace of the US labour market recovery translates into acute uncertainty about the timing of Fed tightening Second. qoq saar absolute value.Barclays Capital | Global Outlook being raised to 1% in the second half of next year. US output gap error. as the Fed pauses to monitor the effects of a presumed fiscal tightening in 2011.5 2. a development that would imply a much greater symmetry between the speed and depth of the recession and the pace of recovery. Uncertainty surrounding the pace of the US labour market recovery translates into acute uncertainty about the timing of Fed tightening. Third. rolling 5 year average Source: Philadelphia Federal Reserve.5 1. However.0 Dec-69 Dec-73 Dec-77 Dec-81 Dec-85 Dec-89 Dec-93 Dec-97 Dec-01 Dec-05 Dec-09 rolling 5 year standard deviation of nominal GDP growth. followed by a slow recovery extending over several years. History suggests that during a period of high GDP volatility. errors in calculating the dimensions of output gaps are abnormally large. We have defined output gap errors as the difference between a gap calculated using the real-time data that were available to policymakers at the time and one calculated using today’s more complete dataset. The chart shows how the absolute value of errors in calculating the US output gaps tends to fluctuate in line with the volatility of nominal GDP growth.0 0.0 2. We are 10 December 2009 13 . in much the same way that inventory cuts globally have proven excessive. as well as a more vigorous snap-back in hiring. Errors in calculating the dimensions of output gaps are abnormally large during periods of high GDP volatility Figure 5: Absolute value. as central banks try to correct the preceding error. There are good arguments in favour of a relatively slow labour market recovery. US firms may have been excessive in cutting employment.5 0 0. where the usual labour market trajectory shows an abrupt rise in unemployment during the crisis. It is also the case that the weakness in capital spending during the last expansion – and during the recession – tells us that the present elevated level of labour productivity is wholly unsustainable. Barclays Capital The misalignment of policy that can emerge from such mistakes then tends to reinforce the original increase in economic volatility. Figure 4 illustrates this point. the uncertainties concerning the actual dimensions of output gaps also raise the medium-term risk of policy errors. The net result – as in the 1970s – can be a period of wide swings in nominal GDP. Under this line of argument. there is also a strong case to be made that the labour market structure in most economies that have experienced banking crises is very different from the near-frictionless labour market environment in the US.

This combination is typically very bullish for local asset markets. the IMF has explicitly advised leaning policy in an inflationary direction. Central bankers unquestionably know that their assessments of economic slack are much more prone to error than usual and that the probability of policy mistakes is commensurately high. this suggests either that policy tightening might be aggressive at some point or that inflation will erode the real return from assets. For the highly leveraged industrialised economies. The other associated risk is that when policy changes. There is no sign of easing in the difficulties of accommodating the food. For the developed economies. in our view. Fourth. While the recession reduced commodity demand and temporarily depressed commodity prices. In the context of the current 14 10 December 2009 . there is no sign of any easing in the underlying long-run difficulties of accommodating the food. This logic lies behind the profile of our US official interest rate forecasts. The balance of risks is therefore heavily biased toward the current interlude of tame headline rates of inflation proving much shorter than has typically been the case over the past quarter century. we should continue to heed the structural shift in the trade-off between global growth and natural resource-based inflation. As global economic activity returns to its 2008 level. With fiscal positions clearly constrained and limited further monetary manoeuvre. The basic point is that the rate of global growth at which commodity prices inflate is now below that at which unemployment rates are steady. is that fiscal tightening will replace some of the monetary tightening that would ordinarily be expected to occur in 2011. In both cases. This shift in the global economic “speed limit” is likely to induce severe policy dissonance between the containment of inflation expectations and the achievement of full employment in the older industrialised economies. As a result. but they certainly will become so as 2010 progresses. which have a strong influence on inflation readings in the developing world. In turn. In such a case. with the Fed anticipated to pause its tightening program at 1% in the first half of 2011. energy and raw material ambitions of the developing world. energy and raw material ambitions of the developing world Fiscal tightening should replace some of the monetary tightening that would ordinarily be expected to occur in 2011 The fifth area of acute uncertainty is how the older industrialised economies deal with the government deficits and high government debt/GDP ratios that are the main inheritance of the credit bubble. Indeed. could start to test policy settings in these economies next year. Our commodity market outlook suggests that agricultural prices. the risk of becoming stuck in a debt-deflation appears to be more severe than an inflationary surge. If anything. albeit negative for the local currency. our outlook for energy and industrial commodity prices suggests that such tests may occur late in 2010 and through 2011. progress on the supply side has been disrupted by the credit crunch. although this time horizon may become compressed if growth surprises to the upside. The most likely outcome. rates of natural resourcebased inflation are likely to follow. while the rise in the volatility of GDP growth is likely to be sustained. These considerations may not be germane at present. the tail probabilities of either deflation or inflation are unusually high. Such a development could be characterised as a loose money/tight fiscal mix. a similar contradiction between foreign exchange targets and domestic monetary policy settings is inevitable. For the developing world. it may have to change fast and hard.Barclays Capital | Global Outlook therefore confronted by a medium-term outlook in which the risk of policy error – in either direction – is very high. This suggests that there is a higher-than-usual probability of a “deliberate” inflationary policy error. policymakers may be tempted to build an inflationary error bias into their calculations. There is a higher-than-usual probability of a “deliberate” inflationary policy error We would caution further on this point. the result of such conflicts tends toward heightened macroeconomic volatility and a general increase in uncertainty concerning the timing of the next recession. financial assets will eventually need an extra ex-ante risk premium to compensate for these threats. the relative risks of a deflationary compared with an inflationary mistake are quite clear. In turn.

In our view. A passive harvesting of beta is unlikely to be productive over the next 12 months The sixth area of risk lies in the probable collapse of high levels of cross asset class correlations that have been apparent over the past two years. We believe global liquidity flows will disproportionately benefit these modestly capitalised markets. the vast majority of funds will be underweight EM equity on a GDP-weighted basis. With credit demand weak. We are biased to staying long in equities For the immediate future – a period that should encapsulate most of the first quarter of 2010 – we are biased to staying long in equities. is unlikely to be productive over the next 12 months. Given the large rise in industrialised economy debt/GDP ratios. While EM equity markets have certainly outperformed this year and risk premia shrunk. is desirable. And since EM equity volatility-adjusted ex-post returns are now superior to OECD volatility-adjusted returns. all asset classes tending to rise and fall in an indiscriminate and homogeneous mass. We would suggest that clean energy sectors may outperform. Our top sector is industrials. the main remaining argument against a sizeable re-weighting into EM equities concerns governance. offering market level forecasts for the year ahead is a rather more pointless activity than usual. as bullish liquidity flows dominate. once the phase of easy liquidity draws to a close. we should expect cross asset class correlations to decrease. Anyone who pretends to have a strong view about where stock markets will close on December 31. basic materials and energy. We also expect a more subdued industrial commodity complex next year. a strategy that has worked effectively for virtually all asset classes this year. such a US policy mix would tend to sustain the bullish liquidity conditions well into 2011. The range of possible outcomes is particularly broad. With the developing world responsible for the majority of global GDP growth and representing just over half of the global economy by level. The Dubai 10 December 2009 15 . as banks will need to deal with a substantial increase in funding costs due to changing liquidity regulations and the ending of government guaranteed bond issuance. banks cannot be described as enjoying pricing power for early 2010. as it must. as investors focus on the implications of the ambitions outlined at the Copenhagen meeting. is deluding both themselves and others. The vast ebb and flow of risk-seeking liquidity has tended to mask any fundamental differentials between classes and region. but an equally strong case can be made for a trend toward de-rating and higher yields. Our suggested mix of sectors remains the same as in the last Global Outlook.Barclays Capital | Global Outlook discussion. we believe a mix of the higher beta developing markets. hence. both by continuing to herd investors out along the yield curve and by the impact on the dollar and. since it is relatively expensively priced. in terms of both timing and asset selection. there is a powerful argument for a convergence – and perhaps even reversal – in the relative levels of economic risks. namely industrials. However. their valuations are by no means in bubble territory. to summarise. In terms of geographical exposure. so there may be a temporary problem in passing these costs on. A strong case can be made for a liquidity-fuelled bubble. on developing economy foreign exchange reserve growth. such as Russia and Brazil. even if it might continue to prove fruitful over the next quarter. Asset price trends over the past couple of years have been dominated by very large variations in investor risk appetites. Thus. we wish to emphasise the unusually high degree of uncertainty regarding market performance next year. The successful investment strategies for 2010 are therefore likely to be marked by tactical dexterity. We advise slowly de-emphasising the US materials sector fairly early in the quarter. A passive harvesting of beta. It is quite possible that markets may oscillate violently between these two poles. We are not enamoured of financials. together with the longer-term context of much better macroeconomic discipline in many emerging economies. given the sizeable medium-term economic risks. technology. 2010. This phase of very high cross asset correlation is likely to persist in the short run. along with the core markets of Europe and US.

yen and dollar. followed by some sideways corrective behaviour in Q2 and Q3 as investors grapple with potential policy shifts. given their strong historic correlations with commodity prices and global growth. Our reasoning here is that after a few months of positive US jobs growth. Bearing in mind that Japan is very far from being a safe haven from the various forces of turbulence presently buffeting the global economy. Investment grade credit is expected to deliver reasonably strong excess returns. but a less impressive total return. Our suggested FX strategy is now somewhat different in emphasis compared with the past few months. During this pause. As far as bond markets are concerned. Although we expect G7 inflation to remain reasonably contained in 2010. As our US equity team highlights. our general expected path for equities next year is a sharp rally in Q1. the scheduled ending of the QE program in March may start to convince some investors that an extensive monetary tightening was underway. We have certainly detected a very clear trend of Western pension funds increasing exposure to EM equity and would expect these flows to continue. we expect further credit spread tightening set against a background of modestly rising yields. The combination of a tight fiscal/very easy money stance could reignite a fierce rally in equities. Away from the yen. we would tend to reduce equity risk somewhat as the quarter progresses. This context suggests that fixed income investors should be moving down the credit curve and shorter on the yield curve. Egregious recent examples have been clearly visible among some of the largest mature economies. We would certainly expect high yield to provide respectable competitive total returns over the year. the combination of a powerful secular theme and robust external and internal liquidity conditions suggests that such bubbles will be most likely to inflate in developing economies. there are significant risks over the longer run outlook for 16 The yen is overvalued on virtually every criterion and against virtually every currency We expect further credit spread tightening set against a background of modestly rising yields 10 December 2009 . But we are not inclined to overstay our welcome in long equity positions We are not inclined to overstay our welcome in long equity positions. we suggest diversifying the short side of the trade out of the dollar and into the yen. but we would note that arbitrary confiscations and deliberate obfuscation of private-sovereign status are problems not necessarily confined to the developing world. Therefore. including the dollar. the risk builds of a sudden acceleration in the pace of employment and the “snap-back” scenario may come into play. We forecast a move above 100 against the dollar over the next year. the analogy might be the way the stock market traded sideways for much of 2004. The yen is overvalued on virtually every criterion and against virtually every currency. given the probable drift up in longer-term yields. there would be a further risk of bubbles inflating. shifting out of the aforementioned sectors into more defensive areas or cash. we do expect a resumption of renminbi appreciation in the second half of the year (about 5% by year end). while we disagree with this prognosis. This rise in yields is expected to be skewed toward the latter half 2010. our belief is that the tightening will be in two stages. with deleveraging and low policy rates keeping yields low at the start of the year. From a tactical perspective. as is Fed policy. If bubbles do emerge over the next year or so. and we would expect the healthier EM currencies to continue to appreciate against the euro. we find it difficult to believe that the yen is correctly priced at present. Our own expectation is for the Fed to start to hike in September and we would certainly expect this prospect to precipitate something of a de-rating in equities over the summer. the perceived relative riskiness of the dollar may decline.Barclays Capital | Global Outlook debacle highlights the risks in this respect. Clearly. More strategically. these views are datadependent. We also think Australian and Canadian dollars will rise. with the Fed engaging in a prolonged pause in 2011 as it waits to observe the repercussions of probable fiscal tightening. With the US economy now starting to demonstrate clear symptoms of returning to self-sustaining growth. Additionally. While we still believe that most EM and commodity-linked currencies will appreciate.

Gold is obviously a commodity very much in the news. We suggest running this mix in combination with a foreign exchange overlay consisting of longs in the CAD. strongly weighted toward the yen. Overall. BRL and assorted other EM currencies against shorts in the G3 currencies. however. cash and high yield credit 10 December 2009 17 . why such a hedge needs to be a commodity devoid of any practical utility escapes our understanding. possibly achieving new absolute highs in the US. However. In general. price curves are not likely to be favourably sloped for the passive investor. While we can appreciate the arguments advanced in the metal’s favour. ample) supplies are generally envisaged to temporarily mitigate the upward pressures stemming from the cyclical recovery in global demand. although the rally is likely to be modest relative to the extreme volatility seen in recent years. Our own bias is therefore to leave others to enjoy the ride in gold. in our view. we do tend toward the view that investment in the means of production. Short yen positions and out-of-the-money gold puts fall into this latter category. there are solid reasons for owning real assets as a hedge against any potential debauchery of financial assets. With an earlier-than-expected turn in liquidity conditions being the main portfolio risk. as opposed to the product. adequate (and in the case of natural gas. while reiterating that we believe deeply out-of-the-money puts are an effective way of hedging against a sharp tightening in global monetary liquidity. which remain the asset class most likely to deliver negative total returns. and we do envisage growing upward risks for inflation among developing economies. cash and high yield credit. our favoured asset allocation is a mix of high beta equity. Short-term supply fundamentals look to be most bullish for agricultural commodities. The policy is essentially a barbell of assets at either end of the risk spectrum. as asset allocators we have extreme difficulty in recognising any inherent fundamental worth. Over the longer run. We favour a mix of high beta equity.Barclays Capital | Global Outlook price stability. AUD. As far as commodity investment is concerned. To be sure. A modest rally in commodity prices Commodity prices should move higher next year. is the correct way to approach these themes. we would expect breakeven inflation rates to move higher over the course of 2010. We do not advise exposure to government bonds. In recognition of these risks. the structurally bullish themes for commodity prices remain very much intact. offering more efficient and cheaper hedging potential than interest rate positions. For metals and energy. the general strategy is to counterbalance assets with a high beta to the business cycle with other positions that might be expected to benefit from any early US tightening.

Korea and India.4 9.7 1.0 1.3 3. -1. Inflation risks remain muted globally. The reasons that underlie this positive outlook are related to the currently depressed levels of activity in G4 countries (Figure 1).7 1.8 1.2 2.9 1.4 2.4 9.0 4.1 3.a.2 10.0 1.0 4.3 4. Thus we expect above-consensus growth in G3 during 2010 (Figure 2). We see relatively little risk of a serious disappointment to global growth.6 10.1 1.0 5. while the laggards of this global recovery – the US and Europe – are likely to remain robust. But we do not think exit strategies will spook business activity in 2010.4 4.9 0. In short.2 3. our view is that the power of a business cycle that Figure 2: Our outlook relative to consensus US q/q saar Eurozone y/y Japan q/q saar UK y/y Brazil y/y Russia y/y China y/y As of: Consensus BarCap Consensus BarCap Consensus BarCap Consensus BarCap Consensus BarCap Consensus BarCap Consensus BarCap 4Q09 1Q10 2Q10 3Q10 2010 2011 3.6 9.1 4.0 3.com Piero Ghezzi +44 (0)20 3134 2190 piero.6 0. 11.0 Figure 1: Global recovery in manufacturing output IP index: Jan 08 = 100 140 China 130 120 110 100 90 80 70 60 Jan-08 India Korea Brazil US Europe Japan May-08 Sep-08 Jan-09 May-09 Sep-09 Source: Bloomberg. Blue Chip.6 1.2 5.5 3. as the forces behind the cyclical rebound in activity in developed economies (ex-Japan) should be strongest in coming quarters.5 4. Barclays Capital 10 December 2009 18 .Barclays Capital | Global Outlook ECONOMIC OUTLOOK Hard to derail Christian Broda +1 212 526 8536 christian.6 n.6 2.2 3.5 2.0 4. EM countries have avoided the magnifying factors of previous recessions (Advanced emerging markets. Source: Haver.4 6.8 2. We expect the end of QE in major economies to gradually take long-term rates higher globally.8 -2.6 2. as we believe that relative to the “normal” rates of growth that markets are now expecting for 2010 (eg. Nick Verdi +44 (0)20 7773 2173 nick. as tighter policies should mostly be the result of strong economic activity.0 0.2 3. as excess capacity remains pervasive.7 8. 2% for G4 economies).0 2. Barclays Capital Note: Europe is a GDP-weighted average of the euro area and the UK.2 1. the somewhat excessive response of businesses during the downturn.0 4. and the continuation of depressioncombating policies through most of 2010.6 1.0 -3.2 1. we expect inflation to rebound early in the year and this to be a trigger for monetary tightening earlier than in the US and Europe.verdi@barcap.7 4.5 1.8 5. forecasting a strong recovery in Asia early in the year (Can Asia bounce? January 2009) and the end of the global recession in the spring (A turn is in sight.1 -1. May 2009).6 3.5 1.9 1.4 -2. risks are tilted towards a stronger recovery. with growth front-loaded in the US and back-loaded in.9 0.3 1.8 1.5 3.2 n.5 0.8 3.1 1.5 5. 12 November 2009) and are already positioned for growth to moderate in coming quarters to around trend levels.3 2.3 1. We continue with this positive outlook coming into 2010.8 1.a.0 0.7 9.9 5.0 9.4 12.ghezzi@barcap.6 9.6 5.broda@barcap.0 3.2 1. We expect this tightening to include a 5% appreciation of the CNY/USD in H2 10.7 5.5 3.0 1.com Our forecasts for 2010 are more positive than those of the consensus Throughout 2009 our global growth calls were systematically above consensus.9 2. In China.com We expect strong global growth in the next two quarters: Asia is likely to slow significantly from its recent rapid pace.

Beyond short-term rates. Source: Barclays Capital Note: Capex defined as private non-residential investment. Source: Haver. Around 40 percent of the discretionary spending put in place around the world is set to hit the market during 2010. Marker represents 4Q10 US forecast. Barclays Capital 10 December 2009 19 . A second global factor behind our stronger-than-consensus outlook is the role played by the support of governments in 2010. the degree of fiscal stimulus that remains in the pipelines is large. That leaves enough room for businesses to stabilize and provide support for growth in coming quarters. Two key factors to track in coming months: 1) how businesses react to stabilizing final sales … Two key global factors will play an important role in tracking our views of the real side of the global economy in coming months. The sharp and fast correction in business production in 2009. As such. well in excess of the fall in global consumption. Moreover. Korea and Japan. the global support in 2009 has also been extraordinary. (lhs) Global new orders less inventories (rhs) Note: New orders-inventories series is normalized. First. The unprecedented policy support in 2009 has helped stabilize consumption and investment. While we expect global tightening to start in 2010. The stability in final sales in Q3 suggests. highlighting what we believe has been downplayed by market participants – the fact that the sharp declines in economic activity do make growth easier. but also because the normal credit channels through which the benefits of monetary policy are transmitted were muted in 2009 and are likely to restart in 2010. This in turn suggests that even slow consumption growth in 2010 is sufficient to generate a stronger rebound in growth as businesses regain enough confidence to keep from reducing inventories at the current pace. has led to the largest inventory cycle in recent recessions.Barclays Capital | Global Outlook is supported by depression-combating policies and is starting from low activity levels will be hard to derail in coming quarters. This is partly the reason for our above-consensus call. the end of QE combined with the return of risk Figure 4: Capex and auto spending as % of GDP 19 18 17 16 15 14 13 12 11 65 70 75 80 85 90 95 00 05 10 Q4 10 forecast US UK … 2) the evolution of the fiscal and monetary exit strategies Monetary policy is likely to continue to support activity in 2010 Figure 3: Global new orders and manufacturing production 20 10 0 -10 -20 -30 -40 98 00 02 04 06 08 10 2 1 0 -1 -2 -3 -4 -5 -6 Global manufacturing output. we expect the drag on the economy from monetary policy paybacks to be delayed to 2011. This share for the US and China is 60% and 50%. that this process of business confidence may start earlier than the markets are expecting. respectively. constructed using subcomponents of country PMIs. in our view. how businesses respond to the stability of final sales plays a key role in the strength of the short-term recovery. as we disagree with many commentators who suggest fiscal policy is going to be a drag on the global economy during 2010. % 3m/3m ann. monetary policy is likely to continue boosting the global economy throughout 2010. not only because of the natural lags with which monetary policy affects the economy. such as Germany. But the recovery has been strongest in countries with the sharpest decline and relatively weak policy response. Figure 3 shows how global orders are running far ahead of inventories – a measure that highlights the pressure to start rebuilding inventories. In terms of monetary policy.

a key obstacle to improving confidence in the US recovery – the lackluster employment picture – has shown clear signs of improvement in November. its peak. and the collapse of demand for cyclical goods like cars. September 2009. light vehicle sales surprised on the upside at 10. As we highlighted in ‘Sweet spot for growth’ in Global Outlook. We expect the improving trend in US employment to continue Figure 5: Consumer confidence is returning 110 100 90 80 70 60 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Global auto sales US retail sales (ex. Thus. the highest reading in a year outside of the cash-for-clunkers boost in July and August.Barclays Capital | Global Outlook appetite by investors is likely to lead to long-term yields. Figure 6 shows the expected path for US payrolls in coming months (as a share of GDP). the stability of final sales and housing markets provides the underpinnings to see investment spending account for the bulk of the demand turnaround in 2010. This underscores how little is needed for a recovery driven by these cyclical factors and how far away we may be from the new ‘normal’. This implies that rising rates are likely to mostly reflect the consolidation of the recovery among developed economies and should not choke off the nascent growth. autos). With the activity data adding more pressure for businesses to expand. and might have already reached. even our above-consensus growth outlook implies a return to spending levels in these goods below the troughs of previous recessions (Figure 4). the recovery looks harder to derail. In the US. Source: Haver. Barclays Capital 10 December 2009 20 .9mn saar (Figure 5). RHS Note: Series are rebased so that Jan 08=100. this suggests that the trend of improving employment is likely to continue: in Q3 09 US productivity continued strong. Overall. and data on home sales continue to run firm. Source: Haver. electronics and housing seems disproportionate to that of other sectors. Incoming PMI data in the US are also consistent with further improvement in growth in Q4 09. The figure underscores the idea that all recent recessions have a similar pattern of employment to GDP and that so-called jobless recoveries were really the result of weak GDP recoveries. Idiosyncratic factors regain importance In 2010. Moreover. Retail sales are values. RHS Euro area retail sales (ex. Q3’s data are consistent with our view that businesses may have overreacted and that job gains will start in early 2010. But as normality gradually returns we expect regions’ idiosyncratic factors to regain importance. the retrenchment of the business sector turned out to be excessive. therefore. which suggests that the unemployment rate is close to. The rate of employment destruction has slowed rapidly and the trend in hours worked is improving. As the positive momentum turns from confidence to real measures. even if this is much weaker than the levels seen prior to 2008. Barclays Capital Figure 6: US employment as % of real GDP 105 Index 100 = start of recession 105 1981 1990 2001 100 100 Current 95 95 90 90 -4 -2 0 2 4 6 8 10 12 Quarters since start of recession 14 16 Note: Dotted line represents forecast. as opposed to other developed economies. a dip back into recession anytime soon seems unlikely. we expect that regional factors will regain importance versus global forces The global crisis of Q4 08 implied that global forces overwhelmed regional factors in economic forecasts. autos).

with GDP rising to around 1.0% in Q1 10 and 0. Furthermore. after experiencing record post-war contraction in GDP of around 4% in 2009. Altogether. ONS. we look for a progressive and gradual recovery during 2010-11. a sharp deterioration in productivity in Europe suggests that the cyclical reaction of business was not as strong as that in the US. mostly as a result of the developments in commodity prices in recent quarters (Figure 7). justifies the expectation that the recovery of western Europe will be weaker than that of the US. growing close to 2. In light of the record degree of economic slack in both the US and Europe. In the UK. in our view.5% growth in 2010. While Europe shares some of the common positive forces with the US – eg. before experiencing gradual improvement in 2011 (1. However. Further fiscal and monetary action is needed to address sluggish We expect core inflation to continue to decline through 2010 in the US and Europe Figure 7: Persistent deflation expected only in Japan y/y % chg 6 5 4 3 2 1 0 -1 -2 -3 06 07 US 08 UK 09 10 11 Japan Euro area Forecasts Figure 8: Inflation expectations will be closely watched Real yields 5% 4% 3% 2% 1% 0% 97 99 01 03 05 07 09 TIPS Euro UK 5% 4% 3% 2% 1% 0% 97 99 01 03 05 07 09 Breakevens TIPS Euro UK Note: Japan CPI excludes perishables. we look for growth to hit a soft patch in H1 10. Barclays Capital Note: Shows a 10-day moving average of swap rates. prevent the recovery from being above ‘trend’ growth as in the US case (by trend we mean the average growth in 2002-07). a strong value of the euro contrasts with the weak dollar and puts particular pressure on the industrial sector in southern Europe. First. Barclays Capital 10 December 2009 21 . We see real annualized GDP growth of 3. additional fiscal stimulus in the pipeline in Germany and improvements in financial markets – several other negative factors. the depressed starting level of activity. initial estimates of strong growth in Q3 were subsequently revised sharply lower. the role that inflation expectations may play in 2010 in central banks’ stances is likely to be larger than normal. core inflation is expected to continue to decline through most of 2010. the construction sector is still retrenching in certain overextended economies (notably Ireland and Spain). particularly in countries that have especially overvalued real exchange rates (such as Greece. in our view.4% in Q2 10. Germany is likely to lead the way of the major economies. this. Source: Haver. Haver Analytics. Third. Eurostat. to +4. we expect RPI inflation to rise from -0. whereas we believe Spain is likely to contract somewhat further in 2010 (by 0. which are either in or moving towards deflation). Except in the UK. Thus.5%).Barclays Capital | Global Outlook Several negative factors are likely to prevent an above-trend European recovery In western Europe.8% y/y in October. headline inflation measures are expected to rise back to the target ranges in most developed economies.5% in 2010 (and 2011). Ireland.0% in Q3 10 and 2. In Japan.6% in Q4 09. Ireland. Within Europe. and extending to around 2% growth in 2011.5% in Q4 10. UK) is likely to dampen the relative recovery of Europe. And finally. easing to 1. inflation expectations remain tightly controlled (Figure 8). a significant fiscal tightening already emerging in the most highly stressed countries (Greece.5%). MIAC.4% by April next year. Source: BLS. Portugal and Spain. before strengthening again to 2. Second. when a “policy gap” leaves public investment and consumption exposed to downward pressure and the economy too dependent on overseas demand.

we expect a tightening of monetary policy next year. there is no reason to expect any change in fiscal policy. Deflation has been more severe in Japan than elsewhere. We expect CPI inflation in China to rise to about 4% by end-2010. We expect 5% currency appreciation in 2010. with dramatically less slack in their economies and higher weights for commodity prices than in the US and Europe. but cutting CO2 emissions is likely to support investment in green energy. Korea and India. This in part guides our timing for policy tightening in coming quarters (Figure 9). up from 8. the UK and the US will experience modestly positive inflation throughout the next two years (Figure 7). We forecast more broad-based economic growth in China In China. On the opposite side of the spectrum. If the government does introduce a large fiscal package. hence. Our view is that the BoJ remains reluctant to boost demand by aggressively using its balance sheet and is counting on the Japanese government to boost demand through fiscal policy. Growth is likely to be more broad-based next year. yet somewhat less influential. The main risk to the outlook comes from inflation. we believe monetary tightening is likely to be back-loaded in 2010.6% in 2009. and we forecast that Japan will remain in deflation through the end of 2011. we project 9. We expect q/q growth to decelerate from 16. but the y/y rate to rise to a peak of 12% in Q1 10. but at a much reduced pace compared with 2009. Quantitative and prudential measures will probably continue to be used to guide credit. while investment becomes the major. We expect consumption to be supported by improvements in employment and policy efforts. and we believe this trend will continue. however. and we keep our back-loaded economic performance expectations in 2010. (+25) // 2Q12 Japan (+20) Canada (+25) China (+27) HK (+25) Chile (+25) Euro area (EONIA. we expect inflation to be a bigger concern during 2010. although the exact timing of a break from the tight USD/CNY range is uncertain. and the benchmark interest rates will be raised only in H2. At this point. in our view. Nevertheless. Barclays Capital 10 December 2009 22 .Barclays Capital | Global Outlook domestic demand and deflation (the output gap is still deep in negative territory at -6. as the risk of inflation outlook differs greatly across countries.6% GDP growth in 2010. Tightening schedules: The balance of risk is driven by traditional biases The disparities between Asia. Household consumption has been growing faster in rural areas than in urban areas in 2009.4% in Q2 09 to about 8% in 2010. with an increased contribution from consumption and net exports. We expect M2 to grow faster than nominal GDP. mainly owing to rises in commodity and service prices. source of growth.7% in Q3 09). in China. +25) Source: OECD Annual Outlook 2009. Authorities have stepped up efforts to curb new investment in some heavy industries owing to over-capacity concerns. the BoJ may follow with additional expansions. the US and Europe are not limited to growth. Figure 9: Monetary tightening timeline 3Q09 Israel (+25) 4Q09 Norway (+25) Australia (+25) 1Q10 India (+50) Korea (+50) Mexico (+25) 2Q10 Indonesia (+25) Peru (+25) Taiwan (+13) Thailand (+25) US (+25) UK (+50) 3Q10 Brazil (+50) Poland (+25) S Africa (+50) Sweden (+25) Czech R (+25) Colombia (+25) 4Q10 1Q11 Euro area (main rate. and ensuing policy tightening that is more aggressive than we currently expect. while we project that the euro area. including asset price rises. before moderating to just above 8% in Q4.

Indeed. our views on Fed and ECB tightening are similar to those of the market. based on "improved conditions in financial markets. The Fed will be closely monitoring the evolution of the housing market and inflation expectations (Figure 8).0% in Q4 11. The ECB has traditionally followed the Fed in terms of hiking after global recessions. Although this is our baseline scenario. As growth recovers. We expect the Fed to start hiking the fed funds rate in September 2010. we are likely to see effective tightening of monetary policies in most major economies during 2010. this rate should average 1. the Fed is likely to gradually prepare markets for rate hikes as the recovery consolidates and it expects monetary policy to start to normalize. Furthermore. we believe the ECB would find pulling the trigger easier if inflation did show on the horizon for 2011. ECB.4 2. with unemployment rates around 9. the Fed Figure 10: ECB reaction function signals gradual increases 7 6 5 ECB policy 'refi' rate (synthetic GDP-weighted history pre 1999. this is not standard Fed thinking.5 4 3 2 1 0 -1 -2 96 98 00 02 04 06 08 10 -6 -4 -2 0 2 4 6 8 10 Japan -0. even though unemployment will remain much higher than normal and core inflation is likely to continue to decline through 2010. in our view. the Fed.Barclays Capital | Global Outlook Bar Japan. FRB. we expect monetary tightening across most economies next year With the exception of the BoJ. BoJ 10 December 2009 23 . Figure 10 updates our ECB reaction function and describes the very gradual pace of increase in the EONIA (overnight) interest rate expected during the next two years.0 Increase in central bank assets since start of 2008 ( in % GDP) 9.2 US -4. an effective tightening remains likely during 2010 via an increase in the EONIA rate back to the levels of the main policy rate.3 8.5% by mid-2010.0% and then rise to 2. and we expect this time to be no different. we look for the ECB to follow. But contrary to the Fed.8 Source: Thomson Datastream. It signals that in Q4 10. it may be hard to tighten. Despite our stronger-than-consensus outlook.5 Euro area -3. EONIA since Oct. core inflation below target and inflation expectations under control. and the positive outlook for housing proves more temporary than we expect. Even if growth is as strong as we expect. The rationale for our call is related to the fact that the Fed has been an advocate of extraordinarily unconventional policies coming into this recession. Barclays Capital Source: BoE. with the biggest objective being to avoid a repeat of the great deflation and depression of the 1930s. The recent indication by the ECB that it intends to withdraw from its non-standard operations at a somewhat quicker pace than we had expected. While we do not expect the ECB to raise the main policy rate until Q1 11. our balance of risk is tilted towards an earlier tightening in the European case. We expect the first fed funds hike to come in September Consistent with history. While inflation expectations are anchored and the prospect of inflation is contained. rather than lead." leaves room for a potential shift higher in EONIA during Q2 10. would not hesitate to delay tightening to 2011.0 5. if there are more hurdles than we expect for growth. the Fed’s sensitivity to any signs of potential weakening makes the risks to our fed funds outlook tilt slightly towards a delay in policy hikes beyond September 2010. 08) Reaction function equation Figure 11: Yet the BoJ has responded least Change in official rates since start of 2008 (in pp) UK -5.

Only if the recently announced policy is the start of a larger program of unsterilized purchases of private loans or assets could this have a more meaningful effect in combating yen appreciation.5 4. also helping to keep Figure 13: Bond yields set to rise 13 Figure 12: Private savings trend higher % of GDP 8 7 6 11 5 4 3 00 01 02 03 04 05 06 07 08 09 10 US private savings (LHS) US non-residential investment (RHS) Note: Private saving is equal to personal saving plus after-tax corporate profits less dividends paid. China has already started the process of reducing money growth that we expect will continue in 2010.0 Nov-08 Feb-09 May-09 UK Aug-09 US Nov-09 Note: Marker denotes end-2010 BarCap forecast for the US and UK. EM countries are likely to kick off their tightening cycle early in the year QE: Sharp impact in. helping to keep rates low (Figure 12). and this could affect the economy in H2 10.0 3. where the relatively weaker near-term outlook is partly the result of the euro’s strength.5 Forecast Q4 10 12 10 9 2. First. the desire to purchase low-risk assets increased. deflation and a weak economy. Marker represents 4Q10 forecast. Against this backdrop. as measured by either interest rate cuts. If the government does introduce a large fiscal package. interest rates to rise by mid-2010. Source: Haver.1% of GDP). and where commodities have a higher weight in consumption. or by the increase in its balance sheet (Figure 11). Second.0 2. such as Korea and India. % 5. the Chinese appreciation will be welcomed in Europe. with inflationary pressures building first in countries with the fastest recoveries. with monetary aggregates growing at a slower pace (targeting 15% y/y rather than the current 27% y/y). in our view. Source: Barclays Capital 10 December 2009 24 . EM countries are likely to start the cycle early in the year. the BoJ has actually shown the least aggressive response. gradual impact out We expect countries with large QE programs to see higher rates in 2010 At least three key macroeconomic factors drove long-term rates lower in 2009.0 4. and. The BoJ announced it would introduce a new operation in which it will provide collateralized loans for up to three months with a tentative target of JPY10trn (or 2. one might have expected the BoJ to have been the most aggressive central bank during and after the recent global recession. a 5% CNY appreciation vis-à-vis a basket of trading partners by 2010. private net savings in major economies increased substantially during the recession. even though it comes too late to prevent the slowdown in growth we expect in H1 10. Barclays Capital 10-year government bond yields.Barclays Capital | Global Outlook The BoJ’s recent decision to expand its QE measures is a positive development Japan is the only major country not expected to tighten monetary policy somewhat in 2010. the BoJ decision to expand its QE measures in recent weeks is a positive development. Instead. Even if modest.5 3. Given the persistent deflation and the fact that Japan’s contraction during the recession was the largest among the G4. the increased risk aversion has meant that for a given amount of net savings. the BoJ may follow with additional expansions. such as Indonesia and Thailand. The ability to affect the deflationary outlook crucially depends on whether the BoJ is going to “sterilize” – or reduce the inflationary measure of its yen issuance by mopping that liquidity with short-term bonds – the new measures.

Assuming that the magnitudes announced were mostly unexpected by markets – a reasonable assumption according to our fixed-income colleagues – and that once announcement markets didn’t immediately expect further expansions. Thus. Outside of Japan. these were unconventional policies that were essentially surprise actions with sharp effects (especially the three key events). Finally. and while we expect both the BoE and the Fed to end their direct purchase of assets sometime early in 2010. We expect all three factors to contribute to higher rates in 2010. they implicitly assume that the informational content of the price action during those days was entirely due to the actual announcements. Except Japan. see The new global balance – Part II. including $300bn Treasury purchases. were already zero). This means that the entire QE program of the Fed ($1. the surprise component on the way in is radically different than on the way out. At their inception. these estimates are already partly priced in. the mopping up of cash liquidity with interestbearing assets – so-called sterilization operations – could lead to higher rates along the yield curve and the removal of part of the stimulative impact on the global economy. We do expect. the end of QE measures is likely to have consequences for the economic outlook. however. We have forcefully argued that QE has been an important driver of lower interest rates and of a weaker USD and GBP relative to JPY and EUR since the summer.75trn) and the BoE ($330 bn) has helped keep rates around 70bp below what they would have been without these programs. with the exception of that in Japan. September 25. As we have been highlighting for months (for a thorough analysis. These specific dates are likely to provide the most information. this has had the effect of lowering long-term rates and weakening the currencies of countries with large QE programs. While no outright sales of assets are expected in the coming quarters. central bankers injected substantial amounts of fresh money to buy longterm assets directly in capital markets (Figure 14). which would effectively imply falls in longer-term yields (given that overnight rates. We expect that the Fed and BoE will not extend their existing programs beyond March. as it requires the actual end of additional fresh money being injected by central bankers to be fully priced in. Figure 14 shows the impact on long-term rates one and five days after key announcements. Second. We estimate that the entire QE program of the Fed and BoE helped keep rates around 70bp lower 10 December 2009 25 . it is useful to review the impact that QE had on markets on the way in. This effect has been gradual. we expect a gradual end to most QE programs in 2010 Our expectation in 2010 is that we see a gradual end to most QE programs. and the BoE early March program of Gilt purchases. we divide the one-day change with the amount of purchases announcement). market imperfections and the lack of full credibility in the announcements may imply that the rise of rates happens smoothly and extends beyond the end of QE. Extra caution is required when interpreting these estimates. Similarly in the case of the ECB. For starters. Because the end of QE is highly anticipated. given the large surprise element of the announcements.5bp in England and 4bp in the US (ie. However. we do not expect an abrupt impact on rates or currencies (or asset prices more generally) when QE ends. the typical way central bankers lend to the private sector. that the end of QE will remove an important driver for lower rates (and weaker USD and GBP) throughout 2010. We begin by focusing on the impact that the end of QE may have on rates. including the Fed’s 25 November announcement of $600bn for purchasing long-term mortgage assets. 2009). asset purchases by the Fed and BoE were intended to facilitate credit to the private sector. then the impact of each $100bn of asset purchases on 10y bonds would have been to depress yields by an average 3. its announcement in March of a large extension of the program. the non-standard liquidity operations are likely to gradually be wound down through 2010. On the way in.Barclays Capital | Global Outlook rates low.

18 -0. Nonetheless. pushing rates and GBP and USD down.69 3. because of market imperfections rates could continue to fall further during early 2010. should gradually reverse (as.65 -0. it does not seem reasonable to expect such a bout of risk aversion. but it is hard to envision this force being even close in magnitude to the panic attack post-Lehman (when 10y UST rates touched 2¼%). given a number of important liquidity considerations. Our central case is for long-term rates to be 100bp higher by end-2010 Two words of caution are warranted. nothing abrupt is expected to happen the day QE ends). as the probability of a return to very weak growth continues to fall (see ‘Sweet spot for growth’ in Global Outlook. This could imply a slower increase in rates than after normal recessions. But even in a slow growth scenario of 2%.55 t-1 -0.76 3.1 = previous day. a sharp increase in job uncertainty. we believe that only under a scenario of very weak economic recovery would rates remain so low.34 3.44 t+5 t-1 -0. for a given level of savings. In short. rising private saving and the large risk aversion of 2009 have had a clear effect on rates.47 -0.77 3.49 3.69 -0. while the timing of higher rates may be delicate. Thus.60 3. Second.81 3. both personal and corporate) to stabilize in 2010.65 3.66 3. even with a relatively strong recovery.49 3. the return to risk by private investors may be slower than after normal recessions. 26 10 December 2009 .04 0. It is true that the move towards riskier assets (and away from cash and treasuries) would be smaller than the one we expect in our outlook. our baseline is no extension).47 t 3.56 3.15 -0.07 t+5 2.91 -0.49 3.01 t-1 3.42 3.03 3. collapse in wealth. we have incorporated the rise in long-term rates throughout 2010 in our economic outlooks.35 -0. of course.81 3.69 2.85 -0.00 3.00 0. a sharp return of risk aversion could still bring down rates. Treasuries $300bn Extensions and modifications to a number of liquidity programs Extension to TALF Asset purchases slowed to end Q1 10 Fed sets out conditions for tightening monetary policy Bank of England 5 Mar 2009 7 May 2009 6 Aug 2009 5 Nov 2009 Asset purchase facility announced (£75bn) APF increased by £50bn to £125bn APF increased by £50bn to £175bn APF increased by £25bn to £200bn 3.19 -0. T = day of specified announcement. September 2009.03 Note: Yields refer to 10y US Treasuries and UK gilts. $100bn GSE) TALF expanded MBS/ABS purchases by expanded $850bn.07 2.85 2. First.28 0.07 -0.17 0.14 -0.43 3.10 2.46 3.06 -0. Source: Barclays Capital But beyond the direct impact of QE. The recession brought about a jump in private savings that helped keep rates low.Barclays Capital | Global Outlook Figure 14: Impact on yield changes of central bank announcements (%) tUS Federal Reserve 25 Nov 2008 10 Feb 2009 18 Mar 2009 25 Jun 2009 17 Aug 2009 23 Sep 2009 4 Nov 2009 New asset purchase programs ($500bn MBS.24 -0. Our baseline scenario is for the global recovery to continue and private savings (ie. because of the magnitudes of QE involved and the behaviour of risk/markets since the summer. This means that these two additional sources of low rates in 2009 are likely not to be as strong in 2010. Even in a 2% growth scenario – which is lower than ours – it is hard to see any of these determinants moving enough to warrant that higher savings will push rates lower.06 0. fall in income).67 2. the same forces that have been active since the summer. we continue to think that long-term rates are likely to be 100bp or more higher than today by end-2010 (Figure 13). It is hard to justify another jump in savings without a massive disruption in the drivers of savings (ie. for why we are not expecting this tail risk to materialize in 2010).84 3.97 3. However.31 3.55 3. But once the Fed or BoE support ends in March (again.06 -0. t .38 3.53 3.23 -0.

Barclays Capital | Global Outlook

Figure 15: Summary of Barclays Capital economics projections: GDP and inflation
Real GDP % y/y Weight* Canada US North America Argentina Brazil Chile Colombia Mexico Peru Venezuela Latin America The Americas Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain Euro area Norway Sweden UK W Europe Czech Republic Hungary Poland Central Europe Russia Turkey Europe Australia PR China Hong Kong, SAR China, Taipei India Indonesia Japan Malaysia Philippines Singapore South Korea Asia South Africa G10 Above countries 1.9 20.7 22.6 0.8 2.9 0.4 0.6 2.2 0.4 0.5 7.9 30.5 0.5 0.6 0.3 3.1 4.2 0.5 0.3 2.6 1.0 0.3 2.0 15.7 0.4 0.5 3.2 20.5 0.4 0.3 1.0 1.8 3.3 1.3 27.8 1.2 11.4 0.4 1.1 4.8 1.3 6.4 0.6 0.5 0.3 1.8 30.5 0.7 44.6 95.8 2007 2.5 2.1 2.2 8.7 5.7 4.7 7.5 3.3 8.9 8.4 5.7 3.1 3.4 2.8 4.1 2.3 2.6 4.6 6.0 1.5 3.6 1.9 3.6 2.7 2.7 2.7 2.6 2.7 6.1 1.1 6.8 6.1 8.1 4.6 3.7 4.0 13.0 6.3 5.7 9.1 6.3 2.3 6.2 7.1 7.8 5.1 8.2 5.1 2.4 5.1 2008 0.4 0.4 0.4 5.8 5.1 3.2 2.4 1.3 9.8 4.8 4.0 1.4 2.0 0.8 0.8 0.3 1.0 2.0 -3.0 -1.0 2.0 0.0 0.9 0.5 1.7 -0.5 0.6 0.5 3.0 0.7 5.0 4.0 5.6 1.1 1.4 2.4 9.0 2.6 0.7 7.3 6.1 -0.7 4.6 3.8 1.1 2.2 5.1 3.1 0.4 2.7 2009 -2.4 -2.5 -2.5 -2.2 0.1 -1.9 0.0 -6.8 0.9 -2.3 -2.3 -2.4 -3.6 -3.0 -7.7 -2.2 -4.8 -1.0 -7.0 -4.8 -4.0 -2.6 -3.6 -3.9 -1.1 -4.4 -4.6 -3.9 -4.7 -6.6 1.3 -1.8 -7.1 -5.9 -4.2 0.9 8.6 -3.3 -3.0 6.0 4.5 -5.2 -2.0 1.2 -1.5 0.1 3.0 -1.8 -3.6 -1.1 2010 3.4 3.5 3.5 3.5 5.3 4.6 3.4 5.1 3.9 2.4 4.6 3.8 1.7 1.9 0.2 1.4 2.4 0.5 0.1 1.2 2.0 1.5 -0.5 1.5 2.3 1.9 1.5 1.4 1.9 0.3 3.0 2.4 4.3 3.8 2.0 2.8 9.6 4.3 6.0 8.2 6.0 1.7 5.0 4.3 6.5 5.0 6.6 2.4 2.6 4.2 2011 3.4 3.1 3.1 2.7 4.4 4.2 4.8 3.2 5.9 3.1 3.8 3.3 2.2 2.4 2.2 1.1 2.4 0.9 1.7 1.7 2.2 1.4 1.5 1.9 2.8 2.7 2.2 1.9 3.1 3.9 4.0 3.9 3.6 4.1 2.4 3.7 9.0 4.0 4.0 8.4 6.3 1.8 4.5 5.3 4.0 4.0 6.2 4.1 2.5 4.1 2007 2.1 2.9 2.8 8.8 3.6 4.4 5.5 4.0 1.8 18.7 5.5 3.3 2.2 1.8 1.6 1.6 2.3 3.0 2.9 2.0 1.6 2.4 2.8 2.1 0.7 2.2 2.3 2.1 2.9 8.0 2.9 3.6 9.3 8.7 2.9 2.4 4.8 2.0 1.8 4.7 6.4 0.0 2.0 2.8 2.1 2.5 2.6 7.1 2.2 3.0 CPI inflation % y/y** 2008 2.4 3.8 3.7 26.7 5.9 8.7 7.0 5.1 5.8 31.4 9.7 2.8 3.2 4.5 3.9 3.2 2.8 4.2 3.1 3.5 2.2 2.7 4.1 3.3 3.8 3.4 3.6 3.3 6.0 6.1 4.1 4.9 14.2 10.2 4.5 4.4 5.9 4.3 3.5 9.1 10.2 1.5 5.4 9.3 6.5 4.7 3.5 11.5 3.3 3.2 2009 0.3 -0.3 -0.3 16.2 4.2 1.5 4.2 5.3 1.2 26.1 7.1 2.6 0.4 0.0 1.6 0.1 0.2 1.3 -1.6 0.7 1.0 -0.9 -0.3 0.3 2.2 -0.3 2.1 0.6 1.0 4.2 3.5 2.9 11.7 6.2 1.8 1.7 -0.7 0.6 -0.7 1.9 5.0 -1.3 0.6 3.2 0.3 2.8 -0.8 7.2 0.1 1.4 2010 1.5 2.2 2.1 15.3 4.6 0.3 2.9 4.5 2.2 31.7 7.3 2.6 1.2 1.6 1.1 1.6 1.3 1.8 -1.4 1.0 0.8 0.7 1.7 1.3 1.8 1.2 2.3 1.4 2.2 3.6 2.7 2.7 6.8 6.4 2.1 2.8 3.0 2.0 1.8 6.5 6.5 -1.0 2.5 6.1 4.0 1.7 2.4 6.1 1.5 2.1 2011 1.9 1.7 1.7 n.a. 5.1 2.4 3.6 3.9 2.5 35.3 7.0 2.5 1.0 1.7 1.0 1.6 1.5 1.2 -1.1 1.2 1.0 1.0 1.4 1.4 2.2 2.0 0.5 1.3 1.6 3.1 2.9 2.6 7.0 6.0 2.0 3.0 3.5 2.5 1.5 5.7 6.6 -0.7 2.5 5.3 1.2 1.6 2.7 5.7 1.3 2.0

Note: * IMF weight of real GDP using PPP, 2008 estimates for real GDP; nominal GDP (2008) for CPI inflation. ** Conventional rate; HICP for euro area. Source: Barclays Capital

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Figure 16: Summary of Barclays Capital economics projections: External and government balances
Current account (% GDP) Weight* Canada US North America Argentina Brazil Chile Colombia Mexico Peru Venezuela Latin America The Americas Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain Euro area Norway Sweden UK W Europe Czech Republic Hungary Poland Central Europe Russia Turkey Europe Australia PR China Hong Kong, SAR China, Taipei India Indonesia Japan Malaysia Philippines Singapore South Korea Asia South Africa G10 Above countries
Source: Barclays Capital

General gov't. (% GDP)** 2011 -0.5 -4.8 -4.4 3.5 -3.4 1.0 -3.4 -1.6 -3.9 7.9 -1.2 -4.4 3.8 -0.4 2.7 -1.8 5.3 -10.4 -0.3 -3.0 9.0 -8.3 -3.7 0.5 16.0 8.9 -2.3 0.8 -3.0 -3.6 -0.4 -2.1 3.2 -4.2 0.5 -5.6 6.0 11.3 3.0 -1.5 0.7 3.8 13.7 3.3 8.9 0.9 5.5 -4.9 -1.3 -0.3 2007 1.6 -1.2 -0.9 0.2 -2.8 8.7 -0.6 0.0 1.7 -2.8 -0.9 -0.9 -0.6 -0.2 5.2 -2.7 -0.2 -3.6 0.3 -1.5 0.2 -2.6 2.2 -0.6 17.7 3.8 -2.6 -0.2 -1.0 -4.9 -1.9 -2.2 5.4 -2.6 0.1 1.6 0.6 8.6 -1.1 -7.3 -2.1 -2.5 -3.2 -1.6 11.1 3.5 -0.9 0.9 -1.1 -0.1 2008 -0.4 -3.2 -2.9 1.4 -2.1 5.2 -0.1 -0.1 2.1 -2.6 -0.7 -2.4 -0.6 -1.2 4.4 -3.4 0.0 -5.3 -7.1 -2.7 0.7 -2.7 -3.8 -1.9 18.8 2.5 -6.3 -1.7 -1.5 -3.8 -3.9 -3.2 4.1 -3.1 -1.4 -0.3 -0.4 3.8 -2.0 -12.9 -0.1 -2.9 -4.8 -0.9 -0.7 3.0 -2.1 -1.2 -2.7 -1.1 2009 -3.7 -9.9 -9.3 -1.7 -4.1 -3.6 -2.6 -2.2 -2.9 -7.7 -3.5 -8.2 -4.4 -5.5 -3.4 -8.3 -3.0 -12.2 -12.2 -5.2 -6.4 -7.6 -10.1 -6.2 9.0 -3.0 -13.6 -6.6 -5.6 -3.9 -5.9 -5.5 -6.9 -6.7 -6.6 -0.2 -3.0 -3.6 -5.3 -10.5 -1.5 -8.8 -9.0 -4.2 -3.2 -5.3 -5.7 -7.7 -8.2 -5.4 2010 -2.8 -8.5 -7.9 -2.4 -3.2 -1.1 -3.6 -2.7 -1.4 -6.7 -3.1 -7.0 -5.2 -5.7 -4.7 -8.7 -5.5 -12.3 -12.1 -4.9 -6.1 -7.7 -10.7 -7.1 9.2 -2.7 -11.9 -7.0 -5.0 -3.9 -6.5 -5.6 -3.0 -5.0 -6.6 0.3 -2.0 -3.0 -4.0 -8.5 -1.3 -9.5 -6.5 -3.5 -0.5 -3.5 -5.2 -5.6 -7.9 -4.5 2011 -1.6 -6.1 -5.7 -3.1 -3.0 -0.6 -3.5 -1.8 -0.4 5.5 -1.8 -4.9 -4.6 -4.8 -2.8 -7.5 -4.4 -11.9 -10.7 -4.4 -4.2 -7.2 -10.2 -6.4 9.4 -1.8 -8.5 -5.8 -4.0 -3.4 -5.5 -4.7 -4.0 -4.9 -5.5 0.6 -1.0 -2.0 -2.0 -7.5 -1.0 -8.0 -5.5 -2.8 1.2 -1.0 -4.0 -5.2 -6.1 -3.2

2007 1.0 -5.2 -4.6 1.6 0.1 4.7 -1.8 -0.8 1.1 8.8 0.8 -4.5 3.5 1.7 4.2 -1.0 7.8 -14.1 -5.4 -2.4 8.7 -9.4 -10.0 0.2 15.9 8.8 -2.7 0.9 -3.0 -6.4 -4.7 -4.7 9.9 -5.8 0.8 -5.9 11.0 12.4 8.6 -1.6 2.4 4.8 15.7 4.9 24.2 0.6 4.4 -7.3 -1.1 -0.6

2008 0.5 -4.9 -4.4 2.3 -1.8 -2.0 -2.8 -1.5 -3.3 12.5 -0.3 -3.6 3.2 -2.5 3.0 -2.3 6.6 -14.3 -5.1 -3.4 4.8 -12.1 -9.6 -1.5 19.5 9.8 -1.6 0.0 -3.0 -7.1 -5.0 -5.1 6.0 -5.6 0.5 -5.8 9.8 14.2 6.2 -3.4 0.0 3.2 17.5 2.3 14.8 -0.7 5.5 -4.4 -1.7 0.1

2009 -2.5 -2.9 -2.9 3.6 -1.3 0.7 -2.9 -1.0 -2.4 1.6 -0.7 -3.7 2.0 -1.0 1.3 -1.9 3.9 -10.7 -3.2 -3.3 6.0 -9.1 -5.2 -0.7 15.1 8.1 -1.8 0.1 -2.5 -0.5 -1.5 -2.2 4.8 -2.3 0.6 -3.4 6.2 10.4 9.9 -0.7 1.7 2.6 14.6 5.1 14.2 5.6 -4.7 -4.4 -1.0 -2.6

2010 -1.5 -3.7 -3.5 2.1 -2.6 1.2 -2.3 -1.2 -4.4 7.3 -0.9 -4.2 2.7 -0.9 1.9 -1.5 4.6 -10.6 -1.7 -3.0 7.7 -8.6 -3.9 0.1 16.6 8.4 -2.6 0.5 -2.6 -2.5 -0.7 -2.1 5.2 -4.1 0.6 -4.6 6.5 11.1 5.3 -1.4 1.0 3.5 13.6 3.4 9.9 2.1 8.2 -4.2 -1.0 0.5

2.5 23.5 26.0 0.5 2.6 0.3 0.4 1.8 0.2 0.5 6.4 32.4 0.7 0.8 0.5 4.7 6.0 0.6 0.5 3.8 1.4 0.4 2.7 22.1 0.8 0.8 4.4 29.4 0.4 0.3 0.9 1.6 2.8 1.2 35.0 1.7 7.3 0.4 0.6 2.0 0.8 8.1 0.4 0.3 0.3 1.6 23.8 0.5 57.0 96.3

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Figure 17: US economic projections
2009 % Change q/q saar Real GDP Private consumption Public consump and invest. Residential investment Equip. & software investment Structures investment Net exports ($bn, real) Final sales Ch. inventories ($bn, real) GDP price index Nominal GDP Industrial output Employment (avg mthly chg, K) Unemployment rate (%) CPI inflation (%y/y) Core CPI (%y/y) Core PCE price index (%y/y) Current account (%GDP) Federal budget bal. (%GDP) Federal funds rate (%) 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0.50 Note: Q/Q data are seasonally adjusted annualized. *Fiscal year basis. Source: Barclays Capital 1.00 1.00 1.00 1.50 2.00 Q1 -6.4 0.6 -2.6 -38.2 -36.4 -43.6 -387 -4.1 -113.9 1.9 -4.6 -19.0 -691 8.1 0.0 1.7 1.7 -3.0 Q2 -0.7 -0.9 6.7 -23.3 -4.9 -17.3 -330 0.7 -160.2 0.0 -0.8 -10.3 -428 9.3 -1.2 1.8 1.6 -2.8 Q3 2.8 2.9 3.1 19.5 2.3 -15.1 -358 1.9 -133.4 0.5 3.3 5.6 -199 9.6 -1.6 1.5 1.3 -2.8 Q4 4.0 2.0 2.8 15.0 10.0 -10.0 -371 2.2 -78.0 1.1 5.0 7.0 -40 10.1 1.5 1.8 1.3 -3.1 Q1 5.0 2.0 2.2 20.0 15.0 -12.0 -375 2.7 -8.0 1.2 6.2 8.0 125 10.0 2.7 1.6 1.3 -3.3 2010 Q2 3.0 2.0 2.0 30.0 8.0 -6.0 -386 2.5 7.0 1.3 4.3 8.0 175 9.7 2.3 1.3 1.1 -3.6 Q3 3.5 2.5 1.4 30.0 8.0 -4.0 -396 2.8 27.0 1.3 4.8 7.0 225 9.4 2.0 1.2 1.0 -3.9 Q4 3.5 3.0 1.0 30.0 6.0 2.5 -402 3.3 32.0 1.2 4.7 6.0 250 9.1 1.7 1.1 1.0 -4.1 Q1 2.5 2.0 0.0 25.0 7.0 4.0 -409 2.4 37.0 1.5 4.0 6.0 275 8.8 1.6 1.2 1.0 -4.4 3.0 2.5 -0.5 20.0 8.0 6.0 -416 2.6 45.0 1.5 4.6 5.5 325 8.6 1.7 1.2 1.1 -4.7 2011 Q2 Q3 3.5 3.0 -1.0 15.0 15.0 8.0 -423 3.2 53.0 1.8 5.4 5.0 350 8.3 1.8 1.3 1.1 -5.0 Q4 3.5 3.5 -1.2 15.0 15.0 8.0 -435 3.4 57.0 1.9 5.5 5.0 350 7.9 1.8 1.4 1.2 -5.3 Calendar year average 2009 -2.5 -0.6 2.2 -19.9 -17.0 -19.0 -362 -1.7 -121.4 1.2 -1.3 -9.8 -340 9.3 -0.3 1.7 1.5 -2.9 -9.9 2010 3.5 2.1 2.5 19.5 8.4 -9.5 -390 2.4 14.5 1.1 4.6 6.0 194 9.6 2.2 1.3 1.1 -3.7 -8.5 2011 3.1 2.6 0.2 23.7 8.7 3.1 -421 2.9 48.0 1.5 4.6 6.0 325 8.4 1.7 1.3 1.1 -4.8 -6.1

Figure 18: Euro area economic projections
% Change q/q Real GDP Real GDP (saar) Real GDP y/y Private consumption Public consumption Investment residential construction non-residential construction non-construction investment Inventories (q/q contribution) Net exports (q/q contribution) Industrial output (ex construction) Employment q/q Q1 -2.4 -9.4 -5.0 -0.5 0.6 -4.9 -2.6 0.4 -8.8 -0.7 -0.6 -8.1 -0.7 2009 Q2 Q3 -0.2 -0.6 -4.8 0.0 0.6 -1.7 -2.0 0.3 -2.6 -0.6 0.7 -1.6 -0.5 0.4 1.5 -4.1 -0.2 0.5 -0.4 -1.4 -0.4 -0.6 0.3 0.2 2.2 -0.5 Q4 0.5 1.9 -1.8 0.0 0.7 -0.5 -1.0 -0.2 -0.5 0.2 0.2 0.3 -0.3 Q1 0.4 1.4 1.1 0.1 0.3 -0.2 -0.8 -0.2 0.1 0.1 0.2 0.0 -0.4 2010 Q2 Q3 0.4 1.7 1.6 0.3 0.2 -0.1 -0.6 -0.1 0.2 0.2 0.1 0.2 -0.3 0.4 1.6 1.7 0.3 0.2 0.2 -0.3 0.0 0.7 0.1 0.1 0.1 -0.2 10.8 1.4 1.0 0.2 ... 1.00 Q4 0.4 1.7 1.6 0.3 0.1 0.5 -0.3 0.0 1.2 0.1 0.0 0.2 -0.1 10.9 1.6 1.0 0.2 ... 1.00 Q1 0.4 1.8 1.7 0.3 0.1 0.5 -0.1 0.0 1.1 0.0 0.1 0.2 0.1 10.8 1.6 1.0 0.3 ... 1.25 2011 Q2 Q3 0.5 1.8 1.7 0.3 0.1 0.6 0.0 0.1 1.2 0.0 0.1 0.3 0.2 10.7 1.5 1.1 0.4 ... 1.50 0.6 2.3 1.9 0.4 0.1 0.6 0.3 0.2 1.2 0.1 0.1 0.5 0.2 10.5 1.3 0.9 0.6 ... 1.75 Q4 0.6 2.4 2.1 0.4 0.1 0.7 0.3 0.4 1.2 0.1 0.1 0.6 0.3 10.2 1.3 0.9 0.7 ... 2.00 Calendar year average 2009 2010 2011 ... ... -3.9 -1.0 2.5 -10.0 -8.9 -2.0 -14.6 -0.7 -1.1 -13.7 -1.7 9.4 0.3 1.4 -0.7 -6.2 1.00 ... ... 1.5 0.4 1.5 -1.0 -2.9 -0.5 -0.4 0.5 0.7 1.1 -1.3 10.7 1.3 1.0 0.1 -7.1 1.00 ... ... 1.9 1.3 0.6 2.0 -0.3 0.3 4.2 0.2 0.4 1.1 0.2 10.6 1.4 1.0 0.5 -6.4 2.00

Unemployment rate % 8.8 9.3 9.6 10.0 10.4 10.7 0.4 1.1 1.2 CPI inflation y/y 1.0 0.2 -0.4 Core CPI (ex food/energy) y/y 1.6 1.6 1.3 1.1 1.0 0.9 -0.2 0.0 0.1 Current account % GDP -1.7 -0.5 -0.4 Government balance % GDP ... ... ... ... ... ... Refi rate (period end) 1.50 1.00 1.00 1.00 1.00 1.00 Note: Q/Q data are non-annualized unless specified otherwise. Source: Barclays Capital

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Figure 19: UK economic projections
% Change q/q Real GDP Real GDP (saar) Real GDP (y/y) Private consumption Public consumption Investment Net exports Industrial output Employment Unemployment rate % CPI inflation y/y Core CPI y/y Current account % GDP Government balance % GDP Key Central Bank rate Q1 -2.5 -9.6 -5.0 -1.5 0.1 -7.3 0.1 -5.1 -0.5 7.1 3.0 1.6 -1.2 ... 0.50 2009 Q2 Q3 -0.6 -2.3 -5.5 -0.6 0.6 -5.2 0.2 -0.5 -0.8 7.8 2.1 1.6 -1.6 ... 0.50 -0.3 -1.2 -5.1 0.0 0.2 -0.3 -0.2 -0.7 0.0 7.8 1.5 1.7 -2.3 ... 0.50 Q4 0.4 1.6 -3.0 0.1 0.2 -0.4 0.1 0.1 -0.1 7.9 2.0 2.1 -2.3 ... 0.50 Q1 0.5 2.2 0.0 0.2 0.1 0.2 0.0 0.2 0.1 8.0 2.8 2.5 -2.4 ... 0.50 2010 Q2 Q3 0.6 2.5 1.2 0.3 0.1 0.2 -0.1 0.3 0.2 8.0 2.7 2.4 -2.6 ... 0.50 0.6 2.5 2.2 0.4 -0.2 0.8 0.0 0.3 0.2 8.0 2.1 1.9 -2.7 ... 1.00 Q4 0.6 2.4 2.4 0.4 -0.2 0.8 0.0 0.3 0.1 8.0 1.5 1.8 -2.7 ... 1.50 Q1 0.5 2.0 2.3 0.6 -0.5 0.0 0.2 0.3 0.1 8.1 0.6 1.4 -2.5 ... 2.00 2011 Q2 Q3 0.5 1.9 2.2 0.5 -0.5 0.1 0.2 0.2 0.0 8.1 0.4 1.2 -2.4 ... 2.50 0.6 2.3 2.2 0.7 -0.7 0.8 0.1 0.3 0.1 8.2 0.5 1.2 -2.3 ... 3.00 Q4 0.6 2.3 2.1 0.7 -0.7 0.9 0.1 0.3 0.1 8.2 0.7 1.2 -2.2 ... 3.50 Calendar year average 2009 2010 2011 ... ... -4.6 -3.0 1.9 -14.1 0.6 -10.3 -1.6 7.7 2.1 1.7 -1.8 -13.6 0.50 ... ... 1.5 0.7 0.5 -0.8 0.0 0.2 0.1 8.1 2.3 2.2 -2.6 -11.9 1.50 ... ... 2.2 2.2 -1.6 1.7 0.5 1.1 0.4 8.2 0.5 1.3 -2.3 -8.5 3.50

Note: Q/Q data are non-annualized unless specified otherwise. Source: Barclays Capital

Figure 20: Japan economic projections
% Change Real GDP q/q saar Real GDP q/q Private consumption q/q Public consumption q/q Residential investment q/q Public investment q/q Capital investment q/q Net exports q/q* Ch. Inventries q/q* Nominal GDP q/q Industrial output q/q Employment q/q Unemployment rate % CPI inflation y/y Core CPI (ex food/energy) y/y Current account % GDP Government balance % GDP Key Central Bank rate Q1 -11.9 -3.1 -1.2 0.7 -6.4 3.7 -8.4 -0.9 -0.4 -3.0 -22.1 -0.5 4.4 0.0 -0.2 1.5 … 0.1 2009 Q2 Q3 2.7 0.7 1.2 0.3 -9.4 6.3 0.0 1.6 -0.7 -0.7 8.3 -0.9 5.2 -1.0 -0.5 3.3 … 0.1 1.3 0.3 0.9 -0.1 -7.9 -1.6 -2.8 0.4 0.1 -0.9 7.4 -0.3 5.5 -2.3 -0.9 3.2 … 0.1 Q4 3.6 0.9 0.3 -0.4 0.6 -2.3 2.1 0.5 0.0 0.2 5.0 -0.3 5.3 -1.8 -1.1 2.4 … 0.1 Q1 1.0 0.3 -0.3 0.3 0.3 -4.4 2.5 0.2 0.0 -0.3 2.3 0.0 5.8 -1.0 -1.2 3.2 … 0.1 2010 Q2 Q3 0.4 0.1 -0.2 0.0 -0.8 -3.6 1.5 0.1 0.0 -0.2 1.5 -0.1 5.8 -1.0 -1.1 3.4 … 0.1 2.0 0.5 0.3 -0.4 -0.3 0.2 0.9 0.2 0.0 0.1 1.8 0.0 5.7 -1.0 -1.0 3.6 … 0.1 Q4 2.5 0.6 0.4 -0.2 0.5 0.8 1.2 0.1 0.0 0.3 2.2 0.1 5.7 -0.9 -0.9 4.0 … 0.1 Q1 1.9 0.5 0.2 0.0 0.5 -2.3 1.6 0.1 0.0 0.3 2.8 0.1 5.5 -1.0 -1.0 4.0 … 0.1 2011 Q2 Q3 1.6 0.4 0.3 -0.1 0.0 -0.5 0.8 0.1 0.0 0.3 1.5 0.1 5.4 -0.7 -0.7 3.8 … 0.1 1.4 0.4 0.4 -0.2 -0.5 -0.5 0.5 0.1 0.0 0.3 1.5 0.3 5.3 -0.6 -0.6 3.7 … 0.1 Q4 1.6 0.4 0.4 -0.2 -0.5 0.0 0.4 0.1 0.0 0.3 1.5 0.2 5.1 -0.5 -0.5 3.7 … 0.1 Calendar year average 2009 2010 2011 -5.2 -0.9 1.2 -13.4 5.7 -19.1 -1.3 -0.1 -6.6 -21.9 -0.5 5.1 -1.3 -0.7 2.6 -8.8 0.1 1.7 0.8 -0.2 -6.4 -7.2 3.1 1.2 -0.1 -0.8 15.2 -0.6 5.7 -1.0 -0.7 3.5 -9.5 0.1 1.8 1.1 -0.5 0.1 -3.3 4.4 0.5 0.1 1.0 8.2 0.4 5.3 -0.7 -0.7 3.8 -8.0 0.1

Note: Q/Q data are non-annualized unless specified otherwise. Source: Barclays Capital

10 December 2009

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Oil prices (in the form of the December 2017 WTI contract) settled above $100/barrel for the first time this year. with benchmark returns basis.150/t. With the very strong gains made across a whole range of different commodity markets since their low point earlier this year and these now extending into Q4. any further upside potential for the main commodity price benchmarks is rather limited. with growing evidence of a robust recovery in OECD economies.norrish@barcap.Barclays Capital | Global Outlook COMMODITY OUTLOOK Cruise control Kevin Norrish +44 (0) 20 7773 0369 kevin. A slowing in the demand recovery. Barclays Capital 10 December 2009 31 . putting the recovery on a par with the scale of commodity price gains during previous recoveries. acceleration in supply growth. consequently. Commodity returns have accelerated again in Q4 After a subdued period in the third quarter. and gold has registered a number of all-time highs. The macroeconomic environment for commodities has been positive for most of the quarter. the LME 3-month copper price reached a high of $7. continued improvements in emerging market economies and a steep decline in the value of the dollar. the S&PGSCI and more broadly diversified DJ-UBS indices up about 6% and 8%. respectively. or an end to the trend of dollar weakness. so far in Q4. RHS) -35% -50% -7% Sep 97 Sep 00 Sep 03 Sep 06 Sep 09 Source: Ecowin. plus the existence of some spare capacity in markets such as oil means that further ahead in 2010 commodity price appreciation is likely to slow significantly. Barclays Capital Source: Ecowin. its highest since September 2008. a period of strong growth ahead for the US and Europe should enable further gains to be made in base metals and oil markets during Q1 10. Those benchmarks are now very close to the levels prevailing at the start of the recession in December 2007.com Although most of the broad uptrend in commodity prices is now over. The major short-term risks come from a further slowing in China’s commodity import demand. LHS) S&PGSCI TR (Q/Q. Figure 1: Commodity returns moved up once again in Q4 Figure 2: A positive global growth outlook suggests more gains to come 9% Global growth momentum & commodity returns F'cst 5% 10% 40% 25% 25% 15% 5% -5% Commodity index returns by quarter S&PGSCI -15% -25% DJUBS 1% -5% -20% -3% -35% -45% Q4 07 Q2 08 Q4 08 Q2 09 Q4 09 TD Global GDP (Q/Q. though price downside is limited in most major markets. These positive trends have contributed to a number of symbolic benchmarks in different commodity markets being reached. it is tempting to conclude that a strong recovery in global growth and commodity demand is now close to being fully priced and that. which would be particularly negative for precious metals prices. commodity returns have accelerated once again.

resulting not just in a stronger dollar but lower growth expectations further forward. we suspect any downward price adjustments are likely to be short-lived. and there is a strong strand of opinion that commodities are already hugely overvalued. Meanwhile. The main short-term risks to this view revolve around financial market perceptions concerning the timing of interest rate rises. This reflects our view that liquidity has not been a direct driver of strength this year in oil or metals markets recently. with precious metals markets. the Barclays Capital base case view of global growth is that there will not be any slowing of momentum until H2 10. Throughout the subsequent global economic recovery process this year. and supply constraints still evident across many different commodity markets. Perhaps somewhat paradoxically. but we would be cautious about discounting the possibility of further. with strong growth in OECD demand likely the driver in early 2010. The initial price recovery for commodities therefore reflected little more than a backing away from some of the more unrealistic and apocalyptic scenarios for the global economy. broad-based commodity gains in early 2010. CFTC hedge fund positioning data suggest that in most major markets net long positions are not yet over-extended though hedge fund net length in gold is close to previous all-time highs. there is upside risk to economic growth in Q1. unless there are some very major shocks. which left prices for most commodities at levels that were simply not sustainable under anything other than a global recession scenario. it is very likely that commodity demand will continue to surprise to the upside. The transmission mechanism is likely to be via short-term fluctuations in the value of the dollar. Much of this year’s price recovery has been in reaction to a phase of panic selling in late 2008 and early 2009. Growth-sensitive commodities such as industrial metals and energy should prove resilient in such a scenario.Barclays Capital | Global Outlook Most of the upward move in commodity prices is over The majority of the move up in commodities prices may now be behind us. perhaps significant. Quarter-on-quarter growth is expected to reach 4.1% in October). notably gold and silver.3% YTD and was down 0. Hedge fund strategies in commodities have massively underperformed relative to the general improvement in prices for most of this year and continue to do so (the HFRX index of hedge fund returns in commodities is -3. especially in the US where our forecasts look modest alongside previous recovery phases. This is far from being a consensus view. With levels of spare capacity and inventories much lower than those prevailing during previous economic recoveries. most at risk. But forecast of strong growth in Q1 10 provides some further limited upside Under this kind of positive growth scenario. with most of 2009’s price appreciation being driven by central bank injections of liquidity and investors’ search for yield. 10 December 2009 32 . Moreover.5% in Q4 and remain at this level for the first and second quarters of 2010. the overall picture for the global economy and for commodity market fundamentals suggests further upward pressure on price levels across many different markets. the weakness of which has been a positive for most commodity sectors recently. a run of better-than-expected US data and the likelihood that this would bring closer the expectation of Fed rate hikes are likely to induce the greatest amount of volatility for commodities. However. Furthermore. and there is very little evidence that the recent increase in prices yet reflects any significant change in this rather cautious attitude toward commodity markets. there has been widespread scepticism regarding its sustainability.

substantially higher than the previous record of $51bn in 2006. Output of copper and aluminium semi-fabricated products is continuing to rise. on a 3-month moving average basis. We now estimate total inflows for the year at about $60bn. With economic growth expected to remain strong in 2010 and almost half of the government stimulus package yet to be spent.500 $mn 7.500 5. boosted by strong demand from the auto sector and for consumer appliances. China’s commodity demand is still expanding fast Figure 3: Investment flows to commodities have picked up again in Q4 11.9 mb/d. though big differences remain between the speed and extent of recovery in different parts of the world. Barclays Capital 10 December 2009 33 .500 May-07 Mar-09 Jun-09 Sep-09 Dec-09 Source: Bloomberg. demand for industrial metals is also strong. ETP issuer websites. However. and particularly between non-OECD and OECD economies. China’s commodity demand has been the big driver of recovery this year and continues to show signs of expanding rapidly. up 30% and 20%.500 9. and in absolute terms.Barclays Capital | Global Outlook Investment activity in commodities has remained strong. exchange-traded products and medium-term notes will hit an all-time high this year. This is already evident in some sharp contractions in China’s import demand for certain commodities. Meanwhile. in our view. notably in the industrial metals sector where imports have fallen sharply after getting a boost from stock-building earlier this year. over September and October. end-user demand for commodities is expected to continue expanding at a healthy rate across most sectors. the greatest demand increase over a two-month period since the peak of the Chinese oil demand shock in 2004. Investment flows into commodities accelerated again in Q4 with preliminary data suggesting inflows in November at their strongest since June this year. with those increased flows being the result of a period of lower prices and improving fundamental conditions. in those commodity sectors where either government stockpiling or commercial inventory rebuilding added significantly to domestic demand early in 2009. respectively. the notion that liquidity has been the most important direct driver of commodities this year is flawed. However. since then. Commodity demand has continued to improve in the past few months. as well as in some agricultural markets.5% y/y in October. demand for broad-based commodity exposure from pension funds and other asset managers has dominated. Chinese demand growth has averaged more than 0. especially soybeans. Its oil demand grew 11. not far off the peak of $270bn hit at the end of Q2 08. MTN-I.500 3. Barclays Capital Source: CFTC. demand growth for primary raw materials could slow quite considerably or even turn negative for a time.500 -500 Net outflow Nov-07 May-08 Nov-08 May-09 Nov-09 Net inflow US Commodity index-linked mutual fund flows Commodity medium term note issuance Commodity exchange traded product flows Figure 4: Hedge fund positioning in oil does not look overextended 140 120 100 80 60 40 20 0 -20 Dec-08 ICE Europe WTI NYMEX WTI Net non-commercial positions in crude oil futures ('000 lots) -2. taking commodity assets under management to about $250bn. A surge in demand for oil and gold exposure from smaller retail investors eased off fairly early in H1. Where liquidity is relevant for commodities is in the positive effect of easy fiscal policy and government stimulus packages on end-use demand.500 1. though liquidity is not the main price driver Our estimates suggest that investment in commodities via index swaps.

plus numerous strikes and some technical problems. Here y/y comparisons are starting to look better due to the weak base of comparison. Thailand and the Philippines is running some 210kbpd higher y/y whilst Middle East oil demand is accelerating. Taiwan. Russian growth is down to oneoff factors (especially tax incentives and the start-up of some new projects). In oil. and we doubt Mine production remains constrained OPEC is maintaining supply discipline and non-OPEC production outlook is poor Figure 5: China’s imports of key commodities continue to ease… 300 250 200 150 100 50 0 Oct-06 China's imports of selected commodities (indexed to Jan 2007) Copper Crude oil Iron ore Soy beans Figure 6: … but end-user demand remains strong.0 Oct-01 Chinese oil demand growth (y/y. with oil demand at highest since 2004 1. demand from India.2 -0.6 0. are now raising their production levels again very quickly.2 -0. there have as yet been very few restarts of previously idled capacity. We expect this momentum to gather pace in early 2010. almost 1m bpd above its strong Russian growth being the main driver. but there is little in the flow of data that points to much of an improvement in demand levels just yet.4 1. demand from India and Brazil is firmly in positive territory compared with year ago levels.6 -1. Anecdotal evidence from some base metals suppliers suggest order levels are improving. though there are some metals sectors in which we see output continuing to grow fast. We expect that to remain the case in early 2010. OECD demand recovery to gather pace in Q1 The main area of demand weakness for commodities remains the OECD. OPEC has continued to maintain a degree of supply side pressure despite the price recovery. mb/d) Oct-07 Oct-08 Oct-09 Oct-03 Oct-05 Oct-07 Oct-09 Source: China Customs preliminary data. Inventories were drawn down very quickly earlier this year when sentiment about the state of final demand was at its worst. A combination of producer caution over the sustainability of current higher prices. OPEC 11 production is now about 26. Commodity supply trends have been more mixed. notably in aluminium where Chinese aluminium smelters. mean that mine output for most base metals has stayed low and concentrate markets have remained tight. Barclays Capital 10 December 2009 34 . and they remain exceptionally low right through the manufacturing chain. Evidence suggests that consumers have been taking an extremely cautious approach to rebuilding manufacturing inventories and that this has kept OECD demand for industrial metals and the transport fuel needed to move goods around the developed world economies. and commodity demand in the OECD could surprise in the form of some very strong growth figures. In oil markets.0 0. while quick to shut down in late 2008. especially copper and aluminium.5mpbd. Nevertheless. Reuters. notably diesel. Barclays Capital Source: China customs. whilst premiums for prompt delivery have also firmed. In industrial metals. despite higher prices. at extremely low levels. and there are also tentative signs of improvement in diesel demand. Within the mining sector. with its aim being to keep prices below $100 and to keep above a bare minimum of $70. with growth in Q3 running at 260kbpd.Barclays Capital | Global Outlook Emerging market commodity demand is also strong outside China.

Barclays Capital 10 December 2009 35 . the spending cuts by major oil producers are likely to exacerbate overall non-OPEC decline rates. In the US. supply in neither market has been cut enough to prevent surpluses developing. The prospect of a further bout of food price inflation in 2010 cannot be ruled out since many of the factors that contributed to higher prices in 2007 and 2008 are still a feature of the markets. in our view. whilst the Brazilian sugar harvest has been affected by too much rain. natural gas switching from coal to gas for US power generation in early 2009 helped keep demand and prices high enough to discourage the supply reductions that were necessary. the world’s third-largest exporter. Barclays Capital Source: JODI. Global inventories are extremely low in a number of grains markets including corn and soybeans. the IEA estimates that capital spending cuts made in the past 12 months could add almost 400kbpd to global decline rates. In its latest World Energy Outlook Report. Though US natural gas supply is less constrained However. China’s demand is continuing to grow very fast. Supply problems have also been a key factor recently in agricultural commodity markets. and the constraints on its output (land and water shortages. Recent data show that big increases in gas directed rigs have taken the rig count back up to levels last seen in April when production had just begun to fall. the global picture for supply of energy commodities is far from uniform. Storage levels have hit record highs. Indeed. though market consensus is currently for another year of growth. The latest data for the UK for example revealed a steep 304kbpd y/y decline in September output. Poor monsoons in India have affected sugar output and required significant imports to make good the gap. and coal and gas prices have lagged a long way behind the recovery in oil. Unusually wet weather has also hampered the recent grains harvests in the US. Meanwhile. agricultural commodities markets have continued to underperform the recovery in other commodity sectors this year. With no OPEC to coordinate output decisions. plus the need to keep a large rural population Weather-related disruption is a common theme in ags markets Figure 7: OECD metals demand is lagging a long way behind the improvement in China 50 30 10 -10 -30 -50 -70 Oct-07 China Japan EU-15 United States Apr-08 Oct-08 Apr-09 Oct-09 Changes in regional copper demand (% y/y) Figure 8: OECD energy demand is improving though still negative y/y 3 2 1 0 -1 -2 -3 -4 OECD Non-OECD Change in global oil demand (Y/Y mb/d) -5 Oct 07 Jun 08 Feb 09 Oct 09 Source: ICSG. the largest fall in any month since November 2005. We suspect that in 2010 the trend of declining non-OPEC supply will reassert itself. resulting in an excess of LNG availability that we think will also help to constrain gas prices increases in the UK in 2010. The US corn harvest is still not complete while drought is slowing soybean planting in Argentina. decline rates in other mature non-OPEC countries continue to accelerate. but where there have been exceptions to this trend it has usually been due to weather-related supply disruptions.Barclays Capital | Global Outlook that it marks the start of a strong growth trend. to rebalance the market. In general.

Meanwhile returns for those investing at the front end of commodity price curves have continued to be constrained by high costs of carry. and/or the minimisation of cost of carry/rolling costs. These strategies have been the most successful this year with excess returns to date running at about 20.Barclays Capital | Global Outlook employed) mean import demand will continue to increase. compared with 15% for the standard DJUBS index.Q4 to date Precious metals Industrial metals Agriculture DJ-UBS S&P 500 Property Livestock Govt Bond Energy -5% Source: Ecowin. With most of the broad upward move in commodity prices now behind us. its exportable surplus is likely to shrink.5% for both. are doing better in slightly more diverse markets in Q4. We see the potential for a robust move up in OECD demand putting pressure on inventory levels in a number of commodity sectors. improvements in many market-specific fundamentals have assisted commodity investment benchmarks to slightly outperform other risky assets in Q4 so far. A positive macroeconomic environment. Figure 10: For index investors momentum strategies and those reducing high cost of carry have performed best QTD returns for selected commodity index strategies 4 Months Deferred Momentum Algorithmic long short Pure Beta Seasonal energy Pre roll Post roll (Total returns) Hedge fund replication 15% -6 Source: Barclays Capital. As Figure 10 illustrates. Moreover. HFRX Indices … but this is likely to change in 2010 Figure 9: Commodities have outperformed other risky assets in Q4 so far Returns of selected asset classes . Investors will also need to be alert to a possible tightening in spreads at the front end of commodity price curves. high oil prices are once again stimulating growth in competing demand for fuel. Those strategies that have been most profitable have incorporated some form of trend following approach. These strategies have significantly outperformed the standard indices. with momentum strategies outperforming by 1. we suspect that long-short strategies will perform much better in 2010. Barclays Capital Excess returns relative to DJUBS index (%) 0% 5% 10% -4 -2 0 2 10 December 2009 36 .5%. especially oil and base metals and so negative roll yields may not be the drag on returns at the front end of the price curves that they have proved to be in 2009. Long-short strategies. stemming from the contango structure. Import demand from the Middle East is also rising very quickly as incomes grow. minimising cost of carry have been best strategies for index investors in 2009… As has been the case through most of the year so far. which have underperformed in strongly trending markets for much of this year. However. the returns achieved by commodity index investors in Q4 09 have varied widely depending on the type of strategy adopted. Momentum strategies. This reflects strong performance in metals and agriculture markets more than offsetting the poor performance of energy and cattle sub-sectors. hedge fund replication strategies continue to underperform to a significant degree.7%. We expect a much more diverse range of performance between different commodity markets next year. rolling a four-month deferred position has outperformed the benchmark DJUBS index by 1. and our detailed recommendations for Q1 exposures by market are as follows. but perhaps more importantly. in sectors where it has traditionally been a net exporter (notably corn). especially for sugar and corn-based ethanol.

Base metals: Like precious metals. Any sustained pull back in prices as a result of a stronger dollar would be a very opportunity to go long. Precious metals: The risks to the upward trend in gold prices have increased. Corn inventories remain low across the world’s largest producerconsumers – the US and China. and there is a risk of lower Chinese import demand for some metals early in 2010. of which the bulk of the global refined product inventory overhang consists. If perceptions take root that the US Federal Reserve is falling behind the curve or that it is prepared to risk higher levels of inflation to not endanger the recovery. and we believe it has been pushed below fair value by market participants that have focused on high levels of LME stocks but have failed to take into account that much of the build had already occurred in 2008 and that. the outlook remains more mixed with an anticipated rebound in global production in 2009-10 from the world’s three largest producer-exporters: the US. which we expect to underperform relative to the rest of the energy complex. but we expect an increase in line with recovering economies. we think that a short position in silver is the best way to position for weakness in precious metals stemming from an end to the dollar weakening trend. in our view. The US has planted record acreage to soybeans. in our view. A recent switch in investment activity to futures markets as purchasing of exchange-traded product buying has slowed. with corn our preferred exposure. and this is now the fastest growing end-use sector. however. There are already signs that this process is underway with non-OECD Asian distillates demand turning strongly positive in September. not just for gold but for precious metals more generally.Barclays Capital | Global Outlook Energy: Price upside to oil depends on further improvements in the flow of oil demand data. more recently. Agriculture: Overall. Meanwhile. Another positive is that China’s trade balance in corn continues to reflect increasing imports and decelerating exports after decades of it having been a large net exporter. we have a constructive view on the grains complex. Although this link has weakened as the importance of China has grown. and in 2010. we are bearish on US natural gas prices. An end to the dollar’s recent weakening trend that has been a key factor in gold price strength would therefore be a major setback. off-exchange consumer and producer stocks have been falling. Production has not fallen fast enough this year. In contrast. production has been hard hit by strikes and other disruptions recently and raw materials markets are very tight. Base metals prices have traditionally been strongly correlated with OECD industrial production trends. With a significant overhang of speculative length in futures markets and extremely weak supply and demand fundamentals. if that is a result of better-than-expected US economic data. then gold prices should continue to rise. in our view. For soybeans. and we expect manufacturing inventory rebuilding to provide a strong boost to diesel demand in Europe and the US in Q1 10. gold’s upside potential will greatly depend on the extent to which nascent inflation fears crystallise into more serious concerns over the next 12 months. Animal feed demand has been the weak link. as this is the level at which investment will slow significantly. while we expect higher 2009-10 Southern Hemisphere output 10 December 2009 37 . Our most favoured short-term exposures in base metals are copper and nickel. gas is unlikely to get the same kind of positive demand boost that it has gained this year in displacing coal in US power generation. suggesting that the risk of liquidation has grown since futures holders tend to be less committed than ETP buyers. Price downside looks limited below $70. especially demand for distillates. Further ahead. Copper inventories relative to consumption are lower than for any other base metal except for lead. rising oil prices have improved ethanol margins in the US. base metals are exposed to the risk of an end to the trend of dollar weakness early in 2010. Nickel has been the weakest base metal in the complex recently. we think US inventory rebuilding of manufacturing inventories should still be enough to provide fresh upward momentum to overall demand and prices. then price softness should not last for long or be very deep. Brazil and Argentina.

Buy the March 2010 Henry Hub natural gas futures contract and sell Jan 2011. However. market focus is likely to turn again to the demand side. China has recently announced plans to rebuild soybean stocks again. Figure 11: Key recommendations Market Energy Key forecasts We see continued improvement in oil demand. offsetting weaker China demand in the months contracts. ahead. With Brazilian supplies onto the global market dwindling as its harvest approaches the tail end. Sugar is also benefiting from higher oil prices. with silver the most vulnerable to a phase of long liquidation. Recommendations Buy the May 2010 NYMEX Crude oil futures contract. imports have fallen off in recent months. Buy the March 2010 ICE sugar contract. We are also positive on sugar after recent supply problems. US natural gas prices look overvalued further forward and we advocate a curve flattening position. we see a recovery in import demand underpinned by strong economic growth. and. stimulating stronger demand from the ethanol industry.Barclays Capital | Global Outlook in the wake of a pickup after this year’s drought-ridden production. Precious metals are highly exposed to an ending of the trend of dollar weakness. especially for diesel as providing some further limited upside to oil prices. Precious metals Agriculture Buy the July 2010 CBOT corn contract. Strong demand from the ethanol sector and a recovery in feed demand should boost corn prices. especially from India where import demand continues to grow due to its own poor harvest. The market is midway through the second consecutive harvesting year in which the sugar market has been in substantial deficit. Sell the May 2010 COMEX silver futures contract. Source: Barclays Capital 10 December 2009 38 . After buying to rebuild stocks in early 2009. Industrial metals Metals are poised to benefit from OECD inventory Buy the June 2010 LME copper and nickel rebuilding. China remains the key demand dynamic in the soybean market and a source of upside risk. and inventories have been run down sharply. looking into 2010. providing a solid basis for further price gains.

The USD will be supported by US growth outperformance in H1 Figure 1: Labour productivity growth (y/y) Figure 2: Net issuance of Treasury and agency securities and corporate bonds and after Fed purchases (annualized) $bn 3.Barclays Capital | Global Outlook FOREIGN EXCHANGE OUTLOOK The return of two-way risks David Woo +44 (0) 20 7773 4465 david. 2010 should see the greenback doing better as elevated USD risk premium diminishes.000 2.woo@barcap. it will do better in 2010 as some of these factors become USD neutral or even positive. Commodity currencies should have one more leg up.000 500 Q1-94 Q1-97 Q1-00 US Q1-03 Q1-06 Q1-09 0 Q1-00 Q3-01 Q1-03 Q3-04 Q1-06 Q3-07 Q1-09 net issues of securities and bonds net issues net of Fed purchases Source: Barclays Capital Germany Source: Barclays Capital 10 December 2009 39 .500 % 6 4 2 0 -2 -4 Q1-91 2. Improved prospects for the USD The USD will do better in 2010 2009 has been a perfect storm for the USD. While GBP’s upside risk remains elevated. The abatement of general global risk aversion and the relative US monetary/fiscal policy stances contributed importantly to the sharp decline of the USD. The dramatic recovery of US labour productivity growth (Figure 1). we expect US growth rates to significantly outstrip the euro area and Japan in H1. In our view. but investors should look for more diversified and low volatility exposures.500 3. should lead to a faster recovery in job growth. we are not forecasting a major USD rally (which would require an aggressive Fed tightening cycle. or a major financial crisis). its downside risk has grown. As a starting point.com The phase of the strong trending market is coming to an end. That said. a structural shock like the IT revolution. What we are looking for is a limited USD rally that will play out largely during H1 10.500 1. Although we cannot be sure that the USD has bottomed. This bodes well for GBP vol. Growth in the euro area and Japan will likely also be held back by the sizeable appreciation of their currencies against the USD in 2009. Japan’s latest policy response to the appreciating JPY will help reduce the perception that USD/JPY is a one-way view.000 1. in absolute and relative terms. the effect of which will only be felt fully in H1 10.

While it is difficult to say from where the increased risk premium will come. 2009): The Fed asset purchase program dramatically reduced the supply of fixed income securities the market had to absorb in 2009 (Figure 2). Although it is impossible to know for certain the final outcome. When the program ends. Second. This should benefit the USD. since the unemployment rate is likely to remain high for most of 2010. Moreover. the next Fed hiking cycle is likely to be less linear and more gradual than previous ones. we argue that with the USD near its multi-decade low. a weaker USD. US relative fiscal position will improve in 2010 We have argued for a long time now that relative fiscal position plays a critical role as a determinant of the USD. With the unemployed in Europe eligible for government assistance for longer than in the US. compared with $2. then the monetary policy is effectively tightened. In the past decade. the USD’s risk premium has tended to fall during periods of underperformance of risky assets. It is probably not an exaggeration to say that other countries with tighter policy at the short end have experienced some effective easing at the long end because of this. the market will have to pick up the slack and absorb the near record issuance in the pipeline. given our expectation for the start of fiscal tightening in 2011. An end of the program will likely cause long-term rates to go up globally.3trn in 2010. the dramatic deterioration of the US budget deficit was a key driver behind the USD depreciation in 2009. the fiscal cost of supporting high unemployment in Europe will remain higher for longer than in the US. We see the end of the Fed’s asset purchase in Q1 as effectively a tightening of monetary policy. However. This can come in the form of higher yields on US fixed income securities or. for that matter. third and fourth effects should dominate the first. There are two reasons for this view. The first has to do with the automatic stabilizer. So what is the outlook for relative US fiscal policy in 2010? Our economics team is forecasting a relative improvement of the US fiscal balance vis-à-vis the euro area and Japan. Our US fixed income team forecasts that total net fixed income supply will still be $2. November 27. the USD risk premium is already quite high. This could reduce the relative risk premium investors require to hold more US assets. If the market views the end of this program as removing an open-ended commitment to maintain very low long-term interest rates. we are inclined to believe that the second.7trn in 2009 (and the $960bn the market has to absorb in 2009).Barclays Capital | Global Outlook End of the Fed asset purchase program should be good for the USD Despite our upbeat forecast for the US in H1. which should lead to an increase in long-term real yields. What would be the effect of the end of the Fed asset purchase program on the USD? We think there are at least four separate channels to which investors need to pay attention (FX Weekly Brief: The case for a stronger USD in 2010. This repricing of discount rates could be negative for risky assets. An end of Fed asset purchases will likely lead to an increase in nominal and real interest rates. but the approach of the crucial mid-term elections 40 10 December 2009 . begins draining excess liquidity from the system. for foreign investors. which may highlight the vulnerability of some of the economies that are either dependent on US growth or sensitive to interest rates and lead them to adopt looser policies than they would otherwise. The market presumably will require an increase in risk premium to do this. we do not expect the Fed to start hiking rates until Q3. The program has driven long-term rates lower globally. and the USD could benefit from its safe-haven status. we believe US monetary tightening does not have to wait until the Fed starts raising short-term interest rates or. Moreover. the recent elections in Japan and Germany have brought in governments promising increased government spending and lower taxes.

This is evidenced by the fact that the rally in US Treasuries since September (which led to a significant reduction of the interest rate differential between the US and Japan) accounts for most of the move in the USD/. and the chance for it to resume a depreciating path is increasing.9 0.Barclays Capital | Global Outlook in the US next year is likely to limit any further loosening of US fiscal policy.5 1.6 0. the fiscal outlook in 2010 should be supportive for the USD against the EUR and the JPY.1 1.3 0.5pp of GDP. we expect the gap between the two to shrink nearly 2. We have an end-2010 forecast for USD/JPY at 100. From this point of view. While the absolute level of the US budget deficit will still be higher than the euro area’s. In sum. but the appreciation of the JPY against the USD should be seen as a reflection more of USD weakness than JPY strength. modification of this rule is possible if it becomes necessary to limit further JPY appreciation.8 1. The monetization of Japan’s chronic large budget deficit is potentially very negative for the JPY. which is the most interest rate-sensitive cross among the major currencies. the market has begun to consider seriously the possibility that the BoJ will increase its monthly outright purchase of JGBs. We forecast that Japan’s budget deficit will exceed the US’s next year. upside risk for the JPY has fallen. the outlook of the USD/JPY. While it is not clear whether the injection of Y10trn of short-term liquidity will be sufficient to alter sustainably investors’ perception of the relative expected returns between holding the JPY and the USD (Figure 3). The BoJ’s decision to introduce a new liquidity-supplying operation helped reverse the JPY’s direction early in December. To the extent that we are looking for a stronger USD in 2010 as the result of relative US monetary tightening. the recent action of Japanese policymakers appears to have changed the balance of risks. Recent policy response to prevent further JPY appreciation may be just the beginning Figure 3: BoJ needs to catch up with Fed – Monetary base in US and Japan USD trn 2. depends more on the general path of the USD than on Japan-specific factors.0 Jan-89 Jan-93 Jan-97 Jan-01 Jan-05 US Monetary Base (LHS) Japan Monetary Base (RHS) Source: Barclays Capital Figure 4: Commodity currency current account balance JPY trn 210 180 150 120 90 60 30 0 Jan-09 USD bn 20 15 10 5 0 -5 -10 -15 Jan-85 Jan-89 Jan-93 Jan-97 Jan-01 Jan-05 Jan-09 Source: Barclays Capital 10 December 2009 41 . at least in the short term.2 0. should move higher over the course of the year. Although the precise timing of when USD/JPY will begin its sustainable upward march is still very uncertain. In this respect. USD/JPY. JPY: Turning point? Outlook for USD/JPY depends more on the USD than the JPY The recent collapse of USD/JPY to near its two-decade low made a lot of noise.JPY spot rate and that EUR/JPY has been trading within a tight range since March. While it set a self-restricting limit for JGB purchases up to the amount outstanding of currency issuance.

especially if liquidity holds up. The February Inflation Report is likely to be crucial for GBP prospects. The UK’s debt position is not as serious as that of some others in the G10. We think this is likely to continue until year-end. First. We think it is more likely to appreciate significantly against the EUR. given the low foreign ownership of JGBs. Large fiscal deficit and political uncertainty could keep investors away from the GBP Positive correlation between GBP and risky assets is likely to return in 2010 10 December 2009 42 . However. Nevertheless. It has the largest deficit of any of the G10 economies and faces an imminent general election. A further increase of asset purchases in November made UK policy more of an outlier relative to the rest of the G10. We think the fiscal woes are overstated relative to those in other economies and that this will become clearer over time. the GBP could increasingly be used as a funding currency for the carry trade and concerns may grow that the UK will allow some monetization of the fiscal debt. Other uncertainties abound. especially if a very close result in the election becomes more probable. it would be easy for concerns to mount that the authorities are not willing to take the difficult measures necessary. The UK faces two big problems on this issue. Since the Democratic Party of Japan (DPJ) took office in September. It has been range-trading in recent months against the USD and EUR. it will likely trigger significant JPY depreciation. If this persists while other G10 central banks join the RBA and Norges Bank in tightening policy. However. are likely to become an increasingly important issue for FX investors.to medium-term outlook for the GBP has become markedly more uncertain over the past quarter. but the fiscal deficit is so large that a significant tightening of policy will be necessary over the next parliament. all of which have starkly different potential outcomes. Third. Will the global recovery continue? Or does the sharp fall in liquidity following the Dubai World shock presage more deterioration in trading conditions? Just what state is the UK economy in: does the improvement in most surveys mean that the recession will end in Q4? How much did the longer-run fair value of the GBP fall during the financial crisis? All of the issues which matter most for the GBP appear to be unusually uncertain. The most important is whether the Bank of England's MPC will persist in its current policy stance. This seems impossible without controversial measures being announced. in our view. investors have begun to fear a further deterioration of fiscal conditions. it has been one of the more activist central banks. There are several crucial issues. This has led to a widening in Japan’s sovereign CDS spread. If so. they are linked) could cause another aggressive sell-off. there are several reasons why the MPC may change its stance surprisingly quickly. If its sovereign credit rating is downgraded.Barclays Capital | Global Outlook JPY will be vulnerable to Japan’s weakening fiscal position A market theme that is likely to become more prominent in 2010 is the relative fiscal policy stance and sustainability of debt dynamics. as well as mounting pressures from politicians to increase spending to stimulate the economy. a likely outcome is that inflation may continue to surprise to the upside relative to growth. Fiscal concerns are mounting for the large developed economies and. which means that the election campaign is likely to be highly contentious and the UK fiscal position will be in the spotlight. the Inflation Report forecasts of strong growth but little upside pressure on inflation appeared optimistic and may prove wrong. fiscal worries or higher commodity prices may lead to longer-run yields picking up. Heightened uncertainty for the GBP GBP’s outlook is clouded The short. many of these issues will be resolved and the GBP could move a long way. relative both to the past and to other currencies. Second. The market generally thinks that this will be the last increase but that policy will be on hold for a considerable period. But come next year. we think the probability of a JGB or JPY crisis in 2010 is low. but a reduction of the credibility of either fiscal or monetary policy (or both. due to the increasing revenue shortfall from the sluggish economy. in our view.

Commodity currencies still have room for gains Commodity currencies may have one more leg up G10 commodity currencies have appreciated significantly over the past six months. First. For example. the CHF crosses of the AUD. therefore. However. This appears to us as mispriced. Three. We are concerned that precautionary buying of commodities as a hedge against inflation or further sharp USD drops may push commodity currencies to levels that place unsustainable pressures on the profit margins of commodity consumers. But we think that the global economic recovery will continue in Q1 and remain driven largely by EM Asia and. On a vol-adjusted carry basis. Why the CHF? The SNB’s intervention makes its vol cheaper relative to JPY. The trade costs approximately 70bp less than a third of any individual call versus the CHF. we do not think that normal valuation standards will prevent G10 commodity currencies from making further gains because the financial and economic shocks that typically terminate a commodity price cycle are unlikely to happen in the next few months. they remain inclined to use policy to mitigate the effects of any incipient economic and financial shocks. We continue to think that the improvement in activity and the US economy will keep demand for commodity currencies firm.Barclays Capital | Global Outlook For all these reasons. However. We still see central bank determination to encourage the recovery as supporting further gains in commodity currencies in the coming months. implied vol for GBP/USD trades at only a modest premium over EUR/USD. NOK and CAD represent better value than their JPY or USD crosses. the recovery in global growth could falter and a sell-off in commodities occur. If anything. will also likely remain a positive for commodity currencies going into 2010. we do not think we are close to that threshold yet. which are the other QE currencies to consider for the trade. The specifics are to be long the worst performing of the AUD. the SNB could end its policy of FX intervention. the Swiss franc TWI is at relatively high levels historically and the SNB is unlikely to move tighten policy ahead of the ECB. However. as Swiss inflation remains subdued. we think vol is better than spot as a way to trade the GBP. Valuation is not as stretched now as in 2008 Investors should look for diversified and low-volatility exposures to commodity currencies Investors need to manage downside risks more carefully than in 2009 10 December 2009 43 . so we do not expect a major pullback in commodities. CAD and NOK against the CHF on a threemonth horizon. There are several risks to our trade. By PPP standards. which we expect to remain on hold throughout 2010. they are more than 20% overvalued on average and collectively their Q2 current account deficit was the highest since mid-1999 (Figure 4). The continued brisk pace of economic expansion in Asia. We would recommend going long commodity currencies via a ‘worst of’ trade. We think that this is unlikely. we do not think the Fed is near to raising rates or doing anything besides signalling less buying. especially China. The Dubai World announcement was a reminder of how quickly investor sentiment can turn. Second is a general sell-off in risk and a CHF rally. EUR or USD vol. commodity intensive.

although we suspect it may not materialise before the end of Q1 10. On one side were concerns about asset bubbles (including warnings by some central bankers) and fears of rising inflation (seen in commodity prices. rate markets have sold off strongly only 3 to 6 months before the start of the tightening cycle in most markets. due in particular to QE-related buying in the US and UK. In short. with yields in most maturities essentially range trading and being less volatile than they had been earlier in 2009. Markets were driven by economic data and the vagaries in risky assets (which have done little in Q4). we believe rates are asymmetrically biased higher from their current historically low levels. Rate markets had a mixed performance over the past quarter. we have revised our rate forecasts lower across the board compared with the September Global Outlook. or Q2 at the latest. and it is only a matter of time before they move up once again. and until then. as abundant liquidity conditions and the support of QE buying for bond markets are fading away. Historically. with markets basically flying solo from Q2 10 onwards. with headline inflation ticking higher as well. probably until a bit later than when the big backup at the short end takes hold. by 30-50bp on average. it likely will not prevent a move up in rates. the net supply picture will change dramatically once QE buying stops in the US and UK. the flattening might occur even later. however. Even if the timing of the sell-off is uncertain. In 2010.morita@barcap. the current range trading environment might prevail. While banks’ purchases of government paper (for carry or liquidity purposes) likely will remain a supportive factor in early 2010. and will likely prompt central bankers to talk more about removing the current very large monetary policy stimulus. Yield curves will likely stay steep for some time. we see wider spreads in the euro area. and a re-tightening of swap spreads in the US and UK. rates investors still spent the quarter caught between two camps. This would lead more people to expect central bank tightening over the subsequent 6 to 12 months.com Chotaro Morita +81 (3) 4530 1717 chotaro. we would not expect a large flattening in the curves before Q2 onwards. Given our expectation that the Fed and the BoE will start hiking rates in Q3 10.Barclays Capital | Global Outlook INTEREST RATES OUTLOOK Asymmetrically biased higher Laurent Fransolet +44 (0) 20 7773 8385 laurent. 44 10 December 2009 .fransolet@barcap. and risk appetite in the past few months has been limited. For the US. Overall. and persistent supply versus demand imbalances.com Rates are biased asymmetrically higher going into 2010. as the terming out of the debt by the Treasury will be an additional negative for the longer end. so that the marginal impact of such bank buying is likely to be much more limited than it has been for most of 2009. the economic data are also likely to have improved and shown that the recovery is self sustaining. Fixed income investors have had a “good year”.rajadhyaksha@barcap. but were generally underpinned by strong liquidity. By that time. we expect a large back-up to take place around the end of Q1. with fewer flows as well. Hence. but the message remains the same: from here rates are asymmetrically biased higher.com Ajay Rajadhyaksha +1 212 412 7669 ajay. A large back-up in rates is on the cards across maturities and currencies in 2010. Markets will have to do without QE in 2010 Rate hike expectations likely to build further and lead to a selloff probably by the end of Q1 10 US: Time to make a decision Financial markets have been unable to make up their mind… The fourth quarter of 2009 was a far cry from the fourth quarter of 2008 – and thankfully so! While markets were far quieter than a year ago. liquidity support from QE will gradually fade away.

However. T-bill supply has turned negative. On the other hand. the Fed has been a big buyer of fixed income securities in 2009. That should change from Q2 next year. Meanwhile. 2s have been helped by risk aversion and the lack of short-term paper. market sentiment about the economy. we expect rates to rise throughout 2010. supply. We expect rates investors to make a decision in 2010 – the argument should be settled in favour of a stronger recovery in 2010. 10s are a different matter – we expect the 10y yield to stop rising in the fourth quarter as Fed hikes dampen inflation expectations. Flattening of the curve likely to come in Q4 10. That is why we have the 10y rising to only 3. a growing Fed balance sheet and a weak labour market exerted a strong gravitational pull lower on yields. the first quarter should see only a mild rise. That should change in the fourth quarter as 10s find support even as 2s keep rising. one factor supporting yields will be the continued growth in the Fed’s balance sheet until next March. We expect very few changes in the 2s/10s yield curve until Q3. Supply-demand imbalances will be more acute in 2010 Supply-demand imbalances will obviously play a role. The economy should keep growing in Q2 as well. as bills keep shrinking. But given our forecasts for the economy to grow at 5% in Q1 10. Then we incorporate Barclays Capital’s models for term premia at key points along the yield curve. the risk/reward at the 2y point is now asymmetric and biased in favour of a move higher in rates. Recent statements from FOMC officials suggest that when the Fed does start hiking. These variables include liquidity. Consequently. Regardless. a bit later than typical 10 December 2009 45 . with November’s payroll data perhaps the first shot across the bow of bond bulls. The 2y point is very vulnerable (even though 2y yields sold off following payrolls). The term premium captures the sensitivity of rates to key variables over and above what they would be based purely on the expected path of fed funds. and foreign demand.7% in Q1. the rise in rates should be muted in Q1. the expected strength of the economy and related Fed policy changes should be a major factor in rates across 2010. Coupon issuance in Treasuries should peak next year even with a smaller deficit. but continued growth in Q2 is likely to make most take notice. Some investors might dismiss Q1 as isolated. Even then. the 2y point typically reacts strongly to the start of hiking cycles and this time is likely to be no different.7%. We use the expected path of fed funds as the first step.1% and 3. another factor behind our forecast. Our economists disagree – they expect the Fed to take a break from hikes in the first half of 2011. volatility. What will drive rates higher in 2010? In general. the Fed is likely to start the process of draining excess liquidity in the third quarter. respectively. it could do so more quickly than in the past. That plays into the sustained sell-off we expect in the second and third quarters. The $1. Finally.7trn in buying power from the Fed is a big hole to fill.Barclays Capital | Global Outlook the USD and inflation breakevens). and commercial paper and agency discount note supply has been dwindling. with 2s and 10s finishing Q1 at 1. probably a few months before it starts raising the funds rate. we make subjective adjustments for factors where historical betas are difficult to quantify (such as a sudden expansion of the Fed’s balance sheet). with the curve staying quite steep. Rate forecasts: A steep 2s/10s curve for much of 2010 … but that should change slowly during 2010 As the rate forecast table at the end of this section shows. But with the Fed still growing its balance sheet. even as supply remains high. Rates should start rising in Q1 largely due to a reversal of year-end risk aversion. The fourth quarter should herald the start of curve flattening in 2s/10s as the Fed hikes. our models expect the 2s/10s curve to still stay steeper than forwards are pricing in. Finally.

inflation should stay muted. Non-agency RMBS securitisation is non-existent. but short of fears of a hyperinflationary spike in bond yields. real yields should also rise next year. November had the first new issue CMBS TALF deal. For details on the supply-demand trade-off in 2010. Finally. Barclays Capital 10 December 2009 46 . Another pet peeve for the rate bears is concerns about hyperinflation. While the bulk of increases in secondary market prices occurred in Q3. US households and foreign investors. But for those who believe that private buying in 2010 will be much more than $1. Hence. Barclays Capital Source: MBA. 13 November 2009. Unfortunately. residential mortgage credit has shown no similar signs of thawing. with strong demand from banks. They point to the cash waiting on the sidelines from many types of private investors. but not more so than we expected. which generated strong investor response. as we show in “Real yields: Bubble to deflate. the strongest argument for bond bulls is simply that any recovery will be very weak.7trn in Fed buying in 2009. We strongly disagree. Non-agency fundamentals (defaults and severities) have continued to worsen. Rates markets should show a similar pattern – with rates rising more than forwards are pricing. Moreover. The weak dollar and rising commodity prices are often used to bolster this argument. And while technical factors can matter for a while. and even in agency MBS. there are risks – on both sides. especially since even our own economic calls are less bullish than history warrants.Barclays Capital | Global Outlook Running with the bond bulls – Or fighting the bond bears? Economic fundamentals should push yields higher across 2010 As with any forecast. History shows that it is difficult for hyperinflationary fears to gain ground while actual inflation prints are low. published in Market Strategy Americas. it is unlikely that inflationary expectations will come unhinged and push yields sharply higher. Figure 2: Tighter mortgage credit = weak refinancing 10000 Figure 1: Mortgage credit has tightened in agency MBS 770 760 FH 30yr 750 740 730 720 FN 30yr 8000 MBA Refi Index 6000 4000 2000 710 700 03 04 05 06 07 08 09 0 02 03 04 05 06 07 08 09 Source: Fannie Mae. but primary issuance is a mixed bag Securitised markets continued to show slow improvement in Q4. the fundamentals should ultimately win. This will help offset the loss of Fed buying. Alphabet soup – TALF. not pop”. at least in 2010. FAS and other developments in securitised markets Asset prices have rallied in every securitized market. Meanwhile. But with the jobless rate likely to stay above 9% through the end of 2010. most types of MBS held on to their gains in Q4. The bearish camp might wonder why yields should not rise more given the loss of Fed buying. But there will be offsetting demand factors. 4 December 2009. Market Strategy Americas. but in our view will not be enough to push yields lower on a sustained basis. the numbers simply do not add up. the bond bulls have their own set of arguments. Freddie Mac. even as breakevens could make further headway next year. Strong demand from private investors is definitely a positive. see “Treasuries: A lot more support than apparent”.

Commercial mortgage losses are likely to pick up next year. the MBA refinancing index is very muted compared with history (Figure 2). 47 It is unlikely that the ECB will be looking to actively push EONIA higher 10 December 2009 . from its current 35bp. but will instead rely on what it recently announced. Home prices in the US have stabilised over the past five months. accounting changes under FAS 166/167. a look at the housing and the securitised landscape leaves us with the following sentiment: While there is unlikely to be a magical change in loss forecasts or a big jump in origination in 2010. losses are “baked into the cake”. the systemic risk due to the securitised and housing markets should be the lowest it has been in many years. Finally. Fortunately. But at those levels. Meanwhile. On the non-agency side. More importantly. and we expect the CMBS world to stabilise only in the second half of 2010. While this transition away from non-conventional measures is being implemented. but risk premiums still have room to shrink. in a way. and the market consensus of a first hike in September (followed by one in December) will likely prove misplaced – we see the first hike only in Q1 11. Euro area: The flight path to normalisation The ECB exit strategy: moving back to normal by Q2 10 On December 3. we believe the end of Fed purchases does not pose a significant risk to the agency MBS market. the ECB will be gradually reverting to its pre-crisis open market operations and procedures. All in all. any nonagency securitisation should be a big boost to sentiment in RMBS. FHA (and the related GNMA program) has faced charges of being too cavalier in its underwriting practices and has now tightened credit as well. and relatively early in the year. This also shows up in MBS refinancing – or lack of it. Figure 1 shows that average FICO scores (credit scores) for loans guaranteed by Fannie Mae and Freddie Mac have gone up sharply in the past nine months. due to be implemented next year. maybe earlier. there likely will be enough liquidity in the market to sustain a low EONIA until at least April and probably June. Non-agency primary issuance has a good shot at re-starting in 2010 – while volumes are likely to be small. agency MBS is unlikely to be affected. should make private label securitisation of credit cards more expensive. a flight path for 2010. our forecast calls for a further 8% fall in prices from current levels. even if it keeps the flexibility to stick with full allotment on the weekly MROs. Losses should be 8-15% for CMBX 1 to 5 series and much higher in construction loans. Essentially. the tail risk of a further massive decline in prices is now very low. as will the foreign exchange operations the ECB has been conducting. the ECB is likely to shun any official rate hikes. we believe agency MBS spreads will widen 20-30bp from current levels when the Fed finishes its purchase programme. By the end of Q1 10. with the trough in Q2 10. Despite record lows in mortgage rates. While this will mean that bank loan losses remain elevated.Barclays Capital | Global Outlook credit has tightened steadily. Consequently. We believe these measures should be sufficient to bring liquidity conditions back to normal. the ECB presented its exit strategy. We believe the ECB will not want to drain additional liquidity from the market. money managers and foreign investors. In our base-case scenario. suggesting a tightening in mortgage credit. We believe the end of Fed purchases does not pose a significant risk to the agency MBS market So what does 2010 hold? In secondary markets. probably by the end of September 2010. we like non-agency MBS relative to other higher-risk alternatives such as high yield corporates. While we expect a mild decline over the next few months (starting with the S&P/Case-Schiller report released in December). all of the additional LTROs will be phased out (leaving just the regular 3m ones). the ECB likely will move back to variable rate tenders for these (after the last 6m one on March 31). and it is only afterwards that EONIA will start moving up towards the refi rate of 1%. Hence. CMBS always lags an economic recovery. there should definitely be strong buying – from banks. since the GSE regulator has anyway waived regulatory capital rules.

The arguments for cross-market outperformance of euro rates are more finely balanced as well. in particular versus the US. and that the money market curve steepens up until the first rate hike. euro short rates should thus continue trading in their range of the past nine months into Q1 10. and while we would stick with it going into 2010. This is leaving euro 5y5y forward rates looking rich versus fundamentals (fair value is about 4. While the potential for a back-up in rates at the longer end is probably more limited than in the US or the UK. historically. on any retightening of.Barclays Capital | Global Outlook Range trading still likely at the short end.15%. we would re-initiate these spread trades. outright or versus the first year of the curve. This has been one of our preferred trades over the past 12 months (especially in 5y5y forward maturities). This is consistent with the fact that. big sell-offs at the short end start about six months before the start of monetary policy tightening in the euro area. Following the December ECB press conference. The current relative richness of medium. we believe the current entry levels for long euro versus short US trades are not attractive (euro rates look as expensive as US rates on our valuation models. with the post-5y forwards still our preferred maturities. Our preferred position remains to be short reds (2011 rates) and greens (2012 rates) in particular.04 x + 29. with these ranges moving up 25bp in both Q1 and Q2 10. and look a bit stretched on a tactical basis. We do not think that the time for the typical big bearish-flattening trend is ripe yet. but not much before the end of Q1 10 Figure 3: Range trading still. with the curve flattening heavily in 2s/10s and 10s/30s. with an upwards bias in the range (as progressively more rate hikes are being expected): we see fair value for 2y swaps at 1. However. in Q1 10. but the range will be moving higher. at least on an outright basis. the short end will be driven less by monetary policy signals from the ECB as such than by liquidity conditions and (rising) medium-term global rate expectations (euro and US post-1y rates tend to be very highly correlated). about 25bp. Rates at the longer end of the euro curve have performed well in Q4 09.65-2. as the supply-demand equation has not really been distorted by QE buying and inflation expectations (and inflation uncertainty) should remain contained. if anything. we would rebuild these short and steepening positions. given what the consensus of economists is expecting: there is currently little or no term premium reflected in these maturities. the current pricing of post-1y rates is very expensive. Note that on market expectations. say. especially in post-15y maturities). this argues against being long that part of the curve.89 Source: Barclays Capital Source: Barclays Capital 10 December 2009 48 . and we are at the bottom of it Therefore. we would expect the Post-5y rates have done very well: they now look expensive outright and fair versus the US Curve flattening is the theme for 2010. Rather. but risks heavily skewed 6 5 4 3 2 1 0 Jan08 Jul08 Jan09 Jul09 Jan10 EUR 1y1y USD 1y1y EUR 5y5y USD 5y5y Figure 4: JPY 2y5y spread and 5y10y spread (bp) 120 100 80 60 40 20 0 0 20 40 60 Oct02/Jan05 Jul06/Sep08 2y5y spread 80 Mar05/Jul06 Dark blue: Sep08 onwards 5y10y spread y = 1. in contrast to what happened in the US (but both were in line with our expectations lasting the September Global Outlook).20 R2 = 0.to long-end euro forward rates is also leaving the curve looking relatively flat. Essentially.75%) for the first time in quite a while. close to the bottom of its range since May.

so we would expect some strategic underperformance of the 15y sector in cash and asset swap space versus the longer end of the curve. We retain a more positive outlook for longer-dated spreads. but by less than 30bp on average.1bn. We would expect the curve to come under bear-flattening pressure out to the 15y sector. we would look for a move of around 20-25bp flatter. as economic sentiment improves. and so represents poor value and is vulnerable to a bearish correction. as in the run-up to the next election (June 10 at the latest) there is likely to be more attention paid to the government’s commitment to ongoing fiscal austerity. which is typical of what is observed in the run-up the first hike in previous BoE rate tightening cycles. around 15-20bp higher than current levels at the time of writing. thus. if anything. we see spreads in the 5-10y sector as most vulnerable to correction. Overall. as on any cheapening. not tightening. perhaps. so say around the end of Q1 10. if not a bit later. policy BoJ still on the easing path The BoJ unexpectedly eased monetary policy on 1 December as JPY appreciation stoked concern about the outlook for the economy and prices. we believe there will be better opportunities to position for this. especially in cash space. without QE BoE to stop QE in January and hike rates in August We expect the BoE’s quantitative easing programme to cease after January’s reverse operations. Therefore. UK: The impact of supply. This is particularly important given the focus on the UK’s AAA sovereign credit rating. 2s/10s has traded in a 30bp range since May 2009. we have revised our rate forecast lower across horizons and maturities compared with our September Global Outlook.Barclays Capital | Global Outlook current range trading to continue until. So. Most recent data revisions suggest that the Q3 09 GDP number will be revised higher. we expect 2y gilt yields to push back towards 1. so it seems clear to us that an aggressive steepening from here – absent a large inflationary shock or changes to the BoE’s reserve remuneration policy – is remote. On the curve. with the MPC then moving to a more neutral. we would expect there to be relatively little mechanical support for the front end of the gilt curve in the first half of the year. even if the recent flattening there could actually continue in Q1 10. Our view is similar in post-10y maturities. giving the MPC more confidence that a recovery is close.30% by the end of the quarter. With FY 1011’s £15bn of redemptions only commencing in June. This is because UKT 5% Mar 2025 (£22. We would look for 2s/10s to flatten around 15bp in cash space. While we are biased towards flattening in the medium term. Flattening of the sterling curves likely in Q1 10 Fiscal consolidation coming to the fore The market will also place an increased focus on fiscal policy. In swaps. as the combination of supply and the end of QE already will likely have placed it on the back foot. roughly 9% of the index float) falls out of the closely tracked +15yr Index on 7 March 2010. amid expectations that the Japanese economic 49 10 December 2009 . The weight of long positions in the front end leaves it vulnerable to further bearish correction. Yields were already vulnerable to downward pressure across the curve. we would expect 2s/10s to come under flattening pressure in Q1 10 as the market begins to price a more aggressive rate profile for the Bank of England. Japan: Easing. Overall. Into the index event. Any perception that the rating will be lowered would put asset swap spreads across the curve under further pressure. we would expect continued buying from institutional investors. “wait and see” mode prior to ultimately commencing its tightening cycle in Q3 10. after short-end rates really start to move up in earnest. real money index-tracking investors will sell the bond and extend out on the curve. The front end of the GBP curve on an outright basis is still populated by longs and carry-based strategies.

the balance between the relatively flat 2y5y sector and relatively steep 5y-longer sector could be sustained to some extent. we would build flattening exposures. and a further narrowing of spreads. at times when the yield curve comes under steepening pressure due to temporary swingbacks in share prices or exchange rates. However. we believe the yield curve is unlikely to steepen due to pressures related to supply. the regression line for the past year has shifted slightly lower than the one during 2002-04. however. In that case. In this sense. this could be described as an anomaly. however. The yield curve has moved back into QE mode At present. especially in the bank sector. it is difficult to see a scenario of bull flattening beyond the 10y sector. and that should be enough to absorb issuance. For January-March 2010. and the movement since 1 December almost appears to signal a return to the correlation of 2002-04. Risks are for flattening and a rally in yields up to the 10y sector Supply increases already announced. In addition. With 3m Libor now around the same level for USD and JPY. While 5y10y flatteners are attractive. As for supply and demand. we recommend a strategy based on directional longs. the regression line would be expected to start moving downward and to the left. if any. On the demand side. when long-term yields showed their steepest drop within the quantitative easing period (Figure 4). it appears that the 5y10y has steepened somewhat excessively in terms of the above correlation between the 2y5y and 5y10y over the past year. and speculation about additional BoJ accommodation could persist. the Japanese currency could come under further upward pressure. we expect surplus funds to continue to increase for now due to sluggish growth in lending. and even if the divergence from the regression line since last year does not correct. suggesting a large capacity to absorb JGBs. will likely be limited. The two have also shown a positive correlation during the past year or so since the events of September 2008. Looking at the shape of the yield curve prior to 2006. Over the next few quarters. among domestic banks. even before the BoJ’s latest policy change. we see a positive correlation between the 2y5y and 5y10y sectors between 2002 and 2004. The BoJ’s actions pushed yields sharply lower out to the intermediate sector.Barclays Capital | Global Outlook recovery would gradually slow towards zero growth in H1 10. which will be released at the end of December. Also. If the market views the measures taken on 1 December as an effective return to the phase of quantitative easing seen up to 2006. we expect FY 10 (ending March 2011) JGB issuance plans. If JPY appreciation or some other deflationary force takes hold. Sizes were already increased sharply from July 2009 to accommodate the stimulus package of the previous administration. the yield curve from the short to the intermediate sector has already flattened to levels seen during the quantitative easing period of 2001-06. given expectations for an increase in 30y JGB issuance in 2010. to confirm that any increase in auction sizes from April 2010 onwards will be kept to a minimum. Given that periods of negative correlation are more frequent between sectors on either side of the 5y-7y sector. and this could also be a factor that limits any steepening. and demand should stay very strong We recommend being long Japanese rates 10 December 2009 50 . there could be a scenario where both the 2y5y and the 5y10y flatten and the long-term yield itself falls sharply. even after accounting for the large shortfall in tax revenues. the yield curve was already starting to resemble the pattern seen during the previous phase of quantitative easing. especially 2002-04. As the yield curve rapidly flattened out to the intermediate sector around the time of the BoJ’s decision on 1 December. there is a strengthening trend toward extending the duration of liabilities through the adoption of internal models for measuring the duration of deposits. this would actually be possible.

Therefore. we are unlikely to see any big spread moves.5% and growth expectations rise towards 1. However. We expect cross-market spreads to remain under pressure. and to position for a more fundamentals-related widening move later in 2010. Greek issuance totalled €31bn in Q1 09. as funding plans have not improved in 2010 and the traditional heavy frontloading of supply early in the new year seems likely. If the selloff is substantial (30-50bp). where fiscal consolidation is in train and issuance will be lower due to the prefunding done in 2009. we would be wary that Moody’s and S&P seem likely to comment adversely on Greece’s rating. This could push implied volatilities significantly down (10-20bp in annualised vols). indicates that the EONIA-Bund component is fair value at around current levels. Therefore. volatility and inflation-linked Swap spreads Room for euro area swap spreads to widen. as long as short rates stay close to these low levels into 2010. and a similar amount seems likely in early 2010. We believe spreads are likely to continue their range trading in the coming months. as we start facing the bear flattening of the EUR curve led by the short end. which are likely to be less vulnerable than other non-German issuers. Schatz ASW will be an outperformer versus the Bund ASW. when we look at a scenario in which short rates (3m GC) move up to about 1. the return would shrink to 51 10 December 2009 . Elsewhere. As we approach potential exit strategies/rate hikes from central banks in late 2010. which has come under pressure from ratings agencies and investors concerns regarding its poor fiscal record and its banking sector’s reliance on ECB funding. with Ireland also suffering. while the persistent richness of Italy in the 6-8y area offers value against Spain. we feel Portugal looks rich versus Spain in the 10y sector. Spain has relatively poor deficit dynamics. provided central banks remain committed to their current benign language. Euro cross-market spreads No broad-based tightening anymore but rather divergences based on supply pressures Euro area cross-market country spreads versus Germany have widened across maturities since early November. but its debt/GDP started at a low level. For instance. We recommend remaining overweight Germany and also staying long in the 10y sector in the Netherlands and Finland. its very high rating seems protected. but if we see a 30bp sell-off. Our view is that until we see that big fundamental widening of swap spreads.Barclays Capital | Global Outlook Spreads. We believe there will be an even better case for this early in 2010. albeit to a lesser extent. We would avoid exposures to Greece in favour of Ireland. especially at the short end After a very sharp tightening move in the first half of 2009. one thing to watch will be if the heavy support issuance has received from Spanish domestic banks (they gobbled up about 70% of the net new issuance in 2009) will continue in 2010. we will see unwinds of positions in carry trades with receiver swaptions (eg. however. we recommend buying the Mar contract Schatz ASW versus selling Bund ASW against it going into 2010. when government bonds and swapped issuance will be very heavy. Our fundamental model for Bund ASW. Volatility Top left of the vol grid could come under pressure as unwinds of carry trade pick up The direction of volatility in the upper-left corner of the swaption surface (options with shorter expiries on short swaps) will depend strongly on the short end of curves. we expect spreads to trade with more of a widening bias. Easily the largest move has been in Greece. then we see fair value for this component at about 20bp wider than current levels. our recommendation for investors in EUR swap spreads is to trade Bund ASW tactically within their recent range going into year-end 2009 and in early 2010. Bund ASW has been trading within a 15bp range since late summer. €6m1y to €2y1y receivers). with market participants eyeing carry trades on the short end of the curve. Thus. Additionally. a €2y1y 3% receiver initiated in the summer would be up 45% by now. therefore. along with short rates and growth expectations. However.5% in 2010.

If consumers react in their typical fashion to higher inflation headlines and we see a widening of bond and swap breakevens. Another theme that will gain importance is that with credit spreads much tighter than they were 6-12 months ago. with several countries likely to issue new bonds in Q1. and there is more limited pressure to engage into some end-of-year de-risking of balance sheets. In the UK. buying of OTM receivers funded by selling OTM payers). RPI inflation is liable to increase notably further. Inflation-linked markets Inflation-linked breakevens are attractive going into 2010 in the US… Relative to other strategies for protecting against inflation. more liquidity and tighter bid/offer spreads in the euro vol market in particular. which should push vol lower in Q1 10 by about 10bp in the GBP 10y10y to 20y30y sector. with CPI inflation likely to spike to 2. reaching 4% by March with a likely peak in April. given that HICP inflation probably will not rise much above 1% in the coming months. In the US. The same applies to a significant sell-off in long rates (eg. if doubts about the self sustainability of the recovery prevail. supporting options in the €10y10y area. at just below 2%. albeit this should be a short-term phenomenon and in part is explained by next year’s VAT hike. which makes entry levels for option hedges historically less attractive. these carry trades are likely to keep performing. However. We think that longer-dated CMS steepeners can attract some interest. The scope for ongoing TIPS outperformance in a rising nominal yield environment will likely be tested by the first 30y auction in over eight years on 22 February. … and the UK 10 December 2009 52 . at -12% (assuming current vol term structure). Volatilities of options on €30y swaps are still 25-30bp annualised vols above their longterm averages.5%). but we would not see it as a cause for concern on its own. and in a 50bp sell-off. In options on long swaps (the €1y20y to €5y30y sector). the increased attractiveness of LOBO loans likely will keep the long end of the vol market well supplied. They are likely to be well supported at the start of 2010 by the coincidence of recovering levels of headline inflation and allocations into the asset class. it would be negative.5%).Barclays Capital | Global Outlook only 7%. this a particular risk in January. ie. 10y bond breakevens. the €30y swap moving to 4. while there is only one auction in the month rather than the traditional two (despite the stated intention of the Treasury to increase TIPS issuance). we saw some ALM activity in November (selling of collars. are entirely consistent with the definition of price stability and are unlikely to widen substantially. Such fears are very unlikely to be an issue for the ECB. The demand for hedging will probably tail off somewhat as rates move higher.9% y/y for December 2009 (albeit as a local peak). Long swap rates have been quite stable in 2009. we can expect a wave of receiving demand from pension funds. which would make receiving via low-strike receiver swaptions more attractive. A further notable rise in 10y breakevens may catch the attention of the FOMC. January CPI inflation is likely to exceed 3%. investors will have to return to structured products to generate an extra yield in a low-yield environment. and we will see only a moderate decline in vol as a result of an extended “rates on hold” scenario. requiring a letter of explanation to the Chancellor. it will be hard for the Bank of England to ignore. inflation-linked bond breakevens appear relatively attractive value in all the major developed markets. the €30y swap moving to 3. We see the likelihood of higher breakevens in the UK as posing more of a policy quandary for the Bank of England. Consumer measures of inflation expectations have already recovered to their average of the past 10 years. This should create hedging flows. but if we see a significant rally (eg.

10 2.10 0.40 3.33 2.25 4.45 0.20 2.85 3.00 3.30 4.00 3.40 1.15 0.10 4.10 0.10 0.85 2y 1.25 1.20 2y 1.77 1.80 1.75 2.23 2.20 4.60 3.85 4.20 0.70 1.40 0.70 4.30 1.20 1.10 0.65 3.50 10y RY 1.15 0.10 3.30 3.15 4.Barclays Capital | Global Outlook GLOBAL BOND YIELD FORECASTS US Treasuries US swap spreads Fed funds 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 0.40 2.25 2.95 10y 3.20 1.00 1.40 1.35 4.80 1.10 0.90 4.35 10y RY 1.60 5.15 4.75 1.55 1.15 2.00 4.65 1.00-0.80 3.75 2.50 5.75 1.55 10y 4.81 3.60 5.50 4.00 2.20 0.50 1.25 4.5 5y 2.00 2.00 3.50 1.15 0.20 2y 0.30 2.20 1.50 4.05 4.80 3.10 4.15 0.75 1.20 3.90 1.30 3.70 2.80 3.40 1.68 0.00 5.50 0.23 2.60 1.35 1.00 1.50 2.35 4.80 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 2y 25 25 25 30 30 30 30 30 5y 15 10 10 15 15 15 15 15 10y 0 0 5 5 10 10 10 10 30y -5 -5 0 0 5 5 5 5 Source: Barclays Capital 10 December 2009 53 .85 2.60 10y RY 1.50 0.15 2.90 2.00 3.10 2.25 1.00 1.15 0.45 1.60 2.10 0.90 1.80 1.50 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 2y 40 45 45 50 50 50 50 50 5y 25 30 30 35 35 35 35 35 10y 20 25 25 30 30 30 30 30 30y -10 -5 0 5 10 10 10 10 UK government UK swap spreads Repo rate 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 0.00 3m Libor 0.60 10y 3.00 3.10 4.00 1.25 0.20 0.20 3.00 1.50 5.75 4.45 3.35 2y 1.15 2.95 2.20 2.50 3.45 0.60 1.60 4.65 1.80 5y 2.15 5y 0.80 1.80 4.32 3.50 4.20 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 2y 30 30 30 30 30 30 35 35 5y 30 30 35 35 35 35 37 40 10y 10 15 17 25 25 30 30 35 30y -20 -15 -10 0 5 5 10 15 Euro government Euro area swap spreads Refi rate 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1.80 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 2y 60 60 65 65 65 65 65 65 5y 35 35 32 30 30 30 30 30 10y 0 -5 -10 -10 -10 -10 -10 -10 30y -20 -15 -5 -5 0 0 0 0 Japan government Japan swap spreads Official rate 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 0.25 2.00 1.00 1.50 3.40 1.70 3.40 4.90 30y 4.90 4.30 3.27 0.00 30y 4.00 5y 3.20 0.50 3m 0.20 1.20 4.10 1.45 2.40 2.50 10y 1.10 3m 0.05 4.25 2.40 30y 2.30 4.25 10y RY 1.60 3.70 5.15 0.50 0.70 1.30 1.35 1.30 1.28 0.50 0.00 3m 0.75 2.50 5.00 2.25 0.90 1.25 30y 4.05 2.45 4.20 1.50 4.10 0.90 5.15 0.50 4.03 1.85 2.80 1.22 1.15 4.40 4.20 2.40 0.00 1.25 4.00 1.50 1.20 5.40 3.20 0.40 3.20 0.10 2.20 0.55 3.00-0.50 2.50 3.80 3.75 2.10 1.55 3.15 3.25 2.

with risk later in the year from the withdrawal of central bank liquidity.8% 26. historically low yields. Demand for corporate credit is likely to benefit from a lack of spread alternatives.2% 11. with continuing room for normalization 2009 will be remembered as a year of epic returns.2% 86.com We expect credit returns in 2010 to be strong by historical standards but lower than in 2009. with continuing room for normalization.6% 49. Performance between now and early next year will likely be robust.3% 49.60% 4-5% 2. amid slow US and European growth.com Robert McAdie +44 (0) 20 7773 5222 robert.5-3. with high grade posting double-digit excess returns and high yield more than 50% total returns. increasing the importance of relative value to generating outperformance. Loans Asia 18.2% 23. Barclays Capital 10 December 2009 54 . We see outperformance in financials.19% (0.mcadie@barcap. Figure 1: Returns forecast Excess Return YTD 2010 Forecast YTD Total Return 2010 Forecast US IG EUR IG US HY EUR HY US Lev. As we enter 2010. we estimate that 2010 will provide closer to 11-12% excess returns – still quite favorable compared with potential returns for equities and some fixed income asset classes (eg.5% 11-12% 10-13% 8-9% 7-9% 6-7% 17. The spread compression in 2009 corresponds to a 65% retracement of the dislocation at the start of 2009.6% 1-2% 7-8% 9-12% 8-9% 7-9% 2. the belly of the high grade cash credit curve. the best on record for that sector. Based on historical averages for spread normalization during economic recoveries. and a heavy supply of government bonds. These returns were driven by the severe dislocation in spreads at the beginning of 2009. and lower rated high grade issuers. Loans EUR Lev.2% 52. We advocate a barbelled portfolio in high yield that takes advantage of historically wide double-B spreads and the potential outperformance of select triple-C paper.8% 28. MBS). combined with an aggressive monetary and fiscal response. the past two cycles suggest that current pricing is roughly in line with pricing six months after GDP has troughed and historically the asset class has provided 20% of excess returns at that point of the cycle. Source: Bloomberg.6% 53. amounting to a further compression of 40-50bp in the US and 30-40bp in Europe.3% Note: Total returns calculations are based on treasury yield forecasts form Barclays Capital Rates Strategy. In high yield. and drive investors toward non-traditional supply such as EM corporates and taxable munis.shah@barcap. we find that credit is closer to being appropriately priced for this stage of the cycle.0% 33. Expect further spread normalization Credit is closer to being appropriately priced for this stage of the cycle.3% 73.2% 33.3) – 0. Given market concerns about the robustness of the rebound and still highly leveraged balance sheets (from the LBO boom). Lower net high grade supply should support spreads in 2010.Barclays Capital | Global Outlook CREDIT OUTLOOK The hunt for yield Ashish Shah +1 212 412 7931 ashish. 2010 could provide another 10% of retracement from the cyclical wides.

investors will likely continue to favor a heavy credit allocation. BB and CCC-rated high yield paper and taxable munis. net spread issuance outside credit will be about $200bn. Looking across subsectors. Against a backdrop of slow US and European growth. low yields and a heavy supply of longer duration government bonds. Cash continues to be priced for outperformance versus CDS. are likely to outperform owing to better technicals – including negative net issuance and build-up of liquidity. Within broader spread products. especially given its room for continued positive returns. better liquidity and normalization in funding costs should lead lower BBB-rated issuers to outperform. Improving fundamentals. include financials.Barclays Capital | Global Outlook Figure 2: Best opportunities Opportunity Summary View Financials Lower quality in IG Barbelled HY portfolio Taxable munis Source: Barclays Capital Financials. Figure 3: USD IG and HY basis pt 0 -5 -10 -15 -20 -25 Sep-08 bp 0 -50 -100 -150 -200 -250 -300 -350 -400 Dec-08 Mar-09 Jun-09 Sep-09 Figure 4: EUR IG and HY basis 50 -50 -150 -250 -350 -450 -550 -650 -750 Dec 07 Jul 08 Feb 09 Sep 09 50 30 10 -10 -30 -50 -70 -90 -110 -130 € HY basis (LHS. excess returns. A barbelled HY portfolio takes advantage of historically wide double-B spreads and potential outperformance of selected CCC paper. and. a small amount by historical standards (Figure 6). but at a slower pace Low G3 yields and a lack of spread alternatives will drive the flow of funds to corporate credit Investors are faced with a return environment of close to zero risk free yields across the G3 currencies (Figure 5). especially banks. lower BBB-rated investment grade paper. bp) HY Basis (LHS. In 10 December 2009 55 . pt) Source: Barclays Capital IG Basis (RHS. The search for yield should continue to drive demand. bp) Given the relatively lower returns forecasts. Our securitized team estimates that even after the end of Quantitative Easing (QE) in the US. or (non-G3) currency risk. Taxable munis appear attractive versus corporates of similar maturity and quality. corporate credit should benefit from a lack of issuance of attractively priced competing spread product. we believe the areas that have the most opportunity for spread normalization. although pockets of positive basis are emerging and we find greater value in US versus European corporates – also highlighted by the greater negative basis. hence. credit risk. bp) Source: Barclays Capital € IG non-financial basis (RHS. This leaves them with four choices if they want to earn returns: duration risk. generating outperformance will increasingly depend on relative value opportunities. equity risk.

Barclays Capital | Global Outlook Figure 5: G3 2y Treasury Yields % Figure 6: USD Spread Products Net Issuance $bn 6 5 4 3 2 1 0 05 Source: Bloomberg JPY EUR USD 1500 1000 500 0 -500 -1000 -1500 2006 2007 2008 Credit Non-Credit Spread Products Total Spread Products Source: Barclays Capital 2009E 2009E. we expect to see a shift in allocation as a result of the meaningful moves in spreads in 2009.9trn will be Treasury issuance. Although the end of QE should lead to wider MBS spreads. The incremental demand for high grade credit from high yield and equity investors as spread levels across high quality bonds and bank hybrids offered equity-like returns has for the most part. Having said that. Furthermore. corporate credit should still benefit from allocation from money managers as banks are likely to be the natural buyer of MBS at wider levels. leading to lower downside in default scenarios. from 27% currently. our securitized team expects a relatively moderate widening in MBS post QE. The (slow) return of leverage The improvement of financing terms in 2009 has helped provide support to the rally across the quality spectrum. abated. we have found pension funds more willing to de-risk their positions by reallocating into credit as they “catch up” to their funding requirements. insurers who are underweight equities because of the crisis continue to allocate cash flow to fixed income. assuming that overall US dollar fixed income net issuance will be about $2. especially high grade and long-dated credit. which became the preferred asset class. Finally. In 2010. Continued desire to earn spread should offset profit-taking from equity investors We expect a continuation of the shift in focus down the quality spectrum and capital structure. with the upcoming implementation of Solvency II in Europe. given their low risk weights. High yield should also receive support as distressed opportunities shrink. 10 December 2009 56 . We expect a continuation of the shift in focus down the quality spectrum and capital structure. Rather than chasing the rally in equities.5trn in 2010. we expect pension funds to continue to provide demand out the curve for high quality credit as those funds continue to match their assets with liabilities (private pensions in the US use AA credit to discount their liabilities). as investors take profit in high grade senior risk and seek to earn higher returns in high yield Within corporate credit. Total Return Swap (TRS) facilities that were offered in the L+ 250bp range near the start of the year are now more widely available in the L+100bp area. As a result. the result will be an increase in the Treasury component in the Barclays Capital Aggregate Index to about 35%. This de-risking of the Aggregate Index should provide room for benchmarked investors to take additional risk and purchase more credit to maintain the same size overweight. severely negative net issuance (when Fed purchases are considered) led agency and agency MBS levels to historically tight levels relative to corporate credit. as investors take profit in high grade senior risk and seek to earn higher returns in high yield.2010E 2010Eex Fed ex Fed 06 07 08 09 2009. of which about $1.

resulting in improved liquidity provision from dealers. Heavy term issuance was demanded by investors as they sought to lock in record-high spreads and relatively high yields on investment grade bonds. which saw a significant increase in non-rated issuance. In addition. market stability will likely lead to a significant decline in spread duration issuance from 2009 levels. the change in cross-currency swap valuations and depth of European demand should limit opportunistic Yankee issuance and keep more supply in euros and sterling. This has left companies with high cash levels and low near-term debt maturities. corporate liquidity has never been better Non-financial corporate supply was heavy in 2009 as companies looked to term out Commercial Paper. In addition. 10 December 2009 57 . The decline in Europe is likely to be more muted at about 25% as we expect significant refinancing of bank loans to continue amid ongoing pressure on bank balance sheets. investor interest in the frontend and mid-curve has grown.Barclays Capital | Global Outlook Figure 7: 3m GC term repo less OIS bp 20 15 10 5 Figure 8: Treasury repo daily trading volume (brokers) $bn 120 100 80 60 40 0 -5 Dec-08 20 0 Dec-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Source: Barclays Capital Source: Barclays Capital we expect leverage terms to continue to improve as banks compete for attractively priced short-term financing facilities. near-term maturities and bank debt. The relatively low risk weightings allocated to mark-tomarket leverage will widen availability for TRS facilities and HG bond repo facilities (Figures 7 and 8) that were non-existent in late 2008. investors will be slow to take up mark-to-market leverage given the lessons learned in the past year regarding liquidity. Market stability will likely lead to a significant decline in spread duration issuance from 2009 levels Furthermore. the ability for issuers to be more opportunistic will be a positive for the market as new issuance should slow into market weakness and pick up into strength. Although we believe companies will continue to take advantage of corporate yields within 70bp of all-time lows. Shorter-dated supply should be easier to market given lower VAR. Given the more normal spreads and low treasury yields. which is driving supply. This refinancing has already shifted the nature of the supply. we expect net USD supply to be down by more than 30% in 2010. helping to dampen market spread volatility. Lower net credit supply should be supportive for spreads and drive investors toward non-traditional supply After aggressive issuance in 2009. In general. this dynamic could be exacerbated by pressure from regulators demanding that European banks reduce their balance sheets. Despite improved availability.

Source: CapitalIQ. In Europe.Barclays Capital | Global Outlook Financials should see a slight increase in gross non-guaranteed supply as the end of guarantee programs is offset by lower wholesale funding needs We favor buying on weakness as credit tightening should lead to new supply. we expect net financial issuance close to zero with gross issuance roughly unchanged from 2009 at €500bn. but issuers will not issue into weakness We expect financials to post a slight increase in gross non-guaranteed supply.0 3. In our investor survey. In EM corporates. Europe. EM corporates show up as the non-traditional area with greatest interest among investors. In the lower parts of the capital structure. but issuers will not issue into weakness. we expect issuance to decline from record levels in 2009. EM corporates and taxable munis will likely lead the way in non-traditional supply Amid more muted supply from non-financials and negative net supply for financials (albeit. we expect limited supply of traditional structures. as government guarantee programs taper off. We still expect financials to see negative net issuance as they have been building liquidity in 2009 through lower CP balances and cash builds from legacy asset run off (Figures 9 and 10).0 0.5 4.0 Q107 Q307 Q108 Q308 Q109 Q309 Figure 10: Cash and equivalents as % of short-term borrowing + current portion of LT debt for banks 80% 70% 60% 50% 40% 30% 20% 10% 0% Q107 Q307 Q108 Q308 Q109 Q309 Note: Includes 67 publicly traded banks with debt > $1bn across US. supply for the financial sector will be somewhat market dependent as most US and European firms have heavy 2010-12 maturities that they will seek to term out into tight spreads. Asia/Pacific and LatAm that had reported 3Q09 earnings by 11/24.0 1. Overall. High yield should also see an increase of net supply as the market tightens and new leveraging transactions start to take place. which have already facilitated deleveraging and will drive reduce net supply. higher for fixed-rate financials). Barclays Capital 10 December 2009 58 . However. owing to robust onshore liquidity in many systems. As a result.0 2.5 1.5 0. we favor buying on weakness as credit tightening should lead to new supply. we think that non-traditional supply will be an important source of potential alpha. Offsetting this will be increased access to the convertible and equity markets. We expect a continuation of these rolls in 2010. Supply in high yield should start to shift from refi to a more diverse calendar High yield will remain focused on refinancing heavy maturities in 2012-14 across loan and bonds: 2009 was a productive year as about $100bn of new issue in the US and about €18bn in Europe were used to help roll maturities. based on regulators’ focus on TCE and contingent capital.5 3. Traditionally.0 4. we expect appetite for EM risk to remain strong.5 2. albeit at a slightly slower pace. EM credit was compared with US high Figure 9: Worldwide short-term borrowing + current portion of LT debt by banks $trn 5.

0% 4. As revenues have stabilized or improved. choosing to build cash and bring down leverage instead.5% 3.0% 5. given the magnitude of the downturn.00 1. as banks there have been less impaired than those in the US and Europe. Cash calculations are based on about 300 Non Financial IG Companies with debt outstanding >1bn that reported 3Q09 earnings by 11/9/09. The recovery to date has largely relied on fiscal and monetary stimulus.5% 5. Barclays Capital 10 December 2009 59 .60 2.20 1.Barclays Capital | Global Outlook yield as a spread asset. A muted cyclical bounce provides a good fundamental backdrop Our economics team has forecast an above-consensus economic recovery. using annualized quarterly EBITDA.40 1. The downside to being in this sweet spot is that it seldom lasts. with the segment trading at a much lower beta than US high yield. so has free cash flow. We expect to see this particularly in the long end. Source: CapitalIQ. and have been able to provide supportive lending. The past two years have demonstrated the improved risk attributes of EM credit. Although recent US/European data have been mixed – with employment showing weak growth and production coming in above expectations – EM growth has been quite supportive and we expect a full two-thirds of global growth to come from EM (about one-third from China alone). This support has seen good follow-through in Asia and LatAm. Cost-cutting and free cash-flow generation make for a fundamentally strong high grade non-financial backdrop High grade non-financial corporates were aggressive in building liquidity and cutting costs during the downturn (Figures 11 and 12). the forecast is still rather muted. with governments running large fiscal deficits to support demand as well as the financial system. Our expectations are for G3 central bankers to maintain monetary support until the recovery is well grounded.0% 3.0% 99 00 01 02 03 04 05 06 07 08 09 Figure 12: Median debt to EBITDA for IG non-financials 2. however. should lead munis to become 20% of the long index after $140bn of eligible supply in 2010. taxable munis should be a meaningful source of supply as Build-America-Bond issuance continues.5% 4.00 00 01 02 03 04 05 06 07 08 09 Note: Net Debt to EBITDA calculations are based on 280+ Non Financial IG Companies with debt outstanding >1bn that reported 3Q09 earnings by 11/6/09. Taxable munis should be a meaningful source of supply as Build-America-Bond issuance continues Among other non-traditional sectors.80 1. where slowing corporate issuance and efficient execution for muni-issuers relative to the non-taxable space. Given that growth in the near term will be skewed toward emerging markets. The shock of the downturn led companies to be conservative on the stock repurchase front. and we have already seen instances of highly Figure 11: Cash and equivalents as % of total assets for IG non-financials 6.20 2.60 1. we would not be surprised if we continue to see allocations to this sector.40 2. continuing to favor the hunt for yield.0% 2.5% 2.

Barclays Capital | Global Outlook liquid companies pursuing M&A. In addition. which were stagnant as banks de-risked their balance sheets and held higher cash or cash equivalent assets. This was in contrast to net interest margins (NIMs). although we expect stock buybacks to restart. CP outstanding has dropped as term government guaranteed issuance was used to take out this year’s maturities and institutions held on to cash coming in from maturing assets. Firms with large capital markets businesses had strong operating performances into rallying high volume markets as wide bid/offer spreads. though. Although this activity is likely to continue and to be a selective idiosyncratic risk for the market. 1-3Q09 annualized for two years (%) 80% 70% 60% Average: 58. we expect M&A activity to be more of a supply risk than the “releveraging” risk of 2005-07. including the current portion of term debt (about 120% in Europe). helped offset lower risk-taking. For large US banks (debt >1bn). Liquidity profile of financials likely to continue to improve. we expect it to be fundamentally benign as companies are looking to M&A as a way to continue to reduce costs and grow revenues rather than take up leverage. Residential losses have been pushed off as modification programs have slowed the conversion of foreclosures to Real Estate Owned Figure 13: Financials as % of credit + FRN indices Figure 14: Median loss across asset classes. enough to go for most of 2010 without refinancing debt. have collapsed.5% 60% 50% 40% 30% 20% 10% 0% 97 98 99 00 01 02 03 04 05 06 07 08 09 Source: Barclays Capital 50% 40% 30% 20% 10% 0% 1st Lien Jr. the overall size of financials’ debt outstanding has shrunk to a more reasonable portion of the high grade universe (Figure 13). Lien C&I CRE Card NCO Source: Barclays Capital 10 December 2009 60 . owing to more limited competition. As a result. making it more possible for investors to roll debt. In that sense. In addition. we think that companies will be less willing to take up overall leverage until the recovery is more firmly in place. cash and equivalents now comprise about 55% of short-term borrowings. This is an important issue because the buyer base for financials has shrunk – banks’ ability to buy other bank paper is muted owing to new regulation and Special Investment Vehicles/conduits. Policy support and time have helped meaningfully improve the liquidity profile of large financial institutions. losses will not The biggest risk for financials in 2008-09 was their liquidity profile rather than their losses The biggest risk for financials in 2008-09 was their liquidity profile rather than their losses. as have multiple capital raises and equitization of junior parts of the capital structure through either exchange offers or subpar tenders. have shown that the better-thanexpected performance is unlikely to continue. Residential and commercial real estate performed better than expectations in the first half of 2009 (Figure 14). which were big buyers of floating rate bank paper. actual / stress test adverse. More recent results. we expect the upgrade/downgrade ratio to continue to improve in 2010.

if anything. Our expectations are that these losses are not likely to abate and. we forecast default rates will peak at about 13-14% by 1Q10. Commercial real estate losses. For European high yield names. These losses may be exacerbated in Europe through forced balance sheet reduction by the regulators. we expect default rates to peak at about 11% by the end of 2Q10. however. Improved market access and credit-positive M&A for high yield issuers should help offset excess leverage. However. lower leverage and better liquidity. the ability to spread the losses over a longer period of time should benefit banks that have strong operating earnings. in the absence of a long-term robust recovery. However. For the most part regulatory changes should be creditsupportive in the long term The past year has highlighted how regulatory actions can create investment uncertainty and 2010 is unlikely to change this view. will represent greater risk. bond and equity markets. Figure 15: USD HY default forecast 16% 14% 12% 10% 8% 6% 5. default rates are likely to remain above average (Figures 15 and 16). For US high yield names.50% 4% 2% 0% Apr-89 Forecast Realized Default Rate (12 mo fwd) Figure 16: EUR HY default forecast 18% 16% 14% 12% 10% 8% 6% 4% 2% 6. we expect that for the most part regulatory changes should be credit-supportive in the long term as they tend in the direction of higher capital. before dropping to 5. The improvement in quantity and cost of funding in the second half of 2009 has allowed companies to improve their liquidity profiles significantly and cost-cutting has improved cash flow prospects despite weak top-line performance.Barclays Capital | Global Outlook (REO). before dropping to 6. leverage issues continue and. Even in the case of hybrids.7% at the end of 2010.5% at the end of 2010. the push on the part of regulators for contingent capital may actually benefit existing structures. but stronger growth would be nice High yield companies have and should continue to benefit from improving market access in the bank. which were already expected to be back-end loaded. the uncertainty regarding future capital structure treatment is reason for concern. have also been delayed as banks have chosen to “extend and pretend” that things will get better rather than foreclosing on properties and taking the capital hits.70% Forecast Europe Actual (12 mo trailing) Sep-94 Mar-00 Sep-05 0% Mar-99 Sep-01 Mar-04 Sep-06 Mar-09 Source: Barclays Capital Source: Barclays Capital 10 December 2009 61 . That said. As a positive.

Risks to our view Consensus fears the end of policy support QE has been a major force in making credit look attractive – especially relative to MBS and covered bonds – and driving fund flows into risk assets. and single-name contracts begin to clear in the near future. given their more robust ratings methodologies and attractive spreads. Similar to the early days of CDS.9trn in January 2009 to about $7. CLNs. we expect new issue synthetics to emerge. Unwinds of negative basis will likely be a source of cash and CDS supply and for the first time in two years. Ironically. based on a survey of Barclays Capital investors in October 2009. Based on data from DTCC. providing the source of funds for new investments in corporate credit.Barclays Capital | Global Outlook Structural changes should help improve CDS liquidity as will lower volatility Expect client clearing and migration to clearinghouses to broaden investor participation In 2010. Open interest will shrink. CLNs and issuance from ‘new’ synthetics should be a source of protection (ie.26trn. a more robust recovery than expected could be a short-term risk to the spread market as central banks would have to withdraw liquidity at a more rapid pace.2trn of spread product off the market. FTD baskets. we expect CDS ‘open interest’ to continue to decline as existing index contracts continue to be cleared through a central counterparty. these structures will likely be used to provide a source of protection in names that trade wide owing to hedging demand in CDS. we expect investors to look at simple structures for getting leverage/incremental spread. it still doesn’t expect the Fed to tighten until September 2010.7trn in November 2009. net sellers of protection) As spreads continue to ratchet in. in contrast to the weak growth scenario where they leave the loose monetary policy intact for an extended period of time (keeping yields low and fueling the hunt for yield). 10 December 2009 62 . we expect to see a migration of dealer single-name risk to clearinghouses and client clearing. the Fed has taken about $1. Although very limited compared with historical issuance. Furthermore. corresponding net outstanding amounts have not dropped materially. However. CDS should make sense as a long for unleveraged investors. This would be offset if market spreads tighten. Negative basis should continue its path of normalization We expect continued normalization in the negative basis as funding costs decrease and cash investors go into less liquid bonds in their search for yield. about 58% expect their CDS volumes to be the same or higher than in 2009. but volume should grow On balance. remaining at about $1. This should lead to more situations with a positive basis. Although our economics team has an above-consensus forecast. which should make buying protection look less attractive from a capital standpoint. In the US alone. We expect higher margin requirements on both buy and sell transactions with no offset for cash basis from the clearinghouse. we estimate that gross outstanding notionals on credit indices dropped from about $10. and simple securitizations are beginning to re-appear and we expect this trend to gather steam.

who may become complacent with the low volatility of long-term rates we have seen over the past three months. the credit markets have been concerned about these risks and have not tightened materially since September. our interest rates strategy team expects 10y Treasury yields to hit 4. In fact.5% by the end of 2010.75 Fed Funds: 10. 1982-84 vs Current bp 700 600 500 400 300 200 100 0 4 Source: Bloomberg. Higher capital requirements and an acceleration of government capital repayment globally could weigh on hybrid valuations. This type of rapid move could also see a redemption wave from retail investors. In fact. However. Figure 17: BBB Long Industrial Spreads Post Cyclical Wides. regulatory/political risk remains high given the level of support that has been provided by regulators and the rapid changes they are making. Barclays Capital Aug 82 .5% 10 16 22 28 Months from widest spread That said. if we look at the spread normalization after the ’80-82 recession. if rates sell off in a disorderly manner and the yield curve steepens.Dec 84 Fed Funds: 0. we were at tighter spreads than today in a similar part of the recovery with materially higher yields (Figure 17).5 Fed Funds: 9.25% Dec 2008 Onwards Fed Funds: 11.Barclays Capital | Global Outlook Given the heavy Treasury issuance calendar. the absence next year of QE may lead to higher interest rates. The ability for the Government Accountability Office (GAO) to audit monetary policy decision-making could unhinge rate and spread expectations as we move to a less independent Fed. though clearly it will limit total returns. Regulatory/political risk Although difficult to quantify. leading to significantly lower liquidity for financial institutions. We highlight a few examples of regulatory changes that could be of concern: Secured creditors could take losses under draft US legislation supported by FDIC head Sheila Bair. investors are likely to re-allocate capital to treasuries and mortgages given the attractive compensation for taking pure duration risk and we would expect a widening of higher quality spreads. even as the interest rate market is pushing out the timing and severity of tightening. Moody’s. 10 December 2009 63 . We believe this modest and measured increase in yields will not pose a headwind for excess return expectations in credit. We expect credit to catch up to this by tightening in December and January and would view these risks to be greater in the second half of 2010 from tighter levels.

was among the least affected by the recession and it is not surprising that M&A first increased in that sector. The bottom line is that the “pain trade” is for the rally to occur in December without broad-based participation. rather than in January when returns will count towards the new performance year. Dealers looking to “re-buy” into the credit business are likely to build positions into year-end in the hope of taking client market share in the new year. As we head into 2010. by virtue of its global footprint. Wal-Mart. If growth remains anemic but corporates have improved visibility. Regulations are ultimately likely to also determine the shape and form of new structured issuance. Our view is that while policymakers want to see growth and they need to support asset markets to see this growth. Lack of regional/global consensus relating to the introduction of new financial regulation could lead to material differences in the operational and competitive landscape for financial institutions that fall under different regulatory regimes. Regulatory uncertainty is likely to keep structured issuance muted in the near term. Assuming that the recovery gathers steam. Shareholder-friendly transactions There has been an uptick in M&A activity over the past year. equities look cheap relative to credit. The regulatory treatment of CDS could cause big shifts in supply/demand dynamics for the product (either leading to significant tightening or widening). AutoZone). 10 December 2009 64 . We have seen activity stirring in consumer products as well and believe that event risk could spread to the cyclical sectors. The real near-term risk is to the upside As we head into 2010. Yearend related selling of synthetic CDOs and portfolio hedging will likely give way to increased risk appetite as investors move from protecting gains in 2009 to generating returns in 2010. the risk of supply disappointing demand is growing as companies become comfortable with market access and their high liquidity positions. We would look at stock buybacks as a mechanism of correcting this differential. The technology sector.Barclays Capital | Global Outlook More aggressive sales of assets by banks receiving support in Europe could fill the “supply shortage” of risky assets. policy errors are highly likely. Stock buybacks are also making a cautious comeback (eg. in our view. the risk of supply disappointing demand is growing In reality. Performance risk aversion going toward year-end has resulted in light positioning and year-end related hedging. leading to a potential gap tighter in derivatives. we feel that the real near-term risk is actually to the upside. the risk of isolated leveraging transactions remains material. While we expect companies in general to be cautious about excessive leverage. then we could see a surge in M&A activity.

drain liquidity and raise rates very slowly while the output gap closes over the next several years. agency debt and Treasuries. As strategists for US equities – one of the most economy-sensitive asset classes. 65 We believe that the primary catalyst for the highly correlated capital market rally was the Fed’s quantitative easing (QE) If growth accelerates. was the Fed’s efforts to cope with the zero bound on its main policy rate beginning late last year. the probability of such a “Goldilocks” type of outcome is quite low. to the detriment of the liquidity-driven rally in share prices. Against this backdrop. in our view. we think the Fed will end the QE purchase program in March as planned. we did not believe that to be the case and saw better value in the credit part of the capital structure until the stress test process (Supervisory Capital Assessment Program or SCAP). leaving the market to absorb more than $2trn of net fixed-income supply in 2010. given the low absolute yields available in the Treasury and investment-grade credit markets. specifically quantitative easing (QE) and related purchases of agency MBS. Although we are far more constructive now than we were at this time last year. stretched multiples and their associated market-implied earnings expectations will likely prove overly optimistic. we think there is little room for error. which was at the epicenter of the global credit crunch – this would presumably make us quite optimistic about the 2010 market outlook. higher taxes. It is possible that growth could “thread the needle”. QE purchases. This should not be comforting to investors. and it will begin draining excess reserves from the banking system through large-scale reverse repos. and we are increasingly convinced that a cyclical economic upswing is well under way. slowing QE has already stalled the highly correlated rally across markets. We believe the next step for the Fed is draining excess reserves. Fed asset purchases are scheduled to slow to a trickle in Q1 10. once again we find ourselves expecting a difficult first half of the coming year. the administration could be patient and refrain from permanently impairing the economy through increased regulation. many equity investors believed that the 40% drop in the S&P 500 after Lehman Brothers’ bankruptcy had reduced equity valuations to extremely low levels. we believe that multiples are likely to compress in 2010. equities are close to their long-term average risk premium relative to Treasuries and investmentgrade credit. stretched multiples and marketimplied earnings expectations will likely prove overly optimistic 10 December 2009 . paying interest on reserves.com We think that US economic growth is likely to prove sustainable. commodity or imported inflation. without triggering any asset. Meanwhile. However. which should begin shortly after employment stops falling. which left yields at their current lows. once again we find ourselves expecting a difficult first half of the coming year We are quite encouraged by recent labor market developments. to the benefit of S&P 500 earnings. If growth slows. the Fed will end the QE purchase program in March as planned. when we expected a sharp correction to retest the October 2008 fallout from Lehman Brothers’ bankruptcy (750). in our view. such as jobless claims and the October and November employment situation reports. meaning the Fed could end QE. greater unionization and reduced labor and economic flexibility. along with recent declines in market-implied growth rates. However. the equity market has already enjoyed considerable multiple expansion in 2009.knapp@barcap. a term deposit facility and perhaps even asset sales. However. have left real Treasury rates sitting near levels that existed in the aftermath of Bear Stearns’ collapse and as the credit crunch was gathering force.Barclays Capital | Global Outlook US EQUITY OUTLOOK The Fed giveth and the Fed taketh away Barry Knapp +1 212 526 5313 barry. We believe that the primary catalyst for the highly correlated capital market rally. The net effect of the highly correlated rally across asset classes is that. Although we are far more constructive now than we were at this time last year. If growth accelerates. as inflation rises. macro data releases (most notably the ISM manufacturing survey) and the rapid normalization of capital markets shifted the focus from solvency to recovery. A year ago.

Barclays Capital | Global Outlook Figure 1: We believe the economic recovery is likely to gain momentum and that 2010 will follow a pattern quite similar to 2004 Index 1250 Index 1600 Fed changes inflation 1500 bias to 'balanced' (Dec 1400 1150 FOMC Meeting) 1300 1200 1050 1100 Nonfarm payroll 1000 950 growth accelerates 900 (Mar payrolls) 800 850 700 600 750 Dec-01 Apr-02 Aug-02 Dec-02 Apr-03 Aug-03 Dec-03 Apr-04 Aug-04 Dec-04 S&P 500 ('02 .'04. when stocks flatlined during the first half of the year Fundamentally. L) Source: Barclays Capital Fed pulls 'considerable' language (late Jan FOMC meeting) S&P 500 ('08 . which we believe will be the equivalent to raising the fed funds rate 2-3%. Back then.7%). if the Fed drains $1trn of reserves from the banking system. we think 2010 will follow a pattern quite similar to 2004. However.725trn of asset purchases were the Fed’s attempt to replicate rate cuts and effectively circumvent the zero bound on its main policy rate. as the Fed begins unwinding unconventional monetary policy. the equity market began a long. our base case is optimistic. slow. given its historical role as a long-duration asset and as a leading indicator. before the Fed hit the zero bound and began QE in late October 2009) to nearly 4% (while the Barclays Capital US Corporate Credit Index yield to maturity fell from 9% to 4. 10 December 2009 66 . Conversely. we are referring to the end of QE: Largescale reverse repurchase agreements. was integral to the stabilization of the economy. This policy approach was very successful in stabilizing capital markets which. When we describe policy tightening. the implementation of a term deposit facility. given the drop in the Fannie Mae 30y fixed current coupon rate from 6% (at the time of the last conventional rate cut. is likely to be at the center of this adjustment. and by assuming that the $1. The equity market. R) We think 2010 will follow a pattern quite similar to 2004. however. had the fed funds rate not been subject to the zero bound. To be clear. we believe the economic recovery is likely to gain momentum.Present. Certainly. and shallow pullback after the Fed removed the “considerable period” language from its vocabulary in the late-January FOMC meeting. there is room for debate about whether QE had an effect on capital markets similar to rate cuts. If the Fed drains $1trn of reserves from the banking system. we are referring to the end of QE. From a market perspective. and perhaps even asset sales. we believe that QE purchases had an effect on capital markets very similar to rate cuts. in turn. when we describe policy tightening. we believe the capital markets are likely to react as if the Fed were raising rates in an environment in which the fed funds rate were not subject to the zero bound. the theoretical change would be equivalent to raising rates from -5% to -2%. the Treasury curve bear flattened from 250bp to 180bp. in our view. the theoretical or synthetic change would be equivalent to raising rates from -5% to -2%. We arrived at this estimate by using the optimal fed funds rate of -5% modelled by the Federal Reserve Bank of San Francisco last May. and the dollar stabilized until six weeks after the first rate hike in midAugust when the equity market bottomed and the dollar was falling again. when stocks flatlined during the first half of the year in anticipation of the end of the easiest monetary policy in decades.

when the Fed added communication strategy to its policy arsenal. Additionally. over the subsequent year. beginning just prior to the first hike in March.4x.7%. this time by 8. 6 mos 8.0x.0x to 12. it flattened to 34bp. the S&P 500 did reverse that decline to close up 2. In 1988. the starting point for valuations was much lower than is the case today. as is the case today.1% over the next year. we looked back at the previous three significant tightening cycles (2004. Again. Equities did have an initial short-term negative reaction. In 2004.4% over the full 12-month period.1x to 10. the use of QE and the complexities involved in removing such unconventional policy stimulus are unlikely to occur without some unforeseen events in 2010. The S&P 500 dropped 6.5x) -6. ’88 Feb.1x to 10. as the forward P/E contracted from 15. 1994 and 1988 policy tightening cycles. ’04 -151bp (116 to -36) -115bp (149 to 34) -141bp (240 to 99) -1. the 2s10s curve flattened from 116bp to -36bp over the next 12 months.1pts (11. the Fed removed policy accommodation in a measured way. there are key differences. We believe that by the time the Fed actually raises rates. just prior to the surprise rate hike in early February. although these previous cycles are helpful. Figure 2: Significant Fed policy tightening and S&P 500 reactions Policy tightening 2s10s UST yield curve (1y chg) S&P 500 FP/E (1y chg) S&P 500 index (initial chg) S&P 500 index (1y chg) Mar. History provides clues rather than a road map for the future. the S&P 500 index and price-to-forward earnings multiples. In 1994. ’94 Jan. 1994 and 1988) that led to stock market corrections and yield curve flatteners – specifically. In 2004. Source: Barclays Capital After the onset of the 2004. 2 mos -8. the equity market was significantly higher in a year’s time.7% in the first two months before recovering to close up 8. We agree with St. Louis Fed President Bullard’s comments in a recent CNBC interview that focusing on interest rates rather than QE purchases and excess reserves is a mistake. though the Fed’s communication strategy diffused the reaction somewhat. falling 8. One of the issues that struck us was that in the days before the zero bound on rates became a factor and communication strategy was not an integral part of Fed policy (pledging to keep rates low for a “considerable” or “extended period”.2% in the first six months before bottoming six weeks after the first rate hike. the Fed took the real fed funds rate from zero to 3% in a year.2%. going all the way from loose to tight policy in a fairly short time. while the forward P/E contracted from 18. beginning just prior to the removal of the “considerable period” language.0x to 12. in that episode.2x to 16. equities corrected initially but recovered later in the full 12-month period The pattern was fairly consistent: In 1988.7% before recovering to close down 0.1% -0.3% Note: The Fed changed its language in January 2004 and raised rates in June 2004.5x. The 2s10s curve flattened from 240bp to 99bp over the subsequent year. Still. however. the market adjustment will largely be complete.Barclays Capital | Global Outlook We believe that by the time the Fed actually raises rates.6pts (18.4x) -1. the general trends were similar. the market did not recover until later in 1995. with the forward P/E contracting from 11. the peak in the yield curve occurred roughly concurrently with the change in its communication strategy.7%. 2 mos -8. the S&P 500 fell over the first two months. We think that 2004 offers the best clues for the 2010 outlook 10 December 2009 67 .3% over the full 12-month period. in essence.2x to 16. however. given that the main policy rate was close to the zero bound and the Fed used communication strategy (pledging to keep rates low for a “considerable period”). In 1994.0x) -2.6pts (15.4% 2. this time we think that it will be equally deliberate. the 2s10s Treasury yield curve. the 2s10s curve was 149bp and. for example) the peak in the yield curve generally occurred near the first rate hike. the market adjustment will largely be complete For further guidance on the implications of monetary policy tightening. about five months before the first rate hike. We think that the 2004 period offers the best clues for the 2010 outlook.

the very large losses in bank mark-to-market accounts (available for sale accounts or AFS) were concentrated in Q4 08. Once we actually get the first rate hike. the window to easy policy. The increase in net revisions was a key factor for fundamental investors in justifying the sharp recovery in share prices. we expect the market adjustment to be largely complete and equities to post positive returns in H2 10. as the comparisons from lower commodity costs will likely end in the current quarter. We believe that our model’s deleveraging variable in the form of C&I loan growth. Our read is that top-down and bottom-up earnings estimates imply an economic recovery roughly twice as strong as economist GDP forecasts. which historically trough nine months after the end of recessions. a Fed euphemism for the labor market. and the stabilization of the US dollar. which implies that the margin expansion story may be winding down. this cycle was extraordinary. resulting in a sharp correction in real rates. the market could be facing another headwind at a time when the Fed is raising its forecast enough to begin removing policy accommodation. we believe that the dominant theme in H1 10 will be the market effect of a reversal of Fed policy. and it might remain steep somewhat longer than in prior periods of Fed policy tightening. while actually lowering our expected growth rate from 20% to 18% Our model’s deleveraging variable and the lingering effects of the credit crunch are key factors behind our belowconsensus forecast We continue to be struck by the dichotomy between equity analyst and strategist forecasts for corporate earnings on one hand and economist forecasts for GDP on the other. margins appear to have bottomed concurrently with the end of the recession. we believe the dominant theme will be the reversal of Fed policy. ultimately leading to a bear flattener. an improving economic environment. So. In addition. when we believe that the Fed will make significant changes to its communication strategy. P/E multiple compression. are the key factors behind our below-consensus forecast. The sharp drop in jobless claims and significant improvement in the cyclical components of the past two employment situation reports meaningfully increases our confidence that the economy is on the verge of benefitting from a labor market recovery. and a falling dollar closing In H1 10. Certainly. and government policies (the foreclosure moratorium. Our model worked well in terms of the timing of the low and the trough level of earnings. producing a sharp real rate correction. If revisions stall further as companies provide 2010 guidance in late January. and US dollar stabilization As we peer out into 2010. With that in mind. while Barclays Capital economists’ relatively optimistic GDP forecast is for output to increase in the first year of the recovery at roughly half of the average post-WWII rate. as we believe that Barclays Capital’s forecast for a 100bp increase in 10y Treasury rates over the first three quarters of 2010 will have an effect similar to a bear flattener. in our view. but not as good as the consensus expects We are increasing our 2010 S&P 500 operating EPS forecast from $60 to $66. while actually lowering our expected growth rate from 20% to 18%. Given the low level of real rates and nominal rates at the front end of the curve. This might explain S&P 500 net revisions being flat in November 2009 after increasing sharply from their lows in December 2008. and a falling dollar is closing. The bulk of the increase in our forecast is attributable to base effects. and the lingering effects of the credit crunch. we are increasing our 2010 earnings forecast from $60 to $66. P/E multiple compression. 10 December 2009 68 . The earnings outlook: Positive. the extremely sharp drop in commodity prices pulled forward the bottom in profit margins. and it is the strongest headwind to Fed policy tightening. an improving economic environment. given how easy policy is currently. Said differently. the HAMP program and regulator forbearance) pushed losses in bank accrual accounts (held to maturity or HTM) out in time.Barclays Capital | Global Outlook We see the window to easy policy. bear flattener. This cycle. However. primarily owing to the front-end loading of financial sector losses. there is some potential for US equities to rally further between now and late January. We do not find much comfort in a steeper curve during the adjustment period (of which we are quite sceptical). the consensus S&P 500 earnings forecast is for the strongest recovery in post-WWII history. the QE unwind could affect the yield curve differently. The missing piece of the economic recovery puzzle is resource utilization.

down 28% in H1 10 before ending the year down 35%. we are likely to see significant P/E multiple compression (from 28x to 17x). followed by some expansion later in the year. we took four different approaches to determine the likely path for equity market multiples in 2010. we considered our long-term Treasury-toequity risk premium model and. While this might sound extreme.) Our CPI valuation model points to multiple compression of 35% in H1 10 as CPI accelerates. which exhibited a decent relationship but not as strong as CPI. a point-in-time snapshot of equity-only valuations is of limited use. There is a very strong relationship between the S&P 500 earnings yield (the inverse of the P/E) and CPI inflation. and a full-year compression of 29% as CPI moderates in H2 10. Third. (Note: The CPI and nominal GDP valuation models were constructed using trailing earnings.82 11 6 1 -4 12 10 8 6 4 2 59 63 67 71 75 79 83 87 91 95 99 03 07 11 S&P 500 TTM Operating EPS Yield Source: Barclays Capital CPI (R) Predicted 10 December 2009 69 . even if we leave the current real risk premium unchanged (3%) as rates rise. but a different path.6% by Q4 10) implies sharp multiple compression in H1 10. Second.35 for nominal GDP) and the typical pattern of an equity market correction in the early stages of easy policy removal. we considered the implications of having flirted with deflation to the return of inflation. We find it interesting that our nominal GDP valuation model implies continued multiple compression throughout 2010.68 since 1959. while our economics department’s forecast for CPI (which calls for a sharp reversal from negative readings in 2009 to roughly 2. we looked at our three episodes in which the removal of easy Fed policy triggered bear flatteners and equity market corrections. the CPI valuation model is probably telling us the correct story. The message is pretty clear: multiples are likely to compress fairly significantly in 2010 The message is pretty clear: Multiples are likely to compress fairly significantly in 2010. even if it stays well within the Fed’s comfort zone.71x + 3. keep in mind that Figure 3: Inflation has been a key driver of equity valuations over time % 16 14 12 10 8 6 4 2 0 59 63 67 71 75 79 83 87 91 95 99 03 07 11 S&P 500 TTM Operating EPS Yield (L) Source: Barclays Capital Figure 4: Our CPI valuation model suggests that earnings yields could witness a sharp reversal heading into 2010 % 16 14 y = 0. Fourth. we looked at the relationship between earnings yields and nominal GDP.Barclays Capital | Global Outlook The valuation outlook: Significant multiple compression is likely in 2010 In our view. Any investor who has ever bought a cyclical asset should not be surprised by our expectation that equities are likely to witness multiple compression next year as the economic recovery makes the earnings rebound sustainable.5%) and our economics department’s forecast for CPI (1.6%).68 Sample: '59 to present Based on headline CPI (% y/y) 2 % y/y 16 Correlation = 0.91 Adjusted R = 0. after inputting the Barclays Capital interest-rate strategy team’s forecast for 10y Treasuries (4. First. followed by a softening to 1. versus 0. Given that the relationship between earnings yields and CPI is stronger than that of nominal GDP (an r-squared of 0. As such. Our nominal GDP valuation model yields a similar conclusion.5% at the end of Q1 10.

7x 13. were flat in November 2010 after rising rapidly since December 2008).8x 14.2x 20. and P/E multiples are higher. our outlook for a period of adjustment (as the Fed begins normalizing policy) and our work on the expected path for multiples and earnings traces an S&P 500 correction to 990 in H1 10 and a subsequent recovery to 1. The offset is a very steep term structure of implied volatility. we derived the 17x P/E from our Treasury-to-equity risk premium model and Barclays Capital forecasts for rates and inflation. financials. the sectors that rank on the cheap end of our equity-only valuation framework are defensive.8x 11.Barclays Capital | Global Outlook trailing earnings are on the verge of a significant jump as Q4 08 operating EPS of -$0. the recovery rally has left the sector at the epicenter of the boom/bust credit cycle.3x 58. if inflation is more moderate. and easy policy removal will likely be far more complex.5% or a large decline in the real equity risk premium from 3% to 2%. Multiple compression during the three periods of Fed-induced yield curve flattening (2004. our earnings model predicts an increase of 18% in 2010. while several (but not all) cyclical sectors rank on the rich end. given that S&P 500 market volatility (implied and realized) is higher now than in any of the three episodes we considered. as a reminder.3x 1. and 10%. Sector recommendations: Getting defensive as the recovery takes hold The recovery rally has left financials. 17%. Specifically. If inflation is stronger than expected.7x 0.120 by the end of 2010 Our year-end S&P 500 target is the product of a 17x P/E and $66 operating EPS In sum. a 10% correction would be slightly larger than those prior episodes. we think it is reasonable to expect multiples to compress at least 10% based on forward earnings. implying a pullback in the S&P 500 of approximately 10% in H1 10 On balance. materials and energy fully priced Although we do not find the S&P 500 to be cheap based on equity-only valuation metrics or our equity risk premium models relative to Treasuries or investment-grade credit. Given our expectation that forward earnings will not move much higher (net revisions. We think it is reasonable to expect multiples to compress at least 10% based on forward earning. Additionally. multiples could compress more than we anticipate.1x Our outlook is for a correction to 990 in H1 10 and a subsequent recovery to 1. The risk to our H1 10 scenario is a somewhat deeper correction. a number of sectors are trading below what we consider fair value.6x 14. using forward earnings.4x 1.09 are about to be replaced by Q4 09 operating EPS in the $16 area. it implies a pullback in the S&P 500 of approximately 10% in H1 10. Our year-end target for 2010 comes from the product of our 17x P/E and $66 operating EPS. our earnings forecast is probably too low. which can be viewed to some extent as the market discounting the end of policy removal.2x 2.8x 16.9x 3.2x 1. Still. But expecting a 5% earnings yield (the reciprocal of a 20x P/E) in an environment in which 10y Treasury rates go to 4. If growth surprises on the upside. our favorite second derivative of earnings growth. respectively. and the two sectors with 70 10 December 2009 . Interestingly. Figure 5: The S&P 500 is currently trading on the high side of fair value Equity-only valuation metrics 12/1/2009 Mean Price / Sales Price / Free Cash Flow Price / Trailing Earnings (As Reported) Price / Trailing Earnings (Operating) Price / Forward Earnings Price / Book Value Dividend Yield EV / EBITDA EV / Sales Note: Mean since 1973.5% would imply CPI inflation of 2.4x 27. it is possible that multiples could compress less than we expect and trade closer to 20x trailing operating EPS. 1994 and 1988) was 9%. which would be too rich for us.3% 6.8x 2.120 by the end of 2010. Source: Barclays Capital 1.6% 10. However.

08 1. In addition. we increased our exposure to defensive sectors.44 0.90 1.17 -0.36 -1. fully priced.85 1.91 1.70 -0. when the major focus for markets will likely be the end of Fed policies intended to replicate rate cuts in a zero bound environment. while maintaining exposure to cyclical sectors poised to benefit from secular tailwinds.47 -0.44 -1.25 -0.02 1.64 0. an emphasis on the business cycle was the key to getting sector allocations right. The z-score transformation was used to normalize each metric.10 1.25 1.01 -1.09 -2.89 0.29 -0.15 0. the financial sector looks rich according to our credit-to-equity risk premium model.29 -0.87 -1.93 1.76 -1.49 -1.32 0.02 1. we have taken a small step toward defensives For most of 2009.90 1. close to the time when the Fed actually raises its main policy rate.27 0.20 0. **Operating.71 0. Meanwhile.04 -0. our most recent changes were to reduce exposure to cyclical sectors facing secular headwinds. the sectors with the least leverage to the US economic recovery – telecom.85 1. but warming to defensives Technology Industrials Energy Health Care ↑ Materials Discretionary ↓ Financials ↓ Staples ↑ Telecom Utilities Underweight Source: Barclays Capital Marketweight- Marketweight Marketweight+ Overweight 10 December 2009 71 .82 -0. as reflected by a marketweight plus on health care and a reduction of our underweight on consumer staples to marketweight minus.70 -1. Our valuation score is the renormalized sum of each sector's normalized relative valuation metrics. Also.67 1.76 3. We believe that the business cycle will remain important in H1 10. healthcare and staples – are the cheapest.09 -1. such as tech and industrials.66 0.86 Note: *As reported. but defensive valuations are looking attractive S&P 500 sector Telecom Healthcare Staples Industrials Technology Discretionary Utilities Energy Financials Materials Valuation sub-component S/P E/P* E/P** FE/P B/P D/P EBITDA/EV Total valuation score*** 1.94 -0.19 -1.21 -0. With that in mind.35 -0.50 0.72 0. Figure 7: We are sticking with cyclicals. namely financials and consumer discretionary.44 -0.00 1.93 1.54 -2.81 -0.48 -1. as was the case with technology and healthcare during the 1994-95 rate hike cycle and energy & materials during the 2004-06 rate hike cycle.55 0. materials and energy.09 0.02 -0.Barclays Capital | Global Outlook Telecom.82 -1.13 1.77 -0.14 -1.51 0.33 0.85 1. Source: Barclays Capital We reduced exposure to cyclicals facing secular headwinds and maintain exposure to cyclicals poised to benefit from secular tailwinds.49 1.73 0.11 2. Figure 6: We continue to recommend GARPy cyclicals.86 0.60 0.47 0.86 0.17 -1.34 -1.03 -0.02 0.46 0.88 2.05 2. health care and staples are the cheapest the most leverage to emerging markets.10 0.98 0.21 -0. we expect secular trends to reemerge.14 2. After the period of adjustment is complete.

and the anxiety about a double dip would gradually dissipate as investors started to see increasingly convincing evidence that a more broad-based recovery was in place. both psychological and financial Three months down the road.ghezzi@barcap. Barclays Capital remains substantially more optimistic than the consensus about the economic recovery in the US. its shelf life is limited. and the ‘wall of money’ moving into risk assets seemed likely to buoy emerging markets. Positioning still seems lighter than it should be in a normalized economic and financial context. but seems to us unlikely to be a disruptive financial event. the recovery is broad and mature enough to bring monetary policy tightening to the fore. in EMEA. it seems to us that this view was broadly on the mark. and we think the time has come for investors to sharpen their pencils and focus on differentiation across asset classes.gavin@barcap. investors still seemed more anxious and pessimistic than we thought warranted.com “Because things are the way they are. we argued that there would be a stronger-than-expected economic recovery. and Ukraine. we remain positive on the basis of investor positioning.Barclays Capital | Global Outlook EMERGING MARKETS OUTLOOK Sharpen your pencil Michael Gavin +1 212 412 5915 michael. not disturbance. In Asia. economic growth. on balance and for a little while longer. The wall of money is gradually coming off the sidelines and being invested. and investment instruments. but light positioning remains a source of support.” Bertolt Brecht While there appears to be some life left in the ‘stronger for longer’ market call. And what is new now? For the immediate future. although less visible in the smaller economies. particularly Brazil and Mexico. more generally. with this performance reliant upon our favourable assessment of high-risk/high-return trades in Argentina. 10 December 2009 72 . We think it is Asia’s turn for currency outperformance. In sovereign credit. but more uneven. we were generally optimistic about economics and markets Last quarter. Although investor anxieties continue to recede as the global economic recovery evolves. in particular. We are also less concerned than many investors about the upcoming termination of the Fed’s purchases of mortgage-related agency securities. And looking ahead to the next few months. and monetary conditions. It is also well under way in Latin America. Economic and financial news flow thus looks likely to remain. we expect a bear market in US Treasuries to suppress total returns to something like 2-3%. All regions of the emerging world are in recovery. in our view. the cyclical bounce that started earlier in the year was likely to continue. In September. things will not stay the way they are. countries. EM FX will not. which is a watershed of sorts. a source of reassurance. and the world. be supported by the dollar downdraft as it was in 2009. Venezuela. the market’s reaction to the recent shock from Dubai World reveals an underlying edginess among investors. and the ‘risk on’ trade is a spent force. More fundamental drivers are set to emerge. including external flows. We also think there is some life left in it. We suggested that the market rally was also likely to continue – valuations did not seem stretched. Recovery is under way.com Piero Ghezzi +44 (0) 20 3134 2190 piero.

EM countries appear to be closing their output gaps on average at a faster rate than developed nations. it would likely spill over to EM risk markets. and Kazakhstan still have room for interest rate reductions in H1 10. to regional GDP growth. and energy. we expect core inflationary pressures to emerge in some economies. growth will continue to be dominated by China and India. in 2010. however. Latin America in recovery Monetary policy in emerging markets EM monetary tightening will be gradual A mark of the crisis was that EM countries were able to pursue aggressive countercyclical policies. As it does. differentiation will be key But looking beyond the immediate future. major 73 10 December 2009 . the broad. Policymakers can look through some of this upward pressure.6%. respectively. Romania. and all else equal. In the smaller countries of the region. food prices (due to adverse weather patterns). but we nevertheless expect regional growth of 4. as a part of which we expect policymakers to allow FX appreciation as a tool to deal with inflationary pressures. particularly monetary policy. notably Korea and Taiwan. starting with Mexico in the March meeting and becoming more generalized later in the year. even if the locus of volatility is commodities. Generally subdued prospects should prevent inflationary pressures from emerging. we doubt that ‘stronger for longer’ will be the dominant theme when we look back on 2010 as a whole. In short.75pp and 1. we think that Russia. market-directional themes that have been our focus will need to be replaced by a renewed vigilance toward overshoots and corrections and.1% in 2010. but not if inflation expectations increase significantly. net exports subtract 0. from the smaller economies.Barclays Capital | Global Outlook But looking beyond the immediate future. to rely a little less on beta and focus on alpha. In 2010. Israel has already started to hike rates. inflationary pressures are building across the region because of a combination of unfavourable base effects.7%. If risk markets continue to rally in the weeks to come as investors build positions. the market context will inevitably become more balanced as the rally matures. we think that a broad market updraft will no longer be the dominant investment theme. Domestic demand remains the locomotive.4% in 2009 and 8. we do expect a gradual normalization of monetary policy. This sets the stage for a gradual tightening of monetary conditions. but deleveraging will take time After economic adjustments that ranged from abrupt to brutal last year. the dollar. Economic recovery is also well advanced in Latin America. where our forecasts are roughly 1 percentage point more optimistic than consensus.70pp.5pp from growth in 2009 and 0. EMEA: Growth returns. Emerging-market economies in recovery Emerging Asia faces a classic V-shaped recovery In a classic V-shaped recovery. we expect emerging Asia to grow 5. with commodity exporters likely to benefit most from the global recovery. We expect growth to be uneven across the region. most notably in Brazil and Mexico. one would expect EM to tighten more aggressively than core countries. and the rest of the region somewhere in between. However.1pp in 2010.or positioning-related correction sometime in late Q1 or Q2 10. It is not hard to imagine the market becoming overextended and setting itself up for an event. which contribute 4. While we do not expect Latin American economies to overheat during 2010. above all. economic performance has disappointed. On the other hand. overextended economies in the Baltics and (perhaps) Hungary struggling to stage a recovery. As the recovery matures. or equities. We begin to shift our focus in this direction with this quarterly. well above the consensus forecast of 3. but substantial differences in the pace of recovery are nevertheless leading to divergent monetary policies. Hungary. an emphasis on relative value and asset selection – in other words. neither positioning nor valuations will remain as supportive. regional economies began to recover in the second and third quarters. for the first time. Moreover. and Egypt may follow in Q2. notably India and Singapore. The acceleration in GDP growth comes.

One of the other lessons from the recent crisis is that the “optimal” level of EM reserves appears to be higher than previously thought. The risk to our scenario would be renewed inflationary pressures that force EM central banks. We do not think that economic recovery alone would bring inflationary pressures. EM central banks may be forced to act hastily. The above suggests that the path of interest hikes is likely to be relatively back-loaded (with the potential exception of countries such as Israel. how that is exerting itself. In Asia (and increasingly in Latin America). the mapping of interest rate hikes into asset prices is highly uncertain. it should assist momentum. and Korea) where interest rates are well below neutral. however. Lower needed real rates and lower inflation expectations imply that end rates after this tightening cycle are likely to be lower than the highs of previous hiking cycles. but as they do so in H2. and in the more open economies. but central banks may decide to use policy rates only after other tools have been attempted. Central banks likely to use other tools before rates Not only might the process of monetary tightening be gradual. In addition. Barclays Capital EMEA/Developed EMEA Asia ex-China 10 December 2009 74 . the appreciation pressures resulting from potential hikes in interest rates imply that rates would be lower than otherwise. We expect the tightening process to be gradual. This implies that EM central banks are reacting (or expecting to react) using quantitative tools. FX will be used to tighten monetary conditions in Asia Rate hikes likely to be back-loaded and amplitude shorter than in the past Risk is renewed inflation pressures due to commodity prices Figure 1: Asia and LatAm equities have outperformed MSCI TR rebased Dec 07 = 100 Figure 2: EM FX may have more room for catch-up 125 120 115 REER. we have already seen renewed focus on credit growth and bank regulation to limit the formation of asset bubbles. the latter may be linked more to global liquidity conditions (particularly the Fed’s) than to country-specific ones. This is particularly true in Asia. where we expect currencies to appreciate across the board in H1. Chile. we believe that the amplitude of the tightening cycle is likely to be shorter than in previous occasions as a result of the regained credibility of many central banks. with the exception of the CNY. One of the lessons of the recent crisis is that they should not ignore asset prices (including the exchange rate) in deciding monetary policy. GDP weighted regional averages (Dec 07 = 100) 120 100 80 60 110 105 100 95 90 40 2005 2006 2007 2008 2009 85 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 LatAm Source: BIS.Barclays Capital | Global Outlook uncertainty remains about the size of the output gaps. In Latin America. particularly inflation targeters. At the same time. and how robust global growth will be once we exclude fiscal stimulus and inventory accumulation. appreciation is likely to be moderate and reserve accumulation is likely to continue. to hike earlier than expected. Barclays Capital Asia/Developed LatAm/Developed Source: MSCI. Even in Asia. We believe instead that if commodity prices were to increase sharply as a result of supply conditions or excessively loose global liquidity conditions. FX appreciation is an alternative tool to tighten domestic monetary conditions. particularly in property markets.

but Asian and Latin American equities have recovered their value relative to developed market equities.Ven. As our global credit strategy team has explained (Global Credit Outlook: The hunt for yield. The first is economics. There may be further room for re-rating EM. Despite continued recovery in Q4. a number of factors position the global credit market to Figure 4: Inflows to EM bond funds 20% 15% 10% 5% 0% -5% -10% Jan-09 EMEA Source: EPFR. we think. but the gains are likely to be small compared with recent history. but certainly including. Outside of Latin America. Equities have not reached their pre-crisis levels. We thought emerging market sovereign credit had recovered pretty completely by September. Barclays Capital 900 800 700 600 500 400 300 200 100 0 2007 2008 2009 Cuml. and a little more. EM credit EM sovereign credit will be driven by a supportive economic context… With crisis-related dislocations largely a matter of history. … by a healthy global credit market… The second major driver is continuing investor appetite for bonds in general and credit in particular. with the valuation headwind created by a probable increase in US Treasury yields and by the gains that we think can be realized through active portfolio management. and tighter monetary conditions) may be more durable and. the recovery of currencies has been substantially less complete than that of credit markets. in some cases. we think a case can be made for modest. Ukr (RHS) Jul-09 Asia Oct-09 LatAm 10 December 2009 75 . Barclays Capital Figure 3: ‘Core’ CDS has completed its recovery from crisis 4000 3500 3000 2500 2000 1500 1000 500 0 2005 2006 Arg. and it has been moving sideways since. EM FX may be something of an exception. The reasonably robust world economic recovery that we foresee should support credit markets generally. not only.Barclays Capital | Global Outlook EM market outlook – No longer undervalued In our judgement. December 4. As we note below. even intensifying in 2010.Ukr Source: Markit. 2009). by three powerful and partly offsetting macro drivers. overall returns on emerging market sovereign credit in 2010 will be driven. and the drivers of currency strength (dollar glut and strong external balances. But even if the recovery is no stronger than generally anticipated. but this is likely to be gradual and marginal compared with the violent market updraft of 2009. EM Bond Flows (% eop AUM 08) Apr-09 EM ex-Arg. additional spread compression in 2010. EM sovereign credit. emerging market assets are no longer undervalued. the outperformance that we think investors can expect from (most) emerging market economies provides an additional and powerful investment case for EM sovereign credit. Ven. it should provide a more solid foundation for credit market performance than would a precarious (and equally wellanticipated) global economy. Looking beyond the cycle. economic outperformance.

600 1. which poses the largest headwind for returns in EM credit: the gradual tightening of global monetary conditions that we expect to begin later in 2010. but instead in some combination of trading around market events and careful attention to asset selection. for the sake of discussion. at least for investors who are risk tolerant enough to hold these credits at their benchmark weights. but total returns will be modest at best Asset selection is back on the agenda The key to outperformance will no longer lie in being on the right side of overall market directionality. More on these calls in a moment. outperforming US Treasuries by 450-550bp. the outlook is more favourable. and Ukraine. with important effects on EM credit market returns. we are inclined to view the upcoming end of the Fed’s bond purchases not as a crippling liquidity shock. Using the Barclays Capital EM Sovereign Index as a benchmark and excluding. which together account for about 12% of the index). Venezuela. but rather a shift in relative supply that increases the share of US Treasury and mortgage-related agency securities that will have to be absorbed by the market. for now. but offering relatively meager total returns. Figure 6: Investment grade EM appears fair to US IG 400 200 0 -200 -400 -600 -800 -1. And we expect global corporate bond issuance to decline from 2009 levels. We see strong underlying demand for credit from a number of institutional investor classes. Our judgement is that spread compression can continue into 2010.400 1. This yields a forecast total return on this ‘core’ benchmark of about 0-1% in 2010. Within this context.Barclays Capital | Global Outlook weather the eventual unwinding of conventional and unconventional monetary stimulus.US corp investment grade Source: Barclays Capital EM IG Source: Barclays Capital EM HY 10 December 2009 76 . If we include Argentina.US corp high yield EM investment grade . at least for investors who cannot hedge their Treasury exposure.200 1. but we believe it will generate a roughly 100bp rise in US yields. and Ukraine. G3 interest rates will likely remain low by historical standards. It will not constitute a major financial shock for risk markets. which will become scarcer relative to safer US government bonds. Spreads on the ‘core’ benchmark can compress. including country allocations and positioning along curves. Venezuela. we note that the significant outperformance that our strategists predict should bring yields on our EM sovereign benchmark from the 0-1% discussed above to 2-3%.000 Jan-04 Figure 5: Continued rebound in EM credit markets 1. notably US pension funds and European insurance companies. … and by a gradual tightening of monetary conditions This brings us to the third driver. Particularly during the first part of the year and even after the backup in yields that we foresee later in 2010. although at some cost in terms of the portfolio’s risk. three important but highly idiosyncratic countries (Argentina. to about 140bp. of course. our working assumption is that sovereign spreads will compress another 30bp in 2010.000 800 600 400 200 0 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 EM high yield . Supply considerations will then leave room for an increase in the price of creditrelated assets. by about 30% in the US and 25% in Europe.

While we think that investors should remain cautiously positioned until the results are in. We estimate that bond investors are more heavily underweight Russian debt than any other country. we expect these countries to return (on a benchmark-weighted basis) -1. to performance Figure 8: Historical investor positioning in EM credit 4% 2% 0% -2% UNDERWEIGHT -4% -6% -8% Indo Hung SOAF Colo Per Arg Mex Tur Pan Ukr Uru Dom Egy Gha Tun Gab Ecu Pak Bra Sri Els Viet Bul Ven Ind Leb Phil Rus OVERWEIGHT Overweight Venezuela Overweight Russia Underweight HG Latin America Overweight Ukraine Other Total 23.14% 0. the model portfolio increases the expected portfolio return by about a quarter percentage point.40% 0. will not fully materialize). generating incremental returns of 114bp over the benchmark portfolio. We expect spreads to decline back to about 900bp over the course of 2010. in our view. Figure 7: Country allocation and forecast outperformance Expected return Contrib. and Peru) appear expensive to similarly rated peers. our judgement is that it will result in better governability. Our model adopts a maximal (5. Underweight high grade Latin America: We have recently noted that higher grade Latin credits (Brazil. and a strong rebound in bond prices. Barclays Capital Jun-09 Oct-09 10 December 2009 77 . This is a much tougher call. Ukraine. The effect on the model portfolio is limited by the (admittedly arbitrary) restriction on the magnitude of country allocations.3%. Mexico. To quantify the scope for country allocations to generate outperformance in 2010 and the associated tradeoffs.6% -1. (We constrain portfolio weights to be positive and no higher than twice the country’s weight in the benchmark portfolio. Russia: Economic recovery and high oil prices set a positive backdrop. Technicals are also intensely favourable. By underweighting these countries. we embedded our regional strategy teams’ outlook for sovereign spreads into a standard portfolio optimization exercise.22% 0. accounting for nearly half the forecast outperformance. and much will depend on the outcome of the January elections. In 2010. even though we impose limits on the model’s tendency to overweight assets with higher expected return. even after factoring in the Mexico downgrade. The main investment themes and sources of outperformance: Venezuela: Our analysis reinforces the common view that Venezuela will likely be a key driver of bond returns in 2010. which would generate returns of about 23%.58% 2. the projected gains from active portfolio selection are meaningful. we would be inclined to adopt as a model portfolio outperforms the benchmark portfolio by about 250bp.5pp) overweight position.3% 4.7% N/A N/A 1. in expectation of large issuance (that.54% GEM dedicated bond fund weights minus Barcap EM Bond Benchmark weights Jan-09 Source: Barclays Capital Source: EPFR Global. Colombia. investors who are less constrained could benefit more. more coherent policymaking. tactical considerations aside.) A ‘moderate risk’ portfolio that.3% 18.Barclays Capital | Global Outlook We have little to say about the former because it is (almost by definition) difficult to forecast. Here are our main conclusions: Country allocation – four themes… First.21% 0.

Although we expect the dollar to remain under pressure in the immediate future. our judgement is ‘no’.60 0. hedging against risks in advance and capitalizing on any overreactions. Grounds for Asian currency outperformance in 2010 seem solid to us because Asia is where external accounts are strongest (Figure 9). That said. The question therefore arises whether it has become a substantially less volatile investment story. the portfolio optimization framework selects only a modest Argentina overweight position because of the high volatility and directionality of its returns. and investors should consider the possibility of knee-jerk market reactions and potentially abrupt movements. Can EM FX strength persist in the face of a stronger dollar next year? The short answer is ‘yes’.20 1. both in this cycle and over the medium term. Barclays Capital Basic Balance/GDP 2010F 10 December 2009 78 . it has been difficult to distinguish between EM FX strength and dollar weakness. even if contained as we expect. two main themes emerge. we expect currencies to appreciate against the dollar almost across the board in Asia. EM FX Will EM FX strength survive the end of USD weakness? In the past year.00 EGP RON RUB IDR KRW PHP INR MXN BRL FX Sharpes Source: Barclays Capital Reserve acum past 5y/GDP Source: Haver Analytics. well above the benchmark return.Barclays Capital | Global Outlook … and an un-theme Finally. Emerging market currencies are supported (to varying degrees in different countries) by strong prospects for economic outperformance. in part because the dollar has been the center of shifts in global risk appetite. The first is Asian currency outperformance. would be a significant shift in the global financial environment.00 0. as the US cyclical recovery permits the Fed to unwind the monetary conditions that have contributed to dollar weakness. on average.20 0. Despite this.80 0.40 0.40 1. healthy external positions. modest exchange rate depreciation in Latin America and EMEA (on a GDP-weighted basis). While we foresee mixed currency performance against the dollar and. a reversal of dollar weakness. With the policymaking leadership and the economic policy framework essentially unchanged. As we look into 2010. and we believe that aggressive positions in Argentine bonds make sense for risk-tolerant investors only. its recovery is most advanced. we expect it to strengthen modestly against the euro and more dramatically against the JPY. a word on Argentina.80 1. still-high carry leads to a forecast return of about 6%. The weakening trend in the USD has certainly supported our positive call on EM FX.60 1. Our view is that there is more to EM FX strength than dollar weakness. While we think that the most important good news is already priced and that spread compression will be marginal. and reasonable valuations.00 1. CNY appreciation should Strong EM FX is not just dollar weakness A stronger dollar raises tactical considerations Asia’s turn to outperform? Figure 9: External balances favor Asia 30% 25% 20% 15% 10% 5% 0% -5% LatAm EMEA -1% EMEA exRussia EM Asia EM Asia ex-China 8% 1% 2% 14% 9% 6% 3% 17% 27% Figure 10: EM FX Sharpe ratio 2.

a theme that could be relevant in 2010 is steepeners in the front end as central banks backload their tightening somewhat. We also like payers as a 2010 theme in Turkey and South Africa but think the right timing has not yet arrived. betas are also declining. the extent of the negative carry and effect of a generally positive environment means timing is important. since the global economic drivers are likely to be more tenuous. it is both a currency and a rates call. expected returns are predicated on the combination of FX appreciation (at least relative to the forwards) and rates compression in different degrees. Our favorite receivers in the front end are Brazil. and ZAR) to outperform the forward one year out. currency recovery has. Korea. … and steepeners in the front end as central banks backload tightening 10 December 2009 79 . It is mostly a rates call in Brazil and a carry/FX call in Poland. with redemptions peaking and inflation rising. ARS. the movement in global risk premium is likely to be smoother as well. Turkey and South Africa… On the short side. our projection that issuance will be above market expectations is behind our bearish rates view. In both countries. despite this. Korea. and Indonesia. First. we elaborate on why these characteristics should result in lower term premia on EM local curves. it is still too early to position against EM FX. Mexico (Dec 24-Mbono).Barclays Capital | Global Outlook be most supportive. central bank-differentiated preferences (between inflation and employment) will likely play a crucial role. In Russia. in our view. Russia. Alpha will be the main driver of performance for rate markets EM rates trades in 2010 are likely to be idiosyncratic. implying that global market drivers will be less important than in 2009. and EGP). PEN. inflation concerns and. hence. as well as by reasonably high carry where the prospect for appreciation is limited (notably the BRL. there are no clear universal investment themes in the sector. we expect all but five (the HKD. pre-emptive monetary tightening are most imminent. Consistent with the prevalence of country-specific drivers. although investors should be mindful of mark-to-market risk. Of the 25 EM currencies for which we provide forecasts. we favour Jan 11. and we think February/March will be a more opportune time. therefore. We also indicated that one of the signatures of the crisis was the ability to pursue aggressive countercyclical policies for the first time in history. the markets are pricing too much tightening. RUB. as Banxico will probably need to move earlier than its output gap would warrant (and the market is pricing in) to fight increased inflation expectations. not the dollar. EM rates We highlighted earlier that EM monetary policy normalization will likely be only gradual and of much smaller amplitude. In Brazil. In Emerging Markets Quarterly: Sharpen your pencil (8 December 2009). we like payers in the front end of Mexico (2y TIIE swaps). alpha will be the main driver of performance in the rates markets. Poland. with Mexico somewhere in the middle. lagged. This implies that even more than in other sub-asset classes. Our favourite receivers in the (monetary policy-driven) front end are Brazil. in some cases. We like long exposure in the long end of domestic bonds in Brazil (NTN-F 17). Finally. EUR/HUF. we like receiving 6m OIS. helped by the fact that the central European currencies’ natural cross is the euro. and Malaysia. In South Africa. and. Third. In Turkey. and in India. In those cases. Korea. Too early to position against EM FX A second theme that emerges is that despite the more mixed outlook for currencies in Latin America and EMEA. TRY. Russia and India We like payers as a 2010 theme in Mexico. and Indonesia. we express our bullishness through the short end of long bonds (currency unhedged). We recommend 1y2y steepeners in Taiwan. currency unhedged in all cases. Second. We expect authorities to hike significantly less than the market has priced in. and India.

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