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2012: a frugal and crucial year
An investment outlook for 2012

2012: a frugal and crucial year | November 2011 I 2

On the eve of another new year, the challenges look more daunting than ever. The western world is slowing quite significantly, despite very easy monetary policies. Nevertheless, fiscal policy will be tightened in many countries. Emerging markets, while still outpacing the west, are slowing too. On the policy front, western central banks will have to assess whether more nonconventional initiatives are required, while their colleagues in the emerging markets will get ready to use the room for manoeuvre they have. Governments will have to bite the bullet under pressure from the markets, although upcoming elections in key countries could trigger surprises in terms of what is decided – or not decided. This environment is more challenging than ever for investors as well. Equity valuations have come down but do not yet incorporate a recession scenario, whereas the traditional safe havens are very expensive. Moreover, when the mood is very low, marginally positive developments can trigger huge reactions. 2012 looks like being a frugal year on the economic front, a crucial year for policymakers and, for investors, a year in which market timing will be of particular importance.

William De Vijlder CIO, BNP Paribas Investment Partners

2012: a frugal and crucial year | November 2011 I 3 Contents MACROECONOMIC AND MARKET ANALYSIS • Macroeconomic outlook • Market outlook 4 9 ASSET CLASSES FOR 2012 • High Income Equities • Emerging Market Equities • Emerging Market Debt • Global High Yield • Convertible Bonds 14 16 18 19 20 CONTRIBUTORS Macroeconomic and market outlook: Joost van Leenders Individual asset classes: Tom Bagguley. Martin Fridson. Sheila Ter Laag Editor: Maryelle Ouvrard Art director: Sandrine Rivière Graphic Designers: Studio BNPP IP. Jennifer Clarke. Ateliers Hiver Project coordination: Hannah Wright . Mathew Powers.

. so austerity is the major focus for many governments. However. While all these much publicised issues remain unresolved. our outlook for 2012 is not very optimistic. In countries that were hit by housing busts. Low growth with elevated recession risks in developed economies Our 2012 outlook for developed economies can be best described as low growth with elevated recession risks. such as the US. as elections are to be held in the US. France and Spain. deleveraging among households has further to run. Spain and Ireland. Many leading indicators in the developed economies point to low growth at best. such as housing and business investment. and China’s leadership should change.2012: a frugal and crucial year | November 2011 I 4 Macroeconomic outlook SUMMARY • • • • • Growth in developed economies to stay low Emerging markets expected to hold up better Limited inflation risks More monetary stimulus possible Dollar to strengthen. although we think a very negative outcome may be prevented. Will developed economies slip back into recession? Will political leaders in the eurozone be able to resolve the sovereign crisis? How will the debates over US government finances evolve? Will central banks see the need for additional monetary stimulus? Politics mattered in 2011 and will certainly matter again in 2012. remain at relatively low levels and thus have less potential to drag down growth the way they tend to do during recessions. Russia. surveys among consumers and producers indicate that there is little confidence that governments can successfully reduce deficits and debt loads within the foreseeable future. In most developed economies. as well as durable goods consumption. Nevertheless. yen to weaken The outlook for 2012 raises some difficult questions. and for good reasons. several cyclical components of GDP. government deficits are high and debts are rising.

The UK faces slowing growth in the eurozone. We think this phase has come to an end. since July 2011. the political will for further stimulus is low. Employment growth is therefore too low to meaningfully reduce unemployment. facing the potential of higher loan losses and tougher capital requirements. Furthermore. India and China) troughed in October 2009. The Super Committee installed after the increase in the debt ceiling in August 2011 will have to provide some clarity on how the fiscal problems in the US should be solved. Furthermore. such as Germany and several smaller European countries. but the options for further stimulus are limited these days. BNPP IP Inflation or deflation in developed countries? In September 2011. Official interest rates and reserve requirements in the BRIC countries (Brazil. households and governments are not alone in still deleveraging. The Germans don’t think it is appropriate to stimulate the economy at this point.such as the gradual shift towards consumer societies . Nevertheless. Brazil has already cut interest rates twice. . Such a shock could be rising oil prices due to geopolitical tensions or failure to address the huge fiscal challenges that many The situation looks better in emerging markets. Source: Bloomberg. while many European countries are anxiously watching their credit ratings and low risk spreads on their government bonds versus Germany. Italy and Spain do not even have the option of fiscal stimulus. In fact. while Japan must cope with a strong yen and weak domestic demand. Since then. where the government can still borrow at very favourable interest rates. Financial sector deleveraging and slow credit growth also have the potential to push some developed economies back into recession. India & China. Households are waiting for companies to start hiring and companies are waiting for households to start consuming. Political bickering will probably intensify in 2012 as the presidential election campaigning will run through most of the year. In general these countries do not face a period of private sector deleveraging and government finances are healthy in most countries. which we think is positive from the viewpoint of inflation and monetary policy. or the US.and between them – such as the increasing mutual trade patterns -. the two parties are at odds between increasing public expenditure and cutting taxes. as shocks with a negative impact have greater potential to push economies into negative territory. However. Overall household income is thus growing only modestly and. The UK and Japanese economies are feeling the brunt through exports. we don’t think that emerging markets can fully decouple from the slow growth environment we foresee in the developed economies. Banks. %-points) 2 1 0 -1 -2 01 02 03 04 05 06 07 08 09 10 11 * Weighted average of short-term interest rates and reserve requirements in Brazil. Russia.2% in the UK. but any large-scale stimulus looks very unlikely: President Obama launched a stimulus plan in September 2011 but it did not get through Congress. In normal times such a stalemate can be broken by monetary or fiscal policy.0% in the eurozone and even reached 5. US (lhs) 50 25 00 01 02 03 04 05 06 07 08 09 10 11 -30 -40 A more favourable outlook for emerging economies Source: Datastream. which have relatively sound government finances. in many countries. too slowly to compensate for inflation. inflation had risen to 3. Many European countries. Indeed. In the US. are also reducing their balance sheets. Strong dynamics. leading indicators for the emerging economies have fallen and are pointing to more moderate growth. According to the IMF there are some countries that have the room for fiscal stimulus. insulate emerging markets to some extent from difficulties in developed economies. to 4. moderating inflation should provide room for emerging market central banks to loosen monetary policy in 2012. Growth remains structurally higher than in developed economies as emerging economies will continue to catch up in terms of innovation and productivity. Russia.2012: a frugal and crucial year | November 2011 I 5 Consumer confidence (indices) 150 125 10 0 -10 -20 Eurozone (rhs) 100 75 developed countries face.9% YoY in the US. So there is an impasse. while younger populations provide demographic tailwinds. including France. interest rates and reserve requirements have been raised significantly in response to accelerating growth and inflation. BRIC monetary policy indicator* (6-month change. Low growth automatically increases the risk of recessions. BNPP IP The corporate sector is generally quite profitable and cashrich. but companies are reluctant to invest in new production capacity or to hire new workers. its major trading partner. both within these countries .

wages are no longer indexed to inflation (with some exceptions). Therefore. This should flatten the yield curve.2012: a frugal and crucial year | November 2011 I 6 CPI (% YoY) 6 4 2 US to demand higher wages. banks in the eurozone tightened credit standards again as the economy weakened and stress on the interbank market increased. We think the Fed’s determination to prevent deflation in the US reduces the likeliness that falling prices will take hold there. the velocity of money has slowed sharply. We do not share these fears. As in previous years. government transfer payments increased from an average of 14% between 2000 and 2007 to an average of 18% in the first nine months of 2011. Indeed. credit would need to start growing more strongly. in the autumn of 2011. Taxes paid are close to historical lows. credit is barely growing. In an environment of high unemployment in the US and the eurozone. In the US. and buy longer-dated bonds. In real terms. deflation looks less likely. to some extent. The ECB will provide emergency loans with six to twelvemonth maturities.9% YoY in September 2011. the Bank of Japan (BoJ) kept interest rates at zero. Granted.3% in real terms. However. Several peripheral eurozone countries may have to go through a period of deflation to restore competitiveness within the monetary union. given relatively low unemployment rates. as the increase in inflation would only hurt households’ purchasing power. For the core eurozone countries. while the Bank of England (BoE) has been the most aggressive with its quantitative easing. the ECB is providing unlimited liquidity to the banking system at low interest rates. and unlimited liquidity provisioning by the European Central Bank (ECB). Indeed.9%. BNPP IP In fact. which is also affected by employment growth and changes in hours worked. The BoE expanded its quantitative easing programme by GBP 75 billion to GBP 275 billion. but again not enough to compensate for rising prices. labour unions have lost power and many workers in developed economies are. The Fed cut rates to zero and embarked on two rounds of quantitative easing. earnings fell by 1.5% YoY in the second quarter of 2011.2% YoY in nominal terms and 0. Household disposable income. Inflation expectations. Employees simply do not have the bargaining power Hourly earnings (% yoy) Source: Datastream. US households are being heavily supported by the government. This is not enough to compensate for inflation. . competing with low-wage workers in emerging economies. Banks have remained reluctant to lend. although this is not our base case scenario. the Fed announced that it will keep rates exceptionally low at least through to mid-2013 and started Operation Twist – an initiative whereby it will sell short-dated Treasury securities. Draghi. on the back of commodities or finished goods without wages rising accordingly. BNPP IP No wonder increasing numbers of investors have become worried about inflation. Unlike in the 1970s. this liquidity has hardly reached the real economy. US unemployment & earnings 10 Eurozone 0 -2 8 -4 00 01 02 03 04 05 06 07 08 09 10 11 6 4 2 0 90 92 94 96 98 00 02 04 06 08 10 Unemployment (%) Source: Datastream. demand for credit has stayed subdued in a deleveraging environment. bought under previous quantitative easing programmes. There are no signs that any of this is happening. average hourly earnings increased by only 1. accompanied by some quantitative easing. More importantly. compensation per employee grew by 2. the development of wage-price spirals or stagflation (low growth and sticky inflation) looks unlikely to us. Despite several rounds of quantitative easing in the US and the UK. it surprised the markets in early November 2011 with a 25bp rate cut after the first policy meeting under the new bank president. This was higher than in the previous nine quarters. but at 3. Of course. It stopped hiking interest rates after the two in April and July 2011. central banks have created huge amounts of money. wages are growing at a modest pace. growth was very modest in August 2011. Rising inflation. have actually fallen in the US and in France over the course of 2011. In other words. is ultimately deflationary. while the amount of base money in the developed economies has increased. In the summer of 2011. we think the greater risk is that some developed economies will face a period of deflation. as derived from the difference between yields on nominal government bonds and on inflation-linked bonds. inflation expectations and wages would need to start rising. For inflation to take off. which could in theory cause runaway inflation. Further monetary stimulus? Central banks in the developed economies have opened all the spigots in the past few years. a result of past tax cuts and low levels of employment. In the eurozone. has held up better.

as it will ease inflationary pressures and enable central banks to loosen monetary policy. the barely averted default of the US government and the increased likelihood of a double-dip recession there kept the US dollar relatively weak. provided that the Fed’s monetary policy remains highly accommodative. or QE3.30 in 2012. we think growth in the eurozone will weaken and that a recession is more likely there than in the US. Currencies 1. including structurally low growth and possibly unsustainable fiscal positions in some countries. The structural decline of the yen has been forecast by many before.6 105 0 07 08 09 10 11 1. but it recovered when a deal was struck at the end of October. So far the BoE has been more focused on growth than inflation in its policy deliberations. just as in QE1. we think the ECB will cut rates further in late 2011 or early in 2012. weaker yen Despite the ongoing sovereign bond crisis and the high risk of a double dip recession in the eurozone. Some growth moderation should be seen as positive. Finally. the euro has held up remarkably well in 2011. In summary: our view on the macro side Stronger dollar. We expect growth in emerging economies to hold up better. BNPP IP The question now is whether central banks in developed countries think they have done enough or believe they should go further. However. We think they will only cut rates below 1% if there are clear risks of deflation. some problems remain. the yen has benefited from risk-averse repatriation flows. This may look strange. and despite some important steps in late October 2011 to address the eurozone sovereign We think developed economies will continue to see low growth in 2012 as governments and households continue to deleverage. so it may look like a risky bet for 2012. We expect the EUR/ USD exchange rate to gradually return below 1. JPY per USD (rhs) 06-09 01-10 06-10 Yen stronger 01-11 06-11 75 Source: Datastream. As we see the eurozone economy as particularly vulnerable to recession. The growth slowdown in the summer of 2011 was partly due to temporary factors such as the steep rise in oil prices from May 2010 to May 2011 and supply disruptions to global manufacturing following the . the Fed may embark on another round of quantitative easing. deflation and loose monetary policy in Japan. the ECB may further cut interest rates in 2012. while during the summer. If growth stays low and unemployment remains high. and if inflation moderates.2012: a frugal and crucial year | November 2011 I 7 Central bank assets (index. The risk of recession will remain high and inflation should moderate.3 1. we could be too pessimistic. given the banks’ tight reins on credit.4 1. However. But there should also be support from the HARP (Home Affordable Refinance Program) scheme to help households with negative equity in their homes. We think there is a high chance that more steps will be taken both in the US and in Europe. This would lower mortgage rates. The BoJ has even intervened in currency markets more than once to prevent the yen from strengthening further. In the first part of the year. Secondly. 1 January 2007 = 100) 400 BoE 300 Fed 200 ECB 100 debt crisis. Risks to our outlook There are several risks to our outlook. First. for several reasons. First of all. it is unlikely that the US dollar will strengthen dramatically in the near term. The euro weakened when the eurozone sovereign crisis flared up again in the autumn of 2011. but the economy needs to weaken much further before the bank becomes even more aggressive. as persistently high inflation is undermining the bank’s credibility. BNPP IP The Japanese yen has been strengthening against the US dollar during most of 2011. We don’t see the euro retaining its current strength through 2012. This still has the potential to weigh on the euro. The most likely target of the purchases would be mortgage-backed securities. Nevertheless. the ECB’s rate hikes supported the currency.5 1.2 1.1 01-09 Euro stronger USD per EUR (lhs) 99 93 87 81 Source: Bloomberg. we don’t think that in 2012 the yen will continue to be able to resist the gravity of weak growth. We doubt that QE3 would have a major impact on the real economy. Monetary policy will stay loose. the weakness in the economy and on the Japanese equity market is partly being caused by the strong yen. thus enabling consumers to refinance their mortgages more cheaply. We foresee a weaker yen in 2012. central banks are generally expected to cut rates or announce other stimulus measures. The BoE’s hands are tied to some extent. but without success. as we foresee. In fact. as refinancing is not an option for many households. as Japan’s growth prospects are modest at best and the BoJ has continued its ultra loose monetary policy.

as not doing so would create a strong fiscal squeeze on a fragile economy. which is positive from an inflation standpoint. Finally. tensions around currencies could intensify in 2012. so at some point emerging currencies may appreciate again. Currency interventions in Japan and Switzerland in 2011 caused sharp moves in currency markets. Yet durable solutions to the fiscal situation in some peripheral countries. Finally. the US elections could result in a stalemate regarding fiscal policy. We expect the temporary tax cuts that expire at the end of 2011 to be extended. Secondly. investment and durable goods consumption were made during the previous recession – even if this did not lead to a full recovery. We also think uncertainty will remain over the longer-term fiscal outlook for the US. The corporate sector is highly profitable and has ample cash. there are downside risks to our moderately bearish outlook on the economic side. However. some form of collective debt issuance by eurozone governments. We don’t think this will be strong enough to lead to large interventions and political tensions. Firstly. financial markets and the global economy.2012: a frugal and crucial year | November 2011 I 8 devastating earthquake and tsunami in Japan in March 2011. And thirdly. and thus aggravated. Such solutions will not be quick in coming. if indeed they are available at all. may have been excessive. this could be accompanied. . to the lack of competitiveness of some member states and to current account imbalances still have to be found. by another financial crisis. and in the meantime. For example. We think growth in China will merely moderate in 2012. a more durable economic recovery could follow. offer peripheral countries support to enable them to grow out of their problems. we expect it to be mild. the pressure is off for the authorities in these countries to weaken their currencies. Regarding China. Eurozone spreads (10-year yield difference with Germany. to growth differentials within the eurozone. as well as bank credit. the growth differential between developed and emerging markets has remained. but we do see it as a risk. China could recapitalise its banks if necessary and there is room for fiscal stimulus through infrastructure spending or tax cuts. If economies slip back into recession. eurozone government leaders outlined a solution for recapitalising the banking sector. On the political front. writing down Greek sovereign debt and further increasing the firepower of the EFSF. Should positive sentiment return and investment and employment start growing more robustly. This could be a leveraged EFSF or the ECB itself. In November 2011. as many adjustments in employment. yet no political backlash. there are risks of negative consequences for confidence. Housing and other infrastructure spending. As many emerging market currencies sold off during the summer of 2011. However. Alternatively. BNPP IP We think that in the end they will arrive at a solution which could contain three parts. meaning any new recession could again be deep or even more drawn-out. There is a strong probability that the leadership transition in China will see a period of economic stability as we think the Communist Party will do its utmost to keep the economy stable before and during the transition. the usual tools to battle a recession – stimulative fiscal and monetary policy – may prove less effective than usual. provide a credible buyer of last resort for the debt of countries facing liquidity problems. which may continue to weigh on consumer and producer confidence. it is now becoming clear that the huge government stimulus that prevented the economy from entering into a recession in 2008/09 is having its drawbacks. bps) 2500 Greece 2000 1500 1000 500 0 01-08 Italy Ireland Portugal 06-08 01-09 06-09 01-10 06-10 01-11 06-11 Source: Bloomberg. and expect that China’s huge foreign exchange reserves will form an important buffer against a strong growth slowdown. Even if a hard landing cannot be ruled out. we could be too confident: political risks will abound in 2012. both in developed and emerging countries. And if developed economies relapse into another recession. we believe that the political leadership transition makes it unlikely in 2012.

Will equities in 2012 be able to finally leave the legacy of the crisis behind? Bond yields have been forecast to rise from historical lows on many occasions in the past years. At the time of writing. Equities: low valuation but many risks On both an absolute and a relative basis. Things may improve over the course of 2012. the price of equities relative to the underlying book values of the companies stands out as extremely low. In Japan. Firstly. which measures prices against a long-term average of earnings to smooth out cyclical patterns.5 during the 2008/09 recession. European and emerging markets . given our somewhat bearish outlook. Price-earnings (P/E) ratios in both developed and emerging markets have fallen well below their long-term averages. However. In 2010. the US cycle-adjusted P/E ratio. This does not mean we are outright totally bearish about the whole year. we are cautious towards risky assets going into 2012. So US equities are not cheap by all measures. equity valuations are low. we do not see these positive valuation metrics as a compelling reason to buy equities at this point. The earnings yield on US and European equities is close to a record high when compared to the yield on government bonds.2012: a frugal and crucial year | November 2011 I 9 Market outlook SUMMARY • Valuations not expected to be the main driver for equities • Emerging equities to benefit from robust growth and lower inflation • US and German government bonds not attractive • Emerging market debt supported by growth and monetary policy • Preference for high yield versus investment grade corporate bonds • Time for commodities has yet to come At the time of writing (early November). equities rallied to new post-financial crisis highs in the final months of the year. Will they stay low in 2012? It should be no surprise that. Secondly. valuations could move lower if the US or the eurozone were to enter a new recession in anticipation of earnings downgrades. is still above its own longterm average. And the comparison with bond yields may anyway be less relevant in a low growth environment where bonds yields are depressed by extremely loose monetary policy. while this fell to 11. the performance of equity markets during 2011 to some extent resembled that of 2010: early strength followed by a summer sell-off. so timing will be very important. the P/E ratio for US equities is around 13.

many arguments to be made in favour of emerging equities. On the other hand. Since 1996. but without positive catalysts.6 percentage points in the past decade. we have doubts about the sustainability of earnings growth. In fact. The discount for emerging markets is currently only 16%.9% of GDP. we do not foresee a lasting rally in equity markets for the time being. we could see a more lasting upturn later in 2012. In short.2012: a frugal and crucial year | November 2011 I 10 are currently trading just above 10 times earnings. but margin expansion looks difficult to achieve as margins are already at or close to record levels. we are not optimistic on those points. Valuations are certainly low for Japan. Yields were so low that even a modest rise would destroy the total return of this asset class. especially relative to developed equities. Although we do not think the eurozone will fall apart or that Italy or Spain will default. We also find emerging equities attractively valued versus developed equities. Finally. True. but this effect is relatively small. As a result. valuations are lower in Europe and earnings expectations are more modest. while P/E ratios fell below 8 during the financial crisis. Greek government debt may be restructured to a larger extent than currently planned and we would not fully rule out debt restructuring in Portugal or Ireland either. but productivity growth has slowed significantly. This has not changed. We think macroeconomic and political developments will be more important. This argues in favour of a more tactical approach to equity markets instead of a buy-and-hold strategy. If the right policy measures are taken and confidence improves. we are positive on this asset class. the P/E ratio of emerging equities has been on average about In our outlook for 2011. Structurally. EM/DE 12-months forward PE 120 100 80 60 40 96 98 00 02 04 06 08 10 Source: Datastream. but with a recession looming this may still be too optimistic. unit labour costs have risen. US equities tend to be more defensive in a downturn. the highest level since the early 1950’s. we don’t think valuations will be the key market driver in 2012. Last year. relative to developed equities. or in 2010 when they traded at a 5% premium. Bond yields to stay low Developed or emerging equities? Regionally we do not have a strong preference for any developed market. more attractively valued than in 2007/08. In fact. Lower commodity prices may be beneficial to some extent. This may be a compelling argument in favour of Japanese equities. Analysts have cut their earnings estimates in the past few months. And emerging equities are. but for US companies. but the ECB has made clear on several occasions that it does not see this as a core activity. While emerging equities cannot escape the gravity of falling developed markets and so remain vulnerable to shocks. But this is shrouded in uncertainty. We pointed to the specific risks of peripheral eurozone government bonds. and the Fed tends to be more aggressive in its attempts to avert recessions. we warned that government bonds were not entirely risk free. Risk spreads on Italian and Spanish bonds have been kept from spiralling out of control by heavy buying from the ECB. valuation may be low today. wage costs are subdued in most developed economies. US corporate profits amounted to 12. In the second quarter of 2011. on the other hand. There are. we do not see this changing much. which averaged 4. but investors should bear in mind that many Japanese companies are geared towards the global economy and that they may continue to struggle with a strong yen. yields are currently lower than when we wrote our outlook for 2011. In other words. transparency and corporate governance during the past decade. has been maintained in the current downturn and we do not expect it to narrow much: emerging markets have favourable demographics and do not face deleveraging processes. earnings are still expected to grow close to 14% next year. There will be rallies. As we described in the previous section. but also downturns. . we also highlighted the risk that rising yields would have on the value of US or German government bonds. Part of this may be structural as companies are making more profit abroad. 25% lower than that of developed equities. we would not want to advise investors to increase their exposure to these bonds. but we think this is justified given emerging markets’ improvements in macroeconomic stability. risks that indeed surfaced during 2011. BNPP IP Thus. growth tends to be higher in the US than in Europe (partly due to more favourable demographics). emerging equity valuations are somewhat above their long-term average relative to developed equities. We have a small preference for US over European equities. Expectations for earnings growth in France and Germany have come down to 8%. The positive growth differential versus developed economies. Furthermore.

Much was recouped in October 2011. from an average of 270bp in the first seven months of the year. when risk appetite returned. In such an environment. but only to a limited extent. We therefore believe the valuation of credit has improved. This should lead to lower yields in local currencies.2012: a frugal and crucial year | November 2011 I 11 10-year government bond yield 5 4 US 3 US) and the risk spread. The return on emerging bonds in foreign currency is related to developed economies’ bond yields (mostly the Better perspectives for emerging fixed income Investment-grade (lhs) 400 300 200 100 2000 1500 1000 500 High-yield (rhs) 0 05 06 07 08 09 10 11 0 Source: Barclays Capital. these bonds sold off sharply when investors feared a double-dip recession. Europe. We are thus more reluctant to increase exposure in investment grade bonds than we are in high yield bonds. In our view. First of all. we would not entirely rule out an increase in bond yields in 2012. . but if we were looking to increase exposure in any asset class. that we don’t see the need to rush into this asset class. Spreads on USD-denominated bonds over US Treasuries widened to over 440bp. It is worth noting however. which could be positive for equities. Risk spreads on investment grade credit have widened further than those on high yield. Some emerging currencies depreciated by 20%. This should put a strong cap on government bond yields. Corporate defaults may rise from the current low levels. which form a large part of the investment grade universe. In fact. such as emerging market debt or high yield credit. Corporates do not face the need to deleverage. companies are forced to focus on their core activities and are less likely to embark on adventurous investment projects or mergers and acquisitions. Germany 2 Credit: we favour high yield 1 01-08 06-08 01-09 06-09 01-10 06-10 01-11 06-11 Source: Datastream. Moreover. Given emerging markets’ generally fundamentally sound fiscal positions. emerging market growth resilience may even lead to currency appreciation. but we think this is already widely priced in. We do not foresee large swings in bond yields in developed economies. We think the pick-up in yields is attractive and a narrower risk spread over the course of 2012 could offer further support. Thus. the risk spread on foreign currency emerging market bonds has widened enough in 2011 to take a modest growth scenario into account. We therefore favour other fixed income instruments. we think growth will stay low. BNPP IP We think that bond yields in the US. Eurozone option-adjusted corporate spread (basis points) 500 2500 We think the prospects for emerging fixed income are more positive. During the summer of 2011. nor do we expect them to appear in 2012 either. emerging currencies will no longer be supported by monetary tightening as they were in 2011. We are currently neutral or negative on most risky asset classes. The increase in the risk spread on high yield bonds has been much more muted. Investment grade spreads have moved close to the levels seen in the financial crisis of 2008/09. despite monetary easing. This has improved the valuation of emerging bonds. if any recession were mild and short or if progress was made on the eurozone sovereign crisis. Credit spreads widened during the 2011 summer sell-off. Bloomberg. in our view. even though investment grade bonds may be more attractively valued on a relative basis. have suffered from the eurozone sovereign crisis. some developed economies may even relapse into recession. Japan and the UK will stay low from a historical perspective. We don’t see upside inflation risks now. central banks in the US. Recession fears may cause further spread widening in the near term and liquidity in these markets has worsened lately. Three developments could make this happen: if the US avoids recession. and as written earlier. with yields as low as they are. even small increases could lead to negative returns on government bonds. Currency developments are of course very important for this asset class. Germany. but we think there is room for further upside. BNPP IP The reason for the difference is that banks. Credit tends to outperform equities and government bonds in a low-growth environment. corporate fundamentals such as profitability and balance sheets are generally strong. at least in Europe. in both US dollars and local currencies. Japan and the UK will be on hold throughout 2012 and we would not even rule out additional stimulus measures. We expect inflation to moderate and monetary policy tightening to be reversed. In 2012. reducing the need for safe havens. Nevertheless. but tend to be negative for bondholders. we think this sell-off will prove to have been overdone. especially high yield. However. it would be credit.

Private equity did suffer during the crisis but with a lag as 2009 and 2010 were the years when immunity was affected. especially in the eurozone. The global economy was doing well and political unrest in the Middle East and North Africa raised fears of disruptions to the supply of oil. One of the characteristics of such an investment is that it usually aims at financing. For example. These developments show that commodities are correlated to the global economic cycle. oil prices started to move sideways. So we think a rotation into commodities will become attractive sometime in 2012. more selectivity and a stricter leverage attribution. Low interest rates on government bonds of safe countries are encouraging investors with a large. We also expect relatively strong growth to be beneficial for emerging market debt. Gold prices continued to increase as investors sought the ultimate safe haven as a shield against the risk of recession and the (in our view. are long term in nature. alternatives across the board played their role of diversification both in terms of returns and of risks. and crisis environments remain favourable for entrepreneurship and innovation. but also sold off sharply in August and September 2011. but also that this area has generally shown itself to be an effective diversifier for portfolio construction on a mid to long-term horizon. we would also recommend a shift from defensive commodities like gold towards more cyclical commodities like base metals. The asset classes we like for upside potential. Thanks to its counter-cyclicality. infrastructure and other real assets. Infrastructure investments refer to the private sector being involved in closing the funding gap for new or existing assets necessary for economic activity. low) risk that too much monetary stimulus could lead to runaway inflation. while offering upside potential when the global economic cycle improves. We believe that. considering a high degree of selectivity. . Nevertheless. They have an average investment horizon of eight to 10 years and they provide limited liquidity. even though some (such as hedge funds) were not negatively correlated.2012: a frugal and crucial year | November 2011 I 12 Commodities – not yet Commodities did well in the first few months of 2011. We are therefore not ready to give a positive recommendation for commodities at this point. The current sovereign debt concerns. Emerging market equities should benefit from a positive growth differential between their economies and developed ones. When that improves. which we have selected from a risk-return perspective. However. as the global economy slowed during the summer and the loss of Libyan oil production was offset by Saudi Arabia’s. Furthermore. Investments in non-public assets such as non-listed companies. while lower inflation and greater accommodative policy should also offer support. emerging market equities. fundamentals for deal flow and distressed opportunities. the best vintages of private equity have proven to be the ones investing within the worst economic environments due to a combination of low valuations. emerging market debt. Base metals peaked relatively early in 2011. Our ideas for 2012 Alternatives During and after the financial crisis of 2008/09. Other real asset strategies such as infrastructure also enable investors to diversify away from the short-term volatility of listed financial markets. 2012 and 2013 should be appropriate years for investing in private markets. yield or a favourable combination of upside potential and defensive characteristics are high income equity. In any case. their three year performance remained positive. the US private equity market outperformed the S&P index by more than 5% as of December 2010. When these fears also receded. should tip the balance in favour of privately funded deals therefore increasing the deal flow. suffering less from short-term market moves due to the valuation methods of transactions. so they can make the most of a difficult situation by capitalising on the weak assets available due to a fragmented environment. unsatisfied appetite for yield to shift assets into the high yield asset class. High income equity should give investors a good yield. the flow of debt capital seen in the bull years will have to be refinanced either through debt or capital. fundamentals are sound and the asset class should benefit from institutional inflows. especially against a background of limited growth in production capacity. Convertible bonds combine defensive characteristics with upside potential. once there is more visibility on how the macroeconomic cycle will develop. We like commodities from a fundamental perspective though: commodity-intensive growth in emerging markets should remain supportive. gold prices dropped sharply. The main reasons for this are attractive pricing. high-yield corporate bonds and convertibles. maintaining and operating public or private sector assets in return for long-term contract payments based on the operational longevity of the underlying. We think Asia will be the best region for this asset class. In the next part of this outlook we highlight several investment ideas for 2012.

2012: a frugal and crucial year | November 2011 I 13 .

low inflation and stimulative monetary policy. more than 35% of the population will be 65 or older in 2050. are offering an even more attractive spread. may turn to high dividend equities. investors seem to have forgotten about the fundamentals of companies. preferably. on bonds. we think the important catalysts for the performance of high dividend stocks will be greater macroeconomic clarity and less risk adversity among investors. Many investors have a significant proportion of cash in their portfolios. BNPP IP Valuation Turning to valuation. currently yielding approximately 5% (S&P High Income Equity World). In relation to bonds. However. the strategy should be to focus on high growth stocks. in our opinion. have shunned equities. The current earnings yield of equities is thus effectively 3-4 times that of bond yields. We believe these demographics will support the demand for high dividend stocks in the Asia Pacific region over the longer term. high dividend stocks look attractive both on an historical basis and compared to bonds. we believe that investors who have traditionally invested in them for their perceived safety and steady yield. it is not entirely fair as the yield on a government bond is all an investor receives. by contrast. when investing in equities. high income equities have done exactly ‘what it says on the tin’ over 2011. In Asia. a high dividend equity strategy can significantly outperform the general equity market and has not only done this in bear but also bull markets. choices are scarce for investors searching for yield. their dividends have provided a cushion. due to market movements. To put it another way. Government bonds have a yield of approximately 2%-3% currently and in some core countries even less. as the significant inflows into money market funds in 2011 show. yet in South Korea. The region is regarded as being characterised by growth and therefore. with cash reserves. both private and institutional. While the comparison of bond and dividend yields is often used in making the case for a high dividend equity strategy. strong balance sheets and greater geographic diversification. a staggering comparison! Taking an historical perspective. for example. Considerations when pursuing this strategy It is not just the absolute level of dividend yield that investors should consider. By historical standards. while the dividend yield is only half the story for equities. One has to be careful not to fall into a ‘value trap’. High income stocks. while the dividend yield on global stocks in general now stands at approximately 3% (MSCI World). Looking ahead. rapidly growing companies can also pay relatively high dividends and nowhere is this clearer than in the Asia Pacific region. Over the short term. the lower end of their longer-term range. Given the low yields available on bonds. not on the side of earnings yield but. Even if these stocks have also experienced a sell-off as investors. US earnings yield & bond yield (%) 16 Asset class drivers With markets being driven mainly by macroeconomic factors. ‘flight to safety’ we have seen by investors has driven down yields on government bonds to historical lows. high dividend stocks have outperformed general equities on both a global and a regional basis. By their very nature.2012: a frugal and crucial year | November 2011 I 14 High Income Equities Brief review of key developments in 2011 To borrow the phrase from the world of advertising. with expectations of subdued global growth. In the difficult market conditions of 2011. In such a low-yielding environment. global high dividend stocks are currently trading at an attractive P/E of around 10. growing. it is paramount they ensure that the dividend level is sustainable and. half of a company’s earnings are retained and can be re-invested. attractively priced dividend stocks. while in China the figure is expected to be 20%. the It is important to remember that companies paying high dividends also have the potential to grow. such stocks offer stronger downside protection than general equities in a declining market. interest rates are set to remain low. as shown in the chart below. there could be a significant increase in demand for equities paying higher dividends. if investors were to gain confidence. which . We see a number of growth stocks that were too expensive yet are now. corporates appear to be generally healthy. Taking a longer-term perspective. negative sentiment and memories of 2008. S&P500 earnings yield 12 8 10-year Treasury yield 4 0 60 65 70 75 80 85 90 95 00 05 10 Source: Datastream. With a pay-out ratio of approximately 50%. the ageing population creates a natural demand for retirement planning. Unlike heavily indebted countries. Japan’s ageing population is often talked about. this has not been the case for over 30 years in the US. With these reserves earning little. This implies a significant mispricing in the market currently.

Asia. . particularly emerging Asia. high dividend equities are attractively valued and offer a higher yield than bonds with the potential for growth. and ensure thorough analysis and research has been conducted: this is the focus of our high income equity investment process. In the worst case scenario.2012: a frugal and crucial year | November 2011 I 15 can occur when a stock looks cheap. both may happen. is the most interesting after the set-back this summer. Asia – while not risk-free – looks relatively attractive now that inflation seems to have peaked and a soft landing in China is likely. but it actually is not. The company’s stock price may decline further or the firm may cut or stop paying dividends. With low growth and elevated recession risks in developed economies. in terms of regions. Conclusion We believe that in the current economic environment. as reflected in a high dividend yield. To try and avoid this potential pitfall it is important to select stocks bottom-up. From a global perspective.

should have considerable upside potential. we expect the best performing markets to be those with a strong presence in the most attractive industries. the Fed signaled it was likely to keep rates low until 2013 and the Brazilian central bank cut its base rate twice. During the markets late-summer downturn. Chinese equities were trading at around 35x earnings. there is considerable potential for EM currencies to strengthen. they have greater monetary flexibility. a more supportive environment for emerging markets began to materialise: the ECB lowered interest rates. We see this as evidence of the increasing confidence investors have in EM governments and sets a foundation for prosperous EM businesses. And as much of the upside in EM equities comes from strengthening EM currencies.2012: a frugal and crucial year | November 2011 I 16 Emerging Market Equities Brief review of key developments in 2011 Uncertainty and volatility ruled the markets over large portions of 2011. the rapid growth of middleclass consumers makes domestic retailers in Brazil an attractive opportunity. EM governments are maintaining high quality balance sheets. including China.. with a clear rotation out of defensive assets and into higher beta equities. the outflows were small. we expect governments to be less concerned over inflation and to focus more on creating growth. For example. it was external macro-issues that caused a large portion of the outflows from emerging markets (EM) throughout much of the first nine months of 2011. Overall however. which will provide them with an edge should investor sentiment turn down again. would drive inflation in emerging markets to dangerous levels. Regionally. inflows to EM equity were minimal. including Russia. we would argue that they have been oversold and are currently undervalued. Compared to 2008. Accordingly. and this should not change any time soon. Additionally. . as emerging markets have higher real interest rates relative to most developed markets. Asset class drivers A key strength of emerging markets is that most companies operating within them are in very good shape. BNPP IP In October 2011. Currently they are trading at around 8x to 9x earnings.e. In 2012. Even with falling GDP growth. EM currencies have also suffered. As emerging markets have a structural reason to maintain higher growth relative to developed markets. EM debt experienced limited outflows when the markets turned down in July 2011. Similarly. The common and global commitment to spur economic growth helps underpin our positive outlook on emerging markets. perhaps more so than equities. While most experienced some inflows in October. South Korea and Taiwan. However. makes South Korea an attractive market. We find equity valuations within emerging markets attractive. While there have been concerns that their growth is slowing. and as they are likely to continue providing investors with higher interest rates. the downside of cyclicality in developed markets can still weigh on emerging markets as the two remain cyclically correlated. EM equities were negatively impacted largely on external factors. While the US and eurozone are struggling to regain any firm growth impetus. Brazil. shifts in consumer preferences towards mobile data devices and the near-certainty that car ownership will increase in China. Even in October. particularly for food. we anticipate greater accommodative policies from many emerging markets. these did not come close to matching the outflows witnessed during the summer downturn. when investors had similar concerns over the strength of financial markets. most emerging markets are still growing faster than Europe and the US. Of course. emerging markets remain the premier region for exposure to growth. investors feared that rising commodity prices. GDP (% YoY) 10 Valuation Emerging economies 5 World 0 Developed Economies -5 00 01 02 03 04 05 06 07 08 09 10 11 Source: IMF. Early in the year. i. countries such as China have actually engineered their slowdowns. As emerging markets are not suffering from the high debt levels that plague developed countries. investors moved sharply back into risk. In 2007. namely lower debt. they too. eurozone sovereign debt issues and the US rating downgrade caused investor concern over the prospects of slowing growth in China. yet numerous global equity markets remained oversold. As 2011 drew to its end. Chinese banks currently trade at around 5x earnings compared with a norm of around 10x earnings. China. when broader markets rebounded. faltering developed market growth. allowing for an easier return to growth policies.

The main one is a hard landing in China. The asset class appears oversold. should it experience any turbulence the effect on EM equities could be substantial. Conclusion The prospects for strong returns from EM equities look excellent. There is a risk that the Chinese government will over-tighten. not just in China but in the majority of emerging markets. we believe the more likely course of action in 2012 will be more accommodative policy. We believe the recent market downturn has provided an excellent opportunity to enter into global EM equities.2012: a frugal and crucial year | November 2011 I 17 Considerations when pursuing this strategy While the prospects for growth in emerging markets are strong and equity valuations are attractive. . There will also be a transition within the Chinese government in 2012 and while this process is expected to be fairly smooth. is fundamentally strong. emerging markets could arguably be the fastest growing component of many portfolios. Over the next decade. and should remain a major component of most asset allocations. However. squeezing developers and restricting credit. there are of course risks to be considered.

Latin America and Africa. Fundamentally. Market worries are that EM growth will falter with DM growth. the emerging market story remains intact and emerging bond markets have already retraced their September losses. Government Source: Bloomberg. transitory and emerging market debt to be among the first assets to rebound. yet although these fears seem credible and realistic. There is also a tail risk from eurozone deleveraging but we do not see this derailing the positive story for EM debt. Despite the recent volatility seen in the markets. Fundamentals are continuing to strengthen and. Possible downside risk comes from a synchronised global slowdown should the sovereign debt crisis worsen. JPMorgan. the European sovereign debt crisis loomed back to the fore. we think economic momentum is not as weak as priced by the market. casting its shadow over global markets. Risk aversion was at its highest since October 2008 and global markets were hit by extreme volatility. Central and Eastern Europe will see the weakest growth due to the region’s strong trade and financing links with Western Europe. the eurozone sovereign debt crisis and European bank deleveraging are also likely to have an impact. Conclusion Asset class drivers We expect the key drivers for emerging markets in 2012 to continue to be growth and strong potential inflows. we see growth remaining solid and at potential output level in Asia. Since EM debt is not immune to events in developed markets. we would expect the damage to emerging markets to be . We continue to see value in EM debt and are positive on the asset class for 2012. solid growth performance allowed emerging market currencies to outperform. However. with some regional divergence. dragging on performance in Q3. Russia/CIS was growing slightly below potential but seems to be firming now. External and corporate debt are both sitting at around 400bp of premium for BBB-rated assets. In the summer. Growth potential is one of the most important drivers of performance in this asset class and we expect growth outperformance in emerging markets to prevail. We are not building our constructive view of emerging market assets on a decoupling or safe haven theory but on fundamentals. Curves then benefited from slowing growth in the second half. the EM corporate asset class story should gather speed and start to attract long-term institutional investors. either of which could lead to the outperformance of emerging market debt. and there is the risk that Central & Eastern Europe growth may be hit should the eurozone slip into recession. An initial inflation scare quickly disappeared as emerging market central banks normalised policy rates. the valuations are more attractive and near-term risks are fading. BNPP IP Considerations when pursuing this strategy There is upside risk potential from the existing weak growth in the eurozone as well as the sovereign debt crisis risk abating.2012: a frugal and crucial year | November 2011 I 18 Emerging Market Debt Brief review of key developments in 2011 During the first half of 2011. While remaining highly resilient through the summer. Emerging bond spreads (yields difference with US Treasuries. EM currencies are currently cheap following the underperformance seen in 2011 but since these are cyclical assets we will watch for the bottom in global growth. however. the emerging market story remains unscathed. EM debt is thus likely to experience volatility contagion from developed markets. September saw emerging markets eventually hit by collateral damage from global events. bps) 550 500 450 400 350 300 250 01-11 04-11 07-11 10-11 Corporates Valuation Valuations are currently cheap compared to historical levels. hard economic data do not validate them. on balance. focusing solely on the tail risks from the sovereign crisis. We see growth momentum continuing and believe that the market is myopic. We also expect structural allocation flows from institutional clients to continue: as investors reconsider the value of sovereign external debt.

31-oct-11 Valuation High yield default rate (%) 5 4 3 2 1 0 Median '97-'10 Source: Moody’s. BNPP IP. credit quality and underlying government bond yields will resume their role as the primary determinants of high yield performance. far outpacing government bonds in both Europe and the US. High yield risk spread (yield difference with US Treasuries. The price deterioration contrasted with the firmness of credit fundamentals. BNPP IP. Global high yield returned 5. A lapse into recession would push the default rate higher. unexpectedly strong 4 GDP growth could push spreads below their historical average. Asset class drivers 1 We believe high yield bonds have the potential for strong performance in 2012. Furthermore. This unusual relationship points to excellent value in high yield bonds. credit quality should remain strong. Returns turned negative for high yield bonds and strongly positive for governments. but probably not to the double-digit levels of 2009. however this is unlikely in 2012. conditions reversed. Over the next six months.57% during the period. as dealers have cut back sharply on their commitment of capital to market-making. or unforeseen geopolitical upheaval. there has been little creation of extremely leveraged buyouts in this cycle. Any signs of improvement in the global economy will generate new pressure for ECB interest rate hikes to ward off inflation. As dealers step up their secondary activity. unsatisfied appetite for yield to shift assets into the high yield asset class. high yield spreads should contract. The default rate should not rise sharply from its current 2% range as long as GDP growth remains modestly positive. providing further support to high yield bond prices. creating the potential for high single-digit returns in 2012. There was no significant escalation in the actual or projected default rate. Low 31-oct-11 interest rates on the government bonds of safe countries are encouraging investors with a large. They would suffer in the event of a disorderly sovereign debt default. Conclusion 2 If eurozone leaders succeed in restoring confidence. 31-oct-11 The high yield spread versus Treasuries is well above its historical median. Corporate balance sheets are stronger than they were prior to the Lehman Brothers crisis and many companies took advantage of highly favourable financing conditions to extend debt maturities beyond 2012. basis ponts) 800 700 600 500 400 300 200 100 0 Median '97-'10 Source: BofA Merril Lynch. Considerations when pursuing this strategy High yield bonds face the same hazards as other risky asset classes such as equities. an economic 5 slowdown. . even though the speculative grade default rate is well below its historical median. The high yield bond asset class became the victim of a general flight to quality as new fears arose of a disorderly Greek default and a possible spreading of the sovereign default problem to other peripheral European countries. a hard landing in China. provided sovereign debt problems 0 cease to dominate'97-'10 Median financial market developments. Barring a double-dip recession.2012: a frugal and crucial year | November 2011 I 19 Global High Yield Brief review of key developments in 2011 The risk premium on high yield corporate bonds tightened during the first four months of 2011 as investors grew less fearful of sovereign debt crisis contagion and double-dip recession. Economists also began to scale back their US growth expectations. The disparity between risk and reward reflects illiquid conditions in the secondary market. On the upside. conceivably vaulting returns into low double 3 digits.

As seen in straight bonds. We therefore believe that in a low growth environment. BNPP IP. Nevertheless. Furthermore. we do not foresee a dramatic rise in rates. and as spreads are at wide levels. if the asset price performs poorly. They would suffer in the event of a disorderly sovereign debt default.2012: a frugal and crucial year | November 2011 I 20 Convertible Bonds Brief review of key developments in 2011 In 2011. – 11. given their short duration. convertible bonds have a more favourable risk/return profile than equities do. Past performance is no guarantee for future returns. This was in large part due to the influence of overall credit spread widening. convertible bonds fulfilled their side of the bargain by outperforming straight equities with less volatility in a down market. an economic slowdown. Valuation Spreads are wide and some bonds are near their bond floors although we cannot say the market is as oversold as it was after the Lehman Brothers crisis. convertible bonds. for example. The nature of a convertible bond portfolio is such that with 50% of stocks rising and 50% falling over a period. particularly at the height of the crisis in August and September. bonds Cash Equities The key driver for convertibles remains their core characteristic of offering investors a way of reducing their risks in the case of a negative scenario while keeping a potential upside should a more optimistic scenario unfold. The value of your investments may fluctuate. the corresponding convertible bonds universe will see a positive return due to the upside capture of rising stocks. The universe is structurally small versus other asset classes and valuations could also be sustained by the rarity value. On the credit side. 1 January 2005 = 100)* 250 200 150 100 50 0 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Asset class drivers Convertibles Gov. as the comparison between different Japanese asset classes over a 15-year period shows in the adjacent graph. it was more extreme in high yield than investment grade credit. which is higher than the downside capture of declining ones. Convertible bonds are therefore particularly suited to a lacklustre environment. underlying equities that reach the strike provide a substantial positive return for the convertible bondholder. convertible bondholders should continue to experience the benefits from the dispersion. It is possible that your investment will increase in value. . On the upside. or any unforeseen geopolitical upheaval. And having lost some of their equity sensitivity. Underlying equities that perform poorly do not impact the convertible bond’s performance as long as the final redemption occurs and the coupon is paid. Considerations when pursuing this strategy Convertible bonds face the same hazards as other risky asset classes such as equities. However. albeit with lower volatility. Conclusion In most market configurations. * JPM data not available after November 2010. they would not be highly sensitive to a hike in interest rates should one occur.38% at the end of September vs. they will be favourably affected by any credit spread narrowing and subsequent equity market rally. the cushioning effect may have disappointed some as the difference was not huge: the total return of the UBS Convertible Global CB index in USD was – 9. however. which also impacted straight bonds. we might expect them to narrow. a hard landing in China. you will lose some or all of your initial outlay. JPMorgan. were more sensitive to bond news. Source: Bloomberg.82% for the MSCI World USD index. It is also possible. that your investment will generate little or no income and that. Japanese returns (total return indices. despite a widening overall. emerging market issuance and potential new issues of exchangeable bonds by sovereigns. as an asset class. merger and acquisition activity.

2012: a frugal and crucial year | November 2011 I 21 Contact Us Joost van Leenders Investment Specialist Allocation and Strategy Jennifer Clarke Investment Specialist Emerging Fixed Income Martin Fridson Global Credit Strategist .com Sheila Ter Laag Investment Specialist Convertible Bonds Tom Bagguley Investment Specialist High Income Equities Mathew Powers Investment Specialist Emerging Market Equities mathew.terlaag@bnpparibas.bagguley@bnpparibas-ip.

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