23990647 barclays capital global outlook 122009

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RESEARCHDecember 2009

GLOBAL OUTLOOKBEYOND THE RECOVERY TRADE

Barclays Capital | Global Outlook

10 December 2009 1

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 2

SUMMARY OF ASSET ALLOCATION THEMES KEY FORECASTS KEY RECOMMENDATIONS

Equities 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 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.

Bonds 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.

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.

Commodities 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 Chinas 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.

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.

Inflation Real yields biased higher in 2010 from ongoing economic recovery, although breakevens then likely to be supported by normalization in inflation.

5y sector offers greatest potential to benefit from a recovery-led repricing of breakevens.

Credit 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.

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 normal-ization 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.

Emerging Markets

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.

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.

Foreign Exchange

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.

Buy USD/JPY. Buy commodity currency basket against the CHF. Sell AUD/CAD. Sell EUR/SEK.


10 December 2009 3

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 4

OVERVIEW

Beyond the recovery trade Following the drama of the past two years, asset valuations have returned to more

normal levels.

The recovery trade is still on for now, as policy remains enormously stimulative, and the growth laggards such as the US are set to post stronger-than-expected economic growth.

But the powerful cyclical forces that have driven the recovery rally are set to give way to structural and intermediate-term issues, resulting in lower correlations among asset classes and regions and the need for portfolio managers to be more selective.

An upturn in the US labour market could lead the Fed to signal before mid-2010 that a withdrawal of policy stimulus is imminent.

Money market rates, the dollar and gold are more vulnerable than equities and credit to potential monetary tightening.

Following two years of high drama and unexpected twists and turns, the past three months have been remarkably stable by comparison. The global economic expansion broadened as the recovery took hold, financial system healing continued, and asset valuations moved higher all largely as expected. With both economies and markets closely tracking Barclays Capital expectations, our forecasts for 2010 are little changed from those in the September Global Outlook.

As far as positioning is concerned, we find it difficult to tear ourselves away from the recovery trade, at least for now. While the economic recovery is approaching its first anniversary in Asia, it is just gaining its footing in most of the developed world, and policy settings have moved very little from those that were put in place at the height of the crisis. 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, most likely in the first half of the year. When it does, portfolio selection will become much trickier and asset managers will have to become more selective. 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. We are on the alert for signs of change in the current liquidity-driven environment, and recommend reducing risk and diversifying positions when these signs emerge.

A maturing cycle 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, which should continue through the first half of next year and keep global growth near its peak. Global growth is expected to slow later in 2010, as the pace of advance in the laggards settles back. That said, we see relatively little risk of a serious growth disappointment given the relative youth of the global expansion, the still-depressed levels of cyclically sensitive sectors such as

Larry Kantor +1 212 412 1458

[email protected]

We are on the alert for signs of change in the current liquidity-

driven environment

2010 may not provide the excitement of 2009, but it should still be favorable for growth and

inflation fundamentals


10 December 2009 5

autos and business investment, and the extreme ease of policy settings everywhere. Similarly, 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. While 2010 may not provide the excitement of 2009, it should be another very favorable year for growth and inflation fundamentals.

Market drivers to become more multidimensional Successful positioning in financial markets over the past couple of years has been a one-act play. Investors positioned either for recovery or defensively and were rewarded accordingly. Correlations between assets and across geographies have been very high and exactly how risk exposure was taken mattered relatively little. We believe that 2010 will be different. While there remains some resistance among investors to a full embrace of the economic recovery story, it has become generally accepted. Consensus growth estimates have risen considerably and are no longer significantly below Barclays Capital forecasts for the first time in more than a year. Moreover, asset valuations have returned to more normal levels. While the market rallies of the past year do not appear excessive relative to underlying fundamentals (except possibly for gold and government bonds), there are no screaming buys left. Equities, credit spreads and commodity prices for the most part seem reasonably valued.

For 2010, we expect much lower correlations among various assets and regions, 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. Among the issues that investors will need to consider are the exit strategies to be taken by central banks, the debt dynamics resulting from severe budget deficits, regulatory responses to the financial turmoil, the intermediate-term consequences particularly for inflation of the extreme liquidity measures employed by central banks, and the adequacy of raw material supply for another emerging market-led expansion.

The recovery trade's final act Before leaving the recovery trade behind entirely, there is one piece of unfinished business the most lagging sector in the most lagging economy the US labor market. Continued deterioration in the labor market has held investors back from fully embracing the recovery story. The November labor market report went some way toward dispelling that concern, but employment is still not increasing and the strength of the US recovery thus remains in doubt.

Ironically, while an upturn in the labor market would be important in confirming that a sustainable recovery is underway, it could also signal that the end of the recovery market rally is in sight. Labor market improvement is a necessary (although not sufficient) condition for the Fed to begin tightening policy. When unemployment starts falling, the course of Fed policy will be back on the table. This is the top intermediate-term issue we would focus on for early 2010.

Low for how long? It is particularly difficult to judge the pace and timing of policy adjustment in the current cycle, 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. It first produced instability in asset prices, which the Fed thought it could contain without serious damage to the real economy. But now that continued asset price swings have led to

There are no screaming buys left

Expect lower correlations among asset classes and geographies

An upturn in the US labor market could signal the end of the

recovery market rally


10 December 2009 6

real economy instability (Figure 1), the Fed may well have to adjust its approach to policy once again. 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, making the outcome even more uncertain.

Figure 1: Volatility in asset prices has led to volatility in the economy

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Source: BEA, S&P and Haver Analytics

We believe that with asset prices already back to at least "neutral" (consistent with Chairman Bernanke's judgment), the financial system very substantially healed, and policy settings as extreme as they are, it is not too early for investors to focus on what the world will look like when the Fed starts withdrawing support. This is not to say that a rate increase is around the corner, and certainly under almost any scenario US monetary policy will remain easy for a long time. 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. Federal Reserve asset purchases are likely to cease as scheduled by the end of Q1 and if, as we believe, the US labor market shows clear signs of improvement over the next few months and asset prices continue to appreciate, the Fed could signal before midyear that a withdrawal of policy stimulus is imminent.

Money market rates, 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, upward revisions to consensus economic forecasts, and rising asset prices. The jump in the unemployment rate in October, followed by comments by a range of Fed officials to the effect that rates will stay low for long, encouraged investors to bid down rates. This has tended to weaken the dollar and strengthen gold and other commodity prices. 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, further lowering their yields.

The approach of a turn in Fed policy could begin to unwind these patterns. The end of Fed purchases of MBS is set to boost net bond supply, which would add to the upward pressure on short-term yields that would naturally occur as investors price in Fed tightening. Higher short-term interest rates accompanied by confirmation of a stronger-than-expected US economic recovery could also boost the dollar, which would be met by reduced central bank buying of Treasuries. We recommend that investors underweight exposure to US (and European) risk free assets across the entire government yield curve, but particularly in the short end. Although we believe that the dollar could remain soft for a few more months, we

It is not too early for investors to focus on what the world will look

like when the Fed starts withdrawing support

The prospect of Fed tightening would likely reverse the trends of

lower government bond yields and a falling US dollar, and

interrupt the steady uptrend in commodity prices


10 December 2009 7

see an upturn in the dollar setting in before long, with the timing of the turn dependent on perceptions of Fed policy. We particularly like prospects for the dollar versus the yen, 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, which we expect to do not much better than tread water over much of 2010.

Equities and credit less vulnerable As noted earlier, equities no longer offer overwhelmingly attractive valuations, and any sign of a shift in Fed policy toward tightening is likely to trigger selling pressure. Indeed, that has been the historical record after large equity rallies that have anticipated economic recoveries and benefited from low interest rates. That said, we do not expect the onset of Fed tightening to trigger a bear market. Profit margins are quite high, and interest rates are coming from such extraordinarily low levels that it will be some time before Fed policy is even remotely restrictive. Indeed, once markets price in a modicum of Fed tightening, the equity market may well start to rise again, particularly if the Fed keeps rates at an accommodative level for an extended period in deference to a still-high unemployment rate.

We feel similarly about corporate credit. Valuations are no longer compelling, 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. Prospects for higher interest rates, however, mean that absolute returns will not be nearly as strong.

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. 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, and emerging markets have been particularly vulnerable to Fed tightening in the past (especially in Latin America). It is true that things really are different this time (see Advanced emerging markets A reassessment of an asset class, Global Economics Special Report, 12 November) and we recommend that investors hold a larger proportion of their assets on average in emerging markets. That said, 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. As a result, emerging market investors should pay particular attention to signs that policy tightening is approaching.

We do not expect the onset of Fed tightening to trigger a

bear market

While the fundamentals for emerging markets have

improved significantly, they are still likely to correct more than

developed markets in response to prospects for tighter

liquidity conditions


10 December 2009 8

ASSET ALLOCATION

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.

However, the length of time that current liquidity conditions persist is open to question. Broadly, we expect markets to do well in the first quarter, with risks of a shift toward tighter monetary policies starting to cloud the outlook in Q2 and Q3.

Going into 2011, we have rising concerns about potential policy mistakes, a possible resurgence of inflation and an earlier than usual termination of the business cycle.

Our favoured current strategy is to barbell the risk spectrum, with positions in high beta equity markets and sectors, 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.

We recommend owning hedges against an unexpected tightening in liquidity, viewing yen FX shorts and out-of-the-money puts on gold as the most efficient hedges. We also like the idea of owning Treasury-TIPS breakeven spreads.

Our market outlook is bullish for the next quarter, but more circumspect thereafter. Both economic and market fundamentals are certainly supportive of most asset classes in the short term. With governments sensitive to the perceived fragility of the initial stages of the expansion, a broad consensus has emerged that significant fiscal tightening should be delayed until the recovery is more firmly established. A similar point applies to monetary policy. In the short run, inflation remains below trend in most economies, with disinflationary output gaps of indeterminate scale visible in the larger industrialised nations. The implication is that, as yet, a globally synchronised policy tightening poses little imminent threat to either economic growth or buoyant asset prices.

We expect liquidity conditions to remain bullish for at least the earlier part of next year. The combination of ultra-low short-term interest rates, private sector deleveraging and a resumption of global official FX reserve growth are the three main factors that will conspire to keep medium- and long-term real interest rates at low levels, even as the various quantitative easing programs draw to a close. A move up in bond yields in the wake of the end of QE programs is likely to be modest, in our view, with US 10y yields unlikely to move far from current levels in Q1 or above 4.5% during the latter part of 2010.

A large rise in longer-term interest rates is improbable while economic slack remains sizeable and private sectors continue to repay debt. The latter factor has provoked a profound alteration in the balance of supply and demand in the capital markets, as total savings increase and total borrowing falls. Domestic US nonfinancial borrowing has declined from a peak of $2.6trn at the end of 2007 to $1.5trn in H1 09. The underlying picture shows the private non-financial sector actively paying off debt, even as government borrowing has increased. US nonfinancial businesses and households repaid their debts at a $435bn pace in Q2 09. During the first half of 2010, it is possible that total nonfinancial borrowing will fall further. The federal deficit has already started to narrow, and we expect a $1.5trn total for 2010, down from the $1.8-2.1trn pace of government borrowing over the past four quarters.

Tim Bond +44 (0) 20 7773 2242

[email protected]

We expect liquidity conditions to remain bullish for at least the

earlier part of next year


10 December 2009 9

Over the first half of next year, it is plausible that households will continue to reduce debt, albeit at a more modest pace than was visible this year. During the same period, business net borrowing is likely to decline further, as the rise in corporate profits outpaces spending on capex, M&A and dividends. Thus, net non-financial borrowing might be running at an annualised pace as low as $1trn or less in the first half of 2010. In short, the US financial cycle has probably entered the sweet spot during which government borrowing has started to decline, while private sector borrowing has yet to increase. This outlook tends to mitigate the upward pressure on yields from the ending of the QE programs.

Clearly, QE has provided a significant portion of total financing this year. Indeed, government borrowing and QE have been of a similar scale in the US and UK. Equally clearly, the end of QE will change the supply/demand balance in the capital markets, resulting in a relative upward move in government bond yields. However, while private sector savings flows remain high, an existential funding crisis is very improbable. Net financial investment by US domestic businesses and households averaged $611bn in H1 09. Meanwhile, inflows from foreign official reserve managers seem destined to increase. 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. These flows tend to be recycled into western bond markets, and so long as the practice of fixed or pegged exchange rates continues, this process is likely to continue to help finance US deficits. In the short run, the growing dichotomy between developing world interest rate trajectories and US policy settings should also accelerate global foreign exchange reserve growth, as countries such as China are forced to intervene more aggressively against hot money flows. The scale of foreign official reserve manager purchases of USD bonds is displayed in Figure 1. Both the y/y and quarterly annualised flows are running at a little more than $400bn at the moment.

Figure 1: 3-month seasonally adjusted moving sum, US budget deficit

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Source: Thomson Datastream

The US financial cycle has entered the sweet spot, during which government borrowing

has started to decline, while private sector borrowing has yet

to increase


10 December 2009 10

The impact on bond yields of the asset reallocations encouraged by the low rate policy also needs to be considered. Low short-term interest rates encourage savers to move out of cash and invest further along the yield curve. This process is visible in the flow out of US money market funds, currently running at a quarterly annualised pace of $1trn. As Figure 2 should illustrate, net flows to money market mutual funds display great sensitivity to the level of short-term interest rates. With more than $3.3trn remaining in US money market funds, so long as the fed funds rate stays near zero, we can have a high degree of confidence that this flow out along the yield curve will persist. This increase in the demand for longer-duration bonds should counterbalance the US governments objective of lengthening the average maturity of the national debt.

Figure 2: US custody holdings of Treasuries and agencies for foreign official institutions, 3-month annualised change, $ bn

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Low short-term interest rates encourage savers to move out of cash and invest further along the

yield curve


10 December 2009 11

We would reiterate a similar point regarding the composition of bank balance sheets. Since bank loans are currently the most expensive form of debt, loan books are bearing the brunt of deleveraging, having shrunk over $500bn from their 2008 peak. If we exclude the data from November, which were distorted by the banking sectors assuming the assets of a failed non-bank intermediary, the quarterly annualised shrinkage has been running at a $1trn pace. In light of the impending near-term rise in corporate profits, it is likely that this decrease in loan books will accelerate, at least in the early part of next year. Although the banking system may have initially welcomed the decrease in their assets, 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. The net effect should be to strengthen the trend for banks to replace maturing loans with high grade securities. Were US bank holdings of bonds to return to the share of assets seen in the last major deleveraging cycle (1992-93), the theoretical bank buying appetite would be between $700bn and $1trn. In this context, 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, which are comprised of short-dated government paper. As these rules are phased in over the next couple of years, a permanent elevation in the funding of government deficits by the banking system will become visible.

To summarise, history suggests that the combination of low short-term interest rates and private sector deleveraging tends to keep longer-term real interest rates low, in spite of apparently onerous government borrowing requirements. To formalise this point, we can show that the fed funds rate, nearby Fed expectations and the growth rate of business borrowing are very effective explanatory variables for modelling medium- and long-term real yields. The equation is illustrated in Figure 3.

As was the case during comparable episodes in the past (1992-93), 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. In 1992-93, an interlude marked by a low fed funds rate and US business sector deleveraging, global equity 12m forward P/E ratios (ex-US) expanded from 16 to 21, as long-term real yields fell 2%. Over the course of 1993, clear bubbles developed in many emerging markets. When the liquidity conditions changed in 1994, with businesses becoming net borrowers once again and the Fed hiking rates, long-term real yields soared 3%, most emerging markets collapsed and global equity P/E ratios fell 6 points. Mexico ended that year in crisis.

Figure 4: Actual and modelled real yields, from fed funds rate, Fed expectations, business borrowing y/y

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TIPS 10y real yield model Source: Barclays Capital

We expect the decrease in loan books to accelerate, at least in

the early part of next year

The combination of low short-term interest rates and

private sector deleveraging tends to keep longer-term real interest

rates low


10 December 2009 12

In comparison with the 1992-93 interlude, todays de-leveraging is much more extensive, with both households and firms paying off debt. Additionally, the trend is more global, with comparable developments visible across much of the OECD, although it is strongest in the UK and US. Furthermore, short-term real interest rates are considerably lower than they were in 1993. In the short run, it is therefore very plausible to argue that conditions are compatible with the formation of asset bubbles. Strong liquidity flows in either direction tend to desensitise markets to fundamental factors, disrupting their ability to effectively incorporate future risks into prevailing pricing. Although investors may know that the phase of abundant liquidity is temporary, they cannot foresee the termination point with any certainty. 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.

In mitigation, we would stress that at the current juncture, with the exception of government bonds and gold, few asset classes display obvious symptoms of a bubble. Indeed, global equities are slightly cheap to fair value on our modelling, credit spreads are at fair value, commercial property is cheap to other asset classes and commodity prices broadly reflect the balance of supply relative to industrial demand. To date, the rally in most asset classes has been driven by, first, sheer undervaluation at the beginning of the year and, later, by improving economic fundamentals. However, the acute depression of long-term 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. In the absence of any change to the underlying causal triumvirate of very low policy rates, private sector deleveraging and developing world exchange rate targeting, we should expect these symptoms to proliferate across more asset classes.

The counterbalancing factor is that central banks are likely to be much more sensitive to potential asset bubbles than used to be the case. 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, 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. The existence of these tools will not, of itself, prevent the formation of bubbles.

We would now caution that this view does not translate to an explicit recommendation to ratchet portfolio risk up to extreme levels. The hypothetical asset bubbles are likely to prove much more unstable and fragile than is typically the case. 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.

First, due to the immense fluctuations in GDP over the past few years, there is an unusually high level of uncertainty surrounding the prevailing degree of economic slack and the speed at which this will be absorbed. For the sake of practical example, 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, so is our ability to predict the imminent rate of growth. The broad consensus is for a relatively slow recovery. However, recoveries often tend to be symmetrical to recessions, and we would stress the upside risks to our own growth forecasts, which are somewhat stronger than the consensus. Under such circumstances, it is extremely hard to gauge how long disinflationary output gaps will persist. Whether the likely duration of bullish liquidity conditions is measured in months, quarters or even years is very much an open question. This uncertainty is compounded by possible shifts in central bank reaction functions, following two successive episodes in which monetary policy has almost certainly played a role in inflating asset bubbles. In this respect, our Fed forecast assumes a two-step normalisation of policy, with the funds rate

Strong liquidity flows in either direction tend to desensitise

markets to fundamental factors

Central banks are likely to be much more sensitive to potential

asset bubbles than used to be the case

The policy outlook is fraught with uncertainty


10 December 2009 13

being raised to 1% in the second half of next year, but then left at that level for some time, as the Fed pauses to monitor the effects of a presumed fiscal tightening in 2011. The broad point is that the policy outlook and hence the financial market liquidity outlook is fraught with uncertainty.

Second, a related point can be made specifically regarding the US labour market and the timing of Fed tightening. There are good arguments in favour of a relatively slow labour market recovery, as well as a more vigorous snap-back in hiring. The former scenario is typical of the aftermath of financial crises, where the usual labour market trajectory shows an abrupt rise in unemployment during the crisis, followed by a slow recovery extending over several years. However, 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. 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. Under this line of argument, US firms may have been excessive in cutting employment, in much the same way that inventory cuts globally have proven excessive. This possibility raises the risk of a much sharper-than-expected snap-back in employment at some stage, 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, the uncertainties concerning the actual dimensions of output gaps also raise the medium-term risk of policy errors. History suggests that during a period of high GDP volatility, errors in calculating the dimensions of output gaps are abnormally large. Figure 4 illustrates this point. 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. 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 todays more complete dataset.

Figure 5: Absolute value, US output gap error, volatility of nominal GDP growth

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Dec-69 Dec-73 Dec-77 Dec-81 Dec-85 Dec-89 Dec-93 Dec-97 Dec-01 Dec-05 Dec-090.0

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rolling 5 year standard deviation of nominal GDP growth, qoq saar

absolute value, output gap error, rolling 5 year average

Source: Philadelphia Federal Reserve, Barclays Capital

The misalignment of policy that can emerge from such mistakes then tends to reinforce the original increase in economic volatility, as central banks try to correct the preceding error. The net result as in the 1970s can be a period of wide swings in nominal GDP. We are

Uncertainty surrounding the pace of the US labour market recovery translates into acute

uncertainty about the timing of Fed tightening

Errors in calculating the dimensions of output gaps are

abnormally large during periods of high GDP volatility


10 December 2009 14

therefore confronted by a medium-term outlook in which the risk of policy error in either direction is very high. In turn, the tail probabilities of either deflation or inflation are unusually high, while the rise in the volatility of GDP growth is likely to be sustained. These considerations may not be germane at present, but they certainly will become so as 2010 progresses. The other associated risk is that when policy changes, it may have to change fast and hard.

We would caution further on this point. 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. For the highly leveraged industrialised economies, the relative risks of a deflationary compared with an inflationary mistake are quite clear. With fiscal positions clearly constrained and limited further monetary manoeuvre, the risk of becoming stuck in a debt-deflation appears to be more severe than an inflationary surge. In such a case, policymakers may be tempted to build an inflationary error bias into their calculations. Indeed, the IMF has explicitly advised leaning policy in an inflationary direction. This suggests that there is a higher-than-usual probability of a deliberate inflationary policy error. In turn, this suggests either that policy tightening might be aggressive at some point or that inflation will erode the real return from assets. As a result, financial assets will eventually need an extra ex-ante risk premium to compensate for these threats.

Fourth, we should continue to heed the structural shift in the trade-off between global growth and natural resource-based inflation. 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. While the recession reduced commodity demand and temporarily depressed commodity prices, there is no sign of any easing in the underlying long-run difficulties of accommodating the food, energy and raw material ambitions of the developing world. If anything, progress on the supply side has been disrupted by the credit crunch. 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. As global economic activity returns to its 2008 level, rates of natural resource-based inflation are likely to follow.

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. For the developing world, a similar contradiction between foreign exchange targets and domestic monetary policy settings is inevitable. Our commodity market outlook suggests that agricultural prices, which have a strong influence on inflation readings in the developing world, could start to test policy settings in these economies next year. For the developed economies, our outlook for energy and industrial commodity prices suggests that such tests may occur late in 2010 and through 2011, although this time horizon may become compressed if growth surprises to the upside. In both cases, the result of such conflicts tends toward heightened macroeconomic volatility and a general increase in uncertainty concerning the timing of the next recession.

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. The most likely outcome, in our view, is that fiscal tightening will replace some of the monetary tightening that would ordinarily be expected to occur in 2011. This logic lies behind the profile of our US official interest rate forecasts, with the Fed anticipated to pause its tightening program at 1% in the first half of 2011. Such a development could be characterised as a loose money/tight fiscal mix. This combination is typically very bullish for local asset markets, albeit negative for the local currency. In the context of the current

There is a higher-than-usual probability of a deliberate

inflationary policy error

There is no sign of easing in the difficulties of accommodating

the food, 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


10 December 2009 15

discussion, such a US policy mix would tend to sustain the bullish liquidity conditions well into 2011, both by continuing to herd investors out along the yield curve and by the impact on the dollar and, hence, on developing economy foreign exchange reserve growth.

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. Asset price trends over the past couple of years have been dominated by very large variations in investor risk appetites. The vast ebb and flow of risk-seeking liquidity has tended to mask any fundamental differentials between classes and region, all asset classes tending to rise and fall in an indiscriminate and homogeneous mass. This phase of very high cross asset correlation is likely to persist in the short run, as bullish liquidity flows dominate. However, once the phase of easy liquidity draws to a close, as it must, we should expect cross asset class correlations to decrease. The successful investment strategies for 2010 are therefore likely to be marked by tactical dexterity, in terms of both timing and asset selection. A passive harvesting of beta, a strategy that has worked effectively for virtually all asset classes this year, is unlikely to be productive over the next 12 months, even if it might continue to prove fruitful over the next quarter.

Thus, to summarise, we wish to emphasise the unusually high degree of uncertainty regarding market performance next year. In our view, offering market level forecasts for the year ahead is a rather more pointless activity than usual. The range of possible outcomes is particularly broad. A strong case can be made for a liquidity-fuelled bubble, but an equally strong case can be made for a trend toward de-rating and higher yields, given the sizeable medium-term economic risks. It is quite possible that markets may oscillate violently between these two poles. Anyone who pretends to have a strong view about where stock markets will close on December 31, 2010, is deluding both themselves and others.

For the immediate future a period that should encapsulate most of the first quarter of 2010 we are biased to staying long in equities. Our suggested mix of sectors remains the same as in the last Global Outlook, namely industrials, technology, basic materials and energy. We advise slowly de-emphasising the US materials sector fairly early in the quarter, since it is relatively expensively priced. We also expect a more subdued industrial commodity complex next year. Our top sector is industrials. We are not enamoured of financials, 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. With credit demand weak, banks cannot be described as enjoying pricing power for early 2010, so there may be a temporary problem in passing these costs on. We would suggest that clean energy sectors may outperform, as investors focus on the implications of the ambitions outlined at the Copenhagen meeting. In terms of geographical exposure, we believe a mix of the higher beta developing markets, such as Russia and Brazil, along with the core markets of Europe and US, is desirable.

While EM equity markets have certainly outperformed this year and risk premia shrunk, their valuations are by no means in bubble territory. We believe global liquidity flows will disproportionately benefit these modestly capitalised markets. Given the large rise in industrialised economy debt/GDP ratios, together with the longer-term context of much better macroeconomic discipline in many emerging economies, there is a powerful argument for a convergence and perhaps even reversal in the relative levels of economic risks. With the developing world responsible for the majority of global GDP growth and representing just over half of the global economy by level, the vast majority of funds will be underweight EM equity on a GDP-weighted basis. And since EM equity volatility-adjusted ex-post returns are now superior to OECD volatility-adjusted returns, the main remaining argument against a sizeable re-weighting into EM equities concerns governance. The Dubai

A passive harvesting of beta is unlikely to be productive over the

next 12 months

We are biased to staying long in equities


10 December 2009 16

debacle highlights the risks in this respect, but we would note that arbitrary confiscations and deliberate obfuscation of private-sovereign status are problems not necessarily confined to the developing world. Egregious recent examples have been clearly visible among some of the largest mature economies. We have certainly detected a very clear trend of Western pension funds increasing exposure to EM equity and would expect these flows to continue. If bubbles do emerge over the next year or so, 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.

We are not inclined to overstay our welcome in long equity positions. From a tactical perspective, we would tend to reduce equity risk somewhat as the quarter progresses, shifting out of the aforementioned sectors into more defensive areas or cash. Our reasoning here is that after a few months of positive US jobs growth, the risk builds of a sudden acceleration in the pace of employment and the snap-back scenario may come into play. Additionally, while we disagree with this prognosis, the scheduled ending of the QE program in March may start to convince some investors that an extensive monetary tightening was underway. As our US equity team highlights, the analogy might be the way the stock market traded sideways for much of 2004. 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. Clearly, these views are data-dependent, as is Fed policy. More strategically, our belief is that the tightening will be in two stages, with the Fed engaging in a prolonged pause in 2011 as it waits to observe the repercussions of probable fiscal tightening. During this pause, there would be a further risk of bubbles inflating. The combination of a tight fiscal/very easy money stance could reignite a fierce rally in equities. Therefore, 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.

Our suggested FX strategy is now somewhat different in emphasis compared with the past few months. While we still believe that most EM and commodity-linked currencies will appreciate, we suggest diversifying the short side of the trade out of the dollar and into the yen. The yen is overvalued on virtually every criterion and against virtually every currency, including the dollar. With the US economy now starting to demonstrate clear symptoms of returning to self-sustaining growth, the perceived relative riskiness of the dollar may decline. Bearing in mind that Japan is very far from being a safe haven from the various forces of turbulence presently buffeting the global economy, we find it difficult to believe that the yen is correctly priced at present. We forecast a move above 100 against the dollar over the next year. Away from the yen, we do expect a resumption of renminbi appreciation in the second half of the year (about 5% by year end), and we would expect the healthier EM currencies to continue to appreciate against the euro, yen and dollar. We also think Australian and Canadian dollars will rise, given their strong historic correlations with commodity prices and global growth.

As far as bond markets are concerned, we expect further credit spread tightening set against a background of modestly rising yields. This rise in yields is expected to be skewed toward the latter half 2010, with deleveraging and low policy rates keeping yields low at the start of the year. Investment grade credit is expected to deliver reasonably strong excess returns, but a less impressive total return, given the probable drift up in longer-term yields. This context suggests that fixed income investors should be moving down the credit curve and shorter on the yield curve. We would certainly expect high yield to provide respectable competitive total returns over the year. Although we expect G7 inflation to remain reasonably contained in 2010, there are significant risks over the longer run outlook for

But we are not inclined to overstay our welcome in long

equity positions

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 17

price stability. In recognition of these risks, we would expect breakeven inflation rates to move higher over the course of 2010, possibly achieving new absolute highs in the US.

Commodity prices should move higher next year, although the rally is likely to be modest relative to the extreme volatility seen in recent years. In general, price curves are not likely to be favourably sloped for the passive investor. Short-term supply fundamentals look to be most bullish for agricultural commodities, and we do envisage growing upward risks for inflation among developing economies. For metals and energy, adequate (and in the case of natural gas, ample) supplies are generally envisaged to temporarily mitigate the upward pressures stemming from the cyclical recovery in global demand. Over the longer run, however, the structurally bullish themes for commodity prices remain very much intact. As far as commodity investment is concerned, we do tend toward the view that investment in the means of production, as opposed to the product, is the correct way to approach these themes. Gold is obviously a commodity very much in the news. While we can appreciate the arguments advanced in the metals favour, as asset allocators we have extreme difficulty in recognising any inherent fundamental worth. To be sure, there are solid reasons for owning real assets as a hedge against any potential debauchery of financial assets. However, why such a hedge needs to be a commodity devoid of any practical utility escapes our understanding. Our own bias is therefore to leave others to enjoy the ride in gold, 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.

Overall, our favoured asset allocation is a mix of high beta equity, cash and high yield credit. The policy is essentially a barbell of assets at either end of the risk spectrum. We suggest running this mix in combination with a foreign exchange overlay consisting of longs in the CAD, AUD, BRL and assorted other EM currencies against shorts in the G3 currencies, strongly weighted toward the yen. We do not advise exposure to government bonds, which remain the asset class most likely to deliver negative total returns, in our view. With an earlier-than-expected turn in liquidity conditions being the main portfolio risk, 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. Short yen positions and out-of-the-money gold puts fall into this latter category, offering more efficient and cheaper hedging potential than interest rate positions.

A modest rally in commodity prices

We favour a mix of high beta equity, cash and high yield credit


10 December 2009 18

ECONOMIC OUTLOOK

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.

We see relatively little risk of a serious disappointment to global growth, as the forces behind the cyclical rebound in activity in developed economies (ex-Japan) should be strongest in coming quarters.

Inflation risks remain muted globally, as excess capacity remains pervasive. In China, Korea and India, 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. We expect this tightening to include a 5% appreciation of the CNY/USD in H2 10.

We expect the end of QE in major economies to gradually take long-term rates higher globally. But we do not think exit strategies will spook business activity in 2010, as tighter policies should mostly be the result of strong economic activity.

Throughout 2009 our global growth calls were systematically above consensus, 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, May 2009). We continue with this positive outlook coming into 2010, as we believe that relative to the normal rates of growth that markets are now expecting for 2010 (eg, 2% for G4 economies), risks are tilted towards a stronger recovery. The reasons that underlie this positive outlook are related to the currently depressed levels of activity in G4 countries (Figure 1), the somewhat excessive response of businesses during the downturn, and the continuation of depression-combating policies through most of 2010. Thus we expect above-consensus growth in G3 during 2010 (Figure 2), with growth front-loaded in the US and back-loaded in. EM countries have avoided the magnifying factors of previous recessions (Advanced emerging markets, 12 November 2009) and are already positioned for growth to moderate in coming quarters to around trend levels. In short, our view is that the power of a business cycle that

Christian Broda +1 212 526 8536

[email protected]

Piero Ghezzi +44 (0)20 3134 2190

[email protected]

Nick Verdi +44 (0)20 7773 2173

[email protected]

Figure 1: Global recovery in manufacturing output

Figure 2: Our outlook relative to consensus

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Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09

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KoreaBrazil

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As of: 4Q09 1Q10 2Q10 3Q10 2010 2011US Consensus 3.0 2.6 2.6 2.8 2.6 3.0q/q saar BarCap 4.0 5.0 3.0 3.5 3.5 3.1Eurozone Consensus -1.9 0.8 1.3 1.1 1.2 n.a.y/y BarCap -1.8 1.1 1.6 1.7 1.5 1.9Japan Consensus 1.6 0.5 0.8 1.3 1.2 1.2q/q saar BarCap 3.6 1.0 0.4 2.0 1.7 1.8UK Consensus -2.9 0.0 1.2 1.9 1.3 2.0y/y BarCap -3.0 0.0 1.2 2.2 1.5 2.2Brazil Consensus 3.7 5.2 5.0 4.9 5.0 4.5y/y BarCap 4.4 6.6 5.7 4.8 5.3 4.4Russia Consensus -2.8 3.5 3.9 2.1 3.0 4.5y/y BarCap 1.2 3.5 5.1 4.4 4.3 3.6China Consensus 10.2 10.4 9.7 9.4 9.6 n.a.y/y BarCap 11.4 12.0 9.7 8.6 9.6 9.0

Note: Europe is a GDP-weighted average of the euro area and the UK. Source: Haver, Barclays Capital

Source: Bloomberg, Blue Chip, Barclays Capital

Our forecasts for 2010 are more positive than those

of the consensus


10 December 2009 19

is supported by depression-combating policies and is starting from low activity levels will be hard to derail in coming quarters.

Two key global factors will play an important role in tracking our views of the real side of the global economy in coming months. First, how businesses respond to the stability of final sales plays a key role in the strength of the short-term recovery. The sharp and fast correction in business production in 2009, well in excess of the fall in global consumption, has led to the largest inventory cycle in recent recessions. 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. Figure 3 shows how global orders are running far ahead of inventories a measure that highlights the pressure to start rebuilding inventories. That leaves enough room for businesses to stabilize and provide support for growth in coming quarters. The stability in final sales in Q3 suggests, in our view, that this process of business confidence may start earlier than the markets are expecting.

A second global factor behind our stronger-than-consensus outlook is the role played by the support of governments in 2010. The unprecedented policy support in 2009 has helped stabilize consumption and investment. But the recovery has been strongest in countries with the sharpest decline and relatively weak policy response, such as Germany, Korea and Japan, highlighting what we believe has been downplayed by market participants the fact that the sharp declines in economic activity do make growth easier. Moreover, the degree of fiscal stimulus that remains in the pipelines is large. Around 40 percent of the discretionary spending put in place around the world is set to hit the market during 2010. This share for the US and China is 60% and 50%, respectively. This is partly the reason for our above-consensus call, as we disagree with many commentators who suggest fiscal policy is going to be a drag on the global economy during 2010.

In terms of monetary policy, the global support in 2009 has also been extraordinary. While we expect global tightening to start in 2010, 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, 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. As such, we expect the drag on the economy from monetary policy paybacks to be delayed to 2011. Beyond short-term rates, the end of QE combined with the return of risk

Two key factors to track in coming months: 1) how

businesses react to stabilizing final sales

2) the evolution of the fiscal and monetary exit strategies

Figure 3: Global new orders and manufacturing production

Figure 4: Capex and auto spending as % of GDP

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Note: New orders-inventories series is normalized; constructed using sub-components of country PMIs. Source: Barclays Capital

Note: Capex defined as private non-residential investment. Marker represents 4Q10 US forecast. Source: Haver, Barclays Capital

Monetary policy is likely to continue to support activity

in 2010


10 December 2009 20

appetite by investors is likely to lead to long-term yields. 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. As we highlighted in Sweet spot for growth in Global Outlook, September 2009, a dip back into recession anytime soon seems unlikely. As the positive momentum turns from confidence to real measures, the recovery looks harder to derail.

Idiosyncratic factors regain importance The global crisis of Q4 08 implied that global forces overwhelmed regional factors in economic forecasts. But as normality gradually returns we expect regions idiosyncratic factors to regain importance. In the US, as opposed to other developed economies, the retrenchment of the business sector turned out to be excessive, and the collapse of demand for cyclical goods like cars, electronics and housing seems disproportionate to that of other sectors; therefore, even our above-consensus growth outlook implies a return to spending levels in these goods below the troughs of previous recessions (Figure 4). 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, even if this is much weaker than the levels seen prior to 2008. Thus, 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.

Moreover, a key obstacle to improving confidence in the US recovery the lackluster employment picture has shown clear signs of improvement in November. The rate of employment destruction has slowed rapidly and the trend in hours worked is improving, which suggests that the unemployment rate is close to, and might have already reached, its peak. With the activity data adding more pressure for businesses to expand, this suggests that the trend of improving employment is likely to continue: in Q3 09 US productivity continued strong; light vehicle sales surprised on the upside at 10.9mn saar (Figure 5), the highest reading in a year outside of the cash-for-clunkers boost in July and August; and data on home sales continue to run firm. Incoming PMI data in the US are also consistent with further improvement in growth in Q4 09. Overall, Q3s data are consistent with our view that businesses may have overreacted and that job gains will start in early 2010. Figure 6 shows the expected path for US payrolls in coming months (as a share of GDP). 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.

In 2010, we expect that regional factors will regain importance

versus global forces

Figure 5: Consumer confidence is returning

Figure 6: US employment as % of real GDP

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Note: Series are rebased so that Jan 08=100. Retail sales are values. Source: Haver, Barclays Capital

Note: Dotted line represents forecast. Source: Haver, Barclays Capital

We expect the improving trend in US employment to continue


10 December 2009 21

In western Europe, we look for a progressive and gradual recovery during 2010-11, with GDP rising to around 1.5% growth in 2010, and extending to around 2% growth in 2011, after experiencing record post-war contraction in GDP of around 4% in 2009. While Europe shares some of the common positive forces with the US eg, the depressed starting level of activity, additional fiscal stimulus in the pipeline in Germany and improvements in financial markets several other negative factors, in our view, prevent the recovery from being above trend growth as in the US case (by trend we mean the average growth in 2002-07). First, a sharp deterioration in productivity in Europe suggests that the cyclical reaction of business was not as strong as that in the US. Second, a strong value of the euro contrasts with the weak dollar and puts particular pressure on the industrial sector in southern Europe. Third, a significant fiscal tightening already emerging in the most highly stressed countries (Greece, Ireland, UK) is likely to dampen the relative recovery of Europe. And finally, the construction sector is still retrenching in certain over-extended economies (notably Ireland and Spain). Altogether, this, in our view, justifies the expectation that the recovery of western Europe will be weaker than that of the US. Within Europe, Germany is likely to lead the way of the major economies, growing close to 2.5% in 2010 (and 2011), whereas we believe Spain is likely to contract somewhat further in 2010 (by 0.5%), before experiencing gradual improvement in 2011 (1.5%).

In light of the record degree of economic slack in both the US and Europe, core inflation is expected to continue to decline through most of 2010, particularly in countries that have especially overvalued real exchange rates (such as Greece, Ireland, Portugal and Spain, which are either in or moving towards deflation). However, headline inflation measures are expected to rise back to the target ranges in most developed economies, mostly as a result of the developments in commodity prices in recent quarters (Figure 7). Thus, the role that inflation expectations may play in 2010 in central banks stances is likely to be larger than normal. Except in the UK, inflation expectations remain tightly controlled (Figure 8). In the UK, we expect RPI inflation to rise from -0.8% y/y in October, to +4.4% by April next year.

In Japan, initial estimates of strong growth in Q3 were subsequently revised sharply lower. Furthermore, we look for growth to hit a soft patch in H1 10, when a policy gap leaves public investment and consumption exposed to downward pressure and the economy too dependent on overseas demand. We see real annualized GDP growth of 3.6% in Q4 09, easing to 1.0% in Q1 10 and 0.4% in Q2 10, before strengthening again to 2.0% in Q3 10 and 2.5% in Q4 10. Further fiscal and monetary action is needed to address sluggish

Several negative factors are likely to prevent an above-trend

European recovery

Figure 7: Persistent deflation expected only in Japan

Figure 8: Inflation expectations will be closely watched

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Note: Shows a 10-day moving average of swap rates. Source: Haver, Barclays Capital

We expect core inflation to continue to decline through 2010 in the US and Europe


10 December 2009 22

domestic demand and deflation (the output gap is still deep in negative territory at -6.7% in Q3 09). 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. If the government does introduce a large fiscal package, the BoJ may follow with additional expansions. At this point, however, there is no reason to expect any change in fiscal policy, and we keep our back-loaded economic performance expectations in 2010.

In China, we project 9.6% GDP growth in 2010, up from 8.6% in 2009. We expect q/q growth to decelerate from 16.4% in Q2 09 to about 8% in 2010, but the y/y rate to rise to a peak of 12% in Q1 10, before moderating to just above 8% in Q4. Growth is likely to be more broad-based next year, with an increased contribution from consumption and net exports, while investment becomes the major, yet somewhat less influential, source of growth. Authorities have stepped up efforts to curb new investment in some heavy industries owing to over-capacity concerns, but cutting CO2 emissions is likely to support investment in green energy. We expect consumption to be supported by improvements in employment and policy efforts. Household consumption has been growing faster in rural areas than in urban areas in 2009, and we believe this trend will continue.

We expect CPI inflation in China to rise to about 4% by end-2010, mainly owing to rises in commodity and service prices; hence, we expect a tightening of monetary policy next year. Nevertheless, we believe monetary tightening is likely to be back-loaded in 2010. Quantitative and prudential measures will probably continue to be used to guide credit, and the benchmark interest rates will be raised only in H2, in our view. We expect M2 to grow faster than nominal GDP, but at a much reduced pace compared with 2009. We expect 5% currency appreciation in 2010, although the exact timing of a break from the tight USD/CNY range is uncertain. The main risk to the outlook comes from inflation, including asset price rises, and ensuing policy tightening that is more aggressive than we currently expect.

Tightening schedules: The balance of risk is driven by traditional biases The disparities between Asia, the US and Europe are not limited to growth, as the risk of inflation outlook differs greatly across countries. Deflation has been more severe in Japan than elsewhere, and we forecast that Japan will remain in deflation through the end of 2011, while we project that the euro area, the UK and the US will experience modestly positive inflation throughout the next two years (Figure 7). On the opposite side of the spectrum, in China, Korea and India, with dramatically less slack in their economies and higher weights for commodity prices than in the US and Europe, we expect inflation to be a bigger concern during 2010. This in part guides our timing for policy tightening in coming quarters (Figure 9).

Figure 9: Monetary tightening timeline

3Q09 4Q09 1Q10 2Q10 4Q10 1Q11 // 2Q12Israel (+25)

Norway (+25)

India (+50)

Indonesia (+25)

US (+25)

Brazil (+50)

Japan (+20)

Australia (+25)

Korea (+50)

Peru (+25)

UK (+50)

Poland (+25)

Mexico (+25)

Taiwan(+13)

Canada (+25)

S Africa (+50)

Thailand (+25)

China (+27)

Sweden (+25)

HK (+25)

Czech R (+25)

Chile (+25)

Colombia (+25)

3Q10Euro area

(main rate, (+25)

Euro area (EONIA, +25)

Source: OECD Annual Outlook 2009, Barclays Capital

We forecast more broad-based economic growth in China


10 December 2009 23

With the exception of the BoJ, we are likely to see effective tightening of monetary policies in most major economies during 2010. Despite our stronger-than-consensus outlook, our views on Fed and ECB tightening are similar to those of the market. We expect the Fed to start hiking the fed funds rate in September 2010, even though unemployment will remain much higher than normal and core inflation is likely to continue to decline through 2010. 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, with the biggest objective being to avoid a repeat of the great deflation and depression of the 1930s. As growth recovers, the Fed is likely to gradually prepare markets for rate hikes as the recovery consolidates and it expects monetary policy to start to normalize.

Although this is our baseline scenario, this is not standard Fed thinking. Even if growth is as strong as we expect, with unemployment rates around 9.5% by mid-2010, core inflation below target and inflation expectations under control, it may be hard to tighten. The Fed will be closely monitoring the evolution of the housing market and inflation expectations (Figure 8). Furthermore, if there are more hurdles than we expect for growth, and the positive outlook for housing proves more temporary than we expect, the Fed, in our view, would not hesitate to delay tightening to 2011. Indeed, the Feds 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.

The ECB has traditionally followed the Fed in terms of hiking after global recessions, and we expect this time to be no different. While we do not expect the ECB to raise the main policy rate until Q1 11, an effective tightening remains likely during 2010 via an increase in the EONIA rate back to the levels of the main policy rate. 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. It signals that in Q4 10, this rate should average 1.0% and then rise to 2.0% in Q4 11. 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, based on "improved conditions in financial markets," leaves room for a potential shift higher in EONIA during Q2 10. But contrary to the Fed, our balance of risk is tilted towards an earlier tightening in the European case. While inflation expectations are anchored and the prospect of inflation is contained, we believe the ECB would find pulling the trigger easier if inflation did show on the horizon for 2011.

Figure 10: ECB reaction function signals gradual increases

Figure 11: Yet the BoJ has responded least

-2

-1

0

1

2

3

4

5

6

7

96 98 00 02 04 06 08 10

ECB policy 'refi' rate (synthetic GDP-weightedhistory pre 1999, EONIA since Oct. 08)

Reaction function equation

-3.0

-4.3

-5.0

2.5

5.2

8.8

9.5

-6 -4 -2 0 2 4 6 8 10

Japan

Euro area

US

UK

-0.4

Change in official rates since start of

2008 (in pp)

Increase in central bank assets since start of 2008 ( in % GDP)

Source: Thomson Datastream, Barclays Capital Source: BoE, FRB, ECB, BoJ

Bar Japan, we expect monetary tightening across most

economies next year

We expect the first fed funds hike to come in September

Consistent with history, we look for the ECB to follow, rather than

lead, the Fed


10 December 2009 24

Japan is the only major country not expected to tighten monetary policy somewhat in 2010. Given the persistent deflation and the fact that Japans contraction during the recession was the largest among the G4, one might have expected the BoJ to have been the most aggressive central bank during and after the recent global recession. Instead, the BoJ has actually shown the least aggressive response, as measured by either interest rate cuts, or by the increase in its balance sheet (Figure 11). Against this backdrop, the BoJ decision to expand its QE measures in recent weeks is a positive development, even though it comes too late to prevent the slowdown in growth we expect in H1 10. 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 2.1% of GDP). If the government does introduce a large fiscal package, the BoJ may follow with additional expansions, and this could affect the economy in H2 10. 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. 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, deflation and a weak economy.

EM countries are likely to start the cycle early in the year, with inflationary pressures building first in countries with the fastest recoveries, such as Korea and India, and where commodities have a higher weight in consumption, such as Indonesia and Thailand. China has already started the process of reducing money growth that we expect will continue in 2010, with monetary aggregates growing at a slower pace (targeting 15% y/y rather than the current 27% y/y), interest rates to rise by mid-2010, and, in our view, a 5% CNY appreciation vis--vis a basket of trading partners by 2010. Even if modest, the Chinese appreciation will be welcomed in Europe, where the relatively weaker near-term outlook is partly the result of the euros strength.

QE: Sharp impact in, gradual impact out At least three key macroeconomic factors drove long-term rates lower in 2009. First, private net savings in major economies increased substantially during the recession, helping to keep rates low (Figure 12). Second, the increased risk aversion has meant that for a given amount of net savings, the desire to purchase low-risk assets increased, also helping to keep

Figure 12: Private savings trend higher

Figure 13: Bond yields set to rise

3

4

5

6

7

8

00 01 02 03 04 05 06 07 08 09 109

10

11

12

13

US private savings (LHS)US non-residential investment (RHS)

% of GDP

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Nov-08 Feb-09 May-09 Aug-09 Nov-09

UK US

10-year government bond yields, %

Forecast Q4 10

Note: Private saving is equal to personal saving plus after-tax corporate profits less dividends paid. Marker represents 4Q10 forecast. Source: Haver, Barclays Capital

Note: Marker denotes end-2010 BarCap forecast for the US and UK. Source: Barclays Capital

The BoJs recent decision to expand its QE measures is a

positive development

EM countries are likely to kick off their tightening cycle early in

the year

We expect countries with large QE programs to see higher rates

in 2010


10 December 2009 25

rates low. Finally, central bankers injected substantial amounts of fresh money to buy long-term assets directly in capital markets (Figure 14). As we have been highlighting for months (for a thorough analysis, see The new global balance Part II, September 25, 2009), this has had the effect of lowering long-term rates and weakening the currencies of countries with large QE programs. We expect all three factors to contribute to higher rates in 2010. We begin by focusing on the impact that the end of QE may have on rates.

Our expectation in 2010 is that we see a gradual end to most QE programs, with the exception of that in Japan. We expect that the Fed and BoE will not extend their existing programs beyond March. Similarly in the case of the ECB, the non-standard liquidity operations are likely to gradually be wound down through 2010. While no outright sales of assets are expected in the coming quarters, the mopping up of cash liquidity with inte

23990647 barclays capital global outlook 122009

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