Barclays Capital Global Outlook 122009

RESEARCH
December 2009
GLOBAL OUTLOOK
BEYOND THE RECOVERY TRADE
PLEASE REFER TO THE LAST PAGE FOR ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES
Barclays Capital | Global Outlook
FOREWORD
Given the massive swings in economies and markets over the past couple of years, it seems unusual that not much has changed since the September issue of the Global Outlook (Still in the sweet spot). The global economy remains in recovery mode, which, after such a severe recession, translates into above-trend growth. The expansion in Asia where the recovery began is now downshifting to a more sustainable pace, but this is being offset by activity in the laggards such as the US, which is just now gaining a head of steam. Meanwhile, much of the extreme policy stimulus including direct purchases of financial assets remains in place. The combination of economic recovery and unusually low policy rates continues to provide strong support to asset prices of nearly all stripes in most regions of the world. Until signs emerge of a change in that environment, we recommend that investors maintain their allocations to risky assets. All good things come to an end, and this unusually friendly environment for financial assets will too, probably in the first half of 2010. Ironically, the signal could well be a confirmation of above-trend economic growth in the US the last shoe to drop in the global recovery story. We believe contrary to the consensus that the US economy has shifted to a 4-5% GDP range for this quarter and next, and that the labor market will generate job growth and establish a peak in the unemployment rate by the end of the first quarter. Such a development would likely generate concerns that the Fed will soon begin to remove its extraordinarily accommodative stance. History suggests that this would interrupt the steady rise in asset prices and produce a market correction. We look for the biggest impacts to be on money market rates (up), the dollar (up) and gold prices (down). That said, any sign of change in the enormously supportive environment is likely to trigger a broad-based correction (just as the lift to asset prices has been broad based), and the equity and credit markets will not be immune. But we do not see the onset of Fed tightening as triggering a bear market in either sector. Valuations are not extreme, and it will be a long time before Fed policy is even remotely restrictive. This publication strives to serve you our clients by providing objective in-depth analysis across all asset classes and regions. We sincerely hope that it helps you make informed investment decisions.
Larry Kantor Head of Research Barclays Capital
10 December 2009
SUMMARY OF ASSET ALLOCATION THEMES

KEY FORECASTS Equities
KEY RECOMMENDATIONS
Our general expected path for equities next year is a sharp rally in Q1, followed by some sideways corrective behaviour in Q2 and Q3 as investors grapple with potential policy shifts. US economic growth is likely to prove sustainable, to the benefit of S&P 500 earnings. However, the equity market has already enjoyed considerable multiple expansion in 2009; as inflation rises, we believe that multiples are likely to compress in 2010. In 2010, rate markets will have to live with the prospects of rate hikes, a decline in the current abundant liquidity, and the lack of support from QE buying. A large sell-off is looming, and is likely to take place around the end of Q1 10. Until then, rates might continue to range trade, with an upwards bias. We see little value in bonds and swaps, especially in the US and UK. Only Japanese rates have potential for a meaningful rally from here. The broad price recovery in commodities is closer to maturity, but there is still upside in several markets including oil and some base metals. A slowdown in 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. Real yields biased higher in 2010 from ongoing economic recovery, although breakevens then likely to be supported by normalization in inflation. We expect credit returns in 2010 to be strong by historical standards but lower than in 2009, increasing the importance of relative value to generating outperformance. Performance between now and early next year will likely be robust, with risk later in the year from the withdrawal of central bank liquidity. Demand for corporate credit is likely to benefit from a lack of spread alternatives, amid slow US and European growth, historically low yields, and a heavy supply of government bonds. All regions of the emerging world are now in recovery, though the recovery is weaker and more varied in EMEA and the smaller countries of LatAm. Monetary easing is largely behind us, and tightening should begin in Q4 (India), gather pace in Q1 (Mexico and Korea) and become generalized in Q2. Tightening will be cautious, gradual and will include FX as a tool. Although we are not sure the USD has bottomed, in H1 10, the greenback should stage a limited rally. USD/JPY enjoys significant upside potential at the end of the Fed asset purchase program. GBP volatility should rise in 2010. Commodity currencies may have one more leg up.
In the immediate term, we are biased to staying long in equities. Our suggested mix of sectors remains industrials, technology, basic materials and energy, but we would recommend shifting into more defensive areas as the quarter progresses. In the US, we have reduced exposure to cyclical sectors facing secular headwinds, namely financials and consumer discretionary, and maintain exposure to cyclical sectors poised to benefit from secular tailwinds, such as technology and industrials. Short-end rates look too low (especially post 1y), and should start selling off around the end of Q1, with the biggest move expected in Q2 10. Strategically, we like being short and in money market steepeners. At the long end, rates are equally expensive in most major markets, and will invariably sell off, keeping the curves steep until at least the end of Q1 10, and probably longer in the US. Cross market, we still prefer euro rates, but entry levels are not currently attractive. Long crude oil, given that improving global diesel demand should provide a further leg-up to prices, but short US natural gas, which still looks oversupplied. Long copper and nickel, which should be among the main beneficiaries of a cyclical OECD recovery in Q1. Long corn and sugar on strong demand for ethanol and recent supply problems. Short silver as it is the precious metals market most exposed to a more stable dollar outlook. 5y sector offers greatest potential to benefit from a recovery-led repricing of breakevens. Financials, especially banks, are likely to outperform owing to better technicals, including negative net issuance and build-up of liquidity. Improving fundamentals, better liquidity and normalization in funding costs should lead lower BBB-rated issuers to outperform. A barbelled HY portfolio takes advantage of historically wide double-B spreads and potential outperformance of selected CCC paper. Taxable munis appear attractive versus corporates of similar maturity and quality. We think high-quality external debt will outperform US Treasuries, but earn quite low total returns. Achieving better than mediocre returns will hinge upon country allocations and asset selection. EM FX strength is more than dollar weakness. Asia FX should outperform on the basis of strong external positions, policy tightening, and CNY appreciation. Buy USD/JPY. Buy commodity currency basket against the CHF. Sell AUD/CAD. Sell EUR/SEK.
Bonds

Commodities

Inflation
Credit

Emerging Markets
Foreign Exchange

10 December 2009
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
OVERVIEW
Beyond the recovery trade

Larry Kantor +1 212 412 1458 larry.kantor@barcap.com

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.
We are on the alert for signs of change in the current liquiditydriven environment
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
2010 may not provide the excitement of 2009, but it should still be favorable for growth and inflation fundamentals
The countries in Asia that have led the global economic recovery have completed the initial period of rapid growth and are now slowing. At the other extreme, the laggards most notably Europe and the US are just now entering the period of maximum growth, 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
10 December 2009
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

There are no screaming buys left
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.
Expect lower correlations among asset classes and geographies
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.
An upturn in the US labor market could signal the end of the recovery market rally
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
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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
60 40 20 0 -20 -40 -60 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 S&P 500, y/y % chg (lhs)
Source: BEA, S&P and Haver Analytics
6 4 2 0 -2 -4 -6
US real GDP, y/y % chg (rhs)
It is not too early for investors to focus on what the world will look like when the Fed starts withdrawing support
We believe that with asset prices already back to at least "neutral" (consistent with Chairman Bernanke's judgment), the 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 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
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
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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

We do not expect the onset of Fed tightening to trigger a bear market
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.
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
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.
10 December 2009
ASSET ALLOCATION
Cross currents
Tim Bond +44 (0) 20 7773 2242 tim.bond@barcap.com
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
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 nonfinancial 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.
10 December 2009
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
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

1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 US seasonally adjusted budget deficit, 3 month annualised, $ trill
Source: Thomson Datastream
10 December 2009
Low short-term interest rates encourage savers to move out of cash and invest further along the yield curve
The impact on bond yields of the asset reallocations encouraged by the low rate policy also needs to be considered. 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
700 600 500 400 300 200 100 0 -100 -200 1972 - Jan 1977 - Nov 1983 - Sep 1989 - Jul 1995 - May 2001 - Mar 2007 - Jan
yy change in custody holdings foreign official inst 3 month annualised change in custody holdings foreign official inst
Source: Haver Analytics
Figure 3: y/y % change in assets under management, US money market mutual funds
50 40 30 20 10 0 -10 -20 1997 - Nov 7 6 5 4 3 2 1 0 1999 - Nov 2001 - Nov 2003 - Nov 2005 - Nov 2007 - Nov 2009 - Nov
% change yy money market mutual fund assets

Source: Haver Analytics, ICI
Fed Funds rate
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We expect the decrease in loan books to accelerate, at least in the early part of next year
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 nonbank 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 (exUS) 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, longterm 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
5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Mar-97
The combination of low short-term interest rates and private sector deleveraging tends to keep longer-term real interest rates low
Sep-98 Mar-00
Sep-01 Mar-03
Sep-04 Mar-06 model
Sep-07 Mar-09
Sep-10
TIPS 10y real yield

Source: Barclays Capital
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Strong liquidity flows in either direction tend to desensitise markets to fundamental factors
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 longterm real yields on government bonds and the meteoric ascent of gold prices are both symptomatic of a potent tide of liquidity that has begun to flood asset markets. 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.
Central banks are likely to be much more sensitive to potential asset bubbles than used to be the case
The counterbalancing factor is that central banks are likely to be much more sensitive to potential asset bubbles than used to be the case. 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.
The policy outlook is fraught with uncertainty
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
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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.
Uncertainty surrounding the pace of the US labour market recovery translates into acute uncertainty about the timing of Fed tightening
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.
Errors in calculating the dimensions of output gaps are abnormally large during periods of high GDP volatility
Figure 5: Absolute value, US output gap error, volatility of nominal GDP growth
7 6 5 4 3 2 1 3.0 2.5 2.0 1.5 1.0 0.5
0 0.0 Dec-69 Dec-73 Dec-77 Dec-81 Dec-85 Dec-89 Dec-93 Dec-97 Dec-01 Dec-05 Dec-09 rolling 5 year standard deviation of nominal GDP growth, 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
10 December 2009 13
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.
There is a higher-than-usual probability of a deliberate inflationary policy error
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 resourcebased 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.
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
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
14
10 December 2009
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.
A passive harvesting of beta is unlikely to be productive over the next 12 months
The sixth area of risk lies in the probable collapse of high levels of cross asset class correlations that have been apparent over the past two years. 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.
We are biased to staying long in equities
For the immediate future a period that should encapsulate most of the first quarter of 2010 we are biased to staying long in equities. 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
10 December 2009
15
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.
But we are not inclined to overstay our welcome in long equity positions
We are not inclined to overstay our welcome in long equity positions. 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 datadependent, 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
16
The yen is overvalued on virtually every criterion and against virtually every currency
We expect further credit spread tightening set against a background of modestly rising yields
10 December 2009
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.
A modest rally in commodity prices
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.
We favour a mix of high beta equity, cash and high yield credit
10 December 2009
17
ECONOMIC OUTLOOK
Hard to derail
Christian Broda +1 212 526 8536 christian.broda@barcap.com Piero Ghezzi +44 (0)20 3134 2190 piero.ghezzi@barcap.com

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.
Nick Verdi +44 (0)20 7773 2173 nick.verdi@barcap.com

Our forecasts for 2010 are more positive than those of the consensus
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 depressioncombating 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 Figure 2: Our outlook relative to consensus
US q/q saar Eurozone y/y Japan q/q saar UK y/y Brazil y/y Russia y/y China y/y As of: Consensus BarCap Consensus BarCap Consensus BarCap Consensus BarCap Consensus BarCap Consensus BarCap Consensus BarCap 4Q09 1Q10 2Q10 3Q10 2010 2011 3.0 2.6 2.6 2.8 2.6 3.0 4.0 5.0 3.0 3.5 3.5 3.1 -1.9 0.8 1.3 1.1 1.2 n.a. -1.8 1.1 1.6 1.7 1.5 1.9 1.6 0.5 0.8 1.3 1.2 1.2 3.6 1.0 0.4 2.0 1.7 1.8 -2.9 0.0 1.2 1.9 1.3 2.0 -3.0 0.0 1.2 2.2 1.5 2.2 3.7 5.2 5.0 4.9 5.0 4.5 4.4 6.6 5.7 4.8 5.3 4.4 -2.8 3.5 3.9 2.1 3.0 4.5 1.2 3.5 5.1 4.4 4.3 3.6 10.2 10.4 9.7 9.4 9.6 n.a. 11.4 12.0 9.7 8.6 9.6 9.0
Figure 1: Global recovery in manufacturing output

IP index: Jan 08 = 100 140 China 130 120 110 100 90 80 70 60 Jan-08 India Korea Brazil US Europe Japan
May-08 Sep-08
Jan-09
May-09 Sep-09
Source: Bloomberg, Blue Chip, Barclays Capital
Note: Europe is a GDP-weighted average of the euro area and the UK. Source: Haver, Barclays Capital
10 December 2009
18
is supported by depression-combating policies and is starting from low activity levels will be hard to derail in coming quarters.
Two key factors to track in coming months: 1) how businesses react to stabilizing final sales
Two key global factors will play an important role in tracking our views of the real side of the global economy in coming months. 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 Figure 4: Capex and auto spending as % of GDP
19 18 17 16 15 14 13 12 11 65 70 75 80 85 90 95 00 05 10 Q4 10 forecast US UK
2) the evolution of the fiscal and monetary exit strategies
Monetary policy is likely to continue to support activity in 2010
Figure 3: Global new orders and manufacturing production

20 10 0 -10 -20 -30 -40 98 00 02 04 06 08 10 2 1 0 -1 -2 -3 -4 -5 -6
Global manufacturing output, % 3m/3m ann. (lhs) Global new orders less inventories (rhs)
Note: New orders-inventories series is normalized; constructed using subcomponents of country PMIs. Source: Barclays Capital
Note: Capex defined as private non-residential investment. Marker represents 4Q10 US forecast. Source: Haver, Barclays Capital
10 December 2009
19
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

In 2010, we expect that regional factors will regain importance versus global forces
The global crisis of Q4 08 implied that global forces overwhelmed regional factors in economic forecasts. 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.
We expect the improving trend in US employment to continue
Figure 5: Consumer confidence is returning

110 100 90 80 70 60 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Global auto sales US retail sales (ex. autos), RHS Euro area retail sales (ex. autos), RHS
Note: Series are rebased so that Jan 08=100. Retail sales are values. Source: Haver, Barclays Capital
Figure 6: US employment as % of real GDP

105
Index 100 = start of recession 105
1981 1990 2001
100
100
Current
95
95
90
90 -4 -2 0 2 4 6 8 10 12 Quarters since start of recession 14 16
Note: Dotted line represents forecast. Source: Haver, Barclays Capital
10 December 2009
20
Several negative factors are likely to prevent an above-trend European recovery
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 overextended 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
We expect core inflation to continue to decline through 2010 in the US and Europe
Figure 7: Persistent deflation expected only in Japan

y/y % chg 6 5 4 3 2 1 0 -1 -2 -3 06 07 US 08 UK 09 10 11 Japan Euro area Forecasts
Figure 8: Inflation expectations will be closely watched

Real yields 5% 4% 3% 2% 1% 0% 97 99 01 03 05 07 09 TIPS Euro UK 5% 4% 3% 2% 1% 0% 97 99 01 03 05 07 09 Breakevens TIPS Euro UK
Note: Japan CPI excludes perishables. Source: BLS, ONS, Eurostat, MIAC, Haver Analytics, Barclays Capital
Note: Shows a 10-day moving average of swap rates. Source: Haver, Barclays Capital
10 December 2009
21
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.
We forecast more broad-based economic growth in China
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
Israel (+25)
4Q09
Norway (+25) Australia (+25)
1Q10
India (+50) Korea (+50) Mexico (+25)
2Q10
Indonesia (+25) Peru (+25) Taiwan (+13) Thailand (+25) US (+25) UK (+50)
3Q10
Brazil (+50) Poland (+25) S Africa (+50) Sweden (+25) Czech R (+25) Colombia (+25)
4Q10
1Q11
Euro area (main rate, (+25)
//
2Q12
Japan (+20)
Canada (+25) China (+27) HK (+25) Chile (+25)
Euro area (EONIA, +25)
Source: OECD Annual Outlook 2009, Barclays Capital
10 December 2009
22
Bar Japan, we expect monetary tightening across most economies next year
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.
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
Figure 10: ECB reaction function signals gradual increases

7 6 5 ECB policy 'refi' rate (synthetic GDP-weighted history pre 1999, EONIA since Oct. 08) Reaction function equation
Figure 11: Yet the BoJ has responded least

Change in official rates since start of 2008 (in pp) UK -5.0 Increase in central bank assets since start of 2008 ( in % GDP) 9.5
4 3 2 1 0 -1 -2 96 98 00 02 04 06 08 10 -6 -4 -2 0 2 4 6 8 10 Japan -0.4 2.5 Euro area -3.0 5.2 US -4.3 8.8
Source: Thomson Datastream, Barclays Capital
Source: BoE, FRB, ECB, BoJ
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The BoJs recent decision to expand its QE measures is a positive development
Japan is the only major country not expected to tighten monetary policy somewhat in 2010. 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.
EM countries are likely to kick off their tightening cycle early in the year
QE: Sharp impact in, gradual impact out

We expect countries with large QE programs to see higher rates in 2010
At least three key macroeconomic factors drove long-term rates lower in 2009. 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 13: Bond yields set to rise
13
Figure 12: Private savings trend higher

% of GDP 8 7 6 11 5 4 3 00 01 02 03 04 05 06 07 08 09 10 US private savings (LHS) US non-residential investment (RHS)
Note: Private saving is equal to personal saving plus after-tax corporate profits less dividends paid. Marker represents 4Q10 forecast. Source: Haver, Barclays Capital
10-year government bond yields, % 5.0 4.5 4.0 3.5 3.0 2.5 Forecast Q4 10
12
10
2.0 Nov-08
Feb-09
May-09 UK
Aug-09 US
Nov-09
Note: Marker denotes end-2010 BarCap forecast for the US and UK. Source: Barclays Capital
10 December 2009
24
rates low. Finally, central bankers injected substantial amounts of fresh money to buy longterm 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.
Except Japan, we expect a gradual end to most QE programs in 2010
Our expectation in 2010 is that we see a gradual end to most QE programs, 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 interestbearing assets so-called sterilization operations could lead to higher rates along the yield curve and the removal of part of the stimulative impact on the global economy. Outside of Japan, the end of QE measures is likely to have consequences for the economic outlook. We have forcefully argued that QE has been an important driver of lower interest rates and of a weaker USD and GBP relative to JPY and EUR since the summer. This effect has been gradual, and while we expect both the BoE and the Fed to end their direct purchase of assets sometime early in 2010, we do not expect an abrupt impact on rates or currencies (or asset prices more generally) when QE ends. We do expect, however, that the end of QE will remove an important driver for lower rates (and weaker USD and GBP) throughout 2010. Thus, it is useful to review the impact that QE had on markets on the way in. At their inception, asset purchases by the Fed and BoE were intended to facilitate credit to the private sector, which would effectively imply falls in longer-term yields (given that overnight rates, the typical way central bankers lend to the private sector, were already zero). Figure 14 shows the impact on long-term rates one and five days after key announcements, including the Feds 25 November announcement of $600bn for purchasing long-term mortgage assets; its announcement in March of a large extension of the program, including $300bn Treasury purchases; and the BoE early March program of Gilt purchases. These specific dates are likely to provide the most information, given the large surprise element of the announcements. Assuming that the magnitudes announced were mostly unexpected by markets a reasonable assumption according to our fixed-income colleagues and that once announcement markets didnt immediately expect further expansions, then the impact of each $100bn of asset purchases on 10y bonds would have been to depress yields by an average 3.5bp in England and 4bp in the US (ie, we divide the one-day change with the amount of purchases announcement). This means that the entire QE program of the Fed ($1.75trn) and the BoE ($330 bn) has helped keep rates around 70bp below what they would have been without these programs. Extra caution is required when interpreting these estimates. For starters, they implicitly assume that the informational content of the price action during those days was entirely due to the actual announcements. Second, the surprise component on the way in is radically different than on the way out. On the way in, these were unconventional policies that were essentially surprise actions with sharp effects (especially the three key events). Because the end of QE is highly anticipated, these estimates are already partly priced in. However, market imperfections and the lack of full credibility in the announcements may imply that the rise of rates happens smoothly and extends beyond the end of QE, as it requires the actual end of additional fresh money being injected by central bankers to be fully priced in.
We estimate that the entire QE program of the Fed and BoE helped keep rates around 70bp lower
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Figure 14: Impact on yield changes of central bank announcements (%)

tUS Federal Reserve 25 Nov 2008 10 Feb 2009 18 Mar 2009 25 Jun 2009 17 Aug 2009 23 Sep 2009 4 Nov 2009 New asset purchase programs ($500bn MBS, $100bn GSE) TALF expanded MBS/ABS purchases by expanded $850bn; Treasuries $300bn Extensions and modifications to a number of liquidity programs Extension to TALF Asset purchases slowed to end Q1 10 Fed sets out conditions for tightening monetary policy Bank of England 5 Mar 2009 7 May 2009 6 Aug 2009 5 Nov 2009 Asset purchase facility announced (75bn) APF increased by 50bn to 125bn APF increased by 50bn to 175bn APF increased by 25bn to 200bn 3.65 3.60 3.81 3.84 3.38 3.66 3.76 3.91 -0.28 0.06 -0.06 0.07 2.97 3.43 3.81 3.85 -0.69 -0.17 0.00 0.01 t-1 3.34 3.03 3.00 3.69 3.56 3.46 3.47 t 3.10 2.85 2.53 3.55 3.49 3.42 3.55 t-1 -0.24 -0.18 -0.47 -0.14 -0.07 -0.04 0.07 t+5 2.69 2.67 2.77 3.49 3.49 3.31 3.44 t+5 t-1 -0.65 -0.35 -0.23 -0.19 -0.06 -0.15 -0.03
Note: Yields refer to 10y US Treasuries and UK gilts. T = day of specified announcement, t - 1 = previous day. Source: Barclays Capital
But beyond the direct impact of QE, rising private saving and the large risk aversion of 2009 have had a clear effect on rates. Our baseline scenario is for the global recovery to continue and private savings (ie, both personal and corporate) to stabilize in 2010. This means that these two additional sources of low rates in 2009 are likely not to be as strong in 2010. The recession brought about a jump in private savings that helped keep rates low. It is hard to justify another jump in savings without a massive disruption in the drivers of savings (ie, a sharp increase in job uncertainty, collapse in wealth, fall in income). Even in a 2% growth scenario which is lower than ours it is hard to see any of these determinants moving enough to warrant that higher savings will push rates lower. However, for a given level of savings, a sharp return of risk aversion could still bring down rates. But even in a slow growth scenario of 2%, it does not seem reasonable to expect such a bout of risk aversion. It is true that the move towards riskier assets (and away from cash and treasuries) would be smaller than the one we expect in our outlook, but it is hard to envision this force being even close in magnitude to the panic attack post-Lehman (when 10y UST rates touched 2%). Thus, as the probability of a return to very weak growth continues to fall (see Sweet spot for growth in Global Outlook, September 2009, for why we are not expecting this tail risk to materialize in 2010), we have incorporated the rise in long-term rates throughout 2010 in our economic outlooks.
Our central case is for long-term rates to be 100bp higher by end-2010
Two words of caution are warranted. First, because of market imperfections rates could continue to fall further during early 2010. But once the Fed or BoE support ends in March (again, our baseline is no extension), the same forces that have been active since the summer, pushing rates and GBP and USD down, should gradually reverse (as, of course, nothing abrupt is expected to happen the day QE ends). Second, even with a relatively strong recovery, the return to risk by private investors may be slower than after normal recessions. This could imply a slower increase in rates than after normal recessions. Nonetheless, because of the magnitudes of QE involved and the behaviour of risk/markets since the summer, we continue to think that long-term rates are likely to be 100bp or more higher than today by end-2010 (Figure 13). In short, while the timing of higher rates may be delicate, given a number of important liquidity considerations, we believe that only under a scenario of very weak economic recovery would rates remain so low.
26
10 December 2009
Figure 15: Summary of Barclays Capital economics projections: GDP and inflation
Real GDP % y/y Weight* Canada US North America Argentina Brazil Chile Colombia Mexico Peru Venezuela Latin America The Americas Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain Euro area Norway Sweden UK W Europe Czech Republic Hungary Poland Central Europe Russia Turkey Europe Australia PR China Hong Kong, SAR China, Taipei India Indonesia Japan Malaysia Philippines Singapore South Korea Asia South Africa G10 Above countries 1.9 20.7 22.6 0.8 2.9 0.4 0.6 2.2 0.4 0.5 7.9 30.5 0.5 0.6 0.3 3.1 4.2 0.5 0.3 2.6 1.0 0.3 2.0 15.7 0.4 0.5 3.2 20.5 0.4 0.3 1.0 1.8 3.3 1.3 27.8 1.2 11.4 0.4 1.1 4.8 1.3 6.4 0.6 0.5 0.3 1.8 30.5 0.7 44.6 95.8 2007 2.5 2.1 2.2 8.7 5.7 4.7 7.5 3.3 8.9 8.4 5.7 3.1 3.4 2.8 4.1 2.3 2.6 4.6 6.0 1.5 3.6 1.9 3.6 2.7 2.7 2.7 2.6 2.7 6.1 1.1 6.8 6.1 8.1 4.6 3.7 4.0 13.0 6.3 5.7 9.1 6.3 2.3 6.2 7.1 7.8 5.1 8.2 5.1 2.4 5.1 2008 0.4 0.4 0.4 5.8 5.1 3.2 2.4 1.3 9.8 4.8 4.0 1.4 2.0 0.8 0.8 0.3 1.0 2.0 -3.0 -1.0 2.0 0.0 0.9 0.5 1.7 -0.5 0.6 0.5 3.0 0.7 5.0 4.0 5.6 1.1 1.4 2.4 9.0 2.6 0.7 7.3 6.1 -0.7 4.6 3.8 1.1 2.2 5.1 3.1 0.4 2.7 2009 -2.4 -2.5 -2.5 -2.2 0.1 -1.9 0.0 -6.8 0.9 -2.3 -2.3 -2.4 -3.6 -3.0 -7.7 -2.2 -4.8 -1.0 -7.0 -4.8 -4.0 -2.6 -3.6 -3.9 -1.1 -4.4 -4.6 -3.9 -4.7 -6.6 1.3 -1.8 -7.1 -5.9 -4.2 0.9 8.6 -3.3 -3.0 6.0 4.5 -5.2 -2.0 1.2 -1.5 0.1 3.0 -1.8 -3.6 -1.1 2010 3.4 3.5 3.5 3.5 5.3 4.6 3.4 5.1 3.9 2.4 4.6 3.8 1.7 1.9 0.2 1.4 2.4 0.5 0.1 1.2 2.0 1.5 -0.5 1.5 2.3 1.9 1.5 1.4 1.9 0.3 3.0 2.4 4.3 3.8 2.0 2.8 9.6 4.3 6.0 8.2 6.0 1.7 5.0 4.3 6.5 5.0 6.6 2.4 2.6 4.2 2011 3.4 3.1 3.1 2.7 4.4 4.2 4.8 3.2 5.9 3.1 3.8 3.3 2.2 2.4 2.2 1.1 2.4 0.9 1.7 1.7 2.2 1.4 1.5 1.9 2.8 2.7 2.2 1.9 3.1 3.9 4.0 3.9 3.6 4.1 2.4 3.7 9.0 4.0 4.0 8.4 6.3 1.8 4.5 5.3 4.0 4.0 6.2 4.1 2.5 4.1 2007 2.1 2.9 2.8 8.8 3.6 4.4 5.5 4.0 1.8 18.7 5.5 3.3 2.2 1.8 1.6 1.6 2.3 3.0 2.9 2.0 1.6 2.4 2.8 2.1 0.7 2.2 2.3 2.1 2.9 8.0 2.9 3.6 9.3 8.7 2.9 2.4 4.8 2.0 1.8 4.7 6.4 0.0 2.0 2.8 2.1 2.5 2.6 7.1 2.2 3.0 CPI inflation % y/y** 2008 2.4 3.8 3.7 26.7 5.9 8.7 7.0 5.1 5.8 31.4 9.7 2.8 3.2 4.5 3.9 3.2 2.8 4.2 3.1 3.5 2.2 2.7 4.1 3.3 3.8 3.4 3.6 3.3 6.0 6.1 4.1 4.9 14.2 10.2 4.5 4.4 5.9 4.3 3.5 9.1 10.2 1.5 5.4 9.3 6.5 4.7 3.5 11.5 3.3 3.2 2009 0.3 -0.3 -0.3 16.2 4.2 1.5 4.2 5.3 1.2 26.1 7.1 2.6 0.4 0.0 1.6 0.1 0.2 1.3 -1.6 0.7 1.0 -0.9 -0.3 0.3 2.2 -0.3 2.1 0.6 1.0 4.2 3.5 2.9 11.7 6.2 1.8 1.7 -0.7 0.6 -0.7 1.9 5.0 -1.3 0.6 3.2 0.3 2.8 -0.8 7.2 0.1 1.4 2010 1.5 2.2 2.1 15.3 4.6 0.3 2.9 4.5 2.2 31.7 7.3 2.6 1.2 1.6 1.1 1.6 1.3 1.8 -1.4 1.0 0.8 0.7 1.7 1.3 1.8 1.2 2.3 1.4 2.2 3.6 2.7 2.7 6.8 6.4 2.1 2.8 3.0 2.0 1.8 6.5 6.5 -1.0 2.5 6.1 4.0 1.7 2.4 6.1 1.5 2.1 2011 1.9 1.7 1.7 n.a. 5.1 2.4 3.6 3.9 2.5 35.3 7.0 2.5 1.0 1.7 1.0 1.6 1.5 1.2 -1.1 1.2 1.0 1.0 1.4 1.4 2.2 2.0 0.5 1.3 1.6 3.1 2.9 2.6 7.0 6.0 2.0 3.0 3.5 2.5 1.5 5.7 6.6 -0.7 2.5 5.3 1.2 1.6 2.7 5.7 1.3 2.0
Note: * IMF weight of real GDP using PPP, 2008 estimates for real GDP; nominal GDP (2008) for CPI inflation. ** Conventional rate; HICP for euro area. Source: Barclays Capital
10 December 2009
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Figure 16: Summary of Barclays Capital economics projections: External and government balances
Current account (% GDP) Weight* Canada US North America Argentina Brazil Chile Colombia Mexico Peru Venezuela Latin America The Americas Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain Euro area Norway Sweden UK W Europe Czech Republic Hungary Poland Central Europe Russia Turkey Europe Australia PR China Hong Kong, SAR China, Taipei India Indonesia Japan Malaysia Philippines Singapore South Korea Asia South Africa G10 Above countries
General gov't. (% GDP)** 2011 -0.5 -4.8 -4.4 3.5 -3.4 1.0 -3.4 -1.6 -3.9 7.9 -1.2 -4.4 3.8 -0.4 2.7 -1.8 5.3 -10.4 -0.3 -3.0 9.0 -8.3 -3.7 0.5 16.0 8.9 -2.3 0.8 -3.0 -3.6 -0.4 -2.1 3.2 -4.2 0.5 -5.6 6.0 11.3 3.0 -1.5 0.7 3.8 13.7 3.3 8.9 0.9 5.5 -4.9 -1.3 -0.3 2007 1.6 -1.2 -0.9 0.2 -2.8 8.7 -0.6 0.0 1.7 -2.8 -0.9 -0.9 -0.6 -0.2 5.2 -2.7 -0.2 -3.6 0.3 -1.5 0.2 -2.6 2.2 -0.6 17.7 3.8 -2.6 -0.2 -1.0 -4.9 -1.9 -2.2 5.4 -2.6 0.1 1.6 0.6 8.6 -1.1 -7.3 -2.1 -2.5 -3.2 -1.6 11.1 3.5 -0.9 0.9 -1.1 -0.1 2008 -0.4 -3.2 -2.9 1.4 -2.1 5.2 -0.1 -0.1 2.1 -2.6 -0.7 -2.4 -0.6 -1.2 4.4 -3.4 0.0 -5.3 -7.1 -2.7 0.7 -2.7 -3.8 -1.9 18.8 2.5 -6.3 -1.7 -1.5 -3.8 -3.9 -3.2 4.1 -3.1 -1.4 -0.3 -0.4 3.8 -2.0 -12.9 -0.1 -2.9 -4.8 -0.9 -0.7 3.0 -2.1 -1.2 -2.7 -1.1 2009 -3.7 -9.9 -9.3 -1.7 -4.1 -3.6 -2.6 -2.2 -2.9 -7.7 -3.5 -8.2 -4.4 -5.5 -3.4 -8.3 -3.0 -12.2 -12.2 -5.2 -6.4 -7.6 -10.1 -6.2 9.0 -3.0 -13.6 -6.6 -5.6 -3.9 -5.9 -5.5 -6.9 -6.7 -6.6 -0.2 -3.0 -3.6 -5.3 -10.5 -1.5 -8.8 -9.0 -4.2 -3.2 -5.3 -5.7 -7.7 -8.2 -5.4 2010 -2.8 -8.5 -7.9 -2.4 -3.2 -1.1 -3.6 -2.7 -1.4 -6.7 -3.1 -7.0 -5.2 -5.7 -4.7 -8.7 -5.5 -12.3 -12.1 -4.9 -6.1 -7.7 -10.7 -7.1 9.2 -2.7 -11.9 -7.0 -5.0 -3.9 -6.5 -5.6 -3.0 -5.0 -6.6 0.3 -2.0 -3.0 -4.0 -8.5 -1.3 -9.5 -6.5 -3.5 -0.5 -3.5 -5.2 -5.6 -7.9 -4.5 2011 -1.6 -6.1 -5.7 -3.1 -3.0 -0.6 -3.5 -1.8 -0.4 5.5 -1.8 -4.9 -4.6 -4.8 -2.8 -7.5 -4.4 -11.9 -10.7 -4.4 -4.2 -7.2 -10.2 -6.4 9.4 -1.8 -8.5 -5.8 -4.0 -3.4 -5.5 -4.7 -4.0 -4.9 -5.5 0.6 -1.0 -2.0 -2.0 -7.5 -1.0 -8.0 -5.5 -2.8 1.2 -1.0 -4.0 -5.2 -6.1 -3.2
2007 1.0 -5.2 -4.6 1.6 0.1 4.7 -1.8 -0.8 1.1 8.8 0.8 -4.5 3.5 1.7 4.2 -1.0 7.8 -14.1 -5.4 -2.4 8.7 -9.4 -10.0 0.2 15.9 8.8 -2.7 0.9 -3.0 -6.4 -4.7 -4.7 9.9 -5.8 0.8 -5.9 11.0 12.4 8.6 -1.6 2.4 4.8 15.7 4.9 24.2 0.6 4.4 -7.3 -1.1 -0.6
2008 0.5 -4.9 -4.4 2.3 -1.8 -2.0 -2.8 -1.5 -3.3 12.5 -0.3 -3.6 3.2 -2.5 3.0 -2.3 6.6 -14.3 -5.1 -3.4 4.8 -12.1 -9.6 -1.5 19.5 9.8 -1.6 0.0 -3.0 -7.1 -5.0 -5.1 6.0 -5.6 0.5 -5.8 9.8 14.2 6.2 -3.4 0.0 3.2 17.5 2.3 14.8 -0.7 5.5 -4.4 -1.7 0.1
2009 -2.5 -2.9 -2.9 3.6 -1.3 0.7 -2.9 -1.0 -2.4 1.6 -0.7 -3.7 2.0 -1.0 1.3 -1.9 3.9 -10.7 -3.2 -3.3 6.0 -9.1 -5.2 -0.7 15.1 8.1 -1.8 0.1 -2.5 -0.5 -1.5 -2.2 4.8 -2.3 0.6 -3.4 6.2 10.4 9.9 -0.7 1.7 2.6 14.6 5.1 14.2 5.6 -4.7 -4.4 -1.0 -2.6
2010 -1.5 -3.7 -3.5 2.1 -2.6 1.2 -2.3 -1.2 -4.4 7.3 -0.9 -4.2 2.7 -0.9 1.9 -1.5 4.6 -10.6 -1.7 -3.0 7.7 -8.6 -3.9 0.1 16.6 8.4 -2.6 0.5 -2.6 -2.5 -0.7 -2.1 5.2 -4.1 0.6 -4.6 6.5 11.1 5.3 -1.4 1.0 3.5 13.6 3.4 9.9 2.1 8.2 -4.2 -1.0 0.5
2.5 23.5 26.0 0.5 2.6 0.3 0.4 1.8 0.2 0.5 6.4 32.4 0.7 0.8 0.5 4.7 6.0 0.6 0.5 3.8 1.4 0.4 2.7 22.1 0.8 0.8 4.4 29.4 0.4 0.3 0.9 1.6 2.8 1.2 35.0 1.7 7.3 0.4 0.6 2.0 0.8 8.1 0.4 0.3 0.3 1.6 23.8 0.5 57.0 96.3
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Figure 17: US economic projections

2009 % Change q/q saar Real GDP Private consumption Public consump and invest. Residential investment Equip. & software investment Structures investment Net exports ($bn, real) Final sales Ch. inventories ($bn, real) GDP price index Nominal GDP Industrial output Employment (avg mthly chg, K) Unemployment rate (%) CPI inflation (%y/y) Core CPI (%y/y) Core PCE price index (%y/y) Current account (%GDP) Federal budget bal. (%GDP) Federal funds rate (%) 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0.50 Note: Q/Q data are seasonally adjusted annualized. *Fiscal year basis. Source: Barclays Capital 1.00 1.00 1.00 1.50 2.00 Q1 -6.4 0.6 -2.6 -38.2 -36.4 -43.6 -387 -4.1 -113.9 1.9 -4.6 -19.0 -691 8.1 0.0 1.7 1.7 -3.0 Q2 -0.7 -0.9 6.7 -23.3 -4.9 -17.3 -330 0.7 -160.2 0.0 -0.8 -10.3 -428 9.3 -1.2 1.8 1.6 -2.8 Q3 2.8 2.9 3.1 19.5 2.3 -15.1 -358 1.9 -133.4 0.5 3.3 5.6 -199 9.6 -1.6 1.5 1.3 -2.8 Q4 4.0 2.0 2.8 15.0 10.0 -10.0 -371 2.2 -78.0 1.1 5.0 7.0 -40 10.1 1.5 1.8 1.3 -3.1 Q1 5.0 2.0 2.2 20.0 15.0 -12.0 -375 2.7 -8.0 1.2 6.2 8.0 125 10.0 2.7 1.6 1.3 -3.3 2010 Q2 3.0 2.0 2.0 30.0 8.0 -6.0 -386 2.5 7.0 1.3 4.3 8.0 175 9.7 2.3 1.3 1.1 -3.6 Q3 3.5 2.5 1.4 30.0 8.0 -4.0 -396 2.8 27.0 1.3 4.8 7.0 225 9.4 2.0 1.2 1.0 -3.9 Q4 3.5 3.0 1.0 30.0 6.0 2.5 -402 3.3 32.0 1.2 4.7 6.0 250 9.1 1.7 1.1 1.0 -4.1 Q1 2.5 2.0 0.0 25.0 7.0 4.0 -409 2.4 37.0 1.5 4.0 6.0 275 8.8 1.6 1.2 1.0 -4.4 3.0 2.5 -0.5 20.0 8.0 6.0 -416 2.6 45.0 1.5 4.6 5.5 325 8.6 1.7 1.2 1.1 -4.7 2011 Q2 Q3 3.5 3.0 -1.0 15.0 15.0 8.0 -423 3.2 53.0 1.8 5.4 5.0 350 8.3 1.8 1.3 1.1 -5.0 Q4 3.5 3.5 -1.2 15.0 15.0 8.0 -435 3.4 57.0 1.9 5.5 5.0 350 7.9 1.8 1.4 1.2 -5.3 Calendar year average 2009 -2.5 -0.6 2.2 -19.9 -17.0 -19.0 -362 -1.7 -121.4 1.2 -1.3 -9.8 -340 9.3 -0.3 1.7 1.5 -2.9 -9.9 2010 3.5 2.1 2.5 19.5 8.4 -9.5 -390 2.4 14.5 1.1 4.6 6.0 194 9.6 2.2 1.3 1.1 -3.7 -8.5 2011 3.1 2.6 0.2 23.7 8.7 3.1 -421 2.9 48.0 1.5 4.6 6.0 325 8.4 1.7 1.3 1.1 -4.8 -6.1
Figure 18: Euro area economic projections

% Change q/q Real GDP Real GDP (saar) Real GDP y/y Private consumption Public consumption Investment residential construction non-residential construction non-construction investment Inventories (q/q contribution) Net exports (q/q contribution) Industrial output (ex construction) Employment q/q Q1 -2.4 -9.4 -5.0 -0.5 0.6 -4.9 -2.6 0.4 -8.8 -0.7 -0.6 -8.1 -0.7 2009 Q2 Q3 -0.2 -0.6 -4.8 0.0 0.6 -1.7 -2.0 0.3 -2.6 -0.6 0.7 -1.6 -0.5 0.4 1.5 -4.1 -0.2 0.5 -0.4 -1.4 -0.4 -0.6 0.3 0.2 2.2 -0.5 Q4 0.5 1.9 -1.8 0.0 0.7 -0.5 -1.0 -0.2 -0.5 0.2 0.2 0.3 -0.3 Q1 0.4 1.4 1.1 0.1 0.3 -0.2 -0.8 -0.2 0.1 0.1 0.2 0.0 -0.4 2010 Q2 Q3 0.4 1.7 1.6 0.3 0.2 -0.1 -0.6 -0.1 0.2 0.2 0.1 0.2 -0.3 0.4 1.6 1.7 0.3 0.2 0.2 -0.3 0.0 0.7 0.1 0.1 0.1 -0.2 10.8 1.4 1.0 0.2 ... 1.00 Q4 0.4 1.7 1.6 0.3 0.1 0.5 -0.3 0.0 1.2 0.1 0.0 0.2 -0.1 10.9 1.6 1.0 0.2 ... 1.00 Q1 0.4 1.8 1.7 0.3 0.1 0.5 -0.1 0.0 1.1 0.0 0.1 0.2 0.1 10.8 1.6 1.0 0.3 ... 1.25 2011 Q2 Q3 0.5 1.8 1.7 0.3 0.1 0.6 0.0 0.1 1.2 0.0 0.1 0.3 0.2 10.7 1.5 1.1 0.4 ... 1.50 0.6 2.3 1.9 0.4 0.1 0.6 0.3 0.2 1.2 0.1 0.1 0.5 0.2 10.5 1.3 0.9 0.6 ... 1.75 Q4 0.6 2.4 2.1 0.4 0.1 0.7 0.3 0.4 1.2 0.1 0.1 0.6 0.3 10.2 1.3 0.9 0.7 ... 2.00 Calendar year average 2009 2010 2011 ... ... -3.9 -1.0 2.5 -10.0 -8.9 -2.0 -14.6 -0.7 -1.1 -13.7 -1.7 9.4 0.3 1.4 -0.7 -6.2 1.00 ... ... 1.5 0.4 1.5 -1.0 -2.9 -0.5 -0.4 0.5 0.7 1.1 -1.3 10.7 1.3 1.0 0.1 -7.1 1.00 ... ... 1.9 1.3 0.6 2.0 -0.3 0.3 4.2 0.2 0.4 1.1 0.2 10.6 1.4 1.0 0.5 -6.4 2.00
Unemployment rate % 8.8 9.3 9.6 10.0 10.4 10.7 0.4 1.1 1.2 CPI inflation y/y 1.0 0.2 -0.4 Core CPI (ex food/energy) y/y 1.6 1.6 1.3 1.1 1.0 0.9 -0.2 0.0 0.1 Current account % GDP -1.7 -0.5 -0.4 Government balance % GDP ... ... ... ... ... ... Refi rate (period end) 1.50 1.00 1.00 1.00 1.00 1.00 Note: Q/Q data are non-annualized unless specified otherwise. Source: Barclays Capital
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Figure 19: UK economic projections

% Change q/q Real GDP Real GDP (saar) Real GDP (y/y) Private consumption Public consumption Investment Net exports Industrial output Employment Unemployment rate % CPI inflation y/y Core CPI y/y Current account % GDP Government balance % GDP Key Central Bank rate Q1 -2.5 -9.6 -5.0 -1.5 0.1 -7.3 0.1 -5.1 -0.5 7.1 3.0 1.6 -1.2 ... 0.50 2009 Q2 Q3 -0.6 -2.3 -5.5 -0.6 0.6 -5.2 0.2 -0.5 -0.8 7.8 2.1 1.6 -1.6 ... 0.50 -0.3 -1.2 -5.1 0.0 0.2 -0.3 -0.2 -0.7 0.0 7.8 1.5 1.7 -2.3 ... 0.50 Q4 0.4 1.6 -3.0 0.1 0.2 -0.4 0.1 0.1 -0.1 7.9 2.0 2.1 -2.3 ... 0.50 Q1 0.5 2.2 0.0 0.2 0.1 0.2 0.0 0.2 0.1 8.0 2.8 2.5 -2.4 ... 0.50 2010 Q2 Q3 0.6 2.5 1.2 0.3 0.1 0.2 -0.1 0.3 0.2 8.0 2.7 2.4 -2.6 ... 0.50 0.6 2.5 2.2 0.4 -0.2 0.8 0.0 0.3 0.2 8.0 2.1 1.9 -2.7 ... 1.00 Q4 0.6 2.4 2.4 0.4 -0.2 0.8 0.0 0.3 0.1 8.0 1.5 1.8 -2.7 ... 1.50 Q1 0.5 2.0 2.3 0.6 -0.5 0.0 0.2 0.3 0.1 8.1 0.6 1.4 -2.5 ... 2.00 2011 Q2 Q3 0.5 1.9 2.2 0.5 -0.5 0.1 0.2 0.2 0.0 8.1 0.4 1.2 -2.4 ... 2.50 0.6 2.3 2.2 0.7 -0.7 0.8 0.1 0.3 0.1 8.2 0.5 1.2 -2.3 ... 3.00 Q4 0.6 2.3 2.1 0.7 -0.7 0.9 0.1 0.3 0.1 8.2 0.7 1.2 -2.2 ... 3.50 Calendar year average 2009 2010 2011 ... ... -4.6 -3.0 1.9 -14.1 0.6 -10.3 -1.6 7.7 2.1 1.7 -1.8 -13.6 0.50 ... ... 1.5 0.7 0.5 -0.8 0.0 0.2 0.1 8.1 2.3 2.2 -2.6 -11.9 1.50 ... ... 2.2 2.2 -1.6 1.7 0.5 1.1 0.4 8.2 0.5 1.3 -2.3 -8.5 3.50
Note: Q/Q data are non-annualized unless specified otherwise. Source: Barclays Capital
Figure 20: Japan economic projections

% Change Real GDP q/q saar Real GDP q/q Private consumption q/q Public consumption q/q Residential investment q/q Public investment q/q Capital investment q/q Net exports q/q* Ch. Inventries q/q* Nominal GDP q/q Industrial output q/q Employment q/q Unemployment rate % CPI inflation y/y Core CPI (ex food/energy) y/y Current account % GDP Government balance % GDP Key Central Bank rate Q1 -11.9 -3.1 -1.2 0.7 -6.4 3.7 -8.4 -0.9 -0.4 -3.0 -22.1 -0.5 4.4 0.0 -0.2 1.5 0.1 2009 Q2 Q3 2.7 0.7 1.2 0.3 -9.4 6.3 0.0 1.6 -0.7 -0.7 8.3 -0.9 5.2 -1.0 -0.5 3.3 0.1 1.3 0.3 0.9 -0.1 -7.9 -1.6 -2.8 0.4 0.1 -0.9 7.4 -0.3 5.5 -2.3 -0.9 3.2 0.1 Q4 3.6 0.9 0.3 -0.4 0.6 -2.3 2.1 0.5 0.0 0.2 5.0 -0.3 5.3 -1.8 -1.1 2.4 0.1 Q1 1.0 0.3 -0.3 0.3 0.3 -4.4 2.5 0.2 0.0 -0.3 2.3 0.0 5.8 -1.0 -1.2 3.2 0.1 2010 Q2 Q3 0.4 0.1 -0.2 0.0 -0.8 -3.6 1.5 0.1 0.0 -0.2 1.5 -0.1 5.8 -1.0 -1.1 3.4 0.1 2.0 0.5 0.3 -0.4 -0.3 0.2 0.9 0.2 0.0 0.1 1.8 0.0 5.7 -1.0 -1.0 3.6 0.1 Q4 2.5 0.6 0.4 -0.2 0.5 0.8 1.2 0.1 0.0 0.3 2.2 0.1 5.7 -0.9 -0.9 4.0 0.1 Q1 1.9 0.5 0.2 0.0 0.5 -2.3 1.6 0.1 0.0 0.3 2.8 0.1 5.5 -1.0 -1.0 4.0 0.1 2011 Q2 Q3 1.6 0.4 0.3 -0.1 0.0 -0.5 0.8 0.1 0.0 0.3 1.5 0.1 5.4 -0.7 -0.7 3.8 0.1 1.4 0.4 0.4 -0.2 -0.5 -0.5 0.5 0.1 0.0 0.3 1.5 0.3 5.3 -0.6 -0.6 3.7 0.1 Q4 1.6 0.4 0.4 -0.2 -0.5 0.0 0.4 0.1 0.0 0.3 1.5 0.2 5.1 -0.5 -0.5 3.7 0.1 Calendar year average 2009 2010 2011 -5.2 -0.9 1.2 -13.4 5.7 -19.1 -1.3 -0.1 -6.6 -21.9 -0.5 5.1 -1.3 -0.7 2.6 -8.8 0.1 1.7 0.8 -0.2 -6.4 -7.2 3.1 1.2 -0.1 -0.8 15.2 -0.6 5.7 -1.0 -0.7 3.5 -9.5 0.1 1.8 1.1 -0.5 0.1 -3.3 4.4 0.5 0.1 1.0 8.2 0.4 5.3 -0.7 -0.7 3.8 -8.0 0.1
Note: Q/Q data are non-annualized unless specified otherwise. Source: Barclays Capital
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COMMODITY OUTLOOK
Cruise control
Kevin Norrish +44 (0) 20 7773 0369 kevin.norrish@barcap.com

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. The major short-term risks come from a further slowing in Chinas commodity import demand, acceleration in supply growth, or an end to the trend of dollar weakness, which would be particularly negative for precious metals prices. A slowing in the demand recovery, plus the existence of some spare capacity in markets such as oil means that further ahead in 2010 commodity price appreciation is likely to slow significantly, though price downside is limited in most major markets.
Commodity returns have accelerated again in Q4
After a subdued period in the third quarter, commodity returns have accelerated once again, with benchmark returns basis, the S&PGSCI and more broadly diversified DJ-UBS indices up about 6% and 8%, respectively, so far in Q4. The macroeconomic environment for commodities has been positive for most of the quarter, with growing evidence of a robust recovery in OECD economies, continued improvements in emerging market economies and a steep decline in the value of the dollar. These positive trends have contributed to a number of symbolic benchmarks in different commodity markets being reached. Oil prices (in the form of the December 2017 WTI contract) settled above $100/barrel for the first time this year; the LME 3-month copper price reached a high of $7,150/t, its highest since September 2008; and gold has registered a number of all-time highs. With the very strong gains made across a whole range of different commodity markets since their low point earlier this year and these now extending into Q4, it is tempting to conclude that a strong recovery in global growth and commodity demand is now close to being fully priced and that, consequently, any further upside potential for the main commodity price benchmarks is rather limited. Those benchmarks are now very close to the levels prevailing at the start of the recession in December 2007, putting the recovery on a par with the scale of commodity price gains during previous recoveries.
Figure 1: Commodity returns moved up once again in Q4
Figure 2: A positive global growth outlook suggests more gains to come

9% Global growth momentum & commodity returns F'cst 5% 10% 40% 25%
25% 15% 5% -5%
Commodity index returns by quarter
S&PGSCI -15% -25% DJUBS
1%
-5% -20%
-3%
-35% -45% Q4 07 Q2 08 Q4 08 Q2 09 Q4 09 TD
Global GDP (Q/Q, LHS) S&PGSCI TR (Q/Q, RHS)
-35% -50%
-7% Sep 97
Sep 00
Sep 03
Sep 06
Sep 09
Source: Ecowin, Barclays Capital
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Most of the upward move in commodity prices is over
The majority of the move up in commodities prices may now be behind us, but we would be cautious about discounting the possibility of further, perhaps significant, broad-based commodity gains in early 2010. Much of this years price recovery has been in reaction to a phase of panic selling in late 2008 and early 2009, which left prices for most commodities at levels that were simply not sustainable under anything other than a global recession scenario. The initial price recovery for commodities therefore reflected little more than a backing away from some of the more unrealistic and apocalyptic scenarios for the global economy. Throughout the subsequent global economic recovery process this year, there has been widespread scepticism regarding its sustainability, and there is very little evidence that the recent increase in prices yet reflects any significant change in this rather cautious attitude toward commodity markets. Hedge fund strategies in commodities have massively underperformed relative to the general improvement in prices for most of this year and continue to do so (the HFRX index of hedge fund returns in commodities is -3.3% YTD and was down 0.1% in October). Meanwhile, CFTC hedge fund positioning data suggest that in most major markets net long positions are not yet over-extended though hedge fund net length in gold is close to previous all-time highs. Furthermore, the Barclays Capital base case view of global growth is that there will not be any slowing of momentum until H2 10. Quarter-on-quarter growth is expected to reach 4.5% in Q4 and remain at this level for the first and second quarters of 2010. Moreover, there is upside risk to economic growth in Q1, especially in the US where our forecasts look modest alongside previous recovery phases.
But forecast of strong growth in Q1 10 provides some further limited upside
Under this kind of positive growth scenario, it is very likely that commodity demand will continue to surprise to the upside, with strong growth in OECD demand likely the driver in early 2010. With levels of spare capacity and inventories much lower than those prevailing during previous economic recoveries, and supply constraints still evident across many different commodity markets, the overall picture for the global economy and for commodity market fundamentals suggests further upward pressure on price levels across many different markets. The main short-term risks to this view revolve around financial market perceptions concerning the timing of interest rate rises. Perhaps somewhat paradoxically, a run of better-than-expected US data and the likelihood that this would bring closer the expectation of Fed rate hikes are likely to induce the greatest amount of volatility for commodities. The transmission mechanism is likely to be via short-term fluctuations in the value of the dollar, the weakness of which has been a positive for most commodity sectors recently. However, unless there are some very major shocks, resulting not just in a stronger dollar but lower growth expectations further forward, we suspect any downward price adjustments are likely to be short-lived. Growth-sensitive commodities such as industrial metals and energy should prove resilient in such a scenario, with precious metals markets, notably gold and silver, most at risk. This reflects our view that liquidity has not been a direct driver of strength this year in oil or metals markets recently. This is far from being a consensus view, and there is a strong strand of opinion that commodities are already hugely overvalued, with most of 2009s price appreciation being driven by central bank injections of liquidity and investors search for yield.
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Investment activity in commodities has remained strong, though liquidity is not the main price driver
Our estimates suggest that investment in commodities via index swaps, exchange-traded products and medium-term notes will hit an all-time high this year. A surge in demand for oil and gold exposure from smaller retail investors eased off fairly early in H1; since then, demand for broad-based commodity exposure from pension funds and other asset managers has dominated. Investment flows into commodities accelerated again in Q4 with preliminary data suggesting inflows in November at their strongest since June this year. We now estimate total inflows for the year at about $60bn, substantially higher than the previous record of $51bn in 2006, taking commodity assets under management to about $250bn, not far off the peak of $270bn hit at the end of Q2 08. However, the notion that liquidity has been the most important direct driver of commodities this year is flawed, in our view, with those increased flows being the result of a period of lower prices and improving fundamental conditions. Where liquidity is relevant for commodities is in the positive effect of easy fiscal policy and government stimulus packages on end-use demand. Commodity demand has continued to improve in the past few months, though big differences remain between the speed and extent of recovery in different parts of the world, and particularly between non-OECD and OECD economies. Chinas commodity demand has been the big driver of recovery this year and continues to show signs of expanding rapidly. Its oil demand grew 11.5% y/y in October, and in absolute terms, over September and October, Chinese demand growth has averaged more than 0.9 mb/d, the greatest demand increase over a two-month period since the peak of the Chinese oil demand shock in 2004. Meanwhile, demand for industrial metals is also strong. Output of copper and aluminium semi-fabricated products is continuing to rise, up 30% and 20%, respectively, on a 3-month moving average basis, boosted by strong demand from the auto sector and for consumer appliances. With economic growth expected to remain strong in 2010 and almost half of the government stimulus package yet to be spent, end-user demand for commodities is expected to continue expanding at a healthy rate across most sectors. However, in those commodity sectors where either government stockpiling or commercial inventory rebuilding added significantly to domestic demand early in 2009, demand growth for primary raw materials could slow quite considerably or even turn negative for a time. This is already evident in some sharp contractions in Chinas import demand for certain commodities, notably in the industrial metals sector where imports have fallen sharply after getting a boost from stock-building earlier this year, as well as in some agricultural markets, especially soybeans.
Chinas commodity demand is still expanding fast
Figure 3: Investment flows to commodities have picked up again in Q4

11,500 9,500 $mn 7,500 5,500 3,500 1,500 -500 Net outflow Nov-07 May-08 Nov-08 May-09 Nov-09 Net inflow US Commodity index-linked mutual fund flows Commodity medium term note issuance Commodity exchange traded product flows
Figure 4: Hedge fund positioning in oil does not look overextended

140 120 100 80 60 40 20 0 -20 Dec-08 ICE Europe WTI NYMEX WTI Net non-commercial positions in crude oil futures ('000 lots)
-2,500 May-07
Mar-09
Jun-09
Sep-09
Dec-09
Source: Bloomberg, MTN-I, ETP issuer websites, Barclays Capital
Source: CFTC, Barclays Capital
10 December 2009
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Emerging market commodity demand is also strong outside China. In oil, demand from India, Taiwan, Thailand and the Philippines is running some 210kbpd higher y/y whilst Middle East oil demand is accelerating, with growth in Q3 running at 260kbpd. In industrial metals, especially copper and aluminium, demand from India and Brazil is firmly in positive territory compared with year ago levels.
OECD demand recovery to gather pace in Q1
The main area of demand weakness for commodities remains the OECD. Here y/y comparisons are starting to look better due to the weak base of comparison, but there is little in the flow of data that points to much of an improvement in demand levels just yet. Inventories were drawn down very quickly earlier this year when sentiment about the state of final demand was at its worst, and they remain exceptionally low right through the manufacturing chain. Evidence suggests that consumers have been taking an extremely cautious approach to rebuilding manufacturing inventories and that this has kept OECD demand for industrial metals and the transport fuel needed to move goods around the developed world economies, notably diesel, at extremely low levels. Anecdotal evidence from some base metals suppliers suggest order levels are improving, whilst premiums for prompt delivery have also firmed, and there are also tentative signs of improvement in diesel demand. We expect this momentum to gather pace in early 2010, and commodity demand in the OECD could surprise in the form of some very strong growth figures. Commodity supply trends have been more mixed. Within the mining sector, despite higher prices, there have as yet been very few restarts of previously idled capacity. A combination of producer caution over the sustainability of current higher prices, plus numerous strikes and some technical problems, mean that mine output for most base metals has stayed low and concentrate markets have remained tight. We expect that to remain the case in early 2010, though there are some metals sectors in which we see output continuing to grow fast, notably in aluminium where Chinese aluminium smelters, while quick to shut down in late 2008, are now raising their production levels again very quickly. In oil markets, OPEC has continued to maintain a degree of supply side pressure despite the price recovery, with its aim being to keep prices below $100 and to keep above a bare minimum of $70. OPEC 11 production is now about 26.5mpbd, almost 1m bpd above its strong Russian growth being the main driver. Nevertheless, Russian growth is down to oneoff factors (especially tax incentives and the start-up of some new projects), and we doubt
Mine production remains constrained
OPEC is maintaining supply discipline and non-OPEC production outlook is poor
Figure 5: Chinas imports of key commodities continue to ease

300 250 200 150 100 50 0 Oct-06 China's imports of selected commodities (indexed to Jan 2007) Copper Crude oil Iron ore Soy beans
Figure 6: but end-user demand remains strong, with oil demand at highest since 2004
1.4 1.0 0.6 0.2 -0.2 -0.6 -1.0 Oct-01 Chinese oil demand growth (y/y, mb/d)
Oct-07
Oct-08
Oct-09
Oct-03
Oct-05
Oct-07
Oct-09
Source: China Customs preliminary data, Barclays Capital
Source: China customs, Reuters, Barclays Capital
10 December 2009
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that it marks the start of a strong growth trend. Meanwhile, decline rates in other mature non-OPEC countries continue to accelerate. The latest data for the UK for example revealed a steep 304kbpd y/y decline in September output, the largest fall in any month since November 2005. Indeed, the spending cuts by major oil producers are likely to exacerbate overall non-OPEC decline rates. In its latest World Energy Outlook Report, the IEA estimates that capital spending cuts made in the past 12 months could add almost 400kbpd to global decline rates. We suspect that in 2010 the trend of declining non-OPEC supply will reassert itself, though market consensus is currently for another year of growth.
Though US natural gas supply is less constrained
However, the global picture for supply of energy commodities is far from uniform, and coal and gas prices have lagged a long way behind the recovery in oil. With no OPEC to coordinate output decisions, supply in neither market has been cut enough to prevent surpluses developing. In the US, natural gas switching from coal to gas for US power generation in early 2009 helped keep demand and prices high enough to discourage the supply reductions that were necessary, in our view, to rebalance the market. Recent data show that big increases in gas directed rigs have taken the rig count back up to levels last seen in April when production had just begun to fall. Storage levels have hit record highs, resulting in an excess of LNG availability that we think will also help to constrain gas prices increases in the UK in 2010. Supply problems have also been a key factor recently in agricultural commodity markets. In general, agricultural commodities markets have continued to underperform the recovery in other commodity sectors this year, but where there have been exceptions to this trend it has usually been due to weather-related supply disruptions. Poor monsoons in India have affected sugar output and required significant imports to make good the gap, whilst the Brazilian sugar harvest has been affected by too much rain. Unusually wet weather has also hampered the recent grains harvests in the US. The US corn harvest is still not complete while drought is slowing soybean planting in Argentina, the worlds third-largest exporter. The prospect of a further bout of food price inflation in 2010 cannot be ruled out since many of the factors that contributed to higher prices in 2007 and 2008 are still a feature of the markets. Global inventories are extremely low in a number of grains markets including corn and soybeans. Chinas demand is continuing to grow very fast, and the constraints on its output (land and water shortages, plus the need to keep a large rural population
Weather-related disruption is a common theme in ags markets
Figure 7: OECD metals demand is lagging a long way behind the improvement in China
50 30 10 -10 -30 -50 -70 Oct-07 China Japan EU-15 United States Apr-08 Oct-08 Apr-09 Oct-09 Changes in regional copper demand (% y/y)
Figure 8: OECD energy demand is improving though still negative y/y

3 2 1 0 -1 -2 -3 -4 OECD Non-OECD Change in global oil demand (Y/Y mb/d)
-5 Oct 07
Jun 08
Feb 09
Oct 09
Source: ICSG, Barclays Capital
Source: JODI, Barclays Capital
10 December 2009
35
employed) mean import demand will continue to increase; in sectors where it has traditionally been a net exporter (notably corn), its exportable surplus is likely to shrink. Import demand from the Middle East is also rising very quickly as incomes grow. Moreover, high oil prices are once again stimulating growth in competing demand for fuel, especially for sugar and corn-based ethanol. A positive macroeconomic environment, but perhaps more importantly, improvements in many market-specific fundamentals have assisted commodity investment benchmarks to slightly outperform other risky assets in Q4 so far. This reflects strong performance in metals and agriculture markets more than offsetting the poor performance of energy and cattle sub-sectors. Meanwhile returns for those investing at the front end of commodity price curves have continued to be constrained by high costs of carry, stemming from the contango structure.
Momentum strategies, minimising cost of carry have been best strategies for index investors in 2009
As has been the case through most of the year so far, the returns achieved by commodity index investors in Q4 09 have varied widely depending on the type of strategy adopted. Those strategies that have been most profitable have incorporated some form of trend following approach, and/or the minimisation of cost of carry/rolling costs. These strategies have significantly outperformed the standard indices. As Figure 10 illustrates, rolling a four-month deferred position has outperformed the benchmark DJUBS index by 1.7%, with momentum strategies outperforming by 1.5%. These strategies have been the most successful this year with excess returns to date running at about 20.5% for both, compared with 15% for the standard DJUBS index. Long-short strategies, which have underperformed in strongly trending markets for much of this year, are doing better in slightly more diverse markets in Q4. However, hedge fund replication strategies continue to underperform to a significant degree. With most of the broad upward move in commodity prices now behind us, we suspect that long-short strategies will perform much better in 2010. Investors will also need to be alert to a possible tightening in spreads at the front end of commodity price curves. We see the potential for a robust move up in OECD demand putting pressure on inventory levels in a number of commodity sectors, especially oil and base metals and so negative roll yields may not be the drag on returns at the front end of the price curves that they have proved to be in 2009. We expect a much more diverse range of performance between different commodity markets next year, and our detailed recommendations for Q1 exposures by market are as follows. Figure 10: For index investors momentum strategies and those reducing high cost of carry have performed best
QTD returns for selected commodity index strategies 4 Months Deferred Momentum Algorithmic long short Pure Beta Seasonal energy Pre roll Post roll (Total returns) Hedge fund replication 15% -6
Source: Barclays Capital, HFRX Indices
but this is likely to change in 2010
Figure 9: Commodities have outperformed other risky assets in Q4 so far

Returns of selected asset classes - Q4 to date Precious metals Industrial metals Agriculture DJ-UBS S&P 500 Property Livestock Govt Bond Energy -5%
Excess returns relative to DJUBS index (%)
0%
5%
10%
-4
-2
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36
Energy: Price upside to oil depends on further improvements in the flow of oil demand data, especially demand for distillates, of which the bulk of the global refined product inventory overhang consists. There are already signs that this process is underway with non-OECD Asian distillates demand turning strongly positive in September, and we expect manufacturing inventory rebuilding to provide a strong boost to diesel demand in Europe and the US in Q1 10. Price downside looks limited below $70, in our view, as this is the level at which investment will slow significantly. In contrast, we are bearish on US natural gas prices, which we expect to underperform relative to the rest of the energy complex. Production has not fallen fast enough this year, and in 2010, gas is unlikely to get the same kind of positive demand boost that it has gained this year in displacing coal in US power generation. Precious metals: The risks to the upward trend in gold prices have increased, in our view. A recent switch in investment activity to futures markets as purchasing of exchange-traded product buying has slowed, suggesting that the risk of liquidation has grown since futures holders tend to be less committed than ETP buyers. An end to the dollars recent weakening trend that has been a key factor in gold price strength would therefore be a major setback, not just for gold but for precious metals more generally. Further ahead, golds upside potential will greatly depend on the extent to which nascent inflation fears crystallise into more serious concerns over the next 12 months. If perceptions take root that the US Federal Reserve is falling behind the curve or that it is prepared to risk higher levels of inflation to not endanger the recovery, then gold prices should continue to rise. With a significant overhang of speculative length in futures markets and extremely weak supply and demand fundamentals, we think that a short position in silver is the best way to position for weakness in precious metals stemming from an end to the dollar weakening trend. Base metals: Like precious metals, base metals are exposed to the risk of an end to the trend of dollar weakness early in 2010; however, if that is a result of better-than-expected US economic data, then price softness should not last for long or be very deep. Base metals prices have traditionally been strongly correlated with OECD industrial production trends. Although this link has weakened as the importance of China has grown, and there is a risk of lower Chinese import demand for some metals early in 2010, we think US inventory rebuilding of manufacturing inventories should still be enough to provide fresh upward momentum to overall demand and prices. Our most favoured short-term exposures in base metals are copper and nickel. Copper inventories relative to consumption are lower than for any other base metal except for lead, production has been hard hit by strikes and other disruptions recently and raw materials markets are very tight. Nickel has been the weakest base metal in the complex recently, and we believe it has been pushed below fair value by market participants that have focused on high levels of LME stocks but have failed to take into account that much of the build had already occurred in 2008 and that, more recently, off-exchange consumer and producer stocks have been falling. Any sustained pull back in prices as a result of a stronger dollar would be a very opportunity to go long, in our view. Agriculture: Overall, we have a constructive view on the grains complex, with corn our preferred exposure. Corn inventories remain low across the worlds largest producerconsumers the US and China. Meanwhile, rising oil prices have improved ethanol margins in the US, and this is now the fastest growing end-use sector. Animal feed demand has been the weak link, but we expect an increase in line with recovering economies. Another positive is that Chinas trade balance in corn continues to reflect increasing imports and decelerating exports after decades of it having been a large net exporter. For soybeans, the outlook remains more mixed with an anticipated rebound in global production in 2009-10 from the worlds three largest producer-exporters: the US, Brazil and Argentina. The US has planted record acreage to soybeans, while we expect higher 2009-10 Southern Hemisphere output
10 December 2009 37
in the wake of a pickup after this years drought-ridden production. China remains the key demand dynamic in the soybean market and a source of upside risk. After buying to rebuild stocks in early 2009, imports have fallen off in recent months. However, China has recently announced plans to rebuild soybean stocks again, and, looking into 2010, we see a recovery in import demand underpinned by strong economic growth. Sugar is also benefiting from higher oil prices, stimulating stronger demand from the ethanol industry. The market is midway through the second consecutive harvesting year in which the sugar market has been in substantial deficit, and inventories have been run down sharply, providing a solid basis for further price gains. With Brazilian supplies onto the global market dwindling as its harvest approaches the tail end, market focus is likely to turn again to the demand side, especially from India where import demand continues to grow due to its own poor harvest.
Figure 11: Key recommendations

Market Energy Key forecasts We see continued improvement in oil demand, especially for diesel as providing some further limited upside to oil prices. US natural gas prices look overvalued further forward and we advocate a curve flattening position. Recommendations Buy the May 2010 NYMEX Crude oil futures contract. Buy the March 2010 Henry Hub natural gas futures contract and sell Jan 2011.
Industrial metals
Metals are poised to benefit from OECD inventory Buy the June 2010 LME copper and nickel rebuilding, offsetting weaker China demand in the months contracts. ahead. Precious metals are highly exposed to an ending of the trend of dollar weakness, with silver the most vulnerable to a phase of long liquidation. Strong demand from the ethanol sector and a recovery in feed demand should boost corn prices. We are also positive on sugar after recent supply problems. Sell the May 2010 COMEX silver futures contract.
Precious metals
Agriculture
Buy the July 2010 CBOT corn contract. Buy the March 2010 ICE sugar contract.
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FOREIGN EXCHANGE OUTLOOK
The return of two-way risks

David Woo +44 (0) 20 7773 4465 david.woo@barcap.com

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. Japans latest policy response to the appreciating JPY will help reduce the perception that USD/JPY is a one-way view. While GBPs upside risk remains elevated, its downside risk has grown. This bodes well for GBP vol. Commodity currencies should have one more leg up, but investors should look for more diversified and low volatility exposures.
Improved prospects for the USD

The USD will do better in 2010
2009 has been a perfect storm for the USD. The abatement of general global risk aversion and the relative US monetary/fiscal policy stances contributed importantly to the sharp decline of the USD. In our view, it will do better in 2010 as some of these factors become USD neutral or even positive. That said, we are not forecasting a major USD rally (which would require an aggressive Fed tightening cycle, a structural shock like the IT revolution, or a major financial crisis). What we are looking for is a limited USD rally that will play out largely during H1 10. As a starting point, we expect US growth rates to significantly outstrip the euro area and Japan in H1. The dramatic recovery of US labour productivity growth (Figure 1), in absolute and relative terms, should lead to a faster recovery in job growth. Growth in the euro area and Japan will likely also be held back by the sizeable appreciation of their currencies against the USD in 2009, the effect of which will only be felt fully in H1 10.
The USD will be supported by US growth outperformance in H1
Figure 1: Labour productivity growth (y/y)
Figure 2: Net issuance of Treasury and agency securities and corporate bonds and after Fed purchases (annualized)
$bn 3,500 3,000 2,500
% 6 4 2 0 -2 -4 Q1-91
2,000 1,500 1,000 500
Q1-94
Q1-97
Q1-00 US
Q1-03
Q1-06
Q1-09
0 Q1-00
Q3-01
Q1-03
Q3-04
Q1-06
Q3-07
Q1-09
net issues of securities and bonds net issues net of Fed purchases
Germany
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End of the Fed asset purchase program should be good for the USD
Despite our upbeat forecast for the US in H1, we do not expect the Fed to start hiking rates until Q3, since the unemployment rate is likely to remain high for most of 2010. Moreover, given our expectation for the start of fiscal tightening in 2011, the next Fed hiking cycle is likely to be less linear and more gradual than previous ones. However, we believe US monetary tightening does not have to wait until the Fed starts raising short-term interest rates or, for that matter, begins draining excess liquidity from the system. We see the end of the Feds asset purchase in Q1 as effectively a tightening of monetary policy. What would be the effect of the end of the Fed asset purchase program on the USD? We think there are at least four separate channels to which investors need to pay attention (FX Weekly Brief: The case for a stronger USD in 2010, November 27, 2009):
The Fed asset purchase program dramatically reduced the supply of fixed income securities the market had to absorb in 2009 (Figure 2). When the program ends, the market will have to pick up the slack and absorb the near record issuance in the pipeline. Our US fixed income team forecasts that total net fixed income supply will still be $2.3trn in 2010, compared with $2.7trn in 2009 (and the $960bn the market has to absorb in 2009). The market presumably will require an increase in risk premium to do this. This can come in the form of higher yields on US fixed income securities or, for foreign investors, a weaker USD. While it is difficult to say from where the increased risk premium will come, we argue that with the USD near its multi-decade low, the USD risk premium is already quite high. If the market views the end of this program as removing an open-ended commitment to maintain very low long-term interest rates, then the monetary policy is effectively tightened, which should lead to an increase in long-term real yields. This should benefit the USD. An end of Fed asset purchases will likely lead to an increase in nominal and real interest rates. This repricing of discount rates could be negative for risky assets, and the USD could benefit from its safe-haven status. In the past decade, the USDs risk premium has tended to fall during periods of underperformance of risky assets. The program has driven long-term rates lower globally. It is probably not an exaggeration to say that other countries with tighter policy at the short end have experienced some effective easing at the long end because of this. An end of the program will likely cause long-term rates to go up globally, which may highlight the vulnerability of some of the economies that are either dependent on US growth or sensitive to interest rates and lead them to adopt looser policies than they would otherwise. This could reduce the relative risk premium investors require to hold more US assets.
Although it is impossible to know for certain the final outcome, we are inclined to believe that the second, third and fourth effects should dominate the first.
US relative fiscal position will improve in 2010
We have argued for a long time now that relative fiscal position plays a critical role as a determinant of the USD. Moreover, the dramatic deterioration of the US budget deficit was a key driver behind the USD depreciation in 2009. So what is the outlook for relative US fiscal policy in 2010? Our economics team is forecasting a relative improvement of the US fiscal balance vis--vis the euro area and Japan. There are two reasons for this view. The first has to do with the automatic stabilizer. With the unemployed in Europe eligible for government assistance for longer than in the US, the fiscal cost of supporting high unemployment in Europe will remain higher for longer than in the US. Second, the recent elections in Japan and Germany have brought in governments promising increased government spending and lower taxes, but the approach of the crucial mid-term elections
40
10 December 2009
in the US next year is likely to limit any further loosening of US fiscal policy. We forecast that Japans budget deficit will exceed the USs next year. While the absolute level of the US budget deficit will still be higher than the euro areas, we expect the gap between the two to shrink nearly 2.5pp of GDP. In sum, the fiscal outlook in 2010 should be supportive for the USD against the EUR and the JPY.
JPY: Turning point?

Outlook for USD/JPY depends more on the USD than the JPY
The recent collapse of USD/JPY to near its two-decade low made a lot of noise, but the appreciation of the JPY against the USD should be seen as a reflection more of USD weakness than JPY strength. This is evidenced by the fact that the rally in US Treasuries since September (which led to a significant reduction of the interest rate differential between the US and Japan) accounts for most of the move in the USD/.JPY spot rate and that EUR/JPY has been trading within a tight range since March. From this point of view, the outlook of the USD/JPY, at least in the short term, depends more on the general path of the USD than on Japan-specific factors. To the extent that we are looking for a stronger USD in 2010 as the result of relative US monetary tightening, USD/JPY, which is the most interest rate-sensitive cross among the major currencies, should move higher over the course of the year. We have an end-2010 forecast for USD/JPY at 100. Although the precise timing of when USD/JPY will begin its sustainable upward march is still very uncertain, the recent action of Japanese policymakers appears to have changed the balance of risks. The BoJs decision to introduce a new liquidity-supplying operation helped reverse the JPYs direction early in December. While it is not clear whether the injection of Y10trn of short-term liquidity will be sufficient to alter sustainably investors perception of the relative expected returns between holding the JPY and the USD (Figure 3), the market has begun to consider seriously the possibility that the BoJ will increase its monthly outright purchase of JGBs. While it set a self-restricting limit for JGB purchases up to the amount outstanding of currency issuance, modification of this rule is possible if it becomes necessary to limit further JPY appreciation. The monetization of Japans chronic large budget deficit is potentially very negative for the JPY. In this respect, upside risk for the JPY has fallen, and the chance for it to resume a depreciating path is increasing.
Recent policy response to prevent further JPY appreciation may be just the beginning
Figure 3: BoJ needs to catch up with Fed Monetary base in US and Japan
USD trn 2.1 1.8 1.5 1.2 0.9 0.6 0.3 0.0 Jan-89 Jan-93 Jan-97 Jan-01 Jan-05 US Monetary Base (LHS) Japan Monetary Base (RHS)
Figure 4: Commodity currency current account balance
JPY trn 210 180 150 120 90 60 30 0 Jan-09
USD bn 20 15 10 5 0 -5 -10 -15 Jan-85
Jan-89
Jan-93
Jan-97
Jan-01
Jan-05
Jan-09
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JPY will be vulnerable to Japans weakening fiscal position
A market theme that is likely to become more prominent in 2010 is the relative fiscal policy stance and sustainability of debt dynamics. Since the Democratic Party of Japan (DPJ) took office in September, investors have begun to fear a further deterioration of fiscal conditions, due to the increasing revenue shortfall from the sluggish economy, as well as mounting pressures from politicians to increase spending to stimulate the economy. This has led to a widening in Japans sovereign CDS spread. If its sovereign credit rating is downgraded, it will likely trigger significant JPY depreciation. Nevertheless, we think the probability of a JGB or JPY crisis in 2010 is low, given the low foreign ownership of JGBs.
Heightened uncertainty for the GBP

GBPs outlook is clouded
The short- to medium-term outlook for the GBP has become markedly more uncertain over the past quarter, in our view. There are several crucial issues, all of which have starkly different potential outcomes. The most important is whether the Bank of England's MPC will persist in its current policy stance. A further increase of asset purchases in November made UK policy more of an outlier relative to the rest of the G10. The market generally thinks that this will be the last increase but that policy will be on hold for a considerable period. If this persists while other G10 central banks join the RBA and Norges Bank in tightening policy, the GBP could increasingly be used as a funding currency for the carry trade and concerns may grow that the UK will allow some monetization of the fiscal debt. However, there are several reasons why the MPC may change its stance surprisingly quickly. First, it has been one of the more activist central banks. Second, the Inflation Report forecasts of strong growth but little upside pressure on inflation appeared optimistic and may prove wrong. If so, a likely outcome is that inflation may continue to surprise to the upside relative to growth. Third, fiscal worries or higher commodity prices may lead to longer-run yields picking up. The February Inflation Report is likely to be crucial for GBP prospects. Fiscal concerns are mounting for the large developed economies and, in our view, are likely to become an increasingly important issue for FX investors. The UK faces two big problems on this issue. It has the largest deficit of any of the G10 economies and faces an imminent general election. The UKs debt position is not as serious as that of some others in the G10, but the fiscal deficit is so large that a significant tightening of policy will be necessary over the next parliament. This seems impossible without controversial measures being announced, which means that the election campaign is likely to be highly contentious and the UK fiscal position will be in the spotlight. We think the fiscal woes are overstated relative to those in other economies and that this will become clearer over time. However, it would be easy for concerns to mount that the authorities are not willing to take the difficult measures necessary, especially if a very close result in the election becomes more probable. Other uncertainties abound. Will the global recovery continue? Or does the sharp fall in liquidity following the Dubai World shock presage more deterioration in trading conditions? Just what state is the UK economy in: does the improvement in most surveys mean that the recession will end in Q4? How much did the longer-run fair value of the GBP fall during the financial crisis? All of the issues which matter most for the GBP appear to be unusually uncertain, relative both to the past and to other currencies. It has been range-trading in recent months against the USD and EUR. We think this is likely to continue until year-end, especially if liquidity holds up. But come next year, many of these issues will be resolved and the GBP could move a long way. We think it is more likely to appreciate significantly against the EUR, but a reduction of the credibility of either fiscal or monetary policy (or both; they are linked) could cause another aggressive sell-off.
Large fiscal deficit and political uncertainty could keep investors away from the GBP
Positive correlation between GBP and risky assets is likely to return in 2010
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For all these reasons, we think vol is better than spot as a way to trade the GBP. For example, implied vol for GBP/USD trades at only a modest premium over EUR/USD. This appears to us as mispriced.
Commodity currencies still have room for gains

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

Laurent Fransolet +44 (0) 20 7773 8385 laurent.fransolet@barcap.com Chotaro Morita +81 (3) 4530 1717 chotaro.morita@barcap.com Ajay Rajadhyaksha +1 212 412 7669 ajay.rajadhyaksha@barcap.com

Rates are biased asymmetrically higher going into 2010, as abundant liquidity conditions and the support of QE buying for bond markets are fading away. A large back-up in rates is on the cards across maturities and currencies in 2010, although we suspect it may not materialise before the end of Q1 10, and until then, the current range trading environment might prevail.
Rate markets had a mixed performance over the past quarter, with yields in most maturities essentially range trading and being less volatile than they had been earlier in 2009. Fixed income investors have had a good year, and risk appetite in the past few months has been limited, with fewer flows as well. Markets were driven by economic data and the vagaries in risky assets (which have done little in Q4), but were generally underpinned by strong liquidity, and persistent supply versus demand imbalances, due in particular to QE-related buying in the US and UK. In 2010, liquidity support from QE will gradually fade away, with markets basically flying solo from Q2 10 onwards. By that time, the economic data are also likely to have improved and shown that the recovery is self sustaining, with headline inflation ticking higher as well. This would lead more people to expect central bank tightening over the subsequent 6 to 12 months, and will likely prompt central bankers to talk more about removing the current very large monetary policy stimulus. Historically, rate markets have sold off strongly only 3 to 6 months before the start of the tightening cycle in most markets. Given our expectation that the Fed and the BoE will start hiking rates in Q3 10, we expect a large back-up to take place around the end of Q1, or Q2 at the latest. Even if the timing of the sell-off is uncertain, we believe rates are asymmetrically biased higher from their current historically low levels. Yield curves will likely stay steep for some time, probably until a bit later than when the big backup at the short end takes hold. Hence, we would not expect a large flattening in the curves before Q2 onwards. For the US, the flattening might occur even later, as the terming out of the debt by the Treasury will be an additional negative for the longer end. While banks purchases of government paper (for carry or liquidity purposes) likely will remain a supportive factor in early 2010, the net supply picture will change dramatically once QE buying stops in the US and UK, so that the marginal impact of such bank buying is likely to be much more limited than it has been for most of 2009. In short, it likely will not prevent a move up in rates, and a re-tightening of swap spreads in the US and UK; however, we see wider spreads in the euro area. Overall, we have revised our rate forecasts lower across the board compared with the September Global Outlook, by 30-50bp on average, but the message remains the same: from here rates are asymmetrically biased higher, and it is only a matter of time before they move up once again.
Markets will have to do without QE in 2010
Rate hike expectations likely to build further and lead to a selloff probably by the end of Q1 10
US: Time to make a decision

Financial markets have been unable to make up their mind
The fourth quarter of 2009 was a far cry from the fourth quarter of 2008 and thankfully so! While markets were far quieter than a year ago, rates investors still spent the quarter caught between two camps. On one side were concerns about asset bubbles (including warnings by some central bankers) and fears of rising inflation (seen in commodity prices,
44
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the USD and inflation breakevens). However, a growing Fed balance sheet and a weak labour market exerted a strong gravitational pull lower on yields. We expect rates investors to make a decision in 2010 the argument should be settled in favour of a stronger recovery in 2010, with Novembers payroll data perhaps the first shot across the bow of bond bulls. Consequently, we expect rates to rise throughout 2010. But with the Fed still growing its balance sheet, the first quarter should see only a mild rise, with 2s and 10s finishing Q1 at 1.1% and 3.7%, respectively.
Rate forecasts: A steep 2s/10s curve for much of 2010

but that should change slowly during 2010
As the rate forecast table at the end of this section shows, the rise in rates should be muted in Q1. We expect very few changes in the 2s/10s yield curve until Q3, with the curve staying quite steep. That should change in the fourth quarter as 10s find support even as 2s keep rising. We use the expected path of fed funds as the first step. Then we incorporate Barclays Capitals models for term premia at key points along the yield curve. The term premium captures the sensitivity of rates to key variables over and above what they would be based purely on the expected path of fed funds. These variables include liquidity, supply, volatility, market sentiment about the economy, and foreign demand. Finally, we make subjective adjustments for factors where historical betas are difficult to quantify (such as a sudden expansion of the Feds balance sheet). Rates should start rising in Q1 largely due to a reversal of year-end risk aversion. The 2y point is very vulnerable (even though 2y yields sold off following payrolls). 2s have been helped by risk aversion and the lack of short-term paper; T-bill supply has turned negative, and commercial paper and agency discount note supply has been dwindling. But given our forecasts for the economy to grow at 5% in Q1 10, the risk/reward at the 2y point is now asymmetric and biased in favour of a move higher in rates. On the other hand, one factor supporting yields will be the continued growth in the Feds balance sheet until next March. That is why we have the 10y rising to only 3.7% in Q1.
What will drive rates higher in 2010?

In general, the expected strength of the economy and related Fed policy changes should be a major factor in rates across 2010. The economy should keep growing in Q2 as well. Some investors might dismiss Q1 as isolated, but continued growth in Q2 is likely to make most take notice. That plays into the sustained sell-off we expect in the second and third quarters.
Supply-demand imbalances will be more acute in 2010
Supply-demand imbalances will obviously play a role. Coupon issuance in Treasuries should peak next year even with a smaller deficit, as bills keep shrinking. Meanwhile, the Fed has been a big buyer of fixed income securities in 2009. That should change from Q2 next year, even as supply remains high. The $1.7trn in buying power from the Fed is a big hole to fill, another factor behind our forecast. Finally, the Fed is likely to start the process of draining excess liquidity in the third quarter, probably a few months before it starts raising the funds rate. The fourth quarter should herald the start of curve flattening in 2s/10s as the Fed hikes. Even then, our models expect the 2s/10s curve to still stay steeper than forwards are pricing in. Recent statements from FOMC officials suggest that when the Fed does start hiking, it could do so more quickly than in the past. Our economists disagree they expect the Fed to take a break from hikes in the first half of 2011. Regardless, the 2y point typically reacts strongly to the start of hiking cycles and this time is likely to be no different. 10s are a different matter we expect the 10y yield to stop rising in the fourth quarter as Fed hikes dampen inflation expectations.
Flattening of the curve likely to come in Q4 10, a bit later than typical
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Running with the bond bulls Or fighting the bond bears?

Economic fundamentals should push yields higher across 2010
As with any forecast, there are risks on both sides. The bearish camp might wonder why yields should not rise more given the loss of Fed buying. But there will be offsetting demand factors, with strong demand from banks, US households and foreign investors. For details on the supply-demand trade-off in 2010, see Treasuries: A lot more support than apparent, published in Market Strategy Americas, 13 November 2009. Another pet peeve for the rate bears is concerns about hyperinflation. The weak dollar and rising commodity prices are often used to bolster this argument. But with the jobless rate likely to stay above 9% through the end of 2010, inflation should stay muted. History shows that it is difficult for hyperinflationary fears to gain ground while actual inflation prints are low. Hence, even as breakevens could make further headway next year, it is unlikely that inflationary expectations will come unhinged and push yields sharply higher, at least in 2010. Meanwhile, the bond bulls have their own set of arguments. They point to the cash waiting on the sidelines from many types of private investors. This will help offset the loss of Fed buying. But for those who believe that private buying in 2010 will be much more than $1.7trn in Fed buying in 2009, the numbers simply do not add up. Strong demand from private investors is definitely a positive, but in our view will not be enough to push yields lower on a sustained basis. Moreover, as we show in Real yields: Bubble to deflate, not pop, Market Strategy Americas, 4 December 2009, real yields should also rise next year. Finally, the strongest argument for bond bulls is simply that any recovery will be very weak. We strongly disagree, especially since even our own economic calls are less bullish than history warrants. And while technical factors can matter for a while, the fundamentals should ultimately win. Rates markets should show a similar pattern with rates rising more than forwards are pricing, but short of fears of a hyperinflationary spike in bond yields.
Alphabet soup TALF, FAS and other developments in securitised markets

Asset prices have rallied in every securitized market, but primary issuance is a mixed bag
Securitised markets continued to show slow improvement in Q4. While the bulk of increases in secondary market prices occurred in Q3, most types of MBS held on to their gains in Q4. Non-agency fundamentals (defaults and severities) have continued to worsen, but not more so than we expected. November had the first new issue CMBS TALF deal, which generated strong investor response. Unfortunately, residential mortgage credit has shown no similar signs of thawing. Non-agency RMBS securitisation is non-existent, and even in agency MBS, Figure 2: Tighter mortgage credit = weak refinancing
10000
Figure 1: Mortgage credit has tightened in agency MBS

770 760 FH 30yr 750 740 730 720 FN 30yr
8000 MBA Refi Index 6000
4000
2000 710 700 03 04 05 06 07 08 09 0 02 03 04 05 06 07 08 09
Source: Fannie Mae, Freddie Mac, Barclays Capital
Source: MBA, Barclays Capital
10 December 2009
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credit has tightened steadily. Figure 1 shows that average FICO scores (credit scores) for loans guaranteed by Fannie Mae and Freddie Mac have gone up sharply in the past nine months, suggesting a tightening in mortgage credit. This also shows up in MBS refinancing or lack of it. Despite record lows in mortgage rates, the MBA refinancing index is very muted compared with history (Figure 2). Meanwhile, FHA (and the related GNMA program) has faced charges of being too cavalier in its underwriting practices and has now tightened credit as well.
We believe the end of Fed purchases does not pose a significant risk to the agency MBS market
So what does 2010 hold? In secondary markets, we believe agency MBS spreads will widen 20-30bp from current levels when the Fed finishes its purchase programme. But at those levels, there should definitely be strong buying from banks, money managers and foreign investors. Consequently, we believe the end of Fed purchases does not pose a significant risk to the agency MBS market. On the non-agency side, losses are baked into the cake, but risk premiums still have room to shrink. Hence, we like non-agency MBS relative to other higher-risk alternatives such as high yield corporates. Non-agency primary issuance has a good shot at re-starting in 2010 while volumes are likely to be small, any nonagency securitisation should be a big boost to sentiment in RMBS. Commercial mortgage losses are likely to pick up next year, and we expect the CMBS world to stabilise only in the second half of 2010; CMBS always lags an economic recovery. Losses should be 8-15% for CMBX 1 to 5 series and much higher in construction loans. Finally, accounting changes under FAS 166/167, due to be implemented next year, should make private label securitisation of credit cards more expensive. Fortunately, agency MBS is unlikely to be affected, since the GSE regulator has anyway waived regulatory capital rules. Home prices in the US have stabilised over the past five months. While we expect a mild decline over the next few months (starting with the S&P/Case-Schiller report released in December), our forecast calls for a further 8% fall in prices from current levels, with the trough in Q2 10. While this will mean that bank loan losses remain elevated, the tail risk of a further massive decline in prices is now very low. All in all, a look at the housing and the securitised landscape leaves us with the following sentiment: While there is unlikely to be a magical change in loss forecasts or a big jump in origination in 2010, the systemic risk due to the securitised and housing markets should be the lowest it has been in many years.
Euro area: The flight path to normalisation

The ECB exit strategy: moving back to normal by Q2 10
On December 3, the ECB presented its exit strategy, in a way, a flight path for 2010. Essentially, the ECB will be gradually reverting to its pre-crisis open market operations and procedures, and relatively early in the year. By the end of Q1 10, all of the additional LTROs will be phased out (leaving just the regular 3m ones), as will the foreign exchange operations the ECB has been conducting. More importantly, the ECB likely will move back to variable rate tenders for these (after the last 6m one on March 31), even if it keeps the flexibility to stick with full allotment on the weekly MROs. We believe these measures should be sufficient to bring liquidity conditions back to normal, probably by the end of September 2010, maybe earlier. In our base-case scenario, there likely will be enough liquidity in the market to sustain a low EONIA until at least April and probably June, and it is only afterwards that EONIA will start moving up towards the refi rate of 1%, from its current 35bp. We believe the ECB will not want to drain additional liquidity from the market, but will instead rely on what it recently announced. While this transition away from non-conventional measures is being implemented, the ECB is likely to shun any official rate hikes, and the market consensus of a first hike in September (followed by one in December) will likely prove misplaced we see the first hike only in Q1 11.
47
It is unlikely that the ECB will be looking to actively push EONIA higher
10 December 2009
Range trading still likely at the short end, but the range will be moving higher, and we are at the bottom of it
Therefore, in Q1 10, the short end will be driven less by monetary policy signals from the ECB as such than by liquidity conditions and (rising) medium-term global rate expectations (euro and US post-1y rates tend to be very highly correlated). Essentially, euro short rates should thus continue trading in their range of the past nine months into Q1 10, with an upwards bias in the range (as progressively more rate hikes are being expected): we see fair value for 2y swaps at 1.65-2.15%, with these ranges moving up 25bp in both Q1 and Q2 10. Note that on market expectations, the current pricing of post-1y rates is very expensive, given what the consensus of economists is expecting: there is currently little or no term premium reflected in these maturities. Our preferred position remains to be short reds (2011 rates) and greens (2012 rates) in particular, outright or versus the first year of the curve. This is consistent with the fact that, historically, big sell-offs at the short end start about six months before the start of monetary policy tightening in the euro area, and that the money market curve steepens up until the first rate hike. Following the December ECB press conference, if anything, we would rebuild these short and steepening positions. Rates at the longer end of the euro curve have performed well in Q4 09, with the curve flattening heavily in 2s/10s and 10s/30s, in contrast to what happened in the US (but both were in line with our expectations lasting the September Global Outlook). This is leaving euro 5y5y forward rates looking rich versus fundamentals (fair value is about 4.75%) for the first time in quite a while. While the potential for a back-up in rates at the longer end is probably more limited than in the US or the UK, as the supply-demand equation has not really been distorted by QE buying and inflation expectations (and inflation uncertainty) should remain contained, this argues against being long that part of the curve, at least on an outright basis. The arguments for cross-market outperformance of euro rates are more finely balanced as well, in particular versus the US. This has been one of our preferred trades over the past 12 months (especially in 5y5y forward maturities), and while we would stick with it going into 2010, we believe the current entry levels for long euro versus short US trades are not attractive (euro rates look as expensive as US rates on our valuation models, and look a bit stretched on a tactical basis, especially in post-15y maturities). However, on any retightening of, say, about 25bp, we would re-initiate these spread trades, with the post-5y forwards still our preferred maturities. The current relative richness of medium- to long-end euro forward rates is also leaving the curve looking relatively flat, close to the bottom of its range since May. We do not think that the time for the typical big bearish-flattening trend is ripe yet. Rather, we would expect the
Post-5y rates have done very well: they now look expensive outright and fair versus the US
Curve flattening is the theme for 2010, but not much before the end of Q1 10
Figure 3: Range trading still, but risks heavily skewed

6 5 4 3 2 1 0 Jan08 Jul08 Jan09 Jul09 Jan10 EUR 1y1y USD 1y1y EUR 5y5y USD 5y5y
Figure 4: JPY 2y5y spread and 5y10y spread (bp)

120 100 80 60 40 20 0 0 20 40 60 Oct02/Jan05 Jul06/Sep08 2y5y spread 80 Mar05/Jul06 Dark blue: Sep08 onwards 5y10y spread y = 1.04 x + 29.20 R2 = 0.89
10 December 2009
48
current range trading to continue until, if anything, after short-end rates really start to move up in earnest, so say around the end of Q1 10, if not a bit later. While we are biased towards flattening in the medium term, we believe there will be better opportunities to position for this. Our view is similar in post-10y maturities, even if the recent flattening there could actually continue in Q1 10. Overall, we have revised our rate forecast lower across horizons and maturities compared with our September Global Outlook, but by less than 30bp on average.
UK: The impact of supply, without QE

BoE to stop QE in January and hike rates in August
We expect the BoEs quantitative easing programme to cease after Januarys reverse operations, with the MPC then moving to a more neutral, wait and see mode prior to ultimately commencing its tightening cycle in Q3 10. The front end of the GBP curve on an outright basis is still populated by longs and carry-based strategies, and so represents poor value and is vulnerable to a bearish correction. Most recent data revisions suggest that the Q3 09 GDP number will be revised higher, thus, perhaps, giving the MPC more confidence that a recovery is close. On the curve, we would expect 2s/10s to come under flattening pressure in Q1 10 as the market begins to price a more aggressive rate profile for the Bank of England. With FY 1011s 15bn of redemptions only commencing in June, we would expect there to be relatively little mechanical support for the front end of the gilt curve in the first half of the year. Therefore, we expect 2y gilt yields to push back towards 1.30% by the end of the quarter, around 15-20bp higher than current levels at the time of writing. We would look for 2s/10s to flatten around 15bp in cash space. In swaps, 2s/10s has traded in a 30bp range since May 2009, so it seems clear to us that an aggressive steepening from here absent a large inflationary shock or changes to the BoEs reserve remuneration policy is remote. The weight of long positions in the front end leaves it vulnerable to further bearish correction. So, we would look for a move of around 20-25bp flatter, which is typical of what is observed in the run-up the first hike in previous BoE rate tightening cycles. We would expect the curve to come under bear-flattening pressure out to the 15y sector, especially in cash space, as economic sentiment improves. This is because UKT 5% Mar 2025 (22.1bn, roughly 9% of the index float) falls out of the closely tracked +15yr Index on 7 March 2010. Into the index event, real money index-tracking investors will sell the bond and extend out on the curve, so we would expect some strategic underperformance of the 15y sector in cash and asset swap space versus the longer end of the curve.
Flattening of the sterling curves likely in Q1 10
Fiscal consolidation coming to the fore
The market will also place an increased focus on fiscal policy, as in the run-up to the next election (June 10 at the latest) there is likely to be more attention paid to the governments commitment to ongoing fiscal austerity. This is particularly important given the focus on the UKs AAA sovereign credit rating. Any perception that the rating will be lowered would put asset swap spreads across the curve under further pressure. Overall, we see spreads in the 5-10y sector as most vulnerable to correction, as the combination of supply and the end of QE already will likely have placed it on the back foot. We retain a more positive outlook for longer-dated spreads, as on any cheapening, we would expect continued buying from institutional investors.
Japan: Easing, not tightening, policy

BoJ still on the easing path
The BoJ unexpectedly eased monetary policy on 1 December as JPY appreciation stoked concern about the outlook for the economy and prices. Yields were already vulnerable to downward pressure across the curve, amid expectations that the Japanese economic
49
10 December 2009
recovery would gradually slow towards zero growth in H1 10. The BoJs actions pushed yields sharply lower out to the intermediate sector. With 3m Libor now around the same level for USD and JPY, the Japanese currency could come under further upward pressure, and speculation about additional BoJ accommodation could persist.
The yield curve has moved back into QE mode
At present, however, the yield curve from the short to the intermediate sector has already flattened to levels seen during the quantitative easing period of 2001-06, and a further narrowing of spreads, if any, will likely be limited. Looking at the shape of the yield curve prior to 2006, we see a positive correlation between the 2y5y and 5y10y sectors between 2002 and 2004, when long-term yields showed their steepest drop within the quantitative easing period (Figure 4). Given that periods of negative correlation are more frequent between sectors on either side of the 5y-7y sector, this could be described as an anomaly. The two have also shown a positive correlation during the past year or so since the events of September 2008. In this sense, even before the BoJs latest policy change, the yield curve was already starting to resemble the pattern seen during the previous phase of quantitative easing, especially 2002-04. As the yield curve rapidly flattened out to the intermediate sector around the time of the BoJs decision on 1 December, it appears that the 5y10y has steepened somewhat excessively in terms of the above correlation between the 2y5y and 5y10y over the past year. However, the regression line for the past year has shifted slightly lower than the one during 2002-04, and the movement since 1 December almost appears to signal a return to the correlation of 2002-04. If the market views the measures taken on 1 December as an effective return to the phase of quantitative easing seen up to 2006, this would actually be possible. In that case, the balance between the relatively flat 2y5y sector and relatively steep 5y-longer sector could be sustained to some extent. If JPY appreciation or some other deflationary force takes hold, however, the regression line would be expected to start moving downward and to the left, and even if the divergence from the regression line since last year does not correct, there could be a scenario where both the 2y5y and the 5y10y flatten and the long-term yield itself falls sharply. As for supply and demand, we expect FY 10 (ending March 2011) JGB issuance plans, which will be released at the end of December, to confirm that any increase in auction sizes from April 2010 onwards will be kept to a minimum. Sizes were already increased sharply from July 2009 to accommodate the stimulus package of the previous administration, and that should be enough to absorb issuance, even after accounting for the large shortfall in tax revenues. Over the next few quarters, we believe the yield curve is unlikely to steepen due to pressures related to supply. On the demand side, we expect surplus funds to continue to increase for now due to sluggish growth in lending, suggesting a large capacity to absorb JGBs, especially in the bank sector. Also, among domestic banks, there is a strengthening trend toward extending the duration of liabilities through the adoption of internal models for measuring the duration of deposits, and this could also be a factor that limits any steepening. For January-March 2010, we recommend a strategy based on directional longs. In addition, at times when the yield curve comes under steepening pressure due to temporary swingbacks in share prices or exchange rates, we would build flattening exposures. While 5y10y flatteners are attractive, it is difficult to see a scenario of bull flattening beyond the 10y sector, given expectations for an increase in 30y JGB issuance in 2010.
Risks are for flattening and a rally in yields up to the 10y sector
Supply increases already announced, and demand should stay very strong
We recommend being long Japanese rates
10 December 2009
50
Spreads, volatility and inflation-linked

Swap spreads
Room for euro area swap spreads to widen, especially at the short end
After a very sharp tightening move in the first half of 2009, Bund ASW has been trading within a 15bp range since late summer. We believe spreads are likely to continue their range trading in the coming months, provided central banks remain committed to their current benign language. Thus, as long as short rates stay close to these low levels into 2010, with market participants eyeing carry trades on the short end of the curve, we are unlikely to see any big spread moves. As we approach potential exit strategies/rate hikes from central banks in late 2010, however, we expect spreads to trade with more of a widening bias. Our fundamental model for Bund ASW, along with short rates and growth expectations, indicates that the EONIA-Bund component is fair value at around current levels. However, when we look at a scenario in which short rates (3m GC) move up to about 1.5% and growth expectations rise towards 1.5% in 2010, then we see fair value for this component at about 20bp wider than current levels. Therefore, our recommendation for investors in EUR swap spreads is to trade Bund ASW tactically within their recent range going into year-end 2009 and in early 2010, and to position for a more fundamentals-related widening move later in 2010, as we start facing the bear flattening of the EUR curve led by the short end. Our view is that until we see that big fundamental widening of swap spreads, Schatz ASW will be an outperformer versus the Bund ASW. We believe there will be an even better case for this early in 2010, when government bonds and swapped issuance will be very heavy. Therefore, we recommend buying the Mar contract Schatz ASW versus selling Bund ASW against it going into 2010.
Euro cross-market spreads

No broad-based tightening anymore but rather divergences based on supply pressures
Euro area cross-market country spreads versus Germany have widened across maturities since early November. Easily the largest move has been in Greece, which has come under pressure from ratings agencies and investors concerns regarding its poor fiscal record and its banking sectors reliance on ECB funding, with Ireland also suffering, albeit to a lesser extent. We expect cross-market spreads to remain under pressure, as funding plans have not improved in 2010 and the traditional heavy frontloading of supply early in the new year seems likely. We would avoid exposures to Greece in favour of Ireland, where fiscal consolidation is in train and issuance will be lower due to the prefunding done in 2009. Greek issuance totalled 31bn in Q1 09, and a similar amount seems likely in early 2010. Additionally, we would be wary that Moodys and S&P seem likely to comment adversely on Greeces rating. We recommend remaining overweight Germany and also staying long in the 10y sector in the Netherlands and Finland, which are likely to be less vulnerable than other non-German issuers. Elsewhere, we feel Portugal looks rich versus Spain in the 10y sector, while the persistent richness of Italy in the 6-8y area offers value against Spain. Spain has relatively poor deficit dynamics, but its debt/GDP started at a low level; therefore, its very high rating seems protected. However, one thing to watch will be if the heavy support issuance has received from Spanish domestic banks (they gobbled up about 70% of the net new issuance in 2009) will continue in 2010.
Volatility
Top left of the vol grid could come under pressure as unwinds of carry trade pick up
The direction of volatility in the upper-left corner of the swaption surface (options with shorter expiries on short swaps) will depend strongly on the short end of curves. If the selloff is substantial (30-50bp), we will see unwinds of positions in carry trades with receiver swaptions (eg, 6m1y to 2y1y receivers). This could push implied volatilities significantly down (10-20bp in annualised vols). For instance, a 2y1y 3% receiver initiated in the summer would be up 45% by now, but if we see a 30bp sell-off, the return would shrink to
51
10 December 2009
only 7%, and in a 50bp sell-off, it would be negative, at -12% (assuming current vol term structure). However, if doubts about the self sustainability of the recovery prevail, these carry trades are likely to keep performing, and we will see only a moderate decline in vol as a result of an extended rates on hold scenario. In options on long swaps (the 1y20y to 5y30y sector), we saw some ALM activity in November (selling of collars, ie, buying of OTM receivers funded by selling OTM payers). The demand for hedging will probably tail off somewhat as rates move higher, and there is more limited pressure to engage into some end-of-year de-risking of balance sheets. Volatilities of options on 30y swaps are still 25-30bp annualised vols above their longterm averages, which makes entry levels for option hedges historically less attractive. Long swap rates have been quite stable in 2009, but if we see a significant rally (eg, the 30y swap moving to 3.5%), we can expect a wave of receiving demand from pension funds. The same applies to a significant sell-off in long rates (eg, the 30y swap moving to 4.5%), which would make receiving via low-strike receiver swaptions more attractive. In the UK, the increased attractiveness of LOBO loans likely will keep the long end of the vol market well supplied, which should push vol lower in Q1 10 by about 10bp in the GBP 10y10y to 20y30y sector. Another theme that will gain importance is that with credit spreads much tighter than they were 6-12 months ago, investors will have to return to structured products to generate an extra yield in a low-yield environment. This should create hedging flows, more liquidity and tighter bid/offer spreads in the euro vol market in particular. We think that longer-dated CMS steepeners can attract some interest, supporting options in the 10y10y area.
Inflation-linked markets
Inflation-linked breakevens are attractive going into 2010 in the US
Relative to other strategies for protecting against inflation, inflation-linked bond breakevens appear relatively attractive value in all the major developed markets. They are likely to be well supported at the start of 2010 by the coincidence of recovering levels of headline inflation and allocations into the asset class. In the US, this a particular risk in January, with CPI inflation likely to spike to 2.9% y/y for December 2009 (albeit as a local peak), while there is only one auction in the month rather than the traditional two (despite the stated intention of the Treasury to increase TIPS issuance). A further notable rise in 10y breakevens may catch the attention of the FOMC, but we would not see it as a cause for concern on its own. The scope for ongoing TIPS outperformance in a rising nominal yield environment will likely be tested by the first 30y auction in over eight years on 22 February. We see the likelihood of higher breakevens in the UK as posing more of a policy quandary for the Bank of England. January CPI inflation is likely to exceed 3%, requiring a letter of explanation to the Chancellor, albeit this should be a short-term phenomenon and in part is explained by next years VAT hike. RPI inflation is liable to increase notably further, reaching 4% by March with a likely peak in April. Consumer measures of inflation expectations have already recovered to their average of the past 10 years. If consumers react in their typical fashion to higher inflation headlines and we see a widening of bond and swap breakevens, it will be hard for the Bank of England to ignore. Such fears are very unlikely to be an issue for the ECB, given that HICP inflation probably will not rise much above 1% in the coming months. 10y bond breakevens, at just below 2%, are entirely consistent with the definition of price stability and are unlikely to widen substantially, with several countries likely to issue new bonds in Q1.
and the UK
10 December 2009
52
GLOBAL BOND YIELD FORECASTS

US Treasuries US swap spreads
Fed funds 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 0.00-0.25 0.00-0.25 0.50 1.00 1.00 1.00 1.50 2.00
3m Libor 0.28 0.27 0.75 1.20 1.20 1.20 1.70 2.20
2y 1.10 1.60 2.00 2.30 2.60 3.00 3.40 3.80
5y 2.50 3.00 3.40 3.60 3.90 4.10 4.40 4.60
10y 3.70 4.20 4.50 4.50 4.60 4.90 5.00 5.00
30y 4.70 5.20 5.50 5.50 5.50 5.60 5.60 5.60
10y RY 1.40 1.70 1.90 1.90 1.90 2.15 2.20 2.20 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11
2y 30 30 30 30 30 30 35 35
5y 30 30 35 35 35 35 37 40
10y 10 15 17 25 25 30 30 35
30y -20 -15 -10 0 5 5 10 15
Euro government
Euro area swap spreads
Refi rate 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1.00 1.00 1.00 1.00 1.25 1.50 1.75 2.00
3m 0.90 1.03 1.22 1.30 1.95 2.23 2.23 2.35
2y 1.75 2.05 2.25 2.45 2.80 3.10 3.30 3.5
5y 2.80 3.00 3.20 3.30 3.55 3.65 3.80 3.95
10y 3.55 3.70 3.80 3.90 4.00 4.05 4.15 4.25
30y 4.05 4.10 4.15 4.20 4.25 4.25 4.30 4.35
10y RY 1.65 1.70 1.85 2.00 2.10 2.15 2.40 2.50 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11
2y 40 45 45 50 50 50 50 50
5y 25 30 30 35 35 35 35 35
10y 20 25 25 30 30 30 30 30
30y -10 -5 0 5 10 10 10 10
UK government
UK swap spreads
Repo rate 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 0.50 0.50 1.00 1.50 2.00 2.50 3.00 3.50
3m 0.68 0.77 1.30 1.85 2.33 2.81 3.32 3.85
2y 1.30 1.45 1.75 2.20 2.40 2.75 2.85 3.00
5y 3.00 3.15 3.20 3.30 3.40 3.45 3.50 3.55
10y 4.10 4.15 4.35 4.50 4.75 4.80 4.85 4.90
30y 4.25 4.30 4.35 4.40 4.45 4.50 4.50 4.50
10y RY 1.00 1.10 1.35 1.55 1.75 1.80 1.80 1.80 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11
2y 60 60 65 65 65 65 65 65
5y 35 35 32 30 30 30 30 30
10y 0 -5 -10 -10 -10 -10 -10 -10
30y -20 -15 -5 -5 0 0 0 0
Japan government
Japan swap spreads
Official rate 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10
3m 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20
2y 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15
5y 0.40 0.40 0.45 0.45 0.50 0.50 0.50 0.50
10y 1.20 1.20 1.25 1.35 1.40 1.40 1.40 1.40
30y 2.10 2.10 2.15 2.20 2.25 2.25 2.25 2.25
10y RY 1.60 1.60 1.65 1.75 1.80 1.80 1.80 1.80 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11
2y 25 25 25 30 30 30 30 30
5y 15 10 10 15 15 15 15 15
10y 0 0 5 5 10 10 10 10
30y -5 -5 0 0 5 5 5 5
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CREDIT OUTLOOK
The hunt for yield

Ashish Shah +1 212 412 7931 ashish.shah@barcap.com Robert McAdie +44 (0) 20 7773 5222 robert.mcadie@barcap.com

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. Lower net high grade supply should support spreads in 2010, and drive investors toward non-traditional supply such as EM corporates and taxable munis. We see outperformance in financials, the belly of the high grade cash credit curve, and lower rated high grade issuers. We advocate a barbelled portfolio in high yield that takes advantage of historically wide double-B spreads and the potential outperformance of select triple-C paper.
Expect further spread normalization

Credit is closer to being appropriately priced for this stage of the cycle, with continuing room for normalization
2009 will be remembered as a year of epic returns, with high grade posting double-digit excess returns and high yield more than 50% total returns, the best on record for that sector. These returns were driven by the severe dislocation in spreads at the beginning of 2009, combined with an aggressive monetary and fiscal response. As we enter 2010, we find that credit is closer to being appropriately priced for this stage of the cycle, with continuing room for normalization. The spread compression in 2009 corresponds to a 65% retracement of the dislocation at the start of 2009. Based on historical averages for spread normalization during economic recoveries, 2010 could provide another 10% of retracement from the cyclical wides, amounting to a further compression of 40-50bp in the US and 30-40bp in Europe. In high yield, the past two cycles suggest that current pricing is roughly in line with pricing six months after GDP has troughed and historically the asset class has provided 20% of excess returns at that point of the cycle. Given market concerns about the robustness of the rebound and still highly leveraged balance sheets (from the LBO boom), we estimate that 2010 will provide closer to 11-12% excess returns still quite favorable compared with potential returns for equities and some fixed income asset classes (eg, MBS). Figure 1: Returns forecast
Excess Return YTD 2010 Forecast YTD Total Return 2010 Forecast
US IG EUR IG US HY EUR HY US Lev. Loans EUR Lev. Loans Asia
18.2% 11.2% 52.3% 73.6% 49.0% 33.8% 26.60%
4-5% 2.5-3.5% 11-12% 10-13% 8-9% 7-9% 6-7%
17.2% 23.6% 53.2% 86.3% 49.2% 33.8% 28.19%
(0.3) 0.6% 1-2% 7-8% 9-12% 8-9% 7-9% 2.3%
Note: Total returns calculations are based on treasury yield forecasts form Barclays Capital Rates Strategy. Source: Bloomberg, Barclays Capital
10 December 2009
54
Figure 2: Best opportunities

Opportunity Summary View
Financials Lower quality in IG Barbelled HY portfolio Taxable munis

Financials, especially banks, are likely to outperform owing to better technicals including negative net issuance and build-up of liquidity. Improving fundamentals, better liquidity and normalization in funding costs should lead lower BBB-rated issuers to outperform. A barbelled HY portfolio takes advantage of historically wide double-B spreads and potential outperformance of selected CCC paper. Taxable munis appear attractive versus corporates of similar maturity and quality.
Figure 3: USD IG and HY basis

pt 0 -5 -10 -15 -20 -25 Sep-08 bp 0 -50 -100 -150 -200 -250 -300 -350 -400 Dec-08 Mar-09 Jun-09 Sep-09
Figure 4: EUR IG and HY basis

50 -50 -150 -250 -350 -450 -550 -650 -750 Dec 07 Jul 08 Feb 09 Sep 09 50 30 10 -10 -30 -50 -70 -90 -110 -130
HY basis (LHS, bp)

HY Basis (LHS, pt)
IG Basis (RHS, bp)

IG non-financial basis (RHS, bp)
Given the relatively lower returns forecasts, generating outperformance will increasingly depend on relative value opportunities. Looking across subsectors, we believe the areas that have the most opportunity for spread normalization, and, hence, excess returns, include financials, lower BBB-rated investment grade paper, BB and CCC-rated high yield paper and taxable munis. Cash continues to be priced for outperformance versus CDS, although pockets of positive basis are emerging and we find greater value in US versus European corporates also highlighted by the greater negative basis.
The search for yield should continue to drive demand, but at a slower pace
Low G3 yields and a lack of spread alternatives will drive the flow of funds to corporate credit
Investors are faced with a return environment of close to zero risk free yields across the G3 currencies (Figure 5). This leaves them with four choices if they want to earn returns: duration risk, credit risk, equity risk, or (non-G3) currency risk. Against a backdrop of slow US and European growth, low yields and a heavy supply of longer duration government bonds, investors will likely continue to favor a heavy credit allocation, especially given its room for continued positive returns. Within broader spread products, corporate credit should benefit from a lack of issuance of attractively priced competing spread product. Our securitized team estimates that even after the end of Quantitative Easing (QE) in the US, net spread issuance outside credit will be about $200bn, a small amount by historical standards (Figure 6). In
10 December 2009 55
Figure 5: G3 2y Treasury Yields

%
Figure 6: USD Spread Products Net Issuance

$bn
6 5 4 3 2 1 0 05
Source: Bloomberg
JPY EUR USD
1500 1000 500 0 -500 -1000 -1500 2006 2007 2008 Credit Non-Credit Spread Products Total Spread Products
2009E 2009E- 2010E 2010Eex Fed ex Fed
06
07
08
09
2009, severely negative net issuance (when Fed purchases are considered) led agency and agency MBS levels to historically tight levels relative to corporate credit, which became the preferred asset class. Although the end of QE should lead to wider MBS spreads, corporate credit should still benefit from allocation from money managers as banks are likely to be the natural buyer of MBS at wider levels, given their low risk weights. As a result, our securitized team expects a relatively moderate widening in MBS post QE. Finally, assuming that overall US dollar fixed income net issuance will be about $2.5trn in 2010, of which about $1.9trn will be Treasury issuance, the result will be an increase in the Treasury component in the Barclays Capital Aggregate Index to about 35%, from 27% currently. This de-risking of the Aggregate Index should provide room for benchmarked investors to take additional risk and purchase more credit to maintain the same size overweight.
Continued desire to earn spread should offset profit-taking from equity investors
We expect a continuation of the shift in focus down the quality spectrum and capital structure, as investors take profit in high grade senior risk and seek to earn higher returns in high yield
Within corporate credit, we expect to see a shift in allocation as a result of the meaningful moves in spreads in 2009. The incremental demand for high grade credit from high yield and equity investors as spread levels across high quality bonds and bank hybrids offered equity-like returns has for the most part, abated. We expect a continuation of the shift in focus down the quality spectrum and capital structure, as investors take profit in high grade senior risk and seek to earn higher returns in high yield. High yield should also receive support as distressed opportunities shrink, leading to lower downside in default scenarios. Having said that, we expect pension funds to continue to provide demand out the curve for high quality credit as those funds continue to match their assets with liabilities (private pensions in the US use AA credit to discount their liabilities). Rather than chasing the rally in equities, we have found pension funds more willing to de-risk their positions by reallocating into credit as they catch up to their funding requirements. Furthermore, with the upcoming implementation of Solvency II in Europe, insurers who are underweight equities because of the crisis continue to allocate cash flow to fixed income, especially high grade and long-dated credit.
The (slow) return of leverage

The improvement of financing terms in 2009 has helped provide support to the rally across the quality spectrum. Total Return Swap (TRS) facilities that were offered in the L+ 250bp range near the start of the year are now more widely available in the L+100bp area. In 2010,
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Figure 7: 3m GC term repo less OIS

bp 20 15 10 5
Figure 8: Treasury repo daily trading volume (brokers)

$bn 120 100 80 60 40
0 -5 Dec-08
20 0 Dec-08
Jan-09
Mar-09
May-09
Jul-09
Sep-09
Feb-09
Apr-09
Jun-09
Aug-09
Oct-09
we expect leverage terms to continue to improve as banks compete for attractively priced short-term financing facilities. The relatively low risk weightings allocated to mark-tomarket leverage will widen availability for TRS facilities and HG bond repo facilities (Figures 7 and 8) that were non-existent in late 2008. Despite improved availability, investors will be slow to take up mark-to-market leverage given the lessons learned in the past year regarding liquidity.
Lower net credit supply should be supportive for spreads and drive investors toward non-traditional supply
After aggressive issuance in 2009, corporate liquidity has never been better
Non-financial corporate supply was heavy in 2009 as companies looked to term out Commercial Paper, near-term maturities and bank debt. This has left companies with high cash levels and low near-term debt maturities. Although we believe companies will continue to take advantage of corporate yields within 70bp of all-time lows, we expect net USD supply to be down by more than 30% in 2010. The decline in Europe is likely to be more muted at about 25% as we expect significant refinancing of bank loans to continue amid ongoing pressure on bank balance sheets.
Market stability will likely lead to a significant decline in spread duration issuance from 2009 levels
Furthermore, this dynamic could be exacerbated by pressure from regulators demanding that European banks reduce their balance sheets. This refinancing has already shifted the nature of the supply, which saw a significant increase in non-rated issuance. In addition, the change in cross-currency swap valuations and depth of European demand should limit opportunistic Yankee issuance and keep more supply in euros and sterling. In general, the ability for issuers to be more opportunistic will be a positive for the market as new issuance should slow into market weakness and pick up into strength, helping to dampen market spread volatility. In addition, market stability will likely lead to a significant decline in spread duration issuance from 2009 levels. Heavy term issuance was demanded by investors as they sought to lock in record-high spreads and relatively high yields on investment grade bonds. Given the more normal spreads and low treasury yields, investor interest in the frontend and mid-curve has grown, which is driving supply. Shorter-dated supply should be easier to market given lower VAR, resulting in improved liquidity provision from dealers.
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Financials should see a slight increase in gross non-guaranteed supply as the end of guarantee programs is offset by lower wholesale funding needs
We favor buying on weakness as credit tightening should lead to new supply, but issuers will not issue into weakness
We expect financials to post a slight increase in gross non-guaranteed supply, as government guarantee programs taper off. We still expect financials to see negative net issuance as they have been building liquidity in 2009 through lower CP balances and cash builds from legacy asset run off (Figures 9 and 10). In Europe, we expect net financial issuance close to zero with gross issuance roughly unchanged from 2009 at 500bn. In the lower parts of the capital structure, we expect limited supply of traditional structures, based on regulators focus on TCE and contingent capital. Overall, supply for the financial sector will be somewhat market dependent as most US and European firms have heavy 2010-12 maturities that they will seek to term out into tight spreads. As a result, we favor buying on weakness as credit tightening should lead to new supply, but issuers will not issue into weakness.
Supply in high yield should start to shift from refi to a more diverse calendar
High yield will remain focused on refinancing heavy maturities in 2012-14 across loan and bonds: 2009 was a productive year as about $100bn of new issue in the US and about 18bn in Europe were used to help roll maturities. We expect a continuation of these rolls in 2010, albeit at a slightly slower pace. High yield should also see an increase of net supply as the market tightens and new leveraging transactions start to take place. Offsetting this will be increased access to the convertible and equity markets, which have already facilitated deleveraging and will drive reduce net supply.
EM corporates and taxable munis will likely lead the way in non-traditional supply
Amid more muted supply from non-financials and negative net supply for financials (albeit, higher for fixed-rate financials), we think that non-traditional supply will be an important source of potential alpha. In our investor survey, EM corporates show up as the non-traditional area with greatest interest among investors. In EM corporates, we expect issuance to decline from record levels in 2009, owing to robust onshore liquidity in many systems. However, we expect appetite for EM risk to remain strong. Traditionally, EM credit was compared with US high
Figure 9: Worldwide short-term borrowing + current portion of LT debt by banks

$trn 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Q107 Q307 Q108 Q308 Q109 Q309
Figure 10: Cash and equivalents as % of short-term borrowing + current portion of LT debt for banks
80% 70% 60% 50% 40% 30% 20% 10% 0% Q107 Q307 Q108 Q308 Q109 Q309
Note: Includes 67 publicly traded banks with debt > $1bn across US, Europe, Asia/Pacific and LatAm that had reported 3Q09 earnings by 11/24. Source: CapitalIQ, Barclays Capital
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yield as a spread asset. The past two years have demonstrated the improved risk attributes of EM credit, with the segment trading at a much lower beta than US high yield. Given that growth in the near term will be skewed toward emerging markets, we would not be surprised if we continue to see allocations to this sector.
Taxable munis should be a meaningful source of supply as Build-America-Bond issuance continues
Among other non-traditional sectors, taxable munis should be a meaningful source of supply as Build-America-Bond issuance continues. We expect to see this particularly in the long end, where slowing corporate issuance and efficient execution for muni-issuers relative to the non-taxable space, should lead munis to become 20% of the long index after $140bn of eligible supply in 2010.
A muted cyclical bounce provides a good fundamental backdrop

Our economics team has forecast an above-consensus economic recovery; however, given the magnitude of the downturn, the forecast is still rather muted. The recovery to date has largely relied on fiscal and monetary stimulus, with governments running large fiscal deficits to support demand as well as the financial system. Our expectations are for G3 central bankers to maintain monetary support until the recovery is well grounded, continuing to favor the hunt for yield. This support has seen good follow-through in Asia and LatAm, as banks there have been less impaired than those in the US and Europe, and have been able to provide supportive lending. Although recent US/European data have been mixed with employment showing weak growth and production coming in above expectations EM growth has been quite supportive and we expect a full two-thirds of global growth to come from EM (about one-third from China alone).
Cost-cutting and free cash-flow generation make for a fundamentally strong high grade non-financial backdrop
High grade non-financial corporates were aggressive in building liquidity and cutting costs during the downturn (Figures 11 and 12). As revenues have stabilized or improved, so has free cash flow. The shock of the downturn led companies to be conservative on the stock repurchase front, choosing to build cash and bring down leverage instead. The downside to being in this sweet spot is that it seldom lasts, and we have already seen instances of highly Figure 11: Cash and equivalents as % of total assets for IG non-financials
6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 99 00 01 02 03 04 05 06 07 08 09
Figure 12: Median debt to EBITDA for IG non-financials
2.60 2.40 2.20 2.00 1.80 1.60 1.40 1.20 1.00 00 01 02 03 04 05 06 07 08 09
Note: Net Debt to EBITDA calculations are based on 280+ Non Financial IG Companies with debt outstanding >1bn that reported 3Q09 earnings by 11/6/09, using annualized quarterly EBITDA. Cash calculations are based on about 300 Non Financial IG Companies with debt outstanding >1bn that reported 3Q09 earnings by 11/9/09. Source: CapitalIQ, Barclays Capital
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liquid companies pursuing M&A. Although this activity is likely to continue and to be a selective idiosyncratic risk for the market, we expect it to be fundamentally benign as companies are looking to M&A as a way to continue to reduce costs and grow revenues rather than take up leverage. In that sense, we expect M&A activity to be more of a supply risk than the releveraging risk of 2005-07. In addition, although we expect stock buybacks to restart, we think that companies will be less willing to take up overall leverage until the recovery is more firmly in place. As a result, we expect the upgrade/downgrade ratio to continue to improve in 2010.
Liquidity profile of financials likely to continue to improve, losses will not

The biggest risk for financials in 2008-09 was their liquidity profile rather than their losses
The biggest risk for financials in 2008-09 was their liquidity profile rather than their losses. Policy support and time have helped meaningfully improve the liquidity profile of large financial institutions, as have multiple capital raises and equitization of junior parts of the capital structure through either exchange offers or subpar tenders. CP outstanding has dropped as term government guaranteed issuance was used to take out this years maturities and institutions held on to cash coming in from maturing assets. For large US banks (debt >1bn), cash and equivalents now comprise about 55% of short-term borrowings, including the current portion of term debt (about 120% in Europe), enough to go for most of 2010 without refinancing debt. In addition, the overall size of financials debt outstanding has shrunk to a more reasonable portion of the high grade universe (Figure 13), making it more possible for investors to roll debt. This is an important issue because the buyer base for financials has shrunk banks ability to buy other bank paper is muted owing to new regulation and Special Investment Vehicles/conduits, which were big buyers of floating rate bank paper, have collapsed. Firms with large capital markets businesses had strong operating performances into rallying high volume markets as wide bid/offer spreads, owing to more limited competition, helped offset lower risk-taking. This was in contrast to net interest margins (NIMs), which were stagnant as banks de-risked their balance sheets and held higher cash or cash equivalent assets. Residential and commercial real estate performed better than expectations in the first half of 2009 (Figure 14). More recent results, though, have shown that the better-thanexpected performance is unlikely to continue. Residential losses have been pushed off as modification programs have slowed the conversion of foreclosures to Real Estate Owned
Figure 13: Financials as % of credit + FRN indices
Figure 14: Median loss across asset classes, actual / stress test adverse, 1-3Q09 annualized for two years (%)
80% 70% 60% Average: 58.5%
60% 50% 40% 30% 20% 10% 0% 97 98 99 00 01 02 03 04 05 06 07 08 09

50% 40% 30% 20% 10% 0% 1st Lien Jr. Lien C&I CRE Card NCO
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(REO). Commercial real estate losses, which were already expected to be back-end loaded, have also been delayed as banks have chosen to extend and pretend that things will get better rather than foreclosing on properties and taking the capital hits. Our expectations are that these losses are not likely to abate and, if anything, will represent greater risk. These losses may be exacerbated in Europe through forced balance sheet reduction by the regulators. As a positive, however, the ability to spread the losses over a longer period of time should benefit banks that have strong operating earnings.
For the most part regulatory changes should be creditsupportive in the long term
The past year has highlighted how regulatory actions can create investment uncertainty and 2010 is unlikely to change this view. That said, we expect that for the most part regulatory changes should be credit-supportive in the long term as they tend in the direction of higher capital, lower leverage and better liquidity. Even in the case of hybrids, the push on the part of regulators for contingent capital may actually benefit existing structures. However, the uncertainty regarding future capital structure treatment is reason for concern.
Improved market access and credit-positive M&A for high yield issuers should help offset excess leverage, but stronger growth would be nice
High yield companies have and should continue to benefit from improving market access in the bank, bond and equity markets. The improvement in quantity and cost of funding in the second half of 2009 has allowed companies to improve their liquidity profiles significantly and cost-cutting has improved cash flow prospects despite weak top-line performance. However, leverage issues continue and, in the absence of a long-term robust recovery, default rates are likely to remain above average (Figures 15 and 16). For US high yield names, we forecast default rates will peak at about 13-14% by 1Q10, before dropping to 5.5% at the end of 2010. For European high yield names, we expect default rates to peak at about 11% by the end of 2Q10, before dropping to 6.7% at the end of 2010.
Figure 15: USD HY default forecast

16% 14% 12% 10% 8% 6% 5.50% 4% 2% 0% Apr-89 Forecast Realized Default Rate (12 mo fwd)
Figure 16: EUR HY default forecast

18% 16% 14% 12% 10% 8% 6% 4% 2% 6.70% Forecast Europe Actual (12 mo trailing)
Sep-94
Mar-00
Sep-05
0% Mar-99
Sep-01
Mar-04
Sep-06
Mar-09
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Structural changes should help improve CDS liquidity as will lower volatility
Expect client clearing and migration to clearinghouses to broaden investor participation
In 2010, we expect to see a migration of dealer single-name risk to clearinghouses and client clearing. We expect higher margin requirements on both buy and sell transactions with no offset for cash basis from the clearinghouse, which should make buying protection look less attractive from a capital standpoint. This would be offset if market spreads tighten.
Negative basis should continue its path of normalization

We expect continued normalization in the negative basis as funding costs decrease and cash investors go into less liquid bonds in their search for yield. This should lead to more situations with a positive basis. Unwinds of negative basis will likely be a source of cash and CDS supply and for the first time in two years, CDS should make sense as a long for unleveraged investors.
CLNs and issuance from new synthetics should be a source of protection (ie, net sellers of protection)
As spreads continue to ratchet in, we expect investors to look at simple structures for getting leverage/incremental spread. FTD baskets, CLNs, and simple securitizations are beginning to re-appear and we expect this trend to gather steam. Although very limited compared with historical issuance, we expect new issue synthetics to emerge, given their more robust ratings methodologies and attractive spreads. Similar to the early days of CDS, these structures will likely be used to provide a source of protection in names that trade wide owing to hedging demand in CDS.
Open interest will shrink, but volume should grow

On balance, we expect CDS open interest to continue to decline as existing index contracts continue to be cleared through a central counterparty, and single-name contracts begin to clear in the near future. Based on data from DTCC, we estimate that gross outstanding notionals on credit indices dropped from about $10.9trn in January 2009 to about $7.7trn in November 2009. However, corresponding net outstanding amounts have not dropped materially, remaining at about $1.26trn. Furthermore, based on a survey of Barclays Capital investors in October 2009, about 58% expect their CDS volumes to be the same or higher than in 2009.
Risks to our view

Consensus fears the end of policy support
QE has been a major force in making credit look attractive especially relative to MBS and covered bonds and driving fund flows into risk assets. In the US alone, the Fed has taken about $1.2trn of spread product off the market, providing the source of funds for new investments in corporate credit. Ironically, a more robust recovery than expected could be a short-term risk to the spread market as central banks would have to withdraw liquidity at a more rapid pace, in contrast to the weak growth scenario where they leave the loose monetary policy intact for an extended period of time (keeping yields low and fueling the hunt for yield). Although our economics team has an above-consensus forecast, it still doesnt expect the Fed to tighten until September 2010.
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Given the heavy Treasury issuance calendar, the absence next year of QE may lead to higher interest rates. In fact, our interest rates strategy team expects 10y Treasury yields to hit 4.5% by the end of 2010. We believe this modest and measured increase in yields will not pose a headwind for excess return expectations in credit, though clearly it will limit total returns. In fact, if we look at the spread normalization after the 80-82 recession, we were at tighter spreads than today in a similar part of the recovery with materially higher yields (Figure 17). However, if rates sell off in a disorderly manner and the yield curve steepens, investors are likely to re-allocate capital to treasuries and mortgages given the attractive compensation for taking pure duration risk and we would expect a widening of higher quality spreads. This type of rapid move could also see a redemption wave from retail investors, who may become complacent with the low volatility of long-term rates we have seen over the past three months.
Figure 17: BBB Long Industrial Spreads Post Cyclical Wides, 1982-84 vs Current
bp 700 600 500 400 300 200 100 0 4
Source: Bloomberg, Moodys, Barclays Capital
Aug 82 - Dec 84 Fed Funds: 0.25%
Dec 2008 Onwards Fed Funds: 11.75
Fed Funds: 10.5 Fed Funds: 9.5%
10
16
22 28 Months from widest spread
That said, the credit markets have been concerned about these risks and have not tightened materially since September, even as the interest rate market is pushing out the timing and severity of tightening. We expect credit to catch up to this by tightening in December and January and would view these risks to be greater in the second half of 2010 from tighter levels.
Regulatory/political risk
Although difficult to quantify, regulatory/political risk remains high given the level of support that has been provided by regulators and the rapid changes they are making. We highlight a few examples of regulatory changes that could be of concern:
Secured creditors could take losses under draft US legislation supported by FDIC head Sheila Bair, leading to significantly lower liquidity for financial institutions. The ability for the Government Accountability Office (GAO) to audit monetary policy decision-making could unhinge rate and spread expectations as we move to a less independent Fed. Higher capital requirements and an acceleration of government capital repayment globally could weigh on hybrid valuations.
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More aggressive sales of assets by banks receiving support in Europe could fill the supply shortage of risky assets. Lack of regional/global consensus relating to the introduction of new financial regulation could lead to material differences in the operational and competitive landscape for financial institutions that fall under different regulatory regimes. The regulatory treatment of CDS could cause big shifts in supply/demand dynamics for the product (either leading to significant tightening or widening). Regulatory uncertainty is likely to keep structured issuance muted in the near term. Regulations are ultimately likely to also determine the shape and form of new structured issuance.
Our view is that while policymakers want to see growth and they need to support asset markets to see this growth, policy errors are highly likely.
Shareholder-friendly transactions
There has been an uptick in M&A activity over the past year. If growth remains anemic but corporates have improved visibility, then we could see a surge in M&A activity. The technology sector, by virtue of its global footprint, was among the least affected by the recession and it is not surprising that M&A first increased in that sector. We have seen activity stirring in consumer products as well and believe that event risk could spread to the cyclical sectors. Stock buybacks are also making a cautious comeback (eg, Wal-Mart, AutoZone). Assuming that the recovery gathers steam, equities look cheap relative to credit, in our view. We would look at stock buybacks as a mechanism of correcting this differential. While we expect companies in general to be cautious about excessive leverage, the risk of isolated leveraging transactions remains material.
The real near-term risk is to the upside

As we head into 2010, the risk of supply disappointing demand is growing
In reality, we feel that the real near-term risk is actually to the upside. Performance risk aversion going toward year-end has resulted in light positioning and year-end related hedging. As we head into 2010, the risk of supply disappointing demand is growing as companies become comfortable with market access and their high liquidity positions. Yearend related selling of synthetic CDOs and portfolio hedging will likely give way to increased risk appetite as investors move from protecting gains in 2009 to generating returns in 2010, leading to a potential gap tighter in derivatives. Dealers looking to re-buy into the credit business are likely to build positions into year-end in the hope of taking client market share in the new year. The bottom line is that the pain trade is for the rally to occur in December without broad-based participation, rather than in January when returns will count towards the new performance year.
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US EQUITY OUTLOOK
The Fed giveth and the Fed taketh away

Barry Knapp +1 212 526 5313 barry.knapp@barcap.com
We think that 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. Fed asset purchases are scheduled to slow to a trickle in Q1 10; slowing QE has already stalled the highly correlated rally across markets. We believe the next step for the Fed is draining excess reserves, which should begin shortly after employment stops falling, to the detriment of the liquidity-driven rally in share prices.
Although we are far more constructive now than we were at this time last year, once again we find ourselves expecting a difficult first half of the coming year
We are quite encouraged by recent labor market developments, such as jobless claims and the October and November employment situation reports, and we are increasingly convinced that a cyclical economic upswing is well under way. As strategists for US equities one of the most economy-sensitive asset classes, which was at the epicenter of the global credit crunch this would presumably make us quite optimistic about the 2010 market outlook. Although we are far more constructive now than we were at this time last year, when we expected a sharp correction to retest the October 2008 fallout from Lehman Brothers bankruptcy (750), once again we find ourselves expecting a difficult first half of the coming year. A year ago, many equity investors believed that the 40% drop in the S&P 500 after Lehman Brothers bankruptcy had reduced equity valuations to extremely low levels. However, we did not believe that to be the case and saw better value in the credit part of the capital structure until the stress test process (Supervisory Capital Assessment Program or SCAP), macro data releases (most notably the ISM manufacturing survey) and the rapid normalization of capital markets shifted the focus from solvency to recovery. The net effect of the highly correlated rally across asset classes is that, in our view, equities are close to their long-term average risk premium relative to Treasuries and investmentgrade credit. This should not be comforting to investors, given the low absolute yields available in the Treasury and investment-grade credit markets. We believe that the primary catalyst for the highly correlated capital market rally, which left yields at their current lows, was the Feds efforts to cope with the zero bound on its main policy rate beginning late last year, specifically quantitative easing (QE) and related purchases of agency MBS, agency debt and Treasuries. QE purchases, along with recent declines in market-implied growth rates, have left real Treasury rates sitting near levels that existed in the aftermath of Bear Stearns collapse and as the credit crunch was gathering force. Against this backdrop, we think there is little room for error. If growth accelerates, the Fed will end the QE purchase program in March as planned, leaving the market to absorb more than $2trn of net fixed-income supply in 2010, and it will begin draining excess reserves from the banking system through large-scale reverse repos, paying interest on reserves, a term deposit facility and perhaps even asset sales. If growth slows, stretched multiples and their associated market-implied earnings expectations will likely prove overly optimistic. It is possible that growth could thread the needle, meaning the Fed could end QE, drain liquidity and raise rates very slowly while the output gap closes over the next several years, without triggering any asset, commodity or imported inflation. Meanwhile, the administration could be patient and refrain from permanently impairing the economy through increased regulation, higher taxes, greater unionization and reduced labor and economic flexibility. However, the probability of such a Goldilocks type of outcome is quite low, in our view.
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We believe that the primary catalyst for the highly correlated capital market rally was the Feds quantitative easing (QE)
If growth accelerates, we think the Fed will end the QE purchase program in March as planned; stretched multiples and marketimplied earnings expectations will likely prove overly optimistic
10 December 2009
Figure 1: We believe the economic recovery is likely to gain momentum and that 2010 will follow a pattern quite similar to 2004
Index 1250 Index 1600 Fed changes inflation 1500 bias to 'balanced' (Dec 1400 1150 FOMC Meeting) 1300 1200 1050 1100 Nonfarm payroll 1000 950 growth accelerates 900 (Mar payrolls) 800 850 700 600 750 Dec-01 Apr-02 Aug-02 Dec-02 Apr-03 Aug-03 Dec-03 Apr-04 Aug-04 Dec-04 S&P 500 ('02 - '04, L)
Fed pulls 'considerable' language (late Jan FOMC meeting)
S&P 500 ('08 - Present, R)
We think 2010 will follow a pattern quite similar to 2004, when stocks flatlined during the first half of the year
Fundamentally, our base case is optimistic; we believe the economic recovery is likely to gain momentum. From a market perspective, however, we think 2010 will follow a pattern quite similar to 2004, when stocks flatlined during the first half of the year in anticipation of the end of the easiest monetary policy in decades. Back then, the equity market began a long, slow, and shallow pullback after the Fed removed the considerable period language from its vocabulary in the late-January FOMC meeting, the Treasury curve bear flattened from 250bp to 180bp, and the dollar stabilized until six weeks after the first rate hike in midAugust when the equity market bottomed and the dollar was falling again. To be clear, when we describe policy tightening, we are referring to the end of QE: Largescale reverse repurchase agreements; the implementation of a term deposit facility; and perhaps even asset sales, which we believe will be the equivalent to raising the fed funds rate 2-3%. We arrived at this estimate by using the optimal fed funds rate of -5% modelled by the Federal Reserve Bank of San Francisco last May, and by assuming that the $1.725trn of asset purchases were the Feds attempt to replicate rate cuts and effectively circumvent the zero bound on its main policy rate. If the Fed drains $1trn of reserves from the banking system, the theoretical or synthetic change would be equivalent to raising rates from -5% to -2%. Certainly, there is room for debate about whether QE had an effect on capital markets similar to rate cuts. However, given the drop in the Fannie Mae 30y fixed current coupon rate from 6% (at the time of the last conventional rate cut, before the Fed hit the zero bound and began QE in late October 2009) to nearly 4% (while the Barclays Capital US Corporate Credit Index yield to maturity fell from 9% to 4.7%), we believe that QE purchases had an effect on capital markets very similar to rate cuts, had the fed funds rate not been subject to the zero bound. This policy approach was very successful in stabilizing capital markets which, in turn, was integral to the stabilization of the economy, in our view. Conversely, as the Fed begins unwinding unconventional monetary policy, we believe the capital markets are likely to react as if the Fed were raising rates in an environment in which the fed funds rate were not subject to the zero bound. The equity market, given its historical role as a long-duration asset and as a leading indicator, is likely to be at the center of this adjustment.
When we describe policy tightening, we are referring to the end of QE; if the Fed drains $1trn of reserves from the banking system, the theoretical change would be equivalent to raising rates from -5% to -2%.
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We believe that by the time the Fed actually raises rates, the market adjustment will largely be complete
For further guidance on the implications of monetary policy tightening, we looked back at the previous three significant tightening cycles (2004, 1994 and 1988) that led to stock market corrections and yield curve flatteners specifically, the 2s10s Treasury yield curve, the S&P 500 index and price-to-forward earnings multiples. One of the issues that struck us was that in the days before the zero bound on rates became a factor and communication strategy was not an integral part of Fed policy (pledging to keep rates low for a considerable or extended period, for example) the peak in the yield curve generally occurred near the first rate hike. In 2004, when the Fed added communication strategy to its policy arsenal, the peak in the yield curve occurred roughly concurrently with the change in its communication strategy, about five months before the first rate hike. We agree with St. Louis Fed President Bullards comments in a recent CNBC interview that focusing on interest rates rather than QE purchases and excess reserves is a mistake. We believe that by the time the Fed actually raises rates, the market adjustment will largely be complete.
Figure 2: Significant Fed policy tightening and S&P 500 reactions

Policy tightening 2s10s UST yield curve (1y chg) S&P 500 FP/E (1y chg) S&P 500 index (initial chg) S&P 500 index (1y chg)
Mar. 88 Feb. 94 Jan. 04
-151bp (116 to -36) -115bp (149 to 34) -141bp (240 to 99)
-1.1pts (11.1x to 10.0x) -2.6pts (15.0x to 12.4x) -1.6pts (18.2x to 16.5x)
-6.7%, 2 mos -8.7%, 2 mos -8.2%, 6 mos
8.1% -0.4% 2.3%
Note: The Fed changed its language in January 2004 and raised rates in June 2004. Source: Barclays Capital
After the onset of the 2004, 1994 and 1988 policy tightening cycles, equities corrected initially but recovered later in the full 12-month period
The pattern was fairly consistent: In 1988, the 2s10s curve flattened from 116bp to -36bp over the next 12 months, beginning just prior to the first hike in March. The S&P 500 dropped 6.7% in the first two months before recovering to close up 8.1% over the next year, with the forward P/E contracting from 11.1x to 10.0x. In 1994, just prior to the surprise rate hike in early February, the 2s10s curve was 149bp and, over the subsequent year, it flattened to 34bp. Again, the S&P 500 fell over the first two months, this time by 8.7% before recovering to close down 0.4% over the full 12-month period, as the forward P/E contracted from 15.0x to 12.4x. In 2004, the general trends were similar, though the Feds communication strategy diffused the reaction somewhat. The 2s10s curve flattened from 240bp to 99bp over the subsequent year, beginning just prior to the removal of the considerable period language. Equities did have an initial short-term negative reaction, falling 8.2% in the first six months before bottoming six weeks after the first rate hike; the S&P 500 did reverse that decline to close up 2.3% over the full 12-month period, while the forward P/E contracted from 18.2x to 16.5x. History provides clues rather than a road map for the future; although these previous cycles are helpful, there are key differences. In 1988, the equity market was significantly higher in a years time; however, the starting point for valuations was much lower than is the case today. In 1994, the market did not recover until later in 1995; however, in that episode, the Fed took the real fed funds rate from zero to 3% in a year, in essence, going all the way from loose to tight policy in a fairly short time. We think that the 2004 period offers the best clues for the 2010 outlook, given that the main policy rate was close to the zero bound and the Fed used communication strategy (pledging to keep rates low for a considerable period), as is the case today. Additionally, the Fed removed policy accommodation in a measured way; this time we think that it will be equally deliberate. Still, the use of QE and the complexities involved in removing such unconventional policy stimulus are unlikely to occur without some unforeseen events in 2010.
We think that 2004 offers the best clues for the 2010 outlook
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We see the window to easy policy, an improving economic environment, and a falling dollar closing
In H1 10, we believe the dominant theme will be the reversal of Fed policy, producing a sharp real rate correction, bear flattener, P/E multiple compression, and US dollar stabilization
As we peer out into 2010, the window to easy policy, an improving economic environment, and a falling dollar is closing, in our view. The missing piece of the economic recovery puzzle is resource utilization, a Fed euphemism for the labor market, and it is the strongest headwind to Fed policy tightening. The sharp drop in jobless claims and significant improvement in the cyclical components of the past two employment situation reports meaningfully increases our confidence that the economy is on the verge of benefitting from a labor market recovery. Given the low level of real rates and nominal rates at the front end of the curve, there is some potential for US equities to rally further between now and late January, when we believe that the Fed will make significant changes to its communication strategy. Certainly, the QE unwind could affect the yield curve differently, and it might remain steep somewhat longer than in prior periods of Fed policy tightening. We do not find much comfort in a steeper curve during the adjustment period (of which we are quite sceptical), as we believe that Barclays Capitals forecast for a 100bp increase in 10y Treasury rates over the first three quarters of 2010 will have an effect similar to a bear flattener, given how easy policy is currently. So, we believe that the dominant theme in H1 10 will be the market effect of a reversal of Fed policy, resulting in a sharp correction in real rates, ultimately leading to a bear flattener, P/E multiple compression, and the stabilization of the US dollar. Once we actually get the first rate hike, we expect the market adjustment to be largely complete and equities to post positive returns in H2 10.
The earnings outlook: Positive, but not as good as the consensus expects
We are increasing our 2010 S&P 500 operating EPS forecast from $60 to $66, while actually lowering our expected growth rate from 20% to 18%
Our models deleveraging variable and the lingering effects of the credit crunch are key factors behind our belowconsensus forecast
We continue to be struck by the dichotomy between equity analyst and strategist forecasts for corporate earnings on one hand and economist forecasts for GDP on the other. Our read is that top-down and bottom-up earnings estimates imply an economic recovery roughly twice as strong as economist GDP forecasts. Said differently, the consensus S&P 500 earnings forecast is for the strongest recovery in post-WWII history, while Barclays Capital economists relatively optimistic GDP forecast is for output to increase in the first year of the recovery at roughly half of the average post-WWII rate. With that in mind, we are increasing our 2010 earnings forecast from $60 to $66, while actually lowering our expected growth rate from 20% to 18%. The bulk of the increase in our forecast is attributable to base effects; this cycle was extraordinary, primarily owing to the front-end loading of financial sector losses. Our model worked well in terms of the timing of the low and the trough level of earnings. However, the very large losses in bank mark-to-market accounts (available for sale accounts or AFS) were concentrated in Q4 08, and government policies (the foreclosure moratorium, the HAMP program and regulator forbearance) pushed losses in bank accrual accounts (held to maturity or HTM) out in time. We believe that our models deleveraging variable in the form of C&I loan growth, and the lingering effects of the credit crunch, are the key factors behind our below-consensus forecast. In addition, the extremely sharp drop in commodity prices pulled forward the bottom in profit margins, which historically trough nine months after the end of recessions. This cycle, margins appear to have bottomed concurrently with the end of the recession, which implies that the margin expansion story may be winding down, as the comparisons from lower commodity costs will likely end in the current quarter. This might explain S&P 500 net revisions being flat in November 2009 after increasing sharply from their lows in December 2008. The increase in net revisions was a key factor for fundamental investors in justifying the sharp recovery in share prices. If revisions stall further as companies provide 2010 guidance in late January, the market could be facing another headwind at a time when the Fed is raising its forecast enough to begin removing policy accommodation.
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The valuation outlook: Significant multiple compression is likely in 2010

In our view, a point-in-time snapshot of equity-only valuations is of limited use. As such, we took four different approaches to determine the likely path for equity market multiples in 2010. Any investor who has ever bought a cyclical asset should not be surprised by our expectation that equities are likely to witness multiple compression next year as the economic recovery makes the earnings rebound sustainable. First, we considered the implications of having flirted with deflation to the return of inflation, even if it stays well within the Feds comfort zone. There is a very strong relationship between the S&P 500 earnings yield (the inverse of the P/E) and CPI inflation. Second, we looked at the relationship between earnings yields and nominal GDP, which exhibited a decent relationship but not as strong as CPI. Third, we considered our long-term Treasury-toequity risk premium model and, after inputting the Barclays Capital interest-rate strategy teams forecast for 10y Treasuries (4.5%) and our economics departments forecast for CPI (1.6%), even if we leave the current real risk premium unchanged (3%) as rates rise, we are likely to see significant P/E multiple compression (from 28x to 17x). Fourth, we looked at our three episodes in which the removal of easy Fed policy triggered bear flatteners and equity market corrections.
The message is pretty clear: multiples are likely to compress fairly significantly in 2010
The message is pretty clear: Multiples are likely to compress fairly significantly in 2010. We find it interesting that our nominal GDP valuation model implies continued multiple compression throughout 2010, while our economics departments forecast for CPI (which calls for a sharp reversal from negative readings in 2009 to roughly 2.5% at the end of Q1 10, followed by a softening to 1.6% by Q4 10) implies sharp multiple compression in H1 10, followed by some expansion later in the year. Given that the relationship between earnings yields and CPI is stronger than that of nominal GDP (an r-squared of 0.68 since 1959, versus 0.35 for nominal GDP) and the typical pattern of an equity market correction in the early stages of easy policy removal, the CPI valuation model is probably telling us the correct story. (Note: The CPI and nominal GDP valuation models were constructed using trailing earnings.) Our CPI valuation model points to multiple compression of 35% in H1 10 as CPI accelerates, and a full-year compression of 29% as CPI moderates in H2 10. Our nominal GDP valuation model yields a similar conclusion, but a different path, down 28% in H1 10 before ending the year down 35%. While this might sound extreme, keep in mind that
Figure 3: Inflation has been a key driver of equity valuations over time
% 16 14 12 10 8 6 4 2 0 59 63 67 71 75 79 83 87 91 95 99 03 07 11 S&P 500 TTM Operating EPS Yield (L)
Figure 4: Our CPI valuation model suggests that earnings yields could witness a sharp reversal heading into 2010
% 16 14 y = 0.71x + 3.91 Adjusted R = 0.68 Sample: '59 to present Based on headline CPI (% y/y)
2
% y/y 16 Correlation = 0.82 11 6 1 -4
12 10 8 6 4 2 59 63 67 71 75 79 83 87 91 95 99 03 07 11 S&P 500 TTM Operating EPS Yield

CPI (R)
Predicted
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trailing earnings are on the verge of a significant jump as Q4 08 operating EPS of -$0.09 are about to be replaced by Q4 09 operating EPS in the $16 area. Additionally, our earnings model predicts an increase of 18% in 2010. Multiple compression during the three periods of Fed-induced yield curve flattening (2004, 1994 and 1988) was 9%, 17%, and 10%, respectively, using forward earnings.
We think it is reasonable to expect multiples to compress at least 10% based on forward earning, implying a pullback in the S&P 500 of approximately 10% in H1 10
On balance, we think it is reasonable to expect multiples to compress at least 10% based on forward earnings. Given our expectation that forward earnings will not move much higher (net revisions, our favorite second derivative of earnings growth, were flat in November 2010 after rising rapidly since December 2008), it implies a pullback in the S&P 500 of approximately 10% in H1 10. The risk to our H1 10 scenario is a somewhat deeper correction, given that S&P 500 market volatility (implied and realized) is higher now than in any of the three episodes we considered, and easy policy removal will likely be far more complex. Still, a 10% correction would be slightly larger than those prior episodes, and P/E multiples are higher. The offset is a very steep term structure of implied volatility, which can be viewed to some extent as the market discounting the end of policy removal.
Figure 5: The S&P 500 is currently trading on the high side of fair value
Equity-only valuation metrics 12/1/2009 Mean
Price / Sales Price / Free Cash Flow Price / Trailing Earnings (As Reported) Price / Trailing Earnings (Operating) Price / Forward Earnings Price / Book Value Dividend Yield EV / EBITDA EV / Sales
Note: Mean since 1973. Source: Barclays Capital
1.2x 20.3x 58.4x 27.8x 14.8x 2.2x 2.6% 10.3x 1.7x
0.8x 16.6x 14.7x 13.8x 11.4x 1.9x 3.3% 6.2x 1.1x
Our outlook is for a correction to 990 in H1 10 and a subsequent recovery to 1,120 by the end of 2010 Our year-end S&P 500 target is the product of a 17x P/E and $66 operating EPS
In sum, our outlook for a period of adjustment (as the Fed begins normalizing policy) and our work on the expected path for multiples and earnings traces an S&P 500 correction to 990 in H1 10 and a subsequent recovery to 1,120 by the end of 2010. Our year-end target for 2010 comes from the product of our 17x P/E and $66 operating EPS; as a reminder, we derived the 17x P/E from our Treasury-to-equity risk premium model and Barclays Capital forecasts for rates and inflation. If growth surprises on the upside, our earnings forecast is probably too low. If inflation is stronger than expected, multiples could compress more than we anticipate. However, if inflation is more moderate, it is possible that multiples could compress less than we expect and trade closer to 20x trailing operating EPS. But expecting a 5% earnings yield (the reciprocal of a 20x P/E) in an environment in which 10y Treasury rates go to 4.5% would imply CPI inflation of 2.5% or a large decline in the real equity risk premium from 3% to 2%, which would be too rich for us.
Sector recommendations: Getting defensive as the recovery takes hold

The recovery rally has left financials, materials and energy fully priced
Although we do not find the S&P 500 to be cheap based on equity-only valuation metrics or our equity risk premium models relative to Treasuries or investment-grade credit, a number of sectors are trading below what we consider fair value. Interestingly, the sectors that rank on the cheap end of our equity-only valuation framework are defensive, while several (but not all) cyclical sectors rank on the rich end. Specifically, the recovery rally has left the sector at the epicenter of the boom/bust credit cycle, financials, and the two sectors with
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Telecom, health care and staples are the cheapest
the most leverage to emerging markets, materials and energy, fully priced. In addition, the financial sector looks rich according to our credit-to-equity risk premium model. Meanwhile, the sectors with the least leverage to the US economic recovery telecom, healthcare and staples are the cheapest.
Figure 6: We continue to recommend GARPy cyclicals, but defensive valuations are looking attractive
S&P 500 sector Telecom Healthcare Staples Industrials Technology Discretionary Utilities Energy Financials Materials Valuation sub-component S/P E/P* E/P** FE/P B/P D/P EBITDA/EV Total valuation score***
1.10 1.50 0.25 -0.20 0.35 -0.51 0.47 -0.94 -0.76 -1.02
1.14 2.76 3.11 2.08 1.82 -0.85 1.44 -1.54 -2.19 -1.72
0.85 1.85 1.49 1.32 0.44 0.98 0.21 -0.82 -1.01 -1.47
0.25 1.73 0.89 0.10 0.77 -0.55 0.09 0.09 -2.03 -0.81
-0.02 1.15 0.21 -0.70 -0.29 -0.29 -0.44 -0.64 0.36 -1.93
1.00 1.46 0.91 1.17 -0.05 2.70 -1.09 -1.17 -1.49 -1.02
0.90 1.93 1.33 0.71 0.67 1.27 0.87 -1.04 -0.02 -0.88
2.13 1.90 1.60 0.86 0.86 0.66 0.34 -1.14 -1.48 -1.86
Note: *As reported. **Operating. Our valuation score is the renormalized sum of each sector's normalized relative valuation metrics. The z-score transformation was used to normalize each metric. Source: Barclays Capital
We reduced exposure to cyclicals facing secular headwinds and maintain exposure to cyclicals poised to benefit from secular tailwinds; we have taken a small step toward defensives
For most of 2009, an emphasis on the business cycle was the key to getting sector allocations right. We believe that the business cycle will remain important in H1 10, when the major focus for markets will likely be the end of Fed policies intended to replicate rate cuts in a zero bound environment. After the period of adjustment is complete, close to the time when the Fed actually raises its main policy rate, we expect secular trends to reemerge, as was the case with technology and healthcare during the 1994-95 rate hike cycle and energy & materials during the 2004-06 rate hike cycle. With that in mind, our most recent changes were to reduce exposure to cyclical sectors facing secular headwinds, namely financials and consumer discretionary, while maintaining exposure to cyclical sectors poised to benefit from secular tailwinds, such as tech and industrials. Also, we increased our exposure to defensive sectors, as reflected by a marketweight plus on health care and a reduction of our underweight on consumer staples to marketweight minus. Figure 7: We are sticking with cyclicals, but warming to defensives
Technology Industrials Energy Health Care Materials Discretionary Financials Staples Telecom Utilities Underweight
Marketweight-
Marketweight
Marketweight+ Overweight
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EMERGING MARKETS OUTLOOK
Sharpen your pencil

Michael Gavin +1 212 412 5915 michael.gavin@barcap.com Piero Ghezzi +44 (0) 20 3134 2190 piero.ghezzi@barcap.com

Because things are the way they are, things will not stay the way they are. Bertolt Brecht 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. All regions of the emerging world are in recovery. In Asia, the recovery is broad and mature enough to bring monetary policy tightening to the fore. It is also well under way in Latin America, particularly Brazil and Mexico, although less visible in the smaller economies. Recovery is under way, but more uneven, in EMEA. In sovereign credit, we expect a bear market in US Treasuries to suppress total returns to something like 2-3%, with this performance reliant upon our favourable assessment of high-risk/high-return trades in Argentina, Venezuela, and Ukraine. EM FX will not, in our view, be supported by the dollar downdraft as it was in 2009, and the risk on trade is a spent force. More fundamental drivers are set to emerge, including external flows, economic growth, and monetary conditions. We think it is Asias turn for currency outperformance.
In September, we were generally optimistic about economics and markets
Last quarter, we argued that there would be a stronger-than-expected economic recovery, the cyclical bounce that started earlier in the year was likely to continue, and the anxiety about a double dip would gradually dissipate as investors started to see increasingly convincing evidence that a more broad-based recovery was in place. We suggested that the market rally was also likely to continue valuations did not seem stretched, investors still seemed more anxious and pessimistic than we thought warranted, and the wall of money moving into risk assets seemed likely to buoy emerging markets.
And what is new now?

For the immediate future, we remain positive on the basis of investor positioning, both psychological and financial
Three months down the road, it seems to us that this view was broadly on the mark. We also think there is some life left in it. Although investor anxieties continue to recede as the global economic recovery evolves, the markets reaction to the recent shock from Dubai World reveals an underlying edginess among investors. Positioning still seems lighter than it should be in a normalized economic and financial context. The wall of money is gradually coming off the sidelines and being invested, but light positioning remains a source of support. And looking ahead to the next few months, Barclays Capital remains substantially more optimistic than the consensus about the economic recovery in the US, in particular, and the world, more generally. We are also less concerned than many investors about the upcoming termination of the Feds purchases of mortgage-related agency securities, which is a watershed of sorts, but seems to us unlikely to be a disruptive financial event. Economic and financial news flow thus looks likely to remain, on balance and for a little while longer, a source of reassurance, not disturbance.
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But looking beyond the immediate future, we think that a broad market updraft will no longer be the dominant investment theme; differentiation will be key
But looking beyond the immediate future, we doubt that stronger for longer will be the dominant theme when we look back on 2010 as a whole. If risk markets continue to rally in the weeks to come as investors build positions, neither positioning nor valuations will remain as supportive. It is not hard to imagine the market becoming overextended and setting itself up for an event- or positioning-related correction sometime in late Q1 or Q2 10; even if the locus of volatility is commodities, the dollar, or equities, it would likely spill over to EM risk markets. In short, the market context will inevitably become more balanced as the rally matures. As it does, the broad, market-directional themes that have been our focus will need to be replaced by a renewed vigilance toward overshoots and corrections and, above all, an emphasis on relative value and asset selection in other words, to rely a little less on beta and focus on alpha. We begin to shift our focus in this direction with this quarterly.
Emerging-market economies in recovery

Emerging Asia faces a classic V-shaped recovery
In a classic V-shaped recovery, we expect emerging Asia to grow 5.4% in 2009 and 8.1% in 2010. In 2010, growth will continue to be dominated by China and India, which contribute 4.75pp and 1.70pp, respectively, to regional GDP growth. The acceleration in GDP growth comes, however, from the smaller economies, notably Korea and Taiwan. Domestic demand remains the locomotive; net exports subtract 0.5pp from growth in 2009 and 0.1pp in 2010. As the recovery matures, inflationary pressures are building across the region because of a combination of unfavourable base effects, food prices (due to adverse weather patterns), and energy. Policymakers can look through some of this upward pressure, but not if inflation expectations increase significantly. Moreover, in 2010, we expect core inflationary pressures to emerge in some economies, notably India and Singapore. This sets the stage for a gradual tightening of monetary conditions, as a part of which we expect policymakers to allow FX appreciation as a tool to deal with inflationary pressures.
EMEA: Growth returns, but deleveraging will take time
After economic adjustments that ranged from abrupt to brutal last year, regional economies began to recover in the second and third quarters. We expect growth to be uneven across the region, with commodity exporters likely to benefit most from the global recovery, overextended economies in the Baltics and (perhaps) Hungary struggling to stage a recovery, and the rest of the region somewhere in between. Generally subdued prospects should prevent inflationary pressures from emerging, but substantial differences in the pace of recovery are nevertheless leading to divergent monetary policies. Israel has already started to hike rates, and Egypt may follow in Q2. On the other hand, we think that Russia, Hungary, Romania, and Kazakhstan still have room for interest rate reductions in H1 10. Economic recovery is also well advanced in Latin America, most notably in Brazil and Mexico, where our forecasts are roughly 1 percentage point more optimistic than consensus. In the smaller countries of the region, economic performance has disappointed, but we nevertheless expect regional growth of 4.6%, well above the consensus forecast of 3.7%. While we do not expect Latin American economies to overheat during 2010, we do expect a gradual normalization of monetary policy, starting with Mexico in the March meeting and becoming more generalized later in the year.
Latin America in recovery
Monetary policy in emerging markets

EM monetary tightening will be gradual
A mark of the crisis was that EM countries were able to pursue aggressive countercyclical policies, particularly monetary policy, for the first time. EM countries appear to be closing their output gaps on average at a faster rate than developed nations, and all else equal, one would expect EM to tighten more aggressively than core countries. However, major
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uncertainty remains about the size of the output gaps, how that is exerting itself, and how robust global growth will be once we exclude fiscal stimulus and inventory accumulation. We expect the tightening process to be gradual.
Central banks likely to use other tools before rates
Not only might the process of monetary tightening be gradual, but central banks may decide to use policy rates only after other tools have been attempted. One of the lessons of the recent crisis is that they should not ignore asset prices (including the exchange rate) in deciding monetary policy. At the same time, the mapping of interest rate hikes into asset prices is highly uncertain, and in the more open economies, the latter may be linked more to global liquidity conditions (particularly the Feds) than to country-specific ones. This implies that EM central banks are reacting (or expecting to react) using quantitative tools. In Asia (and increasingly in Latin America), we have already seen renewed focus on credit growth and bank regulation to limit the formation of asset bubbles, particularly in property markets. FX appreciation is an alternative tool to tighten domestic monetary conditions. This is particularly true in Asia, where we expect currencies to appreciate across the board in H1, with the exception of the CNY, but as they do so in H2, it should assist momentum. Even in Asia, however, appreciation is likely to be moderate and reserve accumulation is likely to continue. One of the other lessons from the recent crisis is that the optimal level of EM reserves appears to be higher than previously thought. In Latin America, the appreciation pressures resulting from potential hikes in interest rates imply that rates would be lower than otherwise. The above suggests that the path of interest hikes is likely to be relatively back-loaded (with the potential exception of countries such as Israel, Chile, and Korea) where interest rates are well below neutral. In addition, we believe that the amplitude of the tightening cycle is likely to be shorter than in previous occasions as a result of the regained credibility of many central banks. Lower needed real rates and lower inflation expectations imply that end rates after this tightening cycle are likely to be lower than the highs of previous hiking cycles. The risk to our scenario would be renewed inflationary pressures that force EM central banks, particularly inflation targeters, to hike earlier than expected. We do not think that economic recovery alone would bring inflationary pressures. We believe instead that if commodity prices were to increase sharply as a result of supply conditions or excessively loose global liquidity conditions, EM central banks may be forced to act hastily.
FX will be used to tighten monetary conditions in Asia
Rate hikes likely to be back-loaded and amplitude shorter than in the past
Risk is renewed inflation pressures due to commodity prices
Figure 1: Asia and LatAm equities have outperformed

MSCI TR rebased Dec 07 = 100
Figure 2: EM FX may have more room for catch-up

125 120 115 REER, GDP weighted regional averages (Dec 07 = 100)
120 100 80 60
110 105 100 95 90
40 2005
2006
2007
2008
2009
85 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 LatAm

Source: BIS, Barclays Capital
Asia/Developed LatAm/Developed
Source: MSCI, Barclays Capital
EMEA/Developed
EMEA
Asia ex-China
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EM market outlook No longer undervalued

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

4000 3500 3000 2500 2000 1500 1000 500 0 2005 2006 Arg,Ven,Ukr
Source: Markit, Barclays Capital
900 800 700 600 500 400 300 200 100 0 2007 2008 2009
Cuml. EM Bond Flows (% eop AUM 08)
Apr-09
EM ex-Arg, Ven, Ukr (RHS)
Jul-09 Asia
Oct-09 LatAm
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weather the eventual unwinding of conventional and unconventional monetary stimulus. Particularly during the first part of the year and even after the backup in yields that we foresee later in 2010, G3 interest rates will likely remain low by historical standards. We see strong underlying demand for credit from a number of institutional investor classes, notably US pension funds and European insurance companies. And we expect global corporate bond issuance to decline from 2009 levels, by about 30% in the US and 25% in Europe. Within this context, we are inclined to view the upcoming end of the Feds bond purchases not as a crippling liquidity shock, but rather a shift in relative supply that increases the share of US Treasury and mortgage-related agency securities that will have to be absorbed by the market. Supply considerations will then leave room for an increase in the price of creditrelated assets, which will become scarcer relative to safer US government bonds.
and by a gradual tightening of monetary conditions
This brings us to the third driver, which poses the largest headwind for returns in EM credit: the gradual tightening of global monetary conditions that we expect to begin later in 2010. It will not constitute a major financial shock for risk markets, but we believe it will generate a roughly 100bp rise in US yields, with important effects on EM credit market returns, at least for investors who cannot hedge their Treasury exposure. Our judgement is that spread compression can continue into 2010. Using the Barclays Capital EM Sovereign Index as a benchmark and excluding, for the sake of discussion, three important but highly idiosyncratic countries (Argentina, Venezuela, and Ukraine, which together account for about 12% of the index), our working assumption is that sovereign spreads will compress another 30bp in 2010, to about 140bp. This yields a forecast total return on this core benchmark of about 0-1% in 2010, outperforming US Treasuries by 450-550bp, but offering relatively meager total returns. If we include Argentina, Venezuela, and Ukraine, the outlook is more favourable, although at some cost in terms of the portfolios risk, of course. More on these calls in a moment; for now, we note that the significant outperformance that our strategists predict should bring yields on our EM sovereign benchmark from the 0-1% discussed above to 2-3%, at least for investors who are risk tolerant enough to hold these credits at their benchmark weights.
Spreads on the core benchmark can compress, but total returns will be modest at best
Asset selection is back on the agenda
The key to outperformance will no longer lie in being on the right side of overall market directionality, but instead in some combination of trading around market events and careful attention to asset selection, including country allocations and positioning along curves. Figure 6: Investment grade EM appears fair to US IG
400 200 0 -200 -400 -600 -800 -1,000 Jan-04
Figure 5: Continued rebound in EM credit markets

1,600 1,400 1,200 1,000 800 600 400 200 0 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
EM high yield - US corp high yield EM investment grade - US corp investment grade
EM IG
EM HY
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We have little to say about the former because it is (almost by definition) difficult to forecast. To quantify the scope for country allocations to generate outperformance in 2010 and the associated tradeoffs, we embedded our regional strategy teams outlook for sovereign spreads into a standard portfolio optimization exercise. Here are our main conclusions:
Country allocation four themes
First, the projected gains from active portfolio selection are meaningful, even though we impose limits on the models tendency to overweight assets with higher expected return. (We constrain portfolio weights to be positive and no higher than twice the countrys weight in the benchmark portfolio.) A moderate risk portfolio that, tactical considerations aside, we would be inclined to adopt as a model portfolio outperforms the benchmark portfolio by about 250bp. The main investment themes and sources of outperformance:
Venezuela: Our analysis reinforces the common view that Venezuela will likely be a key driver of bond returns in 2010. We expect spreads to decline back to about 900bp over the course of 2010, which would generate returns of about 23%. Our model adopts a maximal (5.5pp) overweight position, generating incremental returns of 114bp over the benchmark portfolio, accounting for nearly half the forecast outperformance. Russia: Economic recovery and high oil prices set a positive backdrop. Technicals are also intensely favourable. We estimate that bond investors are more heavily underweight Russian debt than any other country, in expectation of large issuance (that, in our view, will not fully materialize). Underweight high grade Latin America: We have recently noted that higher grade Latin credits (Brazil, Colombia, Mexico, and Peru) appear expensive to similarly rated peers, even after factoring in the Mexico downgrade. In 2010, we expect these countries to return (on a benchmark-weighted basis) -1.3%. By underweighting these countries, the model portfolio increases the expected portfolio return by about a quarter percentage point. Ukraine. This is a much tougher call, and much will depend on the outcome of the January elections. While we think that investors should remain cautiously positioned until the results are in, our judgement is that it will result in better governability, more coherent policymaking, and a strong rebound in bond prices. The effect on the model portfolio is limited by the (admittedly arbitrary) restriction on the magnitude of country allocations; investors who are less constrained could benefit more.
Figure 7: Country allocation and forecast outperformance

Expected return Contrib. to performance
Figure 8: Historical investor positioning in EM credit

4% 2% 0% -2% UNDERWEIGHT -4% -6% -8%
Indo Hung SOAF Colo Per Arg Mex Tur Pan Ukr Uru Dom Egy Gha Tun Gab Ecu Pak Bra Sri Els Viet Bul Ven Ind Leb Phil Rus
OVERWEIGHT
Overweight Venezuela Overweight Russia Underweight HG Latin America Overweight Ukraine Other Total
23.3% 4.6% -1.3% 18.7% N/A N/A
1.14% 0.40% 0.22% 0.21% 0.58% 2.54%
GEM dedicated bond fund weights minus Barcap EM Bond Benchmark weights
Jan-09
Source: Barclays Capital Source: EPFR Global, Barclays Capital
Jun-09
Oct-09
10 December 2009
77
and an un-theme
Finally, a word on Argentina. While we think that the most important good news is already priced and that spread compression will be marginal, still-high carry leads to a forecast return of about 6%, well above the benchmark return. Despite this, the portfolio optimization framework selects only a modest Argentina overweight position because of the high volatility and directionality of its returns. The question therefore arises whether it has become a substantially less volatile investment story. With the policymaking leadership and the economic policy framework essentially unchanged, our judgement is no, and we believe that aggressive positions in Argentine bonds make sense for risk-tolerant investors only.
EM FX
Will EM FX strength survive the end of USD weakness?
In the past year, it has been difficult to distinguish between EM FX strength and dollar weakness, in part because the dollar has been the center of shifts in global risk appetite. The weakening trend in the USD has certainly supported our positive call on EM FX. Although we expect the dollar to remain under pressure in the immediate future, we expect it to strengthen modestly against the euro and more dramatically against the JPY, as the US cyclical recovery permits the Fed to unwind the monetary conditions that have contributed to dollar weakness. Can EM FX strength persist in the face of a stronger dollar next year? The short answer is yes. Our view is that there is more to EM FX strength than dollar weakness. Emerging market currencies are supported (to varying degrees in different countries) by strong prospects for economic outperformance, both in this cycle and over the medium term; healthy external positions; and reasonable valuations. That said, a reversal of dollar weakness, even if contained as we expect, would be a significant shift in the global financial environment, and investors should consider the possibility of knee-jerk market reactions and potentially abrupt movements, hedging against risks in advance and capitalizing on any overreactions. As we look into 2010, two main themes emerge. The first is Asian currency outperformance. While we foresee mixed currency performance against the dollar and, on average, modest exchange rate depreciation in Latin America and EMEA (on a GDP-weighted basis), we expect currencies to appreciate against the dollar almost across the board in Asia. Grounds for Asian currency outperformance in 2010 seem solid to us because Asia is where external accounts are strongest (Figure 9); its recovery is most advanced; CNY appreciation should
Strong EM FX is not just dollar weakness
A stronger dollar raises tactical considerations
Asias turn to outperform?
Figure 9: External balances favor Asia

30% 25% 20% 15% 10% 5% 0% -5% LatAm EMEA -1% EMEA exRussia EM Asia EM Asia ex-China 8% 1% 2% 14% 9% 6% 3% 17% 27%
Figure 10: EM FX Sharpe ratio

2.00 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 EGP RON RUB IDR KRW PHP INR MXN BRL FX Sharpes
Reserve acum past 5y/GDP

Source: Haver Analytics, Barclays Capital
Basic Balance/GDP 2010F
10 December 2009
78
be most supportive; inflation concerns and, therefore, pre-emptive monetary tightening are most imminent; and, despite this, currency recovery has, in some cases, lagged.
Too early to position against EM FX
A second theme that emerges is that despite the more mixed outlook for currencies in Latin America and EMEA, it is still too early to position against EM FX. Of the 25 EM currencies for which we provide forecasts, we expect all but five (the HKD, ARS, PEN, EUR/HUF, and ZAR) to outperform the forward one year out, helped by the fact that the central European currencies natural cross is the euro, not the dollar, as well as by reasonably high carry where the prospect for appreciation is limited (notably the BRL, RUB, TRY, and EGP).
EM rates
We highlighted earlier that EM monetary policy normalization will likely be only gradual and of much smaller amplitude. We also indicated that one of the signatures of the crisis was the ability to pursue aggressive countercyclical policies for the first time in history. In Emerging Markets Quarterly: Sharpen your pencil (8 December 2009), we elaborate on why these characteristics should result in lower term premia on EM local curves.
Alpha will be the main driver of performance for rate markets
EM rates trades in 2010 are likely to be idiosyncratic. First, since the global economic drivers are likely to be more tenuous, central bank-differentiated preferences (between inflation and employment) will likely play a crucial role. Second, the movement in global risk premium is likely to be smoother as well, implying that global market drivers will be less important than in 2009. Third, betas are also declining. This implies that even more than in other sub-asset classes, alpha will be the main driver of performance in the rates markets. Consistent with the prevalence of country-specific drivers, there are no clear universal investment themes in the sector. Our favourite receivers in the (monetary policy-driven) front end are Brazil, Russia, and India. We expect authorities to hike significantly less than the market has priced in. In Brazil, we favour Jan 11, and in India, we like receiving 6m OIS. In both countries, the markets are pricing too much tightening, in our view, although investors should be mindful of mark-to-market risk. In Russia, we express our bullishness through the short end of long bonds (currency unhedged); hence, it is both a currency and a rates call. We like long exposure in the long end of domestic bonds in Brazil (NTN-F 17), Mexico (Dec 24-Mbono), Poland, Korea, and Indonesia, currency unhedged in all cases. In those cases, expected returns are predicated on the combination of FX appreciation (at least relative to the forwards) and rates compression in different degrees. It is mostly a rates call in Brazil and a carry/FX call in Poland, Korea, and Indonesia, with Mexico somewhere in the middle.
Our favorite receivers in the front end are Brazil, Russia and India
We like payers as a 2010 theme in Mexico, Turkey and South Africa
On the short side, we like payers in the front end of Mexico (2y TIIE swaps), as Banxico will probably need to move earlier than its output gap would warrant (and the market is pricing in) to fight increased inflation expectations. We also like payers as a 2010 theme in Turkey and South Africa but think the right timing has not yet arrived. In Turkey, the extent of the negative carry and effect of a generally positive environment means timing is important, and we think February/March will be a more opportune time, with redemptions peaking and inflation rising. In South Africa, our projection that issuance will be above market expectations is behind our bearish rates view. Finally, a theme that could be relevant in 2010 is steepeners in the front end as central banks backload their tightening somewhat. We recommend 1y2y steepeners in Taiwan, Korea, and Malaysia.
and steepeners in the front end as central banks backload tightening
10 December 2009
79
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Barclays Capital Global Outlook 122009

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RESEARCH

Barclays Capital | Global Outlook

Larry Kantor Head of Research Barclays Capital

Barclays Capital | Global Outlook

SUMMARY OF ASSET ALLOCATION THEMES

Barclays Capital | Global Outlook

Barclays Capital | Global Outlook

Beyond the recovery trade

Barclays Capital | Global Outlook

Market drivers to become more multidimensional

Expect lower correlations among asset classes and geographies

The recovery trade's final act

Low for how long?

Barclays Capital | Global Outlook

US real GDP, y/y % chg (rhs)

Barclays Capital | Global Outlook

Equities and credit less vulnerable

Barclays Capital | Global Outlook

Barclays Capital | Global Outlook

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

Barclays Capital | Global Outlook

% change yy money market mutual fund assets

Fed Funds rate

Barclays Capital | Global Outlook

Sep-04 Mar-06 model

TIPS 10y real yield

Barclays Capital | Global Outlook

The policy outlook is fraught with uncertainty

Barclays Capital | Global Outlook

Barclays Capital | Global Outlook

Barclays Capital | Global Outlook

We are biased to staying long in equities

Barclays Capital | Global Outlook

Barclays Capital | Global Outlook

Barclays Capital | Global Outlook

Nick Verdi +44 (0)20 7773 2173 nick.verdi@barcap.com

Figure 1: Global recovery in manufacturing output

Barclays Capital | Global Outlook

2) the evolution of the fiscal and monetary exit strategies

Monetary policy is likely to continue to support activity in 2010

Figure 3: Global new orders and manufacturing production

Barclays Capital | Global Outlook

Idiosyncratic factors regain importance

We expect the improving trend in US employment to continue

Figure 5: Consumer confidence is returning

Figure 6: US employment as % of real GDP

1981 1990 2001

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

Barclays Capital | Global Outlook

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

Barclays Capital | Global Outlook

Tightening schedules: The balance of risk is driven by traditional biases

Canada (+25) China (+27) HK (+25) Chile (+25)

Euro area (EONIA, +25)

Source: OECD Annual Outlook 2009, Barclays Capital

Barclays Capital | Global Outlook

We expect the first fed funds hike to come in September

Figure 10: ECB reaction function signals gradual increases

Figure 11: Yet the BoJ has responded least

4 3 2 1 0 -1 -2 96 98 00 02 04 06 08 10 -6 -4 -2 0 2 4 6 8 10 Japan -0.4 2.5 Euro area -3.0 5.2 US -4.3 8.8

Source: Thomson Datastream, Barclays Capital