2014 global outlook - credit suisse
TRANSCRIPT
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CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION™
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2014 Global Outlook Global Fixed Income & Economics Research
Closer to the Top, Further from the Exit
From fat tails to long tail: growth is unexciting, markets are mostly buoyant,
and central banks are competing for new ideas to provide liquidity stimulus.
Policy rebalancing: we expect fiscal policy to be less of an impediment to
US growth in particular in 2014, thereby allowing the Fed to innovate away
from asset purchases. The urgency for monetary policy to fight deflation is
instead likely to center on Japan and the euro area.
Market opportunities: international policy divergences are small but
significant. Changes in expected central bank liquidity have a snowball effect
on asset prices. Finally, corporate capex is the swing variable for growth and
hence expected returns.
19 November 2013
Fixed Income & Economics Research
http://www.credit-suisse.com/researchandanalytics
Research Analysts
Eric Miller
Global Head
+1 212 538 6480
Credit Suisse
Fixed Income Strategy & Economic Teams
(see inside for contributor names)
19 November 2013
2014 Global Outlook 2
Table of Contents
Foreword 3
2014 Global Market Outlook and Themes 5
Global Economy Outlook .........................................................................................................7
Recovery and restructuring: Europe in 2014 ................................................................... 15
Youth unemployment and income inequality ................................................................... 23
Is Abenomics working? .................................................................................................... 27
Beyond the G3 ................................................................................................................. 33
China: reform agenda dominates 2014 ............................................................................ 39
Central Bank Outlook ............................................................................................................. 43
Reshaping the Financial System ............................................................................................ 51
Market Implications of Persistent Deleveraging ..................................................................... 59
Market risk premia: a systematic approach ..................................................................... 67
The Corporate Landscape ..................................................................................................... 71
Expected Returns and Risk Analysis ..................................................................................... 79
2014 Global Product Outlook 83
Commodities .......................................................................................................................... 87
Credit Strategy ....................................................................................................................... 91
European Credit Strategy ................................................................................................ 91
Global Leveraged Finance Strategy ................................................................................ 95
Emerging Markets ................................................................................................................ 101
Non-Japan Asia ............................................................................................................. 101
Latin America ................................................................................................................. 103
EEMEA .......................................................................................................................... 107
Equity Strategy ..................................................................................................................... 113
FX Strategy .......................................................................................................................... 119
Global Interest Rate Strategy ............................................................................................... 123
European Rates ............................................................................................................. 123
US Rates ....................................................................................................................... 130
Japan Rates................................................................................................................... 136
Securitized Products ............................................................................................................ 139
Agency MBS .................................................................................................................. 140
Non-Agency MBS .......................................................................................................... 143
CMBS ............................................................................................................................ 145
Technical Analysis ............................................................................................................... 149
Credit Suisse Forecasts 155
19 November 2013
2014 Global Outlook 3
Foreword The storm and thunder of the immediate post-crisis environment has gradually been
replaced by something calmer, quieter, and yet lacking in vitality outside the financial
markets. We are now in the long-tail rather than the fat-tail phase of the systemic crisis
that moved around the globe from 2007 into 2013.
The balm of central bank liquidity has offered material comfort first to bonds and now
equities, but the key to medium-term prosperity comes from sustained strength in
corporate investment, which so far has been only stilting. We see signs of progress in
financing availability away from traditional intermediation routes as well as plenty of
opportunity given the substantial shortfalls in many areas underlying the health of the
corporate sector. However, our 2014 macro backdrop is one whereby we still see this
transition as frustrating.
We expect a rebound in developed markets to be led by the US and Europe. With risks at
bay in the latter, we could begin to see policy address the region's "stock" problems,
including the lack of confidence in the banking sector and the high level of unemployment.
The absence of a new demand shock in the euro area should help support a stabilization
in emerging markets.
While we expect the cyclical outlook for EM growth to improve, structural weakness is
likely to persist (exerting a negative influence on commodities). Hence, the focus on the
impact of China's reform package will be on how quickly China might allow productivity to
rebound as well how it alters the orientation of growth.
Refocusing on the developed markets, we think about policy prospects at several levels:
Fiscal drag should ease in 2014, led by the US. This is the source of our expectation
for stronger growth.
Monetary policy will seek to deliver effective stimulus everywhere, but the urgency of
action is greatest in Japan, followed by the euro area. In the former, we expect new
quantitative measures. In the latter, any stronger threat of deflation could bring
negative rates. By contrast, in the US, we expect asset purchases to taper with
instead greater emphasis on keeping short-term rates depressed for a long time. By
historical standards, those divergences are small, but they drive what we expect to be
significant opportunities in FX, equities, and to some extent, rates.
Regulatory policy is an ongoing source of transformation in the structure of the
markets and the broader provision of credit to the real economy. This creates
changes in the characteristics of assets and the tail risks for portfolio managers;
these changes require attention in times when liquidity is plentiful, because the
heightened dependence on monetary policy expectations means that portfolio
adjustment after the fact will be expensive if it is indeed achievable.
In assessing risks to our outlook, we believe that there is more upside in the economy than
in expected portfolio returns. A stronger recovery in corporate investment could deliver
faster growth but would likely accelerate the tapering of asset purchases. By contrast,
weaker growth would likely hurt equity returns by more than it would boost performance in
fixed income.
As we move into the long tail of the crisis, our outlook is one in which we see still-active
engagement by policymakers. Where this is mirrored by active engagement from portfolio
managers, we expect the combination to deliver superior risk-adjusted returns in 2014.
We thank you for your business in 2013 and look forward to engaging with you in 2014.
Eric Miller
212 538 6480
Ric Deverell
+44 20 7883 2523
Sean Shepley
+44 20 7888 1333
Neal Soss
212 325 3335
19 November 2013
2014 Global Outlook 4
19
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2014 Global Market Outlook and Themes
2014 Core Views
Global Economy Outlook
The 2014 global economy looks to be the most orderly in many years, comprising a seemingly stable triangle of modest
growth, low inflation, and diminishing potential.
We expect global growth to accelerate to 3.7% in 2014 after 2.9% in 2013. More of the speed-up happens in developed market
economies, narrowing the growth gap with the EM universe.
Upside risks to our forecast are probably centered on capital investment; downside risks look to be centered on the spillover
financial stability effects of central bank policies, particularly the Fed’s taper.
Central Bank Outlook
Monetary policy in 2014 is likely to remain both highly stimulatory and highly innovative.
We expect Fed policy to evolve toward stronger forward guidance, lower asset purchases, and more gradualism. As in 2013,
other countries will have to adapt.
Innovation around the zero bound and cross-market spill-overs suggest more market opportunities than an outlook of near-zero
policy rates would normally imply.
Reshaping the Financial
System
The global financial system is being reshaped by regulation and weak credit demand.
The private sector is struggling to create liquidity and safe assets, and the public sector is attempting to offset this with policy
support.
Until a new system emerges that is capable of facilitating ample private credit and liquidity creation, interest rates will stay
lower than would otherwise be the case. Bouts of significant illiquidity and jerky price action may be frequent.
Market Implications of
Persistent Deleveraging
Reduced intermediation capital tends to create less liquid assets, raising required risk premiums and cross-asset correlation,
particularly in downdrafts.
"So far, so what?" is a fair reaction: central bank stimulus programs have disguised the impact of reduced market liquidity in a
way that is not likely to be threatened in our core scenario.
What does change, however, is the exposure to tail risk: stronger activity that causes inflation expectations to rise even
modestly would likely widen rather than tighten credit spreads, for instance. We introduce a market liquidity index to gauge the
most reliable hedges for periods of liquidity withdrawal.
The Corporate Landscape
We expect moderate continued returns from all corporate-issued assets, with a strong influence from the path of yields.
We expect reasonable 2014 EPS growth, albeit below consensus.
Cash M&A, buybacks, and other leveraging transactions should grow steadily but not yet to the point of being a general threat
to bondholders.
Expected Returns and Risk
Analysis
Our base case for 2014 is further double-digit returns in equities, with fixed income largely experiencing a repeat of the
subdued returns seen in 2013.
Our return expectations have an unfavorable skew: we do not expect returns to rise in the event of stronger-than-expected
activity but think that they will fall if activity weakens.
Our Black-Litterman-type model allocates to equities and risky fixed income assets in preference to governments and agencies
in our base-case scenario. It favors reversing this and adding real rate and EM sovereign exposure if growth turns down.
19 November 2013
2014 Global Outlook 6
19 November 2013
2014 Global Outlook 7
Global Economy Outlook A seemingly stable triangle 2014 Core Views
The 2014 global economy looks to be the most orderly in many years, comprising a
seemingly stable triangle of modest growth, low inflation, and diminishing potential.
We expect global growth to accelerate to 3.7% in 2014 after 2.9% in 2013. More of
the speed-up happens in developed market economies, narrowing the growth gap
with the EM universe.
Upside risks to our forecast are probably centered on capital investment; downside
risks look to be centered on the spillover financial stability effects of central bank
policies, particularly the Fed’s taper.
The 2014 global economy looks to be the most orderly in many years. We see a
seemingly stable triangle, reflective more of the long tail of past crises than the fat tails of
the crises themselves.
One side of the triangle is persistent but lackluster growth. The euro area has left its
double-dip recession behind, but we expect its recovery to be qualitatively similar to
America’s – persistent but not robust enough to quickly bring back into productive use a
massive overhang of unemployed resources. We expect the US to have a fifth year of
business improvement that is qualitatively the same, although a tad faster, than the last
four. The broad emerging markets universe looks to be stabilizing on a slightly better
growth path than recent disappointing performance.
One effect of the lackluster growth is that output gaps remain stubbornly large. Otherwise-
productive resources remain underutilized, in some cases like periphery Europe’s youth to
a startling degree. That gives rise to the second side of the triangle in the form of
relatively low or below-desired inflation in much of the global economy. This is
visible from wages to commodities to consumer goods. We consider it more likely that the
current low inflation regime will drift up, rather than resolve into broad deflation.
Nonetheless, we would emphasize that inflation will drift up, not gallop. The good news is
that low inflation enhances the credibility of monetary policy forward guidance about
“low(er) for long(er) short term interest rates.” The bad news is that low inflation makes it
harder to get real interest rates low enough, or negative enough, to entice business
investment and the other traditional components of a boom.
Despite the statistical and conceptual difficulties, the logic of the situation is that output
gaps can close either because realized GDP picks up to match the old potential or else
because potential subsides to match the sluggish realized outcomes. The third side of
the current triangle is that potential GDP growth rates seem to be falling.
Exhibit 1: Output gap (advanced economies) Exhibit 2: Global CPI inflation (developed markets)
Percentage of potential GDP with 2014 IMF forecast yoy %
-5
-4
-3
-2
-1
0
1
2
1995 1998 2001 2004 2007 2010 2013
-1
0
1
2
3
4
5
03 04 05 06 07 08 09 10 11 12 13 14
DM
Fcst.
Source: Credit Suisse, IMF Source: Credit Suisse, Thomson Reuters DataStream, Haver Analytics®
Neal Soss
+1 212 325 3335
Henry Mo
+1 212 538 0327
Axel Lang
+44 20 7883 3738
We see a stable
triangle of modest
growth, low
inflation, and
diminishing
potential
19 November 2013
2014 Global Outlook 8
Simple growth accounting attributes potential GDP to the size of the labor force, its
productivity, and the private and public capital assets labor has available to use. The
demographics of a world with falling fertility and rising old age dependency pose a challenge
to potential GDP. Moreover, productivity is hard to predict, and capital investment has
been tepid or misdirected in many countries. Exhibits 3 and 4 show that developed market
(DM) and emerging market (EM) trend growth rates, proxied by their ten-year moving
average growth, have been declining recently.
The prospect that the triangle of sluggish growth, low inflation, and subsiding
potential would become a lasting sub-optimal equilibrium helps explain the
commitment of central banks to easy monetary policies even if the tools they use to
deliver easy monetary policies change from time to time.
Exhibit 3: A declining trend, DM growth Exhibit 4: A slowing trend, EM growth
yoy %, ten-year moving average yoy %, ten-year moving average
1.0
1.2
1.4
1.6
1.8
2.0
2.2
2.4
2.6
2.8
3.0
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Fcst.
4.0
4.5
5.0
5.5
6.0
6.5
7.0
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Fcst.
Source: Credit Suisse, Thomson Reuters DataStream, Haver Analytics® Source: Credit Suisse, Thomson Reuters DataStream, Haver Analytics®
Global growth is on track to finish 2013 at 2.9%, a touch lower than in 2012 (3.1%,
Exhibit 5). With less than a quarter left for the year 2013, the global economy appears set
to again expand at below what we estimate as its trend growth of 3.5% this year (Exhibit 6).
Exhibit 5: Global growth forecast revisions
yoy %
2012
2013 Growth Forecast 2014 Growth Forecast
2015 Nov13 Sep13 Change Nov13 Sep13 Change
Global 3.1 2.9 3.0 -0.1 3.7 3.8 -0.2 3.9
Developed markets 1.5 1.1 1.1 0.0 2.1 2.1 0.0 2.2
US 2.8 1.7 1.6 0.1 2.6 2.5 0.0 2.8
Euro area -0.6 -0.4 -0.2 -0.1 1.3 1.3 0.0 1.7
Japan 2.0 1.8 2.0 -0.2 2.2 2.3 -0.1 1.2
UK 0.2 1.4 1.3 0.1 2.8 2.5 0.3 2.5
Emerging markets 4.9 4.7 4.8 -0.1 5.3 5.4 -0.2 5.7
Brazil 0.9 2.4 2.4 0.0 3.0 3.0 0.0 3.0
Russia 3.4 1.3 1.6 -0.3 2.3 2.8 -0.5 2.5
India 5.0 5.4 5.4 0.0 6.6 6.6 0.0 6.9
China 7.7 7.6 7.6 0.0 7.7 7.7 0.0 8.2
Source: Credit Suisse, Haver Analytics®, Thomson Reuters DataStream
This triangle helps
explain the
commitment of
central banks to
easy monetary
policies
19 November 2013
2014 Global Outlook 9
The global outlook for 2014 is somewhat cheerier. We expect the global economy to
achieve above-trend growth next year (3.7%), supported by a rebound in developed
markets. Specifically, developed markets should almost double aggregate growth to 2.1%
in 2014 from the estimated 1.1% this year, while emerging market growth quickens
modestly to about 5.3% from 4.7% in 2013. As a result, the spread between EM and DM
growth rates is expected to narrow to 3.2 pp in 2014, the smallest since 2002 (Exhibit 7).
Excluding Chinese growth, the spread between EM and DM growth follows a similar
pattern, suggesting that the slowdown in EM is broad-based and is not just a China story.
As to the 2015 growth outlook, our first cut is for an acceleration to 3.9% real GDP growth.
Exhibit 6: Global growth outlook Exhibit 7: Growth gap between EM and DM
yoy % ppt
2.63.6
4.8 4.5 5.0 5.2
2.4
-0.8
5.2
3.93.1 2.9
3.7 3.9
1.42.0
3.12.6 2.8
2.4
-0.1
-3.7
2.6
1.5 1.51.1
2.1 2.2
4.5
6.1
7.5 7.3
8.38.8
5.5
2.7
8.2
6.4
4.9 4.75.3
5.7
-6
-4
-2
0
2
4
6
8
10
02 03 04 05 06 07 08 09 10 11 12 13E14E15E
Global
Developed markets
Emerging markets
0
1
2
3
4
5
6
7
00 01 02 03 04 05 06 07 08 09 10 11 12 13E14E15E
EM - DM
EM ex. China - DM
Source: Credit Suisse, Thomson Reuters DataStream, Haver Analytics® Source: Credit Suisse, Thomson Reuters DataStream, Haver Analytics®
The expected rebound in DM growth is largely led by the US and the euro area. The
US has endured a fiscal drag for the last three years, capped by 2013’s tax increases and
spending sequestration. Barring more fiscal adjustment, which we are not forecasting, the
sequential fiscal drag lightens over the next 1.5 years, leading to the consensus
expectation of real growth accelerating toward 3%. If achieved, that would be the fastest
US growth since 2005.
In the euro area, both hard and soft data released over recent months have further
confirmed our view that the economy is recovering, but only gradually. The negative fiscal
and financial forces that have dragged the economy down are abating, while the large
macro/external imbalances experienced by peripheral countries have been corrected to a
large extent. We look for the euro zone to grow by 1.3% in 2014. In the UK, the growth
prospects are particularly promising, notably supported by buoyant business confidence,
which should pave the way for increased corporate spending. We expect the economy to
grow by a solid 2.8% next year (see Recovery and restructuring: Europe in 2014).
We also expect slightly faster growth in Japan next year (2.2%). Specifically, additional
monetary easing and a few demand stimulus measures from the so-called "third arrow" of
Abenomics, such as privately financed infrastructure investment, should offset the
dampening effect from fiscal tightening (see Is Abenomics working?).
The stabilization in DM demand has helped stop the slump in EM exports and hence
supports growth (Exhibit 8). Moreover, the notable pick-up in DM PMIs since April is
spilling over to the emerging markets now, with EM’s aggregate manufacturing PMI
improving in recent months after its continuous decline in the first seven months of this
year (Exhibit 9).
We expect above-
trend growth next
year, supported by a
rebound in
developed markets
The rebound in DM
should be led by the
US and the euro area
In Japan, additional
easing should offset
the dampening effect
of fiscal tightening
19 November 2013
2014 Global Outlook 10
Exhibit 8: G3 real domestic demand Exhibit 9: G3 demand vs. EM exports
4Q 2007=100 yoy %
94
95
96
97
98
99
100
101
102
103
104
4Q07 3Q08 2Q09 1Q10 4Q10 3Q11 2Q12 1Q13
US
Euro area
Japan
-15
-10
-5
0
5
10
15
20
-5
-4
-3
-2
-1
0
1
2
3
4
5
'00 '02 '04 '06 '08 '10 '12 '14
G3 domestic demand
EM ex. China realexports, rhs
Fcst.
Source: Credit Suisse, Thomson Reuters DataStream, Haver Analytics® Source: Credit Suisse, Thomson Reuters DataStream, Haver Analytics®
With improvement in G3 final demand and stabilization in China, we expect
emerging market growth to improve to about 5.3% in 2014 from 4.7% in 2013. China's
growth has stabilized. We maintain our view that steady growth can be sustained
between 7.5% and 8.0%, as (1) infrastructure projects, mainly city infrastructure
investments, are restarted; (2) housing transactions and construction pick up
significantly; and (3) exports show positive growth again. Furthermore, even industrial
investment by SOEs seems to be accelerating again.
However, international trade has decelerated considerably relative to global GDP
growth in recent years, which cautions us on the spillover effect to EM exports from
DM demand.
Some of the changes may be related to the fact that the recovery in DM demand has
so far been concentrated in domestic-intensive and interest-sensitive consumer
activities, which would likely have less beneficial spillover to emerging market
export economies.
US imports have been flat relative to the recovery in autos and housing. Some of the
shortfall is due to several years of softness in business investment in equipment, which is
very import-intensive. Other import-intensive items, such as consumer non-durables
(excluding food and energy), have been lackluster and have also contributed to weak
import growth. Capital goods ex. autos and consumer non-durables ex. food and autos
together account for almost half of total non-petroleum imports in the US.
We judge our baseline scenario forecast to encompass about two-thirds of the
probability distribution of possible futures. The remaining third seems to us to be split
roughly equally over pleasant upside surprises and unwelcome downside risks.
What could go right?
Business fixed investment has been relatively anemic in the developed market economies
of the US, UK, euro area, and Japan for several years (Exhibits 10-13). This is not
completely unexpected in the context of the Great Recession, the Not-So-Great Recovery,
double-dip recessions, and persistent low nominal economic outcomes. Many industries in
most of these countries sport lower capacity utilization rates now than long-term averages
from the years preceding the financial crisis.
Emerging market
growth should
improve; we believe
that China's steady
growth can be
sustained
19 November 2013
2014 Global Outlook 11
Exhibit 10: US net business investment Exhibit 11: Euro area net private investment
% GDP, US recession period shaded % GDP
0
1
2
3
4
5
6
'61 '66 '71 '76 '81 '86 '91 '96 '01 '06 '11
1
2
3
4
5
6
7
1995 1999 2003 2007 2011 2015
Avg.:1995-2007
Forecast
Source: Credit Suisse, Thomson Reuters DataStream, Haver Analytics® Source: Credit Suisse, Thomson Reuters DataStream, Haver Analytics®
Exhibit 12: Japan net business investment Exhibit 13: Euro area new motor vehicle registrations
% GDP SA/WDA, thousands
-4
-2
0
2
4
6
8
10
80' 83' 86' 89' 92' 95' 98' 01' 04' 07' 10' 13'
600
700
800
900
1000
1100
1200
90 92 94 96 98 00 02 04 06 08 10 12 14
Source: Credit Suisse, Thomson Reuters DataStream, Haver Analytics®; Note: Depreciation data from 2011 are estimated by Credit Suisse.
Source: Credit Suisse, ECB, Haver Analytics®
Nonetheless, depreciation and obsolescence proceed inexorably, and many productivity-
enhancing opportunities can only be realized when embedded in new software and/or
hardware. Monetary policies have contributed to – some would say engineered – relatively
accommodative financing conditions in the form of low interest rates and bullish stock
markets. Above-forecast business capex would be a most welcome upside surprise.
If this came to pass, the emerging market economies (taken as a group) would likely also
benefit given prevailing patterns of international trade.
Relatively subdued private fixed investment and, in many developed market jurisdictions,
public infrastructure investment, combined with the puzzle of poor labor force participation
and the predictable fact of aging populations, come together to put a lid on potential GDP
growth (see Youth unemployment and income inequality). Of those three contributing
factors, an investment surge is the most readily forecastable way to reboot medium-term
productivity and potential GDP advances, with all the benefits that would bring. The
prospects for an investment surge remain in the happy upside possibilities column, not yet
in our baseline forecast expectation.
Above-forecast
business capex
would be a most
welcome upside
surprise
An investment surge
could reboot medium-
term productivity and
potential GDP
advances
19 November 2013
2014 Global Outlook 12
We note that the issue of lessened potential GDP growth is not restricted to
developed market economies (see Beyond the G3). Population aging, for example, is
already well underway in China, and old-age dependency ratios will soon soar. Changes in
the one-child policy, which may be forthcoming, will still take a generation’s time to alter
the demographic drag on economic growth. (We note in passing that Africa is the only
major piece of global geography that is young and expected to stay young by world
standards for many decades to come. This is a major plus for potential GDP growth, but
there is not yet quite the range of financial market outlets in Africa that can be found
elsewhere.) Moreover, it is widely asserted that China’s political economy model has led
to severe misallocation of what has otherwise been a prodigious fixed investment program.
Forthcoming reforms, subjecting more capital expenditure decisions to private cost-benefit
calculations, could make investment more efficient for the medium term (see China: reform
agenda dominates 2014).
Mexico is another case where public policy reforms can make a big difference in the
efficiency of capital investment. Here, the issue is most visible in the energy sector. The
newly installed government has put forward proposals to permit broader private-sector
participation in the energy industry, which presumably would increase the volume and
efficiency of capital expenditures.
The same issue of what might loosely be called pent-up demand may also affect
aspects of consumer behavior. While auto sales are already up solidly from recession
lows in the US, UK, and Japan – and so might not be expected to tack on another equally
big increment – the same cannot be said of the euro area. There, car registrations are
hovering just above the lowest levels seen in 25 years. Replacement demand alone could
deliver stronger-than-expected consumer outlays in the auto sector. To different degrees
in different locations, residential investment also has an accumulated deficit compared to
population dynamics. However, as we discuss in the previous section, above-forecast
growth in domestic-intensive and interest-sensitive consumer activities in developed
market economies would likely have less beneficial spillover to emerging market export
economies.
Fiscal adjustment is another source of upside potential. In Europe, we expect
continued episodic progress on the public finances of the member states and the
integration of banking systems. It is hard to imagine anything more, but even this implies a
diminution of fiscal drag on the 2014 economy. In the US, by contrast, the fiscal
retrenchment of the state and local government sectors may be reversed for the next year
or two. Clearly, individual problems such as Detroit remain and could even intensify, but
the sector taken as a whole seems to be enjoying a stronger revenue profile, reflecting the
general business upswing now entering its fifth year. One consequence of a stronger-than-
forecast state and local sector would be faster job growth – one out of seven payroll
employees in the US works for state or local government.
What could go wrong?
The record of the years since 2007 reads a bit like validation of Murphy’s Law – what can
go wrong will go wrong – with the macroeconomic corollary that Herculean fiscal and
monetary policy efforts are required to cushion the damage.
Political dysfunction in some major national capitals has, sadly, been a prominent
source of downside risk to financial stability, and hence to economic performance,
in recent years. We would be remiss in not citing it as a risk factor for 2014, particularly
with budget and debt ceiling deadlines still looming in the US and Europe’s effort to create
consolidated bank supervision and resolution regimes still aborning.
Nonetheless, we do not give these risks particularly large weight. In the US context, the
consensus of current political commentator opinion is that neither Democrats nor
Republicans have incentive or appetite for another cliffhanger shutdown cum possible debt
default episode. We note further that financial markets during the autumn 2013 episode were
Reforms in China
and Mexico could
also provide
upside...
...as well as fiscal
adjustment
Political dysfunction
is a risk, but we do
not give it particularly
large weight
19 November 2013
2014 Global Outlook 13
characterized more by low transaction volume disengagement than dramatic price
fluctuations. (This observation is just about equally accurate for major foreign financial
markets, foreign exchange rates, and commodities prices as it is for US markets
themselves.) More generally, there is very little direct evidence in hard data that confidence
effects actually altered the trajectory of business job count or capex decisions or consumer
durable goods purchases during the repeated fiscal cliff and other high-drama episodes of
recent years. Watching the political class in action seems more a spectator activity (some
might consider it bad theater at that) than an influence on business cycle rhythms in the US.
The same phenomenon seems to be developing in the euro zone. Ever since ECB chief
Draghi’s decisive verbal intervention in summer 2012, shocks that might earlier have
unnerved markets and derailed economies seem now to come and go with nary a ripple.
The crisis of confidence in our political institutions seems hardly to have abated,
but our collective willingness to get on with business seems to have revived. To
phrase this somewhat casually in the American context: “Suppose they had a government
shutdown and hardly anyone seemed to care.”
The risk that we are more attentive to at the moment is the learning curve
associated with new central bank procedures. “Forward guidance” is becoming the
preferred tool of monetary policy at many leading central banks. While the tool is not
completely new (central banks have attempted to communicate with financial market
participants and the general public from time to time in the past), the elevation of this
practice to “pride of place” in the monetary policy toolkit has gone beyond a mere
difference of degree.
Central bankers are encountering some of the difficulties inherent in the complex of human
interactions involving transparency, communication, and forward guidance. They would do
well to reread Nobel Prize-Winner Daniel Kahneman’s insights into the predictable
discrepancies between what the lips say and the ears hear. (Paul Simon didn’t get a Nobel
Prize, but he did sell a lot of records with the lyric “a man hears what he wants to hear and
disregards the rest.”)
The most notorious illustration (so far) of the difficulties of forward guidance, of course,
relates to the Federal Reserve’s taper-talk versus the Federal Reserve’s taper-inaction.
Bank of England Governor Carney’s experience with thresholds and knock-outs, and the
markets’ reactions thereto, is only a less extreme illustration.
The process of central banks learning how to talk to us and our learning how to
listen to them is fraught with risks to financial stability (see Central Bank Outlook).
To take just one example: we do not doubt the sincerity of the FOMC’s members when
they proclaim a 6.5% unemployment rate in the US as a threshold for considering interest
rate adjustment and not an automatic trigger for such action. Yet behavioral finance
literature on anchoring and framing strongly suggests that the subtlety of the distinction
between thresholds and triggers will be lost on many market participants. There is also
ambiguity about the BoJ’s inflation-targeting policy and the forward guidance, according to
our Japan economist. Will the BoJ keep buying JGBs until sustained +2% inflation is
achieved, or will it stop or at least reduce the purchase once the CPI hits +2%?
Confusion about the central bank’s intentions – and thus the likely evolution of the rate of
interest on cash – is particularly debilitating because of the foundational role of the cash
rate in modern finance theory. Think of the Capital Asset Pricing Model or its not-too-
distant cousin the Sharpe Ratio as prime illustrations.
At the moment, financial markets in the US, UK, and Japan (in descending order of
intensity) seem uncertain about what the central bank is telling them and how much
to believe it.
Market participants
and monetary
authorities need to
learn to talk to one
another
19 November 2013
2014 Global Outlook 14
One predictable effect is disengagement. In the presence of “model uncertainty,” less
trading, smaller positioning, and more “closet indexing” are expected outcomes. There is
monetary policy literature on the merit of smaller central bank actions in a less certain
environment. One possible innovation to watch for in a Yellen-led Fed is more
frequent small adjustments in the stance of policy in contrast to the relatively
infrequent, discrete, bold, policy moves that characterized Bernanke’s second term.
The reason this might matter for real economic performance is that the thinness of
markets afflicted by disengagement implies infrequent, but larger and more discrete,
moves in financial variables than would occur in more normal market circumstances (see
Reshaping the Financial System and Market Implications of Persistent Deleveraging).
The issue of whether “tapering” is equivalent to “tightening” rests analytically on whether
the “flow” of central bank purchases or the “stock” of central bank holdings dominates the
pricing of the bond market. Last summer, it appeared that the “flow” dominated as Fed
taper-talk coincided with (provoked?) a significant fall in bond prices and rise in yields.
One episode, however, does not prove a rule, and it may well be that the eventual
undertaking of Fed tapering, which we expect in 2014, will be met with more equanimity
among market participants.
Reinstating the “stock effect” probably rests on severing the link between slowing or
ending the central banks’ balance sheet expansion, on the one hand, and market
perceptions of the timing and scale of policy interest rate hikes, on the other. That, in turn,
rests on the success of central bankers in communicating forward guidance about the
evolution of fed funds and the other policy rates.
On that score, the low (and below-target) inflation rates in the US, euro zone, and
Japan may, perhaps counter-intuitively, actually be an upside risk for economic
growth. Surely, one of the downside risks to be feared is that the Fed will sanction, or
financial markets impose, a growth-crunching rise of interest rates. But, we believe to the
degree that low inflation enhances the Fed’s credibility in asserting that fed funds will
remain “low for longer” yield curve arbitrage will avert that risk. We continue to believe that
none of the major central banks would actively resist more economic growth if it were
fortunate enough to achieve it. The communications challenge is getting financial markets
to believe it too.
While our base case is that market participants and monetary authorities will learn
to talk to one another without further episodes like mid-2013, the risk scenario is
that further learning will entail further pain.
We may see the
undertaking of Fed
tapering met with
more equanimity
among market
participants
Central banks will
be faced with the
challenge of
communicating with
financial market
participants
19 November 2013
2014 Global Outlook 15
Recovery and restructuring: Europe in 2014 2014 Core Views
The euro area should continue to recover as it emerges from the recessions and
crises of recent years. We look for 1.3% growth in 2014 and 1.7% in 2015.
That stability is largely because many of the euro area’s flow problems – notably
large external deficits in the periphery – have been addressed.
The challenge for policymakers in 2014 is to use this economic and financial stability
to better address the euro area’s stock problems ‒ for example, the continued lack of
confidence in the health of the financial sector and high levels of unemployment that
risks both deflation and political instability.
The euro area crisis – as characterized by persistent and acute financial volatility and
recession – looks to have passed. But that doesn’t mean that the euro area’s problems are
over. There are still considerable financial, economic, and political challenges ahead.
Although policymakers won’t have to deal with those challenges against a backdrop of
crisis, how they are dealt with will determine whether the euro area’s nascent, weak, and
fragile recovery can become more robust.
In thinking about these challenges and how they may be addressed in 2014, we think it is
important to distinguish between
Stock problems (large quantities of private and public debt whose sustainability
markets continue to question) and
Flow problems (both the need and ability of institutions, sectors, and economies to
borrow and incomes of those sectors and economies to grow).
In effect, it’s the difference between solvency – perceived or actual – and liquidity.
Much discussion about the euro area fails to distinguish properly between issues related to
stocks and issues related to flows. During the crisis, when both stocks and flows were
problematic, this wasn’t necessarily an issue. But now it is.
In general, we think
flows are no longer a problem. Large current account deficits in the periphery have
been eliminated, and GDP has started to grow. Indeed, we think the positive change in
the flows is a key reason that the crisis is behind us. That said,
the euro area still has a stock problem. Many euro area economies have high levels of
private, public, or total debt, and markets remain skeptical about its sustainability.
Next year should see further improvements in the flow situation. That should contribute
further to financial and economic stability, but by itself, it is unlikely to make a difference to
the stock problem. That still requires policy action, especially as it can remain a headwind
to growth. A less febrile financial and economic environment should make a favorable
backdrop for those issues to be addressed. But at the same time, it also reduces its
urgency. The policy response may come in the form of the ECB’s Asset Quality Review
and associated bank stress tests.
This year saw a decisive change in the flows in the euro area. There have been two
related shifts:
Peripheral economies have moved from large and sustained current account deficits to
rising current account surpluses; and
Euro area GDP has stopped shrinking and, very modestly, started growing.
Neville Hill
+44 20 7888 1334
The crisis has
passed, but
challenges remain
There’s a difference
between problems
associated with
stocks and flows;
the latter have been
addressed, but the
former have not
The flow situation
should improve
further; the stock
problem needs
policy action
19 November 2013
2014 Global Outlook 16
Both of these developments have been material. In our view, the former is the more
critical. Exhibit 14 shows how dramatically the external balances of the periphery have
turned around. In late 2011, the periphery collectively had a current account deficit of
around 4% of GDP. By the summer of this year, it was a surplus close to 2% of GDP.
That development has been key to restoring financial stability, in our view. The shift to
current account surplus removed these economies’ need for external finance. In effect,
these economies are now liquid: private-sector savings are sufficiently large to finance
public-sector deficits.
The market response to the materialization of many political risks in 2013 – Italy in March
and September; Cyprus in March, and Portugal in July – was notable by its orderliness
and lack of correlation and contagion: country sovereign risk was efficiently repriced. We
attribute that financial resilience to the current account surpluses. As long as they are
sustained, then the crisis should be kept at bay.
There’s good reason to think that will remain the case. The elimination of the periphery’s
current account deficit has largely been due to a collapse in domestic demand and
imports. But there has also been a steady expansion in exports, in turn due to rapid
improvements in relative cost competitiveness as high unemployment bears down on
wage growth. That’s an ongoing process, meaning that relative export performance should
continue to improve in the absence of a marked appreciation of the euro. It should also be
supported by the impact of structural reforms introduced during the crisis. So even in an
environment in which domestic demand and imports stop falling, the periphery’s trade and
current account surpluses – and associated financial stability – should continue to rise.
Exhibit 14: The periphery in financial surplus Exhibit 15: Regaining competitiveness
Euro area periphery 5 (Italy, Spain, Portugal, Ireland, Greece) current account balance as % GDP; seasonally adjusted
Changes in real effective exchange rates (deflated by unit labor costs) relative to the rest of the world
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
2005 2006 2007 2008 2009 2010 2011 2012 2013
-25
-20
-15
-10
-5
0
5
10
15
20
25
30
IRE SPA GRE POR NETH ITA FRA GER
1999-2008
2008-Q1 2013
Source: Credit Suisse Source: Credit Suisse
The restoration of financial stability was a necessary condition for a shift in cyclical flows
from recession to recovery. That also got under way this year. So far, the upswing has
hardly been vigorous. As Exhibit 16 shows, it looks as if euro area GDP has been rising
since the spring, but cyclical indicators are only at levels consistent with annualized growth
of below 1%. In effect, the recovery this year has largely been driven by headwinds
against growth abating, in particular tight financial and fiscal conditions. Those headwinds
should ease further next year. Fiscal tightening is minimal (Exhibit 17), and financial
conditions have eased through the course of this year. So the tentative upswing in growth
should steadily gather momentum.
The periphery’s
move into external
surplus has been a
key development ...
… that has improved
the financial resilience
of the euro area
And that trend
should continue
The euro area
economy has
moved from
recession to
recovery
19 November 2013
2014 Global Outlook 17
Exhibit 16: An insipid recovery Exhibit 17: Fiscal headwinds continue to abate
Euro real GDP growth and the composite PMI Change in the euro area government structural balance, pp GDP
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
25
30
35
40
45
50
55
60
1999 2001 2003 2005 2007 2009 2011 2013
Euro area composite PMI, lhs
Euro area GDP, q/q, rhs
-2
-1
0
1
2
1999 2001 2003 2005 2007 2009 2011 2013 Source: Credit Suisse Source: Credit Suisse
From a flows perspective, the euro area periphery is slowly moving from a vicious cycle of
poor competitiveness, unsustainable current account deficits, financial volatility, and
recession to a virtuous cycle of improving competitiveness, external surplus, financial
stability, and recovery. Assets geared to those factors should continue to perform well.
Perhaps the most serious constraint on the capacity of the euro area to capitalize on that
virtuous circle are the legacies of both the misallocations of capital in the euro area that
preceded 2008 and the past six years of financial crisis and recession. Those legacies are
financial (impaired assets), economic (output and employment well below their prior peak),
and political (increasing support for more “radical” parties). The improved backdrop
described above should make for a more benign environment for policymakers to address
these legacy issues. But it also reduces their urgency.
On the financial side, the stock problem is most apparent in the lack of confidence in the
banking sector. Markets remain unwilling to finance banks at rates close to the ECB’s low
policy rate – especially in the periphery – and those high financing costs are being
transmitted through to the real economy. Rising non-performing loan ratios – a result of
both poor lending ahead of the crisis and the deep recessions in recent years – have
undermined confidence in the quality of assets on many banks’ balance sheets.
That means the forthcoming Asset Quality Review of the banking sector, conducted by the
ECB ahead of it taking over supervisory responsibility, could be key. It will take the best
part of a year and is likely to be thorough in its scope, examining 130 banks comprising
85% of euro area bank assets. And it will look at all asset classes. If it is conducted
effectively, it could prove to be a cathartic event (see European Economics: Banking
Union – the year ahead, Parts I and II.)
But the cost of identifying, dealing with, and provisioning against some of the more
problematic assets could mean losses for some investors and institutions. The principle of
“bail-in” of bank creditors to absorb bank losses – established in the Cypriot bailout this
year – may well be applied.
Although some of the most pressing problems in the banking system in Europe were found
in the periphery, its banking sectors (with the exception of Italy's) have been examined by
the "Troika" and had capital injected during their rescue programs. So these banking
sectors have already had the quality of their assets assessed and provisions raised
against expected losses. As Exhibit 18 shows, those banking sectors with relatively high
non-performing loan ratios also tend to be those that have a higher share of capital and
reserves on their balance sheet.
“Stock” problems
pose risks and a
headwind to
recovery
Low confidence in
banks’ balance
sheets makes for
tight financial
conditions
The ECB’s Asset
Quality Review
could change that
But that will mean
losses for some
We are nearer the end
than the start of
dealing with bank
problems in the
periphery
19 November 2013
2014 Global Outlook 18
That means there may be scope for investors to be surprised in other banking sectors.
Although the Italian banking sector is not particularly large and did not extend excessive
credit in the years prior to the crisis, a decline in real GDP of 9% from its peak is likely to
have impaired some domestic assets. The French and Dutch banking sectors are also
fairly large relative to GDP. The former has relatively high foreign and derivatives
exposure, while the latter has particularly high exposure to a domestic economy
experiencing a significant fall in house prices.
The prospect of a thorough balance sheet examination and a falling cost of capital (in the
form of rising equity markets) seems to be facilitating a pre-emptive increase in bank
capital (Exhibit 19). That may allow for a much-needed consolidation of the banking
system if the weaker banks are absorbed by stronger institutions that can issue capital on
more favorable terms.
So it may be that the incentives set by the prospect of the AQR are sufficient to bring
about a more credible and better capitalized banking system, capable of better supporting
growth. That would pose a significant upside risk to euro area growth through the course
of next year.
Exhibit 18: Banking sectors with deteriorating asset quality tend to have higher provisions
Exhibit 19: The euro area banking sector has been raising capital and deleveraging
Data from ECB consolidated banking statistics, 2012. Consequently NPL data may not be consistent
Euro area banking sector capital and reserves as % liabilities
0
2
4
6
8
10
12
4 5 6 7 8 9 10 11 12
Gro
ss n
on
per
form
ing
loan
s/d
ebt
%
Capital and reserves % assets
GER
NET
BEL
ITA
SPAPOR
FRA
5.0
5.5
6.0
6.5
7.0
7.5
1999 2001 2003 2005 2007 2009 2011 2013
Source: Credit Suisse Source: Credit Suisse
Of course, the downside risks are also considerable. Ineffective, inconsistent, and patchy
implementation of the AQR and bank resolutions would undermine confidence in the policy
framework and risk a resumption of destructive cross-border capital and deposit flows that
were a feature of the recent crisis. Given euro area policymakers’ track record of effective
policy implementation, this risk cannot be ignored. The fact that the ECB is driving this
process is encouraging. But its credibility will depend on there being sufficiently robust
backstops, and that requires the will and wherewithal of national governments.
The need for governments to provide an effective backstop for banks requiring capital
draws attention to another stock problem: high levels of government debt. But we think this
is a problem that has been sufficiently addressed.
For a start, the expected continued decline in government deficits should limit the extent to
which debt ratios rise further. Low rates and policies (such as the ESM and OMT) that
have mutualized much sovereign risk should mean governments should have few
problems servicing that debt next year (Exhibit 21). Indeed, it is likely that the ESM will
Some “core”
banking sectors
could pose
problems
The AQR could be a
stimulus for
recapitalization and
restructuring of the
banking sector
European
policymakers have
been poor at
implementation
High levels of
government debt are
less of a concern to us
19 November 2013
2014 Global Outlook 19
extend further financial support to Portugal, Greece, and (possibly) Ireland next year, and
we do not expect private-sector creditors of those governments to be haircut. Furthermore,
the ESM is likely to serve as the “backstop” for sovereigns in financing a backstop for their
bank resolution funds.
Exhibit 20: Deficits on a downward path Exhibit 21: Government debt service relatively low
Interest payments as % GDP, 2014
Govt debt
% GDP 2010 2011 2012 2013E 2014E 2014E
Euro area -6.2 -4.1 -3.7 -2.9 -2.5 96
Germany -4.1 -0.8 0.2 0.0 0.0 79
France -7.1 -5.3 -4.9 -4.0 -3.5 96
Italy -4.3 -3.7 -2.9 -3.2 -2.7 132
Spain -9.7 -9.4 -10.6 -6.5 -5.7 97
Netherlands -5.0 -4.4 -4.1 -3.2 -3.3 76
Belgium -3.9 -3.9 -3.9 -2.9 -2.7 102
Austria -4.5 -2.4 -2.5 -2.3 -1.5 74
Greece -10.8 -9.6 -10.0 -4.0 -3.3 175
Finland -2.8 -1.1 -2.3 -1.5 -1.2 58
Portugal -9.9 -4.4 -6.4 -5.5 -4.3 124
Ireland -30.9 -13.3 -7.5 -7.5 -4.5 120
Cyprus -5.3 -6.3 -6.3 -6.5 -8.5 124
General government balances
0
1
2
3
4
5
ITA IRE GRE POR SPA BEL EA FRA GER NETH
Source: Credit Suisse Source: Credit Suisse
The resilience of sovereign debt – thanks to policies such as the ESM and OMT, as well
as the move into external surplus in the periphery – creates a more favorable environment
for dealing with the stock problem in the banking sector.
However, one “stock” problem that presented a challenge to financial stability this year and
could pose a growing threat is the high level of unemployment in many countries,
especially among young people. We discuss this on pages 23-26.
That poses two risks.
A risk to political stability, as evidenced in the elections in Greece in 2012 and Italy and
2013, as well as the political turbulence in Portugal over the summer.
A risk of deflation as high unemployment bears down on wage growth and prices, as is
currently evidenced by low rates of headline and core inflation.
Support for more radical, “non-mainstream” political parties has been rising. Despite the
extraordinary levels of youth unemployment and tough austerity policies pursued in the
periphery, those risks have not yet manifested themselves in acute instability, but the
longer those conditions persist, the greater the risk.
Episodes of severe economic dislocation in the past have often been associated with
upheavals in the political landscape. The 1930s is a stark example. Less dramatic, but in
the same vein, is the 1970s stagflation that eventuated in Reagan, Thatcher, and
Gorbachev. The current episode has so far been more noteworthy for how little political
upheaval it has brought.
Europe’s national electoral calendar is fairly empty next year, so the chances of this risk
materializing in 2014 look limited. The next major member state to hold an election will be
Spain in late 2015. The unemployment stock problem will need to be addressed – through
stronger growth – by that point, in our view. As it happens, markets will have a chance to
gauge the severity of that risk in the European parliamentary elections in May: “non-
mainstream” protest parties have historically done well in those elections.
Political instability
is a “stock” problem
that remains a risk
19 November 2013
2014 Global Outlook 20
Exhibit 22: Unemployment high in the periphery Exhibit 23: Support for “non-mainstream” parties
Unemployment rates (%) Support for “non-mainstream” parties
6
8
10
12
14
16
18
20
1999 2001 2003 2005 2007 2009 2011 2013
Periphery 5
France, Netherlands, Belgium
Germany
0
10
20
30
40
50
60
GER FRA ITA SPA BEL NET AUT GRE IRE POR FIN
Pre-crisis election
Latest election (if held during crisis)
Latest polls
Source: Credit Suisse Source: Credit Suisse
That brings us back to the recovery. A continued upswing is necessary for those stock
problems to be addressed. But there are risks. We forecast GDP growth of just 1.3% in
2014. After the recessions of the past few years, that’s hardly vigorous. And it is
vulnerable to new shocks.
In particular, the failure of core euro area economies to reduce their current account
surpluses at the same time as peripheral economies adjusted their external surpluses
upwards has left the euro area with a – potentially unsustainably – large current account
surplus. That leaves the economy vulnerable to significant currency appreciation.
Exhibit 24: The euro area’s unbalanced adjustment Exhibit 25: An unbalanced economy
Regional trade balances as % euro area GDP Euro area current account balance as % GDP
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
1999 2001 2003 2005 2007 2009 2011 2013
"Core"
"Periphery"
"Others"
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
1980 1985 1990 1995 2000 2005 2010 Source: Credit Suisse Source: Credit Suisse
Continued recovery
remains vital
19 November 2013
2014 Global Outlook 21
The unbalanced nature of the euro area’s adjustment is also manifesting itself in extremely
low inflation. That high unemployment in the periphery has put considerable downward
pressure on wage and price inflation, which, in turn, is a key driver of the improvement in
these countries’ competitiveness (Exhibit 15). But, because demand growth in core
European countries has remained so weak, inflation outside the periphery has also
remained low. So, once again, an excess of adjustment in the periphery and a lack of
offsetting adjustment in the core has led to a sub-optimal outcome for the euro area
economy as a whole. Worryingly low inflation and a high current account surplus are both
symptomatic of the same problem.
Although inflation is low, there’s little evidence yet that the disinflation will drift into full-
blown deflation. In particular, the recovery since the spring appears to have led to a slight
firming in pricing behavior that, in turn, should mean inflation has troughed. But given how
low inflation is, especially in the periphery, another negative shock to growth may push the
euro area – or parts of it – into deflation.
In cutting policy rates to just 0.25%, the ECB showed that it was prepared and able to
respond to the risk of deflation. Although the impact on the real economy is likely to be
limited, it was a strong signal that the ECB will ease further if downside risks materialize.
So if the recovery stalls in 2014, there would be a meaningful policy response. Given how
low the rate structure of the ECB’s policy framework now is, that would likely imply a move
toward negative rates.
Exhibit 26: Euro area core and headline inflation Exhibit 27: Inflation in the euro area
%
-1
0
1
2
3
4
1999 2001 2003 2005 2007 2009 2011 2013
Core
Headline
-1
0
1
2
3
4
5
1999 2001 2003 2005 2007 2009 2011 2013
Germany/France/Netherlands
Periphery 5
Source: Credit Suisse Source: Credit Suisse
One noteworthy feature of our forecast is that the gap in growth performance between the
weaker and stronger economies in the euro area should narrow further over the coming
year. That’s analogous to the observation in our forecasts for the global economy that the
gap in growth rates between developed and emerging economies is also likely to narrow.
Much like our global forecast, that’s largely a consequence of the hitherto weaker
economies doing better rather than the stronger economies doing worse. Indeed, for
countries such as Italy, Spain, Portugal, and Greece, we expect GDP to grow on average
in 2013, after at least two years of falling output.
19 November 2013
2014 Global Outlook 22
From a market standpoint, the market implications of this euro area growth convergence in
2013 were quite the opposite of those for EM countries – peripheral yields fell as current
account surpluses isolated their markets from the effects that hurt most EM assets. In the
section on European Rates, our strategists argue that looking ahead to 2014, they think
that peripheral yields are now likely close to their lows.
Although structural and cyclical headwinds against growth in the periphery remain
considerable, we do think it has considerable scope to grow in coming years, if demand is
sufficiently strong. A combination of substantial economic slack (as evidenced by high
unemployment and low wage and price inflation) and crisis-driven progress on supply-side
reforms means that output is well below potential at present. Given that, these economies
have the capacity to realize solid growth in coming years.
But, as we noted above, one issue is whether demand can be sufficiently strong to meet
that supply. At present, it clearly isn’t. That’s evident in low inflation and a high current
account surplus.
So further policy measures to stimulate demand would be welcome. Because the longer
the gap between actual and potential output persists, the greater the risk that hysteresis
reduces that potential. One aspect of that is clearly a rise in long-term unemployment. But,
as Exhibit 29 also shows, investment in Europe has been dismal since the start of the
global financial crisis. The capital stock has grown at a very slow pace in the past half
decade. So unless demand and investment recover, it may start to cannibalize the longer-
term prospects for European growth.
Exhibit 28: Long-term unemployment rates Exhibit 29: Net fixed capital formation
% As a % GDP
0
2
4
6
8
10
12
14
16
GER IRE GRE SPA ITA POR
2007
2012
-1
1
3
5
7
9
11
1991 1994 1997 2000 2003 2006 2009 2012 2015
EA 12
Periphery
Source: Credit Suisse Source: Credit Suisse
19 November 2013
2014 Global Outlook 23
Youth unemployment and income inequality 2014 Core Views
Our study of 20 countries reveals that there has been a large increase in income
inequality. Our study of 20 countries reveals that there has been a large increase in
income inequality in China and large decreases in Russia, Brazil, and Mexico over
the latest 15 years or so that data is available.
The youth unemployment rate is much higher than the total unemployment rate in
most countries – an area of serious concern for policy makers.
Income inequality and youth unemployment are now becoming an important focus of
attention for national heads, central banks, and fiscal authorities ranging from the US
to Germany, UK, Spain, Portugal, etc., and Japan, as well as China, Brazil, Mexico,
and India.
In this section, we present changes in unemployment rates and income inequality across
20 countries grouped as European countries (France, Germany, Greece, Ireland, Italy,
Netherlands, Portugal, Spain, Switzerland, and the United Kingdom), Other Advanced
countries (Australia, Canada, Japan, and the US), and the EMG6 (Brazil, China, India,
Mexico, Russia, and Turkey). The post-Lehman credit crisis and subsequent sovereign
credit weaknesses have changed the income inequality and unemployment dynamics
prevalent since the mid-1990s, more so in the advanced economies.
We tabulate the latest overall income inequality changes as measured by the Gini
coefficient in Exhibit 30. The Gini coefficient measures the relationship of cumulative
shares of the population arranged according to disposable income to the cumulative share
of the total disposable income received by them. It ranges between 0 in the case of perfect
equality and 100 in the case of perfect inequality.
Exhibit 30: Gini Index
Scale from 0 to 100
Gini coefficient of equivalized disposable income1 Gini coefficient (at disposable income, post taxes and transfers)
1995 2011 1995 2010
European
countries
France 29.0 30.8
Other Advanced
countries
Australia 30.9 33.4
Germany 29.0 29.0 Canada 28.9 32
Greece 35.0 33.5 Japan 32.3 33.6 (2009)
Ireland 33.0 29.8 United States 36.1 38.0
Italy 33.0 31.9 1994 2010
Netherlands 29.0 25.8
EMG6
Brazil 60.2 (1995) 54.7 (2009)
Portugal 37.0 34.2 China 35.5 (1993) 42.1 (2009)
Spain 34.0 34.0 India 30.8 33.9
Switzerland 33.7 (2000) 29.7 Mexico 51.9 47.2
United Kingdom 32.0 33.0 Russia 48.4 (1993) 40.1 (2009)
Turkey 41.5 40
Source: European countries: Eurostat; Other Advanced countries: OECD; EMG6 and 2000 data for Switzerland: WDI
1 For European countries, the Gini coefficient is defined on equivalized disposable income – a modified version of disposable income.
Equivalized disposable income is total net household income post- tax and deductions, divided by the number of household members converted into equalized adults. Household members are equivalized by weighting each according to their age.
Amlan Roy
+44 20 7888 1501
Sonali Punhani
+44 20 7883 4297
Angela Hsieh
44 20 7883 9639
19 November 2013
2014 Global Outlook 24
Of the European countries, Portugal had the highest Gini coefficient in 2011 ‒ i.e., the
highest income inequality level. The US and Brazil also have relatively higher levels of
income inequality. The changes in the Gini Index are mixed, with small increases and
decreases in most countries and a large increase in China (by 6.6 points over 1993-2009)
and large decreases in Russia (8.3 points over 1993-2009), Brazil (5.5 points over 1995-
2009), and Mexico (4.7 points over 1994-2010), as shown in Exhibit 31.
Exhibit 31: Changes in the Gini Index, 1995-2011
-4-3 -3 -3
-2 -1
0 01
2 1 2 3 3
-8
-6-5
-2
3
7
-9
-5
-1
3
7
~~
~S
witz
erl
and
Irela
nd
Ne
therl
and
s
Port
ug
al
Gre
ece
Ita
ly
Germ
any
Spain
UK
Fra
nce
Japa
n**
US
A*
Aust
ralia
*
Ca
nad
a*
~~
Russ
ia**
Bra
zil*
*
~M
exi
co*
~T
urk
ey*
~In
dia
*
~~
Chin
a**
European countries Other Advancedcountries
EMG6
Source: European countries: Eurostat; Other Advanced countries: OECD; EMG6 and 2000 data for Switzerland: WDI
*: Data is for 2010; **: Data is for 2009; ~: Data is for 1994;~~ : Data is for 1993, ~~~: data is for 2000
We present the ratio of S80 to S20 (share of top income quintile to the bottom income
quintile), an alternative measure of income inequality in Exhibit 32. We note the higher
differences in countries such as Brazil, Mexico, China, Russia, and Turkey. Increases in
income inequality from the 1990s to recent times are seen in China, the US, Spain, and
Canada, with decreases in inequality within Brazil, Russia, Mexico, and Portugal.
Exhibit 32: S80/S20 disposable income quintile share
S80/S20 ratio: Share of income of top quintile divided by share of income of the bottom quintile
4.6 4.56.0 4.6 5.6
3.85.7 6.8
4.5 5.3 5.7 5.3 6.27.9
20.6
10.1
5.0
10.77.3 8.3
0
5
10
15
20
25
30
Fra
nce
Ge
rma
ny
Gre
ece
Ire
land
Ita
ly
Ne
therl
and
s
Po
rtu
ga
l
Sp
ain
~~
~S
witze
rla
nd
UK
Au
str
alia
*
Ca
nad
a*
Ja
pa
n**
US
A*
Bra
zil*
*
~~
Ch
ina
**
~In
dia
*
~M
exic
o*
~~
Ru
ssia
**
~T
urk
ey*
European countries Other advancedcountries
EMG6
1995 2011
Source: European countries: Eurostat; Other Advanced countries: OECD; EMG6 and 2000 data for Switzerland: WDI
*: Data is for 2010; **: Data is for 2009; ~: Data is for 1994;~~ : Data is for 1993, ~~~: data is for 2000
19 November 2013
2014 Global Outlook 25
Exhibit 33 presents the total unemployment rate and youth unemployment rate for 20
countries in 2012.
Exhibit 33: Total vs. youth unemployment rate, 2012
%
105
24
1511
5
16
25
48
5 74
86
3 4 5 69
24
8
55
3035
9
38
53
8
21
1214
8
1613
610 10
1518
0
10
20
30
40
50
60
Fra
nce
Germ
any
Gre
ece
Irela
nd
Ita
ly
Ne
therl
and
s
Port
ug
al
Spain
Sw
itzerl
and
UK
Austr
alia
Ca
nad
a
Japa
n
US
A
Bra
zil
Ch
ina
*
India
*
Me
xic
o
Ru
ssia
Turk
ey
European countries Other advancedcountries
EMG6
Total unemployment (% of total labour force)
Youth unemployment (% of labour force aged 15-24)
Source: ILO, OECD for China (*- Data is for 2010)
We highlight that youth unemployment rates are in general much higher than total
unemployment rates, despite the increases in the numbers of skilled and educated youth
with increased years of schooling. Youth unemployment rates were more than double total
unemployment rates in most selected countries and more than triple the total
unemployment rate in Italy. This has implications for lifetime income, lifetime savings, as
well as related social implications at the aggregate level.
Exhibits 34-37 present the evolution of youth unemployment rates over time for the
selected 20 countries.
Exhibit 34: Youth unemployment rate, European countries, 1980-2012
Exhibit 35: Youth unemployment rate, European countries, 1980-2012
% of labor force aged 15-24 % of labor force aged 15-24
0
5
10
15
20
25
30
35
40
France Germany Italy
Netherlands Switzerland UK
0
10
20
30
40
50
60
Greece Ireland Portugal Spain
Source: OECD, Credit Suisse Source: OECD, Credit Suisse
19 November 2013
2014 Global Outlook 26
Exhibit 36: Youth unemployment rate, other selected advanced countries, 1980-2012
Exhibit 37: Youth unemployment rate, selected emerging markets, 1985- 2012
% of labor force aged 15-24 % of labor force aged 15-24
0
5
10
15
20
Australia Canada Japan USA
0
5
10
15
20
25
30
Mexico Russia Turkey Brazil
Source: OECD, Credit Suisse Source: OECD, WDI, Credit Suisse
Exhibit 38 presents changes over time in youth unemployment rates. In the last four to five
years, South European countries (such as Spain, Portugal, Greece, and Italy) as well as
Ireland have seen dramatic increases in youth unemployment rates as an undesirable
consequence of their debt and banking crises. This is an area of concern for European
leaders and policy makers. The fiscal and monetary authorities are focusing more on
unemployment issues, of which youth unemployment is a major portion.
Exhibit 38: Changes in the youth unemployment rate, 1990-2012
-2
4 4 45
11
15
23
28
32
-1
24
5
2 24
9
-2
2
6
10
14
18
22
26
30
34
Ne
therl
and
s
Germ
any
Ita
ly
Fra
nce
~S
witzerla
nd
UK
Irela
nd
Spain
Port
ug
al
Gre
ece
Austr
alia
Ca
nad
a
Japa
n
US
A
Turk
ey
~~
Russia
~M
exic
o
Bra
zil*
European countries Other Advanced countries Emerging markets
Source: OECD, WDI, Credit Suisse
*: Data is for 2011; ~: Data is for 1991;~~ : Data is for 1992
The youth unemployment rate will have to be a sub-target for the central banks too, as
many of them have dual or triple mandates that require keeping both unemployment and
inflation under control. In a world of lower inflation, benign neglect of unemployment, which
used to be acceptable, is no longer so in the recent post-crisis world. This changing
dynamic will require central banks and fiscal authorities to change their policy stances. We
believe the solutions to the pension, youth unemployment, income inequality, and elder-
population health problems require holistic approaches relying on intergenerational
solidarity. But for the time being, countries need to tackle youth unemployment to ensure a
better future for the younger generations.
19 November 2013
2014 Global Outlook 27
Is Abenomics working? 2014 Core Views
The "second arrow" has veered off the course, and the "third arrow" is lacking impetus.
We expect the BoJ to fire another "arrow" aimed at devaluing the yen by February.
As recovery of base pay is likely to remain modest, CPI inflation rate should not exceed
1% materially into 2015, delaying any normalization of monetary policy by the BoJ.
Overview
It seems that we may need to revisit our basic understanding of Abenomics, at least for
now. The so-called three arrows of Abenomics consist of
(1) bold monetary easing,
(2) flexible fiscal policy, and
(3) a growth strategy aimed at bolstering the economy's supply capacity.
However, it is becoming more difficult to expect all three arrows to hit the "target" of faster
economic growth together. As the government has decided to opt for steady fiscal
tightening into FY2015, the "second arrow" (flexible fiscal policy) has already veered off
course. In the meantime, the "third arrow" (a growth strategy) is lacking impetus and might
take some time to hit the target. Only the "first arrow" appears to remain on target, with the
Bank of Japan (BoJ) continuing to expand the monetary base and increase its JGB
holdings with a mandate of achieving 2% inflation by around the middle of CY2015.
As the "third arrow" of Abenomics looks unlikely to boost economic growth in the short run,
monetary policy must be responsible for offsetting the prospective fiscal drag into FY2015.
In other words, we believe that the BoJ will fire another "arrow" aimed at devaluing the yen
in a situation where the Abe administration is unwilling to risk a sharp economic slowdown.
Our baseline scenario is for the BoJ to announce (1) a 30-40% increase in the pace of
monthly JGB purchases and (2) upgrades to the targeted holding amounts of risk assets,
such as equity ETFs, by several trillion yen for the end of CY2014 (perhaps at its regular
board meeting to be held on 22 January or on 18 February). The summary of our GDP
growth projections into FY2015, along with estimated impacts from policy changes, are
summarized in Exhibit 39.
Exhibit 39: GDP projections and impacts from policy changes into 2015
%, pp, impacts on GDP
FY2013 FY2014 FY2015
Fiscal policy (tax and spending policy changes) 0.9 0.6 (0.1)
Substitution effects of the scheduled VAT hikes 0.5 (0.5)
Demand stimulus from the "third arrow"
0.4 0.4
Monetary easing * 0.9 0.8 (0.1)
Trend real growth 0.2 0.2 0.2
Expectations effect
0.3 0.5
Predicted real GDP growth rate 2.5 1.8 0.9
Note: * assuming additional easing in Jan/Feb 2014 Source: Cabinet Office, MoF, Credit Suisse
Outlook for fiscal policy
The government has decided to opt for fiscal tightening into FY2015, having stuck with its
medium-term fiscal austerity target of halving the primary balance deficit by FY2015 (and
wiping out the deficit by FY2020). Fiscal tightening in the pipeline primarily includes (1) the
VAT hikes from 5% to 10% by October 2015, which are estimated to boost general
government tax revenue by about ¥13 trillion, or 2.8% of GDP, and (2) about ¥3 trillion of
downsizing of the supplementary budget for FY2013 from FY2012 (we assume no major
supplementary budgets for FY2014-15 at the moment). No significant reforms aimed at
capping social security expenditures are expected for FY2014-15.
Hiromichi Shirakawa
+ 81 3 4550 7117
Takashi Shiono
+81 3 4550 7189
All three arrows are
unlikely to hit the
"target" of faster
economic growth
together
Monetary policy
must be responsible
for offsetting the
prospective fiscal
drag into FY2015
19 November 2013
2014 Global Outlook 28
By our estimate, as the combined effect of the net tax hike (the VAT hikes and corporate
tax cuts) and the supplementary budget downsizing, a fiscal drag or a dampening impact
of the fiscal tightening on real GDP after incorporating multiplier effects would be as large
as 1.0 pp of GDP into FY2015, as shown in Exhibit 39; we recently adjusted our estimates
for the fiscal drag, with our latest econometric analysis having found that public
expenditures tend to have longer-lasting impacts on GDP. Capital investment tax breaks
and corporate income tax cuts are expected to total around ¥2 trillion, or 0.4% of GDP, for
FY2014, but that alone is unlikely to be seen as a significant incentive for companies to
spend more on capex and personnel in the absence of better economic growth prospects.
Companies could start to get cold feet if the outlook for domestic consumption does
indeed deteriorate in the wake of the VAT hike. We therefore expect the impact of the
capex tax break to be limited to rationalization measures, such as investment in energy-
efficient technologies in particular during FY2014. Considering the so-called substitution
effect from the scheduled VAT hike (from 5% to 8% in April 2014), or a temporary boost to
household consumption and housing investment before the tax hike followed by a sudden
contraction of demand after the hike, we forecast that the real GDP growth rate will be
pushed down by 1.3 pp for FY2014.
Despite the prospective substantial fiscal tightening into FY2015, the country's longer-term
fiscal sustainability should remain under a major threat from aging demographics. Truly,
the “social security deficit” could expand from around 10% of GDP in FY2013 to 14-15% of
GDP by FY2020, assuming a zero nominal trend GDP growth rate. By our calculation,
wiping out the social security deficit and preventing government debt outstanding from
expanding in absolute terms would require the VAT rate to rise to 31%-32% by FY2020 or
the trend nominal GDP growth rate to be boosted to around 4.5%. We continue to find it
difficult at the moment to construct any realistic scenario that would get the country's fiscal
sustainability back on track again.
Outlook for the "third arrow"
As for the "third arrow," the government's proposed supply-side measures (excluding the
aforementioned corporate tax cuts) focus on (1) reallocation of economic resources and
(2) deregulation.
With regard to resource reallocation, policymakers are aiming to encourage industrial
consolidation (including scrapping of unproductive facilities and retrenchment of excessive
numbers of workers) and facilitate labor migration or mobility. Our own analysis indicates
that there are currently around 1.8 million excess workers in the manufacturing sector,
while we note about a 2.6 million labor shortage in the non-manufacturing sector as a
whole, with excess demand for labor particularly severe in the construction, medical &
welfare, and general services sectors (refer to Japan Economic Analysis No.44 for more
details). Reallocation of resources could therefore have a meaningful impact on economic
growth going forward, but we expect labor migration to progress only gradually given that
per-worker wages are so much lower in the services sector than for manufacturing workers.
Moreover, a significant shift of labor into non-manufacturing driven by massive restructuring
in the manufacturing industries could lower both labor productivity and the average wage at
the macroeconomic level unless productivity-enhancing capital expenditures expand
materially in small to medium-sized firms in the services sector.
Deregulation may offer somewhat greater hope for Japan's economic future. For example,
it is not entirely implausible to assume that agricultural production capacity might rise as a
consequence of trade liberalization under the TPP initiatives and more efficient land use.
Deregulation of property investment and medical services in major urban areas – via an
expansion of "special economic zones" and other measures aimed at attracting foreign
businesses to Japan – might also contribute positively to economic growth. However, it is
important to recognize that "deregulation" is not the same as "no regulation" and that it will
probably take a decent amount of time for new rules to be finalized and new legislation to
be prepared.
We forecast that the
real GDP growth
rate will be pushed
down by 1.3 pp for
FY2014
The country's
longer-term fiscal
sustainability is
vulnerable as a
result of aging
demographics
Reallocation of
resources could have
a meaningful impact
on economic growth
Deregulation may
offer somewhat
greater hope for
Japan's economic
future
19 November 2013
2014 Global Outlook 29
While supply-side measures impact the economy only slowly, there are actually a few
demand-side stimulus components from the third arrow, such as private-sector driven
infrastructure investment (PFI/PPP), exports of infrastructure products (power plants or
transportation related), and increasing foreign tourist visits amid loosening of visa issuance
conditions. In sum, these measures could invite a 0.3-0.4 pp boost to GDP for 2014, but
this impact does not look large enough.
Interim assessment of aggressive monetary easing and the outlook for
monetary policy
The BoJ decided to double the size of the monetary base into the end-2014 on 4 April
2013, shocking the market. Aggressive monetary easing does appear to have had at least
some success to date, but we characterize the situation as primarily a monetary
phenomenon and have yet to be convinced that aggressive monetary easing is having a
meaningful impact on real economic activity.
The devaluation of the yen associated with the "Kuroda shock" has indeed boosted the
CPI amid an upshift of the market's expected inflation rate, a decline in real long-term
interest rates, and rising stock prices. The yen's depreciation has boosted nominal
corporate earnings (Exhibit 40).
Exhibit 40: Major nominal/monetary indexes
5-yr BEI 5-yr JGB yields
5-yr real JGB
yields USDJPY
Nominal
effective yen
Real effective
yen TOPIX
Corporate
profit Core CPI
end period, % end period, % end period, % end period, %
end-p,
CY10=100
end-p,
CY10=100 end period yoy %
end-p,
yoy %
2012/3Q 0.664 0.197 -0.467 77.96 109.44 101.38 737 6.3 -0.1
2012/4Q 0.829 0.185 -0.644 86.75 101.16 93.10 860 7.9 -0.2
2013/1Q 1.376 0.136 -1.240 94.22 89.68 81.88 1035 6.0 -0.5
2013/2Q 1.083 0.313 -0.770 99.14 87.69 80.27 1134 24.0 0.4
2013/3Q 1.537 0.243 -1.294 98.27 86.12 78.67 1194
0.7
Latest 1.537 0.207 -1.330 98.96
1186
Note: Latest as of the close on 11 Nov. 2013 Source: BoJ, MIC, MoF, the BLOOMBERG PROFESSIONAL™ service, Credit Suisse
However, this monetary shock has yet to translate into a noticeable real shock. A look
at stock prices alone might create the illusion that the Japanese economy has
recovered quite dramatically, but improvements in real economic activity have actually
been much more modest. First, real exports have risen only moderately despite quite a
sharp decline in the yen's real effective exchange rate, while real imports remain
elevated, resulting in the real trade balance showing little improvement. In other words,
yen devaluation (a monetary shock) has yet to provide a substantial boost to real net
exports (Exhibit 41). Moreover, scheduled cash earnings – a yardstick for labor market
supply/demand – have remained flat at best, as the total number of employed has
recovered only slowly and the pace of decline in the unemployment rate has been
modest so far. Importantly, real cash earnings of corporate workers have dropped. The
recent strength of private consumption and residential investment has been driven in
large part by temporary demand ahead of the April 2014 sales tax hike, while increased
construction investment owes much to higher public works spending. The Kuroda shock
appears to have had very little impact on real economic variables.
We have yet to be
convinced that
aggressive monetary
easing is having a
meaningful impact on
real economic activity
19 November 2013
2014 Global Outlook 30
Exhibit 41: Major real data
Real export
index
Real import
index
Real export/
real import
Total employed,
s.a.
Unemployment
rate
Real cash
earnings index,
s.a.
average,
CY10=100
average,
CY10=100
average, mn average, % average
2012/3Q 97.15 111.38 0.87 62.7 4.27 99.70
2012/4Q 93.07 105.35 0.88 62.7 4.23 99.13
2013/1Q 94.48 108.69 0.87 62.9 4.20 100.10
2013/2Q 97.80 108.65 0.90 63.0 4.03 99.93
2013/3Q 96.72 111.44 0.87 63.1 3.97 98.15
Source: BoJ, MIC, MHLW, Credit Suisse
Importantly as well, while
nominal corporate profits
and cash flow have
increased, firms have yet to
ramp up their capital
spending, resulting in a
widening of the cash flow-
investment gap (a proxy for
corporate savings), as seen
in Exhibit 42. The "first
arrow" of Abenomics has
indeed had some success
in boosting household and
corporate sentiment by
driving up stock prices, but
this has simply added to
corporate savings without
translating into meaningful
increases in employment or
export volume.
It seems to be the case that the
"first arrow" is being impeded
by structural headwinds,
including industrial "hollowing
out," adverse demographics,
and deteriorating corporate
competitiveness. Any further
attempts to provide a monetary
shock may have comparatively
little impact on the real
economy unless these
structural headwinds can
somehow be overcome.
Nonetheless, we stress that the
impact of the previous
monetary shock is set to wane
by spring next year if monetary
policy is kept on hold and the
yen remains somewhere around its current level (Exhibit 43). While there is indeed no
guarantee that an additional monetary shock will help to boost real economic activity, it does
seem unlikely that the real economy will make significant improvements if monetary support
is allowed to fade into spring given that fiscal policy is being tightened almost simultaneously.
Exhibit 42: Corporate cash flow, capex, and the gap
non-financial private corporate sector, % of GDP
-6
-4
-2
0
2
4
6
8
10
12
14
16
Jun
-83
Jun
-85
Jun
-87
Jun
-89
Jun
-91
Jun
-93
Jun
-95
Jun
-97
Jun
-99
Jun
-01
Jun
-03
Jun
-05
Jun
-07
Jun
-09
Jun
-11
Jun
-13
Corporate cash flow
Corporate capital expenditure
Gap
Source: MoF, Credit Suisse
Exhibit 43: USDJPY
%
-20
-15
-10
-5
0
5
10
15
20
25
30
35
40
Se
p-1
0
Dec-1
0
Mar-
11
Jun
-11
Se
p-1
1
Dec-1
1
Mar-
12
Jun
-12
Se
p-1
2
Dec-1
2
Mar-
13
Jun
-13
Se
p-1
3
Dec-1
3
Mar-
14
Jun
-14
Se
p-1
4
USDJPY actual yoy
USDJPY flat at 99 yoy
Source: the BLOOMBERG PROFESSIONAL™ service, Credit Suisse
19 November 2013
2014 Global Outlook 31
Our baseline scenario is for the BoJ to announce (1) a 30%-40% increase in the pace of
monthly JGB purchases and (2) upgrades to the targeted holding amounts of risk assets,
such as equity ETFs, by several trillion yen for the end of CY2014 (perhaps at its regular
board meeting to be held on 22 January or on 18 February).
The central bank may be reluctant to hike its JGB purchases given that it is already buying
an amount equivalent to 70% of gross issuance. We therefore think that there is a chance
for the BoJ to consider purchasing foreign bonds. Such purchases are permitted only with
the goal of increasing the monetary base, not for the purpose of devaluing the yen.
As a separate issue, the Abe administration looks to remain keen on amending the current
Bank of Japan Law that became effective in 1998, and we expect it to establish a special
task force under the prime minister to study potential amendments of the law by spring
2014. Detailing the inflation-targeting framework and introduction of a dual mandate
scheme should be the major focuses.
Another monetary shock, equivalent to another 15%-20% boost to the outstanding of
monetary base at the end-CY2014, would lead to a weaker yen, further improvement in
corporate profitability, and recovery in nominal employees' cash earnings (preventing
major deterioration in real wages) and would offset the prospective fiscal tightening at
least to some extent. Nonetheless, it is unrealistic to forecast real GDP growth to
accelerate for FY2014, as any positive impacts of monetary easing occurring in CY2013
are likely to fade into the second half of CY2014. Any delay of additional monetary easing
or a minor action by the central bank would leave the economy exposed to a great risk of a
more substantial slowdown and likely reduce the Abe administration's ability to conduct
economic and fiscal overhauls going forward. Success of Abenomics continues to rely on
monetary easing (the first arrow), and the rest of the world will need to accept further
depreciation of the yen.
Some tend to argue that the currency could weaken even without a major additional
monetary stimulus from the BoJ, if the so-called "portfolio rebalancing" effects kick in and
Japanese domestic private savings start to outflow substantially. There also seems a view
that the launch of NISA (Nippon<Japan's> Individual Savings Account) would help to
promote the savings outflow. While we think that expecting a more substantial savings
outflow is not entirely impossible, we remain fairly cautious about a change in money flow.
The declined capacity to recycle savings amid the shrinking current account surplus,
remaining conservative asset and liability management of major domestic institutional
investors, and a prospective limited change in risk appetite by households amid little
improvement in medium-term income prospects would be the main backdrops.
Outlook for wages
As the VAT hike invites an inflationary shock, average households' real purchasing power
is likely to deteriorate materially unless wages increase. The current outlook for wages into
2014 is such that (1) visibility remains low about the possibility of base pay starting to
recover, but (2) total cash earnings of workers, including bonus and overtime pay, could
grow by 2%-3% in FY2014 as long as corporate income is boosted by 10% or so with the
yen depreciating by 10%-15% vis-à-vis the USD by autumn.
Our baseline
scenario is for the
BoJ to announce a
30%-40% increase in
the pace of monthly
JGB purchases and
upgrades to
targeted holding
amounts of risk
assets
The rest of the world
will need to accept
further depreciation
of the yen
Although visibility
about a recovery in
base pay in 2014
remains low, workers'
total cash earnings
could grow
19 November 2013
2014 Global Outlook 32
Growth of base pay remains in
negative territory despite the
ongoing gradual decline in the
unemployment rate, and in that
sense, the so-called Phillips
curve in its simplest version has
become more unstable
(Exhibit 44). Wages of services
sector workers have been
sluggish. Declining (real) wages
amid heightened excess
demand for labor, as
represented by rising job-offer to
applicant ratios in the services
sector, tend to suggest the
existence of structural downward
pressures on wages stemming
from low labor productivity.
As the medium-term trend in
the CPI inflation rate is sensitive
to growth of base pay, we foresee CPI hanging between around 0.5% and around 1.0%
into 2015 despite the BoJ's prospective monetary easing. This suggests that, in our base-
case scenario, any normalization of monetary policy will remain a very remote issue even
around the end of CY2014.
Exhibit 44: Annual growth of base pay and the unemployment rate
%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%5.0%5.5%6.0%
1986-1997
1998-2013Q3
base pay yoy %
Unemployment rate, %
Source: MHLW, MIC, Credit Suisse
19 November 2013
2014 Global Outlook 33
Beyond the G3 2014 Core Views
We estimate that the EM countries’ potential real GDP growth rates have declined
by about 1 percentage point on average in the post-2008 period compared to the
pre-2008 period, primarily driven by the slowdown in fixed investment spending.
Some tentative evidence suggests that demographics are also contributing to the
lower potential growth rates, although these trends are slow to take shape.
The cyclical outlook for EM growth is improving, however, as stronger growth in
EM’s trading partners should boost external demand and still-low real interest rates
in most EM countries should continue to support domestic demand.
As a result of relatively subdued EM growth, commodity markets are likely to remain
lackluster, while many EM currencies come under further pressure in 2014 as a
result of Fed tapering.
EM: structural slowdown, cyclical upturn
The following is an excerpt from a note – Emerging Markets: Structural slowdown,
cyclical upturn – initially published under the same title in the Emerging Markets
Quarterly – Q1 2014.
Real GDP growth in emerging markets (EM) countries has been slowing steadily
since 2010, when it staged an impressive recovery following the global recession in
2009. Overall EM growth slowed to 4.4% yoy in 1H 2013 from 8.3% yoy in 2010. (Most EM
countries have not released their 3Q 2013 GDP figures yet.) Slowdown in fixed investment
spending accounted for almost half (2 percentage points) of the overall slowdown during
this period. The drivers of the real GDP growth slowdown since 2010 were broadly similar
across EM countries.
Exhibit 45: Demand-side contributions to % year-on-year change in EM real GDP
pps, with the exception of real GDP growth
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.02000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 1H2013
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 1H2013
Net exports (pps)Change in Inventories (pps)Fixed Investment Expenditures (pps)Government Consumption (pps)Private Consumption (pps)real GDP, %yoy
*Observations for 25 EM countries (Brazil, Mexico, Colombia, Venezuela, Argentina, Peru, Chile, Russia, Turkey, South Africa, Poland, Hungary, the Czech Republic, Israel, Ukraine, China, India, Indonesia, South Korea, Thailand, Malaysia, Philippines, Taiwan, Singapore, and Hong Kong) were weighted by PPP-adjusted GDP weights.
Note: Source: Haver Analytics®, Credit Suisse
We believe that the slowdown in fixed investment spending was driven by a few
factors. The slowdown in EM countries’ internal and external demand jointly dampened
capex spending growth in the post-crisis period, in our view. In the period after 2008, FDI
into EM held up well as a share of EM GDP, but cross-border lending – which also
supported EM growth in the pre-crisis period – more than halved as a share of EM GDP.
Also importantly, the maturity of cross-border lending became shorter in the post-crisis
period. It is also worth noting that unfavorable shocks to the terms of trade might have also
contributed to the slowdown in fixed investment spending growth in some EM countries.
Natig Mustafayev
+44 20 7888 1065
Berna Bayazitoglu
+44 20 7883 3431
Ric Deverell
+44 20 7883 2523
Aggregate EM growth has
slowed 4 percentage
points since 2010, with the
slowdown in fixed
investment spending
accounting for about half
of the overall slowdown
Slower growth both in
internal and external
demand dampened
capex spending growth
in EM countries
19 November 2013
2014 Global Outlook 34
The slowdown in fixed investment spending has driven EM countries’ potential
growth rates lower. We estimate that the EM countries’ potential real GDP growth rates
have declined by about 1 percentage point on average in the post-2008 period compared to
the pre-2008 period (Exhibit 46). On our estimates, the largest declines in potential growth
rates were seen in Russia and China, while Mexico and Indonesia stand out with their
favorable potential growth dynamics compared to the pre-crisis period. Mexico’s potential
growth rate is set to increase further.
Exhibit 46: Changing dynamics of EM growth
Trend real GDP growth* Average real GDP growth
Period 1 Period 2 Period 1 Period 2
Latin America 3.9 3.3 5.1 4.1
Brazil 3.8 2.9 4.2 2.7
Mexico 2.4 2.6 3.3 3.6
EEMEA 5.2 2.5 6.6 3.6
Czech Republic 4.5 0.4 5.5 0.4
Hungary 2.6 0.0 3.2 0.3
Poland 4.4 2.9 5.3 3.1
Russia 6.1 2.1 7.6 3.6
South Africa 4.1 2.4 4.8 2.9
Turkey 5.2 4.1 6.8 5.5
Non-Japan Asia 8.1 7.0 9.0 7.0
China 10.4 8.5 11.6 8.6
India 7.5 6.3 8.6 6.0
Indonesia 5.3 5.7 5.5 6.3
Korea 4.2 3.1 4.4 3.0
Emerging Markets 6.6 5.5 7.7 5.8
* Calculated using the Hodrick-Prescott filter on quarterly series starting from 1Q 1998.
* Regional averages and EM-aggregate are based on the set of EM countries regularly covered by Credit Suisse economists.
Source: Haver Analytics®, Credit Suisse
There is some tentative evidence suggesting that demographics are also
contributing to the slower potential growth rates in EM countries. Russia, Korea,
and China are among the EM countries with very weak demographic trends, while
Mexico, Indonesia, and India are among the best-positioned.
The statistical estimation of the trend real GDP growth rate might lead to over- or
under-statement of potential growth rates in some cases. The main discrepancies
between the figures depicted in Exhibit 46 and our economists’ views are for Russia’s pre-
crisis potential growth rate (6.1% versus 4.0%-5.0%) and China’s post-crisis potential
growth rate (8.5% versus 7.0%-8.0%). According to our economists, Mexico’s potential
growth rate is 3.0% (versus 2.4%-2.6% in Exhibit 46) both in the pre-crisis and post-crisis
period, and the Czech Republic’s pre-crisis potential growth rate was 3.5% (versus 4.5%
in Exhibit 46) and post-crisis potential growth rate is 2.0% (versus 0.4% in Exhibit 46).
Despite the structural slowdown, the cyclical outlook for EM growth is improving,
as stronger growth in EM’s trading partners should boost external demand and still-
low real interest rates in most EM countries should continue to support domestic
demand. Our economists expect quarter-on-quarter real GDP growth rates both in the US
and the euro area to pick up steadily in 2014. We estimate that the EM countries’ trading
partners will grow 3.3% (on a weighted-average basis) in 2014-2015, up from 2.6% in the
2010-2013 period, based on the IMF’s comprehensive set of real GDP growth forecasts.
The EM countries that are likely to see the largest pick-up in their trading partners’ real
GDP growth rates in 2014-2015 are Turkey, Mexico, Poland, Czech Republic, Hungary,
and China, on our calculations.
The slowdown in fixed
investment spending
has adverse
implications for EM
countries’ potential
growth rates
The cyclical outlook for
EM growth is
improving, however, as
stronger growth in
EM’s trading partners
should boost external
demand and still-low
real interest rates in
most EM countries
should continue to
support domestic
demand
19 November 2013
2014 Global Outlook 35
We estimate that a 1-percentage-point increase in the quarter-on-quarter growth
rate of the US pulls EM countries’ quarter-on-quarter growth rates higher by 0.6
percentage point on average in the subsequent quarter (Exhibit 47). This first-quarter
impact is broadly similar across EM regions. Over the subsequent four quarters, the
cumulative impact on EM countries’ growth rates of such an increase in US quarter-on-
quarter real GDP growth rate increases to 1½ percentage points on average, on our
estimates, but the four-quarter impacts are varied across EM regions. We estimate that
Latin America (1.7 percentage points) and EEMEA (1.9 percentage points) benefit more
than non-Japan Asia (0.7 percentage point) in the four quarters following a 1-percentage-
point increase in the quarter-on-quarter growth rate of the US.
Exhibit 47: Impact on EM countries’ quarter-on-quarter real GDP growth rates of a 1-percentage-point increase in the US’s quarter-on-quarter real GDP growth rate
Cumulative impulse responses (pp) based on VAR analysis
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Bra
zil
Mexi
co
Cze
ch R
ep
Hungar
y
Pola
nd
Russ
ia
S.
Afr
ica
Turk
ey
Chin
a
India
Indonesi
a
Kore
a
after 1 quarter
after 4 quarters
Source: Credit Suisse
Exhibit 48: Impact on EM countries’ quarter-on-quarter real GDP growth rates of a 1-percentage-point increase in the euro area’s quarter-on-quarter real GDP growth rate
Cumulative impulse responses (pp) based on VAR analysis
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Bra
zil
Mexi
co
Cze
ch R
ep
Hungar
y
Pola
nd
Russ
ia
S.
Afr
ica
Turk
ey
Chin
a
India
Indonesi
a
Kore
a
after 1 quarter
after 4 quarters
Source: Credit Suisse
We estimate that a
1-percentage-point
increase in the
quarter-on-quarter
growth rate of the US
pulls EM countries’
quarter-on-quarter
growth rates higher
by 0.6 percentage
points on average in
the subsequent
quarter
19 November 2013
2014 Global Outlook 36
We also estimate that a 1-percentage-point increase in the euro area’s quarter-on-
quarter growth rate pulls EM countries’ quarter-on-quarter growth rates higher in
the subsequent quarter by 0.5 percentage point on average (Exhibit 48). This first-
quarter impact is broadly similar across different EM regions. Over the subsequent four
quarters, the cumulative impact on EM countries’ growth rates of such an increase in the
euro area’s quarter-on-quarter real GDP growth rate increases to 1 percentage point on
average, on our estimates. Four-quarter impacts are again varied across EM regions. We
estimate that the EEMEA region benefits the most from a 1-percentage-point increase in
euro-area growth, with the four-quarter impact reaching 1.2 percentage points on average.
In Latin America, the cumulative impact over the four quarters is 1 percentage point and
in non-Japan Asia 0.7 percentage point.
We believe that aggregate EM growth bottomed in mid-2013, with a modest pick-up
already under way in 4Q. Overall, we expect EM’s real GDP growth to pick up to 5.3% in
2014 and 5.7% in 2015 from an estimated 4.7% in 2013. The modest pick-up we project in
non-Japan Asia in 2014 (based on a broadly unchanged growth estimate for China in 2014
from 2013) is likely to be accompanied by relatively more notable pick-ups in EEMEA and
Latin America, consistent with the impact estimates highlighted above.
Tighter global financial conditions due to US monetary policy pose downside risks
to our near-term real GDP growth forecasts for EM countries. However, we think that
there is a good chance that the recovery in the developed countries might offset the
adverse impact on EM growth of tighter global financial conditions.
Exhibit 49: Net private capital inflows* into EM
$bn % of EM GDP
0
2
4
6
8
10
12
-100
0
100
200
300
400
500
600
700
800
900
1995
1997
1999
2001
2003
2005
2007
2009
2011
1H
13
NJA ex-China
LATAM
EEMEA
EM, % of GDP (right)
* Change in non-resident claims. ** EEMEA regional aggregate includes Russia, Turkey, South Africa, Poland, Hungary and the Czech Republic; NJA aggregate includes India, Indonesia, South Korea, Thailand and Malaysia; LATAM aggregate includes Brazil, Mexico and Chile.
Source: Haver Analytics®, International Monetary Fund, Credit Suisse
Although capacity constraints might also emerge as a downside risk in a few EM
countries, this is not a dominant risk for the overall EM universe, in our view. In
none of the EM countries do our economists expect a further deterioration in the potential
growth rates from current estimates. This expectation hinges crucially on the cyclical pick-
up that we expect in the global economy. However, even if this cyclical pick-up
materializes, whether it is transformed into higher potential growth rates for EM in the
medium term remains uncertain.
We believe that
aggregate EM growth
bottomed in mid-2013,
with a modest pick-up
under way; we expect
EM’s real GDP growth to
rise to 5.3% in 2014 and
5.7% in 2015 from an
estimated 4.7% in 2013
19 November 2013
2014 Global Outlook 37
Commodities remain an EM play…
As we highlighted in The Long And Winding Road, since the early 2000s, commodity
prices have been highly correlated with growth in emerging market industrial production,
with the correlation with developments in the developed world much reduced. Against this
backdrop, in many ways, the outlook for growth in the emerging markets is the key driver
for industrial commodity prices.
In line with this, it is notable that despite a strong rebound in global industrial production
growth over recent months, EM growth has continued to lag. In large part, this explains the
relatively muted rebound in commodity prices.
While we expect broad measures of EM growth to continue to improve over the course of
2014, the peak currently forming in global IP growth suggests that EM IP may also be
approaching a local peak and hence that the recovery in commodity prices may also be
coming to an end.
Looking further out, we think that the combination of increased supply for many
commodities and continued structurally weaker EM growth is likely to cause many prices
to continue to stagnate through 2014, with those commodities experiencing a long-awaited
increase in supply coming under the most pressure.
Exhibit 50: Commodity prices are highly correlated with EM industrial production growth
Exhibit 51: EM growth is still weak
Index
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
93 95 97 99 01 03 05 07 09 11 13
24 month rolling correlation ofchanges in EM IP and Copper
24 month rolling correlation ofchanges in DM IP and Copper
40
45
50
55
60
65
2005 2006 2007 2008 2009 2010 2011 2012 2013
DM PMI NO EM PMI NO
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service Source: Markit, Credit Suisse
EM FX remains vulnerable to Fed tapering in 2014
As we highlighted in our EM FX Forecast Update, after a period of intense pressure, the
EM world earned some breathing space in September, when the Fed surprised the market
and decided to delay the much-anticipated tapering. However, while the bounce caused
many analysts to turn bullish EM FX, we think that the larger challenges have been
delayed rather than averted.
We expect only those currencies with strong fundamentals to attract substantial inflows in
over 2014, with the likely January Fed taper leading to renewed pressure on those EM
countries and currencies with weak growth, structural issues, and large funding needs.
With the developed world very much on the ropes, EM growth dramatically
outperformed over 2010 and 2011, with those countries attracting cumulative portfolio
inflows of $450 billion from mid-2009 to end 2012 (it was zero in the previous decade).
While these flow began to reverse after of the Fed's September no taper, we think that
the outflows to date have been relatively minor, suggesting that over time much
of this flow is likely to reverse and many currencies remain under pressure as a
result of continued EM economic underperformance.
19 November 2013
2014 Global Outlook 38
Exhibit 52: EM portfolio inflows have increased dramatically in recent years
$bn
(100)
0
100
200
300
400
500
600
700
800
900
2000 2003 2006 2009 2012
Fed QE
Cumulative Portfolio Flows
Cumulative FDI
Bank Lending & Other Investment
QE1
QE2
QE3
Includes: Argentina, Brazil, Chile, India, Indonesia, South Korea, Mexico, Philippines, Malaysia, Taiwan, Thailand, and Turkey. Latest data point is as of Q2 2013 (except for Argentina and India, which are as of Q1 2012). Our analysis follows http://www.federalreserve.gov/pubs/ifdp/2013/1081/ifdp1081.pdf
Source: Haver Analytics®, International Monetary Fund, Credit Suisse
19 November 2013
2014 Global Outlook 39
China: reform agenda dominates 2014 2014 Core Views
2014 is likely to be an unusual year for China, as growth prospects are less of a
concern while the reform agenda dominates attention. In the recently concluded third
plenary session of the 18th party congress for the ruling Chinese Communist Party,
President and General Secretary Xi Jinping revealed an ambitious and
comprehensive reform package.
Fiscal reform, among all the initiatives, looks the most likely to be launched in 2014. A
gradual change in the Hukou system is likely too. Although the “one-child” policy was
not mentioned explicitly by the party plenum, we think that China will ease on it. On
the other hand, land and SOE reforms are likely to be slow.
Xi's reform package is probably the most comprehensive and ambitious reform
architecture in the history of the People's Republic. The success of Xi's reform is
likely to be determined by a detailed policy design and policy execution.
2014 is likely to be an unusual year for China, as growth prospects are less of a
concern while the reform agenda dominates attention. In the recently concluded third
plenary session of the 18th party congress for the ruling Chinese Communist Party,
President and General Secretary Xi Jinping revealed an ambitious and comprehensive
reform package, which provides guidelines in areas like government reform, land reform,
tax reform, financial reform, and social safety net reform.
Exhibit 53: Xi's comprehensive reform ideas have been unveiled
2
4
6
8
10
12
14
16
19
78
19
83
19
88
19
93
19
98
20
03
20
08
20
13
Real GDP Growth (% YoY)
Growth stagnation in the aftermath of Cultural Revolution
The economy was stalled
The economy was indeflation
The economy was stalled
Rural Reforms
SpecialEconomic Zone
Joining WTO & Bank Reforms
Xi's Reform
Source: NBS, Credit Suisse
Structural reforms are critical for China to get back to organic growth, in our view. The
old growth model, driven by exports and housing, is running out of steam, yet the new
growth model, based on consumption, has not quite established itself yet. Naturally, growth
momentum has been on the decline. Beijing refuses to allow growth to slow much, worrying
about social stability. Therefore, it is using extreme monetary and fiscal policies to boost the
economy. GDP growth has stabilized, but growth-related issues have not been addressed. It
is taking an increasing amount of policy stimulus to generate a unit of growth. More
importantly, the growth is being achieved with a proliferation of local debt and shadow-
banking activities, creating what we consider to be systematic risks for the future.
Dong Tao
+852 2101 7469
The reform agenda
dominates attention
19 November 2013
2014 Global Outlook 40
The core issue in China nowadays is that private investment has disappeared
because the manufacturing sector has become largely unprofitable. Moreover,
government spending has been no replacement for the capital engagement by the private
sector. In order to re-engage the private sector, the country needs structural reforms,
which over the past decade have largely been overlooked by the previous leadership. We
think that China needs to open up the services sector to private competition, break the
banking monopoly, and lower the corporate tax. The current regime, led by President Xi
Jinping and Premier Li Keqiang, realizes this and, in our judgment, is committed to
reforms, even at the expense of slower growth.
We believe that there are two major concept changes for the Xi-Li regime:
(1) The role of government. The new leaders want to reduce the role and influence of the
government by surrendering some of its power of ex-ante investment approval and
focusing more on ex-post regulation. In other words, FDIs should not kowtow to gain
government approval. If the proposed investment is not in priority-listed restricted areas,
FDIs should be free to enter.
(2) The role of the market. The new leaders believe that policies should be market based
instead of administratively forced. We provide the example of housing policies. The
government plans to phase out administrative restrictions on non-resident buying
apartments and price ceilings and use mortgage rates or property taxes to influence
market demand and supply. We consider these new concepts as revolutionary by Chinese
standards. As Xi pointed out, rebalancing the power between government and the market
reflects the spirit of all his reform initiatives.
Exhibit 54: Xi's comprehensively deepening reform agenda
Overall goal Improve and develop socialism with Chinese characteristics, promote the modernization
of the nation's governance systems and governance functions
The key Economic structural reform
Core of economic structural reform Relationship between government and the market, to promote the market to be the
“decisive force” in resource allocation and to better utilize the supportive role of
government
Other main points Form a leading group for deepening structural reforms
Strengthen the environment for rule of law
Enhance the nation's "cultural software," establish modern public "cultural service"
system
Allow a better and greater share of development outputs, create a more fair and
sustainable social security system, deepen the reforms in the medical system
Establish a comprehensive system for environmental protection
Establish a national security council
By 2020 Make decisive inroads in key reform areas
Source: Xinhua News, Credit Suisse
A wide range of reform initiatives was mentioned at the party plenum, but the
details are missing at this stage. Obviously, these reform initiatives have different time
frames and imply various degrees of difficulty. We focus here on those most relevant and
those we think are most likely to be launched in 2014.
Fiscal/tax reform, among all reform initiatives, looks most likely to be launched in
2014. With this reform, Beijing wants to clarify the benefits and responsibilities between
the central and local government, reshuffle tax codes, stabilize the tax burden, and
improve transparency in the budget. We believe that this reform was specifically
mentioned to incentivize both central and local government, as we assume some (albeit
limited) revenue will be passed on from Beijing to local government.
China needs to open
up the services
sector to private
competition, break
the banking
monopoly, and
lower corporate tax
Rebalancing the
power between
government and the
market reflects the
spirit of the reform
initiatives
19 November 2013
2014 Global Outlook 41
We expect that tax on corporate profits to be converted into VAT, with a minor
reduction in the effective tax rates. This would be part of the effort of transforming the
Chinese tax system into a consumption-based tax environment. It is likely that property tax
will be introduced to more cities. Various forms of taxation will be piloted in different
programs, but the new taxes are more likely to apply to new transactions than to existing
housing stock.
Rural reform is the third economic area that was addressed in the plenum's
communiqué, under "urban-rural unified development strategy." The government
intends to "grant more asset rights to farmers," to make the terms of trade more equal
between industrial and agricultural products, and to create a better balance in resource
allocations between the urban and rural populations. We take this to mean allowing
farming land transactions at market prices and granting farmers the right to access
healthcare and education.
The government decides to ease the one child policy. We believe that the "one-child
policy" has outlived its usefulness and that the country faces a labor shortage five years
down the road. The demographic cliff-fall appears severe, highlighted by labor shortages
in the coastal area and surging migrant workers’ salaries. We expect that a "two-singleton"
couple will be allowed to have a second child as soon as 2014 and that the birth
restrictions will be totally abolished two to three years later. Millions of additional newborn
babies (on top of the current 16 million per year) are expected to create fresh demand with
a decent multiplier effect.
Gradual change in the Hukou system is likely. The Hukou system has been the main
way for the government to segregate the rural population from the urban population. It
appears as if Beijing has finally made up its mind to get rid of it, though migration to the
top-tier cities remains difficult. This is part of the urbanization plan and is linked to land
reform. The program is likely to kick off in 2014, but two issues, in our view, remain
unsolved: (1) Job creation – urbanization is not about how many new houses and roads
are built but about how many new jobs are created. (2) Social safety net – providing the
rural population with decent healthcare coverage and education costs a lot of money.
It is likely, in our view, that China will ease state control of gasoline prices and
power tariffs. The new administration is keen to let prices be set by market demand and
supply rather than rely on administrative measures.
Furthermore, we expect Beijing to start to reshape the role of government. The party
says that it intends to let the market play a "decisive role" in resource allocation,
while the government, the currently dominating factor in the economy, plays a
supportive role in managing the country. The ruling party has called for innovative
governing and a strengthened environment for the rule of law. This idea was initially
launched two months ago when the Shanghai Special Trade Zone was established, but
putting the concept into party doctrine is a very significant step. To us, this is a
revolutionary change in the Chinese philosophy of governance. However, we do expect
some watering down of the idea as it progresses because it undermines vested interest
groups.
More details about land reform may become available in 2014, but resistance from
vested interest groups is likely to be considerable. After an enthusiastic grand
revealing by Xi, the ball is now back in the bureaucrats’ court. They are the ones who will
refine the details and execute the strategy. The reform initiatives may also be influenced
by vested interest groups. Delays and watering down of the proposals should be expected.
It is hard for us to assess how much reform can be accomplished in 2014, but Xi has just
taken an important first step in what we see as the right direction.
Fiscal/tax and rural
reform look likely
The reform initiatives
represent an
important first step
19 November 2013
2014 Global Outlook 42
Exhibit 55: Key ideas of economic structural reform
Enhance the basic economic system Adhere to the basic economic system, with public ownership playing a dominant
role and diverse forms of ownership developing side by side
Activate the state-owned economy, improve modern management of state-
owned enterprise
Vitalize and support the development of privately owned economic activities.
Improve the modern market system Create a more open and competitive market system, as it is the foundation to
allow the market to determine resource allocation
Promote the free flow of commodities and production factors, remove barriers to
entry, improve the efficiency of resource allocation
Improve the price mechanism in which the market plays the key role
Establish a land market that is unified for urban and rural areas
Promote fiscal reform Improve the financial market system
Clarify benefits and responsibilities between the central and local governments
Reshuffle the tax code, stabilize tax burdens, improve transparency
Promote rural reform Promote urban-rural unified development
Provide equal opportunities for the rural population to participate in and share
the bonus of development
Grant more asset rights to the rural population
Make the terms of trade more equal between industrial and agricultural products.
Create a better balance in resource allocations between the urban and rural
population("Hukou" reform is likely, in our view)
Further open up Promote an orderly free flow of international and domestic production factors
Reduce investment barriers
Speed up the construction of the Free-Trade Zone
Increase the degree of openness of inland areas
Source: Xinhua News, Credit Suisse
19 November 2013
2014 Global Outlook 43
Central Bank Outlook Innovation at the zero bound goes pandemic 2014 Core Views
Monetary policy in 2014 is likely to remain both highly stimulatory and highly innovative.
We expect Fed policy to evolve toward stronger forward guidance, lower asset
purchases, and more gradualism. As in 2013, other countries will have to adapt.
Innovation around the zero bound and cross-market spill-overs suggest more market
opportunities than an outlook of near-zero policy rates would normally imply.
Central bank policy will remain exceptionally accommodative in 2014, in our view. We
believe that none of the major central banks will raise rates by this time next year.
However, for us, that covers less than half the ground that investors should be concerned
about as far as monetary policy is concerned.
We say that because monetary policy around the zero bound remains highly innovative.
Central banks are pragmatically seeking to garner traction with the real economy, and
changes in policy focus or implementation continue to have very powerful effects across
financial markets. As our section on the Market Implications of Persistent Deleveraging
sets out, swings in liquidity driven by central bank policy – either actual or expected –
operate as critical drivers of returns and relative asset performance.
Some of the spillover effects from policy innovation are positive: there has, for
example, been widespread gravitation by European central banks toward the forward
guidance model that Bernanke's Federal Reserve instituted.
But negative spillover effects are often more prominent: the attempt to increase
the influence of policy commitments through increased transparency has, in particular,
proved highly problematic as the market sought to anticipate a change in policy as a
threshold approached, only for the central bank to judge the threshold no longer
appropriate.
Specifically, for EM countries, the prospect of the Fed tapering its asset purchases brought
sharp currency depreciations that were unwelcome, while, in Europe, the same process
brought inappropriately high term premiums. The result was further policy innovation as
the central banks affected sought to regain control.
We think that the key themes for 2014 are set to be the following:
Innovation in providing stimulus: we expect a Yellen Fed to taper asset purchases
and provide stronger guidance that locks down the front end of the curve for longer. We
also expect a more gradualist approach to policy. If successfully executed, both
innovations would likely reduce market volatility compared with 2013's "taper talk."
Divergence: we think that Japanese monetary policy needs to be much easier. Also,
we expect the ECB to be willing to engage in new stimulus, potentially including a
negative deposit rate. By contrast, the UK seems much closer to achieving the
"escaper velocity" that Governor Carney has sought to attain, consistent with the BoE
discounting the need for new stimulus.
Further spillover: the shock from tapering should be greatly reduced by the rise in
term premiums that has already taken place since May 2013. But with the Fed the
dominant influence on actual and expected liquidity, the impact of its policy evolution
dictates much of our thinking on market returns and dynamics.
Monetary policy (like foreign policy) beginning at home: with falling labor market
participation creating substantial domestic strains in income inequality, the major
central banks are likely to treat the implications of their decisions on the rest of the
world as secondary to their domestic concerns.
Christel Aranda-Hassel
+44 20 7888 1383
Mark Astley
+44 20 7883 9931
Thushka Maharaj
+44 20 7883 0211
Carlos Pro
212 538 1863
Dana Saporta
212 538 3163
Sean Shepley
+44 20 7888 1333
Hiromichi Shirakawa
+81 3 4550 7117
Neal Soss
212 325 3355
19 November 2013
2014 Global Outlook 44
In the rest of this section, we set out our expectations for major central bank policy in 2014
and examine the international nature of Fed policy transmission.
Central bank outlook: more stimulus and more innovation
Given the severity of the crisis and the inadequate pace of the recovery globally, extremely
accommodative policies from the developed economies’ central banks are expected to
persist through 2014. Indeed, the risk is that monetary policy in the developed world as a
whole becomes even more accommodative than in 2013. The spillover effects from the
major central bank policies will require that emerging market countries plan ahead in
preparation for potentially significant capital swings.
Exhibit 56: Easing in the first world has implications for the entire world
Total central bank assets as a percentage of nominal GDP
0
10
20
30
40
50
60
70
07 08 09 10 11 12 13 14
Fed ECB
BoJ BoE
CS Fcst.
Source: Federal Reserve, ECB, BoJ, BoE, Credit Suisse
Federal Reserve: the key challenge for the Fed in 2014, in our view, is to scale back the
magnitude of its asset purchase program (QE3) while fortifying its forward guidance on low
policy rates. We contend that the Fed cannot continue purchasing MBS and Treasury debt
at the current $85 billion/month pace indefinitely, as this would risk taking out a potentially
disruptive share of debt issuance. But even as it addresses these technical issues, the
Fed still needs to convey its intention to maintain a highly accommodative policy stance.
Our base case is for the Committee to announce a modest initial $10 billion taper early in
2014, perhaps in January. We have penciled in a series of tapers of increasing intensity,
with an end to QE3 in September 2014. Another possibility is that, having whittled down
QE3 to perhaps a quarter of its current size by next summer, the Fed may choose to
continue small and variable “maintenance doses” of asset purchases through year-end
and maybe into 2015. This idea warrants greater consideration if and when Janet Yellen
assumes the chairmanship, as it is our view that she would have a tendency to make
smaller, more frequent adjustments to policy than did Ben Bernanke.
European Central Bank: following a weak euro-area inflation print, the ECB surprised
markets by cutting its key policy rate by a quarter point to 0.25%. The bank shied away
from cutting its 0% deposit rate by taking the unusual step of shifting to an asymmetrical
corridor. Although the ECB’s key policy rate is now at a similar level to the Fed’s 0%-
0.25% band, the ECB chose to preserve the accommodative bias of its forward guidance
by stating that it has an “artillery” of options to ease policy further. This keeps the door
open to a negative deposit rate and further LTROs. But the bar for a negative deposit rate
is high and requires inflation to move decisively below the current annual rate of 0.7%,
which is unlikely, in our view.
Policy spillovers are
not new, but they
have been attracting
increased attention
in recent years
The Fed is set to
taper, with
enhanced forward
guidance
ECB is likely to
continue dovish
talk, with the risks
still skewed to
further easing
19 November 2013
2014 Global Outlook 45
We expect the ECB to reiterate its expectations for a very modest recovery and low inflation
baseline for a prolonged period in its December projection. This – together with its decision
to extend unlimited funding all the way into mid-2015 against the backdrop of the pending
Asset Quality Review – signals that very accommodative monetary policy is here to stay
throughout 2014. Risks of dovish innovations from the ECB limit the room for German yields
to rise; we expect 10-year Germany to end 2014 at 2.1%. An accommodative ECB supports
further peripheral spread compression, particularly in Spain.
European markets have always reacted to US financial developments, and the
interdependence of money markets has increased since the establishment of the
European Monetary Union.
While US and European cycles are largely synchronized, they are not always fully in
tandem. This was particularly the case in the early 1990s, when Europe started the
downswing nearly two years after the US reached a trough. In a more recent episode,
Europe suffered a sovereign debt crisis-induced double dip that the US avoided.
The US has mustered four and a half years of positive growth, with the euro area only
managing the first positive quarter in 2Q this year. The long lag in the euro area and the UK
recoveries called for the need for Europe to dissociate itself from US taper talk earlier this year.
Bank of England: while our central case is that the MPC will maintain the current highly
accommodative monetary policy in 2014, there are risks of growing pressures and
communication challenges. We think that policy is likely to remain on hold until wage
growth picks up from its current low level. And the MPC stressed on 13 November that
there is substantial spare capacity to be worked off, as it cut its inflation projection. But the
significant shift earlier in the date when the MPC expects the unemployment rate to fall
below the 7% threshold, to 4Q 2014 on constant rates and 3Q 2015 on market rates, was
important news. And the strengthening recovery recognized by the MPC, with strong hiring
intentions, means that there are risks of further shifts forward and hence potential growing
market expectations of rate rises during 2014 (from 1Q 2015 at present). So the MPC’s
stance that the 7% rate is not a trigger for policy tightening, but instead a "way station" for
further analysis, is likely to come into greater focus in 2014 with associated communication
challenges. Deputy Governor Bean has already commented that the threshold could be
revised. Ultimately, however, the MPC’s aim in implementing forward guidance was to give
firms and households, and not necessarily financial markets, confidence that rates will
remain on hold for a substantial period. And there are signs of success here.
Europe is lagging
the US cycle
BoE is likely on
hold, but market
expectations of rate
hikes may build
19 November 2013
2014 Global Outlook 46
Exhibit 57: Correlation between US and European rates high ‒ forward guidance repriced into USD and EUR but not in GBP
Exhibit 58: UK unemployment rate expected to breach 7% in early 2015
31-Dec-11 30-Jun-12 30-Dec-12 30-Jun-13
0.0
0.1
0.2
USD Spot5y - 2y1y EUR Spot5y - 2y1y
GBP Spot5y - 2y1y
5
6
7
8
08 09 10 11 12 13 14 15 16
Potential unemployment rate path
Source: Credit Suisse Locus
Source: Credit Suisse
The ECB and the BoE adopted forward guidance in different forms to counteract the
effects of higher US rates feeding into Europe. We measure the effectiveness of forward
guidance using a range of market indicators, including the slope of the front end
(Exhibit 57) and realized volatility of short rates. In both the EUR and UK, front-end rates
have been very correlated to the US. Currently, the market is skeptical about guidance in
the UK, as evidenced by the steeper money market curve. Our economists forecast that
UK unemployment will fall to 7% in early 2015 (Exhibit 58), similar to the date when the
market is pricing in policy tightening. We favor long positions in the UK front end as a
positive carry way to position for the BoE remaining accommodative for the better part of
2014.
Bank of Japan: the policy board of the BoJ has stuck to its medium-term expectation that
a virtuous circle of production, income, and spending is likely to be maintained into 2015. It
also continued to foresee core CPI inflation rate (excluding the impacts of the VAT hikes)
to rise toward the targeted 2% rate into 2015.
We believe that the BoJ will need to fire another "arrow" aimed at devaluing the yen if the
Abe administration is unwilling to risk a sharp economic slowdown. Our baseline scenario
is for the BoJ to announce (1) a 30%-40% increase in the pace of monthly JGB purchases
and (2) upgrades to the targeted holding amounts of risk assets, such as equity ETFs, by
several trillion yen for the end of CY 2014 (perhaps at its regular board meeting on 22
January or on 18 February).
The central bank may be reluctant to hike its JGB purchases given that it is already buying
an amount equivalent to 70% of gross issuance. We therefore think that there is a chance
that the BoJ will consider purchasing foreign bonds. Such purchases are permitted only
with the goal of increasing the monetary base, not for the purpose of devaluing the yen.
As a separate issue, the Abe administration remains keen on amending the current Bank
of Japan Law, which became effective in 1998, and we expect it to establish a special task
force under the prime minister to study potential amendments of the law by spring 2014.
Detailing the inflation-targeting framework and introduction of a dual mandate scheme will
be the major focuses.
ECB and BoE
forward guidance
attempts to offset
spillover effects
from the Fed
BoJ may need to
provide further
stimulus in 2014
19 November 2013
2014 Global Outlook 47
EM interaction – think push, not pull: economic historians have investigated the relative
importance of “pull” and “push” factors in international capital flows. Are fluctuations in
capital flows more sensitive to “pull” factors (such as economic growth, inflation, or budget
deficits) in the countries receiving capital inflows, or are they more sensitive to “push”
factors (such as economic fundamentals, financial stability, or the stance of monetary
policy) in the key global financial centers where capital flows are arranged?
Different historical episodes seem to weight the “pull” and “push” factors somewhat
differently, but a general conclusion would give pride of place to the “push” factors. This
probably reflects the notion that the willingness to lend is more variable than the
willingness to borrow.
When conditions in the key capital markets are placid, the willingness to lend is ascendant,
certainly so relative to the contrary circumstance where financial turbulence and tighter
money afflict the key capital markets. Conditions in New York, London, and Frankfurt thus
become powerful predictors of the availability of global capital in emerging markets and
the periphery. When capital availability is loose in the core, EM and periphery countries
can accumulate current account deficits and foreign debts; when capital availability in the
core is constrained, the suffering is likely to be most intense in these EM and periphery
countries that most fully availed themselves of the earlier largesse.
The dollar bloc was initially a group of currencies formed after the US left the gold standard
in the 1930s. At a time of global economic upheaval, Canadian and Latin American countries
acquiesced in a fixed currency relationship that reflected their underlying dependence on the
US economy. Today, EM currencies have far more varied currency relationships, but we
believe that the underlying dependency on the US as the driver of capital market conditions
continues to justify the epithet earned in the Great Depression.
Policies without borders
Regardless of its intention and execution, no nation’s monetary policy can guarantee
solely domestic consequences. The more influential a country’s role in the global
economy, the greater its potential to generate significant policy spillovers. The United
States is particularly porous in this respect.
Over the past few decades, changes in Federal Reserve policies have had relatively
significant influences beyond domestic borders. US monetary policy spillover has
permeated both developed and developing economies, sometimes arriving as a welcome
stream, other times invading as a corrosive torrent. As a general proposition, the more
corrosive the capital inflow (i.e., the more it was used to finance domestic consumption
and property development), the more devastating the effects of subsequent capital outflow
when the tide turned.2
One need only revisit the outcry from some corners of the globe in 2010 against QE2 or,
alternatively, the nearly universal adverse reaction to last spring’s QE3 “taper talk,” to find
evidence that the extra-national effects of Fed policy – whether real or perceived – are a
matter of great import to economies of all types and sizes.
Below, we briefly summarize the mechanisms by which Federal Reserve policies affect
foreign economies (Exhibit 59).
2 Fed Governor Jerome Powell, in his 4 November speech, cited notable historical examples of large and volatile cross-border
capital flows aggravated by foreign policy spillovers. These include such crises as "Latin America in the early 1980s, Mexico in 1994, the Asian financial crises beginning in 1997, Russia in 1998, Argentina in 2001, and Brazil in 2002."
Capital flows reflect
“push” factors
… which can
reveal nascent
vulnerabilities
Fed policy affects
foreign economies
via real, banking
sector, and financial
market channels
19 November 2013
2014 Global Outlook 48
Exhibit 59: US monetary policy spillover mechanisms
Monetary policy-related linkages between international economies
Source: Credit Suisse
Real economy linkages: to the extent Fed policy impacts domestic growth prospects and
consumer demand, it affects the attractiveness of the US as a market for other nations’
exports. The second-order impact is on the growth prospects of US trading partners
themselves and, ultimately, on the policies of their respective central banks (and on the
shapes of their yield curves). That said, academic literature suggests that trade linkages
generally are more important for fiscal policy shocks than for monetary policy shocks.
Banking sector linkages: Fed policy affects US banks’ lending policies (the “credit
channel” of monetary policy), which also impacts lending conditions in non-US countries
(because US banks lend to foreign entities, as well). Monetary policy changes may also
lead non-US banks to reconsider the profitability of lending to US entities. This may, in
turn, affect non-US bank lending policies in their home markets, ultimately influencing non-
US growth prospects, the policies of foreign central banks, and international yield curves.
Financial market linkages: the “interest rate channel” is an especially important
mechanism by which the effects of Fed monetary policy changes are disseminated beyond
US borders. Fed policy decisions affect money markets, foreign exchange markets,
commodities markets, and equity markets globally.
We can also lump into this category the linkages related to global investor confidence/risk
appetite. In admittedly simplistic terms, whether the market is "risk on" or "risk off" can be
affected by views on Fed policy (for example, the so-called “Bernanke put”). The portfolio
rebalancing impacts of the Fed’s large-scale asset purchase policy (LSAP or QE) can be
viewed as a specific example of this risk appetite financial market linkage.
1. LSAPs impact non-US equities by affecting the equity risk premia (with subsequent
implications for growth prospects via the wealth effects).
2. LSAPs impact bond term premia beyond the US (with implications for global
investment, growth, and foreign central bank policies).
3. LSAPs impact currencies via their betas on risk assets (safe havens versus risky
currencies) and hence inflation/export/growth prospects in non-US jurisdictions.
19 November 2013
2014 Global Outlook 49
Estimating the Fed’s international impact
Other empirical studies that have attempted to quantify the Fed’s global influence have
concentrated on the spillover effects of restrictive policy shocks, as opposed to
unexpected episodes of accommodation.
Exhibit 60: US monetary policy shocks tend to have sizable spillovers
Growth impact on industrial production (%) of a surprise 100 bp interest rate increase in the US (1977-2008)
Source: International Monetary Fund, Credit Suisse
Note: Dashed lines indicate the 90 percent confidence interval around the point estimate. The y-axis shows the cumulative impact on the level of industrial production. X-axis units are months; t = 0 denotes the month of the policy shock.
A recent study by the International Monetary Fund (IMF), for example, estimates the
impact of US monetary policy tightening surprises on foreign industrial production.3 IP was
used in lieu of GDP growth because it is available monthly across countries.
The IMF study suggested that “monetary policy shocks in major economies…may have
strong impacts on economic conditions in other countries, particularly those with pegged
exchange rate regimes.” The global impact was found to be significant in the case of the
US monetary policy shocks. In particular, the IMF estimated that a surprise 100 bp
tightening in the US fed funds rate typically contracts the level of industrial production in
other countries by about 0.7% after eight months versus 1.7% in the US (Exhibit 60).
Term premiums have a common driver
As one indication of the way in which these financial market linkages operate, we highlight
work by our US strategists to estimate 10-yeay ZC term premia following the approach
outlined by the Fed’s Kim-Wright model.
3 International Monetary Fund, World Economic Outlook: Transitions and Tensions, October 2013.
IMF estimates
significant impacts
of Fed tightening on
foreign countries
Correlations in bond
term premia
illustrate linkages
19 November 2013
2014 Global Outlook 50
Exhibit 61: German 10-year ZC term premium Exhibit 62: UK 10-year ZC term premium
Source: Credit Suisse Locus Source: Credit Suisse
In Europe, due to a lack of data, we use a simplified approach (as outlined in Cochrane
and Piazzesi) to estimate 10-year term premia. Exhibits 61 and 62 show the results for 10-
year Germany and the UK.
Historically, term premia in Europe have been highly correlated with US term premia, once
again highlighting the interdependence of European and US rate markets and ultimately
the global influence of the Fed’s monetary policy. We expect rates in Europe to rise next
year but to outperform US rates, as term premia in Europe remain depressed but also as
growth and inflation expectations are expected to remain lower in Europe than in the US.
* * *
The mandates of the Federal Reserve and other central banks are primarily domestic. But
as the global financial system becomes more interconnected, the effects of their policies
on the rest of the world need to be taken into account. This is especially true of the Fed.
That said, Federal Reserve policy is not the only factor playing a role in the experiences of
foreign economies, and it is often not even the most significant. Different countries have
varied institutional structures and economic backdrops, which are among the reasons they
respond to external monetary policies in different ways.
Throughout 2014, we expect policymakers at the Fed and elsewhere to remain sensitive to
the effects of their decisions on foreign jurisdictions. At the same time, however, they are
likely to resist pressure to put primary weight on global considerations in formulating policy
– lest their decision-making becomes overly complicated and potentially paralyzed.
We believe that the degree to which the Federal Reserve takes its potentially significant
policy spillovers into account will be put to the test early in 2014. If our baseline
expectation is borne out, the Fed will begin tapering next quarter. As the history above
suggests, this may require some renewed defensive policy guidance in Europe. And in
Emerging Markets, which saw painful capital outflows this past spring just on the talk of
taper, US monetary policy poses downside risks to our near-term economic forecasts.
The tone of FX markets in 2014 will also take its cue from the direction of monetary policy
among the major central banks. A gradual tapering by the Fed, while the ECB and the
Bank of Japan remain focused on stemming the resurgent deflationary threat, is US dollar
bullish, in our view.
Renewed challenges
come with Fed
tapering
19 November 2013
2014 Global Outlook 51
Reshaping the Financial System Liquidity required
2014 Core Views
The global financial system is being reshaped by regulation and weak credit demand.
The private sector is struggling to create liquidity and safe assets, and the public
sector is attempting to offset this with policy support.
Until a new system emerges that is capable of facilitating ample private credit and
liquidity creation, interest rates will stay lower than would otherwise be the case.
Bouts of significant illiquidity and jerky price action may be frequent.
“The only thing useful banks have invented in 20 years is the ATM.”
- Paul Volcker, 2009
“To strike a balance between making banks safer and maintaining market liquidity, we
need to draw lessons from the financial crisis, when contagion risks from stressed banks
spread rapidly through the global financial system via counterparty credit concerns,
liquidity hoarding, and mass deleveraging.”
- Mark Carney, 2013
These quotations come from very different central bankers. Volcker, a man of the pre-
1980 bank-centric system, is no friend of market liquidity. Carney, a man of the pre-2008
market-centric system, is enmeshed in the struggle to build a policy framework that allows
recent financial innovations to survive and become permanent.
Shadow banking has survived the crisis. But the financial system is being reshaped, just
as the commercial banking system was in the 1930s. In order to understand the evolution
now under way, it is helpful to focus first on how the mid-century bank-based financial
system created liquidity.
Although the histories of modern financial systems are a blur of innovation and evolving
practices, the US system in the 1950s and 1960s was an archetypical bank-centric system.
What banks did then was simple: they issued deposits – money – and made loans. The
liquidity transformation explicit in this business required a degree of public-private
partnership. During the 1930s, deposit insurance and expanded lender of last resort
facilities were provided in exchange for increased regulation. This public support allowed
the moneyness of the banks’ deposits to go unchallenged. After World War II, banks were
also left with large portfolios of Treasury debt. The illiquidity of the loans owned by the
banks hardly mattered because they were held to maturity and because the banks’
Treasury portfolios offered ready access to cash.
In a traditional bank-based system, the need for money creation by the banks and the
state is high partly because liquidity in tradable assets is low. Non-bank financial
intermediaries (such as insurers, pension funds, and other asset managers) held long-
term financial assets (such as corporate bonds and stocks) on a near-permanent basis.
Like loans, tradable securities were infrequently traded and therefore illiquid by
contemporary standards.
The low liquidity of tradable assets in the bank-centric system can be described in a
stylized model of market-making behavior from Treynor (1987)4. Exhibit 63, called the
Treynor diagram, shows the prices quoted by a dealer (bid and ask) versus dealer
inventories of the underlying security. Dealers improve market liquidity by quoting tight bid-
ask spreads, attracting investors who are willing to trade frequently. Dealers respond to
4 Treynor, Jack. 1987. "The Economics of the Dealer Function." Financial Analysts Journal 43 (6): 27-34. We thank Professor
Perry Mehrling for highlighting this work.
James Sweeney
212 538 4648
Shadow banking
has survived the
crisis, but the
financial system is
being reshaped, just
as the commercial
banking system was
in the 1930s
19 November 2013
2014 Global Outlook 52
increasing (decreasing) inventories by lowering (raising) their price quotes. The distance
between the red and gray lines on the chart are the bid/ask spreads quoted to investors
who frequently trade. When inventory becomes unbalanced, market prices get to levels
where value or outside spread investors will transact. In the old commercial bank-
dominated financial system, market liquidity was low because a high proportion of dealing
was to this type of investor. Mid-century market participants were essentially value-
oriented or “outside spread” investors.
Exhibit 63: Treynor diagram
Pri
ce
Pri
ce
Ask
Bid
Inside Spread
Outside Spread
Long InventoriesShort Inventories
Source: Credit Suisse
In the financial system that emerged in recent decades, the proportion of inside spread or
flow investors rose substantially. This required significant increases in dealer activity.
Dealers helped their businesses grow by funding their clients’ trades, usually on a
collateralized basis. Technological advances, financial deregulation, and increases in gross
global capital flows played major roles in permitting these developments.
All this is the essence of “shadow banking,” which we define as “money market funding of
capital market borrowing.” (See here5 for a more detailed version of this idea, and also more
on the Treynor model.) Shadow banks face market pricing of their funding and their assets,
and they hedge and lay-off risks with derivatives. This system is a stark difference from mid-
century banks, which issued deposits at regulated rates and held loans to maturity.
Rather than creating money directly like a commercial banking system, a well-functioning
shadow banking system creates liquidity in tradable assets, making them money-like. As
assets are traded in heavy volume and bid-ask spreads tighten, market liquidity rises,
making it possible to lend against the same securities on little margin. Thus, market liquidity
(tight bid-ask spreads) and funding liquidity (smaller haircuts) improve together.
In a shadow banking system, more dealers and more trading allow inside spreads to define
liquidity rather than outside spreads. Collateralized funding proliferates, boosting the funding
liquidity of securities, and allowing dealers to facilitate short positions. Derivatives markets
and securitization provide further paths to liquidity creation. Active inside spread investors
dominate market action, bid/ask spreads are tight, and haircuts on securities loans are low.
Shadow banking can give rise to ample private safe assets and forms of money substitutes.
Securities that can be borrowed against with low haircuts become shadow money that
satisfies the speculative6 and precautionary
7 motives for holding deposit and currency
money, thus crowding out some demand for deposits. The ability of investment managers to
5 Mehrling, Perry and Pozsar, Zoltan and Sweeney, James and Neilson, Daniel H., "Bagehot was a Shadow Banker: Shadow
Banking, Central Banking, and the Future of Global Finance" (November 5, 2013).
6 Demand for money as a portfolio asset that is expected to outperform other assets that might depreciate. 7 Demand for money to insure against the risk of an inability to roll liabilities or make necessary payments.
A well-functioning
shadow banking
system creates
liquidity in tradable
assets, making them
money-like
19 November 2013
2014 Global Outlook 53
hedge duration, credit, and foreign exchange risks in derivatives markets further reduces the
demand for old-fashioned money. The ability to securitize assets and sell senior tranches
marks another way of creating liquidity.
Safe asset creation is also facilitated by the large stock of gross debt created by a shadow
banking system. In 2007, there was much more debt, and much more financial debt
relative to non-financial debt, than in 1960 (Exhibit 64). In the new system, credit
intermediation chains were much longer than in the bank-based system. That means a
loan from a saver to a borrower passed through more balance sheets. For example,
instead of borrower-bank-lender, the chain might be borrower-auto finance company-
hedge fund-dealer-money market fund-saver. As a result, there are also more chief
investment officers and more financial activity generally.
However, it is unclear whether the evolution to shadow banking increased the net amount
of lending to the non-financial sector beyond what an unchanging traditional commercial
banking sector would have done. Except for the housing bubble period from 1999-2006,
the increase in household and non-financial corporate debt to GDP ratios for the United
States increased only gently after 1980 (see Exhibit 65), in contrast to popular perceptions.
Exhibit 64: Evolution of the financial system
0%
5%
10%
15%
20%
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
Commercial Bank Loans Non-Financial Debt Financial Debt Monetary Base (RHS)
1960
2007
2012
% of GDP
Source: Credit Suisse, Federal Reserve
Exhibit 65: US private non-financial debt
30%
40%
50%
60%
70%
80%
90%
100%
110%
Q11980
Q11983
Q11986
Q11989
Q11992
Q11995
Q11998
Q12001
Q12004
Q12007
Q12010
Household Debt to GDP
Nonfinancial business debt to GDP
Source: Credit Suisse, Federal Reserve
19 November 2013
2014 Global Outlook 54
This increased supply of safe liquid assets met an eager source of demand. Because
deposit insurance is limited, large asset managers,8 such as corporate treasurers and
financial CIOs, reduced their risks by owning diversified pools of relatively safe short-term
securities. The globalization of trade, meanwhile, increased the size and number of these
cash pools. This created a demand for shadow bank liabilities, such as repo and money
market fund shares, which provided a source of liquidity for the expanding system. This
was the dealers’ source of funding that they channeled to the inside spread investors.
The cyclical dynamics generated by this enlarged financial system were different from the
bank-based system. For one thing, the increased number of financial balance sheets
meant that there were more investment managers who could take fright and decide to
hoard safe assets. In the 2008 crisis, the supply of private safe assets fell as the
propensity to hoard rose. (And since then, new regulations have structurally increased the
demand for safe and liquid assets!)
In a shadow banking system, if credit conditions get easier when asset prices are rising, a
self-reinforcing whirlpool of liquidity creation can develop procyclically. In the
housing/credit boom, ersatz safe assets were created. Private safe assets, private shadow
money, dealer liquidity, perceptions of counterparty reliability, and available funding
liquidity all collapsed at the same time in late 2008. The resulting bust was more severe
than it could have been because there were many holes in the regulatory and policy
structure undergirding the financial system at that time.
The bust was characterized by a collapse in the funding and market liquidity of private
assets. Private shadow money plunged. This could have been a massively deflationary
shock. We define US private shadow money as the nominal amount that could be
borrowed against the stock of private debt securities at current repo haircuts. It fell by
roughly 35% in 2008 (Exhibit 66). We define euro zone private shadow money as the
nominal amount that could be borrowed at the ECB discount window against the discount
eligible stock of private debt securities at current repo haircuts. This would have collapsed
since 2008 if the ECB had not massively increased the range of collateral it accepts,
including foreign currency-denominated financial securities (Exhibit 67).
Exhibit 66: US shadow money
10
12
14
16
18
20
5
6
7
8
9
10
11
Q4 2
004
Q2 2
005
Q4 2
005
Q2 2
006
Q4 2
006
Q2 2
007
Q4 2
007
Q2 2
008
Q4 2
008
Q2 2
009
Q4 2
009
Q2 2
010
Q4 2
010
Q2 2
011
Q4 2
011
Q2 2
012
Q4 2
012
Q2 2
013
Private Shadow Money
Public Shadow Money (RHS)
TRILLIONS OF DOLLARS
Source: Credit Suisse
8 Pozsar, Zoltan. 2011. " Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System.” IMF Working Paper 11/190.
Cyclical dynamics in
the enlarged
financial system
differed from the
bank-based system
In 2008, the private
sector struggled to
create liquidity and
safe assets
19 November 2013
2014 Global Outlook 55
Exhibit 67: European private shadow money
Source: Credit Suisse
In the United States, the policy response was dominated by fiscal actions: a huge increase
in the creation of public shadow money through increased deficits. It included direct capital
injections to banks, and direct liquidity support of private assets through a large widening
of acceptable collateral at the discount window, and special Treasury-backed facilities
(such as the PPIP and TALF and various other facilities). Of course, monetary policy has
also been used in a more traditional way through interest rate and balance sheet policy.
In Europe, the main policy response was monetary: a huge increase in eligible collateral,
an allowance of huge intra-European payments deficits to be funded through the Target2
system, and of course lower interest rates. Europe obviously eased fiscal policy too, but its
periphery found out that the market was intolerant of some countries running high debt-to-
GDP ratios, causing a second round of crisis.
In these various ways, the public sector created liquidity to offset missing liquidity from the
shadow banking system. In both the United States and Europe, public balance sheet
substituted for collapsing private shadow money and seems to have mostly but not
completely averted the deflationary consequences of the destruction of a large part of the
stock of private money substitutes. In the United States, the increase of the public debt-to-
GDP ratio since 2007 is symmetrical to the decline in the financial debt ratio, hinting at a
degree of substitutability of two forms of near-money (Exhibit 68).
Exhibit 68: Financial and government debt (as % of GDP)
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
200%
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
Financial Debt
Government Debt
Sum
Source: Credit Suisse, Federal Reserve
Public balance sheet
substituted for
collapsing private
shadow money
19 November 2013
2014 Global Outlook 56
Crisis, response, evolution
Inevitably, we have seen a large regulatory response to the groundbreaking use of public-
sector balance sheets to replace collapsed private-sector liquidity. The contours of the
regulations hint at a willingness to allow shadow banking to go on. For example, in the
quotation above, Mark Carney mentions a need for policymakers to “maintain market
liquidity.” Still, the magnitude of change should not be underestimated. Just as commercial
banks became intertwined with governments after the Great Depression, shadow banks
now face similar pressures.
The newly emerging system is likely to be much less elastic and liquidity-generating than
the old version. Market participants must navigate through a period when liquidity is
reduced and financial balance sheets are shrinking due to both weak real recovery and
new regulatory headwinds.
Myriad new regulatory efforts are under way. Capital requirements have increased for
many types of financial entities, not just banks. The "too big to fail" problem is being
attacked with specific curbs on activity by large institutions – exactly the ones that were
providing the marginal liquidity before 2008. Funding markets are being seriously impacted
by Basel III liquidity ratios, proposed money market fund legislation, proposed
rehypothecation/reuse rules on and off exchanges, and proposed minimum repo haircuts.
Gross asset ratio proposals could severely raise the costs to dealers of providing matched
book repo funding. New securitization rules limit the volume of new transactions. Europe’s
proposed financial transactions tax would further throw sand in financial intermediation.
Volcker rule-type regulations directly limit dealer inventory positions, tilting the balance
away from inside-spread traders and toward value investors, with a significant impact on
market liquidity and trading volumes.
The list of proposed regulations – which go well beyond what we have described – is so
long that it makes one wonder whether shadow banking will survive. However, traditional
banking was not uninvolved in shadow banking or the bubble dynamics of the last decade,
and it is facing increased regulation as well, of course. Recent Fed guidance on the
liquidity coverage ratio, for example, would limit banks’ ability to carry out straightforward
business, such as extending lines of credit to businesses.
There is a version of the Coase Theorem that says that an economy with a stable legal
structure will develop the forms of financial intermediation it requires. The long history of
financial markets highlights the plasticity of financial systems: they have a great capacity
to overcome almost any obstacle, including regulation. History, in fact, suggests that
regulation is the greatest source of financial innovation. Most likely, the current round of
regulation will be no different.
During the transition to a new system, volumes of financial transactions are likely to stay
low, and maintaining government reflationary policies, including low interest rates, will be
necessary.
Financial innovation will be bubbling visibly where it can. In the US, we already see frothy
conditions in some credit markets and policymakers struggling to squelch some forms of
activity. These is robust CLO issuance, regulatory-driven collateral swap activity,
expanding mortgage REITs, a later prospect for new entities to absorb the private-label
mortgage portfolios from reformed GSEs, new money dealer entrants getting into cleared
repo anonymously through FICC, and credit hedge funds eagerly purchasing assets
forcibly shed by SiFis under new capital rules.
Regulatory
response is likely to
lead to a much less
elastic and liquidity-
generating system
An economy with a
stable legal structure
will develop the forms of
financial intermediation
it requires
19 November 2013
2014 Global Outlook 57
We believe that investors who do not focus on the changes in the financial system are
likely to get much wrong in the years ahead. So will the managers of financial institutions
slow to recognize the obsolescence of certain business models. Real economy factors ‒
such as further technological advances, China’s growing role in the international monetary
system, and the poor demographics of the developed world ‒ will further influence the next
round of financial system evolution.
For the time being, the financial system is paying a double penalty for the crisis. It is
shrinking unprofitably, and struggling to maintain liquidity along the way. In our view,
however, Coase’s Theorem in the long run will hold, and the financial system will bounce
back vibrantly in a new form. As long as liquidity can be profitably provided, entities will
arise to do that business. 2014 is a year when the new entrants will not have gained the
size to eliminate the market structure, liquidity, and volume problems evident in 2013.
Price action is likely to be “jerky,” characterized by occasional bouts of illiquidity in which
prices gap lower while buyers are temporarily absent, as in June of this year. Still, we
believe that these conditions will not be permanent. But 2014, and 2015 too, will be a time
of transition.
Ultimately, the reason we are confident that shadow banking will survive is that we listen to
what the policymakers are saying. Creating stable funding markets, resolution regimes,
and effective pricing for policy puts are exactly the measures necessary for shadow
banking to go on developing. Carney’s recent speech, in which he said that the Bank of
England would lend collateral and cash against “anything we can value” is a clear example
of policymakers developing regulation with the future life of the shadow banking system in
mind, not its destruction.
We stress the need
to focus on the
changes in the
financial system
Until a new system
emerges, interest rates
are likely to stay lower
than would otherwise be
the case; bouts of
significant illiquidity and
jerky price action may
be frequent
19 November 2013
2014 Global Outlook 58
19 November 2013
2014 Global Outlook 59
Market Implications of Persistent Deleveraging Liquidity: "you'll miss me now that I'm gone!" 2014 Core Views
Reduced intermediation capital tends to create less liquid assets, raising required risk
premiums and cross-asset correlation, particularly in downdrafts.
"So far, so what?" is a fair reaction: central bank stimulus programs have disguised
the impact of reduced market liquidity in a way that is not likely to be threatened in
our core scenario.
What does change, however, is the exposure to tail risk: stronger activity that causes
inflation expectations to rise even modestly would likely widen rather than tighten
credit spreads, for instance. We introduce a market liquidity index to gauge the most
reliable hedges for periods of liquidity withdrawal.
We examine the ongoing market impact of deleveraging at two levels:
The changes that occur within an asset class as intermediation capital is withdrawn, and
The portfolio impacts of reduced liquidity across a set of assets.
Reduced liquidity of an asset should be expected to raise the ex ante premium required to
hold it as well as potentially increase its realized correlation with risky assets during
extreme downdrafts. Consistent with this, we show signs of increased ex ante premiums in
high yield, changing skew and correlation behavior in credit while also showing historical
evidence of high cross-market correlation of time-varying (read: liquidity-varying) term
premiums within rates.
Nonetheless, investors might well ask why they should be concerned with this argument
when spreads are, in most cases, highly compressed by historical standards. For us, there
are two parts to the answer:
First, central bank stimulus programs to market liquidity have served to depress the level
of core rates such that the extent of the repricing required in newly less liquid assets is
masked.
Second, the disguised increase in dependence on central bank policy decisions creates
the potential for historically unusual macro correlations for less liquid assets: for instance,
stronger activity that allowed a rise in inflation would likely widen credit spreads instead
of tighten them.
Historically, less liquid markets have not disrupted the allocation of capital, as discussed in
Reshaping the Financial System. However, the accounting regime for banks and long-
dated investors was very different in those earlier periods.
The combination of reduced market intermediation liquidity, high dependence on
central bank stimulus programs, and mark-to-market accounting regulation sets the
stage for substantial macro dislocation, in our view.
Through the construction of a market-based index that tracks the performance of a
set of trades that do well when liquidity is abundant, we are able to examine
possible hedges to phases of liquidity withdrawal. Intuitively, much of the exposure
that provides an offset to the pro-liquidity trades involves negative carry: curve-flattening
exposure in rates, long FX, or equity-implied volatility, for example. But, we also find that
the response of the money market curve is highly dependent on the source of the liquidity
shock, highlighting the importance of active management of this part of the portfolio.
Sean Shepley
+44 20 7888 1333
Bill Papadakis
+44 20 7883 4351
Thushka Maharaj
+44 20 7883 0211
The stage is being
set for substantial
macro dislocation
19 November 2013
2014 Global Outlook 60
Performance under stress
The starting point for our analysis is that improved liquidity reduces the ex-ante premium
required to hold an asset. In general, to be useful as a "consumption asset," an asset has
to be liquid – i.e., exchangeable into cash without requiring the holder to accept a
significant discount. Where this is not the case, the greater the likelihood that the asset's
return profile will become increasingly like other risky assets.
One way to consider this is to examine the performance of selected assets in phases of
risk aversion. We assess this on the basis of declines in the S&P 500 index and start by
showing the difference that credit quality and liquidity make within the major government
bond markets, given that they are expected to generate negatively correlated returns with
equities in periods of equity drawdowns.
Exhibit 69 shows the results for six major government bond markets. As the largest, most
liquid market, Treasuries display the strongest positive returns during periods when
equities decline, closely followed by Bunds. Other markets in which liquidity is less reliable
or inherent credit risk higher display lower returns during these periods.
Exhibit 69: The most liquid bond markets tend to outperform in risk-off periods Results during periods of monthly declines of 5% or more for S&P 500 index, 1980 – today
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
1.4%
IT 10YR ES 10YR FR 10YR UK 10YR DE 10YR US 10YR
Average returns during large SPX declines
total returns
Source: Credit Suisse
Extending the analysis to credit, Exhibit 70 compares the returns between high grade and
high yield corporate credit for the same periods. These are calculated based on the total
return data for Credit Suisse Liquid Indices: LUCI is the US high grade corporate credit
index, and LUHY is its high yield equivalent. While both are perceived as risky assets and
tend to suffer losses in downturns as a consequence, there is a stark difference in their
average returns over the periods in question: investment grade (IG) losses are less than
1% on average, whereas high yield (HY) bonds lose approximately 5% more.
Reduced intermediation
capital tends to create
less liquid assets, raising
required risk premiums
and cross-asset
correlation, particularly in
downdrafts
19 November 2013
2014 Global Outlook 61
Exhibit 70: Credit, IG versus HY Exhibit 71: Equities, large cap versus small cap Results during periods of monthly declines of 5% or more for S&P 500 index
-6%
-5%
-4%
-3%
-2%
-1%
0%
LUCI LUHY
Average returns during large SPX declines
-9.3%
-9.2%
-9.1%
-9.0%
-8.9%
-8.8%
-8.7%
-8.6%
-8.5%
Russell 1000 Russell 2000
Average returns during large SPX declines
Source: Credit Suisse Source: Credit Suisse
Finally, within the equity market, we note that the less liquid components of the market (in
this case, small-cap stocks) underperform during downdrafts for the broader market.
Indeed, the notion of compensation for liquidity risk in small cap stocks was one of the
systematic return factors identified by Nobel prize winner Eugene Fama (see Exhibit 71).
Performance across different market liquidity regimes
Considering variations in liquidity premiums over time, we focus on two distinct measures
of term premiums within the rates markets. Exhibit 72 shows the rolling return from a naïve
strategy of lending 3-month LIBOR 12 months forward and reviewing the P/L only at the
point at which the contract rolls into cash. It highlights the strongly time-varying nature of
term premiums, with the long period of positive premiums following 1994 sitting in
particularly strong contrast with the equally long period of negative premiums between
2003 and 2007.
Exhibit 72: Realized 12-month term premium
Rolling 4th 3-month future less subsequently realized 3-month LIBOR
30-Dec-94 31-Dec-99 30-Dec-04 30-Dec-09
0
250
500
12m USD realised term premium 12m EUR realised term premium
GBP realised term premium
Source: Credit Suisse Locus
The results are broadly consistent with the models of long-dated term premiums analyzed
by our interest rate strategists – see the section on central bank policy for a more detailed
discussion of term premiums. As highlighted by Exhibit 73, estimated term premiums
declined through the 1990s, with a strong co-movement between the UK and the US.
Similarly, both moved into negative territory during 2011 under the influence of the Fed's
forward guidance and asset purchase programs.
Term premiums are
strongly and
positively correlated
across markets
19 November 2013
2014 Global Outlook 62
Exhibit 73: 10-year estimated term premiums
Using the Rosenberg-approach of weighted average 1- to 7-year instantaneous forward rates
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Ma
r-9
0
Ma
r-9
2
Ma
r-9
4
Ma
r-9
6
Ma
r-9
8
Ma
r-0
0
Ma
r-0
2
Ma
r-0
4
Ma
r-0
6
Ma
r-0
8
Ma
r-1
0
Ma
r-1
2
Pe
rce
nta
ge
po
int (%
)
UK Term Premium 10y
US Term Premium 10y
Source: Credit Suisse Locus
That term premiums are strongly positively correlated across markets suggests a
dominant common driver (in our assessment, closely associated with the impact of
Fed policy on levels of general market liquidity and risk) rather than idiosyncratic national
drivers.
Excess returns consistently available in the 1990s when intermediation capital was
relatively low were (in some cases, more than completely) arbitraged away during the
2000s when system-wide leverage increased.
Differences in liquidity across markets are nonetheless also evident in the
distribution of term premiums. In the more liquid USD market, a concentration of non-
normal small positive excess returns has been apparent at the front end of the curve
both pre-2000 and post-2009. By contrast, the less liquid GBP market has had a flatter
distribution with a larger right-hand tail.
In the 10-year sector, we also note the 1994 experience of the GBP market whereby
term premiums rose much more sharply than in the USD market in response to a Fed
policy shock. This provides a reminder that the EM response to the threat of Fed
tapering in 2013 has historical precedents: liquidity shocks are often more intense the
lower the natural level of liquidity in an asset.
Exhibit 74: Pre-2000 realized 3-month term premiums Exhibit 75: Post-2009 realized term premiums
Rolling 4th 3-month future less subsequently realized 3-month LIBOR Rolling 4
th 3-month future less subsequently realized 3-month LIBOR
-200.00 -100.00 0.00 100.00 200.00 300.000
50
100
150
200
USD pre-2000 GBP pre-2000
0.00 25.00 50.00 75.00 100.00 125.00 150.000
25
50
75
100
USD 2009-now GBP 2009-now
Source: Credit Suisse Locus Source: Credit Suisse
19 November 2013
2014 Global Outlook 63
Evolving skew and correlation within credit and equities
Focusing on the dynamics within the equity and credit markets, although the immediate
impact of the LEH bankruptcy was to prompt a sharp increase in systemic risk premiums
that fed across markets, over time, this is being replaced by a more marked divergence in
behavior between the two asset classes.
First, in terms of correlation within each market, we note that there has been significant
divergence. Exhibit 76 shows the realized sectoral spread correlation within the US credit
market with the implied correlation between the top 50 companies in SPX. Historically, the
two have co-moved, but over the last two years, excess spread returns in credit have
become increasingly positively correlated (consistent with reduced liquidity) even as
equities have become less correlated (consistent with better liquidity / reduced systemic
risk). On a total return basis, correlation within credit has also risen, as shown in Exhibit 77,
but this is well within the bounds of the historical range and, in our view, in any case
dominated by the level of rates.
Exhibit 76: Sectoral spread correlation is up in credit, while equity market correlation has eased
Exhibit 77: On a total return basis, credit correlation is within its range and also divergent
Realized credit correlation based on daily spread changes of index sectors Realized credit correlation based on daily total returns of index sectors
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
6m realized credit correlation
SPX (top50) 6m implied correlation
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
0.70
0.75
0.80
0.85
0.90
0.95
1.00
credit correlation (total returns)
equity correlation (realized, RHS)
Source: Credit Suisse Source: Credit Suisse
This same behavior appears to be behind the increasing evidence of negative skewness in
credit returns.
Exhibit 78 shows the skewness of the daily return distribution in each year over the last
decade for both credit (including both LUCI and HY sectors of the market) and equities.
Whereas equities have exhibited a lower level of skewness than seen in 2007, for example,
IG and HY return skewness has increased to make new highs in the low rate / low spread /
low liquidity environment seen since mid-2012.
The divergence in
the behavior of
equity and credit
markets is marked
19 November 2013
2014 Global Outlook 64
Exhibit 78: A regime shift for the distribution of credit returns
Skewness of daily returns distribution for IG credit, HY credit, and equities in the last ten calendar years
-2.00
-1.50
-1.00
-0.50
-
0.50
1.00
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Skewness of Total Returns in Credit and Equities
LUCI
LUHY
SPX
Source: Credit Suisse
Ex ante risk premiums rising in HY
Because central bank policies have generally operated to depress term, credit, and
liquidity risk premiums, evidence of where liquidity risk premiums are increasing is
generally limited. Nonetheless, our HY credit strategist, Jonathan Blau, highlights the
divergence between HY credit spreads and realized default losses, shown in Exhibit 79.
The significantly higher levels of compensation above default losses that have prevailed
since 2009 compared to previous periods appear to be a reflection of reduced capital
among the dealer community and hence lower market liquidity. The compensation for
investors in terms of spread-to-worst for holding these assets is approximately 80% higher
in the post-crisis period than the long-run average in the period from the beginning of the
dataset in the mid-1980s until 2008.
Exhibit 79: A notable increase in the compensation over default losses for high yield investors post-crisis
200 bp
400 bp
600 bp
800 bp
1000 bp
1200 bp
1400 bp
1600 bp
1800 bp Spread to Worst
HY Default Loss Rate (7-Months Later)
Average Difference: 2009-2013: 527bpAverage Difference: 1986-2008: 290bp
Source: Credit Suisse
19 November 2013
2014 Global Outlook 65
The hypothesis of reduced liquidity resulting in a higher ex-ante required premium by
investors who wish to be compensated for it also receives further confirmation from our
analysis of spread volatility, as shown in Exhibits 80 and 81. In particular, we observe that
the less liquid EM credit market exhibits significantly higher spread volatility compared to
both IG and HY, which is currently yielding about 150 bp more than EM, suggesting that the
liquidity of the asset can matter more than its creditworthiness in some respects.
Exhibit 80: Spread volatility, in absolute terms… Exhibit 81: …and as a percentage of the level
SBI = EM credit, LUCI = US IG credit, LUHY = US HY credit
-
20
40
60
80
100
120
140
-
200
400
600
800
1,000 annual bp vol
SBI
LUHY
LUCI (RHS)
0%
20%
40%
60%
80%
100% vol as percentage of benchmark spread
SBI
LUCI
LUHY
Source: Credit Suisse Source: Credit Suisse
Constructing risk offsets for liquidity withdrawal
As described in Macro Tactics: policy innovations and toolkit additions, we have
constructed an index based on some of the most representative pro-liquidity macro trades,
aiming for a fairly diversified basket where no one asset class dominates the performance
of the entire portfolio (see Exhibit 82).
Exhibit 82: Liquidity benchmark performance since 2007
Portfolio inception 1 January 2007. Fed QE periods highlighted
-20,000,000
-15,000,000
-10,000,000
-5,000,000
0
5,000,000
10,000,000
15,000,000
20,000,000
Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13
Cumulative PNL for pro-liquidity portfolio
Cumulative
Source: Credit Suisse
19 November 2013
2014 Global Outlook 66
Looking at the major post-2009 phases of liquidity withdrawal (i.e., as defined by the most
significant drawdowns in the pro-liquidity portfolio), we find that they have been
characterized by
A stronger dollar and higher FX-implied volatility;
Higher interest rate volatility as well as wider swap spreads in both USD and EUR rates;
Flatter core rates curves, with USD and EUR 5s30s the most consistently reliable
flattener; and
Money market curve flattening, with the strong exception of the liquidity decline that was
prompted by the prospect of Fed tapering.
Given this, we define potential hedges for possible sources of liquidity risk in 2014 as set
out in Exhibit 83.
Exhibit 83: Selected hedges for 2014 macro and central bank risk
Recession Core inflation picks up Fed tapers
Rates Long duration.
Flatteners in money market and coupon curve.
Rates vol falls.
Short duration.
Steepeners.
Rates vol rises.
Short real rates, short breakevens.
Money market steepeners – long-end flatteners.
Rates vol rises.
FX Short EM, short cyclical G10.
USD & JPY call skew bid.
Long USD and long EUR / EM.
USD call skew bid, but not JPY.
Long USD / EM.
USD and JPY call skew bid.
Source: Credit Suisse
We suggest some
potential hedges for
periods of liquidity
withdrawal
19 November 2013
2014 Global Outlook 67
Market risk premia: a systematic approach 2014 Core Views
We follow our introduction of the liquidity index by highlighting systematic approaches
to extracting market risk premia across major asset classes.
The strategies use a range of investment styles to exploit traditional and alternative
sources of risk premia, including carry, fair value, merger arbitrage, dividend yield,
and volatility.
Low correlation among the strategies and with market benchmarks suggests that
combining them could deliver the benefits of diversification to a balanced portfolio.
The liquidity index we introduce in our discussion of the market impacts from persistent
deleveraging (see Market Implications of Persistent Deleveraging) illustrates how a naïve
strategy of exposure to liquidity has benefitted from central bank stimulus programs since
2009. It has also suffered very large drawdowns, however, suggesting that approaches to
profiting from market risk premia need to be carefully calibrated and/or have embedded
risk management features.
In the analysis below, we highlight a series of Credit Suisse strategies that aim to extract
traditional and alternative sources of risk premia across asset classes in a systematic
fashion. Exhibit 84 summarizes the strategies.
Exhibit 84: Index descriptions and performance statistics, Dec 2006 to Oct 2013
Statistics reflect excess returns. Performance for CSAVI is based on the average of 5 rolls. For the Dividend Alpha Index, data are only available starting in July 2008.
Strategy / Style / BBG Ticker / Description Risk Premium Launch Date
Avg. Ann. Return /
Sharpe Ratio Maximum Drawdown
Interest Rates
Credit Suisse Adaptive Volatility Index – Global (CSAVI) / Volatility / CSVIG2
Sells delta-hedged interest rate option straddles in the USD/JPY/EUR rates markets. The strategy
aims to improve risk-adjusted returns by dynamically adjusting its leverage depending on the
prevailing volatility environment.
Volatility/Carry 09/2012 3.8% / 2.41 2.8%
Equities
Credit Suisse Global Carry Selector II / Volatility / GCSCS2UE
Extracts equity volatility risk premia embedded in the option prices of four global indices (S&P 500,
Euro Stoxx 50, DAX and Nikkei 225). The strategy systematically sells variance swaps and
opportunistically buys forward variance swaps as a hedge.
Volatility/Carry 09/2012 8.1% / 0.78 15.2%
Credit Suisse Dividend Alpha Index / Carry / CSEADVAE
Looks to isolate the dividend risk premium in Euro Stoxx 50 dividend futures by going long the front
dividend futures contracts and stripping out the portion of return attributable to equity price action with
an offsetting position in the Euro Stoxx 50.
Dividend Yield 10/2013 10.4% / 0.98 28.2%
LAB Merger Arbitrage / Merger Arbitrage / CSLABME
Systematically profits from announced merger deals by going long the target and short the acquirer.
Gains are realized when deals are completed.
Merger
Arbitrage 01/2010 1.5% / 0.27 17.3%
Currencies
FX Metrics Carry / Carry / FXMXCEUS
Exploits the systematic bias in forward rates by investing in an equally weighted basket of top high-
yielding currencies and selling an equally weighted basket of low-yielding currencies. Carry 01/2009
G10: 1.8% / 0.14
EM: 2.6% / 0.27
G10: 32.0%
EM: 20.1%
FX Metrics Value / Value / FXMXVEUS
Buys the most undervalued currencies and sells the most overvalued ones on an equally weighted
basis based on the Credit Suisse FX Fair Value model, an econometric model driven by long- run
fundamentals (PPP, rate differentials, productivity, and external balances).
Fair Value 01/2009 G10: 0.9% / 0.10
EM: 6.5% / 0.68
G10: 23.0%
EM: 18.7%
Source: the BLOOMBERG PROFESSIONAL™ service, Credit Suisse
Baldwin Smith
212 325 5524
Riad Houry
+44 20 7883 0168
Cheng Ju
212 325 9812
Yongchu Song
212 538 7013
19 November 2013
2014 Global Outlook 68
Selling options to capture the volatility risk premium
The Credit Suisse Adaptive Volatility (CSAVI) and Global Carry Selector II (GCS II) indices
look to capture the volatility risk premium in rates and equities by selling options. CSAVI
aims to exploit the bias between implied and realized volatility in the USD, JPY, and EUR
interest rate swap markets by selling one-month into 10-year swaption straddles and delta
hedging the position until expiry. The strategy aims to improve risk-adjusted returns by
dynamically adjusting its leverage depending on the prevailing volatility environment.
The Global Carry Selector II Index (GCS II) is an equity volatility arbitrage strategy that
extracts equity risk premia embedded in the option prices of four global indices (S&P 500,
Euro Stoxx 50, DAX, and Nikkei 225). The strategy systematically sells variance swaps
and opportunistically buys forward variance swaps as a hedge.
As shown in Exhibit 85, CSAVI has delivered stable performance, despite the recent
volatility across developed bond markets. GCS II, which generated strong positive returns
following the financial crisis, had a difficult start to 2013. Since June, however, the strategy
has recovered some of its year-to-date losses.
Dividend yield and merger arbitrage in equities
The Dividend Alpha Index invests in Euro Stoxx 50 dividend futures to systematically
harvest the embedded dividend risk premium. The index looks to isolate the dividend risk
premium by going long the two front dividend futures contracts and stripping out the
portion of the return attributable to equity price action with an offsetting position in the Euro
Stoxx 50 price index.
The Liquid Alternative Beta (LAB) Merger Arbitrage strategy seeks to gain exposure to a set
of announced merger deals by going long the stock of the target company and short the
stock of the acquirer company. Exhibit 86 summarizes the performance9
of the two
strategies.
Exhibit 85: Harvesting the volatility risk premium in equities in global rates, Dec 2006 to Oct 2013
Exhibit 86: Dividend Alpha and LAB Merger Arbitrage, Dec 2006 to Oct 2013
Data for the Dividend Alpha Index are only available since July 2008.
80
100
120
140
160
180
95
100
105
110
115
120
125
130
135
Dec-06 Dec-08 Dec-10 Dec-12
CSAVI Global (LHS) GCS II (RHS)
85
90
95
100
105
110
115
75
100
125
150
175
Dec-06 Dec-08 Dec-10 Dec-12
Dividend Alpha (LHS) LAB Merger Arb (RHS)
Past performance should not be taken as an indication or guarantee of future performance. Source: the BLOOMBERG PROFESSIONAL™ service, Credit Suisse
Past performance should not be taken as an indication or guarantee of future performance. Source: the BLOOMBERG PROFESSIONAL™ service, Credit Suisse
9 Past performance should not be taken as an indication or guarantee of future performance.
We look to
systematically
extract various risk
premia, including
carry, fair value,
merger arbitrage,
dividend yield, and
volatility
19 November 2013
2014 Global Outlook 69
The Merger Arbitrage Index, which has a high beta to the US equity market, suffered in
2008 but has subsequently generated positive returns every year except in 2012. Year to
date, the Merger Arbitrage strategy is up 6.0%. The Dividend Alpha Index has been up
every year since 2008, with a notable spike in performance in 2009 due to the record
amount of dividend payments by Euro Stoxx 50 companies in that year.
FX enhanced beta strategies: profiting from currency carry and fair value
We consider two FX enhanced beta strategies in G10 and EM. The Credit Suisse FX
Metrics Carry Index ranks the currencies in its universe based on the yield in the relevant
one-month FX forward and goes long an equally weighted basket of top high-yielding
currencies and short an equally weighted basket of low-yielding currencies. The FX
Metrics Value Index ranks currencies based on their divergence from their fair value, as
estimated by the FX Fair Value Model, and goes long the most undervalued currencies
and short the most overvalued currencies.
Exhibit 87 illustrates the carry performance since December 2006, for G10 and EM. The
performance of the G10 carry strategy is typical of currency carry strategies, generating
steady income in normal market conditions and deteriorating in periods of stress. The EM
carry strategy recovered faster than its G10 counterpart immediately following the financial
crisis. It generated robust returns in the two years following the crisis (+20.7% in 2009 and
+7.9% in 2010) but has subsequently struggled.
Exhibit 88 illustrates the performance of the FX value portfolio. The performance of the
G10 value portfolio appears roughly symmetrical to that of the G10 carry portfolio. While
the G10 carry strategy tends to perform in line with risk assets, G10 value is most
profitable when markets are selling off, as currencies tend to revert toward their fair values.
Exhibit 87: FX metrics carry, Dec 2006 – Oct 2013 Exhibit 88: FX metrics value, Dec 2006 – Oct 2013
70
80
90
100
110
120
130
140
Dec-06 Dec-08 Dec-10 Dec-12
FX Carry G10 FX Carry EM
90
100
110
120
130
140
150
160
Dec-06 Dec-08 Dec-10 Dec-12
FX Value G10 FX Value EM
Past performance should not be taken as an indication or guarantee of future performance. Source: the BLOOMBERG PROFESSIONAL™ service, Credit Suisse
Past performance should not be taken as an indication or guarantee of future performance. Source: the BLOOMBERG PROFE4SSIONAL™ service, Credit Suisse
Correlation profile
We examine the correlation profile of the strategies in Exhibit 89. The most positive
correlation (+0.60) is between CS LAB Merger Arbitrage and FX Metrics G10 Carry, as
both of these have a high beta to equity markets. The most negative correlation (-0.60) is
between the G10 carry and value strategies, confirming our earlier observation that the
risk premium harvested by the FX value strategy, at least in G10, tends to generate profit
when carry is selling off. Overall, return correlation among the various strategies is
relatively low, reflecting the diversity in asset class and investment styles among the
selected indices.
Combining
strategies could
deliver the benefits
of diversification to
a conventional
portfolio
19 November 2013
2014 Global Outlook 70
Exhibit 89: Weekly return correlation, Dec 2006 to Oct 2013
For correlation calculations with the Dividend Alpha Index, we use data going back to July 2008.
CSAVI GCS II Dividend Alpha LAB Merger Arb FX Carry G10 FX Carry EM FX Value G10 FX Value EM
CSAVI 1.00
GCS II 0.09 1.00
Dividend Alpha 0.24 0.13 1.00
LAB Merger Arb 0.39 0.05 0.25 1.00
FX Carry G10 0.33 0.15 0.24 0.60 1.00
FX Carry EM 0.19 0.12 0.25 0.27 0.50 1.00
FX Value G10 -0.19 -0.04 -0.14 -0.45 -0.60 -0.26 1.00
FX Value EM 0.23 0.13 0.22 0.32 0.38 0.53 -0.16 1.00
Past performance should not be taken as an indication or guarantee of future performance.
Source: the BLOOMBERG PROFESSIONAL™ service, Credit Suisse
We extend our analysis to include correlation with major equity and fixed income
benchmarks. Exhibit 90 summarizes the results. As expected, the correlation with global
equities is highest for the FX G10 Carry and LAB Merger Arbitrage indices. The correlation
with benchmarks for most other indices is generally low – and negative for FX Value G10
– indicating that these strategies could deliver the benefits of diversification to a
conventional portfolio.
Exhibit 90: Weekly return correlation, Dec 2006 to Oct 2013
For emerging market bonds, we use the CS Sovereign Bond Index. For correlation calculations with the Dividend Alpha Index, we use data going back to July 2008.
CSAVI GCS II Dividend Alpha LAB Merger Arb FX Carry G10 FX Carry EM FX Value G10 FX Value EM
MSCI World 0.24 0.17 0.18 0.63 0.73 0.43 -0.43 0.47
MSCI EM 0.22 0.17 0.29 0.59 0.77 0.53 -0.44 0.44
CS Global Govt Bonds 0.02 -0.07 -0.02 0.05 -0.14 -0.31 0.00 -0.18
CS EM Bonds 0.27 0.07 0.44 0.53 0.55 0.44 -0.33 0.41
Past performance should not be taken as an indication or guarantee of future performance.
Source: the BLOOMBERG PROFESSIONAL™ service, Credit Suisse
19 November 2013
2014 Global Outlook 71
The Corporate Landscape May the road rise up to meet you 2014 Core Views
We expect moderate continued returns from all corporate-issued assets, with a
strong influence from the path of yields.
We expect reasonable 2014 EPS growth, albeit below consensus.
Cash M&A, buybacks, and other leveraging transactions should grow steadily but not
yet to the point of being a general threat to bondholders.
We expect moderate continued returns from all corporate-issued assets, with a strong
influence from the path of yields.
The corporate sector remains in good health and in general has good access to finance,
yet not such good health or such good access that we expect strong anti-bondholder
activity.
Margins appear to remain strong, some sort of growth is taking place (although we have
increasing questions about the low level of euro-area nominal growth and the risks that
introduces), and balance sheet re-composition does not look set for a radical shift.
Earnings expectations are moderate, and margins remain supported. This looks set to
continue until either financial crisis conditions resume, which we do not expect yet, or a
global incomes shift from profits to labor, which also does not look imminent, although we
think that the global profit share is close to an extreme.
This is a respectable environment for equities and a “Goldilocks” environment for credit,
absent a substantial yield sell-off.
In Europe, in particular, one learning point from the crisis has been that corporate bonds
can trade through governments, albeit they remain closely correlated (see European
Credit Strategy section). Arguably, in some cases, some corporate (and financial) credits
are emerging as the store of value. That said, behind the core risk of a rates sell-off, a
continuing tail risk to all markets is a “flare-up” of the issues that we still see as
unaddressed in the euro area. Growth,10
however, buys time.
We expect reasonable 2014 EPS growth, albeit below consensus
We recently revised up modestly our 2014 earnings growth forecasts for the US and
Europe (see Equities: a pause before further advances, 1 November 2013). In the US, we
now forecast EPS growth of 7.1%, up from 6.8%, and in the euro area, we forecast 10.5%,
up from our previous estimate of 7.5%. We remain below consensus for both regions
(IBES consensus forecast is 10.9% for the US and 15.4% for the euro area).
10 Dealing with a financial stock problem, nominal growth is needed, with the real/inflation breakdown somewhat secondary.
European Credit Strategy
William Porter
+44 20 7888 1207
Global Equity Strategy
Mark Richards
44 20 7883 6484
Andrew Garthwaite
+44 20 7883 6477
We expect moderate
continued returns
from all corporate-
issued assets
For 2014, we forecast
7.1% and 10.5% EPS
growth in the US and the
euro area, respectively
19 November 2013
2014 Global Outlook 72
Exhibit 91: US earnings model specification Exhibit 92: Euro area earnings model specification
Model inputs, % chg Coeff. t-value 2013E 2014E
US Real GDP 3.4 3.0 1.6% 2.6%
Non-fin. corporate GDP deflator 6.0 2.6 1.2% 1.6%
Total costs (ULC+NULC)* -7.2 -5.9 1.0% 1.3%
USD trade-weighted -0.4 -1.5 5.8% 5.0%
IBES consensus $108.6 $120.4
Credit Suisse $106.4 $114.0
IBES consensus 5.3% 10.9%
Credit Suisse 3.2% 7.1%
Model specifications
RSQ 0.74
Model output - S&P 500 operating EPS
*ULC= Unit labour costs, NULC (nonlabor unit costs = 50% depr./10% interest/
40% taxes)
Expl. Variables: Lead Coeff. Latest 2013E 2014E
Euro-area GDP yoy% 2Q 2.8 -0.6 0.6 1.5
Euro-area PPI yoy% 2Q 0.7 0.3 0.4 1.1
Euro-area unit labour costs yoy% 2Q -6.6 1.1 1.1 1.0
Euro TWI yoy% 2Q -0.1 9.4 7.7 0.0
Intercept 12.2
R2 0.67
MSCI EMU EPS, yoy 6.1% 10.5%
IBES Consensus -3.9% 15.4%
Source: Thomson Reuters DataStream, Credit Suisse estimates Source: Thomson Reuters DataStream, Credit Suisse estimates
The main drivers of earnings in our top-down model are as follows:
GDP growth (which has a beta of 3 to 1 to earnings).
Output price inflation (i.e., pricing power).
Costs (approximately 70% are labor costs and c30% are non-unit labor costs, which are
in turn made up of depreciation, tax, and interest in a ratio 53, 34, 13).
Currency (30% of US sales come from outside the US in NIPA data and closer to 40%
on S&P 500 data, and 57% of European revenues are from outside the euro area).
Economic momentum in both the US and Europe is improving, helping support our
upgrades, but we remain cautious overall, particularly in Europe, and therefore somewhat
below consensus. However, weaker growth than consensus would tend to lower yields,
providing support. The path of rates is a key element in our appraisal of possible returns in
corporate securities.
Margins remain well supported, even in the US
On both Worldscope and Flow of Funds data, the net income margin for the quoted non-
financial sector in the US remains at the top end of its historical range. In our survey of
clients, roughly two-thirds of respondents believe that margins will fall over the next two
years. We believe that high margins are well supported.
Looking at bottom-up data, we see that high margins have been driven by abnormally low
interest and depreciation charges. We expect these to continue and therefore assume in
our assessment of interest charges that BBB bond yields will remain at current levels,
rather than increase, and that the depreciation charge will only pick up with a lag.
We expect margins
to stay strong
19 November 2013
2014 Global Outlook 73
Exhibit 93: US net profit margins are close to the top end of their historical range
Exhibit 94: Abnormally low interest and depreciation charges have supported net profit margins in the US
2%
4%
6%
8%
10%
12%
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013
US equities non-financial net profit margin
US profit share of GDP, non-financial corporate sector (NIPA, rhs)
16.5
5.9
16.3
7.4
2.4 1.7
5.14.9
3.1
2.2
0
2
4
6
8
10
12
14
16
18
EB
ITD
A
Inte
rest
Dep
reci
atio
n
Tax
Net
pro
fit
EB
ITD
A
Inte
rest
Dep
reci
atio
n
Tax
Net
pro
fit
post-1990 average latest
Source: Thomson Reuters DataStream, Credit Suisse Source: Thomson Reuters DataStream, Credit Suisse
We believe that the key driver of margins is the cost of labor. The secular rise in the profit
share of GDP is mature but does not look set to reverse soon. Cyclical peaks in the profit
share of GDP have tended to occur at a minimum of ten months after wage growth has
started to accelerate (on average 21 months) and have also tended to occur when hourly
wage inflation was running between 3.5% and 4%. Currently, it is just 2.2%. We believe that
the broadest measure of labor pricing power in the US is the employment cost index. This
has remained steady between 1½% and 2% for the past year, and we do not see it picking
up until at least mid-2015. As a further extension of the cycle, equities have tended to peak 1
to 1½ years after the margin peak. This suggests some years of continuation of the current
margin environment, absent some sharp exogenous change, such as a trade war.
Exhibit 95: Profit share of GDP and wage share move in opposite directions
Exhibit 96: ... and margins only tend to peak 20 months after wage growth has picked up
52%
53%
54%
55%
56%
57%
58%
59%5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
1950 1960 1970 1980 1990 2000 2010
Profits Wages, rhs, inverted
% of GDP
Peak in US
margin
US hourly wage
growth, yoy
Trough in wage
growthLag (mm)
Jun-84 3.5% Aug-83 10
Dec-88 3.5% Dec-86 24
Sep-97 3.9% Mar-96 18
Sep-06 4.1% Feb-04 31
Average 3.7% 21
Current 2.2%
Source: Thomson Reuters DataStream, Credit Suisse Source: Thomson Reuters DataStream, Credit Suisse
19 November 2013
2014 Global Outlook 74
It is also worth noting that margins are not nearly as extended outside of the US (see
Exhibit 99), with euro-area margins notably depressed. We think that there are good
reasons why the tax and interest charges in Europe can fall, which in turn would help net
margins.
Margins are only one aspect of the return on equity. The other two components (asset
turns and leverage) have plenty of scope to rise, in our view, as late-cycle risky behavior
shifts value from the credit to the equity markets. This phenomenon has barely been in
evidence so far and as it emerges should boost the RoE.
Europe
The situation for European corporates is quite different from that of their US counterparts.
We have already noted that margins are less extended. There has been massive
divergence in Europe from US EPS.
Twelve-month forward EPS in Europe is actually close to its 2008 low (40% off its peak),
while US EPS is nearly double 2008 trough levels (see Exhibit 97).
Exhibit 98 shows that top-line growth has not been materially different for the two indices
but that weaker margins and dilution (via financials) have led to significantly weaker EPS
growth.
Exhibit 97: 12-month forward EPS for the Euro Stoxx are in line with the 2008 trough, while doubling for the S&P 500
Exhibit 98: Poorer margin expansion and dilution are to blame rather than weak sales growth
170
220
270
320
370
420
50
60
70
80
90
100
110
120
Oct-03 Oct-05 Oct-07 Oct-09 Oct-11 Oct-13
S&P 500 Euro Stoxx 50, rhs
12-month fwd EPS
26.0%
16.4%
22.8%
1.7%
28.0%
49.3%
93.7%90.0%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Sales EBITDA Earnings EPS
Euro Stoxx 50
S&P 500
% ch in 12m fwd estimates from 2008-09 trough
Source: Thomson Reuters DataStream, Credit Suisse Source: Thomson Reuters DataStream, Credit Suisse
Our European earnings model incorporates a top-down proxy on corporate margins by
looking at the gap between producer price inflation (excluding construction and energy)
and unit labor cost inflation. The former is running at negative 0.1% (September) and the
latter at 1.1% (2Q). Exhibit 100 shows that the gap between these two inflation rates
correlates well with euro-area EPS growth.
The outlook for corporate profits is therefore dependent on an end to the disinflation in
corporate selling prices and/or a reduction in ULC. We think that the latter is more likely.
According to the ECB, “unit labor cost growth is projected to decelerate in 2013 and in
2014” (ECB Staff Projections, September 2013).
19 November 2013
2014 Global Outlook 75
Exhibit 99: Profit margins are less extended globally Exhibit 100: Euro-area EPS growth is strongly
driven by the gap between producer price inflation
-2%
0%
2%
4%
6%
8%
10%
Q4 1983 Q4 1987 Q4 1991 Q4 1995 Q4 1999 Q4 2003 Q4 2007 Q4 2011
World US Euro area
Net income margin, equity market ex financials, %
-10
-8
-6
-4
-2
0
2
4
6
8
10
-50
-40
-30
-20
-10
0
10
20
30
40
50
Q3 1997 Q3 1999 Q3 2001 Q3 2003 Q3 2005 Q3 2007 Q3 2009 Q3 2011 Q3 2013
EPS growth, %
PPI (exc. construction & energy)minus ULC inflation, % pt, rhs
Source: Thomson Reuters DataStream, Credit Suisse Source: Thomson Reuters DataStream, Credit Suisse
M&A
There have been a number of false dawns about a surge in M&A activity throughout the
post-2009 recovery. The volume of deals remains depressed (as a proportion of market
cap) despite a general recovery in CEO business confidence, low corporate leverage and
reduced macro uncertainty, and high FCF, which even after dividends is at above-average
levels.
The Deloitte survey of UK CFOs shows that M&A is still the preferred option for corporates.
However, this has been the case for a number of years, and it is worth noting that
discretionary spending and hiring have seen the biggest rise relative to their historical
average (based on data starting in 3Q 2010).
Exhibit 101: M&A has lagged the improvement in corporate confidence
Exhibit 102: M&A remains the preferred option for UK CFOs' use of cash, but discretionary spending and hiring are improving
20
30
40
50
60
70
80
0%
2%
4%
6%
8%
10%
12%
1982 1986 1990 1994 1998 2002 2006 2010 2014
Global M&A, 12-month rolling sum, % of market cap
US CEO business confidence, rhs, lead 7Q
-10
0
10
20
30
40
50
60
70
80
90
Discspending
Hiring Capex M&A Operatingcosts
Div's Fin. costs Cash
% pt change from 4-yr avg
Latest
Outlook in next 12 months (net % balance reporting an increase)
Source: Thomson Reuters DataStream, Credit Suisse Source: Thomson Reuters DataStream, Deloitte UK CFO Survey, Credit Suisse
19 November 2013
2014 Global Outlook 76
Equity versus credit: buyback mountain
Climbing a mountain can be a dispiriting experience for beginners. As each summit is
attained, a new, higher one appears. Only when it appears there actually is no summit is it
finally attained. Late-cycle corporate behavior, buying back the equity of the issuer or
someone else, funded by debt, has shown this behavior throughout the corporate recovery
that started from 1Q 2009. On balance, we still expect “buyback mountain” to
underperform expectations, although a gentle rise toward a still-distant peak looks likely.
Clearly, the credit “Goldilocks” conditions cannot endure as the cycle matures. Either
economic growth will falter or late-cycle phenomena will take hold. The latter is of far more
concern to us, with higher yields a clear and present danger should growth accelerate and
with corporate risky behavior highly likely late in the cycle, in our view. We could be so
bold as to say that the cycle cannot mature without it or without some exogenous shock to
earnings.
So with the endogenous sources of earnings growth maturing, we expect late-cycle value
transfers to start from bonds to equities at some point. This would be constrained in the
financial space, particularly in Europe, and could lead to financials (after the AQR/stress
test) finally becoming a safe haven in credit markets again for the first time in seven years.
However, throughout the recovery there has been a steady substitution of equity with debt;
it has simply not been heavy, and has room to accelerate, in our view. It has been driven
by the fact that corporate bonds have been the preferred source of funds in recent years,
with a general trend away from issuing equity. This is even true in Europe as bank finance
is replaced. Clearly cost is a consideration: corporate credit is a cheaper source of funding
for companies than equities. Hence, in net terms the corporate sector has reduced its
share count by 2% of market cap a year. We think this continues, but is not yet ready to
accelerate strongly.
Exhibit 103: Corporate bonds remain the preferred source of funds for US corporates
Exhibit 104: In contrast, euro-area corporates had net issuance of €99 billion of securities other than shares in the 12 months to August, compared to net equity issuance of just €12 billion
-1200
-1000
-800
-600
-400
-200
0
200
400
600
800
1000
Q1 1980 Q1 1984 Q1 1988 Q1 1992 Q1 1996 Q1 2000 Q1 2004 Q1 2008 Q1 2012
Equity
Corporate bonds
Net issuance by US non-financial corporates, $bn, annualised rate
-20
0
20
40
60
80
100
120
140
160
180
Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12
Equities Securities other than shares
Euro area, net issuance by Non-financial corporations, €bn, 12m sum
Source: Thomson Reuters DataStream, Credit Suisse Source: Thomson Reuters DataStream, Credit Suisse
We see a respectable
environment for equities
and a “Goldilocks”
environment for credit
absent a substantial yield
sell-off
Substitution of
equity with debt has
room to accelerate
(but perhaps not
strongly)
19 November 2013
2014 Global Outlook 77
That said, according to the Deloitte survey of UK CFOs, corporates, at least in the UK, are
more enthusiastic about issuing equity than they have been since 4Q 2009. However,
sentiment about issuing bonds remains significantly higher than that of equities.
Exhibit 105: There has been a pick-up in sentiment regarding equity issuance in recent months
Exhibit 106: Equity still looks to credit as a guide at major turning points
-120
-100
-80
-60
-40
-20
0
20
40
60
80
100
Q3 2007 Q3 2008 Q3 2009 Q3 2010 Q3 2011 Q3 2012 Q3 2013
Equity
Bonds
Is it a good time to issue: (net balance in favour)
25/08/1987 15/10/1987 1.7
16/07/1990 20/03/1989 -16.1
17/07/1998 29/04/1998 -2.6
24/03/2000 28/12/1999 -2.9
09/10/2007 12/06/2007 -4.0
median -2.9
majo
r peaks
Credit lead (-) /
lag (+), mthEquity market peak
US high yield credit
spread low
Source: Thomson Reuters DataStream, Deloitte UK CFO Survey Source: Thomson Reuters DataStream, Credit Suisse
19 November 2013
2014 Global Outlook 78
19 November 2013
2014 Global Outlook 79
Expected Returns and Risk Analysis Base case sees further gains in equities; expected portfolio returns have negative skew
2014 Core Views
Our base case for 2014 is further double-digit returns in equities, with fixed income
largely experiencing a repeat of the subdued returns seen in 2013.
Our return expectations have an unfavorable skew: we do not expect returns to rise
in the event of stronger-than-expected activity but think that they will fall if activity
weakens.
Our Black-Litterman-type model allocates to equities and risky fixed income assets in
preference to governments and agencies in our base-case scenario. It favors
reversing this and adding real rate and EM sovereign exposure if growth turns down.
We summarize our recommended asset allocation in Exhibit 107 – it affirms the
overweight of equities and risky fixed income securities relative to governments, low
spread markets, and commodities that we advocated in our September review. Our
leitmotif of a year ago that capital would either be "unavailable or unremunerative"
continues to be one that we expect to define investor behavior.
We augment our approach with a Black-Litterman-type allocation model that quantifies
these views and provides a breakdown globally as well as within asset class. We discuss
the approach we follow in more detail below.
Exhibit 107: Recommended portfolio allocation
Global asset classes; base case
Asset Class CS Recommendation Benchmark Weight Black-Litterman Weight
Government Underweight 26% 12%
Credit and Spread markets Market Weight 14% 4%
Risky fixed income Overweight 4% 24%
Equities Overweight 51% 54%
Commodities Underweight 5% 6%
Source: Credit Suisse
Exhibit 108: Recommended allocation Exhibit 109: Deviation from benchmark weights
Global asset classes Global asset classes
0%
20%
40%
60%
80%
100%
Base Good Bad
Risky FI Spreads Govies Equities Commodities
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
Base Good Bad
Risky FI Spreads Govies Equities Commodities
Source: Credit Suisse Source: Credit Suisse
Ira Jersey
212 325 4674
Sean Shepley
+44 20 7888 1333
Bill Papadakis
+44 20 7883 4351
Glenn Russo
212 538 6881
Our leitmotif of a year ago
‒that capital would either
be "unavailable or
unremunerative"‒
continues to define
investor behavior
19 November 2013
2014 Global Outlook 80
Our base case for 2014 is further double-digit returns in equities, with fixed income largely
experiencing a repeat of the subdued returns seen in 2013 (we set out our full
expectations for returns in Exhibit 114 at the end of this section).
Using the Black-Litterman portfolio approach introduced in Macro Tactics: policy
innovations and toolkit additions, we calculate a model portfolio incorporating our expected
return forecasts and prior performance. The charts below show recommended weights
versus a benchmark allocation. We calibrated the model to achieve a long-only allocation
and present the results scaled to a fully invested portfolio to highlight the extremes in
preferences. The benchmark allocation we used was based on the market cap of the
underlying indices, with a 5% weight elected for commodities.
We show deviations both for our base case and for the good and bad scenarios for the
economy described in the Global Economy Outlook section above.
The highlights from the analysis that we find notable are as follows:
Overall, though not reflected in the charts, the raw output from the model indicated a
bias toward overweighting cash in the base case. This seems consistent with an
intuitive approach of ensuring adequate cash balances to be able to benefit from
policy-induced back-ups in spread markets.
Within "safe" fixed income assets, both in governments and core credit assets, the
model recommends an underweight except in the event of an economic downturn. The
recommended weighting for Japanese corporates and European covered bonds is
consistently below benchmark.
Additionally, EM corporate bonds, US mortgages, US investment grade corporates,
and European sovereigns stand out as the assets in which the model prefers to
increase allocations in the base case. In the event of an adverse economic outturn, US
mortgages maintain an overweight allocation, along with UK corporates and EM
sovereigns. Interestingly, the model slightly underweights US Treasuries in a poor
scenario to make room for supra-sovereigns (SSAs) and TIPS.
Exhibit 110: Deviation from benchmark weights Exhibit 111: Deviation from benchmark weights
Govies and near-govies Risky fixed income
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
Base Good Bad
US Treasuries UK Gilts Euro GovtJapan Govt US SSA Europe SSAUK Linkers Euro Linkers US TIPS
-1.40%
-1.20%
-1.00%
-0.80%
-0.60%
-0.40%
-0.20%
0.00%
0.20%
0.40%
0.60%
0.80%
Base Good Bad
US HY Euro HY EM Sov. EM Corps
Source: Credit Suisse Source: Credit Suisse
Within equities, the model favors overweights in SX5E, NKY, and UKX versus SPX and
EM equities. It recommends a broad underweight of equities in the event of a significant
economic downturn. However, in an adverse economic scenario in which all equities
perform poorly, S&P 500 seems to be the best of the worst choices, while EM equities
would have the lowest weighting.
Expect further
double-digit returns
in equities, with
fixed income largely
experiencing a
repeat of the
subdued returns
seen in 2013
19 November 2013
2014 Global Outlook 81
Exhibit 112: Deviation from benchmark weights Exhibit 113: Deviation from benchmark weights
Spreads Equities
-1.50%
-1.00%
-0.50%
0.00%
0.50%
1.00%
1.50%
2.00%
Base Good Bad
US IG Euro IG Japan CorpsUK Corps US MBS US AgencyEuro Cov. Bonds
-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
6.00%
Base Good Bad
S&P 500 Eurostoxx 50 Nikkei 100FTSE 100 MSCI EM
Source: Credit Suisse Source: Credit Suisse
Exhibit 114: 2014 – scenario-based expected returns
Forecast returns refer to the performance of a reference index and may not equate to a specific investment product. They may also not match the forecasts for specific products carried in the rest of this publication.
Index Base case Deviation versus base case
Good Bad
Fixed income – govies and agencies
US Treasuries USGI -1.4% -1.7% 5.0%
UK Gilts UKTI -1.9% -3.1% 6.9%
Euro Government EURGI 1.8% -1.1% 0.2%
Japan Government JGI -1.8% -1.9% 3.2%
US SSA SASI -0.7% -0.6% 3.4%
Europe SSA EASI -1.1% -1.3% 3.6%
UK Linkers GILI -3.4% -3.6% 10.4%
Euro Linkers EILI 0.5% -1.0% -1.0%
US TIPS TIPS -3.7% -1.5% 10.7%
Fixed income – credit and spread markets
US IG LUCI -0.5% -0.7% 6.0%
Euro IG LEI EUR 0.2% -1.2% 2.7%
Japan Corporates LJCI -0.4% -0.1% 0.4%
UK Corporates LEI GBP -1.0% -0.6% 7.6%
US MBS MTGI -0.7% -2.3% 6.6%
US Agency LUAI -0.5% -1.0% 2.1%
Euro Covered Bonds CBI 0.4% -0.6% 0.3%
Fixed income – risky spread
US HY DLJHVAL 5.6% 0.6% -0.2%
Euro HY DLJWVLHE 5.3% 0.2% -1.5%
EM Sovereign SBI 0.9% -0.4% 5.9%
EM Corporates EMCI 4.0% -0.2% 0.1%
Equities
S&P 500 SPX 9.8% 1.2% -15.8%
Eurostoxx 50 SX5E 16.1% 1.9% -18.1%
Nikkei 100 NKY 15.1% 1.9% -18.1%
FTSE 100 UKX 14.9% 1.1% -16.9%
MSCI EM MXEF 12.5% 2.5% -27.5%
Source: Credit Suisse
19 November 2013
2014 Global Outlook 82
19
No
ve
mb
er 2
01
3
201
4 G
lob
al O
utlo
ok
8
3
2014 Global Product Outlook
Product 2014 Core Views 2014 Thematic Trade Ideas
Commodities
Commodity prices are likely to be under pressure again as we
enter 2014, as EM IP growth slows.
Looking further ahead, however, we think that much will depend on
supply, with performance likely to vary considerably across the
complex. Iron ore and copper are likely to remain under pressure,
while oil remains relatively robust.
The unwinding of the bubble in gold prices is likely to continue in
2014.
We suggest positioning for the next big fall in gold prices, with
three- to six-month put spreads offering the best risk-reward
exposure.
We also recommend shorting copper, using four- to seven-
month tenor option structures (see Copper: Chinese market slips
into surplus).
For those with a 6-month-plus horizon, we suggest building a core
long position in platinum, taking advantage of dips close to or below
$1400.
European Credit
Strategy
Credit should generate excess returns; the question is what
underlying rates markets do.
Strong correlations persist, driven by macro factors. This should
break down, but the crisis is not over, just evolving on the
expected political time frame.
Corporate health should continue, keeping technicals strong,
but we are getting later in the credit cycle.
We recommend selling protection on iTraxx Fin Senior versus
iTraxx Main.
We like long CDS versus cash bonds where basis is strongly
positive.
We like long short-call subordinated bonds with floating-rate
back ends.
Global Leveraged
Finance Strategy
We expect rising Treasury rates to be the main driver of returns
in US and European high yield in 2014, with projected returns of
5% and 5.5%, respectively. Default rates should remain
contained, with exceptionally low levels in Europe. Most default
risk is concentrated in a few companies.
Leveraged loans have been largely unaffected by changes in
rates or anticipation of tightening central bank policies, and we
expect low volatility and strong returns in 2014. We project that
US loans will return 5% and European loans 6%.
We expect low-duration bonds and bonds less correlated to
rates – typically lower-rated – to outperform.
Riskier bonds and loans in Europe have more potential for
upside.
Loans are likely to outperform bonds when the difference in
yields between loans and bonds falls well below the average of
75 bp and approaches parity.
Emerging Markets
Most EM economies should recover gradually in 2014, but with
output gaps still large, inflation should remain below policy
thresholds generally.
Brazil, Hungary, South Africa, and Poland ‒ where we expect
inflation to be problematic ‒ are the main exceptions. In
contrast, we see disinflation in India, Indonesia, Russia, and
Turkey.
In Asia, being long the 2019 bond sector in India and paying 5-
year IRS in Malaysia are our strongest views.
In EEMEA, we recommend receiving 2-year IRS in Israel and
paying 5-year rates in Poland and Hungary.
In Latin America, we suggest fading sell-offs in rate markets in
Mexico and Colombia. In Chile, we maintain a received bias,
while we are cautious on Brazilian rate markets. In corporates, we
prefer HY over HG given the attractive spread pick-up.
19
No
ve
mb
er 2
01
3
201
4 G
lob
al O
utlo
ok
8
4
2014 Global Product Outlook
Product 2014 Core Views 2014 Thematic Trade Ideas
Equity Strategy
Relative valuations, excess liquidity, and still-cautious
positioning suggest that equity markets can continue to move
higher.
Corporate earnings look set to grow at a mid- to high-single-digit
rate, and profit margins remain supported as long as there is
slack in the labor market.
We target 1900 for SPX.
FX Strategy
We believe that the USD is likely to begin a multi-year rally.
Yen and AUD are likely to fall the most against the dollar.
"Twin-deficit" EM currencies are likely to experience episodic
turbulence, as US monetary policy is gradually "normalized."
We recommend positioning for a renewed substantial downside
in AUDUSD.
We look for USDJPY to rise to 115.
Divergences should open in Europe. We look for Scandies to
fall materially, in contrast to Sterling.
In EM, we have the most conviction on structural weakness in
RUB in 2014. We also suggest being short TRY, ZAR, CLP, and
BRL. We expect outperformance from MXN.
European Rates
We are modestly bullish rates; we expect German yields to rise
less than the forwards.
We believe that the steepening trend of the current cycle is near
the end.
We think that peripheral yields have reached the secular low.
We believe that investors should use the sell-off to 1.9% to
reset long 10-year Germany.
EUR 10-year looks set to outperform US and GBP.
We favor 5s10s or 5s30s flatteners in gilts and euro
governments.
US Rates
We expect the Fed to move to taper, but “enhanced guidance”
and perhaps even an IOER cut would help to convince the
market of its intention to remain easy for an extended period.
Treasuries should sell off modestly as the economy improves
toward our 3.35% 2014 year-end target on 10s. We expect the
2014 move to be significantly more orderly than the mid-2013
sell-off.
Bouts of delivered volatility should periodically result from the
market challenging the Fed’s low-rate commitment; we would
view significant back-ups in the first few years of the Eurodollar
strip as buying opportunities while fading any outsized 5s10s
flattening.
Implied vols should track a bit higher with rates, but we expect
implieds to remain at a generally low level relative to historical
ranges.
We recommend being long greens and blues (e.g., 2y1y, 3y1y).
We expect 10s to underperform on the curve driven primarily by
5s10s steepening.
We also recommend being long 5y5y TIPS breakevens.
19
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5
2014 Global Product Outlook
Product 2014 Core Views 2014 Thematic Trade Ideas
Japan Rates
We expect supply-demand for the on-the-run 10-year JGB to
continue trending toward tightness in 2014.
The BoJ's inflation target of 2% is not reflected in the BEI on
CPI linkers.
We recommend replacing JGB with JHF MBS, seeking higher
yields.
Securitized
Products
Higher rates, Fed tapering, and regulatory changes are
important common themes across the various securitized
products sectors.
While the initial taper move may cause increased spread
volatility and widening, we believe that it will eventually present
a buying opportunity, as we expect post-taper spreads across
products to narrow.
The rebound in housing should continue, albeit at a more
moderate pace; we project gains of roughly 5% in 2014.
We recommend underweighting Agency MBS initially as the
market transitions away from Fed demand. Post-taper, we
expect an overweight opportunity to arise eventually on longer-
duration bonds as a result of higher turnover than market
expectations.
In non-Agency, we suggest rotating into short-duration bonds as
taper expectations firm and then rotating into more levered cash
flows, which are likely to become attractive after the
announcement.
In CMBS, our bias is for higher-quality assets, with legacy AMs
our favored trade. We believe that greater differentiation will be
made on the recently issued deals, which will benefit seasoned
bonds slightly.
Technical Analysis
We remain medium-term bullish Japanese equities and
medium-term bearish JPY.
We expect 10-year US/Germany to extend its core-widening
trend to new highs.
We expect Base Metals to resume their medium-term bear
trends.
We are bullish Nikkei, USDJPY, EURJPY, and GBPJPY.
We expect 10-year US/Germany (bond) widening and
recommend going long 30-year US bonds at 4.20%.
We suggest shorting Copper.
19 November 2013
2014 Global Outlook 86
19 November 2013
2014 Global Outlook 87
Commodities The long and winding road: bear market cycles 2014 Core Views
Commodity prices are likely to be under pressure again as we enter 2014, as EM IP
growth slows.
Looking further ahead, however, we think that much will depend on supply, with
performance likely to vary considerably across the complex. Iron ore and copper are likely
to remain under pressure, while oil remains relatively robust.
The unwinding of the bubble in gold prices is likely to continue in 2014.
2014 Thematic Trade Ideas
We suggest positioning for the next big fall in gold prices, with three- to six-month put
spreads offering the best risk-reward exposure.
We also recommend shorting copper, using four- to seven-month tenor option structures
(see Copper: Chinese market slips into surplus).
For those with a 6-month-plus horizon, we suggest building a core long position in
platinum, taking advantage of dips close to or below $1400.
As outlined in The Setting of the Sun, we believe that the “glory days” of the commodity
bull market are well behind us, with prices likely to continue to revert to more normal levels
over coming years. However, while on average the complex is likely to remain under
pressure, as always, pricing will be a function of supply and demand, as well as valuation.
As shown in Exhibit 116, history suggests that within secular bear markets, there are
still clear cycles, with the modulations in the cycle continuing to be driven by industrial
production.
Exhibit 115: Commodities appear to be at the beginning of a secular bear market
Exhibit 116: But within structural bear markets, there are still cycles …
Real CRB Index Real CRB Index , year-over-year change, monthly
100
150
200
250
300
350
400
450
500
1970 1975 1980 1985 1990 1995 2000 2005 2010
-30%
-20%
-10%
0%
10%
20%
30%
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service
Ric Deverell
+44 20 7883 2523
Bear markets still
have cycles
19 November 2013
2014 Global Outlook 88
Demand still tepid
Since the early 2000s, commodity prices have been highly correlated with growth in
emerging market industrial production, with the influence of growth in the developed world
much reduced.
In line with this, it is notable that despite a strong rebound in global industrial
production growth over recent months, EM growth has continued to lag – in large part
explaining the relatively muted rebound in commodity prices.
While we expect broad measures of EM growth to improve gradually over the course
of 2014, many industrial commodity prices are likely to come under pressure as we
enter the new year as a result of the looming global IP momentum peak.
Looking further out, we think that the combination of increased supply for many
commodities, as well as continued structurally weaker EM growth (we expect China to
slow back toward 7%) is likely to cause many prices to continue to stagnate through
2014, with those commodities experiencing a long-awaited increase in supply coming
under the most pressure.
Exhibit 117: Commodity prices are highly correlated with emerging market industrial production growth
Exhibit 118: EM growth is still weak
Index
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
93 95 97 99 01 03 05 07 09 11 13
24 month rolling correlation ofchanges in EM IP and Copper
24 month rolling correlation ofchanges in DM IP and Copper
40
45
50
55
60
65
2005 2006 2007 2008 2009 2010 2011 2012 2013
DM PMI NO EM PMI NO
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service Source: Credit Suisse
Supply divergence is the key
While the EM industrial production cycle drives the near-term dynamics of the commodity
cycle, over time, supply is also a key driver of the level of prices. To that end, after many
years of high levels of investment, we are likely to see a substantial divergence in 2014 in
terms of supply performance among commodities, with supply increasing substantially for
iron ore and copper, improving modestly for oil, but falling back a little for many of the
basic materials for which prices have already unwound most of the super cycle gains.
EM IP growth has
been the key
cyclical driver
19 November 2013
2014 Global Outlook 89
Exhibit 119: For some, commodities supply is finally improving
Ratio
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Copper Iron Ore Oil Aluminium Nickel Zinc T. Coal Lead
Ratio of 2014 forecast supply growth to 2010-13 average
Source: Credit Suisse, Customs Data, IEA, Wood Mackenzie, WSA, Company Data
Of course, one of the key factors that helps balance supply and demand is valuation, with
those commodities that remain relatively "expensive" likely to undergo the largest
corrections in 2014.
Exhibit 120: Some commodities remain very expensive
Note aluminium price is deviation from post-1900 trend due to its consistent long-run decline in value
-50%
0%
50%
100%
150%
200%
250%
Zinc T. Coal Aluminium Nickel Lead Tin Copper Iron Ore Gold BrentCrude
Current price versus 1900-2000 avg
Source: the BLOOMBERG PROFESSIONAL™ service, IMF, Credit Suisse
Summary of individual commodity forecasts
While the commodity complex is likely to remain under pressure in 2014, as has been the
pattern in recent quarters, a substantial divergence is likely among individual commodities
‒ with those that face increasing supply likely to fall, while those for which prices are
already below long-run averages likely to see supply growth slow.
Over the coming year, we expect three commodities to fall substantially (iron ore, copper,
and gold), six to be essentially flat (tin, thermal coal, US and UK natural gas, Brent, and
silver), while seven should increase modestly, with the PGMs leading the charge.
Those commodities
with the greatest
supply growth are
likely to come under
pressure
The most expensive
are among the most
vulnerable
Prices are likely to
diverge in 2014
19 November 2013
2014 Global Outlook 90
Exhibit 121: The commodity outlook remains mixed – with substantial intra-commodity divergence likely
Change from current spot to 4Q 2014 forecast
-40%
-30%
-20%
-10%
0%
10%
20%
Iro
n O
re
Co
pp
er
Go
ld Tin
The
rmal
Co
al
U.K
. Nat
Gas
U.S
. Nat
Gas
Bre
nt
Silv
er
Nic
kel
Alu
min
ium
WTI
Zin
c
Pal
lad
ium
Pla
tin
um
Lead
Source: Credit Suisse
19 November 2013
2014 Global Outlook 91
Credit Strategy
European Credit Strategy Rates dominant
2014 Core Views
Credit should generate excess returns; the question is what underlying rates markets do.
Strong correlations persist, driven by macro factors. This should break down, but the
crisis is not over, just evolving on the expected political time frame.
Corporate health should continue, keeping technicals strong, but we are getting later
in the credit cycle.
2014 Thematic Trade Ideas
We recommend selling protection on iTraxx11
Fin Senior versus iTraxx Main.
We like long CDS versus cash bonds where basis is strongly positive.
We like long short-call subordinated bonds with floating-rate back ends.
Credit looks likely to offset some of the risks of its rates component during 2014 and
should outperform short of a resumption of the euro crisis. So we are a “nervous long.”
The nervousness is based in the inability of the market to signal macro stresses,12
and we
refuse to draw the desired conclusion that this means that the crisis is over; it is simply
evolving on a political time frame or on the time frame of an economic cycle, not a market
time frame. Corporate health is a major consolation.
In terms of pure market inputs, rates now dominate the discussion, clearly in credit and
even to some extent in equities. Short rates are intensely political and longer rates
increasingly so as central-bank intervention creeps along the curve.13
A nexus of the two
would be a discussion about QE on the part of the ECB as nominal GDP growth
underperforms.
Imposing more rational pricing of macro risk has been a large part of the business of 2013,
and it might not yet be complete, although the process is certainly mature, in our view.
Backed up by the very obvious systematization carried by all measures, particularly the
OMT threat, this, via the traders’ option pricing mechanism we described last year, forces
the market’s pricing of macro risks to zero, for the time being at least.
Obviously, this pricing cannot survive the actual return of crisis conditions, so market
pricing is likely to be discontinuous; risks will be not priced at all and then suddenly will be
priced at very high levels when and if a systemic threat presents itself. On current trends,
we still expect that, but timing is difficult. A key conclusion of our analysis is that markets
will not be useful barometers of stress.
The continuing transition into this regime shows up in still very high correlations between
various measures of credit risk. See the exhibits below.
11 iTraxx is a trademark of International Index Company Limited.
12 For reasons we gave last year, the market clearing price of euro-area macro risk is heading towards zero regardless of actual risk.
13 And the question of who is taking the lead, central banks or the market, is a very politicized economic debate.
William Porter
+44 20 7888 1207
The crisis is not
over, just evolving
on the expected
political time frame
19 November 2013
2014 Global Outlook 92
Exhibit 122: It’s still all one trade Exhibit 123: … however you look at it
iTraxx Main active contract (“Main”) and avg of ES and IT 5-year sovereign CDS ITraxx Financial Senior active contract less Main and avg ES and IT 5-year CDS
0
50
100
150
200
250
0
100
200
300
400
500
600
700
Jan-10 Jan-11 Jan-12 Jan-13
Ave(ES, IT)
Main (RHS)
-20
0
20
40
60
80
100
120
140
160
0
100
200
300
400
500
600
700
Jan-10 Jan-11 Jan-12 Jan-13
Ave(ES, IT)
Snr-Main (RHS)
Source: Credit Suisse HOLT iTraxx is a trademark of International Index Company Limited. Source: Credit Suisse HOLT
This, we expect to break down at some point.
Which means the dynamic of 2013 should be spelt out again. Risks were all correlated to
a sovereign risk price, which was headed toward zero. Improving corporate credit metrics
supported this key trend but were, in our view, secondary. We expect them to continue
and possibly to be able to part company with sovereign-derived measures of stress.
So credit might provide a haven against a moderate return of sovereign risk, the problem
being that a moderate return is not consistent with our “traders’ option” thinking. Rather, a
severe return is the mechanism, and it is unlikely in the short term but eventually inevitable.
For 2014, we think this firmly leaves the risks to credit in the (higher) rates camp. But for
higher rates, a recovery would be needed that does not look likely with underlying issues
still unaddressed. “Nervous long” therefore feels like the conclusion in European credit.
Primary market outlook
We provide a very brief preview. A theme of our research for many years has been that,
under the euro, the European capital markets will step up as a source of corporate funding,
gradually replacing the very heavy reliance on bank markets and helping banks to delever.
We are a “nervous
long"
19 November 2013
2014 Global Outlook 93
Exhibit 124: First-time issuer volumes remain healthy as more and more companies take advantage of public markets, with banks still in a delevering phase …
First-time issuer volumes in €bn
0
10
20
30
40
50
First time issuervolume
Source: Credit Suisse
In our view, this supply is more than matched by demand, and we have never been
concerned with supply.14
Further helping the technical picture will be demand from the corporate sector. As
examined above, we do not expect this sector to change its supply dynamics dramatically,
but this is a risk. Without it, the supply technicals should stay strong (see Exhibit 125).
Exhibit 125: With high levels of cash and heavy redemptions, issuers may take the opportunity to carry out LME and reduce debt, helping supply technicals even more
Bond redemptions vs. cash and marketable securities, European IG non-financial issuers, €bn
1.0 yrs
1.5 yrs
2.0 yrs
2.5 yrs
3.0 yrs
0
50
100
150
200
250
300
350 Redemptions (next 2 years)
Cash & marketable securities
Redemptions covered by cash [in years, RHS]
Source: Credit Suisse
14 See "European Credit Strategy: supply is no problem. Say's who?," September 2003.
Corporate health
should continue,
keeping technicals
strong
19 November 2013
2014 Global Outlook 94
We are still relatively early in the credit cycle in Europe, and GDP growth in 2014 is also
expected to be modest, so while debt-funded M&A should tick up from current low levels,
we do not expect a transformation.
Exhibit 126: We do not expect transformational shifts in M&A, although a slow pick-up seems possible
Announced M&A volumes in €bn, European target or European acquirer with non-European target
0
200
400
600
800
1000
1200
Non-Europe Target,Europe Acquirer
Europe Target
Source: Credit Suisse
19 November 2013
2014 Global Outlook 95
Global Leveraged Finance Strategy Central bank actions and rate moves should drive returns and spreads
in 2014
2014 Core Views
We expect rising Treasury rates to be the main driver of returns in US and European
high yield in 2014, with projected returns of 5% and 5.5%, respectively. Default
rates should remain contained, with exceptionally low levels in Europe. Most default
risk is concentrated in a few companies.
Leveraged loans have been largely unaffected by changes in rates or anticipation of
tightening central bank policies, and we expect low volatility and strong returns in
2014. We project that US loans will return 5% and European loans 6%.
2014 Thematic Trade Ideas
We expect low-duration bonds and bonds less correlated to rates – typically lower-
rated – to outperform.
Riskier bonds and loans in Europe have more potential for upside.
Loans are likely to outperform bonds when the difference in yields between loans
and bonds falls well below the average of 75 bp and approaches parity.
The key factor driving price movements in the high yield market during 2013 was volatility
in Treasury rates. Five-year Treasury yields rose from their low of 65 bp on 2 May to a
high of 185 bp on 5 September as a result of concerns about the anticipated tapering of
QE. The yield of the CS High Yield Index followed the rate move, increasing to the high for
the year of 7.02% on 25 June, two months after the all-time low of 5.09% on 9 May.
Yields are currently 5.95% (as of 12 November).
We expect Treasury movements to continue to be the most important factor influencing
high yield returns in the coming year. Credit Suisse's interest rate strategists expect the 5-
year Treasury to increase to 1.90% in late 2014 from the current level of 1.41%.
Exhibit 127: CS High Yield Index Yield vs. 5-year Treasury yield
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
1/3/11 5/3/11 9/3/11 1/3/12 5/3/12 9/3/12 1/3/13 5/3/13 9/3/13
Yie
ld
HY Yield
5-Year Treasury
5.95%
1.45
7.02%
1.85%
Source: Credit Suisse
The high yield spread remained in a relatively tight range in 2013. The CS High Yield
Index spread was 476 bp as of 13 November, not far off the low of 444 bp achieved on 10
May. While the spread did increase with the mid-year Treasury spike, reaching a high of
554 bp in June, firm underlying fundamentals and improving economic forecasts have
tightened credit spreads.
Jonathan Blau
+1 212 538 3533
Daniel Sweeney
212 538 8213
James Esposito
212 325-8459
Daniyal Khan
212 325 2873
We expect Treasury
rate moves to be the
dominant factor in
high yield returns in
2014
19 November 2013
2014 Global Outlook 96
Exhibit 128: CS High Yield Index spread
1079 bp12/31/90
307 bp2/28/97
1080 bp10/31/02
307 bp2/28/05
271 bp5/31/07
1816 bp11/28/08
2/8/2011488 bp
10/4/2011868 bp
0bps
400bps
800bps
1200bps
1600bps
2000bps
Sp
read
to
Wo
rst
476 bps 11/13/13
Average: 585 bp
Source: Credit Suisse
Credit Suisse Economics Research forecasts that 2014 GDP growth will increase to 3.0%
by the end of the year. Based on our GDP-to-spread model, this level of GDP growth
implies a 2014 spread of 529 bp, about 60 bp wider than today. Exhibit 129 compares
the spread (inverted on the right-hand scale) to GDP growth in the following quarter.
For 4Q 2013 forward, we are using Credit Suisse Economics Research forecasts. We note
that while a long-term correlation is apparent, during the recent cycle, the relationship
between GDP and spread movement has diminished and in fact moves inversely at times.
Exhibit 129: Next-quarter real GDP year-over-year % change vs. CS HY Index Spread
0 bp
200 bp
400 bp
600 bp
800 bp
1000 bp
1200 bp
1400 bp
1600 bp
1800 bp-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
Sp
read
to W
ors
t
Next
Qtr
Yo
Y R
eal G
DP
%C
hng
Next Qtr YoY Real GDP %Chng HY Spread-to-Worst
YoY% CS Economic Forecasts
Correlation = .74
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service
The reversal in the GDP-to-spread relationship is shown in Exhibit 130, which maps the
period of 2010 to present. During this time frame, higher spread has been associated with
periods of higher GDP growth, and vice versa. We attribute this new trend to the impact of
accommodative Fed policies. When GDP is weaker, accommodative policy drives prices
higher and spreads lower, and when GDP is stronger, the anticipation of a tighter policy
lowers prices and widens spreads.
Accommodative Fed
policy has reversed the
relationship between
GDP and spread
change since 2010
19 November 2013
2014 Global Outlook 97
Exhibit 130: HY STW vs. next-quarter real GDP year-over-year change since 2010
y = 7937.79x + 435.42R² = 0.36
300 bp
400 bp
500 bp
600 bp
700 bp
800 bp
900 bp
1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
HY
Sp
read
-to
-Wo
rst
Next Qtr Real GDP YoY %Chng
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service
As a result of these recent spread and GDP movements, we are not using the higher
spread predicted by the model in our 2014 projections. Rather, we expect the spread to
remain range-bound in the coming year near current levels. Our baseline total return
projection for 2014 for US high yield is 5%, as a result of the forecast 50-bp increase in 5-
year Treasury rates and a limited change in spread.
Exhibit 131: Historical and projected high yield default rates
2.9%
4.8%
1.6%
3.8%
7.9%8.8%
3.3%
1.8%0.9%
2.3%1.4%
0.9%1.4%
4.1%4.5%
9.2%
15.5%
4.3%
1.3%
2.6%
0.7%0.5%
5.5%
9.4%
1.6%1.8%
1.7%1.4%
2.9%
1.1%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
Default Rate
Source: Credit Suisse
We project a 2%-3% default rate for high yield bonds in 2014, which is an increase from
the 2010 to present range of 1.4%-1.8%. Our bottom-up forecast for 2014 is 2.9%. A
significant portion of default risk resides in just a few large issuers facing near-term credit
issues, most notably Energy Future Holdings, which increase the 2014 level well above
that of the previous years. As these one-off legacy LBO transactions are well known to the
market, we believe that they will not have an impact on 2014 spreads or returns. In 2015,
the default projection decreases to 1%-2%, as much of the risk associated with the large
distressed issuers rolls off.
We project 5% total
return for US high
yield in 2014
19 November 2013
2014 Global Outlook 98
The Credit Suisse Leveraged Loan Index discount margin, calculated to a three-year
refinancing, is 494 bp as of 13 November, a 61-bp tightening year to date. The year saw a
steady tightening of the discount margin with limited volatility from Treasuries or
anticipated Fed policy changes. We think that fundamentals in 2014 will continue to
support loan spreads. We expect a modest tightening in 2014 as the economy continues
on its strengthening path and as default rates are contained to a few well-anticipated
issuers.
Exhibit 132: CS Leveraged Loan Index three-year discount margin
616 bp10/31/01
632 bp10/31/02
235 bp3/30/07
12/31/081842 bp
8/31/2011724 bp
100bps
300bps
500bps
700bps
900bps
1100bps
1300bps
1500bps
1700bps
1900bpsD
isco
unt
Ma
rgin
*Discount margin (DM) assumes 3-year average life
494 bp 11/13/13
Average : 454 bp
Source: Credit Suisse
Loan yields, calculated to a three-year refinancing, are currently 5.27%, 71 bp lower than
high yield bond yields of 5.98%. The average difference between these yields has been 75
bp since December 2009. The difference between the yields increased in mid-2013 to a
high of 1.40% on 25 June, corresponding to the rise in Treasury rates. The loan market
largely absorbed the Treasury move and avoided the swings of the bond market.
Exhibit 133: High yield bond yield less leveraged loan yield
-2.00%
-1.50%
-1.00%
-0.50%
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
6/30/2008 6/30/2009 6/30/2010 6/30/2011 6/30/2012 6/30/2013
HY
Bo
nd
Yie
ld -
Lo
an Y
ield
HY Bond Yield - Loan Yield
0.71%
Treasury Impact
Source: Credit Suisse
We use this relationship to make return projections for loans based on our high yield return
projections. In 2014, our expected high yield return is primarily driven by the change in
interest rates. But given that we expect Treasury rates to be a limited factor for loan yields,
we have backed out the impact of the expected 2014 rate movement in our loan
projections. Our baseline total return projection for 2014 for US leveraged loans is 5%.
Leveraged loans
remained largely
resilient to Treasury
volatility and
anticipated Fed policy
changes in 2013
We expect US loans
to return 5% in 2014
19 November 2013
2014 Global Outlook 99
We project a 3%-4% default rate for institutional loans in 2014, which is an increase from
the 2012-to-present range of 2%-2.5%. This projection is elevated because of one well-
known issuer, Energy Future Holdings. Given that this anticipated default is already priced
into the market, we expect it to have little impact on the overall market.
Western European high yield spreads are currently 433 bp, 196 bp tighter than the long-
term average. European spreads have tightened as PMIs have improved and as GDP has
swung to positive. We expect continued tightening at a slower pace in 2014.
Exhibit 134: CS Western European HY Index spread
353 bp9/30/1997
1250 bp9/28/2001
219 bp5/31/2007
12/31/20081799 bp
0bps
200bps
400bps
600bps
800bps
1000bps
1200bps
1400bps
1600bps
1800bps
2000bpsS
pre
ad t
o W
ors
t
Average STW: 629 bp
433 bp 11/13/2013
Source: Credit Suisse
European high yield BB spreads are currently 40 bp tighter than US BB spreads, but
European B spreads are 21 bp wider than US B spreads. We believe that there is room for
spread tightening in the lower-rated credit categories. However, we note the downside risk
versus the US, which materialized from European macro factors in both 2011 and 2012.
Both years saw periods of dramatic increases in the US/European spread difference,
reaching 200-300 bp.
Exhibit 135: Western European high yield spread vs. US high yield spread
BB B
-200 bp
-150 bp
-100 bp
-50 bp
0 bp
50 bp
100 bp
150 bp
200 bp
250 bp
300 bp
Sp
read
Diffe
ren
ce
European BB - U.S. BB STW
-40 bp
-200 bp
-100 bp
0 bp
100 bp
200 bp
300 bp
400 bp
Sp
read
Diffe
ren
ce
European B - U.S. B STW
21 bp
Source: Credit Suisse
We use a similar approach to European high yield projections that we use for the US. We
expect that European spreads will continue to outperform the GDP-implied spread as a
result of liquidity in the euro-zone economies. However, we do expect a negative impact
from a rise in interest rates. Credit Suisse's rates strategists expect the 5-year Bund to
increase by over 50 bp, to 130 bp, by the end of 2014. Our baseline total return projection
for 2014 for European high yield is 5.5%.
Lower-rated
European high yield
has room for spread
tightening in 2014
We expect European
high yield to return
5.5% in 2014
19 November 2013
2014 Global Outlook 100
We project a very low 0%-1% default rate for European high yield in 2014, following the
low default trend of the past two years.
Our total return projection for 2013 for European leveraged loans is 6.5%. The projection
considers the relationship in yields between European high yield and European loans as
well as the positive momentum in the European loan market currently.
The European loan discount margin has steadily tightened from 2011 highs, with a
corresponding decline in the default loss rate. The European leveraged loan market is the
only market that we follow where defaults increased following the 2011 spread-widening
episode. The European loan market was directly impacted by bank illiquidity during the
European crisis, but it is now healing rapidly, a positive sign. We expect the default rate to
be 2%-4% in 2014, in line with the current rate of 3.5%, and to decrease to 1%-3% in 2015.
Exhibit 136: Western European leveraged loan discount margin vs. default loss rate
4.59%
1973 bp
0 bp
200 bp
400 bp
600 bp
800 bp
1000 bp
1200 bp
1400 bp
1600 bp
1800 bp
2000 bp
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
3-Y
ear D
isco
un
t Marg
in
Defa
ult
Lo
ss R
ate
Loan Default Loss Rate (8 Months Later) West. Euro. Loan Discount Margin (3 years)
Correlation: 0.90
2.22%
Average Difference 2004 - 2008: 364 bpAverage Difference 2009 - 2012: 634 bp
9/30/13 540 bp
Source: Credit Suisse
Exhibit 137: Leveraged finance return and default projections
Performance Actual Projected 2014
Annual Total Return YTD 11/12/13 as of Nov 2013
US High Yield Bonds 6.05% 5%
US Leveraged Loans 5.45% 5%
W. European High Yield (Hedged in €) 7.91% 5.5%
W. European Lev. Loans (Hedged in €) 7.86% 6.0%
Default Rate Summary Actual Default Rate Default Rate
LTM Oct 2013 Projected 2014 Projected 2015
US High Yield Bonds 1.40% 2% - 3% 1% - 2%
US Leveraged Loans 2.27% 3% - 4% 1% - 2%
W. European High Yield (Hedged in €)* 0.50% 0% - 1% 0% - 1%
W. European Lev. Loans (Hedged in €)* 3.51% 2% - 4% 1% - 3%
*LTM as of 9/30/13 Source: Credit Suisse
With improving health
in the European
leveraged loan market,
we project a 6.5%
return for 2014
19 November 2013
2014 Global Outlook 101
Emerging Markets 2014 Core Views
Most EM economies should recover gradually in 2014, but with output gaps still
large, inflation should remain below policy thresholds generally.
Brazil, Hungary, South Africa, and Poland ‒ where we expect inflation to be
problematic ‒ are the main exceptions. In contrast, we see disinflation in India,
Indonesia, Russia, and Turkey.
2014 Thematic Trade Ideas
In Asia, being long the 2019 bond sector in India and paying 5-year IRS in Malaysia
are our strongest views.
In EEMEA, we recommend receiving 2-year IRS in Israel and paying 5-year rates in
Poland and Hungary.
In Latin America, we suggest fading sell-offs in rate markets in Mexico and Colombia.
In Chile, we maintain a received bias, while we are cautious on Brazilian rate markets.
In corporates, we prefer HY over HG given the attractive spread pick-up.
Non-Japan Asia A better year ahead?
2014 Core Views
Real GDP growth should be stronger in 2014 than in 2013, albeit only moderately so.
Our projections are based partly on an improvement in global trade activity, which will
have a positive knock-on effect on domestic demand.
We expect inflation pressures to remain tame, generally keeping a firm lid on policy
rates, which are already supportive of economic activity in most NJA economies.
Asia's key concern is the return of US QE tapering tensions. While India and
Indonesia have progressed recently ( the current account deficit falling in the former,
inflation dropping in the latter), their currencies remain relatively vulnerable to "risk-
off" shocks.
2014 Thematic Trade Ideas
Market curves are likely to bear steepen on better growth prospects and QE taper.
The Philippines and Malaysia are more vulnerable; we recommend reducing duration
and pay rates.
India and Indonesia are more attractive, in our view, as the bulk of negatives are
largely discounted.
A better year for NJA? Although it would be far from accurate to suggest that all is right
with the non-Japan Asia (NJA) region, we expect the next 12 months to be better than the
previous 12. This is reflected in our 2014 GDP growth forecast, for example, which we
have revised slightly higher to 6.6%. In fact only two countries in the region (Indonesia and
the Philippines) are set to register weaker year-average growth in 2014 relative to 2013.
As a first stab at 2015 growth in the region, we are looking for a further rise to 7.0%,
largely as a result of a more meaningful pick-up in the Chinese economy. This is largely
based on domestic reforms impacting private investment.
Inflation to remain subdued …: At the same time, inflation looks set to remain firmly
under wraps, with the NJA average ending 2014 at a downwardly revised 4.0% from 3.8%
in December 2013. Indeed, if we strip out China, our forecasts are consistent with inflation
dropping moderately over the coming year.
Ray Farris
+65 6212 3412
Neal Soss
212 325 3335
Ashish Agrawal
+65 6212 3405
Robert Prior-Wandesforde
+65 6212 3707
Dong Tao
+852 2101 7469
19 November 2013
2014 Global Outlook 102
… and policy interest rates low: This in turn helps explain why we expect policy interest
rates to remain low and stable in most of NJA. In our view, Bank Negara Malaysia will be
the only central bank in the region to hike in 2014 and even then by just 25 bp. Meanwhile,
Bank Indonesia should cut interest rates in the second half of the year as inflation falls
below 5%; we have penciled in 100 bp of reductions between July and October. In China,
we now envisage the People’s Bank of China (PBOC) keeping the lending rate on hold
throughout the forecast period, having lowered our inflation projections.
Tapering test: A couple of other important forecast changes are worth mentioning. Both
relate to the current account and are in opposite directions. We have revised down India’s
external deficit for 2013-2014 to 2.9% of GDP (from 3.8%) and revised up Indonesia’s to
3.6% of GDP for 2013 and 2.8% of GDP in 2014. Unfortunately, however, the fact that
both countries have current account deficits at all leaves their respective currencies
vulnerable to US QE tapering concerns ‒ –something that looks to have re-started. Our
US economists continue to expect tapering to begin at the January meeting of the Federal
Reserve.
Local rate strategy – bearish undertones to persist on growth, QE taper …
The uptrend in Asian rates is likely to continue in 2014. We expect Asian fixed income
markets to stay under pressure as a result of improving growth, both in the developed
economies and in Asia, and weak fixed income sentiment as US Treasury yields rise and
the non-resident bond bid weakens further. We expect market curves to bear steepen as
the term premium rises and markets price in a higher probability of scaling back
accommodative monetary policy. The belly and longer segments of market curves are
likely to be more vulnerable, but it is probably early to change our constructive view on
shorter segments.
The Philippines market could be most vulnerable in 2014. 10-year bonds are currently
trading at 3.65% levels, and valuations appear rich, especially when compared with record
growth, above 7% and relatively muted inflation around 3%. The SDA rate cuts and
restrictions on access have pushed market rates well below policy rates, with T-bill yields
just shy of 0%. We expect this "one-off" demand dynamic to weaken soon and rates to head
higher as markets anticipate policy normalization by the BSP next year. We recommend
reducing duration and overall exposure to markets. We look to position short by paying
swaps once near-term support wanes. Risks to our view come from negligible inflation
pressures in 2014.
Malaysian rates markets are also likely to experience volatility and weakness. The
non-resident bid for bonds, especially over the past five years, has shown signs of
weakening and reversing on QE taper fears. Persistent foreign demand had depressed
term spreads and a stable exchange rate and low inflation helped sustain this demand.
This is changing: currency volatility has risen and headline inflation is rising as subsidies
are being reduced. A cessation in non-resident flows should bias rates higher and prompt
the curve to bear steepen. We recommend reducing duration and paying 5-year IRS.
Risks to our view are from only modest weakening in foreign demand.
We are relatively more constructive on India's and Indonesia’s rates markets. Both
experienced intense pressure in 2H 2013 as markets priced in Fed taper risk. Central
banks in both countries tightened monetary policy aggressively and introduced reforms
that should help reduce their current account deficits and lower inflation. Inflation is likely
to stay elevated in the near term but should fall next year.
Between the two, we are more constructive on India at present. Valuations (10-year
bonds at 9.1%) are attractive, and India is in the late stages of policy tightening. Foreign
holdings have shrunk aggressively. Current plans to have Indian bonds included in key
bond indices after planned regulatory changes and easing in aggregate limits could drive
material rebuilding of foreign holdings. We expect the bond curve to bull flatten, led by the
10-year segment. The light supply pipeline in 1Q 2014 should allow bonds to weather
The weak undertone
is likely to persist
in 2014
Risks in the
Philippines are
especially high
We see risks in
Malaysia from high
foreign ownership
Macro factors and
valuations support our
constructive outlook
on high yielders
In India, markets are
likely discounting
most risks
19 November 2013
2014 Global Outlook 103
"taper" risks. We are selectively constructive duration and recommend long positions in
2019 bonds, both outright and as asset swaps. Risks to our view come from persistently
high inflation readings and material fiscal slippage.
In Indonesia, we are cautious. The potential for near-term negative news flow and the
recent rise in foreign holdings keep us cautious. However, valuations are in neutral
territory, and slower growth and lower inflation will likely allow the BI to lower rates next
year and in turn fuel gains in bonds. We would look to add duration risk if the ongoing sell-
off pushes yields into attractive territory (10-year around 8.75%-9%) or once we gauge
that taper risks are properly reflected in market levels. Risks to our view are from sizable
unwinding of holdings by foreign investors.
Latin America Trading Latam fixed income under tapering
2014 Core Views
We believe that the Fed’s removal of monetary stimulus will continue to dominate EM
fixed income markets into 2014.
In the process of pricing in tapering, rates and sovereign credit markets are likely to
continue to widen and steepen, but most of the adjustment seems to have taken
place. We expect EM rate and credit markets to outperform other asset classes once
US rates stabilize.
We foresee renewed corporate earnings momentum in 2014 in select Latam
countries (such as Mexico and the Andean region) and in select sectors in domestic
consumption, utilities, and banks.
2014 Thematic Trade Ideas
We see continued market volatility in 2014. As a result, relative value and curve
trades remain our preferred investment strategy into 2014.
In rate markets, we expect Mexican rates to offer good investment opportunities. We
maintain a received bias in Chilean rates, while we are cautious on Brazilian rate
markets.
In Latam corporates, we prefer HY over HG due to the attractive spread pick-up and
generally solid corporate liquidity positions, especially in Mexico HY corporates.
We believe that the Fed’s likely reduction of its monetary stimulus will continue to
dominate EM fixed income markets into 2014. We maintain our cautious stance with
low-duration exposure as EM fixed income markets are likely to remain volatile and under
pressure with US rates moving higher. Our US rates research team expects 10-year US
Treasury yields to move to 2.6% and 3.35% by year-end 2013 and 2014, respectively,
from 2.7% currently. However, we would expect volatility in EM to recede when US rates
eventually stabilize. The real interest rate differential should continue to favor Latam fixed
income markets, and we expect rate and sovereign credit markets in the region to
outperform once US rates find an equilibrium level consistent with tapering.
In the process of pricing in tapering, Latin America rates and sovereign credit
markets are likely to continue to widen and steepen, but the worst of the adjustment
to higher rates seems to be behind us. Latin America 2s10s local currency rates
spreads widened on average 150 bp since April and are already at their historical highs.
Similarly, spreads of sovereign credit are currently close to 2011 and mid-2012 levels, up
200 bp from May’s levels. Rate curves could continue to steepen and credit spreads could
widen as 10-year Treasuries move above 3.0% in 2014. We believe that the more
vulnerable countries in Latin America are Brazil, Mexico, and Colombia, while the
sensitivity in Chilean rates to US rates is much lower.
In Indonesia, further
weakness is likely to
push bonds into
attractive territory
EM Strategy
Daniel Chodos
212 325 7708
Alonso Cervera
+52 55 5283 3845
EM Corporate Credit
Jamie Nicholson
212 538 6769
Celina Apostolo Merrill
212 538 4606
Andrew De Luca
212 325 7443
Fed’s tapering is
likely to continue
dominating EM price
action in 2014
Most of the
adjustment to
higher EM rates and
spreads seems to
have taken place
19 November 2013
2014 Global Outlook 104
EM bond fund outflows remain a risk to EM bond markets. According to EPFR Global,
most of the outflows seen this year have come from retail investors. In our view, retail
redemptions accelerated following the negative returns the asset class experienced in May
and June this year, which makes it vulnerable if the performance in EM bonds remains in
negative territory. Institutional investors, in turn, have largely maintained their positions in local
bonds but have hedged their exposure via buying USD/EM FX and paying EM swap rates.
While we are primarily concerned with tapering in the US (and secondarily in China
growth/commodity prices), idiosyncratic factors are also likely to attract investors’
attention in 2014. Elections in Colombia (legislative in March and presidential in May) and
Brazil (presidential in October) could add to market volatility, although we do not expect
any market stress related to the electoral calendar. Investors should also watch for signs
of a turnaround in Brazil’s economic growth and the extent of activity deceleration in Chile,
Colombia, and Peru for early indications of monetary policy changes. In Mexico, the
implementation risk of the energy reform is likely to be the focus among investors.
Exhibit 138: EM rate, sov. credit, and FX performance Exhibit 139: EM bond fund flows vs. bond returns
Changes in rates, sovereign credit spreads, and FX from 2 May to 13 November. Using SBI country sub-indices for credit. Changes in rates and credit in basis points. Changes in FX in % (local currency per USD; - = depreciation; rhs)
Weekly EM fund flows in $bn (rhs). Rolling four-week average price returns of CS SBI and EMLC bond indices, in %
-20
-10
0
10
20
30
40
-200
-100
0
100
200
300
400
US
T
BR
L
CL
P
CO
P
MX
N
PE
N
HU
F
ILS
PL
N
RU
B
TR
Y
ZA
R
IDR
KR
W
MY
R
TH
B
Rates Sov. Credit FX (rhs)
-6
-5
-4
-3
-2
-1
0
1
2
3
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
Jan-1
3
Fe
b-1
3
Mar-
13
Ap
r-13
May-1
3
Jun
-13
Jul-
13
Au
g-1
3
Se
p-1
3
Oct-
13
Flows (rhs)
Hard ccy
Local ccy
Source: Credit Suisse Source: EPFR Global, Credit Suisse
Given this backdrop, we see bumpy markets rather than a directional market trend
in 2014. As a result, relative value and curve trades remain our preferred investment
strategy into 2014. In general, we think that investors should be patient looking for market
dislocations arising from sell-off periods.
In rate markets, we expect Mexican local yields to offer good investment
opportunities. These opportunities have arisen as a result of the recent sell-off of the
short end of local rate curves. We would look at fading these sell-offs when the market
prices in rate hikes in the near term. We would also focus on long-end flatteners when US
Treasuries stabilize, as the TIIE and Mbono curves are among steepest in EM. The
expected congressional approval of the energy reform is likely to reduce the term risk
premium, while the peso should benefit from the anticipation of capital inflows.
We are cautious on Brazilian rate markets. Rates will most likely remain volatile in 2014
as taper and idiosyncratic factors continue to play out (worsening fiscal accounts, resilient
inflation, and BRL weakness, among others). We would avoid duration and only look at
receiving tactically very short-end contracts in pre-CDI swaps when the curve prices in
aggressive hikes.
Valuations look attractive in fixed income markets in Chile, Colombia, and Peru. In
Chile, we maintain a received bias on back-ups and note that real rates look attractive.
The central bank is likely to continue to cut the policy rate further in 2014, which should
Domestic factors
should also attract
investor attention
Relative value trades
remain our preferred
strategy into 2014
We expect Mexican rate
markets to offer good
opportunities. We remain
cautious on Brazil
19 November 2013
2014 Global Outlook 105
keep the front end well anchored. We also see value in real rates. Inflation breakevens
remain low (1-year B/Es are currently at 2.1%), but we expect changes in the inflation
methodology to put inflation on an upward trend in 2014. In Colombia and Peru, the front
end of the local swap and bond markets tends to price in too many rate hikes, so we will
be tactically receiving rates in these markets. Specifically in Peru, attractive yields and
limited FX volatility make long positions in Soberanos bonds attractive.
In sovereign credit, high-beta credits present challenges. A potential for technical
default by Argentina still presents a material risk, while the deterioration in the economy
and policy mismanagement in Venezuela should continue to pressure sovereign and
PDVSA bonds. We prefer the short sector of the sovereign or PDVSA curve, in particular
the 2014 bonds, where the carry and roll down is attractive, with low default and
issuance risk.
In the FX space, we are relatively bearish the BRL and CLP and constructive on the MXN
in the medium term. For our FX research team’s views on these currencies, please see
our FX Compass report of 13 November 2013.
On the corporate front, we expect continued mixed performance in 2014. Latam
corporates underperformed other EM regions and US HY corporates in 2013 (in 2013 to
date through November). Underperformance in Latam HY reflected defaults by Mexican
homebuilders and OGX (which combined represent 6% of par value of Latam HY).
Negative returns in Latam HG corporates reflected the heavy weighting of commodity
sector companies (metals & mining and oil companies comprise 43% of Latam HG) and
long-duration bonds (18% of Latam HG matures in ten years or more). Additionally,
telecom sector regulatory change and potential M&A negatively affected America Movil
bond performance (AMX bonds represent 6% of Latam HG). We expect Latam HG
performance in 2014 to continue to be negatively affected by commodity sector pricing risk
and concern about duration due to Fed taper risk. However, we expect Latam corporates
to outperform hard-currency sovereign bonds, which are generally longer duration.
Exhibits 140 and 141: Latam corporates underperformed in 2013 to 11 November
2013 through 11 November 2013 through 11 November
6.1%
0.2%
-2.3% -2.3%
-6.1%-6.7%-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%Total Return (2013 YTD) Return Vol (2013 YTD)
3.3%2.8%
0.2%
-0.7%-1.3%
-2.3%
-3.9%-4.5%
-6%
-4%
-2%
0%
2%
4%
6%
8%Total Return (2013 YTD) Return Vol (2013 YTD)
Source: Credit Suisse Source: Credit Suisse
We prefer Latam HY over Latam HG, especially under a Fed taper scenario. We
believe that Latam HY should perform well in 2014 as a result of attractive spread pick-up
over US HY (and the potential for spread tightening, especially in Mexican HY), supported
by generally solid corporate liquidity positions. Our Latam HY corporate index trades
nearly 300 bp wide to the Credit Suisse US HY index, whereas in January 2013, this
spread differential was less than150 bp wide. We believe that a 50 bp spread tightening in
Latam HY to US HY in 2014 is achievable given the current historically wide spread
differential and our view that Latam corporate defaults in 2014 will be lower than in 2013.
We expect
continued mixed
performance in
Latam corps
We prefer Latam HY
over Latam HG
corporates
19 November 2013
2014 Global Outlook 106
However, we note that substandard bankruptcy codes in Latam jurisdictions still merit
higher overall spreads relative to comparable US credits. We also see room for moderate
spread tightening (of about 25 bp) in Latam HG given that current spreads are around 150
bp wide to US HG versus a historical average pick-up of around 100 bp.
The mixed economic outlook for the region and a still-volatile market environment
call for more selective positioning. We favor credits in Mexico that should benefit
from renewed economic momentum following transitional government spending delays
in 2013. Additionally, Mexico is poised to benefit from an improved US growth scenario
(especially export-focused sectors such as auto parts). Utilities and banks in the Andean
region should benefit from a solid economic growth outlook for that region, although we
are moderately cautious about the Peruvian consumer sector, which could see a drag in
spending due to weaker mining sector profits. We see a mixed outlook in Brazil as a
result of (1) a high concentration of commodity companies facing an uncertain pricing
outlook (but exporters should benefit from currency weakness), (2) the ongoing
government influence that can have an outsized impact on certain sectors (for example,
a critical driver of Petrobras’ profit momentum hinges on a domestic fuel price
adjustment), and (3) the uncertain timing and impact of expected infrastructure spending.
Within countries and sectors, there is a significant potential differential between winners
and losers; thus, management quality is critical.
Still-low rates should support ongoing strong new issuance. Latam corporate new
issuance has remained strong in 2013, despite market volatility, with US$83 billion of debt
issued year to date through a record 196 new issues (versus US$97 billion raised in 194
new issues in 2012, including quasi-sovereigns). With relatively low absolute rates, we
believe that Latam corporates will continue to pursue liability management by tapping the
market to refinance at lower coupons. Additionally, we expect first-time issuers to come to
market, increasing the importance of bottom-up credit work and bond selection.
Exhibit 142: Latam HY vs. US HY Exhibit 143: Latam HG vs. US HG
2013 through 11 November 2013 through 11 November
11.3
10.0
8.9
8.0
7.0
6.0
0
50
100
150
200
250
300
350
0
2
4
6
8
10
12
Jan
-12
Ma
r-12
Ma
y-1
2
Jul-1
2
Se
p-1
2
Nov-1
2
Jan
-13
Ma
r-13
Ma
y-1
3
Jul-1
3
Se
p-1
3
Nov-1
3
Yie
ld D
iff (bp
s)
Yie
ld-t
o-W
ors
t (%
)
Yield Diff. (RHS)
Latam HY YTW (Avg. YTW 8.9%)
US HY YTW (Avg. YTW 6.6%)
329313
255
186
137109
0
50
100
150
200
0
50
100
150
200
250
300
350
Jan
-12
Ma
r-12
Ma
y-1
2
Jul-1
2
Se
p-1
2
Nov-1
2
Jan
-13
Ma
r-13
Ma
y-1
3
Jul-1
3
Se
p-1
3
Nov-1
3
Sp
read
Diff (b
ps
)
BM
Sp
read
(b
ps
)
Basis Diff. (RHS)
Latam HG Bench Spread (Avg. Spread 252bps)
US HG Bench Spread (Avg. Spread 134bps)
Source: Credit Suisse Source: Credit Suisse
Selectivity is key
Latam corporate
new issuance
should remain
strong
19 November 2013
2014 Global Outlook 107
EEMEA A story of two halves
2014 Core Views
The cyclical growth outlook for EEMEA countries is improving as the gradual
recovery in the euro area continues. EEMEA economies should continue to have the
largest spare capacity among all EM regions for most of 2014, on our estimates, but
the region’s negative output gap is likely to close by about mid-2015.
We expect headline inflation rates to edge higher in most EEMEA countries in 2014
as economic activity continues to pick up, but we project further disinflation in Russia
and Turkey. The EEMEA currencies that we think have the scope for appreciation in
2014 are the Polish zloty and the Israeli shekel.
Under our baseline scenarios, we expect monetary policy easing in Russia and Israel
and tightening in South Africa in 2014. However, the growth and inflation outlook
suggests that monetary policy will be tightened in all EEMEA countries except Russia
in 2015.
2014 Thematic Trade Ideas
For EEMEA rates and sovereign spreads, we expect 2014 to start in a bearish phase
and then transition into a bullish phase, based on our global scenario for 2014.
We recommend paying 5-year rates in Hungary and Poland and receiving 2-year
rates in Israel.
We are neutral on EEMEA sovereign credit spreads and bearish on Ukraine in the
absence of an IMF program.
We present the economic outlook for the EEMEA region in the first three paragraphs,
followed by the fixed income top-down outlook in the next two paragraphs
The growth outlook for EEMEA countries is improving as the gradual recovery in
the euro area continues. We expect notable (1.0-3.0 pp) pick-up in CE3 countries’ full-
year real GDP growth rates in 2014 compared to 2013. Additionally, we expect Russia’s
disappointing growth performance in 2013 to reverse somewhat as both household and
investment spending growth picks up in 2014. EEMEA economies will continue to have the
largest spare capacity among all EM regions for the most part of 2014 even as the full-
year regional real GDP growth picks up to 2.9% in 2014 from an estimated 2.1% in 2013.
The region’s output gap is likely to close by about mid-2015, on our estimates.
We expect headline inflation rates to edge higher in most EEMEA countries in 2014
as economic activity continues to pick up, but we project further disinflation in
Russia and Turkey. At the regional level, we expect headline inflation to increase
modestly to 4.7% in 2014 from an estimated 4.4% in 2013. By end-2014, most EEMEA
countries will have inflation rates at or slightly above target, on our estimates. Although
the current account balances across EEMEA countries are likely to worsen or
remain broadly unchanged in 2014, in our view, we do not foresee financing
difficulties as a result of the changes in US monetary policy. However, most EEMEA
currencies are likely to remain under depreciation pressure. The EEMEA currencies that
we think have the scope for appreciation in 2014 are the Polish zloty and the Israeli shekel.
Shahzad Hasan
+44 20 7883 1184
Nimrod Mevorach
+44 20 7888 1257
Berna Bayazitoglu
+44 20 7883 3431
The EEMEA region
is set to benefit from
the gradual recovery
in the euro area
Headline inflation
rates are likely to
edge higher in most
EEMEA countries in
2014, except in
Russia and Turkey
19 November 2013
2014 Global Outlook 108
Under our baseline scenarios, we expect monetary policy easing in Russia and
Israel and tightening in South Africa in 2014. We expect policy rates to remain
unchanged in the other EEMEA countries. However, compared to what we envisage in our
baseline scenarios for 2014, we think that there is scope for looser monetary policy in the
Czech Republic and Hungary and scope for tighter monetary policy in Poland, Russia, and
South Africa. We think that the risks to our end-2014 policy rate forecast for Israel are
balanced. In Turkey, we do not expect the MPC to hike the policy rate (one-week repo
rate) higher before the G3 central banks start hiking their policy rates, but there is some
likelihood that the MPC might hike the upper end of the short-term interest rate corridor
further in 2014, depending on the size, timing, and the source of a possible exchange rate
shock. Our growth and inflation outlook for the region suggests that monetary
policy will be tightened in 2015 in all EEMEA countries except Russia.
The outlook for EEMEA rates and spreads next year is highly uncertain, but we
think that 2014 could become a story of two phases. For simplicity, let’s call the two
phases bearish and bullish. During the bearish phase, US Treasury yields should widen
in response to Fed tapering, increasing volatility in global fixed income markets and
causing a large sell-off in EM rates and spreads. In the bullish phase, US Treasury yields
should stabilize, most likely around 3.35%, as forecast by our US rates strategists’ for end-
2014, with reduced volatility and improved valuations in EM fixed income attracting buying
interest. Exhibit 144 shows that in 2013, EEMEA rates widened in line with rising US
Treasury yields, with rate curves bear steepening. This could continue during the bearish
phase of 2014 but reverse in the bullish phase.
While we have separated our 2014 outlook into bearish and bullish halves, in reality
there remains significant uncertainty about next year. The timing and extent of QE3
taper by the Fed under a new chairperson next year remains unknown. If the Fed replaces
QE with more dovish forward guidance, the impact on US Treasury yields and EM fixed
income may be small. Meanwhile, stronger growth in the developed world might improve
global risk appetite for EM assets. Bank of Japan (BoJ) is embarking on large-scale
quantitative easing, expanding its balance sheet from 45% of GDP at end of 2013 to 58%
of GDP by end-2014, according to our economist. This would add the equivalent of $700
billion of additional liquidity next year, helping offset the loss of the Fed’s QE3 during 2014.
However, the transmission mechanism from BoJ balance sheet expansion to EM debt is
not as strong as the Fed’s QE asset purchases, in our view. US rates are the global
benchmark for fixed income, while JGBs are not. By suppressing US Treasury yields, the
Fed has been able to trigger “hunt for yield” globally, but this dynamic does not come into
play when JGB yields are compressed, in our view. We think that, on balance, price
action in US rates will be far more important for EM fixed income markets than
additional liquidity from the BoJ.
Having presented our top-down outlook, we next present country-specific views.
We would look to pay 5-year rates in Hungary during the second quarter of next
year. Inflation in Hungary has been on a downtrend, declining from 6.6% in September
2012 to 0.9% in October 2013, but the dis-inflation trend is set to reverse next year,
according to our economist. We estimate that Hungary’s negative output gap is narrowing,
which implies that the loose monetary and fiscal policies might pose upside risks to
inflation. Although utility price regulations should keep headline CPI subdued for most of
2014, underlying inflationary pressures are building up, and CPI inflation is likely to exceed
the central bank’s 3% yoy target in 4Q 2014, in our economist’s view. We project that
inflation prints will start showing increases during the second quarter (Exhibit 145), which
is when we recommend establishing payers. The Monetary Council will be reluctant to
tighten monetary policy, in our view, putting pressure on the belly and long end of the IRS
curve to move higher.
Monetary policy
outlook for 2014 is
diverse, but we
expect higher policy
rates in 2015 in all
EEMEA countries
except Russia
Under our global
scenario, the Fed
will start to taper in
January and end
QE3 in September;
therefore, 2014
should start in a
bearish phase and
transition to a
bullish phase
In Hungary, we
would look to
establish 5-year
payers in 2Q as
inflation picks up
but the central bank
remains dovish
19 November 2013
2014 Global Outlook 109
Exhibit 144: EEMEA rate curves higher and steeper so far in 2013
Exhibit 145: Hungary’s inflation likely to breach the central bank’s target by Q4 2014
Change in EEMEA rates during 2013 (bp) %
-10
0
10
20
30
40
50
60
70
80
90
100
1y 2y 5y 10y 1s2s 2s5s 5s10s
0
1
2
3
4
5
6
7
8
9
10
01/0
6
07/0
6
01/0
7
07/0
7
01/0
8
07/0
8
01/0
9
07/0
9
01/1
0
07/1
0
01/1
1
07/1
1
01/1
2
07/1
2
01/1
3
07/1
3
01/1
4
07/1
4
01/1
5
07/1
5
Headline inflation rate
Central Bank target
CS forecast
Source: the BLOOMBERG PROFESSIONAL™ service, Credit Suisse
EEMEA rates are average swap rates for the Czech Republic, Hungary, Israel, Poland, Russia, South Africa and Turkey
Source: the BLOOMBERG PROFESSIONAL™ service, Credit Suisse
We recommend receiving 2-year IRS in Israel. We expect the Monetary Committee to
continue to focus on weakening the shekel and project 50 bp of cuts during 2014, taking
the policy rate to 0.50% by end-2014. We think that the best way to position for such a
scenario is by receiving the 2-year rate, which has the best carry and roll in the front end
of the swap curve (9.7 bp over three months). Israel front-end rates are less sensitive to
swings in the EM risk appetite than longer-tenor swaps, another benefit of staying at the
short end of the IRS curve.
We recommend paying 5-year rates in Poland. Our economist believes that
improvements in the labor market and credit growth will continue to support a pick-up in
domestic demand, but the rebound is likely to remain gradual, and the MPC is likely to keep
the policy rate unchanged at 2.50% until end-2014. The pension reform ‒ due to be
implemented in 1Q 2014 – is likely to trigger outflows of at least of $3 billion to $4 billion from
the Polish bond market, according to our estimates, which would put pressure on rates to
widen further. Improving economic indicators suggest that the next move from the central
bank will most likely be a rate hike in early 2015, according to our baseline scenario.
Russia’s moderate growth, improving inflation profile, low beta to US rates, and
expectation of rate cut(s) from the central bank will keep buying interest in OFZs, in
our view. Russian rates outperformed US rates during the global sell-off that started on 2
May 2013, with the curve bear steepening. We expect this dynamic to remain in place in
2014. Our economists’ pencil in one 25 bp cut in the policy rate in 3Q 2014. On the
negative side, the Ministry of Finance has an ambitious issuance calendar, with more than
half of the new issuance targeted on the 7-year and longer part of the OFZ curve. The
belly and long-end bonds are sensitive to global risk appetite as the share of foreign
investors in local bond market has increased significantly since the OFZs became
Euroclearable in early 2013.
South Africa and Turkey rates will remain high beta next year as well, in our view.
This year, South Africa and Turkey have been the worst-hit local markets in EEMEA,
returning -19.0% and -14.1%, respectively, according to the Credit Suisse local currency
bond index (EMLC). Our economists estimate that the full-year current account deficit will
remain broadly unchanged in Turkey but widen in South Africa in 2014. We pencil in 100
bp of policy rate hikes in South Africa but none for Turkey. On the other hand, the central
In Israel, we suggest
receiving 2-year IRS
due to favorable
risk-reward due to
policy rate cuts and
high carry and roll
We recommend paying
5-year rates in Poland to
position for outflows due
to the index effect of
pension fund reforms
We are neutral on
Russian rates
We see South Africa
and Turkey rate
curves as fair
around current
valuations
19 November 2013
2014 Global Outlook 110
bank’s policy response is expected to remain discretionary in Turkey, with lira volatility and
global risk appetite dictating it, in our view. We view the shape of rates curves as fair, with
the steep curve in South Africa (new issuance concentrated on the long end) and the flat
curve in Turkey (the front end reacts to tightening or easing of liquidity conditions in the
local market) reflecting technicals that prevail in each market.
EEMEA sovereign credit spreads should widen in response to rising US Treasury
yields, in our view, and vice versa. Liquidity in external debt is concentrated in
intermediate (10-year maturity) and long-end (30-year maturity) bonds. At the time of
writing, sovereign bond yield curves were mirroring the term structure of the US Treasury
curve, with no spread premium for taking on additional duration risk associated with
holding a bond with 20-year or longer maturity. We find the belly of sovereign bond curves
more attractive at these levels.
We remain bearish on Ukraine in the absence of an IMF program. Ukraine’s very large
financing needs, declining FX reserves, and ratings downgrades have cut off the country’s
access to capital markets. Ukraine’s readiness to accept tough reform conditions for a new
IMF program remains uncertain. As our base case, we expect an IMF deal in 2Q 2014.
The need to curb domestic demand in order to cut the large current account deficit is very
likely to extend this year’s recession into 2014. Without IMF support, the risk of a balance
of payments crisis next year would be very high, in our view.
Exhibit 146: Summary of EEMEA fixed income strategy views
Country Macro view Local currency rates Sovereign credit
The Czech Rep.
Our economist expects real GDP growth to return to positive territory in 2014, after two years of contraction, due to improving demand from the Eurozone. Our economist also expects inflation to reach the central bank’s 2% target by end-2014. The central bank is likely to keep its monetary policy loose throughout 2014 via super-low policy rate and FX interventions aiming to keep the currency weak.
Neutral. Super-loose monetary policy will keep rates around their historical lows, in our view. The EUR-CZK basis swap could move significantly lower if FX intervention volumes are sizable, in our view.
Hungary Our economist expects real GDP growth to increase to 1.5% in 2014 from 0.5% in 2013 and inflation to pick-up to 3.4% yoy by end-2014 from 1.1% yoy at end-2013. According to our economist, another 40 bp of cuts to the policy rate by end-2013 should end to the aggressive easing cycle that started in August 2012.
Pay 5-year rates in 2Q.In our view, inflation will start picking up in 2Q 2014, breaching the central bank’s target during 4Q, but we expect NBH to remain dovish. This will result in belly and long-end rates moving higher, in our view.
Bearish near-term. The authorities have indicated that they might issue up to $5 billion worth of Eurobonds in the coming months, which should keep spreads under pressure near-term, in our view.
Israel The sequential real GDP growth will hover around 3.5%-4.0% throughout 2014, while inflation dynamics should remain benign, according to our economist’s forecast. The Monetary Committee will continue to focus on weakening the shekel, and our economist projects 50 bp cuts in the policy rate in 2014, taking the policy rate to 0.50% by end-2014.
Receive 2-year rates. The 2-year rate offers an attractive risk-reward due to the likelihood of further policy easing and an attractive carry and roll.
Poland Our economist forecasts that the policy rate will remain unchanged at 2.50% until end-2014. Improvements in the labor market and credit growth will continue to support a pick-up in domestic demand, but the rebound is likely to remain gradual, in our view.
Pay 5-year rates. Although our baseline scenario envisages unchanged policy rate in 2014, the risks are skewed to the upside. We expect index effect of the pension fund reform to weigh negatively on the local rates curve.
Neutral. Polish credit spreads will likely remain low beta in EEMEA, in our view.
We are neutral on
EEMEA sovereign
credit spreads
In Ukraine, we
expect an IMF deal
during 2Q
19 November 2013
2014 Global Outlook 111
Exhibit 146: Summary of EEMEA fixed income strategy views
Country Macro view Local currency rates Sovereign credit
Russia Real GDP growth momentum will remain sluggish, despite one-off pick-up in investment in 4Q 2013 and 1Q 2014.Inflation is expected to decline from 6.0% in 2013 to 5.2% in 2014, based on our economists’ projection. The macro backdrop should lead to a 25 bp cut in the one-week repo rate in 3Q 2014, according to our economists.
Neutral. Moderate growth, improving inflation profile, low beta to US rates and expectation of rate cut(s) from the central bank will keep buying interest in OFZs, in our view. On the negative side, the Ministry of Finance has an ambitious issuance calendar.
Neutral. An ongoing deterioration in the current account surplus and a sluggish real GDP growth dynamics are playing negatively for credit spreads, in our view. However, we expect Russia credit spreads to remain relatively tight due to stable oil prices.
South Africa Our economist expects year-on-year inflation to increase to 6.0% in 2014 from 5.6% in 2013, but to bottom at 5.3% in April 2014. An expected deterioration in South Africa’s terms of trade next year should lead to a sharp increase in the already elevated current account deficit and to a 100 bp hikes in the policy rate in 2014, in our economist’s view.
Bearish. South Africa rates and currency will remain vulnerable to the swings in the global risk appetite. The bond and the swap curves are expected to remain steep, given the Treasury’s issuances focus on long-end bonds.
Neutral. The ongoing deterioration in the government’s debt to GDP ratio and the current account deficit are posing a downside risk to South Africa’s credit rating. However, credit spreads have already adjusted significantly higher in 2013.
Turkey The central bank will continue to address lira weakness via a combination of FX sales and tightening monetary conditions, according to our economist’s view. The recent decline in credit growth momentum and an improvement in exports outlook will lead to favorable current account numbers in 1H 2014. In addition, year-on-year headline inflation should slow in 1Q 2014 as a result of base effects.
Bearish. Turkey xccy rates and bonds will continue to play a high beta role to the EM risk sentiment, in our view. A favorable headline inflation and current account dynamics in the near-term could only partly offset negatives from the global front, in our view. The xccy curve should remain extremely flat as long as the lira remains under depreciation pressure.
Neutral. Turkey credit spreads remain hostage to EM risk sentiment.
Ukraine Very large financing needs, declining FX reserves and ratings downgrades have cut off the country’s access to capital markets. Ukraine’s readiness to accept tough reform conditions for a new IMF program remains uncertain. The need to curb domestic demand in order to cut the large current account deficit is very likely to extend this year’s recession into 2014.
Bearish. Without IMF support, the risk of a balance of payments crisis next year would be very high in our view.
Source: Credit Suisse
19 November 2013
2014 Global Outlook 112
19 November 2013
2014 Global Outlook 113
Equity Strategy We remain positive on equities for 2014 and continue to target 1,900 for the S&P 500 by 2014 year-end
2014 Core Views
Relative valuations, excess liquidity, and still-cautious positioning suggest that equity
markets can continue to move higher.
Corporate earnings look set to grow at a mid- to high-single-digit rate, and profit
margins remain supported as long as there is slack in the labor market.
2014 Thematic Trade Ideas
We target 1900 for SPX.
There are, in our opinion, the following main reasons for continuing to be
constructive on equities:
Equities are still cheap against bonds, even factoring in our bond team's forecasts.
Excess liquidity remains supportive for equities. The policy bias is easy monetary policy
and a move away from fiscal austerity, which is good for equities, bad for bonds.
A rise in inflation expectations is helpful for equities.
Funds flow and long-term positioning still look supportive for equities.
Margins appear set to stay higher than investors expect.
Credit spreads appear set to remain tight, and credit marginally leads equities.
Overall, we think that equities will peak when there is clear euphoria.
Macro surprises have rolled over, but this looks to be a mid-cycle correction.
We do, however, believe that there will be a period of consolidation near term as some of
the tactical indicators have become extended at the time of writing (see Equities: a pause
before further advances, 1 November 2013).
The equity risk premium is still too high
The US ERP remains elevated at 6.8% using the IBES consensus earnings numbers. If
we use our more conservative earnings assumptions, the US ERP is still 5.4%.
Exhibit 147: US equity risk premium (ERP) on consensus earnings is 6.8% and 5.4% on our earnings forecast
US ERP12mth fwd
EPS
12-24mth
fwd EPS
growth
3-5yr fwd
EPS growthERP
ERP on 12m forw ard consensus EPS estimates $118.9 10.7% 11.2% 6.8%
ERP on our EPS forecasts $113.5 6.4% 6.4% 5.4%
ERP on trend operating EPS of $82 $82 6.4% 6.4% 4.6%
3.2% Historical 110- year average equity risk premium
Source: Thomson Reuters, Credit Suisse
Our model of the warranted ERP (that depends on the stage of the economic cycle, ISM
and credit spreads) suggests that it should be 4.5%.
Similarly, the decline in macro uncertainty and the volatility of equities relative to bonds
suggest that the ERP should be lower.
Global Equity Strategy
Andrew Garthwaite
+44 20 7883 6477
Marina Pronina
44 20 7883 6476
Mark Richards
44 20 7883 6484
Sebastian Raedler
44 20 7888 7554
Robert Griffiths
44 20 7883 8885
Nicolas Wylenzek
44 207 883 6480
We remain
constructive on
equities
19 November 2013
2014 Global Outlook 114
Exhibit 148: The gap between the actual equity risk premium (ERP) and the warranted ERP should continue to close as macro uncertainty falls
Exhibit 149: The ratio of equity to bond volatility is consistent with a fall in the ERP to around 4%
30
50
70
90
110
130
150
170
190
-50%
-30%
-10%
10%
30%
50%
70%
1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
US ERP, actual vs warranted, % difference
US policy uncertainty index, 1-year rolling average, rhs
US policy uncertainty index, latest 6m average
2
3
4
5
6
7
8
9
10
1
3
5
7
9
11
13
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
ERP on consensus EPS
Ratio of equity to bond volatility, 1y (rhs)
Source: Thomson Reuters Datastream, Credit Suisse Source: Thomson Reuters Datastream, Credit Suisse
Easy monetary policy and less tight fiscal policy are supportive for equities
Outside of the US, we think that monetary policy will surprise on the dovish side:
The ECB could easily implement another LTRO or cut the deposit rate (the
rationale being that inflation is just 0.7%, with core inflation of 0.8%). The monetary
transmission mechanism is still broken, with real lending rates to SMEs in the periphery
at 6% – close to double those of the core European countries – with 40% of SMEs in
the periphery having little or no access to bank finance.
We also expect the BoJ to step up QE in 1Q 2014 (as Japanese wages are now
declining again and our economists believe that on current policies, Japanese inflation
will be just 0.5% next year).
It is striking that the Fed projects 5.7% unemployment by end-2016 (which is close
to their own estimate of full employment) and even then only forecasts a 1.75% Fed
funds rate, which in real terms is slightly below zero and still highly accommodative
(historically, the real fed funds rate has averaged 2%, and the Fed estimates the long-
run nominal Fed funds rate to be 4%).
The net result is that developed market central bank balance sheets are likely to expand
by another 16% between now and end-2014, and partly as a result of this, excess liquidity
is running at 6.3% (as shown in Exhibit 150).
We also note that equities only corrected two weeks after the end of QE1 and QE2. Our
economists expect QE3 to finish in September 2014.
19 November 2013
2014 Global Outlook 115
Exhibit 150: Global excess liquidity rising at c6% appears supportive of equity market valuations
Exhibit 151: Market peaks after the end of QE1 and QE2
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
120%
-4
-2
0
2
4
6
8
10
12
14
16
18
1983 1989 1994 2000 2005 2011
OECD excess liquidity (3m lead)
Global equities, 12m % change in PE (3mma, rhs)
80
85
90
95
100
105
1 6 11 16 21 26 31 36 41 46 51 56 61 66
Following the end of QE1 (March 2010)
Following the end of QE2 (June 2011)
Number of days
Source: Thomson Reuters Datastream, Credit Suisse Source: Thomson Reuters Datastream, Credit Suisse
We still believe that the problematic time for equities is likely to be the period around the
first rate hike (mid-2015, in our view), and when the cost of capital changes at the short
end, this is likely to drive a period of deleveraging. For the record, the first rate hike in the
previous six rate cycles has seen the S&P 500 correct by between 2.2% to 8.7%, a similar
scale to the correction that followed initial fears of tapering in the summer.
Fiscal policy: on balance, in Europe, the US, and Japan, fiscal policy in 2014 looks likely
to be easier than in 2013. In Europe, we expect governments to be allowed more time to
hit their fiscal targets (as long as restructuring continues), and fiscal easing should add
about 0.5% to GDP growth next year. In Japan, the supplementary budget is likely to
offset most of the impact of the consumption tax hike, and in the US, fiscal tightening next
year is likely to be 1.75% of GDP less than in 2013, thus providing a boost to growth.
Looser monetary and looser fiscal policy are on balance positive for equities relative to
bonds.
If bond yields rise, the rise is likely to be led by a rise in inflation
expectations, and that is good for equities
There is a close correlation between equity multiples and inflation expectations, and we
believe that inflation expectations are likely to rise as a result of continued monetary policy
proactivity. This would validate the current valuation of equity markets.
Easy monetary
policy bias and a
move away from
fiscal austerity is
good for equities
19 November 2013
2014 Global Outlook 116
Exhibit 152: Equity multiples are moved by inflation expectations
Exhibit 153: Inflation expectations are one of the primary drivers of the equity multiple
0.2
0.7
1.2
1.7
2.2
2.7
3.2
3.7
8
9
10
11
12
13
14
15
2008 2009 2010 2011 2012 2013
US 12m fwd P/E
US 5Y 5Y breakeven inflation rate, rhs
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
0.6
OECDexcessliquity
5y5yinflation
expectations
US 10yrTreasury
yield
US 10yrTIPS yield
S&P 500EPS netupgrades
S&P 50012m fwd
EPS growth
Correlation with 12m fwd P/E (last3yrs, 4wk ch)
Source: Thomson Reuters Datastream, Credit Suisse Source: Thomson Reuters Datastream, Credit Suisse
We think that inflation expectations are likely to rise as it becomes apparent that fiscal and
monetary policy into a recovery remain looser than many investors had expected. Note
that equities do not tend to de-rate until inflation expectations rise above 4%.
On our models, we estimate that equity-to-bond valuations become neutral when the US
10-year bond yield rises to around 3.50% (once we adjust for the impact of rising bond
yields on the interest charge, GDP growth, and valuation).
Exhibit 154: Impact of higher rates on earnings, housing, GDP, and equity valuations
Impact of higher interest rates
100 bps on corporate bond yields -> 30 bps on interest charge -> 3% off US earnings
100 bps on the mortgage rate -> Mortgage rate goes to 5.6% -> Housing affordability falls to average
100 bps on the 10-yr Treasury yield -> Sensitivity based on OECD model -> GDP level falls by 0.1% in yr1 to 1.1% in yr5
100 bps on the 10-yr Treasury yield -> Sensitivity based on CS savings ratio model -> GDP falls by 0.4%
100 bps on the 10-yr Treasury yield -> Impact on equity valuations -> Bond yield of 3.65% causes ERP to falls to warranted ERP Source: Thomson Reuters Datastream, Credit Suisse
Funds flow still looks very supportive
Since 2008, global bond funds have seen $1.2 billion of inflows, compared to $200 billion
of selling of global equities by retail and institutions, according to EPFR data. Retail buying
shows signs of picking up as we see clear examples of a bond-for-equity switch (which
has admittedly slowed in the past quarter).
19 November 2013
2014 Global Outlook 117
Exhibit 155: Since 2008, bond funds have seen around $1,188 billion of inflows, while equity funds have experienced about $200 billion of outflows
Exhibit 156: Inflows into equity funds are close to an eight-month high, while bond funds are experiencing outflows
-198 -178
79.7
1,188
99
-110.1
-400
-200
0
200
400
600
800
1,000
1,200
1,400
1,600
Since Jan 2008 2011 Last six months
Flows into global funds, USD bn
Equities Bonds
-11%
-6%
-1%
4%
9%
14%
19%
24%
Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Oct-12 Apr-13 Oct-13
3-month annualized inflows, % of net assets, all regions
Bonds
Equities
Source: EPFR, Credit Suisse research Source: EPFR, Credit Suisse research
We believe that returns drive flows and that, by March 2014 (on unchanged current prices),
the five-year rolling risk-adjusted return for equities will rise to just over 1. This would be
the highest since 2008 and, more importantly, a level close to that of government bonds.
This may persuade actuaries to advise institutions to increase allocations toward equities.
Moreover, over the past five years, equities have outperformed bonds by 13% a year.
Exhibit 157: Trailing risk-adjusted returns for equities are set to spike to be similar to bonds by Q1 2014, potentially encouraging greater allocations
Exhibit 158: The five-year rolling annualized excess return of equities over bonds now exceeds 13%
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
MSCI AC World
Global govt bond
Corp bonds
Commodities
5-yr risk-adjusted returns (dotted lines projected using current index levels and current volatility)
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
5-year rolling annualized excess returns of US equities vs bonds
Source: Thomson Reuters Datastream, Credit Suisse Source: Thomson Reuters Datastream, Credit Suisse
19 November 2013
2014 Global Outlook 118
19 November 2013
2014 Global Outlook 119
FX Strategy 2014: the year of the dollar, with monetary policy divergence in the driving seat 2014 Core Views
We believe that the USD is likely to begin a multi-year rally.
Yen and AUD are likely to fall the most against the dollar.
"Twin-deficit" EM currencies are likely to experience episodic turbulence, as US
monetary policy is gradually "normalized."
2014 Thematic Trade Ideas
We recommend positioning for a renewed substantial downside in AUDUSD.
We look for USDJPY to rise to 115.
Divergences should open in Europe. We look for Scandies to fall materially, in
contrast to Sterling.
In EM, we have the most conviction on structural weakness in RUB in 2014. We also
suggest being short TRY, ZAR, CLP, and BRL. We expect outperformance from MXN.
For much of the past year, the market consensus among the FX analytical community was
bullish toward the USD. However, while the preconditions for a dollar rally were starting to
build in early 2013, we have for some time thought that the bull run would not start until
2014 – see USD Bull Market? Not Yet.
In the event that this theme has indeed played out, with the dollar having been broadly
flat over the course of 2013, as the early-2013 rally peaked in May and then faded
over the second half of the year.
Exhibit 159: The USD fell substantially from July to October
Index
73
74
75
76
77
78
79
79
80
81
82
83
84
85
Jan13 Feb13 Mar13 Apr13 May13 Jun13 Jul13 Aug13 Sep13 Oct13 Nov13
DXY Index
Fed Daily Majors TWI Index (rhs)
Source: the BLOOMBERG PROFESSIONAL™ service
As we move toward the end of the year, however, we believe that just as the market was
too bullish the dollar for much of the past year, it is likely that many analysts become too
bearish post the September "no taper," with the correction most likely all but complete just
as the speculative community finally capitulated on the long dollar thesis.
Somewhat counter-intuitively, the USD normally weakens when yields are moving
materially higher, as occurred around the middle of 2013 (see here).
Ric Deverell
+44 20 7883 2523
In our view, market
consensus was too
bullish USD in
2013…
… but became too
bearish USD post
"no taper"
19 November 2013
2014 Global Outlook 120
Exhibit 160: Foreign Treasury purchases fall when US yields are increasing
Exhibit 161: But they resume once yields stabilize at a higher level
bp change, 3mma $mn, 3mma
-20,000
0
20,000
40,000
60,000
80,000
100,000
120,000
140,000
160,000-90
-70
-50
-30
-10
10
30
2007 2008 2009 2010 2011 2012 2013
10-Year Monthly Change
Treasuries Purchased (RHS, Inverted)
-30,000
-20,000
-10,000
0
10,000
20,000
30,000
40,000
50,000
60,000-20
-10
0
10
20
30
Jul-12 Jan-13 Jul-13
10-Year Monthly Change
Treasuries Purchased (RHS, Inverted)
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service
Given that we believe that much of the "bond bust" has already occurred (it is unlikely that
10-year yields will move another 160 basis points higher from the current level), foreign
investors should now be attracted by higher yields rather than worry about further capital
losses, with purchases likely to resume.
While a January taper could generate further rates volatility, we think that the
maximum period of shock is behind us, with the Fed likely to work very hard (our
economists think that the Fed might change its forward guidance) to ensure that the
short end of the curve remains anchored for some time, thereby limiting the scope for
a sustained move higher at the long end.
Exhibit 162: US yields are likely to settle at a higher level as we enter 2014
Percentage
1.4
1.6
1.8
2.0
2.2
2.4
2.6
2.8
3.0
Oct12 Dec12 Feb13 Apr13 Jun13 Aug13 Oct13
US 10 year yield
average 1.8%
remains elevated100bp rally in
3 months
Source: the BLOOMBERG PROFESSIONAL™ service
Higher but stable
US yields are likely
to attract foreign
investors
19 November 2013
2014 Global Outlook 121
Central bank divergence the key to 2014 FX
In large part, the dollar bull story for 2014 is a function of the likely direction of monetary
policy among the major central banks. We believe that the Fed is likely to begin a gradual
process of "normalizing" policy in January (with December a possibility), while the ECB
and the Bank of Japan remain focused on stemming the resurgent deflationary threat.
In our view, the market is in the process of substantially changing its narrative on the
US. Rather than being "fragile," we think that US growth has been remarkably resilient
over recent months given the magnitude of fiscal and monetary tightening.
Note that fiscal policy tightened by nearly 2½ percentage points of GDP in 2013
(more than in any one year in Europe), and 10-year yields increased by 140 basis
points.
In contrast, it is becoming increasingly clear to us that Japan is tipping back into
deflation, while the disinflationary forces in Europe are also beginning to build.
Exhibit 163: Monetary policy is likely to diverge, . . . Exhibit 164: Driving the early stages of a dollar rally
90
100
110
120
130
140
150
1964 1971 1978 1985 1992 1999 2006 2013
Narrow USD REER
-33% over 9 years
+46% over 6 years
-34% over 7 years
+27% over 9 years
-24% over 9 years
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service
Forecasts
While the dollar is likely to enjoy a broad-based rally, we believe that idiosyncratic factors
will continue to drive a substantial divergence among currency pairs.
Among the G-10, we remain most bearish the AUD and the JPY, while we expect the
EUR finally to test the bottom of the recent 1.28-1.40 range in the second half of 2014.
Our expectation that USDJPY will increase to 115 in 12 months is predicated on a
further aggressive monetary easing by the Bank of Japan, probably in 1Q.
For the AUD, the structural weakness story should see the next leg over coming
months as Chinese growth softens and commodity prices fall. The market is also
likely to look ahead to the looming fall in mining investment that we believe should
occur around the middle of 2014.
Regarding the EUR, the initial move lower will be driven by the more dovish ECB,
with any break below the recent range a function of the new resurgent USD. Our
central scenario is that euro dollar falls to 1.28 in 12 months, but substantial further
falls are possible if the dollar bull rally takes off.
As the Fed begins to normalize policy, the EM world is again likely to come under
episodic pressure, with those countries with twin deficits and structural issues likely to
see the most pressure.
2014 dollar rally is
likely to be driven
by monetary policy
divergences
Japan and Europe
face issues
We expect the
largest dollar rises
against AUD and
JPY
Twin-deficit EMs are
likely to come under
pressure
19 November 2013
2014 Global Outlook 122
We expect TRY, ZAR, BRL, and RUB to fall the most (as well as KRW in response to
JPY weakness). Meanwhile, THB, MXN, and PLN (versus EUR) should prove relatively
resilient, in our view.
Exhibit 165: CS G10 currency forecasts – 12-month change vs. spot
Exhibit 166: CS EM currency forecasts – 12-month change vs. spot
Percentage change vs. USD Percentage change vs. USD (* indicates vs. EUR)
-16%
-14%
-12%
-10%
-8%
-6%
-4%
-2%
0%
CAD GBP CHF EUR NOK SEK NZD JPY AUD
12 month forecasted change from spot (vs USD)
-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
TH
B
MX
N
PL
N*
PH
P
CN
Y
INR
MY
R
IDR
TW
D
SG
D
HU
F*
RU
B
BR
L
KR
W
ZA
R
TR
Y
12 month forecasted change from spot vs USD (*vs EUR)
Source: Credit Suisse Source: Credit Suisse
19 November 2013
2014 Global Outlook 123
Global Interest Rate Strategy
European Rates Modestly bullish outright duration
2014 Core Views
We are modestly bullish rates; we expect German yields to rise less than the
forwards.
We believe that the steepening trend of the current cycle is near the end.
We think that peripheral yields have reached the secular low.
2014 Thematic Trade Ideas
We believe that investors should use the sell-off to 1.9% to reset long 10-year
Germany.
EUR 10-year looks set to outperform US and GBP.
We favor 5s10s or 5s30s flatteners in gilts and euro governments.
Key macro drivers for 2014
The US as the driving force: the timing of Fed tapering, US growth, and inflation
should be the key drivers for European yields. US potential growth is expected to be
higher than in Europe, and so we expect US yields to rise versus Europe.
Disinflation risks likely to keep the ECB accommodative: the ECB forecasts that
inflation will remain low for a “prolonged period,” which supports policy rates remaining
“low or lower” in 2014. It has an artillery of options available if inflation continues to fall:
cutting the Deposit Rate to negative territory, introducing further LTROs, or suspending
minimum reserve requirements (€110bn) for banks. Although not our central scenario,
the ECB could remove the SMP drain (€184bn) or consider QE. The ECB currently
forecasts that inflation will remain at 1.3% in 2014, and our economists’ expect the same
in 2015. While disinflation risks persist, the ECB will keep forward guidance in place –
another reason for yields in Europe to remain low versus the US.
Structural reform/political risks and banking risks: the growing popularity of the
extreme left both in the core and periphery makes the European Parliamentary elections
(mid-2014) interesting, in our opinion. We also expect delays in the broader European
agenda due to these elections. This, together with the ECB’s comprehensive review of
the banking system (AQR), is expected to generate peripheral market volatility. We
would use weakness in peripheral spreads to add to our long Spain view.
UK policy tightening risk in 2014: UK growth in 2013 outperformed expectations, and
this is expected to continue in 2014. With growth data better than expected and
unemployment falling toward the BoE’s 7% threshold, it will be hard for the market to
ignore the risk of policy tightening in the latter half of 2014.
Modestly bullish on outright duration
We see three main scenarios for next year:
(1) Negative scenario: disinflation risks force the ECB to cut the deposit rate to
negative. Disinflation in the periphery also raises questions about debt sustainability
in Europe.
(2) Optimistic scenario: US economic data improves significantly, the Fed tapers
sooner than expected, and European economic data continues its current positive
trend.
(3) Central scenario: growth in Europe is positive but remains weaker than pre-crisis
levels. US rates rise as Fed tapering starts gradually in January.
Helen Haworth
+44 20 7888 0757
Adam Dent
+44 20 7883 7455
Panos Giannopoulos
+44 20 7883 6947
Thushka Maharaj
+44 20 7883 0211
Marion Pelata
+44 20 7883 1333
Florian Weber
+44 20 7888 3779
Disinflation risks
keep ECB in easing
mode; we expect
US-EUR divergence
Two opposing
forces driving rates
19 November 2013
2014 Global Outlook 124
In the lower-for-longer scenario, we see a case for rates to fall, with 10-year Germany
reaching 1.5%, while in the optimistic scenario, 10-year yields could rise to 2.5% by end-
2014. These two opposing forces are likely to buffet yields.
Our yield forecasts for the central scenario are shown in Exhibit 167. We expect yields to
rise but not as much as is priced into the forward curve. Our main reasons are as follows:
Inflation is likely to remain low for a prolonged period, which should keep the ECB easy
in 2014.
The market has built in a lot of optimism already, and the risk is that growth disappoints
current expectations.
Our forecasts are 20 bp below the forwards in the first half of the year, but by year-end, we
expect 10-year Germany to end up close to the current forwards. So our base-case
scenario is for a 0% absolute return on a 1-year horizon (excluding transaction costs and
taxes). We acknowledge that the risks from disinflation could push returns into positive
territory.
Exhibit 167: German 2014 yield forecasts
German Credit Suisse Forecasts Market forwards
Benchmarks Current 4Q 2013 1Q 2014 2Q 2014 3Q 2014 4Q 2014 2Q 2014 4Q 2014
ECB Repo 0.25 0.25 0.25 0.25 0.25 0.25
2-Yr Yield 0.10 0.15 0.15 0.2 0.25 0.3 0.20 0.35
5-Yr Yield 0.70 0.70 0.75 0.85 0.95 1.15 0.93 1.16
10-Yr Yield 1.78 1.70 1.75 1.85 1.95 2.10 2.00 2.16
30-Yr Yield 2.73 2.60 2.60 2.70 2.75 2.85 2.8 2.87
Source: Credit Suisse
Curve outlook – 5s10s to flatten
Higher yields support a steeper curve out to 2s5s. But further out we expect 5s10s and
5s30s to flatten.
Throughout 2013, we held a curve-steepening view, as we thought that central bank
reflationary policy should push curves steeper. Curves have steepened consistently
throughout the year, with 5s30s reaching 10-year highs. We have recommended taking
profits on this structural steepening view.
We see the 5s10s curve flattening in either a bullish or bearish scenario: either the data
remain very strong and the market shifts some risk premium into the 5-year sector or the
disinflation risk becomes more severe and a rally is led by 10s. To best capture the risks
from both scenarios, we see better risk/reward in receiving curvature than via flatteners, as
curvature longs carry positive.
Curvature outlook – expected to compress around the 10-year point
Given our view that 5s10s can flatten going forward, the more protected and positive-carry
way of positioning for this is via receiving 5s10s30s (Exhibit 169). When rates normalize, it
is likely that 2s5s10s curvature will be higher and 5s10s30s lower.
That said, while we think that 5s10s30s curvature will fall on a terminal basis, it could well
rise in the interim, especially during bear-steepening episodes. We would use cheapening
in the 5s10s20s and 5s10s30s flies to enter a bullish position.
Buy Germany on
weakness
Curve dynamics
should be driven by
the 5- to10-year
sector
We recommend
receiving curvature
when it is at the top
end of the range
19 November 2013
2014 Global Outlook 125
Exhibit 168: Receiving EUR 5s10s20s has bullish bias Exhibit 169: EUR 5s10s20s are driven by 5s10s
31-Dec-11 30-Jun-12 30-Dec-12 30-Jun-13
20
30
40
1.5
2.0
2.5
EUR 5s10s20s 10s, rhs
30-Dec-04 01-Jul-07 30-Dec-09 30-Jun-12
-20
-10
0
10
20
30
40
-25
0
25
50
75
EUR 5s10s20s 5s10s, rhs
Source: Credit Suisse Locus Source: Credit Suisse
Money markets outlook – Eonia constrained by tight corridor
Eonia rates are likely to exhibit low volatility: given the reduced corridor between the
main refinancing rate and the deposit rate, Eonia forwards are unlikely to spike
significantly on liquidity fears. Should the favored tool be a negative deposit rate, we
expect Eonia and GC to fix negative but not overly so (for instance, ~-10 bp for a 25 bp
policy rate cut), with possibly a slow shift upward afterward. We expect Euribor to remain
sticky above 10 bp.
Buy the dips in FRA-Eonia: FRA-Eonia should widen in the event of a negative depo rate,
plus risks of occasional widening from AQR-related negative headlines on the banking
system all through 2014. In the other direction, with volatility and outright levels so low, we
think that chances are minimal for the basis to tighten further, even in the event of another
VLTRO or corridor tightening.
EUR vol outlook
Vol to remain directional to the level of rates during normalization: we would only
expect the relationship between rates and vol to loosen up when rates have fully
normalized and CBs have actually started their hiking cycles (so this is a story for beyond
2014).
Favor buying USD vol over EUR: greater risks lie in the US in terms of unwinding
ZIRP/expansionary balance sheet policies (see EST, 8 November 2013).
Regulatory developments to remain key driver: we do not expect swaption products to
become centrally cleared in 2014, which suggests that liquidity could be challenging at
times.
Bottom-right part of the vol surface to outperform in 2014 (also over a multi-year
horizon): this can be expressed by owning bottom-right vega outright, as a vega spread
(e.g., short 5-year expiries versus 15-year ones) or as a vega fly (e.g., 2y30y-5y30y-
15y30y; see EST, 25 July 2013).
Payer skew to remain elevated: the payer skew would fall to historical norms only when
rates have normalized and could even richen further if rates were to rise disorderly. That
said, as we mostly expect rates to be range-bound into 2014, the rich payer skew is likely
to offer opportunities in terms of one-by-two option structures in gamma space.
FRA-Eonia spreads
are likely to widen
19 November 2013
2014 Global Outlook 126
European governments – better data and lower supply support tighter
spreads and wider German ASW
We think that the division of countries into four major groups prevails. We believe that
Germany will remain the safe haven in significant risk-off moves.
Negative net issuance in Germany argues for wider swap spreads in 2014 (see our
Global Supply Outlook 2014). The German ASW has tightened significantly since mid-
October, consistent with an improving outlook for the global and European economy. We
think that there is only a marginal safe-haven premium priced into German ASW at current
levels. A potential depo rate cut to negative levels and/or a severe risk-off move could lead
to significant widening of the German ASW, with the risk that the ECB narrows the repo-to-
deposit rate corridor, which would compress spreads. Hence we would rather buy when
the ASW reaches the lower end of our expected ranges than sell at the higher end.
Exhibit 170: German ASW ranges
Euribor ASW Eonia ASW
Current
Low end of range
High end of range Current
Low end of range
High end of range
Schatz 32.9 30 40 6.8 4 15
Bobl 46.8 37 57 13.5 7 22
Bund 32.0 20 40 -1.15 -5 10
30y 2 0 15 -14.7 -16 3
Source: Credit Suisse
An improving economy argues for tighter spreads between Germany and the rest of
the core. We consider Austria, Finland, and the Netherlands as forming this group of
attractive countries. Given our view on German ASW, we prefer to express this by owning
non-German core sovereign bonds against swap.
A healing economy and very accommodative central bank argue for tighter spreads
between semi-core countries and Germany. France and Belgium are in between the
core and the periphery. In particular, France is politically seen as core, although it is
economically weaker than the others. We think that this is best expressed via being long
30-year France versus swap.
The spread between the periphery and Germany should continue gradually
tightening given the better economic data. However, we expect the low in BTP 10-year
yields to be close to 4% and for SPGB to be close 3.75%, near the current levels
(Exhibit 171). Therefore, further spread tightening should be driven more by a gradual rise
in rates in Germany and less by falling peripheral yields. While volatility in core markets
has been relatively high following the Fed taper discussion, the periphery was relatively
calm. We think that this could change in 2014 given our central macro drivers. This would
also mean that peripheral bond carry trades become less attractive on a vol-adjusted basis.
Within the periphery, we would overweight Spain versus Italy based on labor market
reforms, reduced Spanish LTRO borrowings, improvements in relative budget deficits, and
the recent change in LCH clearing treatment for BTPs.
Buy German ASW at
the low end of our
range
We recoomend a
long non-German
core versus swap
We recommend a
long 30-year France
versus swap
We suggest
overweighting Spain
versus Italy
19 November 2013
2014 Global Outlook 127
Exhibit 171: BTP and SPGB yields are already close to our structural lower bound
01-Jul-02 30-Dec-04 01-Jul-07 30-Dec-09 30-Jun-12
2.5
5.0
7.5
10y Italy 10y Spain 4% 3.75% 10y Germany
Source: Credit Suisse Locus
We think that both Ireland and Portugal will exit the full sovereign bailout programs
in 2014. While we think that Ireland should be able regain full market access without
further European support, we think that Portugal is likely to receive a “light” form of bailout
via an Enhanced Conditions Credit Line (ECCL) from the ESM. In theory, this would allow
the ECB to activate the OMT program, although we deem this unlikely. Exhibit 172
summarizes our views and highlights our trade expressions.
Exhibit 172: Summary of investment recommendation
Country group Country Outright Curve Trades Publication
Germany Benchmark Neutral Long 30-year vs. swap EST: 13 September
Non-German core Overweight Flatter 5s30s flattener EST: 8 November
Austria Long 30-year vs. swap EST: 2 August
Finland Long 30-year vs. swap EST: 26 July
The Netherlands Long 10-year vs. swap EST: 31 May
Semi core Overweight Flatter
France Long 30-year France on
ASW
EST: 23 August
Belgium 5s30s flattener EST: 8 November
Periphery Benchmark Steeper
Italy Underweight Long 7-year Spain vs. 10-
year Italy
EST: 25 October
Spain Overweight 7s10s steepener EST: 25 October
Ireland Benchmark
Portugal Benchmark
Source: Credit Suisse
UK outlook – short outright duration
The main drivers for the UK markets are as follows:
Improving growth and employment outlook, which calls into question forward guidance.
The expectation that the government will be less austere ahead of the 2015 elections,
which may mean more fiscal stimulus rather than monetary stimulus.
The strength of UK growth and employment data supports higher yields. We do not expect
any extension of QE or expansion of the FLS in 2014. The only area where the BoE can
provide a dovish innovation is by changing the unemployment threshold for forward
guidance. Our forecasts for gilt yields and curves are summarized in Exhibit 176.
Limited need or
room for further
monetary stimulus?
19 November 2013
2014 Global Outlook 128
We expect yields to move higher
as growth expectations build for
2014 but also as unemployment
falls closer to the 7% threshold.
Forward guidance and dovish
rhetoric can anchor rates out to 2
years, but further out, they will be
dependent on the pace of recovery.
Market expectations for timing of
the first 25 bp rate hike in the UK
is 1Q 2015, according to our
gamma distribution model applied
to the Sonia curve. The evolution
of these implied expectations is
shown in Exhibit 173 (see EST,
5 July 2013 for more details of the
model). This looks too aggressive
to us. We would fade this via 2s5s steepeners, rather than outright longs.
UK curve outlook – 5s10s to flatten and 2s5s10s to cheapen
Curve dynamics in the UK are likely to be driven by market perception of forward guidance.
Continuing positive data surprises are likely to reduce the expected lifespan of the
guidance, making the 5-year sector vulnerable; thus, we can see both 5s10s flattening and
GBP 2s5s10s moving higher. Exhibit 174 shows that this would be a normalization from
the extreme steepness of recent years. We would use a successful dovish communication
from the MPC to reset pay positions in GBP 2s5s10s at -10 bp.
Exhibit 174: 5s10s should flatten in a sell-off Exhibit 175: UK 30-year asset swap spreads vs. the
UK budget deficit (% GDP)
30-Dec-04 01-Jul-07 30-Dec-09 30-Jun-12
-50
0
50
1002
3
4
5
6
GBP 5s10s GBP 10y (RHS, INV)
-12
-10
-8
-6
-4
-2
0
2
4-150
-100
-50
0
50
Jan
-98
Se
p-0
0
Jun
-03
Ma
r-0
6
De
c-0
8
Se
p-1
1
Jun
-14
Ma
r-1
7
Bu
dg
et D
eficit a
nd
OB
R f
ore
ca
st
(in
vert
ed
)
UK
T 3
0y
AS
W
30y ASW monthly
UK bud. Deficit (rhs)
OBR Mar Forecast
Source: Credit Suisse Locus Source: Credit Suisse
Gilt swap spread outlook – supported by lower issuance
We see room for Gilt issuance to be revised down by up to £20 billion in 2014-2015, as the
economic recovery feeds through into a more balanced budget, although some of this
windfall may be spent rather than saved ahead of the 2015 elections. A lower deficit and
issuance should support gilts versus swaps, as the relationship in Exhibit 175 indicates.
Our macro model for spreads also suggests that swap spreads are too cheap (see
LDI Focus: 11 November for more details).
Exhibit 173: Current OIS market expectations are for first hike in 1Q 2015
0%
2%
4%
6%
8%
10%
12%
14%
No
v-1
3
May
-14
No
v-1
4
May
-15
No
v-1
5
May
-16
No
v-1
6
May
-17
No
v-1
7
May
-18
No
v-1
8
May
-19
No
v-1
9
First hike distribution over quarterly periods
Short-sterling
Sonia
Source: Credit Suisse
We suggest using
the rally to reset
shorts in GBP
2s5s10s
We recommend
buying 30-year gilts
versus swaps
19 November 2013
2014 Global Outlook 129
UK Inflation outlook – data to stay robust
Our economists anticipate that UK inflation will have troughed in October and that RPI
growth returns to around 3.6%-4.0% for most of 2014, which would support breakevens.
The long (and super-long) linker sector, in particular, is likely to stay well supported by the
consistent demand from LDI investors whenever they break too far into positive real yields,
suggesting that linkers should lag the nominal sell-off.
It is worth noting that the BoE’s reaction function will become increasingly tied to inflation
as unemployment nears 7%. Consequently, longs in front-end breakevens would be a
good hedge for longs in front-end rates – or, alternatively, real yields would be a more
attractive way to express outright longs.
Exhibit 176: UK 2014 yield forecasts
Credit Suisse Forecasts Market forwards
UK - Gilts Current 4Q 2013 1Q 2014 2Q 2014 3Q 2014 4Q 2014 2Q 2014 4Q 2014
Base Rate 0.5 0.5 0.5 0.5 0.5 0.5
2-Yr Yield 0.435 0.5 0.6 0.7 0.8 0.9 0.72 1.05
5-Yr Yield 1.55 1.6 1.7 1.8 2 2.2 1.90 2.20
10-Yr Yield 2.8 2.8 2.9 2.95 3.05 3.15 3.00 3.16
30-Yr Yield 3.62 3.55 3.6 3.7 3.8 3.9 3.72 3.82
Source: Credit Suisse
CHF/SEK rates outlook – themes for 2014
The risk scenario is that 5-year CHF swaps rise to much higher levels than the
current 0.63%. Our FX colleagues in a recent report suggested that EURCHF could be
close to fair value (see G10 FX Forecast Update: 2 October). This suggests that Swiss
inflation could end up a lot closer to European inflation than the historical spread of 1%. Of
course, it remains to be seen whether European inflation moves lower toward Swiss
inflation or the other way round.
One of the most compelling carry trades is still likely to be CHF 5y5y-10y10y forward
steepeners (currently +15 bp, target 30 bp-40 bp area, carry +27bp/annum); see
EST, 29 August 2013. The alternative is to receive 5s10s20s.
We do not expect central bank policies to diverge much. Currently, we see the risk
for a SEK rate cut in December 2013 or February 2014. But, in the longer term, we
expect the Riksbank to hike earlier or at the same time as the ECB and thus expect any
relative dislocations between SEK and EUR to mean revert. SEK-EUR spreads are the
widest around the "greens" area, and we expect that area to tighten relative to the rest
of the curve.
We like long UK
breakevens
19 November 2013
2014 Global Outlook 130
US Rates The Fed’s pivot
2014 Core Views
We expect the Fed to move to taper, but “enhanced guidance” and perhaps even an
IOER cut would help to convince the market of its intention to remain easy for an
extended period.
Treasuries should sell off modestly as the economy improves toward our 3.35% 2014
year-end target on 10s. We expect the 2014 move to be significantly more orderly
than the mid-2013 sell-off.
Bouts of delivered volatility should periodically result from the market challenging the
Fed’s low-rate commitment; we would view significant back-ups in the first few years
of the Eurodollar strip as buying opportunities while fading any outsized 5s10s
flattening.
Implied vols should track a bit higher with rates, but we expect implieds to remain at a
generally low level relative to historical ranges.
2014 Thematic Trade Ideas
We recommend being long greens and blues (e.g., 2y1y, 3y1y).
We expect 10s to underperform on the curve driven primarily by 5s10s steepening.
We also recommend being long 5y5y TIPS breakevens.
We believe that 2014 will be the year of the Fed’s pivot, away from QE and toward even
stronger low rate guidance. This should be effective in anchoring the front end of the
Eurodollar curve, allowing investors to earn roll-down, while cheapening in the QE-
intensive ten-year sector should allow 5s10s to steepen toward record levels near 150
(from 133 currently). 30s should outperform at least initially and only begin to price a
period of above-trend inflation once the developed world begins to sustain higher core
inflation prints. This suggests that 10s30s flattening will start the year with the prospect for
steepening as and when inflation stabilizes. To begin 2014, we prefer 5y5y BEI wideners
as the better pro-reflation trade given entry levels.
Our forecasts for the year ahead are informed by our own expectations as well as the
output from our yield models. Below we show our fair value model, which we have been
using as a guide for some time, and we also show the model for 10s based on the Fed’s
policy rate projections, which we introduced in our 24 October weekly.
Exhibit 177: Our fair value model for 10s is consistent with our forecasts, implying 3.30% at year-end
Exhibit 178: The Fed’s policy rate forecasts imply year-end 2014 fair value of 3.43% on 10s
2.90%3.05%
3.25%
3.35%
1.25%
1.75%
2.25%
2.75%
3.25%
3.75%
Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14
10s (%)
Modeled 10s
CS Forecast
2.99%
3.17%
3.32%3.43%
1.25%
1.75%
2.25%
2.75%
3.25%
3.75%
Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14
Fair
Actual
Quarter-end
Source: Credit Suisse, Federal Reserve, the BLOOMBERG PROFESSIONAL™ service Source: Credit Suisse
Carl Lantz
212 538 5081
Michael Chang
212 325 1962
Ira Jersey
212 325 4674
William Marshall
212 325 5584
Carlos Pro
212 538 1863
The Fed is likely to
move toward even
stronger low-rate
guidance
19 November 2013
2014 Global Outlook 131
Below, we highlight some of the core themes for the year ahead.
QE must be finite
It is rare for a market to be as preoccupied with academic papers, as the rates market was
with English (the Director of the Fed’s Division of Monetary Affairs), Lopez-Salido, and
Tetlow’s “The Federal Reserve’s Framework for Monetary Policy.”
The market has taken the paper as a sign that the Fed may be preparing to enhance its
forward guidance substantially. English’s approach to modeling an “optimal control” path
for rates is reminiscent of Yellen’s November 2012 speech, so it demands careful
attention, in our opinion. The punch line here is that he sees an optimal policy path, with
hikes beginning in 2017, compared to Yellen’s presentation, which suggested an early-
2016 lift-off.
Largely overlooked, however, has been the paper’s discussion of large-scale asset
purchase (LSAPs). This brief section appears toward the end of the paper and does not
attempt to relate purchases back to the appropriate path for rates. Still, their “simple
model” of the costs and benefits as well as the accompanying footnote are worth noting.
Their model for benefits assumes a positive first derivative to purchases and negative
second derivative – i.e., the benefits are increasing at a decreasing rate. This
understanding of QE is consistent with most of the literature and our own analysis, which
has found the marginal impact of asset purchases to be diminished at this point in time.
The costs of QE are often discussed but rarely in a concrete fashion. This paper
asserts that the costs of purchases have a positive first and second derivative –
they are increasing at an increasing rate. It follows, therefore, that there is some
point at which costs become explosive and quickly outweigh the benefits.
What makes this stylized model most interesting, in our view, is the accompanying
footnote that refers to neither a paper nor a speech but rather an acknowledgement of a
helpful suggestion from a notable colleague.
“39
We thank Ben Bernanke for suggesting this approach.”
At what cumulative purchase size
the Fed would encounter such a
scenario is not laid out in the paper,
and it is hard to identify the points on
the cost and benefit curves where
the current volume of purchases
falls. Judging from the Fed’s
statements in the spring, but inaction
in September, it is probably safe to
assume that the Fed believes we are
near the point at which the benefits
of further purchases begin to
outweigh the costs but with great
uncertainty attending these estimates.
In Exhibit 179, we show a stylized
illustration of the trade-offs of the
Fed’s purchases.
At some point, the
costs of QE outweigh
the benefits,
suggesting that QE
must be finite
Exhibit 179: Though it is difficult to pin down where exactly on the cost and benefit curves the current stock of asset purchases falls, the framework presented in the Fed paper suggests that QE must be finite
Asset Purchase Cumulative Size
Benefits
Costs
Source: Credit Suisse, International Monetary Fund
19 November 2013
2014 Global Outlook 132
An IOER cut would help “sugarcoat” tapering and end the Fed subsidy
to banks
The Fed has been paying 25 bp on excess reserves (IOER) and required reserves (a
much smaller quantity) since it cut the target rate for funds to 0-25 bp in December 2008,
which has generally been in excess of the overnight rate available in the GC repo market.
On a cumulative basis, the Fed has paid “excess interest” to the banking system of
$5.1 billion since December 2008.
Exhibit 180: On a cumulative basis, the Fed has paid “excess interest” to the banking system of $5.1 billion since December 2008
Exhibit 181: The IOER rate has tended to run above the O/N repo rate
0
1,000
2,000
3,000
4,000
5,000
6,000
0
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
Dec-08 Mar-10 Jun-11 Sep-12
Reserve Balances with FederalReserve Banks (EOP, Mil.$)
Excess Interest (rhs, Mil. $)
-0.15%
0.00%
0.15%
0.30%
0.45%
0.60%
Nov-09 Feb-11 May-12 Aug-13
GCF Repo Index
IOER
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service, Haver Analytics® Source: Credit Suisse
The spread has not always been this large, and reserve balances have, of course, been
growing over time. Over the past six months, for example, GC has averaged 7 bp, or 18
bp below IOER. Per the latest H4.1 report, there were $2.45 trillion in reserves outstanding
as of 13 November. On an annualized basis, this works out to a $4.4 billion payment
to banks, in excess of what they could earn in overnight repo, assuming this 18 bp spread
and current reserve levels (e.g., on an immediate halt to LSAPs).
In theory, if either rate were to be higher than the other, it should be the repo rate. While
the risk of a loss in a repo transaction, which essentially is a loan securitized by US
Treasuries, is low, it is not zero. The loan (reserve deposit) to the Fed should be as close
to risk-free as it gets because the central bank can create its own currency.
Continued development of the Fed’s fixed-rate full allotment reverse repo facility should
allow the Fed to floor the GC rate. This allows the Fed to set a floor on money market
rates directly, rather than relying on IOER to “pull” other rates up by offering banks an
arbitrage whereby they can borrow money cheaply in the fed funds or repo market to
deposit at the Fed at 25 bp. The spread between the effective rate and IOER exists largely
to compensate banks for the cost of using balance sheets to capture this arbitrage
opportunity.
With the Fed able to floor GC rates directly through the reverse repo facility, and with any
motivation to recapitalize banks via this channel long since passed, we think that the Fed
should normalize the spread between IOER and GC.
The best method of normalization, in our view, would be to cut IOER to, or close to,
zero at the same meeting the Fed chooses to announce a tapering of bond purchases.
This concrete action would underscore an expected strengthening of forward guidance
and work to disentangle actions on interest rates from asset purchases in the collective
market psyche. This could coincide with the Fed taking the GC floor up from 4 bp to
around 5 bp and leaving it there until actual rate hikes come to pass.
We expect the Fed
to disentangle
actions on interest
rates from asset
purchases
19 November 2013
2014 Global Outlook 133
Though alternatives exist, including a smaller cut in IOER and larger increase in repo, we
think that the best and most accommodative move would be to cut IOER to 0%.
Reducing IOER would also correspond with the ECB’s recent refi rate cut and potential
deposit rate cut. It could also open the door to negative deposit (IOER) rates in the US if
more stimulus is desired without the costs of balance sheet expansion. Money funds and
bill auctions could be insulated by a positive floor on GC rates. In this sort of outturn, the
current subsidy to banks holding reserves would become an outright tax.
The optimal blues
The market’s focus on English and company’s work has justifiably focused on the different
ways in which the Fed could strengthen its guidance and the optimal thresholds for any
such approach. The paper keys in on the important notion that “policymakers may have a
strong incentive to renege on their commitments” down the road amid potential
overshooting of inflation and output objectives. The authors draw distinctions between two
options: one whereby policymakers’ decisions are rule-based, à la optimal control, and
one whereby they use a rule-based model but also firmly commit to maintain
accommodation until specified thresholds are reached. They conclude that using
“thresholds, if understood and seen as credible, can significantly improve economic
outcomes.”
Below, we show the paper’s projections, along with the market’s implied path for policy
rates and, for reference, the optimal control path from Yellen’s November 2012 speech.
The employment threshold that English et al settle upon is 5.5%, and it is illustrated in the
Optimal (Commitment) path below. As one might expect, the market, which lines up
reasonably well with the path implied by the Fed’s current projections, would have
substantial room to rally in a shift to any of these policy rates.
A shift to optimal control of any type would argue for being long the blues, and for those
who expect an even more aggressive twist of a lowered threshold, the golds seemingly
offer even more upside.
Exhibit 182: The market is currently priced for a much sooner path of hikes than implied by any optimal control path
Exhibit 183: A shift to an optimal control regime points to substantial upside in the blues and, in a more aggressively dovish approach, the golds
Difference between projected policy rate path and market implied path
0%
1%
2%
3%
4%
5%
2012 2014 2016 2018 2020 2022
Optimal (Commitment) (English, et. al., Oct 18, 2013)Optimal (Discretion) (English, et. al., Oct 18, 2013)Yellen Optimal Control (Nov '12 Speech)Market Pricing
-2.0%
-1.6%
-1.2%
-0.8%
-0.4%
0.0%
Dec-13 Dec-15 Dec-17 Dec-19 Dec-21
Optimal (Commitment) (English, et. al., Oct 18, 2013)Optimal (Discretion) (English, et. al., Oct 18, 2013)Yellen Optimal Control (Nov '12 Speech)
Source: Credit Suisse, Federal Reserve, International Monetary Fund Source: Credit Suisse, Federal Reserve, International Monetary Fund
A shift to optimal
control of any type
would argue for
being long the blues
19 November 2013
2014 Global Outlook 134
Modestly higher implied vol on 10-year tenors versus 5-year tenors
We look for implied swaption volatilities to drift modestly higher in 2014 against the
backdrop of moderately higher rates on upcoming Fed tapering. However, the possibility of
strengthened lower-for-longer rate guidance should limit the extent of the rebound in
implied volatilities. Specifically, we expect implied vol on 10-year tenors to outperform on
the vol surface against 5- and 30-year tenors and vol term structures on front-end rates to
remain relatively steep.
In recent years, vol on 5s has rarely outperformed vol on 10s other than on extreme rate
sell-offs, notably on tapering, which forced an overly complacent market to rehedge for
higher rates. The sell-off in mortgages further exacerbated the repricing of vol on 5s earlier
this year. However, with mortgage investors now better hedged and markets constantly
readjusting pricing for tapering, we believe that it is now more difficult for rates to
unexpectedly gap higher. As shown in Exhibit 184, relatively range-bound rates and a
reduced rate gap risks suggest underperformance in vol on 5s relative to 10s going
forward.
Exhibit 184: Relatively range-bound rates and reduced rate gap risks suggest underperformance in vol on 5s relative to 10s going forward
31-Dec-11 30-Jun-12 30-Dec-12 30-Jun-13
-20
-10
0
0.75
1.00
1.25
1.50
1.75
1y5y
Bp
Vol
- 1
y10y
Bp
Vol
Cur
rent
5s
/ 1yr
Rol
ling
Avg
1y5y Bp Vol - 1y10y Bp Vol Ratio of Current 5yr Rate to 1yr Rolling Avg of 5yr Rate (rhs) Source: Credit Suisse Locus
Consistent with recent directionality, we expect short-dated payer skews on 5-year tenors
to increase modestly as rates drift higher from here. However, long-dated payer skews
across all tenors tend to trade inversely to rates and should continue to gradually decline
as longer-dated forward rates rise.
TIPS: Long forward breakevens
Our preferred trade in TIPS remains being long 5y5y breakevens to position for a rebound
in forward inflation expectations under a highly accommodative Yellen Fed in 2014.
As we noted in our market insight, “Inflation: Near-term softness means upside risk to
forwards,” an extension of the near-term soft patch for inflation (on the back of weak core
goods prices) could disappoint the Fed’s expected steady path of return to 2% and prompt
a more forceful policy reaction from the committee in the months to come.
As discussed above, potential Fed responses include the introduction of a lower-bound
threshold for inflation to constrain hikes until forward inflation attains a certain level or a
reduction in the current 6.5% unemployment guidepost.
Our PCA and macro-fundamental models for TIPS breakevens support further our
constructive view on forward BEI heading into 2014. Both frameworks suggest that the
belly and long end of the TIPS breakevens curve trade cheap.
Implied vols should
track a bit higher,
but we expect
implieds to remain
at a generally low
level versus
historical ranges
We suggest
positioning for a
rebound in forward
inflation expectations
via long 5y5y TIPS
19 November 2013
2014 Global Outlook 135
On a PCA basis, the constant-maturity 5y5y breakevens measure monitored by the
Federal Reserve trades nearly 12 bp cheap to the level implied by its medium-term
relationship with other global asset classes (equities, currencies, and commodities).
Exhibit 185 presents the cheapness that we find in the 5y5y point on the PCA framework.
Exhibit 185: 5y5y TIPS breakevens appear cheap to the level implied by their medium-term relationship with equities, currencies, and commodities
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service, Federal Reserve
For the on-the-runs, the fair-value estimates presented in Exhibit 186 show 5y5y BEI
trading 7 bp-13 bp cheap to our models, depending on the framework used. It is worth
noting that despite the “model” cheapness of spot 5-year BEI, we do not favor longs as a
“structural” macro trade into 2014, as short-term fluctuations in energy markets can have a
substantial impact on spot BEIs. Instead, we continue to recommend trading the front end
tactically.
Exhibit 186: Fair value estimates for TIPS breakevens based on our PCA and macro models
Actual PCA model PCA-based Cheapness Macro model Macro-based Cheapness
5-year 1.85 2.08 23 bp 2.00 15 bp
10-year 2.20 2.35 15 bp 2.34 14 bp
30-year 2.34 2.40 6 bp 2.39 5 bp
5y5y implied 2.55 2.62 7 bp 2.68 13 bp
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service
19 November 2013
2014 Global Outlook 136
Japan Rates JGB yields have been held low by the BoJ's QQE
2014 Core Views
We expect supply-demand for the on-the-run 10-year JGB to continue trending
toward tightness in 2014.
The BoJ's inflation target of 2% is not reflected in the BEI on CPI linkers.
2014 Thematic Trade Ideas
We recommend replacing JGB with JHF MBS, seeking higher yields.
The BoJ introduced its quantitative and qualitative easing (QQE) policy on 4 April,
targeting 2% inflation in about two years and buying the equivalent of about 70% of newly
issued JGBs in the secondary market. Exhibit 187 (as of end-December 2013) and
Exhibit 188 (as of end-December 2014) show the expected amount of BoJ holdings and
amount outstanding in the market for each maturity sector of JGBs. The end-December
2014 numbers assume that JGB issuance and BoJ purchases continue at the same pace
in FY2014 as in FY2013. The BoJ owns a rising share of JGBs in the 5-year to 10-year
zone, and supply-demand for the on-the-run 10-year JGB is still trending toward tightness.
JGB yields should remain low and stable, under pressure from the BoJ's bond buying.
With JGB yields being held at low levels, we recommend raising portfolio yields by
replacing 10-year JGBs with JHF MBS. The risk with this trade is a widening of JHF MBS
spreads.
Exhibit 187: JGBs outstanding by years of residual maturity (forecast)
Exhibit 188: JGBs outstanding by years of residual maturity (forecast)
As of end-December 2013 As of end-December 2014
58
208
133
171
25
58
3416
0%
5%
10%
15%
20%
25%
30%
35%
40%
0
50
100
150
200
250
300
Up to 1yr over 1yr to 5yr over 5yr to 10yr over 10yr
Trilli
on y
en
BoJ's JGB holdings (B)Amount of JGBs outstanding in the market (A)BoJ's share (B/(A+B), RHS)
69
191
112 18022
81
63
26
0%
5%
10%
15%
20%
25%
30%
35%
40%
0
50
100
150
200
250
300
Up to 1yr over 1yr to 5yr over 5yr to 10yr over 10yr
Trilli
on y
en
BoJ's JGB holdings (B)Amount of JGBs outstanding in the market (A)BoJ's share (B/(A+B), RHS)
Source: BoJ, Credit Suisse Source: BoJ, Credit Suisse
CPI linkers have not priced in the BoJ's target of roughly 2% inflation
within about two years
Exhibit 189 shows the year-on-year change in the core CPI implied by the BEI using a pair
of CPI linkers with maturity dates exactly one year apart,15
together with our Economics
Research team's forecasts.16
The decision has already been made to raise the
consumption tax rate by 3pp, from 5% to 8%, in April 2014. Another 2pp increase in the
consumption tax rate is scheduled for October 2015, and the final decision on whether to
15 For detailed calculations, see page 5 of our Japan Economic and Bond Weekly dated 24 October 2013.
16 See the forecasts of the year-on-year change in the core CPI shown in Exhibit 22 on page 12 of our Japan Economic Adviser dated 17 October 2013.
Tomohiro Miyasaka
+81 3 4550 7171
Replace JGB with
JHF MBS
19 November 2013
2014 Global Outlook 137
proceed with that second rate hike will be made in December 2014. As shown in
Exhibit 189, inflation implied by the BEI reflects an increase in the year-on-year change in
the core CPI as a result of the first consumption tax rate hike, followed by a sudden drop in
the core CPI one year after that impact disappears and then another rise in the core CPI
(year on year) caused by the second consumption tax rate hike. It then reflects a drop in
inflation below 1% after the impact from that second tax hike disappears (the portion
marked by an arrow in Exhibit 189). The BoJ has announced a price stability target of 2%
in about two years. Judging by Exhibit 189, we note that although the BEI is pricing in the
impact from the consumption tax rate hike, it does not appear to be pricing in any impact
from BoJ policy.
Exhibit 189: Year-on-year change in core CPI implied by the BEI on CPI linkers
12 November 2013 market close
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Dec-13 Dec-14 Dec-15 Dec-16 Dec-17
Yo
Y c
ha
ng
e in
co
re C
PI
(%)
YoY change in core CPI implied by BEI
Our economic team's forecast
Source: Credit Suisse
BoJ's inflation
target of 2% not
reflected in the BEI
on CPI linkers
19 November 2013
2014 Global Outlook 138
19 November 2013
2014 Global Outlook 139
Securitized Products A transition year as rates head higher
2014 Core Views
Higher rates, Fed tapering, and regulatory changes are important common themes
across the various securitized products sectors.
While the initial taper move may cause increased spread volatility and widening, we
believe that it will eventually present a buying opportunity, as we expect post-taper
spreads across products to narrow.
The rebound in housing should continue, albeit at a more moderate pace; we project
gains of roughly 5% in 2014.
2014 Thematic Trade Ideas
We recommend underweighting Agency MBS initially as the market transitions away
from Fed demand. Post-taper, we expect an overweight opportunity to arise
eventually on longer-duration bonds as a result of higher turnover than market
expectations.
In non-Agency, we suggest rotating into short-duration bonds as taper expectations
firm and then rotating into more levered cash flows, which are likely to become
attractive after the announcement.
In CMBS, our bias is for higher-quality assets, with legacy AMs our favored trade. We
believe that greater differentiation will be made on the recently issued deals, which
will benefit seasoned bonds slightly.
Unsurprisingly, the impact of higher rates and the timing of the Fed’s decision to taper are
common themes affecting our outlook for securitized products in the coming year. In
addition, regulatory concerns, economic growth, and supply/demand fundamentals will
also play critical roles, as will the ongoing legal settlements in non-Agency MBS.
Tapering should have a more dramatic impact in the Agency sector than in the other
securitized products sectors as the market transitions away from Fed demand. Initially,
spreads could widen 10-15 bp as the taper is first digested, but we expect this to present
an overweight opportunity for the sector, as the market transitions away from Fed reliance.
Similarly, for credit sectors, such as non-Agency and CMBS, the announcement could
bring spread and rate volatility near term. However, over a longer horizon, we believe that
spreads will tighten as fundamentals improve along with a slowly expanding economy.
The move to a higher interest rate regime is one the securitized product markets need to
adjust to in 2014 as well. Higher rates are likely to diminish, but not overwhelm, housing
affordability, in our view. The gradually strengthening economy and expected job growth
should provide an offset to the negative impact of higher rates. We expect home prices to
increase roughly 5% nationally in 2014.
We see a similar theme in CMBS, where the underlying fundamental story continues to
improve, keeping the commercial real estate recovery on track and allowing legacy credit
problems to be resolved. On the residential side, prepayment rates will clearly be affected
by a shift in interest rates, and turnover-related prepayment themes will be a focus of the
coming year.
We would be remiss not to mention the ongoing regulatory and policy changes as well.
These include Basel III capital and liquidity standards, GSE loan limits, as well as the
implementation of QM and risk-retention rules, all of which continue to affect the market
and which we discuss further below.
Roger Lehman
212 325 2123
Tapering will clearly
be felt in the Agency
sector but should
affect the credit
sectors as well
The markets need to
adjust to a higher
interest rate regime
Regulatory and
policy changes
cannot be ignored
19 November 2013
2014 Global Outlook 140
Agency MBS 2014 should be a transition year
2014 Core Views
The MBS market should transition away from a complete reliance on the Fed in 2014.
Increased bank Basel III focus, a decline in GSE loan limits, and higher g-fees are on
tap.
We expect gross issuance of $1 trillion, net issuance of $205 billion, and excess
demand of $80 billion.
2014 Thematic Trade Ideas
We recommend underweighting MBS initially and expect a 10-15 bp wider basis as
the taper is digested.
We recommend overweighting opportunistically post taper, as turnover-driven themes
eventually should offer value.
The key risk is an extensive delay in the taper, which could keep MBS at stretched
valuations.
We expect 2014 to be a transition year on multiple fronts, the key being a shift from
complete reliance on Fed demand to a more normal participation of private investors. In
addition, several important regulatory and policy changes on tap for next year include
banks increasing compliance to Basel III capital and liquidity standards, implementation of
QM rules, a potential reduction in GSE loan limits, continued g-fee increases, and a
possible change of leadership at FHFA and related policy changes. Notably, although the
legislative process on GSE reform should continue to make progress, we do not expect
final legislation until at least 2015.
The net effect of these factors should be a significantly wider (10-15 bp) MBS basis (to 65-
70bp from 55bp currently), lower gross issuance ($1.0 trillion compared to $1.65 trillion
projected for this year) as a result of a decline in refis, and higher net issuance ($205
billion compared to $185 billion projected this year) as a result of increased purchase
activity (on an annual basis).
We project roughly $80 billion in excess net demand in 2014 compared to $30 billion in
estimated excess demand in 2013 (Exhibit 190). In contrast to a solely Fed-dominated
demand profile in 2013, a number of private investors should turn buyers in 2014.
However, this demand is likely to be realized at wider spreads and only after the market
has fully digested the Fed’s taper.
Exhibit 190: MBS supply/demand outlook – 2014 should be a transition year
$B, negative numbers reflect supply
Jan Taper (Base case) Mar Taper No Taper
Fed 500 164 229 499
Organic Supply -185 -205 -205 -138
GSEs -65 -40 -40 -40
Money Managers -120 75 75 25
Banks -25 60 60 0
REITs -40 0 0 20
Foreign Investors -35 25 25 -25
Excess Demand 30 79 144 341
2014 Projections2013 Est
Source: Credit Suisse
Mahesh Swaminathan
212 325 8789
Qumber Hassan
212 538 4988
Vikram Rao
212 325 0709
2014 should be a
transition year for
the MBS market
Supply/demand –
We expect a
transition away from
the Fed
19 November 2013
2014 Global Outlook 141
Our base-case expectation of a January start to the Fed taper bakes in continued Fed net
purchases through the first half of the year, with reinvestments of paydowns continuing at
least through year-end. FOMC chair-nominee Janet Yellen’s written testimony to the
Senate Banking Committee, released on 13 November, raises the risk of a delay in the
start of taper. Any delays in starting the taper would only extend the mortgage market’s
Fed-centric condition, which would temporarily keep spreads at historically low levels and
increase the risk of a sharp widening down the line, in our view. Furthermore, delays in
tapering could negatively impact liquidity based on Fed purchases, which already
constitute an elevated share of non-specified pool gross issuance (Exhibit 191).
Exhibit 191: Fed purchases now constitute an elevated share of non-specified pool gross issuance
$B, negative numbers reflect supply
40%
60%
80%
100%
120%
140%
Fe
d's
ta
ke
ou
t FN 30
Total MBS
Actual Projection
Source: Credit Suisse
A confluence of regulatory changes continue to dampen bank demand for MBS. We
expect banks to eventually buy MBS given attractive returns and liquidity advantages but
only after the market digests the Fed’s next steps. Banks currently remain reluctant to buy
MBS because of concerns about injecting volatility into capital ratios through unrealized
P/L on available-for-sale (AFS) holdings under Basel III. To avoid this mark-to-market
volatility, some banks have increased the share of MBS in held-to-maturity (HTM)
accounts at the expense of traditional AFS accounts (Exhibit 192). Some others have
favored mortgage loans over MBS due to the former’s held-for-investment (HFI) treatment.
Increased leverage ratio requirements for global systemically important banks (G-SIBs)
may lead them to favor mortgage loans over MBS given the former’s higher yield on an
equal notional basis. Although Agency MBS holdings offer higher return on a risk-weighted
basis, leverage ratio limits may tilt the decision in favor of loans.
Exhibit 192: Bank portfolios' share of securities in held-to-maturity (HTM) has increased sharply in response to Basel III treatment of unrealized AFS P/L
8%
9%
10%
11%
12%
13%
Jun-13Jun-12Jun-11Jun-10Jun-09Jun-08Jun-07Jun-06
HT
M s
ha
re o
f se
cu
ritie
s
Source: Credit Suisse, Federal Reserve
Fed outlook – We
expect a January taper,
but Yellen introduces
the risk of delay
Banks – Navigating
shifting regulatory
sands is key
19 November 2013
2014 Global Outlook 142
We expect modest further increases in g-fees next year, of roughly 10-15 bp from the 50
bp average in 2013. This implies a corresponding increase in mortgage rates, all else
equal.
Based on FHFA’s statements, we expect an announcement of a loan limit reduction over
the next month, with an effective date of May or June 2014. The national limit for GSEs
may be reduced to $400k from $417k and $600k from $625k in high-cost areas. This
should result in roughly $20 billion of currently GSE-eligible mortgages to fall out next year.
GSE reform bills should continue to make progress in both chambers of Congress next
year, but we do not expect final legislation until at least 2015 based on multiple bills with
significant differences that may need to be reconciled. We expect a bill from the Senate
Banking Committee leadership sometime next year, containing many elements of the
Corker/Warner bill. The House Financial Services Committee has released the PATH Act
incorporating Chairman Hensarling’s vision of housing finance reform, and Representative
Maxine Waters is expected to release a separate proposal.
Turnover related prepayment themes should gain focus in 2014 based on our bearish rate
outlook. Corresponding to our projected range of a 4.70%-4.90% 30-year mortgage rate,
only 20%-25% Agency-backed mortgages remain refinanceable (at least 50 bp incentive).
This compares to a more than 60% refinanceable Agency MBS universe on average
during 1H 2013 and roughly 40% more recently.
Under our projected mortgage rate outlook, only 5% and higher coupons are refinanceable
in the 30-year sector. Roughly 70% of this population is currently HARP (or MIP
grandfathering) eligible. The remaining 30% is leveraged to both HPA as well as policy risk.
Our analysis of recent prepayment data suggests a fully seasoned turnover speed of
roughly 5-6 CPR on 30-year conventional loans and marginally lower in the GNMA sector
(with delinquent loan buyouts resulting in an increase in overall Ginnie discount speeds to
6-7 CPR) .
Prepay speeds on the currently HARP-eligible population declined sharply in
September/October, potentially as a result of an adverse rate shock effect. These speeds
could rebound in a re-rally if borrowers recover from the shock and realize that they still
have a significant incentive to refinance. A modest pick-up in speeds may occur even if
rates remain unchanged or modestly sell off. However, HARP cohorts are unlikely to
retrace historical speed levels in a rally, barring a new low in rates.
Corresponding to our rate outlook, the post-HARP refinanceable universe mainly
comprises 5s. This is split in a 60/40 ratio between conventional and GNMA MBS,
respectively. All else being equal, prepay speeds on this population should increase
gradually with HPA, credit curing, and further opening up of underwriting standards.
However, the dampening effect of higher rates should offset this trend.
Furthermore, prepay speeds on roughly three quarters of the post-HARP population are
also exposed to policy risk. Roughly 70% of this population becomes eligible for
HARP/MIP grandfathering if the eligibility cut-off dates for these programs are extended by
one year. This increases to 85% in the case of extension through December 2010. Such
an outcome hinges on Mel Watt or someone with similar views being confirmed as FHFA
director. This issue is on the back burner for now but will regain focus early next year, in
our view.
GSEs – G-fee
increases, loan limit
decline, and reform
still to come
Prepayment outlook
– Turnover and
policy remain key
themes
We expect turnover
speed of 5-6 CPR
HARP-eligible
universe – We expect
it to be flat to
modestly higher near
term and expect lower
highs in a rally
Post-HARP universe –
Some speed-up from
HPA is likely, but a
cut-off date extension
is needed to run
19 November 2013
2014 Global Outlook 143
Non-Agency MBS Building on a sustainable recovery
2014 Core Views
Looking ahead to 2014, we remain constructive on non-Agency RMBS based on
steadily improving fundamentals and favorable supply-demand technicals. We expect
home prices to increase by roughly 5% nationally in 2014.
The biggest near-term risk, in our view, is how expected tapering unfolds and the
spread volatility we believe it will bring. We think that the announcement will drive
spreads on longer locked-out cash flows wider but that spreads will grind tighter
thereafter on the back of an improving economy.
2014 Trade Ideas
We favor rotating into shorter-duration bonds as taper expectations firm up. We
prefer longer-reset clean hybrids and Alt-A Fixed bonds in the lower-beta, shorter-
duration sectors.
After the announcement, we believe that longer, more levered cash flows will become
more attractive. In the higher-beta sectors, we prefer seasoned subprime mezzanine
tranches and POA Dupers.
Housing outlook
The turnaround in housing during early 2012 accelerated in 2013, backed by record-high
affordability, higher demand, and a shortage of supply. Higher rates pose a challenge, but
not an insurmountable hurdle, in our view.
The rebound in housing should continue, albeit at a more moderate pace; we project gains
of roughly 5% in 2014. We expect most of the major drivers behind the recent recovery in
home prices to continue in 2014. We believe that the slowdown in momentum is largely
driven by two factors: a decline in affordability and a decline in distressed supply.
We believe that higher rates will only diminish, not overwhelm, housing affordability. Even
at a 5% mortgage rate, the affordability index would decline to 146, still higher than the
historical average of 127 during the 1990s. Moreover, the favorable economics of owning
versus renting continues at the national level, though we believe that rising rates and HPA
may bring this to neutral in late 2014. However, if a gradually strengthening US economy
and robust job growth accompany the rate increase, this may not pose as big a challenge
to a continued recovery in housing as generally perceived.
Further supporting home price gains is the post-crisis low of distressed supply, which had
a disproportionately high impact on home price appreciation. The impact of the National
Mortgage settlement continues to reverberate across the housing market. The servicing
guidelines make foreclosure a much more onerous process; in turn, foreclosure starts
have been cut in half since the start of 2012. The CFPB’s new servicing guidelines, which
are expected to take effect in January 2014, will bring all servicers under its purview and
will likely contribute to a further slowdown in liquidation rates and distressed supply into
the market. Additional modification activity from high-touch servicers should gradually
bring down the distressed supply as well.
We expect housing demand to remain stable over the course of 2014. In addition, we
expect a moderate easing of credit standards in 2014. Subdued demand for refinancing
and a stable home price growth environment will induce lenders to gradually relax their
underwriting standards. We expect any such easing to start at the top end of the housing
market – where most loans generally stay on bank portfolios. Such easing would also be
supported by a generally softer approach taken by regulators in defining Qualified
Mortgage (QM) and Risk Retention (QRM) standards for residential mortgages.
Marc Firestein
+1 212 325 4379
Mahesh Swaminathan
+1 212 325 8789
The housing
rebound should
continue, albeit at a
more moderate
pace; we expect
home prices to
increase roughly 5%
in 2014
19 November 2013
2014 Global Outlook 144
Jumbo 2.0 outlook
New issuance of private-label prime jumbo is about $12.6 billion and on pace to finish
between $13 billion and $13.5 billion for the year. Next year’s issuance will depend in large
part on the policy stance taken by the FHFA. In addition, banks will continue to find jumbo
loans attractive, particularly in a bear steepener. With no drop in loan limits, we project
about $10 billion in new issuance. Given the six-month lag in loan limit reductions, we
believe that an immediate announcement of reductions to $400K and $550K for
conforming and high cost limits, respectively, would lead to roughly $15 billion.
We believe that jumbo 2.0 AAAs provide attractive relative value versus Agency MBS at
current valuations (3.5 coupon 3-16 back of FN 3.5s). In our view, jumbo 2.0 AAAs are
likely to tighten against MBS after the market fully digests a Fed taper and the MBS
market finds stable footing. However, in the immediate aftermath of the announcement,
jumbo 2.0 AAAs could widen based on liquidity concerns; we would view any such
widening as a buying opportunity.
Legacy RMBS continues to offer value
Legacy RMBS in 2013 was characterized by a gradual improvement in credit performance,
high prepayment rates, slowing liquidation rates, and only a marginal improvement in
severities. In 2014, we expect most of these drivers to remain in place. Tactically, we favor
rotating into shorter-duration bonds ‒ in particular, longer-reset hybrids ‒ as taper
expectations firm up,. After the announcement, we believe that longer, more levered cash
flows will become more attractive.
Despite the mid-year swoon in risky asset prices, private-label RMBS sectors registered
healthy year-to-date returns in 2013, ranging from 4.5% for the better-credit prime sector
to 25% for the more levered subprime LCFs. Alt-As, option ARMs, and more levered prime
re-REMIC mezzanine bonds returned anywhere from mid-teens to high teens. We believe
that the total-return profile of legacy assets has the potential to remain strong, particularly
in higher-carry bonds, such as Alt-A ARMs and POA Dupers.
We expect CDRs to remain at low levels and potentially decline modestly, especially in
non-judicial states, as servicers adapt to the CFPB’s new servicing rules in 2014. In
addition, the rising share of judicial loans in the delinquency pipeline, particularly in
subprime, should also keep CDRs range-bound. This should support valuations on option
ARM and subprime mezzanine bonds as well as currently sequential subprime front pays,
in our view.
During 2013, despite significant gains in home prices, we have seen loss severities post
only limited gains. We think that the current servicing regulatory framework is significantly
adding to the cost of servicing loans, most notably in judicial states, and these have
increased significantly since 2011. We think that these cost increases will act as a
headwind and will diminish some of the gains we may see from improving LTVs going
forward.
Modification activity continues to grow, especially in non-subprime sectors. More than half
of the outstanding subprime universe and over a quarter of the Option ARM loans have
already received a modification. In addition, re-modification of previously defaulted
modifications continues to grow apace along with principal modifications. With a large
swath of the legacy RMBS now serviced by specialty servicers, we think this activity is
unlikely to diminish in 2014.
Prepayments picked up significantly in 2013, with LTV remaining the largest driver. We
expect prepayments to slow, especially for better-credit borrowers with equity. However,
we believe that prime and Alt-A high-coupon, high-LTV speeds will remain elevated as a
result of incremental home price gains and recasting IO loans. Despite increasing rates,
we believe that a large proportion of these will continue to have prepayment incentives.
In the immediate
aftermath of a Fed
taper announcement,
jumbo 2.0 AAAs
could widen on
liquidity concerns,
creating a buying
opportunity
We recommend
tactically rotating
into shorter-
duration bonds;
post taper, longer,
more levered cash
flows should
become more
attractive
19 November 2013
2014 Global Outlook 145
In 2013, we saw a few instances of large forbearance-related losses getting recognized.
While a majority of the trusts with forborne principal have already recognized these losses,
investors should remain cognizant that there is still about $3 billion of forborne balances
within deals that have not yet been recognized as losses.
Legal settlements are likely to remain one of the important themes in 2014. The CW
settlement approval hearing continues to progress, as does the ResCap reorganization. In
addition, the pending settlement with J.P. Morgan have drawn even further attention to
legal activity in the legacy space.
CMBS Continued slow healing keeps us positive on performance
2014 Core Views
The biggest change and perhaps the biggest challenge for the market, in the
upcoming year, is the move to a higher interest rate environment. Nevertheless, we
believe that there are mitigating factors that could counterbalance the potential
negative effects of rising rates. We are, on net, positive on the potential performance
of CMBS in 2014.
Increased availability of financing and leverage is a positive for the sector. We
forecast that private-label CMBS issuance could reach $110 billion to $115 billion in
2014, with another $60 billion to $65 billion in Agency CMBS issuance.
We see continued improvement in the legacy delinquency rate, as the pace of new
credit problems slow and the resolution rate (liquidations, modifications, and cures)
stays relatively robust.
The trend in new-issue credit may paint the opposite picture in 2014. We have seen a
deterioration in many of the credit metrics we follow on new deals.
2014 Thematic Trade Ideas
CMBS appears relatively cheap, as it has underperformed corporates and equities.
We believe that this bodes well for spreads toward the end of this year and into the
start of 2014.
We maintain a general bias for staying in the higher-quality assets, and our favored
trade remains the legacy AM sector, especially the wider names.
We believe that greater differentiation should be made on recently issued deals, with
the slightly seasoned cohort benefitting over more recently issued transactions. The
need for this differentiation may be highlighted by the introduction of CMBX Series 7.
The CMBS and commercial real estate markets have gone through a very slow, but
consistent, healing process over the past several years, and we expect that this recovery
to remain on course in 2014. As a result, many of the major themes affecting the market in
the recent past are likely to remain relevant in 2014 as well.
The biggest change, and perhaps the biggest challenge for the market, in the upcoming
year is the move to a higher interest rate environment. Higher rates may not only affect
commercial real estate price performance (through higher cap rates and borrowing costs)
but also could impact the supply, demand, and credit performance of CMBS. The mid-year
interest rate rise helped reverse the CMBS spread tightening that occurred in the first half
of 2013.
Nevertheless, we believe that there are mitigating factors that counterbalance the
potential negative effects of rising interest rates, which, on net, leave us positive on the
performance of CMBS in 2014. However, with spreads similarly positioned to where they
were a year ago (give or take), we reiterate our call that carry will be an important
component of return. In addition, we believe that investors will gravitate toward
Roger Lehman
212 325 2123
Sylvain Jousseaume
212 325 1356
Serif Ustun
212 538 4582
We expect the
recovery of CMBS
and CRE to remain
on course in 2014
Mitigating factors can
counterbalance the
negative effect of
rising rates
19 November 2013
2014 Global Outlook 146
marginally increasing leverage (either through structure or financing), which is also
supportive of tighter spreads. This generally leaves us constructive on the higher-quality
assets as well as on structurally sound legacy securities, which should benefit from
continued credit improvement.
Our base-case scenario, as laid out by our economics team above, is for continued, albeit
moderate, economic growth in the US. We believe that this forecast is supportive of further
improvements in real estate fundamentals (such as occupancy and rents) in the coming
year. While cap rates may rise some, along with the forecast for interest rates to move
higher, the negative impact from that should be partially offset by higher cash flows from
improving property-level performance. In addition, our view is that any rise in cap rates will
not be on a one-for-one basis with Treasury rates.
We also believe that increased availability of financing and leverage is a positive for real
estate prices. The private-label CMBS market continues to expand, and we believe that it
could reach $110 billion to $115 billion in new issuance next year (up from an estimated
$83 billion tally this year). In addition, Agency CMBS could total $60 billion to $65 billion
(down about 15% versus this year). The improvement in financing is not just in CMBS, and
we see many other lending platforms, most notably banks, also providing more financing
for commercial real estate.
Greater financing availability, higher real estate prices, and improving fundamentals are all
positives for legacy CMBS credit, in our opinion. As a result, we should see further
declines in the overall legacy conduit delinquency rate in 2014. The pace of new credit
problems rolling into the delinquency bucket should fall, compared to the past several
years, with any additions more than offset by the progress made on the resolution of
distressed loans in the pipeline (through cures, liquidations, and modifications).
We expect the pace of liquidations to remain high. While significant progress has been made
on the credit-impaired loan bucket, there is still a large pipeline of severely delinquent and
REO loans left to resolve. We expect additional large-scale portfolio sales in 2014 (such as
CWCapital’s planned auction), and this could make the pace of liquidations uneven
throughout the year. While modifications will remain important at the loan and deal level, the
frequency should decline further in the coming year, as the tendency remains to modify large
loans and liquidate smaller ones. However, the trend toward a higher rate of mod-recidivism,
which we previously identified, is likely to stay intact.
We also believe that the coming set of conduit maturities will not pose a significant
problem in 2014. We have a more benign view of refinance rates than the market
consensus on these loans, as well as loans with later maturities (2015 to 2017). Our base
case analysis shows that over 80% of the $36 billion in conduit loans due in 2014 should
successfully pay off. While higher rates may negatively impact the refinance success rate
to some degree, we are not overly concerned at this juncture. We have also seen an
increasing trend toward defeasance, another credit positive, for the legacy sector.
The trend in new issue credit may paint the opposite picture in 2014. We have seen a
continued deterioration in many of the credit metrics we follow on newly issued deals.
Given our view that lending volumes will continue to pick up, we see the potential for
further deterioration in underwriting quality in CMBS, and especially in conduit deals. We
believe that investors should be especially cognizant of the growing amount of leverage,
especially for conduit loans that start as interest only and then begin to amortize.
We also expect more pari passu loans in conduit deals, where the loan is split into
components and placed in multiple transactions. We don’t believe that such loans
necessarily have higher credit risk, but the use does limit an investor’s ability to diversify
exposure across deals.
The private-label CMBS
market could reach $110
billion to $115 billion next
year with another $60
billion in Agency
issuance
Greater financing
availability, higher real
estate prices, and
improving fundamentals
are all positives for
legacy CMBS credit
We expect
continued
deterioration in new-
issue credit metrics
19 November 2013
2014 Global Outlook 147
There are, of course, risks to our forecast, and many of these are similar in nature to
the hazards the market has faced over the previous year: debate over the budget
ceiling, regulatory and capital requirement changes, potential tapering of QE by the
Fed, as well as the potential downside risks to the economy. All of these could affect
the sector’s performance.
However, the biggest concern we have is how the market reacts to a move to a higher
interest rate regime. After moving tighter over the first part of the year, CMBS spreads
widened, as Treasury yields shot up, from May to September. It has been our contention
that while part of the widening was related to the level of interest rates, a surge in rate
volatility was far more damaging. We believe that the forecasted move to higher rates over
the coming year will be less detrimental to CMBS as investors are more prepared and
better positioned with regard to duration.
CMBS appears relatively cheap, as it has underperformed the moves in corporates and
equities. We believe that this bodes well and could lead to tightening toward the end of this
year and into the start of 2014. We maintain a general bias for staying in higher-quality
bonds, and our favored trade remains the legacy AM sector, especially the wider trading
names. Many of these AMs remain nearly 100 bp off the 2013 tights.
Within legacy CMBS, the ongoing process of problem loan resolutions has instilled more
clarity on ultimate deal-level losses. This, in turn, is resulting in greater deal differentiation,
as the winners and the losers can now be more clearly identified. However, this is still
happening at a glacial pace. Realized losses on the 2006 and 2007 vintage are only
around 4%, a fraction of expectations for the ultimate cohort loss severities.
We believe that the AM sector, which is largely well insulated from losses, will continue to
benefit as this process unfolds. At the same time, parts of the legacy sector are likely to
underperform, as losses are realized (2013 brought the first AJ-level loss). While we see
good value in certain legacy AJs and other lower-credit enhanced bonds, these tranches
need to be assessed, case by case and deal by deal, with careful due diligence. A blanket
recommendation cannot be made.
We also find good relative value in certain legacy super-seniors. These short-duration
alternatives should see continued strong demand throughout 2014. However, we echo the
same warning we raised heading into 2013, due to the high premium dollar price and
increased ability to refinance: these bonds also have potential risk from cash flow
variability, and care is needed to assess this. We believe that the multifamily tranche
(A1A) sell program is likely to pick back up in 2014, but there will be demand to meet the
potential supply, in our view.
Longer-duration and declining new origination credit quality make us a little more wary on
the most recent deals. We see the potential for the super-senior bonds to tighten heading
into the new year, as they appear relatively cheap to similar-duration corporate bonds. We
also believe that the increasing leverage that is available to bond buyers may help spreads
tighten on the most well enhanced bonds.
Further down the stack, we recommend more caution. Many buyers that are typically oriented
toward the middle of the new issue stack are longer-term, buy-and hold investors and may be
reluctant to add to their exposure until there is more clarity about the direction of rates.
Given our view on the general decline in credit quality on these new issue deals, we
believe that greater differentiation between deals and between recent cohorts will be made
in 2014. We believe that the credit-quality curve could flatten for the former while it
steepens for the latter. The introduction of CMBX Series 7 in January should help highlight
and focus the difference in quality between 2012 and 2013 originations.
CMBS appears
relatively cheap, as it
has underperformed
the moves in
corporates and
equities
We believe that the
AM sector will
continue to benefit
from the loan
resolution process
On the more recent
deals, we believe
that super-seniors
are cheap
Greater differentiation
between recent
cohorts is needed
down the credit stack
19 November 2013
2014 Global Outlook 148
19 November 2013
2014 Global Outlook 149
Technical Analysis Déjà vu
2014 Core Views
We remain medium-term bullish Japanese equities and medium-term bearish JPY.
We expect 10-year US/Germany to extend its core-widening trend to new highs.
We expect Base Metals to resume their medium-term bear trends.
2014 Thematic Trade Ideas
We are bullish Nikkei, USDJPY, EURJPY, and GBPJPY.
We expect 10-year US/Germany (bond) widening and recommend going long 30-
year US bonds at 4.20%.
We suggest shorting Copper.
We remain bullish Japan
As we have stated on several occasions throughout the year, we have been bulls of Japan
and have viewed the sideways ranging in both the equity market and the JPY from July as
potential bullish continuation patterns. Although September saw an initial attempt to restart
the uptrend, this proved to be a false dawn. The one-year anniversary of Abenomics
though looks to be acting as the trigger for a final confirmed break out of the range, and
we not only look for a fresh bull phase but also a potential repeat of the rally that we saw
at the end of 2012 and the beginning of this year.
Exhibit 193: Nikkei 225 ‒ weekly Exhibit 194: Nikkei 225 ‒ monthly
Source: CQG, Credit Suisse Source: CQG, Credit Suisse
For the Nikkei 225, strength has finally extended above critical resistance at 14760
through 14955 – the highs seen in July, September, and October and their associated
trendline ‒ to mark the completion of a bullish “triangle” pattern. We look for this to provide
the platform for a fresh bull leg back to the 15880/15945 May high/78.6% retracement.
With the top of the multi-year downtrend from 1996 just above here at 16155, the market
will then face a critical test.
David Sneddon
+44 20 7888 7173
Christopher Hine
212 538 5727
The Nikkei and
USDJPY are
breaking higher
from their ranges
We expect the
Nikkei to retest
15880/945
19 November 2013
2014 Global Outlook 150
As impressive as the strength earlier in 2013 was, the Nikkei remains in its multi-
year downtrend from 1996, and only above 16155 above would suggest that a
secular change of trend has taken place.
Our bias though is that 16155 will be cleared in 2014, and if this target can be achieved, it
should open up a challenge on the 18300 high of 2007 and ideally on to 19115 – the
38.2% retracement of the entire 1989/2008 bear market – 26% higher than current levels.
While we look for 14025 to now ideally hold setbacks, only a break below 13745 would
see the break higher negated for the completion of a top and a fall to 13190/85.
For the broader TOPIX index, above 1222/32 similarly would suggest that a bullish
“triangle” continuation pattern has been completed, and we would look for a move back to
the 1290 high from May. An eventual move above here is expected in due course, for
1392.
USDJPY has not unsurprisingly similarly been contained within a converging “triangular”
range since early July, and an attempt to clear trend and price resistance at 99.76/99 is
under way. A conclusive break above here should add weight to the scenario that the
broader trend is turning bullish again, although we would like to see the market above the
100.62 September high to really mark a more convincing break higher. If achieved, this
should then see a retest of 101.54/61 next – the July high and 78.6% retracement of the
May/June decline. Above here should clear the way for a fresh look at 103.10/74.
Exhibit 195: USDJPY ‒ monthly Exhibit 196: EURJPY ‒ weekly
Source: CQG, Credit Suisse Source: CQG, Credit Suisse
Long term, the 103.10/74 barrier remains critical, as not only is this the high so far
for 2013 from May but is also the 38.2% Fibonacci retracement of the entire
1998/2011 bear market. In a similar manner to the multi-year downtrend for the
Nikkei, a clear foothold above 103.10 is needed to confirm that a more significant
bull trend is under way for 105.60 initially, then back to 110.60/111.60. This remains
our “ideal” roadmap.
Support from the rising 200-day average and a recent low at 97.890/62 ideally is holding to
keep the immediate risk higher in the range.
The secular
downtrend from
1996 remains intact,
though at 16155
USDJPY is expected
to retest 103.10/74
Above 103.74 can
target 110.60/111.60
19 November 2013
2014 Global Outlook 151
Elsewhere, we remain long-term bulls of EURJPY, and we look for a move back to the
135.48 recent high and eventually our 139/141 long-held target – the 2009 highs and
61.8% retracement of the 2008/2012 bear market. Bigger picture, we would not rule out
149.25.
Back to 3% for 10yr US......and beyond ?
The rally in US fixed income from early September has been viewed as a correction within
a broader evolving bear trend, and 10-year US yields have moved back to and held key
resistance at 2.47/2.40% ‒ the 38.2% retracement of the May/September sell-off, the mid-
July yield lows, and the key yield highs of October 2011 and 2012 itself. The subsequent
rejection of this resistance maintains the broader bearish scenario and leaves the market
critically poised.
With the Yellen confirmation now out of the way, the spotlight is on key support at
2.76/2.80% ‒ the October yield high and 61.8% retracement of the September/October
rally. Despite 2.40% holding, above 2.80% is needed to confirm a fresh yield base and a
move back to retest the 3.00/05% September highs/base target. While a fresh recovery off
here should be allowed for, our broader bias would be for an eventual move higher to our
3.22/3.26% long-held objective. An overshoot to 3.36% should be allowed for, but we
would look for this to then hold, and indeed, we suspect that this 3.26/3.36% zone may
present an ideal buying opportunity for the 10-year next year.
Resistance at 2.59% needs to hold to maintain the immediate bearish tone. Below can see
a retest of 2.47/2.40%. It should be noted though that a break below 2.40% would
mark an important change and the completion of a large (bullish) yield top.
Exhibit 197: 10-year US yield ‒ weekly
Source: CQG, Credit Suisse
With the immediate direction for the 10-year US yield still not conclusive, our
favorite trade remains 10-year US/Germany widening ‒ another recommendation
that we had in our 2013 outlook.
We remain bullish
EURJPY for 139/141
10-year US above 2.80%
can target 3.00% and
ideally 3.25%
19 November 2013
2014 Global Outlook 152
Here, a large spread base remains intact, and we have viewed the setback from the July
peak as a correction only. The recent subsequent widening leaves the 102/105 bp
highs/trendline under attack again. We continue to look for a clear break above here to be
seen in due course, for a move to 121.5/123.5 bp – the highs of 2005 and 2006 – and
potentially even 234 bp, the measured target from the base.
30-year US bond yields have been contained in a high-level “triangular” range following
their late-August peak, holding well above resistance at 3.50% ‒ the 38.2% retracement of
the May/August sell-off. The current weakness leaves the market attempting to break
trend support from February at 2011 at 3.86%.
A move through the 3.94% recent high should be sufficient to confirm not only a
conclusive trend break but also the completion of a bullish “triangle” continuation pattern.
We expect this to then clear the way for a fresh sell-off to 4.13%, ahead of critical long-
term support at 4.20/4.30%.
4.20/4.30% is not only the 78.6% retracement of the 2011/2012 rally but the top of the
secular multi-year downtrend channel from 1990 (c.f. Exhibit 198). The market would
then face one of its most important tests of support since 2010/2011.
With US Duration Risk Appetite still deep in “panic” but potentially getting close to
a momentum turn, one final move higher in 30-year US yields, combined with a
confirmed move out of “panic” by Risk Appetite, may well prove an excellent
opportunity to get long the 30-year US bond, ideally at 4.20%.
Resistance is pegged at 3.70% initially, with 3.56/50% then seen as pivotal. Below here
would raise the prospect of a much lengthier sideways-ranging phase for the long end of
the US bond market and a move to 3.36%
Exhibit 198: 30-year US bond yield ‒ monthly
Source: CQG, Credit Suisse
10-year US/Germany
is widening to new
highs
The top of the
secular downtrend
from 1990 for the
30-year is 4.20%
A Duration Risk
Appetite turn at
4.20% should
present a good
buying opportunity
19 November 2013
2014 Global Outlook 153
Base Metals to resume their medium-term bear trends
Exhibit 199: CSCB Industrial Metals Index – weekly Exhibit 200: Copper (LME) – weekly
Source: Updata, the BLOOMBERG PROFESSIONAL™ service, Credit Suisse Source: Credit Suisse, CQG
Base metals have since summer 2013 broadly taken breathers from their medium-term
bear trends, which can be seen from the broad CSCB Industrials metals index (c.f.
Exhibit 199 above). The index though remains capped by “neckline” resistance at 299.29
and, with ongoing downward pressure from the falling 200-day average at 287.40, has
turned lower to again weigh on key support at 268.88 – half the entire 2009/11 rally. We
look for an eventual break beneath here to signal a fresh leg lower to 244.23 next ahead of
the 61.8% retracement level at 223.67. Above 299.29/302.36 is needed for a base.
Copper has also resolved its former range, since June 2013, to the downside, and the
snap below $7025/11 has established a better top. We look for further downside to $6721
next ahead a key support zone at $6602/$6505 – the June 2013 low and half the entire
2009/11 rally. We allow for a fresh hold here but expect an eventual break lower to set a
major top for $6038 initially. Beneath the latter would see a more extended fall to $5810
ahead of the 61.8% retracement level at $5635. Above $7420 is needed for a base and
through $7534 to turn the trend higher again.
Aluminum is currently trading in what appears to a bearish “symmetrical triangle” pattern.
However, prices have again sold off to weigh heavily on the range low at $1788. We look
for an eventual resolution to the downside and through the 2013 low at $1758 to see a
fresh down leg to $1698, then the 78.6% retracement level at $1605 with pattern targets
lower still at $1564/45. Above $1906/11 is needed to set a base.
Nickel is similarly trading sideways in a “triangular” range. However, we also look for an
eventual breakdown below $13524 to test $13205 and through here to confirm the start of
the next bear leg for $12978 initially with pattern targets at $11925/870. Above
$14979/$15001 is needed for a base.
Lead and Zinc remain relatively locked in multi-year converging ranges. However, given
the drag from the broader group, the risks stay to the lower end of these range. Lead’s
key support is $1898/78, which we look to try and hold at first. Beneath here is needed to
aim at $1742. Zinc aims at the converging range lows at $1812/11, and a move through
here is needed for a more bearish turn to $1745, then $1719/$1687. Given the more
resilient outlook for these metals, we continue to favor being long them on a relative basis
versus the broader group.
We remain bearish
Copper for $6038
19 November 2013
2014 Global Outlook 154
19 November 2013
2014 Global Outlook 155
Credit Suisse Forecasts
Interest Rate Strategy forecasts
US - Treasuries 1Q 2014 2Q 2014 3Q 2014 4Q 2014 Japan - JGBs 1Q 2014 2Q 2014 3Q 2014 4Q 2014
Fed Funds Rate 0-0.25 0-0.25 0-0.25 0-0.25 Overnight Call Rate 0.10 0.10 0.10 0.10
2-Yr Yield 0.35 0.40 0.50 0.55 2-Yr Yield 0.11 0.12 0.13 0.14
5-Yr Yield 1.60 1.75 1.90 1.95 5-Yr Yield 0.25 0.30 0.35 0.40
10-Yr Yield 2.90 3.05 3.25 3.35 10-Yr Yield 0.70 0.75 0.80 0.85
30-Yr Yield 3.95 4.10 4.25 4.30 30-Yr Yield 1.70 1.75 1.80 1.85
UK - Gilts 1Q 2014 2Q 2014 3Q 2014 4Q 2014 EU – German Benchmarks 1Q 2014 2Q 2014 3Q 2014 4Q 2014
Base Rate 0.50 0.50 0.50 0.50 ECB Repo 0.25 0.25 0.25 0.25
2-Yr Yield 0.60 0.70 0.80 0.90 2-Yr Yield 0.15 0.20 0.25 0.30
5-Yr Yield 1.70 1.80 2.00 2.20 5-Yr Yield 0.75 0.85 0.95 1.15
10-Yr Yield 2.90 2.95 3.05 3.15 10-Yr Yield 1.75 1.85 1.95 2.10
30-Yr Yield 3.60 3.70 3.80 3.90 30-Yr Yield 2.60 2.70 2.75 2.85
FX Strategy forecasts
Major Currencies
vs. USD EURUSD USDJPY GBPUSD USDCHF USDCAD AUDUSD NZDUSD USDSEK USDNOK
3m 1.300 95.000 1.557 0.946 1.060 0.900 0.811 7.077 6.500
12m 1.280 115.000 1.552 0.953 1.080 0.800 0.741 7.344 6.797
vs. EUR EURJPY EURGBP EURCHF EURCAD EURAUD EURNZD EURSEK EURNOK
3m 123.500 0.835 1.230 1.378 1.444 1.603 9.20 8.45
12m 147.200 0.825 1.220 1.382 1.600 1.727 9.40 8.70
Emerging Currencies
vs. USD USDCNY USDINR USDIDR USDKRW USDMYR USDPHP USDSGD USDTHB
3m 6.11 60.0 11300 1060 3.15 44.3 1.245 31.0
12m 6.07 62.0 11800 1120 3.20 43.0 1.280 30.8
vs. USD USDZAR USDTWD USDTRY USDBRL USDMXN USDRUB EURHUF EURPLN
3m 10.60 29.20 2.17 2.25 13.10 33.50 300.00 4.15
12m 11.00 30.30 2.24 2.40 12.60 34.60 310.00 4.10
Global Commodities forecasts
Commodity 2014 Ann Avg (f) 2015 Ann Avg (f) 2016 Ann Avg (f)
Brent (US$/bbl) 110 100 95
WTI (US$/bbl) 104 92 87
U.S. Natural Gas (US$/MMBtu) 3.90 4.20 4.40
Copper (US$/t) 6625 6750 7250
Aluminium(US$/t) 1863 2000 2100
Iron Ore (US$/t) 104 90 93
Gold (US$/oz) 1180 1200 1250
Silver (US$/oz) 21.30 22.60 23.10
Global Leveraged Finance Strategy forecasts
Total Returns (%) 2014 Projections
Default Rates (%) 2014 Projections
Default Rates (%) 2015 Projections
US High Yield Bonds 5% 2%-3% 1%-2%
US Leveraged Loans 5% 3%-4% 1%-2%
W. European High Yield (Hedged in €) 5.5% 0%-1% 0%-1%
W. European Lev. Loans (Hedged in €) 6% 2%-4% 1%-3%
Source: Credit Suisse
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Exhibit 201: Credit Suisse Global and Developed Economics forecasts
2013 2014E Q4 to Q4 Annual Average
Q1 Q2 Q3E Q4E Q1 Q2 Q3 Q4 12 13E 14E 15E 12 13E 14E 15E
Global Real GDP (q/q ann) 2.3 3.5 3.3 3.8 3.6 3.4 3.8 4.0 2.8 3.2 3.8 … 3.1 2.9 3.7 3.9
IP (q/q ann) 3.7 2.2 4.2 6.4 4.3 3.2 5.7 5.9 2.0 4.1 4.8 … 2.6 2.6 4.6 …
Inflation (y/y) 2.8 2.6 3.0 3.0 3.0 3.3 3.1 3.4 2.9 3.0 3.4 … 3.1 2.8 3.2 3.5
Develop markets Real GDP (q/q ann) 1.0 2.1 2.0 2.0 2.2 1.8 2.6 2.5 0.7 1.8 2.2 … 1.5 1.1 2.1 2.2
Inflation (y/y) 1.5 1.3 1.4 1.1 1.1 1.5 1.6 1.9 1.8 1.1 1.9 … 1.9 1.3 1.5 1.9
US Real GDP (q/q ann) 1.1 2.5 2.8 1.9 2.5 2.7 3.0 3.0 2.0 2.1 2.8 2.9 2.8 1.7 2.6 2.8
IP (q/q ann) 4.1 1.1 2.3 4.8 3.6 3.5 4.1 4.3 2.8 3.0 3.9 4.1 3.6 2.5 3.6 4.1
Inflation (y/y) 1.7 1.4 1.6 1.1 0.9 1.2 1.3 1.9 1.9 1.1 1.9 1.8 2.1 1.4 1.3 2.1
Japan Real GDP (q/q ann) 4.1 3.8 1.2 3.8 3.1 -1.2 3.5 2.3 0.4 3.2 1.9 -0.5 2.0 1.8 2.2 1.2
IP (q/q ann) 2.3 6.2 7.3 11.3 -3.0 2.4 8.0 4.8 -5.9 6.8 3.0 … 0.6 -0.5 4.3 2.0
Inflation ex. fresh food (y/y) -0.3 0.0 0.7 0.7 0.7 2.7 2.7 2.8 -0.1 0.7 2.8 … -0.1 0.3 2.2 1.7
Euro Area Real GDP (q/q ann) -0.9 1.1 0.4 1.3 1.3 1.4 1.8 1.5 -1.0 0.5 1.5 1.8 -0.6 -0.4 1.3 1.7
IP (q/q ann) 1.3 3.9 -0.9 2.1 3.2 3.1 3.0 3.0 -3.1 2.1 3.1 3.3 -2.4 -0.5 2.9 3.3
Inflation (y/y) 1.9 1.4 1.3 0.8 0.9 1.2 1.0 1.5 2.2 0.9 1.5 1.5 2.5 1.4 1.1 1.4
UK Real GDP (q/q ann) 1.1 2.9 3.2 2.3 2.3 3.1 3.1 3.3 0.0 2.4 3.0 2.1 0.2 1.4 2.8 2.5
Inflation (y/y) 2.8 2.7 2.7 2.5 2.7 3.0 3.0 2.7 2.7 2.5 2.7 2.5 2.8 2.7 2.8 2.6
Emerging markets Real GDP (q/q ann) 3.6 4.9 4.9 5.7 5.2 5.2 5.2 5.6 5.0 4.8 5.4 5.8 4.9 4.7 5.3 5.7
Inflation (y/y) 4.3 4.1 4.6 4.9 5.0 5.2 4.9 5.0 4.2 4.9 5.0 5.3 4.3 4.4 4.9 5.1
NJA Real GDP (q/q ann) 5.0 6.1 7.1 7.0 6.3 6.2 6.8 6.7 6.7 6.3 6.6 7.1 6.1 6.2 6.6 7.0
Inflation (y/y) 3.4 2.9 3.6 4.1 4.2 4.4 3.9 4.0 3.4 4.1 4.0 4.4 3.7 3.4 4.1 4.3
China Real GDP (q/q ann) 6.1 7.8 9.1 7.8 7.0 7.4 8.2 7.8 7.9 7.7 7.7 8.3 7.7 7.6 7.7 8.2
IP (q/q ann) 9.4 10.0 10.4 10.5 10.3 10.0 10.0 10.0 10.0 10.1 10.0 10.4 10.1 9.7 10.0 10.3
Inflation (y/y) 2.4 2.4 2.8 3.5 3.9 4.0 3.8 4.0 2.1 3.5 4.0 4.1 2.6 2.7 3.9 4.1
India* Real GDP (q/q ann) 6.5 3.9 6.0 7.2 7.8 6.0 6.2 6.7 4.7 5.9 6.7 6.9 5.0 5.4 6.6 6.9
Inflation (WPI, y/y) 6.7 4.8 6.1 6.6 6.3 6.8 5.2 5.0 7.3 6.6 5.0 6.9 7.4 5.9 5.5 6.2
EMEA Real GDP (q/q ann) 1.1 1.9 1.6 3.2 2.7 2.9 2.5 3.1 1.3 2.0 2.8 3.3 2.8 2.1 2.9 3.4
Inflation (y/y) 5.2 5.0 5.1 4.9 4.4 4.7 4.5 4.9 5.2 4.9 4.9 4.9 4.8 4.9 4.4 4.7
Russia Real GDP (q/q ann) -1.0 -1.1 1.6 4.9 2.8 1.6 0.8 1.6 1.5 1.1 1.7 3.0 3.4 1.3 2.3 2.5
Inflation (y/y) 7.1 7.2 6.4 6.2 5.3 5.1 4.9 5.0 6.5 6.2 5.0 5.1 5.1 6.7 5.1 5.2
Turkey Real GDP (q/q ann) 6.0 8.5 2.8 0.0 4.1 6.1 6.1 6.1 1.5 4.3 5.6 3.2 2.2 4.0 4.2 4.5
Inflation (y/y) 7.2 7.0 8.3 7.9 6.3 6.7 5.7 6.8 6.8 7.9 6.8 7.2 8.9 7.6 6.4 7.7
Lat. America Real GDP (q/q ann) 2.1 4.1 -0.2 3.9 3.9 3.9 2.3 4.0 2.8 2.3 3.5 3.6 2.9 2.5 3.4 3.6
Inflation (y/y) 6.4 7.4 7.8 8.1 8.4 8.4 8.6 8.4 6.1 8.1 8.4 8.5 6.2 7.3 8.4 8.3
Brazil Real GDP (q/q ann) 2.6 6.0 -2.0 2.4 4.4 3.6 1.7 2.7 1.4 2.2 3.0 3.0 0.9 2.4 3.0 3.0
Inflation (y/y) 6.4 6.6 6.1 5.8 5.8 5.9 6.2 6.0 5.6 5.8 6.0 5.6 5.4 6.1 6.0 5.8
Mexico Real GDP (q/q ann) 0.1 -2.9 3.1 4.5 2.7 5.5 4.0 5.6 3.2 1.3 4.4 4.3 3.8 1.0 3.7 4.4
Inflation (y/y) 3.7 4.5 3.4 3.4 3.5 3.2 3.7 3.7 4.1 3.4 3.7 3.5 4.1 3.7 3.6 3.6
Source: Credit Suisse estimates, Thomson Reuters DataStream. Note: IMF PPP weights are used to compute regional and global aggregate figures. *Annual figures for India are on fiscal year basis
GLOBAL FIXED INCOME & ECONOMICS RESEARCH
Eric Miller
Co-Head, Securities Research & Analytics
+1 212 538 6480
PRODUCT RESEARCH
STRATEGY
Ric Deverell
Sean Shepley
+44 20 7883 2523
+44 20 7888 1333
[email protected] [email protected]
SECURITIZED PRODUCTS US MACRO PRODUCT
MARKET STRATEGIES GLOBAL STRATEGY
Roger Lehman Carl Lantz
Sean Shepley James Sweeney
+1 212 325 2123 +1 212 538 5081
+44 20 7888 1333 +1 212 538 4648
[email protected] [email protected]
[email protected] [email protected]
EM CREDIT EMEA MACRO PRODUCT
TECHNICAL ANALYSIS INDEX & ALPHA STRATEGIES
Jamie Nicholson Helen Haworth
David Sneddon Baldwin Smith
+1 212 538 6769 +44 20 7888 0757
+44 20 7888 7173 +1 212 325 5524
[email protected] [email protected]
[email protected] [email protected]
LEVERAGED FINANCE STRATEGY APAC MACRO PRODUCT
Jonathan Blau Ray Farris
+1 212 538 3533 +65 6212 3412
[email protected] [email protected]
GLOBAL ECONOMICS / DEMOGRAPHICS
Neal Soss
+1 212 325 3335 [email protected]
GLOBAL / US ECONOMICS BRAZIL ECONOMICS
EUROPE / UK ECONOMICS CEEMEA ECONOMICS
Neal Soss Nilson Teixeira
Neville Hill Berna Bayazitoglu
+1 212 325 3335 +55 11 3701 6288
+1 212 325 3335 +44 20 7883 3431
[email protected] [email protected] [email protected] [email protected]
LATAM ECONOMICS NJA ECONOMICS
JAPAN ECONOMICS DEMOGRAPHICS
Alonso Cervera Dong Tao
Hiromichi Shirakawa Amlan Roy
+52 55 5283 3845 +852 2101 7469
+81 3 4550 7117 +44 20 7888 1501
Disclosure Appendix
Analyst Certification The analysts identified in this report each certify, with respect to the companies or securities that the individual analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.
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Emerging Markets Bond Recommendation Definitions Buy: Indicates a recommended buy on our expectation that the issue will deliver a return higher than the risk-free rate. Sell: Indicates a recommended sell on our expectation that the issue will deliver a return lower than the risk-free rate.
Corporate Bond Fundamental Recommendation Definitions Buy: Indicates a recommended buy on our expectation that the issue will be a top performer in its sector. Outperform: Indicates an above-average total return performer within its sector. Bonds in this category have stable or improving credit profiles and are undervalued, or they may be weaker credits that, we believe, are cheap relative to the sector and are expected to outperform on a total-return basis. These bonds may possess price risk in a volatile environment. Market Perform: Indicates a bond that is expected to return average performance in its sector. Underperform: Indicates a below-average total-return performer within its sector. Bonds in this category have weak or worsening credit trends, or they may be stable credits that, we believe, are overvalued or rich relative to the sector. Sell: Indicates a recommended sell on the expectation that the issue will be among the poor performers in its sector. Restricted: In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances. Not Rated: Credit Suisse Global Credit Research or Global Leveraged Finance Research covers the issuer but currently does not offer an investment view on the subject issue. Not Covered: Neither Credit Suisse Global Credit Research nor Global Leveraged Finance Research covers the issuer or offers an investment view on the issuer or any securities related to it. Any communication from Research on securities or companies that Credit Suisse does not cover is a reasonable, non-material deduction based on an analysis of publicly available information.
Corporate Bond Risk Category Definitions In addition to the recommendation, each issue may have a risk category indicating that it is an appropriate holding for an "average" high yield investor, designated as Market, or that it has a higher or lower risk profile, designated as Speculative, and Conservative, respectively.
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Credit Suisse’s Distribution of Global Credit Research Recommendations* (and Banking Clients)
Global Recommendation Distribution**
Buy 3% (25% banking clients)
Outperform 28% (67% banking clients)
Market Perform 64% (53% banking clients)
Underperform 5% (13% banking clients)
Sell <1% (<1% banking clients)
*Data are as at the end of the previous calendar quarter. **Percentages do not include securities on the firm’s Restricted List and might not total 100% as a result of rounding.
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