2014 global outlook - credit suisse

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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

[email protected]

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


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

[email protected]

Ric Deverell

+44 20 7883 2523

[email protected]

Sean Shepley

+44 20 7888 1333

[email protected]

Neal Soss

212 325 3335

[email protected]

19 November 2013


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


19 November 2013


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

[email protected]

Henry Mo

+1 212 538 0327

[email protected]

Axel Lang

+44 20 7883 3738

[email protected]

We see a stable

triangle of modest

growth, low

inflation, and

diminishing

potential

19 November 2013


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


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


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


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.


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


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


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


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


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


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


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

[email protected]

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


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


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

https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&document_id=1023963451&source_id=emcsplus&serialid=VrLgFx1FJty10mUPdntwYen%2bA%2bTJAQ4mXPXGrTaJupg%3d

https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&document_id=1023963441&source_id=emcsplus&serialid=hZ1D8Fr44v94BvFzAJN8BJdy%2fPLH8BHmUisKPUclD0A%3d

19 November 2013


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


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


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


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


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


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


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


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


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


19 November 2013


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

[email protected]

Sonali Punhani

+44 20 7883 4297

[email protected]

Angela Hsieh

44 20 7883 9639

[email protected]

19 November 2013


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


*: 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


*: Data is for 2010; **: Data is for 2009; ~: Data is for 1994;~~ : Data is for 1993, ~~~: data is for 2000

19 November 2013


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


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


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

[email protected]

Takashi Shiono

+81 3 4550 7189

[email protected]

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


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

https://plus.credit-suisse.com/r/aQNbd3

19 November 2013


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


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


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


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


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

[email protected]

Berna Bayazitoglu

+44 20 7883 3431

[email protected]

Ric Deverell

+44 20 7883 2523

[email protected]

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

https://doc.research-and-analytics.csfb.com/docView?sourceid=em&document_id=x540730&serialid=fkFJV22BullyCC0qtvfa76N57VloDx0bzQyGJlv3gE0%3d

https://doc.research-and-analytics.csfb.com/docView?sourceid=em&document_id=x540730&serialid=fkFJV22BullyCC0qtvfa76N57VloDx0bzQyGJlv3gE0%3d

19 November 2013


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


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


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


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


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.

https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&document_id=805646060&source_id=emcmt&serialid=P2Rqlu2iTEMQ7Ik%2fxaLNr016IU3yg03qa4y%2bXZnDgug%3d

https://plus.credit-suisse.com/r/HVanhO

19 November 2013


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

http://www.federalreserve.gov/pubs/ifdp/2013/1081/ifdp1081.pdf

19 November 2013


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

[email protected]

The reform agenda

dominates attention

19 November 2013


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


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


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


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

[email protected]

Mark Astley

+44 20 7883 9931

[email protected]

Thushka Maharaj

+44 20 7883 0211

[email protected]

Carlos Pro

212 538 1863

[email protected]

Dana Saporta

212 538 3163

[email protected]

Sean Shepley

+44 20 7888 1333

[email protected]

Hiromichi Shirakawa

+81 3 4550 7117

[email protected]

Neal Soss

212 325 3355

[email protected]

19 November 2013


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


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


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


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


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

http://federalreserve.gov/newsevents/speech/powell20131104a.htm

19 November 2013


Exhibit 59: US monetary policy spillover mechanisms

Monetary policy-related linkages between international economies


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


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

https://plus.credit-suisse.com/r/NUXraI

http://www.imf.org/external/pubs/ft/weo/2013/02/pdf/text.pdf

19 November 2013


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

http://www.stanford.edu/~piazzesi/cp.pdf

http://www.stanford.edu/~piazzesi/cp.pdf

19 November 2013


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

[email protected]

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


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


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

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2232016

19 November 2013


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


19 November 2013


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


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

http://www.imf.org/external/pubs/ft/wp/2011/wp11190.pdf

19 November 2013


Exhibit 67: European private shadow money


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


Public balance sheet

substituted for

collapsing private

shadow money

19 November 2013


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


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


19 November 2013


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

[email protected]

Bill Papadakis

+44 20 7883 4351

[email protected]

Thushka Maharaj

+44 20 7883 0211

[email protected]

The stage is being

set for substantial

macro dislocation

19 November 2013


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


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


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


-9.3%

-9.2%

-9.1%

-9.0%

-8.9%

-8.8%

-8.7%

-8.6%

-8.5%

Russell 1000 Russell 2000



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


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


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


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


19 November 2013


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)


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


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


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


19 November 2013


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


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


https://plus.credit-suisse.com/r/rxvUys

19 November 2013


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.


We suggest some

potential hedges for

periods of liquidity

withdrawal

19 November 2013


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%


Baldwin Smith

212 325 5524

[email protected]

Riad Houry

+44 20 7883 0168

[email protected]

Cheng Ju

212 325 9812

[email protected]

Yongchu Song

212 538 7013

[email protected]

19 November 2013


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


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


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


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


FX Carry G10 FX Carry EM

90

100

110

120

130

140

150

160


FX Value G10 FX Value EM


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


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.


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.


19 November 2013


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

[email protected]

Global Equity Strategy

Mark Richards

44 20 7883 6484

[email protected]

Andrew Garthwaite

+44 20 7883 6477

[email protected]

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

https://doc.research-and-analytics.csfb.com/docView?sourceid=em&document_id=x538026&serialid=GDsSbH4B9vPfAn8ey3BiK2i2Epa%2fN3f1GQ%2fGjxF%2f0jg%3d

19 November 2013


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


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%


19 November 2013


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


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).

http://www.ecb.europa.eu/pub/pdf/other/ecbstaffprojections201309en.pdf

19 November 2013


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


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


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


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


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


19 November 2013


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%


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


Ira Jersey

212 325 4674

[email protected]

Sean Shepley

+44 20 7888 1333

[email protected]

Bill Papadakis

+44 20 7883 4351

[email protected]

Glenn Russo

212 538 6881

[email protected]

Our leitmotif of a year ago

‒that capital would either

be "unavailable or

unremunerative"‒

continues to define

investor behavior

https://plus.credit-suisse.com/r/bhQCu0

19 November 2013


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


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


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


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%


19 November 2013


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.

https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&source_id=csplusresearchcp&document_id=1024463421&serialid=nF2SMjeWruCEBYQ%2f2CNxVE9L%2fhXwH8QLdu5%2boIVRHFw%3d


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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.

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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


19 November 2013


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

[email protected]

Bear markets still

have cycles


https://plus.credit-suisse.com/u/LPFNSz

19 November 2013


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


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


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


19 November 2013


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.


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

[email protected]

The crisis is not

over, just evolving

on the expected

political time frame

19 November 2013


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


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


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]


14 See "European Credit Strategy: supply is no problem. Say's who?," September 2003.

Corporate health

should continue,

keeping technicals

strong

https://plus.csintra.net/researchplus/CSPlusPageAction?pageId=RESEARCH_ARTICLE&rp_ravWindow=true&rp_docId=20088552

19 November 2013


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


19 November 2013


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%.


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%


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

[email protected]

Daniel Sweeney

212 538 8213

[email protected]

James Esposito

212 325-8459

[email protected]

Daniyal Khan

212 325 2873

[email protected]

We expect Treasury

rate moves to be the

dominant factor in

high yield returns in

2014

19 November 2013


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


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

https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&source_id=csplusresearchcp&document_id=1025309591&serialid=N5xfEik5Rq83BpceYdZ3vENdGXhosxawcH0EDFYpa%2b8%3d

19 November 2013


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


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


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


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


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


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


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


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


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


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


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


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.


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.


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

[email protected]

Neal Soss

212 325 3335

[email protected]

Ashish Agrawal

+65 6212 3405

[email protected]

Robert Prior-Wandesforde

+65 6212 3707

[email protected]

Dong Tao

+852 2101 7469

[email protected]

19 November 2013


… 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


"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.


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

[email protected]

Alonso Cervera

+52 55 5283 3845

[email protected]

EM Corporate Credit

Jamie Nicholson

212 538 6769

[email protected]

Celina Apostolo Merrill

212 538 4606

[email protected]

Andrew De Luca

212 325 7443

[email protected]

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


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


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)


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

https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&document_id=1025279451&source_id=emrna&serialid=Lg1ImuJCw6sXMET8MPydKEDaLfmt9ksVAqtjjMNNWhA%3d

19 November 2013


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)


Selectivity is key

Latam corporate

new issuance

should remain

strong

19 November 2013


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.


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

[email protected]

Nimrod Mevorach

+44 20 7888 1257

[email protected]

Berna Bayazitoglu

+44 20 7883 3431

[email protected]

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


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


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


EEMEA rates are average swap rates for the Czech Republic, Hungary, Israel, Poland, Russia, South Africa and Turkey


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


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


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.


19 November 2013


19 November 2013


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.


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

[email protected]

Marina Pronina

44 20 7883 6476

[email protected]

Mark Richards

44 20 7883 6484

[email protected]

Sebastian Raedler

44 20 7888 7554

[email protected]

Robert Griffiths

44 20 7883 8885

[email protected]

Nicolas Wylenzek

44 207 883 6480

[email protected]

We remain

constructive on

equities



19 November 2013


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


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


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


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)


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


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


19 November 2013


19 November 2013


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."


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

[email protected]

In our view, market

consensus was too

bullish USD in

2013…

… but became too

bearish USD post

"no taper"

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19 November 2013


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


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


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)


19 November 2013


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.


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

[email protected]

Adam Dent

+44 20 7883 7455

[email protected]

Panos Giannopoulos

+44 20 7883 6947

[email protected]

Thushka Maharaj

+44 20 7883 0211

[email protected]

Marion Pelata

+44 20 7883 1333

[email protected]

Florian Weber

+44 20 7888 3779

[email protected]

Disinflation risks

keep ECB in easing

mode; we expect

US-EUR divergence

Two opposing

forces driving rates

19 November 2013


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


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


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


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

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19 November 2013


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


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

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19 November 2013


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


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


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?

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19 November 2013


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


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


We suggest using

the rally to reset

shorts in GBP

2s5s10s

We recommend

buying 30-year gilts

versus swaps

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19 November 2013


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


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

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19 November 2013


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.


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

[email protected]

Michael Chang

212 325 1962

[email protected]

Ira Jersey

212 325 4674

[email protected]

William Marshall

212 325 5584

[email protected]

Carlos Pro

212 538 1863

[email protected]

The Fed is likely to

move toward even

stronger low-rate

guidance

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19 November 2013


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


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


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


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

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19 November 2013


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


19 November 2013


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.


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

[email protected]

Replace JGB with

JHF MBS

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19 November 2013


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


BoJ's inflation

target of 2% not

reflected in the BEI

on CPI linkers

19 November 2013


19 November 2013


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.


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

[email protected]

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


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.


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


Mahesh Swaminathan

212 325 8789

[email protected]

Qumber Hassan

212 538 4988

[email protected]

Vikram Rao

212 325 0709

[email protected]

2014 should be a

transition year for

the MBS market

Supply/demand –

We expect a

transition away from

the Fed

19 November 2013


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


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


Fed outlook – We

expect a January taper,

but Yellen introduces

the risk of delay

Banks – Navigating

shifting regulatory

sands is key

19 November 2013


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


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

[email protected]

Mahesh Swaminathan

+1 212 325 8789

[email protected]

The housing

rebound should

continue, albeit at a

more moderate

pace; we expect

home prices to

increase roughly 5%

in 2014

19 November 2013


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


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.


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

[email protected]

Sylvain Jousseaume

212 325 1356

[email protected]

Serif Ustun

212 538 4582

[email protected]

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


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


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


19 November 2013


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.


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

[email protected]

Christopher Hine

212 538 5727

[email protected]

The Nikkei and

USDJPY are

breaking higher

from their ranges

We expect the

Nikkei to retest

15880/945

19 November 2013


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


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


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


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


19 November 2013


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%


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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

[email protected]

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



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



LEVERAGED FINANCE STRATEGY APAC MACRO PRODUCT

Jonathan Blau Ray Farris

+1 212 538 3533 +65 6212 3412


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.

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http://www.credit-suisse.com/locus

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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.

Credit Suisse Credit Rating Definitions Credit Suisse may assign rating opinions to investment-grade and crossover issuers. Ratings are based on our assessment of a company's creditworthiness and are not recommendations to buy or sell a security. The ratings scale (AAA, AA, A, BBB, BB, B) is dependent on our assessment of an issuer's ability to meet its financial commitments in a timely manner. Within each category, creditworthiness is further detailed with a scale of High, Mid, or Low − with High being the strongest sub-category rating: High AAA, Mid AAA, Low AAA - obligor's capacity to meet its financial commitments is extremely strong; High AA, Mid AA, Low AA − obligor's capacity to meet its financial commitments is very strong; High A, Mid A, Low A − obligor's capacity to meet its financial commitments is strong; High BBB, Mid BBB, Low BBB − obligor's capacity to meet its financial commitments is adequate, but adverse economic/operating/financial circumstances are more likely to lead to a weakened capacity to meet its obligations; High BB, Mid BB, Low BB − obligations have speculative characteristics and are subject to substantial credit risk; High B, Mid B, Low B − obligor's capacity to meet its financial commitments is very weak and highly vulnerable to adverse economic, operating, and financial circumstances; High CCC, Mid CCC, Low CCC – obligor's capacity to meet its financial commitments is extremely weak and is dependent on favorable economic, operating, and financial circumstances. Credit Suisse's rating opinions do not necessarily correlate with those of the rating agencies.

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.

Structured Securities, Derivatives, and Options Disclaimer Structured securities, derivatives, and options (including OTC derivatives and options) are complex instruments that are not suitable for every investor, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Supporting documentation for any claims, comparisons, recommendations, statistics or other technical data will be supplied upon request. Any trade information is preliminary and not intended as an official transaction confirmation. OTC derivative transactions are not highly liquid investments; before entering into any such transaction you should ensure that you fully understand its potential risks and rewards and independently determine that it is appropriate for you given your objectives, experience, financial and operational resources, and other relevant circumstances. You should consult with such tax, accounting, legal or other advisors as you deem necessary to assist you in making these determinations. In discussions of OTC options and other strategies, the results and risks are based solely on the hypothetical examples cited; actual results and risks will vary depending on specific circumstances. Investors are urged to consider carefully whether OTC options or option-related products, as well as the products or strategies discussed herein, are suitable to their needs. CS does not offer tax or accounting advice or act as a financial advisor or fiduciary (unless it has agreed specifically in writing to do so). Because of the importance of tax considerations to many option transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions. Use the following link to read the Options Clearing Corporation's disclosure document: http://www.theocc.com/publications/risks/riskstoc.pdf Transaction costs may be significant in option strategies calling for multiple purchases and sales of options, such as spreads and straddles. Commissions and transaction costs may be a factor in actual returns realized by the investor and should be taken into consideration.

Backtested, Hypothetical or Simulated Performance Results Backtested, hypothetical or simulated performance results have inherent limitations. Unlike an actual performance record based on trading actual client portfolios, simulated results are achieved by means of the retroactive application of a backtested model itself designed with the benefit of hindsight. Backtested performance does not reflect the impact that material economic or market factors might have on an adviser's decision-making process if the adviser were actually managing a client’s portfolio. The backtesting of performance differs from actual account performance because the investment strategy may be adjusted at any time, for any reason, and can continue to be changed until desired or better performance results are achieved. The backtested performance includes hypothetical results that do not reflect the reinvestment of dividends and other earnings or the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid. No representation is made that any account will or is likely to achieve profits or losses similar to those shown. Alternative modeling techniques or assumptions might produce significantly different results and prove to be more appropriate. Past hypothetical backtest results are neither an indicator nor guarantee of future returns. Actual results will vary, perhaps materially, from the analysis. As a sophisticated investor, you accept and agree to use such information only for the purpose of discussing with Credit Suisse your preliminary interest in investing in the strategy described herein.

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Some investments referred to in this report will be offered solely by a single entity and in the case of some investments solely by CS, or an associate of CS or CS may be the only market maker in such investments. Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Information, opinions and estimates contained in this report reflect a judgment at its original date of publication by CS and are subject to change without notice. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise. The value of securities and financial instruments is subject to exchange rate fluctuation that may have a positive or adverse effect on the price or income of such securities or financial instruments. Investors in securities such as ADR's, the values of which are influenced by currency volatility, effectively assume this risk. Structured securities are complex instruments, typically involve a high degree of risk and are intended for sale only to sophisticated investors who are capable of understanding and assuming the risks involved. The market value of any structured security may be affected by changes in economic, financial and political factors (including, but not limited to, spot and forward interest and exchange rates), time to maturity, market conditions and volatility, and the credit quality of any issuer or reference issuer. Any investor interested in purchasing a structured product should conduct their own investigation and analysis of the product and consult with their own professional advisers as to the risks involved in making such a purchase. Some investments discussed in this report may have a high level of volatility. High volatility investments may experience sudden and large falls in their value causing losses when that investment is realised. Those losses may equal your original investment. Indeed, in the case of some investments the potential losses may exceed the amount of initial investment and, in such circumstances, you may be required to pay more money to support those losses. Income yields from investments may fluctuate and, in consequence, initial capital paid to make the investment may be used as part of that income yield. Some investments may not be readily realisable and it may be difficult to sell or realise those investments, similarly it may prove difficult for you to obtain reliable information about the value, or risks, to which such an investment is exposed. This report may provide the addresses of, or contain hyperlinks to, websites. Except to the extent to which the report refers to website material of CS, CS has not reviewed any such site and takes no responsibility for the content contained therein. Such address or hyperlink (including addresses or hyperlinks to CS's own website material) is provided solely for your convenience and information and the content of any such website does not in any way form part of this document. Accessing such website or following such link through this report or CS's website shall be at your own risk. This report is issued and distributed in Europe (except Switzerland) by Credit Suisse Securities (Europe) Limited, One Cabot Square, London E14 4QJ, England, which is authorised by the Prudential Regulation Authority ("PRA") and regulated by the Financial Conduct Authority ("FCA") and the PRA. 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Investment principal on bonds can be eroded depending on sale price or market price. In addition, there are bonds on which investment principal can be eroded due to changes in redemption amounts. Care is required when investing in such instruments. When you purchase non-listed Japanese fixed income securities (Japanese government bonds, Japanese municipal bonds, Japanese government guaranteed bonds, Japanese corporate bonds) from CS as a seller, you will be requested to pay the purchase price only.

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