Investment Banking wallet outlook - all eyes on equity derivatives

- "Our analysis clearly illustrates the IB wallet is going ex growth, declining -4% 09-12E CAGR and to grow only 3% CAGR in 10E-12E."
- "The main catalyst for our base case ex growth revenue trend is that clean fixed income revenues are likely to decline from the peak 2009 year by -22% in 2010E/09E and a further -4% CAGR in 2010-12E, accounting with 55% share for the largest part of the $330bn IB revenue wallet in 2009."
- "So where is the IB revenue wallet growth going to come from? In respect to IB product cycle in different economic stages, with the market becoming more risk open, one should expect a shift to the next risky asset class to drive IB revenues after 2009 being the best FICC trading year ever: Equities, in our view."
- "In addition, there is no sign of innovation within the IB industry driving a new IB revenue wallet super-cycle. One of the products offering potential long-term growth is Insurance-linked-securities. However, following the structured credit crisis we do not see client appetite to buy illiquid structured products. For details on Insurance-linked securities, please refer to our note, “Insurance Linked Securities: The second leg of growth in the ABS market?” published on 4 June 2007."
- "Hence, the key driver for growth in the IB wallet going forward has to be equities. In particular, we focus on equity derivatives rather than highly commoditized cash equity business as the key IB revenue driver considering its higher long-term profitability, lower operating gearing, and more diverse business mix."
- "Equity Derivatives – the key determinator for IB wallet growth. We analyse in detail the key sub-business segments within equity derivatives and their potential IB revenues impact. We conclude equity derivative business is to grow 9% CAGR 2010-2012E – the fastest growth within all IB client flow related businesses assuming 5% CAGR equity market performance in 10-12E."
- "The historic equity derivative revenue growth rates of c.15%p.a. are unlikely to be achievable as clients operate with less leverage and demand relatively simple structured products. More importantly regulation should be a trigger of structural change in Equity Derivatives reducing profitability, with ROEs declining from 42% to 22% in a 2011E sensitivity, mainly due to new capital rules accounting for 2/3rd of change rather than revenue loss related regulation at 1/3rd. The regulatory changes will lead to re-assessment of the business model in our view and structural trend changes within the business wallet as we outline in detail in our report."
- "We expect Delta One to be a key growth segment in our view, accounting for $10.7bn revenues wallet in 2009 with CAGR 9% 10-12E. These activities require large scale operations to maintain significant size index-based portfolios and competitive technology with the appetite and willingness to hedge at times longdated risk. Investment costs required for algorithmic trading are relatively high, and equity finance activities are balance sheet intensive, as a result, we believe this segment will remain dominated by the scaled players with strong balance sheets. In addition we see material growth opportunities within ETFs at 20%p.a. The key players are GS, SG and BNPP."

- "Within equity derivative structuring we expect retail business to remain relatively slow and unlikely to reach peak volume levels at highly leveraged and risk payoffs post the structuring crisis. However, strategic corporate business will remain a material high growth segment in our view. We expect structuring to grow from a 2009 wallet of $7.7bn by CAGR 10% 10-12E. Overall, due to difficult to hedge risk and capital charges post Basel 2.5, IBs require scale in the structuring business to generate acceptable ROEs over-the-cycle in our view leading to further consolidation in this business segment. As a result, we expect the structured equity derivatives industry to become more oligopolistic post regulatory changes. There are business opportunities so and we remain surprised about competitors’ inability to replicate a Societe Generale Lyxor-type structure. The key players are SG, BNPP, DB and GS."
- "Our largest sub-segment business concern is regarding the equity derivative flow business, becoming more cash equity-like with literally every IB now focusing on expanding this business segment, with a 2009 wallet of $7.5bn and CAGR 5% 10-12E. We witness overcapacity building up reducing spreads and increasing operating leverage. In addition, with regulation increasing price transparency the more commoditized equity derivative flow business is becoming even more of a scale platform business with a strong IT infrastructure a key differentiator. More importantly, the race to own high trading market share is key for price discovery (i.e. liquidity provider) to optimize client facilitation business and generate flow prop related revenues. Hence, the importance of flow prop as such will not be diminished but becomes more vital in a continuously declining flow equity derivative profitability world. We see flow prop as part of client facilitation business in a more transparent equity derivative trading business. Overall, very few players (3-4) will be able to be liquidity providers in such a scale focused business and we are concerned about the aggressive expansion strategy of all IBs including Tier II players to build-up scale. Within flow equity derivative, there is the potential for some IBs to close geographic gaps and grow the flow business aggressively, in particular French and European Banks in the US, with ongoing structural growth in Asia. The player by far being strongest in this segment is GS. We see the oligopolistic flow market structure still uncertain with MS, UBS, DB and French Banks potential contenders in our view."

European worries resurfacing

- The coming surge in food prices
"Rising demand, supply constraints and feedback loops all point to that."
- United States: Right diagnosis, wrong cure
"The President is right to try to boost growth, but we think his latest proposals are awry."
- Europe: Perceptions on inflation expectations
"Short-run measures of inflation views reflect perceptions more than expectations."
- Japan: Improvements in efficiency of capital stock
"Companies have been steadily improving productivity and efficiency."
- Asia ex-Japan: Taking stock of monetary policy
"We single out four economies, where the current monetary stance risks being too loose."
- Emerging Markets: EEMEA: All politics is local
"A constellation of political risks is emerging, which could impact financial markets."
- Europe: Tales from the periphery: Has the crisis returned?
"The widening in sovereign spreads looks unjustified by the news."
- Sweden: A possible second term for the right
"We expect the ruling coalition to win narrowly in the 19 September general election."
- Australia: Strong, broad-based growth ahead
"We are revising up our GDP growth forecasts for 2010 and 2011."
- Canada: A cut (hike) above
"The recovery looks more sustainable; we see policy rates reaching 1.25% by year-end."
- Turkey: Auto demand on auto-pilot
"The recent acceleration in auto sales suggests that the slow recovery is speeding up."
- Romania: Metastable equilibria
"H2 should test the political resolve for austerity measures and the ability to endure them."

EMU strains should not upset global markets

- Overview: "EMU stresses have resurfaced this week. We expect ongoing volatility in spreads but do not anticipate a full-blown crisis. As a result we think the flight to quality reaction and the spike in volatility should reverse."
- US Rates Strategy: "We make a critical evaluation of the recent performance of our 10yr yield valuation framework."
- Euro Rates Strategy: "Belgium is in a far stronger position fundamentally than the peripherals but we think the short term risk is that spreads will continue to widen as the market looks at the risk/reward of being long here."
- Sterling Rates Strategy: "The 10yr Gilt-Bund spread looks out of line with money-market expectations. We recommend a flattener in GBP against a steepener in EUR."
- Global Inflation Strategy: "Total returns for inflation-linked bonds have been surprisingly high in 2010. We expect supply to cap the performance of euro break-evens in the coming weeks. UK break-evens look fundamentally too low."
- APAC Rates Strategy: "We look to enter 7s30s flatteners in JPY."
- "In AUD, target long Dec IB’s at 95.25 and long Dec bills at 95.00. Diverging central bank views also favour AUD/NZD OIS spread wideners."
- Flow Analysis: "Flow data suggestive of waning appetite for fixed income. We saw a sharp fall in demand for US fixed income last week in all maturities. By contrast, demand for Europe held up well with continued duration extension."

The global economy is losing steam

- Setback. "Our picture of a W-shaped economic recovery after the Great Recession appears to be materializing. The expiration of the fiscal packages running into the billions and the reversal of the inventory cycle are now increasingly slowing the pace of global growth. Consideration is being given to new stimulus programs, first and foremost in the US."
- US. "The slowdown there started as far back as this spring and will, moreover, be more pronounced than originally anticipated. There is the growing fear that the economy will slide back into recession. We would not go that far, but we are making a downward revision to our growth expectations for 2010/11 (pages 4-7)."
- Fed. "It is not only the US administration that intends to stimulate again. The central bank has announced its intention to prevent a further shrinking of its balance sheet. Consequently, we do not expect the first rate hike until the beginning of 2012."
- EMU. "The European economy is holding up pretty well. This appears to confirm what ECB economists discovered as far back as 2009: The US cycle is feeding through to Europe less strongly and above all later than in former years. But here too, the slowdown is inevitable. The rapid pace of growth reported this spring cannot be maintained. For 2010/11, we expect GDP growth of 1.6% and 1.3%, respectively (pages 8-9)."
- ECB. "A slide back into recession is, however, improbable, with the result that the central bank could really lean back and continue its exit from the ultra-expansive monetary policy – were it not for the resurfacing concerns about the solidity of European banks and the rapid sovereign bond spread widening (cf. Weekly Comment, pages 2-3)."

Japan: Limited room for capex to increase

- Limited room for capex to increase
• "Recent capex-related data suggests that corporate capital expenditure has finally bottomed out"
• "However, our analysis of the capital stock adjustment cycle suggests that there is limited likelihood of capex expansion in the foreseeable future"
• "Cyclically, we anticipate capex will reenter a soft patch towards the early 2011, with exports and domestic production likely to slow"

- Corporate and Consumer Sentiments Deteriorated Sharply
• "Corporate and consumer sentiments deteriorated sharply in August reflecting the recent sharp yen appreciation and a decline in stock prices as well as concerns about slump after the last-minute demand before the expiration of eco car subsidies"

- Demand for Funds Remains Weak
• "Bank lending continued to drop, falling 2.0%yoy in August, reflecting the weak demand for funds among the private corporate sector"

Fiscal fables

- Macro viewpoint: Fiscal fables "The Obama administration has announced a series of proposals this week aimed at boosting growth. These policies, if enacted, will have a negligible impact on our forecast of a growth recession through the end of next year."
- Fed watch: Incomplete transition "Former Vice Chairman Donald Kohn’s retirement from the Board of Governors signals the end of an era. As he was close to Bernanke and other centrists on the FOMC, his dovish comments in a subsequent interview are noteworthy. The fact that his replacement has not yet been approved will be a challenge for the Fed."
- Housing watch: Despite low rates "Record low rates have done little to stimulate housing demand, leaving a growing imbalance between housing supply and demand. We expect the government to introduce more policies to address this glut of supply. One proposal gaining some traction is to facilitate the conversion of foreclosures into rental properties."
- The week ahead: Spending and production: not so bad "We expect a modest gain in retail sales, showing a decent back-to-school shopping season. Consumers are still spending, but are doing so conservatively. New information on the manufacturing front will also be released. We expect the industrial production to pick up with a solid gain in manufacturing output, but for the Empire State survey to point to an impending slowdown."

Investors rush into AUD on buoyant economic data

- "The latest IMM data cover the week from 31 August to 7 September."
- "Positioning becoming an increasing risk to AUD: The Australian dollar has rallied almost 5% against USD since GDP data published on 1 September showed that the Australian economy re-accelerated during Q2. The strong activity data, combined with further employment growth, have also seen the money market turn from pricing a small probability of a cut to now pricing a full 25bp hike in 12 months. As a result, noncommercial investors have added to AUD longs, which now stand at 44 percent of open interest. Hence, positioning is increasingly becoming a downside risk to AUD."
- "Close to neutral positioning in EUR/USD: With EUR/USD stuck in an approximate 1.26-1.29 range since the middle of August it is little surprise that non-commercial investors have refrained from taking a strong directional view. Net short EUR positions stand at 9.2 percent of open interest, down from 10.6 percent the week prior."
- "Short CAD positions are unwound: After having turned marginally short CAD two weeks ago speculative investors are now once again net long and long positions are likely to have been built further after the Bank of Canada hiked by 25bp the day after the IMM data was collected."

Repair of Fair

- Neutral Duration — "With the recent rise, 10yr Treasury yields are near our fair value. We recommend selling the 5yr versus 2yr and 10yr Treasuries."
- Fair Value Model Review — "We review recent performance of our fair value model and make an adjustment to address unusual Fed accommodation."
- Citi Strength Indicator Explained — "The Citi Strength Indicator is made up of four auction metrics and can be used to enhance trading strategies post auction."
- MBS Market Overpricing Government Refis — "A government manufactured refi wave remains a remote probability in our view, although we find market-implied probabilities of such an event are 50-75%."
- Agency Debt — "Two multi-billion dollar five-year agency/supranational deals have printed so far in September. We find the five-year Freddie Mac deal attractive."
- US Rate Strategy Model Portfolio — "The portfolio is down 0.1% month-to-date."

A Kan victory and the risk of a yen stuck at ¥70-¥80

- Kan has the edge — "The media is reporting that PM Naoto Kan has a lead over opposing candidate Ichiro Ozawa in the DPJ leadership election. This writer also thinks Mr. Kan has the edge. However, Mr. Ozawa also has a chance of winning. We forecast a weaker yen and stronger share prices if Mr. Ozawa wins."
- If Mr. Kan wins — "We think this would be neutral or negative for share prices. We would not expect any big changes in the economy-related posts such as the Minister of Finance, the Chief Cabinet Secretary, or the State Minister for Economic and Fiscal Policy in the post-election cabinet. We would thus expect barely any change in basic economic policy."
- Little hope of additional monetary easing — "The BoJ has taken steps to ease monetary policy. Miyako Suda, a member of the policy board, was said to have been against this, on the grounds that it would heighten the risk of creating a breeding ground for bubbles in the long run. We note the gulf between her perception and the market."
- Risk of yen strength after the leadership election — "Our greatest concern is of rapid yen strengthening after a victory for Mr. Kan in the September 14 leadership election. With the government having already played its hand on monetary and fiscal policy, it is unlikely to come up with effective measures on the strong yen."
- Continued outperformance by domestic-demand stocks near term — "We expect stocks that benefit from low interest rates and deregulation to continue to outperform. We anticipate additional deregulation measures for real estate, tourism and other areas to be incorporated into the government’s economic steps that will be unveiled this week."
- Stocks to watch — "Sumitomo Realty & Development (+6.1% versus TOPIX YTD through September 8), Tokyu Real Estate (+8.6%), in real estate, All Nippon Airways (+37.3%) and East Japan Railway (+23.7%) in tourism, and SoftBank (+21.6%) and Dwango (+7.8%) in IT."

The corporate self-financing rate: A crucial variable in the aftermath of the crisis

- "The crisis has led companies to self-finance their investments: in the aftermath of the Lehman bankruptcy, they lost access to credit and the financial markets seized up, which showed them the danger of financing investments by running up debt."
- "In several countries (United States, United Kingdom, Germany), the selffinancing rate (cash-flow-to-investment ratio) already exceeds 100%. In the countries where this is not yet the case (France, Spain, Italy), we should expect either a drive among companies to increase productivity (and hence job losses), a slowdown in wages, or a decline in investment. This is already happening in Spain and Italy, but not yet in France."
- "A requirement that the self-financing rate should exceed 100% will lead to a permanent fall in the corporate debt ratio, a fall in companies’ return on equity, more unfavourable income sharing for wage earners and a fall in demand."

In the wake of the crisis, the same factors will be found in the euro zone in the medium term as those which accounted for the appreciation of the German mark in the past

- "The appreciation of the German mark, in the 1980s and the early 1990s before the creation of the euro, was due to three factors: Germany's strong export capacity; the high level of domestic savings; the credibility and conservatism of the central bank which attracted capital."

- "After the 2007-2009 crisis, these factors will be found in the euro zone: export capacity, again mainly thanks to Germany; high level of savings as a result of the halt in borrowing by households (whereas before the crisis, savings in the euro zone were very low due to countries with strong credit growth); rising corporate profits; fiscal deficit reduction; ECB more conservative than the Federal Reserve."

- "It is therefore reasonable to foresee a medium-term trend appreciation of the euro, similar to that of the German mark in the past, even though this is not the trend seen in the short term."

Public debt, money supply and inflation

- Overview: Public debt, money supply and inflation

- France: Is the decline in unemployment sustainable? "According to the French statistical office,  INSEE, the jobless rate in metropolitan France fell 0.2 percentage points to 9.3% in Q2 2010. INSEE also recently released detailed employment figures suggesting that the upturn in job creations is not yet strong enough to trigger a sustainable decline in the jobless rate. Whereas surveys suggest that economic growth remained relatively dynamic over the summer, we expect a slowdown towards the end of the year. Consequently, the unemployment rate is thus rather likely to level off in the quarters ahead."

Gold heading towards USD 1,600

- "The Fed's decision to reinvest the proceeds from maturing and prepaid agency debt and MBS in longer-term Treasuries and to continue rolling over its holdings of Treasury securities as they mature has eliminated the slight tightening bias of US monetary policy."

- "Thus far, it is not yet clear whether this will now also result in a lengthening of the Fed balance sheet. In the past, however, the gold market reacted extremely positively to a monetization of government debt."

- "In the second quarter of 2010, demand for gold measured in tons increased by 34% yoy. On a USD basis, a new record was even posted for the quarter. The reason for this is the surge in investor demand triggered by the Fed decision and the renewed widening of CDS spreads in Europe."

- "In the interim, a growing number of Chinese investors is also discovering the gold market. Although China has advanced in recent years to become the world’s largest gold producer, its annual production of most recently 330 tons is by no means sufficient to satisfy this demand."

- "Hence, China announced key gold market reforms at the beginning of August. Foreign companies are now permitted to offer their gold coins at the Shanghai Exchange, and more banks are permitted to import gold from abroad. The Chinese demand will now increasingly be felt on the global markets."

- "We are, therefore, raising our target price for 2011 from USD 1,250 to USD 1,400 per troy ounce. For 2012, we now expect USD 1,600 per troy ounce (in each case calendar year averages)."

The trade in goods between Europe and the BRIC

- "In the past year, trade in goods between Europe and the large emerging countries (Brazil, Russia, India and China) has once again been very vigorous. A particularity is found in the fact that exports and imports have increased at similar paces, which may suggest that the import content in these exports is high."
- "We look at, country by country, what types of goods currently contribute the most to the growth in trade between the six large EU-15 countries and the BRIC. We can see that their nature differs:
• Mainly exports of cars, transport equipment and machines for industry against imports of iron ores and semi-processed food products with Brazil;
• Exports of cars, perfume and office equipment against oil with Russia;
• Exports of metals and transport equipment against oil, clothing and cloth with India;
• Exports of cars, machines for industry and transport equipment against electronic products for telecommunications, office equipment and electrical equipment with China."
- "These observations do not mean that the import content in European exports to the BRIC is low. Oil is needed upstream in most production processes, and the major European manufacturers have offshored to the other emerging countries. These observations simply show that trade in goods between Europe and the BRIC is differentiated and that the simultaneous change in exports and imports does not fundamentally result from the fragmentation of the value chains."

Turkish lira on the edge

- Market movers ahead: TCMB on hold, Polish inflation low "We do not expect any major change in rhetoric from the Turkish central bank (TCMB) when it announces its rate decision next week. Along with the market consensus, we expect the TCMB to keep rates on hold, with the borrowing rate staying at 6.50%. That said, the TCMB will keep all options open and, if anything, we would recommend investors to be positioned for more dovish rhetoric. Read more on page 4. Polish inflation and industrial production will be in focus next week. We expect inflation in August to surprise on the downside compared to the consensus and stay flat at 2.0% y/y (consensus sees a moderate increase to 2.1% y/y). We see industrial production surprising on the upside in August to grow by 15% y/y, up from July’s 10.3%."
- Fixed income outlook: CHF/HUF at 230 will trigger MNB hike "Hence, there is no doubt that the MNB is considering to hike interest rates despite the fact that inflationary pressures seem to be moderating and growth remains lacklustre. Judging from our Monetary Policy Tracker one should not really expect that kind of aggressive rate hikes that is now being priced in by the markets – as it confirms that inflationary pressures are easing which in itself is an argument for rate cuts. So why is the MNB considering rate hikes? And is it rational for the markets to speculate the MNB might hike rates? The most important reason is of course that the situation in Hungary in no way can be described as “normal” as concerns over financial sector stability continue to “overrule” everything else. Read more on pages 3-4."
- FX outlook: volatile week ahead for the lira "Next week could be something of a rollercoaster for the Turkish lira, with three big events on the agenda: the referendum on constitutional changes (Sunday 12 September), the Q2 GDP numbers (Tuesday) and the rate decision from the TCMB (Thursday)."
- Scorecard-based trade of the week: buy ILS/ZAR "For the fourth week in a row, the highest-scoring currency in our EMEA FX Scorecard is the Israeli shekel, while the lowest-scoring is the South African rand. Therefore we continue to recommend buying ILS/ZAR, based on our EMEA FX Scorecard."

India: Frame-by-Frame

- Maintain a Neutral bias on the market "The market continues to remain resilient with YTD gains now exceeding 6%. Among the larger markets in Asia, India’s outperformance has been strong, despite macro worries on inflation and the current account deficit. We believe that inflation concerns should start to abate as base effects begin to kick in. On the flip side, we see some patches of slowdown in the economy and expect mild near-term weakness in industrial production numbers. We retain our Neutral bias on the market."
- Near-term weakness in activity and peaking inflation "Systemic liquidity has eased somewhat since the tightness in June and July, which coincided with large outflows on account of telecom auctions. Meanwhile, real activity indicators suggest a slowing down of economic activity in the near term, the pace of which has been hastened by supply constraints and unfavourable base effects. Inflation has most likely peaked as agricultural output normalises this year and global commodity prices remain close to flat on an annual basis."
- Fund flows — allocations have favoured debt over equities "Fund flow activity reveals that FII flows have moderated in both equity and debt markets in August. That said, FII inflows into debt in the year so far stand at a record high. Domestic mutual funds have continued to be net sellers of equities and have instead channelled funds into debt instruments. The supply of paper in the primary market has come off during the past few months amid market volatility and global uncertainty."
- Consensus earnings — largely flat "Consensus earnings estimates for the Sensex are largely flat YTD. Autos, banks, oil & gas and media have seen the largest upgrades, while telecom, real estate and capital goods have seen the largest cuts in consensus earnings estimates."
- Valuations not cheap "The 12-month forward consensus-based market earnings multiple at 15.6x stands at a slight premium to its five-year average of 14.8x. With respect to regional peers, the Indian market does look a bit expensive at current levels."

EM Equity in Two Decades: A Changing Landscape

- "Significant shifts in global equity markets: Over the next two decades, emerging equity market capitalization could increase substantially in absolute terms and overtake developed markets. The primary drivers are rapid economic growth and capital market deepening. China may exceed the US in market cap terms by 2030."
- "The EM landscape in two decades: Emerging equity cap could rise from $14tr to $37tr in 2020 and $80tr by 2030, bringing the EM share of global equity cap from 31% to 44% and 55% by these respective dates. The EM weight in the MSCI AC World index may also increase from 13% to 19% and 31% by 2020 and 2030. The BRICs’ share of world equity cap may be 30% by 2020 and 41% by 2030 vs. 18% now. For the N-11, the share could rise to 6% in 2030, from 5% now."
- "DM savings pools will need to own more EM: We estimate that developed market institutional asset managers currently hold 6% in EM equities within their total equity portfolio. This weighting may rise to 18% by 2030, implying net purchases of $4tr. The institutionalization of EM savings pools will also gather pace; this may help dampen EM equity volatility and valuation swings."
- "EM opportunities and challenges: EM equities offer investors attractive potential returns, but will require a greater allocation of business resources. Financial intermediaries have substantial revenue opportunities, but will need to localize further; operating costs and competitive pressures will rise."

QE and the Dollar: Lessons from QE-1 (Part I)

- QE and the Dollar: Lessons from QE-1 (Part I) "The potential for renewed Quantitative Easing (QE-2) has increased in recent months as the outlook for US growth has deteriorated. The first phase of Quantitative Easing (from December 2008 to March 2010) coincided with significant dollar weakening and our analysis shows that QE-1 was a key driver of the weakness, although not the only factor at play. Another round of Quantitative Easing (QE-2) is looking increasingly likely in coming months and this would be a latent catalyst for renewed USD weakening."
- Canada: A cut (hike) above "The Canadian economy is showing signs of a more sustained recovery, with strong domestic demand offsetting the drag from weaker US growth. With inflation well contained, the Bank of Canada is expected to continue to normalise rates. We also remain constructive on the outlook for CAD."
- Refining Flipping NOLI, and retaining a neutral view "We retain our neutral call on risky FX. Both Flipping NOLI and our alternative way indicate that there remains some error between actual and market-implied NOLI. However, the error has narrowed considerably since we recommended a tactically bullish stance (Flipping NOLI to reveal a positive side, 27 May 2010) – both as a result of prices of risky assets appreciating, and as a consequence of NOLI declining."
- SEK - Swedish National Debt Office starts to unwind long SEK positions "The Swedish National Debt Office (SNDO) announced that it will start to reduce its long SEK exposure, by gradually selling SEK in the market. The SNDO had accumulated a long position worth SEK50bn during the crisis, and may take up to a year to unwind its long SEK exposure. This suggests a daily pace of selling to the tune of EUR20mn, but the pace could be quicker, depending on market conditions. We do not think this will reverse the trend of SEK appreciation, but it does reduce the appreciation potential in the short term."
- New USD/JPY forecasts: A new all-time low? "USD/JPY has declined as the prospects of an economic recovery in the US have declined and expectations of lower US interest rates have taken hold. The situation in the US has a greater impact on USD/JPY than Japanese domestic policies and we think that any additional monetary easing by the BOJ or forex intervention by MOF is unlikely to halt the rise in JPY. We have therefore lowered our quarterly USD/JPY forecasts for end-September 2010 to end-March 2012 to take this into account. We cannot rule out the possibility that at some time between now and the middle of next year USD/JPY may briefly break below the all-time low of 79.75 it recorded in April 1995."
- Speculative positions/interest rate spreads and effectiveness of intervention to sell JPY "A growing number of market participants appear to take the view that with the BOJ now having eased monetary conditions, the monetary authorities' next move will be to intervene in the forex market. Using historical data on the size of speculative positions at the start of intervention and the US-Japanese interest rate spread once intervention began, we estimate the extent to which USD/JPY could rally if the monetary authorities intervene to sell JPY. We find that if USD/JPY declines to 82-83, intervention could trigger a brief rally, but probably to no more than 85-86 if US economic sentiment does not improve as well."
- BoK reinforces its pro-growth bias – stay received KRW IRS, long KTBs and long KRW "The Bank of Korea’s decision to keep policy rates unchanged today reinforces our view that the market continues to overestimate just how hawkish Asian central banks will be. We recommend investors stay received KRW IRS and long KTBs. In terms of the KRW IRS forward curve, the 1fwd 1yr offers the most attractive slide-to-volatility ratio, while we continue to look for opportunities to initiate a recommendation to buy the 10yr KTB. We also maintain our long KRW (vs. EUR) recommendation despite the BoK’s pause. Normalising monetary conditions via FX strength remains a possibility, while support should continue to come from a strengthening Balance of Payments and increasing global political pressure."

- Recommend long HKD 2y3y vol against rates level and term premium "We introduce a fair-value  ramework for swaption volatility based on overall rates levels and term premium. HKD 2y3y  volatility appears to be cheap according to our model. This seems to be a good time to build long 2y3y ATM straddles against HKD IRS 2s and 5s."

- INR OIS curve – Receive 1fwd1Y OIS "Following the Reserve Bank of India (RBI)’s last meeting on 27 July, OIS yields have moved sharply higher. Although yields have retreated from their highs, they are still well above levels before the meeting. However, Indian data releases following this policy meeting suggest that inflation and growth are moderating. Global data trends have also raised questions about the sustained global recovery. As the RBI highlighted explicitly the risks of weaker global growth and its impact on India in its previous policy meeting, we view the change in macroeconomic data as an opportunity to establish our bullish call on rates and believe that receiving the 1fwd 1yr is the most efficient way of expressing this view."

- Malaysia: Updated outlook for interest rate markets "The momentum of economic growth is fading rapidly in Malaysia, as it is across Asia and in the US. With Bank Negara Malaysia (BNM) comfortable with its neutral monetary policy stance, we retain a preference for long-duration positions in MYR interest rate markets. However, the recent rally in the MYR interest rate markets has removed much of the value from the front end of the IRS curve. For investors looking to express a long-duration view via MYR IRS, considerations of slide, volatility and liquidity suggest that receiving the MYR 2fwd 2yr offers greatest value."
- Recommend adding a long PHP trade "We recommend a long 3M PHP/INR (3M 1.0525) position which carries negatively by -0.40% over this period. We expect the Philippine government to be able to enjoy its honeymoon period, having been inaugurated only two months ago. We would also expect to see improvements in the Philippines' ability to attract investment. Despite the recent hostage stand-off, the security situation in the Philippines in general is as good as it has been for years. PHP is also supported by solid basic balance characteristics. The caveat is that President Aquino has a major task on his hands to sustainably improve the fiscal accounts. In addition, there is a risk that the president's popularity declines - his handling of the hostage situation received bad press, and as the typhoon season closes in, the government's crisis management abilities could come under further scrutiny."
- Recommend adding a short EUR/KRW trade "We have chosen to reopen our short EUR/KRW position. KRW remains undervalued and is backed by a relatively strong balance of payments (including increasing interest in the KTB market). At the margin, we would expect less aggressive intervention against KRW appreciation ahead of the G20 event in Korea on 11-12 November. We are also less concerned that the North Koreans could cause problems around this time. However, as the global economy slows, appreciation pressures on KRW may subside, and/or the authorities may be less likely to allow appreciation. Indeed, we try to provide some (imperfect) insulation against any global risk sell-off by expressing the trade against EUR. However, we also show indicative pricing for KRW versus JPY on a 3M basis, as it is against JPY that the valuation proposition seems clearest."
- EMFX RV can be simple: Buy MXN vs ZAR "Cross-continent relative value FX trades usually come across as a stretch to investors, though occasionally there are straightforward opportunities. Given the current state of the world on risky assets, return profiles (flat year-to-date) and the lack of interest on high-beta trades, we think selling ZAR/MXN is an interesting proposal."

Deflation: Will America and Europe Follow Japan?

- "Investors are asking whether America and Europe will follow Japan into deflation. We think not. Japan fell into secular deflation because of a unique combination of structural factors. These factors are (a) high central bank independence with low accountability, (b) advanced aging of the population, (c) an electoral system that strongly over-represents the interests of older voters, and (d) a current account surplus that dulls the need for structural reforms."
- "Japan will likely remain in deflation, because none of the structural factors is likely to change soon."
- "The US is unlikely to fall into deflation. The Federal Reserve is more accountable and transparent than the Bank of Japan. The US is young; the electoral system does not over-represent older voters; the current deficit increases pressure for structural reform."
- "Europe is less likely than Japan but more likely than the US to fall into deflation. This is because Europe lies between Japan and the US on the four factors."
- "The best investment strategy is to seek yield and monetary assets in Japan, and seek beta and real assets in the US. Europe falls between the two. Inflation linked bonds are attractive. They provide protection in high inflation countries and high real rates in low inflation countries."
- Risk Scenario - Global Inflation: "In the risk scenario, where common global factors overcome regional differences, all developed economies are likely to tilt toward inflation. Nominal assets in all countries would likely underperform, and real assets outperform. Linkers would be attractive in most countries."

Household deleveraging poses near term risks to consumer spending

- "Household deleveraging has been progressing at a substantial pace. The question is how much further it has to go, and the answer to this question is crucial to the outlook for GDP growth."
- "Progress on the debt side of the household balance sheet has been impressive. We estimate that the debt/income ratio has fallen from a peak of 136% of income in 2008 to less than 120% currently, and at the current rate of personal saving and loan defaults is on track to fall to near 100% by the end of next year. This implies that the household debt service ratio will fall below the range it has been in for several decades."
- "Movements in the saving rate, the key link between the household balance sheet and consumer spending growth, depend not just on debt and debt service, but also on the asset side of the balance sheet, or more specifically on movements in wealth--the gap between assets and debt. Household assets are up from their crisis lows thanks to the bounce in the stock market, though they have taken a hit in the middle of 2010 and remain far below their pre-crisis peak."
- "The key issue is how much more households will feel the need to adjust their saving rate up (and accelerate debt declines for a while longer) in reaction to the large net loss in wealth that has occurred over the past several years. We tested a wide range of specifications of the causal relationship between wealth and saving, and we find that households appear to respond to a three-year moving average of their wealth to income ratio relative to a longer term wealth goal that is best defined as a 20-year moving average of the wealth to income ratio."
- "Given current expected trends in household assets and debt, this relationship sees the saving rate rising further, into the 7-1/2 to 8% range by late 2011, after which it begins to recede slowly. The implication is that consumer spending will continue to be a significant drag on growth through next year, after which it will become a modest engine of growth (consumer spending growing faster than income). This finding reinforces the notion that the Fed will be on hold at least through 2011."

Right diagnosis, wrong cure

- Roundup: Right diagnosis, wrong cure "The President is right to look for ways to boost growth, but his latest proposals are unlikely to provide much support. We are keeping our forecasts unchanged."
- Outlook: more needed from Washington "The weak economy requires more policy stimulus – we believe it will be forthcoming."
- Preview of the week ahead "The retail sales report will help determine the extent of the consumer slowdown. We expect core CPI inflation to be about unchanged for another month."

Living on the edge

- Market Movers ahead
• "In the US focus will be on the August retail sales report and industrial activity indicators. We expect a positive surprise in retail sales."
• "In the euro area it will be a quiet week in terms of data, with the most interesting release being the German ZEW."
• "In Asia focus will be on developments in the yen, which has become a central theme in the leadership contest in the Democratic Party of Japan."
• "SNB is expected to keep rates on hold at the monetary policy meeting next week."
- Global Update
• "News out of Europe has been mixed. German industrial data disappointed and the German banking association said that Germany‟s 10 biggest banks may need EUR105bn of additional capital under Basel III rules."
• "This week offered further comfort in terms of better-than-expected US data from the labour market and from the trade balance."
• "In addition, Obama proposed further economic stimulus. In Japan focus is still on the strong yen and the possibility of Japanese intervention in the FX market to stem the appreciation. However, this issue has been complicated by increased Chinese buying of Japanese bonds."
• "In Sweden GDP data was revised substantially higher, but we continue to expect slower growth ahead."
- Focus
• "This week we published new global forecasts. A flow of disappointing news has led us to revise down our growth forecasts – in particular for the US."
• "While we see a limited risk of a recession, double-dip fears are likely to remain present for a while."

Back to School/Harvest Festival

- Pan-European — Back to School
• Revision — "Risk off in 2008. Risk on in 2009. Risk on and off in 2010. Mixed macro. Strong profits. Attractive valuation. Conundrums, crossovers & cults."
• Homework — "Key themes include: growth/EM, quality, size, country and deequitisation. We raised beta in early May and early July. We lower beta now."
- UK — Harvest Festival
• Autumnal colours — "Easing macro trends suggest earnings estimates are too high. But this looks more than priced into markets. We maintain our 6000 FTSE 100 target."
• Under the duvet — "Quality bias, backing earnings momentum, emerging markets exposure, de-equitisation and size tilt are the key themes."

Taking stock of monetary policy

- Global Letter • The coming surge in food prices
- Feature Articles
• Taking stock of monetary policy
• Australia: Strong, broad-based growth ahead
- Data Preview
• The week ahead
- Chart Alerts
• India: Monetary conditions move into restrictive zone
• Hong Kong: RMB deposits rose 85.5% y-o-y in July
- Outlook 2010-2012
• Australia: Growth momentum building
• China: Reform platform for sustainable growth
• Hong Kong: Moderating, but solid growth
• India: RBI may be close to pausing
• Indonesia: Reserve requirement hike begins normalisation
• Malaysia: Rate hikes are over for now
• New Zealand: Earthquake reconstruction to boost growth
• Philippines: Going for growth 
• Singapore: More property market measures
• South Korea: When doves cry
• Taiwan: Robust economic expansion continues
• Thailand: Still in the mood for normalisation 
• Vietnam: Some encouraging fiscal numbers 

Reality rests between slowdown and speed-up scares

- "The slowdown scare of mid-2010 has passed. The sum of purchasing managers’ reports from around the world probably captures the environment best: growth has slowed, but not so immodestly as to sustain fears of the dreaded double-dip relapse into renewed recession."
- "In the near term, we continue to expect the global economy to muddle through the frequent slowdown scares, albeit expanding at a slightly slower pace than our July estimates. Our 2010 global GDP forecast remained unchanged at 4.6%, while the growth forecast for 2011 moved down by one tenth to 4.3%."
- "While such expectations are reassuring as far as they go, even if realized they would leave a huge amount of global GDP still missing relative to the pre-crisis path (Exhibit 1). The global economy would need to grow much faster to restore the recessionary loss of GDP that nearly seven billion people rely upon for their material well-being."
- "Inflation pressures remain subdued. We expect the slow recovery, especially in the First World, to keep inflation low, with deflation an unlikely but not implausible contingency."
- "Against this backdrop, we expect major central banks including the Fed, BOJ, ECB, and BOE to continue to keep rates “lower for longer.” We also expect central banks in commodity-intensive economies like Brazil, Canada, and Australia to move to the sidelines in their tightening cycles earlier than our prior expectation. In Non-Japan Asia, we continue to expect the pace of interest rate “normalisation” to be slow this year (with the exception of India)."
- "The “reach for yield” required by pension plans and other financial structures linked to the First World’s entitlement culture is likely to continue to be very frustrating. The flow of capital to the outperforming emerging market segment of the global economy could intensify. More generally, financial markets, having just begun to shake off their slowdown scare, may now be at the threshold of incorporating a speed-up scare into their valuation psychology."

Onshoring: Is it a reality?

- "It is often suggested that there has been excessive offshoring, and that there will now be onshoring to OECD countries of industrial production formerly offshored to emerging countries. Some countries (France) provide aid to companies which onshore. Some companies may have problems with their offshored production: quality, response times, difficulties of supervision."
- "In this flash, we seek to ascertain whether, at the macroeconomic and not the anecdotal level, there are signs of onshoring in euro-zone countries, looking at employment, output, direct investment, market shares, the external balance, imports and production capacity. The answer is no: the trends in employment, output, direct investment and market share are not headed in the right direction; dependence on imports is not diminishing."

China: 2H10 Earnings Likely Mixed

- Earnings trend – "2H10 corporate earnings will likely face conflicting forces, moderating growth and persistent though benign inflation. We expect overall earnings growth to slow in the second half of the year alongside growth normalization."
- Earning surprises – "Price inflation and policy calibration could bring earnings surprises in related sectors. We expect CPI to stay above 3% in the 2H10 thanks to higher food prices and money velocity. Policy tightening in the property and energy sectors could also generate favorable earnings expectations for large listed companies."
- Sector outlook – "There is no clear evidence suggesting that valuations are converging across sectors. Economic and policy changes in the second half of the year would still favor high valuation plays. In our view, insurance and consumer staples are likely to see positive earnings surprises and will
outperform in 2H10."
- Top picks – "Ping An (2318.HK; HK$69.40; 1L) and Mengniu Diary (2319.HK; HK$23.05; 1L) may outperform in light of 2H10 earnings and economy outlook. Ping An posted a stronger 1H10 results and should be able to deliver strong operating momentum this year due to improving life business mix and P&C turnaround. For Mengniu Dairy, earnings momentum may start to pick up in 2H10 on 1) stabilizing raw milk cost, which management saw pull back somewhat since July, 2) improving product mix as Mengniu is shifting to higher value-added products, we recommend to buy on recent weakness."

Is it possible to live with a very high public debt ratio?

- "Some analysts believe that euro-zone countries facing problems with their public finances (Greece, Ireland, Portugal, Spain) will not succeed in reducing their fiscal deficits and in stabilising their public debts, and that the sovereign debt crisis will therefore resume."
- "We believe, conversely, that the efforts these countries have made, which are already visible, will enable them to stabilise their public debt ratios. Accordingly, we believe that we are not dealing with a short-term problem (continued high fiscal deficits, speculative attacks once again, default risk), but a medium-term problem: will these countries be able to live with a very high public debt, even stabilised, which will make it necessary to maintain a significant primary budget surplus, and hence a restrictive fiscal policy?"
- "The answer depends on the level of risk premia that these countries will have to pay and the political and social capacity to maintain restrictive fiscal policies. As examples, we look at the dynamics seen in the euro-zone countries where public debt ratios were high prior to the crisis: Italy and Belgium. These countries were able to implement a primary budget surplus of
6 percentage points of GDP. This is not very different from the order of magnitude needed in Greece, Ireland, Portugal and Spain if the countries’ risk premia (spreads over Germany) return to the level seen before the sovereign crisis."
- "However, if spreads remain at the current level, the permanent primary fiscal surplus needed to stabilise the public debt ratios would be huge (8 to 13 percentage points de GDP), and it is then very unlikely that the public indebtedness will be bearable in the medium term."

If the world’s confidence in the US economy is lost, the result would be a selffulfilling crisis

- "Many factors could cause a loss of confidence worldwide in the US economy:
• insolvency among part of the households and holders of commercial real estate loans, and as a result chronic weakness of retail banks, the real estate sector and the Agencies;
• enduring deterioration in the US labour market situation, especially due to far lower flexibility;
• ongoing weakening of wage incomes, deleveraging and impoverishment among households, condemning household demand - which was the engine of the US economy - to long-lasting weakness,;
• slimming-down and lower profitability in the finance sector, whose weight was considerable;
• persistent external deficit, due to the shortfall in savings that has not been corrected, and therefore a persistent risk of a long-run depreciation of the dollar that would logically discourage foreign investors (the People's Bank of China?);
• risk of insolvency of public finances at some point in the future."
- "If non-residents (including central banks) share this pessimistic view, they will stop investing in the United States, which will create a huge financing problem, leading to a sharp rise in interest rates, a worsening of all solvency problems (households, real estate, government, Agencies, etc.) and a decline in domestic demand, i.e. precisely the developments that non-residents dread. Such a loss of confidence cannot have the same self-fulfilling effects in countries that are self-sufficient in terms of savings, such as the euro zone."

Two irreversible changes in companies' behaviour due to the crisis?

- "We believe that the crisis may have irreversibly changed the behaviour of companies in OECD countries in two areas:
• policy of self-financing investment, and not depending on external financing; this is due to the problems created by the bank credit crunch and the freeze-up of financial markets in the aftermath of the Lehman bankruptcy, and implies striving for higher profitability, hence distortion of income sharing to the detriment of wage-earners, both by looking for productivity gains and by squeezing wages;
• acceleration of offshoring and hence the deindustrialisation of OECD countries (even in Germany, which is nevertheless less affected than the other countries), through the search for the lowest production costs to improve profitability, and due to the expected widening growth gap between emerging countries and OECD countries."
- "These two trends are very unfavourable to wage-earners' purchasing power: distortion of income sharing in favour of profits, accelerated destruction of industrial jobs, which are more skilled and pay higher wages than the average job."

China Properties: Forget Policy Worries; Pick the Key Names

- Strong sales volume rebound in Aug fully expected — "Transaction volumes in the primary market show an expected strong rebound in Aug. The 15 key cities we tracked in China posted an average 42% MoM increase in volume. ASP also recorded 4% monthly growth. Beijing, Hangzhou and Shenzhen were major contributors to the price rise; ASP in other cities remained flattish/ slightly up."
- Market fears of new measures — "Many investors believe the meaningful rebound in volume without a robust price decline may touch the nerves of the Central government and trigger another wave of measures to be rolled out soon. We do not rule out the chance of new policies being introduced and believe tightening would be essential for a more sustainable long-term growth for the sector."
- Don’t over-react even as the policies are unveiled — "In our view, after the introduction of powerful measures in mid April, the measures available now are really limited. In our view, property tax, restriction on pre-sales proceeds and LAT settlement could be potential measures, but the impact may not be as significant as thought, given the strength of demand. Moreover, in contrast to early 2010, when the policy impact was huge, given the policy switch from supportive in 2009's to early 2010's tough tightening, this time we already have tough tightening. The impact from additional measures may not that that significant. Leading developers that can operate effectively even in the tightening period could emerge as market consolidators and enjoy enlarging their market share."
- It’s time for govt to reassess the overall policy direction — "We believe developers are more cooperative in this round of tightening by staying low-profile and launching projects with lower prices. Many of them are also involved in the government's social welfare housing projects. Now, it’s a critical time for government to reassess its policy direction and the reasons for the market’s prosperity, which is not mainly caused by developers. In our view, further tightening measures may still be ineffective if the fundamental picture is not changed: 1) Ample liquidity, created by the government itself during the economic stimulus; 2) Huge wealth accumulation and the desire for anti-inflation investment vehicles of Mainland Chinese, and 3) Government being the largest taker in the property-profit cake."
- Stick to the big names — "We believe the current share price has factored in most of the bad news. In our view, we should not pay too much attention to policy. The sector is in tough tightening mode already and the impact from potential new measures may not be as significant as thought. We suggest investors add to positions at the moment, but stick to the big names such as Shimao, Agile, China Vanke, COLI."

Steady as she slows

- "Global growth settling below trend in 2H10"
- "Encouraging signs that weakness is not intensifying"
- "EM domestic demand holds up as manufacturing sector slows sharply"
- "Next week: Looking for rate hikes from the BoC and BoK; expecting the RBI to pause on September 16"

Readings

Is this the Right Time for the Fed to go Negative? - Wall Street Journal
Renminbi tensions - FT Lex
Some say bypassing a higher education is smarter than paying for a degree - WaPo
A Productivity Boom-in-Waiting? - Project Syndicate
How To Tell When There’s Structural Unemployment - Think Progress
The wholly fallible Ben Bernanke - Guardian

Greater China: Issues in Focus

- China: Moderation Continues "Against the backdrop of the authorities’ redoubled efforts to shut energy-inefficient production units, industrial production growth continued to moderate due to intensified supply-side adjustment. While fixed-asset investment growth saw a further slowdown, tailwinds (e.g. loosening of controls on new projects, aggressive implementation of the social housing program, easing in local government financing) have now appeared. We also expect the Chinese authorities to allow a faster appreciation of the RMB against the USD given the rising political pressure and the prospective large trade surplus in 2H10 compared to 1H10. Given the heightened uncertainties, we have launched the China Macro Risk Radar (CMRR) to provide a framework to systematically assess and monitor risk events of low probability but potentially high impact."
- Hong Kong: Robust Growth and Capital Inflow "The Hong Kong economy sustained robust growth in 2Q10 with real GDP expanded 6.5% YoY. We now expect GDP to grow 6% and 4% in 2010 and 2011 respectively. The Hong Kong banking system saw a significant increase in RMB deposits in July without hurting the growth of HK$ or other foreign currency deposits, signaling a genuine expansion in the banking sector balance sheet upon the further development in the offshore RMB business. We also observed capital inflow in July, and fundamentally the stock of excess liquidity in the banking system still remained sizable, offering little upward pressure on interest rates."
- Taiwan: 2Q GDP Beat Expectations by Wide Margin "Taiwan’s GDP expanded 12.5% YoY in 2Q10, driven mainly by an upside surprise in private consumption growth which should increase the overall economy’s resilience in the event that external demand faces any uncertainties. With the economy expanding faster-than-expected, we believe that interest rate normalization will continue for the rest of the year. We expect two more rate hikes in 2H10 (+12.5 bps each) to bring the policy re-discount rate to 1.625% by year-end."

Three themes for the rest of 2010: The US, carry and converging views on recovery (or recession)

- "With the financial market summer behind us, investors are looking ahead to an important few months. Macro returns have been poor, judging from most industry indices. Yet the landscape at present seems to offer an attractive mix for making up lost ground. Net speculative positioning across financial markets appears mixed at best; our CFTC positioning indices suggest speculative positioning has increased in the past month and is broadly positive risk – i.e. long commodities and short USD – but our separate hedge fund positioning analysis suggests this, often market-moving, group is very negative risk, holding shorts in stocks, longs in USD and longs in rates (Macro Chart Alert – Macro hedge fund pessimism, 01-Sep-2010). More important, we appear to be at a major inflexion point for the global economy. For much of this year, the main macro debate had centred on when G4 central banks would begin to normalise the super-easy stance of monetary policy. But over the past month, the tide has turned. Having effectively “eased” policy at its 10 August meeting by committing to sustain its balance sheet at current levels, our economics team now expects the Fed to announce outright balance sheet expansion this autumn (see Bernanke provides a call to action). The BOJ followed up quickly, announcing additional (admittedly modest) policy easing measures at its emergency meeting last week. Finally, the ECB confirmed it will maintain its “full allotment” policy of liquidity provisioning into 2011, even as it hinted at upside risks to its inflation forecast for the coming months."
- "To be fair, core G4 bond markets have moved rapidly to price in this new policy environment – so much so that our rates strategy teams are increasingly uncomfortable with the risk-reward of long duration position. That said, as we look across global financial markets, we still see plenty of opportunities to capture this shifting macro backdrop. In our latest Thinking Macro, we highlight three strategies for trading the shifting policy trends in the next few months."

Foreign exchange market once again in hands of Federal Reserve

- "U.S. real GDP data revisions by the Bureau of Economic Analysis this past July 30 put a dent in our growth and monetary policy scenarios."
- "The data revisions, which showed the U.S. economy running at an even lower capacity utilization rate than initially reported, converged with a soft job market to leave the financial markets feeling disenchanted about the possibility of an imminent interest rate hike in the United States."
- "The euro should not trend up in any sustainable fashion over the medium term. However, if macroeconomic policy in the United States takes a more stimulative turn, the greenback is likely to depreciate to some extent. This is why we believe the European currency will in the short term climb a little above its present level without, however, gaining any undue momentum."
- "Moreover, if the Fed sticks with its extremely accommodative monetary policy, a quick flurry of interest rate hikes this side of the border could launch the loonie into orbit. The Bank of Canada will therefore likely adopt a “stop and go” strategy."
- "Against this backdrop, we still see the loonie attaining parity with the greenback, only now at a slightly later date and at a somewhat slower pace."

Overwriting: adding alpha across Asia

- Overwriting has boosted returns on every Asia index since 2008 "A systematic strategy of selling monthly 1-mo 105% index calls has boosted returns across equity indices in Asia over the past two years. When coupled with a simple momentum filter determining whether or not to overwrite, returns have improved even further. The outperformance has been particularly significant on HSI, where systematic overwriters have outperformed long-only by 960bp annually since Jan 1, 2008."
- Slower-paced upside environment conducive to overwriting "While we remain positive on markets, we do not anticipate the explosive valuation upside that was experienced in 2005-07 and 2009. Instead, we believe markets will rise as earnings appreciate, which we expect to be a lower volatility, more gradual move higher and conducive to buy-writes."
- We screen for buy-writes: China Telecom, KB Financial, Canon "The additional returns from overwriting have turned many negative performing stocks into positive performers. On AEJ telcos, consumer, and utilities, for example, overwriters have outperformed by over 30pp since 2008. We screen for opportunities and find China Telecom, Canon, and KB Financial attractive buy-writes."

Enterprise 2.0: How companies are tapping the benefits of Web 2.0

- "Web 2.0 is currently the subject of much debate in (expert) public circles – with one of the driving factors being the increasing private use of social media. The growing popularity of the phenomenon – not only among young people – confronts decision-makers with the question of whether they want to deploy Web 2.0 tools actively in their own company. Companies can no longer ignore Web 2.0: the fact that the young generation is making a habit of Web 2.0 indicates that its importance will increase in future."
- "Today, 20% of the companies in the US and Europe use blogs, forums or wikis for internal or external purposes. Web 2.0 applications offer the opportunity to develop networked exchanges and consolidate knowledge. Web 2.0 builds on the input of the participants. In this way, Web 2.0 tools offer recognisable advantages over Web 1.0 communication and traditional knowledge management."
- "Web 2.0 use is predicated on a corporate culture that is big on openness and transparency. Companies must ask themselves the basic question of whether they are ready for this. Clear targets and supportive management are key to the success of Web 2.0 projects."
- "Sequencing: first in-house, then externally – first light-touch, then process-oriented. Companies often start to experiment in-house with Web 2.0 tools before they actively involve their customers or suppliers. Communication and marketing are still the primary objectives linked with Web 2.0 today – but there is also potential to be tapped in the areas of innovation and collaboration."
- "External use: experiments with social networks and microblogging. Frequently, companies recycle information produced for traditional corporate communication on these platforms. But this has little impact on corporate processes and their communication culture. This contrasts, for example, with a corporate blog that opens the door to the critics and their issues, demanding an open exchange of views."

Two Risks, Two Views

- Long double-dip risk — "in August, markets responded negatively to the slide in the US data. Yet our economists continue to believe that double dip concerns are overstated. And, even if they do come to fruition, we believe corporates in core Europe are relatively well equipped to handle the downside. So we retain a moderate long overall."
- Short periphery credit risk — "although sovereign spreads were under pressure in August, we did not see the same divergence in core vs. periphery corporate spreads as earlier this year. Our work on past sovereign crises suggests this could be temporary. We’d be short periphery credits, especially the banks."
- Don’t chase the real junk — "rock bottom spreads analysis suggests credit is least well protected against another economic downturn at the bottom end of the credit quality curve. We favour being slightly more conservative, and holding double- and triple-Bs rather than triple-Cs."

Domestic Switch Over?

- Volatile — "Equity markets have appeared almost schizophrenic of late. Mid-year optimism gave way to a new sell-off in August before another rally this month. The six-month trading range is intact; we continue to expect an upside breakout in Q4."
- Multiple contraction — "Emerging markets are largely flat in 2010 (+2%). Earnings have risen strongly – even if momentum is now slowing. The consequent severe multiple contraction this year (trailing P/E from 20x to 14.7x) represents a buying opportunity, assuming the global economy and earnings stay on track."
- Rotation Over? — "The well-documented switch from global cyclicals into domestic growth stocks (which generated outperformance of 10% over the summer) seems to be ending, based on long-term optimism over the global economy, combined with rich valuations in domestics (notably consumer staples)."
- Valuations v. Earnings — "Across sectors on valuations and EPS momentum, the cyclicals look far better placed than most domestic sectors, notably Cons. Staples. Also, Industrials look rich, while Health Care, IT, Telecoms and Utilities are attractively valued. We are Overweight Materials and Underweight Cons. Staples."
- Stock Screens — "We screen for Global Cyclicals with 2011 P/Es of 9x EPS growth; the list includes Vale, S-Oil, Severstal, Mechel, Adaro and BBMG. We screen for Consumer Staples stocks with P/Es >20x and weak EPS growth; the list includes Modelo, Hindustan Unilever, Tsingtao, CP ALL and BIM."

Asia: Markets revive, backed by positive regional indicators

- Markets revive, backed by positive regional indicators "Asian markets were on the upside over the last week, encouraged by strong regional indicators and improved global sentiment."
- China’s PMI and 2Q GDP for Australia underscore Asia’s economic vitality "China posted a better-than-expected August PMI (see Highlights). Moreover, 2Q GDP growth in Australia also beat expectations (3.3% y/y, consensus: 2.8%), as domestic and external demand improved. That said, Korean exports fell in August (see Highlights), as regional export growth continues to show signs of slowing. On the inflationary front, prices remained under control in Korea (2.6% y/y) and Thailand (3.3% y/y), and picked up in Indonesia (6.4% y/y)."
- The uncertain global environment is keeping monetary authorities on a cautious footing "As expected, Bank Negara Malaysia and Bank Indonesia left their policy rates unchanged last week. However, Bank Indonesia raised its reserve ratio to 8% from 5%, in order to drain liquidity in the midst of rising inflation. Moreover, the Bank of Japan and the government unveiled a new stimulus plan (see Highlights)."
- In the coming week…. "Trade figures in China (see What to watch), Philippines and Taiwan, inflation in Philippines and Taiwan, industrial production in India and Malaysia, and machinery orders in Japan. On the monetary policy front, we expect Australia, Korea and Japan to all leave rates unchanged."

Asian Markets – Different Actors, Same Script

- The view amongst investors is that these markets are unusual/different — "The good news is, they are not. If we take the performance of the market since the turn in earnings, the region is up the same percentage as on average in all the cycles since 1975. In all other cycles, Year 2 of the recovery was a year of multiple contraction, and unless markets rise by 36% between now and year end, so will this year. We may perceive it to be different but perception does not make for reality."
- In Year 2, markets historically reward earnings, they are doing so again — "The highest return factors in Year 2 have historically been upward revisions to earnings, rising margin forecasts, and low P/E stocks. Over the last 6 and 12 months the second best investment factor has been EPS revisions. Multiples expand out of the market trough as investors anticipate a recovery, then they look for proof of a recovery. They find proof in the year post the lows, i.e. Year 2-now."
- LEI continues to fall but liquidity indicator showing tentative turn around signs — "Our LEI fell from -56 to -65.5 over the month, signaling that the growth outlook remains weak and has weakened further. The correlation between LEI and equity markets remains high at 0.6. Now the good news, our excess liquidity indicator, which turned negative in March, has turned up (smaller decline) vs. the prior month. This is signaling that, at least in Asia ex, liquidity for the market is less tight than before."
- August was a poor return month as per the last 30 years — "That clearly was no different, and next comes September which historically is only slightly better. August and September are the only two months of consecutive negative returns in Asia ex over 30 years. The surprise is that on average October is actually quite good."

Can the world grow without fiscal and monetary stimulus?

- "Our concern is based on the observation of recent trends: after the tightening of monetary conditions and the slowdown in credit and after the beginning of the reduction in fiscal deficits, there has been a slowdown in global growth."
- "This could show that highly stimulatory monetary and fiscal policies are needed to maintain robust global growth, which would be worrying. Why would that be the case? We can imagine that:
• global private savings have become excessive, which explains the slump in consumption;
• risk aversion has increased due to the crises, which explains the depression in investment;
• the private sector debt ratio has become excessive, and this must be offset by an abnormally expansionary monetary policy."

How can excess indebtedness be avoided?

- "Excess indebtedness always leads to a serious economic and financial crisis (as we saw in the early 1990s, the early 2000s and since 2007). What accounts for excess indebtedness? The fact that borrowers link their borrowing capacity to the present value of their income, their wealth and interest rates, and not to the future values of these variables, which can be unfavourable."
- "So to avoid excess indebtedness, the risk premium in the calculation of borrower solvency (and hence of the maximum acceptable indebtedness) must be increased. If banks and financial markets do not do so spontaneously, the government can do so by taxing credit, only during expansion periods and of course not in periods of sluggish growth or low credit growth, either through banks (which will then include the tax in the cost of the loan) or through borrowers."
- "The counter-cyclical bank capital ratios proposed currently by the Basel committee may play this role."

eIDS in Europe: Not (yet) yielding profits for the cross-border financial services sector

- "E-government and online shopping are on the increase, but the use of cross-border financial services still lags some way behind."
- "At the European level a number of electronic identity cards (eIDs) and the qualified electronic signature (QES) do already exist. Together they possess the potential to form another of the foundations of the internal market for financial services – especially for opening accounts."
- "The future of e-services hinges on two mutually reinforcing developments: harmonising the diverse regulatory regimes across Europe and boosting acceptance among the general public."

Funding update: ECB’s bank liquidity stays on max, periphery needs it most

- Full allotment extension is a positive "The ECB has opted to keep the full allotment stance on bank liquidity supply. This is important as a switch to a competitive auction would be unwelcome news for liquidity ‘have nots’, as we believe it would introduce scope for triggering a sharp increase in funding costs and hence bank COE for the European bank sector as a whole."
- Sharp fall in ECB use for the core’… "Not all European banks are in need of the ECB facilities. In fact, its aggregate use has fallen sharply, driven by a remarkable decrease in use by banks based in the European ‘core’. For these banks, we believe this trend will continue since:
1. Market rates allow for cheaper funding when compared to the cost of ECB facilities, both for euro and US dollar funding.
2. Funding markets have partly re-opened, with the amount of unsecured issuance picking up
significantly;
3. The deposit gap continues to shrink, structurally reducing the reliance on wholesale funding."
- … but the ‘periphery’ has no other funding options "In contrast, the reliance of the Greek banks on ECB funding continues to grow and now stands at the equivalent of 20% of sector assets (European ‘core’ at 1.1%). These banks continue to have limited access to the wholesale funding markets, with the ECB facility a critical funding avenue, the importance of which continues to grow. A switch from full allotment to a competitive auction would result in a spike in the cost of funding, adding further pressure on these institutions, in our view."
- Our preferred sector positioning "We recommend being positioned within the (few) banks that we expect to exhibit positive volume growth trends (eg Unicredit, Erste Bank), to benefit from structural change (eg Lloyds), while we recommend avoiding banks on the ‘periphery’, most notably domestic Spanish, Italian and Greek banks."