alpha generator - davy group · 2018-01-24 · 1 davy research alpha generator passing the baton...

Passing the baton

Global growth expectations back on the rise, the hand-off from public stimulus to private re-engagement now gaining traction

Sovereign debt crisis lessening in impact, indicative of investor look-through to a comprehensive resolution

Reflation trade still intact, but now past its absolute sweet spot in a more nuanced asset-allocation process

January 27, 2011

For the attention of US clients of Davy Securities, this third-party research report has been produced by our affiliate, J&E Davy

Alpha Generator

1 Davy Research

Alpha Generator

Passing the baton

• Global growth expectations back on the rise, the hand-off from public stimulus to private re-engagement now gaining traction

• Sovereign debt crisis lessening in impact, indicative of investor look-through to a comprehensive resolution

• Reflation trade still intact, but now past its absolute sweet spot in a more nuanced asset-allocation process

January 27, 2011 Donal O'Mahony, Global Strategist

Barry Dixon, Head of Equity Research

Aidan Donnelly, Investment Analyst

Ronan O'Houlihan, Investment Director

Please refer to important disclosures at the end of this report. Davy is regulated by the Central Bank of Ireland and is a member of the Irish Stock Exchange, the London Stock Exchange and Euronext. Davy is authorised by the Central Bank of Ireland and regulated by the Financial Services Authority for the conduct of business in the UK. All prices as of close of previous trading day unless otherwise indicated. For the attention of US clients of Davy Securities, this third-party research report has been produced by our affiliate, J & E Davy.

Research Report: Alpha Generator January 27, 2011

2 Davy Research

Contents Foreword 3

Executive summary 4

Asset allocation 5

Investment themes 6

Global economy 10

Money markets and policy outlook 15

Asset market valuations 18

Asset market volatility 22

Asset market correlations 23

Investor sentiment 24

Investor positioning 25

Equity markets 26

Emerging markets 33

Government bonds 36

Corporate bonds 39

Commodities 42

Foreign exchange 45

Tech watch 48

Forecasts 50

Important disclosures 51


3 Davy Research

Foreword Four years ago, exuberant snowboarders at the World Economic Forum in Davos were not wont to embrace official forewarnings of mispriced risk premia in financial assets. Four years on, and the world has changed, but the snowboards remain, and Davos is shifting its emphasis away from crisis-management towards a potential global growth spurt. Optimism is founded on the healing nature of past deleveraging efforts, on the reflationist commitment of leading policymakers, and on the increasing hegemony of EM nations on the global economy stage. The baton-pass is finally underway between public stimulus and private re-engagement, and self-sustaining economic expansion is the ultimate prize. However, this transition is not without its challenges, nor indeed potential policy missteps. It is the task of this document to assess such risks, by way of objective input into the global asset allocation process. Donal O'Mahony, Global Strategist


4 Davy Research

Executive summary Growth transitioning to a more self-sustaining phase

• Global growth expectations back on the rise, some incipient rebalancing between developed and developing economies reinforcing a more benign outlook.

• 'Hand-off' from public stimulus to private re-engagement now gaining traction, aided by waning deleveraging impulses and grinding sentiment uplift.

• Policymakers have reinforced their reflationist credentials, with transmission effects apt to improve as credit multipliers revive.

Economic risks more fundamental than systemic

• Euroland sovereign credit crisis endures, but cross-markets' fallout less so, suggestive of investor look-through to a comprehensive resolution.

• Headline inflation risks clearly augmenting, most acutely in the EM arena; latter tightening will extend, albeit more of the 'quantitative' (credit controls, price controls, capital controls) variety.

Asset-allocation increasingly nuanced

• Global reflation trade still extant, if perhaps past its absolute sweet spot; 'risk-on/ risk-off' correlations now giving way to a more nuanced asset allocation process.

• Preference remains for real (equities, commodities, index-linked) over nominal (conventional bonds) assets, with equities in the vanguard on relative valuation and investor repositioning grounds.

• Treasury bond yields steadily reconnecting with underlying fundamentals; orderly bear market in prospect, but disorderly outcome may yet follow a reorientation of sovereign credit concerns.

• US dollar struggling to exploit euro currency travails, with explicit Sino/Japanese support for the EU project a clear marker of reserves diversification intent; gold to retain its preferred currency status.


5 Davy Research

Asset allocation

Table 1: Asset allocation matrix (three-month view)

Equities Bonds Credit Money Forex/€

Euroland +1 -2 0 -1 N/A

UK +1 -2 0 -1 -1

US +2 -2 0 -1 -1

Japan +1 -1 0 0 0

EM 0 -2 -1 -1 +1

Code: +3/-3 very attractive/very unattractive

View Recommendation

Equities • Improving global macro/earnings outlook bolstering valuation support

(absolute and relative) for a de-rated and under-owned asset class.

• Transition from debt-deflationary environment to a mildly inflationary alternative additionally supportive on margins expansion grounds.

• Exit EM overweight on accumulating policy risks, whilst upgrading US market on stepped-up earnings momentum.

• Continue to favour cyclical plays (industrials, IT and especially consumer discretionary) over defensives (utilities).

Bonds

• Reflationary policies increasingly gaining traction with economies and investors, benchmark yields duly pressured higher in consequence.

• Bond risk premia historically depressed, allowing ongoing normalisation without injurious real economy/asset market side-effects.

• Short duration, eyeing 4.68% breakout risk in 30-year Treasuries. Fade curve steepeners for a more neutral disposition.

• Position for wider Atlantic spreads, and more sustained reconvergence of euroland core/periphery. Long index-linked.

Credit • Credit metrics still supportive of ongoing spread compression, although

total return prospects no longer outsized as benchmark yields advance.

• Deleveraging cycle is over, with M&A now in the early throes of revival. Credit event risks to remain more idiosyncratic than systemic protem.

• High beta and high yield the outperformers as yield grab extends; BB still the risk/reward sweet spot in sub-investment grade space.

• Financials still blighted by sovereign/regulatory fixations, but attractive valuations to trigger catch-up gains as crisis resolves.

Money

• Unconventional policy strategies drawing to a close, with 'exit' strategies now back in focus for both liquidity and rate settings.

• Distinctive policy reaction functions make for a highly uncertain outlook, but generalised tightening risks are greater than pre-supposed.

• Continue with outright short positioning and bear-flattening calendar plays across 2011/2012 Libor futures strips.

• Box-trade eurodollar/euribor strips, long the spread in 2011 maturities and short the 2012s.

Forex

• Low conviction levels across G7 foreign exchange given multiple cross-currents, but EU debt resolution will propel euro crosses higher.

• EM currency revaluations still the line of least resistance, albeit somewhat constrained by pervasive interventionist mindsets.

• Defensive US dollar approach, eyeing 75.60 revisit on TWI. Long euro and yen crosses, short Swiss franc and sterling.

• Overweight EM currencies generally, and Asia basket specifically. Long SEK (versus CAD/AUD) amongst G10 minors.

Source: Davy


6 Davy Research

Investment themes Double-dip fears abated The aftershocks of the global credit crisis continue to reverberate, but their detrimental impact on economic performance and prospects is patently on the wane. Last year’s 'double-dip' preoccupations have now faded from view, that second-quarter momentum loss signalling a pause to refresh rather than endure. Such refreshment is apparent from the grinding recovery in financial conditions to levels highly conducive to the global reflation trade. Policy accommodation is a necessary but not sufficient condition for such a reflationary end-game. Sufficiency will stem from the self-sustaining re-engagement of private sector agents in the economic process, such that the financial transmission effects of extraordinarily stimulative policy stances can increasingly materialise. Such is the inflexion point at which the world economy has now arrived. The 'quantity' of 2011 global growth performance might not differ markedly from the 2010 out-turn, but the 'quality' of such growth may substantially improve.

'Hand-off' from that initial policy- and inventory-induced growth surge to a more sustainable economic expansion is critically dependent upon those post-crisis deleveraging instincts being exhausted across both the bank and non-bank sectors. Happily, time heals, and improving credit impulses are finally being displayed across the developed economies. Bank lending standards are on an easing trajectory, while corporate and household borrowing appetites are slowly reviving beyond the defensive refinancing activity of the past three years. Any pick-up in private sector releveraging would be well timed, given the deleveraging pressures now being brought to bear on strained public finances. Improving credit conditions are particularly important for the revitalisation of the small business sector, whose critical contribution to employment creation in the major industrialised economies is routinely under-appreciated.

• The aftershocks of the global credit crisis continue to reverberate, but their detrimental impact on economic performance and prospects is patently on the wane

• The 'quantity' of 2011 global growth performance might not differ markedly from the 2010 out-turn, but the 'quality' of such growth may substantially improve

Figure 1: Global economic surprises

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• Bank lending standards are on an easing trajectory, while corporate and household borrowing appetites are slowly reviving beyond the defensive refinancing activity of the past three years


7 Davy Research

Policy stances still highly accommodative Of course, the rebound in global growth expectations is also directly attributable to the policymakers themselves, given their impressive reaffirmation of reflationist intent in the midst of recent 'soft patch' fixations. Pride of place in this respect lies with the US authorities, whose renewed injections of both monetary and fiscal stimuli constitute an increasingly potent tailwind for global growth momentum. To be sure, such bravura has not been replicated elsewhere. However, the recent willingness to forestall 'exit' strategies for emergency liquidity operations and/or interest rate settings, across both the developed and developing world, is a clear display of central-banking solidarity towards the common goal of global economic rehabilitation.

Figure 3: Euroland SovX CDS and S&P500 Index

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Figure 2: US small business credit conditions and hiring plans

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Source: Bloomberg


8 Davy Research

Whereas monetary policymakers have remained, broadly speaking, on the same page, the fiscal authorities are demonstrably less so. Although the issue of public debt sustainability is a global concern, the enforcement of fiscal discipline differs markedly across the major blocs. Varying degrees of structural deficits are a part-explanation in this regard, but perhaps more influential is the willingness or otherwise of bond market 'vigilantes' to enforce such discipline. That the evolving sovereign credit crisis has thus far been confined to the euroland area is a telling reminder that the real crisis lies not in public debt levels per se, but rather in the options available to finance them. The crisis in euroland endures, evidenced by those fresh peaks for sovereign CDS indices in some of the early sorties this year. However, fallout across the broader asset classes is not what it was, indicative perhaps of investor look-through towards a comprehensive resolution, one that the euroland authorities appear increasingly minded to deliver.

Inflation risks augmenting A clear risk is that investor concerns regarding public debt sustainability become more globalised over the next 12 months, thereby imposing a far broader constraint on fiscal policymakers than has been the case to date. Meanwhile, an incipient constraint on monetary policymaking has already unfolded. Headline inflation risks are augmenting across the global economy, courtesy of a surge in key commodity prices as physical markets tighten. Such risks are being felt most acutely in EM regions, wherein stronger growth dynamics and sustained liquidity inflows are reinforcing the inflationary threat. Benchmark policy rates have been lifted in China, Thailand, South Korea, Russia, Brazil and India over the past four weeks, and more will follow. However, these mercantilistic nations will likely lean more heavily on 'quantitative tightening' (viz credit controls, price controls, capital controls) in order to mitigate unwelcome currency appreciation. Headline inflation risks represent a conundrum for the central banks of more slowly-recovering developed economies. The Bank of England is one obvious candidate here, but the ECB is now also displaying some initial policy discomfiture in this regard.

Reflation trade past its sweet spot All told, the combination of strengthening growth prospects, improving balance sheets, easy policy stances and enhanced financial transmission effects represent a benign backdrop for financial market performance. However, while the global reflation trade is still extant, it may now be past its absolute sweet spot. The heightened 'risk on/risk off' correlations of the past 12 months appear to be giving way to a more nuanced asset allocation process. Global liquidity conditions remain abundant, but competing wants for such liquidity are now developing, both between economies and markets, and among the various asset classes themselves.

Investor preferences will likely be swayed by real (equities, commodities, index-linked) over nominal (fixed income) assets, with equities in the vanguard on both relative valuation and investor positioning grounds. The M&A cycle is now gathering pace, and this pick-up in 'insider' appetite for risk assets has indeed proved to be the harbinger of similar behavioural shifts across both institutional and retail investor classes.

• Although the issue of public debt sustainability is a global concern, the enforcement of fiscal discipline differs markedly across the major blocs

• A clear risk is that investor concerns regarding public debt sustainability become more globalised over the next 12 months, thereby imposing a far broader constraint on fiscal policymakers than has been the case to date

• Strengthening growth prospects, improving balance sheets, easy policy stances and enhanced financial transmission effects represent a benign backdrop for financial market performance

• The combination of under-ownership and under-valuation augurs well for the equity asset class in 2011, all the more so with improving profit margins yet to establish their peak


9 Davy Research

The combination of under-ownership and under-valuation augurs well for the equity asset class in 2011, all the more so with improving profit margins yet to establish their peak.

Figure 4: G10 FX Carry and S&P500 Index

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In fixed income, benchmark Treasury yields are steadily reconnecting with underlying fundamentals, QE2 distortions notwithstanding. The supply pressures on this market are unrelenting, but the captive demand evident during the post-crisis period is now receding, suggestive of higher yields ahead. Benign policy rate settings should ensure an orderly adjustment, but a more disorderly outcome could yet follow any migration of sovereign credit concerns across the Atlantic. This theme might also reveal itself in the foreign exchange market, where that recent explicit Sino/Japanese support for the euroland project (in both words and deeds) is a clear marker of reserves diversification intent. Against this backdrop, gold appears likely to retain its preferred currency status.

Figure 5: 10-year Treasury yields and US economic surprises

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10 Davy Research

Global economy It is fair to say that the global economy is in a far happier state than was the case six months ago. Then, the world was gripped by fallout from the euroland sovereign credit crisis, with widespread predictions of economic 'double-dip' as negative feedback loops resurfaced. Now, the spectre of double-dips has disappeared from view, airbrushed away by rebounding economic data points and revived confidence readings.

Growth momentum improving, and rebalancing The IMF's prior forecast of 4.8% global growth for 2010 has now been raised to 5% and although some moderation is still expected (to 4.4%) in 2011, activity will increasingly resemble a self-sustaining expansion as private sector deleveraging instincts fade. Global growth performance will remain highly uneven, however, with emerging economies still in the vanguard, but improving prospects for the US economy will help bridge the gap to some degree between developing and developed nations.

Once again, the recovery in economic prospects is testament to the reflationist zeal of global policymakers, who responded to last year's momentum loss with collective stimulatory intent. The US authorities are proving to be exceptionally motivated in this respect, evidenced by yet further monetary and fiscal injections before the end of last year.

Of course, such unfettered US policy-making contrasts starkly with more constrained circumstances elsewhere, and not least in euroland, where pre-emptive fiscal tightening is being foisted upon struggling peripheral economies by uncooperative bond markets. However, the ECB has endeavoured to provide some offset, delaying its exit strategy from unconventional liquidity support. Meanwhile, monetary tightening has also been forestalled in many faster-growing economies across the developed and developing world. Such combined re-nurturing of global financial conditions is once again bearing fruit, with global activity indicators now back on an upward curve.

• The IMF's prior forecast of 4.8% global growth for 2010 has now been raised to 5%

• Global growth performance will

remain highly uneven, with emerging economies still in the vanguard, but improving prospects for the US economy will bridge the gap to some degree between developing and developed nations

Figure 6: US financial conditions and global PMI composite

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11 Davy Research

Corporate risk appetites reviving The combination of recovering economic momentum, ongoing balance sheet repair and highly accommodative policy settings is underpinning risk assets and thereby cajoling global corporates to embrace a more expansionary mindset. Cash balances in this sector are at historically elevated levels, and now await productive re-deployment. The omens are clearly improving in this regard, given the incipient revival in M&A activity, a broadening out of capex spend beyond the replacement cycle and, most critically of all, a pick-up in labour demand. With banking systems also better placed to facilitate the credit transmissions process, the year ahead should witness greater traction from the reflationary policies in place.

US jobs engine cranking into gear Such trends are increasingly apparent in the US economy, where the recovery is broadening out in a more balanced and sustainable fashion. It is instructive to note the convergence of ISM manufacturing and non-manufacturing indices at their current robust readings (57), signalling catch-up by the services sector after an initially sluggish response to US recovery. The importance of such reconvergence stems from the fact that services are the main job-creating engine of the US economy. Labour market indicators are improving on cue, that conspicuous decline in weekly jobless claims data being corroborated by rebounding private services sector payrolls and a declining unemployment rate.

• The combination of recovering economic momentum, ongoing balance sheet repair and highly accommodative policy settings is underpinning risk assets and thereby cajoling global corporates to embrace a more expansionary mindset

Figure 7: US CEO confidence and S&P500 index

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12 Davy Research

Small firms joining the recovery effort Undoubtedly, payroll creation continues to lag that of previous recovery experiences, casting doubts on the durability of the current expansion. A key element in this story is the US small firms sector, which employs over half the US workforce, but whose participation in the recovery to date has been severely retarded by non-availability of credit. US bank lending standards have been on an easing trajectory for the past year, but the willingness to extend loans to small firms is of more recent vintage, and is in part the response to explicit Federal Reserve interjections. Nonetheless, this particular spigot has now re-opened, and improving credit conditions have triggered a rebound in capital spending and hiring intentions to 28-month highs.

US consumers back in the malls The rebalancing of US growth contributions between the manufacturing and services sectors, and between large corporates and small, will also deliver that much-needed rebalancing between firms and households so necessary for self-feeding expansion. For all the well-touted concerns regarding the over-indebted US consumer, it is clear that households are again responsible for an increasing share of the US recovery dynamic. Household asset/liability ratios are again tracking higher, suggesting that the worst of the deleveraging process is now complete. Credit impulses are improving, slowly in respect of housing, but more abruptly so in the case of auto purchases and other consumer durables. Overall consumer spending appears to have tracked at a 4% annual growth rate in the last quarter, the best performance in four years, and is likely to reclaim the mantle of US growth driver during 2011 as housing incomes rebound.

• Improving credit conditions have triggered a rebound in capital spending and hiring intentions to 28-month highs

• Household asset/liability ratios are again tracking higher, suggesting that the worst of the deleveraging process is now complete

• Overall consumer spending appears to have tracked at a 4% annual growth rate in the last quarter, the best performance in four years, and is likely to reclaim the mantle of US growth driver during 2011 as housing incomes rebound

Figure 8: ISM manufacturing and non-manufacturing indices

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Figure 9: ISM manufacturing employment and NFIB hiring intentions

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13 Davy Research

Durable Euroland performance One of the most encouraging features of the past several months has been the ability of the euroland economy to maintain its recovery momentum in the face of the sovereign debt crisis. Admittedly, this is in large part due to the stellar performance of the German economy which, with a GDP growth out-turn of 3.6% in 2010, enjoyed its strongest expansion since 1990. Crucially, this recovery coincided with a sharply improved labour market, the unemployment rate now at 19-year lows.

Germany's improving labour markets are not being replicated across the euroland region, those performance gaps between core and peripheral economies continuing to endure. Of course, there are structural ingredients to such periphery economy shortcomings, and these will remain until enforced fiscal and regulatory adjustments finally bear fruit.

Figure 10: US consumer credit outstanding and auto sales

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• One of the most encouraging features of the past several months has been the ability of the euroland economy to maintain its recovery momentum in the face of the sovereign debt crisis

Figure 11: European unemployment rates (EU, Germany, Spain)

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14 Davy Research

However, with Germany accounting for over one-quarter of euroland output, and overall EC industrial and consumer sentiment readings having returned to late-2007 levels, there are legitimate grounds for further topside surprises in euroland growth performance this year.

Clouded UK outlook In contrast, the outlook for the UK economy remains mired in uncertainty, that decent GDP momentum build during mid-2010 being ostensibly derailed in the final quarter. Whereas the business investment and traded goods sectors remain primed for growth, the household sector is being buffeted by weakening real incomes and a developing fiscal squeeze. Although the recent decoupling of CIPS manufacturing and services indices has been magnified by weather effects, the constraints on domestic demand are now building, being reinforced by a more cautionary labour market trend. With nominal GDP gains also leaking more into higher prices than volumes, the Bank of England's policy dilemma is apparent to all.

In truth, the Bank of England is not alone on the policy dilemma front, courtesy of strengthening headline inflation rates across virtually all economies. Sharp commodity price advances (especially food) are the culprit here, with disproportionate impact on the more heavily skewed CPI baskets of the developing world. Policy tightening has now resumed in these latter regions, albeit still clearly circumscribed by undesirable currency appreciation. Policy responses in the developed economies are less clear-cut, not least given the differing mandates under which major central banks operate. Nonetheless, policy risks may be greater than pre-supposed as 2011 progresses, leaving renewed macroeconomic uncertainties to follow with a lag. Table 2: Summary of GDP forecasts (volume range, % change year-on-year)

Davy 2010

Consensus 2010

Davy 2011

Consensus 2011

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Euro area 1.8 1.7 1.5-2.0 1.6

UK 1.7 1.7 1.8-2.2 2.0

Global 5.1 5.0 4.4-4.8 4.4

Source: Davy; Consensus Economics; IMF

• The outlook for the UK economy remains mired in uncertainty

Figure 12: UK CIPS manufacturing and services indices

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15 Davy Research

Money markets and policy outlook The act of monetary policymaking has always been viewed as more of an art than a science, but the artistic endeavours of the major central banks have become even more uncharted in recent times. The challenges posed by the global credit crisis have spawned an array of unconventional policy responses, embracing both liquidity support operations and balance sheet expansions. Such interventions were necessitated by dysfunctional financial market conditions, but they have not been without risk of unintended consequences, not least in terms of the efficacy of future 'exit' strategies, but also on a more real-time basis.

Unintended consequences of easy policies The abundance of global liquidity, reinforced by the Federal Reserve's QE2 launch in early November, has sparked a surge in commodity prices, most notably in the agricultural complex which now reconverges on 2008 peaks. This clearly represents a major policy challenge for EM economies, whose robust growth profiles are threatening to overheat on foot of excessive capital inflows and rising inflation expectations. However, presentational problems are also developing for the central banks of more slowly-recovering OECD economies, where headline inflation rates are rebounding above targeted levels, and where inflation expectations are firming in sympathy. And all of this, remember, from the starting point of 'emergency' policy rate debasement across the major economic blocs. Money market participants are paying heed, and forward curves are shifting higher in consequence.

With the South Korean president declaring "a war against inflation" in early January, it is no surprise that his central bank and those of the BRIC nations and Thailand have further tightened monetary policy during the past four weeks. Real interest rates are patently too low in the EM world. Nonetheless, on the basis that exchange-rate stability is as important as price stability for many central banks, it is likely that any further rate hikes will be delivered cautiously in the year ahead. Rather, policymakers will likely lean more heavily on 'macroprudential' measures

• The challenges posed by the global credit crisis have spawned an array of unconventional policy responses, embracing both liquidity support operations and balance sheet expansions

• The abundance of global liquidity, reinforced by the Federal Reserve's QE2 launch in early November, has sparked a surge in commodity prices

Figure 13: Forward rates (US, Euroland, UK)

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• On the basis that exchange-rate stability is as important as price stability for many central banks, it is likely that any further rate hikes will be delivered cautiously in the year ahead


16 Davy Research

to restrict capital and credit flows and thereby mitigate currency appreciation risk.

Post-QE2 steer nervously awaited

The pick-up in commodity prices is also beginning to reverberate across reported US inflation rates (both headline and pipeline), but for now this appears of scant concern to a Federal Reserve actively engaged in 'opportunistic inflation' in order to deliver on its dual mandate of full employment and price stability. Bernanke's QE2 experiment has certainly sparked an inordinate degree of criticism at home and abroad, with certain Congressional members even calling for a reopening of the Federal Reserve Act to adjust the Fed's mandate. The FOMC is stoically resistant in this regard, its latest minutes signalling a "high threshold for making changes to the program" as economic conditions evolve. For the moment, the Fed's renewed balance sheet expansion continues apace, its $600bn purchase programme for Treasury securities set to run its full course to the end of June.

In fairness, QE2 was not without some opposition around the FOMC table itself. Hoenig's dissension was a standing dish throughout 2010, given his concerns that "high levels of monetary accommodation increased risks of future imbalances and, over time, would cause an increase in long-term inflation expectations". Hoenig has now rotated off the FOMC aviary, but replacing him at the hawkish end are Messrs Fisher and Plosser, the latter now publicly concerned that the bank's "aggressive" monetary stance "may soon backfire" if the Fed does not "begin to reverse" it. This remains a minority view, but financial markets will be seeking a post-QE2 steer on Fed policy intent, and that outlook is perhaps more clouded than generally believed.

Hawkish feather-ruffling elsewhere A sudden cloud has also appeared overhead the ECB's policy outlook, this courtesy of a more hawkish Trichet disposition at the latest press conference. Euroland HICP is now above target and will likely remain so for several months at least. In response, a single-minded ECB has formally shifted its inflation risk assessment to the upside, and is now in

• For the moment, the Fed's renewed balance sheet expansion continues apace, its $600bn purchase programme for Treasury securities set to run full course to the end of June

Figure 14: Federal Reserve balance sheet and Fed funds rate

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17 Davy Research

"monitoring closely" mode. Of course, the sovereign credit crisis is not yet resolved, and the ECB is a key player in this saga. However, Trichet was quick to remind that the ECB's liquidity operations and policy rate decisions may disconnect, as was the case (however fatefully) in July 2008. Indeed, a 'one cap fits all' monetary policy constraint in a twin-speed euroland economy may best be overcome by recalibrating interest-rate requirements for the strengthening core, whilst maintaining liquidity subventions for the struggling periphery. The most discomfited of all the major central banks is likely the Bank of England, for which inflation concerns are hardly a recent phenomenon. UK CPI (at 3.7% in December) has remained above its 2% target for 52 of the past 66 months, and appears condemned to a 3% handle for the remainder of this year. Media fixation is building, and the general public's longer-term inflation expectations are also rising (3.8% latest per YouGov survey), this a far from ringing endorsement of MPC policy stewardship. No sign of panic yet for Mervyn King & Co, but the MPC has been publicly split on its appropriate policy stance since October last, and global inflation pressures have intensified in the interim. Be reminded that this central bank has previous form in the 'fine tuning' stakes, so a precautionary hike across the bow cannot be ruled out as the year unfolds.

Table 3: Interest rate forecasts

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Key rate 3M LIBOR Key rate 3M LIBOR

Euroland 1.00 1.10-1.20 1.50-2.00 1.90-2.10

UK 0.5 0.75-0.95 1.00-1.50 1.35-1.55

US 0.00-0.25 0.30-0.50 0.50-1.00 0.90-1.10

Japan 0.00-0.10 0.15-0.35 0.00-0.10 0.25-0.45

Source: Davy

• A 'one cap fits all' monetary policy constraint in a twin-speed Euroland economy may best be overcome by recalibrating interest-rate requirements for the strengthening core whilst maintaining liquidity subventions for the struggling periphery

• The most discomfited of all the major central banks is likely the Bank of England, for which inflation concerns are hardly a recent phenomenon

Figure 15: UK inflation expectations and bank base rate

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18 Davy Research

Asset market valuations Core/periphery sovereign debt spreads in the euroland economy It is a sorry reflection on the current state of play in euroland sovereign bond markets that standard deviations in 10-year yields and spreads now exceed those peak readings of the 1990s, the 1992/1993 ERM disturbances included. Concerns about sovereign credit risk in euroland endure, those design flaws of a suboptimal currency zone (monetary union with fiscal disunion) having been cruelly laid bare by the unfolding consequences of the Greek debt tragedy. Such concerns have been compounded by the reactive and compromised response of EU politicians to deal with the problem, by the reticence of the ECB to instigate overpowering credit easing, and by the missed opportunity to de-link sovereign and banking credit concerns through a credible and comprehensive recapitalisation of the euroland banking system.

According to the theory of interest-rate parity, any yield spread between two bonds is equivalent to the forward exchange-rate premium on one of the two currencies. Thus, elimination of exchange-rate risk (a la EMU) should see yield spreads between comparable bonds effectively disappear. Of course, fixed income investors have never regarded the various sovereign issues as complete substitutes for one another. Since all EMU members have been responsible for own-issuance activity, and have been solely liable for their outstanding debt, so too have individual market differences in both ratings and liquidity determined the evolution of respective yield spreads. Of course, ratings stability and bountiful liquidity ensured negligible risk premia across the EMU sovereign debt divide throughout its first eight years of existence. In this, sovereign spreads were replicating the general debasement of risk premia characteristic of the global credit bubble.

• Concerns about sovereign credit risk in euroland endure

Figure 16: Euroland sovereign spreads

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19 Davy Research

However, they also reflected a fundamental misjudgement on the part of investors regarding the inherent stability of the single currency project.

Nominal convergence mistaken for real convergence Whereas the Maastricht criteria ensured convergence of nominal variables for would-be euroland participants, the implicit assumption that real convergence would necessarily follow on a sustained basis was to prove fatally misguided. Whilst real divergences could initially be anticipated on the basis of disparate economic structures, fiscal settings and creating-creating propensities, the conspicuous absence of labour market flexibility/mobility, macroprudential fiscal surveillance and any associated fiscal transfers ensured that such divergences extended over time.

The consequence was a misalignment of real interest rates across the region, with ensuing misallocations of capital serving to amplify individual economic and asset price cycles, and thereby sowing the seeds of subsequent financial instability. The 2007 credit crisis kick-started the process of widening sovereign spreads, but it was the enforced entanglement of bank credit risks (both actual and contingent) that was to impact most acutely on spread volatility and performance.

Perceived default risks expose EMU shortcomings EMU bond markets continue to pay a heavy price for their suboptimal currency status, given a sum-of-parts sovereign credit risk deemed far greater than the whole. The GDP-weighted 5-year CDS of the euroland area now stands at 162bps, substantially above that of the US (49bps) or UK (62bps).This, despite lower aggregate fiscal deficits and debt, a current account surplus, lower inflation bias and, crucially, a necessarily pre-emptive and aggressive fiscal consolidation process.

• Whereas the Maastricht criteria ensured convergence of nominal variables for would-be euroland participants, the implicit assumption that real convergence would necessarily follow on a sustained basis was to prove fatally misguided

Figure 17: Current account balances as % GDP (EU, Germany, Spain)

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• It was the enforced entanglement of bank credit risks that was to impact most acutely on spread volatility and performance

• EMU bond markets continue to pay a heavy price for their suboptimal currency status


20 Davy Research

Liquidity risks confused with solvency risks Euroland's CDS spread represents an elevated risk-premium associated with fiscal disunion, one that raises the spectre of an enforced sovereign default. With the ostensible safety-net of debt monetisation and/or currency devaluation no longer a policy tool for heavily-indebted euroland sovereigns, concerns have grown that the real burden of creditor claims may be more directly reduced via default. With liquidity risks masquerading as solvency risks across the system, aggressive downgrades by rating agencies fomenting investor anxieties, and certain politicians (and market luminaries) seeking to legitimise default as an unavoidable end-game, it is small wonder that the natural investor base for peripheral sovereigns has shrunk dramatically, with self-fulfilling consequences regarding implicit default risk.

Figure 18: Euroland, US and UK CDS spreads (5yrs)

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• Euroland's CDS spread represents

an elevated risk-premium associated with fiscal disunion, one that raises the spectre of an enforced sovereign default

Figure 19: EU public debt and debt financing (% GDP)

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21 Davy Research

Indeed, the instability currently engendered by elevated sovereign default risks has analogies with that hitherto unstable ERM construct. Then, market forces were quick to separate strong and weak currencies and, in self-fulfilling fashion, trigger frequent exchange-rate realignments. To be fair, many (but not all) of these currency devaluations were entirely legitimate on fundamental grounds. Now, a multi-currency arrangement has been replaced by a multi-sovereign alternative, but the latter is also segmenting on the basis of strong and weak names, with repeat risk of a self-fulfilling process towards unnecessary but potentially unavoidable debt realignments (sic).

On the inexorable path to fiscal union Happily, the EU authorities appear finally resolved to end the current crisis, in a manner that can shrink the fiscal disunion premium to the benefit of all. Their key intervention mechanism (EFSF) is already in place, but now requires quantitative and qualitative enhancement to improve its effectiveness. Final details await confirmation, but the prospect of stepped-up bond purchases will mitigate liquidity risks, whilst the quid pro quo of strengthened fiscal surveillance/integration will allay medium-term solvency concerns. Of course, European authorities (and their voting populations) are not yet at the 'political union' stage, so the fiscal disunion premium on sovereign credit spreads will not disappear in full. Further, the threat of future burden-sharing arrangements for sovereign bondholders in the event of any renewed debt crises will likely leave a permanent stain on core/periphery spreads. Nonetheless, it shouldn't be lost that a once suboptimal currency zone is now being rendered more optimal, with a more collectivised approach to fiscal policymaking (and perhaps debt financing) promising a sustained reconvergence of sovereign spreads. Note that the entire spectrum of US investment-grade corporates from AAA to BBB currently resides in a 175bps spread range. A revised steady-state equilibrium for euroland sovereign spreads may lie well within that range.

• The EU authorities appear finally resolved to end the current crisis

• Note that the entire spectrum of US investment-grade corporates from AAA to BBB currently resides in a 175bps spread range. A revised steady-state equilibrium for euroland sovereign spreads may lie well within that range.


22 Davy Research

Asset market volatility

Much of last year was characterised by the steady increase in volatility across all major bond markets. This trend peaked with the heightened concerns around peripheral European concerns. Although levels have fallen since then, they remain at elevated levels. In equities, the absolute level of volatility remains low and well behaved, but the relationship between actual and implied volatility for the S&P continues to be of interest. For most of last year, actual volatility was significantly lower and, in absolute terms, is currently at multi-year lows.

The stability seen in foreign exchange markets for almost two years shows no sign of ending. Across all major currency pairs we have been locked in a tight band of volatility; in the absence of any major global incident, this will likely remain. In the commodity area, the major point of note is the co-incidental reduction of volatility across all sub-categories since the end of November last year. Gold volatility had been trending higher from historically low levels, but this too has recently reversed.

• In equities, the absolute level of volatility remains low and well behaved, but the relationship between actual and implied volatility for the S&P continues to be of interest

• The stability seen in foreign exchange markets for almost two years shows no sign of ending

Figure 22: Currencies*

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23 Davy Research

Asset market correlations

The common topic in the correlations charts this quarter is the emerging nuances of the liquidity trade of the last two years. Up to now the trade was characterised by all beta assets acting alike in a 'risk-on, risk off' fashion. Recently, however, we have begun to observe differentiation in the behaviour of these trades. In the foreign exchange market, valuation constraints are emerging with higher yielding G10 currencies coming under pressure, while EM forex remains structurally cheap. Within the commodity space, the champion of the liquidity trade is very much industrial metal, which continues to perform strongly, while precious metals and foods show signs of fatigue.

In equities, the best example of this trend is in the small/mid cap space. The oft-perceived riskier US small cap index is seeing major changes develop in its relationship with risk aversion assets like Treasuries, gold and the US dollar. The strong negative correlation has broken down. One asset class bucking this trend is the emerging market equities. Correlations between Asian, European and Latin American emerging markets – having weakened for most of 2011 – are now increasing back to highs. Given differential outlooks in these areas, this recent trend may soon unwind.

• Within the commodity space, the champion of the liquidity trade is very much industrial metal

• Correlations between Asian, European and Latin American emerging markets – having weakened for most of 2011 – are now increasing

Figure 24: Asian dollar index and FX carry*

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Figure 25: Commodities*

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24 Davy Research

Investor sentiment Global investor sentiment is back on the rise at both institutional and retail level, those lingering sovereign debt concerns clearly trumped by brightening growth prospects. The State Street Investor Confidence Index has rebounded sharply, with December's 104.4 print scaling nine-month highs. The US sub-component is leading the charge, followed by Asia, although the European index has retreated somewhat on foot of its domestic debt distractions.

US retail sentiment has been trending higher since the mid-2010 lows. The differential of bulls to bears (per weekly AAII survey) spiked to 46.9 in late-December (high since April 2004) before a new-year retreat.

Exuberant equity sentiment is occasioning a more defensive posture in the 'risk free' asset class. Treasury sentiment has retreated to six-month lows (per JPM survey), matching the pull-back in the Bull/Bear index (per SMR survey).

Sentiment bias is broadly unchanged in the currency markets, albeit to lesser extremes than heretofore. Yen overvaluation remains the strongest judgment call (per ML Global Fund Manager Survey), with the euro next in line, albeit this view is moderating in light of the recent market pullbacks. EM currencies are still considered the most undervalued of all, although once again recent market movements have tempered this viewpoint.

• Global investor sentiment is back on the rise at both institutional and retail level

• EM currencies are still considered the most undervalued of all, although once again recent market movements have tempered this viewpoint

Figure 28: Global investor confidence (America, Europe, Asia)

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Investor confidence US Investor confidence Europe Investor confidence Asia

Source: Bloomberg

Figure 29: US equity bull/bear spread (AAII)

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AAII Bulls - Bears Source: Bloomberg

Figure 30: US Treasury bond sentiment

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Figure 31: Perceptions of currency over/undervaluation

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Source: Merrill Lynch


25 Davy Research

Investor positioning A progressive improvement in investor sentiment is also reflected in real money positioning. January's ML Global Fund Manager Survey reports a risk and liquidity composite – combining readings on risk appetites, investor time horizons and cash weightings – of 46, high since April last and well above its longer-term average (40). Cash balances remain very subdued, averaging 3.7% in the latest survey.

Interestingly, the hedge fund community appears to have pared back its risk exposures somewhat after a sustained six-month expansion, both in terms of net long equity positioning (to 31% from 35% in December) as well as in gearing levels (to 1.26x from 1.48x).

Treasury bond positioning is becoming increasingly defensive, with weighted duration ratios running at 98.6% of target (per SMR money manager survey), the low since January 2009. Spread diversification into corporate bond markets endures, with allocations (33.5%) continuing to straddle record highs. In foreign exchange, bearish sentiment towards the euro single currency has once again about-turned sharply, this typifying the repositioning gyrations of the past five months. Long dollar unwinds are also apparent on a multi-currency basis.

• A progressive improvement in investor sentiment is also reflected in real money positioning

• Treasury bond positioning is becoming increasingly defensive

Figure 32: Risk and liquidity composite

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Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010

Risk and liquidity summary Average


Figure 33: Hedge fund positioning

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Figure 34: Treasury duration exposure

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Source: Bloomberg

Figure 35: IMM non-commercial euro longs (versus $)

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Source: Bloomberg


26 Davy Research

Equity markets Still a lot to play for 2010 proved to be another good year for equities with global markets returning an average of 8% following the 23% return generated in 2009. The US outperformed Europe, while Germany was the star performer within the euro area. The performance in emerging markets was mixed following the stellar rise in 2009. The question now is whether equity markets can provide a superior return for the third year in a row. We believe that they can.

Table 4: Equity market performance (local currency)

2008 2009 2010

World -40% 23% 8%

US -38% 23% 13%

Euro area -46% 23% 0%

Germany -40% 24% 16%

UK -31% 22% 9%

Ireland -66% 27% -3%

Japan -42% 19% -3%

China -65% 80% -14%

India -58% 90% 16%

Brazil -41% 83% 1%

Source: Bloomberg

Valuations remain undemanding despite strong earnings growth Global equity markets remain reasonably valued in an historic context, despite expectations of decent earnings growth in 2011 and 2012.

Table 5: EPS growth and valuation by region

Earnings growth (%) P/E

2010 2011 2012 2010 2011 2012

Global 42% 15% 13% 15.0 12.9 11.3

US 42% 14% 14% 15.3 13.4 11.8

Europe 38% 16% 13% 12.8 11.3 10.0

Germany 65% 10% 13% 12.4 11.3 10.0

UK 36% 16% 11% 12.7 10.5 9.4

China 35% 15% 16% 15.7 13.1 10.9

India 23% 24% 21% 16.9 13.7 11.5

Brazil 29% 18% 14% 13.2 11.1 9.7

Source: Bloomberg

• 2010 proved to be another good year for equities with global markets returning an average of 8% following the 23% return generated in 2009


27 Davy Research

Figure 40: Forward P/E for healthcare rel to S&P 500

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Source: Factset

Figure 41: Forward P/E for energy rel to S&P 500

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Source: Factset

Figure 36: Forward P/E for materials sector rel to S&P 500

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Source: Factset

Figure 37: Forward P/E for US industrials rel to S&P 500

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Figure 38: Forward P/E for consumer cyclicals rel to S&P 500

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Figure 39: Forward P/E for US consumer staples rel to S&P 500

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28 Davy Research

Equity markets also look cheap relative to bonds.

Given the relatively attractive valuation levels and mid-teen percent earnings growth, equity markets should return 15-20% this year –making it perhaps the most attractive asset class.

Figure 46: European earnings yield ratio

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10 German bond yield / E 300 earnings yield average = 0.6 Source: Factset

Figure 47: US earnings yield ratio

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US 10 year bond yield / S P X 500 earnings yield average = 0.8 Source: Factset

Figure 42: Forward P/E for IT rel to S&P 500

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Figure 43: Forward P/E for telcos rel to S&P 500

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Figure 44: S&P financials price/book

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Figure 45: DJ Stoxx financials price/book

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29 Davy Research

This assessment depends on two key factors: • the validity of earnings growth assumptions; • the risks to valuation levels.

Earnings growth forecasts look achievable The latest estimates forecast 2011 earnings growth of 14% in the US and 16% in Europe. Both forecasts are based on revenue growth of just over 5%. This implies an increase in margins of almost 100bps, which is impressive in the current environment where input costs (energy and other commodities) continue to rise. This is presumably driven by a combination of the impact of operating leverage as volumes recover and an ability to recover input cost increases.

Top-line growth assumptions are not demanding Global GDP is expected to grow by 4.4% this year, with emerging markets likely to continue to outperform developed economies. US GDP growth is forecast to increase to 3.1% from 2.9% in 2010, while the eurozone area is expected to grow by 1.6%. In this context, is mid-single-digit percent top-line growth in developed markets reasonable? Historically, revenue growth for the S&P 500 index has generally exceeded the rate of US GDP growth. This is due to the impact of revenue growth from outside of the US, particularly in emerging markets.

On this basis, 5-6% top-line growth in the US and Europe this year is not an unrealistic expectation.

Margins close to previous peaks While it is likely that top-line growth can exceed 5%, can margins increase by 100bps or more? Our analysis suggests they can do so without significantly exceeding previous peaks.

• Global GDP is expected to grow by 4.4% this year, with emerging markets likely to continue to outperform developed economies

Figure 48: S&P 500 revenue growth and US GDP growth

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FY 1998 FY 1999 FY 2000 FY 2001 FY 2002 FY 2003 FY 2004 FY 2005 FY 2006 FY 2007 FY 2008 FY 2009 FY 2010 FY 2011

Revenue growth (%) GDP growth

Source: Datastream


30 Davy Research

While it is difficult to get good data on long-term corporate profits margins in the US, we have derived a series using the measure of "Corporate Profits" from the US national accounts as a percent of US GDP. The chart below indicates that implied 2011 margins are at or slightly above previous highs. Given the level of cost rationalisation through the last down-cycle, however, it is likely that margins in this cycle could exceed the previous – implying some further upside is possible. Figure 49: Corporate profits as a percent of US GDP

5%

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Q1 1990 Q2 1992 Q3 1994 Q4 1996 Q1 1999 Q2 2001 Q3 2003 Q4 2005 Q1 2008 Q2 1990

Margin (%)

Implied 2011 margin based on GDP and profit growth forecasts

Source: Derived from US Bureau of Economic Analysis

Valuation Given the consensus view of 15% earnings growth, the second important factor to look at when assessing likely equity market returns in 2011 is valuation. The chart below shows the annual performance for the S&P500, deconstructed between earnings growth and the re- or de-rating of the market in that year. Figure 50: S&P annual returns 1960-2010

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EPS Change Rating Change Trailing PE

Source: Bloomberg


31 Davy Research

As can be seen, a feature of the last two years has been the de-rating in the market. While it is not unusual to see back-to-back years of P/E compression, particularly coming out of a recession, what is of greater interest is that this year could see a further reduction in the valuation ascribed to the market. History would tell us that this process is typically completed by year two, but there have been times when this has not been the case. The period from 2002-2006 is a good case in point as we saw a prolonged five-year compression of valuations. Most periods of de-rating in the market have, not surprisingly, one thing in common – the initial valuation level at which the market was trading. The chart above also shows the end-year trailing P/E for the market. To the extent that the market was trading at an elevated valuation, there has always followed some period of correction. A rule of thumb would seem to be that the greater the valuation disparity relative to recent history, the longer it takes for this to be corrected. So what can we say about 2011? We enter this year with the market trading at P/E levels similar to those seen at the end of the last compression phase in 2002-2006. This would give us some comfort that the period of de-rating is now complete. Could we be wrong about this? There are certainly a number of external factors globally that could cause the market to de-rate. A continuation in the upward move in the price of commodities like oil and industrial metals would form headwinds for companies, particularly for profit margins. Any threat to growth in emerging market countries, either from over- zealous monetary policy social unrest caused by escalating food prices, would heighten risk perceptions, impacting the multiple. Worries about an increased probability of sovereign default or a deteriorating outlook for consumer demand, driven by renewed negative feedback loops, would cause investors to re-assess the valuation they place on equities. But it is not all bad news. There are forces that could drive an upward re-rating for equities. As we have highlighted in past publications, investor appetite for equities has waned significantly in the last 18 months. A reversal of this trend and the commensurate money inflow would be positive. Any upgrade to global growth projections, driven by accelerating consumer demand or business expenditure, would likewise raise the multiple that investors are willing to pay, particularly if the augmented growth forecasts are seen as sustainable into future years. In conclusion, we feel that, absent significant deterioration in the global outlook, there are reasons to believe that the de-rating cycle of the last

• We enter this year with the market trading at P/E levels similar to those seen at the end of the last compression phase in 2002-2006

• Any upgrade to global growth projections, driven by accelerating consumer demand or business expenditure, would likewise raise the multiple that investors are willing to pay


32 Davy Research

two years has now played out, and that any resolution to some of the lingering worries could see some multiple expansion to drive equity prices higher.

Cyclical sectors continue to provide value Earnings growth is still likely to be strongest in cyclical sectors in 2011, with rising commodity/input costs resulting in better pricing and higher volumes driving operational leverage. This is clear from sector growth forecasts. With the market itself looking cheap relative to historic levels, most sectors are also undervalued relative to longer-term averages. In particular, consumer sectors – both cyclicals and defensives – look cheap (as does healthcare), although earnings in the healthcare sector are not as certain. Materials and industrials also have scope to upgrade in terms of both ratings and earnings forecast as the year progresses.

Table 6: Sector earnings growth and valuation

EPS growth P/E P/E

2010 2011 2010 2011 10-year average

Consumer discretionary 51.7% 15.2% 17.6 15.2 18.4

Consumer staples 16.3% 8.8% 15.3 14.1 17.5

Energy 58.6% 13.7% 15.2 13.4 13.1

Financials Na 22.0% 1.2* 1.1* 1.7*

Healthcare 17.8% 7.0% 12.0 11.2 16.7

Industrials 31.4% 18.5% 18.0 15.2 16.5

Information technology 50.9% 12.3% 15.7 13.9 22.0

Materials 79.9% 32.6% 19.0 14.3 16.0

Telecommunication services 5.5% 12.2% 17.7 15.8 14.9

Utilities 11.2% -1.7% 12.5 12.7 13.1

S&P 500 58.3% 13.9% 15.5 13.6 15.0

* Price/book Source: Datastream; Factset

On balance therefore, we would maintain a cyclical bias to portfolios focusing on sectors where input cost recovery is more likely, and where companies have strong financial positions.

Table 7: Davy sector weightings

Overweight Market weight Underweight

Industrials Materials Financials

Information technology Healthcare Telecommunications

Consumer cyclicals Energy Utilities

Consumer staples

Source: Davy estimates

• Earnings growth is still likely to be strongest in cyclical sectors in 2011

• We would maintain a cyclical bias to portfolios focusing on sectors where input cost recovery is more likely and where companies have strong financial positions


33 Davy Research

Emerging markets Investors have been excited by the inflationary consequences for emerging markets. The thesis is that emerging markets will inevitably have very low or negative real interest rates for a prolonged period. With banking systems flush with liquidity, this should enable them to fund a great credit-driven increase in asset prices and to produce very high profits for foreign investors, as such asset price rises are accompanied by controlled exchange rate appreciation. Investors in assets will be the main beneficiaries as the rebalancing of global growth results in an appreciation of the real exchange rate in emerging markets, driven by higher inflation. As exchange rate intervention can enforce such price rises through negative real interest rates, asset prices will do particularly well in this period. What’s not to like in that scenario? Well, it assumes that domestic policymakers will resign themselves to the inevitable bubble; that emerging market policymakers learned nothing from the 1997-1998 crash; and that they are still intellectually aligned with Greenspan’s view that their job is not to stop bubbles but to clean up after them. In short, it assumes a degree of stupidity that may be possible but is not probable. The more inflationary the current monetary system proves to be, the more likely it is that it will be changed. Those changes will begin in the emerging markets where inflation is already accelerating. Emerging countries are entering more challenging macro territory. The two-speed nature of global growth leads to a monetary stance in the developed markets that is too loose for the emerging markets. The result is significant capital inflows into EM, which leads to stronger local currencies and puts domestic central bankers in a tough spot. EM policy makers are likely to confront more difficult trade-offs between growth and inflation.

Inflation is staging a comeback A look at recent data and comments in this area is very instructive. • rate increases in the BRICs, Thailand and South Korea. • Malaysian inflation rising above 3%; • the 4.5% petrol price hike in India will be a precursor for RBI

tightening by 50bp; • Indonesian inflation concerns have led to an IDR6.9trn decline in

foreign-held Indonesian bonds; • a jump in Chile's inflation expectations for 2011 to 3.6% from 3.2%. Of equal importance was the statement by the Brazilian Central Bank, which made it clear that it will rely on other measures in addition to raising interest rates, making a reference to the macroprudential measures implemented at the end of last year. It is no secret that policymakers are concerned with BRL appreciation. In our view, the Central Bank will try to raise interest rates by less than would be required under current circumstances by blending traditional monetary policy with specific measures aimed at containing consumer demand.

• The more inflationary the current monetary system proves to be, the more likely it is that it will be changed

• The two-speed nature of global growth leads to a monetary stance in the developed markets that is too loose for the emerging markets


34 Davy Research

The current monetary system is transforming private-sector capital flows into high-powered money in emerging markets. One way to mitigate this is to use capital controls to reduce these inflows and the balance-of-payments surplus. If such surpluses can be reduced, then the inflationary impact will be reduced. Capital controls represent a barrier to arbitrage and can give authorities greater power to move interest rates independently of the Federal Reserve while simultaneously managing the exchange rate. Investors need to realize that these controls are intended to allow local authorities adopt tighter monetary policy. They signal a clear intention to stop an expected bubble. While they may not work immediately, the key point is that they can be progressively tightened.

Figure 52: Relative performance MSCI world versus MSCI emerging

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Figure 51: Brazilian Real

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• Capital controls represent a barrier to arbitrage and can give authorities greater power to move interest rates independently of the Federal Reserve while simultaneously managing the exchange rate


35 Davy Research

Investors will thus increasingly be playing a game of chicken with the emerging market authorities. If capital continues to flow in following the first capital controls, then the authorities will have to tighten further. However, this turns emerging market investment into something very different than profiting from a bubble or benefiting from higher long-term economic growth: it becomes a gamble that markets can overwhelm governments. This is a dangerous game to play when the Washington consensus in favour of unfettered markets is on the wane, especially since you can buy cheap equities in developed markets. Developed equities relative to emerging equities are at a level that has previously halted underperformance. As the Fed’s recent actions have shown, it is desperate to promote credit growth rather than snuff it out. This acceleration in credit growth, when it comes, will boost equity prices. Investors in the emerging markets are now in the cross-fire as the authorities seek to control credit growth. We continue to favour participating in emerging markets economic growth through developed equity markets.

• We continue to favour participating in emerging markets economic growth through developed equity markets


36 Davy Research

Government bonds Benchmark government bond yields have not always been positively correlated with the ebbs and flows of global stock markets over the past few years, but such has certainly been the case during the past three months. The formal launch of the Federal Reserve's QE2 gambit on November 3rd has boosted the reflationist mindset of financial market participants, and this has been further reinforced by strengthening global growth signals following that mid-year lull. The Treasury bond market has led the charge towards higher yields, with the pivotal 10-year rising by 100bps (to a 3.56% peak) in the post-QE2 aftermath, and this move primarily attributable to a rebound in real yields from their exceptionally depressed levels. Bond risk premia on the rebound Adding to the pressure for higher Treasury yields was a substantial and unexpected US fiscal stimulus, enacted mid-December, this injection contrasting starkly with those enforced austerity measures elsewhere. The overall US policy stance should now ensure that the prospect of tail-risk deflationary outcomes will recede even further into the background, such that the normalisation of bond risk premia in the Treasury market and elsewhere can extend. Crucially, such premia remain historically low despite recent adjustments, implying that further normalisation may occur for some time without any undue impact on real economy or risk market performance. The rebuilding of Treasury risk premia is most graphically displayed in ultra-long dated maturities, the overall coupon curve (2/30yr) having now stretched to historical peaks at 400bps. A sustained bear steepening since that final Fed funds rate reduction in December 2008 is also without precedent.

Ostensibly, there are limits to the scale of Treasury yield adjustment without the helping hand of Fed policy tightening (actual or anticipated). However, repositioning risks run deep in this particular

• The formal launch of the Federal Reserve's QE2 gambit on November 3rd has boosted the reflationist mindset of financial market participants

• The overall US policy stance should now ensure that the prospect of tail-risk deflationary outcomes will recede even further into the background,

Figure 53: Fed funds rate and 2/30yr Treasury curve

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37 Davy Research

market, and this may cause an overshoot in yields well ahead of any policy trigger. Simply put, investors (be they private, institutional or official) now appear to be too long of 'risk-free' Treasuries at too low a rate, and are thus apt to reallocate. This dynamic is already apparent in mutual fund flows (given fixed income outflows in favour of stocks), on commercial bank balance sheets (given reductions in outstanding Treasury holdings as C&I lending revives), and among global reserve managers (given flatlining Fed custody balances amidst stepped-up forex reserves accumulation by Asian central banks). Of course, the good ship QE2 still sails, but its buyback endeavours will be condemned to dry dock by mid-year, leaving supply/demand balances in this pivotal bond market all the more challenging at current yield levels.

Euroland debt crisis nearing resolution There is nothing new about the challenges facing the euroland sovereign bond markets, wherein a financing crisis for peripheral nations has been playing out, to varying degrees of intensity, since April of last year. This crisis was sparked by the exposing of a structural fault line (viz fiscal dis-union) in the single currency project. That it has endured may be rationalised on the basis of a reactive rather than pre-emptive policy response to the problem at hand. It is not that the new intervention mechanism (viz EFSF) lacks merit, but rather that its operational basis requires enhancement 'quantitatively and qualitatively' to ensure crisis resolution. With the Spanish bond market clearly viewed as the key battleground in this regard, and with 10-year Bond/Bund spreads having matched 15-year wides (at +280bps) earlier this month, the odds are growing of a comprehensive package being unveiled by EU officialdom before the current quarter is out. It is noteworthy that the renewed tensions in euroland core/periphery spreads have proved of scant benefit to benchmark Bunds, where yields have been rebounding sharply across the maturity spectrum. In part, this

Figure 54: US Treasury holdings (US banks and Fed custody)

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US banks holdings of treasuries Foreigner holdings of treasuries

Source: Bloomberg

• It is noteworthy that the renewed tensions in euroland core/periphery spreads have proved of scant benefit to benchmark Bunds


38 Davy Research

reflects the osmotic impact of a more bearish Treasury trend. It may also reflect a rational investor look-through beyond the debt crisis resolution, whereby any degree of collective bond issuance will only prove injurious to über-rich Bund yields. Last, but not least, there is the looming spectre of a more hawkish ECB disposition, not necessarily regarding its liquidity support operations in a still fragile eurosystem, but rather the policy rate levels at which such support is proffered.

Table 8: Government bond market forecasts

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Euroland 1.35-1.55 3.30-3.50 2.50-2.70 3.70-3.90

UK 1.15-1.35 3.85-4.05 2.00-2.20 4.40-4.60

US 0.65-0.85 3.50-3.70 1.05-1.25 4.30-4.50

Japan 0.15-0.35 1.30-1.50 0.35-0.55 1.65-1.85

Source: Davy

Figure 55: German IFO index and 10-year bund yields

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39 Davy Research

Corporate bonds Last year, corporate bond markets could never hope to match the record-breaking returns garnered during 2009, but a +7.4% out-turn for the ML global corporate bond index compares more than favourably with global sovereign (+3.8%) and equity (+9.6%) alternatives. Credit's excellent risk/reward characteristics have served this asset class very well during the post-crisis aftermath, with improving fundamentals and technicals reinforcing each other in self-sustaining fashion. Although not entirely immune to the vagaries of investor risk sentiment over the past 12 months, any gyrations in credit spreads have tended to play out more demonstrably in the synthetic markets, with cash markets relatively becalmed by comparison. The performance of global high yield markets (+15.2%) has been particularly noteworthy, that ongoing compression of credit curves reflecting an inveterate quest for yield.

Excellent fundamentals, but well-priced On a spot basis, credit fundamentals for the non-financial corporate sector appear as favourable as they have ever been. Balance sheets are well endowed with defensive liquidity, the economic and earnings cycles are on the rise, likewise ratings drift, whilst default expectations are plumbing fresh depths. To be sure, absolute yield levels are now historically depressed, and this has clearly dulled the appetite of retail investors, a key constituent in the 2009 credit market revival. However, any moderation in demand is being largely matched by a moderation in supply, leaving market technicals relatively unscathed protem. Supply restraint is more evident in Europe, although a revival in syndicated loan activity is part-instrumental here. Meanwhile, issuance has continued at breakneck pace in high yield, the refinancing wall of the next four years being opportunistically chipped away in exuberant market conditions. Of course, credit markets have also been grappling with the contagion risks associated with the euroland sovereign credit crisis for some time now. Naturally, financials have been most adversely impacted, given the

• A +7.4% out-turn for the ML global corporate bond index compares more than favourably with global sovereign (+3.8%) and equity (+9.6%) alternatives

Figure 56: US high yield spreads and VIX index

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• On a spot basis, credit fundamentals for the non-financial corporate sector appear as favourable as they have ever been

• For the moment, however, the natural investor base for European bank credit (and certain sovereigns) is progressively eroding


40 Davy Research

acute inter-dependencies of the sovereign and banking sectors. Fresh peaks in European sovereign CDS in early 2010 have been matched by senior financials, both still fixated by political/regulatory threats to 'bail-in' bondholders in response to any future burden-sharing requirements. The plausibility of such 'haircuts' being actually applied in the future is open to rigorous debate. For the moment, however, the natural investor base for European bank credit (and certain sovereigns) is progressively eroding. Signs on, given the limited and defensive nature of issuance activity (e.g. covered bonds, short-dated floaters, ABS) in the current climate.

A credible resolution to the euroland sovereign debt crisis will have a constructive impact on credit markets in general, and bank credit in particular. Financials have seriously underperformed their non-financials counterparts, in a manner that undervalues the degree of balance-sheet cleansing across this sector. Catch-up may be reinforced by the outcome of renewed bank stress tests in late-spring and by a more measured consideration being given to future regulatory (Basle 3, Bank Resolution Mechanism) issues. Against that, any pick-up in sentiment will likely be accompanied by an avalanche of issuance, thus providing a natural brake on spread reconvergence.

Figure 57: European sovereign and senior financial CDS

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• A credible resolution to the euroland sovereign debt crisis will have a constructive impact on credit markets in general, and bank credit in particular


41 Davy Research

Balance sheet event risks beginning to emerge More broadly, a pick-up in M&A activity represents a latent threat to pristine credit fundamentals. The new year has commenced with a flurry of deals on both sides of the Atlantic, raising expectations in certain quarters of a bumper 2011 as corporate risk appetites revive alongside recovering economies. In truth, there is no denying the bloated nature of corporate cash balances, nor the alluring valuations of corporate equity relative to debt, nor indeed a re-awakening of the leveraged loans market following its prolonged slumber. However, although indices of CEO confidence are indeed reviving, they continue to reside well below 2005-2007 averages, thus suggesting a more incremental/idiosyncratic approach to deal-making over the next 12 months. Nonetheless, a progressive combination of rising capex, M&A, dividend increases and share buybacks is harbinger of an inflexion point in the credit quality cycle.

Table 9: Corporate bond market forecasts

Current 3 months 12 months

US high grade +181 +140 +140

US high yield +506 +465 +425

iTraxx Main 99 85 75

iTraxx Xover 406 380 350

Source: Davy

Figure 58: European non-financials/financials CDS ratio

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• A pick-up in M&A activity represents a latent threat to pristine credit fundamentals

• A progressive combination of rising capex, M&A, dividend increases and share buybacks is harbinger of an inflexion point in the credit quality cycle


42 Davy Research

Commodities Commodity prices continued their sharp rally over recent months, as the prospects for growth in both emerging and developed markets improved while supply-side shocks threatened a number of markets. Soft commodities increased by nearly 20% in the past three months, while energy prices rose almost 15%. Metals were more subdued, rising by 'just' 7%.

Oil prices unlikely to strengthen much further The price of crude oil has continued to perform strongly in recent months, with Brent grades now a little shy of $100 per barrel. The price rose by one-third in 2010 as a whole, but most of this was due to an acceleration towards the end of the year as evidence of an improving global economy gathered pace. This coincided with an unusual period of weather patterns leading to prolonged cold spells in the US and Europe, thus ensuring that demand remained strong. The two apparent demand stimuli led to a sharp mark-up in traded oil markets. However, there is no shortage of oil supply. On the contrary, there is evidence of stock building in the last few months as producers have responded to better pricing.

• Commodity prices continued their sharp rally over recent months

• The price of crude oil has continued to perform strongly in recent months

Figure 59: CRB Commodity Index

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Figure 60: DJ UBS Industrials Metals Index

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Figure 61: DJ UBS Agriculture Index

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Figure 62: DJ UBS Energy Index

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43 Davy Research

Some commentators see oil prices heading to former highs of just under $150 per barrel. However, this time round, there is much more OPEC spare capacity to provide a buffer, which is currently believed to be around 6m barrels of oil per day – about three times more than the last price spike. We do not believe that OPEC particularly wants a market characterised by peaks and troughs in pricing. In fact, leading members of OPEC have consistently said that an oil price between $80 and $90 per barrel suits both producers and consumers. We believe that the decisive moment to call a step-change in oil pricing will come when northern hemisphere weather moderates. Until then, we see an oil price of $85 per barrel as a sensible long-term forecast for oil prices.

Soft commodity prices move higher as supply shocks continue Agricultural commodities continue to move higher. In certain cases, prices are above the highs of the previous cycle in 2007-2008. The main driver of the move on this occasion has been supply-side shocks. Weather events across the globe have impacted already much-stretched global stock piles. Prices are expected to remain higher for longer, given the typical timeline required to replenish stocks. The demand side is very much underpinned by a growing world population and the evolving dietary habits in emerging markets. The use of various commodities as sources of energy is also playing an important role on the demand side. The grains typically receive the most press and indeed have been excellent performers in 2010. Wheat finished as the best-performing grain with a 2010 return of +58% (narrowly beating corn +57%). However, some of the commodities that have now set new highs in 2010 are butter, coffee and sugar. Coffee was the best-performing soft commodity (of the ones we track) in 2010 with a gain of 72%.

Metals continue to rise, although investors need to be more selective Industrial metals also rose in the last quarter, although the performance varied sharply by type. Copper and nickel – regarded as one of the strongest lead indicators of growth – were the best-performing metals, driven by continuing strong growth in demand. Others such as lead and zinc were not as buoyant. As an asset class, we expect prices to continue to remain strong as economic growth sentiment improves in both developed and emerging markets.

Table 10: Industrials metals price performance – three months

Three-month price performance

Copper 14.1%

Aluminium 2.3%

Lead 2.1%

Tin 5.1%

Zinc -5.8%

Nickel 11.3%

Source: Datastream

• Leading members of OPEC have consistently said that an oil price between $80 and $90 per barrel suits both producers and consumers

• Agricultural commodities continue to move higher

• Industrial metals also rose in the last quarter, although the performance varied sharply by type


44 Davy Research

Gold's glister is waning somewhat The rally in gold prices has been underway since February 2001, its $254 launch-pad culminating in a record $1431 peak by December 2010. This is now the most durable rally in history, and the absolute trough-to-peak price advance is also a record. Last year's 29% gains comfortably exceeded those of bonds and stocks, this being a standing dish of the past nine years. However, gold's upward momentum has clearly slowed, now losing its leadership in the commodities complex to more direct cyclical plays. This transition reflects a shift in investor psychology away from safe-haven fixations and towards a more upbeat global growth prognosis. In consequence, speculative positions in gold have now been pruned, with ETF holdings shrinking by 72 tonnes from a record 2115 tonnes in late-December. Spot gold prices are retreating in sympathy, and bearish chart technicals have reinforced the sell-off. This correction may endure protem, but a longer-term top in gold prices is not yet at hand. The nine-year rally has been sustained by more fundamental than speculative influences, given the about-turn in global secular disinflationary trends, a declining dollar and, not least, gold's establishment as a legitimate reserve asset by the world's central banks. Expect fresh highs as 2011 progresses.

• Gold's upward momentum has clearly slowed, now losing its leadership in the commodities complex to more direct cyclical plays


45 Davy Research

Foreign exchange Although scattered accusations of a 'currency war' continue to pervade the foreign exchange arena, this particular theme has receded sharply over the past few months, leaving implied foreign exchange volatilities to join their equity counterparts at nine-month lows. The broad macro environment remains primed for 'carry' activity, not least given the perceived stability of (highly attractive) funding costs. However, it is apparent that G10 'carry' trades are losing their lustre, with stretched valuations (e.g. the Australian dollar) now compressing expected returns such that reversal risks are amplified on any volatility spike.

EM appreciation the currency trade of choice Rather, the focus is increasingly shifting to EM currencies, where valuations offer scant impediment, and where the macro backdrop is highly conducive to appreciation potential. Of course, intervention risks (of various forms) are ever-present in this particular space. However, with 'inflation wars' now supplanting 'currency wars' across the developing economies, and the pivotal Renminbi yuan apt for some catch-up appreciation in consequence, it is conceivable that greater official forbearance towards EM currency gains will reveal itself this year.

Euro re-rating in prospect Of course, EM currency appreciation is by some distance the strongest consensus trade for 2011, sufficient grounds in itself for a somewhat circumspect approach. Meanwhile, there is little consensus regarding the outlook for the major currencies, all of which are still perceived as being blighted by structural shortcomings. The euroland sovereign debt crisis continues to fixate, with renewed tensions in core/periphery spreads prompting a fresh build-up of speculative shorts against the single currency. Such tensions now appear to be hastening a comprehensive crisis resolution, one that may yet render EMU a more optimal currency zone. If so, then EMU 'break-up' commentary will dissipate, and speculative shorts will be squeezed.

• Although scattered accusations of a 'currency war' continue to pervade the foreign exchange arena, this particular theme has receded sharply over the past few months

• The focus is increasingly shifting to EM currencies

Figure 63: G10 FX carry basket and Asia dollar index

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• The euroland sovereign debt crisis continues to fixate, with renewed tensions in core/periphery spreads prompting a fresh build-up of speculative shorts against the single currency


46 Davy Research

Also threatening the short size of the euro/dollar market is the reaction function of the ECB, now that hawkish credentials are being reasserted in the face of mounting inflation risks. Trichet & Co may well maintain exceptional liquidity support operations for the duration of this year, but this will not in itself be a barrier to any policy rate adjustment. The forex focus will therefore likely wean itself off systemic concerns in favour of more fundamental drivers (viz rate differentials). In this context, the cyclical tailwinds behind euro/dollar advancement are apt to increase, not least given the expected tardiness of Fed policy normalisation.

US dollar shortcomings to be re-exposed Counter-intuitively, the stronger US growth prospects now materialising will reinforce a weaker dollar outlook, not least in response to improving risk appetites, but also in consideration of US funding frailties. US twin deficits are not receding, and real interest rate support (both absolute and relative) remains insufficient to sustain the requisite capital inflow. The US dollar retains its reserve currency status, but this privilege comes with certain responsibilities, and the dollar's custodians face mounting criticism for their questionable stewardship in this regard. Arguments in favour of a global 'multilateral' currency system are being increasingly advanced at G20 level, with last year's Chinese kite-flying now being joined by outspoken French support. Note, in this context, that Fed custody holdings on behalf of foreign central banks have been flatlining since mid-November, during which time global reserves have accumulated strongly. With the largest reserve managers (China and Japan) also conspicuous in their recent support of the euroland project, both such developments are clearly indicative of reserves diversification intent. Meanwhile, worrying developments in the US municipal bond markets may yet presage a shift in sovereign debt concerns across the Atlantic, with ominous ramifications for the foreign exchange markets.

• The cyclical tailwinds behind euro/dollar advancement are apt to increase

Figure 64: Euro/dollar and IMM non-commercial positioning

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• Arguments in favour of a global 'multilateral' currency system are being increasingly advanced at G20 level


47 Davy Research

Swiss franc no longer on a roll Any improvement in the euro's prospects should provide general support for other European currencies, the Swiss franc excepted. The latter has been a major beneficiary of risk aversion and safe haven flows since the credit crisis erupted, with exceptional gains garnered last year on foot of the euro's debt travails. The Swiss franc is now considerably overvalued on all metrics and may well have its funding currency status restored as the euro crisis resolves. In contrast, the Swedish krona is the most attractively valued of G10 currencies and is also equipped with the most robust fundamentals of all developed economies. Ongoing re-rating looks assured for the coming year, being reinforced by Riksbank activism on the policy normalisation front.

Table 11: Foreign exchange forecasts


Euro/dollar 1.3640 1.39-1.43 1.44-1.48

Sterling/dollar 1.5815 1.55-1.59 1.57-1.61

Yen/dollar 82.40 80.00-84.00 78.00-82.00

Euro/yen 112.40 114-118 115-119

Euro/sterling 0.8625 0.88-0.92 0.90-0.94

Source: Davy

• The Swiss franc is now considerably overvalued on all metrics and may well have its funding currency status restored as the euro crisis resolves

Figure 65: Swiss franc and Swedish krona EER indices (normalised)

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48 Davy Research

Tech watch

S&P 500 index US equity indices have delivered sustained up-moves over the past two months, with the S&P500's early-December breakout above 1230 (Fibo resistance and 2010 double-top) triggering a seven-week advance to 1296 highs. Market breadth continues to support the up-move, the NYSE Advance/Decline still in a solid uptrend from the March 2009 cycle lows.

The S&P500 has now virtually doubled from its 667 trough, while the Nasdaq composite is within sight of 2007 bull market peaks. However, the former chart is quite congested in the 1300 area, while warning signs of a corrective pull-back are also building elsewhere. The influential DJ Transportation average has posted a bearish weekly reversal at cycle highs, while leading small cap indices are also displaying bullish fatigue. A double-bottom risk on the VIX index completes the bearish threat.

The S&P500 is some way removed from its 55dma (at 1238 and rising), so an ultimate re-test of this metric would not surprise in the vicinity of 1250, being 38.2% retracement of the December/January up-move. If breached, the 1230 breakout region will provide even firmer support. Longer-term, 1360 continues to attract, with potential extension to the 1440 area.

Thirty-year Treasury yield The Fed's QE2 gambit has certainly lifted all boats, US Treasury bond yields included. A rare (and bearish) monthly reversal for 5-year yields last November certainly captured the sea-change in mood, but it has been the friendless 30-year that has led the charge to higher yields, given that trough-to-peak spike of 100bps (to 4.63%) from early-October lows.

Long-end yields are now approaching major resistance at 4.68%, being channel top of a multi-annual downtrend. Treasury bears ventured here before in early April of last year, but were sharply rebuffed at the 4.86% level. These are critical levels, having both cyclical and secular dimensions, and so will not be relinquished easily. Low open-interest readings highlight lack of investor conviction, but longer-term moving averages suggest that trend changes may be afoot. Any ultimate 4.86% breach will invite 2007 highs at 5.44%.

• US equity indices have delivered sustained up-moves over the past two months

• Low open-interest readings highlight lack of investor conviction at current levels, but longer-term moving averages suggest that trend changes may be afoot

Figure 66: S&P 500 index

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Close 100% 76% 61.8% 50% 38.2% 23.6% 0% Source: Bloomberg

Figure 67: Thirty-year treasury yield

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49 Davy Research

Asia dollar index Conviction levels have not been running too highly in foreign exchange markets over the past two years, epitomised by the ongoing re-rating of gold as an alternative currency play, and by a US-dollar trade-weight which, for all its gyrations, is now little changed from early-2009 readings. How noteworthy, therefore, to observe an orderly bull trend in the Asia dollar index over the same period, having now fully round-tripped to early-2008 peaks at 116.35. This is a natural resting point for short-term consolidation, being also a 61.8% retracement of the 1995/1998 crisis down-move. Corrective risks will seek containment above 2009/2011 channel support at 113.10 (and rising). Further out, bulls will target the channel top circa 119 currently, with a longer-term retracement objective at 121.48 also in the mix.

Gold price The bull market in gold is both lengthy and orderly, higher highs and higher lows having now been posted for nine consecutive years. Seasonal biases have also been maintained, with final quarter strength lifting spot prices to all-time peaks at $1431 in early-December.

Long-standing targets (inverted head-and-shoulders at $1340, channel top at $1440) have now been secured, inviting a consolidation period. A triple-top is posited on the daily chart, the trigger for which being a break of late-October lows at $1315. Clearance here will invite bearish extension to the 200dma (at $1282 and rising).

No indications yet that a major top is in place. Corrective down-moves should attract buyers, with a revised channel top target circa $1500 being a likely focus later this year.

• The bull market in gold is both lengthy and orderly, higher highs and higher lows having now been posted for nine consecutive years

Figure 68: Asia dollar index

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Figure 69: Gold price

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Close 55 Day m. avg 200 Day m. avg Source: Bloomberg


50 Davy Research

Forecasts

Table 12: Money and government bond markets

3 months 12 months

Key rate 3M LIBOR 2 year 10 year Key rate 3M LIBOR 2 year 10 year

Euroland 1.00 1.10-1.20 1.35-1.55 3.30-3.50 1.50-2.00 1.90-2.10 2.50-2.70 3.70-3.90

UK 0.50 0.75-0.95 1.15-1.35 3.85-4.05 1.00-1.50 1.35-1.55 2.00-2.20 4.40-4.60

US 0.00-0.25 0.30-0.50 0.65-0.85 3.50-3.70 0.50-1.00 0.90-1.10 1.05-1.25 4.30-4.50

Japan 0.00-0.10 0.15-0.35 0.15-0.35 1.30-1.50 0.00-0.10 0.25-0.45 0.35-0.55 1.65-1.85

Source: Davy

Table 13: Corporate bond markets


US high grade +181 +140 +140

US high yield +506 +465 +425

iTraxx Main 99 85 75

iTraxx Xover 406 380 350

Source: Davy

Table 14: Equity markets


DJ Stoxx 285.97 290-295 315-320

FTSE 5917.71 6175-6225 6450-6550

S&P 1291.18 1300-1320 1425-1450

Topix 929.28 940-950 975-1000

Hang Seng 23788.83 24750-25000 25750-26000

MSCI EM 1135.92 1160-1175 1220-1250

Source: Davy

Table 15: Foreign exchange markets


Euro/dollar 1.3640 1.39-1.43 1.44-1.48

Sterling/dollar 1.5815 1.55-1.59 1.57-1.61

Yen/dollar 82.40 80.00-84.00 78.00-82.00

Swiss franc/dollar 0.9445 0.93-0.97 0.93-0.97

Canadian dollar/dollar 0.9980 0.97-1.01 0.94-0.98

Australian dollar/dollar 0.9935 0.98-1.02 1.02-1.06

Euro/yen 112.40 114-118 115-119

Euro/sterling 0.8625 0.88-0.92 0.90-0.94

Source: Davy

51 Davy Research

Important disclosures

Analyst certification Each research analyst primarily responsible for the content of this research report certifies that: (1) the views expressed in this research report accurately reflect his or her personal views about any or all of the subject securities or issuers referred to in this report 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.

Investment ratings definitions Davy ratings are indicators of the expected performance of the stock relative to its sector index (FTSE E300) over the next 12 months. At times, the performance might fall outside the general ranges stated below due to near-term events, market conditions, stock volatility or – in some cases – company-specific issues. Research reports and ratings should not be relied upon as individual investment advice. As always, an investor's decision to buy or sell a security must depend on individual circumstances, including existing holdings, time horizons and risk tolerance. Our ratings are based on the following parameters: Outperform: Outperforms the relevant E300 sector by 10% or more over the next 12 months. Neutral: Performs in-line with the relevant E300 sector (+/-10%) over the next 12 months. Underperform: Underperforms the relevant E300 sector by 10% or more over the next 12 months. Under Review: Rating is actively under review. Suspended: Rating is suspended until further notice. Restricted: The rating has been removed in accordance with Davy policy and/or applicable law and regulations where Davy is engaged in an investment banking transaction and in certain other circumstances.

Distribution of ratings/investment banking relationships Investment banking services/Past 12 months

Rating Count Percent Count Percent

Outperform 51 58 25 67

Neutral 25 28 9 24

Underperform 7 8 0 0

Under Review 3 3 2 5

Suspended 0 0 0 0

Restricted 1 1 1 2

This is a summary of Davy ratings for all companies under research coverage, including those companies under coverage to which Davy has provided material investment banking services in the previous 12 months. This summary is updated on a quarterly basis. The term 'material investment banking services' includes Davy acting as broker as well as the provision of corporate finance services, such as underwriting and managing or advising on a public offer.

Regulatory and other important information Davy is regulated by the Central Bank of Ireland and is a member of the Irish Stock Exchange, the London Stock Exchange and Euronext. Davy is authorised by the Central Bank of Ireland and regulated by the Financial Services Authority for the conduct of business in the UK. No part of this document is to be reproduced without our written permission. This publication is solely for information purposes and does not constitute an offer or solicitation to buy or sell securities. This document does not constitute investment advice and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities/strategy discussed in this report may not be suitable or appropriate for all investors. The value of investments can fall as well as rise and there is no guarantee that investors will receive back their capital invested. Past performance and simulated performance is not a reliable guide to future performance. Projected returns are estimates only and are not a reliable guide to the future performance of this investment. Forecasted returns depend on assumptions that involve subjective judgment and on analysis that may or may not be correct. Any information related to the tax status of the securities discussed herein is not intended to provide tax advice or to be used as tax advice. You should consult your tax adviser about the rules that apply in your individual circumstances. This document has been prepared and issued by Davy on the basis of publicly available information, internally developed data and other sources believed to be reliable. Whilst all reasonable care has been taken in the preparation of this document, we do not guarantee the accuracy or completeness of the information contained herein. Any opinion expressed (including estimates and forecasts) may be subject to change without notice. We or any of our connected or affiliated companies or their employees may have a position in any of the securities or may have provided, within the last twelve months, significant advice or investment services in relation to any of the securities or related investments referred to in this document. While reasonable care has been taken in the preparation of the information contained in this document, no warranty or representation, express or implied, is or will be provided by Davy or any of its shareholders, subsidiaries or affiliated entities or any person, firm or body corporate under its control or under common control or by any of their respective directors, officers, employees, agents, advisers and representatives, all of whom expressly disclaim any and all liability for the contents of, or omissions from, this document, the information or opinions on which it is based and/or whether it is a reasonable summary of the securities in this document and for any other written or oral communication transmitted or made available to the recipient or any of its officers, employees, agents or representatives. Neither Davy nor any of its shareholders, subsidiaries, affiliated entities or any person, form or body corporate under its control or under common control or their respective directors, officers, agents, employees, advisors, representatives or any associated entities (each an "Indemnified Party") will be responsible or liable for any costs, losses or expenses incurred by investors in connection with the information contained in this document. The investor indemnifies and holds harmless Davy and each Indemnified Party for any losses, liabilities or claims, joint or several, howsoever arising, except upon such Indemnified Party’s bad faith or gross negligence.

52 Davy Research

Share ownership policy Davy allows analysts to own shares in companies they issue recommendations on, subject to strict compliance with our internal rules governing own-account trading by staff members. We are satisfied that our internal policy on share ownership does not compromise the objectivity of analysts in issuing recommendations.

Conflicts of interest Our conflicts of interest management policy is available at www.davy.ie/ConflictsOfInterest.

US Securities Exchange Act, 1934 This report is only distributed in the US to major institutional investors as defined by S15a-6 of the Securities Exchange Act, 1934 as amended. By accepting this report, a US recipient warrants that it is a major institutional investor as defined and shall not distribute or provide this report or any part thereof, to any other person.

Distribution of research to clients of Davy Securities in the US Davy Securities distributes third-party research produced by its affiliate, J & E Davy. Davy Securities is a member of FINRA and SIPC and is regulated by the Central Bank of Ireland.

Confidentiality and copyright statement Davy, Research Department, Davy House, 49 Dawson St., Dublin 2, Ireland. Confidential © Davy 2011.

http://www.davy.ie/ConflictsOfInterest

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