Global Investment Strategy. Scenario Analysis Autumn 2012

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1 Global Investment Strategy Scenario Analysis Autumn 212

2 Introduction 2 The combination of bullish investors, low market volatility and low financial stress suggests that risk assets are vulnerable to a correction on any bad news, particularly as the US fiscal cliff looms closer. We don t believe any of the market s top three concerns - the US fiscal cliff, a Eurozone break-up, and a China hard landing will crystallise in 213. Consequently, any pronounced market weakness should be used as an opportunity to increase exposure to risk assets. The outlook for the global economy and hence markets is highly uncertain at present. We assign a probability of just 5% to our central scenario playing out as planned. Consequently, this document also looks at the macroeconomic and market implications of five alternative scenarios: multiple Eurozone exits; Greece exiting the Eurozone alone; a hard landing of the Chinese economy; the US hitting the fiscal cliff; and finally, a corporate re-awakening. Investors with a different central scenario from our own may choose to position their portfolio for one of the alternative scenarios. Others may choose to hedge some of the risks implied by the alternative views of the world. Either way, it seems likely that at some point over the coming year the market will at least partially price one or more of these alternative scenarios.

3 Macro Scenario Outlines: Four downside risks, one upside Oxford Economics baseline forecast (5% probability) Eurozone avoids breakup, with ECB and governments taking significant steps to ensure Eurozone survival. Risk premia fall; consumer & business confidence gradually recover. Recovery is limited by high debt, weak job growth, fiscal retrenchment. Equities and peripheral debt are expected to outpeform safe-haven bond markets and gold. 3 Scenario 1: Multiple Eurozone exits (25% probability) Fiscal austerity in Greece becomes unbearable; government falls, defaulting on all external debt. Financial contagion spreads, as run on banks in peripherals leads to credit crunch. Cyprus, Portugal, Spain, Italy and Ireland forced out of the Eurozone. Safe-haven bond markets and the dollar expected to outpeform risk asset like equities, particularly EM, peripheral debt and commodities. Scenario 2: Sole Greek exit (5% probability) Greece leaves Eurozone in 213Q3, but European authorities act quickly and forcefully to prevent further exits. Intervention entails massive bond purchases, further bailouts, temporary capital controls & an acceleration of plans for a banking and fiscal union. Be underweight equities, peripheral bonds, the new Drachma, the euro and commodities. Scenario 3: China hard landing (1% probability) Commercial property crash and external weakness leads to banking sector stress. Flight from risk leads to falling share and property prices, and investment slumps, forcing government to recapitalise banks. Asian supply chain affected as domestic engine of growth stalls. Be underweight equities, particularly China plays, emerging market bonds and commodities. Scenario 4: US fiscal cliff (1% probability) Political stalemate causes much larger fiscal tightening than in baseline, damaging business and consumer confidence. Additional QE and weaker US$ provide only partially offsets, and trade and financial linkages lead to global slowdown. Be overweight bonds, underweight equities and underweight oil. Scenario 5: Corporate re-awakening (5% probability) Swift and decisive action by authorities in US and Europe resolves some macroeconomic uncertainty. Cash hoarded on corporate balance sheets is spent on investment, procurement and staff increases faster than assumed in baseline. Be underweight bonds, gold and oil. Be overweight equities and emerging markets.

4 Macro Scenario 4 World GDP % year US fiscal cliff Multiple Eurozone exits Unlike many market participants, we expect Europe to remain intact in 213 though policy progress towards securing the Eurozone s future will remain fitful over the next 18 months. Congress will see sense and a compromise agreement will see fiscal policy tighten by 1.5% of GDP rather than the up to 5% currently feared. The central scenario assumes that the economy gradually gains traction, with US rates not expected to rise until late

5 Under the baseline scenario, equity markets rise in US Equity Market Stockmarket index US fiscal cliff Multiple Eurozone exits US Equity Market Price/Earnings Actual 2 15 Historic Average 1 5 Q1 2 Q1 22 Q1 24 Q1 26 Q1 28 Q1 21 Q1 212 Source : Oxford Economics/Datastream Market pricing reflects the considerable downside risks facing the economy - US equities currently trade on a trailing PE of 14.9, 14% below their historic average. Equity markets are likely to fall a little between now and the end of the year due to concerns over the fiscal cliff intensifying as the deadline approaches. But in 213, with the fiscal cliff negotiated, the Eurozone intact and China avoiding a hard landing, we expect US equity prices to rise.

6 particularly in the eurozone periphery 6 Some of the most pronounced rises should be seen in Europe where valuations are low and surveys show investors are underweight. Generally, we expect European equity markets to comfortably outpace the US. The strongest performer among the eurozone equity markets could be Greece, given that it trades on a little over 1 times earnings. Another equity market we believe will perform strongly in 213 is China, thanks to a historically low PE ratio (<7); a V-shaped economic recovery starting in 212Q4; and liquidity expansion policies post November s change of leadership. US and European Equity Markets Relative P/E, US:EMU Actual Historic average 1 Q1 25 Q1 27 Q1 29 Q1 211 Source : Oxford Economics/Datastream Greek equity market Stockmarket index 6 5 Expected annual % rise in equity markets Greece China Germany France US

7 Under baseline scenario, peripheral bond yields fall 7 1-year government bond yields - Spain & Italy % As it becomes more apparent that Eurozone policy makers will finally match rhetoric with action, we expect further falls in peripheral bond yields Italy Spain 3 Expected 1-year government bond yields (%) Spain Italy Portugal Greece Ireland 212Q Q Q Q Q

8 at the expense of safe-haven government bonds 8 1-year government bond yields % 6 1-year government bond yields % Spain 4 5 Italy 3 US UK 2 Germany Germany 2 1 Expected 1-year gov't bond yields (%) US UK German y 212Q Q Q Q Q We believe that government bond yields bottomed out in 212Q2 in safe-haven bond markets such as the US, UK and Germany. We expect them to gradually rise from historically low levels as tail risks diminish further. In these countries, we expect yields to rise at an accelerating pace as the recovery gains traction and nominal growth accelerates.

9 Under the baseline, emergers ease rates, others on hold 9 Short term interest rates - developed markets % US UK Eurozone Short-term interest rates - emerging markets % 25 Russia 2 Brazil 15 1 India 5 China We expect many emerging nations to remain in easing mode this year and the next, with interest rates not expected to trough until 213 in China and India. Given the Fed s commitment to keep rate on hold until the labour market has clearly improved, we don t expect US short rates to begin rising until late 215. Rate rises will be even longer coming in the UK and the Eurozone due to the need to deleverage, with rates on hold in the UK until late 216 and until late 217 in the Eurozone.

10 Oil prices are weak & rising bonds yields weigh on gold 1 World oil price $/barrel 14 World gold price $/troy ounce 45 Foreacst Source : Oxford Economics With world growth relatively subdued under our central scenario, we expect the Brent oil price to end 213 around 6% below its current level at $12. As the global recovery accelerates from a 2.3% pace in 212 to 2.6% in 213, 3.6% in 214, and 2.6% in 215 we expect the oil price to then rise to $19 at the end of 214 and $114 in 215. Although we don t expect the gold price to change much during 212, we expect gold to fall in value by 11% in 213 and 14% in 214. Rising bond yields in the US, the UK and Germany will increase the opportunity cost of holding this non-yielding asset and progress towards a more permanent solution to the Eurozone crisis will reduce demand for safe-haven assets.

11 Investment implications of our central scenario 11 Policy rates will be slow to rise. Given the Fed s commitment to keep rates on hold until the labour market has clearly improved, we don t expect US short rates to begin rising until late 215. Rate rises will be even longer coming in the UK and the Eurozone due to the need to deleverage, with rates on hold in the UK until late 216 and until late 217 in the Eurozone. We expect many emerging nations to remain in easing mode this year and the next, with interest rates not expected to trough until 213 in China and India. Be overweight equities. Equities are expected to out-perform safe-haven bond markets in 213 as tail risk fears diminish and the global economic recovery gains traction. We favour the European and Chinese equity markets over the US. Europe will benefit from further policy progress towards fiscal and banking union and China from more stimulative policy following November s change of leadership. Be overweight peripheral Eurozone debt. With tail risk fears expected to diminish and the Eurozone expected to survive we believe peripheral Eurozone government debt will outperform safe-haven bond markets like the US, the UK and Germany. Be underweight oil in the near term. With world growth relatively subdued under our central scenario, we expect the Brent oil price to end 213 around 6% below its current level at $12. As the global recovery accelerates from a 2.3% pace in 212 to 2.6% in 213, 3.6% in 214, and 2.6% in 215 we expect the oil price to then rise to $19 at the end of 214 and $114 in 215. Be underweight gold. Although we don t expect the gold price to change much during 212, we expect gold to fall in value by 11% in 213 and 14% in 214. Rising bond yields in the US, the UK and Germany will increase the opportunity cost of holding this non-yielding asset and progress towards a more permanent solution to the Eurozone crisis will reduce demand for safe-haven assets.

12 Investment implications of our central scenario 12 US UK Eurozone Japan GDP (%) CPI (%) Policy rate (bps change) Equities (%) year government bond yields (bps change) World oil price (%) World gold price (%) World copper price (%)

13 Scenario 1: Multiple Eurozone Exits 13 The new Greek government only enjoys a slim majority and could fall should the burden of austerity demanded by the bailout package prove unacceptable. Alternatively, Greece would be forced out of the single currency if its creditors withhold funding and Greece resorts to issuing its own currency to meet payment obligations. Either way, a Greek exit would be very difficult to contain. Financial contagion would spread instantaneously throughout the Eurozone with steep increases in bond spreads, falls in share prices and a very significant tightening of credit conditions. Fear that other peripheral countries could also leave the Eurozone would trigger a run on banks, leading to their collapse. Multiple exits, involving Portugal, Ireland, Spain, Italy and Cyprus would likely ensue. As well as financial linkages, trade and confidence effects would send an economic shockwave across the globe. In exiting countries, the level of GDP would drop sharply, falling to around 15% below our central scenario in 214 and 215. The eleven countries remaining in the Eurozone would be plunged into a deep recession, with GDP falling by nearly 1% relative to our central scenario.

14 Multiple Eurozone exits would hit the global economy hard 14 World: GDP % year 5 4 The impact of a breakup in 214Q1 on the remaining countries in the Eurozone would be huge, with GDP contracting by over 2% in 214 and by over 4% in Multiple exits The UK would also be badly affected due to close trade and financial links to the Eurozone. By comparison, the US economy is more sheltered, but the breakup will still push the US close to recession in 215. In China, growth would dip to 4.9% in 215 and the level of GDP would be 5% below baseline at the end of 216. Annual % GDP growth World Eurozone US UK Breakup Breakup Breakup Breakup

15 leading to rate cuts in the residual Eurozone 15 Eurozone*: REFI rate % 4.5 Eurozone*: CPI Inflation % y/y * Remaining countries Multiple Exits * Remaining countries Multiple Exits Interest rates would fall to zero in most of the major economies and remain there until after the end of 217 as central banks attempt to offset the impact of the financial shock on growth and prevent a deflationary spiral. In contrast, inflation in the countries exiting the monetary union would surge as a result of steep currency depreciation increasing import prices. This would drive up nominal rates in the exiting countries. Short term interest rates, annual average (%) Remaining Eurozone Greece Portugal Spain Italy Ireland Breakup Breakup Breakup Breakup Breakup Breakup

16 A breakup would push safe-haven bond yields below 1% year US government bonds % 6 Safe-haven bond markets would see strong inflows, sending yields on these bonds plunging Multiple Exits Expected 1-year government bond yields (%), 214Q2 Breakup US UK Germany

17 while peripheral bond spreads rise sharply 17 1-year government bond yields, quarter average (%) Greece Portugal Spain Italy Ireland Breakup Breakup Breakup Breakup Breakup 212Q Q Q Q Q Q Q Q Q Q Spanish 1-year government bonds % Multiple Exits Peripheral bond spreads would rise sharply, but the risk premium for emerging markets would not rise to the level hit at the worst point of the global financial crisis at the end of 28 due to their improved risk profile

18 Equity markets would sell off particularly sharply in the exiting countries, but all markets would be hit 18 Spanish equity market Stockmarket index Fall in stockmarket relative to baseline % Multiple Exits US equity market Stockmarket index Italy Spain Portugal Greece Ireland Germany France UK US Japan China Multiple Exits 6 4 2

19 New currencies would undershoot fair value and the residual euro would initially weaken 19 Initially, national exchange rates would drop by around 4% against the euro in Greece and Cyprus, 33% in Italy, Spain and Portugal, and by 25% in Ireland. These countries have suffered a substantial loss of competitiveness over the past decade and their new exchange rates would adjust to compensate for this. Their currencies would probably overshoot fair value initially as they experienced large-scale capital outflows. We expect the residual euro to initially weaken by around 15% against the dollar as turmoil significantly dampens the value and return prospects of investment in the Eurozone. As activity stabilises and the Eurozone emerges as a more stable entity, the euro exchange rate may appreciate. Currency devaluation against Euro in 1st yr % Eurozone*: $/ $/ euro weaker Ireland Greece Italy Spain Portugal * Remaining Multiple exits

20 Oil and gold probably both fall in value 2 World oil price $/barrel 14 World gold price $/troy ounce Multiple Exits Multiple Exits With world GDP growth slumping to just 1.4% in 214 and then being flat in 215, the oil price falls to a trough of $8/barrel in the first half of 215. As the global financial system deleveraged, hardpressed investors would be forced to sell liquid assets to meet margin calls as a result the gold price would fall to below $9 by 215Q3.

21 Investment implications of multiple Eurozone exits 21 Interest rates would be cut to zero in most of the major economies and remain there until after the end of 217, further QE would be deployed, as central banks attempt to limit the impact of the financial shock on growth and prevent a deflationary spiral. In contrast, inflation in the countries exiting the monetary union would surge as a result of steep currency depreciation increasing import prices. This would drive up nominal rates in the exiting countries. Be overweight safe-have bonds. We believe that US treasuries, bunds and gilts would outperform equities and peripheral Eurozone bonds as their yields fell to 1.3%, 1.% and.7% respectively. Peripheral government bonds would fall sharply in value with Italian ten-year yields rising to 15% and Spanish yields rising to 16%. Be underweight emerging markets debt. Spreads would rise albeit they would not reach the level hit at the worst point of the global financial crisis at the end of 28 due to their improved risk profile. Be underweighted equities. The equity markets of the exiting countries are expected to fall by 2% to 3% and the major global markets to fall by around 1%. Equity holdings should be skewed towards defensive sectors and less cyclical markets, like the US, rather than emerging markets. Be overweight the dollar. Overseas holders of peripheral economy assets will also make currency losses as new national exchange rates drop by around 4% against the euro in Greece and Cyprus, 33% in Italy, Spain and Portugal, and by 25% in Ireland. We expect the residual euro to initially weaken by around 15% against the dollar as turmoil significantly dampens the value and return prospects of investment in the Eurozone. Be underweight commodities. With world GDP growth slowing to just 1.4% in 214 and then being flat in 215, the oil price falls to a trough of $8/barrel in the first half of 215 and the copper price falls by 25%. As the global financial system deleveraged, hard-pressed investors would be forced to sell liquid assets to meet margin calls as a result the gold price would fall to below $9 by 215Q3.

22 Investment implications of multiple Eurozone exits 22 US UK Eurozone Japan Multiple Eurozone Exits GDP (%) CPI (%) Policy rate (bps change) Equities (%) year government bond yields (bps change) World oil price (%) World gold price (%) World copper price (%)

23 Scenario 2: Sole Greek Exit 23 This scenario assumes that Greece leaves the Eurozone in Q3 213 but that the European authorities are able to intervene quickly and forcefully enough to prevent other peripheral countries from exiting the euro along with Greece. To prevent multiple exits, the ECB would need to engage in massive bond purchases to keep yields at manageable levels, the remaining peripheral countries would require bailouts, and plans for banking and fiscal union have to be accelerated. In the short term, temporary capital controls would probably be needed to stem deposit outflows from peripheral banks. The additional bailouts would have to be funded by the core Eurozone countries, partly at the expense of domestic spending which would damage growth.

24 Grexit: Eurozone recession would deepen 24 Eurozone*: GDP % year Greek exit Despite all of the measures taken by the authorities to limit the impact of a Greek exit the Eurozone recession would deepen in 214, with growth contracting by 1.2%. Growth in other major economies, such as the US and China, would be impacted as well World GDP growth would be 3.%, on a PPP basis, in 214, compared to 4.4% in our central scenario. -8 * Remaining countries -1

25 causing major economies to ease monetary policy 25 Eurozone*: REFI rate % Interest rates would be cut to almost zero in the Eurozone, the US and the UK, as central banks attempted to offset the impact of the financial shock on growth and prevent a deflationary spiral. We believe that rates would stay at zero in the US and the Eurozone until late 217 and until late 216 in the UK *Remaining countries Greek exit In contrast base rates would rise to 7.7% in Greece as the central bank attempted to offset the inflationary impact of a sharp currency depreciation. Central Bank rates (%) Greece US Eurozone UK Grexit Grexit Grexit Grexit 212Q Q Q Q Q

26 The new drachma would depreciate steeply 26 Maximum currency movements post-grexit % /drachma /$ / $/ Greek CPI inflation % year Greek exit The combination of rate cuts and the growth impact of the shock would cause the euro to depreciate 11% vs sterling and 16% against the dollar. The new Drachma would depreciate by around 5% against the euro, lowering its debt burden and eventually helping to restore competitiveness. In the short term, the depreciation would lead to soaring inflation which would cut households real incomes very sharply. In response the Greek central bank would increase by 7 bps, raising the cost of outstanding domestic debt.

27 Grexit: Greece would not be the only periphery economy to see bond yields rise 27 Greek 1-year government bond yields % 4 Spanish 1-year government bond yields % Greek Exit 7 Greek exit Source : Oxford Economics Source : Oxford Economics Greece would be cut off from international financial markets. The yield on Greek 1-year government bonds would rise by around 1 basis points and end 214 at around 34%. Markets would then price in a higher probability of other peripheral countries exiting at some point. For example, the yield on 1- year Spanish debt would rise from the current 6.7% to 8.5% at the end of 214 and the yield on Italian debt would rise from 4.8% to 8.4%.

28 while AAA and AA-rated bonds see safe-haven flows 28 German 1-year government bond yields % Greek exit.5. Source : Oxford Economics 1-year government bond yields, quarter average (%) US UK Germany Grexit Grexit Grexit 213Q Q Q Q Q Q Q Q year government bond yields, quarter average (%) Greece Portugal Spain Italy Ireland Grexit Grexit Grexit Grexit Grexit 213Q Q Q Q Q Q Q Q

29 Peripheral equity markets fall by 2%, with lesser falls elsewhere 29 Grexit: Fall in stockmarket relative to baseline % Portugal Greece Spain Ireland Italy France Japan US UK Germany China Investors confidence would slump and share prices in Greece Italy and Spain would fall 2% below the level assumed in our central scenario. The US, UK and German markets would fall 7% compared with the central scenario.

30 Grexit: Oil and gold prices would both fall 3 World oil price $/barrel Weaker demand would cause the oil price to end 214 about 14% lower than assumed under our central scenario at $94 per barrel Greek exit World gold price $/troy ounce Source : Oxford Economics Greek exit As the global financial system deleveraged, hard-pressed investors would be forced to sell liquid assets to meet margin calls as a result the gold price would end % lower than assumed under our central scenario at $ Source : Oxford Economics

31 Investment implications of a Greek exit 31 Interest rates would be cut to almost zero in the Eurozone, the US and the UK. Rates would not rise in the UK until late 216 and until late 217 in the US and the Eurozone. Be underweighted equities. Investors confidence would slump and share prices in Greece, Italy and Spain would fall, at worst, 2% below the level assumed in our central scenario. The US, UK and German markets would fall 7% compared with the central scenario. Be underweight peripheral bond markets. The yield on Greek 1-year government bonds would rise by around 1 basis points and end 214 at around 34%. Markets would then price in a higher probability of other peripheral countries exiting at some point. Consequently, the yield on 1-year Spanish debt would rise from the current 6.7% to 8.5% at the end of 214 and the yield on Italian debt would rise from 4.8% to 8.4%. Be underweight the new Drachma and the euro. The combination of rate cuts and the growth impact of the shock would cause the euro to depreciate 11% vs sterling and 16% against the dollar. The new Drachma would depreciate by around 5% against the euro. Be underweight commodities. Weaker demand would cause the oil price to end 214 about 14% lower than assumed under our central scenario at $94 per barrel. As the global financial system deleveraged, hard-pressed investors would be forced to sell liquid assets to meet margin calls as a result the gold price would end % lower than assumed under our central scenario at $112.

32 Investment implications of a Greek exit 32 US UK Eurozone Japan Greek Exit GDP (%) CPI (%) Policy rate (bps change) Equities (%) year government bond yields (bps change) World oil price (%) World gold price (%) World copper price (%)

33 Scenario 3: China Hard Landing 33 At the heart of this scenario is a near 2% fall in Chinese property prices in the second half of 212, which would wipe out all the gains seen since 27. Other property markets in Asia are also assumed to be affected with Hong Kong and Singapore experiencing price falls of 5-1%. The Chinese hard landing is triggered by a sharp correction in the Chinese property and construction sectors which leads to a large rise in non-performing loans. Risk premia in China would rise, pushing up the cost of borrowing. As a consequence, investment would fall sharply, hitting GDP growth and leading to lower employment, which would subsequently weigh on consumption. Chinese house prices House price index Chinese hard landing Source : Oxford Economics

34 China hard landing: Chinese growth and inflation slow 34 China: GDP % year China hard landing China: CPI % year China hard landing Under our China hard landing scenario, the level of Chinese GDP falls to around 4.5% below the path assumed under our central scenario. Rather than reaccelerating, Chinese growth slows further in 213 with the growth rate falling to just 5.1%.

35 leading to interest rate cuts across Asia 35 Chinese 3-month interbank rate % China hard landing China and other economies in the region would respond by easing monetary and fiscal policy. Chinese 3-month interest rates would end 214 around 1.3pp lower than assumed under our central scenario at 2.4%. At their trough, Indian rates would be almost 2% lower than our central scenario at 5.7%. Australian rates would be around 1.4 pp lower, than assumed under our central scenario, at 2.7%. Source : Oxford Economics

36 and knock-on effects are felt around the world 36 World: GDP % year Given the size of the Chinese economy, the shock would have global implications. GDP growth in the US would be cut to around 1.8% in 213, rather than the 2.3% assumed under our central scenario, while the Eurozone s recession would be extended for a year with GDP falling of.6% in both 212 and China hard landing Higher costs of borrowing and weaker trade hit other emerging markets with growth slowing to around 4% in the emerging market bloc as a whole in 213. World GDP growth is around 1 percentage point lower than in the baseline in 213, at 2.4%.

37 China hard landing: Weaker profit growth hits equities 37 Chinese equities Stockmarket index China hard landing Source : Oxford Economics % China hard landing: Fall in stockmarket relative to baseline China Germany France US UK Japan A slowdown in demand for China s exports and a slump in the construction sector would lead to weak profitability and banking sector stress. Consequently, share prices in China are assumed to fall by over 4%. A rise in risk premia and financial contagion would lead to falls in share prices in the major financial centres in the US, Eurozone and the UK, of around 1%.

38 and risk aversion pushes up emerging market bond yields 38 Risk premia on emerging market interest rates % China hard landing Chinese 1-year government bonds % China hard landing A flight from risk would lead to a rise in emerging market spreads of around 1 basis points over the course of 213. This would push up the cost of borrowing in emerging markets leading to slowing consumption and investment.

39 China hard landing: Weak global growth weighs on commodities 39 World oil price: China hard landing $/barrel China hard landing Source : Oxford Economics World gold price: China hard landing $/troy ounce China hard landing Source : Oxford Economics Weaker demand would cause the oil price to fall to $8 by the middle of 213 and the copper prices is assumed to end 213 about 2% lower than under our baseline scenario.

40 Investment implications of China hard landing 4 Be underweigh equities, particularly China plays. A rise in risk premia and financial contagion is expected to cause falls in US, Eurozone and UK equities of around 1%. Chinese share prices would be hit much harder with an expected fall of over 4%. Be underweight emerging market bonds. Depending on the market, developed economy bond yields are either flat under this scenario or rise more slowly than under our baseline. Emerging market spreads rise by almost as much as during the financial crisis. Be underweight commodities. Weaker Chinese and global growth mean that the oil price falls to $8 by the middle of 213 and the copper prices is assumed to end 213 about 2% lower than under our baseline scenario.

41 Investment implications of China hard landing 41 US UK Eurozone Japan China Hard Landing GDP (%) CPI (%) Policy rate (bps change) Equities (%) year government bond yields (bps change) World oil price (%) World gold price (%) World copper price (%)

42 Scenario 4: US Fiscal Cliff 42 Unless congress agrees on an alternative plan for the reduction of federal debt, the US faces a significant tightening of fiscal policy on 1 January 213 as a number of automatic tax rises and spending cuts take effect. The Congressional Budget Office estimates that the combined measures amount to around a 5.% of GDP tightening of fiscal policy for calendar year 213. Our baseline forecast assumes that much of this tightening will be avoided. But there is a risk that political gridlock leads to a much more restrictive fiscal stance.

43 US fiscal cliff: A technical recession in H US GDP % year Fiscal cliff US GDP growth slows down significantly, falling in recession in the first half of the year. In the quarter that it hits the fiscal cliff, 213Q1, the economy shrinks at an annual rate of 1.7% and it continues to decline by 2.% in Q2. Growth turns positive again in the second half of the year and stages a strong rebound due to compensating fiscal measures. Our scenario calls for growth of 8.9% (annualised) in 213 Q3 as these measures take place. In 214, US GDP increases by 3.5%.

44 triggering further QE from the Fed 44 US CPI % year 6 US Quantitative Easing US$, Billions US fiscal cliff US fiscal cliff We believe that the Federal Reserve would step in immediately to support the economy with additional quantitative easing, boosting its balance sheet to eventually reach around 22% of GDP and maintaining that level for one year before beginning to unwind it.

45 US fiscal cliff: Growth in the rest of the world affected 45 World GDP % year US fiscal cliff The rest of the world would be significantly affected via The rest of the world would be significantly affected via a decline in business and consumer confidence and decline in business and consumer confidence and weaker demand from the US. weaker demand from the US. The Eurozone recovery would be delayed by one year with The 212 s Eurozone.5% recovery contraction would followed be delayed by a further by one.4% year fall with in 212 s output.5% in 213. contraction The UK and followed Japanese by a economies further.4% would fall in output also be in affected 213. The by a UK decline and Japanese in business economies and consumer would also confidence, be affected and by GDP a decline growth would in business slow down and significantly, consumer confidence, although remaining and GDP growth in positive would territory. slow down significantly, although remaining in positive territory. Emerging market economies would suffer a deceleration of external demand growth and subdued capital inflows, although Emerging domestic market economies demand growth would would suffer remain a deceleration robust. Chinese of external GDP demand growth growth would and slow subdued to 7.2% in capital 213, inflows, around although 1 domestic pp below the demand growth growth rate assumed would remain our robust. central Chinese scenario, GDP growth and then would reaccelerate slow to to 7.2% 9.6% in , around 1 pp below the growth rate assumed in our central scenario, and then reaccelerate to 9.6% in 214. Growth rates (% year) US World Eurozone UK China Japan Fiscal cliff Fiscal cliff Fiscal cliff Fiscal cliff Fiscal cliff Fiscal cliff

46 with implications for interest rates and equities globally 46 1-year government bond yields* Basis points US Eurozone UK -1 US fiscal cliff - fall in stockmarket relative to baseline % *Difference in yields between US fiscal cliff and baseline forecasts, end US China UK Germany France Japan US ten-year bond yields end 213 about 5 bps lower than under our central scenario and dip as low as 1.4% in Q The US equity market falls by 2% from its year end level. Smaller falls are experienced in Europe, the UK and Japan.

47 US fiscal cliff: Oil price lower; gold little impacted 47 World oil price: US fiscal cliff $/barrel US fiscal cliff World gold price: US fiscal cliff $/troy ounce US fiscal cliff Source : Oxford Economics Source : Oxford Economics

48 Investment implications of US fiscal cliff 48 Be overweight bonds. US ten-year bond yields end 213 about 5 bps lower than under our central scenario and dip as low as 1.4% in Q Be underweight equities, particularly the US. The US equity market falls by 2% from its year end level. Smaller falls are experienced in Europe, the UK and Japan. Be underweight oil. With global growth slowing to 1.9% in 213,.7 ppt lower than assumed under our central scenario, the oil price ends % below its current level at $94.

49 Investment implications of US fiscal cliff 49 US UK Eurozone Japan US Fiscal Cliff GDP (%) CPI (%) Policy rate (bps change) Equities (%) year government bond yields (bps change) World oil price (%) World gold price (%) World copper price (%)

50 Scenario 5: Corporate Re-awakening 5 In the developed economies, the corporate sector has built up a large financial surplus. Due to the uncertain macroeconomic outlook, companies have so far preferred to sit on these substantial cash balances rather than use them to fund new equipment, mergers and acquisitions, and extra workers. If policymakers can take decisive action with respect to the sovereign debt crisis in Europe and the fiscal cliff in the US, much of the uncertainty surrounding the macroeconomic outlook would dissipate. Business confidence would be boosted further if tensions in the Middle East ease. Swift and significant intervention in the US would entail a clear stance on fiscal policy; and further bond buying, bailouts, and credible progress towards fiscal and banking union in the eurozone. Higher business confidence would then feed through to higher investment more quickly than assumed under our baseline scenario.

51 Corporate re-awakening: Stronger world growth 51 World: GDP % year Upside As business confidence improves, quarterly investment rises by 1.5% more than in our baseline scenario throughout 213 in the major economies. Workers wages in these economies would also rise as companies increase their workforce. With both total employment and disposable income up, this feeds through to higher consumption Stronger growth in the US and Europe entails knock-on benefits for emerging markets via increased trade and capital inflows. Growth rates (% year) World US Eurozone UK China Japan Upside Upside Upside Upside Upside Upside

52 though supply-side boost keeps inflation in check 52 World: CPI % year Increased investment leads to a rise in the capital stock and higher total factor productivity. This boost to the supply-side prevents higher demand from creating inflationary pressures. World inflation would be.6-.7pp lower than under our central scenario in 213 and 214. Nevertheless, the improved growth outlook enables major developed economy central banks to start raising interest rates more quickly than assumed under our central scenario. Upside Central bank rates (%) US Eurozone UK Upside Upside Upside 213Q Q Q

53 Corporate re-awakening: Impact on equity markets less marked on bond markets 53 US: 1-year government bonds % 6 5 Bond yields rise but the rise is smaller that it might have been due to lower inflation than under our baseline scenario, as a result of the lower oil price and the boost to the supply side. 4 Upside Equity market: upside - US Stockmarket index Upside The difference between the performance of the equity market under the upside scenario and the baseline is relatively modest. Equities end 217 2% higher than under the baseline scenario. 4 2 Source : Oxford Economics

54 Corporate re-awakening: Oil and gold weaker 54 World oil price: upside $/barrel Upside Lower political tensions would reduce the risk premium embedded in the oil price which ends 214 $17 below the price assumed in our central scenario at $92 per barrel, despite stronger global growth. 4 2 Source : Oxford Economics World gold price: upside $/troy ounce With interest rates rising even more quickly than under our baseline scenario, the opportunity costs of holding gold increases. Stronger growth will reduce fears about the survival of the financial system. The gold price falls and ends % below its current price Upside Source : Oxford Economics

55 Investment implications of corporate re-awakening 55 Policy rates rise more quickly than markets are expecting. The improved growth outlook enables major developed economy central banks to start raising interest rates more quickly than assumed under our central scenario. For example, Fed funds start rising in early 214 rather than in late 215. Be underweight bonds. Faster nominal GDP growth than under our central scenario means that bond yields rise more quickly as well. For example, US ten-year yields rise from their present level of 1.8% to 3.3% at the end of 214, compared with a rise to 2.6% under our central scenario. Be overweight equities. With world GDP growth of 4.6% in 214, better even than the pre-financial crisis boom years of 26 and 27, fears of tail risks dissipate and equity markets rise. Be overweight emerging markets. Strong, inflation free, global growth helps emerging market risk premia gradually fall. Due to the falling oil price favour oil consumers over oil producers. Be underweight oil. Lower political tensions reduce the risk premium embedded in the oil price which ends 214 $17 below the price assumed in our central scenario at $92 per barrel, despite stronger global growth. Be underweight gold. With interest rates rising even more quickly than under our baseline scenario, the opportunity costs of holding gold increases. The gold price falls and ends % below its current price.

56 Investment implications of corporate re-awakening 56 US UK Eurozone Japan Corporate Re-Awakening GDP (%) CPI (%) Policy rate (bps change) Equities (%) year government bond yields (bps change) World oil price (%) World gold price (%) World copper price (%)

57 57 Appendix for detailed forecasts Alternative equity market forecasts United States 12,738 12,868 14,489 14,989 15,411 Germany UK 2,981 2,796 3,48 3,327 3,63 Japan Eurozone break-up United States 12,738 12,868 14,489 14,538 13,888 Germany UK 2,981 2,796 3,48 3,227 3,269 Japan China hard landing United States 12,738 12,868 13,764 13,19 14,641 Germany UK 2,981 2,796 2,896 2,928 3,448 Japan Corporate reawakening United States 12,738 12,868 14,489 15,78 15,471 Germany UK 2,981 2,796 3,48 3,341 3,577 Japan Greek exit United States 12,738 12,868 14,489 14,39 14,795 Eurozone UK 2,981 2,796 3,48 3,184 3,449 Japan US fiscal cliff United States 12,738 12,868 14,42 15,356 16,345 Eurozone ,23 UK 2,981 2,796 3,45 3,417 3,732 Japan

58 58 Appendix for detailed forecasts Alternative 1-year yield forecasts United States Eurozone UK Japan Eurozone break-up United States Eurozone UK Japan China hard landing United States Eurozone UK Japan Corporate reawakening United States Eurozone UK Japan Greek exit United States Eurozone UK Japan US fiscal cliff United States Eurozone UK Japan

59 59 Appendix for detailed forecasts Alternative short rate forecasts United States Eurozone UK Japan Eurozone break-up United States Eurozone UK Japan China hard landing United States Eurozone UK Japan Corporate reawakening United States Eurozone UK Japan Greek exit United States Eurozone UK Japan US fiscal cliff United States Eurozone UK Japan

60 6 Appendix for detailed forecasts Alternative exchange rate forecasts US$ Effective $/ / $/ /$ Renminbi/$ Eurozone break-up US$ Effective $/ / $/ /$ Renminbi/$ China hard landing US$ Effective $/ / $/ /$ Renminbi/$ Corporate reawakening US$ Effective $/ / $/ /$ Renminbi/$ Greek exit US$ Effective $/ / $/ /$ Renminbi/$ US fiscal cliff US$ Effective $/ / $/ /$ Renminbi/$

61 61 Appendix for detailed forecasts Alternative commodity price forecasts Brent Oil ($/bl) Gold 1,367 1,682 1,627 1,355 1,26 Copper 8,634 7,511 7,727 8,165 8,572 Agriculture Eurozone break-up Brent Oil ($/bl) Gold 1,367 1,682 1,627 1, Copper 8,634 7,511 7,727 8,162 6,699 Agriculture China hard landing Brent Oil ($/bl) Gold 1,367 1,682 1,62 1,182 1,41 Copper 8,634 7,511 7,697 7,125 7,82 Agriculture Corporate reawakening Brent Oil ($/bl) Gold 1,367 1,682 1,627 1,334 1,23 Copper 8,634 7,511 7,727 8,43 8,18 Agriculture Greek exit Brent Oil ($/bl) Gold 1,367 1,682 1,627 1,329 1,121 Copper 8,634 7,511 7,727 8,9 7,623 Agriculture US fiscal cliff Brent Oil ($/bl) Gold 1,367 1,682 1,627 1,342 1,24 Copper 8,634 7,511 7,727 8,87 8,432 Agriculture

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