Market Update. Where are capital markets headed?

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1 Market Update Late March 2013 Where are capital markets headed? Earlier this month we issued a Market Update paper which took a closer look at the improving global macroeconomic picture. In this month s second paper we outline what we can expect from capital markets in the months ahead. Robert Parker, Head, Strategic Advisory Group. Member of the Global Investment Committee Overview With growth momentum building in H2 2014, US Treasury yields should move moderately higher A further sell off in Bunds is unlikely given easy ECB policy Given US recovery and low level of credit downgrades, investment grade spreads should remain low Technical factors suggest that the year to date rally in equities may now meet some resistance The EUR s reaction to Cyprus has been fairly muted It is premature to forecast a strong uptrend in gold over the next six months Fixed Income Markets G3 Government Bonds The yield range in 10-year US Treasuries has been % over the last three months, with the trend being one of a moderate uptrend. The capital flow into equity markets from US Treasuries has been offset by the impact of quantitative easing (QE), the persistence of low US inflation, fears over the impact on the US economy of the fiscal sequestration and the persistence of an exceptionally easy monetary policy from the Federal Reserve (the Fed). It should be noted that the yield curve has steepened, with 2-year Treasuries at 24bps, with a very narrow yield range over the last three months of only 23-28bps. The key questions are the pace of US recovery, the re-emergence of inflation, the ending of QE and the extent of flows into equities. The Fed has been clear that any reduction in QE will only take place towards the end of 2013 or during H1 2014, thereby anchoring short yields. At worst, 2-year US Treasuries will trade to 50bps by end Q3 2013, although with inflationary expectations deteriorating in late 2013 and with growth momentum building in H to 2.5%, 10-year Treasuries should see a continued trend of yields moving moderately higher, with a target of 2.5% during Q and with yields testing 3% in Q year Bund yields are close to zero, given contagion fears over Cyprus and the potential impact on bank deposits in the weaker eurozone economies. 10-year Bunds have rallied, so that yields are now close to the lower end of their three month range of %. Assuming that the Cypriot bailout is now satisfactorily resolved (with a higher write-down for larger depositors) and that pressure does not build up on banks in Italy, Spain and Portugal, then Bunds should trade back towards 1.8 2% by end Q3 2013, assuming that the recent recovery in the German economy persists, with growth improving to 1.5%+ annualised in H A further sell-off is unlikely given the easy European Central Bank (ECB) policy, the move to a near budget surplus in Germany and the consequent lack of funding pressure. Historical and future performance indications and financial market scenarios are no guarantee for current or future performance. 1/5

2 10-year JGB yields are trading close to 60bps, near the lower end of their three month trading range of 59-82bps. 2-year JGB yields are 2bps and the range over the last three months has been 2-6bps, reflecting expectations that the Bank of Japan (BoJ) will keep official interest rates close to zero. The low level of 10-year yields discounts correctly expectations that the BoJ will increase QE through the purchase of JGBs, but does not discount a probable move from deflation to at least 1% y-o-y inflation in Q3 2013, the budget deficit in excess of 10% of GDP, the overall level of debt to GDP of 230%, the limited buying power of the banks to add to their JGB holdings, the acceleration in growth with capital flows continuing to favour the equity market and the likely negative reaction of retail savers to the end of deflation. Consequently, the scope for JGB yields to decline further is limited and logically, yields should back up through 1% by end Q3 2013, although the pace of yield increase will be moderated by BoJ QE. Eurozone Government Bonds There is no evident pressure on 10-year spreads in the Dutch (spread 28bps with Germany), Finnish (21bps) and Austrian (30bps) markets although French spreads (64bps) have started to slowly widen. Although the Dutch economy will remain in recession in H and the budget deficit will exceed 3.5% of GDP, Dutch spreads should remain close to 30bps, with Finnish spreads supported by a budget deficit close to 1% and Austria with a budget deficit close to 2%, remaining close to current levels. The lack of growth in France, with a deficit close to 4% of GDP, should pressure French spreads by Q towards 100bps. 10-year Portuguese yields are close to their lows over the last 3 months at approximately 6% and given the stability in the Portuguese banking system, the progress on the bailout and Portugal s ability to issue paper in the market, yields should trade around current levels for the next three to six months. Likewise, 5-year Irish paper has traded through 3% and, given the continued progress of the bailout, should trade in a range of 2.5 3%. 2-year Ireland is currently trading close to 1%. 10-year Italy has traded back to close to 4.7% in mid March, compared with a three month high of 4.9%, due to political uncertainty, concerns that the Monti reform program may be reversed and given the lack of any signs of the economy picking up. Since Italy is bound by the eurozone pact, the probability of the Monti reforms being cancelled is low, although future progress may be slowed down. Despite the lack of growth, the fiscal position remains strong, with a budget deficit this year of less than 2.5% of GDP and with additional financing needs in 2013 of less than EUR 40bn. A further market sell-off to 5% is unlikely, despite the political uncertainty. 10-year Spanish yields have stabilised below 5% and despite the slow progress of reducing the budget deficit (at approximately 6% of GDP this year), the evidence that the economy is forming a base, the progress on restructuring the banking sector, the move to current account surplus and the improvement in competitiveness, suggests that the probability of Spain accessing the Outright Monetary Transactions (OMT) is now decreased, with 10-year yields moving to 4.5% over the next three months. Greece s 10-year yields have reversed to 11.5% in mid March, given the Cyprus crisis and the on-going lack of progress in Greece achieving its bailout targets. Trading is minimal and yields are likely to remain above 11% for the rest of Other European Bond Markets 10-year UK Gilt yields have traded back towards 1.85%, due to the weakness of the economy and the expectation that a new governor at the Bank of England (BoE) will relax monetary policy further. The market has not been affected by the depreciation of the GBP, nor by the probability of the 2013 budget deficit staying above 6% of GDP. The Consumer Prices Index (CPI) will remain close to 3%, with growth in H struggling to exceed 0.5% y-o-y. Although logically yields should be considerably higher, the extension of QE and the long duration of existing debt should prevent a major sell-off, implying that yield movements will be in-line with the Bund and US Treasury markets, implying a move to % by end Q Given the Cyprus crisis and the on-going lack of progress in Greece achieving its bailout targets, yields are likely to remain above 11% for the rest of year Swedish yields at 1.95% are close to the higher end of their three month range. Inflationary pressures are minimal, the credit rating is stable and real GDP growth should progressively improve to 1.5 2% during H The spread with Bunds (currently at 55bps) should narrow to 40bps by Q Denmark continues to have the lowest spreads with Germany in the EU at 17bps. The budget deficit should improve to less than 2% of GDP, with a stable currency and credit rating and with growth recovering to close to 1% in Yield spreads with Bunds should remain tight. 2-year Swiss yields remain negative at -12bps, with 10-year yields at 70bps, i.e. 67bps under Bunds. Given the budget surplus, inflation close to zero and despite action by the Swiss National Bank (SNB), there is still strong demand for the currency and there is no reason to forecast a narrowing of the negative spread with Bunds. Commodity Linked Markets 10-year Australian yields at 3.5% are close to the higher end of their three month range of %. The budget deficit should narrow this year to less than 2%, with inflation less than 3% and with growth moderating to 2.5 3%. The pace of interest rate cuts by the Reserve Bank of Australia (RBA) has slowed, but the risk of a further sell-off in the market is low and 2-year yields at 2.9% are attractive relative to other markets. 2/5

3 10-year Canadian yields are trading 10bps lower than US Treasuries and although growth will underperform the US with inflation muted and a budget deficit of less than 1% of GDP, there is little case for investing in longer duration Canadian paper, although it is worth noting the positive spread with the US of 70bps for 2 years. Investment Grade/High Yield USD investment grade spreads have been stable at just under 90bps, with a range over the last three months of 78 99bps. By sector, spreads vary from 93bps for healthcare, to 196bps for subordinated financials. Attractive sectors are energy at 150bps and materials at 155bps. Given the recovery in US macro data and the continued low level of credit downgrades and defaults, spreads should persist for the foreseeable future at the current narrow levels around bps. Although public expenditure cuts/sequestration will cut public sector earnings and employment, real consumption should grow by 2 2.5% annualised over the balance of In EUR, the ITRX main index is at 119bps, which is towards the higher end of the range over the last three months of bps. The spread with the US in subordinated financials is at 230bps, although spreads are significantly narrower in healthcare, energy and materials. The recent spread widening reflects a perception that growth data will remain weak and, therefore, that default rates will rise. However, if growth surprises in Germany on the upside and if firmer evidence emerges of the recessions in Spain and Italy easing, then spreads should narrow back to bps. The USD CDX high yield spread has improved back to 393bps, compared with a range of bps over the last three months. Positive factors have been the rally in equity markets and low default rates. Assuming that equity market setbacks remain minor, then spreads should persist at under 400bps. In EUR, the ITRX Crossover Index is at 480bps, i.e. a spread of close to 90bps, with the USD market reflecting weaker growth prospects in Europe. Spreads for the consumer sectors are above 500bps, while materials and utilities are expensive. As growth recovers, spreads should narrow back below 450bps. Emerging Market Debt The emerging market debt CDX Investment Grade Index in USD is currently less than 90bps and although downside risk is low, valuations are now stretched. 10-year Brazilian yields in USD are at their three month high at 3.18%, as are Colombian yields at 3.40%. In CEE, the same applies to 10-year Russia in USD at 3.23% and Turkey at 3.70%. There has been clear evidence of investor profit taking from previously stretched valuations and the relative value of emerging market debt in USD versus both local currency debt and emerging market equity markets, remains poor. In local currency, yield movements have been variable within Asia. Indonesia 10-years is at its highest level for three months at 5.4%, while South Korean and Philippine yields are at their lowest levels at 2.9% and 3.5% respectively. In EMEA, Russian, Turkish, Hungarian and South African yields are all at their high levels for the last three months, reflecting the pick-up in inflation and the expectation that monetary policy will become tighter. Likewise in BRL, 10-year yields are at their highest level for three months at 9.2%. In the case of Indonesia, Brazil and Turkey, yields are starting to discount monetary tightening and at least for the next three months, should stabilise at current levels. Equity Markets Recent Market Developments Despite a number of potential negative factors, i.e. the US sequestration, the Italian election result, the Cyprus problem, aggressive posturing by North Korea and continued problems in the Middle East, equity markets have held up. Amongst developed markets, the Nikkei has a y-t-d gain of close to 20%, while in Europe, the Swiss market has advanced by 15%. The S&P 500 has also been strong and is now up 9% y-t-d. Positive factors have been the prospective easing of fiscal policy by the BoJ, a further easing in BoE monetary policy, the improved data from Germany and the probability of Spain and Portugal forming a base, stronger data out of the US and the expectation that sequestration will only reduce GDP growth by 0.6%. However, a number of emerging markets have performed badly. Brazil has now decreased by close to 9% y-t-d, while in India, the Sensex 30 has declined by approximately 4%. All Russian indices have declined, while in CEE, the Polish and Czech indices have fallen by 3% and 5% respectively. The only strong markets have been the Philippines, Thailand and Indonesia, all up over 10% y-t-d due to continued strong domestic and foreign capital flows. However, overall, MSCI emerging equities have continued to underperform developed indices. Market Outlook Although valuations are less attractive, supportive factors for equities are: the poor risk/reward in money markets and fixed income, with corporate bond spreads narrow the high level of dividend yields the high level of corporate cash supporting dividends share buy backs and M&A activity the persistence of easy monetary policies in G4 improved economic data in the US, Japan and Germany the easing of the eurozone crisis (ex Cyprus) expectations that, at least in H2 2013, corporate earnings growth will be on an uptrend Technical factors suggest that the uptrend this year may now meet resistance, but the probability of a serious market setback is low and the balance of probabilities suggests an erratic uptrend, at least for the balance of In developed markets, outperformance should be maintained in the US, Northern Europe and Japan and given the relative expense of defensive sectors relative to cyclicals, there are strong grounds for switching into cyclicals with exposure to materials, energy, industrials and technology. 3/5

4 In emerging markets, an opportunity may emerge to build positions in the undervalued Chinese and Brazilian markets in Q2 2013, while profits should be taken in South East Asia and Mexico, where valuations are stretched. It remains premature to overweight emerging equities relative to developed markets. Cyprus and Italy and concern over weak French data, will support the CHF at least in the next two to three months. Therefore, against the USD, assume a trading range for April and May of Later in 2013, if a recovery in the USD occurs, then a H break through parity may occur. Foreign Exchange Markets Developed Currencies USD/EUR: The reaction to the Cyprus problem has been relatively muted, with the EUR holding at However, the trend has been one of EUR depreciation since late January, when it was trading close to Negatives have been the Cyprus issue, the inconclusive election result in Italy, concern over weak French data, the clear message from the ECB that they would protest a EUR level in the high 1.30s and stronger US data. The USD was not impacted by the sequestration issue and the markets are ignoring the potential problem with the debt ceiling expiring at the end of May. Long market positions in the EUR All indices of volatility for commodity prices are at record lows of around 8% volatilities in Q were close to 30%. in late January have now largely been closed off, while the currency is supported by the increased eurozone trade and current account surplus. There is technical support for the EUR over the next two to three months at 1.27/28, but the ceiling has now come down to Assuming that political issues in Cyprus and Italy do not deteriorate, then in April/May the EUR could move back into the low 1.30s, but thereafter the risks remain for a more sustained USD. Positive factors for the USD are the reduction in the US energy trade deficit, the decrease in the deficit with China, the persistence of a positive growth differential and expectations that US QE3 will be unwound in H Consequently, during Q3 2013, there is a high probability that the EUR breaks down into a new trading range towards GBP: The depreciation in the GBP against the USD from 1.62 last December to below 1.50 in March, has now stabilised. However, weak growth prospects, a further easing in monetary policy, the slow progress in reducing the budget deficit and the lack of improvement in the trade position will prevent any GBP recovery and a further break down to 1.45 is likely around mid-year. AUD/CAD: The AUD is supported by interest rate differentials, support for commodity prices at current levels and by growth improving later in Technically, it has a floor of 0.98 /parity, but the upside remains capped at Conversely, the CAD has weakened on a negative interest rate differential for long maturity bonds and the growth differential with the US. Although the downside is limited to 1.05, the scope for a CAD rally is unlikely. The trend appreciation in the SEK against the EUR from 8.8 last December to below 8.3 in March has now stabilised and a one to two month trading range of is now likely. However, given the strength of Swedish macro/ fiscal factors, another move in H to is likely. The reversal in the NOK against the EUR to around 7.55 is due to profit-taking, the correction of an overvalued position and weaker oil prices. The major market long position has now been significantly reduced. At current levels against the EUR, the NOK should now stabilise. Emerging Currencies Amongst emerging currencies, the key issue in Asia is the depreciation of the JPY, thereby breaking the upside for most of the currencies. Consequently, the CNY should hold at 6.2, the KRW may reverse further to 1,150, the SGD dollar to 1.28 and the overvalued PHP to 42. Fundamental factors suggest that the INR should weaken to 56, while the recent strength of the THB to 29 appears short lived. USD/JPY: The JPY has now stabilised in a range of 92 to 98 after its sharp depreciation since October. Although Japanese QE will increase, the budget deficit and debt levels are negatives, as is the unattractive level of JGB yields with a move to inflation. The JPY is now significantly oversold, with major market short positions still in place. Positive factors at this level are the currency s undervaluation against its Asian counterparts and the improvement in Japanese export, consumption and activity data. CHF: The CHF has stabilised against the EUR at around and although the SNB would ideally like to see a further decline towards 1.25+, problems in the eurozone in In EMEA, weaker oil prices and the Cyprus problem are negative for the RUB which should now trade back to 31.5, while the TRY should hold around 1.82 given capital inflows. In Latin America, the BRL is holding 1.98 on expectations that monetary policy will not be eased further. Commodity Markets Since 2006, all indices of volatility for commodity prices are at record lows, with the 30-day annualised volatility numbers all around 8%. In contrast, volatilities in Q were close to 30%. 4/5

5 Oil Brent has reversed over the last month from USD 118 p/b to less than USD 110 p/bl, pushed lower by weaker February data from China and the unwinding of speculative long positions. In addition, geopolitical risks have not escalated and expectations have improved of a settlement with Iran. Assuming that after the Chinese New Year, Chinese data will strengthen, that speculative longs are now minor and that Saudi policy will continue to target a range of USD p/b, then Brent should hold above USD 105 p/bl over the next three months, but with a ceiling of USD 115 p/bl. Gold Speculative long positions have trended lower since mid Positive factors are the continuation of QE, the expansion of QE in the UK and Japan, the mismanagement of the Cyprus problem and increased geopolitical risk in North Korea. However, currency markets are relatively stable and inflation is yet to accelerate. Consequently, while there is a floor on gold of USD 1,500 p/oz, it is premature to forecast a strong uptrend and over the next six months any upside is likely to be limited to USD 1,700 p/oz. Copper Prices have stabilised above USD 7,500 p/tn, as inventories have been unwound and reflecting short-term weaker data from China. Assuming that Chinese data in Q2 reflects growth moving back to 8% and with inventories now relatively low, then price support should hold at USD 7,500 p/tn, with upside to USD 8,500 over the next six months. Soft commodities Soft commodities generally remain overvalued, with no evidence of supply constraints. Corn, currently at US cents 730 p/bu, should reverse back to below US cents 700. CH/E/ Important Legal Information This material has been prepared by the Private Banking & Wealth Management division of Credit Suisse ( Credit Suisse ) and not by Credit Suisse's Research Department. 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