Global Investment Strategy. Scenario Analysis Winter 2012/13

Global Investment Strategy Scenario Analysis Winter 2012/13

Introduction Our central scenario is for a reacceleration in global growth in 2013 and 2014, which should be help risk assets outperform during 2013. We have increased our conviction that this scenario will happen, from 50% to 60% probability. In addition, the risks are now less skewed to the downside than they were during 2012 with a 15% risk to the upside and 25% to the downside. The combination of bullish investors, low market volatility and low financial stress suggests that risk assets are vulnerable to a temporary pull back on any bad news, particularly if negotiations over the US sequester drag on or the Italian elections prove inconclusive. However, given our positive outlook for the global economy over the next two years, any pronounced market weakness will provide an opportunity to increase exposure to risk assets. Nevertheless, the outlook for the global economy, and hence financial markets, remains uncertain. Consequently, as well as looking at the macroeconomic and market implications of our baseline scenario this report looks at the positive tail risk of a corporate reawakening and three negative tail risks: multiple Eurozone exits; a slower upturn in the US and emerging markets; and tensions in the Middle East. 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 during 2013 the market will at least partially price one or more of these alternative scenarios. 2

Macro scenario outlines: one upside tail risk and three downside tail risks Oxford Economics baseline forecast (60% probability) Steps to ensure Eurozone survival are taken, although they are not enough to kick-start significant growth. Risk premia fall; consumer & business confidence gradually recover. Recovery is limited by high debt, weak job growth, fiscal retrenchment. EMs robust as earlier policy easing feeds through and the growing middle class supports consumer spending and trade. Possible strategies: overweight equities, (particularly emerging markets) peripheral bonds and high-yield debt rather than safehaven bond markets and gold. Scenario 1: Corporate reawakening (15% 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. Possible strategies: overweight equities and emerging markets but underweight government bonds, gold and oil. Scenario 2: Multiple Eurozone exits (15% probability) Fiscal austerity in peripheral countries becomes unbearable, lack of growth pushes unemployment yet higher, pro-exit parties gain popularity, run on banks, debt defaults. Greece, Portugal, Ireland, Spain, Italy and Cyprus leave Eurozone in Q1 2014. Possible strategies: safe-haven bond markets and the dollar expected to outperform risk asset like equities, (particularly emerging markets), peripheral debt and commodities. Scenario 3: Slower upturn in the US & emerging markets (5% probability) US consumers and businesses focus on reducing debt and cut spending. Longer unwinding of China s property bubble. Impact of monetary and fiscal stimulus in EMs disappoints. Triggers even larger policy stimulus that eventually fuels an upturn. Possible strategies: underweight equities, emerging market debt, oil and copper but overweight safe-haven bonds. Scenario 4: Middle East tensions (5% probability) Political tensions escalate in Egypt, Syria and Iran, concerns about stability in the region push oil prices close to $250 per barrel. Business and consumer confidence hit. Political situation stabilises gradually allowing oil prices to return to baseline by 2015. Possible strategies: overweight oil, gold and safe-haven bonds but underweight equities. 3

Macro Scenario Some of the tail risks which plagued the global economy in 2012 have diminished: China has pulled off a soft landing; the Eurozone has survived to fight another day; and the US has, at least partially, avoided the fiscal cliff. This should make for a less volatile equity market and eventually boost business confidence in planning and investment. Indeed, positive tail risk such as a corporate reawakening should not be ignored. World: GDP % year 6 5 4 3 2 1 0 We expect the world economy gradually to gain traction, with growth accelerating from 3.0% in 2012 to 4.2% in 2014, led by the US, emerging Asia and Latin America. -1-2 4

Under the baseline scenario, equities rise in 2013 US: Equity S&P 500 composite index (1941-43=10) 1900 1700 US: Equity Price/Earnings 35 30 1500 25 1300 1100 900 20 15 Historic Average Actual 700 10 Q1 2000 Q1 2002 Q1 2004 Q1 2006 Q1 2008 Q1 2010 Q1 2012 Source : Oxford Economics/Datastream Under our central scenario, we expect diminishing negative tail risks to cause further underperformance from low yielding safe-haven assets like cash, government bonds, gold and Swiss francs relative to risk assets such as equities, high-yield debt and industrial commodities. However, with equities having risen strongly last year and PEs close to historic averages, much of the reduction in tail risk is already in the price, limiting the scope for further large equity market gains in 2013 (unless growth surprises on the upside). Under our central scenario, we expect US equity prices to rise by a further 7%, a smaller gain than last year but still exceeding the returns we envisage from investing in cash or US government bonds. 5

particularly cyclical markets like emergers and the Eurozone Although relative valuation is fairly neutral, emerging market and Eurozone equities have both tended to outperform US equities when expectations about the global growth outlook are improving. Consequently, as investors growth expectations improve during 2013-14 we expect these markets to outperform. Since ECB president Mario Draghi s speech in late July 2012 promising to save the euro, fund managers have closed their underweights in Eurozone equities. We expect positions will rise further as it becomes more broadly accepted that the Eurozone will survive. This process will be supportive of outperformance by Eurozone equities. US and European Equity Markets Relative Price:Earning ratio, US/Eurozone 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1 Historic average Q1 2005 Q1 2007 Q1 2009 Q1 2011 Source : Oxford Economics/Datastream US and emerging equity markets Relative Price:Earning ratio, US/Emerging Markets 1.9 US comparatively more expensive Actual 1.7 Historical average 1.5 1.3 1.1 0.9 0.7 US comparatively more expensive Actual 0.5 Q1 2005 Q1 2007 Q1 2009 Q1 2011 Source : Oxford Economics/Datastream 6

Under baseline scenario, peripheral bond yields are fairly stable As we expect the Eurozone to survive, we believe it will pay to hold peripheral Eurozone debt in 2013. However, the large capital gains from holding these bonds have probably passed. There may still be a benefit from yield pickup relative to core bond markets and the scope for further capital gains in Portugal and Greece. 10-year government bond yields - Spain & Italy % 7 7 6 6 5 5 4 Spain Italy 4 3 Expected 10-year government bond yields (%) Spain Italy Portugal Greece Ireland 2012 Q4 5.6 4.8 7.9 16.1 4.8 2013 Q4 5.5 5.2 7.5 17.2 5.0 2014 Q4 5.5 5.2 6.8 17.2 5.0 2015 Q4 5.4 5.3 6.4 16.9 5.0 2016 Q4 5.4 5.3 6.2 15.3 5.0 2017 Q4 5.4 5.4 6.1 12.5 5.0 7

but safe-haven government bond yields rise 10-year government bond yields % 6 10-year government bond yields % 7 5 4 US UK 6 5 4 Spain Italy 3 3 2 Germany 2 1 Germany 1 0 We believe that government bond yields bottomed out in Q2 2012 in safe-haven markets such as the US, UK and Germany. We expect them to rise gradually 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. Expected 10-year gov't bond yields (%) US UK Germany 2012 Q4 1.7 1.8 1.4 2013 Q4 2.0 2.0 1.7 2014 Q4 2.6 2.3 2.0 2015 Q4 3.3 2.6 2.4 2016 Q4 4.0 3.2 2.9 2017 Q4 4.7 3.8 3.2 8

Emergers are tightening but others still on hold Short term interest rates - developed markets % 7 UK 6 US 5 4 3 Eurozone 2 1 0 Short-term interest rates - emerging markets % 25 Russia 20 Brazil 15 10 India 5 China 0 Interest rates in India are not expected to trough (at 7.5%) until H2 2013, but the other BRIC economies are now in tightening mode. Chinese rates are forecast to rise from 2.25% to 3.0% by the end of 2014. Given the Fed s commitment to keep rates on hold until the labour market has clearly improved, we do not expect US short rates to begin rising until late 2015. Rate rises will be even longer coming in the UK and the Eurozone due to the need to deleverage, with rates on hold until late 2016 in the UK and late 2017 in the Eurozone. 9

Oil prices are weak & rising bonds yields weigh on gold World oil price $/barrel 140 120 100 80 60 40 20 0 Source : Oxford Economics World gold price $/troy ounce 2000 1800 1600 1400 1200 1000 800 600 400 200 0 Foreacst With world growth relatively subdued under our central scenario, we expect the Brent oil price to end 2013 at $102, around 7% below its December average. The oil price should then rise to $109 by the end of 2014 and $114 in 2015 as the global recovery accelerates from 3.0% in 2012 to 3.5% in 2013, 4.2% in 2014, and 4.4% in 2015. Although the gold price did not change much during 2012, we expect gold to fall in value by 11% in 2013 and 14% in 2014. 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. 10

Investment implications of our central scenario 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 do not expect US short rates to begin rising until late 2015. Rate rises will be even longer coming to the UK and the Eurozone due to the need to deleverage, with rates on hold in the UK until late 2016 and until late 2017 in the Eurozone. In contrast, we expect many emerging nations to be in tightening mode this year and next, with interest rates in China expected to rise from 2.25% to 3%. Equities will continue to outperform safe-haven bond markets in 2013 as tail risk fears continue to diminish and the global economic recovery gains traction. We think there are more likely to be upside surprises in emerging markets and European equities than the US. Europe will benefit from further policy progress towards fiscal and banking union and emerging markets from rising confidence about the outlook global growth. Peripheral Eurozone government debt is likely to outperform safe-haven bond markets like the US, the UK and Germany as we expect tail risk fears to diminish and the Eurozone to survive. Oil prices to fall in the near term. With world growth relatively subdued under our central scenario, we expect the Brent oil price to end 2013 around 7% below its December average at $102. As the global recovery accelerates from a 3.0% pace in 2012 to 3.5% in 2013, 4.2% in 2014, and 4.4% in 2015 we expect the oil price to rise to $109 at the end of 2014 and $114 in 2015. Gold loses its shine. Although the gold price did not change much during 2012, we expect gold to fall in value by 11% in 2013 and 14% in 2014. 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 US UK Eurozone Japan 2013 2014 2013 2014 2013 2014 2013 2014 GDP (%) 2.2 3.1 1.0 2.1-0.2 1.0 0.4 1.8 CPI (%) 2.4 2.1 2.2 1.7 1.8 1.5-0.5 1.1 Policy rate (bps change) 0 0 0 0 0 0 0 0 Equities (%) 6.8 6.9 4.3 8.7 5.1 10.1 7.9 14.0 10-year government bond yields (bps change) 30 59 21 25 8 22 9 17 World oil price (%) -7.9 7.3 - - - - - - World gold price (%) -9.6-15.1 - - - - - - World copper price (%) 1.9 6.5 - - - - - - Note: All calculations Q4/Q4 12

Scenario 1: Corporate Reawakening Policymakers could surprise on the upside by taking swifter and broader-ranging action than we currently anticipate. This applies to the Eurozone primarily but is also true of the US where an agreement on a medium-term plan for fiscal policy would provide very useful clarity to businesses. In this environment, cash hoarded on corporate balance sheets in a number of countries gets spent on investment, procurement and staff increases more quickly than implied by our baseline forecast. The probability of this scenario has increased from 5% in September to 15%. We assume that this policy awakening starts at the beginning of next year. Under this scenario, US GDP would accelerate towards 4.5-5% in 2014 and 2015. Eurozone growth would rise towards 1.5-2%, still very modest rates but at least growth rates that would allow a gradual decrease in unemployment. After 3% in 2012, world GDP growth, on a PPP basis, would rise to 4.1% in 2013 and then to around 5.2% in 2014. 13

Corporate reawakening leads to stronger growth As business confidence improves, quarterly investment rises by 1.5% more than in our baseline scenario throughout 2013 in the major economies. World: GDP % year 6 5 Upside 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. 4 3 2 1 Stronger growth in the US and Europe entails knock-on benefits for emerging markets via increased trade and capital inflows. 0-1 -2 Growth rates (% year) World US Eurozone UK China Japan Upside Upside Upside Upside Upside Upside 2013 2.4 3.0 2.2 3.1-0.2 0.4 1.0 1.8 8.1 9.5 0.4 1.2 2014 3.5 4.6 3.1 4.6 1.0 2.1 2.1 3.3 9.0 10.1 1.8 3.2 2015 3.8 4.6 3.4 4.8 1.4 1.8 2.4 2.9 8.7 9.5 2.2 3.3 2016 3.5 3.3 3.0 3.0 1.5 1.3 2.5 2.4 8.1 7.6 1.1 0.6 2017 3.5 3.1 3.0 2.6 1.5 1.3 2.4 2.4 7.5 6.8 1.6 0.8 14

but supply-side boost keeps inflation in check 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 0.6-0.7pp lower than under our central scenario in 2013 and 2014. World: CPI inflation % year 7 6 5 Nevertheless, the improved growth outlook enables major developed economy central banks to start raising interest rates more quickly than assumed under our central scenario. 4 3 2 1 Upside 0 Central bank rates (%) US Eurozone UK Upside Upside Upside 2013 Q4 0.2 0.2 0.7 0.8 0.5 0.5 2014 Q4 0.1 0.5 0.7 1.0 0.5 1.3 2015 Q4 0.2 1.3 0.7 1.8 0.5 1.5 2016 Q4 0.7 1.5 0.7 2.0 0.9 1.4 2017 Q4 2.2 2.0 1.0 2.3 1.9 1.9 15

Impact of corporate reawaking on equity markets less marked than on bond markets US: 10-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 3 2 1 US: Equity S&P 500 composite index (1941-43=10) 1900 1700 1500 1300 Upside The difference between the performance of the equity market under the upside scenario and the baseline is relatively modest. Equities end 2017 2% higher than under the baseline scenario. 1100 900 700 16

Corporate reawakening leads to a lower gold price Lower political tensions would reduce the risk premium embedded in the oil price which ends 2014 $17 below the price assumed in our central scenario at $92 per barrel, despite stronger global growth. World gold price $/troy ounce 1900 1400 Upside 900 400 17

Investment implications of corporate reawakening 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 2014 rather than in late 2015. Government bonds expected to underperform. 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 to 3.3% at the end of 2014, compared with a rise to 2.6% under our central scenario. Equities expected to outperform. With world GDP growth of 4.6% in 2014, better even than the pre-financial crisis boom years of 2006 and 2007, fears of tail risks dissipate and equity markets rise. Emerging market assets expected to perform particularly well. Strong, inflation free, global growth helps emerging market risk premia gradually fall. Due to the falling oil price favour oil consumers over oil producers. Gold expected to be hit hard. 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 2014 around 25% below its end 2012 level. 18

Investment implications of corporate reawakening US UK Eurozone Japan Corporate re-awakening 2013 2014 2013 2014 2013 2014 2013 2014 GDP (%) 3.1 4.6 1.8 3.3 0.4 2.1 1.2 3.2 CPI (%) 2.1 1.2 2.1 1.0 1.6 1.0-0.6 0.3 Policy rate (bps change) 0 35 0 75 0 26 0 50 Equities (%) 7.3 6.7 4.8 7.3 8.0 9.7 8.1 11.5 10-year government bond yields (bps change) 28 129 17 79-10 88 4 68 World oil price (%) -14.3-3.1 - - - - - - World gold price (%) -10.9-17.4 - - - - - - World copper price (%) 0.4 3.6 - - - - - - Note: All calculations Q4/Q4 19

Scenario 2: Multiple Eurozone exits in 2014 We have reduced the probability of multiple Eurozone exits from 20% in September to 15%. It now looks less likely that creditor fatigue or markets will force the Eurozone apart but social unrest could still do so. We consider the case of six countries leaving the Eurozone in 2014 Q1: Greece, Portugal, Ireland, Spain, Italy and Cyprus. Exiting countries suffer GDP falls of around 15% compared to our baseline within a couple of years. A sharp rise in inflation cuts real household incomes, and unprecedented uncertainty would all but halt investment and recruitment. Eurozone exits may be the trigger for reforms of the labour and product markets but their benefits would take time to materialise. The remaining Eurozone countries also suffer very large declines in GDP. The exiting countries represent large export markets in which demand collapses. Corporate balance sheets are hit by losses on assets in the exiting countries as defaults multiply. The GDP of the remaining Eurozone countries falls by around 10% below our baseline forecast within two years. The world economy approaches recession during 2014. World GDP growth, on a PPP basis, slows to 2.3% and 1.3% in 2014 and 2015 respectively. 20

Multiple Eurozone exits would hit the global economy hard The impact of a breakup in 2014 Q1 on the remaining countries in the Eurozone would be huge, with GDP contracting by over 2% in 2014 and by over 4% in 2015. World: GDP % year 6 5 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 2015. In China, growth would dip to 4.7% in 2015 and the level of GDP would be 5% below baseline at the end of 2016. 4 3 2 1 0-1 -2 Multiple Eurozone exits Annual % GDP growth World Eurozone US UK Breakup Breakup Breakup Breakup 2012 2.3 2.3-0.4-0.4 2.2 2.2-0.1-0.1 2013 2.4 2.3-0.2-0.3 2.2 2.2 1.0 1.0 2014 3.5 1.3 1.0-2.5 3.1 1.3 2.1-1.0 2015 3.8 0.0 1.4-4.1 3.4 0.3 2.4-2.1 2016 3.5 2.2 1.5-0.4 3.0 2.2 2.5 0.5 2017 3.5 4.3 1.5 2.1 3.0 3.3 2.4 2.8 21

leading to rate cuts in the residual Eurozone Eurozone*: REFI rate % Eurozone*: CPI inflation % year 5 5 4 4 3 3 2 2 1 0 1 * Remaining countries Multiple Eurozone exits 0-1 -2-3 * Remaining countries Multiple Eurozone exits Interest rates would fall to below zero in residual Eurozone and remain there until after the end of 2017 as the ECB attempted 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 2012 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 2013 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 2014 0.3-0.4 0.3 4.2 0.3 3.0 0.3 3.0 0.3 3.0 0.3 2.8 2015 0.4-0.4 0.4 7.3 0.4 7.6 0.4 7.5 0.4 7.4 0.4 5.8 2016 0.5-0.3 0.5 5.8 0.5 5.4 0.5 5.3 0.5 4.9 0.5 4.9 2017 0.6-0.2 0.6 3.0 0.6 2.6 0.6 2.4 0.6 1.4 0.6 0.522

A breakup would push safe-haven bond yields below 1%... US: 10-year government bond yields % 6 5 Expected 10-year government bond yields (%), 2014Q2 Breakup US 2.3 1.6 UK 2.2 1.1 Germany 1.9 1.3 4 3 2 1 Multiple Eurozone exits 0 Safe-haven bond markets would see strong inflows, sending yields on these bonds plunging. 23

while peripheral bond spreads rise sharply 10-year government bond yields, quarter average (%) Greece Portugal Spain Italy Ireland Breakup Breakup Breakup Breakup Breakup 2012Q3 23.8 23.8 9.8 9.8 6.4 6.4 5.7 5.7 5.9 5.9 2012Q4 17.2 17.2 8.6 8.6 5.5 5.5 4.9 4.9 4.7 4.7 2013Q1 17.2 17.2 8.2 8.2 6.0 6.0 5.1 5.1 4.9 4.9 2013Q2 17.2 17.2 7.9 7.9 5.5 5.5 5.2 5.2 4.9 4.9 2013Q3 17.2 18.7 7.7 9.2 5.5 6.5 5.2 6.2 4.9 5.9 2013Q4 17.2 20.2 7.5 10.0 5.5 7.5 5.2 7.2 5.0 6.5 2014Q1 17.2 21.3 7.2 10.7 5.5 8.5 5.2 8.2 5.0 7.5 2014Q2 17.3 22.3 7.0 11.0 5.5 9.5 5.2 9.2 5.0 8.0 2014Q3 17.3 27.2 6.9 14.9 5.5 13.5 5.2 13.2 5.0 11.0 2014Q4 17.2 29.2 6.8 16.8 5.5 15.4 5.2 15.2 5.0 12.0 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 2008 due to their improved risk profile Spain: 10-year government bond yields % 17 15 13 11 9 7 Multiple Eurozone exits 5 3 24

Equity markets would sell off particularly sharply in the exiting countries, but all markets would be hit Spain: Equity Madrid General Index (2005=100) 180 160 Change in stockmarket relative to baseline % 0 140 120 100 80 60 40 20 Multiple Eurozone exits -10-20 -30-40 -50-60 US: Equity S&P 500 composite index (1941-43=10) 2000 China UK France Germany US Japan Ireland Italy Portugal Greece Spain 1750 1500 1250 1000 Multiple Eurozone exits 750 500 25

New currencies would undershoot fair value and the residual euro would initially weaken Initially, national exchange rates would drop by around 40% 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 % 0-5 Eurozone*: $/ $/ 1.6-10 -15-20 -25-30 -35 1.4 1.2 Multiple Eurozone exits -40-45 Ireland Greece Italy Spain Portugal * Remaining countries 1 26

Oil and gold both expected to fall in value World oil price $/barrel World oil price $/troy ounce 140 2000 120 1800 1600 100 1400 1200 80 60 Multiple Eurozone exits 1000 800 600 Multiple Eurozone exits 40 400 With world GDP growth slumping to just 1.3% in 2014 and then being flat in 2015, the oil price falls to a trough of $79/barrel in the first half of 2015. 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 $900 by 2015 Q3. 27

Investment implications of multiple Eurozone exits Interest rates would be cut to zero or below in most of the major economies and remain there until after the end of 2017, 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. Safe-haven bonds expected to perform well. We believe that US treasuries, bunds and gilts would outperform equities and peripheral Eurozone bonds as their yields fell to 1.3%, 0.9% and 0.6% respectively. Peripheral government bonds would fall sharply in value with Italian and Spanish ten-year yields rising to 16%. Emerging market debt expected to underperform. Spreads would rise albeit they would not reach the level hit at the worst point of the global financial crisis at the end of 2008 due to their improved risk profile. Equities expected to sell-off sharply. The equity markets of the exiting countries are expected to fall by 20% to 30% and the major global markets to fall by around 10%. Equity holdings should be skewed towards defensive sectors and less cyclical markets, like the US, rather than emerging markets. Risk off trade to benefit the dollar. Overseas holders of peripheral economy assets will also make currency losses as new national exchange rates drop by around 40% 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. Risk off trade to hit commodities. With world GDP growth slowing to just 1.3% in 2014 and then being flat in 2015, the oil price falls to a trough of $79/barrel in the first half of 2015 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 $900 by 2015 Q3. 28

Investment implications of multiple Eurozone exits US UK Eurozone Japan Multiple Eurozone Exits 2013 2014 2013 2014 2013 2014 2013 2014 GDP (%) 2.2 1.3 1.0-1.0-0.3-2.5 0.4 0.0 CPI (%) 2.4 0.3 2.2 1.5 1.8 1.2-0.5-0.2 Policy rate (bps change) 0-15 0-50 0-75 0-10 Equities (%) 3.6-0.7 2.2 0.0 2.0 2.3 4.7 5.8 10-year government bond yields (bps change) 30-60 22-101 9-43 9-33 World oil price (%) -7.9-20.4 - - - - - - World gold price (%) -9.6-33.6 - - - - - - World copper price (%) 1.9-16.8 - - - - - - Note: All calculations Q4/Q4 29

Scenario 3: Slower upturn in US and emerging markets Although the US private sector has already deleveraged to a significant extent, more effort to reduce debt may be needed. Similarly, we could be overestimating momentum in emerging markets for two main reasons: the Chinese property bubble may take longer to unwind than we currently anticipate; and monetary and fiscal stimulus actions in a number of countries could be less efficient than we expect. These shocks are transmitted into other sectors and countries via trade, financial and confidence linkages. We have modelled a scenario involving more deleveraging in the US and a slower upturn in emerging markets. Under this scenario global growth in 2013 and 2014 is cut from 3.5% and 4.2%, under our baseline, to 2.5% and 3.0%. As a result, world output is 2% lower at the end of 2014 than assumed under our baseline and the price level is 0.6% lower. The authorities respond with more extensive quantitative easing, for example the stock of assts held by the Fed hits 22% of GDP at the end of 2014, 3.5 ppt higher than under our baseline. Nevertheless, 2013 growth in the BRICs falls below 5%. In addition, Chinese growth falls below 6%, compared to 8.1% in the baseline, and US growth slips to 0.6%, compared with 2.2% under the baseline. We assign just a 5% probability to this scenario. 30

Additional deleveraging hits growth US: GDP % year 6 5 4 3 2 1 0-1 -2-3 -4-5 -6-7 US & EM slower upturn Growth in the BRICs falls below 5%. 2013 growth in China falls below 6%, compared to 8.1% in the baseline. By the end of 2014, BRICs GDP is 2.5% (nearly $500 billion) below baseline. Lower oil prices are not enough to offset the negative trade and financial shocks to the Eurozone. The recession extends into 2013. GDP growth falls to -1% (-0.2% in the baseline). The Eurozone only regains pre-crisis levels of activity in mid-2016, one year later than in the baseline. More rapid US deleveraging than assumed in our baseline forecast, such that the savings rate is maintained at around 3.5% rather than falling back to the 2-3% range seen in the lead-up to the financial crisis. As a result, US economy stagnates with GDP growth only 0.6% in 2013 and 1.2% in 2014. The economy reverts to 3% growth only in 2015, nearly 2 years later than under our baseline scenario. World: GDP % year 7 6 5 4 3 2 1 0-1 -2-3 US & EM slower upturn 31

Central banks respond as best they can UK: Policy rate % 6 US: Quantitative easing US$; Billions 4000 US and EM slower upturn 5 3500 4 3000 2500 3 2 1 0 US and EM slower upturn 2000 1500 1000 500 0 Weaker global growth than under our baseline results in larger fall in inflation with world inflation dropping from 3.6% in 2012 to 1.5% in 2014 rather than the 2.0% envisaged by our baseline scenario. This is despite central banks easing policy in an effort to get growth moving again with the ECB cutting rates from 0.75% to 0.5% and the Bank of England cutting rates from 0.5% to 0.15%. With the Fed funds rate at just 0.125%, the US central bank has to pursue more extensive quantitative easing. Consequently, instead of peaking at 19% of GDP in Q1 2014, QE peaks at 22% of GDP at the end of 2014. 32

Weaker growth and inflation result in slower rise in bond yields US: 10-year government bonds % 6.0 Risk premium on emerging market rates % 5 5.0 4.0 4 US and EM slower upturn 3.0 2.0 1.0 US & EM slower upturn 3 0.0 2 Weaker growth and lower inflation mean that ten-year bond yields rise more slowly than assumed under our baseline scenario in the US, the Eurozone and the UK. They end 2014 30bps, 10bps and 18bps, respectively lower than assumed under our baseline. Over the course of the first three quarters of 2013, risk premia in emerging markets rise as policy stimulus disappoints, peaking at around 100 bps higher than under our baseline. 33

Slower upturn scenario is negative for equity markets The developments assumed in this scenario would likely be accompanied by a global loss of confidence, reflecting itself in stock markets and investment intentions across a wide range of countries. We expect the largest investment impacts in emerging markets. US: Equity S&P 500 composite index (1941-43=10) 1700 US equity prices fall by 8% in the first half of 2013 before stabilising in Q3 and starting to recover in Q4. As a result, equity prices are 12% lower than assumed under our baseline scenario by the end of Q3. 1200 US and EM slower upturn 700 34

and for growth sensitive commodities World oil price $/barrel 140 World copper price US$ per MT 10000 120 9000 8000 100 7000 6000 US and EM slower upturn 80 US and EM slower upturn 5000 60 4000 3000 40 2000 With energy-intensive economies such as the US and China growing much more slowly, energy demand and hence oil prices fall compared to baseline. Oil prices fall to around $90/barrel by the end of 2013, 18% below their December 2012 average and 12% lower than predicted under our baseline scenario. Weak growth means that industrial commodity prices also fall with the Copper price 10% lower than its December 2012 average by the end of 2014 and 16% lower than predicted under our baseline scenario. 35

Investment implications of slower upturn in the US and emerging markets Interest rates cuts in Eurozone and UK even more QE in the US. The ECB cuts rates from 0.75% to 0.5% and the Bank of England cuts rates from 0.5% to 0.15%. With the Fed funds rate at just 0.125%, the US central bank pursues more extensive QE, QE peaks at 22% of GDP at the end of 2014, 3 ppt higher than under our baseline. Equities expected to underperform. Equity prices fall across the globe under this scenario with US equity prices falling by 8% in the first half of 2013 before stabilising in Q3 and starting to recover in Q4. Government bonds expected to outperform. Safe-haven bond yields are not expected to rise materially in the first half of 2013 so investors should be overweight government bonds rather than cash at the expense of equities. Emerging market debt expected to underperform. Over the course of the first three quarters of 2013, risk premia in emerging markets rise as policy stimulus disappoints, peaking at around 100 bps higher than under our baseline. Commodities expected to suffer. With energy-intensive economies such as the US and China growing much more slowly, oil prices fall to around $90/barrel by the end of 2013, 18% below their December 2012 average. Weak growth also hits industrial commodity prices with the Copper price 10% lower than its December 2012 average by the end of 2014. 36

Investment implications of slower upturn in US, EM US UK Eurozone Japan Slower upturn in US, Emerging Markets 2013 2014 2013 2014 2013 2014 2013 2014 GDP (%) 0.6 1.2 0.5 1.2-1.0 0.2 0.0 0.7 CPI (%) 2.3 2.0 1.7 0.8 1.3 0.6-0.5 0.9 Policy rate (bps change) -2-4 -11-16 -4-9 12 28 Equities (%) -6.0 15.5-8.1 17.6-7.4 19.1 5.8 16.6 10-year government bond yields (bps change) 31 27 16 12 5 14 16 22 World oil price (%) -18.8 1.5 - - - - - - World gold price (%) -15.9-23.5 - - - - - - World copper price (%) -5.2-4.1 - - - - - - Note: All calculations Q4/Q4 37

Scenario 4: Middle East tensions Political tensions have been on the rise in recent months in a number of countries in the Middle East and North Africa region. In Egypt and Tunisia, the transition is increasingly threatened by confrontation between Islamists and leftists. In Syria, there is little indication of an end to the civil war and fears grow of a political vacuum being filled by Al Qaeda, and of the conflict spreading to Lebanon, Jordan and Iraq. Concerns are also rising in Yemen. But perhaps the most severe escalation in geopolitical risk would come from a confrontation between Israel and Iran, the latter which is also facing a deepening economic, and possibly political, crisis. Rising geopolitical risk has typically been associated with sharp spikes in oil prices. We therefore look at a scenario centred around a spike in oil prices, to close to $250/barrel in early 2013. We assign a 5% probability to this scenario. 38

Geopolitical tension pushes gold price to new high World oil price $/barrel 240 200 160 Middle East tensions We assume oil prices increase in the first half of 2013 as tensions in the Middle East heighten. They reach close to $250/barrel in mid 2013. After this spike, oil prices slowly return to baseline levels as the geopolitical situation improves gradually. 120 80 World gold price $/troy ounce 2200 40 2000 1800 1600 Middle East tensions Geopolitical uncertainty combined with fears of an inflation spiral push the gold price up to a new high of $2188 per troy ounce, 30% above its December 2012 average. 1400 1200 1000 800 600 400 39

Middle East tensions cause a technical recession in the US Oil-intensive emerging markets such as China are the worst affected. Chinese GDP growth falls to around 5.5% by mid-2013 and averages only 6% in the year as a whole. World: GDP % year 6 5 Commodity-dependent countries like Brazil benefit from the rise in oil prices. But the negative impact on world trade and financial markets tends to dominate. Even in Brazil, GDP falls below baseline. 4 3 2 1 0 Middle East crisis The US experiences two quarters of declining output in 2013. For the year as a whole, GDP growth averages only 0.3%. The economy starts to recover in 2014 but growth is still only 1.3%. The unemployment rate peaks at 8.8%. -1-2 -3 This scenario makes an already weak Eurozone weaker still. GDP contracts by 1.8% in 2013 and before flat lining in 2014. For the peripheral countries, this means further losses in tax revenues that will lead to even longer fiscal austerity. 40

Developed economy central banks look through the inflation rise but emerging market central banks do not World: CPI % year 8 US: Federal funds rate % 6 6 Middle East crisis 5 4 4 3 2 0 2 1 0 Middle East crisis Rather than falling from 3.6% in 2012 to 2.4% in 2013, global inflation rise to 5.0%. Central banks in advanced economies see through the oil-related increase in inflation and keep interest rates at the very low levels as in the baseline. However, in emerging markets, with inflation in some cases relatively high to start with, such policy accommodation is not possible. The oil price spike therefore will either prevents further policy easing where that was expected or hastens the pace of policy tightening. 41

Middle East tensions are good for government bonds but bad for equities US: Equity S&P 500 composite index (1941-43=10) 1900 1700 1500 Investor, business and consumer confidence are negatively affected. Major developed economy equity prices fall by around 20% within 2 to 3 quarters. Falls are larger for growth sensitive oil importers like Hong Kong, -30%, and smaller for net oil exporters like Russia, -10%. 1300 1100 900 700 Middle East tensions US: 10-year government bonds % 6.0 5.0 4.0 Bond investors focus more on the negative impact of higher oil prices on real and nominal GDP than on higher inflation. As a result of the oil shock, US nominal GDP ends 2013 2.3% lower than under our base line scenario. US ten-year bond yields fall as low as 1.4% and end 2013 around 50 bps lower than under our baseline scenario. 3.0 2.0 1.0 Middle East crisis 42

Investment implications of Middle East tensions Tighter monetary policy in emerging markets. Central banks in advanced economies look through the increase in inflation and keep interest rates low but in emerging markets the oil price spike either prevents further policy easing or hastens the pace of policy tightening. Large falls expected in equity markets. Major developed economy equity prices fall by around 20%. Falls are larger for growth sensitive oil importers like Hong Kong, -30%, and smaller for net oil exporters like Russia, -10%. Bonds expected to benefit. US ten-year bond yields fall as low as 1.4% and end 2013 around 50 bps lower than under our baseline scenario. Gold expected to perform well as well as oil. As an assumption of the scenario the oil price rises to close to $250/barrel in mid 2013. In addition, geopolitical uncertainty combined with fears of an inflation spiral push the gold price up to a new high of $2188 per troy ounce, 30% above its December 2012 average. 43

Investment implications of Middle East tensions US UK Eurozone Japan Middle East tensions 2013 2014 2013 2014 2013 2014 2013 2014 GDP (%) 0.3 1.3 0.1-0.2-1.8 0.0-0.6 0.9 CPI (%) 5.7 2.2 5.7 2.9 4.2 3.3 0.7 2.1 Policy rate (bps change) 4 3 6 0 11 5 4 5 Equities (%) -7.2 16.7-9.5 18.8-8.8 20.3-6.3 24.4 10-year government bond yields (bps change) -24 65-10 35-3 22-8 21 World oil price (%) 74.7-27.4 - - - - - - World gold price (%) 25.9-37.5 - - - - - - World copper price (%) 41.9-21.6 - - - - - - Note: All calculations Q4/Q4 44

Alternative equity market forecasts 2012 2013 2014 2015 2016 2017 Central Scenario United States (S&P 500) 1,416 1,512 1,616 1,697 1,799 1,910 Germany (DAX) 7,315 7,941 8,631 9,219 9,945 10,742 UK (FTSE All-Share) 3,086 3,219 3,500 3,782 4,040 4,309 Japan (TOPIX, 1st section composite) 760 820 935 1,009 1,078 1,147 Multiple Eurozone Exits United States 1,416 1,314 1,533 1,696 1,799 1,911 Germany 7,315 6,888 8,188 9,220 9,948 10,751 UK 3,086 2,792 3,318 3,781 4,037 4,302 Japan 760 712 886 1,007 1,075 1,145 Slower upturn in US, Emerging Markets United States 1,416 1,467 1,456 1,554 1,680 1,813 Germany 7,315 7,703 7,781 8,342 9,168 10,122 UK 3,086 3,154 3,153 3,424 3,729 4,079 Japan 760 795 842 924 1,012 1,100 Middle East tensions United States 1,416 1,331 1,537 1,648 1,773 1,896 Germany 7,315 6,996 8,220 8,967 9,764 10,610 UK 3,086 2,836 3,334 3,681 3,970 4,263 Japan 760 804 937 1,014 1,096 1,177 Corporate re-awakening United States 1,416 1,520 1,623 1,724 1,851 1,951 Eurozone 7,315 8,160 8,783 9,293 10,028 10,804 UK 3,086 3,234 3,470 3,730 4,047 4,326 Japan 760 822 916 991 1,064 1,136 Note: All figures are Q4 averages Appendix for detailed forecasts 45

Alternative 10-year yield forecasts 2012 2013 2014 2015 2016 2017 Central Scenario United States 1.7 2.0 2.6 3.3 4.0 4.7 Eurozone 3.4 3.4 3.7 3.9 4.2 4.4 UK 1.8 2.0 2.3 2.6 3.2 3.8 Japan 0.7 0.8 1.0 1.8 2.1 2.1 Multiple Eurozone Exits United States 1.7 1.5 2.1 3.3 4.0 4.5 Eurozone 3.4 3.3 3.5 3.9 4.2 4.3 UK 1.8 1.7 2.1 2.5 2.9 3.3 Japan 0.7 0.7 0.9 1.8 2.0 1.9 Slower upturn in US, Emerging Markets United States 1.7 2.0 1.4 2.1 2.4 2.1 Eurozone 3.4 3.5 3.0 3.9 4.4 4.1 UK 1.8 2.0 1.0 1.7 2.1 2.3 Japan 0.7 0.8 0.5 1.4 1.6 1.0 Middle East tensions United States 1.7 2.0 2.3 2.7 3.4 4.2 Eurozone 3.4 3.4 3.6 3.8 4.2 4.4 UK 1.8 2.0 2.1 2.4 2.9 3.6 Japan 0.7 0.9 1.1 1.8 1.6 1.1 Corporate re-awakening United States 1.7 2.0 3.3 4.2 4.6 4.8 Eurozone 3.4 3.3 4.1 4.7 4.6 4.5 UK 0.5 0.5 1.3 1.5 1.5 2.0 Japan 0.7 0.8 1.5 2.4 2.7 2.4 Note: All figures are Q4 averages Appendix for detailed forecasts 46

Alternative short rate forecasts 2012 2013 2014 2015 2016 2017 Central Scenario United States 0.3 0.3 0.3 0.5 1.0 2.4 Eurozone 0.2 0.2 0.3 0.4 0.5 0.8 UK 0.5 0.5 0.5 0.5 1.0 2.0 Japan 0.2 0.2 0.1 0.4 1.3 1.7 Multiple Eurozone Exits United States 0.3 0.4 0.4 0.4 0.8 2.1 Eurozone 0.2 0.4 0.5 0.5 0.6 0.7 UK 0.5 0.6 0.6 0.6 0.6 1.7 Japan 0.2 0.2 0.2 0.3 0.7 1.7 Slower upturn in US, Emerging Markets United States 0.3 0.3 0.2 0.2 0.2 0.2 Eurozone 0.2 0.3-0.4-0.3-0.3-0.2 UK 0.5 0.5 0.1 0.1 0.1 0.3 Japan 0.2 0.2 0.0 0.0 1.0 1.3 Middle East tensions United States 0.3 0.3 0.3 0.4 0.9 2.3 Eurozone 0.2 0.2 0.2 0.2 0.2 0.5 UK 0.5 0.4 0.3 0.2 0.7 1.8 Japan 0.2 0.3 0.5 0.5 0.5 0.0 Corporate re-awakening United States 0.3 0.3 0.7 1.5 1.7 2.2 Eurozone 0.2 0.3 0.6 1.4 1.8 2.1 UK 0.5 0.5 1.3 1.5 1.5 2.0 Japan 0.2 0.2 0.6 0.9 1.8 2.3 Note: All figures are Q4 averages Appendix for detailed forecasts 47

Appendix for detailed forecasts Alternative exchange rate forecasts 2012 2013 2014 2015 2016 2017 Central Scenario US$ Effective 73.4 77.0 80.3 81.6 82.0 82.0 $/ 1.6 1.6 1.5 1.5 1.5 1.5 / 1.2 1.2 1.3 1.3 1.3 1.3 $/ 1.3 1.2 1.2 1.2 1.2 1.2 /$ 80.9 90.0 94.8 96.4 98.0 99.0 Renminbi/$ 6.3 6.1 5.9 5.8 5.6 5.5 48 Multiple Eurozone Exits US$ Effective 73.4 75.6 78.9 81.3 81.4 80.4 $/ 1.6 1.6 1.6 1.5 1.5 1.5 / 1.2 1.3 1.3 1.3 1.3 1.3 $/ 1.3 1.3 1.2 1.2 1.2 1.2 /$ 80.9 90.0 94.6 96.2 98.2 97.4 Renminbi/$ 6.3 6.3 6.0 5.8 5.6 5.5 Slower upturn in US, Emerging Markets US$ Effective 73.4 77.0 80.4 79.6 76.8 76.1 $/ 1.6 1.6 1.5 1.6 1.8 1.8 / 1.2 1.2 1.3 1.3 1.3 1.3 $/ 1.3 1.2 1.2 1.2 1.4 1.3 /$ 80.9 90.0 85.3 88.7 93.0 96.2 Renminbi/$ 6.3 6.1 6.0 5.8 5.5 5.2 Middle East tensions US$ Effective 73.4 76.6 80.5 82.3 82.7 82.4 $/ 1.6 1.6 1.5 1.5 1.5 1.5 / 1.2 1.2 1.3 1.3 1.3 1.3 $/ 1.3 1.3 1.2 1.2 1.2 1.2 /$ 80.9 89.8 94.2 96.3 99.6 101.4 Renminbi/$ 6.3 6.3 6.1 5.9 5.7 5.5 Corporate re-awakening US$ Effective 73.4 76.6 79.7 81.2 81.6 80.8 $/ 1.6 1.6 1.5 1.5 1.5 1.6 / 1.2 1.2 1.3 1.3 1.3 1.3 $/ 1.3 1.2 1.2 1.2 1.2 1.2 /$ 80.9 90.0 94.7 97.3 98.1 97.5 Renminbi/$ 6.3 6.1 6.0 5.9 5.7 5.4 Note: All figures are Q4 averages

Alternative commodity price forecasts 2012 2013 2014 2015 2016 2017 Central Scenario Brent Oil ($/bl) 111 102 109 114 119 123 Gold 1,738 1,572 1,335 1,267 1,277 1,289 Copper 7,869 8,020 8,542 8,678 8,816 8,956 Agriculture 132 122 121 122 124 126 Multiple Eurozone Exits Brent Oil ($/bl) 111 193 140 114 119 123 Gold 1,738 2,189 1,368 1,202 1,277 1,311 Copper 7,869 11,167 8,753 8,232 8,818 9,109 Agriculture 132 124 128 126 129 131 Slower upturn in US, Emerging Markets Brent Oil ($/bl) 111 102 81 85 99 110 Gold 1,738 1,571 1,042 899 1,060 1,206 Copper 7,869 8,016 6,671 6,157 7,318 8,383 Agriculture 132 121 97 104 121 131 Middle East tensions Brent Oil ($/bl) 111 90 91 100 111 121 Gold 1,738 1,462 1,118 1,125 1,190 1,237 Copper 7,869 7,459 7,152 7,702 8,216 8,593 Agriculture 132 116 116 124 123 125 Corporate re-awakening Brent Oil ($/bl) 111 95 92 91 95 98 Gold 1,738 1,549 1,279 1,214 1,218 1,217 Copper 7,869 7,902 8,183 8,313 8,411 8,454 Agriculture 132 122 118 117 118 122 Note: All figures are Q4 averages Appendix for detailed forecasts 49