20121213 Deutsche Bank World Outlook

Global

13 December 2012

World Outlook Stumbling Along at the Edge of the Cliff

Deutsche Bank Securities Inc.

DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 072/04/2012.

Economics

Editors

Peter Hooper Chief Economist (+1) 212 250-7352 [email protected]

Thomas Mayer Chief Economist (+44) 20 754-72884 [email protected]

Michael Spencer Chief Economist (+852) 2203 8305 [email protected] Production editor

Stefan Schneider (+49) 69 910-31790 [email protected]

List of Contributors

Steven Abrahams

David Bianco

Michael Biggs

Adam Boyton George Buckley Robert Burgess Gustavo Canonero Bankim Chadha John Clinkard Gareth Evans Peter Garber Darren Gibbs Caroline Grady

Priya Hariani

Markus Heider

Dominic Konstam

Joseph LaVorgna Michael Lewis

Matthew Luzzetti

Mikihiro Matsuoka Gilles Moec

Keith Parker

Thomas Pearce

Jan Rabe

Carl Riccadonna

Alan Ruskin

Brett Ryan

Stefan Schneider Torsten Slok Lars Slomka Marco Stringa Parag Thatte John Tierney Mark Wall Ju Wang Francis Yared

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As year end and the policy precipice in the US draw near, we find the global economy trudging along at significantly below trend, held back by uncertainty about US fiscal policy prospects and a European economy still mired in mild recession. Emerging markets are still pushing things along, but they too are not invulnerable to a policy misstep at this juncture.

Our baseline economic forecast, shaded to the optimistic side of consensus, assumes that politicians will (1) agree at the last second to reduce the cliff to a manageable slope, (2) agree, at least vaguely, to do something next year about the mountain of debt beyond, and (3) actually succeed on that score by next spring, though not without some measure of uncertainty and pressure from the markets along the way.

This, we think, will set the stage for a pick-up in the second half of 2013 and a return to global trend growth in 2014, even with continued subpar performance in Europe. The US should join emerging markets as a modest engine of growth once the cloud of fiscal uncertainty has lifted, and we see the S&P 500 reaching 1500 and the 10-year Treasury yield 2.75% by end 2013.

The potential costs of a misstep are high. A breakdown in fiscal talks and a jump off the full cliff, even if remedied by Congress next spring, would push the US into recession in H1 and cut world growth next year by as much as 1pp. This would put as many as 25 million jobs at risk globally. It would also mean a plunge in markets toward 1200 and 1.25% this winter.

Though the hour is growing late, a more positive surprise is possible as well, and more rapid and sure-footed progress toward a grand bargain on US tax and entitlement reform, along with cliff avoidance, could give the markets and the economy a significant lift, adding 0.5 pp and over 10 million new jobs to global growth next year.

Economic Forecast Summary GDP growth, % CPI inflation, % 2011 2012F 2013F 2014F 2011 2012F 2013F 2014F

G7 1.5 1.4 1.1 2.0 2.6 1.9 1.7 2.2 US 1.8 2.2 1.9 2.9 3.1 2.1 2.3 2.5 Japan -0.5 1.6 0.2 0.3 -0.3 -0.1 -0.6 1.7 Euroland 1.4 -0.5 -0.3 1.1 2.7 2.5 1.6 1.6 EM Asia 7.6 5.9 6.7 7.5 6.0 3.8 3.8 4.2 China 9.3 7.7 8.2 8.9 5.4 2.6 3.0 3.5 India 7.9 4.6 6.8 7.1 9.5 7.5 6.6 6.3 EMEA 4.7 3.0 3.5 3.9 6.5 5.2 5.6 5.1 Russia 4.3 4.0 4.3 4.2 8.4 5.2 7.4 6.1 Latam 3.9 2.7 3.7 3.9 8.5 8.0 8.0 8.1 Brazil 2.7 1.0 3.5 4.2 6.6 5.4 5.3 5.8 Advanced economies 1.4 1.2 1.0 2.0 2.6 1.9 1.7 2.1 EM economies 6.3 4.7 5.5 6.0 6.6 4.9 4.9 5.1 Global 3.8 2.9 3.1 3.9 4.5 3.3 3.3 3.5

Source: DB Research

13 December 2012 World Outlook

Page 2 Deutsche Bank Securities Inc.

Table of Contents

Global Overview Stumbling along at the edge of the cliff 3 US From cliff dive to cliff catastrophe? 12 Europe A false sense of security 16 Japan Approaching a trough of business cycle 23 Asia (ex Japan) Sensitivity to US, EU growth will determine 2013 performance 26

Latin America Ready for a good year if global risks remain contained 28

Global Asset Allocation The fiscal cliff and after 30 US Equity Strategy This holiday season’s best destinations are technology & industrials 33 European Equities Pro-Cyclicals 35 Rate Outlook A benign path, interesting detours 38 US MBS & Securitization Outlook Dominated by demand 42 FX Strategy The Yen beats a fresh path, the Euro an old range 43 Commodities The US fiscal cliff and energy independence 45 Geopolitics The fiscal cliff and the pacific pivot 47 Forecast tables Key Economic Indicators 49 Interest Rates 50 Exchange Rates 51 Long-term Forecasts 52 Contacts 53


Deutsche Bank Securities Inc. Page 3

Global Overview: Stumbling along at the edge of the cliff

Introduction1

The 2013 global economic outlook is shaping up to be driven largely by how policymakers deal with the approaching policy precipice in the US. Whether and just how the President and Congressional leaders come to terms on tax and expenditure policies in the days and months ahead has significant implications for our outlook for economic growth and financial markets.

Our baseline scenario is for a relatively benign resolution to the fiscal cliff negotiations, in which the drag from fiscal tightening is whittled down from 4.25% to about 1.5% of GDP and policymakers are able to make some progress during 2013.H1 toward longer-term tax and entitlement reform. In this setting, our outlook for global economic prospects is little changed since our last World Outlook, with near-term global growth expected to remain significantly below trend at 3.1%. However, there are clear policy risks to this view: a more positive outcome on the fiscal cliff would bode well for economic growth and risk assets in the year ahead, while a plunge over the cliff would push the global economy as much as a percentage point further below trend growth, costing as many as 25 million jobs globally next year.

These policy risks are the common thread running throughout this publication. Each section presents our outlook under our baseline view just outlined. This is, in our view, the most likely outcome. In addition, each section discusses the expected deviations from our baseline view in response to two alternative scenarios for fiscal cliff negotiations. On the downside, a trip over the fiscal cliff, which we believe would be temporary as market pressures would eventually induce political compromise, would deduct about 2% from our US growth outlook, leaving the US economy essentially flat on the year and global growth running noticeably below trend at 2%. On the upside, a grand bargain that not only averts a majority of the fiscal drag embodied in current US law by year-end but also has policymakers agreeing on tax and entitlement reforms in the early portion of 2013, portends well for global growth. In this scenario, global growth would be propelled closer to trend of 4%. Because of this disparity in outcomes, it is clear that how this policy uncertainty is resolved will be a key driver for economic growth and financial markets in the year ahead.

As a final introductory note, relative to our previous World Outlook publications, we have consolidated our geographical coverage of the economic outlook to five major regions of the world. This allows for greater emphasis on our central theme and on our views on the markets. In

1 The Authors of this report wishes to thank Manjuri Das, Siddhartha Chanda, Kuhumita Bhattacharya, Baqar Zaidi and Moumita Paul, employees of Infosys Ltd., a third party provider to Deutsche Bank offshore research support services, for their assistance.

what follows, we begin with the economic story in our baseline forecast, then we turn to a discussion of the fiscal cliff and its risks, and finally we present our views on the equities, rates, MBS, FX, and commodities markets plus some geopolitical commentary.

Global Economics

Recent developments and prospects As the end of the year and the fiscal cliff in the US draw near, our fundamental view of global economic prospects has not changed appreciably, though the risks around our baseline view are coming more sharply into view. World growth near the turn of the year remains subpar—in the vicinity of 3%, nearly a percentage point below its longer-term trend. The outlook for the first half of 2013 remains subdued, but we continue to expect a recovery to more trend-like growth during the second half and for the year 2014.

Figure 1: Global GDP growth forecast & revision (% yoy) Forecast level

Dec’12 WO Forecast change since

Sep’12 WO 2012F 2013F 2014F 2012F 2013F 2014F

G7 1.4 1.1 2.0 0.0 -0.2 -0.1

US 2.2 1.9 2.9 0.1 -0.1 -0.2

Japan 1.6 0.2 0.3 -0.8 -0.6 0.2

EA -0.5 -0.3 1.1 0.0 -0.3 0.1

EM Asia 5.9 6.7 7.5 -0.2 0.0 0.5

China 7.7 8.2 8.9 0.0 0.0 0.9

India 4.6 6.8 7.1 -1.0 0.1 0.1

EMEA 3.0 3.5 3.9 -0.1 -0.1 -0.1

Russia 4.0 4.3 4.2 0.0 0.0 0.0

Latam 2.7 3.7 3.9 -0.2 -0.1 -0.2

Brazil 1.0 3.5 4.2 -0.5 -0.7 -0.3

Advanced economies

1.2 1.0 2.0 0.0 -0.2 0.0

EM economies

4.7 5.5 6.0 -0.1 0.0 0.2

Global 2.9 3.1 3.9 0.0 -0.1 0.1

Source: DB Research

The outlook across major regions of the world This pattern of sluggish growth in the near term followed by stronger performance later next year and the year beyond holds across most regions of the world. Advanced economies show greater weakness in the near term, but both they and the emerging market economies are expected to recover to trend-like growth rates by 2014. Among AEs, the expansion of activity in the US has been slowed recently by caution on the part of the US business community in the face of various fiscal and regulatory policy



uncertainties looming ahead. Capital goods orders have fallen off considerably since last spring despite the fact that the growth of industrial output capacity is still below norm while capacity utilization has returned to norm. Meanwhile Europe for now remains mired in a mild recession brought on by a combination of fiscal drag and relatively tight credit market conditions. Euro-area debt markets remain under stress as uncertainties about adjustment programs in Spain and Italy persist. Japan’s economy has fallen back into recession around the middle of the year as the boost from post-tsunami rebuilding and stimulus wore off and exports declined. Contraction is likely to continue through Q4 but many indicators suggest the recession will end in Q1.

Figure 2: PMIs have signaled softer growth

35

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2009 2010 2011 2012

US ISM composite

Euroarea PMI composite

China PMI composite

Index

Source: Markit, ISM, HSBC, Haver Analytics, DB Research

Prospects for advanced economy growth We expect growth conditions to improve in the US later next year after fiscal uncertainties are resolved to a significant extent (we will have a good deal more to say about the fiscal cliff and beyond below). Europe is expected to move from modestly negative growth toward modestly positive growth during the course of 2013 as progress is made on the policy front in Spain and Italy and to a lesser extent in France. But that pickup will likely remain anemic well into 2014 as further fiscal contraction is in store and periods of market pressure will no doubt be required to beget needed reforms.

Japan faces its own possibility of significant political influence over economic policy with an election this week potentially bringing in a government with a much more aggressive fiscal and monetary policy bias. Our baseline forecast has fiscal consolidation and only slightly faster money supply growth. We are of the view that monetary stimulus would be more effective than fiscal stimulus in boosting nominal growth. The outcome of the elections and personnel decisions at the Bank of Japan may have a bearing on monetary policy and hence on the 2013 outlook.

Emerging market economies EMEs, now accounting for about half of the global economy, remain the relative engine of growth. We see their growth averaging more than triple that of advanced

economies over the next two years, rising strongly from 4.7% growth in 2012 to 6.0% in 2014. Growth in the EMEs as a group has been depressed by the slowdown in the AEs – many are small, very open economies – and this constraint will be alleviated from mid-2013. But even the larger economies can’t avoid some knock-on effect from slower AE growth. In addition, though, the Chinese government has restricted housing investment to try to manage down a property bubble and very consciously allowed GDP growth to slow to more than we had expected rather than risk reigniting the bubble with renewed stimulus. India’s economy has struggled with mounting bottleneck costs from inadequate infrastructure, red tape and a “twin deficits” problem, which all contribute to high inflation and discourage investors. Brazil’s growth model seems to be running out of steam – investment effort is weakening – as the government has pursued a more inflationary pro-consumption policy that is less conducive to growth. Among the BRICs only Russia has done well, restrained by lower oil prices but otherwise pursuing sound policies.

Comparison to other economic forecasts Our forecast for global growth is very much a consensus view — at least it lies well within the range of consensus forecasts. The median of the Bloomberg and Consensus Economics surveys show global growth forecasts that are below ours, while the most recent IMF World Economic Outlook has global growth that is well above ours over the next two years. The differences among these forecasts predominantly reflect differences in views about prospects for emerging market economies. We are much more positive than consensus forecasts on the growth outlook for the Chinese, Indian and Russian economies (less so on Brazil) and slightly more positive even than the IMF. The various consensus forecasts are remarkably similar to our own for both the US and the EA (Figure 3), with the exception of EA growth in 2013, where we expect growth to be roughly 0.5% slower than the outside forecasters.

Figure 3: Consensus Forecasts

2011 2012F 2013F 2014F Worl

d DB (Dec) 3.8 2.9 3.1 3.9 Bloomberg (Nov Survey)

3.8 2.2 2.5 3.2

Consensus (Oct Survey)

3.8 2.5 2.8 N/A

IMF (Oct) 3.8 3.3 3.6 4.1

US DB (Dec) 1.8 2.2 1.9 2.9 Bloomberg (Nov Survey)

1.8 2.2 2.0 2.8


1.8 2.1 2.0 2.8

IMF (Oct) 1.8 2.2 2.1 2.9

EA DB (Dec) 1.4 -0.5 -0.3 1.1 Bloomberg (Dec Survey)

1.4 -0.4 -0.1 1.2


1.4 -0.5 0.2 1.2

IMF (Oct) 1.4 -0.4 0.2 1.2 Source: DB Research, Bloomberg Finance LP



Inflation We expect global consumer price inflation to remain relatively stable over the forecast period, easing a bit in advanced economies in 2013 and then picking up modestly in both AEs and EMEs in 2014. We see inflation easing in both Europe and Japan over the coming year ahead, and then rising back well into positive territory. Among major EMEs, China is expected to show a steady uptrend in inflation through 2014 while India shows an easing from a substantially higher rate of inflation. Our forecasts for most regions have been revised down modestly since September, with India and Latin America as exceptions.

Figure 4: Inflation forecast & revision (% yoy) Forecast level

Dec’12 WO Forecast change since

Sep’12 WO 2012 2013F 2014F 2012F 2013F 2014F

G7 1.9 1.7 2.2 0.0 -0.1 0.0

US 2.1 2.3 2.5 -0.3 -0.3 -0.1

Japan -0.1 -0.6 1.7 -0.1 -0.2 0.0

EA 2.5 1.6 1.6 0.0 -0.2 -0.1

EM Asia 3.8 3.8 4.2 0.0 -0.4 0.0

China 2.6 3.0 3.5 -0.2 -0.5 0.0

India 7.5 6.6 6.3 0.5 0.3 0.2

EMEA 5.2 5.6 5.1 0.0 0.0 -0.1

Russia 5.2 7.4 6.1 0.0 0.0 0.0

Latam 8.0 8.0 8.1 0.2 0.5 0.4

Brazil 5.4 5.3 5.8 0.1 0.3 0.0

Advanced economies

1.9 1.7 2.1 0.0 -0.1 0.0

EM economies

4.9 4.9 5.1 0.0 -0.2 0.1

Global 3.3 3.3 3.5 0.0 -0.1 0.0 Source: DB Research

Central bank policy Major central banks are still very much in easing mode. The Fed has just announced that it will step up its recent significant pace of balance sheet expansion. And as we have noted, we expect the BOJ to become more activist in this regard as well. The ECB too is likely to step up its involvement in this area as its OMT facility begins to take effect. Reversal of these policies will eventually take place, but not until beyond our current forecast horizon through 2014. Some EM central banks, though, won’t be able to wait for the Fed to kick off a new rate hike cycle. While many EMEs will see lower rates in 2013 – notably Brazil, India, Russia, South Africa and Turkey – others, including China, will see rates begin to rise before year end.

Figure 5: Central bank balance sheets expanding

0

50

100

150

200

250

300

350

400

450

500

1990 1994 1998 2002 2006 2010

Fed ECBBoJ BoE

Index, Jan-2008=100

Source: FED, ECB, BoJ, BoE, Haver Analytics, DB Research

Fiscal cliff risks

Since the publication of our June WO, the focus of the market has shifted dramatically from Euro risk to the risk of an abrupt tightening of US fiscal policy around yearend that is built into current legislation. As we noted above, growing uncertainty about how the so-called fiscal cliff, as well as the impending debt ceiling and the unstable US debt position under current policies will be handled is already depressing US growth. We estimate that the currently elevated level of policy uncertainty is subtracting at least a full percentage point from growth via its depressing effect especially on business fixed investment spending. How the fiscal cliff is resolved is now the key uncertainty in our global forecast. In what follows we begin by summarizing the key elements of the fiscal cliff. We then outline our baseline assumption for how it will be resolved and consider both a representative worst-case scenario and a better-case scenario. There is a wide range of possible outcomes, and our intent here is to illustrate how sensitive our economic and market forecasts are to plausible outcomes that lie both to the downside and the upside of our base case. Not surprisingly, we see a wider range of possibilities to the downside. Next, we assess the implications of the alternative scenarios for the rest of the world and the global economy. And finally, we summarize the views of our various market strategy teams about prospects for the markets that are consistent with both our baseline economic forecast and alternative fiscal cliff scenarios. Additional analysis is found in the regional economic and strategy sections that follow. The various components of the fiscal cliff are described in more detail in the US Section below.

The three key elements of the overall fiscal cliff include:

(1) the expiration of the payroll tax cuts and various extended unemployment benefits and several other spending programs at yearend amounting to a little over 1% of GDP



(2) automatic across the board cuts of roughly 10% of defense and nondefense discretionary spending (the “sequester”) taking effect early in January and amounting to roughly 0.5% of GDP

(3) the expiration of the various Bush tax cuts, the AMT fix and various other tax “extenders” at year end. These amount to about 2.5% of GDP overall, 2% of GDP when income and dividend tax cuts on upper-income families are excluded.

Altogether, the cliff amounts to roughly 4-1/4% of GDP. The current state of the negotiations as we go to print is that the two sides are far apart on their initial positions, but are talking. Both sides agree that the sequester should be removed, spending cut in the longer term (including some entitlement reform), and revenue raised from upper income families. The major sticking points are:

(A) How to raise taxes on upper-income folks –via higher tax rates as favored by Democrats or via base broadening (capping deductions) as favored by Republicans.

(B) How and how much to cut spending and reform entitlements. Republicans want substantial commitment in this area up front, Democrats have offered only to discuss possible entitlement reform in the future on a more limited scale.

(C) How much near-term stimulus to include. Democrats want a lot (including extending all of (1) above), plus a new USD50 bn stimulus package; Republicans want none of this.

(D) Whether to raise the debt ceiling. Democrats want to remove it as part of a deal on the fiscal cliff; Republicans want to leave it in place.

Baseline scenario: a deal to delay much of the cliff Our baseline forecast assumes that an agreement will be reached by year-end to delay the sequester (item (2) above) and extend the tax cuts except on upper incomes (most of (3) above). This would leave a little over 1-1/2% of GDP in fiscal drag next year (item (1) and taxes on upper income families). What form the tax increase on upper income folks will take is uncertain but it is likely to entail some increase in marginal rates, possibly with some increase in the definition of “upper income” and/or some capping of deductions. The deal will also likely spell out some agreement to tackle entitlement reform and tax reform in the new year in ways that will not affect the current year’s budget. But we assume that a lot of details will remain to be ironed out.

Implications for the markets and the economy While initial market reaction to a “deal” will be positive, we expect that considerable uncertainty about future tax liabilities and entitlement will remain and will continue to

dampen private spending plans. Another point of uncertainty is how ratings agencies will react to a delay of fiscal adjustment and relatively vague promises of progress to come—we see a good chance of a downgrade in the offing. This uncertainty and some resulting setbacks in the market, plus near term fiscal drag amounting to 1.5% of GDP will keep GDP growth relatively depressed in the first half of the year. Assuming that significant progress is then made by mid-year on a “grand bargain” encompassing both tax and entitlement reform, we see the markets and the economy getting a significant lift in the second half. We expect that progress toward a grand bargain will mean continuing fiscal drag for several years to come, though less intense than that in store for 2013. This drag will keep an economy that might otherwise be growing at close to 4% as it continues to recover from the great recession in the vicinity of 3% during 2014.

Positive risk scenario: Grand bargain We see a wide range of possible outcomes around this baseline scenario. On the positive side, while a grand bargain detailing significant tax and entitlement reform seems very unlikely this year, an agreement that contains more specificity on that score and less uncertainty would both reduce the chances of a downgrade and the continued drag that we anticipate on private spending until these details are worked out next year. More rapid progress in the new year toward a grand bargain that puts US fiscal policy on a sustainable path would also give the markets and the economy a lift sooner. While we do not place high probability on such an outcome, a plausible upside scenario could add another 1% point to our baseline US growth assumption, enough to push the stock market up to 1600 by year end (compared with 1500 for the S&P 500 index in our baseline forecast). The Fed would likely exit 6 to 12 months sooner, and this expectation, along with the stronger economy would raise the 10-year Treasury yield to 3% and EUR/USD would rise slightly.

Negative risk scenarios It is still quite possible that the two sides will not be able to reach a broad “agreement” on the fiscal cliff by year end. In a mildly negative scenario much of the cliff might still be effectively avoided by the Republican House falling back to passing the current Senate bill that extends the AMT fix and the Bush tax cuts on all but upper-income families. The sequester would be allowed to go through, but could be dealt with retroactively in January causing some but not major disruption. Any other bridge to further work in the new year would be shaky at best. Absent any meaningful prospects for dealing with the more fundamental problem of unsustainable budget arithmetic, this scenario would invite a major downgrade of US treasury debt. This would be a blow to confidence and the markets and would mean a



slower growth outcome than in the baseline, but would stop short of a recession.

Worse case scenario: over the cliff A still more negative, yet quite plausible, scenario would entail failure to extend any of the Bush tax cuts or delay the sequester. Households and firms would be hit by a substantially greater increase in tax withholding, as well as sizable increases in their tax liabilities on 2012 income (the AMT and various extenders). Large cuts in discretionary spending would be phased in and sizable numbers of workers laid off by Federal government agencies and contractors. While a downgrade would be avoided, business and consumer confidence and the markets would be hit hard, with the S&P 500 dropping toward 1200 and the 10-year treasury yield toward 1.25%. We would expect to see USD/JPY down 3 to 4% and EUR/USD down close to 3% in the near term, but EUR/USD would likely retrace up to its starting levels. US GDP growth would be hit hard, dropping nearly 4% at an annual rate below baseline for the first half of the year, bringing H1 growth down to -2%AR. We assume the shock to the markets and the economy would jolt Washington politicians into action, causing them to redouble their efforts and reach an agreement that contains significant and important elements of tax reform and entitlement reform that puts the US fiscal trajectory on a more sustainable track. The markets would recover, though not all the way to the baseline levels, with the S&P 500 reaching 1400 by end 2013, and the economy would bounce back into significantly positive territory in H2, yielding near zero growth for the year. This is not a “worst” case scenario because it assumes that the political system responds constructively to the havoc it wreaked by going over the cliff.

Figure 6: Implications of different cliff scenarios for 2013 outlook

Baseline Over the

cliff

Grand

Bargain

Global GDP growth (%) 3.1 2.0 3.6

US GDP growth (%) 1.9 0.0 3.0

Euroland GDP growth (%) -0.3 -1.3 0.2

EM GDP growth (%) 5.5 4.5 6.0

S&P 500 (year-end) 1500 1400 1600

10-year Treasury yields (%

y.e.)

2.75 2.0 3.0

Note: Probabilities: Baseline or better 60%; Grand Bargain:25%; Over the cliff 20%; Source: DB Research

Probabilities How confident are we that any of these scenarios will be realized? Not highly. While the Administration and Congressional leadership seem to appreciate the importance of reaching an agreement, long-standing

differences remain and recent history, going back to the debt ceiling standoff in the summer of 2011, is not encouraging. Roughly speaking, we would place a 60% probability that the outcome is at least as favorable as our baseline assumption of an agreement to avoid most of the cliff and to discuss tax and entitlement reform next year (without agreement on any specifics on the latter score). And we would place about a 25% probability on the more favorable “grand bargain” outcome, where most of the cliff is avoided and the two sides put together a convincing case that meaningful budget reform (including tax and entitlement reform) will be achieved next year. That leaves 40% probability to something that falls short of an agreement, and in that space we would attach 20% probability to an outcome at least as bad as our “over the cliff” scenario, where the full measure of fiscal drag in the cliff is felt temporarily during H1 2013.

The longer-term problem: too much debt Whatever the outcome of the cliff negotiations will be, the need to reduce US public deficits and debt over the longer term remains. We project US federal debt to approach 80% of GDP, and net general government debt to exceed 80% over the next two years, a level that many economists regard as weighing on economic growth. For now, markets are tolerating high public deficits and debt, but this cannot be taken for granted. As we have noted, ratings agencies will have itchy trigger fingers in the months ahead. Doubts about the long-term sustainability of public finances could lead to a back-up of yields or force the Fed to intervene on a larger scale to stabilize the bond market. In both cases financial stability in the US may be endangered.

Implications for global economy Our “over the cliff” scenario suggests a repeat – albeit on a smaller scale – of the “Lehman shock” in which the US economy suddenly plunged into recession, dragging Europe, Japan, and most export-sensitive emerging market economies down with an external shock greater in magnitude to anything that had ever preceded it. Just how bad could things be on a global scale this time around?

Europe Europe has been far more aggressive than the US in reducing public sector budget deficits but has made comparatively little progress in reducing private sector debt. This combination has not been good for growth: High private sector debt and fiscal austerity have both weighed on domestic demand. Foreign demand has been a mitigating factor, but it has not been strong enough to keep the economy out of recession. Given the inherent weakness of domestic demand in Europe at present, we would expect any downward revisions of US growth to translate into a significant downward revision in Europe. The magnitude of the transmission can only be guessed as various models



give a fairly wide range of transmission coefficients. In our view, a realistic ratio of changes in US growth to changes in growth in Europe could be close to 2:1. Hence, should US growth be dragged down from the 2% baseline value for 2013 by two percentage points to 0%, we would expect a drop in European growth below the baseline of -0.3% by roughly 1 percentage point to -1.25%. Similarly, in case of a last minute “Grand Bargain” that would lift US growth by 1%, we would expect an improvement by 0.5 percentage points above baseline to close to +0.2%.

Japan The implications for Japan would be much the same as for Europe, especially if as expected; the more negative turn of events in US policy induced a significant appreciation of the yen against the dollar. The worse case fiscal cliff scenario would be more than enough to stifle the modest growth we see there over the year ahead, moving Japan back into a slight recession.

Emerging markets Emerging market economies would be hit by a full US cliff scenario via three channels of transmission: (1) a decline in demand for EM exports; (2) a decline in commodity prices; (3) a reversal of capital flows back to the US and Europe. The former channel will be, we think, the most important. So the small, very open, economies of Hong Kong, Singapore, Taiwan, South Korea, Mexico, Hungary and the Czech Republic are, we think, the most vulnerable because of their dependence on exports to the US and Europe to drive growth. Importantly, China and India are “low beta” economies, much less influenced by US and EU growth dynamics than most other emerging markets. Brazil too is less export-driven than, say, Mexico. The relative resilience of these big economies to a pure export shock helps to dampen the overall impact on the EME group.

A key additional source of pressure on EM in 2008/09 came from the freezing of interbank liquidity. This particularly hurt EMEA economies due to the prominent role Western European banks play there. With the ECB expected to continue to provide liquidity backstops to member country banks, we are less concerned about this channel of contagion. However, we would expect a reversal of portfolio capital flows and some withdrawal of credit back to the “core” countries from EM.

Note also that compared to the 2008/09 crisis we expect oil prices might fall significantly less (about 25%) after a “fiscal cliff” shock than the 58% drop observed after July 2008. So the risks to oil exporters like Russia and Venezuela are perhaps less than they were in 2008 when oil prices were at an all-time high.

However, relative to 2008, there is also less scope for monetary policy in EM to respond to a “fiscal cliff” shock.

Interest rates are already near historic lows in many countries and inflation rates in EMEA and Latin America are at relatively elevated levels, which leave little room for policy accommodation. A reversal of capital flows would likely put pressure on EM currencies to depreciate, and in some countries this would exacerbate inflation concerns.

Finally, while EM growth prospects are likely to be badly hurt by a “fiscal cliff” shock, the effect would be short-lived. Assuming, as we do, a rapid policy response in the US the shock would – like the “Lehman’s shock” – be brief. Exports could recover quickly and EM growth would be stronger in the second half of the year than our baseline forecast, making up much of the decline early in the year. Symmetrically, the economies worst hit by the “fiscal cliff” shock could be expected to be the biggest beneficiaries of the rebound.

Overall, therefore, given the shock – if it happens – occurs early in the year and there is a quick policy response, we see perhaps surprisingly little effect, relative to the higher baseline growth rates in EM, on EM growth for the year as a whole. Against a roughly 2% decline in annual US GDP growth and a 1% decline in EU GDP growth compared to our baseline forecasts, we would expect average growth rates in each of the EM regions to fall by about 1ppt relative to our baseline forecasts.

Global impact To sum up, the worse case over the cliff scenario would reduce global GDP in 2013 by about 1% point or possibly a bit more relative to baseline. This would move world output growth to just over 2%--near recession levels and the lowest rate since the great recession of 2009, when world growth dipped into negative territory for the first time since the 1930s. We would expect growth to bounce back to somewhat above trend in 2014 under this scenario. That said, with nearly half of the world’s population of 7 billion currently employed, a reduction in world GDP next year approaching 1% would put as many as 25 million jobs at risk.

Figure 7: World GDP growth would be depressed temporarily in our over the cliff scenario

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1970 1976 1982 1988 1994 2000 2006 2012

World GDPBaseline scenarioOver the clif f scenario

%Forecasts

Source: IMF, Haver Analytics, DB Research



Model-based and other estimates of the effects of the fiscal cliff Impact of fiscal cliff on US economy According to the Congressional Budget Office (CBO), if allowed to go through, the full fiscal cliff would plunge the US economy into a recession in 2013 with real GDP growth of -0.5% and the unemployment rate rising to 9.1%.2 This contraction is concentrated in the first half of 2013, with real GDP projected to decline by 2.9 percent at an annual rate during the first half of the year and expand at an annual rate of 1.9 percent in the second half.

Analysis by the IMF is broadly consistent with this conclusion. 3 IMF models that take into account the ineffectiveness of monetary policy to offset a fiscal contraction of this size because of the zero bound on rates suggest that the full fiscal cliff would subtract 2.0% to 2.7% from growth next year. Given the IMF’s baseline estimate for the US economy to grow at 2.25% in 2013, these models suggest that growth with the fiscal cliff would range from -0.5% to 0.25%. However, these models do not consider the possible negative feedback effects from a decline in financial market confidence to economic activity. Once these effects are considered – modeled as a 15% decline in equity prices and 15bps fall in long-term Treasury yields – IMF analysis suggests that real GDP could contract by as much as 2.5% in 2013.

These estimates are generally more pessimistic than our baseline full fiscal cliff scenario for several reasons. First, unlike the CBO and IMF analysis that assume the fiscal contraction persists throughout 2013 and beyond, we believe that a plunge over the cliff would supply sufficient market pressure to induce policymakers to come to an agreement in the first half of next year. This agreement, in turn, would allow economic growth to accelerate during the second half of 2013, leaving the economy flat on the year. Second, our estimates assume that policy uncertainty associated with the fiscal cliff has been a quantitatively important drag on the economic recovery in 2012. Consistent with this, a resolution of this uncertainty – brought about by an agreement that lessens the fiscal contraction and provides clarity on future paths for taxes and government spending – should unleash pent up demand for consumer durables, housing, and business investment. As a result, we expect above-trend growth in the second half of 2013.

2 See Congressional Budget Office (November 2012), “Economic Effects of Policies Contributing to Fiscal Tightening in 2013.” (http://www.cbo.gov/sites/default/files/cbofiles/attachments/11-08-12-FiscalTightening.pdf) 3 See International Monetary Fund (July 9, 2012), “2012 Spillover Report.” (http://www.imf.org/external/np/pp/eng/2012/070912.pdf)

Figure 8: Impact on US GDP from going over the cliff Percent deviation from baseline 2013

CBO -2.9

IMF -2.4

DB -2.0 Source: DB Research

Of course, alternative fiscal paths that eliminate components of the fiscal contraction embodied in current law would result in more benign outcomes in 2013. For example, the CBO estimates that eliminating the automatic spending reductions specified in the Budget Control Act would add 0.8% relative to a full fiscal cliff baseline. Moreover, eliminating these spending cuts, extending most tax provisions for all but upper-income households, indexing the AMT for inflation, and allowing for a down payment on spending cuts of roughly USD50bn – a plausible compromise scenario in our view – would add about 2.0% to GDP growth relative to the fiscal cliff.

Impact on global growth As we have noted, the impact of the fiscal cliff on the US economy would spill over to global growth through several channels. First, fiscal contraction would reduce US income and therefore decrease demand for imports from US trading partners. Second, policymakers’ inability to effectively come to a compromise on fiscal negotiations and the subsequent downgrade of US debt that would be sure to follow, would impact risk appetite more globally, exerting downward pressure on the value of risk assets such as equities. Emerging market economies would also be vulnerable to movements in commodity prices and capital flows.

The IMF has considered the spillover effect from the fiscal cliff to global economic growth, focusing primarily on trade channels as the transmission mechanism from the US to other countries. This analysis concluded that the fiscal cliff would reduce growth most for its immediate neighbors, with Mexico and Canada experiencing a negative impact on growth of about 1 to 1.5 percentage points. The impact on advanced Europe and Japan would be more limited, reducing output growth by about 0.25 to 0.5 percentage points. The effect on emerging markets is estimated to be of a similar magnitude, although more manageable given higher baseline growth rates and greater policy flexibility for emerging market economies. We would expect these spillover effects to be more severe when the negative impact of business, consumer, and financial market confidence effects are considered, along with the effects of depressed commodity prices and capital outflows on EMEs.

Market forecasts/baseline strategy views

As we have noted in the foregoing analysis, our baseline macroeconomic outlook and the uncertainties associated



with various possible outcomes for the fiscal cliff negotiations view have important implications for global markets. The balance of this overview is therefore devoted to a summary presentation of our house view on market prospects both under the central base case, and in the event of a more negative (and in some cases more positive) outcome for the cliff talks. This discussion essentially summarizes the more detailed sections on market prospects that follow in the document.

Global Asset Allocation: The fiscal cliff and after Consistent with this baseline economics view, our asset allocation team sees the global financial markets positioned for at least a partial fiscal cliff: underweight equities and overweight rates, as a significant risk premium (-9%) is priced into the S&P 500 and rates (-25bps on the 10Y UST). However, rather than broad-based risk aversion, the uncertainty created by the fiscal cliff has prompted asset reallocation out of the US, with outflows from US equities being matched by equal inflows into non-US equities. A positive resolution to fiscal cliff negotiations would beget a significant upside for the S&P 500 given the degree of US equity underweights and the typical post-election rally. Conversely, an adverse scenario of continued gridlock that triggers the fiscal cliff would move the market to price in a full recession putting the S&P 500 at about 1200. We expect several post financial crisis market trends to continue, including: the unusually high sensitivity of risk assets to growth concerns and macro data, elevated cross asset correlations, undue impact of policymakers on markets, and high risk premia in equities and credit.

US Equities Strategy: Much is riding on the cliff outcome Our US equity strategy team has cut our 2012 end S&P 500 target from 1475 to 1450 with risk of higher taxes, especially on dividends, post-election. Under a successful resolution of US fiscal uncertainty, amounting to fiscal drag of 1.5% or less, our 12-month target is 1500, with 2013 estimated EPS up 5% to USD108. Consistent with our growth outlook, EPS growth is skewed to the second half of 2013. However, the details of the fiscal cliff resolution are particularly important. If tax hikes amount to 1% of GDP or less in 2013, our 12-month target is 1550, while a new top dividend tax rate of 25% or less puts 1600 well within reach for 2013 end. On the other hand, if the US enters a recession from going over the cliff, the S&P 500 would fall to about 1200 in the first quarter. We think the best reward/risk opportunity is at Tech and Industrials, as a resolution to the fiscal cliff will benefit sectors with revenue sensitivity to business spending, which weakened in the second half of 2012 due to heightened economic policy uncertainty. Given that oil prices are a significant driver of S&P EPS, a movement away from oil price stability would be adverse.

European Equities Strategy: Pro-Cyclicals Our European Equity team’s target for the Stoxx 600 by the end of 2013 is 315, implying a 13% upside. This outlook is based on expected earnings growth of 6.0% in 2013 driven by a rebound in global GDP as the US recovery persists, EM growth accelerates, and European growth begins to improve in the first half of 2013. Our relatively optimistic view on European growth is based on a positive credit impulse as the pace of private sector deleveraging slows and private sector demand recovers, coupled with a decreasing drag from fiscal austerity and improved demand for European exports as global growth accelerates. Given this outlook, we recommend a strategy focused on domestic cyclicals, especially with exposure to consumer spending, business investment, and global trade. Moreover, we favor Italian equities, based on our view that Italy should lead the growth rebound in Europe, and value over growth, as we expect the rotation from growth into value to continue with a positive economic surprise.

Rates Outlook: A benign path, interesting detours Assuming a relatively benign resolution of fiscal negotiations resulting in about 1.5% of fiscal drag in 2013, our global rates strategy team expects yields to move higher over the year, with 10Y UST reaching 2.25% by the end of Q1 and 2.75% by year end and Bunds to reach 1.60-1.80% in Q1 and 2.25% at the end of 2013. Paths to lower rates include a lack of fiscal agreement in the US, heightened European political risk, and supply/demand factors relating to further central bank balance sheet expansion. A full fiscal cliff scenario would put significant downward pressure on yields, with 10Y UST reaching about 1.25%. Lower yields would be driven both by weakened growth prospects and expectations of more aggressive central bank accommodation to offset slipping growth. Conversely, a swift and benign fiscal cliff resolution would lead to higher rates (e.g. 3.0% on 10Y UST) by reducing short term uncertainty, supporting global economic growth, and lowering expectations about the scope of future central bank easing. As rates grind higher, we expect the long end to sell off first, favoring steepening trades.

MBS and Securitization Outlook: Dominated by demand US agency MBS should do well in 2013 relative to benchmark rates as Fed and other sources of demand outstrip supply by nearly USD450 billion. The new securities targeted by the Fed could easily outperform Treasury debt of similar duration by 100 bp to 150 bp. Healthy US residential and commercial real estate and improving consumer balance sheets should lift CMBS and ABS issuance again, with tight spreads in other markets keeping these sectors well bid. Continuing efforts to reform mortgage finance should set the stage for a slow return of private residential MBS.



FX Strategy: The Yen beats a fresh path, the Euro an old range Our global FX strategists expect currency volume to remain at historically low levels in the year ahead, giving special attention to currency specific factors and relative value trades. The yen will weaken for two reasons. In the short term, an expected shift in Bank of Japan focus toward more reflationary policies, although widely discounted, will put downward pressure on the yen. Longer term, weakened competitiveness of Japanese exporters, evidenced by their declining market share in the last 15 years, portends for a weaker yen. With these pressures in mind, Y82 and Y90 are our forecasts for 3 and 12 months, respectively, and any USD/JPY pullbacks toward Y80 should be bought. The EUR/USD is likely to remain in a similar range in 2013 as in 2012, testing 1.35 in Q1 on reduced EMU risk premia, but falling well short of its 12-month straddle breakeven near 1.40, as the divergence between US and European real growth rates become a constraining factor.

Commodities: The fiscal cliff and US energy independence Our commodity strategists expect the strength in precious metals to continue over the year ahead, as negative real interest rates persist, the US dollar weakens in the first half of the year, and central banks continue to diversify into gold. Indeed, gold and silver return approximately 20% per annum on average when US real interest rates are negative. In addition, the rebound in economic activity in China will trigger a recovery in industrial metal prices. The outlook for oil prices is uncertain, despite the fact that Brent crude oil prices have broadly respected a USD100-120 trading range since 2011. Under our base case of a relatively positive fiscal cliff resolution, we expect crude oil prices to remain strong, with the growth of US shale production sustaining the large discount of WTI versus other regional crude oil

benchmarks. Downside risks to this outlook include a negative outcome on the fiscal cliff that would impair global economic growth. In fact, in years when global growth has been at or below 2.5%, crude oil prices have fallen by a minimum of 20% within a three month period. This suggests that Brent would fall to around USD85 in this adverse scenario.

Geopolitics: The fiscal cliff and the pacific pivot Our global strategist mulls over the potential implications of the fiscal cliff for US defense posture in a critical region of the world. With the reductions in war time spending and caps in the Budget Control Act, expected defense expenditures would be about USD546 billion in 2013 and USD644 billion by 2021. If the sequester is triggered, USD55 billion will be stripped from these totals for each year through 2021. However, the sequester and caps on defense spending in the Budget Control Act concern total spending, leaving some discretion to Congress and the Administration about the allocation among various military services. Because the US Navy is at the center of the US strategic shift toward the Pacific, the Army and marine ground forces are likely to be reduced the most. But if the Navy took proportionate share of the sequestration cuts, 10% of its fleet would be mothballed, and the Pacific pivot would amount to an increase of 10 ships in the Pacific and a 30 ship reduction in all other waters. This rebasing means that fewer naval units would be immediately available in the Atlantic or Mediterranean and more available in the Western Pacific.

Peter Hooper, (1) 212 250 7352 Thomas Mayer, (49) 69 910 30800 Michael Spencer, (852) 2203 8305

Matthew Luzzetti (1) 212 250 6161



US: From cliff dive to cliff catastrophe?

The US economy continues to underperform relative to past economic cycles, and we expect this trend to continue into at least the first half of 2013.

We remain constructive on the longer-term outlook, but in the near-term the so called “fiscal cliff” poses a significant downside risk. If unaddressed, this impending fiscal austerity will be sufficient in magnitude to push the economy into recession in H1 2013.

Under our baseline scenario, we expect about two-thirds of the scheduled austerity to be delayed. If this is the case, then the economy will slow in H1 2013 but subsequently rebound in H2.

However, the risk that current political negotiations fail is non-negligible given that there has been little progress to this point. Thus, in the following commentary we address not only our baseline estimation, but also the economic consequences under plausible “best” and “worst” case scenarios.

Since the end of the last recession, the economy has grown at roughly a 2% annualized pace, which is less than half of the historical average to this point in the business cycle. As we look ahead to 2013, we project a similar growth rate, but there are substantial risks around this forecast owing predominantly to how the fiscal cliff is resolved. Our baseline case assumes that only one-third of the scheduled tax increases will go through and that the sequestered spending cuts will be delayed. Then by

midyear, the Administration and the Congress will enact substantial elements of a comprehensive, long-term budget reform, which will set the stage for a more robust recovery in the second half of the year.

Alternatively, if no agreement is reached on the cliff, under current law USD 520 billion in tax increases and USD 130 billion in spending cuts are set to go into effect in 2013, as measured on a calendar year basis. This is equivalent to 4.2% of GDP, which is enough in our view to turn expansion into recession. In this scenario, assuming confidence and the financial markets took a substantial negative hit, the economy would shrink significantly in the first half of the year, thereby intensifying pressure on Washington to reach an agreement. In response to an eventual compromise, real GDP growth would move back into positive territory in the second half, by enough to leave full year growth roughly unchanged. Under this scenario, the unemployment rate would move back above 8.5% relative to our current baseline forecast which assumes only moderate fiscal drag and an unemployment rate that drifts slightly lower by yearend.

Moreover, assuming that we do not go over the entire cliff, it is possible that the positive lift to confidence and financial markets from a “grand bargain” could be quite powerful, in which case second half growth could be significantly stronger as a result. We discuss the range of plausible scenarios in the analysis to follow. Given the fluidity of current negotiations, the range of uncertainty surrounding our forecasts is larger than usual.

Figure 1: Macro-economic activity & inflation forecasts

Economic activity 2012F 2013F 2014F(% qoq, saar) Q1 Q2 Q3F Q4F Q1F Q2F Q3F Q4F % yoy % yoy % yoyGDP 2.0 1.3 2.7 1.3 1.5 2.0 2.8 3.0 2.2 1.9 2.9Private consumption 2.4 1.5 1.4 1.5 1.0 1.0 2.3 2.5 1.8 1.4 2.7Investment (inc. inventories) 6.1 0.7 6.7 -2.5 12.6 11.1 10.2 9.9 9.5 7.4 8.4Gov’t consumption -3.0 -0.7 3.5 4.6 -0.8 -0.8 -0.2 0.4 -1.0 0.9 0.4Exports 4.4 5.2 1.1 -2.0 -3.0 3.0 3.0 3.0 3.4 0.4 4.1Imports 3.1 2.8 0.1 0.0 2.0 3.0 4.0 4.0 2.8 2.0 5.2Contribution (pp): Stocks -0.4 -0.5 0.8 -0.8 0.4 0.0 0.0 0.0 0.1 0.0 0.0

Net trade 0.1 0.2 0.1 -0.3 -0.7 -0.1 -0.3 -0.3 0.0 -0.3 -0.3

Industria l production 5.1 4.5 6.6

Unemployment rate, % 8.3 8.2 8.1 7.8 7.6 7.5 7.4 7.3 8.1 7.5 7.3

Prices & wages (% yoy)CPI 2.8 1.9 1.7 1.9 1.9 2.3 2.4 2.5 2.1 2.3 2.5

Core CPI 2.2 2.3 2.0 2.1 2.1 2.2 2.5 2.6 2.1 2.4 2.7

Producer prices 3.5 1.1 1.6 1.8 2.2 3.9 3.3 3.6 2.0 3.2 3.6

Compensation per empl. 1.2 1.9 2.6 3.5 2.8 2.8 2.9 2.9 2.3 2.9 2.9

Productivity 1.0 0.9 1.3 1.1 1.6 1.7 1.5 1.5 1.1 1.5 1.5

2012 2013

Source: National authorities, DB Research



Figure 2: Economic growth is expected to continue to lag past business cycles

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Forecast

Source: BEA, Haver Analytics, DB Research

Figure 3: The total impact of impending austerity measures would pose a massive drag on 2013 real GDP

Revenue increases

Bush tax cuts, AMT expire 225 300 1.9

Payroll tax cuts expire 85 110 0.7

Other tax increases 65 90 0.6

ACA high income tax 18 20 0.1

Revenue subtotal 393 520 3.4

Spending cuts

Automatic cuts -54 -70 0.5

Extended unemplmt. benefits expire -34 -50 0.3

Medicare saving -10 -10 0.1

Expenditure subtotal -98 -130 0.8

Cumulative impact 491 650 4.2

USD billions Fiscal yearCalendar

year

Calendar year % of

GDP

Source: CBO, DB Research

What is our baseline? We expect two-thirds of the tax increases will be delayed as well as the full extent of the spending cuts. This is based on past history as well as the fact both parties have significant common ground. For example, on tax policy, the main disagreement regarding the Bush Era tax cuts is whether to extend them for all income brackets or just allow the top two rates (33% and 35%) to rise back to their Clinton Era levels of 36% and 39.6%. Thus, the issue is whether to extend tax rate cuts for 100% or 98% of the population. Regarding Medicare reimbursement and the alternative minimum tax (AMT), Congress has always found ways to temporarily fix these problems in the past, and we expect a similar outcome at present. Both parties want the payroll tax holiday to expire; Democrats have worried about the financial footing to Social Security from the tax cut while Republicans have never liked the temporary nature of the tax cut that does not change incentives to work and to invest.

There is also general agreement on letting extended unemployment benefits expire. Similarly, neither party wants the automatic spending cuts to occur. (These are nearly split between defense and non-defense discretionary spending.) Republicans do not want to cut the former, while Democrats want to preserve the latter. Aside from high end tax rates, the only other area of substantive disagreement is the Affordable Care Act (ACA), also known as Obama Care. This raises the tax rate on investment income to 3.8% from 1.5% for high wage earners. We do not view this relatively small budgetary item (USD20 billion) as a determining factor with respect to the cliff. In total, we expect roughly one-third of the USD 520 billion tax portion of the cliff to survive (USD 180 billion) which translates into 1.2% of GDP.

Figure 4: Most budget plans place the deficit to GDP ratio on a sustainable trajectory

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% of GDP

Administration Budget 2013CBO current law baselineHouse Budget Committee proposal 2013CBO current policy alternativeBow les-SimpsonActual

Forecast

Source: CBO, House Budget Committee, Fiscal Commission, DB Research

Despite much common ground, we believe that a deal will not come until the eleventh hour given the current degree of political gridlock. Of course, such a standoff could evoke a substantial negative financial market reaction, which would in turn compel politicians to work quickly to resolve the matter. While a deal this year to avert most of the fiscal cliff will contain some elements of a grand bargain, the bulk of the details may not be known until next year. Difficult choices on revenue increases and spending/ entitlement reforms will not be agreed to until well into the first half. We believe this continuing uncertainty will weigh on growth. It is possible that a deal to avoid the cliff is worth a bit more than USD180 billion on output if Republicans agree to higher tax rates and more modest spending cuts in lieu of the sequester. Under this baseline scenario, there is a first half GDP slowdown but no recession.

How bad could it be? The plausible worst-case scenario is that which entails the most political gridlock. In other words, the Administration and Congress are unable to reach even a temporary compromise to blunt the impact of the cliff in Q1. As a.



result, on the revenue side the payroll tax holiday expires, the Bush-era tax cuts reset for all income brackets, and the alternative minimum tax (AMT) threshold drops significantly. These measures are worth approximately USD 320 billion collectively (USD 120, USD 110 and USD 90 billion, respectively). Such an abrupt and caustic mix of tax increases would impart a significant financial and psychological shock on a broad swath of households, thereby resulting in a sharp drop in disposable income, consumer and business confidence and private consumption. In turn, such recoil would undoubtedly result in recession, and this would be amplified by an additional USD 200 billion in federal outlays, including cuts to defense, unemployment benefits and Medicare. The cumulative USD 600+ billion dollar impact of the cliff is sufficiently large to prove insurmountable for the economy given the tepid pace of growth at present.

Figure 5: The revenue share of GDP must rise while the spending share must fall

12141618202224262830

2000 2011 2022

% of GDP

Revenue: Administration Budget 2013Outlays: Administration Budget 2013Revenue: House Budget Committee proposal 2013Outlays: House Budget Committee proposal 2013Revenue: ActualOutlays: Actual

Forecast

Source: CBO,OMB, House Budget Committee, DB Research

Of course, an important component of the cliff resolution will be further action regarding the US debt ceiling. According to the CBO, the debt ceiling once again becomes a serious issue in mid-February 2013. At that time there will be the prospect for a repeat of the budget showdown which occurred in the summer of 2011. In a worst-case scenario, Republicans could block (or significantly delay) a debt ceiling increase in retaliation for a lack of compromise from the Democrats regarding tax rate increases. A debt ceiling standoff could result in a number of negative consequences, including a credit rating downgrade, a possible government shutdown, delayed payment of government contracts/wages/social benefits and/or late debt service payments.

We estimate that under the aforementioned scenario GDP would contract by roughly -2% in the first half of the year and the unemployment rate would increase by at least a full percentage point. We expect the deterioration in the economic data and accompanying financial market response (i.e. equity market decline) would force both

parties to expedite a compromise—akin to the failed TARP1 vote in 2008. Under the recessionary circumstances described above, the resulting deal could include tax relief and possibly even modest economic stimulus. This would be necessitated by the limited scope for a monetary policy response given that rates are already at the zero bound and significant quantitative easing measures will already be underway. The upside is that the economic pain of the first half of the year will make it easier to achieve faster growth in the latter half. Even so, full year growth will likely be flat, which will result in negligible improvement in employment.

Figure 6: Absent significant fiscal reform, the share of federal debt to GDP will rise substantially

55

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2011 2013 2015 2017 2019 2021

% of GDP Federal debt held by public

ObamaRyanBow les-SimpsonCBO current law baselineCBO current policy

Source: CBO, OMB, House Budget Committee, Fiscal Commission, DB Research

What does the best case scenario look like? Given that there is simply not enough time remaining before yearend for a comprehensive resolution, the best case scenario now relies upon a two-part plan. The first part requires a quick fix to delay the initiation of austerity measures, i.e. “kicking the can” into the latter part of H1 2013. This could be accomplished by instituting an AMT fix and delaying the onset of various tax increases and sequestrations for several months while a “grand compromise” is developed. The second component of this scenario further requires a meaningful resolution in H1 2013. This would require tax revenue increases (due to a combination of reduced deductions and higher rates); and it would require long-term spending reductions spanning defense, discretionary programs, as well as modifications of entitlement programs such as Medicare, Medicaid and Social Security. Recall that in the CBO’s “full cliff” scenario, publicly-held debt as a share of GDP falls below 60% by the early 2020s; with “no cliff” it rises toward 90% over the same period. (It is roughly 73% at present.) The “middle ground” of our best case scenario would likely stabilize the long-term debt-to-GDP ratio near current levels. If politicians begin to show real initiative and willingness to compromise, then a lapse in public confidence, which would weigh on spending, investment and hiring—as well as the financial markets—could be avoided. In turn, the macroeconomic landscape materially



improves, and both first and second half growth could exceed 3%. This would mark the strongest economic performance since 2004-05.

Figure 7: Individual income taxes account for nearly half of total federal revenues

Individual income

taxes, 46%

Corporate income

taxes, 10%

Social insurance taxes and

contributions, 35%

Excise taxes, 3%

All other, 6%

Federal revenues by source

Source: MTS, DB Research

Figure 8: More than half of all federal outlays are in a narrow range of spending categories

Defense, 19%

Social security,

22%

Medicare, 13%

Interest payments,

6%

All other, 40%

Federal outlays

Source: MTS, DB Research

Monetary reaction

Ironically, under the range of scenarios presented in the preceding commentary, there is little deviation in the Federal Reserve policy response in 2013. This is due to the fact that the resulting growth, inflation and unemployment rate changes are not sufficient to push the Fed off course from its planned asset purchases in the year ahead. In a downside scenario, they could potentially try to accelerate the pace of asset purchases, but we doubt there is significant scope for such a move before market liquidity issues arise. On the contrary, it is unlikely that the economy could outperform sufficiently to drive an early termination of QE in the year ahead. If all goes well, policymakers could potentially shift from their current mid-2015 guidance regarding the first rate hike (which we believe implies and end to asset purchases in early-to-mid 2014); but they would not move so aggressively as to phase out asset purchases in 2013. We fully anticipate that the FOMC will abandon its calendar date guidance for economic thresholds sometime next year, but this will not change the Fed reaction function. Chairman Bernanke has already indicated a predilection for holding rates down longer into the recovery, so regardless of the cliff/economic outcome in 2013, the Fed course is largely set. The variability of monetary policy outcomes does not become an issue until 2014 at the earliest.

In the event that the cliff is not reduced, the economy will tip into recession, thereby resulting in a significant financial market correction as well as a backup in the unemployment rate toward 9%.

If the cliff issue is successfully resolved, there is a significant possibility for the intensification of a virtuous economic feedback loop driven by the ongoing housing market recovery, continued labor market gains and pent-up demand from both households and businesses.

Figure 9: External balances & financial forecasts

2012F 2013F 2014F Financial forecasts Current 3M 6M 12MOfficial 0.16 0.16 0.16 0.16

Fiscal balance, % of GDP -7.1 -5.8 -4.8 3M rate 0.10 0.10 0.10 0.10Trade balance, USD bn -417 -456 -503 10Y yield 1.72 1.75 2.25 2.75Trade balance, % of GDP -2.7 -2.8 -2.9 USD per EUR 1.31 1.35 1.30 1.20Current account, USD bn -491 -536 -589 JPY per USD 84 82 86 90Current account, % of GDP -3.1 -3.3 -3.4 USD per GBP 1.61 1.61 1.57 1.50

Source: National authorities, DB Research, as of December 13

Joseph A. LaVorgna, (1) 212 250 7329 Carl J. Riccadonna, (1) 212 250 0186

Brett Ryan, (1) 212 250 6294



Europe: A false sense of security

We maintain that the euro area crisis is resolvable. The crisis is 3 years old and there is evidence of the two principal ingredients of resolution starting to be delivered – macroeconomic rebalancing to make the sovereigns investable again and integration to ‘share of the burden’ of adjustment.

Markets had been less and less willing to give the benefit of the doubt to the euro area and the ECB had to respond with exceptional policies to help buy the time. The ECB OMT is a significant step forward for sovereign liquidity backstops.

However, there is a false sense of security. The crisis is not resolved and we believe both Spain and Italy will require ESM/OMT support. The US ‘going over the fiscal cliff’ could be the catalyst. Even if the cliff is averted (our baseline), we expect markets to refocus on Spain and Italy’s unconvincing economic and political capacity to deliver sustainable fiscal and economic adjustment. We see these euro crisis tests unfolding in the H1 2013.

In H2, there is basis for the euro crisis area to enjoy some cyclical relief, as recovering foreign demand, easier domestic austerity and a more supportive euro area credit impulse combine.

Our fear is that without market pressure, the politicians will under-deliver on the stronger structural crisis-fighting tools, for example, direct bank recapitalization. Without progressing the structural crisis fixes the euro area leaves itself

open to slipping back into crisis. We do not expect crisis exit velocity to be reached in 2013, either politically or economically.

Relative to the last World Outlook, we have trimmed our euro area GDP growth expectations for 2013 to -0.3% (from 0.0%), but continue to see a return to modest if subpar growth in 2014 (1.1% vs 1.0% previously). Germany and its nearest neighbours are expected to reassert their outperformance in 2013 as the global economy accelerates. In our baseline, we expect a 25bp ECB refi rate cut at end Q1.

If the US ‘goes over the fiscal cliff’, we see euro area GDP contracting 1.2% in 2013, accelerating a refi rate cut and raising the probability of further non-standard policy, e.g., structured LTROs like the BoE ‘Funding for Lending Scheme (FLS).

If our view of a modest UK recovery and sticky inflation are right we would expect no further monetary easing by the BoE. The risk of a UK sovereign downgrade has risen following December's mini-budget. In Sweden weaker growth suggests a further rate cut is needed. While Denmark is likely to retain negative official rates Norway looks set to tighten next year. Switzerland should maintain ultra-loose policy and retain the franc cap.

Figure 1: Macro-economic activity & inflation forecasts: Euroarea Economic activity 2012F 2013F 2014F(% qoq, saar) Q1 Q2 Q3 Q4F Q1F Q2F Q3F Q4F % yoy % yoy % yoyGDP -0.1 -0.7 -0.2 -1.7 -0.5 0.3 0.9 1.2 -0.5 -0.3 1.1Private consum ption -1.1 -1.7 -0.1 -1.2 -0.6 0.0 0.4 0.6 -1.1 -0.4 0.5Investm ent -4.7 -6.9 -2.9 -5.5 -3.2 0.0 0.8 1.6 -3.8 -2.5 2.1Gov’t consum ption 0.6 -0.4 -0.6 -0.8 -0.4 -0.4 -0.4 -0.4 -0.2 -0.5 -0.5Exports 2.0 6.4 3.5 0.0 2.0 3.4 4.0 4.1 2.9 2.7 4.4Imports -1.1 2.5 0.8 0.6 0.8 2.3 2.8 3.4 -0.5 1.6 3.6Contribution (pp): S tocks -0.1 0.0 -0.7 0.4 -0.1 -0.2 0.0 0.2 -0.6 -0.1 -0.1

Net trade 1.3 1.8 1.2 -0.2 0.6 0.6 0.6 0.5 1.5 0.6 0.6

Industria l production -1.9 -1.9 1.2 -4.2 -1.5 -0.2 0.9 1.3 -2.0 -1.0 1.6

Unemploym ent rate, % 10.9 11.3 11.5 12.0 12.2 12.4 12.5 12.6 11.4 12.4 12.3

Prices & wages (% yoy)HICP 2.7 2.5 2.5 2.3 1.8 1.6 1.5 1.5 2.5 1.6 1.6

Core inflation 1.5 1.6 1.6 1.5 1.3 1.2 1.1 1.2 1.5 1.2 1.5

Producer prices 3.7 2.2 2.4 2.6 1.5 1.8 1.7 1.6 2.7 1.7 2.0

Com pensation per empl. 2.0 1.6 1.5 1.3 1.2 1.2 1.1 1.2 1.6 1.2 1.4

Productivity 0.4 0.2 0.1 0.0 -0.2 0.1 0.3 1.0 0.2 0.3 1.0

2012 2013




#1. Macroeconomic rebalancing is possible The two principal components of resolution of the euro crisis are macro rebalancing and integration (‘burden-sharing’ between euro area members). The market is starting to appreciate the progress that has been made with the rebalancing required to make these sovereigns investable again. Fiscal deficits have already fallen sharply. From 7.5% of GDP in 2009, the average GIIPS primary budget balance has fallen to 1.7% of GDP in 2012 and we project to be 0.3% in 2013 and a surplus of 0.9% of GDP in 2014. The corrections in current account deficits are more impressive still, with balanced positions or surpluses in 2013 in Ireland, Portugal and Spain, with structural trade balance adjustments notable in Iberia. These three peripherals are showing improvements in competitiveness and export growth.

Figure 2: Structural trade balance adjustments: Spain and Portugal are looking good

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1975 1980 1985 1990 1995 2000 2005 2010

Italy PortugalSpain France

Structural trade balance, % of GDP

Source: Haver Analytics, DB Research

#2. Europe more accepting of this as a banking crisis The rebalancing of current account deficits reflects deleveraging, both public and private. The harsh bank deleveraging in 2012 served as a reminder that the crisis was not merely a fiscal crisis. Spain’s failure to comprehensively address its banks in H1 2012 added to the crisis in the summer. Ultimately this led to an EFSF bank recapitalization deal for Spain. But doubts about the ability to sustain E100bn of recap related debt also heralded a policy innovation from euro area leaders.

The decision by leaders in June to fix an obvious euro design flaw and implement a common supervision regime for euro area banks was a big step forward. We were encouraged by the commitment to a pan-euro recapitalization mechanism once the common supervisor is in place. With this, markets could afford to be more confident about resolving the negative feedback loop between weak sovereigns and weak banks.

Figure 3: Deleveraging hit hard in early 2012

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Credit impulse (lhs)Real private domestic demand (rhs)

% yoy% of GDP

Source: ECB, Eurostat, DB Research,

A disappointing lesson to take from the crisis is that without market pressure, politicians tend to under-deliver. The risk is little real progress is made in implementing common supervision and complementing it with common resolution policies this side of the German election.

#3. Troika getting more flexible on fiscal policy With banks risk averse, the ECB has limited influence over bank lending despite ample liquidity. Inevitably, this turns the stoplight back on fiscal policy. Several decisions this year demonstrate the Troika newfound capacity for flexibility on fiscal consolidation, including the Troika decision to allow Portugal to run higher deficits in 2012 and 2013 in order to let the automatic fiscal stabilisers more room to operate, and the European Commission’s recent decision not to escalate the excessive deficit procedure against Spain despite forecasting a 6% of GDP deficit in 2013 compared to a target of 4.5% of GDP.

Figure 4: The rate of austerity is beginning to slow

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0.5

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1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Fiscal stance (increase in the cyclically-adjusted budget deficit)

Forecast

Looser f iscal policy

TighterFiscal policy

% of GDP

Source: European Commission, DB Research

The Commission accepts that the outlook for Spanish economic growth has weakened. As such, the Commission is effectively targeting cyclically-adjusted deficits. If growth forecasts are accurate, this means the structural fiscal tightening should represent a cap on 2013



austerity. Since the tightening of the fiscal stance in 2013 is just two-thirds of that of 2012, the peak in austerity (defined on a rate of change basis) has been passed.

To maximize the benefits, the fiscal multiplier will also have to improve. For this, the economy needs easier access to bank credit. The credit impulse (second derivative of credit) says that the euro area does not need a positive flow of bank credit in 2013 to create upside relative to our GDP forecast. All that is required is no further deleveraging. With bank recapitalization having advanced and bank funding easing thanks to OMT, slower bank deleveraging in 2013 is credible.

#4. The ECB can be a lender of last resort With market perceptions of break-up risk rising in the summer, the ECB had to respond. In September the ECB confirmed OMT (Outright Monetary Transactions), an unlimited conditional secondary market intervention facility. The credible threat of OMT intervention kept the market for Italy and Spain open at reasonable interest rates in recent months, but we are not confident this will persist. The credible threat of intervention limits the incentive to short the bonds, yet we do not see governments applying without some market pressure. Market pressure comes down to demand versus supply. Spain and Italy still have large gross funding requirements for 2013 (EUR151bn for Italy, EUR105bn for Spain). Absorbing this volume of bonds privately requires the willingness of foreign investors to roll their positions, particularly in Spain.

Figure 5: ECB ‘credit easing’ policies have had a big impact on yields; OMT effect ought to be more lastingSovereign yields, % 3Y LTRO OMT

Announced 3m later Announced 3m later Current12/8/2011 3/8/2012 7/27/2012 10/27/2012 12/4/2012

Italy 3Y 6.56 2.56 4.59 2.85 2.3510Y 6.45 4.81 5.96 4.90 4.40

Spain 3Y 5.10 2.86 5.89 3.68 3.4010Y 5.81 5.06 6.74 5.59 5.23

Germany 3Y 0.45 0.28 0.04 0.13 0.0710Y 2.02 1.80 1.40 1.54 1.41

Ita-Ger 3Y spd 6.11 2.28 4.55 2.71 2.2810Y spd 4.44 3.01 4.56 3.37 2.99

Spn-Ger 3Y spd 4.65 2.58 5.85 3.55 3.3310Y spd 3.80 3.26 5.35 4.06 3.81

Source: Bloomberg Finance LP, DB Research

We expect events and/or conditions to create the market pressure to push both Italy and Spain into applying for ESM/OMT assistance. In our view, both face questions about their economic and political capacity to deliver sustainable fiscal and economic adjustment. With the Italian technocratic government falling before a new electoral law is approved, the probability of Mario Monti returning as PM has declined. Italian fiscal performance has also slipped and the economy remains fragile. Structural reforms are fundamental for Italy’s medium-term debt sustainability. The continuation and completion

of the reforms promoted by Monti’s government are dependent on the outcome of the elections. An unstable or worse anti-reform government would increase the probability that Italy might need external support. A pro-reform, stable government may avoid a MoU as long as a recovery materialises in second part of the year. Spain has many challenges: its funding has not fully re-nationalised yet, the bank recap is timid, the growth outlook remains challenging and the Catalan election result is likely to stoke separatist tensions. The latter may undermine EU/ECB confidence in conditionality (see “Spain: The limits of ‘virtual intervention’”, Focus Europe, 7 December 2012).

While we see a 25bp refi rate cut at the end of Q1, we believe the ECB will be reluctant to cut the deposit rate into negative territory. There are non-normal costs from such a policy (e.g., reduced operating incentives for money market funds, and perverse incentives for banks to raise lending costs, a visible reaction to negative deposit rates in Denmark). Only with a considerable deterioration in the outlook might such a policy be considered.

Figure 6: Taylor Rule supports a final rate cut

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1999 2001 2003 2005 2007 2009 2011

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5

%


#5. Extremists being kept out of national governments There needs to be sufficient political will for rebalancing, reform and integration. Elections are the ultimate arbiter. If there is no popular acceptance for the policies necessary to resolve the crisis, there is little even the ECB will be able to do to sustain the euro. Money printing against the popular will of the core states will increase break-up risk, not reduce it.

Populist and anti-European fringe parties are attracting votes, but more so in the core countries than in the periphery. Despite growing support, however, no populist fringe party is currently among the ruling parties in the EU. Nonetheless, the electoral successes of right-wing populist and newly established left-wing factions may hamper the formation of properly functioning governments in future, though (see “European party



landscape in transition”, DB Research, 14 November 2012).

With elections in both Italy and Germany in 2013, the euro area will be testing political appetite at the debtor and creditor ends of the crisis spectrum and in countries that are ‘too big to be ignored’. Our baseline expectation is continuity in Germany with Merkel to return as German Chancellor, if at the head of a CDU-SPD grand coalition. In Italy, however, we are becoming less confident that a coalition will be elected that can allow Mario Monti to return as technocratic leader. This will shake market confidence.

#6. Euro area determined to keep Greece a member For the third time in as many years, the euro area has demonstrated its capacity to give Greece a chance. The latest deal required squeezing the programme parameters like loan margins so hard that the deal has been popularly labeled ‘OSI-lite’. Having already shifted the bulk of Greek debt on to the official sector, this indicates the price the euro area is willing to pay to avoid the failure of the Greek programme and an exit scenario.

Greece’s negative feedback loop – no investment, no growth, no confidence in debt stabilization – remains unresolved, and we expect that further efforts to reduce Greek debt will be required. These were already hinted at with the Eurogroup commitment on 26 November. But that is a medium-term story (when Greece is back in primary surplus, that is, not before the German election).

If the Greek domestic political will and social stability is there, the deal should buy the sovereign some stability into 2013. That is not to say the Eurogroup won’t be busy: we expect ESM/OMT deals for both Spain and Italy; a restructuring of Ireland’s promissory notes before the end of March with possible OMT assistance in the return to sovereign markets; and around mid-year a supplementary loan programme for Portugal (the ECB recently said the OMT will only be available for those who already have market access).

2013: After a fragile start, H2 could see cyclical relief…but ongoing structural vulnerability

We forecast euro area GDP to contract 0.3% in 2013 (down 0.3pp since the last World Outlook) and recover to 1.1% in 2014 (up 0.1pp). On a component basis, the downward revision in 2013 is driven by private domestic demand. On a country basis, the euro area remains divided. The downward revision is partly Greece and Portugal but more a reflection of weaker forecasts for Germany and the core. The latter reflects weaker carryover effects due to slow end-2012 performances, more a reflection of the downturn in global growth than anything else. This is stabilizing. Through 2013, we expect

the old ‘DM bloc’ to outperform the rest of the euro area, the five peripheral economies to be approaching stable GDP by the end of next year but the group of countries in the middle – dominated by France – to only growth slowly in H2.

Figure 7: Developed Europe GDP growth Real GDP growth, % yoy

2011 2012F 2013F 2014F

Germany 3.0 0.8 0.3 1.5

France 1.7 0.1 -0.3 1.0

Italy 0.4 -2.1 -0.9 0.5

Spain 0.4 -1.3 -1.1 0.6

Netherlands 1.1 -1.0 -0.1 1.7

Belgium 1.8 -0.2 0.0 1.0

Austria 2.7 0.5 0.9 1.3

Finland 2.7 -0.1 0.0 1.2

Portugal -1.7 -2.9 -1.2 0.8

Greece -6.0 -6.5 -4.2 0.9

Ireland 1.4 0.2 0.8 1.9

Euro Area 1.5 -0.5 -0.3 1.1

UK 0.9 -0.1 0.9 1.8

Sweden 3.8 1.2 1.2 1.9

Denmark 1.1 -0.5 1.0 1.5

EU 1.5 -0.3 0.0 1.3

Switzerland 1.9 1.0 1.5 1.7

Norway 1.3 3.2 2.0 2.5

Source: DB Research

Thinking of the euro area in aggregate, when we look into 2013, we see the potential for two distinct periods to the year, broadly the first and second halves. In the nearer term (the next quarter or two) we see a vulnerable picture: ongoing, mild recession with risk of political shocks, externally from the US fiscal cliff, internally from the Italian election if not also from Spain if it fights a move into the OMT.

Beyond the next three to six months, economic growth is more believable. We see three legs to this argument. First, modest recoveries are expected in the US and China, helping support optimism in a recovery in external demand over the course of the next 12 months and into 2014. Second, a switch to targeting cyclically-adjusted budget deficits means austerity is more likely to have been capped at a lower rate than in 2011 and 2012. Third, there is more hope for a positive credit impulse as the deleveraging pressures start to subside. Bank recapitalisation is quite advanced, sources of funding are improving and the remaining deleveraging is heavily weighted towards investment banking operations rather than retail loan books (see “European Banks Strategy: An end to deleveraging in sight”, DB Equity Research, 4 December 2012). In the final quarter of 2013, we expect euro area GDP growth to be 1.2% year-on-year.

Cyclical resolution is not structural resolution. Without progressing the structural crisis fixes (e.g., direct bank recapitalisation) the euro area leaves itself open to slipping back into crisis. In now typical fashion, rather than



removing all doubt about member state debt sustainability, the Troika will react on an “as needed” basis. Until and unless the market forces the issue -- that is, loses some confidence -- the official won't implement policy advancements. We do not expect crisis exit velocity to be reached in 2013, either politically or economically.

Figure 8: Developed Europe fiscal balances Fiscal balance, % of GDP

2011 2012F 2013F 2014F

Germany -0.8 0.0 -0.4 -0.2

France -5.2 -4.6 -3.6 -2.8

Italy -3.9 -2.9 -2.3 -2.5

Spain -9.4 -7.9 -6.1 -5.1

Netherlands -4.4 -4.0 -3.2 -2.0

Belgium -3.7 -3.4 -3.3 -2.6

Austria -2.5 -3.1 -2.8 -2.5

Finland -0.6 -0.8 -0.8 -0.5

Portugal -4.4 -5.3 -4.8 -3.4

Greece -9.4 -7.0 -6.1 -5.0

Ireland -13.4 -8.3 -8.0 -6.2

Euro Area -4.2 -3.3 -2.7 -2.3

UK -8.0 -5.3 -6.7 -5.9

Sweden 1.9 -0.5 -0.5 0.0

Denmark -1.6 -4.5 -3.0 -2.0

EU -4.4 -3.5 -3.2 -2.6

Switzerland 0.4 0.0 0.2 0.5

Norway 9.9 12.5 12.0 11.5Source: DB Research

Alternative scenario: what if the US goes over the fiscal cliff?

The IMF estimates that the impact on output in Europe of the US “going over the fiscal cliff” would be between one eighth and one quarter of the impact in the US (elasticity varying dependent on the precise economy; Ireland is the only country where the elasticity is higher at three-eighths). We estimate a simple VAR model based on euro and US GDP, the real effective exchange rate, euro short term interest rates US corporate spreads and the ECB Bank Lending Survey. On a data set up to 2007, the elasticity of a shock to US implies an elasticity of about 0.3, not much different to the IMF. However, on a data set to 2012, the elasticity is twice that at 0.6. Given the high economic and financial correlations through the credit crisis, this is not so surprising. To be conservative, we assume elasticity mid way between these two estimates.

Our US economists estimate that going off the cliff would result in no growth for 2013 on average compared to their baseline of 2%. Using 0.45 elasticity, this would equate to a reduction in our 2013 euro area GDP forecast to -1.2% from -0.3%, with the vast majority of the impact in H1. This would both significantly deepen as well as lengthen the euro area recession.

If the US does go over the fiscal cliff, (a) irrespective of how the fiscal cliff is resolved, Spain in our view needs to

trigger ECB/ESM support. This is not a foregone conclusion for Italy. However, given Italy's chronic lack of growth - the most important source of concern regarding debt sustainability - a negative outcome for the fiscal cliff triggering a major delay in the recovery of world demand would in our view precipitate such request from Italy, with the challenge that such crucial decision would have to be made in a political vacuum, with the looming elections (b) the probability of the ECB easing the refi policy rate increases significantly it would have to do so earlier, say January or February; and (c) the longer the US political parties remain divided, the likely more persistent will be the USD decline and EUR rise. This would also put pressure on the ECB to consider a non-standard policy, but it depends on the persistence of the currency appreciation (see “ECB non-standard policies: What’s possible”, Focus Europe, 16 November 2012).

Figure 9: Other indicators & financial forecasts: Euroarea

2011 2012F 2013F 2014FM3 growth, % yoy eop 1.5 5.1 2.0 2.8Fiscal balance, % of GDP -4.1 -3.3 -2.7 -2.3Public debt, % of GDP 87.3 92.7 94.5 94.3Trade balance, EUR bn -11.5 59.6 98.6 141.5Trade balance, % of GDP -0.1 0.6 1.0 1.4Current account, EUR bn 8.7 87.2 122.6 162.3Current account, % of GDP 0.1 0.9 1.3 1.6

Financial forecasts Current 3M 6M 12MOfficial 0.75 0.50 0.50 0.503M rate 0.18 0.20 0.20 0.3010Y yield 1.34 1.65 1.90 2.50USD per EUR 1.31 1.35 1.30 1.20JPY per EUR 109 111 112 108

GBP per EUR 0.81 0.84 0.83 0.80Source: DB Research, as of December 13

Other European themes in 2013

Italian election Following the de-facto removal of the support by ex-PM Berlusconi’s party, current PM Monti announced he would resign as soon as the 2013 budget is approved. Early elections will most likely occur in February (in any case no later than 10 March). In falling before a new electoral law was approved, the probability of a Monti-led grand coalition immediately after the elections has materially diminished. There is no guarantee that the winner of the elections will enjoy a stable majority in the parliament given the diverging criteria for assigning majority premia in the two houses of parliament, which in the Italian institutional system have equal power. Hence, although the centre-left’s support in opinion polls has increased, it is unclear whether a post-election stable majority can be secured. Higher uncertainty could affect markets, e.g. higher government yields. That, in turn, could delay the



projected improvement in the real economy. In the medium term to enhance public debt sustainability it is essential that the next government implements and completes the structural reform programme initiated by Monti. Italian elections will be an increasing source of potential volatility.

German election Germany is facing federal elections in Sept/ Oct 2013. Chancellor Merkel continues to score high in terms of popularity while Peer Steinbrueck, her social democrat challenger, is trailing behind. A majority of Germans consider Merkel the better person to handle the euro crisis. The polls so far show a close race with neither party camp - the ruling coalition of CDU/CSU and FDP or the opposition of SPD and Greens - able to achieve a majority of votes. The CDU will come out as strongest party but might have to search for a new coalition partner as the Liberals will have to fight their way back into the parliament (threshold of 5% of votes required). The figures might well allow only for a grand coalition of CDU and SPD - a re-launch of the 2005 - 2009 political setting. Even with a new government, there will be no fundamental shift in German policy towards euro area policy. CDU and SPD clash over details such as the transparency of rescue costs but in substance both the current chancellor and her challenger agree on the euro policy course - all relevant decisions on euro area issues have seen cross-party parliamentary approval. In addition, public opinion and the Constitutional Court as major veto players will restrain the policy of any new government.

UK recovery and credit rating It came as no surprise that the government admitted to slower growth and higher deficits in its latest mini-budget,

missing its target of a reduction in net debt/GDP by 2015. We have revised our forecasts for growth down notably over the last year to a small contraction in 2012, a more modest expansion in 2013 (sub-1%) and below-average growth the year after (1.8%). But with inflation sticky this modest recovery should limit the need for further monetary easing. Even if, as we expect, QE is finished it will take some time before rates are raised - normally it takes less than 12 months to turn policy around but this time we see the BoE waiting for two years before taking back policy accommodation.

A key risk for next year is the possibility of losing the triple-A sovereign rating. Two rating agencies (Fitch and Moody's) currently have the UK on negative outlook, and both are intent on reviewing the situation early in 2013.

Figure 10: Other indicators & financial forecasts: UK 2011 2012F 2013F 2014F

M4 growth, % -1.5 -3.7 2.5 4.5Fiscal balance, % of GDP, FY -8.0 -5.3 -6.7 -5.9Trade balance, GBP bn -100.2 -106.3 -108.7 -104.6Trade balance, % of GDP -6.6 -6.8 -6.8 -6.3Current account, GBP bn -29.0 -73.0 -70.0 -58.0Current account, % of GDP -1.9 -4.7 -4.4 -3.5

Financial forecasts Current 3M 6M 12MOfficial 0.50 0.50 0.50 0.503M rate 0.52 0.55 0.60 0.7010Y yield 1.82 2.20 2.50 3.10USD per GBP 1.61 1.61 1.57 1.50GBP per EUR 0.81 0.84 0.83 0.80

Source: DB Research, , as of December 13

Figure 11: Macro-economic activity & inflation forecasts: UK Economic activity 2012F 2013F 2014F(% qoq, saar) Q 1 Q 2 Q 3F Q 4F Q 1F Q 2F Q 3F Q 4F % yoy % yoy % yoyGDP -1.2 -1.5 3.9 -0.6 0.6 1.1 1.4 1.7 -0.1 0.9 1.8Private consum ption 1.4 -1.0 2.5 0.0 0.4 0.8 0.8 1.2 0.6 0.7 1.2Investm ent 13.6 -10.5 2.2 0.0 1.6 2.8 3.2 3.6 1.1 1.1 3.7Gov't consum ption 13.1 -6.1 2.3 -0.8 -1.2 -1.2 -1.6 -1.6 2.5 -1.1 -2.1Exports -6.3 -4.1 6.9 -0.4 2.0 2.8 4.0 4.4 0.1 2.3 4.9Im ports -0.5 5.6 -1.6 -0.1 0.6 1.1 1.4 1.7 1.9 0.8 1.8Dom estic dem and 5.6 -3.6 2.4 -0.2 0.2 0.6 0.6 0.9 1.1 0.4 0.9

Contribution (pp): S tocks -4.9 5.2 0.9 0.1 0.0 0.0 0.0 0.0 -0.6 0.2 0.0

Net trade -1.9 -3.1 -0.2 -0.1 0.4 0.5 0.8 0.8 -0.6 0.5 1.0

Industria l production -1.2 -3.6 2.9 -2.8 0.8 0.8 1.2 1.6 -1.9 0.3 1.5

Unem ploym ent rate, % 8.2 8.0 7.8 7.9 8.1 8.2 8.3 8.3 8.0 8.2 8.1

Prices & wages (% yoy)CPI 3.5 2.7 2.4 2.6 2.4 2.5 2.4 2.4 2.8 2.4 2.2

Producer prices 3.9 2.7 2.2 2.5 2.0 1.6 2.0 1.8 2.8 1.8 1.9

Com pensation per em pl. 0.5 1.8 1.9 1.8 2.6 1.8 2.2 2.7 1.5 2.3 3.0

Productivity -0.1 -1.3 -1.7 -1.3 -0.2 1.3 1.2 1.7 -1.1 1.0 1.7

2012 2013




Of the twelve countries left still rated triple-A by all three agencies, the IMF estimates that by 2016 the UK will have the highest public debt/GDP ratio. It is debatable what would happen to yields in the event of a downgrade. Recent downgrades of France (November 2012) and the US (August 2011) may not provide good guidance as France was already downgraded earlier in the year and the US was large enough to benefit from a flight to quality. On average across countries each notch lower on the rating adds about 60bps to yields. However, with a still credible fiscal policy, a relatively small foreign holding of gilts and an independent currency, we doubt yields would rise this much - if at all.

Switzerland and SNB peg While an easing of the euro sovereign crisis thanks to ECB actions earlier in the year has removed some of the immediate downward pressure on EUR/CHF, the franc remains close to the 1.20 floor the SNB has imposed since September 2011. It seems unlikely we will see sizable downside to CHF in the near-term on account of Switzerland's large current account surplus. Still, our FX strategists do see some modest move lower in CHF over the next year as previous safe-haven flows are reversed. Whether this will prove sufficient for the SNB to move the minimum FX rate higher (for example, to EUR/CHF1.25) is debatable; our forecasts are for 1.23 by end-2013, reflecting an improving euro area situation. A key consequence of currency strength has been to maintain downward pressure on inflation, which has been sub-zero for over a year (headline and core). The central bank sees inflation turning positive again over the next two years, but its forecasts remain subdued (below 0.5% in 2013 and 2014). Growth has so far held up reasonably well, the

last three years of expansion only being broken once by a contraction in Q2 this year. Business surveys generally remain weak but have shown more encouraging signs recently suggesting that slower growth around the turn of the year may be short-lived.

Scandinavia The most notable change to our forecasts for Scandinavia recently has been that of Sweden, where we now expect the Riksbank to ease policy again at its December meeting. Despite the Governor's concerns about the long-run implications of low interest rates (particularly on household debt, which remains at relatively high levels) recent economic data suggest the need for further monetary accommodation. The economy has expanded at a reasonable rate of 2.5% annualised in the first three quarters of 2012, but weaker business surveys indicate a slowdown in official GDP growth is imminent. Inflation remains low enough to allow further easing although core rates have risen over recent months.

Elsewhere, Norges Bank looks likely to be the first of the Scandinavian central banks to tighten policy in 2013. The statistics office has revised down its forecasts for growth recently but the revisions are only modest and mainland GDP is expected to run at a pace of around 3% in 2013. Our own view is for slower growth than this but as momentum picks up during the course of the year demand for higher rates should increase. Danish growth, on the other hand, is expected to remain weak and we would not be surprised to see output contract in 2013.

DB European Economics (44) 20 7545 2087/88

(49)69 910 31790



Japan: Approaching a trough of business cycle

A downward momentum in activity has begun to weaken in Oct/Nov data, suggesting a trough of the current downturn likely in around March-2013.

The initial phase of the ensuing recovery likely will be gentle and led by global growth.

We see some room for additional fiscal and monetary stimuli in 2013 under the new administration following the December-2012 election.

Gentle recovery in 2013

Bottoming in leading index Our leading index of the business cycle has finally stopped falling, indicating that the phase of the greatest downward momentum in activity is probably over. A growing number of economic indicators are showing signs of stabilization or improvement, including new job offers, auto sales, construction starts and production. We expect the trough of the cycle to be behind us by March 2013 and real GDP should register five consecutive quarters of growth from Q1 2013 to Q1 2014. The initial stage of the ensuing recovery likely will be gentle and led by global growth. It probably will take many years of recovery before domestic demand gains traction.

US fiscal cliff could stifle Japan’s recovery The looming US fiscal cliff could delay the trough by 3-6 months and stifle the recovery, through slower growth of US-bound exports and JPY appreciation. A 1% point lower US growth and a 5% JPY appreciation would restrain Japan’s GDP growth by 0.3%point.

Figure 1: Leading index of the business cycle

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DB leading indexCoincident index

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Source: Cabinet Office, DB Research

Figure 2: Japanese exports follow global manufacturing PMI

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Figure 3: Macro-economic activity & inflation forecasts E c o n o m ic ac tiv ity 2012F 2013F 2014F(% q o q , saar) Q 1 Q 2 Q 3 Q 4F Q 1F Q 2F Q 3F Q 4F % yo y % yo y % yo yG D P 5.7 -0.1 -3.5 -1.5 1.4 1.4 1.7 1.8 1.6 0.2 0.3P r iva te c ons um pt ion 4.7 0.3 -1.7 -0.8 1.0 1.0 1.2 2.2 2.1 0.3 -0.6Inves tm ent -8.5 1.4 -9.0 -2.9 -0.7 2.0 3.1 4.5 1.1 -0.7 0.0G ov’t c ons um pt ion 5.7 1.9 2.4 1.0 0.4 -0.8 -1.6 -1.6 2.2 0.1 -0.1E xports 13.9 3.3 -18.9 -9.0 3.8 8.0 9.9 10.2 0.5 0.1 8.4Im ports 9.7 7.4 -1.8 -7.8 2.1 5.8 7.0 7.0 5.4 1.6 5.2Contr ibut ion (pp):

P r iva te inventory 1.2 -1.1 0.9 -0.5 0.6 0.3 0.4 -0.4 0.1 0.2 0.2

N et t ra de 0.8 -0.5 -3.1 -0.3 0.3 0.4 0.5 0.6 -0.7 -0.2 0.6

Indus t r ia l produc t ion 5.2 -7.7 -15.7 -8.7 3.0 5.1 6.1 5.1 -1.0 -1.6 2.2

U nem ploy m ent ra te, % 4.6 4.4 4.2 4.3 4.3 4.3 4.3 4.2 4.4 4.3 4.2

P ric es & w ag es (% yo y)CP I 0.2 0.2 -0.3 -0.5 -1.0 -0.8 -0.3 -0.1 -0.1 -0.6 1.7

Core CP I 0.1 -0.1 -0.3 -0.2 -0.6 -0.5 -0.3 -0.1 -0.1 -0.4 1.7

P roduc er pr ic es 0.3 -1.0 -1.9 -1.2 -1.6 -1.3 -0.2 0.4 -0.9 -0.7 2.3

Com pens a t ion per em pl. 0.4 -0.4 0.2 -0.3 -0.4 0.0 0.0 0.3 -0.2 0.0 0.6

P roduc t ivity 0.8 2.6 0.6 1.8 2.9 1.8 2.1 1.3 1.1 2.0 0.0

2012 2013




Current account to stay in surplus Japan’s current account is likely to remain in surplus, even if at lower levels, thanks to continued expansion in income surplus and forthcoming gentle global recovery. The underlying trend of CPI inflation is likely to remain around or below zero, given a deflationary output gap, strong JPY exchange rates and stable commodity prices. Consumption tax hikes are scheduled in April 2014 (from 5% to 8%) and October 2015 (to 10%).

New administration’s policy options Following the 16 December lower house election, a new administration, likely led by LDP, might formulate a FY12 supplementary budget of JPY3-5trn and a somewhat stimulatory FY13 initial budget, appoint a more dovish BoJ governor and two deputies, adopt a more compulsory 2% inflation targeting to weaken JPY rates, and allow for restarts of nuclear power plants. We are skeptical about the ability of fiscal policy to end deflation as Japan has done a few dozen fiscal packages over the past 20+ years with little success. We are more hopeful of assigning this task to monetary easing, which still maintains several transmission channels including via asset prices.

US monetary easing can outrun Japan Our sensitivity analysis shows that 10% JPY depreciation would raise CPI by 0.64%; a JPY10trn rise in monetary base would raise CPI by 0.15%, and 0.5% higher global growth would raise CPI by 0.28% in 12 months. However, a monetary policy stance has to be judged in relative terms where the US is likely to accelerate its easing from January 2013. We think it would be very difficult for the BoJ to outrun the Fed easing, which could limit JPY depreciation. Over the past 24 months, monetary base has grown at annualized JPY15trn. The new BoJ governor could double this speed but not achieve more than that, in our view.

Failure to reduce the US fiscal cliff.

A large-scale fiscal stimulus and monetary easing after Dec 2012 lower house election.

Figure 4 :Other indicators & financial forecasts 2011 2012F 2013F 2014F

M2 growth, % 2.7 2.5 2.9 3.1Fis ca l ba lanc e, % of GDP -9.7 -10.2 -9.8 -7.8Public debt, % of G DP 213.3 223.7 233.7 239.3Trade ba lanc e, US D bn -20.2 -68.1 -59.4 -43.8Trade ba lanc e, % of GDP -0.3 -1.2 -1.1 -0.8Current account, U S D bn 121.1 61.5 65.3 83.4Current account, % of G DP 2.1 1.0 1.2 1.6

Fin an c ial fo recasts Cu rren t 3M 6M 12MO ff ic ia l 0.10 0.10 0.10 0.103M ra te 0.32 0.30 0.30 0.3010Y y ield 0.73 0.80 0.80 0.90JP Y per US D 84 82 86 90JP Y per E UR 109 111 112 108

Source: DB Research, , as of December 13

Figure 5 :Balance of payments in Japan

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Figure 6: Peaking post-quake reconstruction spending

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Figure 7: Least aggressive monetary easing in Japan

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Mikihiro Matsuoka, (81) 3 5156 6768



Asia (ex Japan): Sensitivity to US, EU growth will determine 2013 performance

Expectations of a recovery in Europe and stronger growth in the US mean export growth in Asia will likely strengthen markedly after mid-2013.This will benefit the export-driven ‘high-beta’ economies more than the less export sensitive economies.

We expect growth in China and India to rise even before the US&EU recovery. China’s inventory cycle is turning more positive for growth and when exports start to grow more quickly we expect China will briefly see GDP growth above 9% in mid-2014.India’s recovery will likely be much more subdued, with growth rising only above 7% in 2014.

Our baseline forecast has central banks starting again to “normalize” monetary policy around mid-2013.

A beneficiary of stronger US, EU growth

Many Asian economies are small, very open economies, and so our baseline forecast of a recovery in Europe and faster growth in the US is very supportive for a number of Asian economies. It will help also that we expect the recovery that has been getting underway in China in recent months will also build through the first half of the year even while US and EU growth is expected to remain very weak.

But within the region, there are some important differences that we think may influence where investors’ capital goes. Hong Kong, Singapore, South Korea and Taiwan are historically ‘high-beta’ economies – with an exaggerated sensitivity to fluctuations in US and EU (‘G2’) growth – while Indonesia, the Philippines, Sri Lanka and Vietnam, despite being very open economies, have historically been ‘low-beta’ economies. And over the past year or two Malaysia and Thailand have, for a few reasons, been surprisingly uncorrelated with the G2.These last six economies we call in the chart below ‘lower-beta’ open economies. And lastly, China and India are much larger, less open “low beta” economies.

Our forecasts show a stable outlook for the ‘lower beta’ economies but significantly higher growth rates in the ‘high beta’ group and in China and India. Indeed, the relative outperformance of the ‘high beta’ group and China is likely, we think, to attract a higher share of capital flows to those economies than they have seen over the past year, to the detriment, we expect, of the ‘lower beta’ economies especially in ASEAN.

Figure 1: GDP growth forecasts for EM Asia

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Note: “High beta” are Hongkong, Singapore, South Korea and Taiwan. “Lower beta” are Indonesia, Malaysia, the Philippines, Sri Lanka, Thailand and Vietnam. “CH&IN” is China and India. All are PPP-weighted averages. Source: CEIC, DB Research

Of greater importance to most investors, though, is the outlook for China and India. Less dependent on exports to drive recovery, these countries are expected to see stronger growth in the coming months. China is in a stronger position, with qoq (saar) GDP growth already having bottomed out in 2012Q1.A deep inventory cycle saw industrial production growth slow sharply early in 2012 despite a much milder slowdown in final demand measures. As de-stocking gave way to re-stocking by year-end, GDP growth rose from an estimated 6.6% in Q1 to above 9% by Q3.As inventories stabilize, qoq growth will slow a little to be bolstered in H2 by rising exports. We see GDP growth rising from 7.7% in 2012 to 8.2% in 2013 and 8.9% in 2014.

In India, more rapid fiscal reforms would be helpful but we see strong consumption growth and the prospects of 100bps of rate cuts starting in March or April – conditional on inflation being lower than it is today – supporting a pickup in growth from about 5.3% currently to 6.8% in 2013 and 7.1% in 2014.Stronger exports help, but less than in most other Asian economies.

Inflation will likely rise in 2013

Rates of inflation have generally fallen over the past year – Sri Lanka is the most notable exception – but except in that country we see little downside from here and expect that in the second half of 2013 inflation will start rising in most economies. First, despite two years of weak exports, output gaps – if they exist at all – are small. So stronger export activity will quickly lead, we think, to tighter labour markets and rising cost pressures.



Figure 2: Inflation in EM Asia

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Second, food price inflation is likely to start rising again and we see this as a key risk to the 2013-14 outlook. Food prices tend to move in about three-year cycles, – note the recent peaks in 2008 and 2011 – and world food prices have been rising faster since mid-year. Asian prices tend to lag global prices by about three months but have as yet shown no upward trend. We expect this may change by mid-2013.

Figure 3: Food prices are a source of inflation risk in2013

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“Fiscal cliff” would be a hard blow

The relative sensitivity across economies to stronger global growth that drives our more positive view on the ‘high beta’ economies could, of course, work against them if the US goes over its “fiscal cliff”. The ‘growth betas’ we calculate – simply an elasticity of GDP growth with respect to GDP growth in the combined US and EU economies calculated since 2000 – were useful in identifying which economies would be worst hit from the “Lehman’s shock”. We update them in the chart below:

Figure 4: ‘Growth betas’ as measures of sensitivity to US, EU

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The smaller, more open, economies would likely see GDP growth fall by about 2ppts in 2013 – likely pushing the ‘high beta’ economies listed above into steep recessions in the first half of the year. China, India, Indonesia and the Philippines would likely see growth slow by 1ppt or less. We would expect most central banks to cut rates and fiscal stimulus would likely be forthcoming to try to cushion the blow.

The US “fiscal cliff” is a key risk. It would imply a sharp shock to exports from Asia turning ‘high beta’ economies into the weakest economies. A “Grand Bargain” by contrast, would reinforce the relative growth outlooks in our forecast.

Second, global food prices – with the important exception of rice – have been rising in recent months. Food is approximately 30% of the typical price index in Asia and while Asian food price inflation is today relatively low, as sustained increase in world prices is likely to be imported into the region.

Figure 5: Deutsche Bank forecasts: Emerging Asia (% yoy, unless stated) 2011 2012F 2013F 2014FReal GDP growth 7.6 5.9 6.7 7.5- Private consumption 6.9 6.3 6.8 7.0- Investment 6.9 6.0 7.2 8.5- Government consumption 7.2 6.8 6.6 5.9- Exports 12.6 6.4 7.4 11.1- Imports 13.7 5.8 7.7 11.2Industria l production 9.2 6.2 7.1 8.9CPI 6.0 3.8 3.8 4.2CA balance, % of GDP 2.1 1.6 1.0 0.7

Asia ex. China and India Real GDP growth 4.3 3.8 4.0 5.1 CPI 4.8 3.3 3.4 4.0

Source: National authorities., DB Research

Michael Spencer, (852) 2203 8305



Latin America: Ready for a good year if global risks remain contained

Economic growth next year is expected to remain close to trend, as the regional economies generally represent solid macro-fundamentals and relative resilience to global factors.

Brazil´s dismal economic performance in 2012 is projected to improve significantly in 2013 due to sizeable policy stimulus.

Outside Brazil, monetary and fiscal policies are likely to remain neutral in most of the big regional economies. Currencies could be challenged by USD strength but still have room for further appreciation across the board

Economic growth next year to be close to trend again

After a mixed year of economic performance, most economies in the region are expected to deliver close to trend growth, or advancing 3.7% on a weighted average basis, after 2.8% this year. However this performance will represent the continuation of strong growth for countries like Chile, Colombia, Mexico, Peru, and Venezuela, and a major recovery for Brazil.

Brazil´s growth was seriously affected by global factors in 2012 in spite of being a relatively closed and large economy. This was due to very open and interrelated financial markets, but also to the increasing costs of doing business in Brazil (as discussed in Unit Labor Costs and Economic Performance in EM, published in May this year). Significant policy stimulus, in particular with reference rates steadily falling by 525bps since late last year, and a bit less than 1% of GDP in fiscal relaxation, is expected to help the economy rebound next year. Some nominal depreciation of the currency (around 6%) is also expected to contribute to a decent recovery in consumption and investment. Thus the Brazilian economy is projected to grow 3.5% in 2013 from a pale 1% this year.

Figure 1: GDP growth

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Argentina is the only major economy in the region that, after witnessing a lackluster economic performance this year, is not likely to see a significant rebound in 2013. This is mostly due to the continuation of unsustainable policies that are suffering increasing time decay (see The Limits of Policy Continuity, published on August 2011). As we do not expect these policies to be reverted, we forecast a relatively subdued economic growth of 2.1% in 2013, from 1.6% last year.

Interest rates and currencies to remain stable

Although 2012 did not witness much action on the policy front with the exception of Brazil, currencies did show an important swing across the year. A steady economic recovery, and/or trend growth continuing, now anticipates a more stable path for rates and currencies during 2013. In a much slower than expected global recovery we could see some more rate cuts in Brazil and Colombia. Otherwise monetary policies across the region are likely to remain unchanged for the whole year. On the exchange rate front, potential USD strength and potential reflux of capital back into developed markets might, however, weigh on regional currencies. This notwithstanding, we see room for appreciation in the MXN, and Andean currencies. The Brazilian authorities seem to continue pursuing a weaker currency, but improving economic conditions will sooner rather than later start adding pressure to inflation, seriously limiting the degrees of freedom to push for a weaker BRL.

Figure 2: CPI inflation

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Medium term concerns remain for few countries though

In addition to global uncertainties some of the regional economies do face increasing challenges to keep the strong growth pace of the past. We addressed these medium term concerns in a recent note (On The Likelihood of EM Diminishing Economic Performance,



published Friday 7, 2012), noting that some of the regional countries have underperformed their own history in recent years even after controlling for global factors. This, in our view, suggests that some idiosyncratic obstacles for growth are present and there is no evidence of any awareness from the authorities. A good example of growth struggle is the Brazilian economy, as commented above. Essentially, Brazil´s low investment rate together with an aging population is the main structural constraint for growth. Unfortunately, the official policy, based on boosting public and private consumption and devaluing the currency, is not the most efficient to promote growth against this background. Thus, under the status quo we expect trend growth to move downwards from an estimated 4.5% in recent years, to something like 3.5% or even below.

Argentina, as commented, is another case where unsustainable polices are already taking their toll on economic performance and this is expected to continue until the political leadership is changed.

Not all regional economies are struggling with economic growth. Chile’s exemplary policymaking continues to deliver very stable and very strong economic growth. Colombia and Peru appear to be simply following the Chilean path and steady FDI is rewarding the policy choice. Good policies have also helped Mexico to withstand the global shock. Actually, Mexico is the new focus for hope in the region as a new administration is starting to push for long awaited reforms with much more conviction than in the past.

Mexico has just passed a labor reform bill, even before incoming President Enrique Peña Nieto was sworn in, providing a powerful signal of legislative coordination between the two largest parties in Congress, a rather uncharacteristic feature of Mexican politics. It reduces the possible political cost to be borne by Peña Nieto, and it opens the door for additional legislative cooperation in other areas. We expect a fiscal reform bill to be discussed during H1 2013, likely be geared towards increasing the tax base and streamlining the tax code. Energy deregulation, on the other hand, may be the tallest order of the new administration. Private participation in the energy sector is forbidden by Art. 27 of the Constitution. A full, deep energy reform requires constitutional changes, which can only be done via a qualified two thirds congressional majority. We do not rule out some progress on energy reform, but believe a complete deregulation of the sector is not the most likely scenario. If full energy reform fails to pass, emphasis will continue on existing joint ventures between Pemex and private companies, which since inception have been fairly marginal, possibly because private capital commitments are unlikely to occur without a more solid constitutional framework.

In addition to global uncertainties some of the regional economies face increasing challenges to maintain the strong growth pace of the past. Increasing wage cost & mediocre investment performance remain worrisome in Argentina and Brazil, in particular due to the authorities’ obsession to keep fueling consumption growth.

Figure 3: Current account

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Figure 4: Deutsche Bank forecasts: Latin America (% yo y, u n less stated ) 2011 2012F 2013F 2014FRea l G D P grow th 3.9 2.7 3.7 3.9- P r iva te c ons um pt ion 4.5 3.7 3.6 3.8- Inves tm ent 6.4 0.9 6.0 7.1- E xpor ts , U S D bn 938.4 968.9 1046.0 1143.5- Im ports , U S D bn 851.9 878.5 962.9 1061.6In f la t ion 8 .5 8.0 8.0 8.1Indus t r ia l produc t ion 2.7 1.4 4.2 4.1U nem ploy m ent , % 6.6 6.3 6.3 6.2Fis c a l ba la nc e, % of G D P -2.1 -2 .0 -2 .3 -1 .8CA ba la nc e, % of G D P -1.0 -1 .0 -1 .4 -1 .4


Figure 5: Deutsche Bank Forecasts (% yoy, unless stated) 2011 2012F 2013F 2014FArgentina GDP 7.0 1.6 2.1 1.9

CPI 24.4 23.8 26.5 26.5CA bal., % GDP 0.1 1.4 2.0 1.9

Brazil GDP 2.7 1.0 3.5 4.2CPI 6.6 5.4 5.3 5.8CA bal., % GDP -2.1 -2.4 -2.6 -2.7

Chile GDP 6.2 5.1 4.7 4.9CPI 3.3 3.1 2.8 3.0CA bal., % GDP -1.7 -2.4 -1.7 -1.2

Colombia GDP 5.9 4.3 4.4 5.0CPI 3.4 3.3 3.0 3.0CA bal., % GDP -2.6 -2.9 -3.0 -3.2

Mexico GDP 3.9 3.8 3.5 3.7CPI 3.4 3.9 3.7 3.6CA bal., % GDP -0.4 -0.4 -1.1 -1.3

Peru GDP 6.9 6.3 6.0 6.2CPI 3.4 3.6 2.6 2.5CA bal., % GDP -2.0 -3.2 -3.4 -2.7

Venezuela GDP -1.5 4.2 5.0 2.1CPI 28.2 26.1 23.3 22.2CA bal., % GDP 4.6 6.3 2.6 3.3

Source: DB Research

Gustavo Cañonero, (1) 212 250 7530



Global Asset Allocation: The fiscal cliff and after

Market is positioned for the fiscal cliff: underweight equities and overweight rates with significant risk premia priced in; and underweight US assets.

In our base case of an orderly resolution we see a significant rally in US equities (+5%) and a modest selloff in rates (10y +25bps).

Four years after the financial crisis, on our view of continued global recovery but strong demand-supply balances for equities and credit, we discuss key themes and trading strategies for 2013.

Markets positioned for US fiscal cliff

We see four key considerations in the near term outlook for financial markets:

US data disappointments since Sandy are likely to persist. Following Sandy, our US macro data surprise index (MAPI) plunged abruptly from peaks into negative territory. We see the risk as being of further disappointments. Historically, the market has partly looked through the impact of temporary disruptions with market reaction half of what our models predict. But with corporates already holding back in front of the fiscal cliff, data disappointment are likely to weigh (DB Global Asset Allocation, Global Earnings Facts, Quotes and Takes from Q3 2012, Nov 14, 2012).

A significant risk premium (-9%) is priced into the S&P 500 and rates (-27 bps on the 10y).Over the last few years, US equities have moved in line with the key macro drivers (macro data; data surprises; and euro stress). Starting in October, there was a growing disconnect with markets flat on election and fiscal cliff uncertainty even as the drivers improved (DB Global Asset Allocation, Financial Markets and the US Election, October 25, 2012).

Figure 1: Big risk premium in equities…

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Source: Bloomberg Finance LP,DB Research

Investors are very underweight equities and overweight rates. Our aggregate equity positioning beta indicates an underweight comparable to that at the troughs of the big 2010 and 2011 corrections (DB Asset Allocation, Big Underweight as Fiscal Cliff Looms, Nov 12, 2012). We note that the S&P 500 rallied 13% in the 2 months after those bottoms as shorts and underweights covered.

Figure 2: …and significant in rates

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Source: Bloomberg Finance LP,DB Research Figure 3: US equity underweights comparable to 2010 & 2011 corrections

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Rather than broad-based risk aversion, the uncertainty created by the fiscal cliff has prompted asset reallocation out of the US. Since early October there have been outflows from US equities but equal inflows into non-US equities, with overall flows flat. Since early October US equities have underperformed the rest of the world by 6pp, breaking out of a very steady 16% avr outperformance channel they held for over 2 years. US equities have given up their entire outperformance ytd and strikingly caught down to Europe. Regional mutual fund positioning is very underweight the US. US corporate credit also underperformed Europe.



Our base case on the US fiscal cliff remains a December resolution or a bridge to a resolution early next year. We put more weight on a credible resolution of the medium term fiscal challenge than on the near term cliff in reducing uncertainty. We note that historically markets have sold off in anticipation of tax increases but rallied significantly after; and cuts in government expenditure have been associated with higher private sector GDP and S&P 500 performance.

Figure 4: Asset allocation out of the US

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Figure 5: Markets have sold off modestly into, but rallied significantly after, tax increases

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Resolution should see significant rally in US equities and modest selloff in rates

A big risk premium and large investor underweight suggest a significant rally on resolution of the fiscal cliff. We see 5% upside for the S&P 500 from current levels as reasonable (1490) given the large underweight and a catch up to a typical post election rally. Rates should sell off and we would see a 25bps move up in the 10y as reasonable.

In the negative case of continued gridlock where we go over the fiscal cliff.

Corporates would pull back further similar to the debt ceiling debacle and we see the market move to pricing in a full recession on the back of outflows (-18% from peak, or 1200 on the S&P 500).

Four years after the financial crisis: Themes and trading strategies for 2013

Four years after the financial crisis, our basic thesis is that the economic, credit and earnings cycles have further to run. We see economic recovery in the US as half way through the cycle, the euro area emerging from recession in Q2 2013 and EM growth turning modestly up. Global growth will be slow and asynchronous, like the 1990s rather than the 2003-08 synchronized expansion which was an exception. We expect the core rates up cycle to begin. Credit metrics show slight increases in leverage but strong coverage and capacity to spend/payout. After stagnating, global earnings should continue to rebound.

Several post financial crisis traits of markets will linger. First, the unusually high sensitivity of risk assets to growth concerns and macro data surprises will endure. Second, cross asset correlations, rising since 2007, will remain elevated. Third, policy makers will continue to have an undue impact on markets. Fourth, risk premia in equities and credit are high with a historic under pricing of equities relative to fixed income. Fifth, demand-supply balances for equities and credit are very positive reflecting a reduction in or lack of supply.

Figure 6: Cross asset correlations are high

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Against a backdrop of continued albeit asynchronous global recovery but strong demand-supply balances for equities and credit, our trading strategies and trades for the next year are:

The cycle has further to run: stay strategically long risk assets. Overweight equities and credit, neutral commodities, underweight rates which we expect to rise and underweight cash.



But it’s a data sensitive world: tactically trade equities and credit using the Macro Data Surprise Index (MAPI). A strategy comprising the investment rule (i) 100% equities if MAPI is above 0.05; (ii) 100% bonds if MAPI is below -0.15; and (iii) 50/50 equities-bonds when MAPI is in between (i.e., neutral) has outperformed bonds by 70% and equities by 120% since June 2007.

Figure 7: Demand-supply balance very favorable for equities…

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Equity fund f low s + changes in futures, cash equities & ETFs shortsS&P 500 net issuanceUSD bln

SSource: ICI, CFTC, NYSE, Compustat, Factset, Bloomberg Finance LP, DB Research

Figure 8: …and in credit because of limited issuance

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Cross asset correlations to remain high. Strategies to exploit the high cross asset correlation include buy/sell S&P 500 vs the CDX.HY on shorter-run divergences.

ECB to demonstrate power of OMT: long Spanish intermediate sector rates, short German bunds. We expect Spain to formally request aid in Q1 and the ECB to buy Spanish bonds at the front end. We see better value in the 5y and expect Bund yields to move higher on ECB OMT purchases as well as a rise in core rates.

Inflation to diverge within euro area: long German and short Spanish 5y inflation through linkers. The large

competitiveness gap to Germany will require prolonged peripheral adjustment that will likely result in higher German inflation vs the peripherals. Current linker yields are 2% for both Spain and Germany despite disparate outlooks for inflation and growth.

Yen weakness one way or another: short JPY against the USD. The basic balance for Japan has deteriorated dramatically with slow global growth, China tension, increased fuel imports and mounting FDI outflows. Post elections the BOJ will likely move to a significantly looser monetary policy which will weigh on JPY.

Long credit but short duration risk: long HG and HY corporates against US Treasuries. In a slow to moderate growth environment, defaults and credit risk will remain low but rates are likely to normalize some. We expect IG and HY credit spreads to grind tighter in 2013.

Stay with stocks with proven growth in free cash flow and dividends:

Stay strategically overweight the dependable growth sectors (Discretionary, Staples, Tech, Health Care, Industrials) where FCF has continued to grow steadily while FCF for the other value sectors has been flat for over 10 years. Stable FCF and earnings growth has fueled consistent outperformance since 2008.

After 11% outperformance in 2012, hold DB’s basket of Dividend growth stocks (DBUSDIVG) against the S&P 500. DBUSDIVG includes firms that have both a solid dividend yield (3.1% currently), have grown dividends significantly over the last year and have high potential to continue to grow dividends.

Tactically trade the value sectors: Financials over Energy and Materials on the view that US rates will rise, pushing up the USD. Telecom over Utilities for a 3% higher total yield within the bond-like sectors.

Regional equity re-ratings likely to revert: After large moves in relative valuations: (i) stay overweight the US given now smaller P/E premium, higher relative growth and highest total yield; (ii) Japan over Europe on upside to global growth and JPY weakness at the lowest relative multiple; (iii) Asia over Latam on higher potential growth and erosion of its historic P/E premium; and (iv) the safety premium within Europe will dissipate.

Agriculture prices to normalize after the drought: long cattle and short corn. The ratio of cattle to corn prices is near historic troughs and should rise from here as corn prices normalize from post drought highs and lower cattle supply supports cattle prices.

Binky Chadha, (1) 212 250 4776 Keith Parker, (1) 212 250 7448 Parag Thatte, (1) 212 250 6605 John Tierney, (1) 212 250 6795



US Equity Strategy:This holiday season’s best destinations are technology & industrials

S&P 500 targets:1450 2012 end, 1500 for 12-months

S&P 500 EPS:2012E USD103, 2013E USD108, 2014E USD115

Sector Strategy: OW – Tech, Industrials, Financials EW –Consumer Discretionary, Materials, Health

Care UW – Energy, Consumer Staples, Utilities,

Telecom.

Fiscal cliff resolution: The details matter Given the election results – which raised the risk of higher taxes, especially on dividends – we cut our 2012 end S&P 500 target from 1475 to 1450 and held our 12-month target at 1500. We consider this target fair until clarity emerges on new legislation that mitigates the fiscal cliff. If this legislation reduces 2013 fiscal drag to 1.5% or less and curbs the scheduled top income and dividend tax rate hikes, then the S&P 500 should rally to 1500 in early 2013 and put 1600 well within reach for 2013 end.

S&P 500 target upside sensitivity to deal details: Fiscal drag on GDP of 1.5% or less: 1500 12-months Tax hikes 1% or less of GDP in 2013: 1550 12-months

New top dividend tax rate 25% or less: 1600 12-months

S&P 500 observed price implied fiscal cliff risk We define “going over the cliff” as the triggering of a US recession; either from a menacing delay in reaching a deal or from new legislation with fiscal drags too large for 1H GDP growth. In this scenario, we think the S&P 500 falls to about 1200 in 1Q or ~15x the USD80-85 of depressed EPS likely with an average US recession. Figure 1 has S&P 500 price implied probabilities of going over the cliff using 1500 as 1Q upside and 1200 as downside. It also shows EPS declines during recessions and PEs on trough EPS.

Figure 1: Market implied over-the-cliff expectations

S&P value if no cliff: 1500 S&P value if"over the cliff": 1200

S&P price

Implied fiscal cliff probability

Full S&P decline

EPS decline

PE on trough

EPS

1500 0% 1959-61 -13% -12% 21.3

1425 25% 1969-70 -34% -13% 18.0

1401 33% 1974-75 -44% -15% 10.8

1380 40% 1980-81 -17% -5% 9.4

1350 50% 1982-83 -23% -17% 12.1

1320 60% 1989-91 -20% -28% 22.6

1299 67% 2000-02 -34% -23% 26.0

1275 75% 2007-09 -53% -45% 20.8

1200 100%

Average -30% -20% 17.6

Source: DB Research

S&P 500 EPS outlook and valuation

Despite storm Sandy related business disruptions and insurance company losses, we still expect 2012 S&P EPS of USD103. We remain comfortable with 2013E EPS of USD108 or 5% growth. We introduce quarterly EPS estimates for 2013 of: USD25.50, USD26.50, USD27.50 and USD28.50. Quarterly growth is skewed to the second half of 2013 as are our house GDP forecasts. We introduce 2014E EPS of USD115.

Figure 2: S&P 500 Quarterly pro-forma EPS

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ForecastUSD

S&P 500 quarterly pro-forma EPS

Source: DB Research

At about 1400, the S&P is 13.5x our 2012E EPS of USD103, below the 14-16 trailing PE range we consider fair on mid-cycle S&P 500 EPS. We think modest PE expansion to 14-15 can be driven by: 1) EPS proving resilient to fiscal consolidation with 5% EPS growth in 2013, 2) continued buybacks and share count shrinkage, 3) further ramp-up in acquisitions and some corporate re-leveraging. PE expansion to 15 or higher is certainly possible, but it likely requires a lower dividend tax rate than currently scheduled to promote continued robust dividend growth.

Figure 3: S&P PE and implied equity risk premium

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%

Source: DB Research



This holiday season buy capital goods producers

Given supportive valuations, we find the S&P 500 attractive going into year end despite fiscal cliff risk. We think the best reward/risk opportunity is at Tech and Industrials. As a decent fiscal cliff fix should remove the last big macro overhang and benefit sectors with revenue sensitivity to business spending, which faltered mid 2012 on global deceleration and then cliff fears. We remain OW Financials, with a preference for capital markets, but the cliff poses more downside risk to this US centric sector.

Three reasons why capex and exports should turn-up:

US has underinvested over the past decade Commodity prices are a powerful capex driver China bottoming will reignite capital goods demand

The US has suffered a lost decade in capex and capacity expansion given aggressive IT spending just before the decade and a poor economy plagued with uncertainties toward the end. Thus US corporate spending on information technology equipment/software and industrial capital goods should return to a healthy 5-7% mid-cycle growth rate as confidence improves.

Figure 4: US has suffered a lost decade of capex

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1993-02 CAGR = 4.2%

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Source: DB Research

Commodity prices drive capex with a lag. High global oil prices will encourage the US to invest in its abundant natural gas and NA oil production potential. There will be related investments in US refining and petrochemical industries. Time will also bring more investment in natural gas powered vehicles and electricity production. Investment in energy production goes hand in hand with investment in energy efficiency.

China construction is likely to be slower than recent years, however, its demand for capital goods should accelerate as its transport infrastructure is used more and its urban living standards rise. Also, high energy and rapidly rising labor costs up against low interest rates will

fuel demand for capital goods that save energy and labor costs.

Our preference within Industrials is for companies that produce capital goods that lift living standards and productivity over those more exposed to construction and the mining of construction oriented commodities

Figure 5: Commodity prices are a powerful capex driver

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CRB Commodity Price Index (lhs)Capex / D&A (S&P 500 ex Fin., 15m lag, rhs)

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Commodity price implied capex gap

Index

Source: DB Research

Figure 6: China labor costs vs. interest rates

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Unit labor cost, yoyPrime lending rate

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Source: DB Research

Risks to view: US tax policy and oil prices

Low and equal capital gains and dividend tax rates and/or foreign earnings repatriation tax relief would provide 12-month target upside. Taxing corporate foreign profits even if not repatriated is a risk.

Oil prices are a significant driver of S&P EPS and the capex outlook. We expect oil price stability, but a significant price decline or surge would be adverse.

David Bianco,(1) 212 250 8169 Priya Hariani, (1) 212 250 2766

Ju Wang, (1) 212 250 7911



European Equities Strategy: Pro-Cyclicals

In our 2013 Outlook titled “Pro-Cyclicals”, we reiterate our positive stance on equities after turning tactically positive on October 12th.

We target a level of 315 for the Stoxx 600 by the end of 2013, implying 13% upside.

This comes from expected earnings growth of 6.0% in 2013 on the back of a rebound in global GDP growth, and a re-rating from 11.3x fwd PE currently to 12.5x.

Our expectation of stronger global growth is based on a sustained recovery in the US, accelerating growth in EM, and an improvement in European growth starting in H113.

With this backdrop we recommend a strategy focussed on domestic cyclicals, and in particular, exposure to consumer spending, business investment and global trade.

We are overweight Banks, Insurance, Construction, Chemicals, Media and Telecom, and underweight Food & Beverage. Our style and country preferences are for value over growth and for Italy over Switzerland.

Global macro outlook

We are positive on the outlook for equities in 2013, largely because of our optimistic view of a rebound in global GDP growth, supported by a sustained recovery in the US, and acceleration in GDP growth in EM.

In the US, household spending has been strong with both residential investment and spending on durable goods up sharply, and we expect this to continue. Business spending has been weak in part due to policy uncertainty. As a result, we anticipate a resolution on fiscal cliff issues to allow a recovery in capex in 2013.

EM has had a difficult 18 months as credit growth has slowed, but we believe the adjustment period may be over and expect better numbers going forward. We think Asia has turned the corner, Latam could be turning the corner presently, but think that EMEA likely has a few difficult months ahead of it.

Our most out of consensus call, however, is that we expect GDP growth in the euro area to rebound in H113. Consensus forecasts appear to be gloomy, with fiscal austerity and private sector deleveraging both expected to be strong headwinds against what is already a fairly modest trend growth rate of around 1%.

Our argument for a turning point in the euro area is based on the credit impulse. If the pace of private sector

deleveraging starts to slow, the credit impulse will turn positive and real private sector demand growth could start to recover (even though credit growth is negative).

If credit growth were to stabilize at -1.3% in the coming months, the credit impulse would rebound to -0.6% in Q4, which is consistent with a stabilisation in demand in Q1 and a return to growth in Q2. Stable GDP implies a PMI of around 50, so even if growth were only to stabilise in Q2, the PMI should start increasing well before that.

Figure 1: The credit impulse and demand growth

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Credit Impulse (lhs)

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Source: ECB, Eurostat. DB Research

A slowdown in the pace of deleveraging, (a positive credit impulse), requires an improvement in both the supply and the demand for credit. We think that whilst the situation has improved from a supply perspective, thanks mainly to the bulk of the stress test adjustments being close to an end, demand for credit remains weak.

However, we expect the decline in demand for credit in the euro area to slow for a number of reasons. Firstly, credit growth is already negative, and all that is required is that firms and households de-lever more slowly. The improvement in sentiment needed to achieve this might be small.

Secondly, we believe that de-stocking has played a role in the weak demand for credit. If firms run down inventories, the boost to cash flows may temporarily lower their demand for credit. De-stocking has been happening (Figure 2), but at some point inventory levels will fall too low and the pace of de-stocking will slow. This will harm cash flows, but could boost demand for credit. This could cause the credit impulse to turn positive.

Finally, weak credit demand could be a function of deteriorating economic sentiment. We expect global GDP to strengthen in the coming months, and since euro area manufacturing depends critically on global developments,



this could have a marginal impact on sentiment and consequently demand for credit.

Figure 2: Inventories and demand for credit

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Source: ECB, Eurostat, DB Research

Despite near-term political risks, we expect Italy to be the leading indicator for this turnaround in European growth. Given that credit growth in Italy is already -2.7% yoy, a slowdown in the pace of deleveraging must at least be possible. As in Europe, the problem appears not to be with the supply of credit but with demand. De-stocking has been more aggressive than it was in 2008-09, which must have boosted cash flows and reduced demand for credit.

In terms of other European countries, we are positive on Spain in the medium term as credit supply conditions should improve, and credit growth is already very low. However, in the near-term domestic demand growth in Q4 should be hit as a result of the VAT hike at the start of September. We think credit growth in France remains too high and view near-term risks to growth as being on the downside. In Germany, Q4 GDP growth is likely to be negative, but if global growth picks up as we anticipate, and the euro area stabilises, we expect the German economy to perform well.

Pro-Cyclicals in 2013

We believe a number of factors could drive the performance of cyclicals in 2013. Firstly, domestic cyclicals, including financials, would benefit from a positive euro area growth surprise as credit growth stabilises. Secondly, a recovery in capex as part of this turnaround need not be excluded and we should look to both the receivers and the spenders. Finally, a return to 3.5% global GDP growth from 2.8% will be good for the global cyclicals.

In the US, a 3 year outperformance of consumer discretionary has been a result of the sectors’ sensitivity

to changes in credit and the sustained positive credit impulse. With our view that the credit impulse should start to improve in Europe, we should draw some observations. Firstly, Euro area consumer discretionary has done well, but there has been divergence from US performance since the credit impulse turned negative in late 2011. Secondly, there is strong divergence in performance between subsectors, and we see upside in those that have lagged behind (airlines, staffers, broadcasters and hotels for example).

It may feel too early to talk about a recovery in capex but going forward we see a recovery in business investment accompanying a recovery in consumption in Europe. Intentions have doubtless been held back by policy uncertainty across Europe, but if growth surprises to the upside, then sovereign risks should reduce and investment trends should start to improve.

The obvious position to take is to focus on the receivers of capex spend. There are many companies that have a strong correlation simply between yoy revenue growth and yoy fixed investment growth in the Euro area, and where the output makes sense. From this analysis in particular, we would highlight media, electricals, engineers and staffers.

As well as the receivers, we think the spenders of capex can also benefit. We find that since 1988 there is around a 4% differential in sales growth on average between companies with high versus low capex/depreciation. Many would argue that increased investment is associated with a dilution of returns, but we find 65 cyclicals (20% of the total in the Stoxx 600) which have shown to be able to increase returns on average in the following two years, with a further 63 cyclicals seeing no dilution.

The final aspect of our strategy is a focus on companies that should benefit most from an increase in global GDP growth in 2013 to 3.5%. As a result we focus on the global cyclicals, where on our estimates, for every 1% above 3% global GDP growth, European global cyclicals generate 20% extra earnings growth compared to 10% for the market as a whole (Figure 3). Sensitivity to global growth underpins our recommendations on Chemicals and Construction.

We also recommend companies with exposure to US business spending which is likely to recovery post a resolution of the US fiscal situation. We would focus on energy infrastructure (European oil services companies and electricals) and US housing (European cement companies which should also benefit from lower US power prices).

In terms of sector positioning, our main position is overweight financials. Banks continue to be attractive for



the potential positive growth surprise producing a further narrowing in sovereign CDS to which the sector is highly correlated. Also, there have been some fundamental improvements as better earnings momentum has started to come through. We reduce our position in Food & Beverage to become further underweight.

Figure 3: Global cyclicals earnings growth

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Source: Datastream, IMF,DB Research

We reinforce our country preference of overweight Italy and underweight the more defensive Swiss market, which has significant exposure to Healthcare and Food & Beverage. This is based on our view that Italy should lead the growth turnaround in Europe, in combination with the very low relative valuation of Italy versus Switzerland.

Finally in terms of style preference, we reinforce a preference for value over growth. We believe that a positive economic surprise should further the rotation from growth into value that had already begun over the summer. It is worth noting that a preference for value over growth is virtually the same as a preference for high debt over low debt. We expect the rotation to continue given that our macro argument is for interest rates to comedown in Europe through a narrowing in sovereign CDS.

Michael Biggs, (44) 20 7545 5506 Gareth Evans, (44) 20 7545 2762

Lars Slomka, DVFA, (49) 699 103 1942 Jan Rabe, (49) 69 910-31813

Thomas Pearce, (44) 20 7541 6568



Rates Outlook: A benign path, interesting detours

We expect yields to grind higher in 2013 with 10YUST reaching 2.25% by the end of Q1 and 2.75% by year end. end. Bunds (and eurozone government bonds in aggregate) should outperform in this moderate sell-off and reach 1.60% -1.80% in Q1 and 2.25% at the end of the year. Bunds should sell off if the ECB keeps the depo rate unchanged as we expect, but outperform (together with eurozone government bonds in general) USTs over the medium term while Gilts are expected to underperform.

Although our medium term view for the path of US rates is quite benign, a number of risk factors could produce interesting detours. For example, we can see a number of paths to far lower rates (e.g. 1.25% on 10Y UST) stemming from macro factors (lack of fiscal agreement in the US, political risk in Europe) as well as potential supply/demand factors (increased central bank liquidity injection).

Similarly, higher rates could result from macro (upside risks to global growth) or supply/demand factors (reduced QE expectations), particularly later during 2013.

A benign path, interesting detours

We expect yields to grind higher in 2013 with 10YUST reaching 2.25% by the end of Q1 and 2.75% by year end. Bunds (and eurozone government bonds in aggregate) should outperform in this moderate sell-off and reach 1.60-1.80% in Q1 and 2.25% at the end of the year, while Gilts should underperform.

The outcome of the fiscal negotiations in the US will be a key driver for the rates market in the months ahead. Going over the full fiscal cliff could not only lower growth and reduce issuance, but also lead to an even more aggressive Fed reaction. Conversely, a swift and benign resolution should reduce short term uncertainty and also lead the market to revise the scope and duration of the Fed’s QE over the medium term.

Our base case remains for a relatively benign resolution of the fiscal negotiations, with ~1.5% of fiscal tightening in 2013. Even though the Fed is likely to deliver on a ~45bn/month unlimited QE4, we expect a mild sell-off on a resolution of the fiscal negotiations as the Fed easing appears all but priced in.

We expect Europe to remain in a mild recession. However, relative to this downbeat base case, the risks should be to the upside.

Although our medium term view for the path of US rates is quite benign, in the short run we see a number of risk factors that could produce interesting detours. For example, we can see a number of paths to far lower rates (e.g. 1.25% on 10Y UST) stemming from macro factors as well as potential supply/demand factors.

The argument for higher rates depends critically upon cliff modification and the ability of the private sector to accommodate fiscal tightening. Certainly there is scope for the fiscal negotiations to fail, in which case equity market underperformance could lower consumer confidence and lead to a higher private savings rate. In the chart below we illustrate a projection from a model of the savings rate that incorporates disposable income, tangible asset values, and consumer confidence. Given a 5% decline in tangible assets (read: housing) and a 25 point decline in confidence, this model suggests the savings rate could rise to just under 7%.

Alternatively the corporate sector might not increase investment if real income growth fails to support final demand either domestically or in major trading partners. Either of these would constitute a failure of the private sector to accommodate fiscal tightening.

Figure 1: US savings rate model with shock to asset values and confidence

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Fitted Saving rate

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Source: DB Research

We see tail risks stemming from supply and demand factors as well. Growth in central bank balance sheets relative to the supply of high quality assets has clearly contributed to keeping rates low. From this perspective, further central bank liquidity creation, new sources of demand (for example the Bank of Japan buying Treasuries from their domestic banks), or a “re-rating”- either via formal downgrade or market perception - of some assets could all accentuate the imbalance.

Similarly, higher rates could result from macro or supply/demand factors, particularly later during 2013. On



the macro side, our excess liquidity indicator suggests that global growth could accelerate by more than 5% in the coming year. Moreover, a housing recovery would greatly bolster the household balance sheet with likely non-linear effects on final demand. On the supply/demand side, disappointment on the size of QE4 in terms of par value or risk equivalents could push real yields significantly higher, though the effect on equities would likely limit the extent to which rates could rise.

Despite the above mentioned improvements, Europe also has the potential to create market stresses. The underwhelming bank recapitalization and persistent delay in activating the OMTs by Spain, the political risks of the elections in Italy and the persistent richness of French bonds relative to fundamentals remain a cause for concern. Also, amongst the program countries, Greece remains the most likely source of political risk.

Under our base case scenario, the first leg of the sell-off should be driven by the long end. Long dated forwards remain depressed and the combination of less fiscal tightening and a QE4 focused on the 5Y-10Y sector of the curve should lead to further steepening of the curve. We also favour steepeners in Europe given a firmly anchored ECB (with some risks of further deposit rate cuts) and reduced tail risks. Finally, we still see some upside (mostly from carry) in being long the 5y5y forward rate in Italy (and Portugal). Conversely, we remain more cautious about Spain for now given the vulnerability of its non-domestic investors and France given the richness of spreads relative to fundamentals.

Also, we continue to focus on hedges to the risk scenarios outlined above. In the US, low rate detours favor conditional bull steepeners, 1x2 1y10y receiver spreads, knock in payers whereby sufficiently low rates “activate” payer structures, knock out payers which survive to expiry only if rates remain low in the short run, and staggered straddle/strangle switches which leave residual long volatility exposure following late in Q1 2013. High rate detours favor payer ladders, curve caps, and hybrid exposure such as 110% S&P calls subject to 10y rates higher than 3%. In Europe, the most obvious hedge would be via receiver spread in the 5Y sector, although the recent rally leaves limited room for upside, and a CDS – bond basis widener in 5Y Spain.

US: Stop worrying and love the (lack of) fiscal tightening At the time of writing, the fiscal negotiations have as yet to produce any decisive outcome. There is however clear scope for compromise which ultimately should result in a moderate ~1.5% fiscal tightening in 2013.

Could that derail a relatively anemic recovery? We don’t think so for several reasons. First, the fiscal impulse (i.e. the amount of fiscal tightening) next year will be

marginally higher than in 2012. Fiscal deficits were reduced by around 1% in 2012, which means that the marginal impact on growth of an additional 0.5% of fiscal tightening in 2013 will be limited. Second, there is some evidence (e.g. Beige Books), that the fiscal uncertainty has already impacted investment and hiring decision in Q4 of 2012, which should reverse on an agreement. Finally, the fiscal multiplier should be trending down, as a significant part of the adjustment of the private sector’s balance sheet is now completed. In practice, this view is supported by the positive dynamics in the loan officer survey, household credit in general (see chart below) and the housing market in particular.

Figure 2: Credit dynamics suggests that the private sector can absorb a limited amount of fiscal tightening

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Also, the market had modestly overpriced the likely duration impact of QE4. Thus, under a base case of USD45bn/month of QE4 with the same net duration impact as Twist, and ~1.5% of fiscal tightening, we see rates drifting higher towards 2-2.25% in Q1. The combination of QE4 (which will be more focused in the 5Y-10Y sector) and the depressed level of long dated forward rates argue for the sell-off to be initially driven by the long-end of the curve.

Figure 3: Long dated forwards are low vs. fundamentals

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10Y20Y UST

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Source: Consensus Economics, DB Research



Further out, if the private sector absorbs the fiscal tightening as well as we expect, the market should start re-pricing the duration/end of QE4. Under a genuinely neutral Fed 10Y UST should end the year around 2.75%. This leg of the sell-off should be driven by 5y5y real rates as it would mostly be about pricing out QE4 expectations. For reference, the 5y5y real rates adjusted for long-term growth expectations could adjust by 125bp and remain at the pre August 2011 historical lows.

Figure 4: 5Y5Y real rate could normalize by 125bps

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The most obvious downside risk to our view would come from a full and unmitigated fiscal cliff. In the context of a model incorporating the change in the structural deficits amongst other variables, we find that such scenario would be consistent with 10Y UST at 1.4%. As under this scenario the Fed is likely to increase its QE program and the market is likely to extend further the low for long expectations, 1.25% level on 10Y UST is achievable.

Conversely, the most obvious upside risk would come from a more decisive resolution of the fiscal cliff which would reduce uncertainty and elicit a more robust private sector growth. In this scenario, 10Y UST should exceed 3% and the last leg of the sell-off should be driven by the 5Y sector of the curve as the market starts pricing a Fed exit.

Finally, note that from a technical perspective, aggressive easing by the ECB (e.g. cut in the deposit rate) could skew rates lower, while a downgrade could this time lead to higher yields. At this point though, we don’t expect any of these considerations to have a material impact on yields.

Europe: boring at last

The picture in Europe is decidedly in favour of carry trades with a mild bearish bias. Virtually no growth and the (outside) risk of deposit cut should keep the front-end anchored and lead to an outperformance of Bunds vs. UST. The general reduction in systemic risk and mild UST driven sell-off should steepen the curve.

Europe ends 2012 with significantly less tail risk than a year ago. At the time, the market was effectively “pricing out” the euro: the relationship between yields and the twin deficits was indeed eerily similar to the pricing in 1995 ahead of the great convergence.

We argued then that the reduction in systemic risk would have to come from greater implicit or explicit fiscal integration (which would reduce the impact of the individual twin deficits on yields) and/or a reduction in imbalances (convergence of the individual twin deficits measures). In the meantime, the ECB would have to warehouse some of the risk on its balance sheet via the LTROs. One year on, significant progress has been accomplished on all fronts.

First, the combination of the OMT, the upgrade of the EFSF to the ESM, and the ultimate strong official sector support to Greece has led to a significant reduction in the premium associated with the euro-breakup.

Second, the successive LTROs and ELAs have effectively led to a significant transfer of risk from the non-domestic private sector to the ECB. This is best summarized by the strong correlation between the Target 2 balances and past cumulative current account position.

Finally, the peripheral countries have engineered (at the cost of severe recessions) improvements of their current account positions On a rolling 4Q basis the CA balance of the GIIPS has improved from -EUR 218bn in Q3 2008 to –EUR 74bn in Q2 2012.

As a result, the implicit (OMT/Target 2) or explicit (EFSF/ESM/Greek deal) partial debt mutualisation has reduced the perceived risk of break-up, the dependence on foreign investors has been considerably reduced (as the risk is warehoused by the ECB via the LTROs and Target2 system) and the current account positions have improved. Even if growth remains anemic, liquidity and systemic risks are greatly reduced.

Figure 5: ECB funding via Target2 system has replaced private sector funding of cumulative current account deficits

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Growth is indeed expected to be weak entering into 2013. However, we would argue that risks are to the upside (albeit from a very depressed level).

Figure 6: EU growth to bottom out in H1-13 according to FCI

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There are several reasons to expect the European bond market to outperform in the mild sell-off scenario for US Treasuries outlined above. First of all, the Eurozone as a whole has better credit metrics than the US or the UK. The Eurozone runs a current account surplus rather than deficit and less than half the fiscal deficits compared to US or UK. Thus, from a pure credit perspective, a theoretical Eurobond should trade better than either Gilts or UST. Of course, the Eurozone is nowhere near completing its fiscal union or launching a eurobond. However, this basic analysis is a reminder that greater fiscal union in Europe does not necessarily imply that Bunds should trade higher than UST or Gilts.

Note also that despite the recent rally, there is still a sizable risk premium in the eurozone bond market. The GDP weighted 5Y rate remains 75bp above its US and UK counterpart even after replacing the yield of countries under a program countries with the (ex) AAA yields.

Figure 7: Room for further reduction of risk premium in the eurozone bond market

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Second, from a monetary policy perspective, the lower growth outlook in Europe would argue for the ECB to be slower to exit than either of its Anglo-Saxon counterparts. This is not what is currently priced by the money market curves, which are steeper in Euros than in USD or GBP.

Despite some notable progress, event risk is not totally eliminated from the Eurozone. From a pure liquidity perspective, Spain remains the most vulnerable as it remains reliant on non-domestic support. Indeed, even though Spain has managed to balance its current account over the last couple of months, a significant proportion of its aggregate debt is held by non-domestic private sector as reflected in its net international investment position. As Spain under-delivered on the bank recapitalization (~50bn vs. ~80bn DB estimate), it should remain structurally more vulnerable to a change in investors’ sentiment. The Spanish central government’s difficulties in reigning in the regions could undermine the progress on fiscal consolidation and the confidence that OMTs will be activated by the ECB which is to a large extent already priced in by Spanish bonds.

For Italy, the key risk remains political in the form of the elections. Liquidity risk is relatively low as unlike Spain, Italy has taken enough funding from the ECB to offset its NIIP accumulated since the creation of the euro. Finally, while Italy has more to do in terms of structural reforms, it should be first to benefit from improved financial conditions as leverage in the private sector (and banking system) was low.

Finally, the French bond market remains expensive vs. any fundamental measure. However, the excess liquidity accumulated by the French banking system, the better than expected (even if still insufficient) drive for reform and the continued investor demand for highly rated paper makes it a difficult to be outright negative on the OATs in an overall constructive environment.

Francis Yared, (44) 20 7545 4017 Dominic Konstam, (1) 212 250 9753



US MBS and Securitization Outlook: Dominated by demand

US agency MBS should do well in 2013 relative to benchmark rates as Fed and other sources of demand outstrip supply by nearly USD450 billion.

Healthy US residential and commercial real estate and improving consumer balance sheets should lift CMBS and ABS issuance again, with tight spreads in other markets keeping these sectors well bid.

Continuing efforts to reform mortgage finance should set the stage for a slow return of private residential MBS.

Agency MBS: dominated by demand

A steady USD40 billion in monthly net demand from the Fed for agency MBS should prove the single most important influence on performance in this USD5.4 trillion sector for 2013. Banks and other investors might add a little to their holdings, but the Fed could end the year owning more than 27% of the outstanding market. The new securities targeted by the Fed could easily outperform Treasury debt of similar duration by 100 bp to 150 bp.

Fed demand and MBS performance could shift, of course, if US employment and inflation deviate from the path expected by the central bank. A long dive off the fiscal cliff or any other factor that weakened labor markets could improve the Fed’s ultimate bid, helping the sector tighten into falling Treasury rates. A strengthening labor market would eventually bring QE3 to an end, but a rise in 10-year rates above 2.5% would also dramatically cut loan refinancing activity and the flow of issuance available to the Fed. Steady Fed demand into rising rates would also tighten spreads.

The biggest risks to MBS performance would come from a sudden stop in Fed buying or aggressive selling by money managers, banks or other large holders of agency MBS. Neither seems likely.

Beyond demand, the risks from changing patterns of borrower prepayments or from regulatory or policy events seem moderate. Government refinancing programs are reasonably well understood by now. A new head for the agency that regulates Fannie Mae and Freddie Mac is likely, posing modest risk of new efforts to refinance some borrowers or modify principal terms for others. Most of this would affect performance in MBS issued before 2010.

CMBS and ABS: more bounce in the markets The market backed by commercial mortgages and consumer loans should see rising issuance, reasonable fundamentals and generally tighter spreads. But the reasons differ.

Spreads in the CMBS market should get some help from a continuing decline in securities outstanding and from stable-to-improving fundamentals. Origination of commercial mortgage loans has climbed in the last few years. But a rising share has gone into the portfolios of insurers and banks, depriving capital markets of some supply. CMBS issuance should climb from around USD50 billion this year to USD60 billion in 2013, a gain but not enough to offset maturing or liquidating securities’. Low rates and a rising economy should help CMBS fundamentals, although loans to retailers are under pressure from a rise in internet shopping.

In ABS, issuance should rise by 10% next year to more than USD200 billion after surging 54% this year. Heavy issuance of securities backed by auto loans, credit cards, student loans, equipment loans and other products should keep feeding the growth. Spreads have little room to tighten in auto, card and equipment loans. Student loans and other exotic ABS stand to tighten further.

Private MBS: stagecraft The reliable return of new private MBS still awaits progress in defining the scope of Fannie Mae and Freddie Mac, and in defining some key regulations under Dodd-Frank that will govern mortgage origination and securitization. But meaningful progress should set the stage next year. Meanwhile, tight spreads in other markets should draw out securitization of seasoned portfolios, portfolios of delinquent loans and related products. Issuance of private MBS, broadly defined, should rise from USD7 billion to nearly USD20 billion.

Steven Abrahams, (1) 212 250 3125



FX Strategy: The Yen beats a fresh path, the Euro an old range

Lost Japanese exporter competitiveness will be more effective than the BOJ at weakening the yen over the medium-term. Y82 and Y90 are forecast for 3 and 12 months respectively.

EUR/USD is likely to stake out a very similar range in 2013 as 2012, first testing the upside near 1.35 in the first quarter on reduced EMU risk premia.

Diminished tail risks related to policy support in all of the US, China and particularly EUR area economies, will add to the impact from the collapse in G10 policy rate dispersion, and rate spreads volatility, to keep currency volume at historically low levels in the year ahead. Special attention will be given to currency specific factors and relative value trades. These trades have already shown a little more promise in 2012, with the annual range between the strongest G10 currency (the NZD) and the weakest (the JPY) at 13%, which is up from the post -Bretton Woods all time low of a 7% in 2011 (but far below the 24% 40 year annual average for this metric).

Figure 1: Percentage difference between strongest and weakest G10 currency performance for last 40 years.

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The promise of relative value trades stems in part from the yen that is making a case to act as the preferred funding currency for 2013. The weaker yen story has two components. Firstly, a short-term story, revolving around increased political pressure for more effective reflationary policies. While widely discounted, this will be a factor at least until we have clarity on the BOJ’s future leadership in April. Barring actions that directly hurt the yen, like very surprising BOJ balance sheet expansion to purchase foreign bonds, there is some real danger that policymaker attempts to reflate, will have limited spillover onto a weaker yen. Any USD/JPY pullbacks toward Y80 should however be bought, because there is a structural story of lost competitiveness that is likely to create more

sustained downward pressure on the yen in the medium-term. One example of competitiveness problems is that Japan’s exporters have lost more global market share in the last 15 years than all other major trading countries (including Italy). Similarly, Japan’s export prices in the last 5 years have been by far the weakest of OECD countries, indicative of sharply weaker terms of trade.

Figure 2. Since Japan’s exports have fallen more as a share of global trade than major trading partners.

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Weak exports and strong FDI outflows have been the key factors pushing Japan’s narrow basic balance into deficit. The yen is then more vulnerable, to moderate portfolio outflows, in a positive risk environment, than it has been for most of its history as a floating rate currency. Like recent trading patterns across all the majors, without strong rate spread drivers, currency moves will remain slow and choppy, but in the context of a mild risk positive environment, we can see the JPY losses extending to Y90 by the end of 2013.

Figure 3:Carry has outperformed in 2012

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Less European tail risk should also make the yen a little easier to use as a funder. In the past year, we have seen carry outperform momentum and valuation strategies (see Figure 3), but the volatility of carry returns have made carry gains difficult to capture.

G10 high yielders with any serious yield no longer exist, and we are generally concerned that the Aussie and Kiwi that do have some small yield advantage have extended valuations acting as a constraint over the medium term.

Figure 4: The CAC up vs. the S&P and a higher EUR/USD point to dissipating EUR risk premia

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Rather than looking for a carry theme within G10, where little yield exists, a preferred long for early in the year is still the EUR, before the USD exerts itself, as the favorite G10 currency as the year progresses. Stronger relative EUR stock performance (see Figure 4) is one indicator of reduced risk premia that leads the EUR. In addition, we expect that a mix of Fed QE4 and some prepayment of past LTRO support will initially see relative Central Bank balance sheets move in favor of the EUR.QE3’s impact on price expectations suggests this is one conduit through which QE4 can play mildly USD negative.

Figure 5: Fed vs. ESCB balance sheet will favor EUR in early 2013

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With speculative positions still short EUR, there is scope for a squeeze as high as 1.35 in Q1, similar to the top of

the range this year. However, we see EUR/USD coming up well short of its 12 month straddle breakeven near 1.40, on the presumption that the still historically wide divergence between US and EUR real growth rates will become a constraining factor for the EUR as the year progresses. Firstly, it will expose the limitations of the ECB’s OMT policy in driving down rates sufficiently low to make policy genuinely accommodative for the periphery. It is expected that weak growth will again stir concerns about long-term periphery debt sustainability in Spain, Portugal and Italy, even if the timing of this is difficult to predict. Secondly, soft EUR area growth will create a strong belief that EUR strength will be regarded by the market and policymakers, as a counterproductive tightening of financial conditions. Between these concerns and a small back-up in US Treasury yields (10yr above 2%) this should be enough to push the EUR back down into the low to mid-1.20s into H2 2013. In the end, the EUR/USD range we have seen so far in 2012 will likely be mirrored in 2013 – a narrow range, even relative to what current volatility predicts.

Figure 6: Annual percentage ranges for EUR/USD

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Alan Ruskin, (1) 212 250 8646



Commodities: The US fiscal cliff and energy independence

Commodities have been the worst performing asset class in terms of total returns so far this year. This weakness has been concentrated in the energy and livestock sectors with industrial metal returns only recently clawing back past losses.

Looking into next year, we expect strength in the precious metals complex will continue; that low inventories will keep weather risk premia embedded in the agricultural sector and that the rebound in economic activity in China will trigger a recovery in industrial metal prices.

However, there remains considerable uncertainty towards the oil price outlook. We believe this uncertainty relates to whether or not the US economy moves back into recession during the first half of next year, the extent to which US shale oil production will surprise to the upside or not and given the low level of OPEC spare capacity.

In the absence of a marked slowdown in global growth we believe crude oil prices will remain strong. We view US shale production growth as sustaining the large discount of WTI versus other regional crude oil benchmarks such as Brent.

However, in the event of a bad outcome to the US fiscal cliff and the US moving into recession we would expect this would unleash downside risks to crude oil prices. In years where world growth has fallen to 2.5% or below crude oil prices have fallen by a minimum of 20% within a three month period.

Since the beginning of 2011, Brent crude oil prices have broadly respected a USD100-120 trading range. This stability has coincided with increasing uncertainty towards the oil supply-demand outlook. For example, the move towards US energy independence is leading to a wide range in US oil production projections over the next few years. Moreover, the dangers of the US economy falling over the fiscal cliff threaten to push the US and potentially global economy into recession. Meanwhile low spare capacity in OPEC is keeping geopolitical risk close to the surface.

We believe these risks help to explain the wide dispersion in 2013 Brent oil price forecasts. Figure 1 tracks the difference between the most bearish and most bullish oil price forecaster since 1999. Over the past few years, the dispersion is rising in both absolute and percentage terms. This may be an indication of the possible binary nature of the oil market in an environment of either

weakening world growth or in the event of further oil supply disruptions.

Figure 1: The dispersion in oil price forecasts is on the rise

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The divergent range of price forecasts may also reflect the uncertainty towards US oil production growth and hence the ramifications for the global oil balance. Over the past year, US oil production has surprised to the upside. This has been primarily triggered by the surge in shale oil production in North Dakota (Bakkan) and Texas (Eagle Ford). Figure 2 illustrates how estimates for US oil production in 2012 and 2013 have been revised higher by the IEA and EIA. In fact, North Dakota alone will be equivalent to around 60% of non-OPEC supply growth in 2012. Given the scale of how US oil supply growth exceeded expectations this year, the bias would be to expect a repeat of this trend on some scale for next year.

Figure 2: Evolution of 2012 & 2013 US oil production forecasts by the IEA & US Energy Department/EIA

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Prospects for US oil production also remain optimistic out to 2015. The US EIA projects US oil supply rise by just



over 960kbd over the next three years compared to an increase of 1.6mmb/d from the International Energy Agency. Meanwhile Wood Mackenzie estimates US oil supply growth will be even larger with production in 2015 2.3mmb/d higher that 2012 levels with US shale oil production projections at the heart of the range in US oil production forecasts. Since the US still prohibits the export of crude oil, we expect this will sustain the significant discount of WTI to Brent and maintain contango in the front part of the WTI forward curve.

On the demand side, we expect the main risk to the oil price outlook is whether or not the US economy falls over the fiscal cliff. We find that oil prices are most vulnerable in environments where world growth slows to 2.5% or below. Figure 3 tracks the performance of the crude oil price in years where world growth is 2.5% or less. It shows that even when OPEC takes action to cut production to remove surplus oil from the market, oil prices have tended to fall by a minimum of 20% in the three months after the first OPEC production cut. This might suggest that Brent crude oil would fall to around USD85 or below in the event of a negative outcome to the US fiscal cliff. Given our assumptions, we attach a low probability to this scenario.

Figure 3: The danger of falling over the US fiscal cliff – the performance of crude oil in periods of weak global growth

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Precious metals have been a reliable source of positive returns Since 2001, the precious metals complex has never posted negative returns on an annual basis. Moreover, of the five broad commodity sectors precious metals have been among the top two performing commodity sectors, ranked in terms of total returns, 90% of the time. However, over the past 18 months gold returns have had to contend with a strengthening in the US dollar and a slowdown in inflows into physically backed gold ETFs. However, we expect 2013 will see new price highs across the sector. This is based on a resumption in US dollar weakness into the beginning of next year, the

maintenance of negative real interest rates and ongoing central bank diversification into gold we are maintaining our bullish outlook. Indeed history would suggest that when US real interest rates are negative then annual returns in gold and silver can average approximately 20% per annum, Figure 4.

Figure 4: Gold and silver returns in different US real interest rate environments

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Food price inflation risks heading into 2013 We view price spike risk in the agricultural sector as high heading into 2013. Global corn inventory-to-consumption ratios are still at precariously low levels and there is the danger that the USDA lowers its estimate for US production again next month due to higher abandonment resulting from drought conditions this summer. On the demand side, we have seen minimal evidence of livestock liquidation, except for the cattle sector and this suggests little demand destruction despite high grain prices. Moreover South American weather merits watching as dry conditions in Southern Brazil (about 20% of total Brazilian corn production) and wet weather in Argentina pose problems for Southern Hemisphere corn production.

Figure 5: DB oil & natural gas price deck

WTI Brent US Nat Gas(USD/bbl) (USD/bbl) (USD/mmBtu)

2012 Q1 102.9 118.4 2.51Q2 94.2 110.2 2.35Q3 92.2 109.5 2.90Q4 90.0 110.0 3.55

2013 Q1 100.0 110.0 3.80Q2 102.0 112.0 3.60Q3 108.0 115.0 3.70Q4 109.0 117.0 3.90

2012 94.8 112.0 2.832013 104.8 113.5 3.752014 100.0 110.0 4.252015 100.0 110.0 4.50

Note: Figures are period average

Source: DB Research

Michael Lewis, (44) 20 7545 2166



Geopolitics: The fiscal cliff and the pacific pivot

What effect will the fiscal cliff have on US geopolitical strategy? The sequester and spending caps on defense spending in the Budget Control Act concern total spending, leaving some discretion to the allocation among various military services. Therefore, some of the military services may be hit with disproportionate cuts. However, the US navy is at the center of the US strategy shift toward the Pacific, so I will concentrate on how such cuts may affect US Navy forces and allocations, assuming that the navy takes proportionate cuts.

The shifting strategic priorities of the US project a large reduction in forces devoted to Afghanistan from the current 68,000 troops to perhaps 10,000 support troops by 2014. Effectively, that shift will signal the end of the wars in Iraq and Afghanistan and underscore the pivot of US strategic attention from southwest and central Asia to the Pacific.

Central to this shift is the assignment of 60% of major US naval forces to the Pacific by 2020 and 40% to other areas, i.e. a shift of around 30 major combatants given current naval strength and expected naval strength. Major fleet combat ships are programmed to fall in the middle term from 280 to 250 even without sequestration, eventually to be restored to about 300 major combat units. 4 Currently, five aircraft carriers are based in the Pacific or US west coast and five are based on the US east coast. One carrier has just been retired, dropping the total from eleven to ten, with one new carrier under construction for delivery in 2015.

Naval forces of Pacific Countries To determine the relative importance of the shift in naval forces and the effect of the fiscal caps, it is helpful to compare the forces in being of the key Pacific naval powers. I will consider only combat ships such as aircraft carriers, cruisers, destroyers, frigates, and submarines.

US: The navy battle fleet tonnage exceeds next 13 navies combined, with 220 major combat ships. Of these, 71 are submarines; all nuclear and only 28 are frigates, the lightest combat ship considered here. It should be noted that the displacement tonnage of one aircraft carrier equals the total displacement of about 40 frigates.

4 CBO, An Analysis of the US Navy’s Fiscal 2013 Shipbuilding Plan, July, 2012.

China: The navy has 139 combatants of these types mostly frigates and submarines, and the submarines are mostly diesel-powered.

Japan: The navy has 69 combatants of these types, again mostly frigates and diesel-powered submarines.

Russia: The navy has 25 major combatants in the Pacific, of which 19 are nuclear submarines.

Republic of Korea: The navy has 24 large combatants, all frigates and diesel-powered submarines.

Australia: The navy has 18 combatants, all frigates and submarines.

It is evident that, except for the US, all Pacific naval powers have a strategy of local defense or denial of sea lanes via submarine warfare. In this environment, an increment of 20 major combatants, especially of the large types in the US navy can have a significant initial impact. Eventually, this impact would be offset by competitive naval construction.

How much will be cut? With the commitment to the wars in Afghanistan and Iraq of the past decade, the US defense budget rose from about 3% of GDP from 1997-2001 to about 4.7 % in 2009-2011. This was an increase from about USD400 billion to about USD700 billion in 2012 dollars. In its early-2011 projections, the CBO expected defense expenditure to be USD725 billion in 2013 and to grow steadily to USD829 billion in 2021. By 2012, with the reductions in war spending and caps in the Budget Control Act, these estimates had fallen to USD546 billion for 2013, rising to USD644 billion by 2021.

However, if the automatic sequestration is triggered, then about USD55 billion will be stripped from these totals for each year through 2021.5 This is a 10% reduction from plans in the early years and an 8.5% reduction in the out years. The spending caps and sequester, however, do not affect the expenditures on contingency operations in 2013, but this spending is rapidly falling.

What may happen to the Pacific Pivot? US defense reductions from the sequestrations need not be proportionate across forces. Within the defense caps, the amounts that each service and program will be cut is at the discretion of the Congress and Administration.

5 See Tables 1 and 2, CBO, Sequestration Update Report: August 2012.



Army and marine ground forces are likely to be reduced the most, because the navy is the senior military branch in the Pacific and this is regarded as an area where naval and air units will predominate. Also, with the wind down of the land wars, fewer land forces will be needed. Two of four army brigades are already scheduled to be withdrawn from Europe, leaving the direct deployment of troops in the NATO area at minimum levels.

Suppose, however that the Navy takes a proportionate share of the sequestration cuts and that this means that 10% of its fleet must be mothballed and construction programs curtailed.

Working from the baseline of 220 ships of the types used in the country comparisons above, a 10% cut means that the navy would have 22 fewer ships than previously planned, or about 200 ships in all. Half of the current force is already stationed at Pacific bases, i.e. 110 ships. If the strategy of basing 60% of the navy in the Pacific is maintained, then 120 ships will be stationed there.

So the Pacific pivot will amount to an increase of ten ships rather than twenty for the strategy in the face of sequestration, or a 9% increase in numbers over current levels. The number of ships based in all other waters will fall by 30, a 27% decline. Of course, naval units can be temporarily deployed in any ocean if the need arises. The rebasing simply means that fewer naval units would be immediately available in the Atlantic or Mediterranean than before and more would be immediately available in the Western Pacific. For deployments in the Indian Ocean and Arabian Sea, squadrons from both the Pacific and Atlantic fleets have been used equally in the past. A shift of forces to the Pacific means that such deployments will take somewhat longer, but they need not transit the Suez Canal.

Presumably, procurement of aircraft for the air force will similarly be curtailed and operational units reduced.

Peter Garber, (1) 212 250 5466



Key Economic Forecasts

2011 2012F 2013F 2014F 2011 2012F 2013F 2014F 2011 2012F 2013F 2014FUS 1.8 2.2 1.9 2.9 3.1 2.1 2.3 2.5 -3.1 -3.1 -3.3 -3.4

Japan -0.5 1.6 0.2 0.3 -0.3 -0.1 -0.6 1.7 2.1 1.0 1.2 1.6Euroland 1.4 -0.5 -0.3 1.1 2.7 2.5 1.6 1.6 0.1 0.9 1.3 1.6 Germany 3.0 0.8 0.3 1.5 2.5 2.1 1.5 1.9 5.7 6.4 5.7 5.5 France 1.7 0.1 -0.3 1.0 2.3 2.2 1.5 1.6 -2.0 -2.1 -2.0 -2.3 Italy 0.4 -2.1 -0.9 0.5 2.9 3.3 1.8 1.5 -3.1 -1.0 -0.3 -0.2 Spain 0.4 -1.3 -1.1 0.6 3.1 2.5 2.2 1.3 -3.5 -1.8 0.0 -0.2 Netherlands 1.1 -1.0 -0.1 1.7 2.5 2.8 2.3 1.8 9.7 9.0 9.0 9.5 Belgium 1.8 -0.2 0.0 1.0 3.5 2.6 1.8 1.7 -1.1 0.0 0.5 1.0 Austria 2.7 0.5 0.9 1.3 3.6 2.5 2.0 1.9 2.1 1.2 1.8 2.1 Finland 2.7 -0.1 0.0 1.2 3.3 3.1 2.5 2.2 -1.2 -1.5 -1.0 -0.5 Greece -6.0 -6.5 -4.2 0.9 3.1 1.1 0.1 -0.2 -6.5 -6.0 -4.0 -3.0 Portugal -1.7 -2.9 -1.2 0.8 3.6 2.8 1.0 1.2 -9.5 -1.5 0.0 1.0 Ireland 1.4 0.2 0.8 1.9 1.2 2.0 1.4 1.5 1.1 2.0 2.5 3.0

Other Industrial Countries United Kingdom 0.9 -0.1 0.9 1.8 4.5 2.8 2.4 2.2 -1.9 -4.7 -4.4 -3.5 Denmark 1.1 -0.5 1.0 1.5 2.8 2.5 2.0 1.8 5.7 5.5 5.0 4.5 Norway 1.3 3.2 2.0 2.5 1.3 0.7 1.6 2.0 14.3 15.0 14.0 13.0 Sweden 3.8 1.2 1.2 1.9 2.6 1.0 1.3 2.0 7.1 7.5 6.5 6.0 Switzerland 1.9 1.0 1.5 1.7 0.2 -0.6 0.4 0.8 10.5 11.0 10.5 10.0 Canada 2.4 2.0 2.3 3.1 2.9 1.7 2.4 2.1 -3.0 -4.0 -3.4 -3.0 Australia 2.4 3.5 1.2 3.9 3.3 1.9 2.8 2.3 -2.3 -3.7 -3.0 -2.8 New Zealand 1.3 2.4 2.2 2.4 4.0 1.1 1.3 2.0 -4.0 -5.2 -5.5 -5.5

Emerging Europe/Africa Czech Republic 1.7 -0.8 1.0 3.4 1.9 3.3 2.5 2.1 -3.1 -1.8 -1.6 -1.7 Egypt 1.8 1.6 3.4 5.0 11.1 8.9 8.3 8.8 -1.6 -3.1 -3.3 -2.9 Hungary 1.6 -1.3 0.0 1.6 3.9 5.7 4.1 3.5 0.9 0.9 1.5 0.9 Israel 4.6 3.3 2.9 3.6 3.5 1.8 2.3 2.3 0.8 -0.8 -0.6 -0.3 Kazakhstan 7.5 5.5 6.0 6.2 7.4 5.4 6.2 6.4 7.6 6.7 5.8 5.2 Poland 4.3 2.2 1.6 2.3 4.3 3.8 2.6 2.3 -4.3 -3.4 -3.0 -3.7 Romania 2.5 0.8 2.5 3.5 5.8 3.4 4.6 3.9 -4.3 -4.0 -4.0 -4.0 Russia 4.3 4.0 4.3 4.2 8.4 5.2 7.4 6.1 5.3 4.3 3.4 1.5 Saudi Arabia 7.1 5.6 3.7 3.4 5.0 4.5 3.8 3.2 26.5 27.1 24.9 21.2 South Africa 3.1 2.3 2.7 3.6 5.0 5.6 5.8 5.7 -3.3 -6.4 -4.6 -3.5 Turkey 8.5 3.0 4.8 5.0 6.5 9.0 6.9 6.5 -10.0 -6.5 -7.5 -8.2 Ukraine 5.2 2.0 4.0 3.9 8.0 1.5 6.0 5.5 -5.6 -6.2 -4.2 -4.4 United Arab Emirates 4.2 2.4 2.7 2.8 0.9 0.7 0.4 1.4 9.1 11.2 13.6 14.3

Asia (ex-Japan) China 9.3 7.7 8.2 8.9 5.4 2.6 3.0 3.5 2.8 2.7 2.0 1.6 Hong Kong 4.9 1.3 2.5 4.5 5.3 4.0 2.5 1.7 6.5 -1.4 -1.4 -0.6 India 7.9 4.6 6.8 7.1 9.5 7.5 6.6 6.3 -3.4 -3.5 -3.4 -3.3 Indonesia 6.5 6.3 6.3 6.5 5.4 4.3 5.1 6.3 0.2 -2.3 -2.7 -2.6 Korea 3.6 2.1 2.5 4.4 4.0 2.2 2.6 3.1 2.4 3.9 2.5 1.2 Malaysia 5.1 5.3 5.0 6.0 3.2 1.7 1.7 2.4 11.0 5.5 5.2 6.5 Philippines 3.9 6.0 5.0 5.0 4.7 3.2 4.0 4.5 3.1 4.3 5.0 5.2 Singapore 4.9 2.5 3.0 4.5 5.2 4.4 2.7 3.0 22.0 11.1 9.5 9.6 Sri Lanka 8.3 6.2 7.0 7.5 6.7 7.5 7.0 6.3 -7.8 -5.0 -3.5 -3.8 Taiwan 4.1 1.1 3.0 4.3 1.4 1.9 1.3 2.2 8.9 8.5 7.1 4.8 Thailand 0.1 5.7 3.9 4.9 3.8 3.0 3.1 3.6 3.4 1.7 2.1 2.3 Vietnam 5.9 4.9 5.2 5.8 18.6 9.3 9.4 11.4 0.2 3.6 -1.9 -0.6

Latin America Argentina 7.0 1.6 2.1 1.9 24.4 23.8 26.5 26.5 0.1 1.4 2.0 1.9 Brazil 2.7 1.0 3.5 4.2 6.6 5.4 5.3 5.8 -2.1 -2.4 -2.6 -2.7 Chile 6.2 5.1 4.7 4.9 3.3 3.1 2.8 3.0 -1.7 -2.4 -1.7 -1.2 Colombia 5.9 4.3 4.4 5.0 3.4 3.3 3.0 3.0 -2.6 -2.9 -3.0 -3.2 Mexico 3.9 3.8 3.5 3.7 3.4 3.9 3.7 3.6 -0.4 -0.4 -1.1 -1.3 Peru 6.9 6.3 6.0 6.2 3.4 3.6 2.6 2.5 -2.0 -3.2 -3.4 -2.7 Venezuela -1.5 4.2 5.0 2.1 28.2 26.1 23.3 22.2 4.6 6.3 2.6 3.3

EM countries 6.3 4.7 5.5 6.0 6.6 4.9 4.9 5.1W orld 3.8 2.9 3.1 3.9 4.5 3.3 3.3 3.5

QUARTERLY GDP

Q1 2012 Q2 2012 Q3 2012F Q4 2012F Q1 2013F Q2 2013F Q3 2013F Q4 2013F Q1 2014F Q2 2014F Q3 2014F Q4 2014F

US 2.0 1.3 2.7 1.3 1.5 2.0 2.8 3.0 3.0 2.9 3.0 3.0

Japan 5.7 -0.1 -3.5 -1.5 1.4 1.4 1.7 1.8 3.7 -8.2 2.3 0.7

Euroland -0.1 -0.7 -0.2 -1.7 -0.5 0.3 0.9 1.2 1.0 1.3 1.3 1.3

United Kingdom -1.2 -1.5 3.9 -0.6 0.6 1.1 1.4 1.7 1.9 2.2 1.8 1.7

Dol lar Bloc Canada 1.7 1.7 0.6 2.1 2.2 2.9 3.2 2.8 3.4 2.8 3.6 2.6 Australia 5.3 2.3 1.9 0.7 -0.2 0.8 3.0 3.8 4.3 4.8 4.4 4.3 New Zealand 4.1 2.3 1.0 1.4 2.2 3.1 2.8 2.4 2.3 2.3 2.3 2.2Source: DB Research, National Statistical Authorities

Grow th of real GDP (% yoy) Inflat ion, CPI (% yoy) Current Account (% of GDP)

(% qoq annual ised)



Interest Rates

(End o f Period)

Current 3M 6M 12M 24M Current 3M 6M 12M 24M Current 3M 6M 12M 24MUS 0.10 0.10 0.10 0.10 0.10 1.72 1.75 2.25 2.75 3.75 0.16 0.16 0.16 0.16 0.16

Japan 0.32 0.30 0.30 0.30 0.30 0.73 0.80 0.80 0.90 0.90 0.10 0.10 0.10 0.10 0.10

Euroland 0.18 0.20 0.20 0.30 0.60 1.34 1.65 1.90 2.50 3.00 0.75 0.50 0.50 0.50 0.50

Other Industrial Countries United Kingdom 0.52 0.55 0.60 0.70 0.95 1.82 2.20 2.50 3.10 3.85 0.50 0.50 0.50 0.50 0.75 Denmark 0.27 0.25 0.30 0.40 n.a. 1.04 1.35 1.65 2.30 n.a. 0.20 0.20 0.25 0.30 n.a. Norway 1.87 2.00 2.25 2.50 n.a. 2.13 2.50 2.80 3.50 n.a. 1.50 1.50 1.75 2.00 n.a. Sweden 1.50 1.15 1.20 1.45 n.a. 1.44 1.70 2.10 2.80 n.a. 1.25 1.00 1.00 1.00 n.a. Switzerland 0.01 0.05 0.05 0.05 n.a. 0.45 0.70 1.00 1.65 n.a. 0.00 0.00 0.00 0.00 n.a.

Canada 1.17 0.95 0.95 1.70 3.20 1.76 1.88 2.00 2.90 4.70 1.00 1.00 1.00 1.75 3.25 Australia 3.23 3.25 2.75 2.50 3.00 3.31 3.25 3.50 3.50 4.00 3.00 3.00 2.50 2.25 2.75 New Zealand 2.59 2.65 2.65 2.65 3.75 3.58 4.00 4.00 4.00 4.50 2.50 2.50 2.50 2.50 3.50

EMERGING MARKETS OFFICIAL RATESCurrent 3M 6M 12M 24M

Emerging Europe Czech Republic 0.05 0.05 0.05 0.05 0.05 Hungary 6.00 5.25 4.75 4.50 4.00 Poland 4.25 3.50 3.50 3.25 3.25 Romania 5.25 5.25 5.25 5.25 5.25 Russia 8.25 8.25 8.00 8.00 8.00 Turkey 5.75 5.25 5.25 5.25 6.50 Ukraine 7.50 7.50 7.50 7.50 7.50 South Africa 5.00 4.50 4.50 4.50 7.00

Asia (ex-Japan) China 3.00 3.00 3.00 3.25 3.50 Hong Kong 0.50 0.50 0.50 0.50 n.a. India 8.00 7.75 7.50 7.00 7.00 Indonesia 5.75 5.75 5.75 6.00 6.50 Korea 2.75 2.50 2.50 2.75 3.25 Malaysia 3.00 3.00 3.00 3.00 3.50 Philippines 5.50 5.50 5.75 6.25 6.75 Singapore 0.38 0.45 0.45 0.70 n.a. Sri Lanka 9.50 9.50 9.00 9.00 n.a. Taiwan 1.88 1.88 1.88 1.88 2.25 Thailand 2.75 2.75 2.75 3.25 3.75 Vietnam 10.00 9.00 9.00 9.00 12.00

Latin America Argentina 9.80 13.50 16.50 17.50 n.a. Brazil 7.25 7.00 6.50 6.50 8.25 Chile 5.00 5.00 5.25 5.50 5.50 Colombia 4.50 4.25 4.25 4.50 5.00 Mexico 4.50 4.50 4.50 4.50 5.00

Sources: DB Research, Bloomberg Finance LP; as of December 13

Off icial rate3M rate 10Y rate



Exchange Rates (End of Period)

FX Rate (v s. US Dol lar) FX Rate (v s. Euro) FX Rate (v s. Yen)

Current 3M 6M 12M 24M Current 3M 6M 12M 24M Current 3M 6M 12M 24MUS 1.31 1.35 1.30 1.20 1.15 84 82 86 90 95

Japan 84 82 86 90 95 109 111 112 108 109

Euroland 1.31 1.35 1.30 1.20 1.15 109 111 112 108 109

Other Industrial Countries United Kingdom 1.61 1.61 1.57 1.50 1.44 0.81 0.84 0.83 0.80 0.80 135 132 135 135 137 Denmark 5.70 5.53 5.74 6.22 6.49 7.46 7.46 7.46 7.46 7.46 14.7 14.8 15.0 14.5 14.6 Norway 5.62 5.48 5.62 6.00 6.09 7.36 7.40 7.30 7.20 7.00 14.9 15.0 15.3 15.0 15.6 Sweden 6.68 6.30 6.35 6.67 6.96 8.74 8.50 8.25 8.00 8.00 12.5 13.0 13.6 13.5 13.7 Switzerland 0.93 0.90 0.93 1.03 1.07 1.21 1.21 1.21 1.23 1.23 90.3 91.5 92.4 87.8 88.8

Canada 0.98 0.98 0.98 1.00 1.05 1.29 1.32 1.27 1.20 1.21 85.0 83.7 87.8 90.0 90.5 Australia 1.06 1.06 1.04 1.00 0.90 1.24 1.27 1.25 1.20 1.28 88.3 86.9 89.4 90.0 85.5 New Zealand 0.84 0.83 0.83 0.80 0.72 1.55 1.63 1.57 1.50 1.60 70.6 68.1 71.4 72.0 68.4

Emerging Europe Czech Republic 19.3 18.7 19.4 21.0 n.a. 25.2 25.2 25.2 25.2 n.a. 4.3 4.4 4.4 4.3 n.a. Hungary 216 207 215 233 n.a. 282 280 280 280 n.a. 0.4 0.4 0.4 0.4 n.a. Poland 3.13 2.99 3.05 3.18 n.a. 4.09 4.03 3.96 3.82 n.a. 26.7 27.5 28.2 28.3 n.a. Israel 3.77 3.83 3.79 3.71 n.a. 4.93 5.16 4.92 4.46 n.a. Romania 3.45 3.27 3.34 3.50 n.a. 4.52 4.41 4.34 4.20 n.a. Russia 30.6 30.5 30.5 30.6 30.8 40.01 41.2 39.7 36.7 35.4 Turkey 1.78 1.80 1.80 1.85 n.a. 2.33 2.43 2.34 2.22 n.a. Ukraine 8.09 8.20 8.20 8.20 8.40 10.58 11.07 10.66 9.84 9.66 South Africa 8.65 8.20 8.20 8.10 n.a. 11.31 11.07 10.66 9.72 n.a.

Asia (ex-Japan) China 6.25 6.23 6.17 6.06 6.10 8.17 8.41 8.02 7.27 7.02 13.4 13.2 13.9 14.9 15.6 Hong Kong 7.75 7.77 7.80 7.80 n.a. 10.14 10.49 10.14 9.36 n.a. 10.8 10.6 11.0 11.5 n.a. India 54.24 53.00 52.25 52.00 n.a. 70.95 71.55 67.93 62.40 n.a. 1.5 1.5 1.6 1.7 n.a. Indonesia 9,697 9,715 9,790 9,900 n.a. 12,685 13,115 12,727 11,880 n.a. 0.01 0.01 0.01 0.01 n.a. Korea 1,073 1,090 1,080 1,070 n.a. 1,404 1,472 1,404 1,284 n.a. 0.08 0.08 0.08 0.08 n.a. Malaysia 3.05 3.03 3.01 2.98 2.96 3.99 4.09 3.91 3.58 3.40 27.4 27.1 28.6 30.2 32.1 Philippines 41.06 39.80 38.80 38.00 39.80 53.71 53.73 50.44 45.60 45.77 2.0 2.1 2.2 2.4 2.4 Singapore 1.22 1.22 1.21 1.21 n.a. 1.60 1.65 1.57 1.45 n.a. 68.5 67.2 71.1 74.4 n.a. Sri Lanka 128.7 124.5 124.3 124.0 n.a. 168.30 168.08 161.59 148.80 n.a. 0.7 0.7 0.7 0.7 n.a. Taiwan 29.05 29.20 28.70 28.30 n.a. 38.01 39.42 37.31 33.96 n.a. 2.9 2.8 3.0 3.2 n.a. Thailand 30.64 30.70 30.50 30.30 n.a. 40.08 41.45 39.65 36.36 n.a. 2.7 2.7 2.8 3.0 n.a. Vietnam 20,816 21,000 21,300 21,500 n.a. 27,232 28,350 27,690 25,800 n.a. 0.004 0.004 0.004 0.004 n.a.

Latin America Argentina 4.87 5.10 5.35 5.87 n.a. 6.37 6.89 6.96 7.04 n.a. Brazil 2.07 2.15 2.10 2.05 2.05 2.71 2.90 2.73 2.46 2.36 Chile 474 498 510 512 n.a. 621 672 663 614 n.a. Colombia 1,795 1,790 1,780 1,750 n.a. 2,348 2,417 2,314 2,100 n.a. Mexico 12.73 12.80 12.60 12.50 n.a. 16.65 17.28 16.38 15.00 n.a.

Sources: DB Research, Bloomberg Finance LP, Datastream; as of December 13



Long-term Forecasts

2011 2012F 2013F 2014F 2015F 2016F 2017F 2011 2012F 2013F 2014F 2015F 2016F 2017FIndustrial countries

USA 1.8 2.2 1.9 2.9 2.7 2.7 2.7 3.1 2.1 2.3 2.5 2.2 2.2 2.2Japan -0.5 1.6 0.2 0.3 0.5 1.4 1.3 -0.3 -0.1 -0.6 1.7 2.0 1.0 -0.3Euroland 1.4 -0.5 -0.3 1.1 1.3 1.5 1.7 2.7 2.5 1.6 1.6 1.8 1.9 2.0United Kingdom 0.9 -0.1 0.9 1.8 2.0 2.0 2.0 4.5 2.8 2.4 2.2 2.0 2.0 2.0Canada 2.4 2.0 2.3 3.1 3.0 2.4 2.4 2.9 1.7 2.4 2.1 1.8 2.0 2.0Australia 2.4 3.5 1.2 3.9 3.4 3.4 3.4 3.3 1.9 2.8 2.3 2.5 2.5 2.5Emerging MarketsRussia 4.3 4.0 4.3 4.2 4.2 4.2 4.2 8.4 5.2 7.4 6.1 5.6 5.2 4.7

South Africa 3.1 2.3 2.7 3.6 4.1 4.8 5.1 5.0 5.6 5.8 5.7 5.5 5.5 5.5China 9.3 7.7 8.2 8.9 8.4 8.0 7.7 5.4 2.6 3.0 3.5 3.0 3.0 3.0India 7.9 4.6 6.8 7.1 7.0 7.5 7.5 9.5 7.5 6.6 6.3 7.0 7.0 7.0Indonesia 6.5 6.3 6.3 6.5 6.5 6.5 6.5 5.4 4.3 5.1 6.3 6.0 6.0 6.0Brazil 2.7 1.0 3.5 4.2 3.8 3.8 3.8 6.6 5.4 5.3 5.8 5.2 5.2 5.0Mexico 3.9 3.8 3.5 3.7 3.7 3.8 3.9 3.4 3.9 3.7 3.6 3.5 3.5 3.5

2011 2012F 2013F 2014F 2015F 2016F 2017F 2011 2012F 2013F 2014F 2015F 2016F 2017FIndustrial countries

USA 1.1 1.2 0.9 1.9 1.7 1.7 1.7 0.7 1.0 1.0 1.0 1.0 1.0 1.0Japan -0.4 1.9 0.5 0.6 0.9 1.8 1.8 -0.1 -0.3 -0.3 -0.3 -0.4 -0.4 -0.5Euroland 1.1 -1.0 -0.8 0.6 0.8 1.0 1.2 0.3 0.5 0.5 0.5 0.5 0.5 0.5United Kingdom 0.2 -0.4 0.6 1.5 1.7 1.7 1.7 0.7 0.3 0.3 0.3 0.3 0.3 0.3Canada 1.3 0.9 1.1 2.0 2.0 1.4 1.5 1.1 1.1 1.1 1.1 1.0 1.0 0.9Australia 1.5 1.8 -0.4 2.4 1.9 2.1 2.1 1.0 1.7 1.6 1.5 1.5 1.3 1.3

Emerging MarketsRussia 4.6 3.9 4.2 4.2 4.3 4.3 4.3 -0.3 0.1 0.1 0.0 -0.1 -0.1 -0.1South Africa 1.9 1.3 1.8 2.7 3.2 3.9 4.2 1.2 1.0 0.9 0.9 0.9 0.9 0.9China 8.8 7.2 7.7 8.4 7.9 7.6 7.3 0.5 0.5 0.5 0.5 0.5 0.4 0.4India 6.6 3.4 5.6 5.9 5.8 6.3 6.3 1.4 1.2 1.2 1.2 1.2 1.2 1.2Indonesia 5.0 5.1 5.0 5.2 5.3 5.3 5.3 1.4 1.2 1.2 1.2 1.2 1.2 1.2Brazil 1.9 -0.3 2.2 2.9 2.5 2.5 2.5 0.9 1.3 1.3 1.3 1.3 1.3 1.3Mexico 2.6 2.4 2.1 2.3 2.3 2.4 2.5 1.3 1.4 1.4 1.4 1.4 1.4 1.4

2011 2012F 2013F 2014F 2015F 2016F 2017F 2011 2012F 2013F 2014F 2015F 2016F 2017FIndustrial countriesUSA 0.13 0.16 0.16 0.16 1.50 3.50 4.50 1.88 2.00 2.75 3.75 4.75 5.00 5.25Japan 0.05 0.10 0.10 0.10 0.50 0.50 0.50 0.99 0.75 0.90 0.90 1.00 1.20 1.20Euroland 1.00 0.75 0.50 0.50 1.00 2.00 3.00 1.83 1.75 2.50 3.00 3.50 4.00 4.00

United Kingdom 0.50 0.50 0.50 0.75 1.75 2.75 3.75 1.98 2.20 3.10 3.85 5.25 5.50 5.50Canada 1.00 1.00 1.75 3.25 4.25 4.25 4.25 1.94 2.13 2.90 4.70 5.00 5.50 5.50

Australia 4.25 3.00 2.25 2.75 4.00 4.00 4.00 3.13 3.75 3.50 4.00 4.50 4.50 4.50Emerging MarketsRussia 8.00 8.30 8.00 8.00 8.00 8.00 8.00 n.a. n.a. n.a. n.a. n.a. n.a. n.a.South Africa 5.50 5.00 4.50 7.00 8.00 8.00 8.00 n.a. n.a. n.a. n.a. n.a. n.a. n.a.China 3.50 3.00 3.25 3.50 3.25 3.00 3.00 n.a. n.a. n.a. n.a. n.a. n.a. n.a.India 8.50 8.00 7.00 7.00 7.50 7.50 7.50 n.a. n.a. n.a. n.a. n.a. n.a. n.a.Indonesia 6.00 5.75 6.00 6.50 7.00 7.00 7.00 n.a. n.a. n.a. n.a. n.a. n.a. n.a.Brazil 11.00 7.25 6.50 8.25 9.00 9.00 9.00 n.a. n.a. n.a. n.a. n.a. n.a. n.a.Mexico 4.50 4.50 4.50 5.00 5.50 5.50 5.50 n.a. n.a. n.a. n.a. n.a. n.a. n.a.

2011 2012F 2013F 2014F 2015F 2016F 2017F 2011 2012F 2013F 2014F 2015F 2016F 2017FIndustrial countriesUSA 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.30 1.30 1.20 1.15 1.15 1.15 1.15

Japan 77 82 90 95 95 95 95 100 107 108 109 109 109 109Euroland 1.30 1.30 1.20 1.15 1.15 1.15 1.15 1.00 1.00 1.00 1.00 1.00 1.00 1.00

United Kingdom 1.55 1.61 1.50 1.44 1.44 1.44 1.44 0.83 0.81 0.80 0.80 0.80 0.80 0.80

Canada 1.02 0.98 1.00 1.05 1.10 1.10 1.10 1.32 1.27 1.20 1.21 1.27 1.27 1.27Australia 1.03 1.06 1.00 0.90 0.85 0.85 0.85 1.27 1.23 1.20 1.28 1.35 1.35 1.35Emerging Markets

Russia 32.20 30.50 30.60 30.80 31.00 31.80 32.60 41.77 39.65 36.72 35.42 35.65 36.57 37.49

South Africa 8.14 8.20 8.10 9.00 8.50 8.50 8.50 10.56 10.66 9.72 10.35 9.78 9.78 9.78China 6.30 6.22 6.06 6.10 5.95 5.85 5.75 8.17 8.09 7.27 7.02 6.84 6.73 6.61India 53.27 53.00 52.00 51.00 51.00 50.50 50.00 69.11 68.90 62.40 58.65 58.65 58.08 57.50Indonesia 9033 9640 9900 9700 9500 9400 9200 11719 12532 11880 11155 10925 10810 10580Brazil 1.88 2.10 2.05 2.05 2.12 2.18 2.25 2.43 2.73 2.46 2.36 2.44 2.51 2.59Mexico 13.99 12.96 12.50 12.65 12.75 12.90 12.90 18.15 16.85 15.00 14.55 14.66 14.84 14.84

Population grow th, % yoyGDP per head, % yoy

GDP grow th, % yoy CPI inf lat ion , % yoy

FX rate v s. EUR (eop)

Key off icial in terest rate , % (eop)

FX rate v s. USD (eop)

10Y bond yie lds (eop)

Source: National Authorities, DB Research



Contacts

Name Coverage Telephone Email

David Folkerts-Landau Global Head of Research +44 20 754 55502 [email protected] Marcel Cassard Global Head, Macro and FI Research +44 20 754 55507 [email protected] Economics Peter Hooper Global Economics +1 212 250 7352 [email protected] Slok Global Economics +1 212 250 2155 [email protected] LaVorgna US Economist +1 212 250 7329 [email protected] Riccadonna US Economist +1 212 250 0186 [email protected] Ryan US Economist +1 212 250 6294 [email protected] Luzzetti Global Economics +1 212 250 6161 [email protected] Thomas Mayer Global Economics +49 69 910 30800 [email protected] Wall Europe Economics +44 20 754 52087 [email protected] Moec Europe Economics +44 20 754 52088 [email protected] Buckley UK Economics +44 20 754 51372 [email protected] Schneider Global Economics +49 69 910 31790 [email protected] Heider Europe Economics +44 20 754 52167 [email protected] Stringa Europe Economics +44 20 754 74900 [email protected] Sidorov Europe Economics +44 20 754 70132 [email protected] Mikihiro Matsuoka Japan Economics +81 3 5156 6768 [email protected] Michael Spencer Global Economics +852 2203 8305 [email protected] Ma China Economics +852 2203 8308 [email protected] Baig Asia Economics +65 6423 8681 [email protected] Lee Asia Economics +852 2203 8312 [email protected] Das Asia Economics +91 22 6658 4909 [email protected] Gustavo Cañonero Latam Economics +1 212 250 7530 [email protected] Carlos de Faria Latam Economics +55 11 2113 5185 [email protected] Losada Latam Economics +1 212 250-3162 [email protected] Roca Latam Economics +1 212 250-8609 [email protected] Robert Burgess CEEMEA Economics +44 20 754 71930 [email protected] Lissovolik CEEMEA Economics +7 495 933 9247 [email protected] Grady CEEMEA Economics +44 20 754 59913 [email protected] Akyurek CEEMEA Economics +90 212 317 0138 [email protected] Masia South Africa Economics +27 11775 7267 [email protected] Adam Boyton Australia Economics +61 2 8258 1688 [email protected] O’Donaghoe Australia Economics +61 2 8258 1606 [email protected] Gibbs New Zealand Economics +64 9 351 1376 [email protected] Clinkard Canada Economics +1 416 682 8221 [email protected]



Contacts

Name Coverage Telephone Email

Strategy Binky Chadha Global Asset Allocation +1 212 250 4776 [email protected] Parker Global Asset Allocation +1 212 250 7448 [email protected] Thatte Global Asset Allocation +1 212 250 6605 [email protected] Tierney Global Asset Allocation +1 212 250 6795 [email protected] Dominic Konstam Rates Strategy +1 212 250 9753 [email protected] Yared Rates Strategy +44 20 7545 4017 [email protected] Sparks Rates Strategy +1 212 250 0332 [email protected] Singhania Rates Strategy +44 207 547 4458 [email protected] Saragoussi Rates Strategy +33 1 4495 6408 [email protected] Steven Abrahams US MBS & Securitization +1 212 250 3125 [email protected] David Bianco US Equity Strategy +1 212 250 8169 [email protected] Hariani US Equity Strategy +1 212 250 2766 [email protected] Wang US Equity Strategy +1 212 250 7911 [email protected] Michael Biggs European Equity Strategy +44 20 7545 5506 [email protected] Evans European Equity Strategy +44 20 7545 2762 [email protected] Slomka European Equity Strategy +49 699 103 1942 [email protected] Rabe European Equity Strategy +49 699 10 31813 [email protected] Pearce European Equity Strategy +44 207 54 16568 [email protected] Bilal Hafeez FX Strategy +44 207 54 71489 [email protected] Ruskin FX Strategy +1 212 250 8646 [email protected] Brehon FX Strategy +1 212 250 7639 [email protected] Michael Lewis Commodities +44 20 754 52166 [email protected] Choi Commodities +65 6423 5261 [email protected] Peter Garber Geopolitics +1 212 250 5466 [email protected]



Appendix 1 Important Disclosures

Additional information available upon request

For disclosures pertaining to recommendations or estimates made on a security mentioned in this report, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr.

Analyst Certification

The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Peter Hooper/Thomas Mayer/Michael Spencer

Deutsche Bank debt rating key

CreditBuy (“C-B”): The total return of the Reference Credit Instrument (bond or CDS) is expected to outperform the credit spread of bonds / CDS of other issuers operating in similar sectors or rating categories over the next six months. CreditHold (“C-H”): The credit spread of the Reference Credit Instrument (bond or CDS) is expected to perform in line with the credit spread of bonds / CDS of other issuers operating in similar sectors or rating categories over the next six months. CreditSell (“C-S”): The credit spread of the Reference Credit Instrument (bond or CDS) is expected to underperform the credit spread of bonds / CDS of other issuers operating in similar sectors or rating categories over the next six months. CreditNoRec (“C-NR”): We have not assigned a recommendation to this issuer. Any references to valuation are based on an issuer’s credit rating. Reference Credit Instrument (“RCI”): The Reference Credit Instrument for each issuer is selected by the analyst as the most appropriate valuation benchmark (whether bonds or Credit Default Swaps) and is detailed in this report. Recommendations on other credit instruments of an issuer may differ from the recommendation on the Reference Credit Instrument based on an assessment of value relative to the Reference Credit Instrument which might take into account other factors such as differing covenant language, coupon steps, liquidity and maturity. The Reference Credit Instrument is subject to change, at the discretion of the analyst.



Regulatory Disclosures

1. Important Additional Conflict Disclosures

Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.

2. Short-Term Trade Ideas

Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the SOLAR link at http://gm.db.com.

3. Country-Specific Disclosures

Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively. Brazil: The views expressed above accurately reflect personal views of the authors about the subject company(ies) and its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is indirectly affected by revenues deriving from the business and financial transactions of Deutsche Bank. In cases where at least one Brazil based analyst (identified by a phone number starting with +55 country code) has taken part in the preparation of this research report, the Brazil based analyst whose name appears first assumes primary responsibility for its content from a Brazilian regulatory perspective and for its compliance with CVM Instruction # 483. EU countries: Disclosures relating to our obligations under MiFiD can be found at http://www.globalmarkets.db.com/riskdisclosures. Japan: Disclosures under the Financial Instruments and Exchange Law: Company name - Deutsche Securities Inc. Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117. Member of associations: JSDA, Type II Financial Instruments Firms Association, The Financial Futures Association of Japan, Japan Investment Advisers Association. This report is not meant to solicit the purchase of specific financial instruments or related services. We may charge commissions and fees for certain categories of investment advice, products and services. Recommended investment strategies, products and services carry the risk of losses to principal and other losses as a result of changes in market and/or economic trends, and/or fluctuations in market value. Before deciding on the purchase of financial products and/or services, customers should carefully read the relevant disclosures, prospectuses and other documentation. "Moody's", "Standard & Poor's", and "Fitch" mentioned in this report are not registered credit rating agencies in Japan unless “Japan” or "Nippon" is specifically designated in the name of the entity. Malaysia: Deutsche Bank AG and/or its affiliate(s) may maintain positions in the securities referred to herein and may from time to time offer those securities for purchase or may have an interest to purchase such securities. Deutsche Bank may engage in transactions in a manner inconsistent with the views discussed herein. Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute, any appraisal or evaluation activity requiring a license in the Russian Federation.

Risks to Fixed Income Positions Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates – these are common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options in addition to the risks related to rates movements.

David Folkerts-Landau Managing Director

Global Head of Research

Marcel Cassard Global Head

CB&S Research

Ralf Hoffmann & Bernhard Speyer Co-Heads

DB Research

Stuart Parkinson Chief Operating Officer

Research

Richard Smith Associate Director Equity Research

Asia-Pacific Germany Americas

Fergus Lynch Regional Head

Andreas Neubauer Regional Head

Steve Pollard Regional Head

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Global Disclaimer

The information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively "Deutsche Bank"). The information herein is believed to be reliable and has been obtained from public sources believed to be reliable. Deutsche Bank makes no representation as to the accuracy or completeness of such information.

Deutsche Bank may engage in securities transactions, on a proprietary basis or otherwise, in a manner inconsistent with the view taken in this research report. In addition, others within Deutsche Bank, including strategists and sales staff, may take a view that is inconsistent with that taken in this research report.

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Unless governing law provides otherwise, all transactions should be executed through the Deutsche Bank entity in the investor's home jurisdiction. In the U.S. this report is approved and/or distributed by Deutsche Bank Securities Inc., a member of the NYSE, the NASD, NFA and SIPC. In Germany this report is approved and/or communicated by Deutsche Bank AG Frankfurt authorized by the BaFin. In the United Kingdom this report is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange and regulated by the Financial Services Authority for the conduct of investment business in the UK and authorized by the BaFin. This report is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. This report is distributed in Singapore by Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch, and recipients in Singapore of this report are to contact Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch in respect of any matters arising from, or in connection with, this report. Where this report is issued or promulgated in Singapore to a person who is not an accredited investor, expert investor or institutional investor (as defined in the applicable Singapore laws and regulations), Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch accepts legal responsibility to such person for the contents of this report. In Japan this report is approved and/or distributed by Deutsche Securities Inc. The information contained in this report does not constitute the provision of investment advice. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch Register Number in South Africa: 1998/003298/10). Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. This report may not be reproduced, distributed or published by any person for any purpose without Deutsche Bank's prior written consent. Please cite source when quoting.

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