Markets-in-2011_DB

Deutsche Bank Markets in 2011 —Foresight with Insight

The Markets in 2011Foresight with Insight

Deutsche Bank Corporate & Investment Bank


Even so, we do expect to see three themes continuing to drive our clients’ investment decisions:

The global economic recovery is set to continue, albeit at an uneven pace. Growth in the mature economies will be anaemic despite central banks fl ooding markets with liquidity.

Sovereign debt markets in peripheral Europe will remain under pressure, although we do not think a default in 2011 is likely.

The seismic move in the balance of power from West to East will continue, as demographic trends ensure that emerging markets continue to off er superior long-term growth potential.

Having long been active in emerging markets, we will continue to facilitate capital fl ows between developed and emerging markets for our clients, and to support the development of the local EM markets.

In this guide, we have attempted to provide some clarity on the outlook for the year ahead by bringing together insight and analysis from our most experienced market experts.

As you determine where to invest and how to mitigate risk in 2011, we aim to distinguish ourselves through the breadth and depth of our analysis and our willingness to take a view.

We hope you fi nd this guide valuable.

ForewordChallenges and opportunities in 2011

As the world economy slowly recovers from the most far-reaching dislocation in living memory, the outlook for markets in 2011 will continue to be uncertain.

Anshu JainHead of the Corporate & Investment Bank Member of the Management Board


Even so, we do expect to see three themes continuing to drive our clients’ investment decisions:

The global economic recovery is set to continue, albeit at an uneven pace. Growth in the mature economies will be anaemic despite central banks fl ooding markets with liquidity.

Sovereign debt markets in peripheral Europe will remain under pressure, although we do not think a default in 2011 is likely.

The seismic move in the balance of power from West to East will continue, as demographic trends ensure that emerging markets continue to off er superior long-term growth potential.

Having long been active in emerging markets, we will continue to facilitate capital fl ows between developed and emerging markets for our clients, and to support the development of the local EM markets.

In this guide, we have attempted to provide some clarity on the outlook for the year ahead by bringing together insight and analysis from our most experienced market experts.

As you determine where to invest and how to mitigate risk in 2011, we aim to distinguish ourselves through the breadth and depth of our analysis and our willingness to take a view.

We hope you fi nd this guide valuable.

ForewordChallenges and opportunities in 2011

As the world economy slowly recovers from the most far-reaching dislocation in living memory, the outlook for markets in 2011 will continue to be uncertain.

Anshu JainHead of the Corporate & Investment Bank Member of the Management Board

Deutsche Bank Markets in 2011 —Foresight with InsightMarkets in 2011 —Foresight with Insight Deutsche Bank

Leaders

1.1 Global Economic OutlookProspects and worries for 2011

1.2 Corporate Multinationals Strategies in 2011 1.3 Emerging Market Capital Flows Will the wave continue?1.4 Mergers & Acquisitions Outlook for the year ahead1.5 Chinese and Indian Multinationals

Companies to watch out for1.6 Risk Management

10 key risks to hedge in 20111.7 Capital Raising

How easy will it be to raise money?

1.8 CreditThe fi nal hoorah

Economics

2.1 The EMU CrisisWill Portugal and Spain follow Ireland?

2.2 ChinaJapanese ghosts, and the outlook for 2011

2.3 United StatesWhat’s diff erent this time?

2.4 GermanyOutlook for 2011

2.5 Emerging MarketsAnother good year but not for all

2.6 ASEAN and North Asia Still attached to the G3?

Markets

3.1 Regulatory ChangeWhat’s coming up

3.2 Asian EquitiesSigns of euphoria

3.3 European EquitiesPrice rises ahead

3.4 US EquitiesStrategic case is compelling

3.5 EM EquitiesWatch out for FX

3.6 Foreign ExchangeDon’t get complacent

3.7 CommoditiesOutlook for 2011

3.8 RatesRising in Q2

3.9 US Real EstateOutlook for 2011

3.10 Asset Backed Securities Investor demand returns3.11 Art

Four artists to watch in 2011

Trading

4.1 High Yield CreditTen high yield trades for 2011

4.2 Investment Grade Credit Trading ideas for the year4.3 Foreign Exchange

Ten FX trades for 20114.4 Commodities

Ten commodity trades for 20114.5 Rates

Ten rates trades for 20114.6 Asset Backed securities Ten ABS trades for 20114.7 Carry Trading

Is the FX carry trade dead?

Risk Management

5.1 Equity HedgingLook beyond the put

5.2 Credit Risk ManagementGetting easier

5.3 Rate HedgingKey risks for 2011

5.4 FX Risk ManagementGoing super-sized

5.5 Longevity RiskLive long and prosper

5.6 Infl ationNo need for panic but take precautions

5.7 Commodity Risk ManagementWhat risks are worth hedging?

Financing

6.1 Bond Market Outlook Uncertainties need resolving

6.2 IPO Market OutlookEncouraging trends

6.3 Trade Finance in Asia Pacifi cEmbracing the old

6.4 Bank RecapitalisationPossible responses

6.5 Bail-Ins: Pros and ConsA fast-track option

6.6 Infrastructure Privatisation rises up the agenda

Investing

7.1 Asset Allocation A model portfolio for 20117.2 Stock Picking Strategies

What value analysis tells us7.3 Exchange Traded Funds

On the march7.4 Hedge Funds: EU Directive

Impact of the new rules7.5 Managed Accounts

Good news for investors and hedge fund managers

7.6 Asset and Liability ManagementNew rules for European insurers

7.7 Portfolio TheoryBinary outcomes, bimodal returns

7.8 Green InvestingOpportunities ahead

Contents


Leaders

1.1 Global Economic OutlookProspects and worries for 2011

1.2 Corporate Multinationals Strategies in 2011 1.3 Emerging Market Capital Flows Will the wave continue?1.4 Mergers & Acquisitions Outlook for the year ahead1.5 Chinese and Indian Multinationals

Companies to watch out for1.6 Risk Management

10 key risks to hedge in 20111.7 Capital Raising

How easy will it be to raise money?

1.8 CreditThe fi nal hoorah

Economics

2.1 The EMU CrisisWill Portugal and Spain follow Ireland?

2.2 ChinaJapanese ghosts, and the outlook for 2011

2.3 United StatesWhat’s diff erent this time?

2.4 GermanyOutlook for 2011

2.5 Emerging MarketsAnother good year but not for all

2.6 ASEAN and North Asia Still attached to the G3?

Markets

3.1 Regulatory ChangeWhat’s coming up

3.2 Asian EquitiesSigns of euphoria

3.3 European EquitiesPrice rises ahead

3.4 US EquitiesStrategic case is compelling

3.5 EM EquitiesWatch out for FX

3.6 Foreign ExchangeDon’t get complacent

3.7 CommoditiesOutlook for 2011

3.8 RatesRising in Q2

3.9 US Real EstateOutlook for 2011

3.10 Asset Backed Securities Investor demand returns3.11 Art

Four artists to watch in 2011

Trading

4.1 High Yield CreditTen high yield trades for 2011

4.2 Investment Grade Credit Trading ideas for the year4.3 Foreign Exchange

Ten FX trades for 20114.4 Commodities

Ten commodity trades for 20114.5 Rates

Ten rates trades for 20114.6 Asset Backed securities Ten ABS trades for 20114.7 Carry Trading

Is the FX carry trade dead?

Risk Management

5.1 Equity HedgingLook beyond the put

5.2 Credit Risk ManagementGetting easier

5.3 Rate HedgingKey risks for 2011

5.4 FX Risk ManagementGoing super-sized

5.5 Longevity RiskLive long and prosper

5.6 Infl ationNo need for panic but take precautions

5.7 Commodity Risk ManagementWhat risks are worth hedging?

Financing

6.1 Bond Market Outlook Uncertainties need resolving

6.2 IPO Market OutlookEncouraging trends

6.3 Trade Finance in Asia Pacifi cEmbracing the old

6.4 Bank RecapitalisationPossible responses

6.5 Bail-Ins: Pros and ConsA fast-track option

6.6 Infrastructure Privatisation rises up the agenda

Investing

7.1 Asset Allocation A model portfolio for 20117.2 Stock Picking Strategies

What value analysis tells us7.3 Exchange Traded Funds

On the march7.4 Hedge Funds: EU Directive

Impact of the new rules7.5 Managed Accounts

Good news for investors and hedge fund managers

7.6 Asset and Liability ManagementNew rules for European insurers

7.7 Portfolio TheoryBinary outcomes, bimodal returns

7.8 Green InvestingOpportunities ahead

Contents


1 Leaders

Global EconomyCorporate Multinationals Emerging Market FlowsMergers & AcquisitionsAsia on the MarchRisk OutlookFinancingCredit


1 Leaders

Global EconomyCorporate Multinationals Emerging Market FlowsMergers & AcquisitionsAsia on the MarchRisk OutlookFinancingCredit


1.1 Leaders

Outlook for Global Economy 2011Prospects and worries for 2011

David Folkerts-Landau Global Head of Research

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DB Forecast

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DB Forecast

Figure 1: Widening gap between EM and G3

Source: IMF G3 EM

Figure 2: Global growthSource: IMF

The world economy is looking for a recovery in private demand to take over the baton from government spending, which is likely to be cut in many countries now facing record peace-time budget deficits and looking to repair public finances battered by the recession. Interest rates in the US, Europe and Japan are at record low levels and are likely to remain so throughout the year as central banks try to keep economies growing in the face of this fiscal retrenchment.

We see the world economy growing by a modest 3.9% in 2011, down from 4.7% this year. We think a double-dip is unlikely and, while we agree with the US Federal Reserve that deflation is a threat, we think this, too, will be avoided. But much of the world will see lacklustre growth by historic standards next year, and slower than 2010.

We expect the US economy to expand at a similar modest pace to 2010 in 2011. We’re anticipating growth of around 2.5% after the Fed, disappointed at the lack of strong growth in the US economy and stubbornly high unemployment, in early November 2010 launched a second round of quantitative easing, or QE2. We think this was necessary, particularly because further fiscal support is unlikely after the mid-term elections, and it should modestly boost growth and inflation next year. But the country’s weak housing market and continued debt reduction by households remain major downside risks to our forecast.

The Eurozone, hampered by the ongoing sovereign debt crisis, should only manage to expand by around 1%, down from 1.5% this year. Indeed, the bloc’s economy

has already begun to decelerate as the peripheral economies are cutting spending sharply and raising taxes to try to bring their huge budget deficits back under control. Growth for the area slowed sharply to 0.4% in the third quarter of 2010 from 1% in the previous three months.

We are likely to continue to see a two-speed Europe with core countries such as Germany continuing to perform strongly but many of the peripheral economies remaining in recession. The recent problems surrounding Ireland and, to a lesser extent, Portugal, highlight the vulnerability of the European economy should markets continue to test various governments’ resolve. In response to the recent volatility, the European Central Bank has postponed its exit from its emergency liquidity support for the continent’s banking system. We do not see it raising interest rates from the current 1% level before Q3 2011 at the earliest.

Japan, recently overtaken by China as the world’s second largest economy, we see barely expanding at all in 2011, after a reasonable showing of over 3% in 2010. The country remains mired in recession and deflation. China and India we expect to grow robustly at 8.7% and 8.1% respectively, but those rates are down slightly because neither will be able to entirely shrug off the slowdown in Western economies.

Indeed, in many Asian countries, inflation remains more of a concern than deflation. The situation has not been helped by inflows of capital from the developing world as investors seek higher returns in emerging markets (EM) than they are able to get in the US, for example, with its

very low bond yields. The inflows into emerging markets are tending to depress yields there at a time when many countries’ authorities are looking for higher interest rates, not lower. China has announced a series of policy tightening measures in the recent past designed to prevent inflation in some parts of its economy.

International discord is a major concern for next year. The unity shown by the G20 nations during the worst of the financial crisis in 2008 and 2009 has, unfortunately, dissipated. Many countries, in particular Germany and Brazil, have been critical of the Fed’s QE2, arguing that the US is intentionally trying to drive down its currency and thus risks igniting a global currency war. We think that these fears are totally misplaced as the principal aims of QE2 are to avoid the very real threat of deflation as well as to spur economic growth.

We also believe that China’s policy on the yuan: of real appreciation via domestic inflation, while gradually adjusting the band within which its currency can fluctuate, is the right one. This should result in gradual yuan appreciation and allow domestic demand to expand and help reduce the global imbalances that were partly to blame for the financial crisis. November’s G20 summit in Seoul made little progress on the fundamental issue of economic imbalances. As the year draws to a close, there is a real risk of further tension in 2011 if emerging economies continue to restrict capital inflows, the dollar continues to weaken or if US Congress backs protectionist measures against China and others it considers to be ‘currency manipulators’.

The coming year is likely to prove challenging for the world economy and policy makers alike. After a strong bounce from the worst recession in decades during 2009 and early 2010, thanks to unprecedented monetary and fiscal stimulus, 2011 is likely to be slower and more difficult for much of the world, especially developed economies such as the US, Japan and the Eurozone. Many emerging economies will continue to perform relatively strongly, however, as the shift in global economic power continues apace. But they will not be immune to slower growth in the developed world.


1.1 Leaders

Outlook for Global Economy 2011Prospects and worries for 2011

David Folkerts-Landau Global Head of Research

10

8

6

4

2

0

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-6

92

GDP growth % yoy

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

DB Forecast

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4

3

2

1

0

-1

% yoy

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

DB Forecast

Figure 1: Widening gap between EM and G3

Source: IMF G3 EM

Figure 2: Global growthSource: IMF

The world economy is looking for a recovery in private demand to take over the baton from government spending, which is likely to be cut in many countries now facing record peace-time budget deficits and looking to repair public finances battered by the recession. Interest rates in the US, Europe and Japan are at record low levels and are likely to remain so throughout the year as central banks try to keep economies growing in the face of this fiscal retrenchment.

We see the world economy growing by a modest 3.9% in 2011, down from 4.7% this year. We think a double-dip is unlikely and, while we agree with the US Federal Reserve that deflation is a threat, we think this, too, will be avoided. But much of the world will see lacklustre growth by historic standards next year, and slower than 2010.

We expect the US economy to expand at a similar modest pace to 2010 in 2011. We’re anticipating growth of around 2.5% after the Fed, disappointed at the lack of strong growth in the US economy and stubbornly high unemployment, in early November 2010 launched a second round of quantitative easing, or QE2. We think this was necessary, particularly because further fiscal support is unlikely after the mid-term elections, and it should modestly boost growth and inflation next year. But the country’s weak housing market and continued debt reduction by households remain major downside risks to our forecast.

The Eurozone, hampered by the ongoing sovereign debt crisis, should only manage to expand by around 1%, down from 1.5% this year. Indeed, the bloc’s economy

has already begun to decelerate as the peripheral economies are cutting spending sharply and raising taxes to try to bring their huge budget deficits back under control. Growth for the area slowed sharply to 0.4% in the third quarter of 2010 from 1% in the previous three months.

We are likely to continue to see a two-speed Europe with core countries such as Germany continuing to perform strongly but many of the peripheral economies remaining in recession. The recent problems surrounding Ireland and, to a lesser extent, Portugal, highlight the vulnerability of the European economy should markets continue to test various governments’ resolve. In response to the recent volatility, the European Central Bank has postponed its exit from its emergency liquidity support for the continent’s banking system. We do not see it raising interest rates from the current 1% level before Q3 2011 at the earliest.

Japan, recently overtaken by China as the world’s second largest economy, we see barely expanding at all in 2011, after a reasonable showing of over 3% in 2010. The country remains mired in recession and deflation. China and India we expect to grow robustly at 8.7% and 8.1% respectively, but those rates are down slightly because neither will be able to entirely shrug off the slowdown in Western economies.

Indeed, in many Asian countries, inflation remains more of a concern than deflation. The situation has not been helped by inflows of capital from the developing world as investors seek higher returns in emerging markets (EM) than they are able to get in the US, for example, with its

very low bond yields. The inflows into emerging markets are tending to depress yields there at a time when many countries’ authorities are looking for higher interest rates, not lower. China has announced a series of policy tightening measures in the recent past designed to prevent inflation in some parts of its economy.

International discord is a major concern for next year. The unity shown by the G20 nations during the worst of the financial crisis in 2008 and 2009 has, unfortunately, dissipated. Many countries, in particular Germany and Brazil, have been critical of the Fed’s QE2, arguing that the US is intentionally trying to drive down its currency and thus risks igniting a global currency war. We think that these fears are totally misplaced as the principal aims of QE2 are to avoid the very real threat of deflation as well as to spur economic growth.

We also believe that China’s policy on the yuan: of real appreciation via domestic inflation, while gradually adjusting the band within which its currency can fluctuate, is the right one. This should result in gradual yuan appreciation and allow domestic demand to expand and help reduce the global imbalances that were partly to blame for the financial crisis. November’s G20 summit in Seoul made little progress on the fundamental issue of economic imbalances. As the year draws to a close, there is a real risk of further tension in 2011 if emerging economies continue to restrict capital inflows, the dollar continues to weaken or if US Congress backs protectionist measures against China and others it considers to be ‘currency manipulators’.

The coming year is likely to prove challenging for the world economy and policy makers alike. After a strong bounce from the worst recession in decades during 2009 and early 2010, thanks to unprecedented monetary and fiscal stimulus, 2011 is likely to be slower and more difficult for much of the world, especially developed economies such as the US, Japan and the Eurozone. Many emerging economies will continue to perform relatively strongly, however, as the shift in global economic power continues apace. But they will not be immune to slower growth in the developed world.


1.2 Leaders

Corporate MultinationalsStrategies in 2011

Jacques Brand Co-Head of Investment Banking Coverage & Advisory

Edward Chandler Chariman, Global Corporate Finance

Stephan Leithner Co-Head of Investment Banking Coverage & Advisory

Yet corporate multinationals have navigated these unprecedented times with apparent equanimity, by and large delivering on their forecasted recovery in earnings. Some have capitalised on the crisis by completing mergers or acquisitions. Others have opted to wait out the storm, tightening their belts wherever possible, investing in research and development, strengthening their balance sheets and adapting their risk management procedures to the new environment. All, however, have been alive to the changing growth patterns in the global economy and to the opportunities – and challenges – this presents for their stakeholders.

As we look to 2011, the road ahead appears uncertain. The sovereign debt crisis is entering a new and potentially more dangerous phase which will test the limits of international coordination as the IMF, ECB, central banks, national governments and supranationals seek to tread the narrow line between political practicalities and capital markets reassurance.

The fiscal impasse in the United States is unresolved. While the flexibility and resilience of the US economy is undoubtedly without parallel, moves to resume sustained consumer led growth seem likely to impose stresses on the international financial system which many outside the US will find unpalatable.

The banking sector will continue to absorb resources. Even as we move towards industry stability, banks remain under-capitalised and exposed to risky assets. Balance sheets will need to be buttressed as institutions exit the period of state ownership and support. Adding to this uncertainty is the daunting amount of new regulation which is set to place additional restrictions on lending capacity.

Meanwhile, a new world order is continuing to develop as the fast growing economies in the eastern and southern hemispheres spawn major multinationals of their own, competing for human resources, technologies and markets head on with their western

counterparts and, above all, defending their own home markets.

All these factors will continue to have a profound impact on companies of all sizes and in virtually all sectors in 2011. The key issues that multinational boards will need to confront are:

How to weigh the near-term risks of emerging markets against their long-term rewards? It is clear that Asian consumption will drive global growth, and that companies which can continue to strengthen their market positions in China and India, in particular, will benefit in terms of the way they are valued by the investment community. But emerging market economic growth and capital inflows appear to be on an unsustainable trajectory. The risk of a bubble – coupled with socio-economic and environmental fragility – reminds us that growth cannot be taken for granted.

2010 has been an extraordinary year: record low interest rates, massive currency swings and rising stock markets juxtaposed with faltering western economies, banks failing stress tests, funds seized by regulators and, of course, several countries in actual or impending financial crisis prompting social unrest and associated shifts in political regimes.

How and when to deploy record amounts of low yielding cash? With corporate liquidity nearing levels last seen in 2007, we expect companies to come under increasing pressure to spend their cash or return it to shareholders. Emerging market M&A present risks: valuations are expensive and execution more complex. We therefore expect EM-oriented M&A to be balanced by an increasing number of European and US market transactions, as companies seek to enhance their product and service offerings better to tackle the opportunities in third markets. Small and medium sized companies will also embrace M&A as never before.

Will funding be available to support external growth? The answer to this question is a resounding ‘yes’. At least for the time being, shareholders would much rather trust corporate management teams to deploy cash resources than making those judgements themselves. And they will express this view via a tolerance for longer pay-back periods on acquisitions than the traditional two to three years, as well as a willingness to support M&A with fresh equity if circumstances require. As for the debt markets, the continued compression in corporate spreads in recent months points to high levels of liquidity and the availability of extraordinary funding opportunities – hybrids, long dated issues and low coupon convertibles to mention a few. The predominant theme, however, will continue to be ‘bonds rather than banks’.

How to manage currency and interest rate volatility and the headwinds of regionalised inflation? We expect higher currency and interest rate volatility to be a feature of markets for the foreseeable future, causing added volatility in corporate earnings and complicating capital investment decisions. In addition, ‘managed inflation’ will be one of the principal tools used by some of the more exposed economies to address the aftershock of the credit crisis, with consequences for commodity and food prices and, in turn, for the management of pension fund liabilities. Finally, additional capital constraints imposed on banks will force up the cost of traditional hedging techniques and favour the adoption of alternative approaches. All of these factors will force renewed attention on risk management and hedging policies around the board table.

Will shareholder structures change? We think so, gradually. For example, we detect a noticeable increase in focus by the major sovereign wealth funds on European and US companies (as opposed to financials), especially those that are the global leaders in their sectors, or have strong exposure to so-called ‘secular growth’ sectors such as natural resources, energy efficiency and certain sub-segments of the food and healthcare industries. Moreover, the lure of high valuations on IPOs in Asia and Brazil will encourage many companies to monetise parts of their business portfolios in those regions.


1.2 Leaders

Corporate MultinationalsStrategies in 2011

Jacques Brand Co-Head of Investment Banking Coverage & Advisory

Edward Chandler Chariman, Global Corporate Finance

Stephan Leithner Co-Head of Investment Banking Coverage & Advisory

Yet corporate multinationals have navigated these unprecedented times with apparent equanimity, by and large delivering on their forecasted recovery in earnings. Some have capitalised on the crisis by completing mergers or acquisitions. Others have opted to wait out the storm, tightening their belts wherever possible, investing in research and development, strengthening their balance sheets and adapting their risk management procedures to the new environment. All, however, have been alive to the changing growth patterns in the global economy and to the opportunities – and challenges – this presents for their stakeholders.

As we look to 2011, the road ahead appears uncertain. The sovereign debt crisis is entering a new and potentially more dangerous phase which will test the limits of international coordination as the IMF, ECB, central banks, national governments and supranationals seek to tread the narrow line between political practicalities and capital markets reassurance.

The fiscal impasse in the United States is unresolved. While the flexibility and resilience of the US economy is undoubtedly without parallel, moves to resume sustained consumer led growth seem likely to impose stresses on the international financial system which many outside the US will find unpalatable.

The banking sector will continue to absorb resources. Even as we move towards industry stability, banks remain under-capitalised and exposed to risky assets. Balance sheets will need to be buttressed as institutions exit the period of state ownership and support. Adding to this uncertainty is the daunting amount of new regulation which is set to place additional restrictions on lending capacity.

Meanwhile, a new world order is continuing to develop as the fast growing economies in the eastern and southern hemispheres spawn major multinationals of their own, competing for human resources, technologies and markets head on with their western

counterparts and, above all, defending their own home markets.

All these factors will continue to have a profound impact on companies of all sizes and in virtually all sectors in 2011. The key issues that multinational boards will need to confront are:

How to weigh the near-term risks of emerging markets against their long-term rewards? It is clear that Asian consumption will drive global growth, and that companies which can continue to strengthen their market positions in China and India, in particular, will benefit in terms of the way they are valued by the investment community. But emerging market economic growth and capital inflows appear to be on an unsustainable trajectory. The risk of a bubble – coupled with socio-economic and environmental fragility – reminds us that growth cannot be taken for granted.

2010 has been an extraordinary year: record low interest rates, massive currency swings and rising stock markets juxtaposed with faltering western economies, banks failing stress tests, funds seized by regulators and, of course, several countries in actual or impending financial crisis prompting social unrest and associated shifts in political regimes.

How and when to deploy record amounts of low yielding cash? With corporate liquidity nearing levels last seen in 2007, we expect companies to come under increasing pressure to spend their cash or return it to shareholders. Emerging market M&A present risks: valuations are expensive and execution more complex. We therefore expect EM-oriented M&A to be balanced by an increasing number of European and US market transactions, as companies seek to enhance their product and service offerings better to tackle the opportunities in third markets. Small and medium sized companies will also embrace M&A as never before.

Will funding be available to support external growth? The answer to this question is a resounding ‘yes’. At least for the time being, shareholders would much rather trust corporate management teams to deploy cash resources than making those judgements themselves. And they will express this view via a tolerance for longer pay-back periods on acquisitions than the traditional two to three years, as well as a willingness to support M&A with fresh equity if circumstances require. As for the debt markets, the continued compression in corporate spreads in recent months points to high levels of liquidity and the availability of extraordinary funding opportunities – hybrids, long dated issues and low coupon convertibles to mention a few. The predominant theme, however, will continue to be ‘bonds rather than banks’.

How to manage currency and interest rate volatility and the headwinds of regionalised inflation? We expect higher currency and interest rate volatility to be a feature of markets for the foreseeable future, causing added volatility in corporate earnings and complicating capital investment decisions. In addition, ‘managed inflation’ will be one of the principal tools used by some of the more exposed economies to address the aftershock of the credit crisis, with consequences for commodity and food prices and, in turn, for the management of pension fund liabilities. Finally, additional capital constraints imposed on banks will force up the cost of traditional hedging techniques and favour the adoption of alternative approaches. All of these factors will force renewed attention on risk management and hedging policies around the board table.

Will shareholder structures change? We think so, gradually. For example, we detect a noticeable increase in focus by the major sovereign wealth funds on European and US companies (as opposed to financials), especially those that are the global leaders in their sectors, or have strong exposure to so-called ‘secular growth’ sectors such as natural resources, energy efficiency and certain sub-segments of the food and healthcare industries. Moreover, the lure of high valuations on IPOs in Asia and Brazil will encourage many companies to monetise parts of their business portfolios in those regions.


Emerging Market Flows: Will the Wave Continue?Is a bubble coming? How will central banks stop one?

Marc BalstonHead of EM Quantitative Research

Robert BurgessEMEA Chief Economist, Research

1.3Leaders

While foreign direct investment (FDI) remained relatively stable through the crisis, bank lending and investments in bond and equity markets were much more volatile. These shorter-term fl ows recovered to an estimated $450 billion in 2010, still some way off their extraordinary pre-crisis peak of almost $800 billion but well up from their crisis-low of less than $100 billion in 2008 (fi gure 1).

Bank lending accounted for much of the run up in infl ows during the last wave of infl ows into EMs, but has been largely absent during the past year as major fi nancial institutions in advanced economies continue to rebuild their balance sheets. Instead, the current wave of infl ows is more concentrated on debt and equity markets. Infl ows into EM equity and debt funds have been running at record levels in the second half of

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Figure 1: Private (non-FDI) capital fl ows to emerging markets by year ($ billion) Source: IIF Portfolio and other Bank credit

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Figure 2: Cumulative infl ows to emerging markets mutual funds since thestart of 2008 ($ billion) EM Equity funds (lhs) EM Debt funds (rhs)

Source: EPFR

premium over developed markets, while also exhibiting a lower level of indebtedness compared to mature markets. International investors remain underweight exposure to EM, certainly in comparison to their share of global GDP (33%) and also relative to their share of world stock market capitalisation (also 33%) and their share of world government debt outstanding (16%). Anecdotal evidence indicates that many major developed market institutional investors hold less than 5% in EM equities and less than 2% in EM debt. And if these factors were not suffi cient, the current exceptionally easy monetary conditions in the US, Europe, and Japan are a further motivation to move capital from advanced to EMs.

We have, of course, been here many times before. Episodes of seemingly

sustainable infl ows into new markets that ended abruptly and painfully are well known, from the Latin American debt crisis of the 1980s through to the Asian crises of the late 1990s. Most recently, we saw credit booms in central and eastern Europe turn to bust as the foreign bank lending that fuelled them dried up.

Will it be diff erent this time?Much of the emerging world is a fundamentally less risky place for investors than it was 10–15 years ago. Public and private sector balance sheets are less leveraged than before and indeed much less leveraged than their mature market counterparts. Financial sectors are more developed and better able to intermediate fl ows. And, should things go wrong, the relatively high share of investments into equity and local currency debt

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bia

Figure 3:Private (non-FDI) capital fl ows to EM by country ($ billion) Source: IIF 2007 2010F

Private capital fl ows into emerging market (EM) economies have rebounded strongly over the past year. Continued strong infl ows will stretch the ability of EM economies to productively absorb them. In this environment, there is a risk that asset price bubbles will start to form.

2010, with over $50 billion of fl ows over the last quarter alone (fi gure 2).

The direction of investment has also shifted, away from EMEA and towards Asia and Latin America. Led by a sharp reduction in bank credit lines, shorter-term investments into Hungary, Romania, Russia, and Ukraine are expected to reach barely 20% of their peak 2007 levels in 2010 (fi gure 3). Flows into Brazil, Chile, China, Indonesia, and Thailand, however, look set to rebound above or close to their recent peaks.

Will capital continue to fl ow into emerging markets in 2011? The fl ows are motivated by a variety of factors, many of which are long term in nature and should continue to drive infl ows well into 2011. Fundamentals are supportive: EM economies are likely to enjoy a sustained growth

markets (as opposed to foreign currency lending) will make for less painful and disruptive burden sharing. Central banks also have much larger cushions of foreign exchange reserves on which to draw.

Nevertheless, there is inevitably a risk that the volume of infl ows will start to stretch the ability of emerging economies to productively absorb them. In this environment, the risk that infl ation accelerates and asset price bubbles form is substantial. Early warning signs are already appearing among countries that have received the largest capital infl ows. Infl ation has started to drift upwards in Brazil, Turkey, and parts of Asia. And policy makers in Hong Kong, China, and Israel, have taken steps to curb rapid growth in local property markets.


Emerging Market Flows: Will the Wave Continue?Is a bubble coming? How will central banks stop one?

Marc BalstonHead of EM Quantitative Research

Robert BurgessEMEA Chief Economist, Research

1.3Leaders

While foreign direct investment (FDI) remained relatively stable through the crisis, bank lending and investments in bond and equity markets were much more volatile. These shorter-term fl ows recovered to an estimated $450 billion in 2010, still some way off their extraordinary pre-crisis peak of almost $800 billion but well up from their crisis-low of less than $100 billion in 2008 (fi gure 1).

Bank lending accounted for much of the run up in infl ows during the last wave of infl ows into EMs, but has been largely absent during the past year as major fi nancial institutions in advanced economies continue to rebuild their balance sheets. Instead, the current wave of infl ows is more concentrated on debt and equity markets. Infl ows into EM equity and debt funds have been running at record levels in the second half of

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Figure 1: Private (non-FDI) capital fl ows to emerging markets by year ($ billion) Source: IIF Portfolio and other Bank credit

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Figure 2: Cumulative infl ows to emerging markets mutual funds since thestart of 2008 ($ billion) EM Equity funds (lhs) EM Debt funds (rhs)

Source: EPFR

premium over developed markets, while also exhibiting a lower level of indebtedness compared to mature markets. International investors remain underweight exposure to EM, certainly in comparison to their share of global GDP (33%) and also relative to their share of world stock market capitalisation (also 33%) and their share of world government debt outstanding (16%). Anecdotal evidence indicates that many major developed market institutional investors hold less than 5% in EM equities and less than 2% in EM debt. And if these factors were not suffi cient, the current exceptionally easy monetary conditions in the US, Europe, and Japan are a further motivation to move capital from advanced to EMs.

We have, of course, been here many times before. Episodes of seemingly

sustainable infl ows into new markets that ended abruptly and painfully are well known, from the Latin American debt crisis of the 1980s through to the Asian crises of the late 1990s. Most recently, we saw credit booms in central and eastern Europe turn to bust as the foreign bank lending that fuelled them dried up.

Will it be diff erent this time?Much of the emerging world is a fundamentally less risky place for investors than it was 10–15 years ago. Public and private sector balance sheets are less leveraged than before and indeed much less leveraged than their mature market counterparts. Financial sectors are more developed and better able to intermediate fl ows. And, should things go wrong, the relatively high share of investments into equity and local currency debt

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Asia EMEA Lat Am

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Figure 3:Private (non-FDI) capital fl ows to EM by country ($ billion) Source: IIF 2007 2010F

Private capital fl ows into emerging market (EM) economies have rebounded strongly over the past year. Continued strong infl ows will stretch the ability of EM economies to productively absorb them. In this environment, there is a risk that asset price bubbles will start to form.

2010, with over $50 billion of fl ows over the last quarter alone (fi gure 2).

The direction of investment has also shifted, away from EMEA and towards Asia and Latin America. Led by a sharp reduction in bank credit lines, shorter-term investments into Hungary, Romania, Russia, and Ukraine are expected to reach barely 20% of their peak 2007 levels in 2010 (fi gure 3). Flows into Brazil, Chile, China, Indonesia, and Thailand, however, look set to rebound above or close to their recent peaks.

Will capital continue to fl ow into emerging markets in 2011? The fl ows are motivated by a variety of factors, many of which are long term in nature and should continue to drive infl ows well into 2011. Fundamentals are supportive: EM economies are likely to enjoy a sustained growth

markets (as opposed to foreign currency lending) will make for less painful and disruptive burden sharing. Central banks also have much larger cushions of foreign exchange reserves on which to draw.

Nevertheless, there is inevitably a risk that the volume of infl ows will start to stretch the ability of emerging economies to productively absorb them. In this environment, the risk that infl ation accelerates and asset price bubbles form is substantial. Early warning signs are already appearing among countries that have received the largest capital infl ows. Infl ation has started to drift upwards in Brazil, Turkey, and parts of Asia. And policy makers in Hong Kong, China, and Israel, have taken steps to curb rapid growth in local property markets.


1.3Leaders

Figure 4: Different approaches to dealing with capital flowsSource: INFFour data points for each region shows: (i) Jan 06; (ii) crisis peak in REER and reserves; (iii) post crisis trough REER and reserves; and(iv) latest observation

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Figure 4: Diff erent approaches to dealing with capital fl ows Four data points for each region shows: Latin America(i) Jan 06; (ii) crisis peak in REER and reserves; EMEA(iii) post crisis trough REER and reserves; and Asia(iv) latest observation Asia (ex China)

Source: Deutsche Bank

What are the policy options for taming these extremes?Given this, a key question is how central banks in EMs will respond to continued fl ows. Their fi rst option is simply to allow currencies to appreciate. However, with past crises still fresh in their minds, EM policymakers are acutely aware that the loss of competitiveness associated with even transitory currency strength can take time to recoup.

A second option is to limit appreciation by intervening. However, the resulting accumulation of foreign reserves can exacerbate overheating in already fast-growing economies, causing credit growth, infl ation, and possible asset price bubbles. Sterilising the intervention can help to prevent money and credit growth. But by keeping interest diff erentials high, it also encourages even further infl ows.

Another option is to try to stem infl ows directly via capital controls or other forms of prudential limits. Their aim is to curb fl ows of so-called ‘hot money’ while prioritising the ‘stickier’ categories of overseas capital, such as foreign direct investment.

In practice, countries have adopted diff erent combinations of these approaches depending on their particular circumstances. Central banks in Latin America, emerging Europe, and Africa, for example, have typically been more comfortable with currency fl exibility whereas those in Asia have intervened more aggressively in the foreign exchange markets (fi gure 4). In Latin America, an increase in reserves equivalent to about 6% of GDP between January 2006 and August 2008 coincided with a 25% real exchange rate appreciation, whereas in Asia, much larger reserve accumulation of 20% of GDP helped to limit real exchange rate appreciation to 7%.

More recently, we have seen central banks step up their foreign exchange purchases in Colombia, Israel, Peru, South Africa, and Turkey. Others have implemented more direct controls on infl ows, though these vary widely in nature. Indonesia, for example, has introduced minimum holding periods for some forms of debt. Thailand has imposed a withholding tax on returns on bond holdings, a measure also being considered by South Korea. Meanwhile Brazil, concerned about

a big rise in the value of the real and large interest rate diff erentials which push up the costs of sterilised intervention, has twice raised its tax on foreign bond infl ows.

Where does this leave investors?The anticipated continued asset-allocation shift towards higher weights for EM in global portfolios is likely to underpin the performance of EM assets for the coming year. While ongoing measures to stem infl ows will likely reduce the attractiveness of some specifi c investments – notably domestic fi xed income in countries willing to impose controls, such as Brazil and Taiwan – they are unlikely to change the overall attractiveness of the asset class.

The extent of the infl ows does raise the risk of infl ation and asset bubbles within EM which argues for a bias towards real assets. The extent of the fl ows also presents a real risk in that if it were to reverse it could be destabilising. However, we fail to see any catalyst for such a reversal and are confi dent that this is a risk which is unlikely to materialise before 2012 at the earliest.


1.3Leaders

Figure 4: Different approaches to dealing with capital flowsSource: INFFour data points for each region shows: (i) Jan 06; (ii) crisis peak in REER and reserves; (iii) post crisis trough REER and reserves; and(iv) latest observation

135

130

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120

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Latin AmericaEMEAAsiaAsia (ex China)

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(iii)

Reserves (% 2006-08)

Figure 4: Diff erent approaches to dealing with capital fl ows Four data points for each region shows: Latin America(i) Jan 06; (ii) crisis peak in REER and reserves; EMEA(iii) post crisis trough REER and reserves; and Asia(iv) latest observation Asia (ex China)


What are the policy options for taming these extremes?Given this, a key question is how central banks in EMs will respond to continued fl ows. Their fi rst option is simply to allow currencies to appreciate. However, with past crises still fresh in their minds, EM policymakers are acutely aware that the loss of competitiveness associated with even transitory currency strength can take time to recoup.

A second option is to limit appreciation by intervening. However, the resulting accumulation of foreign reserves can exacerbate overheating in already fast-growing economies, causing credit growth, infl ation, and possible asset price bubbles. Sterilising the intervention can help to prevent money and credit growth. But by keeping interest diff erentials high, it also encourages even further infl ows.

Another option is to try to stem infl ows directly via capital controls or other forms of prudential limits. Their aim is to curb fl ows of so-called ‘hot money’ while prioritising the ‘stickier’ categories of overseas capital, such as foreign direct investment.

In practice, countries have adopted diff erent combinations of these approaches depending on their particular circumstances. Central banks in Latin America, emerging Europe, and Africa, for example, have typically been more comfortable with currency fl exibility whereas those in Asia have intervened more aggressively in the foreign exchange markets (fi gure 4). In Latin America, an increase in reserves equivalent to about 6% of GDP between January 2006 and August 2008 coincided with a 25% real exchange rate appreciation, whereas in Asia, much larger reserve accumulation of 20% of GDP helped to limit real exchange rate appreciation to 7%.

More recently, we have seen central banks step up their foreign exchange purchases in Colombia, Israel, Peru, South Africa, and Turkey. Others have implemented more direct controls on infl ows, though these vary widely in nature. Indonesia, for example, has introduced minimum holding periods for some forms of debt. Thailand has imposed a withholding tax on returns on bond holdings, a measure also being considered by South Korea. Meanwhile Brazil, concerned about

a big rise in the value of the real and large interest rate diff erentials which push up the costs of sterilised intervention, has twice raised its tax on foreign bond infl ows.

Where does this leave investors?The anticipated continued asset-allocation shift towards higher weights for EM in global portfolios is likely to underpin the performance of EM assets for the coming year. While ongoing measures to stem infl ows will likely reduce the attractiveness of some specifi c investments – notably domestic fi xed income in countries willing to impose controls, such as Brazil and Taiwan – they are unlikely to change the overall attractiveness of the asset class.

The extent of the infl ows does raise the risk of infl ation and asset bubbles within EM which argues for a bias towards real assets. The extent of the fl ows also presents a real risk in that if it were to reverse it could be destabilising. However, we fail to see any catalyst for such a reversal and are confi dent that this is a risk which is unlikely to materialise before 2012 at the earliest.


1.4 Leaders

Outlook for Mergers & Acquisitions in 2011Cheap debt and strong cash levels will turn corporates to M&A

Henrik Aslaksen Global Head of Mergers and Acquisitions

With access to cheap debt and high levels of corporate cash levels1, boardrooms are faced with a choice: return capital to shareholders or fund growth.

For corporates struggling with anaemic growth in their home markets, the choice will be easier to make. Expect deal making to continue steadily increasing in 2011 as a result.

Pools of capital Previous upswings in deal activity focused on particular sectors or deal structures – the technology boom in the late 1990s/2000 and leverage in 2007 – but the upturn in this deal cycle is spread quite broadly across various sectors and transaction types.

At the turn of this past year, some predicted certain sectors such as financial institutions and oil and gas as the hotbeds for M&A activity. In retrospect, the market hardly followed this trend. The top 20 deals of the year span almost every sector and included corporate reorganisations, strategic deals, asset disposals and emerging market activity2.

As we look to 2011, what remains as the most telling indicator during the upturn is where the pools of capital are. The most robust capital markets are found in highly developed countries– like the United States and western Europe. These markets also play host to some of the world’s largest companies with the strongest appetites for growth. Since capital is mobile, it is fair to assume the deal flow will follow the money.

We recently developed an ‘affordability index’, which tracks the gap between the implied P/E multiple of single A rated debt and the P/E multiples of broad market indices such as the S&P 500 and Euro Stoxx 50. The greater the index value, the more ‘affordable’ it is for a company that can raise single A rated debt to fund the acquisition of a target trading at levels comparable to that of the broader market.

To illustrate, the composite yield on 10-year single A rated corporate debt in the US is currently approximately 4%. For an acquirer whose marginal tax rate is 40%, the implied P/E of new debt is therefore 41.7x (the inverse of

the after tax cost of debt). The latest 12-month P/E of the S&P 500 is about 14.7x, which gives the index a value of 27, about the highest it has ever been. By comparison, during the peak of the up cycle in 2007, the index stood at circa 13.

Underpinning this is an arbitrage opportunity: low interest rates have significantly reduced the costs of funding a transaction using debt providing an alternative source for corporates to fund growth.

Disciplined approach to deal making In the early stage of this recovery, companies kept an inward focus by streamlining assets and pruning portfolios. As M&A activity continued, we saw the market for leveraged buyouts trickle back, especially in the US.

With greater stabilisation in the capital markets and corporate cash piles increasing, the boardroom mood appears to have shifted from reactive to proactive.

Since funding growth is cheap, boards have a strong argument to pursue

deals as long as they are disciplined on price. This strategy is likely to drive medium-sized transactions in the range of $1–5 billon, large enough to provide meaningful synergies and/or growth in emerging markets.

When BHP’s $43 billion offer for Potash Corporation was rebuffed by regulators, we were reminded that stakeholders will play a role in deal-making that is equal to or greater than that of shareholders.

This stakeholder influence is a factor that will continue to be a characteristic of deal activity.

BRICs Every corner of the market has focused on how to invest in the BRIC countries of Brazil, Russia, India and China.

Though these markets present long-term growth potential, we believe challenges remain for deal activity in

these countries in the near-term. Lack of developed capital markets outside China and little knowledge of how to navigate new regulatory schemes, like Brazil’s, will continue to make deal making challenging, though not impossible.

Until these channels are better developed, the BRIC deals that crop up will be sporadic. For this reason, the ‘bread and butter’ deals should continue to originate from the developed economies, where gross domestic products are growing at stable rates and capital is readily available.

Towards stable growth Economic growth is undeniable in emerging markets. Real GDP forecast for 2011, for example, is estimated to be 7.4% for Asia (excluding Japan), and 4.5% for both Brazil and Russia3. Real GDP for G7 economies is projected to grow 2.2% in 2011.

1. Cash/market capitalisation ratios for S&P of 11.6% as of Q3 2010, and 12.2% for Euro Stoxx 2010E; Source: Compustat and Deutsche Bank estimates

2. Source: Thomson Reuters3. Source: Deutsche Bank Economic Research

Underneath the overhang of fiscal deficits, currency swings and sluggish macroeconomic growth, the ground appears fertile for merger and acquisition (M&A) activity.

Deal volume in the near-term will likely follow a similar pattern of growth relative to their respective regions, however the majority of activity will continue to come from developed economies. Regardless of where the deals are, the upswing looks set to continue.


1.4 Leaders

Outlook for Mergers & Acquisitions in 2011Cheap debt and strong cash levels will turn corporates to M&A

Henrik Aslaksen Global Head of Mergers and Acquisitions

With access to cheap debt and high levels of corporate cash levels1, boardrooms are faced with a choice: return capital to shareholders or fund growth.

For corporates struggling with anaemic growth in their home markets, the choice will be easier to make. Expect deal making to continue steadily increasing in 2011 as a result.

Pools of capital Previous upswings in deal activity focused on particular sectors or deal structures – the technology boom in the late 1990s/2000 and leverage in 2007 – but the upturn in this deal cycle is spread quite broadly across various sectors and transaction types.

At the turn of this past year, some predicted certain sectors such as financial institutions and oil and gas as the hotbeds for M&A activity. In retrospect, the market hardly followed this trend. The top 20 deals of the year span almost every sector and included corporate reorganisations, strategic deals, asset disposals and emerging market activity2.

As we look to 2011, what remains as the most telling indicator during the upturn is where the pools of capital are. The most robust capital markets are found in highly developed countries– like the United States and western Europe. These markets also play host to some of the world’s largest companies with the strongest appetites for growth. Since capital is mobile, it is fair to assume the deal flow will follow the money.

We recently developed an ‘affordability index’, which tracks the gap between the implied P/E multiple of single A rated debt and the P/E multiples of broad market indices such as the S&P 500 and Euro Stoxx 50. The greater the index value, the more ‘affordable’ it is for a company that can raise single A rated debt to fund the acquisition of a target trading at levels comparable to that of the broader market.

To illustrate, the composite yield on 10-year single A rated corporate debt in the US is currently approximately 4%. For an acquirer whose marginal tax rate is 40%, the implied P/E of new debt is therefore 41.7x (the inverse of

the after tax cost of debt). The latest 12-month P/E of the S&P 500 is about 14.7x, which gives the index a value of 27, about the highest it has ever been. By comparison, during the peak of the up cycle in 2007, the index stood at circa 13.

Underpinning this is an arbitrage opportunity: low interest rates have significantly reduced the costs of funding a transaction using debt providing an alternative source for corporates to fund growth.

Disciplined approach to deal making In the early stage of this recovery, companies kept an inward focus by streamlining assets and pruning portfolios. As M&A activity continued, we saw the market for leveraged buyouts trickle back, especially in the US.

With greater stabilisation in the capital markets and corporate cash piles increasing, the boardroom mood appears to have shifted from reactive to proactive.

Since funding growth is cheap, boards have a strong argument to pursue

deals as long as they are disciplined on price. This strategy is likely to drive medium-sized transactions in the range of $1–5 billon, large enough to provide meaningful synergies and/or growth in emerging markets.

When BHP’s $43 billion offer for Potash Corporation was rebuffed by regulators, we were reminded that stakeholders will play a role in deal-making that is equal to or greater than that of shareholders.

This stakeholder influence is a factor that will continue to be a characteristic of deal activity.

BRICs Every corner of the market has focused on how to invest in the BRIC countries of Brazil, Russia, India and China.

Though these markets present long-term growth potential, we believe challenges remain for deal activity in

these countries in the near-term. Lack of developed capital markets outside China and little knowledge of how to navigate new regulatory schemes, like Brazil’s, will continue to make deal making challenging, though not impossible.

Until these channels are better developed, the BRIC deals that crop up will be sporadic. For this reason, the ‘bread and butter’ deals should continue to originate from the developed economies, where gross domestic products are growing at stable rates and capital is readily available.

Towards stable growth Economic growth is undeniable in emerging markets. Real GDP forecast for 2011, for example, is estimated to be 7.4% for Asia (excluding Japan), and 4.5% for both Brazil and Russia3. Real GDP for G7 economies is projected to grow 2.2% in 2011.

1. Cash/market capitalisation ratios for S&P of 11.6% as of Q3 2010, and 12.2% for Euro Stoxx 2010E; Source: Compustat and Deutsche Bank estimates

2. Source: Thomson Reuters3. Source: Deutsche Bank Economic Research

Underneath the overhang of fiscal deficits, currency swings and sluggish macroeconomic growth, the ground appears fertile for merger and acquisition (M&A) activity.

Deal volume in the near-term will likely follow a similar pattern of growth relative to their respective regions, however the majority of activity will continue to come from developed economies. Regardless of where the deals are, the upswing looks set to continue.


1.5 Leaders

Colin Fan Head of Global Credit Trading and Emerging Markets

The Rise and Rise of Chinese and Indian MultinationalsWhat companies to watch out for

At multinationals across the region, that’s exactly what is starting to happen. Chinese and Indian companies, having built vast customer bases and balance sheets at home, are increasingly seeking to acquire and expand overseas. Everything is in their favour. They have cash at a time when potential targets elsewhere in the world are cheap, they are buoyed by fast expanding domestic economies and they now have the confidence to grow.

There were more than 100 merger and acquisition transactions with Chinese acquirers each year from 2007 to 2009, compared to less than 30 in each of the first four years of the decade1. Meanwhile, the value of foreign acquisitions by Chinese companies increased more than 30 times between 2003 and 2008. Chinese companies have also begun to make jumbo cross-border

purchases, like China Petrochemical Corp’s $8.83 billion purchase of Addax Petrolum in 2009. Indian companies have also been active: Bharti Airtel’s $9 billion purchase of Zain’s telecommunication assets in Africa this year showing the scale of this new found ambition.

Many Indian companies deleveraged during the expansion in the Indian equity markets and now have ready access to debt finance. Chinese companies, meanwhile, are in many cases even more cash-rich and enjoy almost unfettered access to capital from banks as well as debt and equity markets on and offshore.

Chinese and Indian businesses have various reasons for buying offshore, chiefly market access, technology and resources they lack at home. The big difference between China’s

usually state-owned. There are well known examples of this, such as CNOOC’s failed bid for Unocal, and it is unlikely to get any easier.

Private sector Chinese companies face less interference. Look at Ping An Insurance’s acquisition of assets from Fortis or Huawei Technologies’ purchase of parts of IBM.

But no matter how genuinely commercial a company’s aspirations, the spectre of state ownership causes problems in other countries (although not, notably, in Africa, where many of the energy acquisitions have taken place). In Europe and the Americas, however, Chinese companies should continue to expect interference with their bids.

In India, where buyers are more frequently pure private sector rather than state-owned, politics is less of a problem. Names like Tata, whose most recent acquisitions include Jaguar Land Rover and Corus, or Reliance Industries, which has been buying shale assets in North America, are considered credible partners who bring expertise to the table without the agenda of a state mandate.

FX is an issue in both countries. It’s less of a problem in India, where the rupee is relatively liberalised, but the FX regime still creates challenges such as the ability of Indian companies to provide corporate guarantees. It’s much more of an issue in China, but here the gradual internationalisation of the RMB is going

to be enormously important. A series of liberalisations over the last year have set up Hong Kong as a proving ground for RMB liberalisation in a host of areas from trade finance to investment products, foreign exchange and local currency bonds. All of these will, in time, help to open up the onshore market to foreign players, and in turn give domestic champions more flexibility to use their profits should they choose to go overseas.

Outlook for 2011 Expect to see further expansion by Asian multinationals in 2011. Companies in India will focus on natural resources. Coal India, which recently completed the largest IPO in Indian history, has $8.4 billion on its balance sheet and is looking for acquisitions in Indonesia, South Africa, Australia and the US. Oil and gas assets are also likely to be in demand among Indian companies, although areas of previous activity – telecoms, financial services, pharmaceuticals, automotive – may be quieter.

For Chinese companies, resources will also be a key target, but China is also keen to secure infrastructure assets in order to participate in the real economy of foreign countries. Despite potential political opposition to such bids, China is unlikely to privatise state-owned companies to facilitate foreign acquisitions. Instead, it will wait to see if the European crisis develops to make Chinese capital more attractive.

We may see greater activity from Chinese banks, who despite accounting for 26% of all Chinese M&A over the last 10 years2, have so far only taken tentative steps towards international expansion, such as ICBC’s purchase of 20% of South Africa’s Standard Bank. The most active acquirers will be firms that import and export rather than firms in sectors such as property and retailing where domestic growth should be sufficient for years to come.

There are a host of companies to watch: Chalco, which may buy bauxite mines for alumina refining; Jiangxi Copper, seeking foreign mines; China Mobile, which is targeting developing market telecommunications operators; port operators China Merchants and Cosco Pacific, again targeting emerging markets; internet-related groups like Tencent and Alibaba, rail equipment companies such as CSR, coal companies seeking coking coal exposure and buyers from other sectors including healthcare, steel and utilities.

Whatever happens, prepare for expansion both next year and for a long while to come.

It tells you a lot about the strength of China’s domestic economy that Industrial and Commercial Bank of China (ICBC) is the world’s largest bank by market capitalisation despite barely having started to venture offshore. It’s not alone: all of China’s top lenders, despite having done little more than build a few branches overseas, rank among the world leaders by market value. When companies that are so powerful at home decide it is time to expand overseas in earnest, there are almost no limits to how big they could become.

current acquisition boom and Japan’s in the 1980s is that Chinese companies are state-owned and make acquisitions for geopolitical reasons as well as for profit.

There are, though, challenges for Indian companies in going overseas. International capital flows into India can slow very quickly if market sentiment turns, and domestic liquidity, though plentiful, comes with a caveat: debt raised onshore can’t be used for acquisitions, just for working capital.

Availability of domestic capital is not a problem in China. League tables of top equity and debt bookrunners in Asia are packed with home grown Chinese names, but Chinese companies seeking to acquire overseas attract a great deal of suspicion from their targets’ governments and electorates, because the bidding companies are

1 & 2. Source: Thomson Reuters


1.5 Leaders

Colin Fan Head of Global Credit Trading and Emerging Markets

The Rise and Rise of Chinese and Indian MultinationalsWhat companies to watch out for

At multinationals across the region, that’s exactly what is starting to happen. Chinese and Indian companies, having built vast customer bases and balance sheets at home, are increasingly seeking to acquire and expand overseas. Everything is in their favour. They have cash at a time when potential targets elsewhere in the world are cheap, they are buoyed by fast expanding domestic economies and they now have the confidence to grow.

There were more than 100 merger and acquisition transactions with Chinese acquirers each year from 2007 to 2009, compared to less than 30 in each of the first four years of the decade1. Meanwhile, the value of foreign acquisitions by Chinese companies increased more than 30 times between 2003 and 2008. Chinese companies have also begun to make jumbo cross-border

purchases, like China Petrochemical Corp’s $8.83 billion purchase of Addax Petrolum in 2009. Indian companies have also been active: Bharti Airtel’s $9 billion purchase of Zain’s telecommunication assets in Africa this year showing the scale of this new found ambition.

Many Indian companies deleveraged during the expansion in the Indian equity markets and now have ready access to debt finance. Chinese companies, meanwhile, are in many cases even more cash-rich and enjoy almost unfettered access to capital from banks as well as debt and equity markets on and offshore.

Chinese and Indian businesses have various reasons for buying offshore, chiefly market access, technology and resources they lack at home. The big difference between China’s

usually state-owned. There are well known examples of this, such as CNOOC’s failed bid for Unocal, and it is unlikely to get any easier.

Private sector Chinese companies face less interference. Look at Ping An Insurance’s acquisition of assets from Fortis or Huawei Technologies’ purchase of parts of IBM.

But no matter how genuinely commercial a company’s aspirations, the spectre of state ownership causes problems in other countries (although not, notably, in Africa, where many of the energy acquisitions have taken place). In Europe and the Americas, however, Chinese companies should continue to expect interference with their bids.

In India, where buyers are more frequently pure private sector rather than state-owned, politics is less of a problem. Names like Tata, whose most recent acquisitions include Jaguar Land Rover and Corus, or Reliance Industries, which has been buying shale assets in North America, are considered credible partners who bring expertise to the table without the agenda of a state mandate.

FX is an issue in both countries. It’s less of a problem in India, where the rupee is relatively liberalised, but the FX regime still creates challenges such as the ability of Indian companies to provide corporate guarantees. It’s much more of an issue in China, but here the gradual internationalisation of the RMB is going

to be enormously important. A series of liberalisations over the last year have set up Hong Kong as a proving ground for RMB liberalisation in a host of areas from trade finance to investment products, foreign exchange and local currency bonds. All of these will, in time, help to open up the onshore market to foreign players, and in turn give domestic champions more flexibility to use their profits should they choose to go overseas.

Outlook for 2011 Expect to see further expansion by Asian multinationals in 2011. Companies in India will focus on natural resources. Coal India, which recently completed the largest IPO in Indian history, has $8.4 billion on its balance sheet and is looking for acquisitions in Indonesia, South Africa, Australia and the US. Oil and gas assets are also likely to be in demand among Indian companies, although areas of previous activity – telecoms, financial services, pharmaceuticals, automotive – may be quieter.

For Chinese companies, resources will also be a key target, but China is also keen to secure infrastructure assets in order to participate in the real economy of foreign countries. Despite potential political opposition to such bids, China is unlikely to privatise state-owned companies to facilitate foreign acquisitions. Instead, it will wait to see if the European crisis develops to make Chinese capital more attractive.

We may see greater activity from Chinese banks, who despite accounting for 26% of all Chinese M&A over the last 10 years2, have so far only taken tentative steps towards international expansion, such as ICBC’s purchase of 20% of South Africa’s Standard Bank. The most active acquirers will be firms that import and export rather than firms in sectors such as property and retailing where domestic growth should be sufficient for years to come.

There are a host of companies to watch: Chalco, which may buy bauxite mines for alumina refining; Jiangxi Copper, seeking foreign mines; China Mobile, which is targeting developing market telecommunications operators; port operators China Merchants and Cosco Pacific, again targeting emerging markets; internet-related groups like Tencent and Alibaba, rail equipment companies such as CSR, coal companies seeking coking coal exposure and buyers from other sectors including healthcare, steel and utilities.

Whatever happens, prepare for expansion both next year and for a long while to come.

It tells you a lot about the strength of China’s domestic economy that Industrial and Commercial Bank of China (ICBC) is the world’s largest bank by market capitalisation despite barely having started to venture offshore. It’s not alone: all of China’s top lenders, despite having done little more than build a few branches overseas, rank among the world leaders by market value. When companies that are so powerful at home decide it is time to expand overseas in earnest, there are almost no limits to how big they could become.

current acquisition boom and Japan’s in the 1980s is that Chinese companies are state-owned and make acquisitions for geopolitical reasons as well as for profit.

There are, though, challenges for Indian companies in going overseas. International capital flows into India can slow very quickly if market sentiment turns, and domestic liquidity, though plentiful, comes with a caveat: debt raised onshore can’t be used for acquisitions, just for working capital.

Availability of domestic capital is not a problem in China. League tables of top equity and debt bookrunners in Asia are packed with home grown Chinese names, but Chinese companies seeking to acquire overseas attract a great deal of suspicion from their targets’ governments and electorates, because the bidding companies are

1 & 2. Source: Thomson Reuters


1.6 Leaders

Ram Nayak Global Head of Structuring

10 Key Risks of 2011 What to hedge against and how

The good news is that nearly all these risks can be hedged thanks to the growth and development of the global derivatives market over the past decade.

The bad news is that it is likely to be expensive – using plain vanilla options at least – because of huge uncertainty among dealers about where the markets are heading.

Some companies will take the view that the cost of hedging outweighs the benefit. We believe this would be unwise given the scale of the potential downside.

Others will prefer not to take any risk at all until the outlook becomes clearer. This, too, is a strategy we would not recommend given the seismic changes underway in the global economy.

1. Eurozone Sovereign Default I do not believe that a major Eurozone sovereign will default in 2011 but if one does, the results would be so catastrophic that it does seem a risk worth hedging. Buying CDS protection on a euro sovereign index may cost you 400 basis points or more. Alternatives are to go short the euro or wideners on the EUR/$ cross currency basis.

2. Capital Markets Freeze Twice in 2010, we saw the bond markets close down to most forms of new debt issuance. The issue – Eurozone sovereign risk – is still live. Solutions include front loading your issuance calendar, private placements and loans secured by equity stakes. In the event of an equity capital markets shutdown, OTC structured alternatives are available. Another related risk is the emergence of a backlog in IPOs. Remedies for this include pre-IPO macro hedging and pre-IPO convertibles.

3. EM Equity Bubble If Asian central banks fail to control inflation or take too aggressive action against it (thereby provoking a slowdown), we may start to see the flow of funds from the US and Europe into Asia slow significantly and perhaps start to flow the other way. We would look to go short Asian currencies. Investors can protect themselves against both using equity put options (expensive) or put options linked to volatility (cheaper).

4. Commodity Price Rises Commodity prices are expected by Deutsche Bank Research to rise significantly during the first half of 2011 as supply remains constrained and investors and consumers demand for commodity price participation increases. Risk management strategies include extendible forwards, options and hybrids.

5. Rate Hikes Deutsche Bank Research expects rates to start rising in the US in Q2 and for the European Central Bank to begin tightening earlier than expected. For investors, front end payers would be a good solution for both.

6. US Dollar Weakness Deutsche Bank FX Research’s view is that the US dollar may surprise on the upside this year. But for companies with extensive US assets, the risk may be too great to leave unhedged. Going short the dollar via a forward is the obvious choice but comes with a stiff opportunity cost price tag. Purchased options could offer better value.

7. Inflation Not an immediate risk for US and European investors but one with the potential to cause havoc in the medium-term given rising inflation in Asia and the long-term effects of QE. We recommend getting in early while hedging levels remain attractive via collars, swaps, inflation linked bonds and swaps.

8. Longevity An absolute must for insurance companies and pension funds with policy holders living longer than ever. The old approach was to buy long-dated bonds but longevity swaps offer greater precision and are much more liquid than they used to be.

9. Regulatory Change We may not know the details yet but it looks certain that within the next 18 months, many users of derivatives will have to clear their trades via a central exchange rather than on an OTC basis. We strongly advise all companies to get their back offices up to speed ahead of time and do a full evaluation on how the changes will impact profitability and infrastructure.

10. Borrowing Cost Rises With banks cutting back for Basel 3 and bond investors focusing on emerging markets or safe havens, a rise in funding costs cannot be ruled out for many firms. Asset backed finance and loans linked to proprietary trading indices can bring costs down to manageable proportions.

The range of risks faced by borrowers and investors in 2011 is perhaps greater than at any time since World War 2: an economic slowdown, sovereign defaults, inflation, rate hikes it is a formidable list.

Against this difficult background, the best approach will be to identify and prioritise the risks that really matter, and then to examine the different options available. A top-down view on risk will also be helpful not only to reduce correlation risk but to find ways to bring hedging costs down by linking risks together.

With this in mind, here are the ten risks that I believe cannot be ignored this year (not in order of severity or probability) and some suggestions on which to hedge and how.


1.6 Leaders

Ram Nayak Global Head of Structuring

10 Key Risks of 2011 What to hedge against and how

The good news is that nearly all these risks can be hedged thanks to the growth and development of the global derivatives market over the past decade.

The bad news is that it is likely to be expensive – using plain vanilla options at least – because of huge uncertainty among dealers about where the markets are heading.

Some companies will take the view that the cost of hedging outweighs the benefit. We believe this would be unwise given the scale of the potential downside.

Others will prefer not to take any risk at all until the outlook becomes clearer. This, too, is a strategy we would not recommend given the seismic changes underway in the global economy.

1. Eurozone Sovereign Default I do not believe that a major Eurozone sovereign will default in 2011 but if one does, the results would be so catastrophic that it does seem a risk worth hedging. Buying CDS protection on a euro sovereign index may cost you 400 basis points or more. Alternatives are to go short the euro or wideners on the EUR/$ cross currency basis.

2. Capital Markets Freeze Twice in 2010, we saw the bond markets close down to most forms of new debt issuance. The issue – Eurozone sovereign risk – is still live. Solutions include front loading your issuance calendar, private placements and loans secured by equity stakes. In the event of an equity capital markets shutdown, OTC structured alternatives are available. Another related risk is the emergence of a backlog in IPOs. Remedies for this include pre-IPO macro hedging and pre-IPO convertibles.

3. EM Equity Bubble If Asian central banks fail to control inflation or take too aggressive action against it (thereby provoking a slowdown), we may start to see the flow of funds from the US and Europe into Asia slow significantly and perhaps start to flow the other way. We would look to go short Asian currencies. Investors can protect themselves against both using equity put options (expensive) or put options linked to volatility (cheaper).

4. Commodity Price Rises Commodity prices are expected by Deutsche Bank Research to rise significantly during the first half of 2011 as supply remains constrained and investors and consumers demand for commodity price participation increases. Risk management strategies include extendible forwards, options and hybrids.

5. Rate Hikes Deutsche Bank Research expects rates to start rising in the US in Q2 and for the European Central Bank to begin tightening earlier than expected. For investors, front end payers would be a good solution for both.

6. US Dollar Weakness Deutsche Bank FX Research’s view is that the US dollar may surprise on the upside this year. But for companies with extensive US assets, the risk may be too great to leave unhedged. Going short the dollar via a forward is the obvious choice but comes with a stiff opportunity cost price tag. Purchased options could offer better value.

7. Inflation Not an immediate risk for US and European investors but one with the potential to cause havoc in the medium-term given rising inflation in Asia and the long-term effects of QE. We recommend getting in early while hedging levels remain attractive via collars, swaps, inflation linked bonds and swaps.

8. Longevity An absolute must for insurance companies and pension funds with policy holders living longer than ever. The old approach was to buy long-dated bonds but longevity swaps offer greater precision and are much more liquid than they used to be.

9. Regulatory Change We may not know the details yet but it looks certain that within the next 18 months, many users of derivatives will have to clear their trades via a central exchange rather than on an OTC basis. We strongly advise all companies to get their back offices up to speed ahead of time and do a full evaluation on how the changes will impact profitability and infrastructure.

10. Borrowing Cost Rises With banks cutting back for Basel 3 and bond investors focusing on emerging markets or safe havens, a rise in funding costs cannot be ruled out for many firms. Asset backed finance and loans linked to proprietary trading indices can bring costs down to manageable proportions.

The range of risks faced by borrowers and investors in 2011 is perhaps greater than at any time since World War 2: an economic slowdown, sovereign defaults, inflation, rate hikes it is a formidable list.

Against this difficult background, the best approach will be to identify and prioritise the risks that really matter, and then to examine the different options available. A top-down view on risk will also be helpful not only to reduce correlation risk but to find ways to bring hedging costs down by linking risks together.

With this in mind, here are the ten risks that I believe cannot be ignored this year (not in order of severity or probability) and some suggestions on which to hedge and how.


1.7 Leaders

Ivor Dunbar Global Head of Capital Markets

Financing OutlookHow easy will it be to raise money in 2011?

The outlook is highly attractive for companies looking to lock in low rates for their bonds. There is a wall of cash looking for exciting equity stories, and the market has shown it will be supportive of well-considered, strategic mergers & acquisitions.

For companies seeking to tap bond markets, borrowing rates are at an all-time low and should remain so as cash-rich credit investors hunt for yield.

2010 saw a glut of sovereign issuance, but 2011 should provide an opportunity for corporate borrowers, particularly those that tapped the markets in 2009 when rates were high, to take advantage of the low-rate environment, and push back the wall of debt maturing in 2012 to lock in new funding at attractive rates.

It is not just big names that are attracting investor attention. Record low interest rates of close to zero are forcing investors to hunt lower down the ratings chain for yield, providing

opportunities for infrequent or debut borrowers.

We saw large numbers of debut issues in Europe in 2010 and this trend will continue as European companies learn to master the post-crisis environment by reducing their reliance on bank lending as a preferred method of financing. With banks continuing to deleverage in the wake of tough new capital requirements such as Basel 3, this theme of disintermediation should continue, with more companies going straight to the capital markets for their financing needs.

At the same time, the crisis and the ensuing regulatory climate has sparked innovation in financing, with banks seeking to issue contingent capital – an instrument that is at once a relatively cheap form of financing and also a capital buffer. However, before they become a mainstream funding method for banks in 2011, there remains a question mark over the regulatory status of tier one capital.

Equity investors are proving they are ready to support initial public offerings. In 2010, there was a scramble for growth stories such as the $20.5 billion flotation of AIA, the Asian operation of AIG, which was the third biggest IPO in history by volume and which was multiple times over-subscribed. In the US, investors showed a similar hunger for GM, whose $18.1 billion IPO was also heavily oversubscribed. Since September, the majority of IPOs in the US have priced above or within the filing range and outperformed in the aftermarket.

However, the apparent ‘perfect storm’ of pent-up investor demand and borrowers’ increasing use of the capital markets for their financing needs is tempered by a more discerning investor base taking a more diligent and sophisticated approach

2011 should provide among the most favourable financing conditions for companies in years, despite headwinds buffeting the global economy and the volatility disrupting capital markets.

to credit research and assessment. Recent events indicate that large cap companies have generally done better in IPOs than smaller, lesser known companies. The difference between a successful equity or bond issue and a failure will lie in whether the company has a strong story to tell and can communicate it to investors.

The challenges of 2010 should continue into 2011 and beyond. The shape of the global economic recovery remains uncertain, while we expect volatility to continue to be a feature of the capital markets as investors maintain a hawkish stance on sovereign and credit risk. Crises such as those experienced by Greece and Ireland in 2010 are disruptive influences on markets that can temporarily prevent companies accessing the capital markets.

However, they should not prevent company boards from executing strategic plans for which funding is available. The ability with which BHP Billiton was able to raise $45 billion for its ultimately unsuccessful bid for Potash proved there was life in the syndicated loans market, and well-run companies with strong balance sheets should find that markets will be supportive of M&A deals of strategic importance. With growth in emerging markets outstripping that in developed western economies, we expect companies to look increasingly towards financing M&A deals to gain an edge.

The losers in 2011 will likely be those unable to come firing out of the blocks because their balance sheets are still being repaired. But for the winners, 2011 should be a year when they can put rivals to the sword.


1.7 Leaders

Ivor Dunbar Global Head of Capital Markets

Financing OutlookHow easy will it be to raise money in 2011?

The outlook is highly attractive for companies looking to lock in low rates for their bonds. There is a wall of cash looking for exciting equity stories, and the market has shown it will be supportive of well-considered, strategic mergers & acquisitions.

For companies seeking to tap bond markets, borrowing rates are at an all-time low and should remain so as cash-rich credit investors hunt for yield.

2010 saw a glut of sovereign issuance, but 2011 should provide an opportunity for corporate borrowers, particularly those that tapped the markets in 2009 when rates were high, to take advantage of the low-rate environment, and push back the wall of debt maturing in 2012 to lock in new funding at attractive rates.

It is not just big names that are attracting investor attention. Record low interest rates of close to zero are forcing investors to hunt lower down the ratings chain for yield, providing

opportunities for infrequent or debut borrowers.

We saw large numbers of debut issues in Europe in 2010 and this trend will continue as European companies learn to master the post-crisis environment by reducing their reliance on bank lending as a preferred method of financing. With banks continuing to deleverage in the wake of tough new capital requirements such as Basel 3, this theme of disintermediation should continue, with more companies going straight to the capital markets for their financing needs.

At the same time, the crisis and the ensuing regulatory climate has sparked innovation in financing, with banks seeking to issue contingent capital – an instrument that is at once a relatively cheap form of financing and also a capital buffer. However, before they become a mainstream funding method for banks in 2011, there remains a question mark over the regulatory status of tier one capital.

Equity investors are proving they are ready to support initial public offerings. In 2010, there was a scramble for growth stories such as the $20.5 billion flotation of AIA, the Asian operation of AIG, which was the third biggest IPO in history by volume and which was multiple times over-subscribed. In the US, investors showed a similar hunger for GM, whose $18.1 billion IPO was also heavily oversubscribed. Since September, the majority of IPOs in the US have priced above or within the filing range and outperformed in the aftermarket.

However, the apparent ‘perfect storm’ of pent-up investor demand and borrowers’ increasing use of the capital markets for their financing needs is tempered by a more discerning investor base taking a more diligent and sophisticated approach

2011 should provide among the most favourable financing conditions for companies in years, despite headwinds buffeting the global economy and the volatility disrupting capital markets.

to credit research and assessment. Recent events indicate that large cap companies have generally done better in IPOs than smaller, lesser known companies. The difference between a successful equity or bond issue and a failure will lie in whether the company has a strong story to tell and can communicate it to investors.

The challenges of 2010 should continue into 2011 and beyond. The shape of the global economic recovery remains uncertain, while we expect volatility to continue to be a feature of the capital markets as investors maintain a hawkish stance on sovereign and credit risk. Crises such as those experienced by Greece and Ireland in 2010 are disruptive influences on markets that can temporarily prevent companies accessing the capital markets.

However, they should not prevent company boards from executing strategic plans for which funding is available. The ability with which BHP Billiton was able to raise $45 billion for its ultimately unsuccessful bid for Potash proved there was life in the syndicated loans market, and well-run companies with strong balance sheets should find that markets will be supportive of M&A deals of strategic importance. With growth in emerging markets outstripping that in developed western economies, we expect companies to look increasingly towards financing M&A deals to gain an edge.

The losers in 2011 will likely be those unable to come firing out of the blocks because their balance sheets are still being repaired. But for the winners, 2011 should be a year when they can put rivals to the sword.


The more optimistic analyst might conclude that while the developed world has problems, globalisation and once in a generation levels of emerging market (EM) growth could allow smoother and longer business cycles to prevail over the next few years. However we feel there is an argument that globalisation has destabilised the economic system for the developed world. The secular 30-year reduction in inflation and the ‘great moderation’ that have had their roots in globalisation, reduced the number and severity of business cycles in the developed world during the ‘golden age’. This arguably led to

Is 2011 the Last Year of the Credit Cycle? The final hoorah

complacency as investors and policy makers extrapolated out the extremely benign pre-crisis economic conditions as far as the eye could see. The lack of inflation also allowed policy makers to ‘fix’ every problem during this period, thus preventing the creative destruction process that arguably allows a reasonably efficient allocation of resources. This also allowed a tolerance of debt from investors, consumers and policymakers alike, that would have been unthinkable a decade or two earlier.

The debt-burdened developed world will now likely have periodic funding

in December 2007, then statistically – if we are correct – the start of the next US recession could be between August 2011 (median) and August 2012 (average).

This means that, again if we are correct, we could be entering the last few quarters of the credit/business cycle. We can’t know what will cause it to end but we suspect that policy makers will be more powerless to prevent it than they have been for several decades. The dilemma for investors is that while the business cycle is ongoing, then all risk assets (including credit) will likely perform fairly well. However be warned that we are nearer to the end of the cycle than the beginning and 2011 may be the final hoorah.

0

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Figure 1: US economic expansion lengths (months) since 1854Source: Deutsche Bank, NBER

Jim Reid Chief Credit Strategist, Research

1.8 Leaders

One of our main secular views is that post the financial crisis, the world will return to the shorter length of business/credit cycles that prevailed through history before the 25-year ‘golden age’ that came to an end with the 2007 great recession. If we are correct, then 2011 could see us entering the last full year of expansion, albeit a year of expansion where there are plenty of potential flash points given the legacy of the debt super-cycle that the developed world has endured since the early 1980s.

issues for the foreseeable future as it looks to fund a colossal amount of private and public debt. With interest rates now constrained by the zero bound and high historical levels of public debt, the hands of governments are collectively tied, leaving policy makers with much less flexibility than they have had for at least 30 years. This means that recessions are likely to happen more naturally over the next few years and given the complete lack of policy flexibility they may occur with a higher frequency than the long-term average.

Figure 1 shows that the last three complete US economic expansions were three of the five longest in the 33 we’ve experienced since 1854, likely due to the complete flexibility the authorities had to manage the business cycle.

The average length of the completed cycle (expansion and recession) over the entire period is 4.7 years, with the median length being 3.7 years. Given that the last recession started

mon

ths


The more optimistic analyst might conclude that while the developed world has problems, globalisation and once in a generation levels of emerging market (EM) growth could allow smoother and longer business cycles to prevail over the next few years. However we feel there is an argument that globalisation has destabilised the economic system for the developed world. The secular 30-year reduction in inflation and the ‘great moderation’ that have had their roots in globalisation, reduced the number and severity of business cycles in the developed world during the ‘golden age’. This arguably led to

Is 2011 the Last Year of the Credit Cycle? The final hoorah

complacency as investors and policy makers extrapolated out the extremely benign pre-crisis economic conditions as far as the eye could see. The lack of inflation also allowed policy makers to ‘fix’ every problem during this period, thus preventing the creative destruction process that arguably allows a reasonably efficient allocation of resources. This also allowed a tolerance of debt from investors, consumers and policymakers alike, that would have been unthinkable a decade or two earlier.

The debt-burdened developed world will now likely have periodic funding

in December 2007, then statistically – if we are correct – the start of the next US recession could be between August 2011 (median) and August 2012 (average).

This means that, again if we are correct, we could be entering the last few quarters of the credit/business cycle. We can’t know what will cause it to end but we suspect that policy makers will be more powerless to prevent it than they have been for several decades. The dilemma for investors is that while the business cycle is ongoing, then all risk assets (including credit) will likely perform fairly well. However be warned that we are nearer to the end of the cycle than the beginning and 2011 may be the final hoorah.

0

20

40

60

80

100

120

MedianAverage

Dec

185

4

Jun

186

1

Dec

187

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May

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May

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Jun

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7

Au

g 1

904

Jan

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Mar

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9

Jul 1

924

Mar

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Oct

194

5

May

195

4

Feb

196

1

Mar

197

5

Nov

198

2

Nov

200

1

Figure 1: US economic expansion lengths (months) since 1854Source: Deutsche Bank, NBER

Jim Reid Chief Credit Strategist, Research

1.8 Leaders

One of our main secular views is that post the financial crisis, the world will return to the shorter length of business/credit cycles that prevailed through history before the 25-year ‘golden age’ that came to an end with the 2007 great recession. If we are correct, then 2011 could see us entering the last full year of expansion, albeit a year of expansion where there are plenty of potential flash points given the legacy of the debt super-cycle that the developed world has endured since the early 1980s.

issues for the foreseeable future as it looks to fund a colossal amount of private and public debt. With interest rates now constrained by the zero bound and high historical levels of public debt, the hands of governments are collectively tied, leaving policy makers with much less flexibility than they have had for at least 30 years. This means that recessions are likely to happen more naturally over the next few years and given the complete lack of policy flexibility they may occur with a higher frequency than the long-term average.

Figure 1 shows that the last three complete US economic expansions were three of the five longest in the 33 we’ve experienced since 1854, likely due to the complete flexibility the authorities had to manage the business cycle.

The average length of the completed cycle (expansion and recession) over the entire period is 4.7 years, with the median length being 3.7 years. Given that the last recession started

mon

ths


2 Economics

EMU CrisisChinaUnited States GermanyEmerging MarketsASEAN


2 Economics

EMU CrisisChinaUnited States GermanyEmerging MarketsASEAN


2.1 Economics

A key question for the Eurozone as the end of a turbulent year approaches is whether Portugal, and even Spain, will be forced to follow Greece and Ireland into seeking a rescue package from the European Union and IMF. And a longer-term question for all four countries is whether they will be able to reduce their budget deficits sufficiently to return their public finances to a sustainable position, with or without external help, or will they end up with no choice other than a debt default?

Why did the Irish crisis happen? In asking what may happen to Portugal and Spain, it is instructive to consider the fate that befell Ireland. During 2010, Ireland’s budget deficit continued to widen despite unprecedented austerity measures. At the same time, over-indebted banks were unable to shake off the impact of the ongoing property slump, forcing the government, which had agreed to underwrite the country’s entire banking system, to dramatically increase its support to the point of jeopardising its own finances.

November’s crisis, however, was due to external developments. First, the European Central Bank made it clear it wished to begin withdrawing the extraordinary support to banks that it had given at the height of the financial crisis, since the European Financial Stability Fund – the support system set up in the wake of the Greek crisis in May – was now in place. Ireland’s broken banks were heavily dependent on ECB funding and so the entire banking system came under strain.

Second, the initiatives by Germany and France in October to create a

new ‘permanent crisis mechanism’ to replace the EFSF when it expires in 2013, spooked investors, especially when German Chancellor Angela Merkel said bond holders would have to share any losses in a sovereign default. That, unsurprisingly, led to a sell-off in the bonds of peripheral economies and pushed government borrowing costs up to record highs – in turn, threatening the ability of those countries to service their enormous debts.

Will Portugal follow? At the time of writing, these two external factors are still valid, so it is not surprising that Portugal is coming under marked pressure. Is Portugal Ireland? Well, the liquidity position of Portuguese banks is very fragile. ECB lending to the country’s banking system, although down from its

August peak, is still at around EUR40 billion – or 7.1% of total bank assets, a similar level to Ireland’s 7.6%.

Meanwhile, Portugal’s government has failed to make sufficient progress on spending cuts. In 2010, its budget deficit actually increased. It also has a persistently high current account deficit of around 10% of GDP, indicative of a deeply entrenched lack of competitiveness.

The government has to refinance EUR10 billion of debt in the first three months of 2011, while banks will have EUR5 billion to roll over, so it is probably rational for the Portuguese government to call for rescue sooner rather than later. This is especially the case as the negotiation process with the IMF/EU could be long because,

The EMU Crisis Will Portugal and Spain follow Ireland?

Gilles Moec Co-Head European Economics Research

Mark Wall Co-Head European Economics Research

unlike Ireland, Portugal’s economy requires extensive structural reform to boost its competitiveness. The government is also a minority one, meaning the opposition will have to be involved in negotiations to change things such as the country’s pension or welfare systems.

Is Spain at risk? Market concern that Spain will need to be bailed out has been a consistent feature of the markets for nearly a year. Fortunately, the country’s fiscal and economic developments have gone in the right direction, making the country fundamentally different from Ireland and Portugal. The budget deficit is falling, as is the current account deficit, and banks are enjoying easy access to money markets for funding, making them less dependent on ECB lending (which only accounted for 1.9% of total bank assets in October 2010).

We think that the cuts made thus far and the budget for 2011 are enough to get Spanish public finances back on a sounder footing. This being the case, we don’t think Spain should engage in further austerity for fear of damaging growth and thus worry markets about the speed of the country’s private sector debt adjustment. But we believe the country does need to speed up the restructuring and recapitalisation of its banking sector to address market concerns on this point.

Even if markets do continue to push Spanish interest rates up, we think the ECB could provide a crucial circuit-breaker by providing lots of liquidity to Spain’s banks. Although it has proved unwilling to provide meaningful support to Ireland or

Portugal, the ECB knows that Spain is so much bigger that it would represent a systemic risk for the euro.

Will debt restructuring be necessary? Many investors argue that debt restructuring (e.g. via maturity lengthening or ‘haircuts’) is unavoidable for some euro member countries, especially Greece. The argument goes that even the three years the rescue package buys the country to reform its finances and enable it to get in a position to service its debts on the open market will simply not be enough.

Greece’s public debt-to-GDP ratio could reach 170% by 2013 if growth is only slightly weaker than the IMF currently expects. This would make it very difficult, although not impossible, to service that debt on the open markets from 2013. We continue to believe, however, that given enough time and external support, a unilateral restructuring of sovereign Greek debt can be avoided.

We think Ireland should be able to return to market financing of its deficit by 2013, even including the enormous cost of bailing out its banks. Spain and Portugal may yet have to recapitalise their banks if market pressure persists. In this regard, Spain looks safer than Portugal. Public debt there should reach only 73% of GDP by 2013, thanks to a very low initial level (53%). This gives it a margin to pay for recapitalisation, especially as its recapitalisation vehicle (the ‘FROB’) can issue up to EUR90 billion, or 9% of GDP.

What about Portugal? As regards a future debt restructuring mechanism, nothing is yet certain although reports indicate that a permanent crisis mechanism would include changes in sovereign bonds issued after 2013 to include ‘collective action clauses’, extensions in the duration of debt and ‘haircuts’ as a last resort. This could, of course, raise risk premiums on the bonds and so raise the cost of finance to governments, but that would depend on the existence of other support arrangements too, such as the continuation of an EFSF-type mechanism.


2.1 Economics

A key question for the Eurozone as the end of a turbulent year approaches is whether Portugal, and even Spain, will be forced to follow Greece and Ireland into seeking a rescue package from the European Union and IMF. And a longer-term question for all four countries is whether they will be able to reduce their budget deficits sufficiently to return their public finances to a sustainable position, with or without external help, or will they end up with no choice other than a debt default?

Why did the Irish crisis happen? In asking what may happen to Portugal and Spain, it is instructive to consider the fate that befell Ireland. During 2010, Ireland’s budget deficit continued to widen despite unprecedented austerity measures. At the same time, over-indebted banks were unable to shake off the impact of the ongoing property slump, forcing the government, which had agreed to underwrite the country’s entire banking system, to dramatically increase its support to the point of jeopardising its own finances.

November’s crisis, however, was due to external developments. First, the European Central Bank made it clear it wished to begin withdrawing the extraordinary support to banks that it had given at the height of the financial crisis, since the European Financial Stability Fund – the support system set up in the wake of the Greek crisis in May – was now in place. Ireland’s broken banks were heavily dependent on ECB funding and so the entire banking system came under strain.

Second, the initiatives by Germany and France in October to create a

new ‘permanent crisis mechanism’ to replace the EFSF when it expires in 2013, spooked investors, especially when German Chancellor Angela Merkel said bond holders would have to share any losses in a sovereign default. That, unsurprisingly, led to a sell-off in the bonds of peripheral economies and pushed government borrowing costs up to record highs – in turn, threatening the ability of those countries to service their enormous debts.

Will Portugal follow? At the time of writing, these two external factors are still valid, so it is not surprising that Portugal is coming under marked pressure. Is Portugal Ireland? Well, the liquidity position of Portuguese banks is very fragile. ECB lending to the country’s banking system, although down from its

August peak, is still at around EUR40 billion – or 7.1% of total bank assets, a similar level to Ireland’s 7.6%.

Meanwhile, Portugal’s government has failed to make sufficient progress on spending cuts. In 2010, its budget deficit actually increased. It also has a persistently high current account deficit of around 10% of GDP, indicative of a deeply entrenched lack of competitiveness.

The government has to refinance EUR10 billion of debt in the first three months of 2011, while banks will have EUR5 billion to roll over, so it is probably rational for the Portuguese government to call for rescue sooner rather than later. This is especially the case as the negotiation process with the IMF/EU could be long because,

The EMU Crisis Will Portugal and Spain follow Ireland?

Gilles Moec Co-Head European Economics Research

Mark Wall Co-Head European Economics Research

unlike Ireland, Portugal’s economy requires extensive structural reform to boost its competitiveness. The government is also a minority one, meaning the opposition will have to be involved in negotiations to change things such as the country’s pension or welfare systems.

Is Spain at risk? Market concern that Spain will need to be bailed out has been a consistent feature of the markets for nearly a year. Fortunately, the country’s fiscal and economic developments have gone in the right direction, making the country fundamentally different from Ireland and Portugal. The budget deficit is falling, as is the current account deficit, and banks are enjoying easy access to money markets for funding, making them less dependent on ECB lending (which only accounted for 1.9% of total bank assets in October 2010).

We think that the cuts made thus far and the budget for 2011 are enough to get Spanish public finances back on a sounder footing. This being the case, we don’t think Spain should engage in further austerity for fear of damaging growth and thus worry markets about the speed of the country’s private sector debt adjustment. But we believe the country does need to speed up the restructuring and recapitalisation of its banking sector to address market concerns on this point.

Even if markets do continue to push Spanish interest rates up, we think the ECB could provide a crucial circuit-breaker by providing lots of liquidity to Spain’s banks. Although it has proved unwilling to provide meaningful support to Ireland or

Portugal, the ECB knows that Spain is so much bigger that it would represent a systemic risk for the euro.

Will debt restructuring be necessary? Many investors argue that debt restructuring (e.g. via maturity lengthening or ‘haircuts’) is unavoidable for some euro member countries, especially Greece. The argument goes that even the three years the rescue package buys the country to reform its finances and enable it to get in a position to service its debts on the open market will simply not be enough.

Greece’s public debt-to-GDP ratio could reach 170% by 2013 if growth is only slightly weaker than the IMF currently expects. This would make it very difficult, although not impossible, to service that debt on the open markets from 2013. We continue to believe, however, that given enough time and external support, a unilateral restructuring of sovereign Greek debt can be avoided.

We think Ireland should be able to return to market financing of its deficit by 2013, even including the enormous cost of bailing out its banks. Spain and Portugal may yet have to recapitalise their banks if market pressure persists. In this regard, Spain looks safer than Portugal. Public debt there should reach only 73% of GDP by 2013, thanks to a very low initial level (53%). This gives it a margin to pay for recapitalisation, especially as its recapitalisation vehicle (the ‘FROB’) can issue up to EUR90 billion, or 9% of GDP.

What about Portugal? As regards a future debt restructuring mechanism, nothing is yet certain although reports indicate that a permanent crisis mechanism would include changes in sovereign bonds issued after 2013 to include ‘collective action clauses’, extensions in the duration of debt and ‘haircuts’ as a last resort. This could, of course, raise risk premiums on the bonds and so raise the cost of finance to governments, but that would depend on the existence of other support arrangements too, such as the continuation of an EFSF-type mechanism.


As international pressure intensifi es on China to step away from renminbi (RMB) intervention, the ghosts of Japan’s battle with currency appreciation are resurfacing.

Some economists and analysts who believe Japan’s Heisei boom of the 1980s, and subsequent bust, was caused by the relentless appreciation of the yen, fear that a similar fate might befall China in the years ahead.

During the 1980s, US public opinion perceived US hegemony to be under threat from Japan. A book by Harvard Professor Ezra Vogel entitled Japan as Number 1: Lessons for America became a bestseller, and Japanese salarymen were reported to sprinkle gold-fl akes on their noodles.

By 1989, Tokyo accounted for more than half of the world’s stock market capitalisation, with the Nikkei trading at 70x earnings. By 1991, property in Tokyo’s Ginza district was said to be selling for $93,000 per square foot with Tokyo land values worth more than all the land in Britain, Germany and France, and the grounds of the Imperial Palace being more valuable than the state of California.

At fi rst glance, the parallels between 1980s Japan and China today might appear striking. Both countries have successfully employed a mercantilist export model to help fast-track economic development. Partial deregulation of the banking sector in Japan was followed by a sharp expansion in credit and a boom in property prices as it has in China. A peak in the working age share of the population in Japan coincided with the top in equity and land prices. China’s working age share of the population is

now also set to decline. Both countries have employed a socio-political model in ‘state-based capitalism’ with the principle aim of minimising unemployment rather than maximising shareholder returns.

However, upon closer investigation, we fi nd the hypothesis that sustained yen strength was the root cause of Japan’s problems to be unconvincing – as we do the idea that China will likely lapse into Japan syndrome as the RMB inevitably strengthens. For a start, Germany’s revaluation of the mark was not followed by a Japan-style bust. Furthermore, Japan has continued to run a sizeable trade surplus. Rather, we believe ill-directed fi nancial sector deregulation and monetary policy error were the major contributors to Japan’s undoing.

The squeeze on lending margins in Japan in the early stages of fi nancial sector deregulation prompted a sharp deterioration in lending standards and an increase in loans to suspect SMEs. The proceeds of capital raisings by corporates were also frequently used for speculative land and stock purchases (a process known as ‘zaitech’). But the eventual collapse in asset prices resulted in a self-reinforcing cycle of loan defaults and negative earnings, compounded by extensive bank cross-shareholdings (banks counted unrealised capital gains on equities as capital). As for monetary policy error, the Bank of Japan initially eased too vigorously in the short-lived 1985 recession, and then refrained from withdrawing the monetary punch bowl for too long in the subsequent recovery. The collapse in the real policy rate from 4.6% in 1983 to -0.5% in 1989 helped fan the fl ames of the asset bubble.

China and the Ghosts of Japan’s Heisei BubbleWill China repeat Japan’s boom and bust?

Brad JonesAsia Investment Strategist, Research

Jun MaChief Economist Greater China, Research

2.2Economics

The lines of demarcationThe following factors suggest to us a more benign adjustment for China. First, at just 47% currently, China’s urbanisation rate is well below Japan’s at the peak of the bubble (63%), with the UN projecting a further 270 million people will become urbanised in China over the next two decades. Second, the consumption share of GDP in China is just 35%, and so has signifi cant scope to take over the baton of growth as fi xed asset investment decelerates, while Japan’s consumption/GDP ratio was already around 54% in the 1980s. Third, Japan’s stock market looked manifestly overvalued, peaking at 5.5x book and a PE ratio of 70x, while China’s stock market currently trades at 2.3x book and 14x PE, and with a considerably lower degree of bank cross-shareholdings. Fourth, China’s

banks have boosted capital ahead of Basel 3 and a potential rise in NPLs, and the ratio of private credit/GDP is much lower in China than in Japan in 1989 (127% versus 193%). Fifth, broadening pension coverage, from a very low base, should support local asset markets over the medium term.

Investment implications We believe there are a number of investment implications that follow from China’s broad policy and demographic trends:

1. China is on the cusp of exporting infl ation abroad, as the working age cohort in China peaks, wage growth accelerates above productivity growth in key sectors, and trend RMB appreciation raises US import prices from China (note Emerging Asia accounts for nearly a third of total US imports).

2. To help secure its strategic needs and rebalance its existing foreign portfolio (which is very exposed to infl ation), China will likely shift its focus to real assets, including stocks (89% of its US asset holdings are in Treasuries and agencies, just 5% in stocks). Note that China’s FX reserves can now hypothetically purchase 25% of the S&P500 market cap (versus 1% a decade ago), and 100% and 150% of the market cap of the MSCI World Materials and World Energy indices respectively.

Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10

4

2

0

-2

-4

6

8%

10%

Figure 2:RMB appreciation will feed into US infl ationSource: US Bureau of Labor Statistics, DB Global Markets Research

US import prices from China12 month change in RMB versus $

Figure 1:China is on the cusp of a shift in real assetsSource: US Treasury Dept, DB Global Markets ResearchData as at Sept – 2010

China’s holdings of US assets (lhs, $ billion) China’s holdings as % of all US asset holdings (rhs)

400

300

200

100

0

10

0

20

30

40

50

60%

500

600

700

800

900

Treasuries Agencies Short-termfixed income

EquitiesCorporateBonds

3. For domestic residents, valuation and policy support will favour equities over property as long-term real wealth preservers, while the corporate bond market remains small and low-yielding bank deposits uninviting. Less than 15% of the population has direct exposure to stocks.

4. With consumer stocks in China trading at elevated valuations, cheap large caps in the developed markets that increasingly derive their revenues from China appear interesting.

5. China’s new fi ve-year plan points to slower but better quality growth, and hence lower shareholder dilution risk in strategic sectors like banking and energy.

6. Unlike Japan, China is unlikely to fully liberalise its capital account while the RMB is still signifi cantly undervalued. The RMB is likely to have already undertaken a signifi cant part of its journey towards fair value by the time liberalisation has materialised in fi ve to 10 years. As such, we think longer-dated RMB forwards off er investors good value.

Brad Jones

Sources: United Nations, Deutsche Bank, Bloomberg et al.

Outlook for 2011

For 2011 as a whole, we maintain our GDP growth forecast of 8.7%, down from 10% in 2010. We expect qoq growth to slow from Q2 of 2011 on the diminishing impact of infl ation expectation on orders, monetary tightening, slower property investments, and deceleration in export growth.

We expect nominal export growth to slow to 15% in 2011 (from 30% in 2010), nominal fi xed asset investment growth to decelerate to 20% in 2011 (from 23% in 2010), while retail sales growth to remain largely unchanged.

We expect H1 2011 to see rising infl ation, with H2 witnessing disinfl ation. We expect monetary policy to get tighter until mid 2011. Benchmark interest rates will likely rise 75bps in the coming seven quarters, and yoy loan growth should decelerate to around 14% in 2011 from nearly 20% in 2010.

For H2 2011, we expect macro policies to shift towards relaxation on disinfl ation as well as moderation in sequential GDP growth.

Fiscal policy in 2011 will also likely become less expansionary, although it will still likely be labeled as “proactive”. We expect the defi cit/GDP ratio will to fall to 2% in 2011, down from 2.5% in the 2010 budget.

Due to infl ationary pressure, we expect the government to postpone the expected hikes in water, gas, power and oil prices in the coming months. Other reforms, such as the increase in state owned enterprise dividend payment ratios, promotion of manufacturing upgrade, RMB internationalisation, tax cuts on service industries, and deposit rate deregulation will likely see progress in 2011.

The key risk for 2011 is that if the government fails to implement aggressive policies (e.g. rate hikes and credit tightening) now it may end up with higher infl ation later in the year. If infl ation rises to 6-7%, the government will have no choices but to take draconian actions that could lead to a hard landing of the economy.

Jun Ma


As international pressure intensifi es on China to step away from renminbi (RMB) intervention, the ghosts of Japan’s battle with currency appreciation are resurfacing.

Some economists and analysts who believe Japan’s Heisei boom of the 1980s, and subsequent bust, was caused by the relentless appreciation of the yen, fear that a similar fate might befall China in the years ahead.

During the 1980s, US public opinion perceived US hegemony to be under threat from Japan. A book by Harvard Professor Ezra Vogel entitled Japan as Number 1: Lessons for America became a bestseller, and Japanese salarymen were reported to sprinkle gold-fl akes on their noodles.

By 1989, Tokyo accounted for more than half of the world’s stock market capitalisation, with the Nikkei trading at 70x earnings. By 1991, property in Tokyo’s Ginza district was said to be selling for $93,000 per square foot with Tokyo land values worth more than all the land in Britain, Germany and France, and the grounds of the Imperial Palace being more valuable than the state of California.

At fi rst glance, the parallels between 1980s Japan and China today might appear striking. Both countries have successfully employed a mercantilist export model to help fast-track economic development. Partial deregulation of the banking sector in Japan was followed by a sharp expansion in credit and a boom in property prices as it has in China. A peak in the working age share of the population in Japan coincided with the top in equity and land prices. China’s working age share of the population is

now also set to decline. Both countries have employed a socio-political model in ‘state-based capitalism’ with the principle aim of minimising unemployment rather than maximising shareholder returns.

However, upon closer investigation, we fi nd the hypothesis that sustained yen strength was the root cause of Japan’s problems to be unconvincing – as we do the idea that China will likely lapse into Japan syndrome as the RMB inevitably strengthens. For a start, Germany’s revaluation of the mark was not followed by a Japan-style bust. Furthermore, Japan has continued to run a sizeable trade surplus. Rather, we believe ill-directed fi nancial sector deregulation and monetary policy error were the major contributors to Japan’s undoing.

The squeeze on lending margins in Japan in the early stages of fi nancial sector deregulation prompted a sharp deterioration in lending standards and an increase in loans to suspect SMEs. The proceeds of capital raisings by corporates were also frequently used for speculative land and stock purchases (a process known as ‘zaitech’). But the eventual collapse in asset prices resulted in a self-reinforcing cycle of loan defaults and negative earnings, compounded by extensive bank cross-shareholdings (banks counted unrealised capital gains on equities as capital). As for monetary policy error, the Bank of Japan initially eased too vigorously in the short-lived 1985 recession, and then refrained from withdrawing the monetary punch bowl for too long in the subsequent recovery. The collapse in the real policy rate from 4.6% in 1983 to -0.5% in 1989 helped fan the fl ames of the asset bubble.

China and the Ghosts of Japan’s Heisei BubbleWill China repeat Japan’s boom and bust?

Brad JonesAsia Investment Strategist, Research

Jun MaChief Economist Greater China, Research

2.2Economics

The lines of demarcationThe following factors suggest to us a more benign adjustment for China. First, at just 47% currently, China’s urbanisation rate is well below Japan’s at the peak of the bubble (63%), with the UN projecting a further 270 million people will become urbanised in China over the next two decades. Second, the consumption share of GDP in China is just 35%, and so has signifi cant scope to take over the baton of growth as fi xed asset investment decelerates, while Japan’s consumption/GDP ratio was already around 54% in the 1980s. Third, Japan’s stock market looked manifestly overvalued, peaking at 5.5x book and a PE ratio of 70x, while China’s stock market currently trades at 2.3x book and 14x PE, and with a considerably lower degree of bank cross-shareholdings. Fourth, China’s

banks have boosted capital ahead of Basel 3 and a potential rise in NPLs, and the ratio of private credit/GDP is much lower in China than in Japan in 1989 (127% versus 193%). Fifth, broadening pension coverage, from a very low base, should support local asset markets over the medium term.

Investment implications We believe there are a number of investment implications that follow from China’s broad policy and demographic trends:

1. China is on the cusp of exporting infl ation abroad, as the working age cohort in China peaks, wage growth accelerates above productivity growth in key sectors, and trend RMB appreciation raises US import prices from China (note Emerging Asia accounts for nearly a third of total US imports).

2. To help secure its strategic needs and rebalance its existing foreign portfolio (which is very exposed to infl ation), China will likely shift its focus to real assets, including stocks (89% of its US asset holdings are in Treasuries and agencies, just 5% in stocks). Note that China’s FX reserves can now hypothetically purchase 25% of the S&P500 market cap (versus 1% a decade ago), and 100% and 150% of the market cap of the MSCI World Materials and World Energy indices respectively.

Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10

4

2

0

-2

-4

6

8%

10%

Figure 2:RMB appreciation will feed into US infl ationSource: US Bureau of Labor Statistics, DB Global Markets Research

US import prices from China12 month change in RMB versus $

Figure 1:China is on the cusp of a shift in real assetsSource: US Treasury Dept, DB Global Markets ResearchData as at Sept – 2010

China’s holdings of US assets (lhs, $ billion) China’s holdings as % of all US asset holdings (rhs)

400

300

200

100

0

10

0

20

30

40

50

60%

500

600

700

800

900

Treasuries Agencies Short-termfixed income

EquitiesCorporateBonds

3. For domestic residents, valuation and policy support will favour equities over property as long-term real wealth preservers, while the corporate bond market remains small and low-yielding bank deposits uninviting. Less than 15% of the population has direct exposure to stocks.

4. With consumer stocks in China trading at elevated valuations, cheap large caps in the developed markets that increasingly derive their revenues from China appear interesting.

5. China’s new fi ve-year plan points to slower but better quality growth, and hence lower shareholder dilution risk in strategic sectors like banking and energy.

6. Unlike Japan, China is unlikely to fully liberalise its capital account while the RMB is still signifi cantly undervalued. The RMB is likely to have already undertaken a signifi cant part of its journey towards fair value by the time liberalisation has materialised in fi ve to 10 years. As such, we think longer-dated RMB forwards off er investors good value.

Brad Jones

Sources: United Nations, Deutsche Bank, Bloomberg et al.

Outlook for 2011

For 2011 as a whole, we maintain our GDP growth forecast of 8.7%, down from 10% in 2010. We expect qoq growth to slow from Q2 of 2011 on the diminishing impact of infl ation expectation on orders, monetary tightening, slower property investments, and deceleration in export growth.

We expect nominal export growth to slow to 15% in 2011 (from 30% in 2010), nominal fi xed asset investment growth to decelerate to 20% in 2011 (from 23% in 2010), while retail sales growth to remain largely unchanged.

We expect H1 2011 to see rising infl ation, with H2 witnessing disinfl ation. We expect monetary policy to get tighter until mid 2011. Benchmark interest rates will likely rise 75bps in the coming seven quarters, and yoy loan growth should decelerate to around 14% in 2011 from nearly 20% in 2010.

For H2 2011, we expect macro policies to shift towards relaxation on disinfl ation as well as moderation in sequential GDP growth.

Fiscal policy in 2011 will also likely become less expansionary, although it will still likely be labeled as “proactive”. We expect the defi cit/GDP ratio will to fall to 2% in 2011, down from 2.5% in the 2010 budget.

Due to infl ationary pressure, we expect the government to postpone the expected hikes in water, gas, power and oil prices in the coming months. Other reforms, such as the increase in state owned enterprise dividend payment ratios, promotion of manufacturing upgrade, RMB internationalisation, tax cuts on service industries, and deposit rate deregulation will likely see progress in 2011.

The key risk for 2011 is that if the government fails to implement aggressive policies (e.g. rate hikes and credit tightening) now it may end up with higher infl ation later in the year. If infl ation rises to 6-7%, the government will have no choices but to take draconian actions that could lead to a hard landing of the economy.

Jun Ma


Peter Hooper Co-Head of Global Economics, Research

2.3 Economics

Outlook for the US Economy What’s different this time?

The year ahead is likely to remain challenging for the US economy following a disappointing pace of recovery in 2010 from the deepest recession in decades. We see growth of real output running modestly above its estimated trend rate of about 2.5% for 2011 – enough to generate significant job growth but not a substantial reduction in the current high rate of unemployment. However, ongoing adjustment of household and business sector balance sheets will clear the way for stronger growth to come in 2012, if not sooner.

The normal cyclical pattern in the US is one where inflation rises as the economy overheats, leading the Fed to step on the brakes and raise interest rates to slow interest-sensitive spending and push the economy into recession. The Fed then cuts rates and interest-sensitive discretionary spending rebounds, leading the economic recovery: the deeper the downturn, the stronger the recovery. This time around, the recovery process should be a good deal more prolonged.

So what’s different this time? This time around, the pace of recovery has been painfully and abnormally slow despite the extreme depth of the downturn and an unprecedented degree of monetary and fiscal policy stimulus. This is because the recent recession was caused not by aggressive Fed tightening to deal with inflation but by the inflation and bursting of residential and commercial real estate bubbles and an ensuing financial crisis. The sectors that normally lead the economy in the recovery phase – household and business spending on structures

and durables goods – face ongoing adjustment. Excess stocks of vacant homes and commercial properties built during the boom years still need to be worked off, and households may want to raise saving rates further for a time to recoup some of the wealth losses they incurred following the plunge in home prices and equities during the downturn.

The key headwinds So far, only one of the economy’s four key cyclical drivers is functioning normally: business spending on capital equipment which is growing fairly robustly from very depressed levels. The other three key drivers – residential and non-residential construction and spending on consumer durables – are still lagging, but they should begin to join in as the excess stock of vacant homes and commercial properties is run down and as household balance sheets are further repaired. How long will these adjustments take? Probably at least another year, and this, along with the unwinding of fiscal stimulus, is why we are cautious about growth prospects for 2010. But there is considerable uncertainty around such estimates, and we could as easily be surprised by a faster recovery than a slower one. Once all four cyclical drivers are back on track, the expansion will look and feel a good deal more robust.

Inflation uncomfortably low for the Fed As a result of the very weak labour market, labour cost inflation has been low and declining, contributing to a downtrend in overall US consumer price inflation. Excluding food and energy, inflation has begun to move

into uncomfortably low territory relative to the Fed’s objectives, and this development has been one factor that induced the Fed to take out some more insurance via QE2. Thanks to the Fed’s aggressive easing, which has also helped to anchor inflation expectations at comfortably positive levels, we expect core inflation to stabilise soon and to edge higher over the year ahead. The Fed will most likely complete its intended QE2 commitment of making another $600 billion in new purchases of Treasury securities. However, with prospects improving for a faster pace of recovery still to come, further purchases seem unlikely, and interest rates will eventually be moving substantially higher.


Peter Hooper Co-Head of Global Economics, Research

2.3 Economics

Outlook for the US Economy What’s different this time?

The year ahead is likely to remain challenging for the US economy following a disappointing pace of recovery in 2010 from the deepest recession in decades. We see growth of real output running modestly above its estimated trend rate of about 2.5% for 2011 – enough to generate significant job growth but not a substantial reduction in the current high rate of unemployment. However, ongoing adjustment of household and business sector balance sheets will clear the way for stronger growth to come in 2012, if not sooner.

The normal cyclical pattern in the US is one where inflation rises as the economy overheats, leading the Fed to step on the brakes and raise interest rates to slow interest-sensitive spending and push the economy into recession. The Fed then cuts rates and interest-sensitive discretionary spending rebounds, leading the economic recovery: the deeper the downturn, the stronger the recovery. This time around, the recovery process should be a good deal more prolonged.

So what’s different this time? This time around, the pace of recovery has been painfully and abnormally slow despite the extreme depth of the downturn and an unprecedented degree of monetary and fiscal policy stimulus. This is because the recent recession was caused not by aggressive Fed tightening to deal with inflation but by the inflation and bursting of residential and commercial real estate bubbles and an ensuing financial crisis. The sectors that normally lead the economy in the recovery phase – household and business spending on structures

and durables goods – face ongoing adjustment. Excess stocks of vacant homes and commercial properties built during the boom years still need to be worked off, and households may want to raise saving rates further for a time to recoup some of the wealth losses they incurred following the plunge in home prices and equities during the downturn.

The key headwinds So far, only one of the economy’s four key cyclical drivers is functioning normally: business spending on capital equipment which is growing fairly robustly from very depressed levels. The other three key drivers – residential and non-residential construction and spending on consumer durables – are still lagging, but they should begin to join in as the excess stock of vacant homes and commercial properties is run down and as household balance sheets are further repaired. How long will these adjustments take? Probably at least another year, and this, along with the unwinding of fiscal stimulus, is why we are cautious about growth prospects for 2010. But there is considerable uncertainty around such estimates, and we could as easily be surprised by a faster recovery than a slower one. Once all four cyclical drivers are back on track, the expansion will look and feel a good deal more robust.

Inflation uncomfortably low for the Fed As a result of the very weak labour market, labour cost inflation has been low and declining, contributing to a downtrend in overall US consumer price inflation. Excluding food and energy, inflation has begun to move

into uncomfortably low territory relative to the Fed’s objectives, and this development has been one factor that induced the Fed to take out some more insurance via QE2. Thanks to the Fed’s aggressive easing, which has also helped to anchor inflation expectations at comfortably positive levels, we expect core inflation to stabilise soon and to edge higher over the year ahead. The Fed will most likely complete its intended QE2 commitment of making another $600 billion in new purchases of Treasury securities. However, with prospects improving for a faster pace of recovery still to come, further purchases seem unlikely, and interest rates will eventually be moving substantially higher.


Tom Mayer Chief Economist, Deutsche Bank Group, Research

2.4 Economics

Germany is back – and not just in soccer and Formula One. Its economy has weathered the crisis extremely well, surprising all market observers. With 2010 growth of 3.75%, Germany was the growth star among the G7 countries. Moreover, it had the highest growth rate since unification, reversing a hefty 4.7% slump in 2009 and proving that German companies and politicians got much right before the crisis.

The success story will continue in 2011, albeit not with the exceptional growth rates seen last summer when real GDP expanded by almost 6.5%

on the German labour market. While elsewhere politicians are fretting about jobless recoveries, the average number of unemployed should fall to almost 3 million in 2011.

So where is the catch? In part, despite all the structural improvements, almost half of Germany’s impressive growth rate in 2010 is down to pent-up demand and the catch up in investment in Germany and abroad. The recovery in important export markets began to lose steam at the end of 2010. The fact that favourable depreciation rules will run out at the end of the year will also weigh on investment activity, while continuing low interest rates will support spending. Against this backdrop, growth looks set to slow to almost 2% this year. But economic growth should be robust and again markedly above potential which we estimate at 1.25%.

The hotly debated question then is whether private consumption – the Achilles heel of the German economy – will take over from net exports and investment as the major growth engine. The signs are encouraging. The recent uptrend in vacancies and the high number of companies that are planning to create new jobs point to continuing employment growth. Despite the imminent discussion about larger wage hikes in 2011, wages are unlikely to grow by much more than 2.5% in 2011, especially since only a minor part of the collective wage agreements is up for renewal this year. As many German companies rely on global value chains and can shift production elsewhere, wage growth that is too strong would quickly lead to job losses in Germany. One-off payments, a

The Outlook for Germany Germany is back!

favourable wage drift and a sound labour market indicate, therefore, that private consumption should increase by around 1% – twice the annual average of the last decade.

The strong recovery and the labour-market upswing should bring relief for public sector budgets. Due to the position in the cycle and the reduction of the structural deficit by half a percentage point, we believe the overall budget deficit will drop just below 3% of GDP. Germany will be the only large country in the Eurozone to fulfil the Maastricht criteria. Furthermore, there is limited risk that German inflation will rise perceptibly, which should be somewhat reassuring for the ECB as it deals with the wider needs of European peripheral countries in the doldrums.

(qoq annualised). Corporate Germany has been thinking and acting globally for many years. Its focus on capital goods and high end consumer goods helps explain its success in emerging Asia. Politicians have embarked on a path of social reform which other countries are now starting to follow.

Prudent fiscal policy, which should bring the fiscal deficit clearly below 3% in 2011, has added to Germany’s clout in reforming the Stability and Growth Pact and implementing a permanent crisis resolution mechanism. The results of these reforms are clearly visible


Tom Mayer Chief Economist, Deutsche Bank Group, Research

2.4 Economics

Germany is back – and not just in soccer and Formula One. Its economy has weathered the crisis extremely well, surprising all market observers. With 2010 growth of 3.75%, Germany was the growth star among the G7 countries. Moreover, it had the highest growth rate since unification, reversing a hefty 4.7% slump in 2009 and proving that German companies and politicians got much right before the crisis.

The success story will continue in 2011, albeit not with the exceptional growth rates seen last summer when real GDP expanded by almost 6.5%

on the German labour market. While elsewhere politicians are fretting about jobless recoveries, the average number of unemployed should fall to almost 3 million in 2011.

So where is the catch? In part, despite all the structural improvements, almost half of Germany’s impressive growth rate in 2010 is down to pent-up demand and the catch up in investment in Germany and abroad. The recovery in important export markets began to lose steam at the end of 2010. The fact that favourable depreciation rules will run out at the end of the year will also weigh on investment activity, while continuing low interest rates will support spending. Against this backdrop, growth looks set to slow to almost 2% this year. But economic growth should be robust and again markedly above potential which we estimate at 1.25%.

The hotly debated question then is whether private consumption – the Achilles heel of the German economy – will take over from net exports and investment as the major growth engine. The signs are encouraging. The recent uptrend in vacancies and the high number of companies that are planning to create new jobs point to continuing employment growth. Despite the imminent discussion about larger wage hikes in 2011, wages are unlikely to grow by much more than 2.5% in 2011, especially since only a minor part of the collective wage agreements is up for renewal this year. As many German companies rely on global value chains and can shift production elsewhere, wage growth that is too strong would quickly lead to job losses in Germany. One-off payments, a

The Outlook for Germany Germany is back!

favourable wage drift and a sound labour market indicate, therefore, that private consumption should increase by around 1% – twice the annual average of the last decade.

The strong recovery and the labour-market upswing should bring relief for public sector budgets. Due to the position in the cycle and the reduction of the structural deficit by half a percentage point, we believe the overall budget deficit will drop just below 3% of GDP. Germany will be the only large country in the Eurozone to fulfil the Maastricht criteria. Furthermore, there is limited risk that German inflation will rise perceptibly, which should be somewhat reassuring for the ECB as it deals with the wider needs of European peripheral countries in the doldrums.

(qoq annualised). Corporate Germany has been thinking and acting globally for many years. Its focus on capital goods and high end consumer goods helps explain its success in emerging Asia. Politicians have embarked on a path of social reform which other countries are now starting to follow.

Prudent fiscal policy, which should bring the fiscal deficit clearly below 3% in 2011, has added to Germany’s clout in reforming the Stability and Growth Pact and implementing a permanent crisis resolution mechanism. The results of these reforms are clearly visible


Gustavo CanoneroHead of EM Economics Research

2.5Economics

The year ahead looks set to be challenging for the global economy. However, 2011 should be another relatively good year for emerging economies particularly when compared to the industrialised world. The smaller and more open emerging market (EM) economies should remain quite sensitive to developments in advanced economies, making the recovery of the industrialised countries a central risk to performance. However, the larger emerging economies look likely to outperform again this year. For them, the impact of signifi cant capital infl ows represents the critical danger, albeit more from a medium-term perspective. How EM manage the availability of cheap fi nancing, which has led to excesses many times in the past, will be the ultimate test of their economic and institutional maturity.

As described in the other outlook pieces of this document, signifi cant uncertainty about the future of the most advanced economies should continue next year, suggesting that returning to fi nancial stability and decent economic growth in the industrialised world will take a while. But EM economies and assets are projected to do well, off ering faster economic growth and robust asset return. Specifi cally, EM economies are projected to grow by 6% in 2011 after growing 5% in 2010. Industrialised countries are forecast for 2% growth. The diff erence in these forecasts is exacerbated by China’s economic projections, but China is not the only driver, with EM GDP growth excluding China forecast to be close to 4.5% in 2011.*

EM economies currently enjoy stronger economic fundamentals than most developed countries – lower public debt, healthier fi nancial systems, relatively low private sector leverage, lower external debt and fi nancing needs, better population dynamics, etc. These factors we expect to facilitate faster economic growth and further fundamental improvement ahead. According to The Day After Tomorrow, a new book by the World Bank, the diverging growth prospects will continue in the medium term, with EM maintaining the upper hand, and regions like East and South Asia, Latin America, and soon Africa, having the potential to turn into ‘newly developed’.

We agree with this view although we note that such an outlook does not necessarily apply to all EM countries. Large and relatively closed economies in EM with limited leverage, like Brazil, China, India, Indonesia, and Russia, although to a lesser extent, are likely to continue diff erentiating positively from the rest of the world in most global scenarios. Similarly, robust economic systems with solid fi scal and external situations like Chile, Peru, Philippines, Colombia, South Africa, Turkey, and Argentina are also expected to outperform. Most other countries in the EM universe have either weak economic fundamentals or are too exposed to global forces. For the fi rst group, outperformance means further strengthening in currencies, likely tightening or stable credit spreads, and further converging real interest rates. For the second group, 2011 could be a diffi cult year, but unlikely to resemble the sharp economic swings of the past.

The reinforced case for EM The traditional case for EM growth outperformance is largely based on continued income and technological convergence. The poorer the country, the greater the scope for convergence tends to be. Beyond this convergence argument there are a few specifi c EM factors that are likely to help sustain high levels of growth in these economies. For example, lower urbanisation rates in EM suggest the potential for sizeable productivity gains. Likewise, demographics should continue to work in favour of most EM for the time being. Similarly, fi nancial development is still narrow, providing substantial scope for increases in productivity of capital. Also, factor endowments, particularly commodities and labour, seem to be ample, while commodities are likely to continue benefi ting from the changing global demand balance.

EM have received an additional boost from the recent fi nancial crisis which has pushed up public debt in industrial countries on top of a negative spending dynamic due to ageing. Public sector debt in the main economies is likely to exceed 110% of GDP during the next decade while the median EM country debt ratio is sure to remain below 50% or decline further. Such a fi scal burden in the developed world together with undercapitalised banking systems will only help the case of EM outperformance in years to come.*

Vulnerabilities and risksThe above arguments notwithstanding, we have some concerns. A traditional reason for caution about EM is based on the relatively weak basis

for rapid and sustained growth given production factor bottlenecks; i.e. the lack of enough accumulation of capital goods, human capital, and technological progress in many EM economies. While lack of fi xed investment might not be a concern in many emerging Asian countries (given the revealed preference for high savings and investment), investment in education and human capital is a much less advanced in Latin America and some EMEA countries, where fi xed investment ratios have remained below 20% even after achieving improved growth performance amid steady macroeconomic stability.

Similarly, while a young population seems to be a common advantage of EM countries versus more developed ones, this is not a general situation. Many eastern European countries face worrying population dynamics, in some cases as bad as Western Europe or Japan.

Likewise, a potential new global equilibrium where the big savers of emerging Asia would have to consume more and export less could be a risk for growth in EM. Some economists believe that emerging Asia’s growth in the past few years has been facilitated

by large production of tradable goods. However, in our view, moving countries like China away from this specialisation in manufacturing could slow Chinese medium-term growth by over 2% a year, refl ecting the inherent instability of the current global balance.

Another typical concern about the current conjuncture is related to the political economy equilibrium that demands a slow process of re-balancing. The rise of protectionist rhetoric in the US and Europe is the most evident expression of such concern. Disillusion with the prevailing international order was probably the main cause of the end of the previous large wave of globalisation, largely precipitated by the Great Depression.

Furthermore, even after a few years of political stability in EM, we cannot totally rule out political shocks in the future. Undoubtedly, democracies are dominating and political stability has been gaining robustness thanks to improving economic performance. Nonetheless, EM investors could still face a 180-degree change in Peru’s policy if the left wing opposition were to win in the presidential election of April next year (which looks unlikely but yet is a possible scenario).

Similarly, we are likely to witness the continuation of growing instability and uncertain support for reforming administrations in EMEA. There is no evidence as yet of such political shifts in emerging Asia, although one could view the growing Naxalite movement in Northeast India, which has weakened central government authority in much of the territory and disrupted investments in commodity extraction, as to some extent a reaction against the way in which free market economics has been brought to the region.

In summary, there are a number of reasons to question, at least, a rosy EM outlook in any global scenario for any emerging economy. Indeed, one could further argue that improved macro fundamentals might well refl ect a super pro-cyclical nature of these indicators, further raising doubts about the actual sustainability of such improvement. However, the main candidate for trouble in the next couple of years could be the continuation of the capital bonanza. That has led to booms and bursts in the past and avoiding them will demand prudent policies and a cautious political stance, not yet a guarantee in many EM countries.

*Source: Deutsche Bank Research

6

5

4

3

2

1

0

-1

1980 1983 1986 1989 1992 1995 1998 2001 20072004

-2

7

Outlook for Emerging Market EconomiesAnother good year ahead but not for all

EM’s growth diff erential versus advanced economiesSource: World Bank, Growth diff erential EM versus Industrial CountryDB Global Markets Research Avg. diff erential per decade


Gustavo CanoneroHead of EM Economics Research

2.5Economics

The year ahead looks set to be challenging for the global economy. However, 2011 should be another relatively good year for emerging economies particularly when compared to the industrialised world. The smaller and more open emerging market (EM) economies should remain quite sensitive to developments in advanced economies, making the recovery of the industrialised countries a central risk to performance. However, the larger emerging economies look likely to outperform again this year. For them, the impact of signifi cant capital infl ows represents the critical danger, albeit more from a medium-term perspective. How EM manage the availability of cheap fi nancing, which has led to excesses many times in the past, will be the ultimate test of their economic and institutional maturity.

As described in the other outlook pieces of this document, signifi cant uncertainty about the future of the most advanced economies should continue next year, suggesting that returning to fi nancial stability and decent economic growth in the industrialised world will take a while. But EM economies and assets are projected to do well, off ering faster economic growth and robust asset return. Specifi cally, EM economies are projected to grow by 6% in 2011 after growing 5% in 2010. Industrialised countries are forecast for 2% growth. The diff erence in these forecasts is exacerbated by China’s economic projections, but China is not the only driver, with EM GDP growth excluding China forecast to be close to 4.5% in 2011.*

EM economies currently enjoy stronger economic fundamentals than most developed countries – lower public debt, healthier fi nancial systems, relatively low private sector leverage, lower external debt and fi nancing needs, better population dynamics, etc. These factors we expect to facilitate faster economic growth and further fundamental improvement ahead. According to The Day After Tomorrow, a new book by the World Bank, the diverging growth prospects will continue in the medium term, with EM maintaining the upper hand, and regions like East and South Asia, Latin America, and soon Africa, having the potential to turn into ‘newly developed’.

We agree with this view although we note that such an outlook does not necessarily apply to all EM countries. Large and relatively closed economies in EM with limited leverage, like Brazil, China, India, Indonesia, and Russia, although to a lesser extent, are likely to continue diff erentiating positively from the rest of the world in most global scenarios. Similarly, robust economic systems with solid fi scal and external situations like Chile, Peru, Philippines, Colombia, South Africa, Turkey, and Argentina are also expected to outperform. Most other countries in the EM universe have either weak economic fundamentals or are too exposed to global forces. For the fi rst group, outperformance means further strengthening in currencies, likely tightening or stable credit spreads, and further converging real interest rates. For the second group, 2011 could be a diffi cult year, but unlikely to resemble the sharp economic swings of the past.

The reinforced case for EM The traditional case for EM growth outperformance is largely based on continued income and technological convergence. The poorer the country, the greater the scope for convergence tends to be. Beyond this convergence argument there are a few specifi c EM factors that are likely to help sustain high levels of growth in these economies. For example, lower urbanisation rates in EM suggest the potential for sizeable productivity gains. Likewise, demographics should continue to work in favour of most EM for the time being. Similarly, fi nancial development is still narrow, providing substantial scope for increases in productivity of capital. Also, factor endowments, particularly commodities and labour, seem to be ample, while commodities are likely to continue benefi ting from the changing global demand balance.

EM have received an additional boost from the recent fi nancial crisis which has pushed up public debt in industrial countries on top of a negative spending dynamic due to ageing. Public sector debt in the main economies is likely to exceed 110% of GDP during the next decade while the median EM country debt ratio is sure to remain below 50% or decline further. Such a fi scal burden in the developed world together with undercapitalised banking systems will only help the case of EM outperformance in years to come.*

Vulnerabilities and risksThe above arguments notwithstanding, we have some concerns. A traditional reason for caution about EM is based on the relatively weak basis

for rapid and sustained growth given production factor bottlenecks; i.e. the lack of enough accumulation of capital goods, human capital, and technological progress in many EM economies. While lack of fi xed investment might not be a concern in many emerging Asian countries (given the revealed preference for high savings and investment), investment in education and human capital is a much less advanced in Latin America and some EMEA countries, where fi xed investment ratios have remained below 20% even after achieving improved growth performance amid steady macroeconomic stability.

Similarly, while a young population seems to be a common advantage of EM countries versus more developed ones, this is not a general situation. Many eastern European countries face worrying population dynamics, in some cases as bad as Western Europe or Japan.

Likewise, a potential new global equilibrium where the big savers of emerging Asia would have to consume more and export less could be a risk for growth in EM. Some economists believe that emerging Asia’s growth in the past few years has been facilitated

by large production of tradable goods. However, in our view, moving countries like China away from this specialisation in manufacturing could slow Chinese medium-term growth by over 2% a year, refl ecting the inherent instability of the current global balance.

Another typical concern about the current conjuncture is related to the political economy equilibrium that demands a slow process of re-balancing. The rise of protectionist rhetoric in the US and Europe is the most evident expression of such concern. Disillusion with the prevailing international order was probably the main cause of the end of the previous large wave of globalisation, largely precipitated by the Great Depression.

Furthermore, even after a few years of political stability in EM, we cannot totally rule out political shocks in the future. Undoubtedly, democracies are dominating and political stability has been gaining robustness thanks to improving economic performance. Nonetheless, EM investors could still face a 180-degree change in Peru’s policy if the left wing opposition were to win in the presidential election of April next year (which looks unlikely but yet is a possible scenario).

Similarly, we are likely to witness the continuation of growing instability and uncertain support for reforming administrations in EMEA. There is no evidence as yet of such political shifts in emerging Asia, although one could view the growing Naxalite movement in Northeast India, which has weakened central government authority in much of the territory and disrupted investments in commodity extraction, as to some extent a reaction against the way in which free market economics has been brought to the region.

In summary, there are a number of reasons to question, at least, a rosy EM outlook in any global scenario for any emerging economy. Indeed, one could further argue that improved macro fundamentals might well refl ect a super pro-cyclical nature of these indicators, further raising doubts about the actual sustainability of such improvement. However, the main candidate for trouble in the next couple of years could be the continuation of the capital bonanza. That has led to booms and bursts in the past and avoiding them will demand prudent policies and a cautious political stance, not yet a guarantee in many EM countries.

*Source: Deutsche Bank Research

6

5

4

3

2

1

0

-1

1980 1983 1986 1989 1992 1995 1998 2001 20072004

-2

7

Outlook for Emerging Market EconomiesAnother good year ahead but not for all

EM’s growth diff erential versus advanced economiesSource: World Bank, Growth diff erential EM versus Industrial CountryDB Global Markets Research Avg. diff erential per decade


Taimur Baig Chief Economist India, Indonesia and Philippines, Research

2.6 Economics

ASEAN Outlook Still attached to the G3?

Three years ago, as the global growth picture began to fray, there was a great deal of discussion about decoupling. The proponents argued that because of their relatively stronger fundamentals, the economies of East Asia would differentiate themselves by not slowing down while industrial country growth decelerated in 2008. There seemed to be some merit in this line of reasoning: Asian economies, by and large, enjoyed low fiscal deficits and debt (both public and private), generous reserves cover, sound banks, manageable inflation, and high savings. They were also characterised by a sizeable pick-up in intra-regional trade. Surely this would insulate them from a slowdown in external demand, the argument went.

The expectations turned out to be premature. While their fundamentals are undeniably strong, the open, trade-oriented economies of Asia still seem to be attached closely to the economic cycle of the G3. The macro data from the past couple of years underscore that point. Outside of China and India, the rest of Asia’s real GDP grew by 3.3% in 2008, followed by almost zero growth in 2009, and is expected to grow by 7% in 2010. This pattern of growth can be derived by taking the G3 growth trajectory and

applying a multiplicative factor of 3. In other words, through the course of this crisis, East Asian economies have revealed themselves to be tightly coupled with the fate of the G3.

Since our G3 forecast for 2011 is lower than 2010 (US: 3%, EU: 1%, Japan 0%), do we therefore believe that East Asia’s growth will be proportionately lower as well? Indeed, we have lowered our growth forecast for the region to 4.6%, dovetailing with the expectation that euro area growth will be lower by 0.5% and Japan’s by 2.5%. Despite the US forecast being essentially the same as the expected outcome for 2010, Asian economies will find external demand weaker because of the other two parts of the G3.

The reason for the tight attachment is not surprising. There exists remarkably close linkage between regional exports and consumption. Even investment looks to follow the export cycle closely. In recent years this linkage has not waned, underscoring why the East Asia region remains a strong beta to G3 growth. Of course there is substantial heterogeneity among the countries in the region. Singapore, Hong Kong and Taiwan reveal the highest degree of export reliance and

elasticity with respect to G3 growth. Malaysia, Thailand and Korea follow, with substantial but relatively smaller correlation with industrial country demand. Indonesia is a stand out, looking closer to India/China with its internal demand dynamic dominating the export dynamic, although the country’s fortune remains tied to the commodity price cycle to some extent.

In addition to the notion of decoupling, there is also this tendency to think of the Association of Southeast Asian Nations (ASEAN) countries as a group, distinct from the North Asian economies. The distinctions, however, dissipate under closer scrutiny. ASEAN includes both Asia’s most export-dependent economy (Singapore) and also its least sensitive economy (Indonesia). As a region, ASEAN is on average slightly less open and slightly less sensitive to global growth than North Asia. Also, ASEAN has a lower share of its exports going to China than North Asia. Still, it doesn’t seem to matter. Whether exports are going to China or elsewhere, the export

dynamic of ASEAN and North Asia remains remarkably similar. This is of course due to the fact that China’s role in Asia today is still largely as a processing location for the rest of Asia’s exports – goods are exported to China, processed (often with little marginal value added) and re-exported from China (mainly to the US and the EU).

While growth should likely slow somewhat, inflation risks could resurface in 2011 in East Asia as commodity prices firm up further. Food prices may also pick up after a relatively benign year. But we don’t think that policy makers would have to raise rates in a hurry as prices should likely rise gradually barring shocks. Other than Indonesia, we don’t find any other East Asian economies flirting with overheating. Policy rates should rise eventually in the region, but at small increments, and mostly in the second half of the year.

The region will likely continue to struggle with managing capital

inflows in the new year. We have already seen several episodes of easy liquidity-driven surges in flows which have caused complications with regard to reserve accumulation, exchange rate appreciation, asset price spikes, and lending booms. We expect these issues to remain front and centre as investors are likely to maintain their interest in Asian markets as growth and interest rate differentials stay compelling. In reaction, more measures to reduce flow volatility ought to be expected. There could also be an added complication if the secular rise in flows is interspersed with periods of risk aversion owing to the fiscal problems in EU’s peripheral countries.

All in all, 2011 should not look a whole lot different from 2010. In our view growth will slow and inflation will rise, but only somewhat. East Asia will remain coupled to G3 demand. Since we don’t expect much vigour in the G3, there should not be much in the way of spectacular performance in this region either.


Taimur Baig Chief Economist India, Indonesia and Philippines, Research

2.6 Economics

ASEAN Outlook Still attached to the G3?

Three years ago, as the global growth picture began to fray, there was a great deal of discussion about decoupling. The proponents argued that because of their relatively stronger fundamentals, the economies of East Asia would differentiate themselves by not slowing down while industrial country growth decelerated in 2008. There seemed to be some merit in this line of reasoning: Asian economies, by and large, enjoyed low fiscal deficits and debt (both public and private), generous reserves cover, sound banks, manageable inflation, and high savings. They were also characterised by a sizeable pick-up in intra-regional trade. Surely this would insulate them from a slowdown in external demand, the argument went.

The expectations turned out to be premature. While their fundamentals are undeniably strong, the open, trade-oriented economies of Asia still seem to be attached closely to the economic cycle of the G3. The macro data from the past couple of years underscore that point. Outside of China and India, the rest of Asia’s real GDP grew by 3.3% in 2008, followed by almost zero growth in 2009, and is expected to grow by 7% in 2010. This pattern of growth can be derived by taking the G3 growth trajectory and

applying a multiplicative factor of 3. In other words, through the course of this crisis, East Asian economies have revealed themselves to be tightly coupled with the fate of the G3.

Since our G3 forecast for 2011 is lower than 2010 (US: 3%, EU: 1%, Japan 0%), do we therefore believe that East Asia’s growth will be proportionately lower as well? Indeed, we have lowered our growth forecast for the region to 4.6%, dovetailing with the expectation that euro area growth will be lower by 0.5% and Japan’s by 2.5%. Despite the US forecast being essentially the same as the expected outcome for 2010, Asian economies will find external demand weaker because of the other two parts of the G3.

The reason for the tight attachment is not surprising. There exists remarkably close linkage between regional exports and consumption. Even investment looks to follow the export cycle closely. In recent years this linkage has not waned, underscoring why the East Asia region remains a strong beta to G3 growth. Of course there is substantial heterogeneity among the countries in the region. Singapore, Hong Kong and Taiwan reveal the highest degree of export reliance and

elasticity with respect to G3 growth. Malaysia, Thailand and Korea follow, with substantial but relatively smaller correlation with industrial country demand. Indonesia is a stand out, looking closer to India/China with its internal demand dynamic dominating the export dynamic, although the country’s fortune remains tied to the commodity price cycle to some extent.

In addition to the notion of decoupling, there is also this tendency to think of the Association of Southeast Asian Nations (ASEAN) countries as a group, distinct from the North Asian economies. The distinctions, however, dissipate under closer scrutiny. ASEAN includes both Asia’s most export-dependent economy (Singapore) and also its least sensitive economy (Indonesia). As a region, ASEAN is on average slightly less open and slightly less sensitive to global growth than North Asia. Also, ASEAN has a lower share of its exports going to China than North Asia. Still, it doesn’t seem to matter. Whether exports are going to China or elsewhere, the export

dynamic of ASEAN and North Asia remains remarkably similar. This is of course due to the fact that China’s role in Asia today is still largely as a processing location for the rest of Asia’s exports – goods are exported to China, processed (often with little marginal value added) and re-exported from China (mainly to the US and the EU).

While growth should likely slow somewhat, inflation risks could resurface in 2011 in East Asia as commodity prices firm up further. Food prices may also pick up after a relatively benign year. But we don’t think that policy makers would have to raise rates in a hurry as prices should likely rise gradually barring shocks. Other than Indonesia, we don’t find any other East Asian economies flirting with overheating. Policy rates should rise eventually in the region, but at small increments, and mostly in the second half of the year.

The region will likely continue to struggle with managing capital

inflows in the new year. We have already seen several episodes of easy liquidity-driven surges in flows which have caused complications with regard to reserve accumulation, exchange rate appreciation, asset price spikes, and lending booms. We expect these issues to remain front and centre as investors are likely to maintain their interest in Asian markets as growth and interest rate differentials stay compelling. In reaction, more measures to reduce flow volatility ought to be expected. There could also be an added complication if the secular rise in flows is interspersed with periods of risk aversion owing to the fiscal problems in EU’s peripheral countries.

All in all, 2011 should not look a whole lot different from 2010. In our view growth will slow and inflation will rise, but only somewhat. East Asia will remain coupled to G3 demand. Since we don’t expect much vigour in the G3, there should not be much in the way of spectacular performance in this region either.

Deutsche Bank Markets in 2011 —Foresight with InsightMarkets in 2011 —Foresight with Insight Deutsche Bank55

3 Markets

RegulationAsian EquitiesEuropean EquitiesUS EquitiesEM EquitiesFXCommoditiesRatesReal EstateAsset Backed SecuritiesArt

Deutsche Bank Markets in 2011 —Foresight with InsightMarkets in 2011 —Foresight with Insight Deutsche Bank55

3 Markets

RegulationAsian EquitiesEuropean EquitiesUS EquitiesEM EquitiesFXCommoditiesRatesReal EstateAsset Backed SecuritiesArt


The rules governing financial markets and financial institutions are likely to change more in 2011 and 2012 than at any time since the markets were first regulated in the 1930s.

Every major company of note will be affected from corporates and banks to hedge funds, insurers and pension funds. The cost will be enormous. Billions of euros will need to be spent on new IT systems and operational infrastructure between both market participants and the authorities that over see them. The impact on the markets will be as great, if not greater, than the Big Bang in the UK in 1986 and the repeal of Glass Steagall in the US in 1999. But many of the final details have yet to be decided; opportunity still exists for businesses likely to be affected to make their voice heard so that the changes benefit rather than harm the world’s financial markets.

So what are the key changes, when will they take place, what impact will they have, and what will companies need to do comply with them?

OTC derivatives This is the big one. Under the Dodd-Frank Act, US organisations will no longer be able to trade most forms of derivatives over the counter with brokers and banks, without also clearing them through an approved central clearing house.

This means that all the back office systems and trading networks of derivative market participants will

Regulatory ChangeWhat’s coming up and what to do about it

need to be overhauled to make them compatible with clearing houses. More significantly, it will also change the amount of margin that is posted. Many clients who have never had to post margin before, will have to, many clients already posting margin will likely have to post more. Derivative pricing and costs are almost certain to change. Details of derivative trades will start to be made public.

Key details such as which derivatives must be executed on a swap execution facility (SEF) and which can continue to be done on an OTC basis, what constitutes a swap execution facility, which derivatives must be cleared centrally, and whether some types of organisations will be excluded from the rules, have been left to the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to determine.

The details of regulatory reform are expected to be in place by July 2011 with implementation beginning for some rules in the third quarter of 2011 (after a 60-day period following publication); while other rules will only come into effect in 2012.

We expect the final rules to require financial institution clients using ‘flow’ derivatives on a wide range of asset classes, such as equity, foreign exchange, credit or interest rates to centrally clear transactions. Corporates will be largely excluded from this requirement.

Daniel Trinder Global Head of Regulatory Policy Stephen Wolff Managing Director, Strategic Investments

3.1 Markets

European organisations will almost certainly be subject to similar restrictions. Plans to move to central clearing, and plans for increased transparency, are included in both the European Market Infrastructure Directive (EMIR) and the Markets in Financial Instruments Directive (MiFID) respectively. The two pieces of legislation are at different stages of development; but further details on both were scheduled for publication by the end of 2010 with a final version of EMIR being agreed in mid-2011 for implementation in early 2012.

As a regulation, EMIR does not need to be approved by national parliaments in the EU to come into force so the timetable is more likely to be met.

The rules in Europe are expected to be broadly similar to those of the US except that the rules forcing trading to be conducted on electronic platforms may be less strict.

Although changes are not expected to occur anywhere in the first half of 2011 – and only in the US in the second half – it is critical that users of OTC derivatives likely to be affected by the new rules prepare a strategy to deal with them.

First off, they will need to choose a clearing partner. Second, they need to stay closely in touch with market developments and, as appropriate, make their views known to legislators and regulators on matters important

to them. There is still time to make a difference to the final details of the proposed changes.

Short selling Regulators are keen to implement new measures on short selling – indeed the German government already has.

Under initial EU proposals, short sellers will need to disclose positions to regulators and large positions to the general public. They will also need to have located the stock, making uncovered short selling impossible. It will also be possible for national European regulators to restrict or ban short selling in their jurisdictions.

If badly crafted, these changes could impair legitimate investment and risk management strategies. A regime that generates greater consistency and transparency should be welcomed but we are particularly concerned that if these measures are not thought through they will have significant detrimental effects on market liquidity, trading volumes and bid-ask spreads.

The rules are not likely to be finalised in mid-2011 and come into effect in 2012.

Commodity markets Commodity markets are generating the attention of regulators on several fronts. Concerns about a lack of transparency, asymmetry of information and speculative activity are leading to increased oversight,


The rules governing financial markets and financial institutions are likely to change more in 2011 and 2012 than at any time since the markets were first regulated in the 1930s.

Every major company of note will be affected from corporates and banks to hedge funds, insurers and pension funds. The cost will be enormous. Billions of euros will need to be spent on new IT systems and operational infrastructure between both market participants and the authorities that over see them. The impact on the markets will be as great, if not greater, than the Big Bang in the UK in 1986 and the repeal of Glass Steagall in the US in 1999. But many of the final details have yet to be decided; opportunity still exists for businesses likely to be affected to make their voice heard so that the changes benefit rather than harm the world’s financial markets.

So what are the key changes, when will they take place, what impact will they have, and what will companies need to do comply with them?

OTC derivatives This is the big one. Under the Dodd-Frank Act, US organisations will no longer be able to trade most forms of derivatives over the counter with brokers and banks, without also clearing them through an approved central clearing house.

This means that all the back office systems and trading networks of derivative market participants will

Regulatory ChangeWhat’s coming up and what to do about it

need to be overhauled to make them compatible with clearing houses. More significantly, it will also change the amount of margin that is posted. Many clients who have never had to post margin before, will have to, many clients already posting margin will likely have to post more. Derivative pricing and costs are almost certain to change. Details of derivative trades will start to be made public.

Key details such as which derivatives must be executed on a swap execution facility (SEF) and which can continue to be done on an OTC basis, what constitutes a swap execution facility, which derivatives must be cleared centrally, and whether some types of organisations will be excluded from the rules, have been left to the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to determine.

The details of regulatory reform are expected to be in place by July 2011 with implementation beginning for some rules in the third quarter of 2011 (after a 60-day period following publication); while other rules will only come into effect in 2012.

We expect the final rules to require financial institution clients using ‘flow’ derivatives on a wide range of asset classes, such as equity, foreign exchange, credit or interest rates to centrally clear transactions. Corporates will be largely excluded from this requirement.

Daniel Trinder Global Head of Regulatory Policy Stephen Wolff Managing Director, Strategic Investments

3.1 Markets

European organisations will almost certainly be subject to similar restrictions. Plans to move to central clearing, and plans for increased transparency, are included in both the European Market Infrastructure Directive (EMIR) and the Markets in Financial Instruments Directive (MiFID) respectively. The two pieces of legislation are at different stages of development; but further details on both were scheduled for publication by the end of 2010 with a final version of EMIR being agreed in mid-2011 for implementation in early 2012.

As a regulation, EMIR does not need to be approved by national parliaments in the EU to come into force so the timetable is more likely to be met.

The rules in Europe are expected to be broadly similar to those of the US except that the rules forcing trading to be conducted on electronic platforms may be less strict.

Although changes are not expected to occur anywhere in the first half of 2011 – and only in the US in the second half – it is critical that users of OTC derivatives likely to be affected by the new rules prepare a strategy to deal with them.

First off, they will need to choose a clearing partner. Second, they need to stay closely in touch with market developments and, as appropriate, make their views known to legislators and regulators on matters important

to them. There is still time to make a difference to the final details of the proposed changes.

Short selling Regulators are keen to implement new measures on short selling – indeed the German government already has.

Under initial EU proposals, short sellers will need to disclose positions to regulators and large positions to the general public. They will also need to have located the stock, making uncovered short selling impossible. It will also be possible for national European regulators to restrict or ban short selling in their jurisdictions.

If badly crafted, these changes could impair legitimate investment and risk management strategies. A regime that generates greater consistency and transparency should be welcomed but we are particularly concerned that if these measures are not thought through they will have significant detrimental effects on market liquidity, trading volumes and bid-ask spreads.

The rules are not likely to be finalised in mid-2011 and come into effect in 2012.

Commodity markets Commodity markets are generating the attention of regulators on several fronts. Concerns about a lack of transparency, asymmetry of information and speculative activity are leading to increased oversight,


with position limits and more comprehensive trade reporting under consideration.

Hedge funds Hedge funds are to be subject to more regulation due to the Alternative Investment Fund Managers Directive in Europe and similar, though less prescriptive proposals in the US. Although the EU proposal is less severe than originally drafted, it will still give rise to many new organisational and governance requirements for hedge fund managers such as stricter internal controls, reporting lines, board composition and management structure, and client service issues for prime brokers.

Shadow banking Numerous regulators and politicians have expressed concern about the ‘shadow banking system’, such as money market funds and non-bank investment vehicles. This pre-occupation is unlikely to go away. Once again a perceived lack of transparency may generate a review of where the boundaries of regulated and non-regulated should be set.

Corporate governance The UK has already issued a broad based call for proposals on how to improve governance in the financial services sector. EU proposals for tighter governance rules for financial services firms will be issued in the spring. Together with reform of the way auditors are regulated, these corporate governance proposals have the potential to significantly impact the way firms are supervised and how they relate to and act as shareholders. As in other areas the dynamic is going to be more intervention in markets not less.

Financial sector taxation While the idea of an international ‘Tobin’ tax, or ‘Financial Transaction’ tax, has lost momentum at the G20 level, France as the next G20 chair may look to reinvigorate thinking in this area. The EU is also committed to developing a ‘Financial Activities’ tax, targeting overall profits and remuneration for financial firms.

With sluggish growth and tight fiscal conditions, the temptation for governments to reach for additional financial sector taxes should remain strong – as has already been seen with the proliferation of bank levies introduced across the EU (UK, Germany, France, Portugal, Hungary, Sweden and Austria).

Regulatory capital The G20 mandated various bodies to tighten up regulatory capital rules. The most high profile initiative is the Basel 3 Accord which narrows the definition of regulatory capital, significantly increases the minimum requirements and introduces global standards for liquidity and introduces a leverage ratio. An additional capital conservation buffer will be required so as to absorb losses in stressed periods and, as it is used up, will increasingly constrain banks’ ability to distribute earnings. The G20 have endorsed the headline requirements and phasing in approach (ahead of full implementation in 2019). Work continues on the detailed text.

3.1 Markets

EU regulatory proposalsSource: Deutsche Bank

US regulatory proposals (via Dodd-Frank Act)Source: Deutsche Bank

Initiative Focus Impacts Timing Clients affected

Short selling – Pan-European legislation including private and public disclosure

– Uncovered positions in Credit Default Swaps (CDS)

– Disclosure of sovereign CDS

– Public disclosure will lead to reduced participation in equity markets

– Detrimental to market ‘early warning’ system

Legislative proposal expected Q1 2011

– All short sellers in the EU markets, particularly hedge funds

– Pension funds that lend stock

OTC derivatives (EU Market Infrastructure Regulation -EMIR)

– Aim of greater transparency – CCP clearing for standardised

derivatives – Move to trading on recognised

venues (via MiFID) – Reporting via trade repositories

– Trading on venues hampered by insufficient liquidity

– Reduced ability to fully hedge exposures

– Lower profitability of derivative trades and reduced liquidity as a result of bid/ask compression

– Need for clients to re-assess clearing solutions

End 2012 to come into full effect

– All regulated firms trading in the OTC markvets

– Corporate end-users (but subject to exemptions and trigger thresholds still to be determined)

Review of markets in Financial Instruments Directive (MiFID)

– Micro-structural issues (HFT, dark pools)

– Solve fragmentation of market data – More transparency in fixed income

markets – Transaction reporting

– Decreased liquidity/trading volumes – Increased regulation of, or

restrictions on, HFT, dark pools, broker crossing networks

– Position limits for commodities

Legislative proposal expected May 2011. 2012/13 for final law

– All investment firms as defined under MiFID

– Possible increased regulation for commodity traders

Alternative Investment Fund Managers Directive (AIFMD)

– Cross-border marketing – Governance – Use of depositories

– Stricter depository liability – Remuneration guidelines for hedge

fund industry and more robust control requirements

Law has been agreed but further rule-making will take place in 2011

– Hedge funds – Prime brokers – Custodians

Market Abuse Directive (MAD)

– Extension of market abuse rules to instruments traded on a Multi-Lateral Trading Facility (MTF)

– Extension of inside information provisions to commodity derivatives

– New requirements may go too wide or create confusion due to differing regimes for different market segments

Legislative proposal due in Q1 2011

– All market participants

Bank levies – UK: 0.07% (0.04% in 2011) on banks with liab. > GBP20 billion

– German: 0.04% for banks with liab. > EUR100 billion (smaller levy for smaller banks)

– US: 0.15% on banks with assets > $50 billion – still under legislative review

– Unclear how US, UK & German approaches will overlap – potential for double-taxation

– Possible implications for moving businesses

– Competitive advantage for non-levy regions (e.g. Asia)

EU proposal expected end of 2010; US still under legislative review

– EU banks


‘Volcker’ rule (ban on proprietary trading)

– Ban on proprietary trading in deposit-taking banks, although several exemptions exist

– PE/HF investment capped at 3%

– Liquidity implications for market dependent on how ‘proprietary trading’ is defined by rule-makers

– Elimination of P and L from proprietary trading

Within 2 years (extensions possible)

– Primarily US banks

Swap desk push-out – Swaps moved into separately capitalised non-bank affiliates (excludes hedging own risk, interest rate, FX, certain metals – approx. 80% of OTC today)

– No federal assistance for swap trading entities


– Primarily US banks with large equity and commodity derivatives business

OTC Derivatives – OTC derivatives required to be centrally cleared, although many exemptions exist

– Less focus on exchange trading and standardisation

– Cleared derivatives will be exchange-traded, which will cause bid/ask compression

– Non-cleared trades subject to greater capital requirements

Rule-making due to be completed July 2011

– Commodity traders

– FCMs – End-users (subject

to exemptions

Capital – U.S. BHCs of foreign banks required to be capitalised in line with U.S. banks

– Significant implications for foreign bank holding companies

– Capital requirements TBD

5-year phase-in for foreign banks

– Non-US banking groups

In response to the ‘too big to fail’ problem, the G20 have endorsed the principles set out by the Financial Stability Board for banks considered systemically important (either nationally, internationally or globally) and further detail will follow in mid-2011. This is likely to result in capital surcharges (higher for a group of some 20 or so globally systemic firms), increased regulatory scrutiny and coordinated decision-making by regulators. The Basel Committee is also working on the mechanics of countercyclical capital buffers and a number of proposals relating to contingent capital and ‘bail in’, designed to reduce the likelihood of tax payers’ money being used to ‘bail out’ banks in future.

Also in the near-term, preparations continue for implementation of Basel 2.5, which introduces new mechanisms to capture the risks in the trading book and stricter treatment of securitisation and correlation trading, essentially trebling the amount of capital held against trading instruments.

Predictions about the impact of Basel 3 on the global economy and availability of credit vary. However it is clear that the next few years will see increased bank capital raising and, as the detail is digested, strategic revision of individual banks’ business models. However, reaching this stage is simply the end of the first act: across the world regulators now have to implement the agreement through national law and there is significant concern within the industry and politically about the potential for inconsistency, particularly in the US, EU and Asia.


with position limits and more comprehensive trade reporting under consideration.

Hedge funds Hedge funds are to be subject to more regulation due to the Alternative Investment Fund Managers Directive in Europe and similar, though less prescriptive proposals in the US. Although the EU proposal is less severe than originally drafted, it will still give rise to many new organisational and governance requirements for hedge fund managers such as stricter internal controls, reporting lines, board composition and management structure, and client service issues for prime brokers.

Shadow banking Numerous regulators and politicians have expressed concern about the ‘shadow banking system’, such as money market funds and non-bank investment vehicles. This pre-occupation is unlikely to go away. Once again a perceived lack of transparency may generate a review of where the boundaries of regulated and non-regulated should be set.

Corporate governance The UK has already issued a broad based call for proposals on how to improve governance in the financial services sector. EU proposals for tighter governance rules for financial services firms will be issued in the spring. Together with reform of the way auditors are regulated, these corporate governance proposals have the potential to significantly impact the way firms are supervised and how they relate to and act as shareholders. As in other areas the dynamic is going to be more intervention in markets not less.

Financial sector taxation While the idea of an international ‘Tobin’ tax, or ‘Financial Transaction’ tax, has lost momentum at the G20 level, France as the next G20 chair may look to reinvigorate thinking in this area. The EU is also committed to developing a ‘Financial Activities’ tax, targeting overall profits and remuneration for financial firms.

With sluggish growth and tight fiscal conditions, the temptation for governments to reach for additional financial sector taxes should remain strong – as has already been seen with the proliferation of bank levies introduced across the EU (UK, Germany, France, Portugal, Hungary, Sweden and Austria).

Regulatory capital The G20 mandated various bodies to tighten up regulatory capital rules. The most high profile initiative is the Basel 3 Accord which narrows the definition of regulatory capital, significantly increases the minimum requirements and introduces global standards for liquidity and introduces a leverage ratio. An additional capital conservation buffer will be required so as to absorb losses in stressed periods and, as it is used up, will increasingly constrain banks’ ability to distribute earnings. The G20 have endorsed the headline requirements and phasing in approach (ahead of full implementation in 2019). Work continues on the detailed text.

3.1 Markets

EU regulatory proposalsSource: Deutsche Bank

US regulatory proposals (via Dodd-Frank Act)Source: Deutsche Bank


Short selling – Pan-European legislation including private and public disclosure

– Uncovered positions in Credit Default Swaps (CDS)

– Disclosure of sovereign CDS

– Public disclosure will lead to reduced participation in equity markets

– Detrimental to market ‘early warning’ system

Legislative proposal expected Q1 2011

– All short sellers in the EU markets, particularly hedge funds

– Pension funds that lend stock

OTC derivatives (EU Market Infrastructure Regulation -EMIR)

– Aim of greater transparency – CCP clearing for standardised

derivatives – Move to trading on recognised

venues (via MiFID) – Reporting via trade repositories

– Trading on venues hampered by insufficient liquidity

– Reduced ability to fully hedge exposures

– Lower profitability of derivative trades and reduced liquidity as a result of bid/ask compression

– Need for clients to re-assess clearing solutions

End 2012 to come into full effect

– All regulated firms trading in the OTC markvets

– Corporate end-users (but subject to exemptions and trigger thresholds still to be determined)

Review of markets in Financial Instruments Directive (MiFID)

– Micro-structural issues (HFT, dark pools)

– Solve fragmentation of market data – More transparency in fixed income

markets – Transaction reporting

– Decreased liquidity/trading volumes – Increased regulation of, or

restrictions on, HFT, dark pools, broker crossing networks

– Position limits for commodities

Legislative proposal expected May 2011. 2012/13 for final law

– All investment firms as defined under MiFID

– Possible increased regulation for commodity traders

Alternative Investment Fund Managers Directive (AIFMD)

– Cross-border marketing – Governance – Use of depositories

– Stricter depository liability – Remuneration guidelines for hedge

fund industry and more robust control requirements

Law has been agreed but further rule-making will take place in 2011

– Hedge funds – Prime brokers – Custodians

Market Abuse Directive (MAD)

– Extension of market abuse rules to instruments traded on a Multi-Lateral Trading Facility (MTF)

– Extension of inside information provisions to commodity derivatives

– New requirements may go too wide or create confusion due to differing regimes for different market segments

Legislative proposal due in Q1 2011

– All market participants

Bank levies – UK: 0.07% (0.04% in 2011) on banks with liab. > GBP20 billion

– German: 0.04% for banks with liab. > EUR100 billion (smaller levy for smaller banks)

– US: 0.15% on banks with assets > $50 billion – still under legislative review

– Unclear how US, UK & German approaches will overlap – potential for double-taxation

– Possible implications for moving businesses

– Competitive advantage for non-levy regions (e.g. Asia)

EU proposal expected end of 2010; US still under legislative review

– EU banks


‘Volcker’ rule (ban on proprietary trading)

– Ban on proprietary trading in deposit-taking banks, although several exemptions exist

– PE/HF investment capped at 3%

– Liquidity implications for market dependent on how ‘proprietary trading’ is defined by rule-makers

– Elimination of P and L from proprietary trading


– Primarily US banks

Swap desk push-out – Swaps moved into separately capitalised non-bank affiliates (excludes hedging own risk, interest rate, FX, certain metals – approx. 80% of OTC today)

– No federal assistance for swap trading entities


– Primarily US banks with large equity and commodity derivatives business

OTC Derivatives – OTC derivatives required to be centrally cleared, although many exemptions exist

– Less focus on exchange trading and standardisation

– Cleared derivatives will be exchange-traded, which will cause bid/ask compression

– Non-cleared trades subject to greater capital requirements

Rule-making due to be completed July 2011

– Commodity traders

– FCMs – End-users (subject

to exemptions

Capital – U.S. BHCs of foreign banks required to be capitalised in line with U.S. banks

– Significant implications for foreign bank holding companies

– Capital requirements TBD

5-year phase-in for foreign banks

– Non-US banking groups

In response to the ‘too big to fail’ problem, the G20 have endorsed the principles set out by the Financial Stability Board for banks considered systemically important (either nationally, internationally or globally) and further detail will follow in mid-2011. This is likely to result in capital surcharges (higher for a group of some 20 or so globally systemic firms), increased regulatory scrutiny and coordinated decision-making by regulators. The Basel Committee is also working on the mechanics of countercyclical capital buffers and a number of proposals relating to contingent capital and ‘bail in’, designed to reduce the likelihood of tax payers’ money being used to ‘bail out’ banks in future.

Also in the near-term, preparations continue for implementation of Basel 2.5, which introduces new mechanisms to capture the risks in the trading book and stricter treatment of securitisation and correlation trading, essentially trebling the amount of capital held against trading instruments.

Predictions about the impact of Basel 3 on the global economy and availability of credit vary. However it is clear that the next few years will see increased bank capital raising and, as the detail is digested, strategic revision of individual banks’ business models. However, reaching this stage is simply the end of the first act: across the world regulators now have to implement the agreement through national law and there is significant concern within the industry and politically about the potential for inconsistency, particularly in the US, EU and Asia.


Global regulatory capital proposalsSource: Deutsche Bank


Securitisation (via Capital Requirements Directive2 - CRD 2 - and Dodd-Frank Act)

– 5% risk retention (10% in Germany), greater due diligence and disclosure

– Higher risk weighting on (re-) securitised assets

– More stringent than US rules, come into effect sooner

– Disadvantages for foreign banks with US securitisation businesses

Dec 31, 2010 – All regulated financial institutions (except insurance companies which are subject to the Solvency 2 proposals which we do not reference here)

Basel 2.5 / CRD 3 – New trading book rules: correlation trading, trading book securitisation, stressed VaR, incremental risk charge

– Remuneration restrictions

– Significant capital impact – EU competitive disadvantage due to

remuneration limits – Stringent diligence requirements on

securitisation

Dec 31, 2011 (with phase-ins)Dec 31, 2010 (for remuneration)

– All regulated financial institutions (except insurance companies which are subject to the Solvency 2 proposals which we do not reference here)

Basel 3 / CRD 4 – New capital rules: capital deductions, equity treatment, composition of capital, capital buffers, leverage ratio

– New liquidity rules: liquidity coverage ratio, net stable funding ratio

– Calibration and limits TBD – Restrictions on what counts as Tier

1 (strong push to equity) – Fixed leverage ratio – Cost of regulatory capital will

increase

Dec 31, 2012 – 2020(various phase-ins)


What to do? We recommend that all companies assess their business, scope of operations and future strategy very rigorously before the new regulations come into effect.

At present, the various initiatives being pursued are not always joined up and even simple questions such as where a trade is executed, booked, settled, cleared or where the custody account is held could have significant implications in terms of what rules apply, with added consequences for processes, resourcing and costs.

It is especially important for the investment community to become more vocal. Many of the crucial proposals are not yet finalised or will have further consultation and rule-making phases during 2011 and

beyond. A frequent plea from policy-makers is that they want, and need, to hear from the investor and client community.

Engaging in the regulatory debate is critical when the stakes are so high. Earlier in 2010 the initial proposals on new capital requirements would have seen banks needing to acquire an extra $5.6 trillion in reserves. Also, the increased activity of the hedge fund community helped to ameliorate parts of the EU hedge funds proposal.

The magnitude of some of these issues has shifted the dynamic of regulatory debates. There is a political dimension to regulatory risk that also needs to be managed.

3.1 Markets

Deutsche Bank’s ‘risk-love barometer’ – which tracks the number of Asian equity indicators showing extreme euphoria minus the number exhibiting extreme panic – has gone off the scale in recent months to reach euphoric levels. Nearly every investor we talk to is a committed bull.

Given this and our relative pessimism about the US dollar, our near-term recommendation on Asian equities is ‘neutral, recognising downside risk.’

Putting aside concerns about excessive investor enthusiasm, a lot of good things are coming together for Asian equities: absolute valuations look fair, our proprietary leading growth indicators are bottoming, deflation risks are evaporating, the terms of trade for Asia are rising, the world’s central banks are easing in the meatiest part of the US presidential cycle, the early monetary tightening in Asia is relatively unthreatening, and technicals are robust.

Many of these indicators were hostile a few months ago – the turnaround has been swift. Historically, little good has come from jumping on the bandwagon when equity sentiment on emerging markets (EM) is as bullish as now. We think any pullback in equities/sentiment would offer a much better opportunity to recognise substantially improved equity fundamentals in Asia. The usual winners in Asia ex-Japan – value and earnings momentum – are again demonstrating their potency. These two factors and profitability form the core of our bottom-up stock selection process. Our favourite markets include Hong Kong, Korea and Malaysia. Our favourite sectors are retailing, autos, capital goods and banks.

Outlook for Asian EquitiesSigns of euphoria

Cyclically, some of the leading indicators of capex – the availability of credit, CEO confidence and global operating cash flows – look to be rolling over, but the levels look fine. We think that once confidence in regulations, fiscal policymaking, trade and currency policy, and central bank control is established, the severe under-investment in this cycle should be behind us. Asia is doing a lot more capex on a sector-by-sector basis compared with the rest of the world. The region that tends to over-invest tends to lag in terms of prospective ROEs in the next cycle. Asia under-invested in the post-crisis 1997-2002 period and its ROEs caught up with the US in the 2003-08 period. In the last few years, the US and Europe have been under-investing versus Asia. Consistency demands we expect Asia’s ROEs to be beaten by the underinvesting US and Europe. The Asian debt-driven crisis of 1997-98 is long gone from corporate memories, and a new cycle of over-confidence could well see a new leverage cycle in Asia to finance new capex, mergers and acquisitions and cross-border acquisitions to secure markets and technology.

While the price of entry is the key for cyclical entry points into equities, we think longer-term investors should rely on the Demi-Ashton ratio (the ratio of people in their 40s to 20s) to guide equity allocations. Equity allocations are low for those in their 20s and 30s, when people are buying ‘stuff’ – a house, education, automobiles, furniture etc. When they reach their 40s, they raise their equity allocations sharply, worried about impending retirement and with excess savings to invest.

History tells us that the ratio of people in their 40s to 20s – the Demi-Ashton ratio – is a key driver of long-term real equity returns.

Here, the news for Asia is excellent. Almost all countries within the region are expected to see an explosion of their Demi-Ashton ratios in the next 20 years. Conversely, the Demi-Ashton ratios in developed markets are projected to fall until 2015 and rise very gently thereafter. The relative rise in EM Demi-Ashton ratios versus the US (as a proxy for developed markets) is remarkable – it rises all the way to 2030, with a decline thereafter.

For long-term investors, a large overweight in EMs versus developed markets is strongly recommended, based on projected demographic differentials. Over the next 5-10 years, the Demi-Ashton ratios are projected to rise the most in Indonesia, India and the Philippines in Asia.

Overall, prospects for the region’s equity markets look strong for 2011.

Ajay Kapur Head of Asia Equity Strategy, Research

3.2 Markets


Global regulatory capital proposalsSource: Deutsche Bank


Securitisation (via Capital Requirements Directive2 - CRD 2 - and Dodd-Frank Act)

– 5% risk retention (10% in Germany), greater due diligence and disclosure

– Higher risk weighting on (re-) securitised assets

– More stringent than US rules, come into effect sooner

– Disadvantages for foreign banks with US securitisation businesses

Dec 31, 2010 – All regulated financial institutions (except insurance companies which are subject to the Solvency 2 proposals which we do not reference here)

Basel 2.5 / CRD 3 – New trading book rules: correlation trading, trading book securitisation, stressed VaR, incremental risk charge

– Remuneration restrictions

– Significant capital impact – EU competitive disadvantage due to

remuneration limits – Stringent diligence requirements on

securitisation

Dec 31, 2011 (with phase-ins)Dec 31, 2010 (for remuneration)


Basel 3 / CRD 4 – New capital rules: capital deductions, equity treatment, composition of capital, capital buffers, leverage ratio

– New liquidity rules: liquidity coverage ratio, net stable funding ratio

– Calibration and limits TBD – Restrictions on what counts as Tier

1 (strong push to equity) – Fixed leverage ratio – Cost of regulatory capital will

increase

Dec 31, 2012 – 2020(various phase-ins)


What to do? We recommend that all companies assess their business, scope of operations and future strategy very rigorously before the new regulations come into effect.

At present, the various initiatives being pursued are not always joined up and even simple questions such as where a trade is executed, booked, settled, cleared or where the custody account is held could have significant implications in terms of what rules apply, with added consequences for processes, resourcing and costs.

It is especially important for the investment community to become more vocal. Many of the crucial proposals are not yet finalised or will have further consultation and rule-making phases during 2011 and

beyond. A frequent plea from policy-makers is that they want, and need, to hear from the investor and client community.

Engaging in the regulatory debate is critical when the stakes are so high. Earlier in 2010 the initial proposals on new capital requirements would have seen banks needing to acquire an extra $5.6 trillion in reserves. Also, the increased activity of the hedge fund community helped to ameliorate parts of the EU hedge funds proposal.

The magnitude of some of these issues has shifted the dynamic of regulatory debates. There is a political dimension to regulatory risk that also needs to be managed.

3.1 Markets

Deutsche Bank’s ‘risk-love barometer’ – which tracks the number of Asian equity indicators showing extreme euphoria minus the number exhibiting extreme panic – has gone off the scale in recent months to reach euphoric levels. Nearly every investor we talk to is a committed bull.

Given this and our relative pessimism about the US dollar, our near-term recommendation on Asian equities is ‘neutral, recognising downside risk.’

Putting aside concerns about excessive investor enthusiasm, a lot of good things are coming together for Asian equities: absolute valuations look fair, our proprietary leading growth indicators are bottoming, deflation risks are evaporating, the terms of trade for Asia are rising, the world’s central banks are easing in the meatiest part of the US presidential cycle, the early monetary tightening in Asia is relatively unthreatening, and technicals are robust.

Many of these indicators were hostile a few months ago – the turnaround has been swift. Historically, little good has come from jumping on the bandwagon when equity sentiment on emerging markets (EM) is as bullish as now. We think any pullback in equities/sentiment would offer a much better opportunity to recognise substantially improved equity fundamentals in Asia. The usual winners in Asia ex-Japan – value and earnings momentum – are again demonstrating their potency. These two factors and profitability form the core of our bottom-up stock selection process. Our favourite markets include Hong Kong, Korea and Malaysia. Our favourite sectors are retailing, autos, capital goods and banks.

Outlook for Asian EquitiesSigns of euphoria

Cyclically, some of the leading indicators of capex – the availability of credit, CEO confidence and global operating cash flows – look to be rolling over, but the levels look fine. We think that once confidence in regulations, fiscal policymaking, trade and currency policy, and central bank control is established, the severe under-investment in this cycle should be behind us. Asia is doing a lot more capex on a sector-by-sector basis compared with the rest of the world. The region that tends to over-invest tends to lag in terms of prospective ROEs in the next cycle. Asia under-invested in the post-crisis 1997-2002 period and its ROEs caught up with the US in the 2003-08 period. In the last few years, the US and Europe have been under-investing versus Asia. Consistency demands we expect Asia’s ROEs to be beaten by the underinvesting US and Europe. The Asian debt-driven crisis of 1997-98 is long gone from corporate memories, and a new cycle of over-confidence could well see a new leverage cycle in Asia to finance new capex, mergers and acquisitions and cross-border acquisitions to secure markets and technology.

While the price of entry is the key for cyclical entry points into equities, we think longer-term investors should rely on the Demi-Ashton ratio (the ratio of people in their 40s to 20s) to guide equity allocations. Equity allocations are low for those in their 20s and 30s, when people are buying ‘stuff’ – a house, education, automobiles, furniture etc. When they reach their 40s, they raise their equity allocations sharply, worried about impending retirement and with excess savings to invest.

History tells us that the ratio of people in their 40s to 20s – the Demi-Ashton ratio – is a key driver of long-term real equity returns.

Here, the news for Asia is excellent. Almost all countries within the region are expected to see an explosion of their Demi-Ashton ratios in the next 20 years. Conversely, the Demi-Ashton ratios in developed markets are projected to fall until 2015 and rise very gently thereafter. The relative rise in EM Demi-Ashton ratios versus the US (as a proxy for developed markets) is remarkable – it rises all the way to 2030, with a decline thereafter.

For long-term investors, a large overweight in EMs versus developed markets is strongly recommended, based on projected demographic differentials. Over the next 5-10 years, the Demi-Ashton ratios are projected to rise the most in Indonesia, India and the Philippines in Asia.

Overall, prospects for the region’s equity markets look strong for 2011.

Ajay Kapur Head of Asia Equity Strategy, Research

3.2 Markets


Figure 4:Drivers of earningsSource: Deutsche Bank, Datastream, IMF Real Fed Funds rate Earnings yield (rhs) Irrational exuberance

Figure 3:Global GDP growth and European earningsSource: Deutsche Bank, Datastream, IMF Global growth (PPP) DS Europe real EPS growth (rhs)

3.3Markets

The Credit Impulse and the Outlook for European EquitiesPrice rises ahead

Michael BiggsCo-Head of European Equity Strategy, Research

Gareth EvansCo-Head of European Equity Strategy, Research

European equities are essentially a play on the global economy, and we expect real global GDP growth of 3.8% in 2011, supported by a sustained recovery in emerging market (EM) and US GDP growth of 3%.

Our optimism is based on the exceptionally low levels of new borrowing currently, and our belief that all that is required for a recovery in demand is that new borrowing rises. In other words, credit growth does not need to turn positive. We call this change in new borrowing the ‘credit impulse’.

GDP globally. The equilibrium level of borrowing is probably somewhere between 5% and 10% of GDP, and while it is diffi cult to know where new borrowing is going to be next quarter, it is highly likely that new borrowing will return to these equilibrium levels in the coming years. And while new borrowing rises, the credit impulse will on average be positive, and real domestic demand growth should be stronger than potential.

If real global GDP growth is 3.8% in 2011, we would expect real earnings growth on the Stoxx 600 of 12%

The US non-fi nancial private sector paid down debt aggressively in 2009 (Figure 1), and as the pace of de-leveraging slowed in 2010 and the amount of new borrowing increased, the credit impulse turned positive and real private sector demand growth rebounded (Figure 2). We expect the pace of de-leveraging to slow further in 2011, and for the recovery in real private sector demand growth to be stronger than the market expects.

This bullish argument is not only relevant to 2011. Private sector new borrowing is currently around -2% of

The macroeconomic environment is excellent for European equities at present: global growth is recovering more strongly than expected and central banks are keeping interest rates low in an attempt to lower unemployment. We expect the Stoxx 600 to rise to 315 by the end of 2011, for a total return of 20%.

1952 1959 1966 1973 1980 1987 1994 20082001 2015

-5

0

-10

5

10

15

20 % of GDP

(Figure 3). The impact of the GDP growth is magnifi ed on earnings due to margin widening, driven by operational gearing on one hand and low unit labour costs stemming from high unemployment on the other.

The outlook for ratings is equally compelling. The earnings yield has been well correlated with the real Fed funds rate over time (Figure 4). At present, equities have already priced in a normalisation of policy rates and, if interest rates remain lower in future than they have been in the past, we would expect equity ratings to be higher.

Equities also look extremely good value relative to credit – the earnings yield on the S&P500 is at 25-year highs relative the real BBB corporate bond yield.

1967 1972 1977 1982 1987 1992 1997 2002 2007 2010

-4

-6

-8

-10

-12

-2

0

2

4

6

8 change, % of GDP % yoy 12

8

4

0

-4

-8

-12

1982 1985 1988 1991 1994 1997 2000 20062003 2009

-1.5

0.5

-3.5

2.5

4.5

6.5

8.5

10.5

12.5 % yoy

2

4

0

6

8

10

12

14

16

1980 1984 1988 1992 1996 2000 2004 2008

0

-1

1

2

3

4

5

6 % yoy

-30

-40

-20

-10

0

10

20

% yoy 30

Figure 1:US new borrowing as a % of GDPSource: Deutsche Bank, US Federal Reserve, BEA Forecast New borrowing as a % of GDP,

non-fi nancial private sector

The consensus expectation for US growth in 2011 is around 2.3%, and the increase in GDP growth we anticipate towards 3% should be suffi cient to trigger the next leg of the equity rally.

So if you agree with our optimistic outlook for European equities, what stocks should you buy? We believe that companies off ering high dividend yields will be the best place to start.

Dividend yields on many European large cap stocks are signifi cantly higher than the returns on cash or fi xed income enabling investors to increase portfolio returns without a signifi cant increase in risk.

Signifi cantly, there are plenty of companies out there that off er good dividend yields and good growth

potential. This is very rare. Historically, companies that pay high dividends have generally not off ered great growth potential and vice versa. But today, there are plenty of stocks that seem to off er both.

A higher risk strategy would be to go long mid-cycle cyclical sectors such as media, technology and, potentially, fi nancial services.

The latter off ers the biggest potential for gains but does have fairly sizeable downside risk in the shape of further sovereign debt events.

All in all, though, our view is that the outlook for European equities is very strong.

Figure 2:US credit impulse and private demand growthSource: Deutsche Bank, US Federal Reserve, BEA Credit impulse (lhs) Private demand growth (c+l, rhs)


Figure 4:Drivers of earningsSource: Deutsche Bank, Datastream, IMF Real Fed Funds rate Earnings yield (rhs) Irrational exuberance

Figure 3:Global GDP growth and European earningsSource: Deutsche Bank, Datastream, IMF Global growth (PPP) DS Europe real EPS growth (rhs)

3.3Markets

The Credit Impulse and the Outlook for European EquitiesPrice rises ahead

Michael BiggsCo-Head of European Equity Strategy, Research

Gareth EvansCo-Head of European Equity Strategy, Research

European equities are essentially a play on the global economy, and we expect real global GDP growth of 3.8% in 2011, supported by a sustained recovery in emerging market (EM) and US GDP growth of 3%.

Our optimism is based on the exceptionally low levels of new borrowing currently, and our belief that all that is required for a recovery in demand is that new borrowing rises. In other words, credit growth does not need to turn positive. We call this change in new borrowing the ‘credit impulse’.

GDP globally. The equilibrium level of borrowing is probably somewhere between 5% and 10% of GDP, and while it is diffi cult to know where new borrowing is going to be next quarter, it is highly likely that new borrowing will return to these equilibrium levels in the coming years. And while new borrowing rises, the credit impulse will on average be positive, and real domestic demand growth should be stronger than potential.

If real global GDP growth is 3.8% in 2011, we would expect real earnings growth on the Stoxx 600 of 12%

The US non-fi nancial private sector paid down debt aggressively in 2009 (Figure 1), and as the pace of de-leveraging slowed in 2010 and the amount of new borrowing increased, the credit impulse turned positive and real private sector demand growth rebounded (Figure 2). We expect the pace of de-leveraging to slow further in 2011, and for the recovery in real private sector demand growth to be stronger than the market expects.

This bullish argument is not only relevant to 2011. Private sector new borrowing is currently around -2% of

The macroeconomic environment is excellent for European equities at present: global growth is recovering more strongly than expected and central banks are keeping interest rates low in an attempt to lower unemployment. We expect the Stoxx 600 to rise to 315 by the end of 2011, for a total return of 20%.

1952 1959 1966 1973 1980 1987 1994 20082001 2015

-5

0

-10

5

10

15

20 % of GDP

(Figure 3). The impact of the GDP growth is magnifi ed on earnings due to margin widening, driven by operational gearing on one hand and low unit labour costs stemming from high unemployment on the other.

The outlook for ratings is equally compelling. The earnings yield has been well correlated with the real Fed funds rate over time (Figure 4). At present, equities have already priced in a normalisation of policy rates and, if interest rates remain lower in future than they have been in the past, we would expect equity ratings to be higher.

Equities also look extremely good value relative to credit – the earnings yield on the S&P500 is at 25-year highs relative the real BBB corporate bond yield.

1967 1972 1977 1982 1987 1992 1997 2002 2007 2010

-4

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-2

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8 change, % of GDP % yoy 12

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1982 1985 1988 1991 1994 1997 2000 20062003 2009

-1.5

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1980 1984 1988 1992 1996 2000 2004 2008

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-1

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% yoy 30

Figure 1:US new borrowing as a % of GDPSource: Deutsche Bank, US Federal Reserve, BEA Forecast New borrowing as a % of GDP,

non-fi nancial private sector

The consensus expectation for US growth in 2011 is around 2.3%, and the increase in GDP growth we anticipate towards 3% should be suffi cient to trigger the next leg of the equity rally.

So if you agree with our optimistic outlook for European equities, what stocks should you buy? We believe that companies off ering high dividend yields will be the best place to start.

Dividend yields on many European large cap stocks are signifi cantly higher than the returns on cash or fi xed income enabling investors to increase portfolio returns without a signifi cant increase in risk.

Signifi cantly, there are plenty of companies out there that off er good dividend yields and good growth

potential. This is very rare. Historically, companies that pay high dividends have generally not off ered great growth potential and vice versa. But today, there are plenty of stocks that seem to off er both.

A higher risk strategy would be to go long mid-cycle cyclical sectors such as media, technology and, potentially, fi nancial services.

The latter off ers the biggest potential for gains but does have fairly sizeable downside risk in the shape of further sovereign debt events.

All in all, though, our view is that the outlook for European equities is very strong.

Figure 2:US credit impulse and private demand growthSource: Deutsche Bank, US Federal Reserve, BEA Credit impulse (lhs) Private demand growth (c+l, rhs)


Binky Chadha Head of US Equity Strategy, Research

Keith Parker Director, US Equity Strategy, Research

Twenty months after the March 2009 bottom in equities and the beginning of economic recovery, US equities remain cheap, both on an absolute basis compared to historical valuations and relative to other asset classes. We think the strategic and tactical cases for US equities will come together in 2011 to produce strong returns (S&P 500 YE 2011 target 1550 representing a 29% return).

The strategic case for US equities is compelling: 1. Equity returns have tended to follow long 10 to 15 year cycles. Despite the 80% bounce from the March 2009 lows, the 10-year return on equities is near 100 year lows and the strategic upside over the longer-run is large

2. Equities are very cheap to Treasuries and credit. The differential between the Operating Cash Flow yield on the S&P 500 (ex-Financials) and Treasuries is running at a very significant 8% (versus a very stable 4.6% historically). The differential versus corporate

Outlook for US Equities Strategic case is compelling

credit yields is running at 5% (versus 2.5% historically). If investors do not shift allocations in favour of equities to close this gap, corporates will arbitrage the differential by issuing debt or using their cash flows to buy back stock as they have already started doing recently.

The tactical case for equities in 2011 1. The economic recovery is strengthening. In our reading, key components of GDP grew solidly over the past 20 months (retail sales 6.2% annualised; core durable goods new orders 17%) even during the period of rising concerns about a double dip recession. This is now spilling into a recovery in the labour market which should see an acceleration in the overall pace of recovery.

2. Economic forecasts remain timid, implying plenty of upside for positive data surprises going into 2011. Equities have been strongly correlated with our macro data surprise index, which is only slightly above the mid-point of

its historical band implying plenty of room to rise further.

3. The bar for earnings also remains low in the near term, as it has been for the last seven quarters, and we expect Q4 earnings – due to start reporting in mid-January – will beat again.

4. The multiple is low, at 14x 2010 earnings. While many arguments have been made for low equity multiples going forward, we note that the multiple averaged 16.5 in the 1930s, about what we consider to be fair value, at a time when unemployment reached 25%. It averaged 18.5 (typical recovery multiple) between the two recessions in the 1930s.

5. The year after mid-term elections has historically seen a large anomaly in S&P 500 returns, with an average return over the last 80 years of 18%. We believe this reflects moves back towards the centre in policy making post the mid-term elections where the president’s party has almost always

3.4 Markets

lost seats in Congress.

6. The demand and supply balance for equities has improved significantly and the outlook is very favourable. Over the last two and a half years, demand has essentially been flat (outflows from mutual funds offset by inflows into ETFs). Supply rose significantly, starting in late 2007 and through end 2008, as financials were forced to issue equity, and corporates curtailed buybacks to retain cash on their balance sheets. Demand remains flat, but our expectation is that flows will return to equities once it is clear that the Fed is done trying to lower rates. But even if demand remains flat, the acceleration in buybacks means the demand-supply balance will remain favourable. There is a strong correlation (75%) between this simple demand-supply balance and S&P 500 quarterly returns, implying this will be reflected in returns.

7. Don’t fret the end of QE2 around mid-2011. It is likely to result in a

sell-off in equities just as rate hikes did in 1994, but this should prove a temporary buying opportunity as it did then.

S&P 500 Ex Financials OCF Yield Source: Bloomberg, Robert Shiller

S&P 500 10yr Rolling Returns(Simple returns excluding dividends)Source: Bloomberg, Robert Shiller

Jan

– 8

1

Oct

– 8

2

Jul –

84

Ap

r –

86

Jan

– 8

8

Oct

– 8

9

Jul –

91

Ap

r –

93

Jan

– 9

5

Oct

– 9

6

Jul –

98

Ap

r –

00

Jan

– 0

2

Oct

– 0

3

Jul –

05

Ap

r –

07

Jan

– 0

9

Oct

– 1

0

-5

5

0

10

15

20

25%

-5%

5

0

10

15

20

25%

S&P 500 ex financials OCF yield RecessionOCF FieldSpread above 10 yearyields (avg. 4.6%)

RecessionOCF FieldSpread above 10 yearyeilds (avg. 4.6%)

18

81

18

87

18

93

18

99

19

05

19

11

19

18

19

24

19

30

19

36

19

42

19

48

19

55

19

61

19

67

19

73

19

79

19

85

19

92

19

98

20

04

20

10

-100

-50

0

50

100

150

200

250

300

350

400%

-100

-50

0

50

100

150

200

250

300

350

400%

S&P 500 10yr rolling returns(Simple returns excluding dividends)


Binky Chadha Head of US Equity Strategy, Research

Keith Parker Director, US Equity Strategy, Research

Twenty months after the March 2009 bottom in equities and the beginning of economic recovery, US equities remain cheap, both on an absolute basis compared to historical valuations and relative to other asset classes. We think the strategic and tactical cases for US equities will come together in 2011 to produce strong returns (S&P 500 YE 2011 target 1550 representing a 29% return).

The strategic case for US equities is compelling: 1. Equity returns have tended to follow long 10 to 15 year cycles. Despite the 80% bounce from the March 2009 lows, the 10-year return on equities is near 100 year lows and the strategic upside over the longer-run is large

2. Equities are very cheap to Treasuries and credit. The differential between the Operating Cash Flow yield on the S&P 500 (ex-Financials) and Treasuries is running at a very significant 8% (versus a very stable 4.6% historically). The differential versus corporate

Outlook for US Equities Strategic case is compelling

credit yields is running at 5% (versus 2.5% historically). If investors do not shift allocations in favour of equities to close this gap, corporates will arbitrage the differential by issuing debt or using their cash flows to buy back stock as they have already started doing recently.

The tactical case for equities in 2011 1. The economic recovery is strengthening. In our reading, key components of GDP grew solidly over the past 20 months (retail sales 6.2% annualised; core durable goods new orders 17%) even during the period of rising concerns about a double dip recession. This is now spilling into a recovery in the labour market which should see an acceleration in the overall pace of recovery.

2. Economic forecasts remain timid, implying plenty of upside for positive data surprises going into 2011. Equities have been strongly correlated with our macro data surprise index, which is only slightly above the mid-point of

its historical band implying plenty of room to rise further.

3. The bar for earnings also remains low in the near term, as it has been for the last seven quarters, and we expect Q4 earnings – due to start reporting in mid-January – will beat again.

4. The multiple is low, at 14x 2010 earnings. While many arguments have been made for low equity multiples going forward, we note that the multiple averaged 16.5 in the 1930s, about what we consider to be fair value, at a time when unemployment reached 25%. It averaged 18.5 (typical recovery multiple) between the two recessions in the 1930s.

5. The year after mid-term elections has historically seen a large anomaly in S&P 500 returns, with an average return over the last 80 years of 18%. We believe this reflects moves back towards the centre in policy making post the mid-term elections where the president’s party has almost always

3.4 Markets

lost seats in Congress.

6. The demand and supply balance for equities has improved significantly and the outlook is very favourable. Over the last two and a half years, demand has essentially been flat (outflows from mutual funds offset by inflows into ETFs). Supply rose significantly, starting in late 2007 and through end 2008, as financials were forced to issue equity, and corporates curtailed buybacks to retain cash on their balance sheets. Demand remains flat, but our expectation is that flows will return to equities once it is clear that the Fed is done trying to lower rates. But even if demand remains flat, the acceleration in buybacks means the demand-supply balance will remain favourable. There is a strong correlation (75%) between this simple demand-supply balance and S&P 500 quarterly returns, implying this will be reflected in returns.

7. Don’t fret the end of QE2 around mid-2011. It is likely to result in a

sell-off in equities just as rate hikes did in 1994, but this should prove a temporary buying opportunity as it did then.

S&P 500 Ex Financials OCF Yield Source: Bloomberg, Robert Shiller

S&P 500 10yr Rolling Returns(Simple returns excluding dividends)Source: Bloomberg, Robert Shiller

Jan

– 8

1

Oct

– 8

2

Jul –

84

Ap

r –

86

Jan

– 8

8

Oct

– 8

9

Jul –

91

Ap

r –

93

Jan

– 9

5

Oct

– 9

6

Jul –

98

Ap

r –

00

Jan

– 0

2

Oct

– 0

3

Jul –

05

Ap

r –

07

Jan

– 0

9

Oct

– 1

0

-5

5

0

10

15

20

25%

-5%

5

0

10

15

20

25%

S&P 500 ex financials OCF yield RecessionOCF FieldSpread above 10 yearyields (avg. 4.6%)

RecessionOCF FieldSpread above 10 yearyeilds (avg. 4.6%)

18

81

18

87

18

93

18

99

19

05

19

11

19

18

19

24

19

30

19

36

19

42

19

48

19

55

19

61

19

67

19

73

19

79

19

85

19

92

19

98

20

04

20

10

-100

-50

0

50

100

150

200

250

300

350

400%

-100

-50

0

50

100

150

200

250

300

350

400%

S&P 500 10yr rolling returns(Simple returns excluding dividends)


John-Paul Smith Head of EM Equity Research

3.5 Markets

Outlook for Emerging Market Equities (Ex Asia)Watch out for FX

Predicting the direction of emerging market (EM) equities in 2011 is harder than ever, for three reasons.

First, there are a large number of moving parts in government and central bank policies, which will be instrumental in driving the markets. How EM governments and central banks respond to issues such as short term overheating in their economies can have drastic effects on overall markets and individual stocks.

Second, the range of outcomes for global growth over the next twelve months is extremely wide and over the past decade global emerging markets have generally been a geared play on global growth.

Finally, there are very few obvious valuation anomalies either on a country or sector level within Global emerging markets (GEM). In general, markets appear to be priced in a relatively rational manner. However, GEM equities look cheap relative to fixed income, just like all the other major equity regions.

For now, the key issue is the impact that any major changes in exchange rate parities will have on the emerging economies and their equity markets. Moves in the value of the Chinese renminbi should be the most influential. This is because many EM countries compete with China and therefore follow its lead in keeping their own currencies artificially

low relative to developed market currencies in order to protect exports.

Were the Chinese to allow the currently undervalued RMB to appreciate in 2011, again other EM currencies would follow. This would hit their exporters’ profitability in the short term but have a very positive effect in the longer term by helping to rebalance the entire global economy.

If however, other EM countries mimic China by keeping their currencies undervalued relative to developed economies, the result would be initially good for exporters’ margins but ultimately poor for global growth.

There is also a strong possibility that more emerging countries will follow Brazil’s example and take measures aimed at restricting the inflow of capital. The Central Bank of Brazil recently introduced a tax on foreign bond investors and other EM countries including Korea and Thailand have adopted similar measures in an attempt to stem capital inflows and prevent their currencies from appreciating.

Some prominent commentators have predicted that continued inflows will result in an EM equity bubble but this seems very unlikely to happen until there is a solution to the exchange rate conundrum.

One reason EM equities may be less attractive in 2011 is that our

economists are forecasting lower rates of global growth over the next few years as compared to the EM bull market of 2002 – 2008. The direction of the wider economy is important because the outperformance of key Latin American and EMEA markets over most of Asia, which we have seen over the past decade has been largely predicated on generalised commodity price inflation driven by demand from developed economies which is unlikely to continue at pre 2008 levels.

Another cause for uncertainty in EM equity prices is the lack of general trends over the last year, which makes it harder to identify broad investment themes across EM countries. Instead, stock pickers are likely to be much more reliant on the structural fundamentals of individual countries and stocks. We favour specific country plays like long Turkey, short Russia over general long positions on CEMA.

This won’t be easy because relative valuations give us very little useful information. Russia, South Korea and Brazil look cheap on most measures but are all structurally challenged in some way. Similarly India, Turkey and Chile which all appear relatively expensive arguably have superior fundamentals at both a country and an average stock level.

By sector, the material and energy stocks, which look cheapest, are discounting the likely downturn

in economic activity and in many cases, company specific corporate governance issues. In contrast, the consumer-linked sectors look fairly expensive due to the widespread expectation that currencies will appreciate somewhat across emerging economies, leading to a switch from export to import-led demand as exports become less attractive to foreign buyers.

Since EM markets look generally priced rationally going into 2011, equity valuations do not give a clear lead on where prices might go. Likewise, a lack of economic momentum – the outlook for EM countries is generally steady and forecasts have not been revised dramatically in recent months – points to considerable volatility in EM markets, which is likely to best suit contrarian investors.

Overall valuations do not seem excessive and there is scope for equities, which are looking cheap relative to fixed income, to rally – but this is only likely to happen once some of the major uncertainties overhanging the global economy are resolved.


John-Paul Smith Head of EM Equity Research

3.5 Markets

Outlook for Emerging Market Equities (Ex Asia)Watch out for FX

Predicting the direction of emerging market (EM) equities in 2011 is harder than ever, for three reasons.

First, there are a large number of moving parts in government and central bank policies, which will be instrumental in driving the markets. How EM governments and central banks respond to issues such as short term overheating in their economies can have drastic effects on overall markets and individual stocks.

Second, the range of outcomes for global growth over the next twelve months is extremely wide and over the past decade global emerging markets have generally been a geared play on global growth.

Finally, there are very few obvious valuation anomalies either on a country or sector level within Global emerging markets (GEM). In general, markets appear to be priced in a relatively rational manner. However, GEM equities look cheap relative to fixed income, just like all the other major equity regions.

For now, the key issue is the impact that any major changes in exchange rate parities will have on the emerging economies and their equity markets. Moves in the value of the Chinese renminbi should be the most influential. This is because many EM countries compete with China and therefore follow its lead in keeping their own currencies artificially

low relative to developed market currencies in order to protect exports.

Were the Chinese to allow the currently undervalued RMB to appreciate in 2011, again other EM currencies would follow. This would hit their exporters’ profitability in the short term but have a very positive effect in the longer term by helping to rebalance the entire global economy.

If however, other EM countries mimic China by keeping their currencies undervalued relative to developed economies, the result would be initially good for exporters’ margins but ultimately poor for global growth.

There is also a strong possibility that more emerging countries will follow Brazil’s example and take measures aimed at restricting the inflow of capital. The Central Bank of Brazil recently introduced a tax on foreign bond investors and other EM countries including Korea and Thailand have adopted similar measures in an attempt to stem capital inflows and prevent their currencies from appreciating.

Some prominent commentators have predicted that continued inflows will result in an EM equity bubble but this seems very unlikely to happen until there is a solution to the exchange rate conundrum.

One reason EM equities may be less attractive in 2011 is that our

economists are forecasting lower rates of global growth over the next few years as compared to the EM bull market of 2002 – 2008. The direction of the wider economy is important because the outperformance of key Latin American and EMEA markets over most of Asia, which we have seen over the past decade has been largely predicated on generalised commodity price inflation driven by demand from developed economies which is unlikely to continue at pre 2008 levels.

Another cause for uncertainty in EM equity prices is the lack of general trends over the last year, which makes it harder to identify broad investment themes across EM countries. Instead, stock pickers are likely to be much more reliant on the structural fundamentals of individual countries and stocks. We favour specific country plays like long Turkey, short Russia over general long positions on CEMA.

This won’t be easy because relative valuations give us very little useful information. Russia, South Korea and Brazil look cheap on most measures but are all structurally challenged in some way. Similarly India, Turkey and Chile which all appear relatively expensive arguably have superior fundamentals at both a country and an average stock level.

By sector, the material and energy stocks, which look cheapest, are discounting the likely downturn

in economic activity and in many cases, company specific corporate governance issues. In contrast, the consumer-linked sectors look fairly expensive due to the widespread expectation that currencies will appreciate somewhat across emerging economies, leading to a switch from export to import-led demand as exports become less attractive to foreign buyers.

Since EM markets look generally priced rationally going into 2011, equity valuations do not give a clear lead on where prices might go. Likewise, a lack of economic momentum – the outlook for EM countries is generally steady and forecasts have not been revised dramatically in recent months – points to considerable volatility in EM markets, which is likely to best suit contrarian investors.

Overall valuations do not seem excessive and there is scope for equities, which are looking cheap relative to fixed income, to rally – but this is only likely to happen once some of the major uncertainties overhanging the global economy are resolved.


Bilal HafeezGlobal Head of FX Research

3.6Markets

Outlook for FX In 2011Don’t get complacent

In the developed world, the Fed is unlikely to alter monetary policy signifi cantly over 2011, unless unemployment falls signifi cantly. And with the absence of support from interest rates, the dollar will struggle to gain traction. What will help the dollar is that the backdrop amongst the other majors is not so positive either. The eurozone is likely to continue to suff er from pangs of existential crisis, the UK will struggle to overcome its many structural drags and Japan will be reliant on the external economy. The majors, therefore, are unlikely to exhibit any strong trends, rather follow broad ranges over the course of 2011. Of course, there could be some surprises that could break the deadlock; the ECB could hike before the Fed, which would spur euro strength, the US

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2

3

4

5

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7

80 99 00 01 02 03 04 05 06 07 08 09 10 94 99 00 01 02 03 04 05 06 07 08 09 1095 96 97 98 99 00 01 02 03 04 05 06 07 08 09 1081 83 85 86 88 90 91 93 95 96 98 00 01 03 05 06 08 10

could become the equity story for the international investor, which could see dollar strength or risk aversion could dominate, which would support the yen.

EMs provide a richer array of possibilities. Infl ation is a bigger issue, notably in Asia, which could lead to a tightening in monetary policy and greater tolerance of currency strength over 2011. China may continue to liberalise its currency regime, through the development of the off shore market. Consequently, we could see broad-based currency strength. Meanwhile, if Fed policy starts to gain traction in the economy, stronger US growth could translate into stronger growth in Latin America. Mexico, in particular, could benefi t and see its currency strengthen.

The biggest concern would be that consensus on EMs is so strong that expectations could be too high. While the backdrop is not identical to the mid-1990s (notably most EM currencies are now free-fl oating), there are less signs of excess credit growth and asset price overvaluations, the belief in the resurgence of EM is similar. Therefore, we would be keeping a close eye on any signs of fi nancial instability in EM and Asia particularly. The lesson of the last few years has been not to be complacent.

Euro likely to remain in choppy range like fi rst half of 1990s Euro

ECB and Fed unlikely to change policy much in 2011 Fed policy rate ECB policy rate

Korea and Mexico notably undervaluedReal eff ective exchange rate, rebased to sample average (100) Mexico Korea

Asia infl ation rising China India US

While 2008 was the unravelling of the US shadow fi nancial system, 2009 was the policy counterattack, 2010 was the splintering of the euro-area system, 2011 will likely be the year of emerging markets (EM). Whether it will be benign or more ominous or both is yet to be determined, but the largest currency moves will likely occur in EMs.


Bilal HafeezGlobal Head of FX Research

3.6Markets

Outlook for FX In 2011Don’t get complacent

In the developed world, the Fed is unlikely to alter monetary policy signifi cantly over 2011, unless unemployment falls signifi cantly. And with the absence of support from interest rates, the dollar will struggle to gain traction. What will help the dollar is that the backdrop amongst the other majors is not so positive either. The eurozone is likely to continue to suff er from pangs of existential crisis, the UK will struggle to overcome its many structural drags and Japan will be reliant on the external economy. The majors, therefore, are unlikely to exhibit any strong trends, rather follow broad ranges over the course of 2011. Of course, there could be some surprises that could break the deadlock; the ECB could hike before the Fed, which would spur euro strength, the US

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20

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80 99 00 01 02 03 04 05 06 07 08 09 10 94 99 00 01 02 03 04 05 06 07 08 09 1095 96 97 98 99 00 01 02 03 04 05 06 07 08 09 1081 83 85 86 88 90 91 93 95 96 98 00 01 03 05 06 08 10

could become the equity story for the international investor, which could see dollar strength or risk aversion could dominate, which would support the yen.

EMs provide a richer array of possibilities. Infl ation is a bigger issue, notably in Asia, which could lead to a tightening in monetary policy and greater tolerance of currency strength over 2011. China may continue to liberalise its currency regime, through the development of the off shore market. Consequently, we could see broad-based currency strength. Meanwhile, if Fed policy starts to gain traction in the economy, stronger US growth could translate into stronger growth in Latin America. Mexico, in particular, could benefi t and see its currency strengthen.

The biggest concern would be that consensus on EMs is so strong that expectations could be too high. While the backdrop is not identical to the mid-1990s (notably most EM currencies are now free-fl oating), there are less signs of excess credit growth and asset price overvaluations, the belief in the resurgence of EM is similar. Therefore, we would be keeping a close eye on any signs of fi nancial instability in EM and Asia particularly. The lesson of the last few years has been not to be complacent.

Euro likely to remain in choppy range like fi rst half of 1990s Euro

ECB and Fed unlikely to change policy much in 2011 Fed policy rate ECB policy rate

Korea and Mexico notably undervaluedReal eff ective exchange rate, rebased to sample average (100) Mexico Korea

Asia infl ation rising China India US

While 2008 was the unravelling of the US shadow fi nancial system, 2009 was the policy counterattack, 2010 was the splintering of the euro-area system, 2011 will likely be the year of emerging markets (EM). Whether it will be benign or more ominous or both is yet to be determined, but the largest currency moves will likely occur in EMs.


Michael Lewis Global Head of Commodities Research

3.7 Markets

Outlook for Commodities In 2011Price rises likely

demand has the highest correlation to credit growth and consequently would be the most sensitive to monetary tightening measures, we believe the underlying growth outlook in China remains positive. Indeed if one compares this cycle to previous monetary tightening periods, the central bank has been more pre-emptive today in tackling inflation than in the boom-bust periods of 1989 and 1994.

In an environment of heightened macro-economic uncertainty, we believe gold prices will continue to benefit from central bank buying and ongoing inflows into physically backed ETFs. In fact gold price overshooting is a high probability event since investors are buying gold when the US dollar is rising as well as falling and as a hedge against inflation as well as deflation. We estimate that gold prices would need to reach $1,455/oz to represent an all time high in real terms and surpass $2,000/oz to represent a bubble.

We believe silver has an even more attractive outlook than gold. Not only will silver benefit from its status as a safe haven, it also tends to outperform gold when the US manufacturing sector is expanding. Indeed as long as the US ISM business confidence

indicator remains above 50 we believe we will see sustained downward pressure on the gold to silver ratio.

Financial factors may also prove bullish for the industrial metals complex in 2011. The launch of physically backed ETFs in the complex will have the ability to significantly tighten market fundamentals. Indeed on our estimates if investment demand was to represent just 2% of global copper demand this would be equivalent to approximately 65% of copper inventories. As a result, we view copper as the most susceptible to price spike risk if these new products attract investment capital.

In agriculture, we see sustained price rallies occurring across the sector as a result of low inventories, for example in corn and sugar, rising shortages of commodities in China such as soybeans, and the sector’s vulnerability to supply disruptions such as occurred in the wheat market in 2010. However, history would suggest that the duration and magnitude of price rallies in agriculture will be shorter and less powerful than those in the energy and industrial metal sectors.

Our bullish outlook for the commodity complex is based on four key beliefs: emerging market growth will be strong, the Fed’s efforts to stimulate growth will be successful, European sovereign risk will eventually be contained, and the physical fundamentals of many markets will tighten because of supply side constraints. However, we believe the increased level of macroeconomic uncertainty will intermittently contaminate sentiment for risky assets such as commodities.

Of the five broad commodity sectors, the energy and industrial metals sectors seem most vulnerable to disruption risk. While oil prices have been driven higher by the Fed’s programme of quantitative easing which has contributed to US dollar weakness and a recovery in US equity

We believe 2011 will be characterised by fresh investment inflows into the commodities complex. The sector’s appeal reflects investor appetite to gain exposure to emerging markets (EM), as a tool to hedge against tail events and market anxiety towards higher inflation ahead. Moreover investors are now able to gain direct exposure to an increasing array of commodities which have typically been outside the investment universe, such uranium, iron ore and coal.

markets, we believe a rally in the oil price will be more sustainable if crude oil inventories fall to more normal levels and if the crude oil forward curve moves into backwardation. We believe this bullish scenario for crude oil will become a reality as 2011 unfolds. However, the weakness in US natural gas markets in response to the surge in domestic shale gas production has left a significant overhang in storage levels which we expect to take several months to work off.

We believe China remains a bullish factor for commodity markets despite short tem disruption risk from monetary tightening. In 2010, the country became an even greater source of demand for commodities such as thermal coal, silver, soybeans and cotton. While industrial metals



3.7 Markets

Outlook for Commodities In 2011Price rises likely

demand has the highest correlation to credit growth and consequently would be the most sensitive to monetary tightening measures, we believe the underlying growth outlook in China remains positive. Indeed if one compares this cycle to previous monetary tightening periods, the central bank has been more pre-emptive today in tackling inflation than in the boom-bust periods of 1989 and 1994.

In an environment of heightened macro-economic uncertainty, we believe gold prices will continue to benefit from central bank buying and ongoing inflows into physically backed ETFs. In fact gold price overshooting is a high probability event since investors are buying gold when the US dollar is rising as well as falling and as a hedge against inflation as well as deflation. We estimate that gold prices would need to reach $1,455/oz to represent an all time high in real terms and surpass $2,000/oz to represent a bubble.

We believe silver has an even more attractive outlook than gold. Not only will silver benefit from its status as a safe haven, it also tends to outperform gold when the US manufacturing sector is expanding. Indeed as long as the US ISM business confidence

indicator remains above 50 we believe we will see sustained downward pressure on the gold to silver ratio.

Financial factors may also prove bullish for the industrial metals complex in 2011. The launch of physically backed ETFs in the complex will have the ability to significantly tighten market fundamentals. Indeed on our estimates if investment demand was to represent just 2% of global copper demand this would be equivalent to approximately 65% of copper inventories. As a result, we view copper as the most susceptible to price spike risk if these new products attract investment capital.

In agriculture, we see sustained price rallies occurring across the sector as a result of low inventories, for example in corn and sugar, rising shortages of commodities in China such as soybeans, and the sector’s vulnerability to supply disruptions such as occurred in the wheat market in 2010. However, history would suggest that the duration and magnitude of price rallies in agriculture will be shorter and less powerful than those in the energy and industrial metal sectors.

Our bullish outlook for the commodity complex is based on four key beliefs: emerging market growth will be strong, the Fed’s efforts to stimulate growth will be successful, European sovereign risk will eventually be contained, and the physical fundamentals of many markets will tighten because of supply side constraints. However, we believe the increased level of macroeconomic uncertainty will intermittently contaminate sentiment for risky assets such as commodities.

Of the five broad commodity sectors, the energy and industrial metals sectors seem most vulnerable to disruption risk. While oil prices have been driven higher by the Fed’s programme of quantitative easing which has contributed to US dollar weakness and a recovery in US equity

We believe 2011 will be characterised by fresh investment inflows into the commodities complex. The sector’s appeal reflects investor appetite to gain exposure to emerging markets (EM), as a tool to hedge against tail events and market anxiety towards higher inflation ahead. Moreover investors are now able to gain direct exposure to an increasing array of commodities which have typically been outside the investment universe, such uranium, iron ore and coal.

markets, we believe a rally in the oil price will be more sustainable if crude oil inventories fall to more normal levels and if the crude oil forward curve moves into backwardation. We believe this bullish scenario for crude oil will become a reality as 2011 unfolds. However, the weakness in US natural gas markets in response to the surge in domestic shale gas production has left a significant overhang in storage levels which we expect to take several months to work off.

We believe China remains a bullish factor for commodity markets despite short tem disruption risk from monetary tightening. In 2010, the country became an even greater source of demand for commodities such as thermal coal, silver, soybeans and cotton. While industrial metals


Dominic Konstam Global Head of Rates Research

Francis Yared Head of European Rates Research

3.8 Markets

Outlook for US and European Rates in 2011Rising in Q2 but not by much

Rates in developed markets are intrinsically below their long-term fair value relative to the long-term growth and inflation outlook.

Our 2011 outlook revolves around the beginnings of some kind of normalisation towards higher rates. Yet there are a lot of tensions that cloud this year’s outlook in respect of the path towards higher rates. These include the debate as to whether quantitative easing is or can be successful in the face of a still weak financial sector and lack of housing recovery; whether inherently sound corporate balance sheets can be a springboard for meaningful job growth; concerns for deteriorating sovereign risk, particularly in the US and Germany and an uncertain fiscal outlook; spillovers from the European periphery crisis; and whether Asia’s and the broader emerging market growth success is sustainable.

Our view is that US rates will remain low in Q1 staying around 2.5% at the 10-year part of the curve, as the pre-committed part of QE2 (all $600 billion of it) flows into the market.

Other factors that should keep rates low will be persistently depressed inflation, an unemployment rate that fails to decline significantly from current elevated levels, and continued uncertainty about European sovereign risk.

But from Q2 onwards they should start

to rise – with US 10 years reaching 3.25% by year end – for the following four reasons:

The four catalysts for the start of rate ‘normalisation’ will be:

1. Core inflation is likely to drift upwards towards 1.3% (which is in line with the central tendency of the most recent FOMC forecast). Food inflation will add further pressure.

2. Concerns about the Eurozone sovereign crisis should ease in Q2 as the refinancing hurdle faced by Spain is cleared and Portugal most likely follows Ireland under the EFSF umbrella.

3. Fiscal policy in the US should remain gridlocked save for an extension of the Bush tax cuts. In the absence of spending cuts, rates will have to go up to meet investor demands. Sovereign risk fears due to the lack of fiscal discipline take over from weak growth concerns associated with the lack of fiscal stimulus.

4. Asian currencies should appreciate against the US dollar as Asian rates rise to combat inflation. This would make the US more competitive, spurring growth and inflation.

Whether the sell-off in US rates will be more sustainable than the one that occurred in Q1 2010 is still uncertain, and will primarily depend on fiscal policy in the US where significant

tightening has yet to take place.

In Europe, the ECB is faced with a difficult dilemma of helping peripheral members to avoid sustained recession and assisting core members in keeping down inflation. The problem remains unresolved: real rates are too low for core and too high for the periphery. One solution is for the ECB to maintain full allotment tenders and possibly hike rates. The risks of premature tightening in Europe are also significantly higher than in the US and the UK, which increases the medium-term deflation risks for the Eurozone area (at least relative to the US and UK).

There are significant risks around this relatively benign scenario. Take US fiscal policy, probably the most important factor driving rates this year. If spending cuts are implemented too early, the US economy may risk a double dip, prompting the Fed to extend quantitative easing which would lead to a significant rally in rates.

Conversely, if the data surprises on the upside, the Fed is likely to discontinues QE, which will lead to a significant upward re-pricing of rates to reflect the unwind of the QE premium and better economic fundamentals.

On balance, however, our forecast is for a relatively moderate increase in both US and European rates from Q2 onwards.




3.8 Markets

Outlook for US and European Rates in 2011Rising in Q2 but not by much

Rates in developed markets are intrinsically below their long-term fair value relative to the long-term growth and inflation outlook.

Our 2011 outlook revolves around the beginnings of some kind of normalisation towards higher rates. Yet there are a lot of tensions that cloud this year’s outlook in respect of the path towards higher rates. These include the debate as to whether quantitative easing is or can be successful in the face of a still weak financial sector and lack of housing recovery; whether inherently sound corporate balance sheets can be a springboard for meaningful job growth; concerns for deteriorating sovereign risk, particularly in the US and Germany and an uncertain fiscal outlook; spillovers from the European periphery crisis; and whether Asia’s and the broader emerging market growth success is sustainable.

Our view is that US rates will remain low in Q1 staying around 2.5% at the 10-year part of the curve, as the pre-committed part of QE2 (all $600 billion of it) flows into the market.

Other factors that should keep rates low will be persistently depressed inflation, an unemployment rate that fails to decline significantly from current elevated levels, and continued uncertainty about European sovereign risk.

But from Q2 onwards they should start

to rise – with US 10 years reaching 3.25% by year end – for the following four reasons:

The four catalysts for the start of rate ‘normalisation’ will be:

1. Core inflation is likely to drift upwards towards 1.3% (which is in line with the central tendency of the most recent FOMC forecast). Food inflation will add further pressure.

2. Concerns about the Eurozone sovereign crisis should ease in Q2 as the refinancing hurdle faced by Spain is cleared and Portugal most likely follows Ireland under the EFSF umbrella.

3. Fiscal policy in the US should remain gridlocked save for an extension of the Bush tax cuts. In the absence of spending cuts, rates will have to go up to meet investor demands. Sovereign risk fears due to the lack of fiscal discipline take over from weak growth concerns associated with the lack of fiscal stimulus.

4. Asian currencies should appreciate against the US dollar as Asian rates rise to combat inflation. This would make the US more competitive, spurring growth and inflation.

Whether the sell-off in US rates will be more sustainable than the one that occurred in Q1 2010 is still uncertain, and will primarily depend on fiscal policy in the US where significant

tightening has yet to take place.

In Europe, the ECB is faced with a difficult dilemma of helping peripheral members to avoid sustained recession and assisting core members in keeping down inflation. The problem remains unresolved: real rates are too low for core and too high for the periphery. One solution is for the ECB to maintain full allotment tenders and possibly hike rates. The risks of premature tightening in Europe are also significantly higher than in the US and the UK, which increases the medium-term deflation risks for the Eurozone area (at least relative to the US and UK).

There are significant risks around this relatively benign scenario. Take US fiscal policy, probably the most important factor driving rates this year. If spending cuts are implemented too early, the US economy may risk a double dip, prompting the Fed to extend quantitative easing which would lead to a significant rally in rates.

Conversely, if the data surprises on the upside, the Fed is likely to discontinues QE, which will lead to a significant upward re-pricing of rates to reflect the unwind of the QE premium and better economic fundamentals.

On balance, however, our forecast is for a relatively moderate increase in both US and European rates from Q2 onwards.


Harris TrifonHead of Commercial Real Estate Debt Research

3.9Markets

Outlook for US Real EstateFalling but not so fast

Global and US CRE Risk PremiumSource: Deutsche Bank, Real Capital Analytics, Bloomberg Finance LP

Spread tightening comparisons (September to November 2010)Source: Deutsche Bank, Markit and Bloomberg Finance LP

Global Market (ex China and US) Global CRE risk premium US Market US CRE risk premium

London 3.22% NYC 4.03%

Tokyo 4.74% DC 4.36%

Hong Kong 1.33% Los Angeles 4.87%

Paris 3.56% San Francisco 4.07%

Singapore 3.57% Chicago 4.93%

Seoul 2.16% Boston 4.80%

Global Average 3.10% US Average 4.51%

In 2011 we expect prices in the US commercial and residential real estate markets to continue to decline, albeit at a much slower rate compared to the last few years. However, price stabilisation in selected markets which was the most signifi cant trend in 2010, should spread to more markets in the coming year. We believe commercial real estate prices will be generally stronger than residential, in part due to the stronger underlying fundamentals of the sector.

In the commercial real estate (CRE) markets, one of the most positive developments in the nascent recovery has been the seemingly insatiable bid for properties in ‘A-list’ cities. More specifi cally, most of the demand has been concentrated on the very best quality properties in these markets. We attribute much of the demand to the global investment community’s continued search for incremental yield among assets deemed to be stable and safe. However, properties in New York, Washington DC, San Francisco and Boston are trading at higher implied risk premiums than other major cities in Europe and Asia. Prices in these US markets should continue to outperform in 2011 as risk premiums continue to decline (and as a result prices increase).

Another factor contributing to the stabilisation of prices in 2011 should be the increased demand for CRE debt. Over the last few months of 2010, CRE debt has been one of the best performers.

The rally in the fi xed income markets in 2010 has contributed to the reemergence of the CRE fi nancing market which has in turn supported property prices. However, much of the impact so far has only aff ected top-tier properties in the best markets,

partly because of the competitive fi nancing market for these properties. In 2011, we don’t believe the trend will change much.

In the residential markets, we expect the US housing market to decline another 3%-5.5% in 2011 which will likely be followed by a tepid recovery. A complete recovery will likely take four to six years primarily due to an excess supply of homes relative to our estimates of demand.

The US housing downturn has destroyed $6 trillion of housing wealth, equivalent to $80K per household. Home prices would need to rise approximately 38% nationally to restore the lost wealth. Housing wealth destruction is the worst in the four sand states California, Florida, Arizona, and Nevada, where values of housing markets have been reduced by $2,339 billion, $842 billion, $324 billion and $192 billion respectively.

We expect NY metro and Santa Barbara, CA to perform the worst due to the low level of aff ordability, with expected declines of 11% and 9% respectively. Minneapolis, MN and Austin, TX we expect to perform the best due to robust job markets and relatively lower inventory of distressed properties.

We expect home prices in both these markets to appreciate by 1.3%. The most signifi cant impact of the housing bubble has been the impact the wealth destruction has had on consumer spending.

50%

40

30

20

IG Corporates HY Corporates REIT CDS CMBX 4 AJ

10

Note: MSAs sorted by traded volume. Averages are based only on the top six cities.


Harris TrifonHead of Commercial Real Estate Debt Research

3.9Markets

Outlook for US Real EstateFalling but not so fast

Global and US CRE Risk PremiumSource: Deutsche Bank, Real Capital Analytics, Bloomberg Finance LP

Spread tightening comparisons (September to November 2010)Source: Deutsche Bank, Markit and Bloomberg Finance LP

Global Market (ex China and US) Global CRE risk premium US Market US CRE risk premium

London 3.22% NYC 4.03%

Tokyo 4.74% DC 4.36%

Hong Kong 1.33% Los Angeles 4.87%

Paris 3.56% San Francisco 4.07%

Singapore 3.57% Chicago 4.93%

Seoul 2.16% Boston 4.80%

Global Average 3.10% US Average 4.51%

In 2011 we expect prices in the US commercial and residential real estate markets to continue to decline, albeit at a much slower rate compared to the last few years. However, price stabilisation in selected markets which was the most signifi cant trend in 2010, should spread to more markets in the coming year. We believe commercial real estate prices will be generally stronger than residential, in part due to the stronger underlying fundamentals of the sector.

In the commercial real estate (CRE) markets, one of the most positive developments in the nascent recovery has been the seemingly insatiable bid for properties in ‘A-list’ cities. More specifi cally, most of the demand has been concentrated on the very best quality properties in these markets. We attribute much of the demand to the global investment community’s continued search for incremental yield among assets deemed to be stable and safe. However, properties in New York, Washington DC, San Francisco and Boston are trading at higher implied risk premiums than other major cities in Europe and Asia. Prices in these US markets should continue to outperform in 2011 as risk premiums continue to decline (and as a result prices increase).

Another factor contributing to the stabilisation of prices in 2011 should be the increased demand for CRE debt. Over the last few months of 2010, CRE debt has been one of the best performers.

The rally in the fi xed income markets in 2010 has contributed to the reemergence of the CRE fi nancing market which has in turn supported property prices. However, much of the impact so far has only aff ected top-tier properties in the best markets,

partly because of the competitive fi nancing market for these properties. In 2011, we don’t believe the trend will change much.

In the residential markets, we expect the US housing market to decline another 3%-5.5% in 2011 which will likely be followed by a tepid recovery. A complete recovery will likely take four to six years primarily due to an excess supply of homes relative to our estimates of demand.

The US housing downturn has destroyed $6 trillion of housing wealth, equivalent to $80K per household. Home prices would need to rise approximately 38% nationally to restore the lost wealth. Housing wealth destruction is the worst in the four sand states California, Florida, Arizona, and Nevada, where values of housing markets have been reduced by $2,339 billion, $842 billion, $324 billion and $192 billion respectively.

We expect NY metro and Santa Barbara, CA to perform the worst due to the low level of aff ordability, with expected declines of 11% and 9% respectively. Minneapolis, MN and Austin, TX we expect to perform the best due to robust job markets and relatively lower inventory of distressed properties.

We expect home prices in both these markets to appreciate by 1.3%. The most signifi cant impact of the housing bubble has been the impact the wealth destruction has had on consumer spending.

50%

40

30

20

IG Corporates HY Corporates REIT CDS CMBX 4 AJ

10

Note: MSAs sorted by traded volume. Averages are based only on the top six cities.


Tom Cheung Head of Credit Solutions Group, Americas

Daniel Pietrzak Head of Credit Solutions Group, Europe

3.10 Markets

Outlook for US and European ABS MarketsGlobal investor demand comes back strongly

The asset backed securities (ABS) market was hit harder by the financial crisis than many other markets. After growing every year since the US ABS market began in 1985, issuance volumes began to fall for the first time in 2007 from $1.24 trillion in 2006 to $864 billion in 2007 and $160 billion in 2008. In Europe, the ABS market was effectively at a standstill during the second half of 2007, 2008 and the first half of 2009.

The downturn affected everyone in the market: 1. Investors, who found themselves owning bonds with marks at only a fraction of what they had paid for them. 2. Financial institutions, who were no longer able to access financing for their credit card, mortgage, auto loan portfolios 3. Individual consumers and businesses, with all types of credit ratings, who were largely unaware of the ABS market yet found it hard or impossible to gain access to credit.

Investor demand began to emerge in the US and Europe in 2009 and surged in 2010, leading to greater new issuance opportunities and significantly tighter spreads. Issuance was possible for a wide range of ‘flow’ deals in the US (consumer ABS market, including auto loans and leases, equipment leases, floorplan loans, rental care fleet financing and credit cards) and in Europe (UK and Dutch residential mortgages, German auto loans). Beyond the flow market, investor demand (US and Europe) grew for higher yielding ‘non-flow’ issuance.

The parabolic growth of the ABS market from 2000 to 2006 was largely driven by home equity and CDO issuance, both highly dependent on the performance of the underlying US residential mortgages. Much has been written about what happened in that market and how that has played out. To date, the market for US private sector mortgage backed bonds remains essentially closed with credit spreads making the loans uneconomic to originate compared with mortgages from the US agencies. But the US ‘flow’ consumer ABS issuance (including auto loans, credit cards and student loans) has been relatively steady for the past two decades.

In the European ABS market, the run on the securitisation market in 2007 and 2008 was driven by a lack of investor demand; however, credit fundamentals remained largely immune to this technical meltdown. European residential mortgage securities have seen limited actual credit losses, resulting from better asset performance, less vintage issues and higher levels of credit enhancement than US mortgage securities. As a result, recent investor demand for UK and Dutch residential mortgage transactions has been very strong.

We believe that the outlook is broadly positive and robust. Global investor demand for asset backed securities has returned, enabling a wide range of financial institutions and corporations to issue debt backed by an increasingly broad range of assets. That said some elements of the pre-crisis market will not return. We do not expect to see the re-emergence of monoclines providing guarantees to help issuers

secure higher ratings on their bonds, and we will not see a revival of highly leveraged collateralised debt obligations (CDOs) solely backed by subordinate residential mortgage backed securities (RMBSs).

We remain relatively pessimistic about a broad re-emergence of US private mortgage securitisation for new non-agency loans in the near future. This will likely require US property prices to stop falling, something that is not expected this year, and investor demand to tighten the pricing between US agency RMBS and private MBS. The agency RMBS market has essentially supplanted private mortgage securitisation, partly because allowable agency loan balances increased from $417,000 pre-crisis to $729,750 today. 2010 securitisation of agency RMBS has been robust with issuance of more than $1.4 trillion in new agency pools and more than $450 billion in agency REMICs. Those volumes are likely to go up in 2011.

We are cautious about the growth prospects for US credit card backed bonds. The contraction of household debt within the US has led to lower credit card balances at the banks. Combined with cheap funding for banks in the deposit market and new accounting consolidation rules, the issuance of credit card backed bonds may therefore remain modest. But investor demand for credit card bonds, long a core element of the ABS market, remains strong. The student loan market remains challenged, with disruptions both in the overall US government guaranteed FFELP program and challenges in the private issuance market.

In Europe, the primary market will continue to remain active out of already started benchmark sectors such as German auto ABS and UK prime RMBS. Additionally, the market should continue to broaden as seen recently with deals backed by UK nonconforming mortgages and Italian residential mortgages. New issuance syndication in Europe has reverted back to a more widely distributed model in the last two months as large anchor investors relinquish their hold on demand side liquidity. However, such large investors will still form a key part of the market for some time to come. All leading European financial institutions will be able to issue ABS this year however we expect much greater investor scrutiny of issuance out of Ireland, Portugal, Spain and Greece. Despite the short term volatility due to sovereign issues, we remain bullish on senior ABS in the long term. This is due to our belief that the product should weather sovereign issues well relative to other asset classes and that spreads are dislocated relative to vanilla credit and US ABS.

The net result of recent market trends is a conspicuous lack of issuance volume for investors when compared to the amount of cash available to invest. The dramatic growth in the home equity and CDO markets leading up to 2007 now means higher levels of cash coming back to investors as their holdings amortise. Further, many structured finance investors have received greater portfolio allocations in 2010 as tightening spreads have lead to outperformance compared with other markets. The combined effect is a strong technical demand for issuance.

Late in 2010, the investor refrain has been ‘is there any more product’? We have seen a movement where the demand has been insatiable for ‘flow’ issuance and the search for yield has lead investors to ‘non-flow’ issuance. Deutsche Bank has been a leader within this market, bringing varied transactions from cell tower lease, rental truck fleet, time-share issuers and other private asset-backed offerings. Other sectors which have experienced limited access to the ABS capital markets in the past few years, such as hard assets (aircraft, rail, container) and CLOs, have begun to see a thawing, and a pipeline of opportunities is developing.

To sum up, we believe that the recovery seen in the global ABS markets in 2010 will continue, and offer abundant opportunities for both issuers and investors.


Tom Cheung Head of Credit Solutions Group, Americas

Daniel Pietrzak Head of Credit Solutions Group, Europe

3.10 Markets

Outlook for US and European ABS MarketsGlobal investor demand comes back strongly

The asset backed securities (ABS) market was hit harder by the financial crisis than many other markets. After growing every year since the US ABS market began in 1985, issuance volumes began to fall for the first time in 2007 from $1.24 trillion in 2006 to $864 billion in 2007 and $160 billion in 2008. In Europe, the ABS market was effectively at a standstill during the second half of 2007, 2008 and the first half of 2009.

The downturn affected everyone in the market: 1. Investors, who found themselves owning bonds with marks at only a fraction of what they had paid for them. 2. Financial institutions, who were no longer able to access financing for their credit card, mortgage, auto loan portfolios 3. Individual consumers and businesses, with all types of credit ratings, who were largely unaware of the ABS market yet found it hard or impossible to gain access to credit.

Investor demand began to emerge in the US and Europe in 2009 and surged in 2010, leading to greater new issuance opportunities and significantly tighter spreads. Issuance was possible for a wide range of ‘flow’ deals in the US (consumer ABS market, including auto loans and leases, equipment leases, floorplan loans, rental care fleet financing and credit cards) and in Europe (UK and Dutch residential mortgages, German auto loans). Beyond the flow market, investor demand (US and Europe) grew for higher yielding ‘non-flow’ issuance.

The parabolic growth of the ABS market from 2000 to 2006 was largely driven by home equity and CDO issuance, both highly dependent on the performance of the underlying US residential mortgages. Much has been written about what happened in that market and how that has played out. To date, the market for US private sector mortgage backed bonds remains essentially closed with credit spreads making the loans uneconomic to originate compared with mortgages from the US agencies. But the US ‘flow’ consumer ABS issuance (including auto loans, credit cards and student loans) has been relatively steady for the past two decades.

In the European ABS market, the run on the securitisation market in 2007 and 2008 was driven by a lack of investor demand; however, credit fundamentals remained largely immune to this technical meltdown. European residential mortgage securities have seen limited actual credit losses, resulting from better asset performance, less vintage issues and higher levels of credit enhancement than US mortgage securities. As a result, recent investor demand for UK and Dutch residential mortgage transactions has been very strong.

We believe that the outlook is broadly positive and robust. Global investor demand for asset backed securities has returned, enabling a wide range of financial institutions and corporations to issue debt backed by an increasingly broad range of assets. That said some elements of the pre-crisis market will not return. We do not expect to see the re-emergence of monoclines providing guarantees to help issuers

secure higher ratings on their bonds, and we will not see a revival of highly leveraged collateralised debt obligations (CDOs) solely backed by subordinate residential mortgage backed securities (RMBSs).

We remain relatively pessimistic about a broad re-emergence of US private mortgage securitisation for new non-agency loans in the near future. This will likely require US property prices to stop falling, something that is not expected this year, and investor demand to tighten the pricing between US agency RMBS and private MBS. The agency RMBS market has essentially supplanted private mortgage securitisation, partly because allowable agency loan balances increased from $417,000 pre-crisis to $729,750 today. 2010 securitisation of agency RMBS has been robust with issuance of more than $1.4 trillion in new agency pools and more than $450 billion in agency REMICs. Those volumes are likely to go up in 2011.

We are cautious about the growth prospects for US credit card backed bonds. The contraction of household debt within the US has led to lower credit card balances at the banks. Combined with cheap funding for banks in the deposit market and new accounting consolidation rules, the issuance of credit card backed bonds may therefore remain modest. But investor demand for credit card bonds, long a core element of the ABS market, remains strong. The student loan market remains challenged, with disruptions both in the overall US government guaranteed FFELP program and challenges in the private issuance market.

In Europe, the primary market will continue to remain active out of already started benchmark sectors such as German auto ABS and UK prime RMBS. Additionally, the market should continue to broaden as seen recently with deals backed by UK nonconforming mortgages and Italian residential mortgages. New issuance syndication in Europe has reverted back to a more widely distributed model in the last two months as large anchor investors relinquish their hold on demand side liquidity. However, such large investors will still form a key part of the market for some time to come. All leading European financial institutions will be able to issue ABS this year however we expect much greater investor scrutiny of issuance out of Ireland, Portugal, Spain and Greece. Despite the short term volatility due to sovereign issues, we remain bullish on senior ABS in the long term. This is due to our belief that the product should weather sovereign issues well relative to other asset classes and that spreads are dislocated relative to vanilla credit and US ABS.

The net result of recent market trends is a conspicuous lack of issuance volume for investors when compared to the amount of cash available to invest. The dramatic growth in the home equity and CDO markets leading up to 2007 now means higher levels of cash coming back to investors as their holdings amortise. Further, many structured finance investors have received greater portfolio allocations in 2010 as tightening spreads have lead to outperformance compared with other markets. The combined effect is a strong technical demand for issuance.

Late in 2010, the investor refrain has been ‘is there any more product’? We have seen a movement where the demand has been insatiable for ‘flow’ issuance and the search for yield has lead investors to ‘non-flow’ issuance. Deutsche Bank has been a leader within this market, bringing varied transactions from cell tower lease, rental truck fleet, time-share issuers and other private asset-backed offerings. Other sectors which have experienced limited access to the ABS capital markets in the past few years, such as hard assets (aircraft, rail, container) and CLOs, have begun to see a thawing, and a pipeline of opportunities is developing.

To sum up, we believe that the recovery seen in the global ABS markets in 2010 will continue, and offer abundant opportunities for both issuers and investors.


Alistair Hicks Curator, Deutsche Bank Art Collection

3.11 Markets

Outlook for ArtFour artists to watch in 2011

In February, Deutsche Bank will be naming sixty floors of its Frankfurt headquarters after artists born after 1957 from around the world. The headquarters will effectively be a survey of ‘world art’. The most exciting trend is a new determination to change the world rather than just snipe at the mechanics of markets and failing structures. For this article I will concentrate on four artists who reflect this desire for change: Francis Alÿs, (a Belgian living in Mexico fascinated in redrawing the world map), Cao Fei (born 1978 in Guangzhou and so not part of the first wave of Chinese propelled to fame by external speculation), Gabriel Orozco (a Mexican sniping brilliantly at central control and structures) and Nedko Solakov (a genuinely funny Bulgarian ideas man who draws like a dream). Their work can be seen at major institutions this year.

There are many ‘sages’ in the market place who would disagree with me.

They would nod wisely and advise that in times of economic turbulence it is safer to steer away from speculative ‘new names’ and buy old masters, Impressionists and the High Modernists, but there are many people sensing big changes in the market.

Francois Curiel of Christie’s has been despatched to Asia to try and ensure that the auction house competes effectively with the rapid rise of Chinese competitors. He is the first to point out that already four of the top auction houses in the world are from China, nine in the top 20. Equally their rivals Sotheby’s recognises a redrawing of the art world, as otherwise why would they have devoted all their Bond Street galleries to Robert Devereux’s British contemporary collection to raise around £5 million for his new African Arts Trust. Phillips’ approach at first sight looks more commercial with their creation of BRIC sales, but this direct correlation between money and

markets and the inherent nationalism is precisely what the ‘agents of change’ are fighting. Not that Phillips’ will lose out as the second wave of artists emerging from these countries will be among the world leaders in the field.

Cao Fei is very much an artist propelled by interest within China and she works in Beijing. She makes films, photographs, operas, installations and interactive works. At Frieze she created a room of her own Room 608 which included some of her favourite things, including a highly realistic imitation mail-order baby (she is a recent mother). Her photographs are still under EUR10,000. Her ideas are socially inclusive. She has made an artwork on ‘Second Life’ on the web called ‘RMB City’. This interactive construction is apparently populated, as the artist observes, mainly by young people trying to escape their everyday lives: “All the COSPLAYERS are extremely young, their heads full of

dreams, from an early age spending all their waking hours in virtual realities, playing video games. So that when eventually they grow up, they find that they are living a lifestyle that is frowned upon and rejected by society and family alike. With no available channels of expression for their feelings and aspirations, they resort to escapism, allowing themselves to become alienated. However, in the very instant that they are turned into genies, chivalrous knights, fairy princesses or geeks, the pleasures and pains of escapism are fulfilled, fleetingly, even if the reality they live in has not changed in the slightest.” She is not advocating escapism from harsh realities, but rather stressing that our internal lives are just as important. “I am not trying to divorce my thinking from the modern reality in China. We live in the New Great Leap. We have demolished everything and are building anew. There is an aura of construction everywhere.”

Gabriel Orozco equally emphasises that “the idea of construction is very important. It is not enough to cut a car in half. You have to build it up again.” In his case he famously cut a Citroen into three pieces, took out the centre third and reassembled it. As a Mexican he is particularly interested in investigating the idea of centrality, not just political, but the change in the way we are trying to move away from centrally-controlled thinking. His work is so diverse that it is almost impossible to pin down. His major sculptures and paintings cost hundreds of thousands, but you can find beautiful drawings he has done on bank notes at around $35,000. As he explores the question of the centre, the circle has become like

his signature, which springs up like a virulent but beautiful disease on his paintings and drawings.

Francis Alÿs also lives in Mexico but he was born in Belgium and is a professional migrant. Many of his filmed performances involve walking. He walks along and through disputed borders. He believes art can help change the world. Gone is the dream of an absolute solution, but as witnessed by his project to move a dune, When Faith Moves Mountains, Lima 2002, he has inherited the passionate belief of Joseph Beuys that artists can help make the world a better place. Despite the absurdity of what he was trying to do, there is a new sense of reality. He made this work in the run up to a contentious election in Peru. A 1984 government document had declared ‘everything is an illusion but power’ By persuading 500 students to shovel dirt to move a mountain the artist was demonstrating that ‘illusion is also power.’ There is an element of the old adage ‘mind over matter,’ but it is also questioning the integrity of our own minds, which are under a constant barrage of mind-washing – mind control. As well as his films and installations Alÿs paints beautiful small paintings, which can now already command above EUR100,000 and makes series of drawings.

Bulgarian Nedko Solakov is constantly kicking against the status quo, but his dealers now are beginning to rack up the prices. Until very recently one could pick up single drawings for around EUR3,000, but now if you want the best you have to buy series of work and will probably need to lay out at least EUR20,000.

One beautiful and funny series of drawings is devoted to his super hero El Bulgaria, who in contrast to El Greco’s emaciated figures wears a cloak that cannot hide his unfashionably round figure.

The art world’s eyes have for the last 150 years hardly left Paris, New York and London. Much has been made in the last few years of Brazil, Russia, China and India as the powerful emerging markets, but this is just part of the story. For the first time ever it is possible to live anywhere in the world and make an international name as an artist. Solakov lives in Sofia and does not like to travel by air, so has just travelled overland to his exhibition in China. It is artists like Alÿs, Fei, Orozco and Solakov, who are leading the way. It is not surprising that my fellow advisor to Deutsche Bank, Hou Hanru, has dubbed them ‘agents of change.’

Francis Alÿs at MOMA, New York May –Nedko Solakov can be seen at the Singapore Biennale in March and at Ikon, Birmingham, England, in September.Gabriel Orozco will be at Deutsche Guggen-heim in SeptemberCao Fei will participate in the inaugural exhi-bition the Museum of the Moving Image in New York opening January

Detail, Gabriel Orozco, UK Atomist (Lateral Diagram 1-4), 2009, tempera and gold leaf on digital print on canvas. Courtesy of the artist and Kurimanzutto, Mexico City.


Alistair Hicks Curator, Deutsche Bank Art Collection

3.11 Markets

Outlook for ArtFour artists to watch in 2011

In February, Deutsche Bank will be naming sixty floors of its Frankfurt headquarters after artists born after 1957 from around the world. The headquarters will effectively be a survey of ‘world art’. The most exciting trend is a new determination to change the world rather than just snipe at the mechanics of markets and failing structures. For this article I will concentrate on four artists who reflect this desire for change: Francis Alÿs, (a Belgian living in Mexico fascinated in redrawing the world map), Cao Fei (born 1978 in Guangzhou and so not part of the first wave of Chinese propelled to fame by external speculation), Gabriel Orozco (a Mexican sniping brilliantly at central control and structures) and Nedko Solakov (a genuinely funny Bulgarian ideas man who draws like a dream). Their work can be seen at major institutions this year.

There are many ‘sages’ in the market place who would disagree with me.

They would nod wisely and advise that in times of economic turbulence it is safer to steer away from speculative ‘new names’ and buy old masters, Impressionists and the High Modernists, but there are many people sensing big changes in the market.

Francois Curiel of Christie’s has been despatched to Asia to try and ensure that the auction house competes effectively with the rapid rise of Chinese competitors. He is the first to point out that already four of the top auction houses in the world are from China, nine in the top 20. Equally their rivals Sotheby’s recognises a redrawing of the art world, as otherwise why would they have devoted all their Bond Street galleries to Robert Devereux’s British contemporary collection to raise around £5 million for his new African Arts Trust. Phillips’ approach at first sight looks more commercial with their creation of BRIC sales, but this direct correlation between money and

markets and the inherent nationalism is precisely what the ‘agents of change’ are fighting. Not that Phillips’ will lose out as the second wave of artists emerging from these countries will be among the world leaders in the field.

Cao Fei is very much an artist propelled by interest within China and she works in Beijing. She makes films, photographs, operas, installations and interactive works. At Frieze she created a room of her own Room 608 which included some of her favourite things, including a highly realistic imitation mail-order baby (she is a recent mother). Her photographs are still under EUR10,000. Her ideas are socially inclusive. She has made an artwork on ‘Second Life’ on the web called ‘RMB City’. This interactive construction is apparently populated, as the artist observes, mainly by young people trying to escape their everyday lives: “All the COSPLAYERS are extremely young, their heads full of

dreams, from an early age spending all their waking hours in virtual realities, playing video games. So that when eventually they grow up, they find that they are living a lifestyle that is frowned upon and rejected by society and family alike. With no available channels of expression for their feelings and aspirations, they resort to escapism, allowing themselves to become alienated. However, in the very instant that they are turned into genies, chivalrous knights, fairy princesses or geeks, the pleasures and pains of escapism are fulfilled, fleetingly, even if the reality they live in has not changed in the slightest.” She is not advocating escapism from harsh realities, but rather stressing that our internal lives are just as important. “I am not trying to divorce my thinking from the modern reality in China. We live in the New Great Leap. We have demolished everything and are building anew. There is an aura of construction everywhere.”

Gabriel Orozco equally emphasises that “the idea of construction is very important. It is not enough to cut a car in half. You have to build it up again.” In his case he famously cut a Citroen into three pieces, took out the centre third and reassembled it. As a Mexican he is particularly interested in investigating the idea of centrality, not just political, but the change in the way we are trying to move away from centrally-controlled thinking. His work is so diverse that it is almost impossible to pin down. His major sculptures and paintings cost hundreds of thousands, but you can find beautiful drawings he has done on bank notes at around $35,000. As he explores the question of the centre, the circle has become like

his signature, which springs up like a virulent but beautiful disease on his paintings and drawings.

Francis Alÿs also lives in Mexico but he was born in Belgium and is a professional migrant. Many of his filmed performances involve walking. He walks along and through disputed borders. He believes art can help change the world. Gone is the dream of an absolute solution, but as witnessed by his project to move a dune, When Faith Moves Mountains, Lima 2002, he has inherited the passionate belief of Joseph Beuys that artists can help make the world a better place. Despite the absurdity of what he was trying to do, there is a new sense of reality. He made this work in the run up to a contentious election in Peru. A 1984 government document had declared ‘everything is an illusion but power’ By persuading 500 students to shovel dirt to move a mountain the artist was demonstrating that ‘illusion is also power.’ There is an element of the old adage ‘mind over matter,’ but it is also questioning the integrity of our own minds, which are under a constant barrage of mind-washing – mind control. As well as his films and installations Alÿs paints beautiful small paintings, which can now already command above EUR100,000 and makes series of drawings.

Bulgarian Nedko Solakov is constantly kicking against the status quo, but his dealers now are beginning to rack up the prices. Until very recently one could pick up single drawings for around EUR3,000, but now if you want the best you have to buy series of work and will probably need to lay out at least EUR20,000.

One beautiful and funny series of drawings is devoted to his super hero El Bulgaria, who in contrast to El Greco’s emaciated figures wears a cloak that cannot hide his unfashionably round figure.

The art world’s eyes have for the last 150 years hardly left Paris, New York and London. Much has been made in the last few years of Brazil, Russia, China and India as the powerful emerging markets, but this is just part of the story. For the first time ever it is possible to live anywhere in the world and make an international name as an artist. Solakov lives in Sofia and does not like to travel by air, so has just travelled overland to his exhibition in China. It is artists like Alÿs, Fei, Orozco and Solakov, who are leading the way. It is not surprising that my fellow advisor to Deutsche Bank, Hou Hanru, has dubbed them ‘agents of change.’

Francis Alÿs at MOMA, New York May –Nedko Solakov can be seen at the Singapore Biennale in March and at Ikon, Birmingham, England, in September.Gabriel Orozco will be at Deutsche Guggen-heim in SeptemberCao Fei will participate in the inaugural exhi-bition the Museum of the Moving Image in New York opening January

Detail, Gabriel Orozco, UK Atomist (Lateral Diagram 1-4), 2009, tempera and gold leaf on digital print on canvas. Courtesy of the artist and Kurimanzutto, Mexico City.


4 Trading

High Yield Credit Investment Grade CreditForeign ExchangeCommoditiesRatesAsset Backed SecuritiesCarry Trading


4 Trading

High Yield Credit Investment Grade CreditForeign ExchangeCommoditiesRatesAsset Backed SecuritiesCarry Trading


Ten High Yield Credit Trades for 2011 Investment Grade Credit Trading Ideas for 2011

4.1 Trading

4.2 Trading

Richard Phelan Head of European Credit Research

Anthony Klarman Head of US High Yield Research

Richard Salditt Credit Trading Strategist North America

James Maxwell Head of European Credit Trading Strategies

1. Long Intelsat Intelsat has nearly four years’ worth of revenue already in non-cancellable backlog and has the potential for some additional upside with recent satellite launches. We believe the next phase of spread tightening for Intelsat will come through partial debt recapitalisation, potential merger with Telesat, potential IPO and growth from some recently launched/purchased satellites.

2. Long Norwegian Cruise Line NCL is one of the leading cruise ship operators and currently operates ten ships with 22,110 berths, 9.4% of total North American capacity by berths. We believe spread tightening will continue given improved fundamentals, lower leverage and possible IPO. Its secured debt offers 11.75%, its unsecured 9.5%.

3. Long Rite-Aid Rite Aid is a top three US drugstore chain that is being prepared for sale by the management team brought in from its successful sale of Pathmark, Inc. It has over $1 billion of liquidity, no meaningful maturities until 2014/15, and over $6.5 billion of asset value, supported by an average industry M&A multiple of 9.3x. Spread tightening should come from front-end traction from its consumer loyalty programme, stabilisation of pharmacy reimbursement rates, new generic introductions, and continued consolidation of independent pharmacies and regional chains.

4. Long Avaya Avaya is the second largest provider of unified communications solutions. It was taken private by Silver Lake and TPG in 2007. We see future principal upside and spread tightening through steady, secular industry trends, aggressive cost cutting plans, integration of the recent acquisition of Nortel Enterprise Solutions, and the potential for the extension of current bank debt through an Amend & Extend and/or partial refinancing.

5. Long Fox acquisition FOXACQ owns eight TV stations serving eight mid-sized markets across the US including Denver, Cleveland, St Louis, Salt Lake City, and Milwaukee. Seven of the eight stations are affiliated with FOX network (the exception is 1 CBS). The company has benefited from the rebound in advertising spend in 2010. Positive drivers for 2011 include growth in core advertising, and the fall in programming expenses. It offers a 13.375% cash-pay coupon.

6. Long HCA Hospitals This dominant for-profit US hospital operator is 4.9x levered with strong free cashflow. We see little chance for another dividend as it would push leverage too close to comparative hospital company enterprise values of 6–6.5x and diminish the potential IPO value. Upside is the IPO.

7. Long Vantage Vantage operates a fleet of high specification drilling units that has long term firm contracts. Catalysts for further tightening include the drillship starting work on Jan 1, 2011 which should turn FCF positive and decrease leverage (with increased EBITDA) from about 11x now to 4x by the end of FY 11E.

8. Long Ineos Global and diversified chemical producer benefiting from improving credit fundamentals, stronger liquidity via divestitures and access to capital markets serving to lengthen debt amortisations.

9. Long ONO Material improvement in FCF (from negative to positive) and EBITDA growth should lead to deleveraging. Considering asset cover and size of the notes, they should be refinanced. Y2W not appropriate, as will be refinanced ahead of maturity over the next two years.

10. Long Norske Skog by selling two-year CDS Selling 2 year protection should be the best way to position for positive event risk in the next six months or so. We expect to see Norske Skog achieve newsprint selling price increases in January, refinance the EUR400 million Feb-12 bank facility in H1 2011, and potentially participate in European newsprint industry consolidation in 2011.

We expect European credit markets to continue to be dogged by sovereign fears, just as they have been in 2010. Investors have responded by favouring corporate credits (investment grade and high yield) over financials. With corporate balance sheets in good shape but financials still subject to political and regulatory risk, there seems little reason for this trend to change. That said, we still see opportunities across the capital structure in the financial sector for those investors willing to withstand some mark-to-market volatility.

In the US, we foresee a moderate year for corporate debt investors with total returns being less spectacular than in 2010 but still positive. We expect to see additional bouts of volatility driven by macro events outside the United States. Equities are likely to outperform credit for the first time since 2006 with high yield probably again outperforming investment grade as it did in 2010.

Europe In European financials, we expect regulatory change to drive institutions to build and restructure capital. We prefer low cash-price Tier 1 securities on pending Basel 3 proposals that should encourage banks to continue calling their subordinated capital – we particularly favour RBS, ABN and UBS in this context. We also favour the incremental yield available in contingent capital securities (‘CoCos’) as the search for yield from strong issuers such as UBS and CS underpins the ‘low-trigger’ CoCos (i.e. those securities where the conversion trigger is just 5% of Core Tier 1).

In the defensive European utilities sector we favour the higher-yielding International Power bonds where we believe an upgrade to mid-BBB is on the cards following the imminent reverse take-over by GDF Suez. The company’s better geographic diversification, stronger financial profile and liquidity package from GDF Suez are supportive for its credit quality.

Among European industrials, we see value in the mining industry where higher commodity prices drive significant discretionary cash flows and deleveraging. In particular we are constructive on Xstrata and Glencore in cash and CDS given their exposure to favourable coal and copper markets. We also see steel markets improving during 2011 and would expect ArcelorMittal spreads to outperform peers thanks to its vertical integration and geographic mix. We are also constructive on the semi-conductor sector, Infineon in particular, where disposals and a capital increase have improved credit fundamentals.

For those looking to enhance yield without sacrificing issuer quality, we advocate the corporate hybrid sector, many offering more than 300bp additional yield over equivalent senior bonds. We favour hybrids from German bellwethers such as RWE, Siemens and Linde, where we see limited coupon deferral or extension risk and consider the risk stemming from subordination as very low. Among the sub-investment grade issuers we like Santos which offers a significant yield pick-up and has a proven track record of defending its ratings

US In the US, we favour sectors that stand to benefit from improving domestic growth and inflation including selected US banks, REITs, commodities and energy companies. Specifically, we would be buyers of Anadarko Petroleum, Citigroup, Dow Chemical, Energy Transfer Partners, International Paper, Kinder Morgan Energy, Rio Tinto and Simon Property.

We’d also take long positions in strong credits trading cheap to peers including InBev, Motorola via basis, NBC Universal, and RR Donnelley.

While we do not expect a return to 2006/2007 LBO mania, we do see intentional releveraging as the biggest risk to $ credit next year and so would avoid those credits that are maybe more likely to add material leverage. We would also avoid credits whose credit profiles remain under pressure.

We’d prefer not to make a big bet in either direction in US financials away from a few specific long/short pairs as the volatility associated with macro risks may continue to outweigh positive underlying credit quality and technical trends, rendering outperformance in financials relative to the market difficult to achieve.


Ten High Yield Credit Trades for 2011 Investment Grade Credit Trading Ideas for 2011

4.1 Trading

4.2 Trading

Richard Phelan Head of European Credit Research

Anthony Klarman Head of US High Yield Research

Richard Salditt Credit Trading Strategist North America

James Maxwell Head of European Credit Trading Strategies

1. Long Intelsat Intelsat has nearly four years’ worth of revenue already in non-cancellable backlog and has the potential for some additional upside with recent satellite launches. We believe the next phase of spread tightening for Intelsat will come through partial debt recapitalisation, potential merger with Telesat, potential IPO and growth from some recently launched/purchased satellites.

2. Long Norwegian Cruise Line NCL is one of the leading cruise ship operators and currently operates ten ships with 22,110 berths, 9.4% of total North American capacity by berths. We believe spread tightening will continue given improved fundamentals, lower leverage and possible IPO. Its secured debt offers 11.75%, its unsecured 9.5%.

3. Long Rite-Aid Rite Aid is a top three US drugstore chain that is being prepared for sale by the management team brought in from its successful sale of Pathmark, Inc. It has over $1 billion of liquidity, no meaningful maturities until 2014/15, and over $6.5 billion of asset value, supported by an average industry M&A multiple of 9.3x. Spread tightening should come from front-end traction from its consumer loyalty programme, stabilisation of pharmacy reimbursement rates, new generic introductions, and continued consolidation of independent pharmacies and regional chains.

4. Long Avaya Avaya is the second largest provider of unified communications solutions. It was taken private by Silver Lake and TPG in 2007. We see future principal upside and spread tightening through steady, secular industry trends, aggressive cost cutting plans, integration of the recent acquisition of Nortel Enterprise Solutions, and the potential for the extension of current bank debt through an Amend & Extend and/or partial refinancing.

5. Long Fox acquisition FOXACQ owns eight TV stations serving eight mid-sized markets across the US including Denver, Cleveland, St Louis, Salt Lake City, and Milwaukee. Seven of the eight stations are affiliated with FOX network (the exception is 1 CBS). The company has benefited from the rebound in advertising spend in 2010. Positive drivers for 2011 include growth in core advertising, and the fall in programming expenses. It offers a 13.375% cash-pay coupon.

6. Long HCA Hospitals This dominant for-profit US hospital operator is 4.9x levered with strong free cashflow. We see little chance for another dividend as it would push leverage too close to comparative hospital company enterprise values of 6–6.5x and diminish the potential IPO value. Upside is the IPO.

7. Long Vantage Vantage operates a fleet of high specification drilling units that has long term firm contracts. Catalysts for further tightening include the drillship starting work on Jan 1, 2011 which should turn FCF positive and decrease leverage (with increased EBITDA) from about 11x now to 4x by the end of FY 11E.

8. Long Ineos Global and diversified chemical producer benefiting from improving credit fundamentals, stronger liquidity via divestitures and access to capital markets serving to lengthen debt amortisations.

9. Long ONO Material improvement in FCF (from negative to positive) and EBITDA growth should lead to deleveraging. Considering asset cover and size of the notes, they should be refinanced. Y2W not appropriate, as will be refinanced ahead of maturity over the next two years.

10. Long Norske Skog by selling two-year CDS Selling 2 year protection should be the best way to position for positive event risk in the next six months or so. We expect to see Norske Skog achieve newsprint selling price increases in January, refinance the EUR400 million Feb-12 bank facility in H1 2011, and potentially participate in European newsprint industry consolidation in 2011.

We expect European credit markets to continue to be dogged by sovereign fears, just as they have been in 2010. Investors have responded by favouring corporate credits (investment grade and high yield) over financials. With corporate balance sheets in good shape but financials still subject to political and regulatory risk, there seems little reason for this trend to change. That said, we still see opportunities across the capital structure in the financial sector for those investors willing to withstand some mark-to-market volatility.

In the US, we foresee a moderate year for corporate debt investors with total returns being less spectacular than in 2010 but still positive. We expect to see additional bouts of volatility driven by macro events outside the United States. Equities are likely to outperform credit for the first time since 2006 with high yield probably again outperforming investment grade as it did in 2010.

Europe In European financials, we expect regulatory change to drive institutions to build and restructure capital. We prefer low cash-price Tier 1 securities on pending Basel 3 proposals that should encourage banks to continue calling their subordinated capital – we particularly favour RBS, ABN and UBS in this context. We also favour the incremental yield available in contingent capital securities (‘CoCos’) as the search for yield from strong issuers such as UBS and CS underpins the ‘low-trigger’ CoCos (i.e. those securities where the conversion trigger is just 5% of Core Tier 1).

In the defensive European utilities sector we favour the higher-yielding International Power bonds where we believe an upgrade to mid-BBB is on the cards following the imminent reverse take-over by GDF Suez. The company’s better geographic diversification, stronger financial profile and liquidity package from GDF Suez are supportive for its credit quality.

Among European industrials, we see value in the mining industry where higher commodity prices drive significant discretionary cash flows and deleveraging. In particular we are constructive on Xstrata and Glencore in cash and CDS given their exposure to favourable coal and copper markets. We also see steel markets improving during 2011 and would expect ArcelorMittal spreads to outperform peers thanks to its vertical integration and geographic mix. We are also constructive on the semi-conductor sector, Infineon in particular, where disposals and a capital increase have improved credit fundamentals.

For those looking to enhance yield without sacrificing issuer quality, we advocate the corporate hybrid sector, many offering more than 300bp additional yield over equivalent senior bonds. We favour hybrids from German bellwethers such as RWE, Siemens and Linde, where we see limited coupon deferral or extension risk and consider the risk stemming from subordination as very low. Among the sub-investment grade issuers we like Santos which offers a significant yield pick-up and has a proven track record of defending its ratings

US In the US, we favour sectors that stand to benefit from improving domestic growth and inflation including selected US banks, REITs, commodities and energy companies. Specifically, we would be buyers of Anadarko Petroleum, Citigroup, Dow Chemical, Energy Transfer Partners, International Paper, Kinder Morgan Energy, Rio Tinto and Simon Property.

We’d also take long positions in strong credits trading cheap to peers including InBev, Motorola via basis, NBC Universal, and RR Donnelley.

While we do not expect a return to 2006/2007 LBO mania, we do see intentional releveraging as the biggest risk to $ credit next year and so would avoid those credits that are maybe more likely to add material leverage. We would also avoid credits whose credit profiles remain under pressure.

We’d prefer not to make a big bet in either direction in US financials away from a few specific long/short pairs as the volatility associated with macro risks may continue to outweigh positive underlying credit quality and technical trends, rendering outperformance in financials relative to the market difficult to achieve.


1. Long gold Gold is enjoying new sources of demand from central banks and private investors. We believe gold will continue to attract investment capital in the current low interest rate environment. We believe gold prices would need to surpass $2,000/oz to represent a bubble.

2. Long silver We expect silver to out-perform gold for as long as the US manufacturing sector activity is expanding. Silver is also trading cheap compared to gold.

3. Long copper We expect demand for copper to remain strong at a time when mine production growth is likely to struggle. The possibility of a physically backed copper ETF would tighten the market still further.

4. Short crude oil contango As global growth continues to recover we expect physical fundamentals in the oil market to tighten and the overhang in US and OECD crude oil inventories to be slowly eliminated, encouraging a flattening in the crude oil forward curve.

5. Bullish long dated crude oil We prefer bullish long dated strategies in crude oil given the threat of market disruption affecting near term demand. Bullish long dated strategies also exploit the fact that finding costs are rising across the sector.

6. Short UK NBP gas We look to sell weather induced rallies in UK gas as a result of cold weather. We believe medium term

fundamentals are bearish with sluggish growth in European demand, higher imports of LNG in addition to the risk of Atlantic arbitrage via US re-export.

7. Long thermal coal We believe thermal coal will benefit from strong Chinese and India demand. Moreover we expect infrastructure problems in South Africa and Australia to persist during the first half of 2011.

8. Long corn We believe rising Chinese shortages and the increasing use of corn as a feedstock for the US ethanol industry will continue to push prices higher. We view increased US acreage as the main hazard heading into the second quarter of the year.

9. Long soybeans We expect rising Chinese imports and the possibility that US farmers reduce plantings in soybeans to be bullish developments for the market.

10. Long EUA carbon emissions We believe higher prices will be triggered by European utilities in general, and German generators in particular, starting to sell forward larger volumes of electricity for 2012 and 2013 delivery. This will encourage hedging of their associated demand for EUAs. With Phase-3 EUAs as yet unavailable on the market, and very unlikely in our view to be available until the second half of 2011 at the earliest, we believe forward selling of power for both 2012 and 2013 will bid up Phase-2 EUA prices.

Ten Commodity Trades for 2011

4.4 Trading


1. Sell $/JPY Japan’s current account surplus and trade links to the rest of Asia should keep JPY well supported. Intervention unlikely to prevent JPY reaching new all-time highs just as it did in 1995 during intervention. Capital flow data that appears to show increased hedging activity and less use of JPY as a funding currency is helping JPY.

2. Buy Asian FX basket versus $ Asian central banks will become more tolerant of currency rises because of inflationary pressure, with stronger growth providing further support.

3. Buy MXN versus $ Mexico looks seriously undervalued given its strong link to the US economy which we expect to surprise on the upside in 2011.

4. Buy CAD/AUD Australian dollar looks overvalued and much good news has already been priced in, while Canada should benefit from US economic recovery

5. Sell $/TRY A strong carry trade. Turkish rates are 7% compared with 0.25% in the US.

Ten FX Trades for 2011

4.3 Trading

6. Buy PLN/CZK Polish rates likely to rise earlier and further than those in Czech Republic.

7. Sell GBP versus EUR UK may suffer from weakness in Irish financial institutions. UK deficit, negative real rates and poor growth prospects should also weigh on GBP.

8. Sell $/PEN A Latin American “catch up” trade led by dollar weakness, rising commodity prices, and rate hikes in Peru.

9. Sell $/RUB Higher oil prices, CBR intervention, prospects of inflows on the back of expansion of privatisation programme (2011–2013) to RUB2 trillion from RUB1 trillion and the forthcoming issuance of RUB denominated Eurobonds. Russia an exception not considering capital controls (see recent comments by presidential advisor Arkady Dvorkovich). Also, budget is outperforming and equities continue to look relatively cheap.

10. Sell EUR/HUF Room for further catch-up with valuation metrics.

Bilal Hafeez Global Head of FX Research


1. Long gold Gold is enjoying new sources of demand from central banks and private investors. We believe gold will continue to attract investment capital in the current low interest rate environment. We believe gold prices would need to surpass $2,000/oz to represent a bubble.

2. Long silver We expect silver to out-perform gold for as long as the US manufacturing sector activity is expanding. Silver is also trading cheap compared to gold.

3. Long copper We expect demand for copper to remain strong at a time when mine production growth is likely to struggle. The possibility of a physically backed copper ETF would tighten the market still further.

4. Short crude oil contango As global growth continues to recover we expect physical fundamentals in the oil market to tighten and the overhang in US and OECD crude oil inventories to be slowly eliminated, encouraging a flattening in the crude oil forward curve.

5. Bullish long dated crude oil We prefer bullish long dated strategies in crude oil given the threat of market disruption affecting near term demand. Bullish long dated strategies also exploit the fact that finding costs are rising across the sector.

6. Short UK NBP gas We look to sell weather induced rallies in UK gas as a result of cold weather. We believe medium term

fundamentals are bearish with sluggish growth in European demand, higher imports of LNG in addition to the risk of Atlantic arbitrage via US re-export.

7. Long thermal coal We believe thermal coal will benefit from strong Chinese and India demand. Moreover we expect infrastructure problems in South Africa and Australia to persist during the first half of 2011.

8. Long corn We believe rising Chinese shortages and the increasing use of corn as a feedstock for the US ethanol industry will continue to push prices higher. We view increased US acreage as the main hazard heading into the second quarter of the year.

9. Long soybeans We expect rising Chinese imports and the possibility that US farmers reduce plantings in soybeans to be bullish developments for the market.

10. Long EUA carbon emissions We believe higher prices will be triggered by European utilities in general, and German generators in particular, starting to sell forward larger volumes of electricity for 2012 and 2013 delivery. This will encourage hedging of their associated demand for EUAs. With Phase-3 EUAs as yet unavailable on the market, and very unlikely in our view to be available until the second half of 2011 at the earliest, we believe forward selling of power for both 2012 and 2013 will bid up Phase-2 EUA prices.

Ten Commodity Trades for 2011

4.4 Trading


1. Sell $/JPY Japan’s current account surplus and trade links to the rest of Asia should keep JPY well supported. Intervention unlikely to prevent JPY reaching new all-time highs just as it did in 1995 during intervention. Capital flow data that appears to show increased hedging activity and less use of JPY as a funding currency is helping JPY.

2. Buy Asian FX basket versus $ Asian central banks will become more tolerant of currency rises because of inflationary pressure, with stronger growth providing further support.

3. Buy MXN versus $ Mexico looks seriously undervalued given its strong link to the US economy which we expect to surprise on the upside in 2011.

4. Buy CAD/AUD Australian dollar looks overvalued and much good news has already been priced in, while Canada should benefit from US economic recovery

5. Sell $/TRY A strong carry trade. Turkish rates are 7% compared with 0.25% in the US.

Ten FX Trades for 2011

4.3 Trading

6. Buy PLN/CZK Polish rates likely to rise earlier and further than those in Czech Republic.

7. Sell GBP versus EUR UK may suffer from weakness in Irish financial institutions. UK deficit, negative real rates and poor growth prospects should also weigh on GBP.

8. Sell $/PEN A Latin American “catch up” trade led by dollar weakness, rising commodity prices, and rate hikes in Peru.

9. Sell $/RUB Higher oil prices, CBR intervention, prospects of inflows on the back of expansion of privatisation programme (2011–2013) to RUB2 trillion from RUB1 trillion and the forthcoming issuance of RUB denominated Eurobonds. Russia an exception not considering capital controls (see recent comments by presidential advisor Arkady Dvorkovich). Also, budget is outperforming and equities continue to look relatively cheap.

10. Sell EUR/HUF Room for further catch-up with valuation metrics.

Bilal Hafeez Global Head of FX Research


4.6 Trading

Conor O’Toole European Securitisation Research

Steven Abrahams US Securitisation Research

Ten ABS Trades for 2011

1. Bullish US Treasuries near-term, bearish long term Supply demand imbalance and elevated risk aversion levels should support Treasuries over the 1M to 3M horizon with yields falling to around 2.5% or below. Beyond, improving fundamentals and higher core inflation levels should trigger a partial normalisation of 10-year UST rates above 3% later on. We recommend zero-cost 6Mx10Y 1x2 payer ratios. The trade is mildly bullish in the short run but should provide significant upside in a moderate sell-off as we move towards expiry. The trade should only lose money in 6 months if the underlying rate sells-off by more than 90bp from current (Dec 2010) levels.

2. Bearish EUR short end Real rates for core countries are not justified by the robust economic picture. Tapping of the EFSF facility is bearish for core rates, as the core countries bear contingent liabilities. The ECB is likely to increasingly differentiate between rate setting and liquidity policies, with liquidity required for the weaker peripherals but rates too low for the core countries. We recommend paying EUR 1y1y swap which is only 43bp above 1Y swap and prices no risk premium to speak off.

1. Long UK non-conforming mortgage Senior AAA-rated UK non-conforming bonds offer returns of 250 to 200 basis points (as of Dec 2010). High credit enhancement ranging between 30% – 40% means principal impairment risk remote – 95% of pool can default with 40% loss severity. Negative default convexity boost returns, while low CPR scenarios still provide returns in excess of 200 bp.

2. Long new issue residential mortgage backed securities (RMBSs) of lower rated sponsors, and legacy RMBS of higher rated sponsors There is little pricing differentiation between legacy and new issue bonds. Yet new issue paper has punitive step up coupons compared to legacy market. We expect sponsors in Dutch and UK prime RMBS to continue calling bonds or providing necessary support in the case of master trusts. However, as a defensive tail-risk hedge we recommend accumulating new issue bonds to insure against bond extension risk reappearing.

3. Long Granite AAAs Granite’s AAA bonds (as of early December) were offering 262 basis points. Even if CPR falls to 8% for life dm still healthy at 165 bps. Continuing deleverage likely to see hard credit enhancement build to 27.5% by end of 2011, without a corresponding deterioration in pool performance.

4.5 Trading



Ten Rates Trades for 2011

3. EUR 2Y–10Y flattener Likely to get increasingly hawkish statements from the ECB about monetary policy, even if liquidity is maintained to support peripheral countries. The risk of policy error increases medium term with deflation risks in the euro area. Favour implementing the trade in swap space in case the tightening of liquidity leads to a spike in Libor rates.

4. 2Y10Y flattener in EUR versus steepener in the US While we expect the 2Y10Y curve to bear flatten in Europe, in the US, with the short end anchored, a sell-off in rates should lead to a steepening of the curve.

5. Short France on ASW basis France scores poorly on our twin deficit measure of fiscal and current account deficits. Tapping of the EFSF facility increases the contingent liability of the core countries and should be bearish for core rates.

6. Long Italy in the 2Y sector Investors in search of yields should favour Italy as a relatively safe peripheral play. The 2Y sector looks most attractive from a carry/roll down perspective.

7. Long Ireland in the 2Y sector The EFSF support package should draw a line under banking sector woes in Ireland. We see limited room for a default/restructuring on Ireland in the near term, as long as Ireland sticks to fiscal consolidation measures.

8. Long front breakevens in the US and UK With real GDP growth of 2.5% to 3%, the risk of deflation in the US is low. We actually expect inflation to normalise towards 2% by the end of 2011 while the market seems to be pricing in less than 1% inflation in 2011. UK inflation appears sticky and the BoE’s spare capacity argument is subject to uncertainty in estimation of the output gap.

9. 5Y–30Y flattener in the UK UK 5Y–30Y curve close to historically steep levels, driven by increased issuance at the long end and the relatively weak balance sheet of ALM players. Q1 2011, (which is the last quarter of the UK FY) will see only limited supply at the long end. BoE QE, if delivered, will target the long end as well given the low free float of bonds already bought.

10. Cross market trade: equity put conditional on a rate sell-off Any re-pricing of the bond risk premium which is not accompanied by significant improvements in the economic outlook should be detrimental to the equity market. This could occur either if sovereign risk is re-priced or in a stagflationary environment. To hedge against this risk, while cheapening the premium paid, one could consider equity (S&P500 and FTSE) puts conditional on rates being 150bp above spot. The conditioning reduces the option premium by about 55%.

4. Long UK buy-to-let MBS At 280-300 bp (as of early December) AIREM senior bonds offer pick up to vanilla paper. Credit performance has stabilised (late stage arrears at 3.8%), losses readily absorbed by excess spread while credit enhancement stands at 18%.

5. Long UK non-conforming mezzanine Focus on 2006 mezzanine UK non-conforming bonds that display principal impairment resiliency under stressed scenarios and pro-rata trigger upside such as RMAC 2006-NS2 that offers over 1000 bps (as of Dec 10) has seen 6.9% cumulative defaults, and can withstand a further 28% defaults under our base scenario.

6. Long US CLO versus Short European CLO Single-A/Triple-B European CLOs trade wide to similar US paper but there is greater concentration risk in European pools, 50 obligors versus typically 100+ in the US.

7. Long US floating-rate CMBS The re-emergence of the CRE financing market will allow more loans to successfully refinance and significant deleveraging.

8. Long US 2005–2006 conduit CMBS Focus on mezzanine tranches from transactions which have an overexposure to properties in top tier markets. The credit performance for these properties will continue to improve and values will recover to pre-crisis levels.

9. Long AAA-Rated traditional consumer ABS (credit cards, autoloans) versus lower rated consumer ABS With increased macro market volatility, AAA rated ‘on-the-run’ ABS is likely to outperform versus cuspier, lower-rated product.

10. Long US Government guaranteed (FFELP) student loans versus US credit cards Credit cards are unsecured consumer credit risk. FFELP student loans benefit from a 97% US government guarantee. For this reason, student loans almost always trade tighter than cards. Today the inverse is true. For example, in 5-years, cards are trading at a spread to LIBOR of 43 bps, while FFELP student loans are at 75 bps. That difference should compress.


4.6 Trading

Conor O’Toole European Securitisation Research

Steven Abrahams US Securitisation Research

Ten ABS Trades for 2011

1. Bullish US Treasuries near-term, bearish long term Supply demand imbalance and elevated risk aversion levels should support Treasuries over the 1M to 3M horizon with yields falling to around 2.5% or below. Beyond, improving fundamentals and higher core inflation levels should trigger a partial normalisation of 10-year UST rates above 3% later on. We recommend zero-cost 6Mx10Y 1x2 payer ratios. The trade is mildly bullish in the short run but should provide significant upside in a moderate sell-off as we move towards expiry. The trade should only lose money in 6 months if the underlying rate sells-off by more than 90bp from current (Dec 2010) levels.

2. Bearish EUR short end Real rates for core countries are not justified by the robust economic picture. Tapping of the EFSF facility is bearish for core rates, as the core countries bear contingent liabilities. The ECB is likely to increasingly differentiate between rate setting and liquidity policies, with liquidity required for the weaker peripherals but rates too low for the core countries. We recommend paying EUR 1y1y swap which is only 43bp above 1Y swap and prices no risk premium to speak off.

1. Long UK non-conforming mortgage Senior AAA-rated UK non-conforming bonds offer returns of 250 to 200 basis points (as of Dec 2010). High credit enhancement ranging between 30% – 40% means principal impairment risk remote – 95% of pool can default with 40% loss severity. Negative default convexity boost returns, while low CPR scenarios still provide returns in excess of 200 bp.

2. Long new issue residential mortgage backed securities (RMBSs) of lower rated sponsors, and legacy RMBS of higher rated sponsors There is little pricing differentiation between legacy and new issue bonds. Yet new issue paper has punitive step up coupons compared to legacy market. We expect sponsors in Dutch and UK prime RMBS to continue calling bonds or providing necessary support in the case of master trusts. However, as a defensive tail-risk hedge we recommend accumulating new issue bonds to insure against bond extension risk reappearing.

3. Long Granite AAAs Granite’s AAA bonds (as of early December) were offering 262 basis points. Even if CPR falls to 8% for life dm still healthy at 165 bps. Continuing deleverage likely to see hard credit enhancement build to 27.5% by end of 2011, without a corresponding deterioration in pool performance.

4.5 Trading



Ten Rates Trades for 2011

3. EUR 2Y–10Y flattener Likely to get increasingly hawkish statements from the ECB about monetary policy, even if liquidity is maintained to support peripheral countries. The risk of policy error increases medium term with deflation risks in the euro area. Favour implementing the trade in swap space in case the tightening of liquidity leads to a spike in Libor rates.

4. 2Y10Y flattener in EUR versus steepener in the US While we expect the 2Y10Y curve to bear flatten in Europe, in the US, with the short end anchored, a sell-off in rates should lead to a steepening of the curve.

5. Short France on ASW basis France scores poorly on our twin deficit measure of fiscal and current account deficits. Tapping of the EFSF facility increases the contingent liability of the core countries and should be bearish for core rates.

6. Long Italy in the 2Y sector Investors in search of yields should favour Italy as a relatively safe peripheral play. The 2Y sector looks most attractive from a carry/roll down perspective.

7. Long Ireland in the 2Y sector The EFSF support package should draw a line under banking sector woes in Ireland. We see limited room for a default/restructuring on Ireland in the near term, as long as Ireland sticks to fiscal consolidation measures.

8. Long front breakevens in the US and UK With real GDP growth of 2.5% to 3%, the risk of deflation in the US is low. We actually expect inflation to normalise towards 2% by the end of 2011 while the market seems to be pricing in less than 1% inflation in 2011. UK inflation appears sticky and the BoE’s spare capacity argument is subject to uncertainty in estimation of the output gap.

9. 5Y–30Y flattener in the UK UK 5Y–30Y curve close to historically steep levels, driven by increased issuance at the long end and the relatively weak balance sheet of ALM players. Q1 2011, (which is the last quarter of the UK FY) will see only limited supply at the long end. BoE QE, if delivered, will target the long end as well given the low free float of bonds already bought.

10. Cross market trade: equity put conditional on a rate sell-off Any re-pricing of the bond risk premium which is not accompanied by significant improvements in the economic outlook should be detrimental to the equity market. This could occur either if sovereign risk is re-priced or in a stagflationary environment. To hedge against this risk, while cheapening the premium paid, one could consider equity (S&P500 and FTSE) puts conditional on rates being 150bp above spot. The conditioning reduces the option premium by about 55%.

4. Long UK buy-to-let MBS At 280-300 bp (as of early December) AIREM senior bonds offer pick up to vanilla paper. Credit performance has stabilised (late stage arrears at 3.8%), losses readily absorbed by excess spread while credit enhancement stands at 18%.

5. Long UK non-conforming mezzanine Focus on 2006 mezzanine UK non-conforming bonds that display principal impairment resiliency under stressed scenarios and pro-rata trigger upside such as RMAC 2006-NS2 that offers over 1000 bps (as of Dec 10) has seen 6.9% cumulative defaults, and can withstand a further 28% defaults under our base scenario.

6. Long US CLO versus Short European CLO Single-A/Triple-B European CLOs trade wide to similar US paper but there is greater concentration risk in European pools, 50 obligors versus typically 100+ in the US.

7. Long US floating-rate CMBS The re-emergence of the CRE financing market will allow more loans to successfully refinance and significant deleveraging.

8. Long US 2005–2006 conduit CMBS Focus on mezzanine tranches from transactions which have an overexposure to properties in top tier markets. The credit performance for these properties will continue to improve and values will recover to pre-crisis levels.

9. Long AAA-Rated traditional consumer ABS (credit cards, autoloans) versus lower rated consumer ABS With increased macro market volatility, AAA rated ‘on-the-run’ ABS is likely to outperform versus cuspier, lower-rated product.

10. Long US Government guaranteed (FFELP) student loans versus US credit cards Credit cards are unsecured consumer credit risk. FFELP student loans benefit from a 97% US government guarantee. For this reason, student loans almost always trade tighter than cards. Today the inverse is true. For example, in 5-years, cards are trading at a spread to LIBOR of 43 bps, while FFELP student loans are at 75 bps. That difference should compress.


4.7Trading

Rashid HoosenallyGlobal Head of FX Structuring

Is the FX Carry Trade Dead?A time-honoured trading strategy under the spotlight

The fundamentals are not encouraging. Interest rates are at all time lows, the outlook for risky assets is uncertain, and both the actual and predicted level of currency volatility is high and we expect it to remain high.

And yet, this was broadly the case in 2009 too, when carry was a top performing currency strategy as the chart (which shows the return of Deutsche Bank’s fl agship carry trading strategies: Harvest and Haven) demonstrates.

So can it continue?The key to carry trades is interest rate diff erentials between currencies. So long as they persist, carry trades are likely to earn excess returns.

We believe they will persist given the fact that economic performances (and by extension interest rates) diverging rather than converging, with the Fed keeping rates low and EM central banks raising them to combat infl ation.

This indicates that carry trades will remain a compelling trading stratgegy in 2011. The downside is drawdown risk.

As carry traders found out in 1997 and 2007, carry trades can go wrong extremely quickly. In both years, the dollar, yen and swiss franc strengthened, whilst sterling, the New Zealand dollar, Icelandic krona and many emerging market high-yielders fell dramatically, forcing traders to unwind carry trades.

So how can you carry on doing the carry trade without becoming exposed too heavily to drawdown risk?One solution is to diversify: broaden the basket to include EM currencies, whilst ensuring G10 currencies still feature in long and short baskets. As well as improving diversifi cation, this accesses signifi cantly higher yield diff erentials. More importantly, it reduces drawdowns and provides signifi cantly improved returns as a result.

Another solution is to change the risk profi le of the trade. Instead of having a simple long-short basket (which is typically referred to as a Delta-1 exposure), buy call options on carry instead. This limits drawdowns and potential losses to the premium paid. In a world in which understanding and predicting stressed exposures and risk is increasingly desirable, this type of strategy has clear benefi ts.

A similar and broadly equivalent strategy has many of the economic benefi ts of this type of risk managed approach to carry without the need to pay premium explicitly.

A third solution is to make one’s exposure to carry ‘dynamic’, by reducing exposure based on some type of forward-looking risk indicator so that in times of increased market risk or stress when large carry unwinds and market illiquidity manifest themselves, exposure is either reduced or avoided altogether.

What is a carry trade?In its simplest form, a carry trade involves investing in assets in countries with high nominal yields to generate positive investment returns over time.

Specifi cally, this would be done by combining a long position in cash or bonds in a high-yielding currency with a loan or short position in a low-yielding one.

In 2005 and 2006, the Australian and New Zealand dollars were popular ‘longs’ (high-yielders) and the Japanese yen was a common ‘short’ or low-yielding currency.

In theory, carry trades shouldn’t work: any excess yield in one currency versus another should, over time, be eroded away by losses in currency depreciation of the ‘weak’ currency – a theory known as uncovered interest parity.

In fact, not only do currencies of high-yielding countries not depreciate over time suffi ciently quickly to erode the extra yield, they as often as not actually appreciate, giving their holders both the interest rate excess, or carry, and a currency gain to boot.

The FX carry trade is as old as the global capital markets themselves which can trace their origins to the end of the gold standard and the Smithsonian agreement in the 1970s. So with the 40th anniversary of the carry trade approaching, are its best years behind us or does the carry trade still have relevance post-crisis?

We also consider spikes in front-end EUR/$ vols to be a simple but liquid, observable and reliable indicators of short term market risk, and thus a good forward-looking predictor of carry drawdowns. Deutsche Bank’s Haven index attempts to exploit this indicator in order to generate positive returns from carry trading while managing risk by deleveraging in advance of drawdowns. Figure 2 shows its historic returns on a backtested basis. Figure 1 shows the return of our benchmark dynamic carry trading index, DB Harvest.

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Disclaimer: Past performance is not a guarantee of future results

Figure 1: DB Harvest Balanced ER Index Figure 2: DB Haven ER Index


4.7Trading

Rashid HoosenallyGlobal Head of FX Structuring

Is the FX Carry Trade Dead?A time-honoured trading strategy under the spotlight

The fundamentals are not encouraging. Interest rates are at all time lows, the outlook for risky assets is uncertain, and both the actual and predicted level of currency volatility is high and we expect it to remain high.

And yet, this was broadly the case in 2009 too, when carry was a top performing currency strategy as the chart (which shows the return of Deutsche Bank’s fl agship carry trading strategies: Harvest and Haven) demonstrates.

So can it continue?The key to carry trades is interest rate diff erentials between currencies. So long as they persist, carry trades are likely to earn excess returns.

We believe they will persist given the fact that economic performances (and by extension interest rates) diverging rather than converging, with the Fed keeping rates low and EM central banks raising them to combat infl ation.

This indicates that carry trades will remain a compelling trading stratgegy in 2011. The downside is drawdown risk.

As carry traders found out in 1997 and 2007, carry trades can go wrong extremely quickly. In both years, the dollar, yen and swiss franc strengthened, whilst sterling, the New Zealand dollar, Icelandic krona and many emerging market high-yielders fell dramatically, forcing traders to unwind carry trades.

So how can you carry on doing the carry trade without becoming exposed too heavily to drawdown risk?One solution is to diversify: broaden the basket to include EM currencies, whilst ensuring G10 currencies still feature in long and short baskets. As well as improving diversifi cation, this accesses signifi cantly higher yield diff erentials. More importantly, it reduces drawdowns and provides signifi cantly improved returns as a result.

Another solution is to change the risk profi le of the trade. Instead of having a simple long-short basket (which is typically referred to as a Delta-1 exposure), buy call options on carry instead. This limits drawdowns and potential losses to the premium paid. In a world in which understanding and predicting stressed exposures and risk is increasingly desirable, this type of strategy has clear benefi ts.

A similar and broadly equivalent strategy has many of the economic benefi ts of this type of risk managed approach to carry without the need to pay premium explicitly.

A third solution is to make one’s exposure to carry ‘dynamic’, by reducing exposure based on some type of forward-looking risk indicator so that in times of increased market risk or stress when large carry unwinds and market illiquidity manifest themselves, exposure is either reduced or avoided altogether.

What is a carry trade?In its simplest form, a carry trade involves investing in assets in countries with high nominal yields to generate positive investment returns over time.

Specifi cally, this would be done by combining a long position in cash or bonds in a high-yielding currency with a loan or short position in a low-yielding one.

In 2005 and 2006, the Australian and New Zealand dollars were popular ‘longs’ (high-yielders) and the Japanese yen was a common ‘short’ or low-yielding currency.

In theory, carry trades shouldn’t work: any excess yield in one currency versus another should, over time, be eroded away by losses in currency depreciation of the ‘weak’ currency – a theory known as uncovered interest parity.

In fact, not only do currencies of high-yielding countries not depreciate over time suffi ciently quickly to erode the extra yield, they as often as not actually appreciate, giving their holders both the interest rate excess, or carry, and a currency gain to boot.

The FX carry trade is as old as the global capital markets themselves which can trace their origins to the end of the gold standard and the Smithsonian agreement in the 1970s. So with the 40th anniversary of the carry trade approaching, are its best years behind us or does the carry trade still have relevance post-crisis?

We also consider spikes in front-end EUR/$ vols to be a simple but liquid, observable and reliable indicators of short term market risk, and thus a good forward-looking predictor of carry drawdowns. Deutsche Bank’s Haven index attempts to exploit this indicator in order to generate positive returns from carry trading while managing risk by deleveraging in advance of drawdowns. Figure 2 shows its historic returns on a backtested basis. Figure 1 shows the return of our benchmark dynamic carry trading index, DB Harvest.

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Figure 1: DB Harvest Balanced ER Index Figure 2: DB Haven ER Index


5 Risk

Management

EquitiesCreditRatesForeign ExchangeLongevityInflationCommodities


5 Risk

Management

EquitiesCreditRatesForeign ExchangeLongevityInflationCommodities


5.1 Risk Management

Vijay Popat Head of Institutional Equity Structuring

Amit Bordia Global Head of Equity Structuring

Equity HedgingLook beyond short dated collars and puts

It can be shown historically that over time the shorter dated collars greatly erode equity performance because so much of equity performance can be concentrated in a single year. They can both be used effectively but require market timing and are essentially opportunistic. They are not effective as a way to structurally reduce equity risk over the medium or longer terms. So what will work? We feel three strategies will be effective: going long forward variance, long-dated equity collars and longer-dated put protection strategies.

Hedging with variance Academic research indicates that there is a very strong correlation between volatility and stock market performance: when stock markets fall significantly, volatility tends to go up1.

By going long volatility via variance swaps (which pay a return based on how volatile stocks are), investors can get protection against market falls.

Unfortunately, they are often as expensive as put options because they are priced on implied volatility but pay out on the basis of realised volatility, and generally realised volatility is 2% to 3% lower.

However, this problem can be overcome by going long forward variance which tracks not the difference between implied volatility and realised volatility over a given term but rather on changes in implied volatility over time. By optimising the part of the volatility term structure, the costs of hedging can be reduced significantly and as a result form an attractive way to reduce equity risk.

This strategy may be difficult for many investors to implement both operationally and in terms of on-going risk management.

For these institutions, a fund or swap linked to an index that tracks the

performance of an optimised forward variance strategy – such as Deutsche Bank’s ELVIS index – may be a good alternative.

Long-Dated equity collars Investors willing to cap their returns over 10 years at around 8.4% compounded (a gain of 123% over 10 years), can finance protection from 90% to 50% using long-dated equity collars.

This implies that if over 10 years the market lost 50%, the protected portfolio would only lose 10%.

This is a dramatic reduction in risk that is achieved only at the cost of capping returns at above levels that are somewhat optimistic (8.4% at the time of writing would represent an equity risk premium of over 5.5% over bonds).

On a risk adjusted basis – i.e. if investors increased their collared equity portfolio allocation to provide a similar risk budget usage – the portfolio would outperform an uncollared portfolio in a rising market up to the point where returns were 11% compounded over 10 years: a gain of 189%.

Longer-dated put protection strategies Longer-dated options (5 to 10 years) look significantly cheaper than short-dated options: for example on 100% strike puts on the S&P500, 4% a year compared to 10% on a one-year put rolled over for five years. However, both are still fairly expensive because of strong demand from insurers in particular and a lack of natural sellers.

Dealers are only really willing to price options that they can hedge out and with so few natural sellers of protection, this has resulted in premiums for 10-year options that imply more volatility than at any time since the 1929 crash.

One way to avoid these inflated premiums is to buy an option on an

equity index which is managed so that the realised volatility is stable.

This is easier said than done but fortunately a number of products have been developed recently that allow investors to get this hedge quite easily.

Our own version of one such product is called TEMPO which tracks a long position in a major index (e.g. the EuroSTOXX 50) that moves partially into cash when volatility exceeds 18% so that the index has a stable realised volatility.

The premiums on options on TEMPO can be substantially lower than that of plain vanilla options: 1.65% a year compared to 2.7% for 5-year 80% strike puts on the Eurostoxx 50 index for example. This is because the dealer does not have to price it using inflated implied volatilities and can dynamically risk manage the exposure because they know its upper level.

In addition the performance of these volatility stabilised indices can be quite favourable compared to passive indices.

We believe this would be a particularly good way to hedge EM equity risk where investors want to increase allocations but where there is substantial potential risk.

1. DB Global Markets Research: ‘Hidden Assets’ Investing Series - Equity Hedging with Volatility, by Pam Finelli and Mehdi Alighanbari

Projections are based on a number of assumptions as to market conditions. There can be no guarantee that the projected results will be acheived.

Source of statistics: Deutsche Bank

The most popular ways to hedge against falling equity markets is to buy short-dated put options or through short-dated collars. Buying puts is very expensive over time because of the large number of people looking for protection and the small number of dealers willing to sell them.


5.1 Risk Management

Vijay Popat Head of Institutional Equity Structuring

Amit Bordia Global Head of Equity Structuring

Equity HedgingLook beyond short dated collars and puts

It can be shown historically that over time the shorter dated collars greatly erode equity performance because so much of equity performance can be concentrated in a single year. They can both be used effectively but require market timing and are essentially opportunistic. They are not effective as a way to structurally reduce equity risk over the medium or longer terms. So what will work? We feel three strategies will be effective: going long forward variance, long-dated equity collars and longer-dated put protection strategies.

Hedging with variance Academic research indicates that there is a very strong correlation between volatility and stock market performance: when stock markets fall significantly, volatility tends to go up1.

By going long volatility via variance swaps (which pay a return based on how volatile stocks are), investors can get protection against market falls.

Unfortunately, they are often as expensive as put options because they are priced on implied volatility but pay out on the basis of realised volatility, and generally realised volatility is 2% to 3% lower.

However, this problem can be overcome by going long forward variance which tracks not the difference between implied volatility and realised volatility over a given term but rather on changes in implied volatility over time. By optimising the part of the volatility term structure, the costs of hedging can be reduced significantly and as a result form an attractive way to reduce equity risk.

This strategy may be difficult for many investors to implement both operationally and in terms of on-going risk management.

For these institutions, a fund or swap linked to an index that tracks the

performance of an optimised forward variance strategy – such as Deutsche Bank’s ELVIS index – may be a good alternative.

Long-Dated equity collars Investors willing to cap their returns over 10 years at around 8.4% compounded (a gain of 123% over 10 years), can finance protection from 90% to 50% using long-dated equity collars.

This implies that if over 10 years the market lost 50%, the protected portfolio would only lose 10%.

This is a dramatic reduction in risk that is achieved only at the cost of capping returns at above levels that are somewhat optimistic (8.4% at the time of writing would represent an equity risk premium of over 5.5% over bonds).

On a risk adjusted basis – i.e. if investors increased their collared equity portfolio allocation to provide a similar risk budget usage – the portfolio would outperform an uncollared portfolio in a rising market up to the point where returns were 11% compounded over 10 years: a gain of 189%.

Longer-dated put protection strategies Longer-dated options (5 to 10 years) look significantly cheaper than short-dated options: for example on 100% strike puts on the S&P500, 4% a year compared to 10% on a one-year put rolled over for five years. However, both are still fairly expensive because of strong demand from insurers in particular and a lack of natural sellers.

Dealers are only really willing to price options that they can hedge out and with so few natural sellers of protection, this has resulted in premiums for 10-year options that imply more volatility than at any time since the 1929 crash.

One way to avoid these inflated premiums is to buy an option on an

equity index which is managed so that the realised volatility is stable.

This is easier said than done but fortunately a number of products have been developed recently that allow investors to get this hedge quite easily.

Our own version of one such product is called TEMPO which tracks a long position in a major index (e.g. the EuroSTOXX 50) that moves partially into cash when volatility exceeds 18% so that the index has a stable realised volatility.

The premiums on options on TEMPO can be substantially lower than that of plain vanilla options: 1.65% a year compared to 2.7% for 5-year 80% strike puts on the Eurostoxx 50 index for example. This is because the dealer does not have to price it using inflated implied volatilities and can dynamically risk manage the exposure because they know its upper level.

In addition the performance of these volatility stabilised indices can be quite favourable compared to passive indices.

We believe this would be a particularly good way to hedge EM equity risk where investors want to increase allocations but where there is substantial potential risk.

1. DB Global Markets Research: ‘Hidden Assets’ Investing Series - Equity Hedging with Volatility, by Pam Finelli and Mehdi Alighanbari

Projections are based on a number of assumptions as to market conditions. There can be no guarantee that the projected results will be acheived.

Source of statistics: Deutsche Bank

The most popular ways to hedge against falling equity markets is to buy short-dated put options or through short-dated collars. Buying puts is very expensive over time because of the large number of people looking for protection and the small number of dealers willing to sell them.


In recent years, credit default swaps or CDS, which provide compensation in the event of a default, have not always been an efficient hedging tool for corporates and institutional investors. The main deterrents have been the high cost of obtaining protection against the most difficult risks, the lack of liquidity in the market and the difficulty of getting out of bespoke contracts.

But the introduction of centralised clearing and the creation of standardised and simplified trading models has greatly reduced these problems. Bid-offer spreads on the benchmark iTraxx index – which tracks a broad universe of credits – are now about 0.5 basis points compared to one basis point two years ago. The cost of protection on many credits has also halved over the past two years from 200 basis points to 100 basis points on most investment grade corporate names (figure 1).

Meanwhile, it has become significantly easier to unwind positions: before it could take weeks to get out of a trade, now trades can be unwound in seconds.

Small and Big Bangs Reform of the CDS market began in 2009 with the Small and Big Bangs which saw dealers adopt standardised CDS maturities, coupon prices and procedures following credit events.

Perhaps the most important change was the establishment of fixed strike prices. Before, as protection, a buyer paid a spread – similar to an insurance premium – that reflected the annual price of protection quoted in basis points of the notional contract. So, for example, if a user wanted five-year protection for a $10 million position on an investment grade company quoted at 400 basis points, they would have to pay 400 basis points a year, or $400,000, as a premium. Over the lifetime of the contract, protection would cost $2 million.

Now, under the new system, a user pays a running coupon of either 100 basis points or 500 basis points (dealers quote both for many names), with the differential between that level and the overall cost of protection paid upfront. So, for example, if a user chooses a 100 strike for the example above they would have to pay 300 basis points, or $300,000, upfront for each year of the CDS (a total of $1.5 million), and 100 basis points, or $100,000, a year.

Although the total cost of protection is the same under the old system, the costs paid for a 100 or 500 strike in the first year differ hugely. It is advantageous to use a 500 running coupon where possible from a cash flow perspective and also in case of default early in the contract. If a user chooses a 100 strike for the above

Credit Risk ManagementGetting easier and, in many cases, cheaper

example and there is a default after a year they would have pay $1.6 million. However, if a user chooses a 500 strike they would be paid 100 basis points, or $100,000, upfront for the five-year CDS (a total of $500,000) and would have to pay 500 basis points, or $500,000 for the first year’s running coupon – giving a total cost of just $400,000.

Strike advantages Standardised strikes also mean that a 100 strike, for example, is available for a given investment- grade credit, regardless of whether the CDS has a one-year or 10-year maturity. In the past, it was complicated to buy forward CDS because of differing spreads and the requirement to transact through a single counterparty: any transaction would have to be bespoke for that client and consequently illiquid. Now standardised strikes make it straightforward for any CDS user to express sophisticated views and change them as necessary.

For example, if a telecoms company in the United States has exposure to a European telecoms company it may be confident that its position is secure over the next year, given the supportive effects of quantitative easing on liquidity in the funding market: the European telecoms company will continue to be able to borrow and will remain solvent. However, the US company may be

5.2 Risk Management

Antoine Cornut Head of European Credit Trading

concerned about its European peer’s longer term outlook and want to lock-in protection at current prices from years two to five. Using fixed price strikes, it is easy for the US company to buy five-year protection and sell one-year protection: the return from selling one-year protection cancels out the cost of buying the first year of five years of protection, so that the US company only begins to pay a premium for protection in year two. If, after one year, the US company changes its mind and decides it does not need protection against the European telecoms firm for the following year, it can simply sell another one year of protection to cover the costs of its protection for that year.

Accurately hedge notionals Companies, unlike financial institutions, usually use CDS to hedge a specific amount of risk to which they are exposed. Historically, this has been difficult in the CDS market because the pay-out in case of default is par minus a recovery rate, which is determined by a committee a month after default. Recovery rates vary considerably: the recovery rate for Dutch chemicals company LyondellBasell in April 2008, for example, was around five cents on the euro in contrast to French multimedia firm Thomson’s bankruptcy at the end of 2009, which had a recovery of 60 cents on the euro. In order to achieve a desired payment, companies have frequently over-hedged, which is costly.

In recent years, the increasing numbers of defaults, especially of high yield names, and widely varying recovery rates have prompted clients to put pressure on dealers to address this problem. Dealers have responded with the development of a liquid recovery swap market, which has grown by a factor of 10 in the past year. Recovery swaps enable users to lock-in a recovery rate at the time they put on the CDS trade. Users decide a recovery rate they would want to receive in the event of default and in return swap the eventual real recovery rate. Should default not occur, the swap expires with no payment to either party. Instead of having to wait for a committee to determine the recovery rate, the buyer can be certain of their pay-out.

By combining CDS with recovery swaps, it is possible to more accurately manage credit risk: a user can hedge a notional and be confident that if a default occurs, they will be paid the exact amount they anticipate in cash. For example, if a user believes that a bank will default in the coming year and seeks protection against it, they can buy CDS protection and sell a recovery swap at 30 cents on the euro, ensuring a pay-out ratio of 70% in the event of default.

Guard against currency volatility CDS users usually buy protection in the most liquid currency for CDS on that name, rather than in the currency

in which the underlying asset is denominated. For US dollar bonds from US issuers, it is straightforward to buy US dollar protection. However, it is more complicated if the risk is in a different currency to that of the most liquid CDS. The majority of British Telecom loans, for example, are in sterling and dollars but 90% of the company’s CDS traded are in euro, meaning that holders of protection against a default are mismatching their assets and liabilities. With foreign exchange volatility set to continue in the foreseeable future, CDS users need to ensure they effectively manage this quanto risk.

In the past, it was not necessarily cost-effective to hedge in a currency other than the most liquid for a given name. However, the standardisation of CDS brought about by the Big Bang and Small Bang has, in addition to increasing volumes in euro (which are the most liquid for European names) and dollars (which are most the liquid for North American names), led to an exponential increase in liquidity for other currency CDS. Consequently, the cost of currency-accurate hedging has fallen significantly. Indeed, analysis by Deutsche Bank indicates that the CDS market is currently under-pricing the required premium to trade a currency other than the most liquid: for example, dealers are charging a premium of 3%–5% of spreads to hedge European companies in dollars (a worthwhile trade given that much outstanding European company debt is in dollars) when the real cost is more than 10%. There now appears to be an attractive opportunity to cost-effectively lock-in currency accurate hedging.

250 Basis points MARKIT ITRAXX EUROPE 12/15


200

150

100

50

0

Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 Jul 08 Oct 08 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Jul 10 Oct 10

Figure 1: Cost of Protection Going DownData: Markit iTraxx Europe index. Source: Deutsche Bank

Credit risk has become easier and, in many cases, cheaper to hedge thanks to changes in the credit default swap market.


In recent years, credit default swaps or CDS, which provide compensation in the event of a default, have not always been an efficient hedging tool for corporates and institutional investors. The main deterrents have been the high cost of obtaining protection against the most difficult risks, the lack of liquidity in the market and the difficulty of getting out of bespoke contracts.

But the introduction of centralised clearing and the creation of standardised and simplified trading models has greatly reduced these problems. Bid-offer spreads on the benchmark iTraxx index – which tracks a broad universe of credits – are now about 0.5 basis points compared to one basis point two years ago. The cost of protection on many credits has also halved over the past two years from 200 basis points to 100 basis points on most investment grade corporate names (figure 1).

Meanwhile, it has become significantly easier to unwind positions: before it could take weeks to get out of a trade, now trades can be unwound in seconds.

Small and Big Bangs Reform of the CDS market began in 2009 with the Small and Big Bangs which saw dealers adopt standardised CDS maturities, coupon prices and procedures following credit events.

Perhaps the most important change was the establishment of fixed strike prices. Before, as protection, a buyer paid a spread – similar to an insurance premium – that reflected the annual price of protection quoted in basis points of the notional contract. So, for example, if a user wanted five-year protection for a $10 million position on an investment grade company quoted at 400 basis points, they would have to pay 400 basis points a year, or $400,000, as a premium. Over the lifetime of the contract, protection would cost $2 million.

Now, under the new system, a user pays a running coupon of either 100 basis points or 500 basis points (dealers quote both for many names), with the differential between that level and the overall cost of protection paid upfront. So, for example, if a user chooses a 100 strike for the example above they would have to pay 300 basis points, or $300,000, upfront for each year of the CDS (a total of $1.5 million), and 100 basis points, or $100,000, a year.

Although the total cost of protection is the same under the old system, the costs paid for a 100 or 500 strike in the first year differ hugely. It is advantageous to use a 500 running coupon where possible from a cash flow perspective and also in case of default early in the contract. If a user chooses a 100 strike for the above

Credit Risk ManagementGetting easier and, in many cases, cheaper

example and there is a default after a year they would have pay $1.6 million. However, if a user chooses a 500 strike they would be paid 100 basis points, or $100,000, upfront for the five-year CDS (a total of $500,000) and would have to pay 500 basis points, or $500,000 for the first year’s running coupon – giving a total cost of just $400,000.

Strike advantages Standardised strikes also mean that a 100 strike, for example, is available for a given investment- grade credit, regardless of whether the CDS has a one-year or 10-year maturity. In the past, it was complicated to buy forward CDS because of differing spreads and the requirement to transact through a single counterparty: any transaction would have to be bespoke for that client and consequently illiquid. Now standardised strikes make it straightforward for any CDS user to express sophisticated views and change them as necessary.

For example, if a telecoms company in the United States has exposure to a European telecoms company it may be confident that its position is secure over the next year, given the supportive effects of quantitative easing on liquidity in the funding market: the European telecoms company will continue to be able to borrow and will remain solvent. However, the US company may be

5.2 Risk Management

Antoine Cornut Head of European Credit Trading

concerned about its European peer’s longer term outlook and want to lock-in protection at current prices from years two to five. Using fixed price strikes, it is easy for the US company to buy five-year protection and sell one-year protection: the return from selling one-year protection cancels out the cost of buying the first year of five years of protection, so that the US company only begins to pay a premium for protection in year two. If, after one year, the US company changes its mind and decides it does not need protection against the European telecoms firm for the following year, it can simply sell another one year of protection to cover the costs of its protection for that year.

Accurately hedge notionals Companies, unlike financial institutions, usually use CDS to hedge a specific amount of risk to which they are exposed. Historically, this has been difficult in the CDS market because the pay-out in case of default is par minus a recovery rate, which is determined by a committee a month after default. Recovery rates vary considerably: the recovery rate for Dutch chemicals company LyondellBasell in April 2008, for example, was around five cents on the euro in contrast to French multimedia firm Thomson’s bankruptcy at the end of 2009, which had a recovery of 60 cents on the euro. In order to achieve a desired payment, companies have frequently over-hedged, which is costly.

In recent years, the increasing numbers of defaults, especially of high yield names, and widely varying recovery rates have prompted clients to put pressure on dealers to address this problem. Dealers have responded with the development of a liquid recovery swap market, which has grown by a factor of 10 in the past year. Recovery swaps enable users to lock-in a recovery rate at the time they put on the CDS trade. Users decide a recovery rate they would want to receive in the event of default and in return swap the eventual real recovery rate. Should default not occur, the swap expires with no payment to either party. Instead of having to wait for a committee to determine the recovery rate, the buyer can be certain of their pay-out.

By combining CDS with recovery swaps, it is possible to more accurately manage credit risk: a user can hedge a notional and be confident that if a default occurs, they will be paid the exact amount they anticipate in cash. For example, if a user believes that a bank will default in the coming year and seeks protection against it, they can buy CDS protection and sell a recovery swap at 30 cents on the euro, ensuring a pay-out ratio of 70% in the event of default.

Guard against currency volatility CDS users usually buy protection in the most liquid currency for CDS on that name, rather than in the currency

in which the underlying asset is denominated. For US dollar bonds from US issuers, it is straightforward to buy US dollar protection. However, it is more complicated if the risk is in a different currency to that of the most liquid CDS. The majority of British Telecom loans, for example, are in sterling and dollars but 90% of the company’s CDS traded are in euro, meaning that holders of protection against a default are mismatching their assets and liabilities. With foreign exchange volatility set to continue in the foreseeable future, CDS users need to ensure they effectively manage this quanto risk.

In the past, it was not necessarily cost-effective to hedge in a currency other than the most liquid for a given name. However, the standardisation of CDS brought about by the Big Bang and Small Bang has, in addition to increasing volumes in euro (which are the most liquid for European names) and dollars (which are most the liquid for North American names), led to an exponential increase in liquidity for other currency CDS. Consequently, the cost of currency-accurate hedging has fallen significantly. Indeed, analysis by Deutsche Bank indicates that the CDS market is currently under-pricing the required premium to trade a currency other than the most liquid: for example, dealers are charging a premium of 3%–5% of spreads to hedge European companies in dollars (a worthwhile trade given that much outstanding European company debt is in dollars) when the real cost is more than 10%. There now appears to be an attractive opportunity to cost-effectively lock-in currency accurate hedging.

250 Basis points MARKIT ITRAXX EUROPE 12/15


200

150

100

50

0

Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 Jul 08 Oct 08 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Jul 10 Oct 10

Figure 1: Cost of Protection Going DownData: Markit iTraxx Europe index. Source: Deutsche Bank

Credit risk has become easier and, in many cases, cheaper to hedge thanks to changes in the credit default swap market.


5.3 Risk Management

Dominic Konstam Head of Rates Research


Rate Risk ManagementKey rate risks for 2011 and how to hedge them

The range of rate risks facing borrowers and investors in 2011 is wide. While there are some historical precedents for the financial shock of recent years (e.g. Japan and the Great Depression), the policy reaction function has been markedly different and their impact on the real economy is highly uncertain. This uncertainty is compounded by the threat posed to the Eurozone by diverging economies and the need to rebalance the global economy.

For us, the four outstanding risks that must be addressed are:

US deflation The underlying dynamics of the sub-components of core inflation suggest that US inflation should stabilise and rise modestly in 2011. However, the sustainability of this rebound crucially depends on real growth in the US staying above 2% and the current output gap not weighing on inflation expectations. This risk will rise if the US tighten fiscal policy prematurely, which is possible given the recent shift in Congress. To hedge against this scenario, we would recommend out-of-the-money receivers on the long-end to protect against an extended period of low rates. We also recommend purchasing 5Y deflation floors, financed by selling 10Y deflation floors. Despite a higher risk of experiencing subdued inflation levels or a deflation in the next few years, rather than over the next 10 years, the trade actually generates a premium take out according to our estimates.

Extreme euro tensions Our base case scenario is one where Spain withstands the market pressure which is likely to persist until the Spanish banking system is more convincingly recapitalised. However, the risks of a self-fulfilling rise in borrowing costs and/or significantly higher recapitalisation costs remain. The EFSF, together with the EFSM and the IMF, could lend up to EUR560 billion, which would leave EUR425 billion to support Spain if both Portugal and Ireland require EUR67.5 billion each. However, even if the EFSF could technically support Spain, the political and economic implication of a Spanish bailout would significantly raise the risk of a euro break-up. The more obvious way to hedge against this risk is to buy protection on the euro, as any breakup is likely to occur with the stronger countries leaving. We would also implement wideners on the EUR/$ cross-currency basis and on the Euribor/Eonia basis in order to capture a flight to quality towards the US dollar and growing tensions in the European banking system.

USD crisis There is a risk that we will see a shift away from the $ as a reserve currency, precipitating its sharp fall. Given the lack of alternatives to the $ at the moment and the keenness of the key emerging market countries to avoid disorderly FX moves, this risk is small. However, it could be exacerbated by the backlash that followed the QE announcement at the end of 2010 and could be supported by the transition China is currently undertaking from an export-led growth model to a consumption growth model (as confirmed by the latest five-year plan). High strike payers on the long end

and 10Y-30Y breakeven steepeners would hedge against this outcome. We would also recommend a widener of the 10Y20Y CPI swap versus 5Y5Y CPI swap. The spread is trading close to flat, as of early December 2010, and is pricing in no inflation risk premium (against 40bp before 2008).

ECB hiking rates early Early growth in core Europe has been extremely robust, with Germany running at close to 3% GDP growth annualised. While growth should decelerate somewhat, it is likely to remain strong and above potential given that (a) neither the public nor the private sectors are over-levered, (b) the economy remains competitive at the current exchange rate, (c) unemployment is back to pre-crisis levels, (d) most assets (housing) are not overvalued, and (e) real rates seem too low.

While the uncertainty around the global outlook and the situation in peripheral Europe remains high, the ECB should remain on hold. However, there is a risk that the ECB decides to raise its policy rates earlier than currently expected, especially if it decides to maintain some of its extraordinary liquidity provisions. Front-end payer spreads offer a good hedge against this risk.


5.3 Risk Management

Dominic Konstam Head of Rates Research


Rate Risk ManagementKey rate risks for 2011 and how to hedge them

The range of rate risks facing borrowers and investors in 2011 is wide. While there are some historical precedents for the financial shock of recent years (e.g. Japan and the Great Depression), the policy reaction function has been markedly different and their impact on the real economy is highly uncertain. This uncertainty is compounded by the threat posed to the Eurozone by diverging economies and the need to rebalance the global economy.

For us, the four outstanding risks that must be addressed are:

US deflation The underlying dynamics of the sub-components of core inflation suggest that US inflation should stabilise and rise modestly in 2011. However, the sustainability of this rebound crucially depends on real growth in the US staying above 2% and the current output gap not weighing on inflation expectations. This risk will rise if the US tighten fiscal policy prematurely, which is possible given the recent shift in Congress. To hedge against this scenario, we would recommend out-of-the-money receivers on the long-end to protect against an extended period of low rates. We also recommend purchasing 5Y deflation floors, financed by selling 10Y deflation floors. Despite a higher risk of experiencing subdued inflation levels or a deflation in the next few years, rather than over the next 10 years, the trade actually generates a premium take out according to our estimates.

Extreme euro tensions Our base case scenario is one where Spain withstands the market pressure which is likely to persist until the Spanish banking system is more convincingly recapitalised. However, the risks of a self-fulfilling rise in borrowing costs and/or significantly higher recapitalisation costs remain. The EFSF, together with the EFSM and the IMF, could lend up to EUR560 billion, which would leave EUR425 billion to support Spain if both Portugal and Ireland require EUR67.5 billion each. However, even if the EFSF could technically support Spain, the political and economic implication of a Spanish bailout would significantly raise the risk of a euro break-up. The more obvious way to hedge against this risk is to buy protection on the euro, as any breakup is likely to occur with the stronger countries leaving. We would also implement wideners on the EUR/$ cross-currency basis and on the Euribor/Eonia basis in order to capture a flight to quality towards the US dollar and growing tensions in the European banking system.

USD crisis There is a risk that we will see a shift away from the $ as a reserve currency, precipitating its sharp fall. Given the lack of alternatives to the $ at the moment and the keenness of the key emerging market countries to avoid disorderly FX moves, this risk is small. However, it could be exacerbated by the backlash that followed the QE announcement at the end of 2010 and could be supported by the transition China is currently undertaking from an export-led growth model to a consumption growth model (as confirmed by the latest five-year plan). High strike payers on the long end

and 10Y-30Y breakeven steepeners would hedge against this outcome. We would also recommend a widener of the 10Y20Y CPI swap versus 5Y5Y CPI swap. The spread is trading close to flat, as of early December 2010, and is pricing in no inflation risk premium (against 40bp before 2008).

ECB hiking rates early Early growth in core Europe has been extremely robust, with Germany running at close to 3% GDP growth annualised. While growth should decelerate somewhat, it is likely to remain strong and above potential given that (a) neither the public nor the private sectors are over-levered, (b) the economy remains competitive at the current exchange rate, (c) unemployment is back to pre-crisis levels, (d) most assets (housing) are not overvalued, and (e) real rates seem too low.

While the uncertainty around the global outlook and the situation in peripheral Europe remains high, the ECB should remain on hold. However, there is a risk that the ECB decides to raise its policy rates earlier than currently expected, especially if it decides to maintain some of its extraordinary liquidity provisions. Front-end payer spreads offer a good hedge against this risk.


Foreign Exchange Risk ManagementGoing super-sized

5.4 Risk Management

Rashid Hoosenally Head of FX Structuring

We expect this volatility to continue in 2011 for two reasons. First, recent macro developments point to a widening, rather than a narrowing in macro divergences globally, which suggest continued strong currency trends. Second, with interest rates at historic lows, an increasing amount of the macro adjustment burden is falling on currencies.

This volatility may be compounded for many companies in 2011 by the probability that much of the risk is likely to be in emerging markets where an ever larger share of their value and cashflow at risk is centred.

We may also see currency risk go ‘supersized’ for corporates if adverse currency moves coincide, as they may well do, with negative growth shocks and collapsing export volumes. This means the ‘pass-through’ of volatility to financials could become much higher.

FX risk has the capacity to severely impact the bottom lines of individual companies. In some situations, currency moves have not only impacted profitability, but also breaches of debt covenants, leverage, net equity, capital adequacy and solvency ratios.

To hedge FX risk effectively, it is necessary to identify how it affects different parts of the business and financial statements. There are, in essence, the two broad categories of currency risk: transaction and translation (see table above).

While transaction risk has a direct impact and has, therefore, always been actively managed, we estimate only 20% of corporates are extensively managing their translation risk. This is despite an increased focus by analysts and investors on translation hedging, specifically the hedging of net equity in foreign subsidiaries and expected earnings.

Looking ahead, it seems likely that it will become more expensive to hedge using traditional instruments.

Regulatory changes imply that banks are likely to have to reserve significantly more capital against OTC hedging instruments in the future.

They will be required to stress such exposures much more, leading to a sharp increase in the calculated size of counterparty risk. Not only this, they will also have to provision much more extensively against this magnified risk. So both the quantity and price of credit valuation adjustments will increase materially.

Corporates with significant uncollateralised OTC exposures to banks could find their credit spreads suffer from technical selling as banks are forced to actively purchase credit protection to hedge counterparty credit exposures. In extremis, this could crowd out liquidity and funding available for general purposes.

Nor are listed and/or cleared instruments, in our view, ideally suited to corporate hedging. They will require significant liquid collateral to meet margin calls on instruments that are hedges for non-cash items, creating a liquidity mis-match and a similar crowding out of funding capacity.

Currency risk has become a crucial issue for many companies since the 2008 crisis, with exchange rate volatility increasing dramatically.

Most corporates will seek to be exempted from requirements to clear hedging instruments centrally.

So what is the solution? One answer could be the appropriate use of certain risk-reducing derivatives, especially purchased options. These can provide corporates with the flexibility they will need to manage less certain exposures and eliminate costly mis-matches.

More importantly, they also neatly avoid the potential pitfalls of hedging with OTC forwards, cross currency-swaps or listed/cleared derivatives by limiting counterparty exposure and, therefore, liquidity and funding risk.

The same will be true for other types of market risk typically hedged with OTC instruments including interest rate and commodity risk. Indeed, it may even be the case that bundling these risks together and hedging aggregate net exposure will create efficiencies.

Purchased options also provide other benefits. Analysts, investors and other economic counterparties including banks and suppliers reward companies with clear and well communicated risk management strategies, and a quantifiable value and cashflow-at-risk hedge book. Purchased options hedge programmes are well suited to this purpose.

2011 should be a good time to refine risk management policies to create hedge strategies based on purchased optionality that address concerns over premium outlay and accounting impact, whilst still providing compelling economic advantages to the hedger that can be clearly communicated to stakeholders.

Greater trends in currency markets

2007 2008 20092006 2010

1.70

1.60

1.50

1.40

1.30

1.20

1.10

EUR/$ Spot

Transaction Monetary Translation

• International competitors

Competitive

• Earnings• Net equity

• Growth metrics• Covenants

Accountingimpact

• Liquid assets• Foreign liabilities

• Operating cash flows

Typical Treasury Focus Typical Management Focus

Direct cash flowimpact

Direct value Impact Businessimpact

Greater trends in currency markets EUR/$ Spot

Transaction and translation risk




Foreign Exchange Risk ManagementGoing super-sized

5.4 Risk Management

Rashid Hoosenally Head of FX Structuring

We expect this volatility to continue in 2011 for two reasons. First, recent macro developments point to a widening, rather than a narrowing in macro divergences globally, which suggest continued strong currency trends. Second, with interest rates at historic lows, an increasing amount of the macro adjustment burden is falling on currencies.

This volatility may be compounded for many companies in 2011 by the probability that much of the risk is likely to be in emerging markets where an ever larger share of their value and cashflow at risk is centred.

We may also see currency risk go ‘supersized’ for corporates if adverse currency moves coincide, as they may well do, with negative growth shocks and collapsing export volumes. This means the ‘pass-through’ of volatility to financials could become much higher.

FX risk has the capacity to severely impact the bottom lines of individual companies. In some situations, currency moves have not only impacted profitability, but also breaches of debt covenants, leverage, net equity, capital adequacy and solvency ratios.

To hedge FX risk effectively, it is necessary to identify how it affects different parts of the business and financial statements. There are, in essence, the two broad categories of currency risk: transaction and translation (see table above).

While transaction risk has a direct impact and has, therefore, always been actively managed, we estimate only 20% of corporates are extensively managing their translation risk. This is despite an increased focus by analysts and investors on translation hedging, specifically the hedging of net equity in foreign subsidiaries and expected earnings.

Looking ahead, it seems likely that it will become more expensive to hedge using traditional instruments.

Regulatory changes imply that banks are likely to have to reserve significantly more capital against OTC hedging instruments in the future.

They will be required to stress such exposures much more, leading to a sharp increase in the calculated size of counterparty risk. Not only this, they will also have to provision much more extensively against this magnified risk. So both the quantity and price of credit valuation adjustments will increase materially.

Corporates with significant uncollateralised OTC exposures to banks could find their credit spreads suffer from technical selling as banks are forced to actively purchase credit protection to hedge counterparty credit exposures. In extremis, this could crowd out liquidity and funding available for general purposes.

Nor are listed and/or cleared instruments, in our view, ideally suited to corporate hedging. They will require significant liquid collateral to meet margin calls on instruments that are hedges for non-cash items, creating a liquidity mis-match and a similar crowding out of funding capacity.

Currency risk has become a crucial issue for many companies since the 2008 crisis, with exchange rate volatility increasing dramatically.

Most corporates will seek to be exempted from requirements to clear hedging instruments centrally.

So what is the solution? One answer could be the appropriate use of certain risk-reducing derivatives, especially purchased options. These can provide corporates with the flexibility they will need to manage less certain exposures and eliminate costly mis-matches.

More importantly, they also neatly avoid the potential pitfalls of hedging with OTC forwards, cross currency-swaps or listed/cleared derivatives by limiting counterparty exposure and, therefore, liquidity and funding risk.

The same will be true for other types of market risk typically hedged with OTC instruments including interest rate and commodity risk. Indeed, it may even be the case that bundling these risks together and hedging aggregate net exposure will create efficiencies.

Purchased options also provide other benefits. Analysts, investors and other economic counterparties including banks and suppliers reward companies with clear and well communicated risk management strategies, and a quantifiable value and cashflow-at-risk hedge book. Purchased options hedge programmes are well suited to this purpose.

2011 should be a good time to refine risk management policies to create hedge strategies based on purchased optionality that address concerns over premium outlay and accounting impact, whilst still providing compelling economic advantages to the hedger that can be clearly communicated to stakeholders.

Greater trends in currency markets

2007 2008 20092006 2010

1.70

1.60

1.50

1.40

1.30

1.20

1.10

EUR/$ Spot

Transaction Monetary Translation

• International competitors

Competitive

• Earnings• Net equity

• Growth metrics• Covenants

Accountingimpact

• Liquid assets• Foreign liabilities

• Operating cash flows

Typical Treasury Focus Typical Management Focus

Direct cash flowimpact

Direct value Impact Businessimpact

Greater trends in currency markets EUR/$ Spot

Transaction and translation risk




Historically, the longevity swap market has been too small and illiquid to provide effective hedges in the size and cost required.

But after years of sporadic deals, the longevity hedge market is now approaching the critical mass needed to offer compelling risk management solutions to a wide range of funds.

In 2010, Deutsche Bank arranged a £3 billion hedge for BMW’s UK pension scheme using longevity swaps, the largest transaction of its kind by some margin.

Under this deal, the pension scheme swapped a fixed stream of projected cash flows, which it pays to the hedger, for ‘floating’ payments from the hedger. These floating payments increase if the pensioners live longer than expected and decrease if people live for less time than expected.

We believe that the success of this deal will pave the way for other pension funds to do similar deals which will, in turn, deepen and expand the market, making longevity risk ever cheaper and easier to hedge.

The risk that people will live longer than expected is certainly not a new

5.5 Risk Management

Rashid Zuberi Head of Complex Life and Pensions Management

Hedging Longevity Risk Live long and prosper

concept: any financial contract that guarantees payments to an individual until death means that the writer of such contracts is exposed to the risk of the individual living longer than expected, so-called longevity risk.

Who traditionally takes on this risk? The two dominant longevity risk takers are insurance companies that write annuities and pension funds that promise to pay lifelong benefits.

For pension providers, longevity risk sits alongside the risks created by interest rates, used to value liabilities, and those created by inflation, often used to adjust the value of promised benefits. While very liquid capital markets in interest rates and inflation allow pension funds to manage these two risks, no such market exists in longevity.

By definition, a ‘liquid’ market means that there are a large number of buyers and sellers and therefore prices are observable and driven by supply and demand. But longevity risk, unlike that associated with interest rates or inflation, has a sizeable number of sellers and a distinct lack of buyers. This is a serious problem: there is circa £1 trillion of outstanding UK pension liabilities in defined benefit schemes exposed to longevity risk.

For counterparties to take on longevity risk, there must be a measurable financial benefit to them. This will transform longevity risk from a one-sided problem for the insurance and pensions industry, into a burgeoning market of risk takers and sellers.

There now seems to be a genuine increase in the presence of protection sellers. For these sellers, the concept of sufficient reimbursement is key: it may not be straightforward financial compensation. Most notably, these risk takers are reinsurance companies for whom this new risk acts as a portfolio diversifier as well as adding some return via the premium they charge. In the future other investors may emerge.

While talking about longevity may sound morbid, the fact is that if pensioners want the security that comes from having an income for life after reaching retirement, they need pension funds and insurers to feel able to manage the longevity risk that arises from offering lifetime annuities. The increasing presence of longevity underwriters will hopefully make this easier to do.

Opportunities for pension funds to protect themselves against pensioners’ increasing life expectancy – so-called longevity risk – are increasing, through the growth of the longevity swap market.

5.6 Risk Management

Daragh McDevitt Global Head of Inflation Structuring

Inflation Risk ManagementNo need for panic but take precautions

As the world emerges from the longest and deepest recession since the Second World War, core inflation in industrialised countries is at multi-year lows.

Central banks have implemented aggressive monetary policies to hasten economic recovery and ward off the threat of deflation. However, in 2011 these trends are likely to be reversed, and the inflation risk will likely switch to the upside.

The great fear that some investors have is that the combination of loose monetary policy and quantitative easing (QE) – ‘printing money’ – in developed countries, together with a diminishing ability of emerging markets to ‘export’ deflation to the rest of the world, is going to lead to rampant inflation.

But investors should not exaggerate the risks; the chances of Weimar Republic or Zimbabwe-style inflation are extremely slim. The worst case scenario for 2011 is probably that inflation will be higher than expected. In two or three years’ time, there is a chance it could move higher still. However, given the uncertainty about inflation expectations, investors could consider taking precautionary measures to protect themselves from future inflationary risk.

Even the experts seem incapable of agreeing about inflation’s future path, with members of the Bank of England’s Monetary Policy Committee, US Federal Reserve’s Open Market Committee and the Capitalise Monetary Policy Committee divided on likely outcomes. The unreliability of existing inflation models against today’s economic backdrop further muddies the water, intensifying uncertainty about the medium-term outlook.

If inflation does rise in developed economies, it is going to be imported – via rising food and energy prices, external factors outside the control of western governments and central banks. Emerging markets are at greater risk. Since late 2010 consumer price inflation has been creeping up in countries including China and Taiwan, partly because the weighting accorded to food in their inflationary ‘baskets’ is greater than in developed countries.

The Asian countries’ policy of pegging their currencies to the US dollar intensifies inflation risk, since it can require them to adopt interest rates which are potentially inappropriate for their faster-growing domestic economies. They are also vulnerable to the inflationary effects of QE2-driven capital inflows.

Investors are increasingly recognising that pre-crisis assumptions about bond yields no longer apply. In the past, investors assumed that low nominal bond yields implied low inflation – but with central banks promising to maintain policy rates at low levels for some time into the future, rising inflation expectations simply push real yields lower.

Portfolios can clearly be vulnerable to massive losses at times of extreme inflation or extremely low inflation or deflation – especially if their liabilities are inflation linked. So rather than running scared from the spectre of high inflation, investors could consider seeking to hedge out risk with some of the readily-accessible and good-value products available on the market.

Inflation-linked bonds currently look an attractive option, given their zero risk premium. The market for index-linked bonds is deep and liquid – it is worth $600 billion in the US, EUR320 billion in the Eurozone and £240 billion in the

UK. Investors who already hold bonds that diversify into the inflation-linked market are, in effect, getting paid to do it, given the limited risk premium1.

Another option for investors who are concerned about the impact of rising inflation is to invest in inflation-linked swaps which provide pure inflation protection. Participants in this market pay a known future amount in exchange for cumulated inflation from trade date to maturity. Investors can also buy options on inflation to protect themselves from tail events.

Buying a collar on inflation (i.e. buying a ‘cap’ and selling a ‘floor’ rather than a swap) is a more attractive investment. Instead of doing a swap at say 2%, investors can buy a cap at 3.5% and, in order to pay for that, sell a floor at 0%. In the event of inflation remaining normal and benign, there would be no payoff and no impact. Deutsche Bank has also recently launched a new range of Exchange Traded Funds containing inflation protection in the shape of inflation bonds or inflation swaps in them.

Investors’ fears of inflation have been causing markets to behave more erratically than is justified by the underlying economics. And, considering what most economists are forecasting, there does not appear to be sufficient inflation risk priced into these markets – which clearly presents investors with opportunities given the changed outlook. However, in our view, investors should avoid the use of gold, oil or random equities as inflation hedges. There is no evidence that such assets have any stable correlation with inflation. We believe they should focus on inflation hedges that work.

1. Source: Deutsche Bank


Historically, the longevity swap market has been too small and illiquid to provide effective hedges in the size and cost required.

But after years of sporadic deals, the longevity hedge market is now approaching the critical mass needed to offer compelling risk management solutions to a wide range of funds.

In 2010, Deutsche Bank arranged a £3 billion hedge for BMW’s UK pension scheme using longevity swaps, the largest transaction of its kind by some margin.

Under this deal, the pension scheme swapped a fixed stream of projected cash flows, which it pays to the hedger, for ‘floating’ payments from the hedger. These floating payments increase if the pensioners live longer than expected and decrease if people live for less time than expected.

We believe that the success of this deal will pave the way for other pension funds to do similar deals which will, in turn, deepen and expand the market, making longevity risk ever cheaper and easier to hedge.

The risk that people will live longer than expected is certainly not a new

5.5 Risk Management

Rashid Zuberi Head of Complex Life and Pensions Management

Hedging Longevity Risk Live long and prosper

concept: any financial contract that guarantees payments to an individual until death means that the writer of such contracts is exposed to the risk of the individual living longer than expected, so-called longevity risk.

Who traditionally takes on this risk? The two dominant longevity risk takers are insurance companies that write annuities and pension funds that promise to pay lifelong benefits.

For pension providers, longevity risk sits alongside the risks created by interest rates, used to value liabilities, and those created by inflation, often used to adjust the value of promised benefits. While very liquid capital markets in interest rates and inflation allow pension funds to manage these two risks, no such market exists in longevity.

By definition, a ‘liquid’ market means that there are a large number of buyers and sellers and therefore prices are observable and driven by supply and demand. But longevity risk, unlike that associated with interest rates or inflation, has a sizeable number of sellers and a distinct lack of buyers. This is a serious problem: there is circa £1 trillion of outstanding UK pension liabilities in defined benefit schemes exposed to longevity risk.

For counterparties to take on longevity risk, there must be a measurable financial benefit to them. This will transform longevity risk from a one-sided problem for the insurance and pensions industry, into a burgeoning market of risk takers and sellers.

There now seems to be a genuine increase in the presence of protection sellers. For these sellers, the concept of sufficient reimbursement is key: it may not be straightforward financial compensation. Most notably, these risk takers are reinsurance companies for whom this new risk acts as a portfolio diversifier as well as adding some return via the premium they charge. In the future other investors may emerge.

While talking about longevity may sound morbid, the fact is that if pensioners want the security that comes from having an income for life after reaching retirement, they need pension funds and insurers to feel able to manage the longevity risk that arises from offering lifetime annuities. The increasing presence of longevity underwriters will hopefully make this easier to do.

Opportunities for pension funds to protect themselves against pensioners’ increasing life expectancy – so-called longevity risk – are increasing, through the growth of the longevity swap market.

5.6 Risk Management

Daragh McDevitt Global Head of Inflation Structuring

Inflation Risk ManagementNo need for panic but take precautions

As the world emerges from the longest and deepest recession since the Second World War, core inflation in industrialised countries is at multi-year lows.

Central banks have implemented aggressive monetary policies to hasten economic recovery and ward off the threat of deflation. However, in 2011 these trends are likely to be reversed, and the inflation risk will likely switch to the upside.

The great fear that some investors have is that the combination of loose monetary policy and quantitative easing (QE) – ‘printing money’ – in developed countries, together with a diminishing ability of emerging markets to ‘export’ deflation to the rest of the world, is going to lead to rampant inflation.

But investors should not exaggerate the risks; the chances of Weimar Republic or Zimbabwe-style inflation are extremely slim. The worst case scenario for 2011 is probably that inflation will be higher than expected. In two or three years’ time, there is a chance it could move higher still. However, given the uncertainty about inflation expectations, investors could consider taking precautionary measures to protect themselves from future inflationary risk.

Even the experts seem incapable of agreeing about inflation’s future path, with members of the Bank of England’s Monetary Policy Committee, US Federal Reserve’s Open Market Committee and the Capitalise Monetary Policy Committee divided on likely outcomes. The unreliability of existing inflation models against today’s economic backdrop further muddies the water, intensifying uncertainty about the medium-term outlook.

If inflation does rise in developed economies, it is going to be imported – via rising food and energy prices, external factors outside the control of western governments and central banks. Emerging markets are at greater risk. Since late 2010 consumer price inflation has been creeping up in countries including China and Taiwan, partly because the weighting accorded to food in their inflationary ‘baskets’ is greater than in developed countries.

The Asian countries’ policy of pegging their currencies to the US dollar intensifies inflation risk, since it can require them to adopt interest rates which are potentially inappropriate for their faster-growing domestic economies. They are also vulnerable to the inflationary effects of QE2-driven capital inflows.

Investors are increasingly recognising that pre-crisis assumptions about bond yields no longer apply. In the past, investors assumed that low nominal bond yields implied low inflation – but with central banks promising to maintain policy rates at low levels for some time into the future, rising inflation expectations simply push real yields lower.

Portfolios can clearly be vulnerable to massive losses at times of extreme inflation or extremely low inflation or deflation – especially if their liabilities are inflation linked. So rather than running scared from the spectre of high inflation, investors could consider seeking to hedge out risk with some of the readily-accessible and good-value products available on the market.

Inflation-linked bonds currently look an attractive option, given their zero risk premium. The market for index-linked bonds is deep and liquid – it is worth $600 billion in the US, EUR320 billion in the Eurozone and £240 billion in the

UK. Investors who already hold bonds that diversify into the inflation-linked market are, in effect, getting paid to do it, given the limited risk premium1.

Another option for investors who are concerned about the impact of rising inflation is to invest in inflation-linked swaps which provide pure inflation protection. Participants in this market pay a known future amount in exchange for cumulated inflation from trade date to maturity. Investors can also buy options on inflation to protect themselves from tail events.

Buying a collar on inflation (i.e. buying a ‘cap’ and selling a ‘floor’ rather than a swap) is a more attractive investment. Instead of doing a swap at say 2%, investors can buy a cap at 3.5% and, in order to pay for that, sell a floor at 0%. In the event of inflation remaining normal and benign, there would be no payoff and no impact. Deutsche Bank has also recently launched a new range of Exchange Traded Funds containing inflation protection in the shape of inflation bonds or inflation swaps in them.

Investors’ fears of inflation have been causing markets to behave more erratically than is justified by the underlying economics. And, considering what most economists are forecasting, there does not appear to be sufficient inflation risk priced into these markets – which clearly presents investors with opportunities given the changed outlook. However, in our view, investors should avoid the use of gold, oil or random equities as inflation hedges. There is no evidence that such assets have any stable correlation with inflation. We believe they should focus on inflation hedges that work.

1. Source: Deutsche Bank


5.7 Risk Management

Sorin Ionescu Commodities Structuring

Commodity Risk ManagementWhat risks are worth hedging and how?

The argument in favour of hedging is compelling. Commodity prices are likely to be just as volatile in 2011 as they were in 2010, and possibly more so because of the increased uncertainty about the economic outlook.

If prices move the wrong way, profits will be seriously impacted. If coal prices go up by 30%, for example, most power generators that rely on coal will see their input costs rise by over 20%, an increase that they may not be able to pass onto their customers because of fixed electricity price agreements with their national regulators.

So what should companies do? Our view is that a substantial amount of risk should be hedged given the scale of the potential moves, and that companies should seek to find ways to reduce the cost of that hedge either by limiting the amount of protection they are buying or by exploring alternative hedging strategies.

Companies will choose the best alternative based on their own risk evaluations, but there are three main options.

The first is a vanilla forward contract. A copper producer can protect against a fall in price of the commodity by fixing the price for a portion of its total production for a fixed period –

typically for a year – at say $8,300 per tonne in an over-the-counter trade with its bank. According to the terms of the forward, the bank will guarantee the price at $8,300 and if the price is below that when the forward expires, the bank will reimburse the difference.

A vanilla forward fixes the selling price, so if the price soars, the company will not benefit from the upside. One way to address this and retain some upside exposure is to use an extendable forward, in which the company gives the bank an option to extend the contract after a year, with the same terms. In this scenario, the bank would allow the producer to lock in at a higher price, say $9,000, but the bank has the option of whether or not to extend the contract by a further year.

The advantage of forwards is that they offer downside protection without the company having to pay an upfront premium.

For producers that want to benefit from the upside of pricing in a volatile market, they can choose an options contract, which involves an up-front premium. This locks any price movement beyond a certain level. For example, a copper producer may be comfortable with price volatility down to $6,000 a tonne, but may want also to retain any upside potential. In this scenario, the producer could buy an out-of-the-money put option with a

strike price of $6,000. On a one-year tenor, this would cost around 4%, or roughly $330 per tonne on a current price of $8,300. The advantage is that should prices rally, the company enjoys all of the upside.

Producers wanting protection against the slightest volatility from the current price can opt for an at-the-money option, which provides protection for any fall in price. This would be more expensive, closer to $1,300 per tonne.

A mining company producing both copper and gold may choose to separately hedge its exposure to the two commodities, by purchasing put options. Assuming for the sake of simplicity that the exposure to the two commodities is similar, the average price of the two put options would be around 12.5% (assuming a 1-year tenor and at-the-market strike). If instead, the producer were to buy a basket option (a put option paying the average performance of the two commodities), the premium can be reduced to 10.5%, a reduction of more than 15% in the hedging cost.

All these strategies can be adapted to meet the needs of investors. Commodities have become an integral part of investor portfolios due to their diversification benefits and potential to protect against inflation shocks.

To hedge or not to hedge? That will be the key question in 2011 for all companies that produce or consume commodities – from the largest mining conglomerate to the smallest transportation company.


5.7 Risk Management

Sorin Ionescu Commodities Structuring

Commodity Risk ManagementWhat risks are worth hedging and how?

The argument in favour of hedging is compelling. Commodity prices are likely to be just as volatile in 2011 as they were in 2010, and possibly more so because of the increased uncertainty about the economic outlook.

If prices move the wrong way, profits will be seriously impacted. If coal prices go up by 30%, for example, most power generators that rely on coal will see their input costs rise by over 20%, an increase that they may not be able to pass onto their customers because of fixed electricity price agreements with their national regulators.

So what should companies do? Our view is that a substantial amount of risk should be hedged given the scale of the potential moves, and that companies should seek to find ways to reduce the cost of that hedge either by limiting the amount of protection they are buying or by exploring alternative hedging strategies.

Companies will choose the best alternative based on their own risk evaluations, but there are three main options.

The first is a vanilla forward contract. A copper producer can protect against a fall in price of the commodity by fixing the price for a portion of its total production for a fixed period –

typically for a year – at say $8,300 per tonne in an over-the-counter trade with its bank. According to the terms of the forward, the bank will guarantee the price at $8,300 and if the price is below that when the forward expires, the bank will reimburse the difference.

A vanilla forward fixes the selling price, so if the price soars, the company will not benefit from the upside. One way to address this and retain some upside exposure is to use an extendable forward, in which the company gives the bank an option to extend the contract after a year, with the same terms. In this scenario, the bank would allow the producer to lock in at a higher price, say $9,000, but the bank has the option of whether or not to extend the contract by a further year.

The advantage of forwards is that they offer downside protection without the company having to pay an upfront premium.

For producers that want to benefit from the upside of pricing in a volatile market, they can choose an options contract, which involves an up-front premium. This locks any price movement beyond a certain level. For example, a copper producer may be comfortable with price volatility down to $6,000 a tonne, but may want also to retain any upside potential. In this scenario, the producer could buy an out-of-the-money put option with a

strike price of $6,000. On a one-year tenor, this would cost around 4%, or roughly $330 per tonne on a current price of $8,300. The advantage is that should prices rally, the company enjoys all of the upside.

Producers wanting protection against the slightest volatility from the current price can opt for an at-the-money option, which provides protection for any fall in price. This would be more expensive, closer to $1,300 per tonne.

A mining company producing both copper and gold may choose to separately hedge its exposure to the two commodities, by purchasing put options. Assuming for the sake of simplicity that the exposure to the two commodities is similar, the average price of the two put options would be around 12.5% (assuming a 1-year tenor and at-the-market strike). If instead, the producer were to buy a basket option (a put option paying the average performance of the two commodities), the premium can be reduced to 10.5%, a reduction of more than 15% in the hedging cost.

All these strategies can be adapted to meet the needs of investors. Commodities have become an integral part of investor portfolios due to their diversification benefits and potential to protect against inflation shocks.

To hedge or not to hedge? That will be the key question in 2011 for all companies that produce or consume commodities – from the largest mining conglomerate to the smallest transportation company.


6 Financing

BondsIPOsTrade FinanceRecapitalisationBail-InsInfrastructure


6 Financing

BondsIPOsTrade FinanceRecapitalisationBail-InsInfrastructure


6.1 Financing

Outlook for Bonds Uncertainties need resolving

How the markets evolve following the resolution of the peripheral sovereign crisis in Europe will be one of the defining themes in the bond market during 2011. While the situation in Greece and Ireland is thought to be reasonably well understoood, insufficient clarity related to the position of Portugal and indeed Spain still exists. Liquidity in the global sovereign and supranational market will be significantly impacted by this, until a much-anticipated resolution has been reached–most likely during the first quarter of the year.

Zia Huque Head of Global Risk Syndicate

In the bank market, liquidity, funding, and capital requirements will remain the most pressing concerns in 2011. As of now, none of these topics are sufficiently clear for issuers or investors. The current debate around potential bail-in characteristics and questions related to debt and capital requirements of systemically important financial institutions (SIFIs) show that investors may not know the full extent of the risks associated with buying senior unsecured debt from global financial institutions. Additionally, on the capital side, uncertainty with regards to the characteristics of hybrid capital leaves no clear delineation of what the loss absorption capability will be of instruments that are not pure equity.

As there is no agreement or conformity yet among global regulators on what hybrid capital characteristics need to

be, the market has been left in limbo. Critical terms need clarification, and only once this has happened can new products and funding strategies be developed. Again, there should be more clarity on these issues by the end of the first quarter of 2011. But what we do know is that the covered bond market will continue to grow in importance with the valuation differential between these instruments and senior unsecured funding growing ever larger. The implied structural subordination of senior debt means that financial institution liabilities will become more akin to corporate debt and without implied umbrella support from governments and with potential dramatically low recovery value upon default, restructuring or bail-in.

Arguably the most fundamental change in approach for institutional investors in 2011 will be in their

attitude to emerging markets (EM). The delineation between looking at market sectors and valuing them within a range-bound return has gone out of the window. European sovereigns are trading anywhere between mid-swaps flat and 12% while certain double-B rated EM sovereigns are trading through Spanish and Italian government bonds.

You can no longer look at asset classes and trade them with a historically acceptable risk return profile. The spread and rate of return dynamics are now completely different for EM credits. Fundamentals in EM are in many cases superior to those in the US and Europe on both the sovereign, corporate and financial level. They have significant potential for growth in a constrained-growth world.

Global investors, therefore, need to stop looking at EM as a separate and distinct asset class, despite its volatility. In global fixed income asset portfolios, EM assets should no longer be 5% to 10% of alpha creation, they need to become a core part of gross portfolio and asset diversification strategies. We see the importance of EM assets in G3 currencies and in local currency product. Ratings have also experienced a massive migration to investment grade within EM. This has lead to the establishment of a solid demand base including traditional investment grade buyers.

Finally, given the new banking regulatory framework we operate in today, lending financial institutions globally will inevitably continue to readjust their global corporate lending profiles. The new regulatory and

capital regime requires significantly greater capital, restricts leverage and puts a much higher cost on risk-weighted assets (RWA). This forcibly increases financing costs, the net effect of which will be that bank lending to global corporates and SMEs will fall on a relative basis. This creates a supply and demand gap that must be met by the capital markets.


6.1 Financing

Outlook for Bonds Uncertainties need resolving

How the markets evolve following the resolution of the peripheral sovereign crisis in Europe will be one of the defining themes in the bond market during 2011. While the situation in Greece and Ireland is thought to be reasonably well understoood, insufficient clarity related to the position of Portugal and indeed Spain still exists. Liquidity in the global sovereign and supranational market will be significantly impacted by this, until a much-anticipated resolution has been reached–most likely during the first quarter of the year.

Zia Huque Head of Global Risk Syndicate

In the bank market, liquidity, funding, and capital requirements will remain the most pressing concerns in 2011. As of now, none of these topics are sufficiently clear for issuers or investors. The current debate around potential bail-in characteristics and questions related to debt and capital requirements of systemically important financial institutions (SIFIs) show that investors may not know the full extent of the risks associated with buying senior unsecured debt from global financial institutions. Additionally, on the capital side, uncertainty with regards to the characteristics of hybrid capital leaves no clear delineation of what the loss absorption capability will be of instruments that are not pure equity.

As there is no agreement or conformity yet among global regulators on what hybrid capital characteristics need to

be, the market has been left in limbo. Critical terms need clarification, and only once this has happened can new products and funding strategies be developed. Again, there should be more clarity on these issues by the end of the first quarter of 2011. But what we do know is that the covered bond market will continue to grow in importance with the valuation differential between these instruments and senior unsecured funding growing ever larger. The implied structural subordination of senior debt means that financial institution liabilities will become more akin to corporate debt and without implied umbrella support from governments and with potential dramatically low recovery value upon default, restructuring or bail-in.

Arguably the most fundamental change in approach for institutional investors in 2011 will be in their

attitude to emerging markets (EM). The delineation between looking at market sectors and valuing them within a range-bound return has gone out of the window. European sovereigns are trading anywhere between mid-swaps flat and 12% while certain double-B rated EM sovereigns are trading through Spanish and Italian government bonds.

You can no longer look at asset classes and trade them with a historically acceptable risk return profile. The spread and rate of return dynamics are now completely different for EM credits. Fundamentals in EM are in many cases superior to those in the US and Europe on both the sovereign, corporate and financial level. They have significant potential for growth in a constrained-growth world.

Global investors, therefore, need to stop looking at EM as a separate and distinct asset class, despite its volatility. In global fixed income asset portfolios, EM assets should no longer be 5% to 10% of alpha creation, they need to become a core part of gross portfolio and asset diversification strategies. We see the importance of EM assets in G3 currencies and in local currency product. Ratings have also experienced a massive migration to investment grade within EM. This has lead to the establishment of a solid demand base including traditional investment grade buyers.

Finally, given the new banking regulatory framework we operate in today, lending financial institutions globally will inevitably continue to readjust their global corporate lending profiles. The new regulatory and

capital regime requires significantly greater capital, restricts leverage and puts a much higher cost on risk-weighted assets (RWA). This forcibly increases financing costs, the net effect of which will be that bank lending to global corporates and SMEs will fall on a relative basis. This creates a supply and demand gap that must be met by the capital markets.


Outlook for IPOs Encouraging trends

Edward Sankey Co-Head of Equity Syndicate

6.2 Financing

This year saw the first credible signs of a return to health in the IPO market since 2007, with around $246 billion of new issuance in the first 11 months of the year, a 260% increase on 2009.*

2010 also saw a much more balanced mix of business, both in terms of sectors and issue types. In 2008 and 2009, new equity issuance was driven by balance sheet repair, with over 50% coming from financials. In 2010, that fell significantly and IPO’s were over 30% of total issuance compared with just 12% last year.

However, IPOs had their challenges and overall volumes, especially in the developed markets, were less than many expected.

Market volatility, caused by macro events especially around the sovereign space, was another problem, with some IPOs falling victim to issues out of the control of sellers and bookrunners.

Volatility has always been one of the determining factors of the success or failure of an IPO because of the length of time it takes to execute a deal (between two and four weeks from launch to execution).

Between 2004 and H1 2007, volatility was relatively benign so it did not pose much of a risk. But it increased significantly during the second half of 2007 and made IPOs almost impossible to complete through 2008 and 2009.

The return of IPOs in 2010 reflects the decline in volatility during the

year, and signs of stabilisation in the global economy.

A significant amount of IPO issuance was driven by corporate spin offs, private equity exits and privatisations, with most of the deals coming from emerging markets especially Asia because of continued uncertainty about the sustainability of the western macro recovery and sovereign debt risk in Europe.

China alone accounted for over $90 billion of IPOs last year (Jan to Nov 28), almost three times that of the United States. Asia as a whole accounted for around $140 billion or approximately 56% of the global total.*

Two of the largest IPOs in history came out of Asia last year in the form of Agricultural Bank of China and AIA. Petronas’ IPO was the largest SE Asian IPO ever.

Demand for these deals was exceptional with inflows into EM equity funds, strong appetite for growth and an explosive increase in retail demand in the region leading to huge order books. This, in turn, allowed many sellers to price the shares at the top end of the valuation ranges.

This is not to say that the developed markets were dead. Europe had its fair share of successful IPOs with markets such as the UK, Germany and Poland being particularly active. And the US recently saw the largest IPO of all time in the form of the GM IPO. Aftermarket performance generally has also been good, often outperforming the various indices.

The outlook for IPO issuance in 2011 is promising with the themes seen in 2010 likely to continue and develop notably strong volumes coming out of emerging markets, the selective nature of the buy side, the preference for larger, more liquid deals and the vulnerability of deals to macro events and market volatility.

Private equity and government sell downs are likely to continue to be a good source of new deals, with the sectoral spread being as wide as it was in 2010.

One key trend that will continue to be a focus is the continued flux in the demand dynamics from the investing universe. Since the collapse of Lehman a number of the usual investors seen in IPOs in previous years have lost assets and become smaller in terms of their potential appetite; indeed a number have closed altogether. This has resulted in a concentration of demand amongst the large ‘long-only’ names and the bigger hedge funds that has become more acute as assets have flowed in their direction. This changes the pricing dynamics and has to be taken into account in execution.

But the trend of investors using the primary calendar to access liquidity due to a continued fall in secondary market volumes is set to continue – meaning broader market conditions permitting, that IPOs are likely to be a key driver of equity issuance for the next 12 to 24 months. *Source: Dealogic


Outlook for IPOs Encouraging trends

Edward Sankey Co-Head of Equity Syndicate

6.2 Financing

This year saw the first credible signs of a return to health in the IPO market since 2007, with around $246 billion of new issuance in the first 11 months of the year, a 260% increase on 2009.*

2010 also saw a much more balanced mix of business, both in terms of sectors and issue types. In 2008 and 2009, new equity issuance was driven by balance sheet repair, with over 50% coming from financials. In 2010, that fell significantly and IPO’s were over 30% of total issuance compared with just 12% last year.

However, IPOs had their challenges and overall volumes, especially in the developed markets, were less than many expected.

Market volatility, caused by macro events especially around the sovereign space, was another problem, with some IPOs falling victim to issues out of the control of sellers and bookrunners.

Volatility has always been one of the determining factors of the success or failure of an IPO because of the length of time it takes to execute a deal (between two and four weeks from launch to execution).

Between 2004 and H1 2007, volatility was relatively benign so it did not pose much of a risk. But it increased significantly during the second half of 2007 and made IPOs almost impossible to complete through 2008 and 2009.

The return of IPOs in 2010 reflects the decline in volatility during the

year, and signs of stabilisation in the global economy.

A significant amount of IPO issuance was driven by corporate spin offs, private equity exits and privatisations, with most of the deals coming from emerging markets especially Asia because of continued uncertainty about the sustainability of the western macro recovery and sovereign debt risk in Europe.

China alone accounted for over $90 billion of IPOs last year (Jan to Nov 28), almost three times that of the United States. Asia as a whole accounted for around $140 billion or approximately 56% of the global total.*

Two of the largest IPOs in history came out of Asia last year in the form of Agricultural Bank of China and AIA. Petronas’ IPO was the largest SE Asian IPO ever.

Demand for these deals was exceptional with inflows into EM equity funds, strong appetite for growth and an explosive increase in retail demand in the region leading to huge order books. This, in turn, allowed many sellers to price the shares at the top end of the valuation ranges.

This is not to say that the developed markets were dead. Europe had its fair share of successful IPOs with markets such as the UK, Germany and Poland being particularly active. And the US recently saw the largest IPO of all time in the form of the GM IPO. Aftermarket performance generally has also been good, often outperforming the various indices.

The outlook for IPO issuance in 2011 is promising with the themes seen in 2010 likely to continue and develop notably strong volumes coming out of emerging markets, the selective nature of the buy side, the preference for larger, more liquid deals and the vulnerability of deals to macro events and market volatility.

Private equity and government sell downs are likely to continue to be a good source of new deals, with the sectoral spread being as wide as it was in 2010.

One key trend that will continue to be a focus is the continued flux in the demand dynamics from the investing universe. Since the collapse of Lehman a number of the usual investors seen in IPOs in previous years have lost assets and become smaller in terms of their potential appetite; indeed a number have closed altogether. This has resulted in a concentration of demand amongst the large ‘long-only’ names and the bigger hedge funds that has become more acute as assets have flowed in their direction. This changes the pricing dynamics and has to be taken into account in execution.

But the trend of investors using the primary calendar to access liquidity due to a continued fall in secondary market volumes is set to continue – meaning broader market conditions permitting, that IPOs are likely to be a key driver of equity issuance for the next 12 to 24 months. *Source: Dealogic


Kaushik Shaparia Head of Trade Finance and Cash Management Asia Pacific

6.3 Financing

Trade Finance Embracing the old and new

Before the financial crisis, there was an excess of liquidity in most markets. The financial community was more liberal in its approach to risk, and bank lending was easily available to corporates. With alternate sources of funding easily available, clients did not need to rely on trade finance instruments for funding their working capital.

Post-crisis, there has been a lack of liquidity, banks have raised their controls around risk and many corporates outside the top tier have had to fall back on traditional trade finance products for financing their working capital.

Risk mitigation remains at the top of the agenda for many corporates, so letters of credit, bills of exchange and guarantees are likely to remain popular. Many suppliers want to be paid quickly and, likewise, buyers want their goods immediately – hence these instruments are still considered relevant forms of payment. Invariably, they have been accompanied by an increase in demand for credit insurance and related products.

We anticipate this resurgence will continue into 2011, especially as intra-Asian trade looks set to scale new

heights. The region has reshaped its trade model, driven by China’s growth and the need to diversify, and become less reliant on trade with the west. This is being demonstrated in Japan, for example, where exports to China jumped by 80% in 2009 returning to pre-crisis levels.*

As intra-region trade grows with suppliers strewn across a vast continent, the financial supply chain (FSC) issues that have been gathering pace in recent years are becoming increasingly important. The crisis has crystallised some of the thinking around FSC and the concerns of corporates that their suppliers may not necessarily have access to liquidity.

The challenge for trade finance providers is to develop financial supply chain solutions for their clients, in particular integrated offerings that encompass foreign exchange (FX) as well as trade and cash. It became very clear during the financial crisis that cash flow management, trade finance and hedging requirements are indelibly linked and are important components of the working capital cycle. A consolidated approach to these issues not only streamlines the operation for clients, but is the natural evolution in supply chain solutions.

Evolutionary too, is the response to the developing internationalisation of the Renmimbi (RMB). The expansion of the RMB Offshore Trade Settlement Program will undoubtedly facilitate further trade growth in the region. This will enable importers and their counterparties to reduce their exposures to foreign currencies and settle trades in RMB. Furthermore, this will increase transparency around costs, pricing, settlement and FX adjustments. Deutsche Bank is now an active player in offshore RMB, which is poised to increase significantly in the short-to medium-term.

Like all markets, the trade finance world can be impacted by dislocation, but the momentum that has built up over the past 12 months, and the near and medium-term outlook for the Asian economies, is positive. *Source: Deutsche Bank

Trade finance is enjoying a renaissance in the Asia Pacific region with traditional instruments that had been somewhat sidelined in past years returning to the forefront of the market.

Neil Kell Head of Financial Institutions, Equity Capital Markets

6.4 Financing

Bank Recapitalisation Possible responses to regulatory and market pressure to raise new equity

A robust recapitalisation of the European banking sector will play an important role in stabilising the wider financial system by restoring bank viability, boosting market liquidity for bank debt and rebuilding and maintaining investor support and confidence.

There is a strong incentive from regulators to adequately recapitalise the banking system to ensure banks have a stronger liquidity position and better funding outlook, which will improve the sector’s standing among international investors. The efficacy of individual bank recapitalisation will be determined by how and when financial institutions implement fundraising strategies and the market’s view of their adequacy.

Despite the injection of substantial equity capital into the European banking system by private investors and governments since 2008 and a significant reduction in banking asset balances, the banking system remains under-capitalised relative to the expected Basel 3 regulations. Regulatory pressure, together with widely disparate capitalisation levels between individual banks, ongoing uncertainty over asset values and impairment levels, elevated bank credit spreads and weak credit availability, support further equitisation of the banking system.

However, despite an increase in bank equity issuance in the second half of 2010, versus H1, regulatory uncertainty prevented a larger number of banks from recapitalising in 2010.

The level of bank recapitalisation activity in the public equity markets in 2011 will be a function of four key factors: greater certainty of the new regulatory capital framework, especially definitions, required regulatory capital levels, timing for achieving new levels, and the availability of credible alternatives for banks needing to bolster their capital levels.

Regulatory clarity is a pre-condition for market clarity though certain elements remain unknown. Exact definitions of equity capital should have emerged this month (December 2010), while buffer requirements for global systemically important financial institutions are expected by mid-2011 and for national SIFIs later that year. Aside from Switzerland, national regulator implementation of regulatory proposals and application of super-equivalence remains unknown. National variations will arise in the form of capital levels and timing and the treatment of individual capital items, such as deferred tax assets or holdings in financial entities.

There is a risk that the market will adopt a ‘highest threshold’ approach, forcing banks with similar business models to match peer capitalisation,

both levels and quality, in other markets. This market-imposed risk could also affect banks falling outside the SIFI designation which could be pulled to SIFI levels of capitalisation by the market.

How banks respond to these pressures in terms of capital strategy and timing depends on their current capitalisation levels and the ‘gap’ to new requirements, the credibility of proposed capital strategies and organic capital generation through retained earnings and deleveraging. How banks react is also subject to the availability of ‘self-help’ alternatives to equity raising, mitigating actions to reduce risk-weighted assets or regulatory capital deductions such as asset sales and changes in business practices, or alternative, non-dilutive qualifying capital instruments such as contingent convertibles.

Whilst the Basel Committee permits banks to implement proposed changes on a phased basis until 2019, the market has formed its own view on individual bank timing, based on the credibility of capital strategy. Banks that provide highly credible capital plans and greater disclosure on how their glide path to capital sufficiency will evolve will be allowed longer

Stephen Westgate Director, European Financial Institutions


Kaushik Shaparia Head of Trade Finance and Cash Management Asia Pacific

6.3 Financing

Trade Finance Embracing the old and new

Before the financial crisis, there was an excess of liquidity in most markets. The financial community was more liberal in its approach to risk, and bank lending was easily available to corporates. With alternate sources of funding easily available, clients did not need to rely on trade finance instruments for funding their working capital.

Post-crisis, there has been a lack of liquidity, banks have raised their controls around risk and many corporates outside the top tier have had to fall back on traditional trade finance products for financing their working capital.

Risk mitigation remains at the top of the agenda for many corporates, so letters of credit, bills of exchange and guarantees are likely to remain popular. Many suppliers want to be paid quickly and, likewise, buyers want their goods immediately – hence these instruments are still considered relevant forms of payment. Invariably, they have been accompanied by an increase in demand for credit insurance and related products.

We anticipate this resurgence will continue into 2011, especially as intra-Asian trade looks set to scale new

heights. The region has reshaped its trade model, driven by China’s growth and the need to diversify, and become less reliant on trade with the west. This is being demonstrated in Japan, for example, where exports to China jumped by 80% in 2009 returning to pre-crisis levels.*

As intra-region trade grows with suppliers strewn across a vast continent, the financial supply chain (FSC) issues that have been gathering pace in recent years are becoming increasingly important. The crisis has crystallised some of the thinking around FSC and the concerns of corporates that their suppliers may not necessarily have access to liquidity.

The challenge for trade finance providers is to develop financial supply chain solutions for their clients, in particular integrated offerings that encompass foreign exchange (FX) as well as trade and cash. It became very clear during the financial crisis that cash flow management, trade finance and hedging requirements are indelibly linked and are important components of the working capital cycle. A consolidated approach to these issues not only streamlines the operation for clients, but is the natural evolution in supply chain solutions.

Evolutionary too, is the response to the developing internationalisation of the Renmimbi (RMB). The expansion of the RMB Offshore Trade Settlement Program will undoubtedly facilitate further trade growth in the region. This will enable importers and their counterparties to reduce their exposures to foreign currencies and settle trades in RMB. Furthermore, this will increase transparency around costs, pricing, settlement and FX adjustments. Deutsche Bank is now an active player in offshore RMB, which is poised to increase significantly in the short-to medium-term.

Like all markets, the trade finance world can be impacted by dislocation, but the momentum that has built up over the past 12 months, and the near and medium-term outlook for the Asian economies, is positive. *Source: Deutsche Bank

Trade finance is enjoying a renaissance in the Asia Pacific region with traditional instruments that had been somewhat sidelined in past years returning to the forefront of the market.

Neil Kell Head of Financial Institutions, Equity Capital Markets

6.4 Financing

Bank Recapitalisation Possible responses to regulatory and market pressure to raise new equity

A robust recapitalisation of the European banking sector will play an important role in stabilising the wider financial system by restoring bank viability, boosting market liquidity for bank debt and rebuilding and maintaining investor support and confidence.

There is a strong incentive from regulators to adequately recapitalise the banking system to ensure banks have a stronger liquidity position and better funding outlook, which will improve the sector’s standing among international investors. The efficacy of individual bank recapitalisation will be determined by how and when financial institutions implement fundraising strategies and the market’s view of their adequacy.

Despite the injection of substantial equity capital into the European banking system by private investors and governments since 2008 and a significant reduction in banking asset balances, the banking system remains under-capitalised relative to the expected Basel 3 regulations. Regulatory pressure, together with widely disparate capitalisation levels between individual banks, ongoing uncertainty over asset values and impairment levels, elevated bank credit spreads and weak credit availability, support further equitisation of the banking system.

However, despite an increase in bank equity issuance in the second half of 2010, versus H1, regulatory uncertainty prevented a larger number of banks from recapitalising in 2010.

The level of bank recapitalisation activity in the public equity markets in 2011 will be a function of four key factors: greater certainty of the new regulatory capital framework, especially definitions, required regulatory capital levels, timing for achieving new levels, and the availability of credible alternatives for banks needing to bolster their capital levels.

Regulatory clarity is a pre-condition for market clarity though certain elements remain unknown. Exact definitions of equity capital should have emerged this month (December 2010), while buffer requirements for global systemically important financial institutions are expected by mid-2011 and for national SIFIs later that year. Aside from Switzerland, national regulator implementation of regulatory proposals and application of super-equivalence remains unknown. National variations will arise in the form of capital levels and timing and the treatment of individual capital items, such as deferred tax assets or holdings in financial entities.

There is a risk that the market will adopt a ‘highest threshold’ approach, forcing banks with similar business models to match peer capitalisation,

both levels and quality, in other markets. This market-imposed risk could also affect banks falling outside the SIFI designation which could be pulled to SIFI levels of capitalisation by the market.

How banks respond to these pressures in terms of capital strategy and timing depends on their current capitalisation levels and the ‘gap’ to new requirements, the credibility of proposed capital strategies and organic capital generation through retained earnings and deleveraging. How banks react is also subject to the availability of ‘self-help’ alternatives to equity raising, mitigating actions to reduce risk-weighted assets or regulatory capital deductions such as asset sales and changes in business practices, or alternative, non-dilutive qualifying capital instruments such as contingent convertibles.

Whilst the Basel Committee permits banks to implement proposed changes on a phased basis until 2019, the market has formed its own view on individual bank timing, based on the credibility of capital strategy. Banks that provide highly credible capital plans and greater disclosure on how their glide path to capital sufficiency will evolve will be allowed longer

Stephen Westgate Director, European Financial Institutions


phase-in periods. A national regulator could impose a shorter period than 2019 and markets may favour early adopters.

National regulators are moving at a different pace to regulatory reform. Switzerland is well above the regulatory minimum and views its new regime to be adequately super-equivalent, whatever the eventual outcome from the Basel Committee. Some banking systems in European peripheral countries may become subject to short-term, forced equitisation by their governments to support sovereign solvency.

During the third quarter of 2010, banks saw mitigating actions as a priority to achieving required capital ratios without recourse to the equity markets. It is likely that not all will be successful. The market will demand much greater clarity on proposed actions and impact of profitability in the first quarter of 2011.

Institutions currently viewed as undercapitalised relative to peers are likely to launch pre-emptive capital raisings in the first quarter, market conditions permitting. These banks are likely to ‘front run’ absolute regulatory clarity in order to demonstrate an ability to satisfy the new framework when it is implemented fully.

Banks may look to alternative, non-dilutive instruments to meet capital requirements once there is clarity later in 2011 on the framework for non-equity capital, such as hybrid and contingent convertibles and their ability to supplement regulatory capital.

Some banks may undertake reactive capital raisings, if the anticipated organic strategy is inadequate. With the majority of European banks favouring the ‘self-help’ approach, the higher the eventual capital level requirements, the greater the number of banks undertaking reactive capital raisings.

Recapitalisations may be triggered by positive or negative events independent of the new regulatory regime. Negative triggers include accelerating loan losses due to slowing economic growth and rising unemployment, unexpected asset impairments or losses on sovereign or bank debt. Positive triggers include improvements to sovereign risk perception, merger and acquisition activity or rapid economic recovery, and expansion of credit growth.

In the current environment, we would expect an orderly series of recapitalisations by the weaker European banks, and government support for those with insufficient public equity market support. However, this view could change if final regulation at a global or national level proves surprisingly penal or if losses are imposed on European sovereign debt or a further recession causes accelerating loan losses. The efficacy of individual bank recapitalisation will be determined by how and when financial institutions implement strategies to improve their capital positions and the market’s view of their adequacy.

6.4 Financing

6.5 Financing

Vinod Vasan Head of European Financial Institutions, Debt Capital Markets

Bail-Ins: Pros and Cons A fast-track option for recapitalisation

Regulators are evaluating the optimal means to limit future government capital injections into ‘too big to fail’ banks in times of stress, to ensure a more equitable outcome in respect of sharing losses and, if ultimately required, appropriate mechanisms to make bank failures manageable.

The Financial Stability Board (FSB) is proposing rules to regulate systemically important financial institutions (SIFIs) and its latest announcement in November 2009 suggests bail-ins be considered initially for global SIFIs (G-SIFIs). The recommendations for institutions designated as such will be made by December 2011.

The bail-in concept is one of a number of potential alternatives for enhancing loss absorption in a bank’s capital structure, and is viewed as a ‘fast track’ solution.

The rationale from regulators is that by gaining access to the large volumes of outstanding senior debt, bail-ins can be considered an alternative to over-regulation and punitive capital volume increases.

However, all capital instruments will have greater loss absorbing features under the Basel 3 proposals. Increased capital requirements, particularly for systemic banks, will also see significant buffers of capital being available to absorb unforeseen losses. Furthermore, contingent capital, depending on the final regulatory objectives, would boost common equity in a time of stress and, importantly, investors are aware of, and compensated for, the instrument’s risk profile in advance.

There are a number of considerations of how and when bail-in could be implemented. These include willingness on a political level, the interaction of statutory and contractual rights, and determining a workable timeline to implement effective national policy frameworks. Importantly, the FSB recognises that the interaction of different rules and approaches in a multi-jurisdiction group is a key question to be resolved.

Legal challenges may arise over the protection of rights of creditors versus the ability of a regulator to exercise bail-in features in a timely way. Market participants would prefer a trigger to be transparent but the regulator is likely to require maximum discretion so the question of how and when regulators should intervene and whether any intervention is assessed as fair on the grounds of law or judgement will arise.

Quantifying the net benefits to the financial system against the net increased cost of senior debt will only play out over time. The impact upon senior debt access and liquidity of imposing bail-in could create additional, more significant issues in respect of available liquidity, cost of funding and margins. In particular, balancing the interests of senior unsecured debt that is subject to bail-in versus secured instruments and to what extent short-end funding should be excluded to facilitate immediate liquidity remain to be considered.

A flight to secured funding not subject to bail-in would depend on the ability and appetite of banks to issue and such debt may not be considered a regular funding source. A bank’s net

interest margin and organic generation of capital will be negatively impacted if senior debt funding costs increase. A key debate is to what extent and when bail-in will be priced in and the risk of creating greater differentiation in the banking sector, particularly market access for non-systemic banks.

Appropriate triggers and interaction of different liability classes remain ambiguous and will remain a focus of the analysis and market acceptance of any ‘new-style’ security by investors. Whilst the ‘bail-in’ concept continues to be approached with suspicion by investors if the event can be assessed as sufficiently remote and investors are compensated for the additional risk solutions may be found.

The next step will be a matter of regulators assessing whether there is a need for stringency or sufficiency of alternatives. Will sufficient volume of loss-absorbing capital dampen regulatory incentives? Will bail-in debt become a real alternative given investor acceptance and relative cost of the instrument? These fundamental questions are very difficult to answer but will need to be addressed over the coming year.

Nigel Howells Director, Capital Solutions Team

What is a bail-in? Bail-in is the concept commonly referred to whereby the principal amount owed on senior unsecured debt is reduced, resulting in a transfer of some of the burden of bank losses onto bondholders, as compared with bail-out where additional capital is injected. How and when a bail in is implemented is dependent on establishing workable regulatory and national policy frameworks. Also important, is the acceptance of bail-in debt by the investor community, the relative cost to competing funding instruments and its potential impact on market liquidity.


phase-in periods. A national regulator could impose a shorter period than 2019 and markets may favour early adopters.

National regulators are moving at a different pace to regulatory reform. Switzerland is well above the regulatory minimum and views its new regime to be adequately super-equivalent, whatever the eventual outcome from the Basel Committee. Some banking systems in European peripheral countries may become subject to short-term, forced equitisation by their governments to support sovereign solvency.

During the third quarter of 2010, banks saw mitigating actions as a priority to achieving required capital ratios without recourse to the equity markets. It is likely that not all will be successful. The market will demand much greater clarity on proposed actions and impact of profitability in the first quarter of 2011.

Institutions currently viewed as undercapitalised relative to peers are likely to launch pre-emptive capital raisings in the first quarter, market conditions permitting. These banks are likely to ‘front run’ absolute regulatory clarity in order to demonstrate an ability to satisfy the new framework when it is implemented fully.

Banks may look to alternative, non-dilutive instruments to meet capital requirements once there is clarity later in 2011 on the framework for non-equity capital, such as hybrid and contingent convertibles and their ability to supplement regulatory capital.

Some banks may undertake reactive capital raisings, if the anticipated organic strategy is inadequate. With the majority of European banks favouring the ‘self-help’ approach, the higher the eventual capital level requirements, the greater the number of banks undertaking reactive capital raisings.

Recapitalisations may be triggered by positive or negative events independent of the new regulatory regime. Negative triggers include accelerating loan losses due to slowing economic growth and rising unemployment, unexpected asset impairments or losses on sovereign or bank debt. Positive triggers include improvements to sovereign risk perception, merger and acquisition activity or rapid economic recovery, and expansion of credit growth.

In the current environment, we would expect an orderly series of recapitalisations by the weaker European banks, and government support for those with insufficient public equity market support. However, this view could change if final regulation at a global or national level proves surprisingly penal or if losses are imposed on European sovereign debt or a further recession causes accelerating loan losses. The efficacy of individual bank recapitalisation will be determined by how and when financial institutions implement strategies to improve their capital positions and the market’s view of their adequacy.

6.4 Financing

6.5 Financing

Vinod Vasan Head of European Financial Institutions, Debt Capital Markets

Bail-Ins: Pros and Cons A fast-track option for recapitalisation

Regulators are evaluating the optimal means to limit future government capital injections into ‘too big to fail’ banks in times of stress, to ensure a more equitable outcome in respect of sharing losses and, if ultimately required, appropriate mechanisms to make bank failures manageable.

The Financial Stability Board (FSB) is proposing rules to regulate systemically important financial institutions (SIFIs) and its latest announcement in November 2009 suggests bail-ins be considered initially for global SIFIs (G-SIFIs). The recommendations for institutions designated as such will be made by December 2011.

The bail-in concept is one of a number of potential alternatives for enhancing loss absorption in a bank’s capital structure, and is viewed as a ‘fast track’ solution.

The rationale from regulators is that by gaining access to the large volumes of outstanding senior debt, bail-ins can be considered an alternative to over-regulation and punitive capital volume increases.

However, all capital instruments will have greater loss absorbing features under the Basel 3 proposals. Increased capital requirements, particularly for systemic banks, will also see significant buffers of capital being available to absorb unforeseen losses. Furthermore, contingent capital, depending on the final regulatory objectives, would boost common equity in a time of stress and, importantly, investors are aware of, and compensated for, the instrument’s risk profile in advance.

There are a number of considerations of how and when bail-in could be implemented. These include willingness on a political level, the interaction of statutory and contractual rights, and determining a workable timeline to implement effective national policy frameworks. Importantly, the FSB recognises that the interaction of different rules and approaches in a multi-jurisdiction group is a key question to be resolved.

Legal challenges may arise over the protection of rights of creditors versus the ability of a regulator to exercise bail-in features in a timely way. Market participants would prefer a trigger to be transparent but the regulator is likely to require maximum discretion so the question of how and when regulators should intervene and whether any intervention is assessed as fair on the grounds of law or judgement will arise.

Quantifying the net benefits to the financial system against the net increased cost of senior debt will only play out over time. The impact upon senior debt access and liquidity of imposing bail-in could create additional, more significant issues in respect of available liquidity, cost of funding and margins. In particular, balancing the interests of senior unsecured debt that is subject to bail-in versus secured instruments and to what extent short-end funding should be excluded to facilitate immediate liquidity remain to be considered.

A flight to secured funding not subject to bail-in would depend on the ability and appetite of banks to issue and such debt may not be considered a regular funding source. A bank’s net

interest margin and organic generation of capital will be negatively impacted if senior debt funding costs increase. A key debate is to what extent and when bail-in will be priced in and the risk of creating greater differentiation in the banking sector, particularly market access for non-systemic banks.

Appropriate triggers and interaction of different liability classes remain ambiguous and will remain a focus of the analysis and market acceptance of any ‘new-style’ security by investors. Whilst the ‘bail-in’ concept continues to be approached with suspicion by investors if the event can be assessed as sufficiently remote and investors are compensated for the additional risk solutions may be found.

The next step will be a matter of regulators assessing whether there is a need for stringency or sufficiency of alternatives. Will sufficient volume of loss-absorbing capital dampen regulatory incentives? Will bail-in debt become a real alternative given investor acceptance and relative cost of the instrument? These fundamental questions are very difficult to answer but will need to be addressed over the coming year.

Nigel Howells Director, Capital Solutions Team

What is a bail-in? Bail-in is the concept commonly referred to whereby the principal amount owed on senior unsecured debt is reduced, resulting in a transfer of some of the burden of bank losses onto bondholders, as compared with bail-out where additional capital is injected. How and when a bail in is implemented is dependent on establishing workable regulatory and national policy frameworks. Also important, is the acceptance of bail-in debt by the investor community, the relative cost to competing funding instruments and its potential impact on market liquidity.


Paul MalanManaging Director, Infrastructure Investment Group

6.6Financing

Infrastructure shortfalls are a shared issue for both developing and developed countries. The World Economic Forum recently estimated the global infrastructure investment defi cit at $2 trillion per year over the next 20 years. Figure 1 shows a selection of estimates of infrastructure needs for regions compiled by a range of industry observers.

Such facilities and services have historically been provided by national governments but accumulated debt and the large budget defi cits of many sovereigns means that they will not be able to meet these infrastructure shortfalls on their own.

As a result, they are increasingly looking to the private sector to fi ll the gap for new investment as well as revisiting the scope for privatisation of existing public sector assets as an alternative source of funding. Figure 2 outlines general goals articulated by some countries and identifi es potential privatisation targets.

Privatisation programmes involving infrastructure have been a key source of government funding since the 1980s. The OECD estimates that over $1.4 trillion of state-owned enterprises were privatised during this period with infrastructure comprising approximately 60% of proceeds. Fiscal imperatives have been a key driver.

For example, the State Government of Victoria in Australia sold approximately A$30 billion of public assets in the 1990s and privatised services valued at a further A$10 billion. As a result, the ratio of state public debt to GDP fell from 27% in June 1995 to 3% in June 2000.

Looking forward, it seems inevitable that governments across the world will need to move increasingly towards the policy outlined by the UK government in its recent National Infrastructure Plan which stated its commitment to playing “its full part in promoting the

infrastructure investment the country needs, using all the available levers right across the range of private and public ownership models.”

Governments are not alone in looking to address capital scarcity and maximise asset and balance sheet effi ciency. An increasing number of privately-owned companies which are active in the infrastructure sector have also signalled their intention to rationalise asset portfolios and refocus activities. E.ON, for example, recently announced a signifi cant disposal program with a target of

Country General Objectives Sample of Possible Asset Sales

UK June 2010 budget provided for £1.5 billion of central government realisations in 2010/11 (already exceeded). Budget 2009 outlined the government’s plan to realise £16 billion in the period 2010-11 to 2013-2014 by selling assets and property.

– High Speed 1 – Sold for £2.1 billion in November 2010

– National Air Traffi c Service (49%) – Advisers appointed

– British Waterways – Oil and Pipelines Agency – Trust Ports

(eg. Port of Dover, Port of Tyne, Harwich Haven. Milford Haven Port)

– Network Rail – British Rail Board Properties – Dartford Crossing

– Withdrawn

Greece Privatisation target to yield EUR7 billion within three years, including EUR1 billion in 2011 (increased from EUR3 billion target announced in June 2010).

– Hellenic Railways Organisation, OSE (up to 49% out of 100%)

– Athens International Airport (up to 55%)

– Athens Water Company, Eydap (10% out of 61%)

– Thessaloniki Water Company, Eyath (23% out of 74%)

– DEPA (up to 65%)

Ireland No explicit statement - National Recovery Plan 2011-2014 forecast EUR1 billion of capital receipts over the period. As a result, possible asset sales are only a sample of state-owned enterprises potentially attractive to investors.

– Dublin Airport Authority (incl. Dublin, Cork and Shannon Airports and Aer Rianta International)

– Port Companies (incl. Dublin, Cork, Drogheda and Galway)

– Electricity Supply Board – Bord Gais Eireann – Eirgrid – Irish Aviation Authority – Irish Rail – Environmental businesses

(incl. wind farms, CHP, waste management, WTE, etc)

Canada: CAD350–400 billion of total municipal, provincial and federal upgrading and new infrastructure needs (Mirza, 2009)

EU: EUR1 trillion investment required over the next decade in the EU’s energy system (EC, 2010)

Central and Eastern Europe: EUR500 billion shortfall compared with Western Europe (Deutsche Bank, 2004)

US: $2.2 trillion estimated investment need over next 5 years (ASCE, 2009)

LatAm: $800 billion investment required through 2014 (WEF, 2010)

MENA: Requirement to invest between $75–100 billion per annum to sustain growth rates and boost economic competitiveness (World Bank, 2010)

Sub-Saharan Africa: $93 billion per annum over 10 years required to raise Africa's infrastructure endowment to a reasonable level (World Bank, 2009)

Australia: AUSD130 billion needed to provide critical economic infrastructure projects (KPMG, 2008)

Asia: $300 billion per annum demand for infrastructure finance in Asia (ADB, 2010)

EUR15 billion of proceeds before 2013 connected with its strategy of reduced asset ownership. E.ON’s announcement follows similar initiatives from other corporates.

Where will the fi nancing come from?Banks have been the predominant source of debt funding for infrastructure investments. The availability of bank loans has, however, been adversely aff ected by increasing capital constraints, market retrenchment and the loss of syndication avenues. Borrowers have also been confronted with issues in select public markets such as the US municipal bond market.

As a result, infrastructure companies have started to look to other sources of capital such as the bond and private placement markets.

Investor demand for infrastructure assets is high because of their attractive investment characteristics. These include a high degree of cash-fl ow predictability, linkage of returns to infl ation (and, in certain cases,

general economic activity), capital security and the high cash yield component of returns.

The participation of these investors will become increasingly important in the years to come, particularly as outstanding infrastructure debt falls due. We estimate that around EUR50 billion of European infrastructure debt is due for refi nancing between 2012 and 2015.

The main source of equity capital for infrastructure has historically been the public equity markets. Over the past fi ve years, however, we have seen the rapid emergence of new private sources of equity capital: infrastructure funds and direct institutional investors (including pension funds, insurance companies and sovereign wealth funds). Approximately $100 billion was invested in private infrastructure funds between 2006 and 2008 and a further $25 billion has been invested in such funds thus far in 2010. Such alternative sources of capital are expected to play an increasingly important role in the fi nancing of infrastructure assets.

Sustained global growth in recent decades, combined with economic and social demands for improved infrastructure, has resulted in a signifi cant and increasing backlog of required spending on infrastructure facilities such as energy networks, water utilities, airports, roads and railways.

Infrastructure BacklogPrivatisation rises up the agenda

Figure 1: Infrastructure investment needs by region and country

Figure 2: Planned and possible privatisations


Paul MalanManaging Director, Infrastructure Investment Group

6.6Financing

Infrastructure shortfalls are a shared issue for both developing and developed countries. The World Economic Forum recently estimated the global infrastructure investment defi cit at $2 trillion per year over the next 20 years. Figure 1 shows a selection of estimates of infrastructure needs for regions compiled by a range of industry observers.

Such facilities and services have historically been provided by national governments but accumulated debt and the large budget defi cits of many sovereigns means that they will not be able to meet these infrastructure shortfalls on their own.

As a result, they are increasingly looking to the private sector to fi ll the gap for new investment as well as revisiting the scope for privatisation of existing public sector assets as an alternative source of funding. Figure 2 outlines general goals articulated by some countries and identifi es potential privatisation targets.

Privatisation programmes involving infrastructure have been a key source of government funding since the 1980s. The OECD estimates that over $1.4 trillion of state-owned enterprises were privatised during this period with infrastructure comprising approximately 60% of proceeds. Fiscal imperatives have been a key driver.

For example, the State Government of Victoria in Australia sold approximately A$30 billion of public assets in the 1990s and privatised services valued at a further A$10 billion. As a result, the ratio of state public debt to GDP fell from 27% in June 1995 to 3% in June 2000.

Looking forward, it seems inevitable that governments across the world will need to move increasingly towards the policy outlined by the UK government in its recent National Infrastructure Plan which stated its commitment to playing “its full part in promoting the

infrastructure investment the country needs, using all the available levers right across the range of private and public ownership models.”

Governments are not alone in looking to address capital scarcity and maximise asset and balance sheet effi ciency. An increasing number of privately-owned companies which are active in the infrastructure sector have also signalled their intention to rationalise asset portfolios and refocus activities. E.ON, for example, recently announced a signifi cant disposal program with a target of

Country General Objectives Sample of Possible Asset Sales

UK June 2010 budget provided for £1.5 billion of central government realisations in 2010/11 (already exceeded). Budget 2009 outlined the government’s plan to realise £16 billion in the period 2010-11 to 2013-2014 by selling assets and property.

– High Speed 1 – Sold for £2.1 billion in November 2010

– National Air Traffi c Service (49%) – Advisers appointed

– British Waterways – Oil and Pipelines Agency – Trust Ports

(eg. Port of Dover, Port of Tyne, Harwich Haven. Milford Haven Port)

– Network Rail – British Rail Board Properties – Dartford Crossing

– Withdrawn

Greece Privatisation target to yield EUR7 billion within three years, including EUR1 billion in 2011 (increased from EUR3 billion target announced in June 2010).

– Hellenic Railways Organisation, OSE (up to 49% out of 100%)

– Athens International Airport (up to 55%)

– Athens Water Company, Eydap (10% out of 61%)

– Thessaloniki Water Company, Eyath (23% out of 74%)

– DEPA (up to 65%)

Ireland No explicit statement - National Recovery Plan 2011-2014 forecast EUR1 billion of capital receipts over the period. As a result, possible asset sales are only a sample of state-owned enterprises potentially attractive to investors.

– Dublin Airport Authority (incl. Dublin, Cork and Shannon Airports and Aer Rianta International)

– Port Companies (incl. Dublin, Cork, Drogheda and Galway)

– Electricity Supply Board – Bord Gais Eireann – Eirgrid – Irish Aviation Authority – Irish Rail – Environmental businesses

(incl. wind farms, CHP, waste management, WTE, etc)

Canada: CAD350–400 billion of total municipal, provincial and federal upgrading and new infrastructure needs (Mirza, 2009)

EU: EUR1 trillion investment required over the next decade in the EU’s energy system (EC, 2010)

Central and Eastern Europe: EUR500 billion shortfall compared with Western Europe (Deutsche Bank, 2004)

US: $2.2 trillion estimated investment need over next 5 years (ASCE, 2009)

LatAm: $800 billion investment required through 2014 (WEF, 2010)

MENA: Requirement to invest between $75–100 billion per annum to sustain growth rates and boost economic competitiveness (World Bank, 2010)

Sub-Saharan Africa: $93 billion per annum over 10 years required to raise Africa's infrastructure endowment to a reasonable level (World Bank, 2009)

Australia: AUSD130 billion needed to provide critical economic infrastructure projects (KPMG, 2008)

Asia: $300 billion per annum demand for infrastructure finance in Asia (ADB, 2010)

EUR15 billion of proceeds before 2013 connected with its strategy of reduced asset ownership. E.ON’s announcement follows similar initiatives from other corporates.

Where will the fi nancing come from?Banks have been the predominant source of debt funding for infrastructure investments. The availability of bank loans has, however, been adversely aff ected by increasing capital constraints, market retrenchment and the loss of syndication avenues. Borrowers have also been confronted with issues in select public markets such as the US municipal bond market.

As a result, infrastructure companies have started to look to other sources of capital such as the bond and private placement markets.

Investor demand for infrastructure assets is high because of their attractive investment characteristics. These include a high degree of cash-fl ow predictability, linkage of returns to infl ation (and, in certain cases,

general economic activity), capital security and the high cash yield component of returns.

The participation of these investors will become increasingly important in the years to come, particularly as outstanding infrastructure debt falls due. We estimate that around EUR50 billion of European infrastructure debt is due for refi nancing between 2012 and 2015.

The main source of equity capital for infrastructure has historically been the public equity markets. Over the past fi ve years, however, we have seen the rapid emergence of new private sources of equity capital: infrastructure funds and direct institutional investors (including pension funds, insurance companies and sovereign wealth funds). Approximately $100 billion was invested in private infrastructure funds between 2006 and 2008 and a further $25 billion has been invested in such funds thus far in 2010. Such alternative sources of capital are expected to play an increasingly important role in the fi nancing of infrastructure assets.

Sustained global growth in recent decades, combined with economic and social demands for improved infrastructure, has resulted in a signifi cant and increasing backlog of required spending on infrastructure facilities such as energy networks, water utilities, airports, roads and railways.

Infrastructure BacklogPrivatisation rises up the agenda

Figure 1: Infrastructure investment needs by region and country

Figure 2: Planned and possible privatisations


7 Investing

Model PortfolioStock PickingExchange Traded FundsHedge FundsManaged AccountsAsset and Liability Management Portfolio TheoryGreen Investing


7 Investing

Model PortfolioStock PickingExchange Traded FundsHedge FundsManaged AccountsAsset and Liability Management Portfolio TheoryGreen Investing


7.1 Investing

Vinay Pande Chief Investment Advisor, Research

A Model Portfolio for 2011... and BeyondWhat assets to hold in an unstable world

Our recommended multi-asset portfolio (see figure 1) is specifically designed to address and benefit from an unstable and unpredictable world.

The portfolio is liquid and, for all intents and purposes, unlevered (with the exception of some relative value positions and some substantial long volatility or option positions).

The portfolio is divided into five main parts: 1. Deutsche Bank Research’s strategic assets, including equities in both developed and emerging markets, emerging market bonds, EMFX overlays, gold and commodities. These are assets we consider to have the biggest positively-biased asymmetric payoff profile, on an option-adjusted valuation basis, across multiple scenarios. This involves an assessment of the nature and intensity of each scenario against the option adjusted valuation of the asset in question. Currently equities and commodities score high marks on this reckoning.

2. Defensive assets, principally long regulated utility positions in Europe.

3. Defensive hedges, including equity variance swaps and a number of short-dated currency and rate option positions. For example, a large out-of-the-money receiver position in Australian interest rates is intended to address a debt deflation scenario, in which Australia’s strong domestic economic fundamentals are overwhelmed by global fundamentals. Large short dated EUR options are designed to protect a multi currency portfolio from USD appreciation, especially in a euro crisis scenario. And

so on. In all cases, as we do in the case of strategic assets, we are looking for cheap options on assets or derivatives with large asymmetric payoffs.

4. A relative value book, in which the largest trade is long US and European equities and short investment grade bonds (acquired synthetically) in the same two regions.

5. A currency overlay of long emerging market foreign exchange versus USD, EUR and GBP.

There is currently no excess cash recommended but there are large cash positions available against the face amount of derivative positions.

We recognise that the unstable world we live in will not last forever. Indeed we suspect that by the end of the decade we will enter a world of lower real growth, of emerging market currency appreciation and of possible higher inflation.

In such a world owning the longest-duration, highest real yielding assets available is a good strategy. Ideally these should be denominated in emerging market (EM) currencies (e.g. Brazilian inflation-linked bonds); or should be assets capable of being

In today’s world of unprecedented uncertainty, it is no longer possible to optimise investment portfolios on an asset class by asset class basis, nor are naïve asset allocation strategies acceptable. More focused investment strategies are required.

hedged back to EM currencies (e.g. Western European regulated utilities); or assets that mirror the behaviour of EM currencies (e.g. agricultural commodities, gold). Each of these asset classes should be bought whenever they are attractively priced, using capital accumulated by astutely navigating the current treacherous markets.

The essence of the investment philosophy is that it is forward-looking. We never assume that the future will resemble the past, unless there is strong reason to believe so. The experience of the very stable 1980s and 1990s has caused a lot of lazy habits to get institutionalised as conventional and acceptable practice as many market participants are learning to their cost.

Figure 1Recommended Portfolio

Weight

Global Equities

Emerging Market Equities

Long EStoxx Mar ‘11 2900 call

Latin American Equities

Brazil Real Bond 2045

Gold

Diversified Commodities

Agricultural Commodities

Short Euro, $, and GBP bskt versus

Long EM FX basket

Strategic Assets

Weight

S&P 500 6-mo Variance Swaps, 2-mo fwd

EURO STOXX 50 6-mo Var. Swaps, 2-mo fwd

Long 1-mo 5.0% AUD 10-Yr Receiver Swaption

Long 1-mo 1.25 EUR Put

Long 1-mo 1.35/1.30 EUR Put spread

Long 1-mo 1.40/1.475 EUR Call spread

Long 3.5-mo 3.65% USD 10-Yr Payer Swaption

Long 3.5-mo 4.05% GBP 10-Yr Payer Swaption

Long 2-mo GBP Put/YEN Call spread

Long 2-mo GBP Put/EUR Call spread

Long 2-mo AUD/Yen 77.5 Put

Short (short $, long RMB) 2-Mo NDF on RMB

81.5

Defensive Hedges

Weight

European Utilities

CAD & NOK TWI

Defensive Assets

Weight

20%of theportfolio

Tactical Overlays / Relative ValueTraders and other Assets

Weight

15%of theportfolio

FX Overlays / Hedges

Max positiveCash exposure equicalent (levered positions)

Portfolio recommendations as of Nov 22 ‘10; for more details, refer to out website gm.db.com/IAG/Research

This simulated portfolio has consistently outperformed both a portfolio of government bonds and an index of hedge funds every quarter since June 2006 with a total return of 163% (versus 47% and 22% respectively) a compound annual growth rate of 25% (versus 9% and 5%). Volatility has been confined to the 7-10% range, unless deliberately allowed to rise when the portfolio is experiencing a large option payoff (See figures 2 and 3).


7.1 Investing

Vinay Pande Chief Investment Advisor, Research

A Model Portfolio for 2011... and BeyondWhat assets to hold in an unstable world

Our recommended multi-asset portfolio (see figure 1) is specifically designed to address and benefit from an unstable and unpredictable world.

The portfolio is liquid and, for all intents and purposes, unlevered (with the exception of some relative value positions and some substantial long volatility or option positions).

The portfolio is divided into five main parts: 1. Deutsche Bank Research’s strategic assets, including equities in both developed and emerging markets, emerging market bonds, EMFX overlays, gold and commodities. These are assets we consider to have the biggest positively-biased asymmetric payoff profile, on an option-adjusted valuation basis, across multiple scenarios. This involves an assessment of the nature and intensity of each scenario against the option adjusted valuation of the asset in question. Currently equities and commodities score high marks on this reckoning.

2. Defensive assets, principally long regulated utility positions in Europe.

3. Defensive hedges, including equity variance swaps and a number of short-dated currency and rate option positions. For example, a large out-of-the-money receiver position in Australian interest rates is intended to address a debt deflation scenario, in which Australia’s strong domestic economic fundamentals are overwhelmed by global fundamentals. Large short dated EUR options are designed to protect a multi currency portfolio from USD appreciation, especially in a euro crisis scenario. And

so on. In all cases, as we do in the case of strategic assets, we are looking for cheap options on assets or derivatives with large asymmetric payoffs.

4. A relative value book, in which the largest trade is long US and European equities and short investment grade bonds (acquired synthetically) in the same two regions.

5. A currency overlay of long emerging market foreign exchange versus USD, EUR and GBP.

There is currently no excess cash recommended but there are large cash positions available against the face amount of derivative positions.

We recognise that the unstable world we live in will not last forever. Indeed we suspect that by the end of the decade we will enter a world of lower real growth, of emerging market currency appreciation and of possible higher inflation.

In such a world owning the longest-duration, highest real yielding assets available is a good strategy. Ideally these should be denominated in emerging market (EM) currencies (e.g. Brazilian inflation-linked bonds); or should be assets capable of being

In today’s world of unprecedented uncertainty, it is no longer possible to optimise investment portfolios on an asset class by asset class basis, nor are naïve asset allocation strategies acceptable. More focused investment strategies are required.

hedged back to EM currencies (e.g. Western European regulated utilities); or assets that mirror the behaviour of EM currencies (e.g. agricultural commodities, gold). Each of these asset classes should be bought whenever they are attractively priced, using capital accumulated by astutely navigating the current treacherous markets.

The essence of the investment philosophy is that it is forward-looking. We never assume that the future will resemble the past, unless there is strong reason to believe so. The experience of the very stable 1980s and 1990s has caused a lot of lazy habits to get institutionalised as conventional and acceptable practice as many market participants are learning to their cost.

Figure 1Recommended Portfolio

Weight

Global Equities

Emerging Market Equities

Long EStoxx Mar ‘11 2900 call

Latin American Equities

Brazil Real Bond 2045

Gold

Diversified Commodities

Agricultural Commodities

Short Euro, $, and GBP bskt versus

Long EM FX basket

Strategic Assets

Weight

S&P 500 6-mo Variance Swaps, 2-mo fwd

EURO STOXX 50 6-mo Var. Swaps, 2-mo fwd

Long 1-mo 5.0% AUD 10-Yr Receiver Swaption

Long 1-mo 1.25 EUR Put

Long 1-mo 1.35/1.30 EUR Put spread

Long 1-mo 1.40/1.475 EUR Call spread

Long 3.5-mo 3.65% USD 10-Yr Payer Swaption

Long 3.5-mo 4.05% GBP 10-Yr Payer Swaption

Long 2-mo GBP Put/YEN Call spread

Long 2-mo GBP Put/EUR Call spread

Long 2-mo AUD/Yen 77.5 Put

Short (short $, long RMB) 2-Mo NDF on RMB

81.5

Defensive Hedges

Weight

European Utilities

CAD & NOK TWI

Defensive Assets

Weight

20%of theportfolio

Tactical Overlays / Relative ValueTraders and other Assets

Weight

15%of theportfolio

FX Overlays / Hedges

Max positiveCash exposure equicalent (levered positions)

Portfolio recommendations as of Nov 22 ‘10; for more details, refer to out website gm.db.com/IAG/Research

This simulated portfolio has consistently outperformed both a portfolio of government bonds and an index of hedge funds every quarter since June 2006 with a total return of 163% (versus 47% and 22% respectively) a compound annual growth rate of 25% (versus 9% and 5%). Volatility has been confined to the 7-10% range, unless deliberately allowed to rise when the portfolio is experiencing a large option payoff (See figures 2 and 3).


Figure 2: Simulated portfolio performance since June 2006Source: Datastream, Hedge Fund Research Inc., iBoxx, DBIQ, Deutsche Bank GMR

18-qtrs return = 163% Simulated PortfolioCompound Annual Growth Rate iBx $ Treasuries 10Y+ = 25% p/a Hedge Fund Research Fund Weighted Comp Ind

Figure 4: Euro Stoxx 50 OAS/ERPSource: Datastream, Bloomberg Finance LP, PricewaterhouseCoopers, Standard & Poors, Deutsche Bank GMR

Euro Stoxx 50 ERP Euro Stoxx 50 OAS/ERP

Figure 5: S&P 500 OAS/ERPSource: Datastream, Bloomberg Finance LP, PricewaterhouseCoopers, Standard & Poors, Deutsche Bank GMR

S&P 500 ERP S&P 500 OAS/ERP

Figure 6: Equity risk premia convergence: EM versus USSource: Datastream, Bloomberg Finance LP, PricewaterhouseCoopers, IBES, Deutsche Bank GMR

ERP spread (MSCI EM in USD less S&P 500) EM FX index

Figure 3: Simulated portfolio realised volatilitySource: Datastream, Hedge Fund Research Inc., iBoxx, DBIQ, Deutsche Bank GMR

3-mo rolling Simulated Portfolioann. volatility iBx $ Treasuries 10Y+ Hedge Fund Research Fund Weighted Comp Ind

Jun 06 Dec 06 Jun 07 Dec 07Jun 08 Dec 08 Jun 09 Dec 09 Jun 10 Dec 10

80

100

120

140

160

180

200

220

240

260

280

00 01 02 03 04 05 06 07 08 09 10

0

1

2

3

4

5

6

7

8

9

10

11%


0

5

10

15

20

25

30

35

40 3 – Mo rolling ann. volatility, %

97 98 99 00 01 02 03 04 05 06 07 08 09 10

0

1

2

3

4

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7

8

9

10

11%

01 02 03 04 05 06 07 08 09 10

1

2

3

4

5

6

7% EPR Spread

60

70

80

90

100

110

120EM FX

7.1 Investing

Deutsche Bank research’s central scenario is that we come out of this crisis alive; it is a sentiment that we subscribe to. We have suffered a market failure, of that there is no doubt, and powerful policy medicine needs to be applied (and is being applied) to further the healing process. There is no guarantee that these policy measures will work and the ex-ante probability of failure has to be assumed to be considerable. The reason for our cautious stance is that the consequences for portfolio performance of such an outcome is likely existential.

However an isolated market failure is NOT proof that free markets can now never work, and it is in that context that rampant bearishness and pessimism looks misplaced. An essential part of the policy medicine is to keep interest rates well behaved for an extended period and hence Deutsche Bank’s bullish central argument for bonds.

The reason we do not own US and European bonds in our portfolio is that we are not constrained to own them. We would also rather receive this policy subsidy than pay it and find bond performance a not very challenging hurdle rate for a well constructed portfolio. As figures 4 and 5 show, the spreads on some risk assets, especially equities, are close to unprecedented levels versus much of the fixed income universe, especially bonds. That risk assets of these kinds earn their place in our portfolio on their own merit should be evident from these charts.


Figure 2: Simulated portfolio performance since June 2006Source: Datastream, Hedge Fund Research Inc., iBoxx, DBIQ, Deutsche Bank GMR

18-qtrs return = 163% Simulated PortfolioCompound Annual Growth Rate iBx $ Treasuries 10Y+ = 25% p/a Hedge Fund Research Fund Weighted Comp Ind

Figure 4: Euro Stoxx 50 OAS/ERPSource: Datastream, Bloomberg Finance LP, PricewaterhouseCoopers, Standard & Poors, Deutsche Bank GMR

Euro Stoxx 50 ERP Euro Stoxx 50 OAS/ERP

Figure 5: S&P 500 OAS/ERPSource: Datastream, Bloomberg Finance LP, PricewaterhouseCoopers, Standard & Poors, Deutsche Bank GMR

S&P 500 ERP S&P 500 OAS/ERP

Figure 6: Equity risk premia convergence: EM versus USSource: Datastream, Bloomberg Finance LP, PricewaterhouseCoopers, IBES, Deutsche Bank GMR

ERP spread (MSCI EM in USD less S&P 500) EM FX index

Figure 3: Simulated portfolio realised volatilitySource: Datastream, Hedge Fund Research Inc., iBoxx, DBIQ, Deutsche Bank GMR

3-mo rolling Simulated Portfolioann. volatility iBx $ Treasuries 10Y+ Hedge Fund Research Fund Weighted Comp Ind


80

100

120

140

160

180

200

220

240

260

280

00 01 02 03 04 05 06 07 08 09 10

0

1

2

3

4

5

6

7

8

9

10

11%


0

5

10

15

20

25

30

35

40 3 – Mo rolling ann. volatility, %

97 98 99 00 01 02 03 04 05 06 07 08 09 10

0

1

2

3

4

5

6

7

8

9

10

11%

01 02 03 04 05 06 07 08 09 10

1

2

3

4

5

6

7% EPR Spread

60

70

80

90

100

110

120EM FX

7.1 Investing

Deutsche Bank research’s central scenario is that we come out of this crisis alive; it is a sentiment that we subscribe to. We have suffered a market failure, of that there is no doubt, and powerful policy medicine needs to be applied (and is being applied) to further the healing process. There is no guarantee that these policy measures will work and the ex-ante probability of failure has to be assumed to be considerable. The reason for our cautious stance is that the consequences for portfolio performance of such an outcome is likely existential.

However an isolated market failure is NOT proof that free markets can now never work, and it is in that context that rampant bearishness and pessimism looks misplaced. An essential part of the policy medicine is to keep interest rates well behaved for an extended period and hence Deutsche Bank’s bullish central argument for bonds.

The reason we do not own US and European bonds in our portfolio is that we are not constrained to own them. We would also rather receive this policy subsidy than pay it and find bond performance a not very challenging hurdle rate for a well constructed portfolio. As figures 4 and 5 show, the spreads on some risk assets, especially equities, are close to unprecedented levels versus much of the fixed income universe, especially bonds. That risk assets of these kinds earn their place in our portfolio on their own merit should be evident from these charts.


Stock Picking Strategies for 2011? What value analysis tells us

Francesco Curto Managing Director Head of CROCI Research

7.2 Investing

The drawbacks of macro-oriented strategies were evident in the risk-on, risk-off trading that characterised much of 2010. Investors who bought in April on hopes of a sustained global recovery would have entered at the peak of the market.

Those who sold positions in June – fearing that Europe’s sovereign debt crisis would spark a systemic melt-down – would have exited at the bottom and missed a 20% run-up in global stock indices during September.

Market patterns in 2010 highlight that equity prices tend to move ahead of macro data; which is why we believe the strategies that will work best in 2011 will be those that look past the macro distractions and continue pursuing value. Our analysis shows that, in the 12 months to last November, focusing solely on identifying value among the 750 companies that the CROCI team cover would have generated 400 basis points of outperformance.

CROCI (Cash Return On Capital Invested) is a proprietary equity valuation process. It was developed in 1996 to help Deutsche Bank’s institutional investor clients compare stock valuations across a broad range of industries and countries on a like-for-like basis. It does this by removing the noise created by reported accounts and ironing out differences between accounting treatment of things like inflation in different countries.

Of course, identifying real value is no simple task. Emerging markets, one of the supposedly hot investment themes of 2011, are a case in point. Massive investment flows have been directed to the emerging world in recent months, partly on the expectation that emerging markets will drive the global economic recovery, but also because, on the surface, emerging equities trade at a significant discount to their developed world peers.

Our research shows that, although emerging markets may appear undervalued at an aggregate level, on Economic PE (the CROCI version

of the price-earnings ratio), most of the discount stems from the fact that regional benchmarks are heavily weighted towards commodities, utilities and financials. Strip out the sectoral bias, and emerging markets look considerably less attractive on a relative basis.

In any case, emerging market equities will not necessarily provide the best exposure to emerging market economies. The engine of economic activity is supposed to be the consumer, and yet consumer sectors are significantly underrepresented in emerging indices. We think investors are better off looking at select consumer companies in Europe and the U.S. that have sizeable emerging market operations. But as the CROCI models have been flagging since the middle of 2010, value opportunities are scarce in consumer sectors worldwide. Nevertheless, we have identified a number of consumer companies – such as Procter & Gamble, which derives

about 30% of its sales from emerging markets – that still represent value.

CROCI analysis has revealed other traps investors should be wary of in 2011. With US ex-financials yielding close to 10-year Treasuries, dividends are becoming an attractive asset class. However, only 15% of companies we analysed passed our dividend sustainability screen. In fact, sectors with the highest yields (telecoms, utilities and energy) ranked the lowest in their ability to maintain dividend pay-outs. To see rising dividends across the board we will need top-line growth, which looks challenging in the current environment. Once again, there are opportunities here, but selectivity will be key.

Staying true to a value strategy in 2011 will require discipline. A raft of macro worries still overhang markets, including the sovereign debt crisis, currency wars and Chinese policy

With so much uncertainty hanging over markets, which equity strategies will work in 2011? In our view, valuation-focused stock picking proved its worth in the volatile environment of the past year and will do so again in the year ahead.

tightening. However, value-focused investors may be able to turn the resulting volatility to their advantage. Provided the global economy is not about to slip back into recession – and so far governments and central banks have shown themselves prepared to do whatever it takes to prevent that outcome – buyers should consider using the dips as entry points. A steady nerve will be required, but – armed with the right strategy – investors should not be deterred.


Stock Picking Strategies for 2011? What value analysis tells us

Francesco Curto Managing Director Head of CROCI Research

7.2 Investing

The drawbacks of macro-oriented strategies were evident in the risk-on, risk-off trading that characterised much of 2010. Investors who bought in April on hopes of a sustained global recovery would have entered at the peak of the market.

Those who sold positions in June – fearing that Europe’s sovereign debt crisis would spark a systemic melt-down – would have exited at the bottom and missed a 20% run-up in global stock indices during September.

Market patterns in 2010 highlight that equity prices tend to move ahead of macro data; which is why we believe the strategies that will work best in 2011 will be those that look past the macro distractions and continue pursuing value. Our analysis shows that, in the 12 months to last November, focusing solely on identifying value among the 750 companies that the CROCI team cover would have generated 400 basis points of outperformance.

CROCI (Cash Return On Capital Invested) is a proprietary equity valuation process. It was developed in 1996 to help Deutsche Bank’s institutional investor clients compare stock valuations across a broad range of industries and countries on a like-for-like basis. It does this by removing the noise created by reported accounts and ironing out differences between accounting treatment of things like inflation in different countries.

Of course, identifying real value is no simple task. Emerging markets, one of the supposedly hot investment themes of 2011, are a case in point. Massive investment flows have been directed to the emerging world in recent months, partly on the expectation that emerging markets will drive the global economic recovery, but also because, on the surface, emerging equities trade at a significant discount to their developed world peers.

Our research shows that, although emerging markets may appear undervalued at an aggregate level, on Economic PE (the CROCI version

of the price-earnings ratio), most of the discount stems from the fact that regional benchmarks are heavily weighted towards commodities, utilities and financials. Strip out the sectoral bias, and emerging markets look considerably less attractive on a relative basis.

In any case, emerging market equities will not necessarily provide the best exposure to emerging market economies. The engine of economic activity is supposed to be the consumer, and yet consumer sectors are significantly underrepresented in emerging indices. We think investors are better off looking at select consumer companies in Europe and the U.S. that have sizeable emerging market operations. But as the CROCI models have been flagging since the middle of 2010, value opportunities are scarce in consumer sectors worldwide. Nevertheless, we have identified a number of consumer companies – such as Procter & Gamble, which derives

about 30% of its sales from emerging markets – that still represent value.

CROCI analysis has revealed other traps investors should be wary of in 2011. With US ex-financials yielding close to 10-year Treasuries, dividends are becoming an attractive asset class. However, only 15% of companies we analysed passed our dividend sustainability screen. In fact, sectors with the highest yields (telecoms, utilities and energy) ranked the lowest in their ability to maintain dividend pay-outs. To see rising dividends across the board we will need top-line growth, which looks challenging in the current environment. Once again, there are opportunities here, but selectivity will be key.

Staying true to a value strategy in 2011 will require discipline. A raft of macro worries still overhang markets, including the sovereign debt crisis, currency wars and Chinese policy

With so much uncertainty hanging over markets, which equity strategies will work in 2011? In our view, valuation-focused stock picking proved its worth in the volatile environment of the past year and will do so again in the year ahead.

tightening. However, value-focused investors may be able to turn the resulting volatility to their advantage. Provided the global economy is not about to slip back into recession – and so far governments and central banks have shown themselves prepared to do whatever it takes to prevent that outcome – buyers should consider using the dips as entry points. A steady nerve will be required, but – armed with the right strategy – investors should not be deterred.


The European exchange-traded products (ETP) market, covering both exchange-traded funds (ETF) and exchange-traded commodities (ETC), has grown exponentially over the last 10 years, and continues to do so. By mid-November 2010, European ETF assets under management (AUM) were up almost 30% year-to-date, taking the total AUM fi gure to EUR219 billion1. The European market is dominated by institutional investors, so much of this substantial growth can be attributed to the increasing use of ETFs by pension funds, asset managers and other professional investment groups.

US, Europe, Asia-Pacifi c ETF assets under management

Exchange Traded FundsOn the march

Thorsten Michalik Head of Exchange Traded Funds

Manooj MistryHead of ETF Structuring

7.3Investing

ETFs are low cost index products that trade on stock exchanges just like regular shares. As such, ETFs are being used by institutional investors for a variety of purposes.

General asset allocationInstitutional investors traditionally gain diversifi cation by buying and selling across the entire range of a portfolio. But this is costly and time consuming. Institutions can take advantage of the diversifi cation built into ETFs to simplify this process while saving on trading costs. For example, ETFs off er an eff ective method of implementing a ‘core/satellite’ strategy where, for instance, the investor might have the conservative, core part of the portfolio invested in well-known equity and fi xed income benchmarks while placing the outer, satellite parts in ETFs linked to emerging markets equities, or to alternative assets, such as commodity or currency indexes, or even to hedge fund indexes (all of which are accessible in ETF format). ETFs are also eff ective tools for fi lling any sector or regional exposure gaps in a portfolio.

Cash equitisation All professional fund managers will at times fi nd they have cash sitting idle as it awaits allocation. The cheap and easy way in which ETF are traded means idle cash can be put to work in the short-term while a longer-term allocation is being decided. This lowers cash drag on a portfolio, boosting returns overall.

Hedging strategiesBecause they can be sold short, ETFs can be used as an alternative to derivatives for hedging portfolios. Also, unlike futures positions, ETF positions do not have to be rolled over.

Dynamic trading strategiesETFs can be used by active investors in a number of ways. For example, they can be used to implement

a sector rotation strategy, which involves taking exposure to, or cancelling exposure to, particular sectors depending on that sector’s economic prospects. Dynamic institutional investors can also use ETFs to put in place strategies designed to generate ‘alpha’ – above market returns – by combining long and short strategies. For instance, if a manager is bearish on US equities but bullish on commodities then he or she could take a short term position in an S&P 500 inverse daily ETF, which gives short S&P 500 exposure, and combine it with a position in the Deutsche Bank Liquid Commodity Index ETF, which tracks the performance of 14 diff erent commodities.

Fixed income and credit adjustmentsETFs are an eff ective way for liability-driven investors to alter duration and credit exposure to meet specifi ed targets, while ETFs that single out infl ation risk, and therefore can be used to rein in infl ation exposure, are also available.

In short, ETFs are becoming increasingly popular with institutional investors partly because they let those investors engage in the kinds of activities they have always engaged in but in a cheap, liquid and reliable format, and/or because they let them meet contemporary asset-liability management challenges. The institutional take-up of ETFs should, therefore, only continue to grow.

The real challenge for European ETF providers at the moment lies in convincing higher numbers of retail investors to use ETFs. This is where the European market currently lags, by a long way, the market in the US. In the US, ETF use is roughly split equally between retail and institutional client segments. Partly this is because most ETFs are linked to stock market returns, and the US retail market has a tradition of being comfortable

About db x-trackersdb x-trackers are Exchange Traded Funds (‘ETFs’). db x-trackers was launched in January 2007 and is now one of the leading ETF providers in Europe.

db x-trackers ETFs are listed on nine diff erent exchanges across Europe and Asia (Borsa Italiana, Borsa de Madrid, Frankfurt Xetra, Paris Euronext, London Stock Exchange, Zurich SIX Swiss Exchange, NasdaqOMX Stockholm, Singapore Exchange and Hong Kong Stock Exchange).

The ETFs are based on various asset classes including equities, fi xed income, currencies and commodities. Investors are able to invest in a very transparent, fl exible and effi cient way. db x-trackers ETFs are domiciled in either Luxembourg or Dublin and comply with the UCITS III regulations.

More information on db x-trackers can be found on www.dbxtrackers.com

Exchange-traded funds (ETFs) are well on the way to becoming accepted as mainstream investments by institutional investors who are increasingly recognising the benefi ts of using the products for their daily investment needs. The challenge is to get more European retail investors to also see those benefi ts.

1. Source: Deutsche Bank, Bloomberg Finance LP

holding equity risk. However, it is surely also a refl ection of the fact that US retail investors are better informed in terms of understanding the benefi ts of using ETFs. The challenge for European providers is to communicate those benefi ts to Europe’s retail market, while continuing to embrace increasing usage by institutional investors.

800

1000

1200

1400

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2000

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1000

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0

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2003 2004 2005 2006 2007 2008 2009 2010YTD*

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TFs


The European exchange-traded products (ETP) market, covering both exchange-traded funds (ETF) and exchange-traded commodities (ETC), has grown exponentially over the last 10 years, and continues to do so. By mid-November 2010, European ETF assets under management (AUM) were up almost 30% year-to-date, taking the total AUM fi gure to EUR219 billion1. The European market is dominated by institutional investors, so much of this substantial growth can be attributed to the increasing use of ETFs by pension funds, asset managers and other professional investment groups.

US, Europe, Asia-Pacifi c ETF assets under management

Exchange Traded FundsOn the march

Thorsten Michalik Head of Exchange Traded Funds

Manooj MistryHead of ETF Structuring

7.3Investing

ETFs are low cost index products that trade on stock exchanges just like regular shares. As such, ETFs are being used by institutional investors for a variety of purposes.

General asset allocationInstitutional investors traditionally gain diversifi cation by buying and selling across the entire range of a portfolio. But this is costly and time consuming. Institutions can take advantage of the diversifi cation built into ETFs to simplify this process while saving on trading costs. For example, ETFs off er an eff ective method of implementing a ‘core/satellite’ strategy where, for instance, the investor might have the conservative, core part of the portfolio invested in well-known equity and fi xed income benchmarks while placing the outer, satellite parts in ETFs linked to emerging markets equities, or to alternative assets, such as commodity or currency indexes, or even to hedge fund indexes (all of which are accessible in ETF format). ETFs are also eff ective tools for fi lling any sector or regional exposure gaps in a portfolio.

Cash equitisation All professional fund managers will at times fi nd they have cash sitting idle as it awaits allocation. The cheap and easy way in which ETF are traded means idle cash can be put to work in the short-term while a longer-term allocation is being decided. This lowers cash drag on a portfolio, boosting returns overall.

Hedging strategiesBecause they can be sold short, ETFs can be used as an alternative to derivatives for hedging portfolios. Also, unlike futures positions, ETF positions do not have to be rolled over.

Dynamic trading strategiesETFs can be used by active investors in a number of ways. For example, they can be used to implement

a sector rotation strategy, which involves taking exposure to, or cancelling exposure to, particular sectors depending on that sector’s economic prospects. Dynamic institutional investors can also use ETFs to put in place strategies designed to generate ‘alpha’ – above market returns – by combining long and short strategies. For instance, if a manager is bearish on US equities but bullish on commodities then he or she could take a short term position in an S&P 500 inverse daily ETF, which gives short S&P 500 exposure, and combine it with a position in the Deutsche Bank Liquid Commodity Index ETF, which tracks the performance of 14 diff erent commodities.

Fixed income and credit adjustmentsETFs are an eff ective way for liability-driven investors to alter duration and credit exposure to meet specifi ed targets, while ETFs that single out infl ation risk, and therefore can be used to rein in infl ation exposure, are also available.

In short, ETFs are becoming increasingly popular with institutional investors partly because they let those investors engage in the kinds of activities they have always engaged in but in a cheap, liquid and reliable format, and/or because they let them meet contemporary asset-liability management challenges. The institutional take-up of ETFs should, therefore, only continue to grow.

The real challenge for European ETF providers at the moment lies in convincing higher numbers of retail investors to use ETFs. This is where the European market currently lags, by a long way, the market in the US. In the US, ETF use is roughly split equally between retail and institutional client segments. Partly this is because most ETFs are linked to stock market returns, and the US retail market has a tradition of being comfortable

About db x-trackersdb x-trackers are Exchange Traded Funds (‘ETFs’). db x-trackers was launched in January 2007 and is now one of the leading ETF providers in Europe.

db x-trackers ETFs are listed on nine diff erent exchanges across Europe and Asia (Borsa Italiana, Borsa de Madrid, Frankfurt Xetra, Paris Euronext, London Stock Exchange, Zurich SIX Swiss Exchange, NasdaqOMX Stockholm, Singapore Exchange and Hong Kong Stock Exchange).

The ETFs are based on various asset classes including equities, fi xed income, currencies and commodities. Investors are able to invest in a very transparent, fl exible and effi cient way. db x-trackers ETFs are domiciled in either Luxembourg or Dublin and comply with the UCITS III regulations.

More information on db x-trackers can be found on www.dbxtrackers.com

Exchange-traded funds (ETFs) are well on the way to becoming accepted as mainstream investments by institutional investors who are increasingly recognising the benefi ts of using the products for their daily investment needs. The challenge is to get more European retail investors to also see those benefi ts.

1. Source: Deutsche Bank, Bloomberg Finance LP

holding equity risk. However, it is surely also a refl ection of the fact that US retail investors are better informed in terms of understanding the benefi ts of using ETFs. The challenge for European providers is to communicate those benefi ts to Europe’s retail market, while continuing to embrace increasing usage by institutional investors.

800

1000

1200

1400

160§0 3000

2500

2000

1500

1000

500

0

600

400

200

2003 2004 2005 2006 2007 2008 2009 2010YTD*

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Asia Pacific ($)Europe ($)US ($)Number of ETPs

AU

M (

$ b

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n)

Nu

mb

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TFs


The EU Directive on Hedge Funds How will the new rules affect hedge funds and investors?

Anthony Byrne Global Head of Securities Lending, European Co-Head of Prime Finance

7.4 Investing

The EU Alternative Investment Fund Managers Directive (AIFMD), approved by the European Parliament in November 2010, will have a major impact on European hedge fund industry and potentially far-reaching implications for European investors in alternative funds.

The key changes concern the way in which funds are marketed to investors, the amount of leverage a fund can take, and the introduction of a depositary requirement.

They are less onerous than those originally proposed but remain significant, requiring hedge funds to make significant alterations to their business model.

It is important to note that while the directive has been passed by the European Parliament, the details are still being finalised under the Level 2 rule making process. The box on the opposite page sets out the timetable.

The directive applies to all alternative investment fund managers (AIFM), both inside and outside the EU, who wish to market their funds to European investors. It sets out a harmonised regime for authorisation of EU AIFMs, common transparency as well as operational requirements. It also establishes a new marketing regime for EU and non-EU alternative investment funds (AIF) by any manager.

The two most hotly debated issues relate to the marketing of the funds of non-EU managers to EU investors and depository liability.

Marketing Central to the directive is a marketing passport under which an AIFM authorised in one EU member state will be able to market an AIF to investors in other member states without additional authorisation or registration requirements. After much discussion and many revised drafts of the text, it was finally agreed that the passport will automatically be available to EU AIFMs managing EU AIFs, but its extension to cover the marketing of non-EU AIFs (by both EU and non-EU managers) was deferred by two years to early 2015.

The most significant positive development for non-EU AIFs is the extension of the national private placement regimes (NPPRs) until at least 2018. This is the regime used by the majority of the hedge fund industry for marketing to European investors today and will not be ‘switched off’ in 2018 unless there is a workable passport in place. So there is still a risk on the horizon, but it is a much better situation than was originally proposed.

Depository and other provisions Unfortunately there are still many undefined areas which may place significant liabilities on service providers and hence will increase costs to the fund and ultimately, investors. For example, each AIFM will be required to appoint a depository responsible for custody, monitoring subscriptions and redemptions, cash flows and valuation. While wording around the depository liability and delegation of responsibility was softened in the final draft, it still raises many questions which could fundamentally change the legal and operating model of prime brokers and custodians.

The AIFM must also comply with other rules covering delegation of functions, leverage, remuneration, annual reports, disclosures to investors, reporting obligations to authorities, valuation and conflicts of interest. Details of these are yet to be finalised and while most firms capture the information, these requirements will place a significant burden in both time and cost to report and measure.

What’s next? As mentioned above, the Level 2 rule making process is upon us and many in the industry view this with some concern. The European leadership decided they would need to reform the supervisory system in the wake of the crisis and will create the European Securities and Markets Authority (ESMA) on the 1st January, 2011. It will be responsible for all matters related to securities markets, exchanges, asset management, rating agencies and also clearing houses and while it will not have direct supervisory powers, it will act as an umbrella organisation for regulators. Notably if there are disputes between competent authorities ESMA will be allowed to settle them in a binding manner. The decision of ESMA will be the final determination as to how the dispute should be resolved.

In relation to AIFMD, there are many different areas in which ESMA will play an important role, ranging from publishing guidelines through to rule making. It is expected to provide the main policy and technical input to the Commission and most expect its powers to increase over time.

Many industry participants and observers feel the end result, while still uncertain, presents a workable solution for most hedge funds utilising the NPPRs while details regarding the passport are determined in the Level 2 process.

Timetable

November 11, 2010 Final text adopted by European Parliament and Level 2 secondary rule making begins

Early 2013 Member states required to transpose the Directive into their national laws. Both EU and Non-EU managers who manage non-EU funds will be able to continue to make use of the National Private Placement Regime (NPPR’s) until at least 2018.

2015 Passport for Non-EU managers may (but also may not be) switched on. The Passport will run in parallel with the existing private placement regime until 2018.

2017 Directive subject to review on its application and scope.

2018 If the Passport is determined to be successful, the National Private Placement Regime may be switched off.


The EU Directive on Hedge Funds How will the new rules affect hedge funds and investors?

Anthony Byrne Global Head of Securities Lending, European Co-Head of Prime Finance

7.4 Investing

The EU Alternative Investment Fund Managers Directive (AIFMD), approved by the European Parliament in November 2010, will have a major impact on European hedge fund industry and potentially far-reaching implications for European investors in alternative funds.

The key changes concern the way in which funds are marketed to investors, the amount of leverage a fund can take, and the introduction of a depositary requirement.

They are less onerous than those originally proposed but remain significant, requiring hedge funds to make significant alterations to their business model.

It is important to note that while the directive has been passed by the European Parliament, the details are still being finalised under the Level 2 rule making process. The box on the opposite page sets out the timetable.

The directive applies to all alternative investment fund managers (AIFM), both inside and outside the EU, who wish to market their funds to European investors. It sets out a harmonised regime for authorisation of EU AIFMs, common transparency as well as operational requirements. It also establishes a new marketing regime for EU and non-EU alternative investment funds (AIF) by any manager.

The two most hotly debated issues relate to the marketing of the funds of non-EU managers to EU investors and depository liability.

Marketing Central to the directive is a marketing passport under which an AIFM authorised in one EU member state will be able to market an AIF to investors in other member states without additional authorisation or registration requirements. After much discussion and many revised drafts of the text, it was finally agreed that the passport will automatically be available to EU AIFMs managing EU AIFs, but its extension to cover the marketing of non-EU AIFs (by both EU and non-EU managers) was deferred by two years to early 2015.

The most significant positive development for non-EU AIFs is the extension of the national private placement regimes (NPPRs) until at least 2018. This is the regime used by the majority of the hedge fund industry for marketing to European investors today and will not be ‘switched off’ in 2018 unless there is a workable passport in place. So there is still a risk on the horizon, but it is a much better situation than was originally proposed.

Depository and other provisions Unfortunately there are still many undefined areas which may place significant liabilities on service providers and hence will increase costs to the fund and ultimately, investors. For example, each AIFM will be required to appoint a depository responsible for custody, monitoring subscriptions and redemptions, cash flows and valuation. While wording around the depository liability and delegation of responsibility was softened in the final draft, it still raises many questions which could fundamentally change the legal and operating model of prime brokers and custodians.

The AIFM must also comply with other rules covering delegation of functions, leverage, remuneration, annual reports, disclosures to investors, reporting obligations to authorities, valuation and conflicts of interest. Details of these are yet to be finalised and while most firms capture the information, these requirements will place a significant burden in both time and cost to report and measure.

What’s next? As mentioned above, the Level 2 rule making process is upon us and many in the industry view this with some concern. The European leadership decided they would need to reform the supervisory system in the wake of the crisis and will create the European Securities and Markets Authority (ESMA) on the 1st January, 2011. It will be responsible for all matters related to securities markets, exchanges, asset management, rating agencies and also clearing houses and while it will not have direct supervisory powers, it will act as an umbrella organisation for regulators. Notably if there are disputes between competent authorities ESMA will be allowed to settle them in a binding manner. The decision of ESMA will be the final determination as to how the dispute should be resolved.

In relation to AIFMD, there are many different areas in which ESMA will play an important role, ranging from publishing guidelines through to rule making. It is expected to provide the main policy and technical input to the Commission and most expect its powers to increase over time.

Many industry participants and observers feel the end result, while still uncertain, presents a workable solution for most hedge funds utilising the NPPRs while details regarding the passport are determined in the Level 2 process.

Timetable

November 11, 2010 Final text adopted by European Parliament and Level 2 secondary rule making begins

Early 2013 Member states required to transpose the Directive into their national laws. Both EU and Non-EU managers who manage non-EU funds will be able to continue to make use of the National Private Placement Regime (NPPR’s) until at least 2018.

2015 Passport for Non-EU managers may (but also may not be) switched on. The Passport will run in parallel with the existing private placement regime until 2018.

2017 Directive subject to review on its application and scope.

2018 If the Passport is determined to be successful, the National Private Placement Regime may be switched off.


Hedge Fund Investors Turn to Managed Accounts Good news for investors and hedge fund managers

Martin Fothergill Director Global Fund Derivatives Group

7.5 Investing

This is a huge shift on past years when managed accounts accounted for less than 5% of inflows to hedges funds.

So what’s driving this trend and what are the implications for investors and managers?

The rise in managed accounts can be traced back to the well-documented events of 2008 which had a profound impact on the way that hedge fund managers and their investors interact.

The desire, and in many cases necessity, for investors to receive more detailed information regarding their investments and have more control over their liquidity resulted in a positive reaction by many hedge funds.

This manifested itself in numerous ways ranging from hedge funds simply being more forthcoming in providing investors with information, improving liquidity terms, and in some cases, fully restructuring their offerings. In an increasing number of cases the result was to allow investors to implement managed account solutions where the investor has more control over and transparency with their own investments.

The Madoff fraud is often cited as the key catalyst in catapulting hedge fund managed accounts to centre stage. While it – and other smaller frauds – have undoubtedly had a meaningful impact, we have found that, two years on, it is the liquidity issues that the industry suffered that seems to have left the most indelible impression.

The problem was an asset-liability mismatch between the liquidity of the hedge vehicle (i.e. the liquidity offered to investors) compared to the liquidity of the underlying portfolio. In the dark days of H2 08 the ‘perfect storm’ occurred, with investors requesting to redeem significant amounts of capital from hedge funds during a period of extreme market illiquidity.

This had an impact across a wide range of hedge funds, ranging from previously liquid hedge fund portfolios with for example monthly liquidity to illiquid strategies with much longer redemption terms. The common theme was the mismatch in liquidity which caused difficulties for all participants. Firms with less liquid strategies commonly suspended their funds, or gated them (limiting the amount of capital that could be redeemed each month or quarter) or transferred the most illiquid portion of the portfolio into ‘side-pockets’. Even those hedge funds which remained fully liquid during the period suffered as investors turned to them as a provider of much needed redemption proceeds.

Consequently investors faced either investment losses or delays in retrieving their cash, realising that just because a fund offered monthly or quarterly redemptions that would not necessarily happen.

These crisis-related difficulties prompted a reassessment of how best to tackle hedge fund investment, and led directly to an increase in the popularity of managed accounts. Hence, having transparency in a portfolio and the ability to monitor,

and control the liquidity of the securities is a significant benefit to investors, and a meaningful change from the ‘arm’s length’ arrangement of investing in a regular fund vehicle. This is one of the core principles behind managed accounts and one of the reasons why they are being increasingly embraced by investors.

What about the hedge fund managers themselves? We have seen a number of trends. Many hedge funds are increasingly open to the idea of managed accounts and the concept of providing associated levels of transparency and liquidity. Furthermore, some funds are in a better position to offer managed accounts because they have addressed the asset-liability imbalance, typically by removing the illiquid portfolio component which proved so troublesome during the crisis.

Firms are also looking closely at their investor bases, the concentration of which contributed to their difficulties during the crisis. They are concluding that the traditional offshore fund structure will not capture a sufficiently diverse investor base and actually precludes them from many investor types. Offering managed accounts is

an important tool being embraced by many managers because managed accounts – and managed account platforms in particular – are attractive not only to existing hedge fund investors but, more importantly, to an entirely new client base.

Another twist on this theme is for firms to offer their funds in regulated UCITS III vehicles, either as single funds or in ‘index’ products which combine a series of managed accounts into a UCITS III compliant index which can be wrapped as a fund or ETF. Such combinations of liquid, transparent and risk controlled managed accounts combined with UCITS III regulation has proved very popular with investors over the last 12 months.

Around twenty percent of the money being invested in hedge funds is not going directly into hedge funds but into managed accounts.

Managed accounts offer investors similar returns to the main hedge fund offered by a firm. But they differ from direct investment in several key respects, offering improved liquidity, transparency and investor control. They also allow clients to segregate their investments in vehicles separate from the main hedge fund, meaning investors retain control over their assets, usually with the ability to redeem much more frequently than the main fund.


Hedge Fund Investors Turn to Managed Accounts Good news for investors and hedge fund managers

Martin Fothergill Director Global Fund Derivatives Group

7.5 Investing

This is a huge shift on past years when managed accounts accounted for less than 5% of inflows to hedges funds.

So what’s driving this trend and what are the implications for investors and managers?

The rise in managed accounts can be traced back to the well-documented events of 2008 which had a profound impact on the way that hedge fund managers and their investors interact.

The desire, and in many cases necessity, for investors to receive more detailed information regarding their investments and have more control over their liquidity resulted in a positive reaction by many hedge funds.

This manifested itself in numerous ways ranging from hedge funds simply being more forthcoming in providing investors with information, improving liquidity terms, and in some cases, fully restructuring their offerings. In an increasing number of cases the result was to allow investors to implement managed account solutions where the investor has more control over and transparency with their own investments.

The Madoff fraud is often cited as the key catalyst in catapulting hedge fund managed accounts to centre stage. While it – and other smaller frauds – have undoubtedly had a meaningful impact, we have found that, two years on, it is the liquidity issues that the industry suffered that seems to have left the most indelible impression.

The problem was an asset-liability mismatch between the liquidity of the hedge vehicle (i.e. the liquidity offered to investors) compared to the liquidity of the underlying portfolio. In the dark days of H2 08 the ‘perfect storm’ occurred, with investors requesting to redeem significant amounts of capital from hedge funds during a period of extreme market illiquidity.

This had an impact across a wide range of hedge funds, ranging from previously liquid hedge fund portfolios with for example monthly liquidity to illiquid strategies with much longer redemption terms. The common theme was the mismatch in liquidity which caused difficulties for all participants. Firms with less liquid strategies commonly suspended their funds, or gated them (limiting the amount of capital that could be redeemed each month or quarter) or transferred the most illiquid portion of the portfolio into ‘side-pockets’. Even those hedge funds which remained fully liquid during the period suffered as investors turned to them as a provider of much needed redemption proceeds.

Consequently investors faced either investment losses or delays in retrieving their cash, realising that just because a fund offered monthly or quarterly redemptions that would not necessarily happen.

These crisis-related difficulties prompted a reassessment of how best to tackle hedge fund investment, and led directly to an increase in the popularity of managed accounts. Hence, having transparency in a portfolio and the ability to monitor,

and control the liquidity of the securities is a significant benefit to investors, and a meaningful change from the ‘arm’s length’ arrangement of investing in a regular fund vehicle. This is one of the core principles behind managed accounts and one of the reasons why they are being increasingly embraced by investors.

What about the hedge fund managers themselves? We have seen a number of trends. Many hedge funds are increasingly open to the idea of managed accounts and the concept of providing associated levels of transparency and liquidity. Furthermore, some funds are in a better position to offer managed accounts because they have addressed the asset-liability imbalance, typically by removing the illiquid portfolio component which proved so troublesome during the crisis.

Firms are also looking closely at their investor bases, the concentration of which contributed to their difficulties during the crisis. They are concluding that the traditional offshore fund structure will not capture a sufficiently diverse investor base and actually precludes them from many investor types. Offering managed accounts is

an important tool being embraced by many managers because managed accounts – and managed account platforms in particular – are attractive not only to existing hedge fund investors but, more importantly, to an entirely new client base.

Another twist on this theme is for firms to offer their funds in regulated UCITS III vehicles, either as single funds or in ‘index’ products which combine a series of managed accounts into a UCITS III compliant index which can be wrapped as a fund or ETF. Such combinations of liquid, transparent and risk controlled managed accounts combined with UCITS III regulation has proved very popular with investors over the last 12 months.

Around twenty percent of the money being invested in hedge funds is not going directly into hedge funds but into managed accounts.

Managed accounts offer investors similar returns to the main hedge fund offered by a firm. But they differ from direct investment in several key respects, offering improved liquidity, transparency and investor control. They also allow clients to segregate their investments in vehicles separate from the main hedge fund, meaning investors retain control over their assets, usually with the ability to redeem much more frequently than the main fund.


European Insurers Face New Solvency Rules Risk management becomes vital

Anthony Vaughan Director, Institutional Client Group

7.6 Investing

Due to come in to force on 31st December 2012, Solvency II is a set of principles for European insurance companies which, in three pillars, lays out a framework for capital adequacy and risk management, with the ultimate aim of enhancing the protection afforded to policyholders. The directive will look to align risk management with risk measurement, and, along with strong public and private disclosure procedures, require that insurance companies hold an amount of capital commensurate with their risk profile. The lower this measure of risk, the less capital the firm needs to hold.

At the heart of the capital adequacy calculations is the Solvency Capital Requirement (SCR) within Pillar 1, calculated annually, which aims to cover all quantifiable risks faced by the insurance company for a 1-in-200 year event. The SCR, used to calculate the Minimum Capital Requirement (MCR), which is the very lowest level of capital a firm shall be allowed to hold, is calculated either using a

standardised formula, or an internal model. The use of an internal model enables a bespoke assessment of the risks that are specific to that particular firm and allows for a more accurate and appropriate measure of risk than the standard formula. Internal models are commonplace among UK, Scandinavian and Dutch insurers who have been operating on risk-based capital adequacy regimes for many years (such as the Individual Capital Adequacy Standards regime in the UK), but will be a daunting and ambitious new project for those in many other European jurisdictions.

Moving to a risk-based framework for capital reserving is an eminently sensible idea, and has been in place for banks since the adoption of the Basel 2 Capital Accord in 2008. It means those insurers that manage their risk (be it market, counterparty, operational, or other risks) efficiently, the lower their SCR, and hence the more capital can be deployed for writing new business, with the resulting improvement in return-on-

capital. Those firms that look to reduce interest rate risk, by duration, or cash flow-matching their liabilities using interest rate swaps, or credit risk using tranched index credit derivatives, or longevity using the emergent longevity swaps market, can reduce their SCR.

Life assurers in the UK, Scandinavia and the Netherlands have for many years used the derivatives markets to quantify, manage and in some cases immunise their market risks and reduce their regulatory capital requirements, and we believe Solvency II will encourage a wave of similar activity in those jurisdictions where the new principles represent a wholesale shift in the way capital is measured. If, as the spirit of the proposed principles contained within the fifth Quantitative Impact Study (QIS5) implies, the swaps curve is to be used to discount liabilities, we expect to see increased demand for long-dated swaps and might see downward pressure on the long end of the EUR swaps curve. Furthermore, holdings of government bonds for their duration-bearing properties will result in a ‘swap spread’ mismatch, which may result in a higher capital charge if accurately captured by internal models. We therefore expect to see insurers looking to eliminate this swap spread risk by entering into derivative contracts known as ‘spreadlocks’, just as UK insurers looked to eliminate swap spread risk resulting from interest rate swap assets duration matching gilt-discounted liabilities. The use of options and option spreads on swap spreads may emerge in 2011 as demand for ‘non-linear’ exposure to swap spreads grows.

Along with risk management, Solvency II is likely to affect investment management, as insurers look to adjust their asset portfolios to incorporate instruments that are capital-efficient under the new guidelines, such as:

1. Inflation-linked government bonds on ‘fixed rate asset swap’, to provide high-yielding duration-bearing instruments with almost-zero capital charge.

2. Negative-basis packages, i.e. corporate bond plus matched maturity credit default swap protection, which, by making use of the ‘risk mitigant’, can potentially be treated under the less-punitive counterparty module rather than spread risk module.

3. Collateralised lending arrangements whereby spread is earned by liquidity-rich insurance companies who, for an agreed time period, switch their liquid instruments for less liquid instruments with a liquidity-poor counterparty, such as a bank.

Deutsche Bank has been at the forefront of managing and understanding the risks run by its insurance company clients across Europe for many years, and one of the lessons we have learned in this time is the importance of being able to swiftly and accurately quantify the market risks of a business, from both an economic and regulatory standpoint. Risk management solutions are then merely an extension of the quantified risk.

Awareness of the quantum of such risks, familiar to many but unfamiliar to more, will in 2011 become crucial to operating a successful insurance business. As the rest of Europe prepares to embark on the path already explored by their UK, Scandinavian and Dutch counterparts, bringing experience and knowledge attained over the past decade, Deutsche Bank looks forward to accompanying them on the hike.

2011 is likely to be a very important year for insurance companies across Europe as the majority of them prepare to reorganise their entire approach to risk and capital in time for the introduction of the Solvency II regulatory framework for EEA insurance companies.


European Insurers Face New Solvency Rules Risk management becomes vital

Anthony Vaughan Director, Institutional Client Group

7.6 Investing

Due to come in to force on 31st December 2012, Solvency II is a set of principles for European insurance companies which, in three pillars, lays out a framework for capital adequacy and risk management, with the ultimate aim of enhancing the protection afforded to policyholders. The directive will look to align risk management with risk measurement, and, along with strong public and private disclosure procedures, require that insurance companies hold an amount of capital commensurate with their risk profile. The lower this measure of risk, the less capital the firm needs to hold.

At the heart of the capital adequacy calculations is the Solvency Capital Requirement (SCR) within Pillar 1, calculated annually, which aims to cover all quantifiable risks faced by the insurance company for a 1-in-200 year event. The SCR, used to calculate the Minimum Capital Requirement (MCR), which is the very lowest level of capital a firm shall be allowed to hold, is calculated either using a

standardised formula, or an internal model. The use of an internal model enables a bespoke assessment of the risks that are specific to that particular firm and allows for a more accurate and appropriate measure of risk than the standard formula. Internal models are commonplace among UK, Scandinavian and Dutch insurers who have been operating on risk-based capital adequacy regimes for many years (such as the Individual Capital Adequacy Standards regime in the UK), but will be a daunting and ambitious new project for those in many other European jurisdictions.

Moving to a risk-based framework for capital reserving is an eminently sensible idea, and has been in place for banks since the adoption of the Basel 2 Capital Accord in 2008. It means those insurers that manage their risk (be it market, counterparty, operational, or other risks) efficiently, the lower their SCR, and hence the more capital can be deployed for writing new business, with the resulting improvement in return-on-

capital. Those firms that look to reduce interest rate risk, by duration, or cash flow-matching their liabilities using interest rate swaps, or credit risk using tranched index credit derivatives, or longevity using the emergent longevity swaps market, can reduce their SCR.

Life assurers in the UK, Scandinavia and the Netherlands have for many years used the derivatives markets to quantify, manage and in some cases immunise their market risks and reduce their regulatory capital requirements, and we believe Solvency II will encourage a wave of similar activity in those jurisdictions where the new principles represent a wholesale shift in the way capital is measured. If, as the spirit of the proposed principles contained within the fifth Quantitative Impact Study (QIS5) implies, the swaps curve is to be used to discount liabilities, we expect to see increased demand for long-dated swaps and might see downward pressure on the long end of the EUR swaps curve. Furthermore, holdings of government bonds for their duration-bearing properties will result in a ‘swap spread’ mismatch, which may result in a higher capital charge if accurately captured by internal models. We therefore expect to see insurers looking to eliminate this swap spread risk by entering into derivative contracts known as ‘spreadlocks’, just as UK insurers looked to eliminate swap spread risk resulting from interest rate swap assets duration matching gilt-discounted liabilities. The use of options and option spreads on swap spreads may emerge in 2011 as demand for ‘non-linear’ exposure to swap spreads grows.

Along with risk management, Solvency II is likely to affect investment management, as insurers look to adjust their asset portfolios to incorporate instruments that are capital-efficient under the new guidelines, such as:

1. Inflation-linked government bonds on ‘fixed rate asset swap’, to provide high-yielding duration-bearing instruments with almost-zero capital charge.

2. Negative-basis packages, i.e. corporate bond plus matched maturity credit default swap protection, which, by making use of the ‘risk mitigant’, can potentially be treated under the less-punitive counterparty module rather than spread risk module.

3. Collateralised lending arrangements whereby spread is earned by liquidity-rich insurance companies who, for an agreed time period, switch their liquid instruments for less liquid instruments with a liquidity-poor counterparty, such as a bank.

Deutsche Bank has been at the forefront of managing and understanding the risks run by its insurance company clients across Europe for many years, and one of the lessons we have learned in this time is the importance of being able to swiftly and accurately quantify the market risks of a business, from both an economic and regulatory standpoint. Risk management solutions are then merely an extension of the quantified risk.

Awareness of the quantum of such risks, familiar to many but unfamiliar to more, will in 2011 become crucial to operating a successful insurance business. As the rest of Europe prepares to embark on the path already explored by their UK, Scandinavian and Dutch counterparts, bringing experience and knowledge attained over the past decade, Deutsche Bank looks forward to accompanying them on the hike.

2011 is likely to be a very important year for insurance companies across Europe as the majority of them prepare to reorganise their entire approach to risk and capital in time for the introduction of the Solvency II regulatory framework for EEA insurance companies.


The key problem that investors have to wrestle with in today’s markets is lack of certainty. This uncertainty can be summarised as doubt over which of the following economic forces is going to prevail at a global level, whether in the near term or over much of the coming decade: a) the extraordinary growth impulse coming from rapid emerging market integration, or b) the equally extraordinary drag coming from the problems of groups of people or regions that are excluded from or are losing out from the current globalisation process.

In contrast, paradoxically, the outlook for the more distant future (end of the decade and beyond) is far less muddy.

Many of the problems that create headlines today (including large net indebtedness of consumers and governments in some countries) are really symptoms of the inherent instabilities in the global economy.

Not only are asset returns highly unstable but the level of volatility itself is unstable. In such uncertain times, there is one word we need to paste across our foreheads: ‘caution’.The guiding principle for investors should be to maximise, for every dollar invested, the responsiveness of their portfolios to a range of macroeconomic outcomes. Or in plain English, to ensure that returns are maximised irrespective of what happens in the markets.

Why established portfolio theories don’t workFigure 1 shows how diff erent the last decade has been from the 1980s and 1990s (and how reminiscent of the last period of instability, the 1970s).

This is by no means just an equity phenomenon; over the past decade investment-grade credit and peripheral European bonds have also exhibited extremely dispersed and even bimodal returns (fi gure 2).

Multi-year bear markets like the Nikkei and multi-year bull markets like the Bovespa and Hang Seng look materially the same (fi gure 3).

Portfolio TheoryBinary outcomes, bimodal returns

Vinay PandeChief Investment Advisor, Research

7.7Investing

The returns are widely dispersed on either side of zero and in a way that has made the task of long-only asset managers enormously diffi cult.

Consider trying to answer the layman’s question – ‘is this market cheap or expensive?’ Whereas this is a reasonably straightforward question in a unimodal world, it is impossible to answer in a bimodal world such as today’s. Indeed one doubts whether it is even relevant. To assume a problem can be dismissed as a ‘tail event’ or a ‘black swan’ event would be to seriously underestimate risk. The mean-variance framework, particularly the use of Value At Risk (VAR) as a risk measure, can be of some value in a unimodal world. But in the new bimodal world, its value is much more questionable.

Variance and Co-variance matrices based on historic data, still widely used by investors and consultants when making asset allocation decisions, deliver misleading answers in a world where the matrices themselves are unstable. In such an environment, hedge assets quickly become risk assets, especially at times of stress.

Whether it’s by force of habit, or due to their lack of experience of periods of unstable returns, many market participants still tend to superimpose on reality an abstraction (such as a version of a bell-shaped distribution curve).

Figure 1S&P 500 price index rolling 1-yr returns for selected periods

Dec 30 ‘27 – Apr 20 ’10

Mean 7.23Median 8.24Max. 171.20Min. -70.60Std. Dev. 20.97Skewness 0.19Kurtosis 5.80

Mean 0.28Median 1.01Max. 39.08Min. -43.25Std. Dev. 19.13Skewness -0.11Kurtosis 2.04


Mean -1.22Median 4.27Max. 68.57Min. -48.82Std. Dev. 19.83Skewness -0.05Kurtosis 2.72

Actual distributionTheoretical Normal

Source: Bloomberg, Standard and Poors, Deutsche Bank

Dec 31 ‘71 – Dec 31 ’76

Jan 2 ‘80 – Dec 31 ’99

Jan 3 ‘00 – Apr 20 ’10

-75

-63

-50

-38

-25

-13 0 13 25 38 50 63 75 88 100

113

125

138

150

163

175

-75

-60

-45

-30

-15 0 15 30 45 60 75

-75

-60

-45

-30

-15 0 15 30 45 60 75

-60

-45

-30

-15 0 15 30 45 60

0.04

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0.03

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sity

Returns %

Returns %

Returns %

Returns %

Figure 2Investment grade CDS: rolling 1-yr returns since January 2005Source: Bloomberg Finance LP, DBIQ Actual distributionStandard & Poor’s, Deutsche Bank GMR Theoretical norm

Figure 3Selected equity markets: rolling 1-yr returns since Jan 2000Source: Bloomberg Finance LP, Actual distributionDeutsche Bank GMR Theoretical norm

-9Returns %

-8 9876543210-1-2-3-4-5-6-7

0.40

0.30

0.20

0.10

0.00

0.50

0.60 Density Mean -0.35Median 0.26Max 7.55Min -8.10Std. dev. 3.04Skewness 0.09Kurtosis 2.93

CDX IG 5-yr: 1-yr returns

-7 76543210-1-2-3-4-5-6

0.40

0.30

0.20

0.10

0.00

0.50

0.80 Density

Returns %

0.70

0.60

Mean -0.07Median 0.43Max 6.48Min -5.85Std. dev. 2.20Skewness 0.12Kurtosis 3.28

iTraxx IG 5-yr: 1-yr returns

-35 -25 -15 -5 3525155

0.080.060.040.020.00

0.10

0.18 Density

0.140.16

0.12

Mean -2.99Median -3.11Max 9.67Min -27.90Std. dev. 8.98Skewness -0.21Kurtosis 1.91

Greece Govt 6% July 19*

Returns %*rolling 4-mo returns, Mar 5, 2009 – Apr 29, 2010 period

-75 -60 -45 -30 -15 75604530150

0.02

0.01

0.00

0.03 Density

Returns %

Mean - 2.20Median -1.82Max 58.44Min -54.35Std. dev. 25.25Skewness 0.24Kurtosis 2.07

Nikkei 225: 1-yr returns

-110 -90 -70 -50 -30 -10 1109070503010

0.03

0.02

0.01

0.00

0.04 Density

Returns %

Mean 6.59Median 11.25Max 101.25Min -60.17Std. dev. 27.86Skewness -0.02 Kurtosis 2.56

Hang Seng: 1-yr returns

-70 -50 -30 -10 13011070 90503010

0.01

0.00

0.02 Density Mean 21.34Median 23.84Max 130.07Min -51.07Std. dev. 37.20Skewness 0.30 Kurtosis 2.46

BOVESPA: 1-yr returns

Returns %


The key problem that investors have to wrestle with in today’s markets is lack of certainty. This uncertainty can be summarised as doubt over which of the following economic forces is going to prevail at a global level, whether in the near term or over much of the coming decade: a) the extraordinary growth impulse coming from rapid emerging market integration, or b) the equally extraordinary drag coming from the problems of groups of people or regions that are excluded from or are losing out from the current globalisation process.

In contrast, paradoxically, the outlook for the more distant future (end of the decade and beyond) is far less muddy.

Many of the problems that create headlines today (including large net indebtedness of consumers and governments in some countries) are really symptoms of the inherent instabilities in the global economy.

Not only are asset returns highly unstable but the level of volatility itself is unstable. In such uncertain times, there is one word we need to paste across our foreheads: ‘caution’.The guiding principle for investors should be to maximise, for every dollar invested, the responsiveness of their portfolios to a range of macroeconomic outcomes. Or in plain English, to ensure that returns are maximised irrespective of what happens in the markets.

Why established portfolio theories don’t workFigure 1 shows how diff erent the last decade has been from the 1980s and 1990s (and how reminiscent of the last period of instability, the 1970s).

This is by no means just an equity phenomenon; over the past decade investment-grade credit and peripheral European bonds have also exhibited extremely dispersed and even bimodal returns (fi gure 2).

Multi-year bear markets like the Nikkei and multi-year bull markets like the Bovespa and Hang Seng look materially the same (fi gure 3).

Portfolio TheoryBinary outcomes, bimodal returns

Vinay PandeChief Investment Advisor, Research

7.7Investing

The returns are widely dispersed on either side of zero and in a way that has made the task of long-only asset managers enormously diffi cult.

Consider trying to answer the layman’s question – ‘is this market cheap or expensive?’ Whereas this is a reasonably straightforward question in a unimodal world, it is impossible to answer in a bimodal world such as today’s. Indeed one doubts whether it is even relevant. To assume a problem can be dismissed as a ‘tail event’ or a ‘black swan’ event would be to seriously underestimate risk. The mean-variance framework, particularly the use of Value At Risk (VAR) as a risk measure, can be of some value in a unimodal world. But in the new bimodal world, its value is much more questionable.

Variance and Co-variance matrices based on historic data, still widely used by investors and consultants when making asset allocation decisions, deliver misleading answers in a world where the matrices themselves are unstable. In such an environment, hedge assets quickly become risk assets, especially at times of stress.

Whether it’s by force of habit, or due to their lack of experience of periods of unstable returns, many market participants still tend to superimpose on reality an abstraction (such as a version of a bell-shaped distribution curve).

Figure 1S&P 500 price index rolling 1-yr returns for selected periods

Dec 30 ‘27 – Apr 20 ’10

Mean 7.23Median 8.24Max. 171.20Min. -70.60Std. Dev. 20.97Skewness 0.19Kurtosis 5.80



Mean -1.22Median 4.27Max. 68.57Min. -48.82Std. Dev. 19.83Skewness -0.05Kurtosis 2.72

Actual distributionTheoretical Normal

Source: Bloomberg, Standard and Poors, Deutsche Bank

Dec 31 ‘71 – Dec 31 ’76

Jan 2 ‘80 – Dec 31 ’99

Jan 3 ‘00 – Apr 20 ’10

-75

-63

-50

-38

-25

-13 0 13 25 38 50 63 75 88 100

113

125

138

150

163

175

-75

-60

-45

-30

-15 0 15 30 45 60 75

-75

-60

-45

-30

-15 0 15 30 45 60 75

-60

-45

-30

-15 0 15 30 45 60

0.04

0.03

0.02

0.01

0.00

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0.03

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0.00

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0.03

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0.03

0.02

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0.00

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sity

Returns %

Returns %

Returns %

Returns %

Figure 2Investment grade CDS: rolling 1-yr returns since January 2005Source: Bloomberg Finance LP, DBIQ Actual distributionStandard & Poor’s, Deutsche Bank GMR Theoretical norm

Figure 3Selected equity markets: rolling 1-yr returns since Jan 2000Source: Bloomberg Finance LP, Actual distributionDeutsche Bank GMR Theoretical norm

-9Returns %

-8 9876543210-1-2-3-4-5-6-7

0.40

0.30

0.20

0.10

0.00

0.50

0.60 Density Mean -0.35Median 0.26Max 7.55Min -8.10Std. dev. 3.04Skewness 0.09Kurtosis 2.93

CDX IG 5-yr: 1-yr returns

-7 76543210-1-2-3-4-5-6

0.40

0.30

0.20

0.10

0.00

0.50

0.80 Density

Returns %

0.70

0.60

Mean -0.07Median 0.43Max 6.48Min -5.85Std. dev. 2.20Skewness 0.12Kurtosis 3.28

iTraxx IG 5-yr: 1-yr returns

-35 -25 -15 -5 3525155

0.080.060.040.020.00

0.10

0.18 Density

0.140.16

0.12

Mean -2.99Median -3.11Max 9.67Min -27.90Std. dev. 8.98Skewness -0.21Kurtosis 1.91

Greece Govt 6% July 19*

Returns %*rolling 4-mo returns, Mar 5, 2009 – Apr 29, 2010 period

-75 -60 -45 -30 -15 75604530150

0.02

0.01

0.00

0.03 Density

Returns %

Mean - 2.20Median -1.82Max 58.44Min -54.35Std. dev. 25.25Skewness 0.24Kurtosis 2.07

Nikkei 225: 1-yr returns

-110 -90 -70 -50 -30 -10 1109070503010

0.03

0.02

0.01

0.00

0.04 Density

Returns %

Mean 6.59Median 11.25Max 101.25Min -60.17Std. dev. 27.86Skewness -0.02 Kurtosis 2.56

Hang Seng: 1-yr returns

-70 -50 -30 -10 13011070 90503010

0.01

0.00

0.02 Density Mean 21.34Median 23.84Max 130.07Min -51.07Std. dev. 37.20Skewness 0.30 Kurtosis 2.46

BOVESPA: 1-yr returns

Returns %


This leads them to make the following basic errors: – They exaggerate the probability

of low probability moderate return outcomes, a recipe for underperformance because it leads to overinvestment in sleepy assets;

– They underestimate the probability of higher oscillation, high frequency outcomes, a recipe for poor risk management and unexpected losses;

The counterparties of cash-market participants in the derivatives space, options-traders, make similar misjudgments when selling volatility or insurance.

Figure 4 shows the return profi les of the cash instrument (S&P); a proprietary equity swap variance product on the S&P off ered by Deutsche Bank called ELVIS (note the ‘x’ axis is laterally inverted); and a combination of these two.

After buying this sort of insurance, Deutsche Bank has been able to enhance investment performance by about 3.5% per annum at the same time as reducing volatility by one-third, every year over the last decade. Such mis-pricing opportunities exist not just in equities and equity variance but across other asset classes as well.

As a general principle the best way of maximising returns in a unimodal world (where discovering price is our objective) is to own cheap options. By extension, discovering the correct price of volatility or insurance is more relevant in a bimodal world and therefore owning options on volatility makes good economic sense. That is exactly what is being achieved in the equity exercise above.

The variance swap with insurance works because it combines assets with volatility counterparts that have attractive, asymmetric payoff s. It is has the ability to produce what is eff ectively an option on a volatility position. Step one is to combine assets with positively-biased asymmetric payoff s and liabilities (or short positions) with the opposite. The next step is to seek out options on these assets and liabilities whose price does not refl ect the asymmetric nature of the payoff s.

Deutsche Bank Investment Advisory Group puts together its multi-asset portfolios, and regularly fi ne-tunes them to maximise returns in a three-stage process which includes mapping macroeconomic scenarios, valuation and payout profi le:

1. Mapping macroeconomic scenariosWe outline plausible medium-term macroeconomic scenarios. Currently these include crises for the Eurozone, the dollar and emerging markets, and, on the other side, more positive outcomes for risk assets. We then repeat the exercise over a longer timeframe. Having identifi ed the scenarios, we assess how a range of asset classes might perform against each scenario.

2. ValuationThe valuation process leads us to assess option-adjusted spread across asset classes, a calculation that suggests what are currently among the most attractively priced assets around – US and European equities.

3. Payout profi leThe next stage is to establish the desired payout profi le, subject to constraints. For reasons including abundant caution, the portfolios are over-engineered to seek a convex profi le across scenarios; the more violent the outcome, the greater the gain that we are seeking.

The constraint set under which we operate is to design a largely

unlevered and liquid portfolio with volatility confi ned to approximately 7%-10% per annum, unless we are receiving a large option payoff , in which case we let our gains run until we choose to delta hedge in order to restore volatility to the 7%-10% per annum zone.

The objective is, as fi gure 5 below demonstrates, to achieve a fi nely tuned portfolio profi le to address all scenarios in a way that more naïve single or multi asset portfolios cannot hope to achieve, even if they use basic option strategies.

80 60 -80-60-40-2002040

0.30

0.20

0.10

0.00

0.40 Density

Returns % (Inverted scale)

Mean 3.92Median -0.75Max 75.54Min -32.94Std. dev. 20.94Skewness 0.49Kurtosis 2.29

6-mo variance swaps, 3-mo forward (S&P 500)

-80 -60 806040200-20-40

0.30

0.20

0.10

0.00

0.40 Density Mean -1.22Median 4.27Max 68.57Min -48.82Std. dev. 19.83Skewness -0.05Kurtosis 2.72

S&P 500

Returns %

-80 -60 806040200-20-40

0.30

0.20

0.10

0.00

0.40 Density Mean 2.68Median 2.40Max 42.75Min -32.65Std. dev. 13.12Skewness 0.38Kurtosis 2.83

S&P 500 plus 6-mo variance swaps, 3-mo forward

Returns %

7.7Investing

Figure 4Equities and forward variance swaps: 1-yr returns for the Jan 3, 2000 – Apr 20, 2010 periodSource: Bloomberg Finance LP, DBIQ Actual distributionStandard & Poor’s, Deutsche Bank GMR Theoretical norm

Hig

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Figure 5Forecast 1 year returns DB Investment Advisory Group Cross- Asset Portfolio Long-dated US Treasury hedged with 1Yr Strike= 4.2%, OTM 19Yr Payer Swaption 50% S&P500 hedged with Put and 50% Long-dated US Treasury hedged with Payer Sw aption S&P500 hedged with 1Yr Strike=1150 Put Long-dated US Treasury 50% S&P500 and 50% Long-dated US Treasury S&P500 70% IG & 30% HY Corporate Bonds Source: Bloomberg, Standard and Poors, Deutsche Bank


This leads them to make the following basic errors: – They exaggerate the probability

of low probability moderate return outcomes, a recipe for underperformance because it leads to overinvestment in sleepy assets;

– They underestimate the probability of higher oscillation, high frequency outcomes, a recipe for poor risk management and unexpected losses;

The counterparties of cash-market participants in the derivatives space, options-traders, make similar misjudgments when selling volatility or insurance.

Figure 4 shows the return profi les of the cash instrument (S&P); a proprietary equity swap variance product on the S&P off ered by Deutsche Bank called ELVIS (note the ‘x’ axis is laterally inverted); and a combination of these two.

After buying this sort of insurance, Deutsche Bank has been able to enhance investment performance by about 3.5% per annum at the same time as reducing volatility by one-third, every year over the last decade. Such mis-pricing opportunities exist not just in equities and equity variance but across other asset classes as well.

As a general principle the best way of maximising returns in a unimodal world (where discovering price is our objective) is to own cheap options. By extension, discovering the correct price of volatility or insurance is more relevant in a bimodal world and therefore owning options on volatility makes good economic sense. That is exactly what is being achieved in the equity exercise above.

The variance swap with insurance works because it combines assets with volatility counterparts that have attractive, asymmetric payoff s. It is has the ability to produce what is eff ectively an option on a volatility position. Step one is to combine assets with positively-biased asymmetric payoff s and liabilities (or short positions) with the opposite. The next step is to seek out options on these assets and liabilities whose price does not refl ect the asymmetric nature of the payoff s.

Deutsche Bank Investment Advisory Group puts together its multi-asset portfolios, and regularly fi ne-tunes them to maximise returns in a three-stage process which includes mapping macroeconomic scenarios, valuation and payout profi le:

1. Mapping macroeconomic scenariosWe outline plausible medium-term macroeconomic scenarios. Currently these include crises for the Eurozone, the dollar and emerging markets, and, on the other side, more positive outcomes for risk assets. We then repeat the exercise over a longer timeframe. Having identifi ed the scenarios, we assess how a range of asset classes might perform against each scenario.

2. ValuationThe valuation process leads us to assess option-adjusted spread across asset classes, a calculation that suggests what are currently among the most attractively priced assets around – US and European equities.

3. Payout profi leThe next stage is to establish the desired payout profi le, subject to constraints. For reasons including abundant caution, the portfolios are over-engineered to seek a convex profi le across scenarios; the more violent the outcome, the greater the gain that we are seeking.

The constraint set under which we operate is to design a largely

unlevered and liquid portfolio with volatility confi ned to approximately 7%-10% per annum, unless we are receiving a large option payoff , in which case we let our gains run until we choose to delta hedge in order to restore volatility to the 7%-10% per annum zone.

The objective is, as fi gure 5 below demonstrates, to achieve a fi nely tuned portfolio profi le to address all scenarios in a way that more naïve single or multi asset portfolios cannot hope to achieve, even if they use basic option strategies.

80 60 -80-60-40-2002040

0.30

0.20

0.10

0.00

0.40 Density

Returns % (Inverted scale)

Mean 3.92Median -0.75Max 75.54Min -32.94Std. dev. 20.94Skewness 0.49Kurtosis 2.29

6-mo variance swaps, 3-mo forward (S&P 500)

-80 -60 806040200-20-40

0.30

0.20

0.10

0.00

0.40 Density Mean -1.22Median 4.27Max 68.57Min -48.82Std. dev. 19.83Skewness -0.05Kurtosis 2.72

S&P 500

Returns %

-80 -60 806040200-20-40

0.30

0.20

0.10

0.00

0.40 Density Mean 2.68Median 2.40Max 42.75Min -32.65Std. dev. 13.12Skewness 0.38Kurtosis 2.83

S&P 500 plus 6-mo variance swaps, 3-mo forward

Returns %

7.7Investing

Figure 4Equities and forward variance swaps: 1-yr returns for the Jan 3, 2000 – Apr 20, 2010 periodSource: Bloomberg Finance LP, DBIQ Actual distributionStandard & Poor’s, Deutsche Bank GMR Theoretical norm

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60% 40%

Figure 5Forecast 1 year returns DB Investment Advisory Group Cross- Asset Portfolio Long-dated US Treasury hedged with 1Yr Strike= 4.2%, OTM 19Yr Payer Swaption 50% S&P500 hedged with Put and 50% Long-dated US Treasury hedged with Payer Sw aption S&P500 hedged with 1Yr Strike=1150 Put Long-dated US Treasury 50% S&P500 and 50% Long-dated US Treasury S&P500 70% IG & 30% HY Corporate Bonds Source: Bloomberg, Standard and Poors, Deutsche Bank


7.8 Investing

Caio Koch-Weser Vice Chairman, Deutsche Bank Group

Investing in Green GrowthOpportunities ahead

Green sectors and industries are set to grow dramatically. This growth will respond to the need to address climate change – but it will also be driven by concerns about energy security, national security, and access to natural resources in a rapidly growing world.

Policymakers around the world are responding to these concerns, and many countries, states, and cities are now engaged in a race to build low-carbon industries, create green jobs, and secure future competitive advantage for themselves. Business is responding, with 93% of CEOs saying that sustainability will be critical to the future success of their companies in a recent survey conducted by the UN Global Compact and Accenture. And investors are deploying capital in the space: according to New Energy Finance, in the first three quarters of 2010, there was over $106 billion of new financial investment in clean energy alone.

What are the opportunities for investment in this major future growth trend? There are many attractive options. Deutsche Bank was recently selected to be the fund manager for the Global Climate Partnership Fund. The fund has been established by the German Environment Ministry in cooperation with KfW, the German development bank. It will foster energy efficiency and renewable energy investments for small and medium enterprises and households in developing countries,

channelling these funds through local banks. This, in turn, will strengthen the ability of domestic financial institutions to fund further low-carbon projects. The fund uses an innovative structure that offers different tranches of shares and notes, each with a different risk and return profile. Money from the German government will take a first loss equity stake, while development finance institutions including KfW will supply mezzanine debt. These tranches will shield private investors from losses. By using this risk mitigation structure, the fund aims to mobilise at least $500 million of investment from the approximately $100 million that has been pledged by the German government and KfW.

Other similar investment products that target projects in the developing world are also in development. The UK’s Department for International Development, the Asian Development Bank, the IFC, and the P8 group of institutional investors have been collaborating on the design of a regional Public Private Partnership Climate Fund for Asia, known as the CP3. Donors would contribute toward the cornerstone equity of the fund, and would allow private fund managers to bid for part of the equity to build their own funds. Risk reducing mechanisms and technical assistance from international financial institutions would be applied at scale to the fund.

And in the developed world, similar partnerships are being built to invest

in low carbon infrastructure and technology, driven by environmental and energy security concerns. Deutsche Asset Management will soon begin raising a fund to invest in low-carbon power generation assets in North America. Specific sectors that the fund will invest in include natural gas, solar, wind, and biomass power generation, transmission and distribution, and midstream energy projects. The targeted capitalisation of $1 billion will be sourced from existing and new third-party clients as limited partners.

Climate change is a pressing global challenge – and it also represents one of the major investment opportunities of the coming decades. There are many attractive investment strategies in the space, and Deutsche Bank is committed to offering products that channel money into this dynamic growth sector to its clients.


7.8 Investing

Caio Koch-Weser Vice Chairman, Deutsche Bank Group

Investing in Green GrowthOpportunities ahead

Green sectors and industries are set to grow dramatically. This growth will respond to the need to address climate change – but it will also be driven by concerns about energy security, national security, and access to natural resources in a rapidly growing world.

Policymakers around the world are responding to these concerns, and many countries, states, and cities are now engaged in a race to build low-carbon industries, create green jobs, and secure future competitive advantage for themselves. Business is responding, with 93% of CEOs saying that sustainability will be critical to the future success of their companies in a recent survey conducted by the UN Global Compact and Accenture. And investors are deploying capital in the space: according to New Energy Finance, in the first three quarters of 2010, there was over $106 billion of new financial investment in clean energy alone.

What are the opportunities for investment in this major future growth trend? There are many attractive options. Deutsche Bank was recently selected to be the fund manager for the Global Climate Partnership Fund. The fund has been established by the German Environment Ministry in cooperation with KfW, the German development bank. It will foster energy efficiency and renewable energy investments for small and medium enterprises and households in developing countries,

channelling these funds through local banks. This, in turn, will strengthen the ability of domestic financial institutions to fund further low-carbon projects. The fund uses an innovative structure that offers different tranches of shares and notes, each with a different risk and return profile. Money from the German government will take a first loss equity stake, while development finance institutions including KfW will supply mezzanine debt. These tranches will shield private investors from losses. By using this risk mitigation structure, the fund aims to mobilise at least $500 million of investment from the approximately $100 million that has been pledged by the German government and KfW.

Other similar investment products that target projects in the developing world are also in development. The UK’s Department for International Development, the Asian Development Bank, the IFC, and the P8 group of institutional investors have been collaborating on the design of a regional Public Private Partnership Climate Fund for Asia, known as the CP3. Donors would contribute toward the cornerstone equity of the fund, and would allow private fund managers to bid for part of the equity to build their own funds. Risk reducing mechanisms and technical assistance from international financial institutions would be applied at scale to the fund.

And in the developed world, similar partnerships are being built to invest

in low carbon infrastructure and technology, driven by environmental and energy security concerns. Deutsche Asset Management will soon begin raising a fund to invest in low-carbon power generation assets in North America. Specific sectors that the fund will invest in include natural gas, solar, wind, and biomass power generation, transmission and distribution, and midstream energy projects. The targeted capitalisation of $1 billion will be sourced from existing and new third-party clients as limited partners.

Climate change is a pressing global challenge – and it also represents one of the major investment opportunities of the coming decades. There are many attractive investment strategies in the space, and Deutsche Bank is committed to offering products that channel money into this dynamic growth sector to its clients.


IFR Awards, Review of the year – Derivatives House of the Year – Interest Rate Derivatives House of the Year – European Loan House of the Year – Investment-Grade Corporate Bond House of the Year

Euromoney, Awards for Excellence – Best Global Investment Bank – Best Global Credit Derivatives House – Best Global Risk Management House – Best FX House in Europe, Asia, Latin America, Central and Eastern Europe – Best Debt House in Australia

Greenwich Associates, European Fixed Income Strategist Report 2010 – No. 1 Interest Rate Swaps and Options* – No. 1 High Yield Cash Bonds and Credit Derivatives and New Issues* – No. 1 Emerging Market Fixed Income Securities*

Risk, Interdealer Rankings – No. 1 in Derivatives

Energy Risk Asia Awards – Derivatives House of the Year – Base Metals House of the Year

Institutional Investor, Research Ranking – No. 1 for Germany and General Retail Sector, European – No. 1 for Large Cap Banks Sector, US – No. 1 for Gaming & Lodging Sector, Asia ex-Japan – No. 1 for Pulp & Paper Sector, LatAm

Structured Products, Asia Awards 2010 – ETF Provider of the Year, Asia

Risk Magazine, Risk Awards – Hedge Fund Derivatives House of the Year

Euromoney, FX Poll – No. 1 Overall, 6 years in a row – No. 1 in North America, 6 years in a row – No. 1 in E-Trading Proprietary Platforms by market share, 6 years in a row

Greenwich Associates, US Fixed Income Strategist Report 2010 – No. 1 Overall Across All Fixed Income Products* – No. 1 Interest Rate Swaps and Mortgage Pass Through Securities* – No. 1 Credit Default Swaps*

Greenwich Associates, Asia ex Japan Fixed Income Strategist Report 2010 – No. 1 Government Bonds* – No. 1 Interest Rate Derivatives*

Global Custodian, Prime Brokerage Survey 2010 – No. 1 Global Overall Prime Broker and Top Rated Global Prime Broker – No. 1 in North America and Europe

Energy Risk, Awards – Electricity Europe House of the Year

The Banker, Investment Awards 2010 – Most Innovative Investment Bank for Risk Management

Asia Risk – Credit Derivatives House of the Year – Prime Brokerage House of the Year

Global Finance World’s Best FX Banks Awards – World’s Best FX Bank every year since 2006

Key Awards and Rankings in 2010

Marketing material

This document is intended for information purposes only. It does not create any legally binding obligations on the part of Deutsche Bank AG and/or its affiliates (“DB”). Without limitation, this document does not constitute an offer, an invitation to offer or a recommendation to enter into any transaction.

We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. We therefore strongly suggest that recipients seek their own independent advice in relation to any investment, financial, legal, tax, accounting or regulatory issues discussed herein. Analyses and opinions contained herein may be based on assumptions that if altered can change the analyses or opinions expressed. Nothing contained herein shall constitute any representation or warranty as to future performance of any financial instrument, credit, currency rate or other market or economic measure. Furthermore, past performance is not necessarily indicative of future results.

This document does not constitute the provision of investment advice and is not intended to do so, but is intended to be general information. Any product(s) or proposed transaction(s) mentioned herein may not be appropriate for all investors and before entering into any transaction you should take steps to ensure that you fully understand the transaction and have made an independent assessment of the appropriateness of the transaction in the light of your own objectives, needs and circumstances, including the possible risks and benefits of entering into such transaction. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but we make no representation or warranty, express or implied, with respect to the fairness, correctness, accuracy, reasonableness or completeness of such information. In addition we have no obligation to update, modify or amend this communication or to otherwise notify a recipient in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. Opinions, estimates, projections and forecasts herein constitute the current judgement of the authors as of the date of this communication. They do not necessarily reflect the opinions of Deutsche Bank.

Assumptions, estimates and opinions contained in this document constitute our judgment as of the date of the document and are subject to change without notice. Any projections are based on a number of assumptions as to market conditions and there can be no guarantee that any projected results will be achieved. Past performance is not a guarantee of future results. This material was prepared by a Sales or Trading function within DB, and was not produced, reviewed or edited by the Research Department. Any opinions expressed herein may differ from the opinions expressed by other DB departments including the Research Department. Sales and Trading functions are subject to additional potential conflicts of interest which the Research Department does not face. DB may engage in transactions in a manner inconsistent with the views discussed herein. DB trades or may trade as principal in the instruments (or related derivatives), and may have proprietary positions in the instruments (or related derivatives) discussed herein. DB may make a market in the instruments (or related derivatives) discussed herein. Sales and Trading personnel are compensated in part based on the volume of transactions effected by them.

The distribution of this document and availability of these products and services in certain jurisdictions may be restricted by law. Any offering or potential transaction that may be related to the subject matter of this communication will be made pursuant to separate and distinct documentation and in such case the information contained herein will be superseded in its entirety by such documentation in final form.

You may not distribute this document, in whole or in part, without our express written permission. DB SPECIFICALLY DISCLAIMS ALL LIABILITY FOR ANY DIRECT, INDIRECT, CONSEQUENTIAL OR OTHER LOSSES OR DAMAGES INCLUDING LOSS OF PROFITS INCURRED BY YOU OR ANY THIRD PARTY THAT MAY ARISE FROM ANY RELIANCE ON THIS DOCUMENT OR FOR THE RELIABILITY, ACCURACY, COMPLETENESS OR TIMELINESS THEREOF. DB is authorised under German Banking Law (competent authority: BaFin - Federal Financial Supervising Authority) and regulated by the Financial Services Authority for the conduct of UK business.

Securities and investment banking activities in the United States are performed by Deutsche Bank Securities Inc., member NYSE, FINRA and SIPC, and its broker-dealer affiliates.

This document is prepared by [Deutsche Bank AG London Branch] and is distributed in Japan by Deutsche Securities Inc. (“DSI”). Please contact the responsible employee of DSI in case you have any question on this document because DSI serves as contact for the product or service described in this document

Futures

Futures:The risk of loss in futures trading, foreign or domestic can be substantial. As a result of the high degree of leverage obtainable in futures trading, losses may be incurred that are greater than the amount of funds initially deposited. Unless governing law provides other, all transactions should be executed through the Deutsche Bank entity in the investor’s home jurisdiction.

Derivatives

Options Disclaimer:Derivatives and options are complex instruments that are not suitable for all investors, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Supporting documentation or any claims, comparisons, recommendations, statistics or other technical data will be supplied upon request. Any trade information is preliminary and not intended as an official transaction confirmation.

In the US, read the http://onn.theocc.com/publications/risks/riskstoc.pdf or contact the sales desk at +1-212-250-4960. Because of the importance of tax considerations to many option transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated option transactions. Please note that multi-leg option strategies will incur multiple commission charges.

Otc derivatives

This communication was prepared solely in connection with the promotion or marketing, to the extent permitted by applicable law, of the transaction or matter

addressed herein, and was not intended or written to be used, and cannot be used or relied upon, by any taxpayer for purposes of avoiding any U.S. federal income tax penalties or any other applicable tax regulation or law. The recipient of this communication should seek advice from an independent tax advisor regarding any tax matters addressed herein based on its particular circumstances.

Principal Protection:If applicable, the principal protection feature applies only if the securities or instruments are held to maturity. Please note: market values may be affected by a number of factors including index values, interest rates, volatility, time to maturity, dividend yields and issuer credit ratings. These factors are interrelated in complex ways, and as a result, the effect of any one factor may be offset or magnified by the effect of another factor.

Calculations of returns:Calculations of returns on instruments referred to herein may be linked to a referenced index or interest rate. In such cases, the investments may not be suitable for persons unfamiliar with such index or interest rate, or unwilling or unable to bear the risks associated with the transaction. Products denominated in a currency, other than the investor’s home currency, will be subject to changes in exchange rates, which may have an adverse effect on the value, price or income return of the products. These products may not be readily realizable investments and are not traded on any regulated market. The securities referred to herein involve risk, which may include interest rate, index, currency, credit, political, liquidity, time value, commodity and market risk and are not suitable for all investors.

Not insured:These OTC derivative instruments are not insured by the Federal Deposit Insurance Corporation (FDIC) or any other U.S. governmental agency. These instruments are not insured by any statutory scheme or governmental agency of the United Kingdom. These securities have not been registered under the United States Securities Act of 1933 and trading in the securities has not been approved by the United States Commodity Exchange Act, as amended.]

Disclaimers

*Based on market share


IFR Awards, Review of the year – Derivatives House of the Year – Interest Rate Derivatives House of the Year – European Loan House of the Year – Investment-Grade Corporate Bond House of the Year

Euromoney, Awards for Excellence – Best Global Investment Bank – Best Global Credit Derivatives House – Best Global Risk Management House – Best FX House in Europe, Asia, Latin America, Central and Eastern Europe – Best Debt House in Australia

Greenwich Associates, European Fixed Income Strategist Report 2010 – No. 1 Interest Rate Swaps and Options* – No. 1 High Yield Cash Bonds and Credit Derivatives and New Issues* – No. 1 Emerging Market Fixed Income Securities*

Risk, Interdealer Rankings – No. 1 in Derivatives

Energy Risk Asia Awards – Derivatives House of the Year – Base Metals House of the Year

Institutional Investor, Research Ranking – No. 1 for Germany and General Retail Sector, European – No. 1 for Large Cap Banks Sector, US – No. 1 for Gaming & Lodging Sector, Asia ex-Japan – No. 1 for Pulp & Paper Sector, LatAm

Structured Products, Asia Awards 2010 – ETF Provider of the Year, Asia

Risk Magazine, Risk Awards – Hedge Fund Derivatives House of the Year

Euromoney, FX Poll – No. 1 Overall, 6 years in a row – No. 1 in North America, 6 years in a row – No. 1 in E-Trading Proprietary Platforms by market share, 6 years in a row

Greenwich Associates, US Fixed Income Strategist Report 2010 – No. 1 Overall Across All Fixed Income Products* – No. 1 Interest Rate Swaps and Mortgage Pass Through Securities* – No. 1 Credit Default Swaps*

Greenwich Associates, Asia ex Japan Fixed Income Strategist Report 2010 – No. 1 Government Bonds* – No. 1 Interest Rate Derivatives*

Global Custodian, Prime Brokerage Survey 2010 – No. 1 Global Overall Prime Broker and Top Rated Global Prime Broker – No. 1 in North America and Europe

Energy Risk, Awards – Electricity Europe House of the Year

The Banker, Investment Awards 2010 – Most Innovative Investment Bank for Risk Management

Asia Risk – Credit Derivatives House of the Year – Prime Brokerage House of the Year

Global Finance World’s Best FX Banks Awards – World’s Best FX Bank every year since 2006

Key Awards and Rankings in 2010

Marketing material

This document is intended for information purposes only. It does not create any legally binding obligations on the part of Deutsche Bank AG and/or its affiliates (“DB”). Without limitation, this document does not constitute an offer, an invitation to offer or a recommendation to enter into any transaction.

We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. We therefore strongly suggest that recipients seek their own independent advice in relation to any investment, financial, legal, tax, accounting or regulatory issues discussed herein. Analyses and opinions contained herein may be based on assumptions that if altered can change the analyses or opinions expressed. Nothing contained herein shall constitute any representation or warranty as to future performance of any financial instrument, credit, currency rate or other market or economic measure. Furthermore, past performance is not necessarily indicative of future results.

This document does not constitute the provision of investment advice and is not intended to do so, but is intended to be general information. Any product(s) or proposed transaction(s) mentioned herein may not be appropriate for all investors and before entering into any transaction you should take steps to ensure that you fully understand the transaction and have made an independent assessment of the appropriateness of the transaction in the light of your own objectives, needs and circumstances, including the possible risks and benefits of entering into such transaction. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but we make no representation or warranty, express or implied, with respect to the fairness, correctness, accuracy, reasonableness or completeness of such information. In addition we have no obligation to update, modify or amend this communication or to otherwise notify a recipient in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. Opinions, estimates, projections and forecasts herein constitute the current judgement of the authors as of the date of this communication. They do not necessarily reflect the opinions of Deutsche Bank.

Assumptions, estimates and opinions contained in this document constitute our judgment as of the date of the document and are subject to change without notice. Any projections are based on a number of assumptions as to market conditions and there can be no guarantee that any projected results will be achieved. Past performance is not a guarantee of future results. This material was prepared by a Sales or Trading function within DB, and was not produced, reviewed or edited by the Research Department. Any opinions expressed herein may differ from the opinions expressed by other DB departments including the Research Department. Sales and Trading functions are subject to additional potential conflicts of interest which the Research Department does not face. DB may engage in transactions in a manner inconsistent with the views discussed herein. DB trades or may trade as principal in the instruments (or related derivatives), and may have proprietary positions in the instruments (or related derivatives) discussed herein. DB may make a market in the instruments (or related derivatives) discussed herein. Sales and Trading personnel are compensated in part based on the volume of transactions effected by them.

The distribution of this document and availability of these products and services in certain jurisdictions may be restricted by law. Any offering or potential transaction that may be related to the subject matter of this communication will be made pursuant to separate and distinct documentation and in such case the information contained herein will be superseded in its entirety by such documentation in final form.

You may not distribute this document, in whole or in part, without our express written permission. DB SPECIFICALLY DISCLAIMS ALL LIABILITY FOR ANY DIRECT, INDIRECT, CONSEQUENTIAL OR OTHER LOSSES OR DAMAGES INCLUDING LOSS OF PROFITS INCURRED BY YOU OR ANY THIRD PARTY THAT MAY ARISE FROM ANY RELIANCE ON THIS DOCUMENT OR FOR THE RELIABILITY, ACCURACY, COMPLETENESS OR TIMELINESS THEREOF. DB is authorised under German Banking Law (competent authority: BaFin - Federal Financial Supervising Authority) and regulated by the Financial Services Authority for the conduct of UK business.

Securities and investment banking activities in the United States are performed by Deutsche Bank Securities Inc., member NYSE, FINRA and SIPC, and its broker-dealer affiliates.

This document is prepared by [Deutsche Bank AG London Branch] and is distributed in Japan by Deutsche Securities Inc. (“DSI”). Please contact the responsible employee of DSI in case you have any question on this document because DSI serves as contact for the product or service described in this document

Futures

Futures:The risk of loss in futures trading, foreign or domestic can be substantial. As a result of the high degree of leverage obtainable in futures trading, losses may be incurred that are greater than the amount of funds initially deposited. Unless governing law provides other, all transactions should be executed through the Deutsche Bank entity in the investor’s home jurisdiction.

Derivatives

Options Disclaimer:Derivatives and options are complex instruments that are not suitable for all investors, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Supporting documentation or any claims, comparisons, recommendations, statistics or other technical data will be supplied upon request. Any trade information is preliminary and not intended as an official transaction confirmation.

In the US, read the http://onn.theocc.com/publications/risks/riskstoc.pdf or contact the sales desk at +1-212-250-4960. Because of the importance of tax considerations to many option transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated option transactions. Please note that multi-leg option strategies will incur multiple commission charges.

Otc derivatives

This communication was prepared solely in connection with the promotion or marketing, to the extent permitted by applicable law, of the transaction or matter

addressed herein, and was not intended or written to be used, and cannot be used or relied upon, by any taxpayer for purposes of avoiding any U.S. federal income tax penalties or any other applicable tax regulation or law. The recipient of this communication should seek advice from an independent tax advisor regarding any tax matters addressed herein based on its particular circumstances.

Principal Protection:If applicable, the principal protection feature applies only if the securities or instruments are held to maturity. Please note: market values may be affected by a number of factors including index values, interest rates, volatility, time to maturity, dividend yields and issuer credit ratings. These factors are interrelated in complex ways, and as a result, the effect of any one factor may be offset or magnified by the effect of another factor.

Calculations of returns:Calculations of returns on instruments referred to herein may be linked to a referenced index or interest rate. In such cases, the investments may not be suitable for persons unfamiliar with such index or interest rate, or unwilling or unable to bear the risks associated with the transaction. Products denominated in a currency, other than the investor’s home currency, will be subject to changes in exchange rates, which may have an adverse effect on the value, price or income return of the products. These products may not be readily realizable investments and are not traded on any regulated market. The securities referred to herein involve risk, which may include interest rate, index, currency, credit, political, liquidity, time value, commodity and market risk and are not suitable for all investors.

Not insured:These OTC derivative instruments are not insured by the Federal Deposit Insurance Corporation (FDIC) or any other U.S. governmental agency. These instruments are not insured by any statutory scheme or governmental agency of the United Kingdom. These securities have not been registered under the United States Securities Act of 1933 and trading in the securities has not been approved by the United States Commodity Exchange Act, as amended.]

Disclaimers

*Based on market share


Sections of this publication have been produced by the Research Department of Deutsche Bank and have been previously published. For relevant research disclosures please use this link:https://gm.db.com/equities

The information and opinions in the research sections of this document were prepared by Deutsche Bank AG or one of its affi liates (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.

Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily refl ect the opinions of Deutsche Bank and are subject to change without notice. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a recipient thereof in the event that any opinion, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. Prices and availability of fi nancial instruments are subject to change without notice. This report is provided for informational purposes only. It is not an off er or a solicitation of an off er to buy or sell any fi nancial instruments or to participate in any particular trading strategy. Target prices are inherently imprecise and a product of the analyst judgement.

As a result of Deutsche Bank’s recent acquisition of BHF-Bank AG, a security may be covered by more than one analyst within the Deutsche Bank group. Each of these analysts may use diff ering methodologies to value the security; as a result, the recommendations may diff er and the price targets and estimates of each may vary widely.

Deutsche Bank has instituted a new policy whereby analysts may choose not to set or maintain a target price of certain issuers under coverage with a Hold rating. In particular, this

will typically occur for “Hold” rated stocks having a market cap smaller than most other companies in its sector or region. We believe that such policy will allow us to make best use of our resources. Please visit our website at http://gm.db.com to determine the target price of any stock.

The fi nancial instruments discussed in this report may not be suitable for all investors and investors must make their own informed investment decisions. Stock transactions can lead to losses as a result of price fl uctuations and other factors. If a fi nancial instrument is denominated in a currency other than an investor’s currency, a change in exchange rates may adversely aff ect the investment. Past performance is not necessarily indicative of future results. Deutsche Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis.

Foreign exchange transactions carry risk and may not be appropriate for all clients. Participants in foreign exchange transactions may incur risks arising from several factors, including the following: 1) foreign exchange rates can be volatile and are subject to large fl uctuations, 2) the value of currencies may be aff ected by numerous market factors, including world and national economic, political and regulatory events, events in equity and bond markets and changes in interest rates and 3) currencies may be subject to devaluation or government imposed exchange controls which could negatively aff ect the value of the currency. Clients are encouraged to make their own informed investment and/or trading decisions. Past performance is not necessarily indicative of future results. Deutsche Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis

Deutsche Bank’s Cash Return On Capital Invested (CROCI®) valuation metric attempts to transform an accounting return to an economic return. Cash fl ows are calculated on an operating (pre-exceptional) basis and compared to the ‘real’ (economic) invested capital in a business. The latter may include items such as R&D or brands that cannot appear on a balance sheet under current accounting standards. A judgement on current share price valuation can

be made by comparing the current and expected Cash Return On Capital Invested with the true asset multiple of the company, sector or region. CROCI charts show the results of our calculation and include annual returns, the real invested capital base on an annualised basis, and the valuation of the company, again on an annualised basis. If you require any further information on our methodology, please contact [email protected]. CROCI® is a registered trade mark of Deutsche Bank AG in certain jurisdictions. Deutsche Bank AG reserves all of its registered and unregistered trade mark rights.

Derivative transactions involve numerous risks including, among others, market, counterparty default and illiquidity risk. The appropriateness or otherwise of these products for use by investors is dependent on the investors’ own circumstances including their tax position, their regulatory environment and the nature of their other assets and liabilities and as such investors should take expert legal and fi nancial advice before entering into any transaction similar to or inspired by the contents of this publication. Trading in options involves risk and is not suitable for all investors. Prior to buying or selling an option investors must review the “Characteristics and Risks of Standardized Options,” at http://www.theocc.com/components/docs/riskstoc.pdf If you are unable to access the website please contact Deutsche Bank AG at +1 (212) 250-7994, for a copy of this important document.

The risk of loss in futures trading, foreign or domestic, can be substantial. As a result of the high degree of leverage obtainable in futures trading, losses may be incurred that are greater than the amount of funds initially deposited.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, and recipients in Singapore of this report are to contact Deutsche Bank AG, 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 defi ned in the applicable Singapore laws and regulations), Deutsche Bank AG, 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 fi nancial 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 fi nancial 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.

Disclaimers

LondonDeutsche Bank AGWinchester House1 Great Winchester StreetLondon EC2N 2DBUK

Tel: +44 (20) 7 545 8000

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Tel: +852 2203 8888

Frankfurt(from February 2011)

Deutsche Bank AGTaunusanlage 1260311 Frankfurt am mainGermany

Tel: +49 69 910 00

New YorkDeutsche Bank60 Wall StreetNew York, NY10005-2836USA

Tel: +1 (212) 250 2500


Sections of this publication have been produced by the Research Department of Deutsche Bank and have been previously published. For relevant research disclosures please use this link:https://gm.db.com/equities

The information and opinions in the research sections of this document were prepared by Deutsche Bank AG or one of its affi liates (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.

Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily refl ect the opinions of Deutsche Bank and are subject to change without notice. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a recipient thereof in the event that any opinion, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. Prices and availability of fi nancial instruments are subject to change without notice. This report is provided for informational purposes only. It is not an off er or a solicitation of an off er to buy or sell any fi nancial instruments or to participate in any particular trading strategy. Target prices are inherently imprecise and a product of the analyst judgement.

As a result of Deutsche Bank’s recent acquisition of BHF-Bank AG, a security may be covered by more than one analyst within the Deutsche Bank group. Each of these analysts may use diff ering methodologies to value the security; as a result, the recommendations may diff er and the price targets and estimates of each may vary widely.

Deutsche Bank has instituted a new policy whereby analysts may choose not to set or maintain a target price of certain issuers under coverage with a Hold rating. In particular, this

will typically occur for “Hold” rated stocks having a market cap smaller than most other companies in its sector or region. We believe that such policy will allow us to make best use of our resources. Please visit our website at http://gm.db.com to determine the target price of any stock.

The fi nancial instruments discussed in this report may not be suitable for all investors and investors must make their own informed investment decisions. Stock transactions can lead to losses as a result of price fl uctuations and other factors. If a fi nancial instrument is denominated in a currency other than an investor’s currency, a change in exchange rates may adversely aff ect the investment. Past performance is not necessarily indicative of future results. Deutsche Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis.

Foreign exchange transactions carry risk and may not be appropriate for all clients. Participants in foreign exchange transactions may incur risks arising from several factors, including the following: 1) foreign exchange rates can be volatile and are subject to large fl uctuations, 2) the value of currencies may be aff ected by numerous market factors, including world and national economic, political and regulatory events, events in equity and bond markets and changes in interest rates and 3) currencies may be subject to devaluation or government imposed exchange controls which could negatively aff ect the value of the currency. Clients are encouraged to make their own informed investment and/or trading decisions. Past performance is not necessarily indicative of future results. Deutsche Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis

Deutsche Bank’s Cash Return On Capital Invested (CROCI®) valuation metric attempts to transform an accounting return to an economic return. Cash fl ows are calculated on an operating (pre-exceptional) basis and compared to the ‘real’ (economic) invested capital in a business. The latter may include items such as R&D or brands that cannot appear on a balance sheet under current accounting standards. A judgement on current share price valuation can

be made by comparing the current and expected Cash Return On Capital Invested with the true asset multiple of the company, sector or region. CROCI charts show the results of our calculation and include annual returns, the real invested capital base on an annualised basis, and the valuation of the company, again on an annualised basis. If you require any further information on our methodology, please contact [email protected]. CROCI® is a registered trade mark of Deutsche Bank AG in certain jurisdictions. Deutsche Bank AG reserves all of its registered and unregistered trade mark rights.

Derivative transactions involve numerous risks including, among others, market, counterparty default and illiquidity risk. The appropriateness or otherwise of these products for use by investors is dependent on the investors’ own circumstances including their tax position, their regulatory environment and the nature of their other assets and liabilities and as such investors should take expert legal and fi nancial advice before entering into any transaction similar to or inspired by the contents of this publication. Trading in options involves risk and is not suitable for all investors. Prior to buying or selling an option investors must review the “Characteristics and Risks of Standardized Options,” at http://www.theocc.com/components/docs/riskstoc.pdf If you are unable to access the website please contact Deutsche Bank AG at +1 (212) 250-7994, for a copy of this important document.

The risk of loss in futures trading, foreign or domestic, can be substantial. As a result of the high degree of leverage obtainable in futures trading, losses may be incurred that are greater than the amount of funds initially deposited.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, and recipients in Singapore of this report are to contact Deutsche Bank AG, 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 defi ned in the applicable Singapore laws and regulations), Deutsche Bank AG, 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 fi nancial 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 fi nancial 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.

Disclaimers

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Tel: +44 (20) 7 545 8000

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Tel: +852 2203 8888

Frankfurt(from February 2011)

Deutsche Bank AGTaunusanlage 1260311 Frankfurt am mainGermany

Tel: +49 69 910 00

New YorkDeutsche Bank60 Wall StreetNew York, NY10005-2836USA

Tel: +1 (212) 250 2500

Markets in 2011 —Foresight with Insight Deutsche Bank

Economy & Finance

Markets-in-2011_DB