17 January 2013 Economics Research

http://www.credit-suisse.com/researchandanalytics

Market Focus
Research Analysts Jonathan Wilmot +44 20 7888 3807 jonathan.wilmot@credit-suisse.com James Sweeney 212 538 4648 james.sweeney@credit-suisse.com Matthias Klein +44 20 7883 8189 matthias.klein@credit-suisse.com Paul McGinnie +44 20 7883 6481 paul.mcginnie@credit-suisse.com Aimi Plant +44 20 7888 7054 aimi.plant@credit-suisse.com Wenzhe Zhao 212 325 1798 wenzhe.zhao@credit-suisse.com Jeremy Schwartz 212 538 6419 jeremy.schwartz@credit-suisse.com

The state of risk appetite

Viewed in longer perspective the state of investor risk appetite is severely depressed arguably worse than at any time in the last 25-30 years. You might call this a secular funk, reflected in the massive de-risking of investor portfolios over the course of the last 12-13 years, the relative valuation of safe versus riskier assets, the tendency to look for a system threatening Black Swan events around every corner and what is for our money an excessive and sometimes indiscriminate use of the deleveraging word. We cannot remember a time even in the late 1970s when pessimism appeared so pervasive and uncertainty about the longer-term future seemed so great among investors and business leaders alike. But in the short-run, some of our measures of risk appetite have started to froth a bit (Exhibit 1). US Credit Risk Appetite is leading the way. Late last year it soared into the euphoria zone, for the first time since early 2010, and is in fact at a 10-year high. Thats some turnaround from the extreme panic of 2011. Global Risk Appetite remains comfortably below the euphoria zone. But it is above its early 2012 peak, and Credit Risk Appetite is sometimes a good leading indicator. Meanwhile, equity sentiment indicators are already uncomfortably high, with the year less than three weeks old. So could we be heading for the first euphoria episode since 2006? And if we do hit euphoria, when is that most likely to happen and what will it mean? Will that be the last chance to get out before the next great crash? Or the big overbought signal that often signals the start of a new bull market phase? The answer at the end of the day will depend on growth, as we explore below. But there is something rather intriguing worth looking at first. A few years ago, we put together a small model designed to give prior warning of major market crises. We called it the Composite Risk Indicator, and the idea was, first, to identify when the potential for a bad market episode was unusually high (propensity), and then to identify potential catalysts that might help precipitate the crisis itself (triggers). Though this was not the original purpose, the system by definition also generates positive risk signals moments when the propensity for a period of good markets (higher-than-normal Sharpe ratios for risk assets) is unusually high.

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17 January 2013

Within the propensity part we found the most useful approach was to look at valuation measures and leverage. When one or more important global asset markets was significantly overvalued, when unusually rapid credit growth to the real economy had taken place in recent years, and/or leverage within the financial sector itself was unusually high, then propensity for a major bad market episode was also high. (And in principle vice versa.) Among the possible catalysts for a crisis in waiting to occur within weeks or months, we put unusually tight monetary conditions, an imminent peak in global growth momentum, and risk appetite euphoria episodes. So the full recipe for a major crisis could be thought of as follows: extreme overvaluation of one or more major global asset classes, abnormally high real economy or high financial system leverage, risk appetite euphoria, imminent turndown in global growth (IP momentum), and hostile monetary policy. So far so intuitive. But the hardest part of this exercise was to find consistent, comprehensive, and timely estimates of financial system leverage. We looked at many plausible candidates but in the end the Holy Grail eluded us and we decided to put in the 5-year moving average of risk appetite itself (Exhibit 3), using it as a rough proxy for the longer cycle in financial system leverage. Statistically this is a bit risqu, but intuitively its very appealing. And it certainly seemed to work in terms of giving appropriate signals in 1987, in 1989/90, in 2002 (positive risk signal) and 2007/8. Now currently the 5-year moving average of Global Risk Appetite is just turning up from an all-time low. A possible interpretation of that is as follows: financial system leverage partly through the impact of regulation, partly through the effect of poor risk asset returns and exceptionally high volatility has overshot to the downside and is just starting to improve from abnormally low levels. So financial system leverage, arguably a leading indicator of real economy credit availability and demand, is potentially starting a new longer-term up cycle! We are aware that this idea will annoy some of our readers, or at least worry them, but we tend to think that our simple leverage proxy suggests that the global credit cycle is starting to shift from a vicious circle process to a more virtuous process which will help support a more complete recovery in the real economy. For us its not just a key policy goal but also a humanitarian imperative to get the major developed economies back on to a more robust growth path, one that offers hope of a return to full employment within a few years. For that you need investors and private sector business leaders who are less frightened, more stable collateral to borrow and lend against, and a gradual re-expansion of funding liquidity; loan demand and loan supply based on both sounder collateral and a sounder capital structure within the banking system.

Market Focus

17 January 2013

Exhibit 1: Global and US credit risk appetite

7
Euphoria 5

3
1

-1
-3

-5
-7 95 97

Global Risk Appetite US Credit Risk Appetite

Panic

99

01

03

05

07

09

11

13

Exhibit 2: Global risk appetite and global IP momentum

20% 16% 12% 8% 4% 0% -4% -8% -12% -16% -20% -24% 90 92 94 96 98 00 02 04 06 08 10 12 Global IP Momentum Global Risk Appetite (daily, rhs) Panic Euphoria 6

4
2

0
-2

-4
-6

-8
-10

Exhibit 3: 5-year moving average of global risk appetite

3.0

2.5
Extremely high

2.0

1.5
1.0 0.5 0.0
Extremely low

Long-run average (1981-2006)

-0.5 -1.0

81

84

87

Panic

Panic

90

93

96

99

02

05

08

11

Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service, Thomson Reuters DataStream

Market Focus

17 January 2013

Obviously, not all parts of the world economy and financial system fully meet those key conditions sound collateral, adequate capitalization, more secure funding for a normalization of credit supply and demand. But we have made some progress everywhere, even in Europe. And in at least two key regions the US and China we think there is reason to believe that a positive turning point is already under way. A key test for a normalization of the credit cycle is a normalization of the cost and availability of longer-term credit for the banks and quasi-banks. So what would you expect to see if the credit cycle is turning up again? A credit risk appetite euphoria due to the outperformance of longer-dated bonds issued by financial institutions and banks! Which is exactly what we have seen in recent months. But the change in market psychology is also visible elsewhere. Exhibit 4 shows how MSCI World is arguably breaking the long-term downtrend it has been in since 2009. Exhibits 5 and 6 look at our World Wealth Index (65% global equities, 35% global fixed income) in two slightly different ways. The first chart shows how we have recently broken out to a new all-time high, with a healthy acceleration post that break out. To us this is in itself a hint that there is considerable room for World Wealth to climb further over the next couple of years, which by definition requires the equity component of the index to do so at a more accelerated pace. The second chart indicates that World Wealth is already shifting towards a steeper and less volatile uptrend than the prevailing norm of the last two years, though we note that the top of the steeper uptrend is a few percent away. The last World Wealth chart (Exhibit 7) shows how the current cycle is tracking previous five-year bull markets quite closely. Given how low leverage is now, and how far we are from full employment, is it possible that this World Wealth cycle could be even longer than five years? So a number market signals are there to support the following hypothesis: 1) 2) 3) On a longer-term view risk appetite remains abnormally low, but the medium-term trend may finally be turning up, consistent with an upturn in the global credit cycle. On a shorter-term basis the prospective returns for equities (absolutely and relative to safe bonds) may have already shifted to a steeper and less volatile uptrend. If so, we should allow for the possibility that the next euphoria may be a big one, like Credit Risk Appetite now, and quite extended too. The subsequent correction, by contrast may be unusually shallow, even if it too takes months to complete.

Market Focus

17 January 2013

Exhibit 4: MSCI World with downtrend

Exhibit 5: World Wealth with tramlines

(in logscale)
6.4 6.2

6
5.8 -39%

-17%

-34% 00 02 04 06 08 10 12

5.6
97 99

Exhibit 6: World Wealth with trend

Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service, Thomson Reuters DataStream

Market Focus

17 January 2013

That is quite a familiar story: at the very moment a new medium-term bullish phase begins markets sometimes get strongly overbought in the short-run, something that is in the end a confirmation of a new and more positive regime rather than a signal of a major and bearish trend reversal. This is more likely to happen when medium-term (real money) investors are poorly positioned for the new trend. That is very much where we think real money is now: under or outright badly positioned for better global growth over the next year or two.

Exhibit 7: World Wealth recoveries from trough

240 220 200 180 160 140 12/08/1982 09/03/1995 09/10/2002 02/03/2009

120
100 0 1 2

years from trough

3 4 5 6

Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service, Thomson Reuters DataStream

At the end of the day, however, market signals can only suggest what the future may bring, and can always be over-ridden by fundamentals or major new shocks. On the fundamental side the main issue is global growth, and whether that is set to improve on a sustained basis. Going back to Exhibit 2 it is clear that Global Risk Appetite as so often has already anticipated a significant pick-up in global production momentum (from a low of -1.3% per annum in November to a local peak/plateau of 7.3% around April/May). This is unusually far ahead of the improvement in global PMI new orders so far seen, but we expect better confirmation over the next few months. But this is where it gets really interesting. A simple comparison of the recovery since March 2009 with the last three expansions suggests we are at the very moment when you might expect to shift from a virtual standstill in global IP growth to a new phase in which growth is both stronger (at or slightly above trend), and significantly less volatile. See Exhibit 8 and our Market Focus from 05 November This Time Its Different.

Market Focus

17 January 2013

Exhibit 8: Global IP cycles compared

15% 10%

Global IP Momentum rebased from trough

5%
0% -5% -10% -15% Nov-82 Dec-92

Nov-01 -20%
-25% 0 12 24 36 48 60
Source: Credit Suisse, Thomson Reuters DataStream

months from trough

Feb-09

Moreover, one could argue that the fragility of growth recently, and the repeated doses of system-threatening political brinkmanship that have contributed to it, have started to shift the momentum of policy in a more growth-friendly direction. With an obvious short-term caveat for US fiscal policy, the global drift of monetary policy, financial regulation and fiscal policy is towards a more stimulative, or somewhat less restrictive path. Add that to the tendency for mid-cycle slowdowns to end at about this stage in prior expansions, the hints from our financial leverage proxy that the global credit cycle is turning up, and the better equity market dynamics discussed above, and you begin to wonder: are we about to see the new normal consensus die a slow death? To be replaced in due course by something less emotionally addictive but altogether more interesting? (Which isnt, by the way, a simple return to the old normal.) In any case, the new normal story has been a brilliant parable for our times, and whats more a highly effective guide to investors since the Greek crisis really started to escalate. Its not so much our forecast that would be foolishly over-confident as our working hypothesis that the best days of the new normal story as an investment road map are already behind us. Like all working hypotheses this one needs to be continually checked and re-checked against the facts. On that score the latest incremental news on global growth contains a couple of surprisingly positive items and one potentially (big) negative. In the positive ledger we see China and Japan. For China the key innovation of the last several weeks has been a dramatic turn round in the domestic equity market, and perhaps most significantly in the fortunes of the bank stocks. Coupled with growing evidence of better credit supply and demand. In Japan, Abenomics has galvanised the equity market, given a big shot in the arm to business confidence and put Japan firmly back on the agenda for global investors. Of course the jury remains out on finally ending Japans long deflationary malaise, but Abe has already transformed the likely path for Japanese growth over the next six months. The top political priority is to make certain of an LDP majority in the Upper House elections this summer (giving the government more leverage over the BoJ among other things), and fiscal policy is being managed to that end. There will likely be no consumption tax increase until the economy is in better shape, while government investment is to get a big shortterm boost. By late summer we now see the level of Japanese industrial production some 4%-5% higher than in our previous forecast.

Market Focus

17 January 2013

That has an important effect on our global IP projections, which now look for more of a growth plateau in Q2/Q3 than a clear-cut peak. These are just the growth conditions that could support an extended euphoria The obvious negative is the second and potentially more bitter round of US fiscal cliff bargaining. Meaning this particular lump of policy uncertainty is down but by no means out. Market talk at the moment is that we are learning to live with all this political brinkmanship and that at the end of the day we will get a last minute agreement on spending cuts to roughly match the tax increases passed in January. So the chances are we wont get much market disruption this time round. We are a lot more cautious. It all depends on exactly which instrument the politicians choose to play their game of chicken with. If it looks at any stage as if there is even a small chance of failing to pass a debt ceiling increase in time, and thus forcing the US government into technical default, however short lived, we think the chances of a nasty sell-off in US Treasuries, the dollar and risk assets all at the same time are all too real. Thats because as we understand it the treasury market would be effectively rendered totally illiquid and untradeable, and in a way that could not be easily restored in a day or two. But perhaps because of the potentially extreme consequences the (Republicans) instrument of choice in this particular stand-off might be the indication to let the spending sequester happen on March 1, using it as a bludgeon to force an agreement on deeper (entitlement) spending cuts in the days or weeks afterwards. That is potentially less disruptive, but far from good news for the economy in the short-run. And it highlights the paradox behind our global IP projections: the medium-term prospect of faster private sector GDP growth in the US, as housing turns and becomes good collateral again, is a higher conviction story than robust growth in the euro zone, or even Japan. But over the next few months there is considerable policy risk to our current US production forecast. And while that risk remains, we think it will be quite hard for US bonds to sell off significantly at the same time as global equities rally further, which is the combination most likely to push Global Risk Appetite all the way into the euphoria zone. And at the limit, Washington still has the capacity to quite seriously damage both the short-term outlook for growth and the new found optimism about equity market performance this year. Either way, we think the most likely timing for a (potentially quite extended) risk appetite euphoria episode will be in the second quarter, just about when global IP growth is plateauing. And even if global growth cools a bit from there, there is a decent chance that the pullback in growth momentum (and global equity markets) will be relatively shallow, ushering in a much more optimistic outlook for global growth in 2014 than most people can yet realistically imagine. Our last panel of charts helps to highlight some of the potential consequences of that. First, it is remarkable just how closely real US earnings per share track the level of global industrial production (Exhibit 9). So if global IP grows in the sort of way it did at the same stage of previous expansions, then we would expect US earnings to largely follow suit (thus remaining way above trend for a surprisingly long time). Second, there need be no real dichotomy between the recent rally in equity markets and faltering earnings momentum: the prospect is for negative earnings surprises to moderate as year-on-year growth in global production picks up, Exhibit 10.

Market Focus

17 January 2013

Third, the longer-term trend in our World Wealth index is fairly closely aligned with the longer-term trend of global industrial production, but with World Wealth tending to oscillate around the growth trend. The periods of what one might call multiple expansion tend to come when the credit cycle is improving, with the crashes back to earth during periods of sharp de-leveraging and recession. So if, and when, confidence in the sustainability of growth improves World Wealth will likely rise faster than growth itself. In sum, the near-term prospects for this risk appetite rally are pretty mixed, but that is in a sense not the really important story. The curious state of risk appetite and financial sector leverage deeply depressed on a longer-term view getting a little frothy in the short term are in a sense pointing in the same direction. For the first time in a few years, there is room to imagine not a perfect future, but a brighter and less unstable couple of years in which the private credit cycle starts to reinforce growth, and growth starts to reinforce the credit cycle. So instead of the central banks having to work overtime to stop a vicious cycle of selfreinforcing credit stress, they will (eventually) be able to return to more conventional policy making, as private sector credit channels start to function more fully again. There are of course many stages yet to come in the long saga of restoring the medium- to long-term sustainability of government finances in the US, Europe and Japan, but more robust (nominal) growth is the essential foundation for more structural solutions to be gradually put in place. There is neither any prospect, nor any overriding need, for radical and complete solutions to be found immediately. Indeed, right now one can say that the most crucial factor is that policy makers do no great harm to the evolving pick-up in global growth. And specifically that Congress and the President end up doing basically the right thing in Act II of the fiscal cliff drama. After, no doubt, exhausting every other alternative.

Market Focus

17 January 2013

Exhibit 9: US and Global IP and EPS

120
115 110
Global IP US IP US EPS (rhs)
(rebased from Feb 08)

180
160 140

105
100 95 90 85

120
100 80 60 40
time in years

80
75 0 1 2 3

20
0 5 6

Exhibit 10: Global IP and earnings surprises

1.15 1.10 1.05 1.00 0.95 0.90 0.85 0.80 0.75 0.70 0.65 0.60 0.55 0.50 0.45 0.40 0.35 12% 10% 8% 6% 4%

2% 0% -2% -4%
Earnings Surprise (Actual Earnings to Forecast Ratio) Global IP yoy% (rhs)

-6%
-8% -10%

85

87

89

91

93

95

97

99

01

03

05

07

09

11

13

Exhibit 11: World Wealth and Global IP, log level 6.8
6.6 6.4 6.2 6 5.8 5.6 5.4 5.2 5 4.8
World Wealth Global IP, rhs Trend World Wealth Growth = 5.2% p.a. (1985 to 2011)

5.9
5.7 5.5 5.3 5.1 4.9

Trend IP Growth = 4.3% p.a. (1985 to 2011)

4.7
4.5

85

87

89

91

93

95

97

99

01

03

05

07

09

11

13

Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service, Thomson Reuters DataStream

Market Focus

10

FIXED INCOME GLOBAL STRATEGY RESEARCH

Jonathan Wilmot, Managing Director Chief Global Strategist +44 20 7888 3807 jonathan.wilmot@credit-suisse.com Eric Miller, Managing Director Global Head of Fixed Income and Economic Research +1 212 538 6480 eric.miller.3@credit-suisse.com

LONDON
Paul McGinnie, Director +44 20 7883 6481 paul.mcginnie@credit-suisse.com Matthias Klein, Director +44 20 7883 8189 matthias.klein@credit-suisse.com

One Cabot Square, London E14 4QJ, United Kingdom

Aimi Plant, Associate +44 20 7888 7054 aimi.plant@credit-suisse.com

NEW YORK
James Sweeney, Managing Director +1 212 538 4648 james.sweeney@credit-suisse.com Wenzhe Zhao, Associate +1 212 325 1798 wenzhe.zhao@credit-suisse.com

11 Madison Avenue, New York, NY 10010

Jeremy Schwartz, Analyst +1 212 538 6419 jeremy.schwartz@credit-suisse.com

Disclosure Appendix
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Jonathan Wilmot, James Sweeney, Matthias Klein, Aimi Plant, Wenzhe Zhao and Jeremy Schwartz each certify, with respect to the companies or securities that he or she analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.
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Investment principal on bonds can be eroded depending on sale price or market price. In addition, there are bonds on which investment principal can be eroded due to changes in redemption amounts. Care is required when investing in such instruments.
When you purchase non-listed Japanese fixed income securities (Japanese government bonds, Japanese municipal bonds, Japanese government guaranteed bonds, Japanese corporate bonds) from CS as a seller, you will be requested to pay the purchase price only.