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ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER
IMPORTANT DISCLOSURES, PLEASE REFER TO https://firesearchdisclosure.credit-suisse.com.
CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION
Client-Driven Solutions, Insights, and Access
Market Focus
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 pessimismappeared 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.
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
17 January 2013
Economics Research
http://www.credit-suisse.com/researchandanalytics
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Market Focus 2
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.
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Market Focus 3
Exhibit 1: Global and US credit risk appetite
Euphoria
Panic
-7
-5
-3
-1
1
3
5
7
95 97 99 01 03 05 07 09 11 13
Global Risk Appetite
US Credit Risk Appetite
Exhibit 2: Global risk appetite and global IP momentum
-10
-8
-6
-4
-2
0
2
4
6
-24%
-20%
-16%
-12%
-8%
-4%
0%
4%
8%
12%
16%
20%
90 92 94 96 98 00 02 04 06 08 10 12
Global IP Momentum
Global Risk Appetite (daily, rhs)
Euphoria
Panic
Exhibit 3: 5-year moving average of global risk appetite
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
81 84 87 90 93 96 99 02 05 08 11
Extremely high
Extremely low
Long-run average(1981-2006)
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service, Thomson Reuters DataStream
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Market Focus 4
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 requiresthe 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) 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.
2) 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.
3) 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.
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Market Focus 5
Exhibit 4: MSCI World with downtrend
Exhibit 5: World Wealth with tramlines
-17% -34%
-39%
5.6
5.8
6
6.2
6.4
97 99 00 02 04 06 08 10 12
(in logscale)
Exhibit 6: World Wealth with trend
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service, Thomson Reuters DataStream
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Market Focus 6
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
100
120
140
160
180
200
220
240
0 1 2 3 4 5 6
12/08/1982
09/03/1995
09/10/2002
02/03/2009
years from trough
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
NovemberThis Time Its Different.
https://plus.credit-suisse.com/r/JRGyoGhttps://plus.credit-suisse.com/r/JRGyoGhttps://plus.credit-suisse.com/r/JRGyoGhttps://plus.credit-suisse.com/r/JRGyoGhttps://plus.credit-suisse.com/r/JRGyoGhttps://plus.credit-suisse.com/r/JRGyoG7/29/2019 Credit Suisse, Market focus, Jan 17,2013
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17 January 2013
Market Focus 7
Exhibit 8: Global IP cycles compared
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
0 12 24 36 48 60
Global IP Momentum rebased from trough
Nov-82
Dec-92
Nov-01
Feb-09months from trough
Source: Credit Suisse, Thomson Reuters DataStream
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 shiftthe 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 th e 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. Ofcourse 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 short-
term boost. By late summer we now see the level of Japanese industrial production some
4%-5% higher than in our previous forecast.
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Market Focus 8
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 toroughly 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.
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Market Focus 9
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 self-
reinforcing 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- tolong-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.
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Market Focus 10
Exhibit 9: US and Global IP and EPS
0
20
40
60
80
100
120
140
160
180
75
80
85
90
95
100
105
110
115
120
0 1 2 3 4 5 6
(rebased from Feb 08)
Global IP
US IP
US EPS (rhs)
time in years
Exhibit 10: Global IP and earnings surprises
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%10%
12%
0.350.400.450.500.550.600.650.700.750.800.850.900.951.001.051.10
1.15
85 87 89 91 93 95 97 99 01 03 05 07 09 11 13
Earnings Surprise (Actual Earnings to Forecast Ratio)
Global IP yoy% (rhs)
Exhibit 11: World Wealth and Global IP, log level
4.5
4.7
4.9
5.1
5.3
5.5
5.7
5.9
4.8
5
5.2
5.4
5.6
5.8
6
6.2
6.4
6.6
6.8
85 87 89 91 93 95 97 99 01 03 05 07 09 11 13
World Wealth
Global IP, rhs
Trend IP Growth= 4.3% p.a. (1985 to 2011)
Trend World Wealth Growth
= 5.2% p.a. (1985 to 2011)
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service, Thomson Reuters DataStream
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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 One Cabot Square, London E14 4QJ, United Kingdom
Paul McGinnie, Director
+44 20 7883 6481
paul.mcginnie@credit-suisse.com
Matthias Klein, Director
+44 20 7883 8189
matthias.klein@credit-suisse.com
Aimi Plant, Associate
+44 20 7888 7054aimi.plant@credit-suisse.com
NEW YORK 11 Madison Avenue, New York, NY 10010
James Sweeney, Managing Director
+1 212 538 4648james.sweeney@credit-suisse.com
Wenzhe Zhao, Associate
+1 212 325 1798wenzhe.zhao@credit-suisse.com
Jeremy Schwartz, Analyst
+1 212 538 6419jeremy.schwartz@credit-suisse.com
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Disclosure Appendix
Analyst CertificationJonathan 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) theviews 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 orindirectly related to the specific recommendations or views expressed in this report.
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