World Outlook Torsten Slok

Deutsche Bank Markets Research
Global Cross-Discipline Date 20 June 2013

Peter Hooper Chief Economist (+1) 212 250-7352 peter.hooper@db.com Michael Spencer Chief Economist (+852) 2203 8303 michael.spencer@db.com
World Outlook
Fed Policy Tapers Global Markets
The June FOMC communication confirmed recent Fedspeak suggesting that a reduction in asset purchases is likely this year if the US economy evolves in line with our (and the Feds) expectations. With renewed focus on eventual Fed exit, rates have risen sharply and risk assets have weakened. These and other market reactions to the Feds policy shift are the focus of our World Outlook this quarter. Consistent with this recent guidance and our forecast, we anticipate an initial taper of QE3 in September, with purchases ending by mid 2014, and very possibly sooner with faster progress in reducing unemployment. Rate hikes should commence by mid-2015, and the Fed will not be selling assets on exit. Market adjustment to this policy shift will not occur without significant disruption and pain, as rates rise further amid heightened volatility. Those markets that have shown signs of becoming frothy during the Feds prolonged period of extraordinary monetary ease should be most vulnerable to this move. Ultimately, however, we expect the rise in rates to be contained, and improved growth prospects should support risk assets, including equities. We continue to see 2013 as a transition year for the global economy, with growth approaching potential by year-end. We have marked down slightly our global growth forecasts for this year and next in light of recent underperformance, most notably in EM economies. Our outlook for AEs remains largely intact, with the exception of a significant upgrade of prospects in Japan. To be sure, a more disorderly market response to the start of a Fed exit from QE is possible and represents the most significant risk to our outlook over the year ahead. If rates rise more sharply than we anticipate, or equities react adversely, the negative market response could well spillover to growth prospects. Such a reaction could cause the Fed to delay or reduce the pace of its tapering. Any setback would be less painful than the recent crisis, as balance sheets and global imbalances have improved significantly since that time.
Economic Forecast Summary

GDP growth ,% 2013F 2014F 1.4 2.2 2.2 3.2 2.0 0.6 -0.6 1.0 6.3 7.3 7.9 8.8 5.5 6.5 2.7 3.6 2.8 3.3 2.8 3.6 2.4 3.1 1.2 4.9 3.0 2.1 5.8 3.9 CPI inflation,% 2013F 2014F 1.5 2.1 1.7 2.3 -0.1 2.3 1.5 1.5 3.3 4.1 2.6 3.5 5.4 5.7 5.1 4.9 6.8 6.0 8.3 8.4 6.4 5.6 1.5 4.5 3.0 2.0 5.0 3.5
G7 US Japan Euroland EM Asia China India EMEA Russia Latam Brazil Advanced economies EM economies Global
Source: DB Research
2011 1.5 1.8 -0.5 1.5 7.5 9.3 7.5 4.9 4.3 4.3 2.7 1.4 6.4 3.8
2012 1.4 2.2 1.9 -0.5 6.1 7.8 5.1 2.8 3.4 2.8 0.9 1.2 4.8 2.9
2011 2.6 3.1 -0.3 2.7 6.0 5.4 9.5 6.4 8.4 8.4 6.6 2.6 6.5 4.5
2012 1.9 2.1 0.0 2.5 3.8 2.6 7.5 5.0 5.1 7.8 5.4 1.9 4.8 3.3
_______________________________________________________________________________________________________________ Deutsche Bank Securities Inc. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 054/04/2013.
20 June 2013 World Outlook: Fed Policy Tapers Global Markets
Table of Contents
Global Overview Fed Policy Tapers Global Markets US Why taper? Why now? Europe An unconvincing calm Japan Recovery has started in Q1 2013 Asia (ex Japan) A slightly delayed recovery Latin America Tested by shifting flows and strong dollar outlook Global Asset Allocation Growth versus stimulusThe Feds taper US Equity Strategy Attractive long-term S&P 500 outlook as economy returns to normal European Equities Strategy The domestic cyclical strategy Rate Outlook Rates to sell-off beyond the peak of monetary stimulus and fiscal tightening Credit Strategy Credit in the face of QE tapering US MBS & Securitization Outlook Fed exit and MBS FX Strategy Rotation within a USD trend Commodities Hazards from new supply, Fed exit and a turn in the US dollar Geopolitics More internationalization of the Syrian Civil War Forecast table Key Economic Indicators Interest Rates Exchange Rates Long-term Forecasts Contacts 3
10
15
23
25
27
29
33
35
37
40
43
44
47
49
51 52 53 54 55
Page 2
Deutsche Bank Securities Inc.
Global Overview: Fed Policy Tapers Global Markets

Introduction1
When last we updated our view in March, we emphasized the importance of central bank liquidity for global asset prices and the ongoing global economic recovery. Recent market developments have underscored this fact. As indications of Fed tapering have intensified, market volatility and rates have risen, and global risk assets have weakened. The outlook for monetary policy will continue to be a focal point for the economy and financial markets in the quarter ahead, and will thus be a common theme in our outlook. In this quarters overview, we begin by outlining recent developments in the global economy and our baseline outlook for the year ahead. We then present our expectations about Fed tapering and eventual exit from its unprecedented accommodation, and discuss our baseline scenario for the economy and markets consistent with these expectations. We also summarize our strategists views for how equities, rates, credit, FX, and commodities will react to this policy shift. Given the uncertainty about the economic conditions on which a taper is contingent, and on the market response to a slower pace of purchases, we also present the risks to our baseline view as we see them. unadjusted for a further contraction in the Euro area and marginally reduced our forecast for US growth this year, on the back of slightly slower growth in the first half than anticipated. In aggregate, these adjustments caused us to markdown global growth prospects for this year and next by 0.2 and 0.1 pp, respectively. Figure 1: Growth returning to trend
10 8 6 4 2 0 -2 -4 -6 2000 World Advanced economies Emerging economies Trend: World Trend: Advanced economies Trend: Emerging economies 2002 2004 2006 2008 2010 % yoy Real GDP grow th Forecasts
Economic outlook
Global growth outlook has weakened slightly As we move into the second half of the year, we continue to see 2013 as a year of transition, with global growth expected to rise closer to potential by year-end (Figure 1). However, growth in the first half of the year has underperformed our prior expectations, particularly in Emerging Market economies, causing us to downgrade slightly our global GDP growth forecasts for this year and next (Figure 2). The downward revisions to growth in EMs were relatively broad-based, with India, Russia and Brazil experiencing the largest downgrades. Growth in China this year was also revised lower by several tenths of a percent. These revisions led to a downward adjustment to 2013 EM growth of 0.6 pp in aggregate. On the other hand, the 2013 growth forecast for advanced economies has been upgraded slightly. In response to the bold policy initiatives of the Abe government, our Japanese growth forecast for this year was increased substantially. Elsewhere in advanced economies, we left our forecast
2012
2014
Source: IMF, Haver Analytics, DB Research
Figure 2: Global GDP growth forecast & revision (% yoy)

Forecast level Jun13 WO 2012 2013F 2014F G7 US Japan EA EM Asia China India EMEA Russia Latam Brazil Advanced economies EM economies Global
Source: DB Research
Forecast change since Mar13 WO 2012 2013F 2014F 0.0 0.0 -0.1 0.1 0.2 0.0 1.0 0.0 0.0 0.0 0.0 0.0 0.1 0.0 0.1 -0.1 0.6 0.0 -0.5 -0.3 -1.4 -0.7 -1.5 -0.7 -0.9 0.1 -0.6 -0.2 0.0 0.0 0.0 0.0 -0.2 -0.1 -0.7 -0.3 -0.9 -0.4 -1.1 0.0 -0.3 -0.1
1.4 2.2 1.9 -0.5 6.1 7.8 5.1 2.8 3.4 2.8 0.9 1.2 4.8 2.9
1.4 2.2 2.0 -0.6 6.3 7.9 5.5 2.7 2.8 2.8 2.4 1.2 4.9 3.0
2.2 3.2 0.6 1.0 7.3 8.8 6.5 3.6 3.3 3.6 3.1 2.1 5.8 3.9
The Authors are grateful to Stefan B. Schneider and Oliver Rakau for their production editing of this report. We also wish to thank especially Manjuri Das, Siddhartha Chanda, Kuhumita Bhattacharya, Baqar Zaidi and Moumita Paul, employees of Infosys Ltd., a third party provider to Deutsche Bank offshore research support services, for their assistance.
1
Page 3
US growth remains on track The concerns of a sequester-induced mid-year slump in the US have not (yet) materialized, as employment growth and consumer spending have proven resilient to tax increases and lower government spending. As a result, our outlook for the US economy has remained broadly intact. Entering this year, we anticipated that the fiscal drag resulting from the expiration of the payroll tax reduction and sequester-related spending cuts would weigh on US growth in H1, but that continued improvements in consumer balance sheets and a strong rebound in housing activity would overcome this drag and push growth toward potential by year-end. Rapid house and equity price appreciation have continued to support consumer balance sheets and, along with a resilient labor market, have supported consumer spending. And housing market prospects, as indicated by low inventory, rising demand, continued price appreciation, and buoyant homebuilder sentiment, are supportive of a strengthening housing recovery in H2. Government policy concerns related to budget negotiations and the debt ceiling have thus far proven to be a non-issue for markets and the economy, and we anticipate that this will continue. As such, the rebound in US growth remains on track, with a disorderly market reaction to Fed tapering as the most significant risk going forward. We discuss the prospects for Fed tapering in more detail in the last section of this overview. Growth outlook upgraded in Japan Our outlook for Japan this year has been revised up meaningfully in response to the bold policy initiatives of the Abe administration, while we left our forecast for 2014 unrevised. The initial market reaction to this policy announcement was substantial, as the yen depreciated significantly, stock values rose, and inflation expectations moved up. And crucial to the ultimate goals of these policies, there is early evidence that these market reactions are spilling over to the real economy. First quarter growth came in well ahead of expectations and business and consumer confidence have risen. However, the unveiling of the third pillar of Abenomics structural reforms was met with market skepticism due to what was perceived as an underwhelming proposal that lacked sufficient scope and detail. This reaction brought about sharp reversals in previous trends, as the yen and stock prices have experienced significant corrections, and volatility has risen. We anticipate that these corrections will prove transitory, and financial conditions should remain supportive of growth in Japan going forward. Growth is still expected to take a significant hit from the VAT hike next year, but we have left our 2014 growth forecast unrevised.
Euro area growth unrevised this year, slight upgrade to 2014 We left our forecast for Euro area growth this year unchanged at -0.6% and upgraded 2014 growth by 0.1pp. Although early growth indicators were generally disappointing this year, recent indicators have been more mixed. Industrial production figures improved meaningfully in Germany and France, but continued weakness for Spain and Italy is evident. On the other hand, PMIs have been broadly disappointing more recently and point to downside risks to near-term growth prospects. We continue to believe that growth should improve in H2, helped in part by improving external demand and slowing fiscal austerity. The ECB has maintained their dovish bias and in theory kept all policy tools on the table. The ECB returned to conventional policy easing in May rather than opt for more contentious unconventional measures (e.g. negative deposit rates, purchasing SME securities), but the recent dataflow has in our view tipped the balance of risks away from further conventional easing. In particular, the trend acceleration in the PMI in recent months should give the ECB hope that the forecast of a H2 recovery remains intact. We now no longer see a final quarter point rate cut as a baseline and see the refi rate remaining at 0.5% over the next 12 months at least and the deposit rate remaining at zero. A final rate cut should be considered a risk scenario if the data reweaken. Emerging market growth outlook downgraded EM growth forecasts for this year have been marked down broadly. A disappointing start to the year in EM growth was due primarily to below-expectation export performance, which resulted from lower global growth, particularly in the US and Euro area. Poor export performance was found across EM Asia and Latam. Lower than expected growth and inflation has led to tighter than optimal policy in China and India. And although we remain above consensus in our outlook for China, we have reduced our GDP growth forecasts by 0.3 and 0.1pp for 2013 and 2014, respectively. In Latam, downward revisions were led by Argentina, Brazil, and Venezuela, while revisions to Colombia, Peru, and Chile were smaller. With this backdrop, we marked down 2013 growth expectations for Brazil, Russia, India, and China by 0.9, 1.5, 1.4, and 0.3pp, respectively, while 2014 growth expectations were generally reduced by a smaller amount, except for Brazil. More recently, rising bond yields in AE, intensifying discussions of Fed tapering, and the implications of these actions for EM capital flows, have led to rapidly rising rates and falling EM currencies. Moreover, expectations of further dollar appreciation could put additional pressure on growth prospects for EM commodity exporters. While dissipating inflation pressures could in theory provide additional room for
Page 4
policy accommodation in these countries to support growth if judged necessary, further concerns about the potential reversal in capital flows during a Feds policy downshift may caution them against more policy easing. Growth outlook above consensus Our world growth outlook remains above the consensus forecasts of private economists this year, but slightly below the IMFs most recent projections (Figure 3). For the US, we are slightly above consensus surveys and the IMF in 2013 and 2014, while our forecast is below consensus and the IMF for the Euro area this year, and generally consistent with other forecasts for 2014. Figure 3: Consensus Forecasts GDP growth, %
World DB (Mar) DB (June) Bloomberg (Jun Survey) Consensus (Apr Survey) IMF (Apr) DB (Mar) DB (June) Bloomberg (Jun Survey) Consensus (Apr Survey) IMF (Apr) DB (Mar) DB (June) Bloomberg (Jun Survey) Consensus (Apr Survey) IMF (Apr) 2012 2.9 2.9 2.9 2.9 2.9 2.2 2.2 2.2 2.2 2.2 -0.6 -0.5 -0.5 -0.5 -0.5 2013F 3.2 3.0 2.2 2.6 3.3 2.3 2.2 1.9 2.1 1.9 -0.6 -0.6 -0.6 -0.4 -0.3 2014F 4.0 3.9 3.0 3.2 4.0 3.2 3.2 2.7 2.7 3.0 1.0 1.0 1.0 0.9 1.1
Figure 4: Inflation forecast & revision (% yoy)

Forecast level Jun13 WO 2012 2013F 2014F G7 US Japan EA EM Asia China India EMEA Russia Latam Brazil Advanced economies EM economies Global
Source: DB Research
Forecast change since Mar13 WO 2012 2013F 2014F 0.0 -0.2 0.0 0.0 0.0 0.0 0.0 -0.2 -0.1 0.0 0.0 0.0 0.0 0.0 -0.3 -0.9 -0.1 -0.1 -0.6 -0.4 -1.1 -0.2 0.3 0.0 0.4 -0.3 -0.5 -0.3 -0.2 -0.3 0.3 -0.1 -0.1 0.0 -0.7 -0.2 -0.1 0.2 0.2 -0.2 -0.1 -0.1
1.9 2.1 0.0 2.5 3.8 2.6 7.5 5.0 5.1 7.8 5.4 1.9 4.8 3.3
1.5 1.7 -0.1 1.5 3.3 2.6 5.4 5.1 6.8 8.3 6.4 1.5 4.5 3.0
2.1 2.3 2.3 1.5 4.1 3.5 5.7 4.9 6.0 8.4 5.6 2.0 5.0 3.5
Outlook for Fed tapering: Expectations and impact

The discussions about Fed tapering will continue to figure prominently in the upcoming months, as we gain further clarity on both the economic outlook and how the Fed expects to manage its exit. This section presents our views for how this process will proceed and how markets and the economy will react. How is Fed tapering and the exit process likely to proceed? The June FOMC meeting results confirmed that the Fed intends to commence tapering this year; we think that is most likely to happen in September if the US economy evolves in line with our baseline expectations (employment gains average 175-200k per month and the inflation slowdown proves transitory). We expect the initial taper to entail cutting MBS and Treasury purchases equally by about one-fourth to one-third. Further cuts will ensue at subsequent meetings, assuming economic reactions are not strongly negative. Assuming a relatively benign economic response, QE is likely to be cut to zero by June 2014 as Chairman Bernanke indicated at the post-June meeting press conference. Indeed, given that Bernanke has tied the end of QE to achievement of a 7% rate of unemployment that is likely to be improved upon going forward, the unemployment forecast of our US economics team suggests that the end of QE could come sooner in 2014 H1. That forecast says that the Fed still see the unemployment rate at 7% by Q1, which would point to a March termination date for QE. The Fed has said it will update its exit guidance in the months ahead; based on what they have told us so far, we can expect it to:
US
EA
Source: IMF, Consensus Economics, Bloomberg Finance LP, DB Research
Global Inflation falling While we continue to expect consumer price inflation to rise from this year to next, inflation has generally been below our expectations so far this year, helped by a slowdown in commodity price inflation and weak global growth that remains below potential (Figure 4). This has caused us to reduce inflation forecasts for this year and next across both EM economies and AEs.
Page 5
Stabilize its balance sheet for another 6-12 months after QE ends Use term deposits and repos to reduce excess reserves shortly before raising rates Raise rates by early-mid 2015 Not engage in asset sales until after the balance sheet has been normalized to its precrisis trend level. We expect this to be achieved by around 2020 via natural runoff as assets mature or are prepaid.
phase must forecast how the market and economy will react to the taper. So long as these key macro variables are on track currently and prospectively (our base case), we would not expect the Feds tapering to be put off by potential and actual disruption in financial markets stemming from the shift in policy. Alternatively, a strong recovery in growth, employment gains, and or substantial rise in core inflation and longer-term inflation expectations would induce a more aggressive exit process, with a more rapid pace of tapering, a more rapid pace of rate increase, and even the reintroduction of large-scale asset sales into the picture. How are markets likely to react to the Feds tapering and exit process? Markets have already moved significantly in response to Fed communication on possible tapering in the months ahead. Following Bernankes testimony to the JEC in late May, government bond yields rose broadly, while equities weakened. In the US, inflation expectations declined, leading to sharp increases in real rates. These market dynamics accelerated in response to the June FOMC statement and Bernanke press conference, which reinforced the real possibility of a start to tapering of asset purchases this year. . While many of these movements are indeed substantial, particularly in light of recently subdued volatility, they are less striking when viewed in a more historical context (Figures 5-7).
What will induce deviations from that expected process? Given the conditionality of the Feds QE program on economic data, we would anticipate deviations from our base case timeline if the trajectory of the economy does not match our outlook for the US economy (which is quite similar to the Feds). If employment gains fail to move up from the average monthly pace of about 150k in recent months or core inflation fails to begin to recover, the pace of tapering will be slower than we expect; it could still begin by September at a slower pace or be delayed until later in the year. A further weakening of employment growth or core inflation from recently reduced rates would likely put off the start date even further. Moreover, because of the endogeneity of the market and economic response to a reduction in purchases, expectations for further reductions beyond the first Figure 5: Bond yields have risen substantially
US 6 5 4 3 2 1 0 Dec-12 Jan-13 Feb-13 Mar-13 A pr-13 May-13 Jun-13
Source: Haver Analytics, DB Research
but remain low compared to history

9 8 7 6 5 4 3 2 1 0 2004 2005 2007 2008 2009 2010 2011 2012 2013 US Spain % Germany Japan Italy UK
Germany Japan
Italy UK
Spain %
10 year government yield (end 2012 - present) 19-Jun
10 year government yield (end 2004 - present) 19-Jun
Page 6
Figure 6: US inflation expectations have fallen

3.0 5 yr-5yr breakeven inflation expectation % 19-Jun 2.8
but remain within historical range

3.0 % 5 yr-5yr breakeven inflation expectation
2.5
2.0
2.5
1.5 19-Jun
2.3
1.0
2.0 Dec-12
Jan-13 Feb-13
Mar-13
A pr-13
May-13
0.5 2004 2005 2006 2007 2008 2009 2010 2011 2012
Figure 7: US real yields have moved into positive territory

10 year bond yields 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 Dec-12 Jan-13 Feb-13 Mar-13 A pr-13 May-13 Jun-13
but remain well below normal

% 10 year bond yields Nominal Inflation-indexed 19-Jun
6 5 4 3
19-Jun
Nominal
Inflation-indexed
2 1 0 -1 -2 2004 2005 2007 2008 2009 2010 2011 2012 2013
Despite the fact that Bernanke and the Fed have endeavored to disconnect the taper decision from subsequent balance sheet reduction and policy rate hikes, the tapering has been interpreted in the context of a more general Fed exit. Indeed, a tapering in September appears already to have been fully priced into the Treasury curve, and there has been a significant shift forward in expectations about the eventual timing and pace of the Feds policy rate hikes (Figure 8).
Figure 8: Implied Fed funds rate path

400 bps 350 Current 300 250 200 150 100 50 0 2013
Source: DB Research
Implied fed rate
May 21, 2013 May 02, 2013
2015
2017
2019
2021
2023
2025
Page 7
Under this base case timeline for Fed tapering, our strategists see the following: Rates: We see the 10-year Treasury yield moving above 2.5% by year-end and eventually moving back well above 4% as policy rates normalize and the Feds balance sheet runs down. Mortgages: Spreads have widened 25 bps, and could stabilize around current levels assuming the Fed indicates (but with less than a binding commitment) that they will not sell or repo MBS. Corporate credit: Yields have jumped and will likely continue to rise by 25% more than the rise in Treasury yields on average, with more pain felt in high-yield, where spreads had declined relatively more in recent years. Equities: The S&P 500 is about 4% below its mid-May peak, a move that may be extended for a time, but that we expect to see reversed by year-end. Equities should benefit from the macro fundamentals underlying the Feds exit, as well as a rotation from fixed income into stocks. We see the S&P 500 moving back into the mid1600s by later this year, and further to 2000 over the next two years. Emerging Markets: EMs have taken a larger hit than US markets, with stocks in some countries down by 5-10% or more, and bond yields up by 50-100 bps. We expect these assets will continue to be affected negatively, in some cases increasingly painfully, as investors that have reached for yield continue to rotate out of these investments. FX: The dollar has declined initially, especially against major currencies, in the wake of talk of tapering. We expect it will eventually strengthen against all currencies, especially the yen and currencies of commodity exporting countries, somewhat less so against the euro. We see the euro depreciating to 1.15 and the yen to 115 by the end of next year. Commodities: Commodity prices have risen modestly on balance since the talk of tapering began. We expect to see a substantial drop in gold prices and some decline in areas that are dollar-sensitive, especially oil and possibly grains. How bad could things get in a worse case scenario? Our strategists believe that fixed income markets could sell off substantially faster than we have outlined in our base case if expectations of the eventual pace of Fed rate hikes were increased significantly, especially if those expectations were prompted by a stronger than expected pickup in growth and inflation expectations that was seen as prompting more aggressive Fed action.
Page 8
Under some conditions, they believe we could plausibly see 10-year Treasury yields move to 3.5% by year end, and credit and mortgage spreads widen substantially further than in the base case. Even in the face of stronger US growth, EM credit and equities could drop sharply. The dollar would strengthen even further unless the Fed stepped in or a flight to safety pushed Treasury yields back down. In the commodity space, declines in metal prices would join into a more general drop in prices. The chances of a major failure (of an emerging market or a financial firm) that would roil the markets would rise sharply. The rise in Treasury yields could quickly be reversed by a large-scale flight to safety. What are the implications for global growth and inflation? Our base-case scenario does not see a significant negative impact on the US economywe see interest sensitive spending, including residential investment, relatively unaffected by rising yields. While systemic risks are low, some emerging market economies, especially those with high debt or external deficits will feel the impact; indeed, many have already. The US and global economies could very well be affected negatively in the worse case scenario, especially if the equity market dropped sharply and the recovery in the housing market was set back. In all likelihood, though, the setback would not be recessioninducing, given the still relatively low levels of investment in durables and structures in the US and given the relatively manageable degree of leverage in most emerging markets. How would the Fed respond to market reactions; what controls will it have over both ends of the curve? The Fed will react to how it sees market movements affecting economic prospects. It will not hold off tapering or exiting simply because it sees a potentially negative market reaction, so long as the underlying momentum in the economy remains intact. If the market reaction looks negative enough to keep employment growth from recovering from its recent slower pace (or if core inflation continues to drift lower), the Fed could delay or reduce the pace of its tapering. A downtrend in employment growth or significant further decline in core inflation with inflation expectations drifting lower would halt and possibly even reverse tapering. It would also elicit more dovish verbal guidance concerning future rate increases and balance sheet management. Where is pain in the markets likely to be most intense? Investors that have reached aggressively for yield, especially in high yield and EM will be hit especially
hard. Flows into these areas have already seen significant reversals. A sharp back-up in yields and drop in equities could put a number of EMs and financial firms at risk. Bottom line: how high are the risks? Most likely, the underlying strength of the US economy is firm enough to weather the normalization of market yields that is coming indeed a normalization that will be needed to keep inflation pressures in check in the longer term. The Fed will endeavor to be clear enough in its communications/guidance and careful enough in the management of its massive balance sheet to avoid major setbacks. That said, the process will not occur without significant disruption and substantial pain in the markets, especially in those that have shown signs of becoming frothy during the Feds prolonged period of extraordinary monetary ease. We recognize that neither economic forecasting nor monetary policy making are exacting sciences; if something can go wrong, it probably will. Given the distance the Fed has to go in tapering and eventually exiting, there is a nontrivial chance that a financial failure could be induced that will cause the markets to tumble, at least temporarily. However, concern about further accumulation of froth in the markets is a key reason why the Fed will move when the macro data say it is time, even if it means pain in the markets. The good news is that a setback, if it does come, will most likely be much less painful than the crisis of 200708, given the much stronger position of household, and
financial and nonfinancial business balance sheets today compared with six years ago. Similarly, the improvement in the fiscal and external balance positions, as well as reduced leverage and increased reserves of major emerging markets since the debt crises of the 1980s and 1990s, means that the potential for downturn in those areas is lessened as well relative to what happened after major Fed policy tightenings in those earlier decades.
Conclusion
Below expectation growth readings and some negative market reaction to Fed tapering, so far this year have caused us to mark down our global growth projections for 2013, most notably for EM economies. Despite this markdown, we continue to see strength in the underlying fundamentals for global growth, and our view that 2013 is a year of transition, in which growth should approach potential by year-end, remains intact. The prominent role of central bank liquidity for markets and the economy may also be at a transition point, as we expect the Fed to begin reducing the pace of asset purchases this September. We expect that the Fed will be able to manage this transition without significant market disruption; however, we do believe there is a non-trivial probability of a disorderly market reaction to this shift in policy. Although not our base case, a disorderly market reaction is the primary risk to our constructive near-term outlook.
Peter Hooper, (1) 212 250 7352 Thomas Mayer, (49) 69 910 30800 Michael Spencer, (852) 2203 8305 Matthew Luzzetti (1) 212 250 6161 Torsten Slok, (1) 212 250 2155
Page 9
US: Why taper? Why now?
A further improvement in the labor market that coincides with a step-up in second half real GDP growth should allow Fed policymakers to slow down the pace of monetary accommodation. The economy has already shown a marked improvement in private domestic demand. Hence, as the fiscal drag fades, economic activity should move substantially higher and the pace of real GDP growth is due to accelerate above 3% by yearend. Given our expectation of the unemployment rate falling to 7.0% around yearend and inflation pressures gradually beginning to reaccelerate, we expect the Fed to commence tapering asset purchases at the September 1718 policy meeting and terminate them during 2014.H1. The Fed will reduce both mortgage and treasury securities purchases simultaneously when tapering. In terms of size, a reduction to USD60 billion in QE from USD85 billion at present would be large enough to signal the labor market was making substantial improvement, but it would not be so large so that policymakers could not ramp purchases back up should the economy meaningfully falter. The USD60 billion in QE could then be reduced by either USD20 or USD30 billion per FOMC meeting, allowing the program to be cut to zero by the end of Q1 2014. A reduction in the pace of monthly bond purchases does not constitute an act of tightening financial conditionsit simply represents a slower pace of easing. However,
stronger economic growth, driven by accelerating private domestic demand should help push long-term interest rates higher.
Housing activityone of the key drivers of growth in the coming quartersshould not be impinged by higher rates because the latter would be occurring against the backdrop of improving job and income prospects. Moreover, given the extraordinarily low levels that interest rates are rising from, the impact on overall housing affordability will be modest.
Tapering does not mean an end to accommodative monetary policy. A reduction in the pace of monthly bond purchases should not result in a meaningful tightening of financial conditionsespecially as long as the Feds balance sheet continues to expand. In determining the initial size of the reduction, policymakers will have to make it large enough so that QE could be removed relatively quickly but not so large as to potentially scare financial markets into thinking the Fed was going to begin the process of removing policy accommodation altogether. In terms of size, a reduction to USD60 billion in QE from USD85 billion at present would be large enough to signal that progress was being made, but it would not be so large so that policymakers could not ramp purchases back up should the economy meaningfully falter in the quarters ahead. The projected USD25 billion reduction would be divided between USD10 billion in mortgages (to USD30 billion per month) and USD15 billion in treasuries (to USD30 billion per month). The USD60 billion in QE could then be reduced by either USD20 or USD30 billion per FOMC meeting, allowing the program to be cut to zero by the end of Q1 2014.
Figure 1: Macro-economic activity & inflation forecasts

E c o n o m ic a c tiv ity (% q o q , s a a r ) GDP P riv a t e c o n su m p tio n in v e n to rie s) G o v t c o n s u m p t i o n E x p orts Im p o r t s C o n t r i b u t i o n (p p ): S t o c k s N e t tra d e In d u s t r i a l p r o d u c t i o n U n e m p lo y m e n t ra te , % P r i c e s & w a g e s (% y o y ) CP I Core C P I P ro d u c e r p ric e s C o m p e n sa tio n p e r e m p l. P ro d u c tiv it y
Source: National authorities, DB Research
Q 1F 2 .4 3 .4 9 .0 - 4 .9 0 .8 1 .9 0 .6 - 0 .2 7 .7 1 .7 1 .9 1 .4 2 .7 0 .2
2013 Q 2F 2 .3 2 .4 9 .2 - 4 .6 3 .9 3 .2 0 .0 0 .0 7 .4 1 .8 1 .7 2 .2 2 .7 0 .1
Q 3F 3 .0 2 .7 1 4 .1 - 2 .0 1 .0 4 .0 0 .1 - 0 .5 7 .2 1 .7 1 .8 1 .6 2 .8 - 0 .4
Q 4F 3 .5 3 .0 1 4 .0 - 0 .2 2 .0 5 .0 0 .1 - 0 .5 7 .0 1 .8 1 .9 1 .9 2 .9 0 .2
Q 1F 3 .2 3 .0 8 .7 0 .6 5 .0 6 .0 0 .0 - 0 .3 6 .8 2 .0 1 .9 2 .6 2 .9 0 .5
2014 Q 2F 3 .2 3 .0 9 .0 0 .6 4 .0 6 .0 0 .0 - 0 .4 6 .7 2 .3 2 .2 3 .2 2 .9 0 .8
Q 3F 3 .3 3 .0 8 .8 0 .6 5 .0 6 .0 0 .0 - 0 .3 6 .5 2 .4 2 .7 3 .5 2 .9 1 .1
Q 4F 3 .2 3 .0 8 .2 0 .6 5 .0 6 .0 0 .0 - 0 .3 6 .4 2 .5 2 .8 3 .6 2 .9 1 .3
2012 % y oy 2 .2 1 .9 9 .8 - 1 .7 3 .4 2 .4 0 .1 0 .1 3 .6 8 .1 2 .1 2 .1 1 .9 2 .0 0 .6
2013F % y oy 2 .2 2 .5 7 .7 - 3 .3 1 .2 1 .2 0 .0 0 .0 5 .0 7 .4 1 .7 1 .9 1 .8 2 .8 0 .0
2014F % y oy 3 .2 2 .9 1 0 .4 - 0 .2 3 .7 5 .4 0 .0 - 0 .4 6 .0 6 .6 2 .3 2 .4 3 .2 2 .9 0 .9
Page 10
Based on the likely path of the economy, the Fed will reinvest its maturing securities so as to maintain the size of the overall balance sheet at what will likely be USD4 trillion. This will persist for a couple of quarters, before policymakers would then allow the balance sheet to organically shrink. But policymakers would still likely wait a quarter or two before actually raising short term interest rates. The first hike in the fed funds rate is not expected until Q1 2015. Employment will drive the taper. Consistent with the FOMCs explicit desire to fulfill the unemployment portion of its dual mandate, the labor market will be instrumental in determining the Feds course of action. In terms of the current underlying trend, the six-month moving average on nonfarm payrolls is +194k, which is down negligibly from +206k in April but slightly better than the +188k reading at the time of the April 30-May 1 FOMC meeting. The pattern is similar for private payrolls where the six-month moving average is +199k compared to +212k in April. To be sure, the fact that initial jobless claimswhich have repeatedly proven to be one of the most reliable forecasting tools for nonfarm payrollshave moved back toward their cyclical lows is an encouraging development for the labor outlook. The four-week moving average on initial jobless claims is running below 350k. This is a key level, which in the past has been consistent with private sector payroll gains in excess of 200k. While claims provide an important real-time indication that the labor market is potentially on the cusp of a meaningful acceleration, there is a fundamental reason why this is occurringthe economy is accelerating in a low productivity environment. Low productivity amid accelerating GDP growth will drive a faster pace of hiring. While the labor market has stumbled through a few false starts, a sustained improvement is becoming increasingly probable, as long as the economic expansion remains intact. Since the end of the recession in mid-2009, real GDP has increased at a 2.1% annualized pace, nonfarm payrolls have increased by an average of 165k per month. If productivity growth remains constant and aggregate demand accelerates, so too does the pace of job creation. If our forecast for a meaningful acceleration in private domestic demand in the second half of this year proves correct, the employment landscape could materially improve. As a result, the outlook for private sector hiring improves appreciably. As we can see in the chart below, the correlation between private sector employment and productivity-adjusted private GDP is extraordinarily high at 95%.
Figure 2: Productivity typically slows as the expansion matures, but this is accompanied by faster job creation
Total private payrolls Real GDP ex-govt minus nonfarm productivity 4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 -8 -9 % yoy
Estimated range for Q4 2013 Private sector payroll scenarios: (% yoy = implied monthly change) 2.0% = +180k 2.5% = +250k 3.0% = +321k
2007
2008
2009
2010
2011
2012
2013
2014
Source: BEA, BLS, Haver Analytics, DB Research
The points in the preceding chart reflect our private sector GDP forecast (4.0%) for yearend adjusted for productivity (1.0%) which is equivalent to our forecasted private payroll gain of 3.0%. (The lower point represents a more conservative estimate.) A more aggressiveyet plausibleproductivity assumption would limit the gain to something closer to 2.0%. The current pace of private payroll growth is 2.0%, consistent with the range of 1.9% to 2.1% over the last eleven months. If the current pace is maintained, this implies an average monthly private payroll gain of 185k through yearend. However, our baseline assumption has private payroll growth rising toward 3%, which implies average monthly gains of 321k. Even if growth is not quite as strong as we project and productivity posts a moderately stronger recovery, a modest downside miss (2.5%) would still achieve an impressive 250k per month. Nonfarm productivity typically weakens at this stage of the economic cycle. Productivity tends to surge well above trend as the economy initially exits recession, and then it subsequently mean-reverts by falling back below trend for an extended period. Barring a surge in capital investment, it is unlikely for productivity to meaningfully reaccelerateonce the labor recovery is underway, productivity trends become increasingly tied to capital investment. While business fixed investment has been recovering, the growth ratecurrently 4.1% year-on-yearis hardly robust enough to foster a dramatic productivity acceleration. Thus, based on historical precedent, the low end of 1-2% productivity growth over the medium term remains our baseline estimate. Housing will drive the output acceleration The recovery in the housing sector is an important tenet of our 2013 outlookand it is also a key reason why we believe a mid-year swoon, akin to the experience of the past few years, may be largely avoided. The housing sector, while relatively small in
Page 11
terms of its direct contribution to GDP, has a large indirect effect. Of the 2.8% real GDP growth we are forecasting through yearend, more than one-third is expected to be due to either the direct contribution from housing construction or the indirect effect of housing wealth-driven consumption. It is noteworthy that every cyclical peak in housing activity has coincided with monetary tightening. In particular, there has never been a peak in the housing cycle that did not correspond with a large cumulative rise in the federal funds rate. This is evident in the chart below which compares the level of the federal funds rate versus the housing-wide share of the economy. (In the last business cycle, official interest rates went up 425 basis points from their previous low.) Figure 3: The housing share of the economy is poised to move higher and will not peak until rates rise sharply
Federal funds rate (lhs) Total housing expenditures as a share of real GDP (rhs) 20 % % 24
Figure 4: Employment gains are holding steady, while the unemployment rate is trending down
Initial jobless claims (inverted axis, lhs) Nonfarm payrolls (rhs) 200 Thous. 3mma, thous. 800 600 400 200 0 500 Correlation= 0.74 -200 -400 -600 700 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: DB Research
300
400
600
-800
16
22
12 20 8 18
0 1960
16 1967 1975 1982 1990 1997 2005 2012
Source: Census, NAHB, Haver Analytics, DB Research
Contrary to what some market participants think, housing has a substantial weight in the economy. It is not as small as the roughly 3% share of real GDP that the residential construction sector comprises, a shopworn comment we hear from investors. Rather, when we add up all housing-related spending from residential construction to housing rents to the items that go into a home, such as furniture and appliances, as well as the costs of maintaining a house, such as insurance, we arrive at a significantly larger figure. We calculate that total economy-wide housing spending as a share of GDP is currently 17.3%, which in isolation is pretty substantial, at least relative to what some market participants incorrectly assume. The current reading is pretty depressed, barely above its all-time record low of 17.0% set in Q4 2011 and Q1 2012. We believe that a return to more normalized levels of housing activity relative to the size of the economy will be a very important driver of economic growth over the next several years.
Rising home prices also provide an upside risk. If housings share of the economy expands, it is likely to coincide with rising home prices since the latter tend to be highly correlated with a pickup in housing related spending. We are projecting a 10% rise in home prices in 2013, which already appears well within reach given that a number of surveys have already crossed this threshold. This is based on an overall lean inventory-tosales ratio, which is unlikely to improve as homebuilders struggle to keep apace of strengthening demand. Rising home values will lift household net wealth, potentially providing an added stimulant to consumer spending beyond what we expect from a recovering labor market. Furthermore, rising home prices also make it likelier that financial institutions will ease mortgage lending standards, because there will be less fear that the collateral for which the loan is being made will decline in value. To the extent that home price appreciation exceeds our forecast, this potentially creates significant upside risks to our GDP forecast. Revisions bear watching On July 31, the Bureau of Economic Analysis (BEA) will release the initial snapshot of Q2 real GDP along with comprehensive benchmark revisions that extend back to 1929. We have made a big deal over this upcoming benchmark revision, because it has the potential to alter investors perceptions of both the depth of the last economic downturn and the speed of the recovery. The last comprehensive benchmark revision occurred in July 2009, just as the economy was emerging from recession. Based on the fact that we have seen a steady pattern of upward revisions to nonfarm payrolls, we believe there is a high probability that real GDP growth will be revised modestly higher over the past couple of years, as well.
Page 12
Figure 5: Economic activity will approach 3% growth in the back half of 2013
8 6 4 2 0 -2 -4 Current recession -6 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10111213141516171819202122 "0" represents the recession end date
Source: DB Research
Real GDP % yoy Forecast
inflationthe latter is due to soft import prices. While inflation pressures may run cooler than we anticipated in the near-term, the longer-term outlook is unchanged. Goods prices may provide some buffer against core services in the near term, but the pressure on service inflation is unlikely to relent as long as economic growth continuesand it will accelerate if faster growth and tighter labor conditions start to generate wage pressures. Figure 7: Inflation will remain tame, allowing policymakers to maintain aggressive accommodation
Average of last 10 cycles
Consumer prices: by expenditure category (A pril 2013) 3.0 1.0 -1.0 -3.0 %
History shows that revisions to nonfarm payrolls over the last few years have consistently been in an upward direction. As a general rule of thumb, payroll revisions tend to be upward during economic recoveries/expansions and downward during economic recessions. Since the economy grows much more often than it declines, revisions on balance are positive. Since January 2011, the change in nonfarm payrolls has been revised up 75% of the time with an average upward revision of +65k. Hence, it is fairly likely that recent payroll gains will eventually be revised above 200k. Figure 6: Payroll revisions have been consistently higher
Difference between current change in nonfarm payrolls and initially reported 300 200 100 0 -100 -200 Thous.
-5.0 -7.0 -9.0 -11.0 -13.0 -15.0 Food Energy Core CPI goods Rent of shelter (ROS) Services ex energy & ROS % yoy 6m % chg, ar
Source: BEA, Haver Analytics, DB Research
Figure 8: The Feds balance sheet is poised to peak in late 2013 and remain elevated for some time
4000 3500 3000 2500 2000 1500 1000 Reserve bank credit outstanding USD bln Current pace of QE through year end Current pace of QE through mid-year
-300 1999
2001
2003
2005
2007
2009
2011
2013
Source: BLS, Haver Analytics, DB Research
500 2005 2006 2007 2008 2008 2009 2010 2011 2012 2013
Source:, DB Research
Disinflation/deflation risks will subside as the growth outlook improves. The latest round of inflation data contained scant evidence of an imminent acceleration of price pressures. Headline inflation remains just above 1.0%, and the producer price index showed little evidence of upstream inflation pressures. While the core inflation trend has been less volatile, it too remains relatively tame at present (1.7%). However, the core inflation outlook appears less benign upon closer inspection, because mounting pressures on services and shelter costs are being masked by slack goods
There are numerous risks around the forecast. On the upside, the impressive surge in home values is gaining speed with prices up 12% over the past year according to CoreLogic. This provides a significant source of stimulus to consumers, possibly offsetting a chunk of the ongoing fiscal drag, which could potentially exert more downward pressure on the economy in the short-term than we are projecting if the fiscal multiplier proves to be
Page 13
larger than what forecasters generally anticipated. A potential offset to the fiscal headwinds is the improvement in state and local finances. This was evident in the latest employment report, which showed state and local government hiring rising +11k at the same time that federal employment fell -14k. State and local expenditures in the GDP accounts have not yet turned positive, but they tend to follow the hiring trend fairly closely, so this could occur later this year. In terms of both employment as well as consumption/investment, state and local government is larger than federal. Thus, improving non-federal tax receipts hold the potential to materially mitigate mandated Figure 9: External balances & financial forecasts
2012 F isc a l b a la n c e , % o f G D P T r a d e b a la n c e , U S D b n T r a d e b a la n c e , % o f G D P C u rre n t a c c ou n t, U S D b n C u rre n t a c c ou n t, % of G D P - 6 .8 -535 - 3 .4 -440 - 2 .8 2013F - 3 .9 -411 - 2 .5 -486 - 3 .0 2014F - 3 .2 -469 - 2 .7 -550 - 3 .2 F in a n c ia l f o r e c a st s O f f ic i a l 3M ra te 1 0 Y y ie l d USD p er E UR JPY p er USD US D p er G BP
spending reductions at the federal level. In conclusion, we anticipate an acceleration in both GDP growth and hiring in the latter half of this year, and this should be sufficient to push policymakers toward a tapering of asset purchases. The risk to our forecast is that if the labor market does not follow through with the improvement we anticipate, then policymakers will be inclined to move more cautiously toward less accommodation, and as a result the tapering of asset purchases is executed in a less aggressive fashion and over a longer timeframe.
Cu rre n t 0 .1 0 0 .1 0 2 .3 9 1 .3 2 98 1 .5 5
3M 0 .1 0 0 .1 0 2 .5 0 1 .2 6 102 1 .5 5
6M 0 .1 0 0 .1 0 2 .7 5 1 .2 0 110 1 .4 7
12M 0 .1 0 0 .1 0 3 .2 5 1 .1 8 113 1 .4 1
Source: National authorities, DB Research, as of June 20
Joseph A. LaVorgna, (1) 212 250 7329 Carl J. Riccadonna, (1) 212 250 0186 Brett Ryan, (1) 212 250 6294
Page 14
Europe: An unconvincing calm
We remain generally constructive on the euro area economy and the crisis. That is not to say the crisis is over: the euro area remains politically complex, financially fragmented and challenged by low potential growth. OMT was a turning point, buying time for the underlying resolution of the crisis macro adjustment (deleveraging, reforms) and integration (ESM, stronger fiscal rules, banking union, etc). Fiscal consolidation weighed heavy on growth and the credibility of OMT has permitted some adjustment to the pace of austerity to something more politically sustainable. There remain vulnerabilities, however. The challenge of stabilizing public debt has increased, not declined, and fear of legacy losses continue to cloud banking recovery. Prospects for a return to economic growth in the euro area in H2 2013 remain good, in our opinion. As long as Fed tapering proceeds in line with a recovering US economy, the effects ought to be manageable for Europe. The ECB has a bias to ease policy via conventional channels it claims to be technically ready for negative interest rates, if necessary but following recent firmer data, which should bolster confidence in eventual economic recovery, we expect the ECB to keep a steady hand on rates. Into 2014, politics could be a headwind, from a risk of not implementing sufficient mutualisation capacity to absorb legacy bank losses to political incapacity in Italy to move the dial on much needed growth enhancing structural reforms; chances are the markets will have to deal with a new Italian election in 2014. We have revised up our view on UK growth this year from 0.5% to just over 1%. However, we have left unchanged our forecast of 1.8% for next year. At the same time, we have
revised down our view on inflation. This combination, in our view, is consistent with no further easing of monetary policy by the BoE (including no forward guidance).
Expectations of Fed tapering have precipitated a withdrawal from EMEA asset markets over the last few weeks. A number of countries in the region would be vulnerable to a further pullback in these flows. South Africa, Turkey and Ukraine, look especially exposed on this front given the scale of their current account deficits and reliance on short-term flows to finance them. We are less worried about the impact of rising US rates on private credit extension, largely on the grounds that most emerging markets in the region have been levering down rather than levering up in recent years.
Euro Area: On course for H2 recovery. Several factors support euro area market and economic sentiment. First, the pace of economic contraction is slowing. The euro area has recorded its longest ever recession (6 quarters), but the prospects for an end to the contraction around mid-2013 remain good. Second, Europe has had a re-think on fiscal policy. This new fiscal realism was evolving in 2012 in Spain and Portugal as the Commission sought to avoid a repeat of the mistakes of the Greek programme of adding austerity on top of austerity. Following concerns that the Italian election outcome was a sign that Europes social capacity for austerity had reached a peak, the Commission has endorsed a softening of austerity in general. We calculate that the fiscal stance (change in structural primary balance) eased by 0.1pp of GDP this year and 0.2pp in 2014. Third, the ECB has re-engaged conventional monetary policy by cutting rates and committing to the full allotment liquidity regime until at least mid 2014. Weakness in core economies meant a greater alignment of economic conditions across countries, improving the efficacy of rate cuts. Likewise,
G D P (% yo y) C PI (% yo y) 2012 5 .0 3 .7 5 .7 3 .3 3 .3 5 .1 0 .6 5 .2 1 .7 8 .9 5 .7 2013F 2014F 5 .1 4 .9 1 .3 2 .2 1 .8 2 .4 1 .5 1 .8 4 .8 3 .8 6 .8 6 .0 1 .0 5 .2 6 .2 6 .4 1 .0 1 .9 7 .3 5 .9 5 .8 5 .2
Figure 1: Macro-economic activity & inflation forecasts:

G D P (% yo y) EU E u ro a re a G e rm a n y F ra n c e Ita ly S p a in UK S w eden D e n m a rk N o rw a y S w itz e rla n d 2012 2013F - 0 .3 - 0 .2 - 0 .5 - 0 .6 0 .7 0 .1 0 .0 - 0 .2 - 2 .4 - 2 .0 - 1 .4 - 1 .5 0 .3 1 .1 1 .1 1 .5 - 0 .5 0 .4 3 .0 2 .3 1 .0 1 .5 2014F 1 .3 1 .0 1 .5 1 .1 0 .5 0 .5 1 .8 2 .0 1 .5 2 .6 1 .5 C PI (% yo y) 2012 2013F 2 .6 1 .6 2 .5 1 .5 2 .1 1 .7 2 .2 1 .1 3 .3 1 .6 2 .4 1 .6 2 .8 2 .7 0 .9 0 .2 2 .4 1 .1 0 .7 1 .8 - 0 .7 - 0 .4 2014F 1 .6 1 .5 1 .8 1 .5 1 .5 1 .6 2 .1 1 .4 1 .8 1 .9 0 .5 EM EA P o la n d H u n g a ry C z e c h R e p u b lic R o m a n ia R u s s ia U k ra in e K a z a k h s ta n Is ra e l T u rk e y S o u th A f ric a 2012 2 .8 1 .9 - 1 .7 - 1 .2 0 .7 3 .4 0 .2 5 .2 3 .1 2 .2 2 .5 2013F 2014F 2 .7 3 .6 0 .8 2 .5 0 .4 1 .1 0 .0 2 .0 2 .3 2 .6 2 .8 3 .3 1 .5 2 .7 5 .3 5 .5 3 .5 3 .3 4 .1 5 .0 2 .1 3 .4
signs of declining fragmentation (e.g., falling Target2 imbalances) aid the pass through of conventional policy.
After recent better than expected PMI data, we no longer expect a final quarter refi rate cut this summer. We now expect the refi rate to remain at 0.5% and the
Page 15
deposit rate at zero. Should the data re-weaken, a conventional policy cut could be back on the table. Prospects for a specific ABS support policy from the ECB have faded also. The EIB can lend to SMEs but without a capital increase this will cannibalise other lending; to help circumvent this, Germanys KfW is increasing its lending to banks in the periphery. Figure 2: GDP growth forecast in H2 2013
Net trade Investment Private consumption 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0
in unemployment (not forecasted until H2 2014), growth should also aid social and political stability, helping the progress of reform and integration, the other part of resolution. Helping the euro area back into positive GDP will be exports. Our US and China economists anticipate a firm acceleration from 2013 into 2014. Real global GDP growth excluding the euro area is expected to accelerate from 3.7% to 4.7%. This is good for Germany but also for those peripherals becoming more competitive (Spain, Portugal, Ireland and Greece). As exports gain traction, investment spending and domestic demand should get a lift. The corporate sector is now a modest net lender, signaling some internal capacity to restart investment even in the absence of credit available. Figure 3: Fiscal austerity is slowing
2.0 1.5 1.0 % of GDP 'Fiscal Stance' (change in the structural primary budget balance) Positive numbers are a tightening of the fiscal stance
Stocks Government GDP
Euroarea: GDP growth and contribution to GDP growth (pp)
Forecast Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13 Q3-13 Q4-13
0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 2001
Our forecasts for euro area GDP growth are unchanged relative to the previous World Outlook: -0.6% in 2013 and +1.0% in 2014. Over the remainder of 2013, we anticipate a return to positive economic growth. This may be small in absolute size (quarterly GDP growth rates of c. 0.2% qoq), but following an extended period of contraction a return to GDP growth will be good news for markets, helping Europe absorb some of the effects of predicted Fed tapering. Economic growth will help reduce fiscal deficits and assist economic adjustment, a key part of crisis resolution. By improving household confidence in an eventual decline
E c o n o m ic a c tiv ity (% q o q , s a a r ) GDP P riv a te c o n su m p tio n In v e s t m e n t G ov Exp Im p Con t c o n s u m p t i o n o rts o rts t r i b u t i o n (p p ): S t o c k s 2013 Q 2F 0 .2 0 .0 - 1 .4 - 0 .7 2 .8 1 .4 - 0 .1 0 .7 2 .4 1 2 .3 1 .4 1 .1 0 .1 1 .0 - 0 .1
Fiscal stance (incl. current forecasts for 2013-14) Forecasts Previous forecasts for 2013-2014 2003 2005 2007 2009 2011 2013
Figure 4: Macro-economic activity & inflation forecasts: Euroarea

Q 1F - 0 .8 0 .3 - 6 .1 - 0 .4 - 3 .1 - 4 .2 - 0 .2 0 .3 0 .5 1 2 .1 1 .9 1 .5 1 .2 1 .7 - 0 .4 Q 3F 0 .3 0 .4 - 1 .9 - 0 .9 5 .0 4 .3 0 .1 0 .5 0 .9 1 2 .4 1 .4 1 .2 - 0 .3 1 .0 0 .3 Q 4F 0 .9 0 .5 1 .8 - 1 .0 5 .7 5 .5 0 .1 0 .4 1 .1 1 2 .5 1 .3 1 .2 - 0 .2 1 .0 1 .0 Q 1F 1 .2 0 .4 2 .0 - 0 .4 4 .1 3 .1 0 .1 0 .6 1 .2 1 2 .6 1 .4 1 .2 0 .2 1 .1 1 .1 2014 Q 2F 1 .4 0 .4 2 .6 - 0 .4 4 .7 3 .8 0 .2 0 .6 1 .0 1 2 .6 1 .6 1 .5 1 .0 1 .2 0 .9 Q 3F 1 .4 0 .4 3 .9 - 0 .8 4 .7 4 .2 0 .2 0 .4 1 .6 1 2 .5 1 .5 1 .4 1 .2 1 .3 0 .8 Q 4F 1 .7 0 .4 4 .9 - 0 .8 5 .3 4 .6 0 .2 0 .6 2 .2 1 2 .3 1 .5 1 .4 1 .3 1 .4 0 .7 2012 % yoy - 0 .5 - 1 .3 - 4 .2 - 0 .4 2 .9 - 0 .7 - 0 .5 1 .6 - 2 .4 1 1 .4 2 .5 1 .5 2 .9 1 .8 0 .1 2013F % yoy - 0 .6 - 0 .5 - 3 .9 - 0 .6 0 .8 - 0 .6 - 0 .2 0 .6 - 0 .9 1 2 .3 1 .5 1 .2 0 .2 1 .0 0 .2 2014F % yoy 1 .0 0 .4 1 .8 - 0 .7 4 .7 4 .0 0 .1 0 .5 1 .3 1 2 .5 1 .5 1 .4 1 .0 1 .3 0 .9
N e t tra d e In d u s t r ia l p r o d u c t io n U n e m p lo y m e n t r a t e , % P r i c e s & w a g e s (% y o y ) H IC P C o re in fla tio n P ro d u c e r p ric e s C o m p e n sa tio n p e r e m p l. P ro d u c tiv it y

Slowing austerity may not in and of itself create recovery but alongside other factors it ought to play a role. Rising financial markets and economic confidence should also help reduce the fiscal multiplier, although
Page 16
full normalization of the multiplier (the IMF last autumn estimated that the multiplier might be as high as 1.7 times) will likely require a flow of bank credit.
Bank liquidity has improved because of the impact of OMT on markets (Cyprus was not a source of much or lasting disruption). Most European banks are expected to be Basel III compliant this year. Nevertheless, while standards on loans are easing, demand for credit remains low. There is no obvious sign of a recovery in bank credit origination yet. The good news is that this does not stop the credit impulse (second derivative of credit) from signaling support for a pick-up in domestic demand in H2 2013. The inventory cycle may be supportive of the initial growth phase. Firms have destocked sharply since the lapse back into recession in 2011. The PMI inventoryto-orders ratio is the lowest since the return to recession. Once businesses are more convinced of economic recovery, an inventory rebuild it likely to kick in. The ECB Bank Lending Survey reported the first rise in demand for loans for inventories and working capital in Q1 for six quarters. Figure 5: Credit impulse supports demand recovery
6 4 2 0 -2 -4 -6 -8 -2 -4 Credit impulse - 3m rolling (lhs) Private domestic demand (rhs) pp of GDP, yoy % yoy 6 4 2 0
funding could rise). If public debt is high and the overlap between domestic taxpayers and holders of large deposits and bank paper is low, a bail-in may be favoured, and vice versa. Common recapitalization still under negotiation is likely to remain constrained, for example, by a cap on ESM involvement. This is unlikely to provide the comprehensive backstop initially expected. How constrained this backstop will be ought to be clearer at the end of June when the draft mechanism is published. The bail-in of depositors in Cyprus reveals a new preference by Europe, as long as there are minimal spillover costs for the stability of the euro area banking system. The European banking system has come quite some way in satisfying new more demanding capital targets, but the uncertain outcome of the AQR/EBA events could undermine bank willingness to extend credit for the time being as well as potentially undermine deposit stability if a fear of harsh treatment a la Cyprus sets in. The 2012 EBA stress test arguably cost the euro area economy dearly as banks sought to satisfy high capital requirements via deleveraging. The effects may be less pervasive in 2014, but a similar dynamic could play out and restrain what will only be at best a nascent economic recovery. The effects are also set to be concentrated in the still economically fragile periphery, risking a re-ignition of the sovereign/banks negative feedback loop. Figure 6: Public debt stabilization challenge increasing
-6
-10 -8 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Natural change in public debt* (lhs) A bsolute natural increase in debt in 2013 (rhs) % of GDP % of GDP 14 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 12 10 8 6 4 2 0 -2
Netherlands
From a crisis resolution perspective, the main event over the next year will be the finalization of the bank asset quality review (AQR) by the ECB next spring en route to the ECB becoming the single supervisory for euro area banks in mid-2014. The conclusion of the AQR will coincide with a new European Banking Association (EBA) stress test. The intention is to use the implementation of the common bank supervisor to flush out once-and-for all legacy bank losses and avoid bank zombification. The Single Supervisory Mechanism (SSM) is a step towards an improved stability architecture for the euro area, but the common oversight wont be complemented with common recapitalization and resolution capabilities until the Single Resolution Mechanism (SRM) is implemented later. The results of the AQR/EBA stress test will have to be borne nationally. This means either bail-out, which potentially stresses the sovereign, or bail-in, which potentially undermines financial sector stability (cost of bank
Portugal
Belgium
Ireland
Finland
Germany
Note: (Excess of debt -stabilizing primary deficit over actual primary balance) - change relative to 6months ago Source: Haver Analytics, DB Research
We see the potential for politics to add volatility to this picture in 2014. Certain issues are more positive than generally perceived. French President Hollande may have assailed the European commission for making prescriptive reform recommendations to France, but the fact is Paris has already set its course for reform. Moreover, a recent opinion poll found three quarters of French want Hollande to press ahead with reforms and are willing to make personal sacrifices for their
Page 17
Greece
Spain
Italy
France
attainment. Germanys use of the public bank KfW to provide credit support to SMEs in the periphery is a sign of how this direct, bilateral support for crisis countries is seen to yield a political dividend ahead of the 22 September German federal elections rather than a political cost. The Greek recovery story would be enhanced if the same logic sees Germany support Official Sector Involvement (OSI) in 2014. Our concern is political stability in the periphery is not assured. From one perspective, there continues to be remarkable stability across the crisis states given the extremely high unemployment rates the European Parliament elections in mid-2014 will test the stability of ruling parties and coalitions but the political picture in Italy does concern us. Miscalculations by the centre-left PD party in the presidential election ushered in a broad but fragile coalition. Quiet markets and an evolving attitude in Brussels permitted an easing in austerity. Unfortunately, the limited room for manoeuvre created by this has been consumed by tax cuts on unproductive factors of production. Hence, our worry is that it wont be self-financing. It is thus unlikely to generate a sustainable positive growth impulse in and of itself, while the path to structural reforms seems all but blocked by a misleading narrative of the crisis that fails to clearly pinpoint the underlying causes of the decade long-disappointing growth. In the absence of structural reforms, we estimate that potential growth would hover around 1% in France and Spain but tend to zero in Italy. Chances are Italy will return to the polls in mid-2014 against the backdrop of still weak growth. This raises the risk of a more staunchly anti-austerity, anti-reform government being elected against a back drop of a deteriorating fiscal position. Italian gross public debt is already anticipated to be 132.2% of GDP this year, the second highest after Greece. Italy might not be much different to the average in terms of the natural increase in debt (the excess of the debt-stabilising primary balance over the actual primary balance) in 2013, but relative to six months ago, Italy has deteriorated the most. Weakening growth and a rising deficit have swamped the decline in funding costs. The sizeable wealth position of the Italian household sector can sustain government issuance, but not without a cost of misallocated capital and weakening mediumterm growth prospects. The degree of protection from OMT might also be questioned. OMT intervention is conditional on an ESM programme being agreed, the politics of which is testy as we have seen in each of the bail-outs to date. There is a risk that OMT has already created moral hazard. Draghi has been reminding markets recently that the OMT backstop rate is high, perhaps higher that the market pricing.
Figure 7: Policy credibility is seeing an endogenous reduction in banks reliance on ECB liquidity but the ECB retains an easing bias
3500 EUR bln Eurosystem balance sheet
3000
2500
2000
1500
Draghi's "whatever it takes" pledge
1000 2007
2008
2009
2010
2011
2012
2013
In the nearer term, the stability of the Italian government depends on a fragmented PD party, former PM Berlusconis legal issues and each partys judgment on whether they can win the majority premium in the lower house. The outcome of an election remains highly uncertain. The centre-right appears to have a significant lead in opinion polls but is unlikely to obtain an outright majority in the upper house. Moreover, the 5SM is still likely to capture a significant portion of votes. Banks remain Spains Achilles Heel. The key to staying off an upward-sloping public debt trajectory is minimizing financing further aid for banking. However, the evolution of the economy is rotating from last years baseline scenario for the recapitalized banks to the adverse scenario. Bank of Spain efforts to prevent ever-greening alone could cost the banks a further EUR10bn. If the market - and the European partners and the IMF, which are closely monitoring banking developments in Spain- need more reassurance and start questioning the Wyman exercise, there is an outside risk that the country could be forced to tap the European credit line again. The conditions may not be as favourable as they were last year, with the growing appetite for bail-in.
Page 18
Figure 8: Periphery yields remain low despite recent sell off

8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 Jan-2012 Spain 10Y sovereign yields Italy 10Y sovereign yields May-2012 Sep-2012 Jan-2013 May-2013 %
than expected external demand and/or continuing domestic deleveraging, raising the debt stabilization challenge further; (2) Italy is far too large an economy and bond market for the rest of the euro area to remain immune to political risk, should it materialize; (3) Spanish banks and the Spanish economy and sovereign remain exposed to a too timid recapitalization. Figure 9: Other indicators & financial forecasts: Euroarea
M 3 g ro w t h , % y o y e o p F isc a l b a la n c e , % o f G D P P u b lic d e b t , % o f G D P T r a d e b a la n c e , E U R b n T r a d e b a la n c e , % o f G D P C u rr e n t a c c o u n t , E U R b n C u rr e n t a c c o u n t , % o f G D P F in a n c i a l f o r e c a st s O f f ic ia l 3M ra te 1 0 Y y ie ld USD p er E UR JP Y p er E UR G BP p er E UR
Source: DB Research, as of June 20
2011 1 .5 - 4 .2 8 9 .0 - 1 5 .7 - 0 .2 1 2 .7 0 .1 C u rre n t 0 .5 0 0 .2 1 1 .6 4 1 .3 2 129 0 .8 5
2012 3 .4 - 3 .7 9 3 .7 8 1 .3 0 .9 1 1 5 .8 1 .2 3M 0 .5 0 0 .5 0 1 .5 5 1 .2 6 129 0 .8 6
2013F 2 .2 - 3 .0 9 6 .8 1 1 0 .5 1 .1 1 5 5 .5 1 .6 6M 0 .5 0 0 .5 0 1 .7 5 1 .2 0 132 0 .8 5
2014F 1 .4 - 2 .5 9 7 .2 1 2 6 .0 1 .3 1 5 7 .3 1 .6 12M 0 .5 0 0 .5 0 2 .0 0 1 .1 8 133 0 .8 4
Impact of Fed tapering on Euro area and ECB OMT continues to exert a strong influence on sovereign yields. By and large, 10Y sovereign yields among the main crisis sovereigns remain below the level at the time of the last WO in late March. The recent sell-off in euro government bonds, in particular the periphery, indicates the sensitivity to Fed tapering. Arguably peripheral yields had proven insensitive to the materialization of risks, including the Italian election, the heavy-handed treatment of Cyprus and some backtracking on banking union. Some adjustment was overdue, in our view. But even with the sell-off, financing rates for Spain and Italy remain comfortably below 5%, well below mid-2012 levels and levels that leave public finances sustainable. There are reasons for Europe and the ECB to be relatively relaxed about tapering. First, tapering will only proceed in the context of a robust enough US economic recovery. In that sense, Europes growth prospects improve as the probability of tapering grows. Some peripherals will be more directly exposed to the US demand than others and those peripherals improving their competitiveness will benefit relatively more (Spain, Portugal, Ireland). Second, in a world in which growth is not getting any worse - bear in mind that tapering should also raise the dollar and weaken the euro - wider spreads in the periphery improve prospects for a returning flow of funds to help normalize financial fragmentation. Third, the OMT backstop remains in place. We doubt the German Constitutional Court will interfere; it has no direct authority over the ECB in any case. However, the period of waiting for the Courts judgment coincides with the lead up to tapering. It is possible that OMT uncertainties weaken the euro areas perceived sovereign backstop temporarily. Euro-area risks The main risks to the euro area are: (1) economic growth does not materialize in H2 2013 due to weaker
German election: no shift in euro policy Germany is facing federal elections on Sept 22, 2013. Chancellor Merkel continues to score high in terms of popularity while Peer Steinbrueck, her social democrat challenger, is trailing behind. A majority of Germans consider Merkel the better person to handle the euro crisis. The wide difference in personal popularity scores is behind the different campaign approach where the SPD has just presented a team of experts around Steinbrueck while the CDU/CSU appear to build their entire campaign squarely on Chancellor Merkels popularity. The polls so far show a close race with neither party camp the ruling coalition of CDU/CSU and FDP or the opposition of SPD and Greens able to achieve the majority of seats in the parliament. The CDU will come out as the strongest party but might have to search for a new coalition partner as the Liberals will have to fight to remain in the parliament (threshold of 5% of votes required). The newly established euro-sceptic party AfD which has received a lot of media coverage recently scores at around 2-3% in the polls and most observers do not expect them to enter the parliament. The generally higher number of smaller parties in this election may in the end mean the only viable option is a grand coalition of CDU and SPD a re-launch of the 2005-2009 political setting. While the ideas of the SPD in her election platform such as higher taxes for better-offs and a wealth tax might be hard to swallow for conservatives, stricter banking regulation is a joint request.
Page 19
The legislation on a modified narrow banking system in Germany has just been adopted by parliament as well as the Bundesrat, the upper chamber, where the opposition currently holds the majority. But even with a new government, there will be no fundamental shift in German policy towards euro area policy. CDU and SPD clash over details such as the transparency of rescue costs but in substance both the current chancellor and her challenger agree on the euro policy course - all relevant decisions on euro area issues have seen crossparty parliamentary approval. In terms of banking union, however, the SPD favors a pan-European resolution fund whereas the ruling coalition prefers a network of national funds. More generally speaking, though, public opinion and the Constitutional Court as major veto players will restrain the (euro-) policy of any new government. German economy: Moderate recovery Even though our forecast for German GDP growth in 2013 has hugged the lower end of the consensus range for quite a while, we have slightly reduced our estimate to 0.1% (from 0.3%). The main reasons for doing so are the below-forecast Q1 GDP reading (0.1% qoq) and the downward revision for Q4 and the 2012 profile, which additionally depressed the starting level for 2013. In spite of a weather-related catch-up effect in Q2 we look for a rather moderate recovery in the course of the year, especially since the global economy is still not offering much support. Private consumption will therefore be the mainstay of growth in 2013, although the 0.8% qoq rise in Q1 has to be seen in connection with the 0.3% decline in the preceding quarter. With employment expected to see an only temporary dent in H2, wages increasing at a 3% clip and low inflation private consumption should expand by around 1% in 2013 and 2014.
In the first quarter exports and imports continued their decline, net-exports did not contribute to growth. While there are signs of foreign orders bottoming out, ifo export expectations have fallen below their long term average during the last three months, prompting us to cut our export growth forecast to 0.75%. With capacity utilization below its long term average the subdued export outlook is weighting on investment spending, which we expect to decline by another 3% in 2013. Nevertheless, given our long held forecast of accelerating global GDP growth, German export and derived from that investment momentum should pick up in the coming quarters, so that both components will contribute to next years 1.5% growth. UK: BoE readies for the Carney era What is the Carney trade? This is the question that we have been hearing most over recent weeks with the previous Bank of Canada Governor due to take up the reins at the Bank of England from the start of July. Mr Carneys willingness to consider the use of monetary policy pre-commitments are well known, as he set out in a speech at the end of last year entitled, simply, Guidance. Indeed, under his stewardship the BoC actively pursued a policy of pre-commitment between the spring of 2009 and mid-2010. Will he use it again at the Bank of England? We think no. It is worth remembering that Mr Carney represents just one voice on the MPC, and the least four of the other eight members would need to agree with him if guidance were to be implemented. Moreover, it appears that a number of Committee members are dubious about the merits of pre-commitments (as are we). Still, the Bank has been commissioned by the government to at least think about the issues of using guidance, and to this end the Committee will be publishing a paper in August which will most probably outline the pros and cons of using such policy.
Figure 10: Macro-economic activity & inflation forecasts: UK

E c o n o m ic a c t iv it y (% q o q , s a a r ) GDP P riv a t e c o n su m p t io n In v e s t m e n t G o v 't c o n su m p t io n E x p orts Im p o r t s D o m e st ic d e m a n d C o n t r i b u t i o n (p p ): S t o c k s N e t tra d e In d u s t r i a l p r o d u c t i o n U n e m p loy m e n t ra te , % P r i c e s & w a g e s (% y o y ) CP I P ro d u c e r p ric e s C o m p e n sa t io n p e r e m p l. P ro d u c t iv it y
Q 1F 1 .3 0 .5 - 3 .0 0 .1 - 3 .1 - 2 .0 0 .1 1 .7 - 0 .3 0 .4 7 .8 2 .8 2 .1 0 .6 - 0 .7
2013 Q 2F 1 .8 1 .2 3 .2 0 .8 3 .2 1 .7 1 .4 - 0 .1 0 .4 3 .2 7 .9 2 .2 1 .4 1 .1 0 .9
Q 3F 1 .4 1 .6 4 .0 0 .4 2 .4 1 .4 1 .7 - 0 .5 0 .3 0 .8 7 .9 2 .1 1 .7 0 .3 0 .7
Q 4F 1 .4 1 .2 4 .0 0 .4 2 .8 1 .4 1 .4 - 0 .4 0 .4 1 .2 8 .0 2 .0 1 .7 1 .2 1 .9
Q 1F 2 .0 1 .2 4 .0 - 1 .2 4 .0 2 .0 1 .1 0 .3 0 .6 1 .6 7 .9 1 .9 1 .5 2 .5 1 .9
2014 Q 2F 2 .0 1 .6 4 .0 - 2 .0 4 .0 2 .0 1 .1 0 .2 0 .6 2 .0 7 .8 1 .1 1 .9 1 .9 1 .6
Q 3F 1 .9 1 .6 4 .0 - 1 .2 3 .2 1 .9 1 .3 0 .2 0 .4 1 .6 7 .7 0 .9 1 .9 3 .0 1 .4
Q 4F 1 .5 1 .6 4 .0 - 0 .4 2 .8 1 .5 1 .5 - 0 .4 0 .4 1 .2 7 .5 1 .4 2 .0 3 .0 1 .0
2012 % y oy 0 .3 1 .2 1 .5 2 .2 - 0 .2 2 .7 1 .5 - 0 .1 - 0 .9 - 2 .4 8 .0 2 .8 2 .8 1 .4 - 1 .0
2013F % y oy 1 .1 1 .1 0 .6 0 .4 - 0 .4 - 0 .2 0 .9 0 .3 - 0 .1 - 0 .6 7 .9 2 .7 1 .7 0 .8 0 .7
2014F % yoy 1 .8 1 .4 4 .0 - 0 .7 3 .4 1 .8 1 .3 0 .0 0 .5 1 .6 7 .7 2 .1 1 .8 2 .6 1 .4
Page 20
Perhaps more pertinent to the current conjecture, further easing (whether it be pre-commitments, lower interest rates, more QE etc.) looks unlikely if the recovery in activity we are seeing proves durable. The economy expanded at a rate of 0.3% qoq in the first quarter and looks set to beat that in Q2 with the PMI surveys pointing towards continued improvement. Thus the Carney trade in our view is that the new Governor appears willing to expand the array of unconventional policies available to the MPC, but only in the event that growth once again disappoints. Assuming he is able to convince the rest of the Committee, we would not expect the MPC under Mark Carneys Governorship to delay further easing in the event of another growth slowdown. And the weakening in the financial markets over recent days suggests that this is not beyond the realms of possibility. That said we remain optimistic about the UK economy. It is not only GDP that looks set to surprise on the upside in the near-term. Confidence (both consumer and business) has turned up, the housing market is showing signs of life again and money supply held by households and non-financial firms continues to grow apace. The relationship between growth and inflation is set to improve too. While inflation could rise over the coming two months (possibly even to 3% or above, which would require an open letter from Mr Carney to the Chancellor), clearer signs are emerging that it will fall meaningfully from the second half of the year: lower upstream prices and a sharp fall in the British Retail Consortiums measure of shop price inflation all point to lower CPI inflation looking ahead. Inflation, therefore, looks less likely to be an impediment to further monetary easing in the event that the recovery stalls. Figure 11: Other indicators & financial forecasts: UK
M4 growth, % Fiscal balance, % of GDP, FY Trade balance, GBP bn Trade balance, % of GDP Current account, GBP bn Current account, % of GDP Financial forecasts Official 3M rate 10Y yield USD per GBP GBP per EUR
At the same time, we have revised down our view on inflation from 3% to 2.6% this year and from 2.3% to its target rate of 2% next year. This combination, in our view, would be consistent with no further easing of monetary policy (that includes guidance). Norway: Dovish central bank despite recovery At the beginning of the year there had been some suggestion that Norway's central bank could ease policy. Since then, however, some of the economic news has taken a turn for the better and in our view suggest against further support. While we retain our view that Norges Bank will not ease policy going forward, the latest central bank forecasts show that the Executive Board now sees a 50-50 chance of a 25bp easing between the end of this year and mid-2014, with higher rates now a more distant prospect. Still, we remain less convinced of this argument given the economic backdrop. Mainland economic growth in Norway maintained a decent rate in the first quarter of around 2.75% annualised, driven by the strongest rise in consumer spending since the end of 2010. Related to the buoyant consumer, the central bank remains concerned about the pace of growth of household borrowing with house prices continuing to rise apace (6% in the year to Q1). On the output side the PMI survey has risen back above 50 to a 12-month high, manufacturing output growth has been negative during only one of the last six months, and capacity utilisation is broadly around its average over the past 15 years. Moreover, inflation has surprised on the upside over the past two months relative to Norges Bank expectations and the currency has fallen by almost 4% since February, raising the prospect of further inflation increases going forward (though that did not stop Norges Bank revising down its forecasts for how long inflation would take to return to target at its June meeting). An improving global growth backdrop should also contribute to a recovery in exports, which represent a sizable portion of GDP in Norway. That all said, a combination of a rising unemployment rate, weaker retail sales around the turn of the last quarter and weaker evidence on future growth expectations from the central bank's regional network survey should help prevent policy from being tightened any time soon. On account of this, and the central bank's latest forecasts/statement, we now expect no change in policy rates for the coming year. EMEA: Some vulnerability to tapering Expectations of Fed tapering have precipitated a withdrawal from emerging asset markets over the last few weeks. A number of countries in the region would be vulnerable to a further pullback in these flows. South Africa, Turkey and Ukraine, look especially exposed on this front given the scale of their current
Page 21
2011 2012 2013F 2014F -1.5 -3.7 1.5 4.0 -7.9 -5.5 -6.5 -6.0 -100.2 -106.3 -105.9 -105.3 -6.6 -6.9 -6.6 -6.3 -20.2 -57.7 -45.3 -40.1 -1.3 -3.7 -2.8 -2.4 Current 0.50 0.51 2.27 1.55 0.85 3M 0.50 0.51 2.25 1.55 0.86 6M 0.50 0.51 2.50 1.47 0.85 12M 0.50 0.60 2.80 1.41 0.84
In this World Outlook we have revised up our view on UK growth this year from 0.5% to just over 1% thanks to the stronger Q1 figure and what is shaping up to be decent growth in the current quarter. However, we have left unchanged our forecast of 1.8% for next year.
account deficits and reliance on short-term flows to finance them (Figure 12). Figure 12: Basic balance in EM
10 8 6 4 2 0 -2 -4 -6 The basic balance is the sum of the current account balance and net foreign direct investment % of GDP
volatility and could push rates higher still in the event of sustained pressure on the lira. Elsewhere, there is little immediate pressure to hike rates: we still expect further moderate easing in Hungary, Israel, Poland, and Russia, though South Africa will probably need to keep rates on hold given the scale of recent rand depreciation. We are less worried about the impact of rising US rates on private credit extension, largely on the grounds that most emerging markets in the region have been levering down rather than levering up in recent years. Western European banks have been gradually reducing their exposures to Central and South Eastern Europe. This process is close to completion and unlikely accelerate further in response to rising US rates. The one possible exception in the region is Turkey, where credit to the private sector has grown rapidly and has been partially (about one-third) foreign-funded. But even here, the level of private debt is still quite low at 47% of GDP compared with an average of about 90% of GDP in other major emerging markets. The sell-off in this region has been exacerbated in some cases by idiosyncratic factors, notably ongoing protests and political uncertainty in Turkey and labour market unrest in South Africa. The end game for the protests in Turkey remains unclear at this stage. But at the very least, political uncertainty has increased and this will weigh on investor confidence, both domestic and foreign, for the next several months. We have, accordingly, revised down our forecast for growth this year to 4.1%. In South Africa, the economy should start to benefit from the weaker rand although gains in competitiveness could yet be eroded by high wage settlements, strikes, and infrastructure bottlenecks, especially in the power sector. Having attracted fewer inflows, Russia is less directly exposed than others in the region to the end of Fed asset purchases. Growth is nevertheless weak: output has been expanding at an annual rate of only 1.3% over the last two quarters. The moderately softer oil prices that we now envisage will also weigh a little further on fiscal and external balances. The government is contemplating how best to stimulate activity. Few concrete measures have so far been agreed. This is undoubtedly disappointing as far as the structural reform agenda goes, which holds the key to generating more investment and higher growth. The decision to leave monetary and fiscal stances more or less unchanged, however, is more welcome given elevated inflation and the need to build credibility in these areas. European Economics London: (44) 20 7545 2087/88 Frankfurt: (49)69 910 31790 EMEA: (44) 20 7547 1930
But even countries in the region with stronger external positions have been buffeted by the recent reversal in foreign appetite for EM assets. While aggregate capital flows to the region are quite modest (well below the peaks reached prior to the global financial crisis and in 2010), there has been a marked shift in the composition of flows towards portfolio investments, especially in debt securities (Figure 13). By the end of last year, foreign private creditors owned almost half of government debt in Hungary and Poland, and over 30% in South Africa and Turkey. Recent currency moves seem to reflect this, depreciating more in countries that have received the largest short-term inflows over the last year or so. Figure 13: Portfolio flows to EMEA
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 2005 2006 2007 2008 2009 2010 2011 2012
This will add to inflationary pressures, though the starting point is a benign one given the weakness of domestic demand in the region and relatively soft commodity prices. Turkey has already tightened domestic liquidity in response to recent market
Page 22
TAI CHN HUN RUS KOR PHL ISR CZE COL THA BRZ CHL IDN POL EGY MEX ROM IND UKR TUR ZAF
Equity Poland, South A frica, Turkey (four quarter sum, % of GDP) Debt
-8
Japan: Recovery has started in Q1 2013
Economic expansion is likely to continue through Q1 2014 with 3.0% real GDP growth, thanks to JPY depreciation, wealth effect and global growth. The VAT hike in April 2014 should temporarily halt growth in 2014, but not trigger another recession.
Figure 1: Leading index of the business cycle

115 110 105 100 95 90 85 80 75 70 1995 DB leading index Industrial production 1998 2001 2004 2007 2010 2013 Index
Abenomics and transmission channels Our leading index of the business cycle has turned upward after its trough in July 2012. We think Abenomics has three stages of transmission channels: 1) JPY depreciation (recovery in exports and corporate earnings) and wealth effects (on consumption) [6month horizon], 2) From earnings recovery to wage growth [12-18 month horizon], 3) Higher conviction in medium-term economic prospect leading to recovery in capital investment [beyond 18-month horizon]. Q2 2013 is likely to be the quarter with the strongest upward momentum in activity. Process more important than outcome Japan has been given a chance to grow faster and for longer without being interrupted by impatient monetary tightening, which is more important than reaching 2% inflation, because it is in this process where beneficial effects on activity and financial markets flourish. We think the following combination summarizes Japans new steady state over the next 3-5 years: 2% nominal GDP growth, 1% CPI inflation, 1% 10-year JGB yield, and 5% M2 growth. When nominal GDP growth exceeds long-term interest rates, 1) government debt stability is facilitated and 2) a virtuous circle between economic activity and financial markets is supported. JPY depreciation expands the current account surplus, leading to a larger buffer to finance the fiscal deficit by private savings. Figure 3: Macro-economic activity & inflation forecasts
E c o n om ic a c tiv ity (% q o q , s a a r ) GDP P riv a te c o n su m p tio n In v e s t m e n t G o v t c o n s u m p t i o n E x p orts Im p o r t s C o n t r i b u t i o n (p p ): P riv a te in v e n to ry N e t tra d e In d u s t r i a l p r o d u c t i o n U n e m p lo y m e n t ra te , % P r i c e s & w a g e s (% y o y ) CPI C ore CP I P ro d u c e r p ric e s C om p e n sa tion p e r e m p l. P rod u c tiv ity - 0 .6 - 0 .3 - 0 .3 - 0 .7 3 .5 - 0 .3 - 0 .2 0 .8 0 .3 2 .1 0 .1 0 .2 2 .3 1 .0 2 .8 0 .3 0 .5 2 .8 1 .9 3 .6 0 .7 0 .7 2 .4 2 .2 1 .0 Q 1F 4 .1 3 .6 0 .6 1 .7 1 6 .1 4 .0 - 0 .1 1 .8 8 .9 4 .2 2013 Q 2F 4 .5 2 .4 4 .3 1 .4 1 3 .8 4 .2 0 .4 1 .5 1 3 .6 4 .1 Q 3F 2 .9 1 .4 1 .8 0 .0 1 0 .6 5 .4 0 .6 0 .9 7 .2 4 .1 Q 4F 1 .6 2 .0 - 1 .0 0 .0 1 0 .4 6 .2 - 0 .2 0 .8 9 .3 4 .1 Q 1F 3 .1 6 .1 - 1 .5 0 .8 8 .1 9 .1 - 0 .4 0 .1 8 .2 4 .1
Source: Ministry of Economy, Trade and Industry, DB Research
Figure 2: Merchandise trade balance

3500 3000 2500 2000 1500 1000 500 0 -500 -1000 -1500 2000 2002 2004 2006 2008 2010 2012 Merchandise trade balance Merchandise trade balance excl. mineral fuel imports
Source: MoF, DB Research
JPY bln, sa
2014 Q 2F - 7 .8 - 1 5 .8 - 7 .2 1 .6 6 .4 - 5 .3 1 .3 1 .8 - 1 4 .2 4 .0 2 .9 2 .9 5 .0 1 .9 - 0 .3
Q 3F 2 .9 3 .0 - 2 .5 1 .6 9 .0 5 .2 0 .6 0 .8 8 .2 4 .0 2 .9 2 .9 4 .5 1 .6 - 0 .3
Q 4F 1 .1 1 .4 0 .5 1 .2 8 .3 5 .0 - 0 .8 0 .7 5 .1 4 .0 2 .8 2 .8 4 .1 1 .3 - 0 .4
2012 % y oy 1 .9 2 .3 4 .2 2 .4 - 0 .1 5 .5 0 .0 - 0 .8 - 0 .9 4 .3 0 .0 - 0 .1 - 0 .9 0 .0 1 .5
2013F % yoy 2 .0 1 .8 0 .9 1 .4 3 .6 1 .4 0 .1 0 .4 1 .9 4 .1 - 0 .1 0 .1 1 .4 0 .6 3 .0
2014F % yoy 0 .6 - 0 .6 - 1 .7 0 .9 9 .0 4 .2 0 .2 0 .9 3 .8 4 .0 2 .3 2 .3 4 .0 1 .8 0 .0
Page 23
Monetary policy: Heading for uncharted territory The new strategy of the BoJ is to 1) set monetary base as instrument and target JPY60-70trn expansion a year, 2) purchase longer-maturity JGBs (gross purchases of JPY80-85trn a year), 3) repeal the banknote rule and 4) reach 2% inflation in two years. We think the next easing actions will be announced in October with a new semiannual outlook report. Options include 1) continued expansion in monetary base in 2015-16, 2) purchasing securitized bank loans, and 3) introduction of level targeting on nominal GDP or prices. Factors behind recent rise in JGB yield 1) Correction to a structurally too pessimistic assessment of Japan by domestic fixed income investors, 2) better medium-term prospect for the Japanese economy, 3) tendency that long-term rates rise under higher stock prices, weaker yen and stable global conditions, 4) a rise in US long-term rates. Economic growth strategy Growth strategy consists of 1) deregulation, 2) corporate tax cuts, and 3) participation in free trade agreements. Deregulation is a compendium of microeconomic measures whose effects take time to materialize and are difficult to measure. Deregulation in the labor market, agriculture, medical services, elderly care services and support for start-up companies is considered a priority, but some measures may be dropped due to strong opposition. Tax incentives for employment, wages, R&D have been introduced in the FY2013 budget but may not work as designed, given low capacity utilization and lack of confidence in medium-term prospects. Across-the-board cut in the corporate tax rate seems off the agenda until 2015. Risks The VAT hike in April 2014 could induce a larger dislocation of demand, triggering a recession.
Figure 5 : Capital investment, cash flow, depreciation

22 20 18 16 14 12 10 8 6 4 2 0 1972 1977 1982 1987 1992 Depreciation Cash flow Capital investment 1997 2002 2007 2012 JPY trn
Source: MoF, DB Research
Figure 6 : Acceleration in monetary base expansion

160 140 120 100 80 60 40 20 0 2000 JPY trn, sa Total reserves Monetary base
2002
2004
2006
2008
2010
2012
Source: BoJ, DB Research
Figure 7 : Price judgment by households

90 80 70 60 50 40 30 20 10 0 -10 2004 2006 2008 2010 2012 Price judgment diffusion index (lhs) CPI inflation excl. fresh food (rhs) % balance % yoy 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5
JPY depreciation may not continue given creditor country status and lower inflation in Japan.
2011 2.7 -9.0 212.4 -21.3 -0.4 119.3 2.0 Cu rren t 0.10 0.23 0.86 98 129 2012 2.5 -9.5 220.0 -67.8 -1.1 63.7 1.1 3M 0.08 0.30 0.90 102 129 2013F 3.6 -9.3 226.5 -80.1 -1.7 58.0 1.2 6M 0.08 0.30 1.00 110 132 2014F 4.5 -7.4 229.5 -31.4 -0.7 103.0 2.4 12M 0.08 0.30 0.80 113 133
Figure 4 :Other indicators & financial forecasts

M 2 g rowth , % Fiscal b alan ce, % of G DP P u b lic d eb t, % of G DP Trad e b alan ce, USD b n Trad e b alan ce, % of G DP Cu rren t accou n t, USD b n Cu rren t accou n t, % of GDP Fin an cial forecasts Official 3M rate 10Y y ield J P Y p er USD J P Y p er E UR
Source: Cabinet Office, Ministry of Internal Affairs and Communication, DB Research
Mikihiro Matsuoka, (81) 3 5156 6768
Page 24
Asia (ex Japan): A slightly delayed recovery
After a slightly disappointing start to the year, our global growth forecasts still imply a midyear pickup in export and GDP growth in Asia that we think will be stronger than consensus expectations. Inflation has proved much more benign than expected, especially in India where another three rate cuts are likely, helping to turn growth around. Higher bond yields have already caused capital flight from Asia, leading to weaker currencies. Higher short-term interest rates likely only in 2014 in most economies may be challenging in economies where debt levels have risen significantly since 2007.
As we reiterated last quarter, we expect that recovery in Europe and stronger growth in the US will lift Asian export growth much higher. Current export growth of 0.5 %yoy for aggregate Asian exports could be as high as 20% by end-2014 if historical relationships hold and US and EU growth rises as much as we expect it will. However, on balance so far this year, growth has been a little disappointing only partly due to exports coming in a little lower than expected. With the exception of the Philippines whose GDP growth rate in 2013 we have raised by 1.3 pp to 7.0% after a remarkably strong first quarter growth forecasts for most other economies have been lowered although only for Malaysia and Taiwan were the revisions material (cuts of 0.5% and 0.9% respectively). The Chinese GDP growth forecast was lowered by 0.3pp to 7.9% this year. We still expect growth to rise sharply to 8.8% next year. The Indian growth forecast has also been lowered slightly after a weaker-than-expected Q1 GDP report. Diverging North/South performance? Electronics exports from North Asia and those from Southeast Asia have diverged recently. Electronics account for about one-third of exports from China, Malaysia, the Philippines, Singapore, South Korea and Taiwan. But whereas the North Asian economies have reported an increase in growth in electronics exports recently, exports from Southeast Asia have fallen. Figure 2: Electronics exports from North and Southeast Asia
80 % yoy, 3mma KR+TWN MY+PH+SG China
Overview Our optimism last quarter proved premature. As it became increasingly apparent that there was significant mis-reporting of Chinese export data in recent months, our expectation of continued sequential growth in exports in Q1 has been reversed. Adjusting Chinese export data for the worst of the over-invoicing problem, a general upward trend to aggregate Asian exports remains, but they appear still to be fluctuating within a narrow band. Figure 1: Asian exports (with adjusted Chinese exports)
1200 1100 1000 900 800 700 600 500 400 300 200 2000 2002 2004 2006 2008 2010 2012 USD bln Asia exports (w ith adjusted Chinese exports)
60
40
20
Note: Chinese exports are adjusted as follows: (1) exports to bonded warehouses and SEZs are removed; (2) exports to HK scaled down since mid-2012 to a constant multiple to reported HK imports from China. These two components of Chinese exports in recent months appear to have been most biased by over-invoicing of exports Source: CEIC, DB Research.
-20
-40 2000
2002
2004
2006
2008
2010
2012
In our view, this reflects the fact that after the postcrisis recovery that saw US&EU GDP growth averaging about 2.3% during 2009-10 since 2011 growth in these economies combined has averaged only about 1%. So, since mid-2011 Asian export growth has averaged about 2.5% qoq (sa) compared with pre-crisis yoy growth rates of about 20%.
Source: CEIC, DB Research
We speculate this might reflect a communications (North) versus computers (Southeast) divide that might see Southeast Asia benefit less from the pickup in global growth than North Asia.
Page 25
China and India Both China and India saw GDP growth come in a little below expectations in Q1 and our growth forecasts have been revised downwards slightly as a result. In China, it seems that policymakers may have misjudged the importance (to growth and inflation) of total social financing, which has been growing 22% yoy, and traditional loans, which have been growing 15%. Hence, policy may have been kept too tight in the expectation that growth would pick up more strongly. As policymakers reassess their framework, and in the face of lackluster external demand, we think they may be leaning towards providing some modest fiscal and/or monetary stimulus. Our leading indicator for China which combines US and EU industrial orders and TSF growth in China, suggests GDP growth should rise in the coming quarters even without fresh stimulus. But if ordinary loans are, in fact, the more appropriate measure of credit, then it would imply a much more modest rise in GDP growth. Figure 3: A leading indicator for China GDP
14 13 12 Forecast 11 10 9 % yoy GDP ex-A g Model
current account surpluses have sold off along with deficit country currencies. While the focus today is on bond yields and capital flows, we think it will eventually turn to the impact of higher yields on domestic borrowing. With most bank loans set with floating rates anchored to short-term rates, this may not be an issue until next year. But given how rapidly debt/GDP ratios have risen and how high the ratios were to begin with, the turn in the monetary policy cycle could be particularly challenging. Figure 4: Private sector debt in Asia
250 % of GDP 2007 200 2012
150
100
50
0 CH HK SG TW TH MY SK IN ID SRL PH
Note: Domestic and external debt of corporate and household sectors (including local governments in China) Source: BIS, CEIC, DB Research
Figure 5: Deutsche Bank forecasts: Emerging Asia

8 7 6 Sep-08 GDP = 2.3 + 0.2*TSF(-2) + 0.04*G2_Ord(-1) R2 = 0.82 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13
(% yoy, unless stated) 2011 Real GDP growth 7.5 - Private consumption 7.2 - Investment 6.7 - Government consumption 7.7 - Exports 12.9 - Imports 13.0 Industrial production 9.2 CPI 6.0 CA balance, % of GDP 1.6 Asia ex. China and India Real GDP growth CPI
Source: CEIC., DB Research
Source: CEIC, Haver Analytics, DB Research
In India, inflation has fallen faster than expected headline WPI inflation is now only 4.9% while core inflation is at 2.6% -- allowing the RBI to cut rates 75bps already this year. We think another 75bps of rate cuts is still likely in the second half of the year although perhaps not in the very near-term given market volatility. These rate cuts are likely to be more important in sparking a turnaround in Indian GDP than the recovery in exports. Vulnerability to rising yields Rising G3 bond yields have caused turmoil in Asian bond markets triggering a selloff that has pushed currencies weaker and yields higher. While we had recognized the vulnerability of some Asian bond markets given the very low yields and heavy weighting on foreign investors, the impact on currencies has surprised us. Even currencies supported by large
Page 26
2012 2013F 2014F 6.1 6.3 7.3 6.5 6.2 7.1 5.5 6.3 7.9 6.4 6.2 6.2 5.3 6.2 11.1 7.1 6.6 11.5 6.3 7.2 8.8 3.8 3.3 4.1 1.3 1.2 1.0 3.9 3.3 4.3 3.6 5.1 4.0
4.3 4.8
Growth in most Asian economies is so highly export-sensitive that the main risk to the outlook is that growth in the US and EU falls short of our forecasts. If recent bond market turmoil is not contained, FX depreciation could lead to a reassessment of inflation, leading to earlier-than-expected rate hikes. Michael Spencer, (852) 2203 8305
Latin America: Tested by shifting flows and strong dollar outlook
Economic growth has surprised on the downside, and we have revised this year regional forecast to 2.8% from 3.5% originally. A shift in global asset preferences and rising US rates are threatening past strong capital inflows, causing some dislocation in regional FX and rate markets, but yet unlikely to derail a decent economic performance this year. The lack of reform appetite however, remains the main long term risk, particularly in countries like Argentina, Brazil, and Venezuela. Mexicos recent progress in the reform front appears as the major regional hope ahead.
Figure 1: Gross capital inflows in Latin America

8 7 6 5 4 3 2 1 0 -1 -2 2004 2005 2006
Source: DB Research
Rolling four-quarter sum , % GDP
FDI 2007 2008
Total 2009 2010 2011 2012
Growth has surprised on the downside During the first months of the year, economic activity has been reported weaker than initially expected. In contrast to 2012, gloomy data have been widespread, including even the strong growth performers of Peru, Chile, and Colombia. Taking aside the two exceptional cases of Argentina and Venezuela, where the recent slowdown is mostly reflecting unsustainable policies, this years surprises seem to be more related to external forces losing steam while domestic consumption remaining quite resilient. Investment spending, nonetheless, appears also to decline in the first quarter of the year. Therefore, based on current trends, we have revised downwards growth expectations for this year from 3.5% initially to 2.8%. In addition, we have also cut 2014 growth forecasts by 0.4pp to 3.6%. Although weak growth numbers were reported across the board in the region, the downward revision looking forward is not homogenous. Argentina, Brazil, and Venezuela are leading the forecast adjustment with around 1pp. Colombia, Peru, and Chile continue to be in the most resilient group, where growth expectations were adjusted by only 0.1- 0.2pp. In Mexico we cut growth forecast by 0.6pp to 2.9% for this year despite the fact that recent trends point to a faster recovery in the US, Mexicos main external partner in trade, foreign direct investment, and remittances. Indeed, we remain optimistic that the Mexican economy could pick up in line with the US in the 2H2013, with the help of stronger public spending, which has remained subdued so far this year reflecting the typical pattern of a transition to a new administration. A positive reform outlook is also expected to cheer up business and consumer confidence in the last quarter of the year.
Figure 2: Private credit growth since 2007

25 20 15 10 5 0 -5 -10 -15 -20 BRA
Source: DB Research
% of GDP Change in credit to private sector
CHL
PER
COL
MEX
A RG
Capital flows might turn around. Sentiment regarding emerging economies seems to have completely turned around in recent weeks as markets started to price the end of Fed asset purchases. This created expectations of capital reverting direction from last few years. This has hit Latin America as the region was one of the major recipients of post QE flows, particularly hard. Furthermore, the regions specialization in commodity production amid potential dollar strengthening and recent Chinese weakness did not help. In addition, the poor economic performance of the past few months created further doubts about the regions ability to cope with such new global backdrop.
Page 27
As we discussed in a recent note2, we find recent levels of capital inflows to the region not alarmingly high. They did represent a significant change in composition, where portfolio flows have replaced bank financing but where FDI has remained relatively stable. Countries like Mexico and Chile did receive a sizeable amount of portfolio flows since QE started in the US, in the order of 5%-7% of GDP. Nevertheless, these are not the countries that showed a concerning increase in domestic credit as a share of GDP in the last few years. Brazil, in that regards, did witness a 15% increase in domestic credit as a share of GDP since 2007 and that could create some vulnerabilities ahead. Actually short term vulnerabilities in the asset universe have been confirmed by recent price action. Indeed, there seems to be a strong correlation between past inflows and the magnitude of the recent sell-off. However, in our view, global inflows have not dramatically changed the fundamental strength of a region that has remained relatively unleveraged, following prudent fiscal and monetary stances. Weaker exchange rates are likely to improve economic conditions in a region where unit labor costs have been increasing in USD terms for almost a decade. In particular since inflation has remained low and there is not a serious pass-through risks. Brazil is probably the exception among the big economies with relatively low inflation, as inflation is accelerating despite sluggish economic growth. This is likely to demand tighter monetary conditions, further challenging the recovery ahead. Medium term still dependent on reforms As we noted, Brazil, consumption-driven growth is reaching its limit as regulatory/interventionist uncertainty prevents investment from a pace necessary for sustainable fast growth. Unfortunately there is no sign that the authorities are addressing these structural bottle necks in any definite way. Expansionary fiscal and monetary conditions are expected to facilitate economic rebound this year and next, but at the cost of increasing strains in the management of the growthinflation trade off. By contrast, likely progress on fiscal and energy reforms later this year could push Mexico on an even faster growth path, making it the clear regional highlight. Meanwhile, macro management is likely to remain business as usual in Chile, Peru, and Colombia, without a major need for key reforms.
Figure 3: Current account

7 % GDP 2011 2012 2013F 2014F
-1
-3
-5 ARG
Source: DB Research
BRA
CHI
COL
MEX
PER
VEN
Figure 4: Deutsche Bank forecasts: Latin America

(% yoy, unless stated) Real GDP growth - Private consumption - Investment - Exports, USD bn - Imports, USD bn Inflation Industrial production Unemployment, % Fiscal balance, % of GDP CA balance, % of GDP
2011 4.3 4.9 7.0 966.6 858.3 8.4 2.9 6.6 -2.2 -0.9
2012 2013F 2014F 2.8 2.8 3.6 3.7 3.8 4.0 2.3 6.2 6.2 975.2 1050.4 1155.0 892.0 965.1 1071.0 7.8 8.3 8.4 1.4 4.2 4.1 6.4 6.4 6.4 -2.6 -2.4 -2.2 -1.4 -1.8 -1.8
Figure 5: Deutsche Bank Forecasts

(% yoy, u nless stated ) A rgentina GDP CPI CA bal., % Brazil GDP CPI CA bal., % Chile GDP CPI CA bal., % Colombia GDP CPI CA bal., % M exico GDP CPI CA bal., % Peru GDP CPI CA bal., % Ven ezu ela GDP CPI CA bal., %
GDP
GDP
GDP
GDP
GDP
GDP
GDP
2011 7.0 24.7 0.1 2.7 6.6 -2.1 5.9 3.3 -1.3 6.6 3.4 -2.6 3.9 3.4 -0.4 6.9 3.4 -2.0 4.2 26.1 6.3
2012 2013F 2014F 1.2 1.5 1.6 24.0 25.7 27.6 1.3 0.1 0.7 0.9 2.4 3.1 5.4 6.4 5.6 -2.4 -3.1 -3.0 5.6 4.7 5.2 3.0 1.8 2.6 -3.6 -4.0 -2.8 4.0 4.2 5.0 3.1 2.6 2.9 -2.9 -3.2 -3.3 3.9 2.9 4.1 3.7 3.7 3.7 -0.8 -1.0 -1.2 6.3 6.1 6.3 3.7 2.5 2.4 -3.1 -3.5 -3.7 5.6 0.9 2.4 23.8 24.8 26.9 2.5 3.2 2.8
Gustavo Caonero, (1) 212 250 7530

2 Capital flows to EM: Ample but (mostly) not alarming, published on June 14, 2013.
Page 28
Global Asset Allocation: Growth versus stimulusThe Feds taper

Two legs of higher rates: one good and one bad for growth assets. The move up in rates, especially since the Feds taper comments have been at the heart of recent market moves. There were two legs of the move up in rates. The first leg saw growth assets rally, as they did in the run up since last November, while carry sold off. The second leg, beginning with the taper comments, saw a broad-based selloff across asset classes. Why? In our reading, an inevitable re-pricing of a very slow pace of Fed rate normalization on better data has been the driver of higher rates. This re-pricing got added impetus on the taper comments but began during the first leg. The driver of growth asset declines was instead the discussion of taper combined with a lack of clarity on the timing and pace of coming normalization that prompted unwinds of positions that had seen the biggest inflows under QE. The ensuing volatility spilled over across asset classes and saw a broad-based positioning unwind. Figure 1: Rates first leg up positive for growth assets
12 10 8 6 4 2 0 -2 -4 -6 -8 % Cross asset returns: May 02 to May 21, 2013
Figure 3: Repricing fed normalization pace driving 10Y

4.5 4.0 3.5 3.0 2.7 2.5 2.0 1.5 1.0 2010 2.2 1.7 1.2 2011 2012 2013 % Eurodollar futures 4 years out (lhs) 10y Treasury yield (rhs) 4.2 3.7 3.2
Source: Bloomberg Finance LP,DB Research
Five reasons why rising rates in a context of stronger growth are positive for equities and credit spreads:
Strengthening growth is by itself positive for growth assets and therefore equities as well as credit quality and credit spreads. The normal cyclical asset reallocation mechanism of new savings flows from fixed income to equities is that of gradually rising rates (10Y yields). This asset reallocation mechanism looks to be alive and well in this cycle with every episode of a backup in rates seeing inflows into equities (Four years after the Financial Crisis, December 18 2012). Rising rates typically see credit spreads tighten as fixed income investors reallocate away from treasuries. Limited vulnerability to outflows. Beyond the episodic inflows around rates increases there has been almost no inflows into US equities for 5 years, with the cumulative inflow near zero (Asset Reallocation to US Equities, January 24 2011). It can therefore hardly be argued that US equities were a beneficiary of the Fed's policies through increased inflows. The correlation between bond yields and equities has been positive since the financial crisis as growth concerns predominated both asset classes. So to argue otherwise would be arguing for a break in this correlation which has been resilient through the launch and pause of various QE programs. In that the Feds taper represents the beginning of the Feds eventual exit, we note that the beginning of past Fed rate normalization cycles were typically nonevents for equity markets; the uptrend in equities continued as the Fed began to hike (Equities And The Feds Exit, December 8 2009). The one exception 1994 is discussed below. Longerdated credit spreads similarly tightened during Fed rate hiking cycles.
Gold JPYUSD US 10y Agri Commodities German 10y EURUSD EM Bonds Latam Fx US HG EM Asia Fx Europe IG US HY MSCI Latam Europe HY Trd Wtd $ MSCI Asia ex Jp Brent Oil MSCI EMEA MSCI USA MSCI AC World MSCI Europe Ind Metals MSCI UK MSCI Japan
Source: Bloomberg Finance LP, Factset, FRB, Haver, DB Research
Figure 2: Second leg up negative

15 10 5 0 -5 -10 -15

Cross asset returns: Since May 21, 2013
Source: Bloomberg Finance LP, Factset, FRB, Haver, DB Research
MSCI Japan MSCI Latam MSCI Asia ex Jp MSCI UK MSCI EMEA MSCI Europe Agri Commodities MSCI AC World EM Bonds Latam Fx Trd Wtd $ Ind Metals MSCI USA US HY US 10y EM Asia Fx Europe HY US HG German 10y Europe IG Brent Oil Gold EURUSD JPYUSD
-20
Page 29
Figure 4: Rates and equities positively correlated

0.9 0.7 0.5 0.3 0.1 -0.1 -0.3 Recession 3m correlation b/w 10y yields and S&P
Higher volume is a negative but is not a necessary implication of normalization. The taper comments added to bond volume which had been rising from very low levels. But normalization cycles do not have to be associated with higher and certainly not high volume. The 1994 rate hiking cycle did raise bond volume. But the 2004 hiking cycle when the Fed raised rates in a steady manner saw bond volume fall steadily. Figure 7: Bond volume rose during the 1994 hiking cycle fell during the 2004 cycle
9 % Fed target rate (lhs) Move Index (rhs) A verage Index 290
-0.5 2004
2006
2008
2010
2012
8 7 6
Source: Bloomberg Finance LP, DB Research
240
Figure 5: Beginning of Fed hiking cycles typically had no impact on equities

A vg in 6 episodes when S&P trajectory was unaffected 110 106 Fed hike 102 98 94 90 Index
5 4 3 2 1 0 1990
190
140
90
40 1993 1996 1999 2002 2005 2008 2011
Trading days around Fed hikes (Fed hike = Day 0)

Note: 6 of the last 8 Fed rate hikes did not impact the upward trajectory of the S&P Source: Bloomberg Finance LP, DB Research
Fed normalization is negative for carry. There is a clear negative association between Fed rate cycles and the performance of rates carry. Fed easing cycles saw positive returns and performance while hiking cycles saw flat at best but usually negative performance. Figure 6: Carry inversely related to Fed cycles
9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 1990 1993 1996 1999 2002 2005 2008 2011 2014
Fed target rate (lhs) Rates carry index (rhs)
Index
325
275
The ghost of 1994: major financial market event with no impact on the trajectory of economic recovery. There are parallels but also important differences between the disorderly fixed income sell off in 1994 and the current one; both in terms of the market and Fed context at the time. Like 1994, the beginning of this Fed normalization follows a record period of postrecession easing and pause, encouraging fixed income carry. In contrast to 1994 which saw aggressive hikes with little communication, the Fed has communicated it is considering a taper while continuing QE; and rate normalization is still 2 years out. In any event, the market and economic impacts of 1994 are worth noting. The first Fed hike in 1994 saw rates carry sell off while equities were resilient. As the Fed hiked quickly again, carry declined further in an extended sell off (down 14% peak to trough) while equities fell by much less (6%) and recovered in four months. Despite the severe sell off in rates and broader market volatility, the impact on a broad set of economic indicators including housing proved very limited.
Page 30
-126 -114 -102 -90 -78 -66 -54 -42 -30 -18 -6 6 18 30 42 54 66 78 90 102 114 126
225 175 125 75
Figure 8: In 1994 rates carry fell 14% while equities fell by 6% and recovered quickly
7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 Dec-1993 85 A pr-1994 A ug-1994 Dec-1994 90 100 Rates and equity perf around 1994 fed hike Index Fed target rate (lhs) % S&P 500, Index = Dec 1993 (rhs) Rates Carry index (rhs) Fed hike in February 1994 110
105
calendar rate guidance and twist. Rates positioning is now neutral but can go short. In contrast, equity positioning has stayed close to neutral during QE3 with exposures cut in recent weeks. Equity positioning can go much longer if macro data turns up and flows resume. At the onset of each QE, investors positioned for a weaker USD but are now very long. Similarly, commodity positions rose during each QE but net longs have been cut with the exception of oil. Figure 10: Bond outflows as Fed starts to hike
% of assets 21 16 11 6 Fed rate hike 12 month sum of bond flows (lhs) Fed rate (rhs) %
95
10 9 8 7 6 5
Figure 9: 1994 saw little to no impact on the recovery

6.25 5.75 5.25 4.75 77 4.25 3.75 3.25 2.75 Dec-1993 76 75 74 A pr-1994 A ug-1994 Dec-1994 % Macro indicators around 1994 fed rate hike Index Fed target rate (lhs) Leading economic indicators (rhs) Fed hike in February 1994 80 79 78
1 -4 -9 -14 1988
4 3 2 1 0 1992 1996 2000 2004 2008 2012
Source: ICI,FRB, DB Research
Source: Bloomberg Finance LP, The Conference Board, Haver, DB Research
The post taper flows and positioning unwind Large bond outflows on Fed normalization historically. Extraordinary monetary policy easing fueled USD1.2tr of inflows above trend into bond funds since 2009. EM bonds benefitted spectacularly, with cumulative inflows of 160% of AUM but also a large 40-60% for other bond segments. Total equity inflows were flat with EM equities again getting large inflows. The first 3 weeks of May saw inflows to bonds, credit and equities continue as rates rose. However, since the taper comments there has been USD27b of bond outflows with HY, government and EM worst hit. EM equity outflows were also large, while US equity flows were flat. Continued pricing in of Fed normalization should see further bond outflows. Outflows from bonds were 14% of AUM in 1994, 8% in 2000 and 5% in 2004. The rise in rates should see the cash that has moved out of bonds go to equities with a lag as it has historically. QE positions cut as investors move closer to neutral. Since QE2, rates positioning has been consistently long, with a rise in longer duration positions (10Y and 15+) after Aug 2011 when the Fed began to provide
Outlook We see higher rates as a central element of the normalization process since the financial crisis. And we continue to expect rates to rise with the 10Y at 2.5-2.65 by year end as expectations roll up the forward curve (After Spring Seasonality, May 21 2013). Higher rates at this stage of the cycle are positive for equities and credit spreads. We view the recent market tumult as reflecting the unwind of large rates carry and other QEdriven flows and positioning. We see this as part of the transition process and as having a transitory impact on risk appetite; but as having a much longer-lived impact on asset reallocation away from QE beneficiaries. Macro data and Fed pushback the near term stabilizers. Spring seasonality again saw data surprises turn down globally. The thesis that they would turn up with a positive data surprise phase to come is tracking. But this will happen only slowly. In the very near term, expectations of Fed policy remain the key. Even after the repricing, market expectations for Fed rate normalization remain far below historical tightening cycles. But Fed communication and clarity on its reaction function can provide an anchor for market expectations and therefore bond yields. Indeed the Fed has already begun to pushback on expecting too quick a pace of rate normalization and we expect it will do so again at this week's meeting and this should provide some stability.
Page 31
Long growth while avoiding asset classes, regions, sectors and stocks with the biggest QE flows and positioning overhangs. The latter are likely to stabilize near term with rates on Fed communication and shorter term positioning has in many cases unwound. But with rates moving higher, excess longer term inflows around QEs means they will likely continue to be subject to recurring pullbacks. Bonds in general and EM in particular have the biggest QE overhang. Equities, especially US equities have the smallest if any QE flows and positioning overhang and a steady source of demand from corporate buybacks. EM equities which were disproportionate beneficiaries of equity inflows during QEs have the biggest overhang. Within equities, the bond-like high dividend yield sectors and stocks were the beneficiaries and are richly valued. Commodities, especially precious metals, had been a big beneficiary of QE but have been in a down channel for over 2 years and have seen some significant outflow and position adjustments already (Trading The Commodity Underperformance Cycle, April 18 2013). Binky Chadha, (1) 212 250 4776 Keith Parker, (1) 212 250 7448 Parag Thatte, (1) 212 250 6605 John Tierney, (1) 212 250 6795
Page 32
US Equity Strategy: Attractive long-term S&P 500 outlook as economy returns to normal
S&P 500 long-term yearend targets: 2013 1625, 2014 1850, 2015 2000 S&P 500 EPS: 2013E USD109, 2014E USD115, 2015E USD120 S&P 500 DPS: 2013E USD36, 2014E USD40, 2015E USD45 Implied PE and dividend yield targets: 2013E 15x and 2.2%, 2014E 16x and 2.2%, 2015E 16.5x and 2.2% Sector strategy: Over-weight Financials and Tech. Under-weight Energy, Staples and Telecom Strategic preference: Global growth industries
Figure 2, S&P fair value as real cost of equity (CoE) falls from 6.5% in 2013 to 5.5% in 2015 as ~2% is accepted as a sustainable long-term risk free real interest rate. Figure 2: S&P 500 fair value at 2013 2015 ends
2013 Nominal CoE LT inflation Real CoE: or ERP: 2013 end 2014 end 2015 end
Source: DB Research
2014 8.5% 2.5% 6.0% 4.0% 1753 1859 1972
2015 8.0% 2.5% 5.5% 3.5% 1800 1900 2006
9.0% 2.5% 6.5% 4.5% 1623 1730 1843
PEs to rise as interest rates are liberated and the private economy drives moderate growth We expect the S&P to deliver attractive returns from decent EPS growth boosted by PE expansion over the next few years amidst a long lasting expansionary cycle. Although Europe is still in recession, China is still slowing and US manufacturing, business spending and exports remain sluggish which all weighs on S&P 500 EPS growth steady US job growth and improvement in housing and discretionary spending despite tax hikes and government spending cuts has reduced recession risks. The US deficit is falling and federal government debt to GDP should stop rising. The US is proving its propensity to continue healing and overcome fiscal drags. This increased investor confidence in S&P EPS sustainability has shifted the debate from normalized earnings to normalized long-term interest rates. If interest rates rise only gradually, i.e. 10yr treasury yields stay under 3% in 2013 and plateau under 4% in 2014, even as Fed asset buying stops, then the S&P PE should climb from 15x today to 16x or higher by 2015. Interest rates staying lower than history on a secular basis as EPS growth stays respectable over the next few years driven by return disciplined reinvestment and also double-digit dividend growth will drive PEs higher. Figure 1: Path to PE expansion from 2013 to 2015
Year & PE 2013 S&P PE 15+ 2014 S&P PE 16+ Criteria: 1) EPS growth >5%; DPS growth >10% 2) US 10yr Treasury yield <3% 3) US deficit falls to equal nominal GDP growth 1) Fed stops asset purchases 2) Interest rates rise only gradually: US 10yr Treasury yield <4%; 10yr TIPS 1-2% 3) Oil: WTI at ~ USD90/bbl, Brent at ~USD100/bbl 1) Long lasting expansionary cycle 2) S&P releveraging, M&A , rotation, etc. 3) Lower repatriation tax rate will promote continued double-digit DPS growth S&P EPS & target USD109 1625 USD115 1850
Only time will prove if interest rates stay low PE expansion usually occurs as recessions end and during early cycle growth on an improving economic outlook. Notable periods of post-war mid-cycle PE expansion are: 1950s, mid 1980s and mid 1990s. The 1950s and mid 1980s PE expansion toward the historic average PE was on fading inflation and acceptance of secularly lower long-term interest rates, similar to today. Whereas the late 1990s PE expansion to above historic averages was on very strong extended cycle EPS growth. Lower long-term real interest rates should boost stock PEs, but investor confidence in sustainably lower rates will take time. Figure 3: S&P PE, implied equity risk premium, rates
30 25 20 A verage PE = 15.9 15 10 5 0 18 16 14 Lower interest rates 12 drove mid 1980s 10 PE expansion 8 6 4 2 0 -2 1960 1966 1972 1978 1984 1990 1996 2002 2008 2014
Note: Shading denotes recession Source: DB Research
LTM PE (lhs) Ratio
Implied ERP (rhs) %
12 10 8 6 4 2 0
10yr Yield
Real 10yr Yield
2015 S&P PE 17+
USD120 2000
Source: DB Research
Cautious near-term as we watch cross asset volatility for other secular shifts beyond rates We expect the S&P to trade within a 1550-1650 range this summer as investors watch the interaction of interest rates, the dollar and oil prices. For the S&P to make a sustained move higher we want to be confident that: 1) EPS deceleration bottoms soon and healthy 4Q
Page 33
growth is likely; 2) interest rates rise only gradually; and 3) the dollar appreciates gradually and oil prices are stable. A sudden jump in interest rates could spark surge fears and dislocate credit, FX and commodity markets. But if markets show orderly transitions to more normal interest rates this summer it strengthens the foundation of longer-term bullish S&P 500 views. S&P net margins are long-term sustainable S&P net margins collapsed during the recession but recovered quickly and continue to grind higher despite a challenging macro environment. At 9.7% now, S&P net margins are 270bps higher than in the mid 1990s. This improvement in net margins came from a lower effective tax rate, lower interest expense due to less net debt and lower interest rates, higher foreign operating margins and changes in the composition of the S&P 500. These factors are mostly structural and support higher mid-cycle or normalized net margins. By sector, over two-thirds of the net margin expansion has come from Tech where all these factors are most pronounced. A weaker dollar helps to boost foreign profits, but not margins as both non-dollar sales and costs rise. EPS sensitivity to interest rate changes at S&P non-financials is limited. A 50bps increase in the average borrowing rate would reduce S&P EPS by 0.6%. This EPS headwind could be managed by increasing debt usage from todays low levels. Figure 4: S&P net margin increase contribution
of better enterprise spending and close the gap with Industrials PE at 15.5x and perhaps even Consumer Staples PE at 18x if it hikes its shareholder distributions. Banks are our preferred US play given cheap valuations and strong dividend growth. Banks balance sheets have healed and earnings have largely normalized but dividends remained depressed. We expect double-digit dividend growth at Banks over the next few years as the payout ratio rises from 20% in 2012 to 35% by 2015. Pre-crisis payout ratio was 44% at Banks. This should drive PE expansion from about ~11.5x now. Figure 5: PE and indicated dividend yield by sector
20
Telecom
18
Consumer discretionary Staples Healthcare Industrials Materials Utilities
2013E PE (ratio)
16
14
Technology
S&P 500
12
Financials Energy
10 1.0
Source: DB Research
1.5
2.0 2.5 3.0 3.5 Dividend yield (%)
4.0
4.5
10.0 9.0 8.0 7.0 6.0
% 0.85 0.80 7.00 0.25
0.80
9.70
Higher EBIT margins
Lower effective tax rate
1995-97 net margin
Constituent changes
Lower interest expense
2012 net margin
Risks to view: Surge in rates or collapse in oil A surge in long-term interest rates would prevent the PE expansion we forecast. But this is unlikely given federal spending cuts, slow loan growth, a stronger dollar and low inflation which is likely to keep the Fed Funds rate on hold until 2015.
Oil prices are a significant driver of S&P EPS and global investment spending. We expect stable oil prices, but a significant Brent or WTI price decline would threaten capex and be adverse to S&P EPS. Prices straying high enough to justify production capacity additions for consumption oriented commodities like energy and agriculture is central to our long-term strategy. This and the expectation that Asia demand for capital goods that employ its transportation infrastructure, provide energy or labor efficiencies and lift urban living standards underlie our constructive view on Industrial Capital Goods, Chemicals, and Oil Services. David Bianco,(1) 212 250 8169 Priya Hariani, (1) 212 250 2766 Ju Wang, (1) 212 250 7911
Source: DB Research
Summer with Banks and Tech Banks and Tech are our overweight sectors for summer as we watch macro conditions. Tech, Financials and Energy are the only sectors still trading <15x 2013 EPS. But we prefer Tech and Financials as a stronger dollar and or global growth concerns could pressure Energy. Tech is trading at ~13.5x 2013E EPS and offers the best dividend growth potential. Techs indicated dividends are up 36%, three times as much as the S&P, and its dividend yield at 1.8% is no longer paltry. Its payout ratio at only 25% suggests more dividend hikes to come. We expect Techs PE to rise on the first signs
Page 34
European Equities Strategy: The domestic cyclical strategy
We continue to have a positive stance on European equities. After a fall over the last 4 weeks, the Stoxx 600 currently sits at 286, giving a little over 10% upside to our 315 target price for 2013. Since earnings expectations have remained flat over the period of decline in equity prices, the Stoxx 600 has de-rated to 12.0x fwd PE. We continue to target a target multiple of 12.5x fwd PE, implying upside potential from a rerating. We expect further gains to come from earnings growth of 6.0% in 2013 on the back of a rebound in global GDP growth. Our confidence in a Euro area growth recovery has grown recently given gains in the May PMIs and strong April IP. We expect positive qoq growth in Q3 but we believe there are upside risks to Q2 growth given this recent data. We continue to believe that a return to growth in this timeframe will be a positive surprise to the market, and in this environment we prefer to hold domestic cyclicals. Our sector strategy is to overweight Banks, Insurance, Construction, Media, Chemicals and Telecom, and underweight Food & Beverage and Healthcare.
that the upside risk to growth comes from the strong April IP numbers we have seen over the past week. In France and Germany, IP grew by 2.2% and 1.8% mom respectively. IP in Spain contracted but by less than expected. Italy mildly disappointed. For the Euro area as a whole, IP grew by 0.4% mom April. Given Aprils number, even if we see IP contract in May, followed by flat growth in June, IP growth for Q2 overall would still be positive. This would imply positive qoq GDP growth for the Euro area in Q2. Figure 1: Euro area IP versus GDP growth
4 2 0 0.0 -2 -4 IP (lhs) -6 -8 -10 2002 GDP (rhs) -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 2004 2006 2008 2010 2012 % qoq Euro area % qoq 1.5 1.0 0.5
Euro area growth surprise expected We continue to expect Euro area growth to surprise to the upside in the coming months. Although our view is for positive qoq growth by Q3, we believe recent data coming from the Euro area suggests that the risks are weighted to the upside with respect to Q2 growth. After disappointing us (but not consensus) by falling sharply from February through to April, the PMIs in the Euro area showed signs of significant improvement in May. The composite for the Euro area rose 0.8 points to 47.7 and if it continues to rise at this rate over the coming months this would be consistent with positive GDP growth by Q3 (an average PMI over 50). The real improvement in PMIs came from the peripheries, Spain and Italy. In Spain, manufacturing rose by 3.4 pts to 48.1 and the details of the survey were even stronger with output gaining 4.2pts and orders up 6.4pts (the second largest rise on record). In Italy services were mildly disappointing but the manufacturing PMI rose a very decent 1.8 points. Despite this improvement the PMIs are still consistent with growth of -0.3% qoq in Q2 in our view. We believe
We have been expecting a positive growth surprise in the Euro area since we turned tactically positive on European equities at the end of last year. The underlying basis for this expectation is because of an improvement in the credit impulse. As the pace of deleveraging in the Euro area has stabilised the credit impulse (the change in credit growth) has returned to neutral. We expect the pace of deleveraging to start to slow from here, which would give rise to a positive credit impulse. In this environment real private sector demand growth should rebound and start to surprise to the upside. We are beginning to see evidence of this turn in the growth rate of demand growth in the Euro area. In Q1 demand growth on a yoy basis improved for the second quarter in a row to -2.6% yoy. On a quarterly growth basis, Q1 demand growth of -0.3% qoq was the best since 2011. We also believe that we are at an important stage in the inventory cycle. The current period of destocking has been severe and nearly the entire decline in GDP between Q2 2011 and now can be explained by the fall in inventories. Recently however, inventory sentiment (from the EC sentiment survey) has stabilised at levels
Page 35
in line with historical norms. This points to a slowing in the pace of de-stocking in Q2 relative to Q1, which is a positive contribution to growth. The inventory component of the PMIs is also consistent with a stabilisation in inventories. Furthermore, we believe the current improvements in inventories are voluntary. The inventory cycle has been well correlated with the demand for credit for working capital purposes, as measured by the ECBs bank lending survey. This increased in Q2 to the highest level since 2011. Favour a domestic-focussed strategy Given the potential for a recovery in Euro area growth, we favour an equity strategy geared towards domestic cyclical exposure. Our sector recommendations as given above reflect this preference. Since the middle of April, cyclical stocks have outperformed defensives by around 8%. Importantly though for our call, there is little evidence to suggest that it has been the domestic stocks that have driven this cyclical outperformance. Figure 2 shows the performance of a basket of domestic cyclical stocks that should benefit the most from recovery in Euro area growth relative to a basket of broader cyclicals. As can be seen, the recent trend has shown no outperformance of the domestically exposed group of stocks. Figure 2: Domestic cyclicals / cyclicals
105 Index 100
We further structure our domestic equity strategy along the lines of 5 key themes. (i) Financials: Performance of financials has been extremely well correlated with changes in the sovereign CDS of the Euro area peripherals. Outperformance is seen as the CDS narrows. Although the CDS have narrowed a long way already, we believe that they can continue to do so in the event of better than expected economic data. (ii) Consumer discretionary: In the US, spending has surprised to the upside thanks to a positive credit impulse over the last 4 years. Alongside this has been a consistent outperformance of the consumer discretionary sector. In anticipation of a positive credit impulse in the Euro area we prefer consumer spending exposed subsectors such as broadcaster, caterers, travel & tourism and autos. (iii) The capex cycle: A turn in the capex cycle is still very much ahead of us. However, there is reason to expect improvement based on the material rise in the business credit impulse over the past 2 quarters to a level that is consistent with a return to flat investment growth in the Euro area. This expectation underpins or recommendation on the Media and Construction sectors. (iv) Southern Europe: Credit growth in both Italy and Spain fell to very low levels, giving a negative credit impulse and a severe contraction in domestic demand. We see significant upside potential from a stabilisation and improvement from these very low levels as this would imply a positive credit impulse and a sharp rebound in domestic demand growth against very depressed expectations. Because of the scope for upside surprise from these countries, we would hold exposure to the peripheral equity markets. (v) High yield: High yield has failed to be a defensive style in the Euro area because of the sharply negative divided revisions they have suffered. It has also been negatively impacted from its exposure to companies with high levels of debt. As the Euro area recovers, both of the headwinds should lessen. The cost of funding of these companies should improve alongside the fall in sovereign CDS. In addition, a better outlook for growth should firm revenue expectations for the high yield companies, which in turn would make dividend yields more believable. Michael Biggs, (44) 20 7545 5506 Gareth Evans, (44) 20 7545 2762 Lars Slomka, DVFA, (49) 699 103 1942 Jan Rabe, (49) 69 910-31813 Thomas Pearce, (44) 20 7541 6568
95
90
85
80 Euro recovery basket (DBCGEA RP) / cyclicals indexed to Nov11 75 Nov-2011 Mar-2012 Jul-2012 Nov-2012 Mar-2013
Furthermore, there is a long way to go in terms of performance for Euro area domestic stocks. Figure 2 also illustrates this point as the price relative between domestic cyclicals and a broader basket of cyclicals remains at lows. Putting the performance of Euro area domestic stocks relative to global stocks shows a period of consistent underperformance lasting for over 4 years.
Page 36
Rates Outlook: Rates to sell-off beyond the peak of monetary stimulus and fiscal tightening
Under our base case scenario of tapering sometime around September, we expect 10Y UST to settle in a 2.25-2.75% range. More importantly, the likely increase in volatility and risk premium in the front-end of the curve should initially be detrimental to carry trades and spread products. We do not expect the ECB to cut the depo rate into negative territory, but the risk of one more refi rate cut is real. Given that the latter has been all but priced out, core EU rates should outperform US rates. Peripheral bond market to be relatively resilient to a reduction of liquidity by the Fed, thanks to a significantly reduced reliance on foreign investors. The BoJ should be successful in reducing volatility in the JGB market. This should lead to steeper curves.
curve, even if it does not necessarily lead to lower 10Y nominal interest rates. Figure 1: Surprise index vs. UST 10Y
5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 2000 2002 UST 10y (lhs) US surprise index (rhs) % 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 2004 2006 2008 2010 2012
Index
Source: DB Research
Post crisis year zero As the Fed is likely to taper its QE program and the peak in fiscal tightening in the US and Europe is overcome, financial markets may be entering the Year Zero of the post financial crisis. The Fed tapering could mark the beginning of a long and most likely uneven process of normalization of interest rates. Such normalization process should be accompanied by an increase of volatility and risk premium from abnormally depressed levels. Under our base case scenario of tapering sometime around September, we expect 10Y UST to settle in a 2.25-2.75% range. More importantly, the likely increase in volatility and risk premium in the front-end of the curve should initially be detrimental to carry trades and spread products. In Europe, we do not expect the ECB to cut the deposit rate into negative territory, but the risk of one more refi rate cut is real. Given that the latter has been all but priced out, core European rates should outperform US rates in the months ahead. At first sight, European peripheral debt could be one of the major casualties of a reduction of the liquidity injected by the Fed. However, we expect peripheral bond market to be relatively resilient, thanks to a much reduced reliance on foreign investors. Given the fragmentation of financial markets in Europe, the ECBs LTRO is far more relevant to the periphery than the Feds QE. In contrast, semi-core names such as France, which have benefited from more significant non-domestic inflows may be more at risk. Finally, we expect the BoJ to succeed in reducing volatility in JGBs. This should lead to a steeper JGB
Fed tapering: the primary market driver The pricing of QE has had its biggest impact on real rates and on the 5Y-10Y sector of the curve. Conversely, a tapering of QE by the Fed should lead to a sell-off driven by the 5Y5Y real rate. A simple comparison of the level of rates vs. a US economic data surprise index suggests that 10Y rates should be close to 2.75% if the QE impact is completely unwound (see figure 1). However, as the quid-pro quo for announcing an early tapering will be to ensure that it wont be disruptive; it is likely that the Fed will manage expectations as to how quickly QE could be ended and the policy rate normalized. This should cap the sell-off in rates, and we thus expect 10Y UST to settle in a 2.25%-2.75% range later this year. By our account, the market is now close to fully pricing a tapering starting in early Q4 and completed in early Q1. Thus the pricing of tapering per-se is unlikely to be the key driver of the rates market. Rather, as the market pricing of the interest rate normalization (i.e. the money market slope beyond 2 years) remains too benign, it is the 2Y-5Y sector that should lead any further sell-off in US rates. To illustrate this fact, we estimate a Crisis Taylor Rule that incorporates the FOMCs latest guidance by widening the unemployment and inflation parameters by 0.5% to reflect the 6.5%/2.5% necessary conditions for a first rate hike. Under such Crisis Taylor Rule and the current FOMCs median forecast, the June 16 Fed Funds should be at 1.40% vs. 1.10% currently.
Page 37
Moreover, at some point the Fed will have to return to its pre-crisis Taylor rule (which we refer to as the Fed Taylor Rule). Under this less dovish Taylor rule, and the same FOMCs median forecasts, June 16 Fed funds should be closer to 2.8% (see table below), i.e. 170bp above current pricing. Figure 2: Market is pricing in benign rate hike cycle vs. Feds Taylor Rule
Crisis Taylor Rule FOMC SPF 25% SPF 75% median percentile percentile forecasts Time of first hike FF in June 2016 Hikes in first year
Source: DB Research
Figure 3: Historical tightening cycles

Hiking cycle Nov-86 Jan-94 Jan-87 Jun-04 Feb-15 Cycle length (mths)
26 13 11 24 90
Total hikes
388bp 300bp 175bp 425bp 350bp
Hikes in Avg Avg first year hikes/year hikes/month

100bp 300bp 175bp 225bp 50bp 179bp 277bp 191bp 213bp 47bp 15bp 23bp 16bp 18bp 4bp
Fed Taylor Rule FOMC median forecasts Sep-14 2.80% 150bps
Market FF futures and OIS swaps Mar-15 1.15% 50bps
Source: DB Research
Jun-15 1.40% 100bps
Mar-16 0.60% 45bps
Dec-14 2.60% 150bps
Figure 4: 5Y volume has room to increase

240 220 Index USD 3M5Y implied normal volume
Similarly the pace of rate hikes priced by the market remains low relative to historical precedent (about 44bp per year on average vs. 200bp per year on average in previous cycles). Notwithstanding its dovish bias, the Fed may find it difficult to support such pricing. Beyond the repricing of higher rates, financial markets should be more directly impacted by the inevitable increase in volatility. Volatility has been pushed down to historically low levels on back of the combined effect of the asset purchase program and the forward guidance. The increased uncertainty around the size of the Feds balance sheet and the scope for a material repricing of the path of monetary policy beyond 2 years should lead to some normalization of volatility. This should have adverse implications, for carry trades whether in the front-end of the core curves of in spread products. The Fed will remain data dependent and as a result, there are risks around the scenario described above. The most obvious risk would be a repeat of the last three years, which saw the Fed relent on its intention to withdraw its stimulus. At the time, a succession of negative events in Europe and the US fiscal crisis in the context of a tepid recovery led the Fed to increase its stimulus. These risks should be lower now as the peak in fiscal tightening is passed in Europe and about to be overcome in the US. Moreover, even though Europe is still facing non-trivial structural and political issues, we expect the European bond market to be more resilient to event risk thanks to a significant de-risking of foreign investors that was facilitated by the Troika loans and the ECBs LTROs. This is particularly true for Italy and Spain where the share of foreign holdings in Italian and Spanish government debt is back to preeuro levels while semi-core markets such as France are more at risk on a beta-adjusted basis given significant participation from foreign investors (see table below).
200 180 160 140 120 100 80 60 40 1999 2001 2003 2005 2007 2009 2011 2013
Source: DB Research
Rather the downside risks to the scenario may now stem from weakness in China that could turn the current disinflationary trend into a more worrying deflationary one. In this scenario, the Fed will most likely delay the policy normalization pushing 10Y UST back towards 1.50%. On the other hand, a faster than expected recovery, or more simply a faster repricing of the rate hike cycles beyond 2015 could lead to a more aggressive bond market sell-off than the one envisaged in our base case scenario. There is certainly scope for such repricing to occur given the very benign hiking cycle currently priced by the market. However, we would expect the Fed to be able to lean against it, at least until the end of this year.
Page 38
Figure 5: Foreign ownership of government bonds

Italy (%) 27.50 51.00 30.00 France (%) 20.40 67.10 62.50
1999 2010 Latest

Source: DB Research
But dont forget Europe and Japan While the Fed is considering reducing its policy easing, the ECB has been debating whether to cut the depo rate into negative territory. Given our relatively constructive view on European growth in the second half of the year, we do not expect the ECB to resort to such extreme measure. However, the risk of another refi cut remains real. As it has been all but priced out by the market, we remain structurally more constructive on European rates relative to US rates. Finally, in Japan the BoJs QE announcement has been met by significant volatility in bond markets and higher yields. The rise in nominal yields should not be a source of concern in itself. Indeed, if the BoJ was successful, breakevens would rise to 2% and real rates would decline. However, in the context of improving macro data the decline in real yields would be unlikely to match the rise in breakevens and as a result, nominal yields would increase. Rather, it is the rise in volatility that should be more of a concern, as QE would have been expected to keep volatility low. Looking ahead, we expect the BoJ to succeed in reducing volatility via amongst others increased liquidity injection. This should be supportive of the front-end of the JGB curve and of steepening positions.
Francis Yared, (44) 20 7545 4017 Jerome Saragoussi, (33)144956408 Abhishek Singhania, (44) 20 7547 4458 Dominic Konstam, (1) 212 250 9753 Stuart Sparks, (1) 212 250 0332
Page 39
Credit Strategy: Credit in the face of QE tapering

Credit vs. Higher Yields With 10Yr US Treasury yields rising over 70bps in the past seven weeks there has been a wobble in credit markets. In this piece we want to highlight what a rising yield environment has typically meant for credit and what it might mean if yields continue to rise. Much depends on whether the rise in yields reflects a genuine improvement in the underlying economic environment or whether it indicates a reduction in demand for Government securities without an associate recovery. We think that the former might continue to lead to spread volatility but ultimately tighter credit spreads over a 3-6 month period. However the latter would be a very difficult environment for credit given how much liquidity has flown into the asset class in recent months. Let's now look at what history tells us of the relationship between yields and spreads. The impact of yield changes on spread Using the BBB rating band as a base case for our analysis, Figure 1 and Figure 2 show what the relationship is between Government yields and spreads over 3 and 12-month periods. We should be able to see if large moves in yields over these time periods have a notable impact on spreads. We used the 3-month period to see whether for example, a short period of sharply higher yields has historically had a greater impact on credit spreads than a similar move spread out over 12-months. We also make a distinction between absolute moves in Government yields and the same moves on a % basis relative to the starting yields. Clearly a 100bps move in yields when the starting point is say 1% might have a different impact on the results than when one sees a 100bps move when yields were 10%. In order to ascertain this, the scatters on the left are absolute yield changes whereas those on the right are a percentage change relative to the starting yield.
Figure 1: 3m absolute change in treasury yield vs. absolute change in spread (left) and 3m percentage change in treasury yield vs. absolute change in spread (right)
Change in BBB Spread (bp)
200 100 0 -100 -200 -300 -400 -300 -200 -100 0 100 200 Change in Treasury Yield (bp) 300
300
R = 10%
300 200 100 0 -100 -200 -300 -400 -40% -20% 0% 20% Change in Treasury Yield (%)
R = 12%
40%
Source: Moodys, GFD, DB Research
Figure 2: 12m absolute change in treasury yield vs. absolute change in spread (left) and 12m percentage change in treasury yield vs. absolute change in spread (right)
500 400 300 200 100 0 -100 -200 -300 -400 -500 -500 -400 -300 -200 -100 0 100 200 Change in Treasury Yield (bp) R = 3% R = 4% 500 400 300 200 100 0 -100 -200 -300 -400 -500 -60% -40% -20% 0% 20% 40% 60% 80% Change in Treasury Yield (%)
300
400
Source: Moodys, GFD, DB Research
Page 40
The impact of GDP on spread Figure 3 shows that there is a reasonably good correlation between GDP and credit spreads through time and is arguably stronger than for yields. Again this makes sense as traditionally the economic cycle is a
large determinant for defaults which in turn should impact spreads. So its fair to say that from the historical US database, yield rises have not been a big problem for credit spreads. Weakness in the economic recovery would be far more worrying.
Figure 3: BBB spread vs. real GDP since 1948 (left) and Single-B spread vs. real GDP since 1988 (right)
16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% 0
R = 27%
6%
R = 41%
Real GDP Growth
Real GDP Growth
4% 2% 0%
-2% -4% -6% 0 400 800 1,200 Single-B Spreads (bp) 1,600
200 400 BBB Spreads (bp)
600
What about 1994? 1994 provides a relevant case study of sharply higher yields, so what reaction did credit spreads have over this period? Figure 4 shows what happened to BBB
spreads and single-B spreads relative to Government yields over the period. .
Figure 4: BBB spreads vs. US treasury yield (left) and Single-B spreads vs. US treasury yield (right)
8.25 7.75 7.25 6.75 6.25 5.75 Jan 93 Jul 93 Jan 94 Jul 94 Jan 95 Jul 95 Jan 96
UST Yield (LHS)
BBB Spreads (RHS)
150 145 140 135 130 125 120 115 110 105 100
8.00 7.50 7.00 6.50 6.00 5.50
UST Yield (LHS)
B Spreads (RHS)
5.00 Jan 93 Jul 93 Jan 94 Jul 94 Jan 95 Jul 95 Jan 96
550 530 510 490 470 450 430 410 390 370 350
As can be seen Government yields rose over 200bps between Q4 1993 and Q4 1994 with around 100bps occurring in the first 5 months of 1994. However there is no real evidence that spreads were negatively impacted. Indeed the initial yield sell off in late 1993 led to a tightening of spreads and spreads didnt start widening until late 1994/early 1995 when yields started to fall. The 1994 analysis is perhaps enhanced with Figure 5 which shows 10 year US Treasury yields alongside US GDP growth between 1993 and the end of 1995. This
argues that the main reason yields rose so sharply was because of a rapidly improving economic environment. By late 1994, this had started to peak, probably due to the Feds aggressive rate rising policy that year, and the economy then weakened back and yields fell through 1995. As we saw above credit spreads struggled more in the lower yield/weaker economic environment of 1995 than the higher yield/stronger economic environment of 1994.
Page 41
Figure 5: US 10 Year treasury yields vs. US real GDP growth (1993-95)

8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 10yr Treasury Yield (LHS) US Real GDP YoY Growth (RHS) 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0%
publication of the minutes of the May FOMC meeting. This has continued in the hours post the June FOMC. Other factors that could also put negative pressure on credit spreads that have perhaps not been apparent through history are the continued increase in regulation for banks that has seen dealers less able to hold on to inventory and therefore provide any sort of buffer when clients look to reduce risk. There is also far more money that has flowed into ETFs, so if credit starts to weaken we may see this investment quickly reallocated, putting further pressure on the credit market. Most of these issues revolve around the flow of investments into credit that may be unwound if there is a pull back in liquidity. However, longer-term if the tapering of QE is justified due to stable and sustainable economic growth, which would likely keep default rates low, then its difficult to justify a scenario where we see a material widening of credit spreads. We would probably expect any move wider in credit spreads to be capped over time as long as the economy responds as per the Fed's expectations. The danger being that by the very nature of the Fed raising the tapering warning flag they create a global risk selloff that endangers the recovery. Jim Reid, (44) 20 754 72943 Nick Burns, (44) 20 754 71970
1.5% 5.0% Dec 92 Jun 93 Dec 93 Jun 94 Dec 94 Jun 95 Dec 95

Source: Bloomberg Finance LP,, DB Research
Is this cycle different? We've now laid out the evidence from the past but its fair to say that this cycle is behaving very differently than any seen through history. The aggressive level of bond buying provided by QE has arguably artificially increased demand for fixed income so even a slow removal of these purchases could have ramifications for flows into credit funds. We have already seen credit spreads widen since Bernankes JEC testimony and the
Page 42
US MBS and Securitization Outlook: Fed exit and MBS

MBS performance under DBs expected Fed exit path MBS will likely widen by 5 bp to 10 bp in concert with other spread assets when the Fed finally confirms a taper. But a credible commitment to hold MBS for at least five to 10 years without selling could more than offset the news of the Feds terminal demand. The combined impact could leave MBS a net 5 bp to 15 bp tighter. MBS itself has arguably priced in a taper. In the few weeks after the initial QE3 announcement, MBS tightened by more than 25 bp. Given the impact of earlier QE on MBS, the tightening corresponded to roughly USD600 billion in implied Fed MBS purchases. The likely taper would deliver on that. On these grounds alone, MBS should hold spread. But MBS performance on confirmation of a taper will depend, too, on performance in competing spread assets corporate debt above all and there spreads stand to widen. Broad parts of the credit markets have relied on a steady rise in Fed liquidity. The taper will mark the likely beginning of the end. Liquidity should reprice. For every 10 bp that investment grade credit widens, MBS should widen by 2 bp. MBS performance also will depend on market confidence in the Feds ability to hold and not sell MBS. If the market has confidence, then MBS could tighten by 15 bp to 25 bp. The tighter spreads would reflect the large share of MBS roughly 30% - that the Fed had effectively taken out of private markets. The market has widened this year in large part out of concern that the Fed might one day sell or use MBS reverse repo in a disruptive exit. Credible assurances from the Fed could reverse that. MBS performance under DBs expected Fed exit path accompanied by a market event The worst case for MBS under an otherwise smooth Fed exit would come from either a sharp widening in credit markets, stress at MBS REITs, lack of market confidence in the Feds commitment to holding MBS or some combination of these. These could collectively widen MBS by 25 bp to 50 bp. A sharp widening in credit spreads would come if market demand for liquidity picked up sharply ahead of uncertainty about the Feds ultimate path. Investment grade credit would suffer the most since compensation for liquidity represents the largest component of its spread. Investment grade spreads have tightened by roughly 50 bp since discussion of QE3 seeped into the markets. They could unwind a large part of that and push MBS 10 bp wider in sympathy. A sharp rise in rates could force MBS selling as MBS REITs tried to bring their duration of equity back into a tolerable range. Higher rates would lengthen the duration of REIT MBS beyond the duration of most of their hedges. The REITs could sell MBS or shed duration in other ways to bring their duration gap back in line. Since REITs hold more than USD340 billion in MBS, every year that sector duration went beyond aggregate risk limits could spur selling of the equivalent of USD49 billion in 30-year 3.0% passthroughs. Risk management in many REITs is opaque, so it is hard to pinpoint the risk. Spreads should widen by 2 bp to 3 bp for every USD50 billion in sales. Concern about Fed commitment to holding its MBS could widen spreads by 25 bp. That spread would reflect complete lack of confidence in the Fed ability to hold, potentially because of concern that inflation might one day force the Feds hand. MBS performance with a macro event A sharp jump in inflation expectations along with likely rising rates and a flattening yield curve would create the most risk for MBS. REITs would come under pressure. Holders of MBS derivatives would come under pressure. The market would doubt the Feds ability to hold MBS indefinitely. These could collectively widen MBS by 35 bp to 75 bp. Steven Abrahams, (1) 212 250 3125
Page 43
FX Strategy: Rotation within a USD trend
The dollar uptrend is going through a period of rotation, dominated most recently by USD gains against commodity and emerging market currencies. Beyond the QE tapering talk, differentials in output gaps and deleveraging cycles, suggest USD rate advantage will build on a multi-year basis helping the USD reassert itself against all G10 currencies. This is more than a tapering real/nominal rate story. The US C/A is not deteriorating in contrast to all upswings since the early 1970s. The dual improvement in the twin budget and trade deficits usually presages a stronger USD by close to 2 years. There are a few areas of caution, notably the lack of improvement in US FDI flows, or net equity flows that were the foundation of USD gains in the late 1990s. The EURs external accounts continue to improve and are one reason why the EUR will lag the bigger USD trend. Year-end forecasts for the USD vs. EUR, JPY and GBP are 1.20, 110 and 1.41 respectively.
Figure 1: US C/A plus the Federal budget deficit as a share of GDP versus the USD TWI against major currencies
2 0 -2 -4 -6 -8 -10 -12 60 US twin deficits (lhs) USD trade weighted index, 2 year lag (rhs) 120 % of GDP USD 160
140
100
80
-14 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: Ecowin, Bloomberg Finance LP,DB Research
40
This is the first recovery since the early 1970s where the current account is not deteriorating at this stage in the business cycle. This partly reflects the USs energy supply side revolution, together with the non-petroleum sectors response to past USD weakness. Figure 2: 2Y rolling change in US current account as a percent of GDP versus real GDP % yoy
-4 -3 % of GDP, 24m rolling change Current account deteriorates % yoy 10 8 6 4 -1 0 1 2 3 4 1960 Current account improves US: Current account (lhs, inverted axis) US: Real GDP (rhs) 1970 1980 1990 2000 2010 2 0 -2 -4 -6 -8 -10
Broad-based USD gains are expected as the Fed shifts to a less accommodative QE phase through the latter part of this year. We expect capital flows to prove responsive to Fed policy signals given the policy divergence with other G4 central banks. Importantly, the positive USD story is much more than a US interest rate cycle. The twin deficits (public sector plus external deficits) that has historically led the USD by two years is starting to improve more sharply than during any cycle in the last 50 years.
-2
This only adds to DBs conviction that the USD is still cheap, as signaled by our long-term PPP, behavioral exchange rate (BEER) and fundamental exchange rate equilibria (FEER) measures. The near term positive USD outlook should be seen in the context of a multi-year uptrend in the USD tradeweighted index that started in July 2011 and is already up over 10% versus major currencies and 7% versus a
Page 44 Deutsche Bank Securities Inc.
broader range of currencies. Additional gains of 20% in the US broad trade-weighted index over the next 3 years would not be extraordinary when placed in the context of other large USD upswings since the fall of Bretton-Woods. For the coming year, there are three groupings of currencies that are most vulnerable to Fed tightening: 1) The more flexible and popular emerging market carry trades where foreigners have considerable domestic bond exposure, including ZAR, MXN, BRL, KRW and TRY. Most other EMG currencies will follow suit as they work to avoid any loss of competitiveness against their peers. 2) The high beta G10 commodity currencies the AUD, NZD, and CAD, will be particularly exposed given commodity cycle weakness relative to equities; and, overvaluation by most long-term measures. Lower commodities historically are associated with a US positive terms of trade shock. Figure 3: USD TWI versus S&P/CRB ratio
120 USD 9 8 110 7 100 6 5 90 4 80 3 2 70 USD nominal trade weighted index (lhs) S&P/CRB Ratio (rhs) 1993 1997 2001 2005 2009 2013 1 0
interest rates are another factor that has helped the EUR of late, as EUR 2 year rates have more than matched the rise in 2yr US T-Note yields. Given the relative growth performance, we expect this spread to more closely reflect the actions by the ECB and Fed and move against the EUR in coming months. As spreads readjust we expect EUR/USD will push down through this years lows. Figure 4: EUR/USD versus 2 year Govt yield spreads
1.4 USD bps 5 0 1.4 -5 1.3 -10 -15 1.3 -20 1.3 -25 -30 1.3 EUR/USD (lhs) EUR-USD 2y yield spread (rhs) Dec-2012 Mar-2013 -35
1.3 Sep-2012
-40 Jun-2013
We are also closely monitoring the extent to which spreads mirror the pattern of 1994, where tightening triggered a bond market rout, Government 10yr bond spreads moved against USD versus most G10 currencies.
rate Fed and the
Figure 5: Change in policy rates and 10yr yields in 1994

Change in 10 yr yield A ustralia US Canada Change in nominal policy rate
60 1989
3) Those G10 currencies with relatively poor fundamentals including the GBP and the JPY - the former because of a lack of external rebalancing, and the latter because a weak currency is an integral part of the reflation strategy ahead of the planned 2014 tightening of fiscal policy. Either the Abe government is successful reflating which will necessarily include a weaker yen to boost financial conditions; or, the yen will weaken longer-term as growth concerns undermine fiscal sustainability. In contrast, without a specific EUR crisis, the EUR will lag rather than lead any USD weakness. This is because it led the early stages of the USD correction, and the large and increasing euro area current account surplus is offering considerable protection. Short-term
UK Japan Sweden Norway Italy France Germany -2 -1 0 1 2 3 4 pp 5
Page 45
The sharp deviation in output gaps, evident in the dramatic rise in euro area unemployment relative to the US since 2009, suggests that in present circumstances, a similar shift in short-term rates against the USD, will not be sustained over the medium-term. Another point of caution, is that so far stronger relative US growth has done nothing to improve the large US FDI deficit, or encourage other flows including corporate bonds and equities, that were the source of USD strength in the late 1990s. The longer these trends continue, the more it will slow the USDs upturn. Figure 6: CNY carry trade reaching JPY-carry trade extreme levels
Total returns (spot+carry) 220 200 180 160 140 120 100 CNY/USD (onshore) USD/JPY 1995-1999 A UD/JPY 2002-2009 Index USD/JPY 1998 unwind CNY/USD (onshhore, scaled) A UD/JPY 2008 unwind
80 2006 2007 2008 2009 2010 2011 2012 2013 2014

Against this there are also potential surprises that could accelerate the USD turn higher. A reversal in the China carry trade that would open the door to a much larger USD adjustment versus Asian currencies could be one such catalyst. The performance of the China carry trade is now reaching levels seen before unwinds of major carry trades of the past including the AUD/JPY preLehmans, and USD/JPY in 1998. Some combination of higher US yields, regulatory clampdown, higher FX volatility and less CNY appreciation could trigger an unwind, providing another leg to the stronger USD trend. Bilal Hafeez, (44) 20 7547 1489 Alan Ruskin (212) 250-864
Page 46
Commodities: Hazards from new supply, Fed exit and a turn in the US dollar
The majority of commodity prices have traded lower during the first half of this year. This has been triggered by concerns towards disappointing Chinese growth, increasing guidance by the Fed towards QE exit and rising market surpluses and expectations of rising supply in a number of key markets such as crude oil, copper and soybeans. Another hazard for the commodity complex has been the gradual appreciation of the US dollar, which we expect will gather steam over the coming year. We find that commodity returns tend to under-perform relative to other asset classes such as US equities in rising dollar environments. While dollar strength has typically been most negative for precious metals, we expect it will also place downward pressure on crude oil prices. Of the four broad commodity sectors we expect industrial metals will be more resilient to a rising dollar and since it will find support from an improvement in global growth. In gold, we expect prospects will be closely tied to the outlook for US growth and by default the speed with which the Fed exits QE, the pace at which US real interest rates normalize and the vigour of the upturn in the US dollar. However, if we are right and world growth starts to accelerate during the second half of the year then we would expect this would be an environment where silver would outperform relative to gold. In crude oil, the rapid growth in US shale oil production has been matched by significant infrastructure expansions, which have helped to reverse the significant discount of WTI relative to Brent. We look for Chinese restocking and tight WTI fundamentals to support crude into H2 2013. Despite our forecast of an eventual acceleration in Chinese economic activity, we doubt this will provide much long term support to the bulk commodity sector. In our view, market balances for iron ore and thermal coal are moving into surplus. We would therefore prefer to position for a China rebound via the industrial metals complex and specifically aluminum, lead and zinc. While the corn market may be supported over the next few weeks by concerns towards the US growing season, we view new crop fundamentals as bearish, not just in corn but also in soybeans in response to increased US plantings and South American supply.
Figure 1: 2013 asset class returns compared

14 12 10 8 6 4 2 0 -2 -4 -6 -4.3 EM -3.6 Commodities Bonds FX Equity -0.2 1.2 Total returns, ytd % Emerging markets: DBIQ EMLE Commodities: SPGSCI Bonds: DBIQ Global IG Sovereign FX: DB Currency returns index Equity: MSCI Global
9.2
Source: Bloomberg Finance LP (Data as of June 11, 2013),DB Research
Of the five broad commodity sectors, precious metals have been the worst performer on a total returns basis so far this year, Figure 2. We believe we are witnessing new headwinds in the gold market, such that many of the forces that had powered gold higher over the past decade are fading and in some instances moving into reverse. Figure 2: 2013 SPGSCI sector returns compared
5 % Spot return Roll return Total return
-5
-10
-15
-20 Precious Industrial Livestock A griculture Energy Metals Metals

Source: Bloomberg Finance LP (Data as of June 11, 2013),DB Research
SPGSCI
Commodities are competing with emerging markets to be the worst performing asset class on a total returns basis so far this year. The poor performance of long only commodity index strategies has been a feature of the commodity complex for the past few years and this has inevitably led to the increasing focus on systematic strategies such as carry, value and momentum.
Indeed headwinds for gold began in July 2011 when the US dollar trade-weighted index began to move higher. This was followed by the US equity risk premium; having peaked in October 2012, it started to move lower which contributed to a broad based sell-off across a range of safe haven assets such as the Japanese yen, the Swiss franc but also gold. Finally at the end of last year Fed rhetoric triggered a turn in US real interest rates. We expect gold will struggle to rally convincingly in environment where US real interest rates are moving higher and the US dollar stages a more vigorous upturn.
Page 47
However, there has been a significant divergence of reactions to the gold price correction during the second quarter not just by region but also investor type. For example, while institutional investors in the western world have been liquidating gold holdings, retail demand across emerging markets has remained strong. In addition we expect EM central banks will remain a source of gold demand going forward as they continue their diversification programme into gold. While we would not rule out a short term bounce in gold given the extreme liquidation that has occurred recently, on balance we expect financial forces will overpower physical drivers over the medium term implying the underperformance of gold relative to industrial metals. Energy and the role of shale Following Chinese destocking over the past five months, we expect physical fundamentals in the oil market will tighten in the second half of the year. Indeed the possibility of a further drawdown in Padd2 inventories may also help to sustain the tightening in the WTI market, which has encouraged a significant flattening in the forward curve and the prospects of the entire curve moving into backwardation in coming months. In an environment where world GDP growth stands at 3% or above, our medium term outlook is increasingly turning towards US shale oil supply growth and the build out of US infrastructure. Indeed one of the biggest forecasting errors that has occurred in commodity markets over the past few years has been attempting to predict US crude oil production growth. Two years ago, industry forecasts suggested US crude oil production would rise 50kb/d in 2012 when in fact it rose by 1 million barrels with upward surprises in US oil production growth continuing into this year. In a scenario where the US continues to prohibit the export of crude oil, we expect the rise in US shale oil production will tend to keep WTI trading at a discount to other crude oil benchmarks. However, we expect a further compression of the spread will be a function of how quickly pipelines and railroads can clear Padd2 inventories. This year has seen significant progress in this regard. Even though the expansion of US crude oil production will remain, at least for the time being, largely contained within the borders of the US, there will likely be spill-over effects on other regional crude oil markets Indeed with US imports of foreign crudes declining, we expect it will mean Brent will have to be priced more competitively in order to find a home in Asian markets. OPEC will naturally be watching US shale oil developments closely since further downward pressure
on the oil price would start to hurt budget balances in key oil producing countries. Indeed work conducted by DBs Emerging Research team reveals that budget breakeven oil prices have risen to a new all time high across many countries in 2013, Figure 3. We estimate that in response to lower oil production and a modest rebound in spending growth, the budget breakeven in Saudi Arabia has reached USD90/bbl (Brent equivalent). However, with substantial accumulated oil savings, Saudi Arabia would still be able to weather even a sustained drop in oil prices. Figure 3: Budget breakevens for key oil producing countries (USD)
2006 32.1 57.9 26.4 64.7 43.4 38.7 18.8 53.7 17.7 21.4 65.4 2007 42.2 66.9 32.6 72.1 41.8 52.7 25.1 80.1 33.0 28.1 72.7 2008 43.9 80.0 42.1 96.4 48.3 47.0 44.5 83.5 89.6 59.7 97.7 2009 69.9 82.9 47.0 69.9 23.4 72.6 104.8 129.3 62.0 109.5 61.9 2010 68.2 103.9 45.7 80.2 60.4 70.6 85.9 105.3 61.7 116.7 79.6 2011 79.2 118.1 47.4 93.1 85.6 84.0 98.3 116.6 59.9 102.8 111.0 2012E 73.1 122.8 53.8 82.4 70.7 80.4 81.4 122.5 76.6 112.3 112.0 2013F 78.8 139.0 60.5 87.8 57.3 90.3 78.1 135.1 65.0 117.8 113.7
GCC Bahrain Kuwait Oman Qatar S.A rabia UAE Nigeria Kazakhstan Russia Brent price
Source: JODI, Haver Analytics,, DB Research
We believe the most likely trigger for a sharp correction in the oil price would be if world GDP growth fell towards 2.5% as this would imply a contraction in global oil demand. In previous environments where world growth has fallen to this level, crude oil prices have dropped by at least 25% within a three month horizon. Currently DB expects world GDP growth to rise 3.1% this year and 4.0% in 2014. Figure 4: DB oil price deck
WTI (USD/bbl) 2012 2013 Q1 Q2 Q3 Q4 2014 2015 2016
Note: Figures are period average Source: DB Research
Brent (USD/bbl) 111.68 112.64 103.00 105.00 107.00 107.00 105.00 100.00
94.15 94.36 94.00 95.00 97.00 96.00 92.00 85.00
Michael Lewis, (44) 20 7545 2166 Soozhana Choi, (1) 202 626 7021
Page 48
Geopolitics: More internationalization of the Syrian Civil War

The Syrian civil war continues as an ever-widening attractor for intervention by external powers, bringing with them ever more sophisticated weapons. Outside forces directly involved in combat appeared early on in the form of radical jihadi combatants on the rebel side and Iranian al Quds advisers and combatants on the side of the Assad government. The rebel side was supplied with weapons initially by Qatar, which was joined by competition from Saudi Arabia.3 Numerous other Sunni majority countries are in support of the rebels. The Western countries have supplied the rebel forces with non-lethal aid and organization. These supplies move across most of Syrias borders: from Turkey in the north, Jordan in the south and Iraq in the east. Syrian weapons were supplied by Iran and Russia with transportation through Syrias Mediterranean ports and by air via Iraq and daily Russian supply flights. Meanwhile, Syrias neighbors have increased their military forces on their borders with Syria to deter combat from spilling over the frontiers, which has occurred sporadically in Turkey and Lebanon. Most noteworthy, these included deployment by NATO of anti-missile units to Turkey, US anti-missile units and an F-16 squadron to Jordan, and Israeli anti-missile units toward its Syrian front.4 The Syrian civil war is in effect also becoming a proxy war between Iran and its clients on the one hand and a loose and shifting alliance of Sunni Arab and Western countries on the other. It has evolved into an Iranian commitment of military personnel and resources in a war in a nonneighboring country at a time when it is economically squeezed by sanctions. Thus, on this battlefront Iran has been challenged in a military conflict without risking the feared closure of the Straits of Hormuz or a war in the territory of a major oil producer. This has created an essentially inevitable basis for prolonging the war and, if the rebels seem to be flagging, an incentive for resupplying them with weapons, training, and more outside forces. Therefore, the Syrian civil war is unlikely to end quickly. Rather, it holds the potential to swirl more and more external forces into the fight. A tangled web of conflicting forces A wide range of interests and conflicting forces keep refueling the Syrian civil war as an accelerating struggle. First, there is a standard local nation state alliance struggle against a rising and dominant Iran. Attempting to overthrow Irans client, the Assad regime, perhaps, a natural strategy. Second, and more virulently, there is the sectarian Sunni-Shia struggle, with the Syrian Sunni majority controlled by the minority Alawite (Shia) Assad regime. In spite of this dimension, the Assad regime has been secular in its rule, so the other minorities in Syria, who could be threatened by a sectarian Sunni victory, have largely been supporters of Assad. Third, there is a rising Turkey caught between a rising Iran and a newly outward reaching Russia. Fourth, there is a traditional Great Power engagement with Russia in a rearming and aggrandizing moment in the face of a seemingly hesitant US and a visibly weak Europe. Fifth, there is the direct USIran conflict of 35 years, now taking the form of crippling sanctions over the nuclear arms dispute. Sixth, there is the continual Israel/Arab/Iran conflict. Finally, there is the humanitarian crisis that has pushed hundreds of thousands of refuges into Turkey, Jordan and Lebanon with the resulting destabilization and push-back on Syria. Despite all these interests, for many outside players there appears to be considerable ambivalence about the desired outcome. The US now has several experiences Afghanistan, Libya, Iraqin which overthrowing secularist governments in Muslim states by arming jihadis or by using its own forces has led to post-conflict disaster. So it has been reluctant to supply weapons to overthrow Assad. The Israelis seem to have no preference over which side wins, seeing both as risky. Nevertheless, they have made three air raids into Syria this year to destroy anti-aircraft missile shipments on the way to Hezbollah.5 The EU is concerned about the humanitarian catastrophe but had been reluctant to provide weapons to the rebels until France and the UK, the drivers of the Libya intervention, swung a recent vote to be allowed to provide weapons themselves. Hezbollah attacks Early in the conflict Hezbollah was not a participant. Gradually, small units and individuals from Hezbollah quietly began to participate alongside Syrian army forces in some of the battles in the interior. However, in the recent battle for Qusair, Hezbollah suddenly revealed itself as an international brigade spearheading the attack for the demoralized Syrian army. The rebel defeat was decisive and the battle was important because Qusair, along with nearby Homs, controlled the road communications between Damascus and the Alawite stronghold along Syrias Mediterranean coast.6 It is also the entry between Syria and northern Lebanon, which the rebel forces could have used to communicate with friendly
See NY Times, Rebel Arms Flow is Said to Benefit Jihadists in Syria, October 14 2012, http://www.nytimes.com/2012/10/15/world/middleeast/jihadists-receivingmost-arms-sent-to-syrian-rebels.html?pagewanted=all&_r=0.
Reuters, Israel strikes Syria, says targeting Hezbollah arms, May 5, 2013, http://www.reuters.com/article/2013/05/05/us-syria-crisis-blastsidUSBRE94400020130505.h
BBC News, US to keep Patriot missiles and F-16s in Jordan, June 15, 2013, http://www.bbc.co.uk/news/world-middle-east-22924078.
ABC News, Syrian and Hezbollah Forces Take Strategic City, June 5, 2013, http://abcnews.go.com/blogs/headlines/2013/06/syrian-andhezbollah-forces-take-strategic-city/.
Page 49
Sunni groups there. The resurgent Syrian forces will conceivably push northward toward Aleppo to try to break the rebel hold on the north of Syria. However, such a push could well turn into a see-saw struggle as more Sunnioriented forces are poured in by the rebels foreign supporters. Russian support for Syria Between Russia and Iran there is a clear mutuality of interest in preserving the Assad regime. Syria is the last Russian client state in the Middle East left over from the Soviet era. It is also Russias only military base in the Mediterranean at just the moment when it is reasserting itself militarily with more forward deployments of naval and air units and a rearmament program. Therefore, Russia has been a natural protector of Syria at the Security Council and an openly large supplier of weapons. Most problematic of these has been the recent announcement that it will supply S-300 long-range antiaircraft missiles to Syria. This is clearly a weapon aimed against intervention by outsiders such as any attempt by Western powers to establish a no-fly zone or any further Israeli air attacks. Depending on the version, these missiles likely have a range sufficient to cover much of Israel and therefore could engage Israeli aircraft over their own bases. Should Assad triumph, the Israelis would likely regard this as a further intensification of the Iranian threat, and thus feel obliged to eliminate such missiles on delivery. Also, the Israelis fear that the S-300 could be delivered to Hezbollah. In a second major intervention, Russia has posted a large naval squadron off of Syria.7 What purpose does a large fleet serve in a civil war fought on land? Originally, it was thought that the deployment was to cover the contingency of evacuating Russian personnel in case of a collapse of the Assad regime. In addition, the fleet deters attempts to interfere with shipping into Syrias ports. But mainly the fleet deploys a significant anti-aircraft and inland bombardment capability along Syrias coast. This increases the risk to any decision by the West to enforce a no-fly zone, although it seems unlikely that Russia would engage in a direct clash. More credibly, it is an additional anti-aircraft deterrent against air attacks from Israel. It also perches a powerful naval squadron exactly where Israels paradigm-changing gas fields are located. Moreover, Russia recently announced that it would permanently deploy a fleet of 16 ships to the Mediterranean Sea for the first time since 1992, signaling that it expects to maintain a permanent toe-hold in Syria. At a time when the US navy is downsizing and redeploying to the Pacific and with what appears to be less US interest
in covering the sea lanes to the Middle East, this could create a major geopolitical problem on Europes southeastern flank. Greece and Cyprus, with their historical sympathies with Russia, may come into play; so for security reasons, the euro zone core arguably cannot be too tough on them. It also creates a strong European security interest in seeing off the Assad regime. Peter Garber, (1) 212 250 5466
See Christian Science Monitor, Russia boosts its naval presence in Syria, sends regime new missiles, May 17, 2013, http://www.csmonitor.com/World/terrorism-security/2013/0517/Russiaboosts-its-naval-presence-in-Syria-sends-regime-new-missiles-video.
Page 50
Key Economic Forecasts

Growth of real GDP (% yoy) 2012 2013F 2014F US Japan Euroland Germany France Italy Spain Netherlands Belgium Austria Finland Greece Portugal Ireland Other Industrial Countries United Kingdom Denmark Norway Sweden Switzerland Canada Australia New Zealand EEMEA Czech Republic Egypt Hungary Israel Kazakhstan Poland Romania Russia Saudi Arabia South Africa Turkey Ukraine United Arab Emirates Asia (ex-Japan) China Hong Kong India Indonesia Korea Malaysia Philippines Singapore Sri Lanka Taiwan Thailand Vietnam Latin America Argentina Brazil Chile Colombia Mexico Peru Venezuela EM Countries World QUARTERLY GDP 2.2 1.9 -0.5 0.7 0.0 -2.4 -1.4 -1.0 -0.3 0.8 -0.2 -6.4 -3.2 0.9 0.3 -0.5 3.0 1.1 1.0 1.7 3.6 2.5 2.8 -1.2 2.2 -1.7 3.1 5.2 1.9 0.7 3.4 6.8 2.5 2.2 0.2 4.4 6.1 7.8 1.5 5.1 6.2 2.1 5.6 6.8 1.9 6.4 1.3 6.5 5.2 2.8 1.2 0.9 5.6 4.0 3.9 6.3 5.6 4.8 2.9 2.2 2.0 -0.6 0.1 -0.2 -2.0 -1.5 -0.7 -0.1 0.4 -0.7 -4.5 -2.6 0.7 1.1 0.4 2.3 1.5 1.5 2.0 2.3 2.7 2.7 0.0 3.4 0.4 3.5 5.3 0.8 2.3 2.8 4.2 2.1 4.1 1.5 3.3 6.3 7.9 3.5 5.5 6.0 2.5 5.0 7.0 2.5 7.0 2.7 5.0 5.3 2.8 1.5 2.4 4.7 4.2 2.9 6.1 0.9 4.9 3.0 3.2 0.6 1.0 1.5 1.1 0.5 0.5 0.8 0.9 1.4 1.1 0.5 0.5 1.8 1.8 1.5 2.6 2.0 1.5 3.0 3.3 2.9 3.6 2.0 5.0 1.1 3.3 5.5 2.5 2.6 3.3 4.4 3.4 5.0 2.7 3.7 7.3 8.8 5.0 6.5 6.0 4.1 6.0 6.0 4.5 7.5 4.6 5.0 5.8 3.6 1.6 3.1 5.2 5.0 4.1 6.3 2.4 5.8 3.9 Inflation, CPI (% yoy) 2012 2013F 2014F 2.1 0.0 2.5 2.1 2.2 3.3 2.4 2.8 2.6 2.6 3.2 1.0 2.8 1.9 2.8 2.4 0.7 0.9 -0.7 1.5 1.8 1.1 5.0 3.3 8.9 5.7 1.7 5.2 3.7 3.3 5.1 2.9 5.7 8.9 0.6 0.7 3.8 2.6 4.1 7.5 4.3 2.2 1.7 3.1 4.6 7.6 1.9 3.6 9.3 7.8 24.0 5.4 3.0 3.1 3.7 3.7 23.8 4.8 3.3 1.7 -0.1 1.5 1.7 1.1 1.6 1.6 2.6 1.2 2.0 2.3 -0.5 0.6 0.8 2.7 1.1 1.8 0.2 -0.4 2.4 2.2 1.0 5.1 1.5 8.3 1.8 1.0 6.2 1.3 4.8 6.8 3.7 5.8 7.3 1.0 1.3 3.3 2.6 3.7 5.4 6.4 1.7 1.9 3.1 2.4 7.5 1.2 1.2 6.9 8.3 25.7 6.4 1.8 2.6 3.7 2.5 24.8 4.5 3.0 2.3 2.3 1.5 1.8 1.5 1.5 1.6 1.7 1.5 1.8 2.1 -0.2 1.1 1.3 2.1 1.8 1.9 1.4 0.5 2.3 2.3 1.8 4.9 1.8 8.8 2.4 1.9 6.4 2.2 3.8 6.0 3.6 5.2 5.9 5.2 2.0 4.1 3.5 3.4 5.7 6.5 3.1 2.6 4.2 3.0 6.5 2.2 2.6 9.3 8.4 27.6 5.6 2.6 2.9 3.7 2.4 26.9 5.0 3.5 (% qoq annualised) Q2 2013F Q3 2013F 2.3 4.5 0.2 1.8 0.0 -1.7 1.8 2.5 2.1 3.0 2.9 0.3 1.0 0.5 -0.8 1.4 2.9 2.2 Current Account (% of GDP) 2012 2013F 2014F -2.8 1.1 1.2 7.1 -2.3 -0.5 -1.1 8.4 -1.4 1.8 -1.9 -3.0 -1.5 4.9 -3.7 5.8 14.1 6.9 13.6 -3.4 -3.7 -5.0 1.7 -2.4 -3.1 1.6 -0.1 6.7 -3.5 -3.9 4.1 23.3 -6.3 -6.0 -8.2 17.3 1.3 2.4 1.1 -5.1 -2.8 3.8 6.1 2.9 18.6 -6.6 10.5 0.7 3.6 -1.4 1.3 -2.4 -3.6 -2.9 -0.8 -3.1 2.5 -3.0 1.2 1.6 7.0 -2.2 0.6 0.5 8.2 0.5 2.5 -1.0 -1.0 0.5 4.0 -2.8 5.0 13.0 7.0 13.0 -2.3 -2.4 -4.0 0.9 -2.3 -3.3 1.2 1.5 5.8 -2.3 -3.5 3.0 15.0 -5.8 -6.0 -5.7 18.1 1.2 2.0 7.6 -4.3 -3.3 2.9 4.1 4.7 14.8 -4.5 10.6 1.8 0.6 -1.8 0.1 -3.1 -4.0 -3.2 -1.0 -3.5 3.2 -3.2 2.4 1.6 6.9 -1.9 0.9 0.3 8.0 1.0 2.8 -1.0 0.0 1.5 4.0 -2.4 5.0 12.5 7.0 13.0 -1.9 -2.5 -4.0 0.1 -2.4 -2.9 0.5 1.8 5.2 -3.1 -3.4 1.2 13.0 -4.4 -7.3 -4.9 19.4 1.0 1.6 8.3 -3.5 -1.9 1.8 5.8 5.7 15.2 -3.7 7.6 0.6 -0.6 -1.8 0.7 -3.0 -2.8 -3.3 -1.2 -3.7 2.8 Fiscal Balance (% of GDP) 2012 2013F 2014F -6.8 -9.5 -3.7 0.2 -4.6 -3.0 -10.0 -4.1 -3.9 -2.5 -1.9 -10.0 -6.4 -7.6 -5.5 -4.4 10.1 -0.7 0.4 -1.4 -3.0 -3.8 -0.8 -4.4 -10.8 -2.0 -4.2 5.1 -3.9 -2.9 -0.1 13.7 -5.0 -2.4 -2.5 7.8 -2.6 -1.6 3.1 -7.4 -1.8 1.5 -4.5 -2.3 6.6 -6.4 -2.8 -3.5 -6.0 -2.6 -3.5 -2.5 0.6 -1.4 -2.2 1.9 -10.2 -3.9 -9.3 -3.0 -0.2 -3.9 -3.4 -6.2 -3.8 -3.0 -2.1 -2.3 -4.9 -5.7 -7.6 -6.5 -2.0 12.0 -1.0 0.3 -1.4 -1.3 -2.1 -1.4 -3.1 -10.0 -2.7 -4.7 5.3 -3.6 -2.5 -1.0 7.3 -4.7 -2.0 -1.8 7.3 -3.0 -2.1 2.7 -7.5 -1.8 -0.2 -4.2 -2.0 7.3 -6.5 -2.9 -3.0 -5.5 -2.4 -3.1 -3.1 -0.9 -1.2 -1.8 1.4 -5.3 -3.2 -7.4 -2.5 0.0 -3.3 -3.0 -5.3 -3.0 -3.0 -1.8 -1.8 -3.7 -4.6 -5.3 -6.0 -2.0 12.0 -0.5 0.3 -0.9 -1.1 -0.6 -1.0 -2.7 -8.0 -2.6 -3.2 4.8 -3.3 -2.0 -0.8 6.9 -3.6 -1.8 -1.6 7.7 -2.5 -1.5 3.2 -7.3 -2.1 0.3 -4.2 -1.8 6.9 -6.2 -1.7 -1.9 -4.5 -2.2 -3.3 -3.3 1.0 -1.1 -1.5 1.3 -3.5
Q1 2012 USA Japan Euroland Germany France Italy United Kingdom Canada G7 2.0 4.8 -0.2 2.5 0.0 -4.0 -0.3 0.8 1.7
Q2 2012 1.3 -0.6 -0.8 0.7 -0.7 -2.5 -1.5 1.6 0.3
Q3 2012 3.1 -3.6 -0.5 0.9 0.3 -1.0 3.8 0.8 1.3
Q4 2012 0.4 1.2 -2.3 -2.7 -0.8 -3.6 -1.2 0.9 -0.3
Q1 2013F 2.4 4.1 -0.8 0.3 -0.7 -2.6 1.3 2.5 1.8
Q4 2013F 3.5 1.6 0.9 1.0 0.9 0.2 1.4 3.1 2.4
Q1 2014F 3.2 3.1 1.2 1.7 0.8 0.5 2.0 3.3 2.6
Q2 2014F 3.2 -7.8 1.4 1.9 1.8 0.9 2.0 3.0 0.9
Q3 2014F 3.3 2.9 1.4 1.5 2.0 1.7 1.9 2.7 2.7
Q4 2014F 3.2 1.1 1.7 1.7 2.1 1.8 1.5 3.1 2.4
Source: DB Research, National Statistical Authorities
Page 51
Interest Rates
(End of Period)
3M rate Current 0.10 0.23 0.21 3M 0.10 0.30 0.50 6M 0.10 0.30 0.50 12M 0.10 0.30 0.50 Current 2.39 0.86 1.64 10Y rate 3M 2.50 0.90 1.55 6M 2.75 1.00 1.75 12M 3.25 0.80 2.00 Current 0.10 0.10 0.50 Official rate 3M 0.10 0.08 0.50 6M 0.10 0.08 0.50 12M 0.10 0.08 0.50
US Japan Euroland
Other Industrial Countries United Kingdom 0.51 Denmark 0.26 Norway 1.76 Sweden 1.13 Switzerland 0.02 Canada Australia New Zealand 1.05 2.90 2.82
0.51 0.30 1.85 1.27 0.05 0.99 3.00 2.65
0.51 0.30 1.85 1.27 0.05 0.95 2.75 2.70
0.60 0.45 2.00 1.45 0.05 1.20 2.75 3.25
2.27 1.77 2.41 2.10 0.88 2.25 3.63 4.09
2.25 1.80 2.35 1.90 0.95 2.65 3.50 3.75
2.50 2.00 2.40 2.00 1.15 3.00 3.75 4.00
2.80 2.25 2.60 2.20 1.40 3.25 4.25 4.50
0.50 0.20 1.50 1.00 0.00 1.00 2.75 2.50
0.50 0.10 1.50 1.00 0.00 1.00 2.50 2.50
0.50 0.10 1.50 1.00 0.00 1.00 2.50 2.50
0.50 0.10 1.50 1.00 0.00 1.25 2.50 3.00
EMERGING MARKETS OFFICIAL RATES Current 3M Emerging Europe 0.05 0.05 Czech Republic Hungary 4.50 3.50 Poland 2.75 2.50 Romania 5.25 4.75 Russia 8.25 8.00 Turkey 4.50 4.50 Ukraine 7.00 7.50 South Africa 5.00 5.00 Asia (ex-Japan) China Hong Kong India Indonesia Korea Malaysia Philippines Singapore Sri Lanka Taiwan Thailand Vietnam Latin America Argentina Brazil Chile Colombia Mexico
6M 0.05 3.50 2.50 4.50 7.75 4.50 7.50 5.00
12M 0.05 3.50 2.50 4.00 7.75 4.50 7.50 5.00
3.00 0.50 7.25 6.00 2.50 3.00 5.50 0.38 9.00 1.88 2.50 7.00
3.00 0.50 6.75 6.50 2.50 3.00 5.50 0.45 9.00 1.88 2.50 7.00
3.00 0.50 6.50 6.50 2.50 3.00 5.50 0.60 9.00 1.88 2.50 7.00
3.00 0.50 6.50 6.50 2.75 3.25 6.00 0.70 9.00 2.00 3.00 8.00
12.00 8.00 5.00 3.25 4.00
13.50 9.00 5.00 3.25 4.00
16.50 9.25 5.00 3.25 4.00
17.50 9.25 5.00 3.50 4.30
Sources: DB Research, Bloomberg Finance LP; as of June 20
Page 52
Exchange Rates (End of Period)

FX Rate (vs. US Dollar) Current US Japan Euroland 98 1.32 102 1.26 110 1.20 113 1.18 3M 6M 12M Current 1.32 129 FX Rate (vs. Euro) 3M 1.26 129 6M 1.20 132 12M 1.18 133 129 129 132 133 Current 98 FX Rate (vs. Yen) 3M 102 6M 110 12M 113
Other Industrial Countries United Kingdom 1.55 Denmark 5.65 Norway 5.90 Sweden 6.49 Switzerland 0.93 Canada Australia New Zealand Emerging Europe Czech Republic Hungary Poland Israel Romania Russia Turkey Ukraine South Africa Asia (ex-Japan) China Hong Kong India Indonesia Korea Malaysia Philippines Singapore Sri Lanka Taiwan Thailand Vietnam Latin America Argentina Brazil Chile Colombia Mexico 1.03 0.92 0.78
1.55 5.92 5.83 6.71 0.99 1.00 0.98 0.80
1.47 6.22 6.04 6.88 1.04 1.00 0.98 0.80
1.41 6.32 6.06 6.78 1.05 1.02 0.95 0.77
0.85 7.46 7.79 8.58 1.23 1.37 1.44 1.70
0.86 7.46 7.35 8.45 1.25 1.26 1.29 1.58
0.85 7.46 7.25 8.25 1.25 1.20 1.22 1.50
0.84 7.46 7.15 8.00 1.24 1.20 1.24 1.53
152 17.3 16.6 15.1 104.9 94.6 90.0 76.3
158 17.2 17.5 15.2 102.8 102.0 100.0 81.6
161 17.7 18.2 16.0 105.6 110.0 107.8 88.0
160 17.9 18.6 16.7 107.5 110.8 107.4 87.0
19.5 226 3.27 3.62 3.43 32.8 1.92 8.17 10.29
20.2 229 3.27 3.53 3.47 31.7 1.85 8.15 9.60
21.0 235 3.33 3.50 3.58 31.8 1.85 8.25 9.10
21.1 237 3.39 3.45 3.60 32.0 1.85 8.40 8.80
25.7 299.1 4.32 4.78 4.53 43.30 2.54 10.79 13.59
25.4 289 4.13 4.45 4.38 40.0 2.33 10.27 12.10
25.2 282 4.00 4.20 4.30 38.2 2.22 9.90 10.92
24.9 280 4.00 4.07 4.25 37.8 2.18 9.91 10.38
5.0 0.4 30.0
5.1 0.4 31.2
5.2 0.5 33.0
5.4 0.5 33.3
6.13 7.76 59.78 9,982 1,146 3.20 43.88 1.27 128.2 30.01 31.05 21,040
6.12 7.77 55.00 10,500 1,130 3.10 42.60 1.26 129.0 30.00 30.50 21,100
6.10 7.80 55.00 10,500 1,120 3.07 42.30 1.25 127.0 29.60 30.00 21,200
6.00 7.80 54.00 10,000 1,140 3.05 41.70 1.25 126.0 29.80 29.70 21,300
8.10 10.25 78.99 13,189 1,514 4.23 57.97 1.68 169.41 39.65 41.02 27,800
7.71 9.79 69.30 13,230 1,424 3.91 53.68 1.59 162.54 37.80 38.43 26,586
7.32 9.36 66.00 12,600 1,344 3.68 50.76 1.50 152.40 35.52 36.00 25,440
7.08 9.20 63.72 11,800 1,345 3.60 49.21 1.48 148.68 35.16 35.05 25,134
16.0 12.6 1.6 0.01 0.09 30.6 2.2 76.9 0.8 3.3 3.2 0.005
16.7 13.1 1.9 0.01 0.09 32.9 2.4 81.0 0.8 3.4 3.3 0.005
18.0 14.1 2.0 0.01 0.10 35.8 2.6 88.1 0.9 3.7 3.7 0.005
18.8 14.5 2.1 0.01 0.10 37.0 2.7 90.4 0.9 3.8 3.8 0.005
5.34 2.22 500 1,896 13.27
5.60 2.12 505 1,910 12.60
5.98 2.15 502 1,930 12.10
6.62 2.17 500 1,950 11.90
7.06 2.94 660 2,505 17.53
7.06 2.67 636 2,407 15.88
7.18 2.58 602 2,316 14.52
7.81 2.56 590 2,301 14.04
Sources: DB Research, Bloomberg Finance LP, Datastream; as of June 20
Page 53
Long-term Forecasts
GDP growth, % yoy 2011 Industrial countries
USA Japan Euroland United Kingdom Canada A ustralia 1.8 -0.5 1.5 1.0 2.4 2.4 4.3 3.5 9.3 7.5 6.5 2.7 2.2 1.9 -0.5 0.3 1.7 3.6 3.4 2.5 7.8 5.1 6.2 0.9 2.2 2.0 -0.6 1.1 2.0 2.3 2.8 2.1 7.9 5.5 6.0 2.4 3.2 0.6 1.0 1.8 3.0 3.3 3.3 3.4 8.8 6.5 6.0 3.1 2.7 0.8 1.2 2.0 3.1 3.3 3.8 3.8 8.5 7.0 6.0 2.2 2.6 1.4 1.4 2.3 2.3 3.3 4.0 4.4 8.0 7.5 6.0 3.0 2.5 1.3 1.6 2.3 2.4 3.3 4.0 4.8 8.0 7.5 6.0 3.2 3.1 -0.3 2.7 4.5 2.9 3.3 8.4 5.0 5.4 9.5 5.4 6.6 2.1 0.0 2.5 2.8 1.5 1.8 5.1 5.7 2.6 7.5 4.3 5.4 1.7 -0.1 1.5 2.7 2.4 2.2 6.8 5.8 2.6 5.4 6.4 6.4 2.3 2.3 1.5 2.1 2.3 2.3 6.0 5.2 3.5 5.7 6.5 5.6 2.2 1.4 1.8 2.0 1.8 2.5 5.6 5.3 3.5 6.5 6.0 5.5 2.2 1.2 1.9 2.0 2.0 2.5 5.2 5.8 3.0 7.0 6.0 5.2 2.2 0.5 2.0 2.0 2.0 2.5 4.7 5.5 3.0 7.0 6.0 5.0
CPI inflation, % yoy 2016F 2017F 2011 2012 2013F 2014F 2015F 2016F 2017F
2012
2013F
2014F
2015F
Emerging Markets
Russia South A frica China India Indonesia Brazil
GDP per head, % yoy 2011 Industrial countries

USA Japan Euroland United Kingdom Canada A ustralia 1.1 -0.4 1.2 0.2 1.3 1.0 4.6 2.3 8.8 6.1 5.1 1.8 1.5 2.1 -0.8 -0.5 0.6 2.4 3.7 1.3 7.3 3.7 4.8 0.0 1.2 2.3 -1.1 0.3 0.9 0.7 2.7 1.2 7.4 4.3 4.8 1.1 2.2 0.9 0.5 1.0 1.9 1.8 3.3 2.5 8.3 5.3 4.7 1.8 1.7 1.2 0.7 1.2 2.1 1.8 3.9 2.9 8.0 5.8 4.8 0.9 1.6 1.8 0.9 1.4 1.3 2.0 4.1 3.5 7.6 6.3 4.8 1.7 1.5 1.8 1.1 1.4 1.5 2.0 4.1 3.9 7.6 6.3 4.8 1.9 0.7 -0.1 0.3 0.8 1.1 1.4 -0.3 1.2 0.5 1.4 1.4 0.9 0.7 -0.2 0.3 0.8 1.1 1.3 -0.3 1.2 0.5 1.4 1.4 0.9
Population growth, % yoy 2016F 2017F 2011 2012 2013F

1.0 -0.3 0.5 0.8 1.1 1.6 0.1 0.9 0.5 1.2 1.2 1.3
2012
2013F
2014F
2015F
2014F
1.0 -0.3 0.5 0.8 1.1 1.5 0.0 0.9 0.5 1.2 1.2 1.3
2015F
1.0 -0.4 0.5 0.8 1.0 1.5 -0.1 0.9 0.5 1.2 1.2 1.3
2016F
1.0 -0.4 0.5 0.8 1.0 1.3 -0.1 0.9 0.4 1.2 1.2 1.3
2017F
1.0 -0.5 0.5 0.8 0.9 1.3 -0.1 0.9 0.4 1.2 1.2 1.3
Emerging Markets
Key official interest rate, % (eop) 2011 Industrial countries

USA Japan Euroland United Kingdom Canada A ustralia 0.13 0.05 1.00 0.50 1.00 4.25 8.00 5.50 3.50 8.50 6.00 11.00 0.13 0.05 0.75 0.50 1.00 3.00 8.25 5.00 3.00 8.00 5.75 7.25 0.16 0.08 0.50 0.50 1.00 2.50 7.75 5.00 3.00 6.50 6.50 9.25 0.16 0.08 0.50 0.75 2.50 2.50 7.75 5.00 3.25 6.50 6.50 9.25 1.75 0.08 0.75 1.75 3.75 4.00 7.75 7.00 3.50 7.00 7.00 10.06 3.75 0.08 1.50 2.75 4.25 4.50 7.75 7.50 3.50 7.50 7.00 9.20 4.50 0.25 2.50 3.75 4.25 4.00 7.75 8.00 3.50 7.50 7.00 9.00 1.88 0.99 1.83 1.98 1.94 3.68 n.a. n.a. n.a. n.a. n.a. n.a. 1.76 0.79 1.32 1.83 1.80 3.28 n.a. n.a. n.a. n.a. n.a. n.a.
10Y bond yields (eop) 2017F 2011 2012 2013F

2.75 1.00 1.75 2.50 3.00 3.75 n.a. n.a. n.a. n.a. n.a. n.a.
2012
2013F
2014F
2015F
2016F
2014F
3.75 0.90 2.50 2.90 4.00 4.25 n.a. n.a. n.a. n.a. n.a. n.a.
2015F
4.75 0.90 3.00 3.85 4.50 4.25 n.a. n.a. n.a. n.a. n.a. n.a.
2016F
5.00 1.10 3.50 5.25 5.50 4.50 n.a. n.a. n.a. n.a. n.a. n.a.
2017F
5.00 1.30 4.00 5.50 5.50 4.50 n.a. n.a. n.a. n.a. n.a. n.a.
Emerging Markets
FX rate vs. USD (eop) 2011 Industrial countries

USA Japan Euroland United Kingdom Canada A ustralia 1.00 77 1.30 1.55 1.02 1.03 32.20 8.14 6.30 53.26 9033 1.88 1.00 87 1.32 1.63 1.00 1.04 30.37 8.49 6.28 54.78 9638 2.04 1.00 110 1.20 1.41 1.00 0.98 31.80 9.10 6.10 55.00 10500 2.15 1.00 115 1.15 1.39 1.05 0.90 32.30 8.70 6.03 53.00 10000 2.25 1.00 115 1.10 1.38 1.10 0.85 33.00 9.00 5.94 53.00 10000 2.30 1.00 110 1.05 1.44 1.10 0.85 33.20 9.00 5.85 52.50 10000 2.37 1.00 110 1.00 1.44 1.10 0.85 34.20 9.00 5.78 52.00 9800 2.44 1.30 100 1.00 0.84 1.33 1.27 41.85 10.58 8.19 69.24 11743 2.44 1.32 114 1.00 0.81 1.31 1.27 40.09 11.21 8.29 72.31 12722 2.70
FX rate vs. EUR (eop) 2016F 2017F 2011 2012 2013F

1.20 132 1.00 0.85 1.20 1.22 38.16 10.92 7.32 66.00 12600 2.58
2012
2013F
2014F
2015F
2014F
1.15 132 1.00 0.83 1.21 1.28 37.15 10.01 6.93 60.95 11500 2.59
2015F
1.10 127 1.00 0.80 1.21 1.29 36.30 9.90 6.53 58.30 11000 2.53
2016F
1.05 116 1.00 0.73 1.16 1.24 34.86 9.45 6.14 55.13 10500 2.49
2017F
1.00 110 1.00 0.69 1.10 1.18 34.20 9.00 5.78 52.00 9800 2.44
Emerging Markets
Source: National Authorities, DB Research
Page 54
Contacts Name
David Folkerts-Landau Marcel Cassard Economics Peter Hooper Torsten Slok Joe LaVorgna Thomas Mayer Mark Wall Gilles Moec Mikihiro Matsuoka Michael Spencer Jun Ma Gustavo Caonero Strategy Binky Chadha Dominic Konstam Francis Yared Jim Reid Steven Abrahams David Bianco Michael Biggs Gareth Evans Bilal Hafeez Michael Lewis Peter Garber Global Asset Allocation Rates Strategy Rates Strategy Credit Strategy US MBS US Equity Strategy European Equity Strategy European Equity Strategy FX Strategy Commodities Geopolitics +1 212 250 4776 +1 212 250 9753 +44 20 7545 4017 +44 207 547 2943 +1 212 250 3125 +1 212 250 8169 +44 20 7545 5506 +44 20 7545 2762 +44 207 54 71489 +44 20 754 52166 +1 212 250 5466 bankim.chadha@db.com dominic.konstam@db.com francis.yared@db.com jim.reid@db.com steven.abrahams@db.com david.bianco@db.com michael.biggs@db.com gareth.evans@db.com bilal.hafeez@db.com michael.lewis@db.com peter.garber@db.com Global Economics Global Economics US Economist Global Economics Europe Economics Europe Economics Japan Economics Asia Economics China Economics Latam Economics +1 212 250 7352 +1 212 250 2155 +1 212 250 7329 +49 69 910 30800 +44 20 754 52087 +44 20 754 52088 +81 3 5156 6768 +852 2203 8305 +852 2203 8308 +1 212 250 7530 peter.hooper@db.com torsten.slok@db.com joseph.lavorgna@db.com tom.mayer@db.com mark.wall@db.com gilles.moec@db.com mikihiro.matsuoka@db.com michael.spencer@db.com jun.ma@db.com gustavo.canonero@db.com
Coverage
Global Head of Research Global Head, Macro and FI Research
Telephone
+44 20 754 55502 +44 20 754 55507
Email
david.folkerts-landau@db.com marcel.cassard@db.com
Page 55
Appendix 1
Important Disclosures Additional information available upon request
For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr
Analyst Certification
The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Peter Hooper/Thomas Mayer/Michael Spencer
Page 56
Regulatory Disclosures 1. Important Additional Conflict Disclosures

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

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

Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates - these are common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options in addition to the risks related to rates movements.
Page 57
David Folkerts-Landau
Global Head of Research Marcel Cassard Global Head CB&S Research Asia-Pacific Fergus Lynch Regional Head Ralf Hoffmann & Bernhard Speyer Co-Heads DB Research Germany Andreas Neubauer Regional Head Guy Ashton Chief Operating Officer Research Richard Smith Associate Director Equity Research North America Steve Pollard Regional Head
International Locations
Deutsche Bank AG Deutsche Bank Place Level 16 Corner of Hunter & Phillip Streets Sydney, NSW 2000 Australia Tel: (61) 2 8258 1234 Deutsche Bank AG London 1 Great Winchester Street London EC2N 2EQ United Kingdom Tel: (44) 20 7545 8000 Deutsche Bank AG Groe Gallusstrae 10-14 60272 Frankfurt am Main Germany Tel: (49) 69 910 00 Deutsche Bank AG Filiale Hongkong International Commerce Centre, 1 Austin Road West,Kowloon, Hong Kong Tel: (852) 2203 8888 Deutsche Securities Inc. 2-11-1 Nagatacho Sanno Park Tower Chiyoda-ku, Tokyo 100-6171 Japan Tel: (81) 3 5156 6770
Deutsche Bank Securities Inc. 60 Wall Street New York, NY 10005 United States of America Tel: (1) 212 250 2500
Global Disclaimer
The information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively "Deutsche Bank"). The information herein is believed to be reliable and has been obtained from public sources believed to be reliable. Deutsche Bank makes no representation as to the accuracy or completeness of such information. Deutsche Bank may engage in securities transactions, on a proprietary basis or otherwise, in a manner inconsistent with the view taken in this research report. In addition, others within Deutsche Bank, including strategists and sales staff, may take a view that is inconsistent with that taken in this research report. 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 reflect 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 financial instruments are subject to change without notice. This report is provided for informational purposes only. It is not an offer or a solicitation of an offer to buy or sell any financial 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 Banks March 2010 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 differing methodologies to value the security; as a result, the recommendations may differ and the price targets and estimates of each may vary widely. The financial 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 fluctuations and other factors. If a financial instrument is denominated in a currency other than an investor's currency, a change in exchange rates may adversely affect 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. 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 financial 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 or Deutsche Securities Asia Limited, Singapore Branch, and recipients in Singapore of this report are to contact Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch in respect of any matters arising from, or in connection with, this report. Where this report is issued or promulgated in Singapore to a person who is not an accredited investor, expert investor or institutional investor (as defined in the applicable Singapore laws and regulations), Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch accepts legal responsibility to such person for the contents of this report. In Japan this report is approved and/or distributed by Deutsche Securities Inc. The information contained in this report does not constitute the provision of investment advice. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch Register Number in South Africa: 1998/003298/10). Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. This report may not be reproduced, distributed or published by any person for any purpose without Deutsche Bank's prior written consent. Please cite source when quoting. Copyright 2013 Deutsche Bank AG
GRCM2013PROD029586

World Outlook Torsten Slok

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

World Outlook Torsten Slok

Uploaded by

Copyright:

Available Formats

Deutsche Bank Markets Research

Global Cross-Discipline Date 20 June 2013

Economic Forecast Summary

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

Deutsche Bank Securities Inc.

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

Global Overview: Fed Policy Tapers Global Markets

Source: IMF, Haver Analytics, DB Research

Figure 2: Global GDP growth forecast & revision (% yoy)

Deutsche Bank Securities Inc.

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

Figure 4: Inflation forecast & revision (% yoy)

Outlook for Fed tapering: Expectations and impact

Source: IMF, Consensus Economics, Bloomberg Finance LP, DB Research

Deutsche Bank Securities Inc.

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

but remain low compared to history

10 year government yield (end 2012 - present) 19-Jun

10 year government yield (end 2004 - present) 19-Jun

Deutsche Bank Securities Inc.

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

Figure 6: US inflation expectations have fallen

but remain within historical range

Source: Haver Analytics, DB Research

Figure 7: US real yields have moved into positive territory

but remain well below normal

2 1 0 -1 -2 2004 2005 2007 2008 2009 2010 2011 2012 2013

Figure 8: Implied Fed funds rate path

Implied fed rate

May 21, 2013 May 02, 2013

Deutsche Bank Securities Inc.

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

Deutsche Bank Securities Inc.

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

Deutsche Bank Securities Inc.

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

US: Why taper? Why now?

Figure 1: Macro-economic activity & inflation forecasts

Deutsche Bank Securities Inc.

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

Source: BEA, BLS, Haver Analytics, DB Research

Deutsche Bank Securities Inc.

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

16 1967 1975 1982 1990 1997 2005 2012

Source: Census, NAHB, Haver Analytics, DB Research

Deutsche Bank Securities Inc.

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

Real GDP % yoy Forecast

Average of last 10 cycles

Source: BEA, Haver Analytics, DB Research

Source: BLS, Haver Analytics, DB Research

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

Source: National authorities, DB Research, as of June 20

Deutsche Bank Securities Inc.

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

Europe: An unconvincing calm

Figure 1: Macro-economic activity & inflation forecasts:

Source: National authorities, DB Research

20 June 2013 World Outlook: Fed Policy Tapers Global Markets

Stocks Government GDP

Euroarea: GDP growth and contribution to GDP growth (pp)

Forecast Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13 Q3-13 Q4-13