slow turn ahead? 2013 Investment Outlook

BlackRock Investment Institute Nigel Bolton What Is Inside Head of European Equities, BlackRock Alpha Strategies First Words and Summary...... 3

Scenario Setting...... 4–5 Peter Fisher TM So What Do I Do With My Money? ...... 6–7 Head of BlackRock Fixed Income policy & economics...... 6–13 Portfolio Management Policy—for Better or Worse...... 6–8 american Exceptionalism?...... 9 Economics of Easing...... 10–11 a Zero-Rate World...... 12–13 Philipp Hildebrand BlackRock policy & markets...... 14–24 Vice Chairman In Search of Fast Rivers ...... 14–15 caution: Turn Ahead...... 16–18 the Other European Story...... 19–20 Bull in the China Shop ...... 21 Russ Koesterich contrarian Dreaming...... 22 BlackRock Chief known Unknowns...... 23–24 Investment Strategist

Income Investing...... 24–32 Fixed Income: Invest for Income...... 24–25 high Yield: Reluctant Risks...... 26 munis: Dealers Come to Town...... 27 Rick Rieder Emerging Market Debt: Price of Fashion...... 28–29 Chief Investment dividends: Yield to Growth...... 30–31 Officer, BlackRock Fundamental Reading REITs ...... 32 Fixed Income

Andrew Swan BlackRock’s 2013 Outlook Forum Head of Asian Some 50 BlackRock portfolio managers exchanged views on the 2013 Equities, BlackRock investing landscape at a Nov. 15–16 event organized by the BlackRock Alpha Strategies Investment Institute. Our mission: Pinpoint market trends, update our investment scenarios and gauge global policy impact on financial assets next year. To prevent the looming US “fiscal cliff” from overshadowing Richard Urwin the forum, we offered a slightly crumpled $1 bill to the first speaker Head of Investments, who did not mention it. Somebody won—in the end. BlackRock Solutions Fiduciary Mandates BLAckrock investment institute The BlackRock Investment Institute leverages the firm’s expertise across asset classes, client groups and regions. The Institute’s goal is to produce Ewen Cameron Watt information that makes BlackRock’s portfolio managers better investors Chief Investment and helps deliver positive investment results for clients. Strategist, BlackRock

Executive Director Chief Strategist Executive Editor Investment Institute Lee Kempler Ewen Cameron Watt Jack Reerink

The opinions expressed are as of December 2012 and may change as subsequent conditions vary.

[2] slow turn ahead? First Words Throttling Back The most likely candidate to pour less fuel onto the monetary fire is the US Federal Reserve. The US economy and Summary is actually growing and looks to gain momentum—if, and this is a big if, Washington can bridge the “fiscal cliff” of automatic tax hikes and come up with a credible plan to Policy will be a key force in financial markets in 2013— address the deficit. US banks are in reasonable shape, and a prime determinant of investment returns. manufacturing is rising and the housing market has turned, boosting consumer confidence and spending. Global central banks are refocusing their efforts to jumpstart anemic growth. The patient (the global We do not expect the Fed to raise rates any time soon. economy) has moved from the emergency room to But it could take its foot off the monetary accelerator the recovery ward—but unfortunately is still in the on signs of quickening job growth in the second half of hospital (and racking up hefty medical bills). 2013. It could stop reinvesting the interest on its massive Treasury and mortgage securities holdings as a first A big question for 2013 is whether the wave of ultra-loose step. This may seem unlikely today, but we must be monetary policies and quantitative easing has crested. ready. 2013 could very well be a game of two halves. Trillions of dollars in monetary stimulus and record-low interest rates have failed to spur much credit growth and Danger in Safety economic activity so far. But what if this changes? Markets need only a whiff of a Fed reversal to empty some of the vast store of investor money in cash and Our 2013 outlook, Slow Turn Ahead?, addresses this low-yielding fixed income assets and put it into equities. question and assesses its impact on markets. Quality businesses and dividend stocks would likely underperform leveraged companies, as the influx could Five Fundamentals for 2013 result in a temporary “dash for trash.” We have become more upbeat about the Casualties would be “safe” assets such as government bonds of the United States, UK, Germany and other 1 prospects for risk assets and stabilizing eurozone core countries. Duration has risen and convexity economic growth (albeit at low levels). Low has fallen: not a winning combination in fixed income. It expectations = potential upside surprises. takes just a miniscule rise in yield to trigger sizable bond price losses. There is a danger in safety, especially because The US economy should gain momentum 2 most investors are positioned for rates to be low for long. and help boost global growth—IF Limited supply of bonds may dull the pain. Washington can avoid the “fiscal cliff” Feeling Good and compromise on a sustainable budget. We feel better about the world’s economic backdrop Many investors lack conviction in markets and markets than in Standing Still…But Still Standing in 3 where risk taking is often punished and July 2012. Our “Age of Separatism” investment scenario, trends last a skinny minute. Rome—and whereby US and emerging markets outperform, gets the highest probability. This is followed by “Stop ‘N Go” with confidence—was not built in a day. on-and-off economic growth and market gyrations. And 4 The era of ultra-loose monetary policy we have upped the odds for “Go Growth” to 20%. may draw to a close, challenging “safe” We have downgraded our “Nemesis” scenario to 10% fixed income assets and heralding a shift because we think the risks of a credit crisis and market toward equities. Safety = new tail risk. sell-off have receded. We do worry about reigning optimism over US exceptionalism—America’s ability to close a gaping Income investing works in a zero-rate budget hole with essentially the same cast of political 5 world—but the hunt for yield has narrowed characters. Much of 2013’s global investing landscape and valuations between top-quality and not-so- our scenarios depend on whether Washington navigates the fiscal cliff and strikes a long-term budget deal— great income assets. Take out the garbage. subjects we plan to revisit throughout the year.

FIRST WORDS AND SUMMARY [3] Scenario Setting

Scenario description odds assets Signposts

Age of The US economy This is a renewed Relative value investing } C orrelations between asset Separatism leads the developed version of our and (emerging market) classes decline further. world. Emerging previous Divergence equities are favorites. 35% } Relative strength of monetary economies—and scenario. We renamed Emerging market debt and fiscal policies by individual assets—outperform. it to emphasize also is attractive. countries. amental

Europe recovers at its long-term d } Washington avoids the “fiscal a snail’s pace while nature—and the US cliff” and outlines a credible un China’s economy economy’s potential F (Previous 35%–40%) budget deal. re-accelerates. to be a global growth locomotive.

Stop ‘N Go Sluggish global This is our previous Risk-on/risk-off rallies } Scattershot growth trends 30% economic growth, Stagnation scenario. dominate trading. This and flat money multipliers. with false dawns in It has become the means super short-term } Haphazard policy moves to the US and emerging market consensus. and super long-term stimulate growth and achieve economies. A We still give it pretty strategies. The hunt for sustainable debt levels. European recession high odds. The crowd yield favors dividend stocks, } The United States agrees on (Previous 40%–45%) and tight credit for could be right. emerging market debt, high a Band-Aid budget deal. those who need it. yield and US commercial Deleveraging keeps mortgage securities and a lid on growth and municipal bonds. risk taking.

Go Growth Key economies such Did we take happy Gear up for a massive } Growth in credit creation and 20% as the United States, pills? Maybe—but risk-on rally, with investor bank lending. China and even the probability of monies parked in cash, } Sell-offs in short-dated Europe grow faster pleasant growth fixed income and quality instruments such as bills and than expected. The surprises has risen, stocks flowing to emerging commercial paper. global economy partly because the market stocks and } A grand US budget bargain that (Previous 5%–10%) starts weaning bar is pretty low. And discounted European and puts its fiscal house in order and itself off monetary a lot of things can go Japanese equities. Subtract stimulates growth. stimulus. right, too. 10% points if } China, Brazil and India carry US Jumps off out growth-boosting structural Fiscal Cliff reforms.

Nemesis Redux A global recession, We see a smaller The usual suspects of US } Populist policies of debt 10% credit crunch, social chance of Nemesis Treasuries, German bunds defaults and protectionism. upheaval and steep as risks of a eurozone and the Japanese yen. Watch } Funding markets seize up again. losses across asset breakup have receded the danger in safety, though. } Social unrest and unexpected classes. Named after and China’s economic Investment grade credit geopolitical crises. the Greek goddess momentum looks should do relatively well. (Previous 15%–20%) who punishes the to be strengthening. Short-term volatility is low, } Political dysfunction reigns in proud. US and Middle East so downside protection is Washington: No budget deal add 10% leaders hold the keys cheap. Get it while you can. and a nasty debt ceiling fight. points if US to Pandora’s Box now. } A “Grexit” or massive deposit Jumps off flight rekindles fears of a Fiscal Cliff eurozone breakup.

Inflate Away High commodities Okay, inflation is still Commodities and hard } Bubbly equity markets. 5% prices and monetary far-fetched. Markets assets such as real } Money velocity jumps. easing drive up can turn on a dime if estate tend to offer some } Inflation beyond food and energy. inflation around the they get a whiff of it, protection. Sell stretched world, effectively though. Few investors safe-haven government } Washington kicks the can cutting the are positioned for bonds. down the road by agreeing on (Previous 0%–5%) developed world’s inflation, and it a budget deal that eliminates debt load. could be triggered all fiscal drag—and ignores by unexpected the deficit. geopolitical events. Stay tuned.

[4] slow turn ahead? The International Monetary Fund (IMF) forecasts 1% fiscal global tightening in 2013—no small potatoes in a 3%–4% To a Happier Place growth world. Europe is spreading out the austerity pain Macroeconomic Signposts for 2013 over time. The United States should see some tightening Bad Things Where Are We? Good Things due to likely tax increases. Fiscal Monetary Tightening Easing

We have become more upbeat about Private Sector Deleveraging 1 prospects for risk assets and economic Deleverages Completed amental growth stabilizing (albeit at low levels). Low China Hard Emerging d Landing Market Growth

un expectations = potential upside surprises. F Nemesis Risks Nemesis Risks Above Normal Negligible Japan may loosen under new political leadership. China has Inflation Inflation plenty of firepower for fiscal stimulus, but a repeat of 2009’s Risk High Risk Low fireworks is unlikely. Current Situation 2013 Direction Many key indicators for growth and risk appetite were perking Source: BlackRock, November 2012. up going into 2013. Sure, this was happening from a low base (and low expectations). But it does lay the groundwork for positive surprises. On balance, we see the world moving toward “good” things. See the chart on the right. Economic momentum in the world looks poised to take a modest turn for the better. See the map below. The European Central Bank’s (ECB) relaxing rules on what banks can post as collateral and the recovery of the US China’s much-feared “hard landing” may be the softest housing market are triggering the release of some in history if growth stabilizes near the current 7%-plus collateral that has gummed up monetary transmission. range. For details on China, see page 21.

Age of Separatism Economic Momentum Around the Globe, 2012

1 Mid-Cycle Slowdown

2 Weakness

3 Potential Trough

4 Early Recovery

5 Strength

6 Potential Peak

Source: BlackRock, December 2012. Notes: Economic cycle selections based on a combination of leading indicators for most developed markets. Purchasing Manager Indices used for Canada, China, India, Mexico, New Zealand, Russia and Turkey. Colors based on historical one-month forward performance of equities in a broad asset allocation model after each cycle. For example, dark blue (4) has been best for equities and dark orange (2) worst.

SCENARIO SETTING [5] } India’s about-face in opening to foreign investment Policy–For halted a rupee meltdown and equity market slide. } Switzerland defended its euro peg and kept rates near Better or Worse zero. The Bank of Japan launched an asset purchase program, partly offset by the government’s hiking value- added taxes over time. The UK kept its quantitative Policy has created Pavlovian markets. Investors and markets easing program and fiscal tightening, even in the face are conditioned to jump whenever policymakers (fail to) of rising consumer prices. act—much like Russian physiologist Ivan Pavlov’s dogs salivated upon hearing a bell they identified with being fed. Aiming for the Best Monetary policy seems to be moving from preventing a Policy is the reality of the new world of investing, and 2012 financial sector collapse to targeting growth. The Fed has was no exception: explicitly linked QE3 to an improved jobs market. The } E CB President Mario Draghi, backed by Germany, pledged Bank of England (BoE) is targeting aggregate credit with to do whatever was necessary to save the euro and buy its Funding for Lending Scheme. short-term bonds of peripheral countries such as Spain and Italy. This lifesaver is called the Outright Monetary The ECB is following with a lag—the OMT is ultimately Transactions (OMT) program. It stabilized eurozone bond about creating greater funding equilibrium within yields and avoided an investment Armageddon. the eurozone. } The US Federal Reserve, led by Chairman Ben The People’s Bank of China has shelved fiddling with Bernanke, launched its third round of quantitative banks’ required reserve ratios in favor of injecting cash easing (QE3)—this time with no expiration date. This into the financial system. It is also encouraging the further compressed yields across the bond world— growth of commercial bond markets. and increased duration risk (the risk of sharp price The monetary overdose has yet to translate into declines if yields were to rise). sustainable economic growth. Sure, it is possible to } c hina’s attempts to slow inflation and prevent a real have creditless recoveries. Think Mexico after its 1994 estate bubble hit fixed asset investment—and sent currency devaluation. These recoveries, however, tend global commodity markets into a swoon. Brazil to be unusually muted and led by a modest pick-up in intervened in trade, currency, and the energy and consumer spending rather than investment, according banking industries. to the March 2011 IMF paper Creditless Recoveries.

So What Do I Do With My Money?TM Fixed Income: Danger in Safety Equities: Global Smorgasbord } Prices of safe-haven government bonds could plunge } We like global companies with strong balance sheets, when yields start to rise. Low yield = high price risk. steady cash flows and growing dividends. } We like global high yield and US munis for income— } We favor high-quality US stocks, global energy and but do not expect much capital appreciation. emerging markets. } We favor emerging market debt. In Europe, we prefer } We are bullish on domestic consumption plays in Italian and Spanish bonds over debt of weak European Brazil and China, North Asian cyclical stocks, and core countries. Mexican banks and industrials. } We are bullish on commercial mortgage-backed } We like discounted exporters on Europe’s periphery securities and collateralized loan obligations. and small “self-help” UK companies. Commodities: Long View Currencies: Dollar Bulls } We like metals with long-term supply gaps and } We are bullish on the US dollar due to the country’s agricultural commodities. China’s appetite is huge. energy boom and long-term growth prospects.

[6] slow turn ahead? Regulation Tide European Mythology A tidal wave of regulation is shaking up the inner guts of Europe looks to spread out the pain of fiscal tightening— global financial markets. There is Basel, Volcker, Vickers, a positive development that is sensible and may halt Solvency II, Affordable Care, environmental rules and so the continent’s downward economic spiral. The focus on on. Liquidity is drying up in areas deserted by banks, cyclically adjusted deficits (as opposed to calendar-based upsetting fast trading strategies and curtailing funding. targets) by the Troika (the European Commission, ECB and IMF) amounts to short-term fiscal easing. Aided by tax Regulatory change is slowly grinding its way into financial cuts in Germany, this may cause the eurozone to beat markets. Some rules are delayed as policymakers consider (extremely low) growth expectations in 2013. the (unintended) consequences of businesses holding back investments. In addition, the flood of rulemaking principles Europe appears to have little maneuvering room for and theories is hitting the rocks of implementation and overt monetary easing because of paymaster Germany’s reality in policy-setting bodies such as the Financial Stability abhorrence of money printing. Like Ulysses, Draghi has tied Board and the Basel Committee. his hands to the mast to avoid hearing the sirens of monetary easing. It is hard to see him pivot from this position. Nevertheless, the regulatory change die is cast and banks are busy downsizing trading desks and cutting At the same time, Draghi has studied other chapters of risk. Liquidity is drying up in credit markets, creating new the Greek mythology book. He is aware of the risk of a visit risks and opportunities for investors, as detailed in Got by the vengeful goddess Nemesis if spiraling borrowing Liquidity? in September 2012. costs for key countries such as Spain and Italy threaten a eurozone breakup. The new dynamics are affecting areas such as trade and project finance, unsecured lending (as deposits are now The best—but somewhat unlikely—scenario is a explicitly senior) and funding backed by illiquid collateral weakening euro. This should boost the region’s exports such as aircraft leasing—just check the “for sale” signs and make domestic producers in southern-tier countries on businesses that specialize in this area. more competitive. For a detailed discussion of Europe, see pages 19–20. Prices of many of these assets are drifting downward as banks are pressured to sell and potential buyers bargain The legacies of the financial crisis—low economic growth, hard. New players, in particular those seeking longer- declining tax revenues, deleveraging, rising unemployment, duration assets, are emerging and taking on board activities record-low bond yields and government transfers that previously the sole purview of banks. If successful, new prop up corporate profits—add up to a central role for markets and sources of return should arise. policy. Changes in policy = changes in asset returns.

Good and Bad Income Pain Trades } Income investing remains our strategy of choice in a } Our biggest contrarian idea is buying Japanese zero-rate world. exporters while selling the yen. } The hunt for yield has created pockets of overheating } Other pain trades include selling “safe” tobacco and narrowed valuations between top-quality and less stocks, buying US companies with cash piles abroad, desirable income assets. and buying securities of European and US financials. } We detail the state of play in fixed income, high yield, } We have warmed up to Indian equities after the emerging market debt, municipal bonds, dividends and country’s reforms on foreign investment. real estate investment trusts on pages 24–32. See page 22 for our contrarian picks. The Gift of Insurance Volatility Reversal? } Short-term implied volatility is eerily low whereas policy } The fire hose of monetary liquidity and investor uncertainties are near financial crisis levels. Consider hunger for yield has depressed short-term volatility, options to hedge downside and upside risks. so maybe a reversal will have the opposite effect.

POLICY & economics [7] US Cliff Notes The United States may turn the corner on growth—if } Staving off the cliff with a Band-Aid is not good enough. Washington can avoid falling off the fiscal cliff and negotiate What is needed—and what markets expect—is a plan a long-term budget reduction plan. The market consensus to put the nation on a sound long-term budget track. has been remarkably complacent. Consider: We hope politicians will rediscover the lost art of } The elections failed to give either party a clear mandate. compromise. Businesses and voters have sent strong Divided government remains, and a high risk of political signals to Washington to work together. If politicians dysfunction with it. So why would we expect Washington remain tone deaf, the fiscal cliff will turn into a fiscal to agree to a deal this time around? cloud overhanging markets in 2013.

} Higher payroll taxes and a cut in extended unemployment If the United States dives off the cliff, however briefly, we figures alone should shave 1% off growth in 2013 in an would expect a temporary sell-off in risk assets. Ditto in economy that is now putting along at a 2% stall speed. case of “game of chicken” negotiations to raise the statutory Economists have largely ignored this impact on growth. debt ceiling. Investors like certainty.

Woof, Woof: Our Pavlovian Responses to Policy Expected Global Policy and Possible Investments in 2013

2013 POLICY 2013 INVESTMENTS

Monetary Fiscal Regulation Equities Fixed Income Long Shot

Loose. The Cliff plunge or Tight, but the Large caps. Corporate Value equities foot may come glide, it will be tide is slowing Small caps if bonds, CMBS, and financials. off the accel- tight(er). a bit. growth perks CLOs and erator in the up but mon- illiquid invest- USA second half of etary policy ments. 2013. stays loose.

Stealth Loosening by Tightening. Peripheral Buy peripheral Financials. loosening with spreading exporters. bonds and sell ON E

Z OMT and other austerity pain lower-quality schemes. over time. core. E U R O

Loose with a Tight, but Tightening, Small caps. Gilts do not look Diversified focus on credit question marks the FSA shows attractive—but miners. creation. are rising. teeth. are under- UK pinned by a flight to safety .

May loosen May loosen Tight. Export stocks under new after (while selling AN central bank December yen). A P

J leadership. elections.

Moderately Moderately Relatively Cyclical stocks BBB corporate India equities. loosening in loosening. loose, but in North Asia. and local China through Plenty of fire tightening for currency

ASIA open market power (except property. sovereign operations. in India). bonds.

Moderately Loosening. Tightening Mexican banks Brazilian rates, tightening. (with plenty of and industrials. Mexican peso, bureaucracy). Brazilian BBB corporate AM consumption bonds.

L AT stocks.

Source: BlackRock, 2012.

[8] slow turn ahead? American Land of the Earnings Upgrades? Analyst Earnings Revisions, 2008–2012 Exceptionalism? 2 UPGRADES

1.5 US economic momentum may gain—if Washington can agree on a credible budget deal that will cut the deficit

TIO 1 and spur growth. This is a tall order, especially considering RA the presidential elections essentially preserved the status quo as discussed in Now for the Hard Part: Investing After 0.5 the US Elections in November 2012. DOWNGRADES The cliff-dependent US growth story, however, has many 0 compelling chapters: 2009 2010 2011 2012 } There is evidence banks are starting to lend as United States Europe Japan collateral values (housing prices) improve. Mortgage Sources: Thomson Reuters and MSCI, November 2012. Note: Ratio of companies with upward 12-month forward earnings estimates vs. lending is becoming a profit center as overall net downward (three-month moving averages). interest rate margins compress in the zero-rate world and banks cut trading activities. } } US housing appears on the mend, as detailed In the US manufacturing gauges generally have perked up a bit. Home Stretch? The US Housing Recovery in June 2012. Longer term, cheap oil and gas should drive development of energy-intensive industries, build out infrastructure, } Downward earnings revisions appear to have bottomed improve the current account balance and perhaps for US companies. See the chart above on the right. increase government revenues, as detailed in US Shale Boom: A Case of (Temporary) Indigestion in July 2012.

} If Washington defies expectations and reaches a Leader of the Deleveraging World budget deal that creates certainty on taxes, business Gross Private Debt-to-GDP Ratios, 1980–2012 confidence and investment could jump. 120% 100 2 The US economy should gain momentum 80 and help boost global growth—IF

amental Washington can avoid the “fiscal cliff” -GDP 60 d

un and compromise on a sustainable budget. T- TO 40 F DEB 20 } The United States is furthest along in the long and painful

0 process of consumer and bank deleveraging (it has yet to start on public deleveraging). See the chart on the left. -20 -8 -6 -4 -2 0 2 4 6 8 We generally like equities for 2013—but we are not YEARS FROM START OF CRISIS enamored. US companies, which sport the best metrics Spain UK Eurozone United States globally, enjoy fat profit margins. Corporate profits as a ■ Average Normal Range percentage of GDP hit a post-WWII record of 11% this year, Sources: Citigroup, US Federal Reserve, Eurostat, ONS, Bank for International Settlements and World Bank, September 2012. according to the Federal Reserve Bank of St. Louis. Notes: The zero baseline signifies a peak in private debt (2007 for Spain, 2008 for the United States and 2009 for the eurozone). Gross private debt includes total Entitlements and tax breaks have created demand for domestic credit to private sector and crossborder lending to the nonbank private products and services without burdening companies with sector by foreign banks. Average is computed using sample of 12 banking crises as defined in “Debt Reduction After Crises,” BIS, September 2010. Shaded area increased output costs. Margins rise and corporate cash corresponds to historic average plus or minus one standard deviation. piles up (as does government debt). This benefit reverses once fiscal tightening sets in.

POLICY & economics [9] Economics LOOKING HARD FOR GREENSHOOTS There are points of light. The Fed’s three rounds of quantitative easing and other measures since 2008 of Easing amount to a “reliquification” plan for credit collateral markets. It is slow going but starting to yield some results in credit creation. “We see money accumulating at the centers, with difficulty The UK could be next. In the program to boost lending, of finding safe investment for it; interest rates dropping banks swap lower-rated collateral for gilts on condition down lower than ever before; money available in great these funds are lent out. The initial tranche of £80 billion is plenty for things that are obviously safe, but not available smallish compared with £375 billion of quantitative easing. at all for things that are in fact safe, and which under We suspect there is more to come, however, provided the normal conditions would be entirely safe … but which are original funds are drawn down. Look (very) hard at UK private now viewed with suspicion by lenders.” credit extension and you can see faint signs of recovery. Citation from a 1931 Harvard Business Review article in Essays on the Great Depression (2000) by Ben Bernanke. Ineffective money multipliers have kept a lid on inflation. Credit demand is subdued and high unemployment keeps Central banks around the globe have embarked on asset- wage expectations low. This is the picture pretty much buying sprees to resuscitate economic growth. When everywhere today, and the reason why we rate inflation referring to their monetary boosters, central bankers have as a low risk for now. been using terms such as “open-ended” and “unlimited”— something akin to swearing in a house of worship. This also has bolstered the belief that low nominal and negative real rates are here to stay. We will question this The unprecedented monetary easing has bloated central “low for long” trade on pages 16–18. bank balance sheets and brought interest rates to zero. Equity markets sprinted forward on a sugar high and now Collateral Damage need real economic growth to extend the rally. Credit markets Credit creation has been impeded by the need to fix the became intoxicated as zero rates intensified the global hunt broken balance sheets of financial institutions. Financial for yield—and may be in for a prolonged hangover. crises tend to render impotent traditional remedies to spur Trillions of dollars in monetary stimulus and record-low economic growth (such as lowering interest rates). interest rates have failed to spur much credit growth and Monetary policy becomes half as effective after a financial economic activity. Money multipliers across the world are crisis, according to Monetary policy in a downturn: Are essentially kaput. See the chart below. financial crises special? by the Bank for International Settlements in September 2012. See charts on the next page.

When Stimulus Falls Flat Credit ultimately is dependent on collateral, and investors Trends in Money Multipliers, 1999–2012 have become very picky about collateral since the financial crisis. They are hoarding safe-haven assets such as US, 12 Japanese, German and UK bonds and avoiding the rest. This is causing the credit transmission system to gum up. 10 We worry about the law of unintended consequences. In a 8 macabre version of Gresham’s Law (bad money drives out TIPLIER good), “good” collateral is hoarded for liability hedging or MUL 6 backing for centrally cleared derivatives.

MONEY Regulators—albeit unwittingly—contribute to hoarding 4 of safe-haven assets by requiring banks to raise capital standards (shorthand for “buy bonds”) and reduce risk (ditto). 2 2000 2002 2004 2006 2008 2010 2012 The long-term implications are clear. Capital forced toward Eurozone Japan US low return = capital unavailable for more profitable Sources: Thomson Reuters, Federal Reserve, ECB and BoJ, November 2012. investment. Japan has had plenty of time to find this out. Notes: Money multipliers calculated as broad money divided by money base. M2 is used for the United States and Japan, M3 for the eurozone.

[10] slow turn ahead? What’s Worse Than a Crisis? A Financial Crisis Interest Rates and GDP Growth After Downturns, 1960–2012 Without Financial Crisis With Financial Crisis 2% Italy 1974 Iceland 1987

1.5 Austria 1977 South Korea 1997 1 United States 1973 United States UK 2007 0.5 1979 UK 1973 0 GROWTH

GDP -0.5 United States 2007 -1 Sweden 1990 UK 1979 -1.5 -8 -6 -4 -2 024-8 -6 -4 -2 024 REAL SHORT-TERM INTEREST RATES REAL SHORT-TERM INTEREST RATES Source: Bank for International Settlements, September 2012. Notes: Each chart shows the impact of average real short-term interest rates on the average output growth over each economic cycle. Data based on a sample of 24 developed countries. Downturns are defined as one or more years with negative GDP growth. in short supply Debt issuance is at record levels, but much consists of Debt Paradox refinancings. Overall supply next year in the US market Net Supply of US Fixed Income, 2000–2013 will be the lowest since 2009, Credit Suisse estimates. $2,400 See the chart on the right.

This is an under-appreciated force in markets and has 1,800 kept a lid on yield rises. Among the reasons: } Much of the record debt issuance is simply refinancing at lower rates. This has, for example, created net 1,200 negative supply in markets such as the $3.7 trillion US LIONS municipal bond market. 600

} Global banks are still busy cleaning up their balance Y IN BIL sheets, “encouraged” by impending rules on tighter capital 0 standards. The top players of the past are missing in action. SUPPL

} c entral banks are buying up government bonds and NET related securities under their various quantitative -600 easing programs. For example, were the Fed to keep up

its purchases of mortgage-backed securities next year, -1,200 it would soak up 60%–70% of gross supply and more than the entire available net supply, we estimate. This means the mortgage market would shrink considerably -1,800

(excluding Fed holdings). 2000 2002 2004 2006 2008 2010 2013 } Dealers have reduced holdings of corporate bonds by ABS ■ BAB ■ Agency MBS ■ Agency ■ Financial Corporates ■ Non-Financial Corporates ■ 75% since the 2007 peak, according to the Federal Treasury ■ Total Fixed Income Supply Reserve Bank of New York. This may reduce their risk, Source: Credit Suisse, October 2012. but it also constrains liquidity. Notes: All figures are net of US Federal Reserve or Treasury purchases. 2012 and 2013 are estimates.

POLICY & economics [11] Many insurers like to diversify their asset allocation, but A Zero-Rate uncertainty over new solvency rules was keeping them wedded to the lowest-risk assets, according to a 2012 World survey of European insurers co-sponsored by BlackRock. This is still the case as we exit the year with the European Solvency II insurance regulation stalled.

Many government bonds now return negative interest after So much demand and so little supply: Zero rates may factoring in inflation, and some short-term instruments trigger a structural shift toward more risk taking—which even carry negative nominal yields. bodes well for equities, selected fixed income markets and alternative investments. This race to the bottom intensified after the CE B cut its deposit rate (the interest banks receive for storing their funds with the ECB overnight) to zero in July. The Mountains of Debt ensuing drops in short-term rates present investors Alas, we are not in this Nirvana yet. There is a lot more with new challenges. wood to chop when it comes to deleveraging. Developed countries are awash in debt, and ballooning government Investors may dislike paying to park their cash, but should debt is only part of the story. You have to look at all the realize that protecting wealth has cost money for much of debt in the ecosystem. It is not a pretty picture. See the history. Think of medieval lords building fortresses and chart below. hiring knights to secure their fortunes. Modern-day cash investors have three choices: This means we are likely in for a prolonged period of sub- par economic growth, according to academics Carmen } Medieval Choice Reinhart, Vincent Reinhart and Kenneth Rogoff in Debt Pay up (not a viable long-term strategy for most). Overhangs: Past and Present. They identified 26 separate } Duration Choice periods in which debt exceeded 90% of GDP for at least five Invest in longer-term securities (duration risk). years in 14 advanced economies. These “debt overhangs” } Risky Choice lasted an average of 23 years and cut annual GDP growth Invest in securities outside the AAA realm (credit risk). by 1.2 percentage points.

Whichever is your poison, zero rates should eventually increase risk appetite. Investing at zero only makes sense Debt, Debt Everywhere when risks are high. Two caveats: Gross Debt Loads in Selected Countries, 2012

} Increased risk taking will likely happen at a glacial pace. PERCENT OF GDP No one expects the cash mountain to magically morph Ireland 1,230 into an equity-buying wave. Japan 646 UK 536 } It should coincide with a rehabilitation of discredited Spain 479 (and discounted) collateral. Belgium 463 France 463 For now, income and cash flows are kings in a world that Eurozone 448 is slowly deflating. Investor hunger for yield comes as Portugal 440 overall fixed income supply is falling, providing a powerful Italy 396 United States 370 driver for spread products (credit trading at a premium to Greece 353 benchmark government bonds). Germany 302 Canada Pension funds and insurers buy and hold “safe” bonds to 292 ■ ■ hedge liabilities and fulfill regulatory requirements. The Government Households Non-Financial Companies ■ Financial Institutions ■ raft of banking regulations discussed earlier is partly Source: Credit Suisse, October 2012. fueling bank demand for low-risk assets.

[12] slow turn ahead? Emerging economies are in much better (debt) shape than the developed world. See the chart below. This bodes well Delving into Deleveraging for economic growth and asset prices. Emerging market 1. Deleveraging = less spending. This raises the specter of equities have underperformed US and European stocks deflation, even more so if governments are tapped out. since hitting a trough in early 2009. This will likely change, especially if we usher in the Age of Separatism. 2. Less spending = less government revenues = bigger budget shortfalls. Once asset prices begin to clear, investment returns can be spectacular given their depressed starting values. 3. Bank deleveraging after a financial crisis mutes the Think the aftermath of the 1997–1998 Asia crisis—or US economic recovery. homebuilders more recently. 4. When private sector debt falls, government debt In general, we are more optimistic about the world’s typically rises because of fiscal stimulus. It happened economic backdrop than we were a year ago. But are we in Japan, and it is happening in the United States. optimistic for the right reasons? 5. This is tougher in Europe: Declining creditworthiness Markets have behaved after this summer’s hiccups, so our + high debt loads + large deficits = fiscal tightening judgment may be a bit clouded. Call it tyranny of the present in many countries. or wishful thinking; it is something investors need to discount. 6. Normally, domestic deleveraging results in an Also remember it is possible to be great at forecasting improved trade balance. It does not work so well when economic trends—and still lose your shirt in the market. most of the developed world is playing this game. There is a growing disconnect between economics and 7. People hoard cash in a deleveraging world to meet markets since the financial crisis. Among the reasons: long-term needs. This is why it is worth watching net } The unprecedented monetary easing and other policy debt levels. actions have created an artificial market environment. 8. Not everyone has to deleverage. Those who do have } A profound risk aversion by businesses, pension funds an outsized impact on asset returns. Think Greece. and individual investors after being scarred by investment losses and funding problems in the crisis.

Debt Divergence Debt-to-GDP in Developed and Emerging Markets, 1900–2011

1980s DEBT CRISIS 2008-2009 (defaults, FINANCIAL CRISIS WWII restructurings, (restructurings (defaults, financial financial and financial WWI AND GREAT repression and repression, repression) 100% DEPRESSION inflation) inflation and (defaults, several restructurings hyperinflations) and a few 80 hyperinflations)

O-GDP 60 T-T Developed Markets

DEB 40

Emerging Markets 20 GREAT DEPRESSION 0 1900 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011 Source: Reinhart and Rogoff. Notes: Debt-to-GDP ratios are based on gross debt loads.

POLICY & economics [13] We probably should use them all, from short-term In Search momentum trades to Graham and Dodd value investing. of Fast Rivers Many investors lack conviction in markets 3 where risk taking is often punished and

amental trends last a skinny minute. Rome—and

Oh, to be back in 2002: Markets behaved the way we d

knew them to for most of our lives. Risk was rewarded, un confidence—was not built in a day. F diversification was real and trends were long-running.

After 2007, it became clear you do not always get paid How do money managers outperform? for taking risk, most markets are highly correlated and The answer is not necessarily by canoeing harder than trends last a skinny minute. See the charts below. others, but finding a fast river. Unfortunately, many fast Increased correlations, more concentrated risks and rivers of the past—mega trends such as the 30-year bond speedy rotations will quash most risk appetites. Another bull market that could carry long-term investors to blissful downer: The perception that policymakers have “fixed” retirement—have turned to silt. many asset prices through diktat and distorted the Most asset classes look reasonably valued compared workings of capital markets. with their history. The big exceptions are safe-haven Cautious allocations are easy to understand with so much government bonds. See the chart at the bottom of the uncertainty and noise—but still hard to justify in terms of next page. The question is how valid these historical (likely low) future investment returns. comparisons are in the new, post-crisis world of investing. It also makes investing with conviction difficult. We are divided as to which investment strategies are best. The real story: Stocks are not cheap; bonds are expensive.

Risk Without Reward Click for Market Returns and Correlations, 2002–2006 vs. 2008–2012 Interactive Charts

PRE-CRISIS (2002 TO 2006) POST-CRISIS (2008 TO 2012) ORE + M RETURN FOR RISK – LESS

– LESS ASSET CORRELATION MORE + – LESS ASSET CORRELATION MORE +

Source: BlackRock, November 2012. Notes: Return for risk is based on recent rewards to 13 asset classes versus their risk. Asset correlation denotes market-wide correlations between asset classes. The white line is a timeline of market movement in each period. Assets were less correlated and returned more for risk before the financial crisis (left chart) than after (right chart).

[14] slow turn ahead? flash floods Investors often say they want to take on more risk, put Safety First—in Equities their cash to work and sell their low-yielding bonds. But Return and Volatility for Bonds and Equities, 2008–2012 global fund flows do not show increased risk appetite as 6 Riskier Assets Perform Better we will see on page 18. Why do investors talk the talk, yet 4 fail to walk the walk?

The main reason: Many fast rivers have turned into flash 2 floods, destroying everything in their path. If you happen

OPE 0

to catch one, your ride will not last long. And if you are in SL the way, you are toast. Few people are up for the gamble, -2 so it is rational to wait for clear signals of a market turn. -4 In addition, risk has been rewarded more clearly in fixed income than in equities over the past five years. More Riskier Assets Perform Worse -6 volatile securities such as high yield outperformed within 2008 2009 2010 2011 2012 the fixed income asset class. See the chart on the right. Fixed Income Equities One reason for the disparity is that investors have focused Sources: BlackRock, Thomson Reuters and Bloomberg, November 2012. Notes: Slope of a linear regression between return and volatility of selected fixed on income-producing assets with clear cash flows. income and equity indices. A positive number indicates more volatile assets seeing Dividend stocks (a less volatile part of the equities market) higher returns and vice versa. have done well, as have higher-yielding (but riskier) bonds.

Past History…May Be History Valuations of Asset Classes vs. Historic Norm 100%

EXPENSIVE 80

60

AVERAGE 40 PERCENTILE RANKING

20

CHEAP

0 d Yiel opean opean UK Gilts easuries Equities Equities Emerging Eur Tr US Equities UK Equities US Inflation UK Inflation US High Expectations Expectations US Asian Equities German Bunds LatAm Equities Market Debt ($) Eastern Eur UK Corporate Credit Sources: BlackRock, Thomson Reuters and Bloomberg, November 2012. Notes: Time periods range from 7 to 30 years. US Treasuries, UK gilts and German bunds represent the real yield. Equity valuations based on average of dividend yield, book values and price earnings ratios. Inflation expectations are 10-year inflation break-even rates or the difference between the yield on Treasuries/gilts and TIPS/linkers.

policy & MARKETS [15] At today’s level of intervention, even a slight change Caution: of tack would have a material effect on markets.

One phenomenon that plays into this: Central bank Turn Ahead staffers around the world have been brought up with the inflation devil. At the slightest sign of an uptick in prices or economic momentum, expect staff economists Suppose you believe the US growth story has the potential to knock on their governors’ doors and say: “We have to become a bestseller. Then the sequel (or companion been so extreme in easing, we need to pull back.” piece) has to be a page turner that relates how the Fed This ties in with low levels of inflation around the world. could be the first major central bank to throttle back from Imagine if the US economy had reacted to monetary ultra-loose monetary policies. stimulus the way it used to. See the chart below. QE3, also known as “QE Infinity” due to its open-ended nature, has put a lot of foam on the runway. Residential The era of ultra-loose monetary policy mortgage securities, in particular, took off (they have 4 since come down to earth a bit). may draw to a close, challenging “safe”

amental fixed income assets and heralding a shift The Fed has led other central banks in unleashing d

un toward equities. Safety = new tail risk.

unprecedented monetary stimuli to jump-start growth. Its F actions have stunned even veteran Fed watchers in their boldness and speed. “Learning by doing” is the new mantra. The odds may say a clear shift in monetary policy is unlikely to happen next year…but we need to be ready. Once the fiscal cloud is lifted and business investment What form would a Fed reversal take? It could no longer returns, the bank may want to clean up a bit. We would not re-invest coupons on bond holdings. expect the Fed to wallop markets with a sudden tightening. What could happen is the Fed’s taking its foot off the Even the plan to formally tie monetary policy to desired monetary accelerator earlier than investors expect— employment and inflation rates may cause a reversal— perhaps by the end of 2013. A string of 200,000-plus or at least volatility. The Fed seems to now target specific nonfarm payrolls (monthly new jobs) would help. thresholds, which are much harder to assess than a calendar date. The Fed appears increasingly prepared to risk sacrificing its inflation-fighting brief on the altar of Inflation Nightmare improved employment. US Money Supply and Inflation, 1980–2012 The Fed’s commitment to ease in a slowly growing economy— $20,000 850 while explicitly targeting employment levels and, therefore, 17,500 750 spending—is an invitation to inflate asset values (provided 15,000 650 fiscal belt tightening does not hurt too much).

12,500 550 Currencies Light the Way 10,000 450 LIONS US dollar strength could herald a policy change, and BIL 7,500 350 CPI INDEX also keep a lid on inflation. Foreign exchange is the dog 5,000 250 that has not barked (too loudly) in the aftermath of the financial crisis. 2,500 150

0 50 Carry trades do not work so well in the zero-rate world, 1980 1992 2002 2012 where investor and trade flows are more powerful drivers.

US Money Supply US Monetary Base The prospect of US energy self-sufficiency, for example, US Consumer Price Index could underpin a bullish dollar stance—and a cautious Projections if Relationship with Monetary Base Were Near Historic Averages view toward countries dependent on dollar funding such Sources: BlackRock and Haver Analytics, October 2012. as Indonesia, Malaysia, Hong Kong and, to some extent, Notes: Dotted lines show estimated path of CPI and broad money supply from the China. It could prove disruptive to winning trades of start of the crisis if the relationship between M2 and the monetary base had been close to the historic average of eight times rather than the current four. the previous era of dollar weakness. Think gold.

[16] slow turn ahead? Losing Combination? Yields and Duration of US Fixed Income, 2006–2012

Yield Duration (Years) 2006 2012 Change 2006 2012 Change

Total 5.34% 1.7% -3.6% 4.46 5.02 0.6

Treasury 4.79% 0.87% -3.9% 4.95 5.52 0.6

Government-related 5.13% 1.47% -3.7% 3.98 5.12 1.1

Agency 5.11% 1.01% -4.1% 3.55 3.87 0.3

Local Authority 5.30% 3.19% -2.1% 7.7 8 9.72 1.9

Sovereign 5.36% 2.72% -2.6% 5.83 8.19 2.4

Supranational 5.02% 0.74% -4.3% 4.29 3.48 -0.8

Corporate 5.66% 2.66% -3% 6.05 7.25 1.2

Industrial 5.81% 2.63% -3.2% 6.64 7.7 4 1.1

Utility 5.79% 2.97% -2.8% 7.1 2 9.17 2.1

Financials 5.47% 2.61% -2.9% 5.16 5.72 0.6

Securitized 5.59% 2.06% -3.5% 3.6 2.93 -0.7

MBS 5.63% 2.08% -3.5% 3.46 2.92 -0.5

ABS 5.32% 0.93% -4.4% 2.77 3.21 0.4

CMBS 5.36% 1.83% -3.5% 4.83 3.17 -1.7

Source: Barclays Capital. Note: Data as of year-end 2006 and end of October 2012.

A strong dollar would be a boon for most of the world. “low for long” no more? Europe’s export machine would become more competitive. With rates this low, it takes only a miniscule rise in yield Most emerging markets would benefit because of increased to trigger a bond price decline that wipes out a year’s worth exports, but those reliant on dollar funding would suffer. of yield. If and when this happens, many investors who are Dollar-denominated commodities would stay flat or weaken fixed income novices are in for a rude awakening. a bit, lessening the risk of inflation. China would likely keep its currency pegged to the dollar, helping boost its Sure, we have seen this movie before. US and other fixed transformation to a consumption society. income markets did not look particularly attractive at the start of 2012. Nominal yields were low and duration was A strong dollar would be a form of global tightening. US high. Yet returns were positive in all sectors—and beat current account deficits could shrink as its energy output other asset classes. grows and China stimulates domestic spending at the expense of its export machine. Take away the China trade Things do change—and markets anticipate these and oil imports, and the United States runs a trade surplus. changes faster than economists (and most investors). This makes for our top contrarian trend of 2013: a Is this a global central banker’s pipe dream? Probably. pick-up in US inflation concerns as housing starts But dreams have a way of becoming reality in markets recover and employment rises. where perceptions or sentiment often matter more than economics. Markets may pre-empt the Fed, and trigger a It is not a high-conviction view—at least not for now— stampede (out of fixed income) for the exits (to equities). and requires Washington to navigate the fiscal cliff and (much tougher) make progress on budget reform. Market Safe-haven fixed income assets look very, very dangerous. positioning around the “low for long” idea is extreme, With record-low yields, an uptick in inflation eats up an however, and markets tend to upset the consensus. Just investor’s meager income. At the same time, duration has look at where investors have been putting their money. risen. This is a bad combination. See the table above. See the charts on the next page.

policy & MARKETS [17] Dash for Trash Asset-backed investments struggle in a world where Bonding with Bonds credit and money multipliers decline. Deleveraging Global Flows into Actively Managed Funds, 2010–2012 does not help markets clear inventories (think real $300 estate). Cash flows are king, as is ranking in the capital structure in case things go pear shaped. 200

By contrast, asset values can climb in places without S 100 deleveraging or in instances where monetary easing OW translates into accelerating economic growth. FL

NET 0 A Fed reversal could unleash a sea change in investor attitudes toward riskier assets, particularly equities. -100 Quality companies and dividend stocks would likely underperform highly leveraged growth stocks, as the -200 massive influx would result in a temporary “dash for trash.” Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 2010 2011 2012 The benefits of a modest rise in inflation expectations Bond ■ Equity ■ Money Market ■ would more than offset likely higher financing costs for Balanced ■ Other ■ most companies. The change would go hand in hand with Source: Investment Company Institute, October 2012. increasing credit multipliers (exception: a spike in energy Note: Flows are new fund sales plus reinvested dividends less redemptions. Data are quarterly. prices due to a Middle East conflict). If this were to happen, companies would start notching up revenue growth again (remember that?). This would assuage Huge budget deficits cause pressure to keep rates low— concerns that profit margins have peaked. otherwise interest payments would spin out of control. This is when the yield on “risk-free” US Treasuries, German A bond sell-off, though logical at these yield levels, is bunds and other safe-haven assets could shoot up and unlikely for now given demand for yield. More likely is a send bond prices back to earth. What has stopped this period of disappointing returns and bolder managers from happening so far? taking more concentrated risk—with consequential risks.

Incoming Income Global Investor Flows Into Exchange Traded Products, 2010–2012

EQUITY DIVIDEND FIXED INCOME $3.5 $12

3 10

2.5 8 S S 2 6 OW OW

1.5 FL 4 FL NET NET 1 2

0.5 0

0 -2

-0.5 -4 2010 2011 2012 2010 2011 2012 Developed Market Dividend ■ Emerging Market Dividend ■ Mortgage ■ High Yield ■ Municipal ■ Money Market ■ Inflation ■ Emerging Market ■ Investment Grade ■ Government ■ Government/Corporates ■ Broad/Aggregate ■ Source: BlackRock. Notes: Monthly net new assets. Dividend funds are 140 equity ETPs listed globally with dividend or income exposures. Data for left chart are from June 30, 2010 to Oct. 31, 2012. Data for right chart are from May 1, 2010 to Sept. 1, 2012.

[18] slow turn ahead? The Other game changer Delighting those who pushed for more aggressive ECB policy, Draghi has finally unveiled his “big bazooka,” the European Story pledge to buy sovereign bonds of up to three years duration.

The OMT program is a game changer. It has limited the risk of a disorderly eurozone breakup, and has already The ECB is unlikely to deliver much inflation—it is just pressured downward short-term yields in countries not in its DNA. Draghi has already pushed the envelope such as Spain and Italy. with easing measures that have gained the approval of Europe’s political leaders and (most) ECB governors. Draghi’s backstop comes with strings attached: adherence to a plan to put government finances in order. The feared We expect Draghi to make good on his promise to do loss of sovereignty has held back Spain and others from “whatever it takes” to save the euro. This could include requesting help and has kept markets on tenterhooks. The bringing down the discount rate to zero and pushing so-called conditionality is not a halfway house. the bank rate into negative territory. Call it easing through (attempted) depreciation. Even so, we like Italian debt in the long run and Spanish bonds in the short term. Consider: Bringing down the euro is not easy. Dollar swap lines have largely eliminated external funding risk. Plus, the eurozone } Spain’s bank stress test was credible, in our view. In is likely to run a current account surplus in 2013. This other countries, including the United States, a realistic implies little or no export of capital unless its citizens lose assessment of the financial sector’s capital needs confidence in the euro. Even a “Grexit”—Greece leaving the has often proved a critical turning point for investor monetary union—may not help. We would expect hoarding confidence—and asset prices. of euros in Greece and nations at risk of contagion. } Spain has implemented much of the structural reform to get its economy growing again. It has also shown it The end game is a mix between debt write-offs, inflation is willing to engage with the IMF and others. Separatism and (phased-in) austerity. The Troika has shifted to may be a real challenge to keeping to conditions set by extending deadlines for austerity. This spreads out the foreign pay masters in the long run. This is partly why pain and limits the risk of a deeper recession. It is needed we focus on short-term opportunities in Spanish bonds. in a weak economy. See the map below.

gloomy forecasts Click for 2013 Consensus GDP Growth Expectations Interactive Map

China 8.1%

US 1.9%

Japan 0.8%

Eurozone 0%

1% ■ More than 3% 1.3% 0.8% ■ 2 to 3%

■ 1 to 2% 0.2% ■ 0 to 1% -0.7% ■ 0 to -1% ■ -1 to -2% ■ -2 to -3% -1.6% -2.1 % ■ -3% and below Source: Thomson Reuters, Consensus Economics, November 2012. -3.8% Notes: Average economist forecasts for real GDP growth in 2013.

policy & MARKETS [19] Europe’s economic prospects are challenged, so rates are Enough Already! likely to stay near zero. Greece and Spain have started to Primary Balances for Selected Countries, 2006–2020 cut government spending and free up labor markets. Their 6% economies are contracting, however. They essentially are Surplus improving margins on lower volumes. 4 Needed to Stabilize OMT is not an economic growth remedy: No insurance policy

GDP Debt 2

TO ever is. Capital outflows from peripheral countries and 0 deleveraging are severe restrictions on growth. Do not be deceived by big jumps in net exports. These often result -2 Y BALANCE from a collapse in domestic demand and imports. And -4 they do not yield higher government revenues. There has

PRIMAR to be a revival of domestic demand, spurred by exporters -6 and export-oriented investments, to make real progress.

-8 The eurozone’s leadership to bring this about does not appear 2006 2008 2010 2012 2014 2016 2018 2020 to exist. Leadership of 17 independent European nations Italy Germany Spain United States does. The continent’s leaders excel at procrastination, Source: IMF Fiscal Monitor, October 2012. Notes: These are cyclically adjusted primary balances or overall balances adjusted late-night summits and sweeping statements. Hastily put- for cyclical effects and excluding net interest payments. The surplus needed is the together communiques have often lacked follow-through. IMF estimate of the primary balance needed in 2020 to return debt-to-GDP to 2011 levels by 2030. The harsh reality: Most policymakers will only act when markets force their hands. Their threshold for market pain, however, is much higher than the average investor’s. The } We could end up with—and find peace with—a perpetual pattern of the European debt crisis has been euphoria— tango dance: Spain or another country draws toward followed by crisis. accepting OMT help when borrowing costs spiral upward, only to pull back when yields recede. Policymakers have been effective at avoiding Armageddon, but less adept at promoting an economic recovery. This has } Italy has not gone as far as Spain in structural reforms led to cheap valuations of European companies. This makes and faces an uncertain election. Its great private wealth, them attractive, especially ones that derive much of their however, makes this a compelling long-term bet. And revenues from overseas. Another booster for European risk its primary budget surplus already is at a level that will assets: The continent’s woes are well known, so a little stabilize its debt—whereas Spain and the United States progress goes a long way in changing investor sentiment. have a long way to go. See the chart above.

NEW FEAR INDEX Nix the VIX Europe’s peripheral bond spreads have become the European Peripheral Bond Spreads and Equities, 2011–2012 new “fear index,” or key indicators for risk appetite. See 700

the chart on the right. Further bond spread declines S 600 in 2013 would likely reduce risk premiums and fuel equity markets. 500 Peripheral Bonds 400 A Grexit is still a possibility—although it probably would BASIS POINT require a Greek decision to call it quits. Investors, companies 300 and policymakers have had time to get reasonably used 100 to the idea. The actuality, however, would likely spark 95 Eurozone Stocks short-term worries about a domino effect. 90

Further debt write-downs are all but certain in Greece INDEX 85 and other countries drowning in debt. Cyprus has been 80 a hot spot, and banks in Ireland are still loaded down 75 2011 2012 with debt. This is likely a long process of cuts, one salami Sources: Thomson Reuters and MSCI, November 2012. slice at a time. Notes: Top chart shows the average spread of Irish, Italian, Portuguese and Spanish bonds over German bunds. Bottom chart shows performance of MSCI EMU index relative to MSCI.

[20] slow turn ahead? Bull in the Asia’s Miracle Gets Real (Again) Asian Equities and Earnings Revisions, 1997–2012 China Shop 20% 80% 15 60

10 40 Will the dragon fly or crash-land? This has been a big 5 20 question for many investors. Our answer: China’s economy will fly—albeit at lower altitudes. 0 0 RETURN

The downdraft in the country’s economic growth rate -5 -20 YOY

looks to have reached an inflection point. Recent data EARNINGS REVISIONS -10 -40 are pointing to an uptick in exports, credit growth, and -15 -60 rising industrial output and profits. See the chart below. -20 -80 This is encouraging for China, Asia…and the world. 1997 2000 2002 2004 2006 2008 2010 2012 China Inc.’s margin squeeze and inventory build-up was Earnings Momentum Total Return (Right Axis) acute in early 2012. This now seems to be abating. The Source: Thomson Reuters, November 2012. economic cycle appears to be turning across Asia-ex Notes: Earnings momentum is total analyst upgrades minus downgrades as a percentage of the total number of estimates. All data for Asia ex-Japan. Japan. Consider: } Monetary conditions are loosening across the region, according to BNP’s Financial and Monetary Conditions China faces big long-term challenges, as discussed in Index. If this persists, we would expect an uptick in Braking China … Without Breaking the World in April 2012. industrial production. Improving economic growth has These include shifting to a consumption society from an historically driven strong equity returns in Asia. investment-driven command economy; fixing an inefficient } c orporate earnings revisions are edging up. See the financial system; managing stubbornly high real estate chart above on the right. We could see them turn prices; staying competitive amid rapid growth in workers’ positive in the first quarter for the first time in two age, pay and expectations; cleaning up the environment; years. Combined with low valuations and low and addressing corruption to avoid social unrest. expectations, this could bode well for Asian equities. Two long-term trends bolster the case for metals and agricultural commodities: } The growth rate of Chinese commodities demand may Yao Ming Rebound? slow, but absolute consumption is set to double this China’s Industrial Profit Growth and PMI, 2010–2012 decade, as detailed in Mind Your Mine! in November 120% 60 2012. This is enough to keep supply/demand dynamics tight, and bodes well for producers of metals with S 90 57.5 looming long-term supply gaps, such as copper. } china cannot feed itself. This structural trend keeps world 60 55

TIVE PROFIT demand for foodstuff trade high, underpinning global

Profit Growth farmland prices, agricultural crops and equipment 30 52.5 makers. One caution: Changing weather patterns make

PMI LEVEL this a volatile growth trade. Think rocketing grain prices 0 50 after the US Midwest drought in 2012.

CHANGE IN CUMULA The impact of China’s recent leadership change is discussed -30 47.5 YOY Manufacturing in The Next Generation: What to Expect From China’s New Activity (PMI) Leadership by BlackRock’s Asia team in November 2012. -60 45 2010 2011 2012 Change will come slowly but surely. The new leadership Sources: China National Bureau of Statistics and HSBC. is in place for a decade—and does not need to worry Notes: Profit growth reflects the year-on-year change in the cumulative year-to-date profit level. A PMI level above 50 indicates expansion of activity. about re-election.

policy & MARKETS [21] Contrarian This investment idea has three main assumptions: } The US dollar rises against the yen and other currencies because of progress on budget deficit reduction and Dreaming growth powered by housing and/or consumption. } A quick exit. Japanese stocks have not paid off in the long run. The Nikkei index is down 75% since peaking We like contrarian thinking—if only to guard against “pain in 1989—but has seen stunning rallies in between. trades”—trades that go against the grain and could catch } The territorial dispute with China over several most investors off guard. uninhabited islands does not blow up. We already detailed the mother of all pain trades—a Fed Other pain trades include: reversal and subsequent bond exodus—on pages 16–18. Buy Indian Equities Our No. 1 contrarian pick for early 2013? } The latest reforms to open up the country to investment Buy Japanese Equities may be the real thing—at a time when many investors This was by far the most popular contrarian investment are skeptical. Our other reasons include: India’s idea at our 2013 Outlook Forum (which makes you wonder entrepreneurship and need for infrastructure just how contrarian it is). investments. A weaker or stable oil price is essential to this idea, given India’s dependence on imported energy. Investor positioning is heavily weighted against Japan, with many fund managers underweighting the country. } A recent government initiative to transfer subsidies and See the chart below. This sets the stage for a nice “pop.” other entitlements directly into people’s bank accounts is a positive for growth. It could result in efficiency gains The idea would be to buy exporters and simultaneously as the program to provide each Indian with a unique ID sell yen to hedge the currency risk. Our reasoning: number expands. } Japanese equity valuations are very, very cheap, both Buy US Stocks With Overseas Cash Piles against their own history and relative to other markets. These companies could repatriate cash if a larger budget } Japan could start monetary easing in earnest under deal includes a corporate tax amnesty or holiday. new political and central bank leadership. Buy European Peripheral Assets } This could be the year Japanese government bonds Talk about investor sentiment. Can you say “bearish?” finally crumble. Sell Global Tobacco Stocks } The growth slowdown in China, Japan’s main trading This crowded defensive sector could get hit if Australia’s partner, has bottomed. branding ban gains traction elsewhere.

Unloved, Underowned…with Upside Global Investor Positioning, November 2012

Real Estate US Equities Pharma EM Equities Global Equities Technology Bonds BEARISH BULLISH Banks SENTIMENT SENTIMENT Eurozone Equities Commodities Resource Equities Japan Equities

-1.5 -1 -0.5 00.5 1 POSITIONING RELATIVE TO HISTORY (Z-SCORE) Source: Bank of America Merrill Lynch Global Fund Manager Survey, November 2012.

[22] slow turn ahead? Known Spreading Sectarian CONFLICT Conflicts in the Middle East have been the focus of global foreign policy for much of the new millennium. They have Unknowns the potential to cause an oil price spike, or “energy shock.” Iran’s nuclear program still ranks as a top risk, but the re-election of President Barack Obama appears to have Short-term market volatility has been eerily low compared turned the odds in favor of a diplomatic solution. with political uncertainty that is at levels hit during the A potentially more explosive risk is a spreading of Syria’s depths of the financial crisis in 2008. See the charts below. Sunni-Shi’ite conflict to Iraq and elsewhere. Population The low volatility has caused many a furrowed brow growth has far outpaced economic growth in the Middle among seasoned investors. The answer may be easy East and North Africa, making this region a powder keg monetary policy and liquidity. If financial markets are for years to come. This is no demographic dividend; it is underwritten (albeit precariously) by central banks and a demographic detriment—unless countries manage to governments, there is no need for asset prices to reflect spur real economic growth. any worries. Ample liquidity, limp money multipliers and low asset price volatility appear linked. From Fishing Boats to War Ships Another risk is China’s territorial dispute with Japan and Short-dated implied volatility in equities has been depressed other nations over uninhabited but resource-rich islands in part by increased call writing—a symptom of the hunt in the East and South China Seas. This is part of the story for yield. Longer-term volatility, which is less influenced by of China’s ascendency and securing of resources. The risk liquidity and call writing, has remained elevated. Investors is the fishing boat skirmishes could turn into something have priced the potential for extreme downside risks higher far more serious. than the potential for extreme upside—which seems sensible. Similar dynamics exist in other asset markets. China has allowed nationalist demonstrations that play to anti-Japanese sentiment. Now that the genie is out The bottom line: Focus on longer-term volatility and term of the bottle, it may be difficult to put it back. Similarly, structure. Short-term volatility trades get burnt up quickly Japanese nationalist politicians may misplay their hand. by time value erosion, but can be cheap insurance against US influence in the region has waned, but it appears major market moves. Indeed, what could jolt these Obama may make another push. seemingly placid markets?

It’s Too Quiet Policy Uncertainty and Market Volatility, 1997–2012

US DEBT CEILING DISPUTE 250 60% 600

200 SECOND GULF WAR LEVEL

40 400 S

150 INDEX INDEX TILITY

AINTY 100 BASIS POINT OLA 20 200 EUROZONE V DEBT CRISIS

UNCERT 50 SEPT. 11 LEHMAN COLLAPSE ATTACKS 0 0 0 1997 2000 2003 2006 2009 2012 1997 2000 2003 2006 2009 2012

United States Europe Equities Currencies Bonds (Right Axis) Sources: www.policyuncertainty.com, Thomson Reuters and Bloomberg, November 2012. Notes: Left chart: The Policy Uncertainty Index uses newspaper coverage of policy-related economic uncertainty, the number of federal tax code provisions set to expire and disagreement among economic forecasters. Right chart: Volatility indices are Merrill Lynch’s MOVE index (US Treasuries), Deutsche Bank’s currency volatility index and the Chicago Board Options Exchange’s VIX index.

policy & MARKETS [23] Other Known Unknowns Fixed Income: A major terrorist attack is a third risk. The US drone program has decimated Al Qaeda’s leadership, but splintered extremist groups have mushroomed in North Invest for Income Africa and have attracted supporters in Western countries.

Other risks include a North Korean provocation against Most investors are desperate for income to match their South Korea or Japan. It may act up to (temporarily) regain liabilities. This is a tall order in a world of record-low the global spotlight and to test China’s new leadership. yields and much longer lives. Result: a global hunt for Populist Dangers yield … any yield. The Italian and German elections are worth watching. A This is fine—as long as you believe rates will indeed be populist outcome in the former could re-ignite worries low for a long time. This has made income investing a about Italy’s staying power in the eurozone. Expect no winner, or fast river, since the financial crisis. major moves toward a common banking regulator or tighter fiscal union before the outcome of the latter. See Income investing works in a zero-rate the political calendar below. 5 world—but the hunt for yield has narrowed How about major policy mistakes that would throw the amental valuations between top-quality and not-so- world back into recession? These worried us greatly a year d

un great income assets. Take out the garbage.

ago. These risks appear to have receded now, or at least F this is what most investors think. So perhaps there is a risk—the risk of complacency. It is not fine if you believe loose monetary policies will translate into growth and inflation at some point. Once We discussed the disconnect between market expectations markets get a whiff of this, the movement out of some for a smooth resolution of the US fiscal cliff and pessimistic of these assets will be profound. views of Washington insiders in US Election Cliffhangers in October 2012. Additionally, the European debt crisis has a To prepare, it is important to identify areas of value in way of coming back—especially if Washington comes up with income investing—and pockets of overvaluation or risk. a budget deal. Markets can only focus on one thing at a time. One trend emerges: Some investors are sacrificing safety and liquidity just to gain a couple of basis points of yield.

In the cash business, for example, spreads between liquid Prepare for Populism instruments such a safe-haven government bonds and 2013 Political Calendar three-month commercial paper have been at record lows. Israel It could make more sense to invest in liquid government Elections securities with negative yields and allocate smaller amounts Jan. 22 to longer-duration debt to make up for the yield loss.

The narrowing spread between quality and less desirable C JAN assets is playing out in every corner of the income world. DE FEB US Debt Ceiling NOV Investors are climbing up the risk ladder—slowly. Mandates, MAR T accounting and regulatory rules limit investment choices of

OC

APR institutional investors and arguably focus them on short-

2013 term results. There are signs of rethinking this, but material SEP

Germany MA

G changes will not come overnight.

Y

Elections AU

JU L

N Sept. 1 and Oct. 27 JU Italy Elections There is also a general risk aversion after the financial crisis April caused steep losses in risk assets. The European debt crisis debunked the myth all eurozone sovereign bonds are created equal. Many peripheral bonds showed unprecedented price Iran declines and volatility, with even short-term bonds diverging Elections widely from benchmark German bunds. June 14

[24] slow turn ahead? LOBSTER POTS Cushion Your Bond Fall Many investors are paralyzed—except when they see an Yields, Duration and Safety Cushions, November 2012 opportunity to grab yielding assets that look relatively safe. Safety Then they plunge in—with little regard for risks of default, Yield Cushion (Basis Duration (Basis price downside and liquidity. Fixed Income Instrument Points) (Years) Points) US Utilities (High Yield) 748 4.2 178 Liquidity risk is under-appreciated and worrying. Many investors do not appear to grasp one simple truth: US Industrials (High Yield) 649 3.7 174 It is a lot easier to buy something than sell it, particularly US High Yield 649 3.9 169 when everybody else wants to sell, too. US Financials (High Yield) 578 4.4 131 India 419 4.6 91 This danger is prevalent in fixed income markets. We have Brazil Corporates 513 6.2 83 likened the situation to a lobster pot: Easy to fall into, but EM Americas Corporates 482 6.4 75 tough to climb out of. Sure, bonds that are easier to trade China Aggregate 402 5.4 75 often command a liquidity premium. The discount of US MBS 216 3.1 71 illiquid bonds, however, often does not make up for the Australia 323 4.6 70 risk of being unable to sell them when needed (unless at a steep discount). US Securitized Assets 213 3.1 69 Malaysia 335 5.3 63 A multi-asset, multi-geography approach to income Kazakhstan 349 5.7 62 investing is justified. If some assets are going to win big Mexico Corporates 438 7. 2 61 and others lose a bit, a balanced approach is the way to go. US CMBS 195 3.3 59 Euro Transport Aggregate 250 4.7 53 SAFETY CUSHIONS South Korea 199 3.9 52 Most higher-yielding bonds have racked up impressive Euro Utilities Aggregate 235 4.8 50 annual price gains in recent years. This is unlikely to last. Euro Consumer Cyclical Aggregate 200 4.1 49 Investors in many higher-yielding fixed income markets US CMBS AAA 153 3.2 48 should invest for income only—and not count on capital US Credit Finance 260 5.6 47 appreciation. This is especially true for high yield and Euro Communications Aggregate 214 4.8 45 municipal bond investors. These markets are for long- Euro Capital Goods 177 4.0 44 term investors, who can hold the bonds to maturity and Indonesia 345 7. 9 43 care little about potential price volatility in between. UK Credit 338 7. 8 43

This is not to say fixed income markets are about to Euro Technology Aggregate 168 3.9 43 implode: The structural bid for yield underpins demand Euro Credit 196 4.6 43 for spread products such as corporate bonds, emerging US Credit Corp 269 7. 0 38 market debt and asset-backed securities. Euro Credit Basic Industry 161 4.2 38 Euro Credit Energy 165 4.5 37 The (relatively) high yield of these assets offers a safety US Credit Industrial 268 7. 5 36 cushion against interest rate spikes. It took a yield rise of US Credit Utility 302 8.8 34 just 15 basis points in the 10-year German bund to trigger US EM Philippines 294 9.0 33 a price decline that would wipe out a year’s worth of yield Euro Credit Consumer Non-Cyc 141 4.3 in late November. By contrast, it took a 178-basis-point 33 yield spike to cause the same losses on high yield bonds US ABS 87 3.2 28 of US utility companies. See the table on the right. Singapore 91 6.2 15 Hong Kong 48 4.2 11 Governments are wallowing in debt, force-feeding banks, US 10-Year Treasury 161 9.1 18 insurers and pension funds ever more bonds, irrespective German 10-Year Bund 138 9.0 15 of potential return. Central banks will likely plot an exit Sources: Bloomberg and Barclays. from their ultra-loose policies in due course and take back Notes: Duration is adjusted for different frequency and callability. The safety cushion liquidity. What prices will today’s low-yielding bills and represents how large a yield rise (in basis points) would trigger a price decline that bonds fetch when this evil day comes? would wipe out one year’s worth of yield. Data as of November 30, 2012.

INCOME INVESTING [25] Zero rates force investors into places that are not their High Yield: natural habitats. This can easily result in a mismatch between investors’ needs and their investments.

Reluctant Risks This not only sets up investors for disappointment. Inexperienced investors are also likely to bail at the first sign of trouble. This magnifies risk-on/risk-off market gyrations. High yield bonds offer superior yield in the zero-rate The stampede into high yield has created risks—and world—with relatively more safety these days: opportunities for smart investors. The companies issuing the } Demand for yield is coupled with limited supply. bonds have not changed—they are just more in demand. Many A large chunk of new issuance is refinancings. The investors who forced themselves into this market will make refinancings allowed the market to scale a steep some money—but risk losing more than they banked on. maturity wall this year, as many of the bonds and bank loans issued in 2005–2007 were coming due. Exhibit 1: Investors look to sacrifice safety over yield. Spreads on bonds of CCC-rated companies are closing } High yield spreads over US Treasuries are around the in on those of B-rated bonds as investors bid up these 25-year average of close to 600 basis points, according bonds in a grab for yield. Their spreads are now 70% wider to Credit Suisse. Bank loans trade at around 540 basis in the lowest quintile since the 1980s. That said, CCC-rated points over LIBOR, above the 15-year average of around bonds are arguably better value than they have been 440 basis points, according to Standard & Poor’s. historically because of less leverage and increased } c urrent default rates are low for high yield bonds. We market participation by large, public companies. expect them to remain low—even if a recession hits. Exhibit 2: High yield groupies tend to make a big deal of the The financial crisis wiped out highly levered companies. asset class’s juicy spreads. These indicate significant default Remember, though, high yield is shorthand for financing risk—whereas companies are in great shape, they argue. of weaker—or riskier—business models. We propose a bottom-up analysis of the high yield spread, } The crisis also cleared out many risk takers on underwriting whereby the excess risk premium stems from exogenous desks. This was helped by the entrance of more risk-averse shocks such as the European debt crisis. See the charts investors into the market. Result: issuance of non-rated below. Viewed this way, our implied default rate was just bonds and CCCs has been 18% of the total this year— 1.24%—again in the bottom quintile since the 1980s and below peaks in the mid-1980s, late 1990s and mid-2000s. half the market implied default rate. This may make sense That said, not everything is hunky-dory in high yield land. for interest coverage (which is great by historic standards), but not for EBITDA-to-debt and other gauges.

Inside the Spread High Yield Spreads and Implied Default Rates, 2011–2012 800 4.5% S

600 TE 3.5 RA LT

400 AU 2.5

200 1.5 IMPLIED DEF SPREAD IN BASIS POINT

0 0.5 2011 2012 2011 2012

Implied Fiscal Cliff Premium ■ Implied European Risk Premium ■ Market Implied Default Rate Implied Risk Premium ■ BlackRock Implied Default Rate Sources: Credit Suisse and BlackRock, November 2012. Notes: Based on the Credit Suisse High Yield Index. The shaded areas represent the proportion of spread attributable to each factor based on BlackRock calculations. BlackRock implied default rate based on calculation to strip out risk factors not specific to high yield.

[26] slow turn ahead? Munis: Dealers Mind the (Quality) Gap Spread Between Washington and California Munis, 2010–2012 Come to Town 120

100

The US municipal bond market tells a similar story. Munis S 80 are attractive due to: } Their relatively high yields on an after-tax basis. A muni 60

bond with a 3% coupon equals a taxable yield of 4.6% BASIS POINT 40 for US investors in the 2012 top income tax bracket. } If taxes for the wealthy rise in 2013, muni bonds become 20 even more attractive. We do not expect an imminent 0 change in the market’s tax-exempt status, as discussed 2010 2011 2012 in US Election Cliffhangers in October 2012. Source: Bloomberg, November 2012 } This is another story of lots of demand and little supply. Notes: California 5% 2022 and Washington 5% 2022 General Obligations. We expect the $3.7 trillion market to shrink by $25 billion a year through 2015 due to a wave of refinancings and a dearth of big infrastructure projects. Defaults are few So far, so good. One warning sign is the avid interest of (but trigger scary headlines). dealers in this market. Munis have delivered attractive spreads, investor inflows have been strong, returns have } Prospects for tax collection in many US states are been excellent and demand is far outstripping supply. improving, boosted by job growth (albeit lackluster) and a better housing market. Increased dealer participation coincides with decreasing trading volumes. See the chart below on the left. Dealers keep markets functioning and provide price transparency.

Beat the Dealer So what is the catch? Let us just say dealers tend to unwind Muni Volumes and Dealer Shares, 2006–2012 at inopportune times. Liquidity—already a challenge in a market that is half the size of the US corporate bond $25 25% market, but has 40 times as many individual issues—can disappear quicker than investors may realize. 20 20 In addition, the flood of new investor money has

LIONS) conveniently glossed over a series of municipal 15 15 bankruptcies and increased use of leverage to eke out

UME (BIL returns. In effect, technical factors are covering up many L

VO sins of state and local budget chiefs. 10 10 DEALER SHARE This has led to unusual valuations, creating opportunities

TRADING 5 5 for smart investors. Consider how cheap it is to go up in credit quality. It cost as little as 20 basis points to buy a 10-year Aa1-rated Washington general obligation (GO) over 0 0 a A1-rated California GO in November, compared with 95 2006 2007 2008 2009 2010 2011 2012 basis points a year earlier. See the chart above. Average Daily Volume Dealer Share (Right Axis) ■ This makes it easier to separate the muni wheat from the Source: Municipal Securities Rulemaking Board, October 2012. chaff—even though the difference may not be apparent yet to many investors.

INCOME INVESTING [27] } New sources of (stable) domestic demand are springing Emerging Debt: up, adding to existing players such as sovereign wealth funds. Assets of emerging market pension funds Price of Fashion jumped 83% between 2005 and 2011, while domestic insurance companies more than doubled their assets. See the chart below.

Investors have flocked to emerging market debt—mostly Some signs of frothy conditions are emerging. Investors for good reasons. Consider: lined up for Zambia’s maiden dollar bond in September, for } Emerging markets generally have higher economic example, and pushed down yields to below Spain’s. Small growth, better demographic profiles and lower private debut issues generally carry a big liquidity risk. These deals and government debt loads than the developed world, are pretty hard to get into, but can be much harder to exit. as detailed in Are Emerging Markets the Next Other emerging market risks such as inflation, weak Developed Markets? in August 2011. corporate governance, nationalism, local credit bubbles and China dependency are well documented. } Emerging debt markets have grown up: They are much bigger and deeper than before the financial crisis. Asia, Investor flows into emerging market debt have shown no in particular, sticks out, as discussed in A Rapidly signs of weakening. See the chart on page 18. This is the Changing Order: The Rising Prominence of Asian Debt structural bid for yield that is playing out elsewhere in Markets in October 2011. income investing and also speaks to the markets’ maturity. } Emerging market issuers are less leveraged than their High foreign ownership, however, generally brings volatility developed world counterparts. For example, 12 emerging (hot money can cool quickly when it smells trouble) and markets ranked among the top 25 sovereigns in our exposes a country’s debt to the sentiments (or should BlackRock Sovereign Risk Index as of Sept. 30, 2012. we say, the whims) of global markets. It also increases Countries such as Malaysia and Peru ranked higher credit risk: A government would much prefer to default on than the UK and France. foreign debt rather than on debt held by its own constituents.

Emerging Appetite Emerging Market Pension Fund and Insurance Assets

PENSION FUND ASSETS INSURANCE ASSETS $2,000

$1,276 2005 1,500 billion

1,000 LIONS

BIL $2,741 2011 billion

500

0 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Latin America ■ EMEA ■ Emerging Asia ■

Source: J.P. Morgan, October 2012.

[28] slow turn ahead? Foreign Devils Foreign Ownership of Selected Sovereign Debt, 2007–2012 50% Peru Hungary 45 Malaysia LEVEL Mexico Poland 40 Indonesia Turkey 35 South Africa FOREIGN OWNERSHIP Brazil 2007 2012 30 Thailand 2007 2008 2009 2010 2011 2012 0% 10 20 30 40 50 60 Spain Italy FOREIGN OWNERSHIP LEVEL Sources: Bank of Italy, Spain Treasury Department and J.P. Morgan. Left chart: Spain 2012 data through Aug. 31 and Italy data through July 31. Right chart: 2012 data through June 30.

Whereas many emerging markets have seen big jumps Bottom line: Local currency debt is as much an income in foreign ownership, Italy and Spain have become much investment as a proxy for emerging market growth (and more reliant on domestic investors. See the charts above. growth cycles). Active currency management is key, and This is a positive for the latter. Given yield levels, Italian is separate from analyzing credit and interest rate risks. and Spanish debt may now compete with emerging markets for investor monies! It’s the Currency, Stupid Another thing to watch is the effect of foreign exchange Composition of Emerging Market Debt Returns, 2003–2012 fluctuations on local-currency bonds in emerging markets. It is typically the largest contributor to total 20% return. See the chart on the right. Know your money. 15 Local currency debt has two engines, one running on income and duration, the other on currency movements. 10 The two engines often work to counterbalance, though the currency impact tends to be more volatile and cyclical. The income engine is better at adding returns for a lower 5 contribution to risk. See the table below. 0

EM Engines that could -MONTH RETURN -5 SIX Income and FX Contributions to Returns and Risk, 2004–2012

INCOME FX -10

Return Contribution 40% 60% -15

-20 Risk Contribution 25% 75% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Income and Capital ■ Currency ■ Sources: BlackRock and J.P. Morgan, September 2012. Source: J.P. Morgan, October 2012. Note: Based on performance of J.P. Morgan GBI-EM from May 2004 through Notes: Based on the J.P. Morgan GBI-EM. Bars show six-month returns broken September 2012. out by those derived from income and capital appreciation and those from currency.

INCOME INVESTING [29] } Income is a global theme. Fast dividend growth of Dividends: emerging market companies makes them an important chapter in the income story. Yield to Growth } Dividend payout ratios are near record lows for US and at the low end for emerging market stocks. See the chart below. Investor yield appetite has put the spotlight on dividend What could end the dividend renaissance prematurely? stocks—for all the right reasons. We discussed many in There is no obvious catalyst—except for a sudden (but Means, Ends and Dividends in March 2012, and they still unlikely) acceleration in global economic growth. This hold true: would likely lead high-quality dividend stocks to } Dividend-paying stocks tend to outperform in both bull underperform in a massive risk rally. and bear markets, according to Ned Davis research of It is, however, useful to look behind the scenes. S&P 500 stocks in the past four decades. } Dividend growth is a great indicator of future equity Exhibit 1: When selecting dividend stocks, the first rule is returns, research by Société Générale shows. It was the to pretty much ignore the yield. Free cash flow, dividend single-largest contributor to nominal returns in the past growth, the payout ratio, a clean balance sheet, and 40 years across developed markets. earnings and revenue growth are much better indicators for success. } c ompanies have raised payouts in response to investor demand. An emphasis on restricted stock rather than The key questions on yield have to be: Is the dividend safe, options for executive compensation helps. Top and is it likely to grow? This is especially true when the corporate honchos are starting to appreciate the company offers an outsized payout. income stream in their own portfolios. One way to assess this is to review a company’s cash flow } Potential US tax increases are a worry, but US after capital expenditures (capex). By this measure, the companies have tended to make investors whole by dividends of both US and European resource and utility hiking dividends, according to Goldman Sachs research. companies look stretched. In fact, US utilities are Notice the recent rush of special dividends to take currently paying out more than covered by post-capex advantage of still-low rates. free cash flow. See the charts at the top of the next page.

When Lower is Better Payout Ratios in Selected Regions, 1970–2012

80%

70

60 TIO

RA 50 OUT Y

PA 40

30

20 1970 1982 1992 2002 2012 United States Europe ex-UK Emerging Markets Source: Société Générale, October 2012. Notes: Payout ratio is the percentage of earnings paid to shareholders in the form of dividends.

[30] slow turn ahead? Diving For Dividend Cover US and European Dividend Coverage and Yields, October 2012 7 Information Technology 6 UNITED STATES EUROPE 5 VER 4 Financials F CO Healthcare 2 Cyclical Healthcare FC 3 Cyclical Consumer

Services Industrials VER Goods Telecoms APEX 1.5 Information C Telecoms Financials

2 F CO Technology T- Cyclical Basic Industries FC Industrials Cyclical Services POS 1 1 Consumer Goods

Resources APEX Utilities C Basic Industries 0 T- 0.5

Utilities POS Resources -1 0 0% 12345 0% 123 4 567

DIVIDEND YIELD DIVIDEND YIELD Sources: Société Générale, Thomson Reuters and MSCI, October, 2012.

Exhibit 2: Dividend stocks, by and large, do not look a higher company valuation supported by underlying pricey. Most are still trading a discount to broader strength in earnings. market indices—albeit at shrinking premiums. Exceptions Consider two stocks that have made significant price exist, including US utility stocks now trading at a premium gains since 2006. For the stock in the chart below on to the S&P 500, from a sizable discount before the the left, the appreciation has been powered by earnings financial crisis. growth. For the stock on the right, the gains have resulted It is nice when the market rerates an investment you from an upward rerating (and, no, this is not a US utility). hold (as long as it is upwards). But we would rather see Which one would you rather own?

Tale of Two Stocks Composition of Returns of Two Sample Dividend Stocks, 2006–2012 200% 150%

175 125

MSCI 150 MSCI VS. VS. 100 125 CHANGE CHANGE 75 100

75 50 2006 2007 2008 2009 2010 2011 2012 2006 2007 2008 2009 2010 2011 2012

EPS ■ PE Source: Thomson Reuters, November 2012. Notes: EPS: 12-month forward earnings per share relative to MSCI World, rebased to 100. PE: 12-month forward price earnings ratio relative to MSCI World, expressed as a percentage.

INCOME INVESTING [31] Reading REITs Lasting Quality US REITs Earnings Growth and NAV Premiums, 2003–2012

The search for yield has lit a fire under real estate 10% investment trusts (REITs). We like to poke around in this small corner of the income universe. 0 } Global yields currently average about 3.7%—not bad in -10 a zero-rate world. More importantly, we expect global EARNINGS GROWTH dividends to grow 6%-8% annually in the next two years. UBS expects the strongest growth in Australia, Singapore and the United States. 20% } REITs in many countries trade at a discount to their net asset values, while earnings growth in the next 0 two years is expected to be strong, led by US REITs, according to research firms SNL and UBS. -20 V PREMIUM

How do you separate the good from the not-so-good NA -40 (or bad)? We put a lot of stock in analyzing leverage and -60 payout ratios. The lower, the better. These high-quality 2003 2006 2009 2012 REITs tend to generate stronger earnings growth (and High Quality Low Quality returns) than others, according to Green Street Advisors. Source: Green Street Advisors, November 2012. The good news? High-quality REITs often trade at only Notes: High-quality US REITs have both lower-than-average leverage and lower- than-average payout ratios than low-quality ones. Payout ratios are determined a slight premium to their less desirable peers. See the by using 12-month forward adjusted funds from operations (AFFO) estimates chart on the right. and annualized dividends. Both groups are roughly the same size. Growth rates measured by 12-month forward AFFO estimates.

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