SYZ & CO - SYZ Asset Management - Insights February 2013 by SYZ Bank

Insights February 2013

Consultant Note

Here are a few more surprises... …

Last year we engaged in a perilous prediction exercise by describing 12 surprises that could have happened in 2012. These forecasts were fairly clearcut or even astonishing, yet a review of the actual results at the end of the year has shown that, at the end of the day, our score was not that bad. At a time when the astrologers and forecasters have already put away their crystal balls, compasses and other instruments of alchemy, SYZ Asset Management is again offering you some surprises that might mark this year 2013. These events or developments – which are both economic and financial – could have a definite impact on asset allocation and therefore on the performance of the portfolios by the end of this year.

A publication of the Global Macro & Fixed Income Strategy team SYZ Asset Management Tel. +41 (0)58 799 10 00 info@syzgroup.com Authors: Adrien Pichoud Fabrizio Quirighetti This document is based on elements, information and data available on February 12, 2013.

Review of the 2012 financial year At the time we write this review, we can classify the results of the 12 surprises forecast for 2012 into three separate groups: those that actually happened, those that materialized partially (or to a large extent) and those that remained big… imaginary surprises. As far as the total successes are concerned, we have counted three of them: • This prediction exercise is indeed being repeated… To our great surprise, this document aroused a lot of interest last year when it was published and the success rate finally achieved an excellent score. • The EUR-CHF exchange-rate remained within a narrow band of between 1.20 and 1.25. The range was even narrower, since the Swiss franc hardly exceeded the level of 1.22 against the euro in 2012. • A strong recovery of residential real estate in the United States and a soft landing for Swiss real estate. For the US economy, the recovery of real estate has been, and still is, a major theme, whereas in Switzerland real estate tends to be associated with risks and is unlikely to contribute to growth in the next few years. The largest category is that of the forecasts that came true partially (or to a large extent). Although the success rate was not 100%, the following seven surprises nonetheless proved extremely useful in asset allocation: • European equities did not necessarily outperform in 2012, but they did experience a much greater increase than even the most optimistic of consensus opinions could have expected at the end of 2011, thanks in particular to the large-scale measures adopted by the ECB and which we had mentioned. • In the same register, Euro-zone government bonds did not outperform all the other fixed-income segments, but they did all the same enjoy an extraordinary and unexpected performance. • Asia (excluding Japan) did not post the least good performance in equities. However, certain major markets, including China, again greatly disappointed investors in terms of stock-market performance last year. • China sneezed but Australia has not (yet) caught a bad cold. Yet some investors must have been quite scared when the Australian dollar suddenly plummeted by more than 10% against the greenback in spring 2012. • The yen found itself under heavy pressure right at the end of the year but that was not (yet) the case for Japanese bonds. Our corollary about the attraction that Japanese equities might possibly regain came completely true in the last few weeks of 2012. • Fear of deflation did not supplant fear of inflation in 2012, but it has to be said that the recurrent fears of inflation were particularly weak and invisible last year. In investment terms, long-term government bonds therefore again enjoyed positive performances (long-term interest rates hit all-time lows in most developed economies in 2012). Page 1

This document has been produced purely for the purpose of information and does not therefore constitute an offer or a recommendation to invest or to purchase or sell shares, nor is it a contractual document. The opinions expressed reflect our judgement on the date on which it was written and are therefore liable to be altered at any time without notice. We refuse to accept any liability in the event of any direct or indirect losses caused by using the information supplied in this document.

Insights February 2013

• The world was obviously and unfortunately not spared by natural disasters, terrorist attacks or new armed conflicts. However, we can pride and congratulate ourselves on having, as it were, anticipated that the end of the world was not (yet) on the agenda. In the end, our failures will not have been as numerous and severe as that. We have listed (only) two: • The dollar did not appreciate significantly against the euro and did not return to 1.15: it ended the year at the same level it had started at (1.32) and did not even come close to the level of 1.20.

• Gold did not go down in value in 2012. Perhaps we got carried away a little too quickly and anticipated this movement “too much”… In the end, with a score well above 50% according to our scale, we think the result is conclusive enough to repeat the experiment this year, and above all, if possible, to improve your chances of success for well-informed investments in 2013 as well.

1. US consumption will rebound by more than expected Despite the announced tightening of US fiscal policy and the uncertainty that still surrounds budgetary policy, we consider that US household consumption will surprise us - once again - with its resilience and robustness. Instead of weakening under the weight of fiscal pressure, its growth will, on the contrary, accelerate in the course of 2013, under the combined influence of a continued recovery of real estate (a positive wealth effect and a wave of re-negotiations at more advantageous rates of mortgages taken out in the past), energy prices that are slightly declining (or in any case that will not increase) and, last but not least, a gradual improvement in the outlook on the labour market.

In this respect, our ISM composite index for employment stood at its highest level since 2006 in January. Basing oneself on the historical relationship between this indicator and the net number of jobs created on the one hand and the variation in the jobless rate in the United States on the other, the probability of a more explosive monthly employment report by next summer has recently gone up. We are therefore expecting 2.5 million new jobs to be created this year in the United States (approx. 200,000 per month) and an unemployment rate that would fall to just below 7% by the eve of 2014.

2. The dollar will strengthen to above 1.20 against the euro Even if our prediction did not come true in 2012, this year we are reiterating our unconditional support for the greenback. Why unconditional? Because our set of arguments has grown even stronger over the months. Here, pell-mell, are the reasons for the dollar’s strong comeback – in both cyclical and structural terms. First of all, it is still an asset that is undervalued against most of the developed countries’ currencies. To convince oneself of this, one need only observe the price difference between the United States and Switzerland, France and Australia or Japan for comparable goods (an electronic tablet, a pair of brand jeans, a sports article, a famous hamburger…). This does not guarantee that the greenback will necessarily appreciate tomorrow, but it enables us in any case to wait quietly. Secondly, the decorrelating effect it has in the portfolios is interesting, particularly at a time when the yields on

good-quality bonds - which should perform this role have been dramatically reduced and are therefore being neglected by private investors. While it is true that the dollar barely appreciated against the euro last year, finally ending up at the same level as that at which it had started, it did nevertheless provide, as we had expected, this well-known “decorrelating” effect in the portfolios. When integrated in the asset allocation in the right proportions, the dollar therefore makes it possible to reduce portfolio volatility for an expected level of return. Thirdly, the difference in the level of economic activity between the United States and the Euro zone, which is blatantly obvious to any investor, will finally have an impact on the exchange rates by the end of this year. Up to now this supporting factor has been cancelled out by the Fed’s monetary policy, which has been much more accommodative than the ECB’s. However, given our rather positive scenario for the US economy (see the Page 2

Insights February 2013

previous surprise), we consider that with an expanding US labour market, the market will begin to expect a less accommodative US monetary policy in the future (in other words, a rise in interest rates could be envisaged for 2014), thus triggering cyclical support from the growth and interest-rate differential in favour of the greenback. Fourthly, the structural burden that has weighed on the dollar over the past decade has vanished. The current-account deficit, which is merely a reflection of the trade balance, has fallen from 5-6% to less than 3%. True, it will not disappear but it has returned to perfectly manageable proportions, thanks to less dynamic domestic demand – in relative terms, it is true – and lesser energy dependence, which is also relative… In 2012 US crude oil imports amounted to 3.1 billion barrels, the lowest level since… 1997! Fifthly, the development and exploration of shale gas and oil is not only helping to reduce the United States’ energy dependence and therefore to reduce their external deficit,

but will also help to attract direct investment flows to the land of Uncle Sam, in particular for reasons of competitiveness among the most energy-guzzling industries… Like what happened during the TNT bubble, such investment flows usually help to support the host currency. In the longer term, and in a certainly less perceptible manner, the end of the globalization process (it will not be possible to relocate indefinitely and there is even already talk of reindustrialization of the United States) and the rebalancing of the global economy should also be synonymous with less downward pressure on the greenback. Finally, the euro can hardly appreciate sustainably without automatically digging its own grave. That means an even gloomier economic outlook, since the only path to salvation remains the zone’s exports to the rest of the world and therefore a further cut in the ECB’s interest rates, unless there is another round of unconventional easing, so as to combat increased risks of deflation

3. US government bonds will post a positive performance in 2013 Given that everybody is fearing an increase in interest rates in the next few months, we are inclined to think that this is precisely what will not happen… Let us try a reductio ad absurdum method of reasoning: if we assume interest rates rise sharply, what would happen to stillconvalescent global economic growth? And that’s where the rub is, because a relapse of the global economy, coupled with the spectre of deflation, would necessarily be an argument more favourable to bonds. Instead we therefore foresee a gradual and very moderate increase in long-term interest rates which will not lead to (heavy) losses on the bond indices since the slight decline in prices will be offset by the coupon. In the absence of inflationary pressures and since the Fed will certainly not raise its key interest rate in the near future, the additional yield earned via a duration risk (long-term bonds) or a credit risk (High Yield or emerging debt) still has an attraction in the fixed-income world similar to that of honey for flies. Moreover, governments did not need the central banks to make sure that financial repression is working properly: the regulatory framework governing banks, insurance companies and various pension funds compels them to continue to re-invest a large proportion of any marginal new euro in bonds (most often government bonds). Which is very timely since in case you didn’t yet know, the developed world is at the

same time facing the ageing of its population… It’s been a long time since the marginal purchaser of long-term sovereign bonds was the ordinary investor or the private client - unfortunately for them in fact… Even if a much-better-than-expected US monthly employment report might cause a strong increase in the long-term interest rates of the US Treasury bond, we remain convinced that this increase is likely to be only temporary, like what happened in spring and summer 2004 (after having risen by more than 1% in the space of 3 months, the US 10-year rate gradually declined again, despite the improvement in the economic outlook). Moreover, at any time the Fed might even “threaten” to close the monetary tap again if interest rates were to rise too quickly, too high and for too long, or if inflation expectations were to get out of control. In this case we would see an immediate flattening of the yield curve: short-term bonds might then suffer even more than their long-term counterparts. The corollary of this assertion is that credit, High Yield, convertible bonds or emerging debt will still display positive performances this year. However, one does not need to be an economist, clairvoyant or bond fund manager to state that it will not be possible to repeat last year’s performances, at a time when volatility and risk have clearly increased. Hence this legitimately mixed sentiment about fixed-income. Page 3

Insights February 2013

4. After seeing its price rise for 12 consecutive years, gold will (at last) slide in 2013 Although 2012 did not confirm our prediction about the yellow metal last year, we are coming back to the subject once again. Indeed, in an environment of a return to normal of the cycle that should see the US economy finally see the light at the end of the tunnel, risky assets again post some good performances, the dollar appreciate and investors begin to anticipate a change of course in the Fed’s monetary policy, we think the gold price will no longer go up and is likely to fall from its present level.

As we have said and repeated many times, the gold price is sensitive to the trend in real interest rates – or rather to the expectations thereof. It is therefore likely to suffer from an expectation that the Fed’s key interest rate will rise and we might see a sharp correction on the yellow metal during the last few weeks of the year…

5. Irish government bonds will again become almost as readily accepted as French Treasury bills At first we had thought of predicting the interest-rate spread between German and Italian 10-year bonds, but we thought that in the end it was too “ordinary” and too easy a bet... Nevertheless we are offering you our forecast free of charge: the yield should narrow to less than 200 basis points by the end of the year. Those who are familiar with this type of exercise will have noted in passing the advantage of venturing to forecast an interest-rate spread rather than the interest-rate itself… This surprise might come true even in the absence of a sharp drop in Italian interest rates, simply as a result of German rates rebounding… On the other hand, we find it much more interesting to take a look at the two extreme countries of the Euro zone in terms of dynamics. They are Ireland, which has already been on a diet of austerity, and France, which has not yet embarked on such a diet (in fact, the country doesn’t follow that type of diet). Not wishing to get involved in facile predictions, we are not going to spend time being overly pessimistic about France. One need only look at the publication of the latest PMI indices, the health of its automotive sector, the lack of any leeway in fiscal terms and, even more worryingly, the diffuse denial by politicians of the fact that the wall, or rather the great wall, is really not very far off.

The turnaround of the Irish economy, in contrast, has gone almost unnoticed, obscured by the heavyweights of economic and financial news - Italy and Spain. In a word, the Irish have done everything right since 2009 and without complaining. Instead of using sticking plaster here and there, the Irish authorities have from the outset opted for very large-scale measures in order to stop the haemorrhage at the level of the carotid. The result: the banks have now been restructured, the adjustment on property is completed, GDP is back on the growth track (+1% foreseen in 2013), the current account balance is now recording large surpluses and public finances are now on the right track (the primary balance will be in equilibrium next year). It is true that this Irish miracle has been helped a lot by the improvement in the outlook for the global economy (last year its exports accounted for… 120% of its GDP). In short, it is a safe bet that the rating of Irish sovereign debt will gradually rise in the coming years, while that of France is more likely to tend to decrease. This dynamic should be manifested increasingly clearly in the prices and yields of these instruments. In our opinion, it is quite likely that the French 10-year rate will stand at above 2.5%, or even higher, at the end of the year while that of Ireland will fall below 3%...

Page 4 This document has been produced purely for the purpose of information and does not therefore constitute an offer or a recommendation to invest or to purchase or sell shares, nor is it a contractual document. The opinions expressed reflect our judgement on the date on which it was written and are therefore liable to be altered at any time without notice. We refuse to accept any liability in the event of any direct or indirect losses caused by using the information supplied in this document.

Insights February 2013

6. Equities will do even better than in 2012 You may tell me they’ve already got off to a good start since the MSCI World index (in local currencies) has already gained more than +6.0%, which is almost half of its 2012 performance (+13.1%)…. And it is perhaps not yet over because with growth prospects that are improving and central banks that will keep the tap wide open for as long as possible, a scenario of “irrational overperformance” on the global equity markets, echoing that of “positive contagion” on peripheral debt, can no longer be ruled out. Particularly as exposure to equities is still generally rather hesitant in the allocations.

In this scenario it is a safe bet that financials will manage to do well. As far as the geographical regions are concerned, Europe (in particular the United Kingdom and Switzerland) and Japan should play the lead role, followed by the emerging countries. High-dividend shares will be the main collateral beneficiaries, at least in terms of flows and “interest”, in view of the atrophy of the coupon in the fixed income segment.

7. The Mexican peso will appreciate, while the Australian dollar will fall In terms of exchange rates, the winning forecast could be to bet on the Mexican peso appreciating, while betting on the Australian dollar depreciating. The “long” leg on the Mexican currency does not merely reflect, indirectly, our positive sentiment about US consumption and the process of re-industrialization of Mexico’s northern neighbour. The Mexican peso is benefiting above all from sound fundamentals: strong economic growth of the order of 3.5% to 4% and thus higher than, for example, that of Brazil, still-positive real interest rates, regained competitiveness (the gap in unit labour costs between Mexico and China has fallen from more than 300% in the early 2000s to less than 30% today) and above all the absence of major imbalances (sound public finances and no external deficit). In addition, the arrival in power of Peña Nieto last December is opening up new horizons for the Mexican economy. If, as he has promised, he carries out the structural reforms needed to further improve productivity: liberalization of the energy sector, investment in education and infrastructure. As for the “short” leg, on the Aussie dollar, it serves as protection against the recurrent fears - but which will necessarily become a reality one day - of a forced landing for the Chinese economy in an environment of a necessary and logical slowdown in its growth. This episode will reveal for all to see the illusion surrounding the Australian miracle and the fragile nature of its currency. The deficit of the Australian current account balance will

begin to deepen again if its ogre of a neighbour loses its appetite, the banks and the Australian market - which managed to avoid the bursting of the TNT and subprimes bubble - will no longer benefit from the continual increases in industrial metal prices and the Australian real-estate bubble will at last burst at that time. If you add to this picture interest rates that have melted like ice in the sunshine in recent years, you get the recipe for a real headlong flight. There is a double attraction to this recommendation. Firstly, it reflects a deep, structural change: we have reached the end of the relocation process caused by globalization and that has characterized the last 10 to 15 years. China’s growth will from now on be less high and different in nature. It is thus certainly also the end of the boom in industrial metals (we do not necessarily foresee an abrupt drop but simply the end of the increase) and as an indirect consequence, the end of the great mining investments in Australia, as was illustrated last summer by the abandonment of BHP’s project to enlarge the Olympic Dam mine, which would have involved USD 30 billion and 15,000 jobs. Secondly, it overcomes a recurrent problem when one wishes to express a negative view about the Australian currency: the carry generally acts against us. By taking the Mexican peso as a “boosted” proxy for the greenback, we will certainly be able to afford to be a little more patient…

Page 5 This document has been produced purely for the purpose of information and does not therefore constitute an offer or a recommendation to invest or to purchase or sell shares, nor is it a contractual document. The opinions expressed reflect our judgement on the date on which it was written and are therefore liable to be altered at any time without notice. We refuse to accept any liability in the event of any direct or indirect losses caused by using the information supplied in this document.

Insights February 2013

8. Emerging debt in “strong currencies” will be the least good fixed-income segment As we come to the last few surprises predicted for this year, we need to do something to help our success rate… We are therefore certainly not taking too many risks in making this forecast, which should sound obvious to all those who have spent a little time studying this asset class. Yield spreads can no longer decrease, especially on emerging sovereign debt, while the risks remain. The carry is so low that it will probably not even cover any increase in interest rates with and/or without credit risk. Moreover, these risks are certainly even greater than one thinks (another way of saying that prices are much too high or yields too low). Since the crisis, it has been more than tempting to buy sovereign emerging debt since those economies benefited both from strong economic growth and a very low level of (government) debt as a percentage of GDP. The problem is that these two trees can conceal enormous forests of private debt, all kinds of levers and other real-estate bubbles. If you have any doubts, try to recall which were the two Euro-zone countries that during the period from 2005-2007 were posting strong GDP growth with a very low level of (government) debt…

Given the excessive infatuation there has been with this asset class since 2009, an ordinary economic accident (or semi-accident) in one of the BRIC countries could lead to a massive outflow of funds. As often in this case, stampedes can be more dangerous than the ill itself. In our opinion, it is no longer necessary for European investors to seek to complicate matters since a basket of Italian, Spanish and, of course, Irish debt with a mixture of first-rate sovereigns and bank debt (the national champions), denominated in both euros and dollars, will give you as many thrills but probably more performance than emerging debt in “strong currencies”. As far as emerging debt denominated in local currencies is concerned, it would obviously not be protected against the scenario described above, but at least its expected yields are relatively higher and it would also be able to benefit from the appreciation of the currency (in a favourable scenario). In short, with debt denominated in local currency, one is paid for the risks taken - less than before, it is true, but still decently.

9. 2013 will at last be the year in which Japan moves out of deflation The Archipelago has been plunged in a deflationary spiral for nearly 20 years, which has led to an uninterrupted decrease in the general level of prices and has greatly limited real growth. GDP measured in current yen is today (5%) lower than it was in 1995, whereas real growth (excluding price variations) has been +15% over the period (less than 1% per year on average)! It is, of course, a spiral to the extent that the decrease in prices renders the traditional monetary policy tools ineffective: even with interest rates at 0%, the real yield is positive if the inflation rate is negative. It also encourages companies and households to be cautious (distribution of profits, savings) rather than to invest and consume. A shock therapy is needed to stop this spiral and reverse the trend. This is what the new Prime Minister, Mr. Abe, promised to win the December elections. To do everything that has been done up to now, but on a larger scale… So the public debt blithely exceeds 200% of GDP and the public deficit has been hovering at around 9% of GDP

for four years? To hell with austerity, long live budgetary stimulus with a plan to support the economy amounting to JPY 10.3 trillion (USD 116 billion). So the Bank of Japan’s balance sheet exceeds 30% of GDP after more than 10 years of unconventional monetary policy? The moderate approach has proved its ineffectiveness and it is time to switch to a higher gear: an explicit inflation target of 2%, an acceleration of Quantitative Easing planned in 2014 and a new Governor for the BoJ, who will be chosen for his ability/determination to implement the reflation plan dictated by the government. By injecting more liquidity into the economy and by increasing public spending in the current environment, the signal is now intended to be less ambiguous than it may have been in the past: this time, it’s serious. We will not be backpedalling at the first signs of an improvement or positive inflation figures! This has been manifested immediately in a sharp drop in the value of the yen, which could be the first domino in the process of climbing out of deflation. Depreciation of more than 15% in a few months will have positive repercussions on exporting companies Page 6

Insights February 2013

through a resumption of investment and recruitments capable of halting the slide in prices and salaries.

stimulus plan will offset this loss of purchasing power with new jobs and higher salaries…

But the first, more immediate effect of the yen’s depreciation will be the surge in prices of imported goods, among which energy ranks first. If this runs the risk of penalizing Japanese households’ purchasing power, it will probably result in pushing up the price indices and therefore help to achieve the objective of “reflating” the economy. It is to be hoped that the additional activity of exporting companies and that generated by the public

Thus while the “true” climb out of deflation (resumption of a virtuous cycle of investment/jobs/growth) will probably take several years, 2013 might see the annual inflation rate already return to positive territory, under the influence of imported inflation caused by the depreciation of the yen. This in any case is the meaning of the economic policies currently being put in place in Japan.

10. Fear of inflation will make a comeback in 2013 As in 1994 and during the last recorded serious crash on the bond markets, we are not ruling out a fear of the inflation ogre emerging towards the end of the year. A fear that is naturally unfounded for the time being, in view of the levels of the unemployment rates in our developed economies but, as often with fears, we are talking here more about the domain of the irrational than that of

Cartesian reasoning. This fear might be triggered following a definite improvement in the outlook for US growth in 2014. If such a fear should make an appearance, this concern would then force the Fed to intervene, in any case orally in the first stage, so as to calm down the markets and reassure them by promising a tightening of its future monetary policy.

11. The German consumer is looking up again Germany’s advantageous position in the crisis that Europe has been going through for the last three years is largely the result of the structural changes put in place during the previous decade. The choice that was made of giving preference to corporate competitiveness at the expense of domestic consumption - an example of mercantilism - has enabled Germany to build up substantial external surpluses (more than 5% of GDP) by exporting to the zones where final demand was strong (Asia, the United States and… southern Europe!). Thus from 2000 to 2009 the real increase in consumption remained well below that in GDP (and very low in absolute terms, +0.4% per year), while the trade surpluses and investment by exporting companies acted as the leading driver of growth. A singular exception among the major developed economies, for which growth is generally based primarily on domestic consumption. Among the many consequences (a high savings rate, wage and salary stagnation, low inflation), residential real-estate prices stagnated or even fell over the decade, while the sector was recording often-spectacular increases in the neighbouring countries. But such a policy only bears fruit when there is enough demand outside the country to fuel growth. With the

European Union in crisis (the EU countries still take more than 50% of Germany’s exports), faltering growth in the emerging countries and a still-convalescent US economy, it is becoming difficult to rely on exports alone. And Germany has recently rediscovered the virtues of domestic demand! Thanks to larger salary increases awarded by companies, a positive price dynamic that appears to have become established in real estate and a wave of immigration that is helping to curb - at least temporarily - the demographic decline, private consumption is in the process of again becoming an essential component of activity growth. Since 2012 the activity index for services (which is more domestic) has in fact been much higher than that for industry (export-related), for the first time since the turn of the millennium! This trend is for the moment only in its infancy since it has not yet given rise to a rebalancing of the external surpluses. At a time when most of the European countries that had accumulated external deficits are in the process of rebalancing their deficits via a mix of a decrease in imports and an increase in exports, it would be logical for Germany to accept at least a decrease in its trade surpluses, in a process that would be a mirror image of what the peripheral Page 7

Insights February 2013

European countries are going through. While the latter are inflicting an austerity cure upon themselves to restore their competitiveness after having spent â&#x20AC;&#x153;without counting the costâ&#x20AC;?, it would be good form for Germany to allow itself to spend part of the revenue that it earns from its exports.

This would help the ongoing rebalancing in the euro zone and might, in addition, make German households happy accustomed as they have been to tightening their belts for 15 years.

With our best wishes for success. Global Macro and Fixed Income Strategy Team SYZ Asset Management Adrien Pichoud and Fabrizio Quirighetti

Page 8 This document has been produced purely for the purpose of information and does not therefore constitute an offer or a recommendation to invest or to purchase or sell shares, nor is it a contractual document. The opinions expressed reflect our judgement on the date on which it was written and are therefore liable to be altered at any time without notice. We refuse to accept any liability in the event of any direct or indirect losses caused by using the information supplied in this document.