Outlook 2010

Year of reflation
 –  Outlook 2010 Year of reflation  –

Welcome to Saxo Bank’s yearly outlook for the global economy

Saxo Bank is an online trading and investment specialist, enabling clients to trade Forex, CFDs, Stocks, Futures, Options and other
derivatives, as well as providing portfolio management via its award-winning platforms. The Bank’s analysts tend to be somewhat
more pessimistic than the average financial analyst and were quite pessimistic on the whole recovery since 2003. Saxo Bank be-
lieved there never was a thorough clean up of the financial system back then and assumed that the low-rate environment would
lead to speculative excesses worse than that of the dot-com bubble. Events during 2008, unfortunately, proved the thesis right.

Although the Bank might have been too bearish during 2009, the notion that central banks would continue to lower rates
throughout 2009, as economic activity and consumer prices reached new lows, seems to have followed the thesis. The Bank be-
lieves that 2010 will be a year of reflation just as the latter half of 2009 has been and the positive trends from 2009 will continue
well into 2010. However, structural headwinds lie ahead of us and could turn 2010 into a rollercoaster ride.

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 –  Outlook 2010 Year of reflation  –

David Karsbøl
Director, Chief Economist
David Karsbøl has a master’s degree in economics from the University of Copen-
hagen, where he specialised in finance, statistics and monetary economics. His
master’s thesis was about the pricing of gold since 1971. In 2009, David was
promoted Director and took over the CIO office in the role of Chief Economist.
He started his career as an insurance analyst in Tryg A/S and joined Saxo Bank in
2003 as a macro strategist. In 2005, David joined the Strategy Team which he has
headed from 2007. Today, he is responsible for the overall macroeconomic views
of Saxo Bank. David concentrates on Business Cycle Analysis and subscribes to the
reasoning of the so-called Austrian School of Economics (Menger, Schumpeter,
von Mises, von Hayek etc.). He believes that understanding debt cycles is integral
to understanding the general business cycle.

Christian Tegllund Blaabjerg

Chief Equity Strategist
Christian Tegllund Blaabjerg has a broad educational background ranging from a
master in Political Science from University of Aarhus to a degree in finance from
ASB, Aarhus School of Business. Prior to joining Saxo Bank in 2007, Christian was
a quantitative analyst in Danish company Novozymes A/S within sales and mar-
keting. Today, Christian works with equity market and single stock analysis using
a top-down approach by identifying the macro forces that will affect the invest-
ment environment before they become obvious and then shift the focus towards
individual issues within the sectors and single stocks. This approach determines
the extent to which stocks are subject to the critical variables, are positioned to
capitalize on them, and are attractively priced.

Mads Koefoed
Market Strategist
Mads Koefoed has a master’s degree in economics from the University of Copen-
hagen, where his primary focus was finance and econometrics. Prior to joining
Saxo Bank, Mads worked for Danske Capital for two years. Mads has been part
of the Strategy team since May 2009 and his role is to concentrate on macr-
oeconomic topics and develop and maintain Saxo Bank’s macroeconomic models
based on econometrics. Mads publishes comments and analysis on macroeco-
nomic topics and is responsible for the Bank’s macroeconomic models.

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 –  Outlook 2010 Year of reflation  –

Robin Bagger-Sjoback
Market Strategist
Robin Bagger-Sjoback has a B.Sc. in International Business and is a macroeconom-
ic analyst. His role includes supplying research notes and updates on various macr-
oeconomic topics and developments. Robin joined the bank in May 2009. In addi-
tion to distributing a variety of research notes on macroeconomic developments,
Robin is partly responsible and a key contributor to Saxo Bank’s Tradingfloor web-
site. Prior to joining Saxo Bank Robin worked for Egon Zehnder International.

John J. Hardy
Consulting FX Strategist
Originally from Texas, John J. Hardy graduated from University of Texas at Austin
(graduated with high honors). He was head of Saxo Banks FX Strategy Team until
2008. Today, he works from the US as a consulting FX strategist for Saxo Bank.
John has developed a broad following from his popular and often quoted daily
Forex Market Update column, received by Saxo Bank clients and partners, the
press and sales traders. John generates trading ideas to profit from swings in the
market on a 1-5 day time horizon. He also writes regular ad-hoc commentaries
focusing on the major currencies, central bank policies, macro-economic trends
and other developments.

Nick Beecroft
Senior FX Consultant
An Honours Graduate from Oxford University, Nick Beecroft brings over 25 years
of international trading experience within the financial industry, including senior
Global Markets roles at Standard Chartered Bank, Deutsche Bank and Citibank.
Nick was a member of the Bank of England’s Foreign Exchange Joint Standing
Committee. Nick also contributes to contributor to Saxo Bank’s Tradingfloor web-
site and relishes regular dialogue on the markets with clients at industry gather-
ings, such as awards dinners and conferences, at which he has in the past spoken.

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 –  Outlook 2010 Year of reflation  –

Andrew Robinson
FX Strategist
Andrew Robinson has close to 30 years of experience in the financial markets and
worked in key financial centers in London, Europe and Singapore. He has been
stationed in Asia for the past 15 years and joined Saxo Capital Markets in 2008.
He currently writes a daily market commentary for the Asian FX trading session
and formulates the FX trading ideas for Saxo bank’s Daily Trading Stance. He also
contributes regularly to the Saxo Capital Markets’ blog and contributes articles
with an Asia perspective to regional print media. Andrew’s FX strategies are based
on a combination of technical analysis, fundamental analysis and market flow
information.

Alan PlaugmaNn
Head of Futures & Options
Alan Plaugmann majored in finance at London University and is a native Danish
speaker and fluent in English. He joined Saxo Bank in 2003 and is a specialist in all
traded futures: Interest Rate and Financial Futures, Equity Index Futures, Currency
Futures and Commodity Futures. Prior to joining Saxo Bank, Alan spent 12 years
in London working at CB Corporation in the Advance Arbitrage Trading Group
and Advance Trading Group with focus on US & European bond arbitrage, market
making and proprietary trading.

Ole Sloth Hansen

Team Lead for CFD & Listed Products
Ole Sloth Hansen is a specialist in all traded Futures, with over 20 years experience
both on the buy and sell side. Ole joined Saxo Bank in 2008 and is today Head
of the CFD and Listed Products Team focusing on a diversified range of products
from fixed income to commodities. He previously worked for 15 years in London,
most recently for a multi-asset Futures and Forex Hedge fund, where he was in
charge of the trade execution team.

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 –  Outlook 2010 Year of reflation  –

Contents

Outrageous Claims 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 7

2010 Top10 Picks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 9

Recapping our 2009 portfolio. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 11

Premises for Yearly Outlook 2010: Year of Reflation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 12

The Big Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 12
Financial markets in 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 12
Megatrend change is here: private deleveraging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 13
Labour markets: still under stress in 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 14
Housing in 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 15
Potential triggers for a double dip . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 15

Growth perspectives for 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 17

US: smooth sailing at first, but serious challenges remain . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 17
Eurozone: modest growth ahead. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 17
Japan: double-dip on the horizon as deflation returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 18

Policy Rates in 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 19

2010: Breaking up the old patterns in FX? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 21

USD: set to recover eventually as carry trade loses its grip. . . . . . . . . . . . . . . . . . . . . . . . . . p. 22
EUR: finding the middle of the road.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 22
JPY: will the JPY carry trade return?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 22
GBP: the contrarian’s pick? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 23
CHF: SNB may not need to worry about intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 23
AUD: high beta Chinese bubble tracker. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 23
CAD: lost in the shuffle. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 24
NZD: carry traders look out…. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 24
NOK: potential never to be realized?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 24
SEK: better than euro?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 24

Top Trades for FX Options in 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 26

Equity Outlook 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 27

Investment themes for equities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 32

Energy in 2010: little excitement in store. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 36

Commodity outlook. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 37

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 –  Outlook 2010 Year of reflation  –
Ou t r a g e o us C l a i m s 2 0 1 0
Saxo Bank’s ten outrageous claims is a “Black Swan”
exercise prepared for investors every year. The bank’s
outrageous claims are an intellectual thought exercise
to help investors mentally stress test their portfolios.
The chance that these claims turn out correct is no bet-
ter than 50-50. We usually get 2-4 right per year.
Last year, we were quite bearish, but the market has
since then turned around and we are now looking at a
year of reflation and consolidation, which is reflected
in the more balanced version of the Outrageous Claims
for 2010.
Bunds yields to reach 2.25%
(Bunds to 133.3, currently 122.6)
As a result of a combination of deflationary forces
and excessive monetary policy, the yield on Bunds
and other sovereign fixed income edges lower when
government fixed income traders refuse to buy into the
“growth story” that is being told by the stock market.
One or more negative, macroeconomic triggers could
force the German 10-Year Government Bond to 133.3
by year-end in a general flight to quality. That would
imply a yield of 2.25%.
VIX to 14 (currently @ 22.32)
The VIX has been trending lower since late October
2008 and the market’s assessment of risk more and
more resembles the one that characterized markets in
2005-2006 when trading ranges generally narrowed
and implied options volatility declined to completely
unrealistic and unsustainable levels. The market is
showing a tendency of exhibiting the same kind of
complacency towards risk, which could bring the VIX
down to 14.
CNY to be devalued by 5% vs. USD
(now @ 6.8250)
The efforts of Chinese authorities to stem the credit
growth to avoid bad loans and the creation of bubbles
could ultimately reveal the Chinese investment-driven
growth as being deficient. The massive, Chinese spare
capacity and an economic backdrop could be a decid-
ing factor in devaluing the CNY vs. the USD.
–  7  –
Gold falls to $870 (currently @ $1130)
A general strengthening of the USD could break the
back of the speculative element in gold as of late.
Although we are long-term bulls on gold (believing it
could reach $1,500 within 2014), this trade seems to
have become too easy and too widespread to pay out
in the shorter term. A serious correction towards the
$870 level could shake out the speculative community
while keeping the metal in a longer-term uptrend.
USDJPY to 110 (currently @ 89.30)
Although the downtrend in the USD is rooted in ir-
responsible fiscal and monetary policies, we believe
that the USD might snap back at some point in 2010,
because the USD carry trade has been too easy and
obvious for too long. At the same time, the JPY is not
reflecting economic reality in Japan, which is struggling
from a huge debt burden and an ageing population.
Angry American public to form third party
in the US
The many bail-outs and the general disapproval with
both of the big parties and the US political institutions
could propel a third and new party to become a decid-
ing factor in Congress following the 2010 mid-term
elections. The US electoral system favours a two-party
political structure, but a demand for real change could
have large groups of the American public forming
a new party as strong as Ross Perot’s in 1992 ,even
though a vote for a third-party might mean wasting a
vote.
US Social Security Trust Fund to go bust
Actually, this is not really an outrageous claim. It is an
actuarial and mathematical certainty, but from a civic
perspective, it might be outrageous that the social
security taxes and contributions have been squandered
away for decades and that there is no money in the
trust fund. 2010 will most likely be the first year, where
outlays from the non-existing trust fund will have to be
financed in part by the Federal government’s General
Fund. In other words, the budget trick, in reality a
“fund” without funds, will for the first time in many
decades become observable on the Federal govern-
ment budget. Thus, part of social security outlays will
 –  Outlook 2010 Year of reflation  –
have to he financed by higher taxes, more borrowing
or more printing.
Sugar to drop one-third
(currently @ $23.33)
The price of sugar has been supported by a combi-
nation of Indian drought and over-normal Brazilian
rain. The forward curve already indicates consider-
able downside beyond 2011, but we believe that a
normalization of the weather will make sugar one of
the less inspiring commodities in 2010. Furthermore,
the high price of ethanol (a big demand for sugar) has
made both Brazil and the US lower the ethanol share
of gasoline by 5%-points. That means lower demand
for sugar.
TSE small index to rise by 50%
(currently @ 888.88)
Small-cap companies have been underperforming the
Nikkei lately, but their fundamentals indicate a consid-
–  8  –
erably better investment case than their big-cap peers.
With a price/book ratio of only 0.77 and only about
12% of the index consisting of financials, we know no
other index that is as cheap. At a continuation of the
recovery (at least positive GDP figures) into 2010, this
index could very well surprise to the upside.
US Trade Balance to turn positive
Last time the US Trade Balance was positive was briefly
in 1975 after a large drop in the USD in the aftermath
of the oil crisis. The USD has become cheap enough to
stimulate US exports and punish imports and the trade
balance has already improved somewhat, but change
takes time and has momentum, so we will not rule out
that the trade balance could show a positive reading
for one or more months of 2010.
 –  Outlook 2010 Year of reflation  –
2 0 1 0 T o p 1 0 P i cks
1) Short EURTRY and ZARTRY
The TRY is currently undervalued in our opinion. Infla-
tion pressures are building in Turkey. Yields are way too
low at the moment, considering the improvements in
the economy observed of late. Meanwhile the EUR and
ZAR are both overvalued in our opinion. ZAR is battling
with a looming aftermath of the World Cup combined
with a weak public sector. The Eurozone has its own
problems, however, exemplified by Greece and the
Club Med. Unemployment is bound to take off amidst
low growth and low yields.
2) Long Bunds
We recommend a long position in Bunds as current
pricing seems too optimistic considering the difficulties
that Germany – and the Eurozone – is still facing. We
expect low growth and inflation in 2010 with numer-
ous sources of deflationary pressures. The labour mar-
ket is still in distress and for the Euro-zone as a whole
we see the unemployment rate above 10% in 2010.
This will put downward pressure on consumers’ will
and ability to spend. In addition, we like the safe haven
status that Bunds have whenever things get rough.
3) Long CRB
The CRB Index has endured a torrid time since the
peak in mid-2008 even though several commodities
bounced back in strong fashion when risk appetite
returned. Globally we expect growth to return quite
satisfactorily even though several heavyweights, Japan
and Eurozone included, will do their best to undermine
it. With global growth the demand for commodities
will continue to be strong, which will send the market
value north in especially the first half of the year.
4) Long US10Y and short JGB
We also favour the FX exposure that is inherent in
this trade. While both the US and Japan are expected
to struggle with weak to mediocre growth and high
unemployment in 2010, we argue this trade with
a simple question: Who wants to lend money to a
debt-burdened retirement-ready Japan in return for a
1.2%-1.3% yield? We also see potential in the UST10Y
due to the deflationary pressure that credit contraction
is inflicting on the US economy (and the long period of
low Fed rates that are the end result).
–  9  –
5) Long TSE Small Cap and short Nikkei
The small cap firms are fundamentally undervalued
relative to their big sister, the Nikkei index. While the
Nikkei Index has shot up roughly 45% from the bot-
tom, the TSE Small Cap has only gained 20%. And
this is despite the fact the fundamentals appear to be
better for small caps. The market is pricing in a 23%
discount to the book value (P/B of 0.77) even with low
exposure to financials. With a weakening JPY, small
caps should do well.
6) Long GWX and short Nasdaq 100
The US stock indices are priced for a steep recovery
heading into 2010, but capital investments will stay
weak and thus the high P/E of Nasdaq is not justified.
Relatively to the NASDAQ universe, the GWX ETF of
companies in developed countries offers a more diverse
exposure to macroeconomic risks. Fundamental valua-
tion is also at play here with a stable dividend yield and
low price/book. Coupled with the small cap potential
if growth resumes, we believe this trade has good
prospects relative to the Nasdaq Index.
7) Sell the March 2011 Sugar contract
Sugar put on a strong display in 2009 as the price
was bid up due to weak supply stemming from the
drought in India and heavy rains in Brazil. Production
is now improving and inventories will be rebuilt in two
years – another bout of abnormal weather conditions
notwithstanding. With supply bound to expand prices
will come under pressure. Moreover the ethanol share
of gasoline has been lowered by 5%-points in both the
US and Brazil, which is a direct hit to sugar demand.
8) Long iShares S&P Global Energy Sector
Index Fund (first half of the year)
We expect the sector to be a beneficiary of the
global economic recovery and consequent rebound
in resource demand. The sector has recently begun
catching up to the move in oil prices, which we expect
to continue. The large integrated players (E&P) which
account for the bulk of the sector’s market cap have
lagged, and we believe a rotation towards this area will
lead to further outperformance. On single stock level
we prefer those companies with exposure to global de-
 –  Outlook 2010 Year of reflation  –

mand for energy, particularly those that are dedicated
to healthy dividend policies.
9) Short EURCAD strangle
The EURCAD is pivotal around 1.5500 and the break
even of 1.3900 and 1.7600 covers nearly all extremes
topside and downside in EURCAD in the last five years.
Furthermore, the low correlation to the USDJPY trade
– we expect the USD to recover some lost ground
against the EUR in 2010 – implies that USDCAD should
improve and keep EURCAD balanced around 1.55-
1.56. Our recommendation is therefore: sell 1 year,
expiration8 Dec EUR Put, strike 1.4500, and, sell EUR
Call 1.6800, receive 590 CAD pips, spot ref 1.5600.
10) Long Dec2010 3 month Short Sterling
futures contract (leverage x20)
Long Dec2010 3-mth Short Sterling futures contracts,
currently 98.21, looking for unchanged rates and
99.40 at expiry. Initially place a stop loss at 97.80, and
trail it 40 ticks below the market. The British economy
is still in the doldrums and has been exceptionally
slow to improve compared to the rest of the global
economy. Thus, the BoE might choose to keep rates
unchanged for an extended period like the Fed.

–  10  –
 –  Outlook 2010 Year of reflation  –
R e c a pp i n g o u r 2 0 0 9 p o r t f o l i o
With Anno Horribilis staring us squarely in the eyes we
constructed our portfolio accordingly. With the world-
wide recession expected to continue and risk appetite
perceived to remain weak, we produced Top 10 Picks
to reflect these circumstances and in hindsight the
portfolio was too negatively one-sided.
Given our chosen name for 2009 “Anno Horribilis”,
the omnipresent insatiable lust for risk surprised us - to
say the least. Particularly the swift pricing in equities
for sharp V-shaped recoveries in the US and Euro-zone
was remarkable given the severity of the downturn.
Another surprise was the strength of the AUD, which
came about courtesy of the enormous stimulus pro-
gram in China – the world’s largest relative to GDP.
China quickly managed to reflate their asset bubble
and Australia hasn’t looked back since.
–  11  –
Our call for the S&P 500 in 500 “unfortunately” did
not materialize – what a rally that would have been.
Instead, two Top Picks soured to such a degree that
overall portfolio performance was affected. Cobber
rallied steadily from the April bottom (return of 120%
in 2009) while our short position in the company Valeo
could not survive the craving for risk.
The performance of our portfolio illustrates the hard
reality that the bounce back in risk appetite in 2009
was so overwhelming that pretty much every risky
asset was a keeper. With markets pricing in strong
growth in every corner of the world, the stage is set for
the economies to deliver.
 –  Outlook 2010 Year of reflation  –
P r e m i s e s f o r Y e a r ly Ou t l o o k 2 0 1 0 : Y e a r o f R e f l a t i o n
2010 will be a year of reflation just as the latter half
of 2009 has been and the positive trends from 2009
will continue well into 2010 as more sceptics will be
triggered to “buy into” the turnaround story after
extraordinary amounts of stimulus to the developed
economies. After the biggest YoY drop since 1938,
the S&P 500 in 2009 had the strongest half-year rally
since 1933. The VIX went to 89.53 at the end of
October and has trended lower since then. An enor-
mous amount of freshly printed money has replaced
impaired assets as the Federal Reserves balance sheet
has exploded. This huge amount of new money is not
buying the stuff that is measured in the consumer price
indices. It is rather being placed in financial assets. So
that is where the inflation shows up.
We were very bearish at the end of 2008, but our
bearish attitude only paid off until 9 March, from
where the stocks soared higher, triggered by the re-
laxation of the FASB rule 157 (mark to market), which
effectively allowed financial institutions to flat-out lie
about the value of their impaired assets. Our attitude
changed slowly from outright negative to scepticism to
moderate bullishness to flat bullishness in the second
half of 2009.
Our bullishness is not grounded on the longer-term
sustainability of the stimuli that have been thrown at
the developed economies, but rather on the fact that
they are likely to “seem” to work well into 2010 and
convince many investors on the sideline that the recov-
ery is real. Make no mistake, the current improvement
in financial markets, in GDP figures and consumer
sentiment is no more real than the speculative boom
fostered by easy money from 2003-2006.
The Big Perspective
In our view, we have now entered the third of three
major credit-induced expansions since the mid-1990s.
The first one (1994-2000) lasted seven years and was
based on deregulation and the “Greenspan put”. The
second (2003-2007) lasted five years and was primarily
driven by record-low interest rates and an unprec-
edented consumption binge. We entered the third one
by the second half of 2009 and this one is not only fos-
–  12  –
tered by low interest rates, but also quantitative easing
and a broad host of government bail-out programs.
The developed world has been dominated by credit-
induced bubbles since the mid-1990s (one could argue
for the past many decades) and every problem has
been met with lower rates and more debt. Every time
GDP was showing signs of contraction, central bank
rates were cut and consumers were willing to pile on
more debt to live beyond their means.
Low interest rates have fostered wild and irresponsible
speculation, over-investments and mal-investments.
We have now reached a point where spare capacity is
rampant in most industries and the debt burden is un-
serviceable, since income generation is stalling. In other
words, the too big a share of our disposable incomes
(both as households and nations) goes to service the
debt, which prohibits strong consumption growth.
What we need now is deleveraging and defaults in
order to reduce the debt burden and make it service-
able again. Unfortunately, every government effort to
“stimulate” and “support” the economy to stand in
the way of this needed change on the path towards
long-term sustainability will only prolong the crisis and
lead to higher costs and lower trend growth.
Financial markets in 2010
Financial markets have reacted quite positively to the
extraordinary stimulus in 2009 and we expect most
of the stimulating factors to continue well into 2010.
Risky assets have risen the most (and dropped the most
in late 2008) and the markets have become a “one-
bet street” – either you are long/in or you are short/
out. The only market that seems to be standing out
is government treasuries, which in a recovery phase
like the one that is being priced into equities by now,
normally should have been losing considerable ground
due to higher inflation expectations. In other words,
the government bonds market smells something fishy.
Overall, though, the market is currently displaying
record risk-willingness, but most indicators of financial
health of stress are also flashing green as opposed to
their deep red colour in late 2008.
 –  Outlook 2010 Year of reflation  –

All leading indicators are roaring higher (although therefore expect market positioning to be quite bullish
one might argue that most are unduly focused at the towards the end of the year and the VIX to continu-
growth of monetary aggregates) and it is thus very ously edge lower. That will be signalling that we are
unlikely to see weak growth the first half of 2010. entering a high danger zone and most investors will
Although growth is likely to be decent, monetary again be searching for the proverbial yield.
policymakers will not be in a position where they feel
they can tighten monetary policy and the combination Megatrend change is here:
of decent growth and extremely lax monetary policy private deleveraging
will be underpinning markets in the first half of 2010. The private sector (both households and businesses) is
We expect the second half of 2010 to be more chal- now deleveraging for the first time in many decades.
lenging, since the market will begin to be materially This is an important step towards re-establishing long-
impacted by the wall of Option-ARM and Alt-A resets term sustainability where demand is compatible with
combined with more writedowns related to Commer- the costs of servicing debt. The problem is that gov-
cial Real Estate, beginning at the end of 2010. ernments are continuing to spend money in order to

VIX Index, RHS Credit Spread (Moody’s BAA Rated Corporate Bond over 30-Year Government Bond Yield), LHS
90 6

80
5
70

60 4

50
3
40

30 2

20
1
10

0 0
02-01-1990

02-01-1991

02-01-1992

02-01-1993

02-01-1994

02-01-1995

02-01-1996

02-01-1997

02-01-1998

02-01-1999

02-01-2000

02-01-2001

02-01-2002

02-01-2003

02-01-2004

02-01-2005

02-01-2006

02-01-2007

02-01-2008

02-01-2009

In the first half of the year, we will likely see continu- stand in the way of deleveraging. The Japanese policy
ously narrowing trading ranges and lower implied response to the deflating Nikkei/Housing bubble from
volatilities in the options market. Every dip is likely to 1990 has been catastrophically costly and inefficient
be bought and the market will look like it was 2005- – yet virtually all governments in the developed world
2006 again. Risk-willingness is likely to stay strong for insist on pursuing the same, regrettable path. In a nor-
a considerable time and it probably won’t fade until mal world, that would be crowding out private sector
the second half of 2010. Although markets will be initiatives, but this is not a normal world. It is a world
(or are?) detached from reality, investors will increas- of hyper-credit creation and therefore, credit markets
ingly face the question: how can you reduce your seem to work quite well in an environment dominated
equity exposure, when GDP growth is still positive? We by record risk-willingness (so far).

–  13  –
 –  Outlook 2010 Year of reflation  –

Bank Lending Declining Despite Extreme Stimulus (Index 2002)

Japan Loans & Discounts Otstanding US Bank Credit Outstanding
Euro Area Loans to Non-Financial Sector Outstanding
1,9

1,7

1,5

1,3

1,1

0,9

0,7
01-05-2000
01-09-2000
01-01-2001
01-05-2001
01-09-2001
01-01-2002

01-05-2002
01-09-2002

01-01-2003
01-05-2003

01-09-2003
01-01-2004
01-05-2004

01-09-2004
01-01-2005
01-05-2005

01-09-2005

01-01-2006
01-05-2006
01-09-2006

01-01-2007
01-05-2007
01-09-2007
01-01-2008

01-05-2008
01-09-2008
01-01-2009
01-05-2009

01-09-2009
We expect the private sector deleveraging to continue rich, low-growth countries for the past decade. This is
in the next decade due to high(er) unemployment, changing and the consumers in the developed world
excessive spare capacity in most industries and continu- will have to tighten their belts. Fifteen of the most in-
ously difficult access to credit. This will result in disinfla- debted countries account for 47% of global consumer
tionary/deflationary pressures in especially the coming expenditure in 2009. In other words, rapid consump-
three years. The headline CPI deflation seen in 2009 tion growth in the developed world will not be a viable
has largely been a result of the YoY effect of collapsing path in the coming years. Emerging markets will have
energy prices in the second half of 2008. Core inflation to rely more on domestic consumption, and capital will
has moderated somewhat over the year, but we expect to a larger degree support the EM currencies, which
more of a flattening in 2010. As a side-effect from will appreciate vs. all the most liquid currencies.
more savings activities, the US current account deficit
will shrink considerably. Asian and ME countries have Labour markets: still under stress in 2010
demonstrated a clear reluctance to keep more USD Labour markets will continue to be under consider-
denominated assets, but US households and banks able stress in all of 2010. Looking at the US, there is
are more than able to replace the lack of buying from a strong, positive correlation between manufacturing
foreigners. The historical holdings of treasuries in US capacity utilisation and Nonfarm Payrolls (NFP). On
households and banks have been significantly higher. average, NFP only turns positive if capacity utilisa-
The same goes for balance sheets of households and tion creeps above 77. It is currently around 71 and
banks in the Eurozone. A combination of higher sav- even in recoveries, it rarely increases by more than 2
ings and a larger allocation of government securities in points per year. The current crisis might be different
household and bank balances will thus help keep the in severity and the recovery might therefore have a
yield curve flat in 2010. sharper V-form, so we will allow an assumption of a
3 points growth per year. Even with that assumption,
The change in international capital flows is another NFP should not be positive on average until 2012. On
megatrend reversal. It is an economic perversity that top of that, NFP actually needs to be above 200K per
poor, high-growth countries have been financing month in order to follow the population growth. We

–  14  –
 –  Outlook 2010 Year of reflation  –
therefore expect the unemployment rate to continue
increasing – but at a slower pace – until Q4 where it
will most likely stabilize around 10.7%.
Looking at Western Europe, the labour market typically
lags the US by around a year. That means that the
Eurozone unemployment rate will rise from the current
9.8% to around 10.2% in Q4. For Japan, we expect
the unemployment to rise as well, but only to 5.2%.
Labour markets in most of the developed world are
under severe stress due to labour arbitrage. The current
economic crisis serves as an excuse to reduce costs by
slashing expensive labour and outsource production
to low-cost countries in Eastern Europe or South East
Asia. Therefore, labour markets in the US and Western
Europe will not exhibit upward wage pressures in the
coming years.
Housing in 2010
Housing markets globally are not only beginning to
stabilize. Some are showing unfettered bubble-like
expansion again. Most noteworthy is Norway, which
barely noted the international crisis in housing. Nor-
wegian homes are now making all-time highs. Similar
thoughts are probably on the minds of the Australian
central bankers that have hiked interest rates by 75
bps. so far in the last half year. In the other extreme
the US housing market is still under considerable pres-
sure due to years of extremely lax and irresponsible
lending standards. While in most countries, the low-
end segment of housing is stabilizing because of low
interest rates and increased affordability, we still see
an additional downside of 5-10% for US housing. The
mid-to high-end of housing might drop even further
in the US due to oversupply and distressed sales. In
other words, housing is still an overall drag on the
performance of the US economy and we don’t expect
residential construction to contribute significantly to
any recovery in the US. Lending standards have been
less irresponsible in the Eurozone, so we only expect a
downside of 5% in general.
Potential triggers for a double dip
The sub-prime problem is about to be factored in,
since most sub-prime mortgages have been reset after
–  15  –
the two-year teaser rate periods. There is no doubt,
that sub-prime mortgages have caused substantial
problems on the balance sheets of financial institu-
tions. However, the wave of resets is now over and
most problems related to sub-prime now seem to be
dealt with. Unfortunately, another big problem is on
the way in terms of resets of the Option-ARMs and
Alt-As (a combined $3 trillion of debt outstanding)
that were primarily taken out by the mid- to high-end
(MTH) segment in US housing. Option-ARMs typically
had a five-year reset period rather than the two-years
in sub-prime and at the same time, the MTH segment
has typically been lagging the low-end segment in the
downturn from 2007. 2009 and most of 2010 are thus
characterized by a sweet-spot valley between reset of
sub-prime and option-ARM’s. The negative dynamics
of the sub-prime resets will be even more ferocious
for the Option ARMs, since they represent a big-
ger market and happen when the owners have even
lower or negative home equity. Taken together, Option
ARMs and Alt-A resets will from the end of 2010 and
onwards drain hundreds of billions of dollars from US
home owners that are in many cases unemployed or
in other ways unable to pay on the high Loan-To-Value
mortgages. At the end of 2009 we estimate that only
$500 billion of outstanding mortgage debt will have
been reset to market rates from teaser rates. Over the
coming three years, this amount will triple. That means
that the number of so-called “strategic defaults” will
continue to increase as any social stigma related to
default will gradually fade away as more and more
Americans hand in the keys to the bank (in the so-
called non-recourse states).
Another major problem stemming from US structured
finance is the Commercial Real Estate (CRE) (about
$3.5 trillion outstanding), which is awaiting a colossal
need for refinancing in the coming years. CRE delin-
quency rates have exploded but seemed to peak in
November. We estimate that 3%-5% of outstanding
CRE debt is likely to default and losses will be horrify-
ing, since the collateral has deteriorated significantly
since the most problematic CRE vintages (2005-2007)
were issued. Most vintages had a five-year refinance
built into the deals and these are now showing up in
the calendar, especially 2010-2013. So also on this
 –  Outlook 2010 Year of reflation  –
note, financial institutions will most likely face huge
losses or a need to allow maturity extensions (like in
the HY corporate bonds market), but this will put their
liquidity provisions under pressure and probably force
policy makers to extend TARP a third time.
One of the biggest and most influential, potential trig-
gers in 2010 could be a sharp decline in economic ac-
tivity in China. China has officially been able to main-
tain an impressive growth throughout 2009, but in our
opinion, the quality of the growth has been extremely
poor and we strongly doubt that they have had real
growth during all of the year. Data on Chinese electric-
ity use show a marked decline in the first half of the
year and the Chinese national accounting seems to us
to be highly contradictory. Lots of anecdotes about the
inconsistency of car sales and gasoline consumption,
empty skyscrapers etc. contribute to our scepticism on
China. Our overall view on China is a mix of shock and
awe and scepticism. There is no doubt that a mix of
strong work ethics and a very high investment-to-GDP
ratio have been underpinning strong growth for years.
But on the other hand, the Chinese economy is mixed
and therefore doesn’t allocate its capital efficiently. We
fear that the so-called investment-driven export model
for China has run into a brick wall of fading, Western
demand. Chinese exports are down almost 20% over
the last year and Chinese overcapacity is rampant in
especially metal manufacturing, concrete etc. Chinese
authorities are now considering how to reduce lending
growth in order to avoid bubbles and bad loans. We
say that it is too late and that will become apparent
in 2010 or 2011. The eyes of the world are looking at
China in the same way as they did on Japan in 1988.
–  16  –
Another potential trigger for market turmoil could be
further unravelling of Dubai debt. We have been of
the opinion that the problems in Dubai would and will
be a non-event to global, financial markets for two rea-
sons. First, the Dubai GDP (about $65 billion) is quite
modest in an international comparison and second, we
hold a great deal of sympathy for the small emirate.
Although the property boom was unsustainable, the
political structure (and tax system) of the country will
provide support for future growth and enable it to
attract business from not only the region, but from the
whole world. Nonetheless, a number of UK banks hold
a large exposure to Dubai, but we don’t expect it to
have material impact on markets in 2010.
Greece, on the other hand, is in danger of a deflation-
ary debt spiral like the one that Ireland has experienced
in 2009. Inflation is still positive (and actually rising to-
wards year-end), but huge budget and current account
deficits will be a real challenge for both Greece itself
and the European Union as a whole. Allowing Greece
to continuously violate the Maastricht criteria (budget
deficit to stay below 3% of GDP) would enforce moral
hazard and free riding. The EUR will suffer from the
dramatic tensions within the EMU and the imbalances
in the PIGS countries will provide an additional reason
to expect the EUR to underperform in the longer run.
Unlike Ireland, Greece has so far not been showing a
political will to solve the problems. On the contrary,
Greece has allowed them to grow for too long. Greece
is a real problem for the EUR, for the EMU and for EU
in 2010.
 –  Outlook 2010 Year of reflation  –

G r o w t h p e r sp e c t i v e s f o r 2 0 1 0

US: smooth sailing at first, but serious
challenges remain
The economy is picking up speed in the US, but how
much of the recovery is dependent on a US Treasury on
overdrive? Much, we believe. Our main scenario is for
weak growth in 2010, though not a double-dip. How-
ever, not much must go wrong before the prospects of
a double-dip increase.
The economy has rebounded somewhat in Q3 (and
most probably Q4) of 2009. This will be carried over
into 2010, supported by continued government
spending, private investment, and stimulus-induced
private consumption. The private consumer has been
aided in the second half of 2009 by various stimulus
programmes. Much of this stimulus is peaking now in
terms of the percentage effect and will soon begin to
level off. Consumption will reflect this in 2010 as con-
sumers will increasingly need to fend for themselves.
But for them to be able to consume, incomes must rise
sufficiently; a daunting prospect with unemployment
expected to remain above 10% throughout the year.
Private investment will also continue to contribute
positively to the economy in 2010 as inventories are
now so low relative to sales that some rebuilding is
needed. Business inventories are to have finally reached
a bottom, and the strength of GDP in 2010 is largely
dependent on the amount of inventory rebuilding
necessary. We do not expect a return to pre-crisis
inventory-to-sales levels, but less will do. Add to this
the fact that residential construction fell off a cliff in
2006 and is only now bottoming out for an annualized
decline of roughly 27%, and you have plenty of room
for an increase in private investment.
We target GDP growth of 2.2% in 2010, but recognise
that there are several risks to our forecast scenario.
Among them a CRE collapse, residential mortgage
resets, and a continued credit squeeze in small busi-
nesses are the most threatening.

US 2009Q4 2010Q1 2010Q2 2010Q3 2010Q4 2010

GDP (QoQ, SAAR) 3.2% 3.0% 2.3% 0.5% 1.6% 2.2%
PCE (QoQ, SAAR) 3.2% 2.1% 2.1% 1.5% 1.8% 2.1%
CPI (YoY) 2.5% 2.1% 1.7% 1.5% 1.2% 1.6%
Core CPI (YoY) 1.8% 1.7% 1.6% 1.7% 1.7% 1.7%
Unemployment Rate 10.1% 10.3% 10.4% 10.6% 10.7% 10.5%

Eurozone: modest growth ahead
The Eurozone exited the recession in 2009 Q3 carried
along by recoveries in Germany and France. But while
the Eurozone is no longer in recession, we foresee a
tough year with weak growth of 1.4%. The region
faces plenty of challenges, but private consumption
worries us the most.
unemployment rate of 10.3% some time in 2010 Q3,
which will curb private spending. The modest spending
by consumers will feed back to companies, which in
turn will take longer to bring the number of unem-
ployed down. It’s a difficult cycle to break, not least
when one’s currency is quite strong against major trade
partners.

All over the Eurozone, consumer spending faces head- The recovery in manufacturing is exhibiting signs of the
winds from weak labour markets. Companies continue sought-after V-shape, confirmed by recent surveys. But
to lay-off workers and we expect this to result in an as in the US, the service sector is facing stronger head-

–  17  –
 –  Outlook 2010 Year of reflation  –

winds than the manufacturing sector where stimulus We expect consumer prices to grow modestly in 2010
has been provided more directly and liberally. Retail after the Eurozone’s first ever bout with deflation in
sales are still down 1.9% year-on-year even though 2009. We target average growth of 0.8% in CPI.
they peaked two years ago.

Eurozone 2009Q4 2010Q1 2010Q2 2010Q3 2010Q4 2010

GDP (QoQ, SAAR) 1.9% 1.8% 0.9% 1.3% 1.2% 1.4%
CPI (YoY) 0.4% 0.9% 1.0% 1.2% 1.0% 0.8%
Core CPI (YoY) 0.7% 0.8% 0.8% 1.2% 1.1% 1.0%
Unemployment Rate 9.8% 10.0% 10.2% 10.3% 10.1% 10.2%

Japan: double-dip on the horizon
as deflation returns
Optimism was widespread as the Japanese economy
posted 2.8% growth in 2009 Q3, but it soon faded as
a revision to inventories brought GDP down signifi-
cantly.
We see risks of a double-dip lurking on the horizon.
Manufacturers are still cutting capital expenditures
and the unemployment rate is still higher than at any
point in the last five years. This will hurt both private
consumption and investment.
With meagre domestic demand it is not surprising
that Japanese officials are worried whenever the Yen
rallies against the currencies of major export markets.
With the domestic market out of the way, exports are
expected to lead Japan towards the path of recovery. A
strong Yen will make Japanese produce more expensive
for foreigners, and it can therefore come as no surprise
that it will not be welcome.
Japan finds itself in familiar waters as deflation has
once again gained a foothold. To combat this Japan
has turned to an old friend: stimulus. We question the
long-term impact of such packages even if it does pro-
duce some short-term gains in the economy. We must
not forget that Japan has produced several comebacks
in the last twenty years, but the end result has inevita-
bly always been the same; weak or even negative GDP
growth, and deflation. We target a weak 1.1% growth
for 2010.

Japan 2009Q4 2010Q1 2010Q2 2010Q3 2010Q4 2010

GDP (QoQ, SAAR) 2.0% 1.3% -0.4% 2.2% -1.9% 1.1%
CPI (YoY) -1.4% -0.7% -0.6% -0.4% -0.3% -0.5%
Core CPI (YoY) -1.0% -0.8% -0.4% -0.6% -0.5% -0.6%
Unemployment Rate 5.0% 4.9% 5.1% 5.0% 5.2% 5.0%

–  18  –
 –  Outlook 2010 Year of reflation  –
P o l i cy R a t e s i n 2 0 1 0
US monetary policy
On 4 November, the FOMC referred specifically
referred to ‘low rates of resource utilisation, subdued
inflation trends, and stable inflation expectations’, as
the economic rationale for keeping rates ‘exceptionally
low’ for an ‘extended period’.
Capacity utilisation is at 70.7% – extremely low in
historic terms – we have to go back to 1982 to see
anything remotely similar. Home vacancy rates are still
historically high; once again the story in the residential
property market is of a market just turning the corner,
but how strongly and how durably? Watch out for
future headwinds, such as the continuing massive
overhang of foreclosures and resets of Option-ARMs
with five-year negative amortization resets, which will
start to haunt the mid- to high-end segment.
We forecast quite subdued (core) CPI throughout
2010. Why? The combination of severe underutilisa-
tion of resources outlined above and a monetary policy
constrained by the zero-bound, represents a potentially
lethal cocktail, such that we should worry more about
a damaging period of deflation, rather than inflation.
Although the Japanese ‘lost-decade’ experience is by
no means an exact analogy, and the US policy response
has been much more aggressive, there are worrying
similarities. Arguably, the US economy was character-
ized by greater imbalances at the height of the ‘bub-
ble’ – with the greatest single problem being that debt-
fuelled consumption topped 70% of GDP – meaning
that the output gap in the US economy is much larger
than Japan ever faced.
The study of just how the public at large formulate in-
flation expectations is a somewhat opaque science, but
economists suggest that there is a tendency to form
inflation expectations somewhat irrationally, involving a
high degree of regard to recent, historical experiences.
If so, then the events of the last year or so, with rapidly
falling headline CPI, could lead to a damaging negative
feedback loop, leading expectations to begin to decline
once more.
–  19  –
All in all, and having due regard to what the Fed is ac-
tually telling us, (please also note how on 7 December,
the very first business day after release of the Novem-
ber employment report, when market rates blipped
up, Chairman Bernanke raced to reiterate the mantra
about ‘keeping rates low for an extended period’),
it seems highly unlikely to us that the Fed would risk
derailing the nascent and fragile, (Bernanke’s word), re-
covery. This is especially true given the declining stimu-
lus that will be forthcoming from already enacted fiscal
measures in 2010 and also the forthcoming natural
diminution in size of the Fed’s unconventional monetary
stimulus measures, to which we alluded above.
The Fed’s Funds Rate should remain unchanged
throughout 2010 and the resets of Option-ARMs,
the Alt-As and the refinance of CRE might force
the Fed to continue TARP’ing away money in
2010.
Eurozone monetary policy
As our forecasts suggest, we see 2010 as a year of
steady but modest recovery, with headwinds including
rising unemployment and subdued consumer spend-
ing and inflation. Against this, manufacturing seems
to be in much better shape, with inventory restocking
continuing, and PMI surveys have also turned for the
positive in many of the larger countries. Whilst there
are undoubtedly large variations in the fiscal health of
various member states (especially the PIGS countries),
the fortunes of the relatively smaller economies should
not be enough to derail recovery in the zone as a
whole.
The strength of the Euro poses a particular challenge
for especially Southern European exports. The risk
remains, however, that EURUSD could go well into the
1.50s due to a continuation of the USD bear trend. The
ECB would probably delay any rise in their official rates
in the face of a much stronger Euro. On 3 December,
the ECB announced that the last 1-year liquidity repo
would take place this month, with the rate to be
variable-indexed to the minimum bid rate at the regu-
lar MROs, and the last six-month operation will take
place in April 2010. Trichet underscored several times
that the change shouldn’t be seen as having any effect
 –  Outlook 2010 Year of reflation  –
on the future trajectory of rates. Euribor futures out
to June 2010 are almost back to their all-time highs,
implying rates at all-time lows.
Our central scenario would be for unchanged
rates, at least until Q4, driven by the fragile mac-
roeconomic landscape, possibly combined with a
strong Euro-the latter being the joker in the pack;
with excessive strength even leading to further,
final rate cuts – we would attach a 10%-20%
chance to this outcome.
Japanese monetary policy
Japan faces almost insurmountable challenges: weak
growth, strong JPY, deflation, leading to rising real
interest rates and fiscal irresponsibility. Although the
situation is improving slightly in 2010, the balance
sheet of Japan is still in a dire situation.
In the absence of further BOJ action, the danger
remains of continued appreciation of the yen with
Endaka, the Japanese word for the strong yen, becom-
ing an acute problem, due to the possible emergence
of a so-called ‘one-way bet’ as far as the market is
concerned.
In light of this, we should expect to see a pot pourri
of further measures from the BOJ, over the coming
weeks and months, possibly including a reduction of
the policy rate floor from 0.1% to 0.05%, a verbal
strengthening of the commitment to keep rates
low, ‘for an extended period’, inflation targeting
and/or a return to the commitment to continue
QE until core CPI had settled above zero. Further-
more, it seems obvious that the JGB purchases
will continue.
United Kingdom monetary policy
In many ways the UK economy faces exactly the same
challenges as the US to a greater or lesser extent; an
over-leveraged populace trying to shirk-off an exces-
sive consumption habit, hitherto fuelled by cheap
credit, high unemployment, a housing market in pain,
displaying a short-term stabilisation, a large output
gap, no foreseeable inflation problem, but massively
over-stretched public finances.
–  20  –
All-in-all a recipe for continued monetary stimulus,
especially in light of both main political parties’ avowed
intent to return the country to a degree of fiscal
probity-indeed we have witnessed the bizarre sight of
the two parties engaging in a desperate bid to appear
the more prudent in the run-up to the forthcoming
election, which must be held before 3 June 2010, and
which looks increasingly likely to be on 6 May.
It would seem unlikely that the Bank of England would
choose to ramp up its asset purchase programme
again, (QE), having put it on a reducing glide path of
£25bn over the next quarter, as opposed to the previ-
ous rate of £25bn per month.
Once again, ‘watch my lips’ should be the guid-
ance here. Despite the recent small increases
on the Bank’s own forecasts for growth and
inflation, Governor King has chosen to remain
stubbornly downbeat in his assessments of the
economy’s prospects for 2010, given the huge un-
certainties with which he, and the MPC, are faced.
Unchanged rates throughout 2010 would be our
central forecast.
Top trades for 2010 in interest rates
• Long 3-mth Dec 2010 Eurodollar contracts, (EDZ0),
to express the view that the FED stays on hold longer
than the market thinks, currently 98.78, target 99.70-
75 at expiry. The stop loss has to be as far away as
98.40, and then trailing- 40 ticks below the market if
the price rises- as there will be hiccups, as caused by
last week’s non-farm payroll release.
• Purchase June 2010 Euribor contract, (ERM0), 99.25
calls for 3.5 ticks. You should at least break-even – if
ECB rates haven’t moved up by then - and this trade
gives you a very cheap option to capture the chance
the ECB has to cut rates to curb massive Euro strength.
• Long Dec 10 3-mth Short Sterling futures contracts,
currently 98.21, looking for unchanged rates and
99.40 at expiry. Initially place a stop loss at 97.80, and
trail it 40 ticks below the market, as with USD futures,
above.
 –  Outlook 2010 Year of reflation  –
2 0 1 0 : B r e a k i n g up t h e o l d p a t t e r n s i n F X ?
The FX market in 2009 was dominated by the axis
of risk appetite and the emergence of the USD carry
trade. 2010 is a new year, however, and we suspect
that, just as few analysts got 2009 right, 2010 could
offer plenty of the unexpected for currency investors
and traders.
2009: the dramatic return from the brink
2009 began with another enormous downdraft in risk
appetite that followed on the previous fall’s global
deleveraging catastrophe. The nadir for risk appetite
was found already in early March, and from there asset
markets staged an enormous, almost uninterrupted
climb into the end of the year. The low yielding USD,
which had gained as a safe haven during the turmoil,
quickly became the funding currency for a vast new
carry trade as risk conditions at first improved, and
then went into outright rally mode. The weak USD
story was an easy one to justify: profligate public
sector spending in the face of tremendous economic
weakness and a simultaneous heavy dependence on
foreign capital flows to keep its bond market afloat.
The favourite currencies to buy against the dollar were
emerging market currencies and commodity currencies
like the Australian dollar
Outlook for 2010: whither risk appetite
and the USD carry trade?
As we head into 2010, we have to ask ourselves
whether the global risk appetite fiesta and current USD
carry trade theme will continue unabated into the New
Year or whether it is getting a bit long in the tooth al-
ready as we exit 2009. The answer is possibly “both”.
Our basic macro outlook calls for the rally in risk to
continue well into the New Year as the market con-
tinues to find hope in the spectacularly easy monetary
conditions provided by the world’s central banks. Those
looking at economic fundamentals will be encouraged
by some signs of improvement (a self-fulfilling side
effect of massive stimulus), but these will be relatively
modest compared to the continued rank speculation
in asset markets. In such an environment, we should
expect lower yielding currencies with inferior growth
rates to suffer – currencies like the US dollar and Japa-
nese Yen. But other forces may be at work besides the
seemingly ubiquitous “axis” of risk in the New Year,
–  21  –
and the USD may experience a resurgence of strength
on new themes.
Measuring the carry trade – the Saxo
Bank Carry Trade Model
During the year, we developed the Saxo Bank Carry
Trade Model in an attempt to determine when risk
conditions are favourable or unfavourable for carry
trades. Risk conditions are a ubiquitous concern for de-
termining the direction in many currencies over the last
several years, particularly the JPY before 2008 and the
USD after. The model measures whether risk conditions
are expanding or contracting (in the chart, whether the
blue line is above or below zero) rather than trying to
determine any absolute “level” and therefore suggests
when the carry trade should be in or out of favour. The
second step is then determining which currencies are
most likely to benefit and suffer from carry trading. The
chart shows a sample USD carry trade basket of the
USD vs. a basket of five emerging market currencies
and AUD and NZD. In the future, the funding cur-
rency for the typical carry trade may shift (for example
to the JPY and/or CHF) even if carry trade conditions
remain positive – or the market might find it difficult to
justify carry trades (outside of EM) with rate spreads so
compressed. Either way, it is clear that tracking risk is
important for understanding the dynamics of currency
movements.
Remember global imbalances?
It became clear during the credit implosion of 2008
and early 2009 that the enormous global imbalances
built up over the previous cycle could come unwound
very quickly if the market was left to its own devices. In
the second half of 2008, after all, the US Trade deficit
shrank by half in just a few months - and the Chinese
trade surplus shrank rapidly in early 2009. Instead, cen-
tral banks and governments stepped in - just as they
always do - to alter the course of economic history and
keep the global imbalances alive, if in a diminished
size. US consumers (and thus the US trade deficit) were
kept alive by a gargantuan Fed-led housing bail-out
and easy credit and consumer demand on crutches
and China’s massive stimulus kept the Chinese growth
engine humming, even as exports are well below the
pre-bubble days.
 –  Outlook 2010 Year of reflation  –
Still, we think that the evening-out of global imbalanc-
es could return as a theme in 2010. If current trends
remain intact in the New Year, the US will post its first
trade surplus, less petroleum, in 2010, and China could
be well on its way to becoming a deficit nation in early
2011. Other nations are seeing similar reversals to
their terms of trade as well – Australia’s trade deficit is
ballooning once again, and Canada’s current account
surplus has gone steeply negative this year after not
having posted a trade deficit since the mid-70s, even
as crude oil surged back above $70 per barrel. Eventu-
ally, the market may wake up to the reality that trade
and capital flows are not favouring an extension of
the market regime that dominated for much of 2009,
especially if the market begins to question the quality
and sustainability of the recovery as 2010 draws to a
close. Below, we will have a closer look at the G10 cur-
rencies in 2010.
USD: set to recover eventually as carry
trade loses its grip
The USD carry trade dominated the market’s atten-
tion as summer yielded to fall in 2009. As the low-
est yielding currency of the G10, and considering its
ballooning public deficits and a central bank engaging
in massive QE, selling the USD seemed a no-brainer
as risk conditions in global asset markets continued to
improve. And while the correlation of the USD with
risk may hold for some time into the New Year, new
themes may materialize that slow or halt this theme.
The cycles are always changing, after all, and usually
just when something appears likely to continue forever.
One troubling aspect of the USD carry trade is that it
may be more of an attractive concept than a reality.
A real carry trade should see tremendous borrowing
in US banks to finance investments around the world.
And yet, credit is still very tight at US banks, which are
hoarding liquidity to defend against further financial
doom still on their balance sheets. Thus, this carry
trade may be more about pure currency bets rather
than any outsized capital flows from the US head-
ing abroad. Developments in interest rate spreads
also favoured the carry trade in 2009, but a dramatic
extension of interest rate spreads to the detriment of
the greenback may not materialize in the New Year if
inflation fails to ignite. The USD outlook is highly un-
–  22  –
certain for the initial months of 2010, but as the year
progresses, it could stage a strong comeback against
the rest of the G10 currencies as huge bets built up
in 2009 in favour of its demise are forced to unwind.
As for the Fed, underlying economic fundamentals are
likely to keep the central bank sidelined on rates for
the balance of the year, with more exit strategy focus
on liquidity facilities rather than rate adjustments.
2010 Trade: Sell EURUSD. Sell AUDUSD on rallies
ahead of parity.
EUR: finding the middle of the road.
The euro finds itself somewhere in the middle of the
pack as we exit 2009. It has done very well against the
USD since EURUSD bottomed in early 2009 with the
focus on the USD carry trade and as China’s repegging
of its currency to the USD saw huge accumulation of
euros through reserve diversification. But if we look
over at a EURAUD chart, we can see how poorly the
currency performed against more high-octane growth
currencies during the year. This kind of middle of the
road performance is likely to continue into 2010. The
euro is overvalued against the USD, and as global
imbalances continue to unwind in the New Year, the
pressure from reserve diversification is likely to diminish
sharply. As well, rate expectations from the ECB are
likely to go nowhere in a hurry even though it appears
the ECB really wants to tighten up monetary condi-
tions as quickly as it can. Conditions in the weakest
Eurozone economies like Greece, Spain and Ireland, all
of which are stuck in the throes of a post-asset bub-
ble environment, are unlikely to be able to sustain a
recovery into 2011, especially if the ECB moves quickly
ahead with reducing the flow from the QE spigots as
quickly as they appear to want to. So the Eurozone
may be at eventual risk of a double dip.
2010 Trade: Sell EUR vs. GBP and USD
JPY: will the JPY carry trade return?
The JPY was a curiosity in 2009. It began the year on
the strong side after the debacle of 2008 on bets that
the world economy would continue to tumble into the
abyss. Rate spreads had collapsed against BoJ rates,
thus removing much of the advantage of the previously
 –  Outlook 2010 Year of reflation  –
popular JPY carry trade. Risk aversion in general was
also associated with a stronger JPY. Even before equity
markets bottomed, however, the JPY began to weaken
as the world realized that a weak global economy was
causing the most pain for export-dependent countries
like Japan and Germany and that a strong currency
would only compound that pain. So the JPY longs
were forced to back off early in the year. Since then,
however, the JPY has been a back-and-forth affair and
has largely followed the course of long US rates, a phe-
nomenon that may continue well into the New Year.
As long as this new liquidity bubble keeps inflating, the
JPY is at somewhat of a disadvantage, especially if this
translates into longer rates ticking higher. Also a poten-
tial JPY negative could be the uncertainty over how
the government plans to stimulate its way out of its
depressing return to deflation. JPY may have dramatic
swings throughout the year as the market tries to get a
grip on whether it believes the recovery will trigger se-
rious inflation down the road. As it is forced to realize
that disinflation is still the greater risk, perhaps by later
in the year, the JPY could stage a partial comeback.
2010 Trade: Buy USDJPY for 100 to 105
GBP: the contrarian’s pick?
GBP suffered greatly during the worst days for risk at
the beginning of 2009, bottoming against the rest of
the G10 currencies in late January and staying more
or less correlated with risk. When it became clear that
the world economy was not going to disappear into
the abyss, GBP rallied, but then sold off again as it was
clear that the BoE wanted to remain one of the most
aggressive in keeping rates low and launching massive
QE measures to fight off a banking and credit col-
lapse in its domestic market. This had the GBP trading
at times like a flavour of the USD carry trade as the
market had begun pricing in more hawkish monetary
policy elsewhere. If asset markets continue on their ro-
bust upward path for most of 2009, then the pound is
likely to perform relatively well, particularly as excessive
bearish sentiment on the currency likely means plenty
of stale sterling shorts that will need to be unwound as
the much talked about Armageddon for the currency
failed to materialize. One risk for the currency in the
New Year could be around the general election, which
–  23  –
by law must be held by June next year. The prospect of
a hung parliament (no party with an outright majority
– many consider this a likely scenario) is unsettling for
many, based on historical examples, and could cause
considerable volatility. Still, on a valuation basis, and
assuming that the bond vigilantes remain on hold for
a couple more years, the pound may do relatively well
against the broader market, especially versus those
currencies that have strengthened the most in the USD
carry trade.
2010 Trade: Buy GBP vs. EUR, CHF and NZD
CHF: SNB may not need to worry about
intervention
The SNB decided to intervene in 2009 through direct
currency manipulation - threatening to sell francs to
keep the risk of deflation at bay – rather than going
the QE route of the likes of the UK and the US. This
policy had the EURCHF cross in a vice grip close to
1.500 for the last nine months of 2009. The Swiss
economy has come back rather smartly from the
economic weakness and financial meltdown that un-
folded, but we find no strong reason to buy the franc
in the New Year. While the SNB may feel confident
enough at some point in 2010 to declare its interven-
tionist policy is at an end, it is unlikely to move on rates
or become positively correlated with risk appetite. CHF
is likely, therefore, to tend to the weaker side of the
market in 2010.
2010 Trade: Sell CHF vs. USD and GBP
AUD: high beta Chinese bubble tracker
AUD has been the high beta currency par excellence
for a long time now. The currency was devastated in
late 2008 by the unwinding of carry trades and the
collapse in interest rate spreads for Australia versus the
rest of the world. These developments were radically
reversed in 2009, however, as the market was im-
pressed by the lack of collateral damage Down Under
from the financial meltdown and owing to Australia’s
huge exposure to a resurgent China, which continues
to import key Australian commodities at breakneck
speed. The Aussie is the highest yielding currency in
the G10 and speculators (very crowded longs) are
 –  Outlook 2010 Year of reflation  –
positioned for more of the same in 2010. While a con-
tinued surge in asset prices could see the Aussie a bit
higher in early 2010, the currency is looking extremely
overvalued versus the broader market, and the sustain-
ability of the Chinese resurgence is questionable at
best. The second half of next year may not be kind to
the Australian dollar versus almost all of the rest of the
G-10.
2010 trade: sell AUDUSD on rallies. Sell AUDCAD
CAD: lost in the shuffle
CAD has shown little independent momentum against
the rest of the market in 2009 as it has found itself
caught between supportive and detrimental factors.
On the one hand, Canada is still a commodity currency
due to Canada’s tremendous endowment of natural
resources and the financial crisis showed that it had
the world’s most stable banks. On the negative side,
however, Canada’s manufacturing sector has been
gutted by the weakness in the US auto sector, and the
weakness in the economy and currency of the USA in
general, it’s dominant trading partner. A persistently
low interest rate and a central bank belly-aching about
the strength of the currency could mean that gains for
the loonie will be hard to come by versus the green-
back in 2010. A weaker oil market in the latter part of
the year could also be the source of further weakness
for the currency.
2010 trade: Sell AUDCAD. Buy USDCAD for 1.1500
NZD: carry traders look out…
As of mid-December of 2009, the New Zealand dollar
was the G10 currency with the highest 12-month
forward expected rate increase at close to 200 basis
points. This is despite the fact that the OECD recom-
mended that the country’s central bank keep rates
unchanged at 2.50% for some time to support the
fragile recovery. Nonetheless, the expected carry
advantage had the market bidding up the kiwi against
the lower yielders – especially the USD – for much of
2009. In 2010, the kiwi’s strength may continue for a
while, especially if the RBNZ moves forward with the
first of an already priced in series of interest rate hikes
in the second quarter, but the forward trajectory of
–  24  –
rate moves appears overdone already. And if the risk
aversion returns with a vengeance in the latter part
of the year, the combination of rate hike expectations
dashed and poor liquidity and economic fundamentals
could prove an ugly cocktail for the kiwi.
2010 trade: Buy a basket of EUR, GBP and USD vs.
NZD by the second quarter.
NOK: potential never to be realized?
The Norwegian krone tried to play safe haven for a
time in early 2009 as the FX market briefly flirted with
the theme of fiscal credibility – a theme that probably
favours the krone more than any other currency due
to the country’s absurdly robust balance sheet and the
massive “strategic reserve” of the oil fund. After that,
the krone reverted back to being a measure of risk
appetite and tracker of the price of oil as well. In the
summer and autumn, the krone was strong on expec-
tations for significant tightening from Norges Bank in
the year ahead. Later, however, the central bank made
it clear that it would not tolerate sharp speculative
strengthening of the currency and that rate hikes could
be cancelled if the currency was too strong. Norges
Bank is a bank to be taken seriously, considering its po-
tential firepower, especially relative to the poor liquidity
in NOK crosses. In 2010, the NOK may perform better
than the higher beta currencies as the year progresses
and could also gain a bit more ground on the euro, but
it will not live up to its full potential due to the scary
presence of Norges Bank and the thin liquidity of the
currency, as well as the potential for a weak energy
market in 2010.
2010 NOK trades: Sell AUDNOK, Buy USDNOK
SEK: better than euro?
The krona has tended to follow the wiles of risk ap-
petite and the strength of the global economy, due
to the tremendous importance of its export sector
for the country’s economic health. Thus, the krona
was very weak in early 2009 on the global deleverag-
ing theme, but staged a fairly strong recovery as the
market decided to put back on some risk. An added
twist for the SEK has been its exposure to the Baltic
States, especially Latvia, where its banks made signifi-
 –  Outlook 2010 Year of reflation  –

cant investments, much of which are likely to go sour
despite an IMF-led bailout, considering that country’s
attitude about repayment. Still, plenty of pain from
the Baltics was priced into the krona long ago. During
2010, we would certainly prefer the Swedish krona
to the euro as long as risk appetite remains on the
up-and-up based on the krona’s tendency to follow risk
appetite. But based on valuation, would also consider
accumulating SEK vs. EUR on any downdrafts in the
risk that result in kneejerk selling of the krona vs. the
single currency.
2010 SEK trades: Sell EURSEK for 9.75, buy USDSEK

–  25  –
 –  Outlook 2010 Year of reflation  –

T o p T r a d e s f o r F X Op t i o n s i n 2 0 1 0

Long USDJPY Call
Buy 1 year, Exp 8th of December USD Call Strike 107,
pay 85 JPY pips, (spot ref 88.70).
Rationale: Weak fundamentals in Japan, no rate hikes
in Japan in the future, while the yield differential to-
wards the USD might deteriorate, resurrecting the JPY
as a funding currency
Short EURCAD strangle
Sell 1 year, Exp 8th of December EUR Put, Strike
1.4500, sell EUR Call 1.6800, receive 590 CAD pips,
spot ref 1.5600.
extremes topside and downside in EURCAD in the last
5 years, low correlation to the USDJPY trade, with the
USD stronger on 2010 the EURUSD should go lower,
USDCAD should improve and keep EURCAD balanced
around 1,55/1,56
Short EURTRY Calls
Sell 1 year, Exp 8th of Dec EUR Call, Strike 2.6800,
receive 530 TRY pips, spot ref 2.2200.
Rationale: Lira undervalued in trade-weighted terms.
TRY lagged other high beta currencies in appreciation.
Fundamentally economy looks robust.

Rationale: EURCAD pivotal around 1,5500, the

break even of 1,3900 and 1,7600 covers nearly all

–  26  –
 –  Outlook 2010 Year of reflation  –
E q u i t y Ou t l o o k 2 0 1 0
In equity markets we expect the cyclical recovery to
continue through 2010, providing additional support
for equity markets in first half of 2010 and in the sec-
ond half of 2010 the strength of the recovery is to be
tested thoroughly by structural headwinds. We expect
the outcome of this test to lead equities lower.
Over the last two years markets have primarily been
driven by investor risk appetite. We expect this trend to
moderate somewhat and anticipate a more balanced
performance between cyclical and defensive sectors as
investor focus returns to fundamentals and valuation.
Furthermore, we expect to see a flight to quality on
single stock level led by a surge back to fundamentals
investing.
Earnings growth will drive equity markets, not valu-
ations. Despite this, there still is room for an expan-
sion of P/E ratios, we expect this to be limited due to
structural challenges preventing further expansion.
We continue to see equity markets fair valued, noting
that the rise in multiples during 2009 reflect investor
expectations for an earnings recovery.
On regional level we prefer emerging markets, are
neutral on US and Europe and underweight on Japan.
Our preference for emerging markets is primarily driven
by the expected growth in GDP, which historically has
been transformed into earnings growth. But the corpo-
rate sector in emerging markets also appears healthier
Table 1: Earnings Growth Forecast ex. Financials.
US
(S&P500)
Sales Growth (YoY) 6.2%
EBIT margin (level) 8.1%
Earnings Growth (YoY) 13.1%
As should be expected our top-down estimate of
earnings growth is lower than the consensus bottom-
up estimate. The gap is mostly a result of our lower
margin expansion forecast, as top-line growth assump-
–  27  –
than their developed counterparts; higher profit mar-
gins, lower leverage and improving asset turnover all
points towards that emerging markets are a premium
region (even though there are significant differences
within this region).
Our major play this year is to increase exposure
towards cyclicals, especially Energy in the first half
of 2010 and then towards defensives in the second
half of 2010. We expect a potential increase in equity
markets until mid-year 2010 and in past market rallies
of this magnitude cyclicals have clearly over performed.
However from mid-year and towards year-end 2010
we expect risk-aversion to re-enter the market as the
market starts to adjust itself to an environment with
higher interest rates, higher taxes, problems with com-
mercial real estate, resets in Option-ARMs in the US
housing market.
Earnings Outlook
We forecast decent earnings growth across all regions
(especially in emerging markets) as in Table 1 below.
However, as the forecasts show, there are significant
differences in the expected earnings growth across
regions and this is mainly due to differences in our GDP
expectations for each region. We arrive at the earnings
estimates by assuming a sales growth derived partly
from a volume and selling price estimates coupled with
an estimate of the EBIT margin.
Europe Japan EM
(DJStoxx600) (Nikkei225) (MSCI EM)
4.7% 2.6% 10.4%
11.2% 7.5% 12.3%
15.0% 8.8% 21.0%
tions are only marginally different. Consensus forecast
imply faster margin expansion than in the previous two
earnings recoveries even though the starting point for
margins are already above the historical averages. Our
 –  Outlook 2010 Year of reflation  –
expectations of lower GDP growth than after previous
recessions make it difficult to justify a record-breaking
margin expansion. Also consensus forecasts imply mar-
gin expansion in every sector, which did not happen
during the earnings boom of 2003-2007.
Sales growth
Sales growth can come from two sources: Volume
growth and price growth. On aggregate, volume
growth in the corporate sector is driven by real GDP
growth. Our economics team forecast limited growth
in Europe, USA and Japan, while they expect signifi-
cantly more growth in emerging markets. Using a
regional split of sales for each of the regions corporate
sectors we arrive at a volume growth estimate for
each of the regions. We expect the volume growth in
Europe to arrive at 2.6%, in the US 4.1%, Japan 2.0%
and 9.4% in emerging markets.
Forecasts for price increases that the corporate sector is
likely to be able to push through have to be based on
expectations for inflation. Our economics team expects
consumer price inflation to remain subdued next year,
at 0.8% in Europe and 1.6% in the US, -0.5% for
Japan and 4.9% in the emerging world. Of course not
all companies sell directly to consumers so PPI’s and
commodity prices also form part of our price growth
forecast.
We assume increased operational leverage. Aggressive
cost cuts by European, US and Japanese companies
are enhancing efficiency, i.e. more products can be
produced for less variable cost. Relatively inflexible
labour costs have also decreased, but naturally less so.
For instance in Europe in 2008, fixed costs accounted
for approx. 28% of total costs for the companies, but
for 2010 we estimate that the share of fixed costs rises
to 30% of total costs, increasing operational leverage.
Across regions we expect a similar development to take
place.
But it is important not to get carried away regarding
the benefits of operational leverage. Naturally it takes
volume growth to have large positive impact on bot-
tom lines. We expect volumes to increase decently in
Europe, US and Japan and somewhat more in emerg-
–  28  –
ing markets; however this is not quite enough to cre-
ate the same kind of operational leverage boost as in
the previous two cycles in Europe, US and Japan – but
it could very well be the case in emerging markets.
Margins
As a result of the above, we expect EBIT margins for
the European, US and Japanese corporate sector to
reach levels around 11.2%, 8.1% and 7.5%, while we
expect the corporate sector within emerging markets
to expand by 12.3%. This forecast implies that margins
will expand by slightly less than in previous two cycles
except for emerging markets, both of which were
accompanied by significantly greater volume growth.
History shows that volume growth is one of the key
drivers of margins, which can be explained by the ef-
fects of operational leverage.
When discussing margin expansion in 2010, it is
important to keep in mind that margins are already sig-
nificantly above historical averages in Europe, US and
Japan and emerging markets. In 2007, European EBIT
margins reached a record of 13%. Margins then con-
tracted during the recession, but thanks to impressive
cost-cutting efforts margins troughed above the levels
we had anticipated and led to the beating of earnings
expectations in both Q2 and Q3 2009. At approxi-
mately 10%, the 2009 expected European EBIT margin
is already 1% above the 25-year average. Given that
profit margins should in theory be (and have histori-
cally been a mean-reverting time series) the scope for
future margin expansion seems generally limited.
Another argument as to why we do not expect the
EBIT margin at least for Europe, US and Japan to
expand significantly is the relation between capacity
utilisation and EBIT margin. The absolute level and
change in capacity utilisation has a direct impact on
corporate margins and volume; historically the path of
EBIT margins has tracked closely with capacity utilisa-
tion levels.
The current collapse in capacity utilisation to record
lows has been accompanied by a record contraction in
margins. The rapid decline in utilisation reflects a pull-
back in demand. As companies cut back on production
 –  Outlook 2010 Year of reflation  –

to meet lower levels of demand, margins suffered from
reduced volume to cover fixed costs and diminished
pricing power. Our expectation for a modest recovery
suggests that capacity utilisation rates should rise dur-
ing the course of 2010, but will remain at somewhat
depressed levels for a number of years.
Valuations
In December last year and in March this year, equi-
ties looked very cheap by most metrics. Market P/Es,
whether based on trailing, prospective or cyclical ad-
justed EPS stood at multi-year lows, while the market’s
average dividend made all-time highs in most regions
(both including and excluding financials). But after
this year’s significant market rebound most valuation
metrics have normalized as demonstrated in the Chart
1 below.

Chart 1: P/E, P/CF, P/Book and CAPE for all regions – current as a % of 20 year average.

Current as a % of 20 year average

180

160

140

120

100

80

60

40

20

0
P/E P/CF P/Book Cape P/E P/CF P/Book Cape P/E P/CF P/Book P/E P/CF P/Book
EUR EUR EUR EUR US US US US JP JP JP EM EM EM

Source: Bloomberg, Thomson-Reuters Datastream, Saxo Bank Strategy & Research.

Note: The boom years of 1998-2001 has been excluded from the calculations.

The US CAPE (cyclically adjusted market P/E) has revert-
ed to its long term mean of 16x, after hitting 25-year
low of 12x in early March. In Europe the market CAPE
also rose, but less dramatically, from 9x to 13.5x.
The expansion in forward market P/Es was even more
dramatic, as a result of significant EPS downgrades and
rising equity markets at the same time. In Europe, for
instance, the 12-month forward EPS has been revised
down by nearly 40% since its peak in October 2008,
which contributed to a near doubling of the forward
market P/E. As a result, the forward market P/E has
also reverted to its mean. Most of the other valuation
measures have also reverted to their mean. So in total,
most valuation measures suggest that equities across
all regions are close to fair value, given that historical
averages are a reasonable proxy for fair value.

–  29  –
 –  Outlook 2010 Year of reflation  –

Further P/E expansion?
The key question for expected equity returns is the
potential for P/E expansion. Can share prices rise
over and above the expected rise in EPS? As long as
monetary policy remains accommodative and inflations
expectations remain benign, history suggests that the
answer is yes. There has been a loose, but unmistak-
able inverse relation between market P/Es and inflation
in the past as documented in Chart 2 below.

Chart 2: Relation between P/Es and Inflation in US

Price Earnings Ratio US CPI YoY% (inverted scale)

35 -4

-2
30
0

25
2

4
20

15
8

10 10

12
5
14

0 16
02-1980

06-1982

10-1984

02-1987

06-1989

10-1991

02-1994

06-1996

10-1998

02-2001

06-2003

10-2005

02-2008

Source: Bloomberg, Shiller, Saxo Bank Strategy & Research.

Indeed below-average bond yields and/or inflation
have been associated with above market P/Es. Given
that the current market P/Es are in line with their
historical averages and that yield ratios are still below
average, there is further room for equities to rerate.
This implies that equity markets could easily rise far
more than what is given by our EPS estimates.
But it is difficult to see what catalyst for such P/E
expansion would be. European, US and Japanese
short-term interest rates are as low as they can get
(even lower US, European and Japanese interest rates
than today’s would spell trouble for equities), inflation
expectations are as benign as they can get and the
potential for further contraction in corporate credit
spreads is very limited.
It may be that our assumptions regarding next year’s
earnings growth are too conservative. If the 2010 EPS
growth turns out to be stronger than expected, equity
markets are likely to remain well supported next year.
But this does not necessarily mean higher P/Es. The
2003-2007 bull market, for instance, was entirely driv-
en by strong and consensus-beating earnings growth,
not by multiple expansions, despite exceedingly cheap
credit and a benign inflationary environment.
In sum, there is scope for further P/E expansion thanks
to contained inflation expectations and loose monetary

–  30  –
 –  Outlook 2010 Year of reflation  –

conditions. Nevertheless, we assume stable or even
maybe slightly contracting market P/Es in 2010. This
is because the risk of changes in interest rates/bond
yields is asymmetric to the upside. Central Banks may
not raise their benchmark interest rates, but it is likely
that the market will start to anticipate a normaliza-
tion of monetary policy at some point in 2010. In
addition we would argue that valuations should be
somewhat lower than in the past because of major
macroeconomic challenges that lie beyond the current
cyclical rebound and in our view marks the entering a
new regime with lower growth, higher taxes, higher
unemployment and a de-levered, re-regulated financial
system.
We expect markets to continue its current rally well
into H1 2010. There will be setbacks during this ride,
but we do not expect a long term trend change at this
point. This will obviously lead us higher in equities by
H1 2010 compared to current levels. However we do
expect a market setback at some point in H2 2010,
possibly due to a disappointing earnings recovery,
rising bond yields due to budget deficit concerns,
problems in commercial real estate or reset of the
Options-ARMs in the US housing market. This explains
why our year-end target is not meaningfully above
current levels.

Index targets
In conclusion our headline index targets are based on
the conservative assumption of a slow earnings recov-
ery in all regions except for emerging markets.

Index Closing Level at 14th June December

of December 2009. 2010 target 2010 target
S&P500 1114 1250 1150
DJ Stoxx 600 247 275 260
Nikkei225 10106 10750 10320
MSCI EM 979 1180 1050

–  31  –
 –  Outlook 2010 Year of reflation  –
Investment themes for equities
Overweight emerging markets
Our preferred regional overweight allocation is in the
emerging markets, based on their superior growth
profile both in GDP and earnings terms and reasonable
valuations at current levels.
Recent performance in GDP growth terms and our
expected growth for this group of countries makes
investment attractive. In addition to the better outlook
for GDP growth compared the developed corporate
world in the emerging world also look in a better
shape than their counterparts in the developed world.
They have maintained higher profits margins, lower
leverage and improved asset turnover which has sup-
ported higher RoE compared to the developed world
since 2001. Combining expected higher GDP growth
and clean balance sheets we see little reason why
emerging markets should not be able to sustain and
possible further expand the current RoE premium to
the developed world.
Buy cyclicals now, buy defensives around
mid-year 2010
As we have pointed out we expect markets to continue
trading higher until around mid-year where we expect
markets to retrace on the back of structural head-
winds.
In our view broader equity markets will rally during
the first half of 2010 with potential upside between
10%-15% from current levels. Past market rallies of
this magnitude have been led by cyclicals and com-
bined with the continued low interest rate environment
we recommend staying exposed into cyclicals in the
first half of 2010. We prefer Information Technology,
Energy and Materials amongst cyclicals, but especially
energy. We expect the sector to be a beneficiary of the
global economic recovery and consequent rebound in
resource demand. The sector has recently begun catch-
ing up to the move in oil prices in H1, which we expect
to continue. The large integrated players (E&P) which
account for the bulk of the sector’s market cap have
lagged, and we believe a rotation towards this area will
lead to further outperformance. On single stock level
we prefer those companies with exposure to global de-
–  32  –
mand for energy, particularly those that are dedicated
to healthy dividend policies.
Despite our view on interest rates market consen-
sus believes that FED will start raising interest rates
mid next year. When markets start to anticipate rate
increases historically, risk has been taken off the table
and exposures have rotated towards defensives. We
suggest that for the second half of 2010 investors look
to buy into defensives.
On single stock level, across sectors, we prefer those
companies that pursue a healthy dividend policy. As
such dividend stocks are well suited for the low-growth
environment that we expect will take shape in the
developed world next year. Lower GDP and EPS growth
potential makes the contribution of dividends to total
returns even more important. There is also historical
evidence that dividend strategies tend to outperform in
periods of maturing economic growth, as we expect to
see in 2010.
A comment on decoupling, Asia and emerg-
ing markets
So-called decoupling is real and it is happening now,
but it is taking years if not decades to play out. Both
the US and the Eurozone suffer from excessive debt
burdens and unsustainable government budget defi-
cits. Investors looking for decent growth will have to
turn their eyes towards Asia (with the possible excep-
tion of Japan) and other emerging market regions that
are not suffering from the same problems. Below, we
are looking at some of the most interesting develop-
ments.
Japan – major challenges ahead
Japanese GDP showed two consecutive quarters of
positive growth in Q2 and Q3 2009 but there are fears
that the recovery may be short-lived. Manufactur-
ing production and exports are predicted to rise but
employment and income will remain stubbornly weak
as the economic stimulus measures initiated last year
as the world economy sputtered run out of gas. With
little or no hope of any robust growth in domestic de-
mand, the fate of the Japanese economy will be highly
dependent on its neighbouring Asian economies, most
 –  Outlook 2010 Year of reflation  –
notably China. Economic indicators are expected to
take a turn for the better but will likely remain low by
absolute measures.
In November 2009, the Japanese government an-
nounced that the country had officially entered
another period of deflation. Weak consumption will
exacerbate the situation as companies lower prices to
grab a bigger slice of a shrinking pie. The low interest
rate environment is therefore unlikely to change in the
near-term with the despondent consumption and slow
growth not providing any reasons for hiking rates. As
we head towards the end of 2009, talk is escalating of
renewed quantitative easing measures from the Bank
of Japan while we also await full details of the already-
planned additional budget from the new government.
Low interest rates will be taken advantage of as firms
raise capital to strengthen their balance sheets and
allocate funds towards capital investment. Another
major risk factor for Japan is the now ruling Democrat-
ic Party of Japan. The party has taken off with out-
standing approval ratings in May but the honeymoon
is expected to be fleeting. We believe the approval rate
for the Democratic Party will start to wane as the fiscal
deficit has potential to increase to more than 200%
of GDP. The disappointment will stem from unclear
economic policies and expensive campaign promises
that are unable to be responsibly met. Shaving 20% of
public spending and allocating cash to the people (a
popular promise on the campaign trail) may only lead
to higher savings with no increase in actual spending.
Indeed, we have already had talk of the first of these
promises being broken. Any further economic stimulus
over and above the supplementary budget is highly
unlikely bearing in mind the current staggering budget
deficit and amount of government debt outstanding.
Further deficit increases may trigger a downgrade in
JGBs resulting in higher long term interest rates.
The unemployment rate will continue to rise until Q2
2010 as companies remain cautious on new hiring.
The underlying social structure of the aging population
in Japan will surely not be helpful. One positive factor
might be corporate earnings that are likely to improve
as inventories gradually adjust downwards. Most
–  33  –
of the earnings are likely to be used to rebuild and
strengthen balance sheets rather than be distributed to
their employees as bonuses or paid out as dividends to
shareholders. As a corollary, unemployment levels will
likely remain high and income will not increase, keep-
ing personal consumption weak. This lower tax base
could put strains on the government’s budget revenue.
All in all, Japanese macro fundamentals look
weak, but especially small cap Japanese stocks
might have some upside, since they are trading at
rock-bottom price-to-book ratios – even with low
share of financial companies.
Indonesia – in a positive cycle
Indonesia might be one of the most interesting emerg-
ing market countries with the transition towards stable
elections and an apparently successful fight against
corruption and terror.
President Susilo Bambang Yudhoyono secured a sec-
ond five-year presidential term in July, despite failing
to meet his 2004 promise of halving the number of
people living below the government’s poverty line.
Mr Yudhoyono and his five-year-old Democratic party
secured 61% of the presidential vote and now has a
strong mandate to carry out necessary reforms and
investment in hard, soft and social infrastructure.
Indonesia enters 2010 having weathered the storm of
the global financial crisis quite successfully. As global
trade disintegrated and a number of South-East Asian
economies saw exports, and consequently growth,
disappear down the proverbial black hole, Indonesia’s
relatively low dependence on external trade (ex-
ports only account for 30% of nominal GDP) helped
insulate it to some extent from the external turmoil.
Nevertheless, growth did ease back to just above 4%
y/y in H1 2009, well below the 6.3% recorded in the
first six months of 2007 and 2008. The government
implemented a fiscal stimulus package in 2009 worth
around 1.4% of GDP consisting mostly of tax breaks,
subsidies and waiving of import duties. Indonesia now
looks on track to record full-year growth in the region
of 4.3-4.5%.
 –  Outlook 2010 Year of reflation  –
The prospects for 2010 are looking just as good
with growth expected to continue to be boosted by
the residual impact of 2009 stimulus measures and
implementation of major policies outlined during
the election campaign (infrastructure development
and reforming bureaucracy). Yudhoyono’s five-year
development plan targets economic growth of 7%
per annum, unemployment at 5% (latest data from
August at 7.87%, a nine-year low) and the poverty
threshold to 8%. The Indonesian government has set
a growth target of 5.5% for 2010 and believes that
the IMF’s forecast of 4.8% to be too low. Indonesia is
also benefitting from the benign inflation environment
we are seeing elsewhere, with latest data showing
inflation at a record low 2.4%, well below the official
forecast of 3.5-5.5% for 2009. If, as expected, the
benign environment prevails, then the drag on growth
will be minimal.
Despite last year’s additional fiscal measures, the gov-
ernment’s fiscal position remains strong. Fiscal restraint
in previous years has helped contain government debt
(both foreign and domestic) to 31% of GDP in 2009
and this is expected to ease further to 30% in 2010.
Indeed, the upgrade to Indonesia’s sovereign rating by
Moody’s in September, and S&P’s outlook in October,
underscores this improving situation.
However, all these positives do present some prob-
lems for the Indonesian authorities and as recently as
November there were rumours that Bank Indonesia
was concerned about “hot money” flowing into
short-term debt instruments and as such was consider-
ing imposing capital controls. The rumours remained
unsubstantiated and the brief “flutter” in both FX and
bond markets was soon dismissed. While the central
bank is active in its intervention in local currency mar-
kets, the operations tend to be more of a smoothing
operation within its mandated guidelines to maintain
stability in the rupiah. Bank Indonesia appears to prefer
a strengthening rupiah to manage inflation pressures
and, in the broader weak dollar environment, further
rupiah strength is likely towards 9,200 by mid-year
before stabilizing.
–  34  –
Indonesian Bank Rate currently stands at 6.5% having
fallen from its recent peak of 9.5% in late 2008. Bank
Indonesia has kept rates steady since July 2009 and,
amid the recovering economy and moves by other
central banks in the region (notably the RBA) there are
increasing expectations of an upward turn in rates in
2010. One big risk that Indonesia faces is a sharp spike
in oil prices, both from in inflation point of view but
also on the fiscal front, given the amount spent on fuel
subsidies in the domestic economy.
If our base case growth of 4.3% does come along
nicely with strong supporting economic numbers,
we could see JCI index up another 12% and test
last year’s highs of 2,838 as early as mid year.
In addition, further strengthening of the rupiah
could see additional upside in returns for inves-
tors in US dollar terms. In general, the Indonesian
economy looks like one of the most promising
places for investments in 2010.
China 2010 Outlook: A bubble brewing?
2009 was the year where the whole world hoped
China’s economic rebound would help rescue the glo-
bal economy. Notably the slowdown in late 2008 was
not simply a result of the global demand but also due
to an ill-timed tightening in credit controls. Hence the
response was much faster when authorities opened up
the credit spigots to maximum and launched massive
infrastructure spending programs. Growth rebounded
from a Q1 low of 6.1% to a projected 8.5% for the
full year and latest surveys are suggesting 2010 growth
could hit 9%-10%, though still short of the 10%
average seen over the past 30 years. We have our
doubts about the figures. Chinese national account-
ing seems to be inconsistent and not comparable to
normal standards. Electricity usage was down into Q2,
but industrial production was up. It doesn’t make any
sense to us.
Is the Chinese growth all stimulus? China’s retail sales
have been strong and inflation is in the positive, the
first time since January 2009. There are differing opin-
ions on how far China can grow with Asian investors
certainly more optimistic in their outlook. Concerns
about whether growth will tail-off once the impact of
 –  Outlook 2010 Year of reflation  –
stimulus measures wears off are valid and, as will likely
be the case in most economies, will likely be confirmed
or refuted in the second half of 2010. Our base case
scenario is for a China economy to continue to grow
well into 2010, supported by strong domestic growth
and a slower recovery in external demand.
However, the Chinese authorities are increasingly trying
to slow lending to avoid bad loans and the creation
of bubbles in real estate and stocks. In November, real
estate prices across 70 major cities registered a 6.5%
increase, the fastest since July 2008 - and even China’s
top developers are warning of price bubbles in cities
like Shanghai, Shenzhen and Beijing.
Chinese growth has been investment-driven. Not only
have huge investments enabled Chinese factories to
meet apparently endless Western demand, but the
building of factories and processing plants for steel,
aluminium etc. have also been going directly (and with
a good reason) into GDP measurement. The problem
is that the Chinese spare capacity in many industries
now is immense. The return on the marginal building
of factories is zero percent (or negative, if the building
and operation runs at a loss). Thus, stimulus in the now
traditional Chinese sense is meaningless. It is simply a
waste of resources, unless the global (demand) growth
comes roaring back.
The investment community has reluctantly but increas-
ingly been recognizing these the above considerations,
but it looks like the general perception is that China in
–  35  –
some way will be able to escape the “excess capacity
trap” by redirecting its huge resources towards domes-
tic demand. We are sceptical about this challenge and
believe that it would take years to conclude.
Much emphasis has been placed on the destination
of all the new loans under the credit expansion. The
release of more explicit directives to lenders about
“relevant” beneficiaries of the loans by the authorities
saw a sharp drop in lending figures and a subsequent
retracement in equity markets. We fear that we might
see more of these incidents in 2010 as authorities are
trying to avoid what they are now lambasting the US
for.
We think a scenario of such pre-emptive tightening
and withdrawal of fiscal stimulus is not a foregone
conclusion. China will not pull the rug out under its
own feet and China has ample reserves to shore up its
economy until concrete, sustainable and robust growth
comes back on the world economy.
Growth in China is likely to stay moderate in 2010
due to worries about bad loans and bubbles. 2009
growth will probably end at 9% and we expect
2010 growth to be around 8.5%. What might be
even more important is that China will decrease
its stockpiling of commodities since the strategic
reserves of basic materials (especially metals) is
unnecessarily high.
 –  Outlook 2010 Year of reflation  –
E n e r g y i n 2 0 1 0 : l i t t l e e xc i t e m e n t i n s t o r e
Despite the world’s long term march toward peak oil
– the time when daily oil supply to the world can no
longer be expanded – oil may see more downside than
upside in the New Year. Even a dramatic geopolitical
disruption related to Iran’s nuclear ambitions may do
little to upset the well-supplied energy markets.
After the spectacular collapse in oil in late 2008 on the
heels of the credit meltdown and worldwide reces-
sion, oil went on to rally more than 100% off its lows
around $35 dollar per barrel in early 2009 to as high as
$82 dollars by later in the year. Prices recovered as risk
appetite recovered in general and on higher demand.
As well, oil was partially caught up in the USD carry
trade and the idea that it was better to own hard
goods rather than paper currency, though this effect
was far more pronounced for gold than oil.
Developments in 2010:
There is a saying that the quickest cure for low oil pric-
es is low oil prices. That’s because the enormous capital
costs of finding and producing oil are so incredibly
high, and any protracted sell-off guarantees a future
supply contraction. In late 2008 and into 2009, we had
a protracted sell-off in oil, but this was preceded by
a multi-year bull market that saw record high prices,
thus confusing the dynamic somewhat, since it gave
impetus for gargantuan investments around the world
in exploration, production and refining. Saudi Arabia
invested in new technologies and restarted mothballed
fields and now has at least 2 million barrels a day in
spare capacity. As well, by mid-2009, the oil price
had rallied back to a level that allows most producers
to run with reasonable to hefty profit margins, even
if the priciest future supply expansion projects were
downscaled or scrapped – especially in the Canadian
oil sands.
So high oil prices choked off some demand and provid-
ed the capital for expansion of capacity in Saudi Arabia
and elsewhere, even as some countries saw overall
capacity continue to decline. On the consumption side,
to take an example, while US oil consumption has
levelled off after significant declines over the last years
of the oil rally, consumption is still running at levels of
five or six years ago and will clearly head south again
–  36  –
if prices were to rise significantly. Many argue that
the developed world’s sluggishness will be outpaced
by strong growth in demand from emerging markets,
especially a resurgent China. One analyst has estimated
that Chinese gasoline consumption could grow 25%
in 2010. While this represents an amazing growth rate,
for perspective, that represents about 275,000 barrels
a day of additional demand: that’s about the same
amount the US has been able to expand its oil produc-
tion over the last few years while demand has declined
and then stagnated.
Besides the largest exporter, Saudi Arabia, and its
unmatched spare capacity, further potential supply
expansions come from:
• Brazil: has nearly doubled its production over the last
10 years and has enormous deep water plays that will
continue to ramp in coming years
• Nigeria: the government has made overtures to the
local rebels who want a share of oil revenues. If the
rebels can be placated, a half million barrels /day could
quickly come on line
• Angola – where production has doubled in five years
and already sits at 2 million barrels per day.
We are firm believers that the earth’s oil endowment
is limited and that peak oil may already be upon us
now or within the next few years, but the combina-
tion of the stable to expanding supply in the short- to
medium-term and the shock to consumption in the
world’s biggest oil consuming nations in recent years
means that enough spare capacity is sloshing around in
the world energy system to amply supply the market at
the $70 dollar price point as we exit 2009.
As the year wears on, the market may realize
this and oil could sell-off back toward $40 a bar-
rel, though that price is unsustainably low for
the long term since it would cause widespread
carnage on the voracious capital and investment
needs oil fields require to keep humming.
 –  Outlook 2010 Year of reflation  –
Commodity outlook
The biggest financial crisis since the great depression
turned into a catalyst for positive price movements
in commodities during 2009. Investors looking for
opportunities combined with a system loaded with
cash from the biggest round of fiscal easing in living
memory turned to commodities as a way of shielding
their investments from dollar weakness and potential
future inflation pressures.
The flow of funds into commodity investments reached
new record highs after the dramatic contraction in
the early parts of 2009 and a continuation of these
flows will be as important as forecast for a continued
economic pick-up. The market will be watching central
banks closely for any signs of the implementations of
exit strategies away from the policy of providing cheap
money. Most importantly the US Fed will play a huge
role in how this scenario will play out
Precious metals
Gold continued its rally and finished 2009 higher for a
ninth year in a row and in the process reaching a new
record high at $1,226.50 in early December before
end of year profit taking kicked in. Investor’s interest in
gold continues unabated and flows into Gold ETFs and
futures reached new record levels.
What’s driving it? In 2009 Central Banks changed
strategy and after 30 years of net selling we are now
seeing net buying, especially from emerging economies
which are looking at ways of diversifying their reserves
away from financial into hard assets. India entered the
market in November buying 200 tons from the IMF
and has indicated that they want to buy a substantial
amount over the coming years. This comes on top of
continued speculation that Russia and China also want
to increase their holdings.
Another source of selling that ceased in 2009 were
forward selling by mining companies as Barrick, the
world’s largest pure gold mining company, announced
that they have stopped hedging their future produc-
tion. Instead they had moved to buy back their hedges
thereby aiding the positive sentiment even further.
This exercise is expected to have cost them up towards
$10 billion and is a good reflection of the failure of a
–  37  –
policy that for years was the norm among gold mining
companies.
Miners have increased supply somewhat in response to
the high prices in order to realize the underground as-
set. Several factors including the year on year expected
increase in value combined with the extra cost of
increase production will keep supply under control in
the coming year.
It is a popular belief that gold should be a hedge
against inflation. We believe that to be inaccurate.
Gold is a hedge against instability. It tends to rise in pe-
riods of unanticipated inflation as well as unanticipated
deflation/disinflation. That is why gold rallied in 1982
and in 1985-1987. That is also why gold is performing
extremely well in the current environment where the
US is experiencing the first deflation since 1955.
Gold still has a long way to go – both in terms of price
appreciation and in terms of years of increases. It will
at times be volatile, experiencing quarterly or yearly
declines of 30-50%, but the overall direction will be
higher. We target $1,200/oz in one year and $1,500/oz
in five. However, in the shorter term, we believe that
gold has been dominated by a big, speculative element
and that a correction might be due because of a dollar
rebound.
An earlier than expected change in US policy towards
tightening their monetary policy could have a negative
impact on gold prices. We do not, however, see this
happening well into 2010 or maybe beyond.
Agricultural products
Agricultural products experienced mixed fortunes in
2009 with Soybeans showing the best return, Corn
being flat and Wheat showing a decline. The weather
played a very big part in these performances as good
growing conditions in the U.S held the price of Corn
and Wheat under control while a drought in Argen-
tina led to a reduction in their output and subsequent
upside pressure on prices.
The price of corn is expected to perform well into 2010
despite a near record output in 2009. This expecta-
 –  Outlook 2010 Year of reflation  –
tion is driven by the continued increase in demand
for ethanol as a way of reducing the dependency on
fossil fuel. Adding to this a recovery in feed demand
and only a small increase in the planted acreage prices
should be well supported. We target 460 cents/bushel
in one year.
Wheat prices are expected to remain subdued relatively
as a combination of high inventories and slow demand
should keep the market ample supplied over the com-
ing year. On this assumption we could see the corn to
wheat ratio continue to climb higher from the current
level at 0.75 potentially targeting 0.90. Wheat does
not enjoy the support from emerging markets demand
and do not have any ethanol exposure. We target 550
cents/bushel in one year.
The impact from the weather should not be ignored as
2009 showed how agricultural prices were held hos-
tage to adverse weather various places on the planet.
Sugar rallied to multi-year highs on a combination of
delayed rain in India, the world’s largest consumer and
too much rain in Argentina the world’s largest pro-
ducer. The weather also had an adverse impact on the
price of rice which began to climb as the Philippines
had to import large quantities due to weather related
drop in domestic production.
We see sugar as having rallied enough to attract new
supply over the coming years and see prices weaker
during 2010. Meanwhile rice is another story and the
risk of a super-spike like the one in 2008 cannot be
ruled out. This comes as global rice production is ex-
pected to fall in 2009-10 for the first time in five years
as the El Nino weather phenomenon is playing havoc
among rice producing nations. For sugar we target
$16.5/lb and CBOT rice $19.5/cwt.
–  38  –
Special note: Demographics – the “distant”
problem approaches fast
The debate about the world’s ageing population and
unsustainable public pension systems has been around
for almost two decades. Our concern is that up until
now, governments in the developed world have only
established modest reforms to tackle this “distant”
problem. What are the economic implications of an
ageing society? In a few words, fewer working people
will have to fund a growing number of non-working
retired people. This is refereed to as the Mid-Young
(MY) or dependency ratio. Within the next five years,
there will be a sharp decline of the working age
population in developed economies as a percentage of
total population (starting today). It is evident, though
that the problem is not as severe in less developed
economies that face a more benevolent demographic
development. In the less developed economies, the MY
ratio will most likely continue increasing in the next 20
years (from about 65% to 67%), while MY ratio will
decline from around 67% to 62% in 20 years. As a
side note, this is an additional reason to expect higher
returns from emerging markets than from developed
markets.
OECD estimations indicate that public pension payouts
will grow exponentially and average around 15% of
aggregate national output throughout the developed
world within a few decades time. As a result of the
severely weakened world economy we argue that the
“distant” problem of an ageing population is not as far
away as policymakers believe. 2010 will according to
our estimates be the first year where the non-existing
Social Security Trust Fund will be in need of money
from the Federal Budget.
 –  Outlook 2010 Year of reflation  –

Federal Budget Income or Expenditure from the OASDI Trust

Funds, fiscal year, Billions of Dollars.
80

60

40

20

-20

-40

-60

-80

-100

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Source: US Congressional Budget Office and Saxo Bank Research

The trust fund has so far been kept off-budget by
Washington and the surplus of social security contribu-
tions over outlays has been consumed by Washington
pork barrel spending. 2010 will be the first year where
the Federal Budget (General Fund) will have to let the
money flow the other way. In economic terms, this is
a non-event, but it might serve as a symbolic event to
many Americans that have assumed the existence of
assets in the trust fund and now find that there are
none. The problem will still be “distant” for the next
seven-eight years, but from 2020, the General Fund
will have to set aside more than $100bn per year to
pay for retirement liabilities, if the current set-up and
coverage is continuing and if CBO assumptions are
realistic.
As mentioned earlier in this outlook we believe future
growth will be low because of the general reluctance
to deal with the crippling debt burden. With a pro-
tracted and jobless recovery with modest GDP growth
of around 2% per year in combination with household
deleveraging, which must also occur at state levels, the
effects of a large and old non-working population will
make a noticeable impact.
The slowdown in the world economy has not only
made people lose their jobs, but also reduced wages
and working hours for the ones still employed. Accord-
ing to the OECD, a worrying issue would be that we
experience a significant drop of middle-aged workers
in the labour force.
It is well known that a considerable share of a devel-
oped nation’s GDP constitutes of private consumption
expenditure (in 2008, US: 71% of GDP, UK: 67%,
France: 58% and Japan: 55%). These economies will
have to restructure as the debt burden has become
prohibitive for further, consumption-driven growth. The
widespread destruction of income generation made
the “distant” problem of retirement and exploding
pension costs move a lot closer in time and we believe
that especially Europe is facing a problem that needs to
be addressed within the next five years, if a sustainable
solution should be reached.

–  39  –
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