2009+Annual+Outlook

2009: A Tale
Of Two Halves
A Roadmap For The Global Recession

Contents

INTRODUCTION

Page 1

GLOBAL EQUITIES
Finding opportunities in a recession

Page 2

FIXED INCOME
Focusing on quality

Page 4

DISTRESSED ASSETS
Catalysing credit normalisation

Page 5

FOREIGN EXCHANGE
Weak confidence spurs dollar and a yen for safety

Page 6

Introduction

Amid unprecedented stress in the core of the global financial system, the world is now in the midst of a
global recession. Major industrial economies are expected to contract well into 2009 as adjustments occur
to raise the level of savings in these economies. The depth, scope and pace of this adjustment and the
recovery of the financial sector are likely to remain important sources of uncertainty for the next few years.
So even as the pace of economic contraction is expected to ease moving into the second half of 2009,
growth is likely to remain below trend even after an expected recovery in 2010.
Mitigating this cautious outlook, however, is the fact that many asset prices already seem to anticipate very
negative outcomes. Indeed, the performance of government bonds, equities and credit instruments in 2008
reflects very adverse expectations for fundamentals in 2009.
As a result, 2009 is expected to be a year of two halves. In the near-term, investment returns are likely
to be driven by ongoing trends of economic contraction, policy easing and de-leveraging, leaving equity
and credit products volatile. But at some point in the year, the extreme valuations seen currently in equity
and credit markets should provide attractive opportunities, as downside risks to economic growth dissipate
and de-leveraging pressures ease.
Against this backdrop, we highlight four investment themes which investors can leverage to navigate the
near-term economic contraction pressures and exploit emerging opportunities as these pressures ease in
the coming year:
•

Value Over Growth

•

Infrastructure

•

Investment-Grade Corporate Debt

•

Distressed Assets

Yet even as opportunities surface, it is crucial to remember that the key to capital preservation and growth
for investors remains diversification and a proper evaluation of one’s risk tolerance.
Chart 1. World GDP growth (PPP)
8%

8%
Actual

7

7

Trend
6

1.25 St.Dev.

6

5

5

4

4

3

3

2

2

1

1

0

0
1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000 2005 2010

Source: Maddison, IMF, and Citigroup (as at 3 December 2008)

2009: A Tale Of Two Halves

01

GLOBAL EQUITIES

Finding opportunities in a recession
Seeking value should yield handsome returns when the market eventually turns, while
renewed government spending on infrastructure presents long-term investment opportunities.

Value over growth
In the wake of the MSCI World’s 48% decline in 2008, global equities are now trading at their
lowest valuations since the early-1980s. However, sceptics are rightly cautious about overly
optimistic earnings expectations, in particular, when referencing valuation opportunities. To
adjust for this, Citi analysts note that in recessions going back to the 1970s, the return on
equity of companies around the world typically bottomed out at around 8%. Assuming this
trend still holds in the current cycle, global equities are trading near 17x expected trough
earnings, again the cheapest they have traded in over two decades.
With attractive valuations in the backdrop, Citi analysts believe that there will be two key
points ahead as this earnings and economic recession plays out. The first point is a turnaround
in share prices on anticipation of economic stabilisation and recovery. This turn is expected
near the middle of 2009. Next, equity prices are expected to get a further boost when downward
earnings momentum abates in 2010 and corporate profits turnaround, as an economic recovery,
albeit moderate, takes hold.
In Asia, the case for value appears strong. Equities in Asia excluding Japan are now trading
at 1.1x book value, close to the levels seen in previous financial crises (1997-98) and severe
global economic slowdowns (2001-02). Looking back to 1975, the region has typically bottomed
out between 21 and 23 months after the valuation peak (third quarter, 2007 in the current
cycle). Drawing on history, this suggests a trough may be reached in the second half of 2009.
Against this backdrop, investors should find opportunities from taking a value approach to
equity markets in 2009. Growth strategies have historically provided shelter for investors
when entering a recession. But as the recession matures, value strategies outperform growth
strategies as low valuations mitigate the impact of on-going earnings disappointments as the
recession ebbs.

Table 1. Value vs growth stocks in recessions that lasted more than six months
Year

Growth

Value

1970
1974
1980
1981
1982
1990
2001
Average Returns
Standard Deviation

-5.8%
-32.4%
38.5%
7.5%
19.0%
0.0%
-17.6%
-0.8%
23.4%

9.9%
-21.7%
26.9%
0.1%
23.0%
10.5%
-6.0%
3.1%
17.8%

Source: Ibbotson Associates. Data from 1969 to 2001.

Undoubtedly, value investing poses its own challenges as it requires a bottom-up approach
in identifying stocks that are not only attractive in valuation, but also possess appealing
fundamentals such as high returns on capital and a strong balance sheet to sustain even a
prolonged economic downturn. Value investing also requires patience, as business momentum,
either through economic recovery or operating and market share gains, needs to first improve
before investors can reap the benefits of this strategy.

02

2009: A Tale Of Two Halves

Key Investment Themes 2H08

Finding opportunities in a recession

Global infrastructure
Just as the global recession is creating value opportunities, the slowdown is also the beginning
of a long-term rebalancing of the consumer-heavy US/world economy. Highlighting this shift
most starkly has been the announcement and anticipation of fiscal stimulus programmes from
the world’s largest economies.

Chart 2. Fiscal stimuli around the world
7.0%
6.0%

% of local GDP

5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
Australia

China

Announced Stimulus

Japan

Korea

UK

Projected Stimulus

France

Germany

EU

US

IMF Recommended Stimulus

Source: Citi Private Bank (as at 3 December 2008)
Note: China stimulus impact estimated by Citi Investment Research; UK/US projections from press reports; US stimulus
expected in 2 parts.

Fiscal programmes announced so far have increasingly focused on infrastructure spending
as tax cuts and consumer-linked stimuli, as seen in the US in mid-2008, have proven to yield
only temporary benefits. Infrastructure spending comes at an opportune time, especially in
developed markets. The OECD notes that government investments (fixed capital investments
in economic parlance) have, as a share of gross domestic product (GDP), been in decline since
1970. In particular, the OECD notes that US infrastructure stock-to-GDP sits at the lowest level
in five decades. With the useful life for public infrastructure (e.g. roads, bridges, power plants)
estimated at 30 to 50 years according to Macquarie, it would seem that large-scale investments
to modernise and beef up infrastructure now is likely to bring much economic and productivity
benefit. And with the recent fiscal stimulus announcements, it appears infrastructure spending
is likely to be on an upcycle for some time to come.

Chart 3. OECD government fixed capital formation as % of GDP
5%

4%

3%

2%
1960

1970

1980

1990

2000

2010

Source: OECD (as at 11 April 2008)

2009: A Tale Of Two Halves

03

FIXED INCOME

Focusing on quality
Down-beaten high-grade corporates offer opportunities with attractive valuations, without
the potential risks of heightened default rates that are expected to plague the high yield
market. As for treasuries and other government debt, valuations have reached levels which
appear unattractive relative to other high quality alternatives.

Favouring investment grade corporate debt
Corporate fundamentals are likely to deteriorate in 2009 amid the global recession. As consumer
and corporate demand fall, profits are likely to decline and could trigger a substantial rise in
default rates, which are expected to rise to between 10% and 12% in 2009.
Yet at the same time, the difficult economic environment has led to a drastic widening in credit
spreads to levels that appear to have overshot fundamentals. This appears especially so for
investment grade bonds.
Indeed, Citi analysts believe that even as corporate fundamentals continue to worsen next
year, de-leveraging pressures are expected to ease off at some point as risk appetite improves.
This would result in tighter credit spreads between investment grade bonds and sovereign
debt, as demand and prices for investment grade bonds rise.
By contrast, Citi analysts are less positive on high yield bonds. Despite historically wide spreads
and yields in the 18% range, Citi analysts believe that significant risks remain in the sector.
Given the weak economic outlook, high-yield defaults are likely to increase. Citi analysts are
thus cautious about the sector, favouring to wait on the sidelines until volatility subsides. In
addition, Citi analysts believe that the difficult economic environment and the ongoing deleveraging process may lead to even wider credit spreads for high yield bonds. As yields move
inversely to price, this would be negative for high yield bond values.

Chart 4. High yield corporate default rates against corporate spreads
Default Rates

1200

STW

1100

14%
12%

1000

STW (bp)

8%

700

6%

600
500

Default Rates

10%

900
800

4%

400

2%

300

0%

200

Jan-85 Jan-88

Jan-91

Jan-94

Jan-97

Jan-00 Jan-03

Jan-06

Source: Citigroup (as at 16 December, 2008)
Corporate default rates of only 0.51% in 2007 are likely to rise significantly in light of the global recession. Historically,
corporate defaults have averaged 3.86% since 1971. In addition, with high yield spreads at or near all time highs, Citi analysts
believe that investors also expect default rate to increase over the next 12 months.

Cautious on government bonds
With long-term interest rates falling dramatically since June to historically low levels, government
bonds, treasuries and high-grade sovereign debt appear to offer little long-term value from
a historical perspective. Current ten-year US treasury yields of less than 3% do not seem
particularly attractive to Citi analysts, considering that US inflation has averaged 2.8% since
1992 and equity markets currently have dividend yields of approximately 3.5%.
In addition, government debt issuance is likely to rise next year to fund expansionary monetary
policies. But the increased supply of treasuries may not be met by a corresponding rise in
demand, which will temper any further rise in government bond prices.
Citi analysts thus remain underweight US treasuries, as current prices appear over-valued and
may start to decline once conditions begin to normalise and supply concerns take hold. Citi
analysts are also cautious on the outlook for UK government bonds, as the forecast for gilt
issuance in the year ahead appears extreme.
Among the emerging markets, Citi analysts continue to recommend investors seeking exposure
to favour economies that are likely to remain better insulated from the global economic
slowdown and countries with a minimal amount of political risk. For new money, Citi analysts
recommend investing in short-term maturities.
04

2009: A Tale Of Two Halves

DISTRESSED ASSETS

Catalysing credit normalisation
With a possible change in economic sentiment later in 2009, distressed asset investors
can look to taking advantage of the current downturn and filling the credit gap left by the
crippled securitisation market.
With 2009 looking to be a year of two distinct halves, distressed asset investors should serve
as a key catalyst for the transition between the first stage – characterised by economic
contraction, policy easing and de-leveraging – to the second stage, in which downside risks
to economic growth dissipate, de-leveraging pressures ease, and currently extreme equity
and credit valuations begin to normalise. Typically, distressed asset investors will attempt
to influence the process by which issuers restructure their debt. Indeed, they were key to the
normalisation of credit markets in Asia during the 1997-98 financial crisis.
The extreme valuations seen currently in equity and credit markets are driven in a large part
by an inability to recycle credit within the global financial system. This is due chiefly to the
shut down of the securitisation market, on which global banks rely heavily. While Citi analysts
do not expect a large scale re-opening of the securitisation market, the entry of distressed
asset investors provides an opportunity for banks to once again generate liquidity on their
balance sheets by selling assets, an activity previously assumed by securitisation. With the
entry of these previously sidelined investors, banks – and the broader financial system – can
begin to reverse the credit tightness that has characterised the global economy over the
past year.

Chart 5. HFRI Distressed/Restructuring Index Returns
40%
30%

Yoy return

20%
10%
0%
-10%
-20%
-30%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Bloomberg (as at 19 December 2008)

In addition, high equity market volatility and wide credit spreads have historically been
favourable for distressed asset strategies. With volatility elevated for much of the past quarter
and Moody’s Baa bond spreads near six standard deviation readings, the current global
financial market backdrop mimics previous periods in which distressed asset investors
performed well.
With default rates now increasing (a key catalyst for many distressed asset investors) and
some US banks having sufficient capital to take further write-downs and sell distressed assets
from their balance sheets, Citi analysts expect distressed asset investors to be more active
in 2009. Just like in the US recession in the early 1990s, the Asian crisis-induced recession
in 1997-98, and the global recession in 2001-02, Citi analysts believe the current downturn
may translate into attractive prospects for the distressed asset space over the next two to
three years.

2009: A Tale Of Two Halves

05

FOREIGN EXCHANGE

Weak confidence spurs dollar and a yen for safety
Heightened risk aversion and crippled credit markets should support dollar and yen
appreciation, though unprecedented Fed easing sets the stage for the greenback’s eventual
fall when financial conditions recover.
Uncertainty over the global economic outlook and volatility in financial markets are likely to
dominate the currency landscape in the first half of 2009. A deepening downturn, coupled
with sputtering credit markets, is expected to keep investors seeking safety first, setting the
stage for further strength in the US dollar (USD) and Japanese yen (JPY). While anticipation
for US president-elect Barack Obama’s fiscal package and the near-zero Fed funds rate have
whetted risk appetites, heightened risk aversion is likely to prevail until clear signs of recovery
in both the economy and banking sector emerge, hopefully in the second half of the year.
A call for dollar appreciation may seem a tad odd at first glance as the US, which is suffering
its worst recession in more than 20 years, is at the epicentre of the current turmoil. In addition,
aggressive monetary response by the Federal Reserve has seen the policy rate slashed down
to an unprecedented level of between 0% and 0.25%. But as is clear by now, ripples from
the initial subprime shock have spread to the rest of the world, with some industrial economies
taking even more damage than the US itself. Also, the Fed is not alone in reducing interest
rates, with the European Central Bank, Bank of England and other central banks likely to make
further cuts of their own in the next few months.

De-leveraging and market dysfunction drive dollar shortage
Heightened risk aversion and market dysfunction have emerged as key determinants of the
dollar’s trajectory in 2008. Tight credit conditions and risk aversion amid a recessionary
outlook are causing investors and companies to raise cash by selling assets they had bought
with dollar loans in a process called de-leveraging. As they do so, they buy back dollars to
repay the loans, hence raising demand for the currency. At the other end, while flush with
cash from the Fed, banks remain highly reluctant to lend it out, preferring instead to hoard
their dollars in safe-haven instruments like US Treasury Bills. Indeed, dollar funding constraints
have reached such extreme levels that the yield on three-month bills recently became negative
for the first time as investors traded a small loss for security.
This trend looks set to prevail for at least the first six months of the year as a meaningful
normalisation of credit markets appears elusive in the near term. But unprecedented easing
by the Fed, along with enormous fiscal spending, should eventually put the dollar on a
depreciation path as long-term fundamental concerns about the US’ external deficit come to
the fore. With interest rates likely to remain low, Citi analysts say a cheaper dollar may be
the only way to attract foreign money needed to fund the US’ large and growing debt.

Chart 6. USD trade-weighted index

90

85

80

75

70

65
Jan-08

Jul-08

Source: Bloomberg (as at 16 December 2008)

06

2009: A Tale Of Two Halves

Jul-08

Oct-08

Weak confidence spurs dollar and a yen for safety

Carry-trade unwind boosts yen
The outlook for the yen is clearer, with signs pointing overwhelmingly towards further
appreciation. Like the dollar, the yen was a favourite funding currency for foreign investments,
given Japan’s low interest rates. But market volatility as well as narrowing interest rate
differentials have prompted a reversal of those carry trades. The unwinding process is expected
to continue well into 2009, lending further strength to the yen – even more so than the dollar.
Indeed, the Japanese currency is expected to appreciate against the greenback through the
year, possibly touching low 80s to the dollar.
The yen’s gain, however, may be tempered if its rise overly hurts Japan’s export-dependent
economy. Japanese policymakers may intervene in the currency market to help the country’s
exports stay competitive in a weak global market.

Euro and sterling in the doldrums
In Europe, the euro-area and UK economies appear headed for a more severe downturn than
in the US, and this is likely to drag down the euro and sterling against the dollar. The sterling,
in particular, is expected to remain weak well into the year, reflecting the UK’s deep recession,
ballooning fiscal deficit and falling interest rates.

Slowing economy and current account concerns dog Asian
currencies
Asian currencies are likely to continue their decline in the coming year. Economic growth in
the region, including China, is slowing, while current accounts are deteriorating. Citi analysts
see the Korean won, Indonesian rupiah and Indian rupee as the most vulnerable due to the
countries’ bigger external financing risks. As for China’s yuan, policymakers are expected to
keep the currency from appreciating against the dollar at least until global financial risks
subside. Falling commodity prices and interest rate cuts are expected to cast a pall over the
Australian dollar in the near term. But the currency may recover some lost ground later in the
year, especially if China, the biggest buyer of Australia’s commodities, avoids the worst of the
global downturn.

2009: A Tale
2009:
Of Two
A Tale
Halves
Of Two05
Halves

07

Economic Growth & Inflation Forecasts
GDP

Global

Inflation

2008F

2009F

2010F

2008F

2009F

2010F

2.6%

0.5%

2.6%

5.2%

2.5%

2.6%

US

1.3%

-1.5%

1.7%

4.0%

0.2%

0.7%

Europe

1.0%

-1.4%

0.5%

3.3%

1.2%

1.3%
-0.2%

Japan

0.2%

-1.2%

1.1%

1.5%

-0.2%

Latin America

4.5%

2.2%

2.8%

8.9%

8.8%

8.7%

Emerging Europe

5.0%

2.4%

4.7%

11.2%

8.5%

5.9%
5.5%

Middle East & North Africa

5.3%

2.6%

4.6%

12.2%

6.9%

Asia

6.9%

5.6%

6.6%

7.0%

2.7%

3.5%

China

9.3%

8.2%

8.5%

6.1%

1.4%

3.5%

Hong Kong

2.5%

0.3%

2.3%

4.5%

2.7%

2.2%

India

6.8%

5.5%

6.6%

10.5%

5.0%

4.5%

Indonesia

6.0%

3.8%

5.0%

10.2%

6.0%

5.0%

Malaysia

5.2%

3.1%

4.9%

5.7%

3.6%

2.4%

Philippines

4.3%

3.0%

4.6%

9.5%

5.3%

3.9%

Singapore

2.2%

-1.2%

3.8%

6.6%

1.2%

2.1%

South Korea

4.2%

2.0%

3.8%

4.7%

3.0%

2.5%

Taiwan

2.1%

1.5%

3.0%

3.6%

1.0%

1.2%

Thailand

4.5%

1.0%

3.1%

5.6%

1.1%

2.5%

Source: Forecasts from Citi Investment Research, as of 3 December 2008

Exchange Rate Forecasts (vs. USD)
1Q09

2Q09

3Q09

4Q09

Europe

1.20

1.17

1.15

1.15

Japan

93

92

90

88

1.43

1.39

1.37

1.37
0.70

UK
Australia

0.65

0.68

0.70

China

6.90

6.85

6.75

6.65

Hong Kong

7.770

7.775

7.775

7.780

India

48.50

48.30

48.25

48.00

Indonesia

10500

9500

9300

9000

3.78

3.80

3.61

3.48

Philippines

Malaysia

52.00

51.50

51.00

49.50

Singapore

1.60

1.65

1.55

1.48

1325

1300

1300

1275

Taiwan

South Korea

34.00

34.30

33.80

33.30

Thailand

36.00

36.25

35.75

35.50

Source: Forecasts from Citi Investment Research, as of 12 December2008

Interest Rate Forecasts
Current

1Q09

2Q09

3Q09

4Q09

US

0.25%

0.00%

0.00%

0.00%

0.00%

Europe

2.50%

1.50%

1.00%

1.00%

1.00%

Japan

0.10%

0.10%

0.10%

0.10%

0.10%

Australia

4.25%

3.50%

3.50%

3.50%

3.50%

UK

2.00%

1.50%

1.50%

1.50%

1.50%

Source: Forecasts from Citi Investment Research, as of 3 December 2008. Current rates as of 19 December 2008.

08

2009: A Tale Of Two Halves

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