SAXO Outlook 2010

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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 believed 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 believes 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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DaviD karsbøl DireCtor, CHief eConomiSt
David Karsbøl has a master’s degree in economics from the University of Copenhagen, 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 marketing. today, Christian works with equity market and single stock analysis using a top-down approach by identifying the macro forces that will affect the investment 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 Copenhagen, 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 macroeconomic topics and develop and maintain Saxo Bank’s macroeconomic models based on econometrics. mads publishes comments and analysis on macroeconomic topics and is responsible for the Bank’s macroeconomic models.

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rObin bagger-sjObaCk marKet StrategiSt
robin Bagger-Sjoback has a B.Sc. in international Business and is a macroeconomic analyst. His role includes supplying research notes and updates on various macroeconomic topics and developments. robin joined the bank in may 2009. in addition to distributing a variety of research notes on macroeconomic developments, robin is partly responsible and a key contributor to Saxo Bank’s tradingfloor website. 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 website and relishes regular dialogue on the markets with clients at industry gatherings, such as awards dinners and conferences, at which he has in the past spoken.

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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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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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oUtrageoUS ClaimS 2010

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 better 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 deciding factor in devaluing the CnY vs. the USD.

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 irresponsible 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 deciding 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 government budget. thus, part of social security outlays will

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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 combination of indian drought and over-normal Brazilian rain. the forward curve already indicates considerable 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-

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.

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2010 toP10 PiCKS

1) shOrt eurtry anD Zartry the trY is currently undervalued in our opinion. inflation 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.

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 bottom, 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

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 numerous sources of deflationary pressures. the labour market 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.

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 valuation 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

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.

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

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).

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-

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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 1.551.56. 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.

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reCaPPing oUr 2009 Portfolio

With anno Horribilis staring us squarely in the eyes we constructed our portfolio accordingly. With the worldwide 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 program in China – the world’s largest relative to gDP. China quickly managed to reflate their asset bubble and australia hasn’t looked back since.

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.

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P r e m i S e S f o r Y e a r lY o U 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 enormous 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 relaxation 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 recovery 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 unprecedented consumption binge. We entered the third one by the second half of 2009 and this one is not only fos-

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 creditinduced 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 unserviceable, 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 serviceable 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 “onebet 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.

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all leading indicators are roaring higher (although one might argue that most are unduly focused at the growth of monetary aggregates) and it is thus very unlikely to see weak growth the first half of 2010. although growth is likely to be decent, monetary policymakers will not be in a position where they feel they can tighten monetary policy and the combination of decent growth and extremely lax monetary policy will be underpinning markets in the first half of 2010. We expect the second half of 2010 to be more challenging, since the market will begin to be materially impacted by the wall of option-arm and alt-a resets combined with more writedowns related to Commercial real estate, beginning at the end of 2010.

therefore expect market positioning to be quite bullish towards the end of the year and the viX to continuously edge lower. that will be signalling that we are entering a high danger zone and most investors will again be searching for the proverbial yield. MegatrenD Change is here: Private Deleveraging the private sector (both households and businesses) is now deleveraging for the first time in many decades. this is an important step towards re-establishing longterm sustainability where demand is compatible with the costs of servicing debt. the problem is that governments are continuing to spend money in order to

VIX Index, RHS
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Credit Spread (Moody’s BAA Rated Corporate Bond over 30-Year Government Bond Yield), LHS
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in the first half of the year, we will likely see continuously narrowing trading ranges and lower implied volatilities in the options market. every dip is likely to be bought and the market will look like it was 20052006 again. risk-willingness is likely to stay strong for a considerable time and it probably won’t fade until the second half of 2010. although markets will be (or are?) detached from reality, investors will increasingly face the question: how can you reduce your equity exposure, when gDP growth is still positive? We

stand in the way of deleveraging. the Japanese policy response to the deflating nikkei/Housing bubble from 1990 has been catastrophically costly and inefficient – yet virtually all governments in the developed world insist on pursuing the same, regrettable path. in a normal world, that would be crowding out private sector initiatives, but this is not a normal world. it is a world of hyper-credit creation and therefore, credit markets seem to work quite well in an environment dominated by record risk-willingness (so far).

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Bank Lending Declining Despite Extreme Stimulus (Index 2002)
Japan Loans & Discounts Otstanding
1,9

US Bank Credit Outstanding

Euro Area Loans to Non-Financial Sector Outstanding

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

We expect the private sector deleveraging to continue in the next decade due to high(er) unemployment, excessive spare capacity in most industries and continuously difficult access to credit. this will result in disinflationary/deflationary pressures in especially the coming three years. the headline CPi deflation seen in 2009 has largely been a result of the YoY effect of collapsing energy prices in the second half of 2008. Core inflation has moderated somewhat over the year, but we expect more of a flattening in 2010. as a side-effect from more savings activities, the US current account deficit will shrink considerably. asian and me countries have demonstrated a clear reluctance to keep more USD denominated assets, but US households and banks are more than able to replace the lack of buying from foreigners. the historical holdings of treasuries in US households and banks have been significantly higher. the same goes for balance sheets of households and banks in the eurozone. a combination of higher savings and a larger allocation of government securities in household and bank balances will thus help keep the yield curve flat in 2010. the change in international capital flows is another megatrend reversal. it is an economic perversity that poor, high-growth countries have been financing

rich, low-growth countries for the past decade. this is changing and the consumers in the developed world will have to tighten their belts. fifteen of the most indebted countries account for 47% of global consumer expenditure in 2009. in other words, rapid consumption growth in the developed world will not be a viable path in the coming years. emerging markets will have to rely more on domestic consumption, and capital will to a larger degree support the em currencies, which will appreciate vs. all the most liquid currencies. labOur Markets: still unDer stress in 2010 labour markets will continue to be under considerable stress in all of 2010. looking at the US, there is a strong, positive correlation between manufacturing capacity utilisation and nonfarm Payrolls (nfP). on average, nfP only turns positive if capacity utilisation creeps above 77. it is currently around 71 and even in recoveries, it rarely increases by more than 2 points per year. the current crisis might be different in severity and the recovery might therefore have a sharper v-form, so we will allow an assumption of a 3 points growth per year. even with that assumption, nfP should not be positive on average until 2012. on top of that, nfP actually needs to be above 200K per month in order to follow the population growth. We

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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. norwegian 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 pressure due to years of extremely lax and irresponsible lending standards. While in most countries, the lowend 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

the two-year teaser rate periods. there is no doubt, that sub-prime mortgages have caused substantial problems on the balance sheets of financial institutions. 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 bigger 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 socalled 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 delinquency 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 horrifying, 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

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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 triggers in 2010 could be a sharp decline in economic activity in China. China has officially been able to maintain 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 electricity 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.

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 reasons. 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 deflationary debt spiral like the one that ireland has experienced in 2009. inflation is still positive (and actually rising towards 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.

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– OutlOOk 2010 Year of reflation –

groWtH PerSPeCtiveS for 2010

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. However, 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 consumers 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 businesses are the most threatening.

us gDP (qoq, Saar) PCe (qoq, Saar) CPi (YoY) Core CPi (YoY) Unemployment rate

2009q4 3.2% 3.2% 2.5% 1.8% 10.1%

2010q1 3.0% 2.1% 2.1% 1.7% 10.3%

2010q2 2.3% 2.1% 1.7% 1.6% 10.4%

2010q3 0.5% 1.5% 1.5% 1.7% 10.6%

2010q4 1.6% 1.8% 1.2% 1.7% 10.7%

2010 2.2% 2.1% 1.6% 1.7% 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. all over the eurozone, consumer spending faces headwinds from weak labour markets. Companies continue to lay-off workers and we expect this to result in an

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 unemployed down. it’s a difficult cycle to break, not least when one’s currency is quite strong against major trade partners. the recovery in manufacturing is exhibiting signs of the sought-after v-shape, confirmed by recent surveys. But as in the US, the service sector is facing stronger head-

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– OutlOOk 2010 Year of reflation –

winds than the manufacturing sector where stimulus has been provided more directly and liberally. retail sales are still down 1.9% year-on-year even though they peaked two years ago.

We expect consumer prices to grow modestly in 2010 after the eurozone’s first ever bout with deflation in 2009. We target average growth of 0.8% in CPi.

eurozone gDP (qoq, Saar) CPi (YoY) Core CPi (YoY) Unemployment rate

2009q4 1.9% 0.4% 0.7% 9.8%

2010q1 1.8% 0.9% 0.8% 10.0%

2010q2 0.9% 1.0% 0.8% 10.2%

2010q3 1.3% 1.2% 1.2% 10.3%

2010q4 1.2% 1.0% 1.1% 10.1%

2010 1.4% 0.8% 1.0% 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 significantly. 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 produce 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 inevitably always been the same; weak or even negative gDP growth, and deflation. We target a weak 1.1% growth for 2010.

japan gDP (qoq, Saar) CPi (YoY) Core CPi (YoY) Unemployment rate

2009q4 2.0% -1.4% -1.0% 5.0%

2010q1 1.3% -0.7% -0.8% 4.9%

2010q2 -0.4% -0.6% -0.4% 5.1%

2010q3 2.2% -0.4% -0.6% 5.0%

2010q4 -1.9% -0.3% -0.5% 5.2%

2010 1.1% -0.5% -0.6% 5.0%

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– OutlOOk 2010 Year of reflation –

P o l i C Y r at 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 underutilisation 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 characterized by greater imbalances at the height of the ‘bubble’ – with the greatest single problem being that debtfuelled consumption topped 70% of gDP – meaning that the output gap in the US economy is much larger than Japan ever faced.

all in all, and having due regard to what the fed is actually telling us, (please also note how on 7 December, the very first business day after release of the november 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), recovery. this is especially true given the declining stimulus 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 spending 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

the study of just how the public at large formulate inflation 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.

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 regular 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

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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 macroeconomic 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, becoming 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. furthermore, 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 excessive 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.

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 previous rate of £25bn per month. Once again, ‘watch my lips’ should be the guidance 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 uncertainties 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 99.7075 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.

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– OutlOOk 2010 Year of reflation –

2 0 1 0 : B r e a K i n g U P t H e o l D Pat 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 already 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 continues 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 Japanese Yen. But other forces may be at work besides the seemingly ubiquitous “axis” of risk in the new Year,

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 determining 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 currency 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, central 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.

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– OutlOOk 2010 Year of reflation –

Still, we think that the evening-out of global imbalances 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. eventually, 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 currencies in 2010. usD: set tO reCOver eventually as Carry traDe lOses its griP the USD carry trade dominated the market’s attention as summer yielded to fall in 2009. as the lowest 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 heading 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-

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 conditions 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 bubble 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

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– 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 phenomenon 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 potential 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 serious 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 collapse 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 robust 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

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 unfolded, 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 interventionist 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 impressed 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

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positioned for more of the same in 2010. While a continued 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 sustainability 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 greenback 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 recommended 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

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 expectations 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 potential 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 appetite 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 deleveraging 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-

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– 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

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toP traDeS for fX oPtionS in 2010

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 towards 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. rationale: eUrCaD pivotal around 1,5500, the break even of 1,3900 and 1,7600 covers nearly all

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.

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– OutlOOk 2010 Year of reflation –

eqUitY oUtlooK 2010

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 second 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.

than their developed counterparts; higher profit margins, 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

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 valuations. Despite this, there still is room for an expansion 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 corporate sector in emerging markets also appears healthier

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 commercial 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.

table 1: earnings growth forecast ex. financials. us (s&P500) Sales growth (YoY) eBit margin (level) earnings growth (YoY) 6.2% 8.1% 13.1% europe (Djstoxx600) 4.7% 11.2% 15.0% japan (nikkei225) 2.6% 7.5% 8.8% eM (MsCi eM) 10.4% 12.3% 21.0%

as should be expected our top-down estimate of earnings growth is lower than the consensus bottomup estimate. the gap is mostly a result of our lower margin expansion forecast, as top-line growth assump-

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

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expectations of lower gDP growth than after previous recessions make it difficult to justify a record-breaking margin expansion. also consensus forecasts imply margin expansion in every sector, which did not happen during the earnings boom of 2003-2007.

ing markets; however this is not quite enough to create 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

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 significantly 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.

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 effects of operational leverage. When discussing margin expansion in 2010, it is

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 bottom lines. We expect volumes to increase decently in europe, US and Japan and somewhat more in emerg-

important to keep in mind that margins are already significantly above historical averages in europe, US and Japan and emerging markets. in 2007, european eBit margins reached a record of 13%. margins then contracted 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 approximately 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 historically 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 utilisation 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 pullback in demand. as companies cut back on production

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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 during 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, equities looked very cheap by most metrics. market P/es,

whether based on trailing, prospective or cyclical adjusted 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 EUR

P/CF EUR

P/Book EUR

Cape EUR

P/E US

P/CF US

P/Book US

Cape US

P/E JP

P/CF JP

P/Book JP

P/E EM

P/CF EM

P/Book 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 reverted 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.

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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 unmistakable 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
35

US CPI YoY% (inverted scale)
-4 -2

30 0 25 2 4 6 15 8 10 12 5 14 0 16

20

10

02-1980

06-1982

10-1984

02-1987

06-1989

10-1991

02-1994

06-1996

10-1998

02-2001

06-2003

10-2005

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 driven 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

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– 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 normalization 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. inDeX targets in conclusion our headline index targets are based on the conservative assumption of a slow earnings recovery in all regions except for emerging markets.

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 S&P500 DJ Stoxx 600 nikkei225 mSCi em

Closing level at 14th of December 2009. 1114 247 10106 979

june 2010 target 1250 275 10750 1180

December 2010 target 1150 260 10320 1050

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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 supported 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 headwinds. 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 combined 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 catching 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-

mand for energy, particularly those that are dedicated to healthy dividend policies. Despite our view on interest rates market consensus 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 eMerging 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 deficits. investors looking for decent growth will have to turn their eyes towards asia (with the possible exception 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 developments. 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. manufacturing 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 demand, the fate of the Japanese economy will be highly dependent on its neighbouring asian economies, most

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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 announced 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 alreadyplanned 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 Democratic Party of Japan. the party has taken off with outstanding 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

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, keeping 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 emerging market countries with the transition towards stable elections and an apparently successful fight against corruption and terror. President Susilo Bambang Yudhoyono secured a second 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 (exports 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%.

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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 government’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 problems 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 considering 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 markets, 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.

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 investors 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 global 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 accounting 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 opinions 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

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– 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 increasingly been recognizing these the above considerations, but it looks like the general perception is that China in

some way will be able to escape the “excess capacity trap” by redirecting its huge resources towards domestic 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.

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– OutlOOk 2010 Year of reflation –

energY in 2010: little eXCitement in Store

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 recession, 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 prices 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 provided 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

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 production 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 combination 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 barrel, 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.

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– 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 production. 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

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 asset. 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 periods 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 argentina 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-

– 37 –

– 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 coming 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 hostage 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 producer. 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 expected 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.

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.

– 38 –

– OutlOOk 2010 Year of reflation –

Federal Budget Income or Expenditure from the OASDI Trust Funds, fiscal year, Billions of Dollars.
80 60 40 20 0 -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 contributions 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 protracted 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. according 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 developed 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 –

DisClaiMer general analysis DisClOsure & DisClaiMer risk warning

these pages contain information about the services and products of Saxo Bank a/S (hereinafter referred to as “Saxo Bank”). the material is provided for informational purposes only without regard to any particular user’s investment objectives, financial situation, or means. Hence, no information contained herein is to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation, or trading strategy would be illegal. Saxo Bank does not guarantee the accuracy or completeness of any information or analysis supplied. Saxo Bank shall not be liable to any customer or third person for the accuracy of the information or any market quotations supplied through this service to a customer, nor for any delays, inaccuracies, errors, interruptions or omissions in the furnishing thereof, for any direct or consequential damages arising from or occasioned by said delays, inaccuracies, errors, interruptions or omissions, or for any discontinuance of the service. Saxo Bank accepts no responsibility or liability for the contents of any other site, whether linked to this site or not, or any consequences from your acting upon the contents of another site. opening this website shall not render the user a customer of Saxo Bank nor shall Saxo Bank owe such users any duties or responsibilities as a result thereof.

Saxo Bank a/S shall not be responsible for any loss arising from any investment based on any analysis, forecast or other information herein contained. the contents of this publication should not be construed as an express or implied promise, guarantee or implication by Saxo Bank that clients will profit from the strategies herein or that losses in connection therewith can or will be limited. trades in accordance with the analysis, especially leveraged investments such as foreign exchange trading and investment in derivatives, can be very speculative and may result in losses as well as profits, in particular if the conditions mentioned in the analysis do not occur as anticipated.

Saxo Bank a/S · Philip Heymans allé 15 · 2900 Hellerup · Denmark · telephone: +45 39 77 40 00 · www.saxobank.com

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