j=f=p~=r~=J=g=OMNN

Disappointment of the past few months to give way to a reacceleration in US growth Since the trend of disappointing US economic data began in late April and the Greek debt crisis started to escalate, equity markets have fallen as much as 7% and bonds have rallied. During the second half of the year, the US economy is likely to reaccelerate thanks to a combination of lower oil prices and a restarting of the Japanese supply chain, which should be particularly beneficial for the auto and information technology industries. The almost 25% rise in oil prices in the three months to the end of April, triggered by Middle East unrest, has since been all but erased, partly reflecting news that the International Energy Association will release oil from its strategic reserves for only the third time since it was founded in 1974. This pullback will boost US business and consumer confidence, which is very sensitive to petrol prices. Consumer confidence should also benefit from a recovering labour market as small businesses get more access to credit and start hiring. Japan is experiencing a pronounced V-shaped recovery from its devastating earthquake and tsunami. Industrial production rose at its fastest pace since 1953 in May and has in the space of two months recovered 40% of its post quake fall. Retail sales have recovered even more rapidly, already regaining 80% of their earthquake-related drop. Although the Greek parliament has voted for further austerity measures in order to receive the next tranche of loans from the EU and the IMF, it seems unlikely that Greeks will stick to these plans. Consequently, further standoffs between Greece and the EU/IMF are likely when its progress is reviewed in September and December. Moreover, Greece remains insolvent - a reality that cannot continue to be avoided indefinitely. With concerns about Greece on the back burner for now and US data likely to take a turn for the better over the rest of the year, investors will slowly become less risk averse and more willing to focus on value. Equities are better value than government bonds at current levels, and we believe willingness to look through the current uncertainty and hold equities will be rewarded. Among bonds, emerging-market and corporate debt, particularly high-yield, offer the best return potential. After all, company and emerging-market balance sheets are in better shape than those of governments in the developed world. Gold continues to provide important ballast to portfolios, and its price should rise further if policy-makers in the developed world continue giving in to the temptation to reduce their heavy debt loads by keeping interest rates below inflation rates and their currencies falling. Emerging-market equities have returned around five percentage points less than developed markets so far this year, hampered by rising inflation and interest rates. However, with oil and agricultural commodity prices well off their earlier highs, inflation pressure looks set to diminish in the second half of the year. This will ease investors concerns of a hard landing and enable emerging-market equities, which trade at a discount to their developed-market peers, to outperform later in the year. Nevertheless, the outlook is not without risks. Greece remains unfinished business, the US will default on its debt if the debt ceiling is not raised by 2 August and the market needs to digest the implications of QE2 coming to an end in the US.
Alan Higgins
Head of Investment Strategy UK

US business and consumer confidence should be lifted by the retreat in oil prices and, in the case of consumers, job growth Japan's recovery from a devastating earthquake has been surprisingly rapid An insolvent Greek government has cleared one hurdle, but more lie ahead

A temporary calm in the euro-zone crisis and improving US data should boost risk appetite

With inflation pressure waning, faster-growing emerging markets should outpace developed peers over the rest of the year But unfinished business in Greece and a showdown over the US debt ceiling loom
Carl Astorri
Global Head of Economics & Asset Strategy

Jean-Maurice Ladure
Head of Investment Strategy Europe

Norman Villamin
Head of Investment Strategy Asia

James Butterfill
Equity Strategist

Henry Lancaster
Senior Investment Analyst

Julien Seetharamdoo
Bond Strategist

Georgios Tsapouris
Investment Strategist

firstname.lastname@coutts.com

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The oil price is well below its April highs amid some stabilisation in Middle-East politics and release of strategic reserves by the IEA
120 110 100 90 80 70 60 50 40 30 Jan 09 May 09 Sep 09 Jan 10 May 10 Sep 10 Jan 11 May 11
Source: Bloomberg

Lower oil and hence petrol prices should give a boost to US consumer confidence, which is sensitive to prices at the pump
-60 % yoy

$ / bl

WTI OIL PRICE

risk premium

-40 -20

US GASOLINE PRICE & CONSUMER CONFIDENCE

% yoy

120 100 80 60 40 20 0 -20 -40 -60 -80

monetary policy + stronger growth

0 20 40 60 04 06 08 Michigan confidence expectations (Lhs, inverted) Gasoline price (Rhs) 10

Source: Datastream, Bloomberg

Lower oil prices should similarly lift business confidence, which was also dented by supply-chain disruption from Japan's quake
-100 -50 0 50 100 150 98 00 02 04 06 Global PMI (Rhs) 08 10 12 WTI (Lhs, adv. 1year, inverted)
Source: Bloomberg

US banks have started lending again, which is key to the recovery given the recession was caused by a seizing-up in lending
65 60 55 50 45 40 35
1700 1600 1500 1400 1300 1200 1100 1000 900 800 04 05 06 07 08 09 10 11
Source: Bloomberg

% yoy

GLOBAL PMI & OIL PRICE

$ bn

US COMMERCIAL & INDUSTRIAL LOANS & LEASES OUTSTANDING

Easier credit conditions should help small businesses start hiring and investing again
25 20 15 10 5 0 -5 -10 -15 95 99 0 07 11

An improving labour market will bring with it a rise in consumer confidence

200 180 160 140 120 100 80 60 40 20 0 70 73

NFIB SMALL BUSINESS SURVEY: LOANS AVAILABILITY & HIRING PLANS

US UNEMPLOYMENT & CONSUMER CONFIDENCE

0 2 4 6 8 10 12

0 -2 -4 -6 -8 -10 -12 -14 -16 -18

76

79

82

85

88

91

94

97

00

03

06

09

Small business hiring plans index (Lhs) Small business availability of loans index (Rhs)
Source: Bloomberg

Consumer confidence current conditions (Lhs)

Unemployment (Rhs, inverted)

Source: Bloomberg

Japan is experiencing a 'V-shaped' recovery from its devastating earthquake and tsunami, bringing disrupted supply chains back online
102 100 98 90 96 94 92 Jan 11 Feb 11 Retail sales (Lhs) All charts are as at 04/07/11 Mar 11 Industrial production (Rhs) Apr 11 85

If economic data continues to improve as we expect, this will boost equity markets at the expense of bonds
100 50 0 -50 -100
Above av. Increasing Decreasing 6.2% 1.8% Below av. 2% -0.2%

JAPANESE RETAILS SALES & INDUSTRIAL PRODUCTION

100 95

CITI SURPRISE INDEX

80 May 11
Source: Bloomberg

-150 04

05

06

07

08

09

10

11
Source: Bloomberg

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The next phase in the monetary cycle will be for rates to rise
INTEREST RATE CYCLE

triggering a shift in asset-class performance in favour of equities in particular, but also commodities and higher-yielding debt
AVERAGE RETURNS DURING PAST FED RATE CYCLES (BPS/MONTH, SINCE 1975) Phase 1 Easy policy Phase 2 Tight policy Phase 3 Tight policy Phase 4 Easy policy Phase 5 Easy policy

Raising rates Raising rates Cutting rates Cutting rates On hold, at bottom US Stocks US 10y gov bonds US Investment grade US High yield Commodities
Source: MRB partners

143 -51 -9 44 134

102 57 51 69 51

41 132 124 47 -82

-50 113 55 42 -84

161 20 87 173 244

Source: MRB partners

Equities are attractively valued relative to bonds and perform better when rates rise
0.7 0.5 0.3 0.1 -0.1 -0.3 -0.5

Banking crises tend to result in debt crises, as is highlighted by the current situation in the euro-zone and showdown over US debt
BANKING AND GOVERNMENT DEBT CRISIS

VALUATION: WORLD EQUITY TO BOND YIELD RATIO

Equities attractive vs. bonds

Bonds attractive vs. equities

81

84

87

90

93

96

99

02

05

08

11

World earning yield to bond yield ratio (log) average

Source: Datastream
Source: Reinhart & Rogoff, 2009

Financial repression is back as rates are kept artificially below inflation in the West to help plug gaping holes in finances
REAL UK DEPOSIT RATES FREQUENCY DISTRIBUTION
Frequency (%/100)

Emerging-market debt has some of the best return potential among bonds, given healthy balance sheets relative to developed markets
3 deficit as % of GDP

deficit as % GDP
HK

Korea

EM & DM COUNTRY DEBT & DEFICIT

Singapore

1
Peru

EM
Switzerland Sweden Brazil Finland Thailand Turkey Mexico

DM

Chile

-1
Estonia China Indonesia

-2

Australia

Israel Pakistan

Canada

-3

Russia Bulgaria Nigeria

-4

Ukraine Philippines Argentina Colombia New Zealand Slovenia Romania Denmark South Africa Slovak Republic

Germany Austria Hungary Netherlands Portugal France Belgium Iceland Italy

Kenya

-5

Czech Republic

Malaysia

-6
Poland Spain Greece Lithuania Latvia UK

-7

Deposit rate (%)

fiscal deficit

-8
India

-9 lower debt -10

US

debt as % GDP
debt as % of GDP 120 140

Source: "The liquidation of government debt", Reinhart & Sbrancia

20

40

60

80

100

Source: IMF

High yield is also among the best placed within bond markets to deliver positive absolute and relative returns
20 18 16 14 12 10 8 6 4 2 0 87

Once rates start to rise, the opportunity costs of owning gold goes up
35 30 25 20 15 10 5 0
% 3m/3m

VALUATION: HIGH YIELD VS 5-YEAR TREASURIES

% Cheap vs. Treasuries

REAL YIELDS & GOLD PRICE

pp 3m/3m

-2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0

Expensive vs. Treasuries 91 95 99 US High Yield - Treasuries 03 07 11

Source: Datastream

-5 -10 09 Gold (Lhs) 10 Real yields (Rhs) 11

All charts are as at 04/07/11

Source: Bloomberg

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Asset Class
CASH 3-month cash rates

Outlook
In stark contrast to emerging markets, the combination of large output gaps and large fiscal deficits will limit the extent of rate rises in developed economies. Bond yields should rise along with inflation expectations and stronger economic data, but the rise will be limited by a surfeit of spare capacity in developed economies and low policy rates. In an environment of gradually rising inflation expectations inflation-linked bonds should outperform nominal bonds, when adjusted for duration. Expected to outperform government bonds in a positive growth environment, and as investors search for yield, but more exposed to rising inflation expectations than equities or high-yield. Better placed than government bonds to provide a positive absolute return as inflation expectations rise and default rates remain low, due to higher absolute yield. Emerging market bonds offer attractive yields with a good chance of currency appreciation as well. In addition, investors are putting money back into EM bonds as a significant part of emerging market central bank tightening has already been priced in. Given the current lull in the euro-zone crisis and expectations of stronger US growth over the balance of the year, investors should be more willing to look through the current uncertainty and focus on value. Equity valuations are more attractive than those of government bonds, and should therefore outperform. Recent cooling of commodity prices and policy tightening has had an impact on CPI which is likely to peak in coming months, EM remains in a secular bull market driven by superior return on equity. The key potential catalysts for a reversal are relative inflation and monetary policy trends. Consequently we see a return to outperformance in 2H 2011. Continued global economic recovery will drive demand and prices, led by emerging economies. While supply fears have faded, spare capacity is at very low levels. Gold is a hedge against geopolitical risk as well as inflation and depreciation of major currencies, though returns are likely to come under pressure from rising interest rates. A reversion to more normal harvests and weather conditions should reverse record prices, providing an opportunity to add exposure to a long-term theme driven by both global warming and rising emergingmarket demand. Attractive yields and a better outlook for markets should drive positive returns, particularly for Central London offices and industrial property. While overall rents are still falling, there are clear signs of stabilisation.

FIXED INCOME Government bonds Index-linked Investment-grade High-yield Emerging-market

EQUITIES

Developed-market

Emerging-market

COMMODITIES

Oil Gold Agriculture

PROPERTY

UK commercial

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