Financial Views and Credit Market Commentary

Market commentary 
As in previous weeks, liquidity remains thin in the credit market – even within the broad
CDS indices. Once we have turned the page on 2010, we think liquidity and activity will
return, but for now most investors already seem to be in Christmas mode.

In terms of fundamental news, the looming downgrade of Spain was the major scare
during the week as Moody’s put its rating on Spain on review for a possible downgrade.
This could imply a downgrade of Spain’s current Aa1 rating (but according to Moody’s
probably not below Aa3). Moody’s cites Spain’s vulnerability to funding stress given its
high refinancing needs in 2011 as well as concerns over potential cost of bank

The difficulties and costs relating to a recapitalisation of a country’s banking system have
recently been highlighted by the events in Ireland, which underlined how important a
sound banking system is for the whole economy. In our view, further question marks on
the stability of Spanish banks could cause market disruptions in 2011 and in this context
the symbiotic relationship between bank and sovereign credit quality is putting downward
pressure on one another and no quick fix is in sight. Therefore, market funding is likely to
continue to be difficult to obtain for the Spanish banks.

Cash spreads have hardly moved during the week and CDS indices are marginally tighter
with iTraxx Europe and iTraxx Crossover trading at 104bp and 443bp, respectively.

The primary market 
No activity is currently taking place in the primary market. This will remain the case until
next year. If general market conditions are supportive, we expect relatively high activity
from the beginning of the year. The comings and goings of distress in the market underline
how important it is for issuers to approach the market when they can and not when they
have to.

Financial Views 
• Our base case assumes that the global economy will continue to expand moderately in
2011. Still, the stock market needs new fuel other than earnings revisions for 2011 to
make the year a good performance year. Earnings growth expectations are in the area
of 15% which in a normal year is equivalent to around 3-4% in global real GDP. It is
hence very important for the global equity market to move on from the earningsdriven market expansion to a value/liquidity driven market expansion. This transformation will in our view not happen without some struggle as fiscal policy tightening, PIIGS crisis, weak job markets in OECD and significant deflationary
pressures are all factors that are likely to postpone investors’ normal rotation from
bond overweights to equity market overweights. We enter the new year with a high
risk-low reward profile as the stock market has already rallied 20% (since Sep) on a
continuation of the economic expansion in 2011. We are hence currently triple
'Neutral' on stocks meaning 'Neutral' on Equities to bonds, 'Neutral' on cyclicals to
defensives and 'Neutral' on value to growth stocks.

Fixed income 
• The sell-off in the fixed income market has intensified. While short-term uncertainty
remains large, we still believe that the sell-off is somewhat overdone and look for
some reversal next year. The big picture, however, is that bond yields have bottomed
out. However, on the back of the recent rise in yields the potential for higher rates in
2011 is now limited. We expect roughly unchanged long bond yields on a six-month
horizon. During 2011, German bonds are expected to underperform the US, as the
ECB moves on with normalisation and eventually tightening, while the Fed will
remain in easing mode for a while longer.
• Intra-Euroland and Scandi: We are long Germany and Italy versus Spain and France.
We also recommend buying T-bills issued from Italy, Ireland, Greece, Portugal and
Spain. We are overweight Scandinavia versus Euroland.

• We remain slightly positive on corporate credit, but the asset class is becoming
mainly a carry play and we do not foresee material spread tightening from current
levels. Companies are still acting conservatively although event risk is on the rise as
companies embark on more shareholder-friendly actions. Furthermore, renewed tension
due to the sovereign debt crisis is weighing on banks at both senior and sub levels.
• Primary market activity is levelling off and recent volatility reduces the probability of
us seeing meaningful new issuance before 2011.

FX outlook 
• We expect EUR/USD to rise in 2011 due to the global economic recovery, a higher
demand for commodities, solid risk appetite and a monetary divergence between the
ECB and the Fed. Investors currently attach a risk premium to the euro but we argue
that this will gradually abate when it becomes clear that contagion fears are
exaggerated. GBP trades closely with USD and will also decline while commodity
currencies will be in demand. The Scandinavian currencies remain attractive and we
keep our bullish view on both SEK and NOK. CHF can perform against USD.
• Please see FX Top Trades 2011 for more views on the FX market next year.

• Oil has remained above USD90/bbl and we emphasise that there in fact have been
improvements in fundamentals to potentially sustain current price levels. Near-term
price setbacks in commodity prices are still likely though, as equities and the euro
could take some hits; also, Chinese policy tightening could spook the market in the
short term.
Full report: Financial Views and Credit Market Commentary